In the far reaches of the south Gobi desert, a cluster of boxy, sky-blue
buildings marks the entrance to the main shaft of the Oyu Tolgoi mine, the
largest industrial project ever developed in Mongolia. Scheduled to open before
the end of the year, the mine — a joint venture between the Mongolian
government and Canada’s Turquoise Hill Resources, a subsidiary of global mining
giant Rio Tinto — will tap the country’s vast reserves of copper and gold.

Oyu Tolgoi hasn’t produced an ounce of metal yet, but already the mine has
begun to transform Mongolia’s economy. Ever since the mineral deposits were
discovered in July 2001, geologists and mining experts have swarmed to this
remote former Soviet satellite to assess the bounty that lies beneath its
deserts and steppes. According to industry estimates, Mongolia’s mineral
reserves may be worth as much as $1.5 trillion at current market prices.
Capital spending alone at Oyu Tolgoi amounted to some $3 billion last year, an
amount equal to 35 percent of the country’s gross domestic product. Once
production gets under way, the mine is expected to produce 450,000 tons of
copper and 330,000 ounces of gold a year, worth a total of nearly $4.1 billion
at current prices.

For a nation whose per capita income of $4,800 makes it one of the
poorest in Asia, such wealth is certainly welcome. But the scale of those mineral
riches also poses considerable risks to the country’s economy. Sudden resource
wealth can drive up inflation and the exchange rate and cause the overall
competitiveness of an economy to decline, a phenomenon known as Dutch disease
after the impact that natural gas discoveries had on the Netherlands in the
1960s. A surge of new revenues can also undermine economic and political
institutions by fostering corruption and diverting the government from
investing enough in physical and human capital.

Without a more nimble, well-coordinated policy response to its nascent
commodities boom, Mongolia’s economy could overheat dangerously. Last year the
country soared to the top of the global growth charts as its economy expanded
at a blistering rate of 17.2 percent. The pace has remained torrid this year,
with output surging at a rate of 16.7 percent in the first quarter, although it
eased off in the second quarter to a slightly more sustainable 13.2 percent.
The downside? Inflation has kept pace, hitting 16 percent in April before
dropping back to 14.9 percent in August, a level still well above the Bank of
Mongolia’s target of 10 percent.

“The economy is not in danger of overheating — it is overheating,
although the temperature has cooled down a bit recently,” says Dale Choi, an
Ulaanbaatar-based analyst at Origo Partners, a private equity firm
headquartered in Beijing that advises investors on China and Mongolia. “But the
government is still constantly being warned by the World Bank that it is
spending too much and growing too fast.”

As fast as the economy is growing, government spending is expanding even
faster. According to the most recent update released by the World Bank,
government spending was 32 percent higher in the first four months of 2012 than
during the same period a year earlier; capital expenditures alone doubled.
Revenue has failed to keep pace, meanwhile, growing by only 21 percent. As a
result, Mongolia’s fiscal deficit rose to 4.2 percent of GDP on a rolling
12-month basis in April while the structural deficit, which discounts the ups
and downs of the economic cycle, stood at 6.1 percent, according to World Bank
data.

Change is in the air, though, that could enable Mongolia to make the
most of its mineral riches. A Fiscal Stability Law, passed by parliament in
2010, should begin to exert some much-needed discipline on the government’s
budgetary policies. The law requires that Mongolia limit structural deficits to
2 percent of GDP from January 2013. It also created a stabilization fund, to be
financed by mining revenues, intended to help the government cushion the impact
of commodity price swings on the Mongolian economy. Even more important, the
government is considering the creation of a sovereign wealth fund that would
safeguard some of the country’s mineral windfall for future generations.

Mongolia is modeling its new approach on the framework established by Chile,
which has used its copper earnings to create well-run stabilization and
sovereign wealth funds. Implementation remains a big question mark, especially
in the volatile political climate that  has followed Mongolia’s
parliamentary elections in June. But if the government succeeds in carrying out
its plans, it could anchor the economy for generations to come.

“The first step is to establish a really prudent fiscal policy —
especially in countries like Mongolia where you are likely to see these
patterns of booms and busts, driven by commodities prices and budget
expenditures, unless you have a really solid fiscal structure in place,” says
Eric Parrado, a former manager of Chile’s stabilization and sovereign wealth
funds who is advising Mongolia. If resource-rich countries can adopt and
implement a disciplined policy approach, they can accumulate “real money in a
sovereign wealth fund fueled by real revenue surpluses,” he adds. Without such
discipline, however, “a fund is not a sovereign wealth fund in anything but
name — it is just a fiscal instrument to pay for services, preexisting
commitments or ring-fence money coming from a specific economic sector.”

