World Economics Data - September 2012

Chalco drops bid for SouthGobi

On 3 September of this year Chalco, the aluminium company of China, decided to drop its proposed US$926 billion takeover of a controlling interest in Vancouver based mining company SouthGobi Resources. [1]This event, although normally routine, in terms of developed stock markets for corporate control, has in this case much wider implications. It threatens to impact severely on the future inflow of investment into Mongolia, a country that is heavily reliant on foreign direct investment (FDI). The principal reason for this is that the deal was killed, not because of any problems with its price, shareholder issues or with its economic and commercial aspects, but instead as a result of hostility expressed by leading Mongolian politicians and an increasingly uncertain regulatory environment within that country.


The Mongolian government’s strong opposition to the sale of a majority stake in the Canadian listed energy company SouthGobi Resources to Hong Kong listed Chalco seemed excessive. On the face of it was just a routine share transaction transferring ownership between two parties which should be regulated only by the rules of the relevant stock exchanges. The proposal by Chalco to buy up to 60% of the equity in SouthGobi Resources was not hostile and the deal had the approval of Toronto and Hong-Kong listed company’s controlling shareholder Turquoise Hill Resources Ltd., a subsidiary of Rio Tinto. The political problems which killed the deal arose because Chalco is an aluminium company controlled by the Chinese government and SouthGobi Resources owns significant operational and developmental coal projects close to the border with Mongolia’s giant southern neighbour. The aborted transaction has led to a situation that requires rapid resolution both for investors into the country and for the future well-being of Mongolia’s citizens. The period from the announcement of the deal in April this year until Chalco decided to drop its offer in the first week in September, has lead to gross uncertainty concerning the openness of Mongolia to foreign direct investment (FDI).This paper explains the background to the issue, explores some of the economic implications for Mongolia and makes some suggestions for a way out of the current impasse.



The Mongolian Economy

Land-locked, but resource rich, Mongolia is a low-income country with a GDP per capita in 2011 of only US$4,800 (PPP), or US$3,056 at official exchange rates. It has been called the Saudi Arabia of coal with proven reserves of 12.2 billion tonnes and estimated potential reserves of some 100 billion metric tonnes of this energy source. Mongolia also has ample reserves of copper, gold, iron ore, oil, molybendum, uranium, tin, tungsten and phosphates. Its geographical position squeezed between Russia to the north and China, its populous and resource-hungry southern neighbour gives it a strategic importance as a local supplier of commodities out of proportion to its tiny population of only 3.2 million people. While the Mongolian economy has seen rapid economic growth in recent years, chalking up annual GDP of 17.3% last year, the country’s continuing and future prosperity is heavily dependent on both commodity prices and upon the attraction of direct investment from foreign companies wishing to extract the country’s natural resources.


The Mongolian government’s hostility to the SouthGobi Resources deal was based on national security grounds and only partly on economics. The deal caused many politicians to express xenophobic concerns about Chinese control over Mongolian mineral assets and it acted as a catalyst speeding up the passage of restrictive legislation in Parliament limiting foreign investment in certain strategic industries including mining.


Fear of its larger neighbours is perhaps understandable in sparsely populated but resource rich Mongolia which was part of the Chinese Empire from the end of the seventeenth century until its declaration of independence on the collapse of the Qing dynasty in 1911. From 1924 until 1989 the Mongolian Republic was a puppet regime of the Soviet Union and Russian is still widely spoken among the country’s elites. There are understandable deep seated fears by Mongolians of the strategic intentions of China and Russia, but Chinese influence over the Mongolian economy is already significant. To take coal as an example, China is currently the largest buyer of Mongolian coal. Chinese major coking coal supplier Winsway has seen its purchases of Mongolian coal rise from nothing in 2006 up to 6.5 million tonnes by 2010.  In July 2011, Shenhua Energy, China’s largest coal producing company, won a tender which would have given it 40% of a consortium, the leading stake, to develop the western block of the massive Tavan Tolgoi property, although this too has been subject to political indecision and interference. This existing Chinese presence in Mongolian mining has been subject to rising political hostility within Mongolia. The country’s President Elbegdorj fears that a dominant position in the possession of mining licences would give Chinese companies too much market power with the ability to control production and pricing to Mongolia’s detriment.


The state owned Tavan Tolgoi resource was discovered during the period when Mongolia was a Soviet satellite state in 1945. It is estimated to have deposits of around 6 billion metric tonnes of high quality coking and thermal coal which will need significant investment to exploit, but little progress has been made so far. Following Mongolia’s transition to a democratic country it allowed foreign companies to prospect the site in southern Mongolia (See Map in Figure 1), but it was later placed back into public ownership with a tender made to international mining companies to exploit its resources. However, the initial tender involving Shenhua and US energy company Peabody has been rejected by the Mongolian authorities.


Resource nationalism is an understandable political response to growing foreign ownership of national resources, but it is not true that generating local wealth from the exploitation of national assets necessitates local ownership. If a country cannot afford to exploit its mineral resources without foreign capital, expertise and technology then excluding external participation will result in far less primary employment and far less local wealth generated than would be the case with open capital markets. The Australian coal-mining industry is an interesting counter example to the supposed merits of resource nationalism. The industry exported over 274 million tonnes of coal in 2009, one third of global export trade, of which 15% was consumed by China. [2] The openness to foreign investment allows mineral extraction activity to contribute substantially to the Australian economy generating direct employment of 158,000 jobs and an estimated 505,600 in indirect employment. The minerals industry as a whole aided the country’s balance of payments with an export value of A$111.5 billion in 2009-10, or 48% of Australia’s total exports according to local industry sources. [3]Yet over 90% of the industry is in foreign hands with the participation of large international operators such as Peabody, Rio Tinto, Anglo-American and BHP Billiton.


