Mongolia in the Shadow of China’s New Normal: Why I’m Still Optimistic

Two articles ago, I wrote about China’s New Normal. If you haven’t read it, please refer to it now since it explains the background for this post. A quick review: China is transitioning from a cheap-labor manufacturing economic base to a service-oriented consumer economy. If done right, China will finally take its place as a more or less Advanced Leading Economy (this is only true in the eastern coastal cities like Beijing and Shanghai, and not at all true in the vast poor lands to the west – but that’s a different article).

But in the meantime, the transition is going to be painful. I’m talking like giving birth painful – to triplets. This year, China is going to post growth at about 7% because that’s what the government stated as their target growth and that’s what’s going to be reported. 7% is a respectable growth rate, but it’s not real. Some analysts are saying that this economy feels like something closer to 4-5%. That’s significantly lower, and that is definitely going to negatively affect growth in Mongolia in three major, related ways: decreased demand for commodities, a weak terms of trade and decrease in the national balance of payments, and disadvantages in foreign exchange.

Even after considering all this, I am still Mongolia-positive – not just a citizen, but also as a rational investor. There are significant possibilities here.  If Mongolia makes smarter policy moves than it has displayed thus far, I think Mongolia could emerge from this period as a much more stable and prosperous economy.

Decreased demand for commodities

A result of the new China is that there is less need for “early cycle” commodities (raw materials used primarily for construction and infrastructure). This includes steel, iron ore, coal and copper. Mongolia, with rich deposits of coal and copper, have been riding a boom from the commodities “super cycle” that started in the early 2000s. Back then, there was heavy investment in China in infrastructure and property, and high activity in export production factories. This created high levels of demand for raw commodities imports. This boom was further drawn out during the 2008-2009 Global Financial Crisis when Beijing introduced a $586bn stimulus package. Times were good for coal and copper-exporting countries.

This is no longer the case. According to the Chinese Coal Industry Association, coal consumption fell by 3.5% in 2014. Coal accounts for 70% of China’s energy use and China burns about 50% of the entire world’s coal. A 3.5% decrease has a tremendous effect on imports. According to China’s General Administration of Customs, total imports of coal in May were down 38.2 percent compared to the previous year. Below, I’ve copied the 2014 export numbers for Mongolia as compiled by the World Bank’s World Integrated Trade Solutions (WITS):

  • The total value of exports (FoB) was US$5,774mn.
  • Mongolia exports to China [were] worth US$5,070mn, with a partner share of 80 percent.
  • The top 5 export products were:
    • Mongolia exported Copper ores and concentrates, worth US$2,574,706.13mn.
    • Mongolia exported Bituminous coal, not agglomerated, worth US$834,090.22mn.
    • Mongolia exported Petroleum oils and oils obtained from bituminou, worth US$634,611.36mn.
    • Mongolia exported Non-agglomerated iron ores and concentrates, worth US$446,378.14mn.
    • Mongolia exported Gold in both semi-manufactured forms, non-monetar, worth US$405,234.22mn.
  • Mongolia Raw materials exports were worth US$5,075mn, product share of 88%.

It would be interesting to see what percentage minerals were out of total export value and volume to China. If anyone has those numbers, please let me know. But, based on these numbers alone, we can get a good sense of what’s going on here. First of all, commodities are a huge part of the Mongolian economy – 80%+ huge. Secondly, China is the major export destination for Mongolian goods. So far, out of Chinese demand, minerals have disproportionately made up the vast majority. Either Mongolia will have to find something else for China to want, or those export numbers are going to continue to decrease significantly.

We see Mongolia moving out of this dependence on raw commodities earlier than anticipated. Considering the numbers above, that’s a grand idea. That’s a part of why I think Mongolia will emerge soundly from this.

Terms of Trade and Balance of Payments

Trade doesn’t only go one way; so far, we’ve only talked about exports. But what about the overall picture? A drop in exports will have a direct effect on the terms of trade. Terms of trade (TOT) is the ratio of export prices to import prices. A lower ratio means that Mongolia now has a “weaker” terms of trade, or a decreased purchasing power of exports. In other words, the amount of import goods Mongolia can purchase per unit of export goods has gone down. Consumers in Mongolia are then heavily disadvantaged. Unfortunately, the terms of trade have been weak for the past two years, and have a less than great diagnosis until about 2017.

