Mongolia opens for business?

Mongolia hands it to a cast of neighbors
By Peter Lee

ULAN BATOR – Before embarking for the United States, Mongolia’s President Tsakhiagiin Elbegdorj sat down with the Washington Post for a charm offensive, at least in terms that Mongolians understand: dispensing comparisons to Genghis Khan that they, at least deem flattering.

Elbegdorj has lessons for USA from Mongolia’s past 
As the leader of a diminished land that was once an invincible superpower, President Tsakhiagiin Elbegdorj has some advice for Americans fatigued by the burdens of global power: Remember Genghis Khan, and stick with your friends. “It is tough, but Mongolia was the biggest power in the world, and we had the same responsibility,” Mr Elbegdorj said … Genghis Khan’s warriors killed lots of people, to be sure, but according to the president … it was done in a good cause.

“Do you think we just went to places and killed?” Mr Elbegdorj said. “No.” Mongolia, he said, used its muscle to keep trade along the Silk Road flowing and to enforce a written law. And “when there was a killer, or in today’s expression, a terrorist nation,” he said, “we were God’s will to make them peaceful … When there was a poor nation, we helped them.”

Perhaps President Barack Obama did not appreciate being compared either to Genghis Khan, or having the United States regarded in terms similar to the currently impoverished, land-locked nation of Mongolia.

During the obligatory group photo of world leaders attending the opening session of the United Nations General Assembly, Obama chose to wave at somebody behind the camera as the picture was snapped, thereby obscuring the face of the supremo standing next to him.

The face behind the hand? Mongolia’s President Elbegdorj.

Talk to the hand, President Elbegdorj.

America’s faux news comedy program The Colbert Report had a hearty laugh at Mongolia’s expense, warning that the affront endangered America’s access to Mongolian pony races, fermented mare’s milk and throat singing. [1]

Maybe Mongolia will have the last laugh, instead.

As the United States lumbers into a decade of economic stagnation and political gridlock, Mongolia is poised to double the per capita gross domestic product (GDP) of its citizens at a single stroke and grow its economy at a rate of almost 10% over the next few years.

Key to Mongolia’s economic future – and its primary political challenge – is development of its immense mineral resources of copper, gold, coal and uranium.

The Scylla and Charybdis of Mongolian economic policy are the twin threats of resource nationalism and resource diplomacy. The vital indicator that Mongolia is open for business is the Oyu Tolgai copper and gold mine in the Gobi Desert.

After years of negotiation (and repeal of a windfall profits tax that foreign resource companies deemed onerous), in 2009 the Mongolian government struck a deal for a joint venture between its state-owned resource giant, Erdenes MGL LLC, and a foreign partner, Ivanhoe Mines (minority owned by Rio Tinto, which will be the actual mine operator).

The mine will take about US$6.3 billion to develop, so the government agreed to limit the Mongolian share of the profits to 34% for 30 years, to allow the foreign partners to recoup their investment.

This was seen as too sweet a deal by certain members of the Mongolian legislature, who recently demanded that the national share be bumped up to 50% immediately.

Elbegdorj, who had indicated during his presidential campaign in 2009 that he favored a 50% deal, acted quickly and favorably to the request. On September 25, his mining minister, D Zorigt, announced that the government wanted to get to the 50% level sooner aka not immediately. [2]

The stage is set for the inevitable horse-trading – and threats from the foreign side that pushing too hard on Oyu Tolgoi will damage the perception of Mongolia as a hospitable environment for foreign investors on other, equally critical projects.

Upon receipt of Zorigt’s letter requesting negotiations on the time frame, Ivanhoe (which has already sunk $3 billion of its own and Rio Tinto’s money in the project) responded:

“The investment agreement has been fundamental in building Mongolia’s reputation as an increasingly reliable and stable destination for foreign investment,” Ivanhoe said. “With many significant resources projects still to be financed and developed – including the proposed overseas listing of Erdenes Tavan Tolgoi – Ivanhoe Mines is confident that Mongolia’s leadership understands the fundamental importance of Oyu Tolgoi’s contractual commitments and stabilized investment agreement that were formalized less than two years ago. [3]

Erdenes Tavan Tolgoi is Mongolia’s other major near-term resource play.

It is also Elbegdorj’s chance to demonstrate that his brand of enlightened resource nationalism can get a mega-project off the drawing board and into production more quickly and equitably than his political rivals.

So far, the results appear rather mixed.

Tavan Tolgoi is called the second-largest coal deposit in the world: 7 billion tons of thermal coal (for power plants) and coking coal (for blast furnace operations in steel mills) near the Chinese border in the Gobi Desert (and quite close to Oyu Tolgoi).

Remarkably, China is interested in Tavan Tolgoi because it represents a source of supply superior to many of its own mines.

Mongolia currently lacks the financial, technological, and logistical wherewithal to develop Tavan Tolgoi itself, a project that would require well over $10 billion in investment.

Crude business logic would seem to dictate opening Tavan Tolgoi to Chinese development.

However, allowing the Chinese to swarm into the Gobi Desert, dig up a big chunk of the motherland, and ship it off to China is a non-starter.

