The recent decision by Chinese state-owned firm Chalco to drop its planned takeover of coal mining company SouthGobi Resources was the culmination of a deadlock that raised questions among investors about just how open Mongolia is to FDI.

The deal, which would have been worth $938m, unravelled in September after mounting opposition had led Mongolia’s parliament to stall it by passing a new foreign investment law. The law, which gave Mongolia’s government and parliament the power to review foreign acquisitions, had put Chalco’s bid for SouthGobi on hold in May. Mongolia’s mining ministry subsequently threatened to suspend SouthGobi’s mining licences and its offices were raided as part of an anti-corruption campaign. Since June, SouthGobi’s operations have stalled, causing its shares to plummet by 60%, leading SouthGobi to file an investment dispute against Mongolia’s government.

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The failed bid was seen by some as a fresh reminder of the political risks involved in investing in Mongolia’s mining sector. “Investors are looking at this market, and it is clear that they are placing a high risk premium on investing in Mongolia,” says an investor that operates in Mongolia’s mining sector who asked to remain anonymous.

“The [new] foreign investment law requires governmental approval if you are buying between 33% and 49% [of a company]. If you bid beyond a 49% controlling stake, you will also need parliamentary approval. The consensus view here is that if the bid is subject to parliamentary approval, it is a deal breaker. No one expects it to happen because all the members of parliament will use it as a tool to gain popularity. This [law] will stop foreign investors from owning 49% [of a company], and without that element of control, it will be difficult for any prudent investor to continue investing in Mongolia.”

Worrying parallels

The new law sparked concerns among investors, who questioned Mongolia’s ability to partner with foreign companies. This led some to draw comparisons between SouthGobi’s case and the Russian government’s lawsuit in 2003 against the former oil major, Yukos. After launching accusations against Yukos of using shell companies to hide revenues from tax authorities in Russia, the Russian government froze the company’s assets, forced it to sell its shares and declared Yukos insolvent in 2006.

“I can see similarities with the Yukos case because what happened was [former Yukos CEO and chairman Mikhail] Khodorkovsky was trying to sell his stake of the company to one of the oil majors from the US,” explains the investor.

“That sale was stopped and there were several politically driven investigations, which led to the eventual bankruptcy of the company. What happened in Mongolia is similar. This law was enacted as a reaction to Chalco bidding to control a Mongolian asset. The Mongolian government tried to suspend the licence without any legal basis, and although it has not actually done it, the threat of suspension has had a material impact on SouthGobi’s operations. None of its customers were willing to place orders as they were worried that at some point, SouthGobi’s mining licence would be suspended. If you look at SouthGobi’s share price, you will see that it has under-performed when compared to other regional coal players.”

Although Mongolia has positioned itself as an open economy that has worked to establish a consistent legal regime for investors, political risk has become a contentious issue that appears to be hampering the progress of major mining projects in the country. According to Rachel Shoemaker, the Asia-Pacific regional manager at specialist intelligence company Exclusive Analysis, SouthGobi’s case is not an isolated incident. In 2011, three other major mining projects encountered political risks in Mongolia. In September last year, the coalition government sought to renegotiate the Oyu Tolgoi mining contract with Canada’s Ivanhoe Mining and the UK/Australian company Rio Tinto. Additionally, the country's flagship Tavan Tolgoi coal project faced uncertainties last year as a contract awarded to foreign investors in July 2011 was nullified due to alleged irregularities. The case of SouthGobi was a reminder that large-scale projects remain politically vulnerable. fDi sought comment from the Mongolian government but received no reply.

Resource nationalism

What cannot be denied is that Mongolia has been in the midst of a mining boom, which could transform the country of 2.8 million people into a wealthy nation. Mining is a major contributor to Mongolia’s economy, accounting for 30% of its GDP and 32% of government revenue, according to Oxford Business Group.

Yet Mongolia’s legislative elections, which took place in June this year, revealed that the country’s politics are intertwined with its mining sector. The distribution of wealth generated from Mongolia’s mining boom emerged as a key flashpoint during the elections. There were sporadic protests staged related to the fairness of deals with foreign firms, and according to Exclusive Analysis, Chinese assets in particular were exposed to elevated risks as the election campaigns of many MPs carried a nationalistic slant.

“The Mongolians have a very strong sense of nationalism, and one of the reasons there have been delays in a lot of the big deals is that Mongolians are keen to maximise what they get out of their mineral resources,” says O Hamid, deputy head of Asia forecasting at Exclusive Analysis. “Apart from the vested interests that the MPs have, there is a very strong sense within public opinion that believes Mongolia should not be short-changed on any deal. However, when things such as the [new] foreign investment law surfaces, it creates a stir among foreign companies that want to go there.”

Chinese influence

The government’s response to Chalco’s bid was interpreted by some as unmasking concerns within Mongolia about the influence of Chinese state-owned enterprises. Although China is the destination for 90% of Mongolia’s exports, the country’s historical influence has made Mongolians wary of China’s excessive involvement in its strategic sectors. Yet, according to Mr Hamid, the parliament’s response to Chalco’s bid was a pragmatic move.

“The Mongolian government has been pragmatic and it realises that [Mongolia] cannot do away with Chinese investments as [the country] exports most of its goods to or through China,” says Mr Hamid. “The issue was more about Chalco being a state-owned enterprise, rather than a Chinese company. The government did not want a Chinese state-owned enterprise controlling such a large chunk of any particular sector, especially mining. That was the big issue – the widespread sense that [Mongolians] did not want any external country, especially China, to dominate any particular sector of their economy.”

Nevertheless some foreign investors remain sceptical, citing the case of SouthGobi as a prominent example of the government’s unwise decision to shun Chinese capital.

“It is pretty obvious,” explains the investor who wishes to remain anonymous. “The law was passed right after Chalco announced its intentions. There is a bit of history between the two countries, and there have been tensions between them. Yet by shunning Chinese capital, [Mongolia] closes itself off to a big pool of capital, and it sends the wrong signals to everyone. Investors [will think] ‘today you are doing this to the Chinese, but there is no guarantee that you will not do it to other investors from other countries thereafter’. Yet my view is that the politicians will become more realistic about how they can tap into Mongolia’s mineral wealth. To do that, they will need to ensure they have a framework that is foreign investor-friendly, so that capital can enter to materialise the benefit from the minerals.”

The Mongolian government must work to strike a balance between establishing a fair legal regime for the major mining firms that are developing the country’s natural resources, while also getting the best deal for its citizens. It remains to be seen whether it will successfully develop a workable framework for large foreign investments under its new law, while also ensuring that no single politician will have the power to curtail the progress of any project.