Tuesday, March 29, 2011

Steppe-ing out

To Ulaanbaatar did Nemo's boss
A business trip decree:
Where copper mines and collieries
Countless dug in series
North of the Teal Sea
(apologies to Coleridge)

TMM recently travelled to Mongolia and thought it might be worth a post, as it has moved from geopolitical buffer zone between Russia and China and a USAID afterthought to front and center for commodities analysts and a point of focus for the EM crowd. The country now has a couple of large listed equities, including the Mongolian Mining Corporation, Ivanhoe Mines, South Gobi, as well as a number of up and comers, including the much awaited Tavan Tolgoi deposit. With rumors of a sovereign bond, the country might even have a local currency issue (whisper around 8% coupon), which would be a pretty compelling story to the EM set:

Small previously poverty stricken nation with a population of around 2.5mm that will become a combination of the Australian Bowen Basin in coal and Chile in Copper seeks to borrow in its domestic currency with a limited FX intervention policy at a rate slightly inside of the policy rate - 11%.

In a world of people looking for FX carry, appreciation and low sovereign leverage this is a comically easy sell. It is no wonder that the "will they/won't they" and "in what ccy" is a favored talking point among the EM bond manager set.

There are of course the skeptics who look at Mongolia and don't see venture stage Chile with none of the dictatorship legacy and crushing inequality, but instead see Kazakhstan. Kazakhstan has a similarly ample resource endowment (oil, copper, gold, uranium, etc) and yet it managed to go from EM wonder to Coyote ugly in the space of one year. Kazakh banks went on a binge of asset growth that was entirely unrelated to mining and the core competencies of the country. Instead they focused on what all those smart guys in London and New York were doing around 2005-2007: lending a boatload of cash to fund real estate projects and when they couldn't get enough of that they decided to own the assets themselves. Last time TMM went to Almaty, there were plenty of “see through” skyscrapers and office blocks – and we gather not much has changed since then. This strategy worked out even worse for the likes of Bank Turanalem, Kazkommertsbank and Halyk Savings Bank than it did for Lehman. Almost every single bank in Kazakhstan went through a restructuring as the eurodollar issues dried up in 2007, causing the domestic credit bubble to collapse. As any bank analyst will now tell you, making market bets on a stable deposit base is risky, but doable up to a point; making similar bets on a flighty international bond market with substantial FX risk is insane. Recoveries were low to abysmal (55% on senior, depending on your discount rate for BTA’s various tranches) and by all accounts the banks have not been the same since and are still crippled by NPLs (see below - Central Asia bank comp table):

The Kazakh Tenge took its pain as well and is only slowly coming back after a 30%+ depreciation, much like the Mongolia Togrog – only the MNT is coming back a lot faster because it does not have a crippled banking system.

So, with those two radically divergent schoools of thought in mind, how does TMM see Mongolia? First, take a drive along Chinggis Khan Avenue in Ulaanbaatar:

But first things first. Banking regulation – Mongolia is a real democracy with a quite colorful media and reasonably good governance. Unlike Kazakhstan, which when TMM visited in 2006-2007 seemed to have no prudential banking regulation to speak of, Mongolia has some fairly common sense banking limits – they actually do seem to risk-weigh assets properly and have 10% exposure limits for single borrower groups (includes related parties and subsidiaries of borrowers). TMM’s discussions with the banks were a lot more positive than they had been in Kazakhstan – not least of all because all the Mongolian banks, and particularly the larger players, seemed to know the sorry story of Kazakhstan.

Diving further into the bank aggregate data, TMM found the quarterly lending report on the Mongol Bank website interesting, to say the least. NPLs and arrears are still very high in the system, even for Mining and Quarrying, which is odd in the midst of a mining boom:

Thankfully, real estate seems low, though anecdotal stories about Ulaanbaatar housing prices are a bit of a worry – they are rising fast and Mongolia appears to be toying with a government-sponsored Fannie Mae. TMM are not fans and, while it would be nice to get people out of the favela-like ger neighbourhoods around UB, lending money to those who can’t pay it back is never that good an idea. Thankfully, that risk does not appear to be on banks’ balance sheets as yet, judging by outstanding mortgage loans and average loans size:

The story on NPLs appears to be the one of different banks’ ability to lend properly – TDB seems fine, but some of the smaller players don’t. Watch this space as banking consolidation is easier during the good times than the bad.

One of the drawbacks of having a colorful democracy in a country with relatively low educational attainment is that it is very easy for fiscal policy to become a pro-cyclical disaster zone, when put in the hands of local politicians who, quite literally, were raised in a ger and aren’t quite of the quality of the Prime Minister. In this regard Mongolia has not distinguished itself to date. The country required an IMF program as recently as 2009 as FX reserves were depleted in 2008/2009, not by imports but by loose fiscal spending. As part of this program, Mongolia now has a Fiscal Responsibility Law for implementation in 2013 and a stabilization fund for excess mining revenues, though ultimately whether this gets done comes down to the parliament – something which TMM will watch closely as the mooted $500mm sovereign bond issuance comes up.