Can Mongolia actually implement its ambitious sovereign wealth plans? The
answer depends largely on the strength and accountability of the country’s
young political institutions. The World Bank Governance Index, which rates
countries on metrics ranging from political stability and rule of law to
regulatory quality and corruption, ranks Mongolia well above resource-rich
countries of the former Soviet Union, such as Azerbaijan and Turkmenistan, but
places it far below governance role models like Chile and Norway.

The latest signals from the country’s fractious political scene are
mixed. The Democratic Party (DP) of President Tsakhiagiin Elbegdorj won the
greatest number of seats, displacing the Mongolian People’s Party (MPP), which
had dominated the coalition government for the past four years. The DP agreed
to form a new coalition with the Mongolian People’s Revolutionary Party (MPRP),
a breakaway faction of the MPP led by former president Nambaryn Enkhbayar. But
there is plenty of scope for disagreement behind the apparent consensus.

The MPRP has a well-deserved reputation for supporting greater resource
nationalism, and Enkhbayar has repeatedly called for the renegotiation of
mineral extraction rights — including the rights to Oyu Tolgoi. But Enkhbayar
was arrested in April on charges of corruption; he has vigorously denied the
charges, claiming they were politically motivated. In early August he was
convicted and sentenced to four years in prison. The case didn’t derail the new
coalition, but it remains to be seen whether the two parties can agree on the
measures necessary to put in place a new sovereign wealth framework.

Mongolia’s pressing economic needs explain the appeal of resource
nationalism and high government spending. Although the country appears poised
at “the threshold of prosperity,” according to Asian Development Bank president
Haruhiko Kuroda, nearly 30 percent of its population of 2.8 million live in
poverty, including many of the 1.2 million who reside in Ulaanbaatar.

“Over half the population in the capital live in traditional gers, or yurts,
which lack any basic amenities,” says Alisher Ali, chairman of Eurasia Capital,
an investment bank based in Ulaanbaatar. “The government needs to build at
least 100,000 new housing units and supply them with infrastructure, including
water and electricity, but that would require an undertaking of at least $5
billion — and the government doesn’t have $5 billion to spare right now.”

The political appeal of resource nationalism is also driven by rising
national-security concerns, which are focused squarely on China. Fully 89
percent of Mongolia’s exports are sent to China, which has an almost insatiable
appetite for the country’s copper and coal. In May parliament rushed through a
vote to amend laws governing foreign-investor participation in resource
development and set a cap on the ownership stakes held by foreign state–owned
companies — a reaction sparked by the announcement in April that Turquoise Hill
Resources would sell a stake of at least 56 percent in coal mining company
SouthGobi Resources to the Aluminum Corp. of China, or Chalco. The deadline for
the offer, potentially worth up to $1 billion, was July 5, but Chalco
twice delayed and later abandoned the bid. The deal collapsed on September 3.
Later that month 24 members of parliament sent a letter to the newly elected
prime minister, Norovyn Altankhuyag, demanding that he reopen discussions with
Turquoise Hill — and by extension, Rio Tinto — and challenge the company’s 65
percent stake in Oyu Tolgoi.

Behind the heated battles of Mongolia’s political parties, however,
officials at the Ministry of Finance and the Bank of Mongolia have been quietly
working since 2009 to prepare the country’s economic infrastructure for the
coming mining boom.

The Fiscal Stability Law aims to insulate the economy from the boom
and bust cycle of commodity prices by setting up a strict fiscal policy
framework. It also created a Fiscal Stability Fund to help mitigate the effects
of commodity-price volatility on the government budget. Much like Chile’s
Economic and Social Stabilization Fund, on which it was modeled in part, the
fund is designed to accumulate reserves when commodity prices are strong and
mining revenue is high and then be drawn on to supplement the government budget
when prices fall.

According to Bazarsuren Batjargal, who until the end of July served as
director general of the Fiscal Policy Department of the Finance ministry, the
fund already holds some assets (figures aren’t readily available but the World
Bank estimates it at 2 percent of GDP, or about $170 million). With the
implementation of the new fiscal rules, which mandate greater savings, the fund
could approach $700 million in assets next year, he says.

In addition to the stabilization fund, the government has been
preparing legislation for the creation of a national pension reserve fund, akin
to Chile’s $4 billion Pension Reserve Fund and Norway’s mammoth $612 billion
Government Pension Fund Global.

