The Canadian
group Fraser Institute recently dubbed Mongolia the second-worst destination
for mining companies, but, nestled deep between Russia and China, this
once-overlooked country plays host to potentially some of the world”s largest
mineral deposits – a fact that cannot be ignored by the global mining industry,
says a report in Interactive Investor. Mongolia has one of the largest
undeveloped copper, gold and uranium deposits in the world, as well as the
largest untapped supply of coal. Its location leaves it perfectly positioned to
take advantage of the ferocious appetite for metals and coal from neighboring
China, which will be the principal driver of demand for Mongolia”s mineral
wealth.

Unfortunately for
Mongolia, there is little in the way of domestic investment, so foreign
investment is vital if it has any hope of overhauling its economy and transforming
its poor transport infrastructure. At present, just 5% of its population is
involved in mining – the very industry that is shaping up to define the
country”s future.

Net foreign
direct investment jumped by 62% in the second quarter of this year, principally
driven by investment flows for mining. “Powered by the growth in the
mining sector, specifically demand for copper and coal from China, the economic
outlook for the country looks stable and positive,” says analyst Edwin
Lloyd at Edison Investment Research.

Mongolia
continues to try and forge a relationship with countries outside of neighboring
Russia and China, developing a “third neighbor policy” and making
efforts to develop business relationships with Korea, Japan, the U.S., Canada
and the EU. These efforts would appear to be paying off, with the World Bank
Report for 2010 ranking Mongolia 60th in terms of ease of doing business –
ahead of China at 89 and Russia at 120.

The country
passed the tipping point when it finally signed a large and significant deal
with Rio Tinto and Ivanhoe Mines to develop the largest undeveloped copper and
gold deposit in the world, Oyutolgoi. The International Monetary Fund said of
the deal: “Mongolia”s economic prospects received a big boost with the
signing of the Oyu Tolgoi investment agreement.”

And it came one
step closer to getting built last week after the partners struck a new
financing plan. “The Oyutolgoi project is a natural fit with our strategy
of focusing on low-cost, long-life assets with significant growth potential.
Together with Ivanhoe and the government of Mongolia, we are determined to
develop Oyutolgoi in a sustainable, mutually beneficial manner for the people
of Mongolia,” Rio Tonto chief executive Andrew Harding said.

Lloyd says the
development of the Oyutolgoi mine alone will be “transformational”,
with Mongolia poised to “generate the highest rate of growth of GDP of any
country in the world over the next 10 years”. But more importantly, the
deal, struck towards the end of last year, was seen as a crucial turning point
in the way the nation viewed foreign direct investment, helping to pave the way
for a pipeline of other contracts to be negotiated.

Nevertheless,
there remain hurdles in the road for the government which is torn between
encouraging foreign investment and satisfying nationalistic sentiment. It has
pledged handouts to every person in the country, and in October announced a 30%
increase in public sector wages. On top of this, the Windfall Profits Tax
expires in January, which accounted for up to 20% of government revenues, and
there are no further plans for continued support from the International
Monetary Fund and World Bank.

“Combined,
these mean the government has to implement a strict fiscal policy over the next
18 to 24 months. This increases the need for foreign investment to exploit the
mining sector,” Lloyd explains. However, while it may require greater
foreign investment, environmental issues have thrown a spanner in the works.

Earlier this
year, Canadian miner Khan Resources saw its uranium mining permits canceled – a
decision it continues to fight – while just last month, Mongolia”s minister for
mineral resources and energy, D. Zorigt, revoked 254 gold mining licenses,
while a further 1,700 licenses have fallen under review, as a result of the
Water and Forest Law, which prohibits mining operations in water basins and
forest areas. It is believed small and unqualified miners were the target, with
fears that the licenses were not properly explored and well thought through.

However, it
highlights the struggle the country faces as it seeks to find the right balance
between surging foreign interest and avoiding the mistakes made by other poor but
mineral-rich countries. Lloyd warns: “The government needs to balance a
political mindset with the need to develop the enormous opportunities
available, for which foreign direct investment is required. There are practical
issues to investment too with a chronic lack of infrastructure.”

He also notes
that Mongolia would need to be careful to avoid misusing the revenues from
mining. “The current redistribution of wealth is because of pressure to
give away some of these mining revenues. As elections in 2012 draw nearer there
will inevitably be pressure on politicians to buy voters,” he concludes.

So while Mongolia
has all the markings of a “rags to riches” tale, it looks like the happy ending
still has some way to go.