Inflation and Central Banking is Mongolia’s weak point however. Local color suggested that capital inflows related to Ivanhoe Mines’ Oyu Tolgoi development were around $7mm per day or about 14 bps of 2010 GDP. To understand just what that means for a small country with a relatively inexperienced central bank, that’s like pushing an additional ~$500mm of AUDUSD through the market every day (~14bps of Australia’s GDP). To date Mongolia hasn’t managed this at all well with regards to inflation – the Central bank has a weak and largely unclear mandate (an inflation target of <10% is like saying real growth >0% to TMM). As can be seen below, policy rates (orange) have only loosely tracked inflation (white) historically, so this is one to watch as well.

This is not going to get any easier for the Mongol Bank (what a name!), especially given that the source of growth for their entire economy is going to be mining, which is a work in progress requiring a lot of financing – just look at what is happening to loan growth:

Which leads TMM to think that local monetary conditions and the like are going to be a pretty wild ride at best until some more solid policy comes from the Mongol Bank.

So with all that in mind, until 2013 when Oyu Tolgoi comes onstream and the government’s fiscal position improves, there is still some serious risk that a commodity collapse plus some reckless fiscal spending in the interim could do Mongolia some real harm. Judging by the NPLs at the Mongolian banks, 2008/2009 was not kind and even if there is no "sudden death" risk as was the case with Kazakh banks (due to their reliance on Eurodollar funding), the loan growth in the system does seem to be a lot more closely tied to real estate and construction than anything else. While this is fine when a country is urbanizing it does take you back to the problem with Mongolia: it’s a one-way leveraged ticket on the CRB index express at this time. As such, it is going to require serious focus and effort from the Central Bank and the Parliament to not get the whole thing derailed at some point.

In the interim it is a fun place to go out, as are most places when people go from grinding poverty to 10%+ p.a. growth in a short time. It tends to make people party like the good times aren’t going to ever end – or, alternatively, party while they still can. TMM hope that for Mongolians and investors alike the Mongol Bank and the Parliament learn when and how to take away the punchbowl.


Anonymous said...

"One of the drawbacks of having a colorful democracy in a country with relatively low educational attainment is that it is very easy for fiscal policy to become a pro-cyclical disaster zone, when put in the hands of local politicians who, quite literally, were raised in a ger and aren’t quite of the quality of the Prime Minister."

With only minor amendemnts we could have been talking about the UK.

Mongolia,skip the research and air ticket costs . Spare 100 Euros ,throw it on the table and spin the wheel.

nick said...

As we Greeks can testify populist politicians are a one way ticket to fiscal disaster....I don't know if they have tapped sovereign debt markets before, but if they do with that rumoured bond issue, then the door is open...I honestly hope that after that things for them don't get out of hand...thanx for another great post guys...cheers...

Anonymous said...

I hate to say it, but the fact that TMM ventured so far from macro to Mongolia seems to be a contrarian sell indicator to me.

For example just one fund owns 30% of all Mongolian free-float so things could get hairy.

Nemo said...

Anon I think you're right.... there's a lot to get excited about but flawless execution at early stages is very rare in EM. Time will tell but suffice to say we are going to be very price sensitive. I think the local exchange is still kind of a joke for now - not really worth the time.

Nic said...

Another great post, thanks guys.

Sid said...

"an inflation target of <10% is like saying real growth >0% to TMM"

Haven't had much experience with post-Soviet states, have you.

Anonymous said...

"that’s like pushing an additional ~$500mm of AUDUSD through the market every day (~14bps of Australia’s GDP)."

TMM, I think that computation was done from AUD's quarterly GDP.

Thanks for all the good posts.

Nemo said...

Whoops. So more like 2 yards a day which would be seriously disruptive and likely something the RBA would have to take a view on.

Anonymous said...

I hope you got out of the city ... the Gobi is lovely, and original in so many ways.

It's quite amazing that you can get Snickers bars and vodka everywhere, even in towns of <150.

Anonymous said...

Heard that the value of the underground reserves in Invan Tolgoi is a multiple of the current GDP, so as it gets taken out of the ground, the multiplier will kick in big time!

Interesring assesment TMM!


Anonymous said...

I missed buying Ivanhoe in 2009. Bear me.

Great post. Thanks

leftback said...

I would rather buy into Sri Lanka, having just visited another country with an early stage growth story and a burgeoning middle class consumer and favorable demographics driving an economy that is emerging from obscurity after a long painful civil war. Smaller and more manageable than India, less tail risk than Pakistan and Bangladesh.