Along with a weak terms of trade, there’s also the curious case of foreign direct investment (FDI). FDI is investment that a company or any other entity from country A that makes in a company or entity in country B (private capital flows). The usual flow of FDI is from multinational companies (MNCs) to developing countries. While there has been recent controversy over the exact benefits of FDI, the general microeconomic theory suggests a positive relationship between FDI and terms of trade. The idea is that MNCs generally pay their employees more and have the technology and business intelligence to create a higher value-added final good (the export). This will raise the price of the export, leading to a stronger terms of trade for the developing country. Moreover, the final good may require inputs that are more advanced, and you get this whole uplifting effect on the whole country.

Several serious issues have led to a severe fall in FDI in Mongolia since 2012. This includes protracted disagreements over the financing for the second phase of the Oyu Tolgoi project and the construction of a railway connecting Mongolia and China. There are also other doubts over the Mongolian government’s “openness” and legal framework. Sudden changes in mining license laws and charges against expatriates for alleged tax issues have driven FDI far down. Annual inward FDI fell from US$4.4bn in 2012 to US$0.8bn in 2014.

With FDI falling rapidly, the Mongolia economy saw its Balance of Payments (a summary of a country’s economic transactions with the rest of the world over a period of time, generally every quarter and year) shrink rapidly. The investment could have created a factory, employed more people, led to greater economic activity, etc., but it didn’t happen.

FDI can be a fickle creature. As long as there is the potential to make money in Mongolia, it will come back.

Foreign exchange

Of course, with any bad story, it doesn’t end there. With all these economic ails, the currency, the Mongolian tugrik, depreciated. This was due, in part, to the weak terms of trade, the fall in FDI and the subsequent decrease in the balance of payments.

But in addition to the inevitable shifting of international trade, the Mongolian central bank decided to take some…interesting courses of action. They decided to pursue expansionary monetary policy. Of course, hindsight is a beautiful thing, and in the moment, what they were primarily trying to do is price stabilization as exports failed to meet expectations. What they actually ending up accomplishing hurt the economy even further.

Expansionary monetary policy is when a central bank increases the money supply in an economy. One way is to just directly print more money. The central bank did this by literally giving every citizen a certain amount of money as representative of one’s “share” of the proceeds from Oyu Tolgoi.

Another way in which the central bank increased the money supply is through price stabilization programs that 1) subsidized loans made to specific industries, and 2) subsidized household mortgages through commercial banks.

When you increase the money supply like this, you are very likely to induce inflation. Inflation is when prices of goods go up, meaning that your money can buy less. For example, if an apple cost 1 tugrik before inflation and you had 10 tugriks, you could buy 10 apples. Good for you! Now, after the inflation, an apple costs 2 tugriks. Your money hasn’t changed; you still have 10 tugriks, but now you can only buy 5 apples. Not so good for you.

In 2014, Mongolia’s annual inflation rate was 11%. You can think of this as the general level of prices for goods and services rose by 11% in 2014, or, in another way, that the purchasing power of the tugrik fell by 11%. Now, governments expect a certain level of inflation or deflation. But 11% was much higher than the target of 8%, leading to ripples across all industries and just general welfare of the economy.

Inflation is now starting to stabilize. September’s year-on-year inflation for 2015 was just 4.9%, a marked improvement.

The upside

Why am I still Mongolia-positive? What do we know? The government and Rio Tinto have a common long-term advantage in keeping Oyu Tolgoi operational. That means that the break-up was just short-term. We can see their reconciliation happening now. Eventually, the money-making machine that everyone is waiting for will fulfill its destiny.

True, China is a bit more difficult because the decrease in commodities demand is likely structural, not cyclical. I believe that China will continue to push more towards renewable sources of energy in bounds and leaps in the near future. Even when Oyu Tolgoi reaches full capacity, Mongolia cannot count on it for the long-long term.

However, Mongolia can use the proceeds in the meantime to start investing in other industries – like wind energy, meat exporting, agriculture and financial services. These are higher-value and definitely more sustainable industries than minerals. That is where the future of Mongolia is, and the future looks bright.

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