Beyond a generic affront to the resource nationalist sensibilities of the Mongolian electorate, a Chinese monopoly on Tavan Tolgoi is impossible.

China’s extensive economic penetration of Mongolia is widely resented, and hostility to China is the default setting of Mongolian politics.

On the popular level, it is not quite safe for Chinese to walk the streets of Mongolia’s capital, Ulan Bator. Mongolia’s democratic miracle does not encompass anything approaching full employment, so any plan for economic development that permits Chinese workers relatively free access to a Mongolian megaproject is political suicide.

On the elite level, Mongolia cannot be excessively cavalier in its relations with China, which accounts for over half of its international economic activity.

The attempt to keep China at arm’s length is expressed diplomatically and discreetly as Mongolia’s “third neighbor” policy. The first two neighbors are China and Russia.

The “third neighbor” is pretty much any nation that Mongolia can entice into a political and diplomatic alliance to counter China. The list of “third neighbors” is theoretically infinite, but for practical purposes consists of the United States, South Korea and Japan and, to a lesser extent, India.

Tavan Tolgoi looks like an attempt to gratify all the neighbors that ends up satisfying none. As the plan stands today:

  • Erdenes MGL has set up a subsidiary company, Erdenes Tavan Tolgoi, which holds the mining licenses.
  • Erdenes TT has divided the coal reserves into two fields: East Tsankhi and West Tsankhi.
  • West Tsankhi is Mongolia’s exclusive slice of coal heaven, containing a majority of the coal reserves, primarily thermal coal, which will be exported largely to China.
  • East Tsankhi – the coking coal – is to be awarded to a foreign group that is expected to pay handsomely for the privilege of developing the mine. High quality coking coal of the sort available at Tavan Tolgoi is a valuable international commodity attractive to steel mills in “third neighbors” in South Korea and Japan, as well as China.

    In the first iteration, the Mongolian government announced that East Tsankhi would be developed by a consortium consisting of China’s Shenhua (40%), America’s Peabody Coal (24%), the Russian Railway Corporation (18%) and the Mongolian Railway Corporation (18%).

    After an outcry from South Korea and Japan – who are, after all, Mongolia’s largest aid donors – the government backtracked and announced that the percentages would be juggled to make room for representatives of the two nations.

    Further complexity is pitched into the situation by the most exciting element of Mongolia’s resource play: the plan to list Erdenes TT simultaneously on the Hong Kong, London, and Ulan Bator stock exchanges.

Thirty percent of Erdenes TT stock will be sold in an initial public offering (IPO) to international investors through the good offices of Deutsche Bank and Goldman Sachs, with an assist from BNP Paribas SA and Australia’s Macquarie Group.

Estimates for the value of the IPO careen from $1.5 to $10 billion, making Erdenes TT the 2012 wet dream for the international investment banking community. Avidity for underwriting the IPO apparently inspired a mass migration of competing financiers to Ulan Bator in the dead of the Mongolian winter, and provoked a shoving match between competing bankers in one of Ulan Bator’s premier drinking establishments.

Ten percent of the stock will be given away to every citizen of Mongolia, giving ever Mongolian title to 538 shares of stock.

Mongolian national companies (with no foreign ownership) will be given the opportunity to buy another 10% “at face value”.

The mechanism to credit each Mongolian, including its itinerant population of nomadic herders, is apparently not yet finalized.

In distributing the shares, hopefully the debacle of privatization in the 1990s – when a predatory and well-informed minority duped many Mongolians into giving up their shares in privatized state corporations for a pittance – can be avoided this time.

The Elbegdorj government is anxious to follow through on a campaign promise to demonstrate the concrete economic benefits of its strategy to ordinary Mongolians.

It is desirable, therefore, that the IPO go through as per schedule at the beginning of next year.

It is even more important to nail down the East Tsankhi consortium, because finalizing the deal will hopefully result in the payment of hundreds of millions of dollars in pre-paid taxes in time to give Mongolians some walking-around money prior to the upcoming elections.

As Mining Minister D. Zorigt put it in an April 2010 interview:

Q: Sources confirm that the pre-payment will be higher than Oyu Tolgoi. How much will it be? D Zorigt: We will work to gain more than Oyu Tolgoi. [4]

China already obligingly signed a $250 million contract for Mongolian coal to be delivered over the next five years. “Obligingly” may be stretching it, because it appears that China is getting the coal at below-market price. The fire-sale price was apparently necessary so that the Mongolian government could move coal out to China this summer and rustle up some much-needed cash for its Human Development Fund. [5]

However, Mongolia’s pursuit of third-neighborliness will put its ambitious Tavan Tolgoi timetable to the test.

The key problem is the railroad.

Russian involvement in the Tavan Tolgoi East Tsankhi is important to the Mongolian government since it would enable construction of a rail line connecting the mine to the Russian rail system and onward to Pacific markets such as Japan and South Korea, thereby eliminating sole (and risky) reliance on the good offices of China in moving the coal to market.

China cuts transportation links to Mongolia whenever Mongolia commits a Dalai Lama-related offense. It also stands accused of unilaterally fiddling with freight rates for Mongolia-related cargo, so a second rail line is a logical piece of geopolitical insurance.