Mongolia’s decision to model its fiscal rules and sovereign funds on Chile’s
example was no accident. In searching for advice and assistance, the Ministry
of Finance turned to Parrado, one of the chief architects of Chile’s sovereign
funds and manager of those funds, as international financial coordinator for
Chile’s Ministry of Finance, for three years ending in 2010.

With copper prices soaring in 2006, Chilean lawmakers passed a Fiscal
Responsibility Act that created two funds: the Economic and Social
Stabilization Fund, designed to provide budgetary support if copper prices
tumble, and the Pension Reserve Fund. The law was controversial at first, with
some lawmakers arguing that the government should use its mining revenues to
reduce economic inequality in the present, but the global financial crisis
silenced most of the critics. The government drew down about $9.2 billion from
the stabilization fund during the crisis to support the budget and the economy,
as the global economy plunged into recession in late 2008.

Today the two funds hold a total of $16.6 billion, or 6.7 percent of
GDP. Managed by the Chilean central bank under a mandate from the Finance
ministry, the funds are invested in sovereign bonds — mostly U.S. Treasuries
and German Bunds — and money market instruments. Between April 2007 and
December 2010, the stabilization fund produced an annualized return of 5.5
percent and the pension fund achieved an annualized return of 5.4 percent.

Parrado, a professor of economics and finance at Adolfo Ibáñez University in
Santiago, co-founded economic consulting firm SCL Partners, which is affiliated
with New York-based GlobalSource Partners, and advises a number of
resource-rich countries, including Colombia, Nigeria and Panama, as well as
Mongolia. He spent several weeks over the summer in Ulaanbaatar working with
officials from the Finance ministry, central bank and parliament to help them
draft legislation that would dedicate a percentage of excess mining royalties
and revenue toward a future pension reserve fund. If that legislation is
approved by parliament in the spring, which seems probable, it will pave the
way for a potentially dramatic reallocation of the coming decade’s
much-anticipated mining revenue.

The political impetus in Mongolia to create a proper sovereign wealth
fund reflects growing awareness of the limitations of the country’s existing
Human Development Fund. This fund, which was opened in November 2009, is
financed by the prepayment of royalties from the Oyu Tolgoi mine. The fund is
used to provide pension, health, housing and educational benefits to the
Mongolian people.

In 2011 every eligible citizen received a monthly cash handout of 21,000
Mongolian tugriks (about $15) from the HDF. The fund also provided tuition
support for students. Overall, the development fund doled out about $580
million last year, according to a working paper, “Managing Mongolia’s Resource
Boom,” released by the European Bank for Reconstruction and Development.
Worryingly, those distributions are not related to the fund’s underlying
investment performance but simply set at the discretion of the government — and
competing political parties have, unsurprisingly, sought to curry favor with
voters by promising ever-greater cash handouts.

“Every citizen in the country is issued a Human Development record book,”
says Origo Partners’ Choi. “You can literally walk into a bank, which delivers
the money, and pick up cash — and it’s not uncommon to see huge lines of people
lining up on a certain day to get their payout.”

If the legislation for a new pension reserve fund is approved and
implemented, it would essentially receive a portion of the revenue currently
earmarked for the HDF, which would be repurposed, according to Batjargal. “The
Human Development Fund is going to graduate and become a multipurpose fund — it
will no longer exist in its current form,” he says. “We have drafted a new law
on government assets and liabilities, in which we have articulated the main
principle of these new sovereign wealth funds, including the fund that will
effectively replace the HDF and a new pension reserve fund, which will likely
be known as the Future Pension Reform Fund.”

No timeline has yet been set for the ratification of the new sovereign
wealth fund platform, but the Democratic Party is already beginning to clarify
its position on Mongolia’s future fiscal policies by putting forward an action
plan designed to reduce the budget deficit, curtail inflation and reassure
foreign investors. Whether the government actually adheres to its
groundbreaking Fiscal Stability Law remains to be seen. Mongolia has something
of a reputation for passing admirable laws and then failing to implement them
fully, according to Alicia Campi, a former diplomat who is president of the
U.S.-Mongolia Advisory Group, a consultancy that focuses on cross-border
business projects. But the government’s plans are promising. If it follows in
Chile’s footsteps — and tilts the fiscal balance toward greater prudence while
preserving mineral wealth for future generations — Mongolia’s economy and
people stand to benefit.

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