In some quarters, the Russian rail line is touted as the economic and geopolitical salvation for Mongolia, as it will shift the country’s center of gravity away from China and toward Russia and Japan and South Korea.

The rail line is an expensive precaution, however.

Tavan Tolgoi is only 200 km from the Chinese border and not much further from a linkup with the Chinese rail system. The Russian line will require 600 to 900 km of new construction costing up to $3 billion on the Mongolian side of the border and perhaps another $2 billion on the Russian side, depending on the route chosen.

Operating costs are another problem.

By the time a Russian port is reached 5,000 km away, freight costs may have tripled (and reduced profits by 90%) compared to a China export channel, according to the World Bank. [6]

Private investment was already available to build the line to China. But the Mongolian government blocked the project in favor of the Russian line – which has already attracted the skepticism of the World Bank and is unlikely to be greeted enthusiastically by other international lenders, let alone the private sector.

Originally, the Russians laid down a marker that they expected 25% of Tavan Tolgoi in return for building the railroad. It seems the Mongolian government hoped to offer less.

To ensure its participation in the Tavan Tolgoi project on appropriate terms, Russia allegedly cut off deliveries of diesel fuel to Mongolia over the summer of 2010, when the Mongolian government was debating its strategy. [7]

At face value, the Russians may be getting more than 25% of the pie. Russian National Railways is slated for 18% and Mongolian National Railways – in which RNR holds a half-interest – is reportedly getting another 18%. [8]

The Russian demand highlights the shaky economic underpinnings of the project – and Russian doubts that the gold-plated insurance policy will pay off.

If economic logic reasserts itself after the mine is set up, the China rail line gets built, and the operators decide to ship coking coal out through Qinghuangdao for $55 per ton instead of through Russia for $84 per ton or more, the Russian tracks will be idle and the investment will have to be recovered by claiming a 25% share of profits from the China-routed exports. [9]

For good measure, the Mongolian government brought in another “third neighbor” to Tavan Tolgoi. Peabody Coal is valued for its technical and environmental good offices, for giving America – missing in action in Mongolia – some skin in the game, and, presumably, further diluting the Chinese stake in the enterprise.

China’s Shenhua Energy is already saddled with two unwanted partners and an effective 25% tax on profits in order to subsidize a Russo-Mongolian strategic rail link.

Now, the word is out that its share may be trimmed further to accommodate Japan and South Korea.

And if the Mongolian government decides to block the China rail line in order to keep the Russian rail line humming, shipping coal to China by truck will become a logistical impossibility as production grows to a projected 30 million tons per year.

China is undoubtedly feeling the love by now.

It also probably feels it has the leverage as well.

The spat between the Mongolian government and Ivanhoe/Rio Tinto revealed that an important source of anxiety is the possibility that China might not provide the access to its electric power grid needed to make the Oyu Tolgai copper project and its US$6 billion investment feasible.

Electricity for Oyu Tolgai in exchange for a rail line to China for Tavan Tolgai? Maybe.

West Tsankhi’s premium coking coal might be salable through Russia, albeit with negligible profits; but if East Tsankhi doesn’t get a rail line to China, Tavan Tolgoi’s millions of tons of commodity thermal coal can’t be delivered competitively to Chinese power plants.

And it’s not going to go anywhere else.

If Oyu Tolgai blows up, the Mongolian government can’t get the lions and lambs lay down together in Tavan Tolgoi West Tsankhi, and it looks like the government is unwilling to do what needs to be done to ensure East Tsankhi’s competitiveness, then international finance’s enthusiasm for the Erdenes Tavan Tolgai IPO is likely to evaporate.

That IPO is a bonanza that the Mongolian government is really counting on to kickstart Mongolia’s economic growth, catapult Mongolia into the first rank of resource economies, and line the pockets of deserving and undeserving Mongolian citizens alike.

Under these circumstances, it is probably best that Mongolia’s mining negotiations are conducted in secret and the Mongolian public isn’t exposed to the contortions needed to simultaneously keep the Chinese on board and the “third neighbor” policy moving forward.

1. Click here to see the video.
2. Mongolia presses on key mine project, Mongolian Economy and Finance, Sep 26, 2011.
3. Ivanhoe stands firm on Oyu Tolgoi project agreement ownership split, Mongolian Economy and Finance, Sep 27, 2011.
4. D Zorigt: Working on to gain more from Tavan Tolgoi than Oyu Tolgoi, Business-Mongolia, Apr 23, 2010.
5. Chinalco signs $250 million deal with Tavan Tolgoi, Business-Mongolia, Jul 27, 2011.
6. Click here for the World Bank report.
7. Japan and Korea to receive stakes in Tavan Tolgoi, The Business Council of Mongolia, Sep 21, 2011.
8. Ulan Bator Railway, Jane’s, Jan 4, 2011.
9. Exporting the Tavan Tolgoi Coal: Choosing the Best Way Out, Mining-Mongolia.

Peter Lee writes on East and South Asian affairs and their intersection with US foreign policy. 

(Copyright 2011 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

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