The case of China and many other countries demonstrates strong economic evidence that FDI stimulates development. The interests of investors are different, sometimes conflicting, but mainly complementing those of national governments. The Australian example and that of countries like Chile shows that government policies should be aimed not restricting inward investment, but at measures that minimize the national resource curse which can create corruption and the underdevelopment of other industries such as has happened in Nigeria with oil extraction. Chalco’s decision to drop the takeover of SouthGobi Resources because of political hostility is a poor precedent for international investment. For Mongolia, however, a failure to permit the transfer of control between Turquoise Hill Resources and Chalco is serious harming its public policy of being investor friendly which could seriously damage economic growth.  The future prosperity of Mongolia’s citizens and their employment prospects are now under threat not just from external market forces in the form of the world market price of coal and other hard commodities, but from the negative actions of its own government which may imperil future FDI inflows. The economic history of the country in recent years demonstrates that the importance of FDI to the Mongolian economy is crucial.



The Importance of FDI

Mongolia’s status as a transitional economy depends on continuing to attract foreign investment. The benefits of investing in Mongolia are laid out in detail, although not very coherently, by what was the Mongolian Foreign Investment and Foreign Trade Agency (FIFTA) on its official website, [4] although FIFTA’s functions has now been abolished and its functions folded into the Ministry of Economic Affairs.


The economic returns from investing in Mongolia have been evident to international corporate investors with FDI into Mongolia rising rapidly in recent years because of, or in spite of FIFTA’s work. However, a change to a regulatory environment which might frighten away FDI will not be good for Mongolia, which according to World Bank figures, has attracted over US$4.2 billion of foreign direct investment between 1992 and 2010, of which 83% or US$3.52 billion poured in the last five years of this period. [5] This amounts to a gross enhancement of Mongolia’s capital stock of around US$1,100 per person.

Inward investment is essential in order to exploit its extensive mineral deposits across Mongolia. The country’s future depends on it since economic activity was traditionally based only on herding and agriculture. The collapse of the USSR and the end of Soviet assistance had a catastrophic impact on Mongolia’s economy with a cumulative fall of over 20% in real GDP and subsequent sluggish growth such that living standards only regained their 1989 peak by 2001. Mongolia opened a stock exchange in 1991, joined the WTO in 1997 and embarked on an extensive privatization programme, but the surge in the trend rate of economic growth illustrated in Figure 2 was favourably impacted by buoyant copper prices and new gold production. Real GDP growth averaged 8% per annum between 2002 and 2008. The Mongolian economy is particularly vulnerable to external shocks and the global financial crisis and the sharp drop in commodity prices lead to a sharp fall in government revenues while real  GDP dropped by 1.3% in 2009. In early 2009, the International Monetary Fund reached a US$236 million Stand-by Arrangement with Mongolia and the country weathered the crisis.



FIGURE 2: Mongolia - Real GDP 1990 – 2011



A major bulwark of Mongolia’s economic transformation, however, has been the impact on GDP caused by the steady increase in FDI investment into the country. Figure 3 shows annual FDI expenditure into Mongolia between 2000 and 2010 from two separate sources, the World Bank and Mongolia’s FIFTA bureau and although there are some discrepancies between the figures the sharp rising trend remains clear. Given the country’s extensive mineral resources, as would be expected, most of the FDI is aimed at extraction, processing and delivering these commodities to consuming countries. Data from the FIFTA bureau show that between 1990 and 2010, the sector – Geological prospecting, oil exploration and mining accounted for 65.3% of all inward investment, while Trade and Catering services accounted for a further 18.9%.


Annual FDI into Mongolia 2000-2010



FDI into Mongolia has been rising as a proportion of GDP and in terms of its share of total investment, while at the same time stimulating the latter while transforming the Mongolian economy. According to World Bank data FDI rose as a proportion of GDP from 5% in 2000 up to 23% by 2010 the latest year that figures are available. This rise in the importance of FDI in the composition of aggregate demand is illustrated in Figure 4. The graph also shows the rise of all investment expenditure which increased from 23% to 50% of GDP over the same period.



FIGURE 4: Mongolia FDI and Investment as % GDP 2000-2010



Mongolian politicians may be fearful of Chinese influence in coal mining on the grounds of national security. However, economic ties between China are already significant and given its geography this is to be expected. Both China and Mongolia are members of the WTO and China is Mongolia’s largest trading partner receiving more than 90% of Mongolia's exports. Furthermore, given the importance of FDI in stimulating Mongolia’s growth a dispute with China is not one with a minor source of money coming into the country. China is already the major investor in Mongolia. Since 1990, over 10,709 foreign companies have invested in Mongolia, but over that period China’s share of FDI by value has been 51% followed by Canada at 8%. The source of FDI by country based on FIFTA data is shown in Figure 5.



FIGURE 5: Mongolia Source of FDI 1990-2010




The Impact of the Foreign Investment Law

Mongolia, a former communist state, but a member of the World Trade Organisation (WTO) since 1997, may boast of its openness to foreign investment, but the government passed a restrictive law in May which belies this policy. On May 17, 2012, the Parliament of Mongolia approved a Foreign Investment Law to regulate investment into a number of key sectors of strategic importance. These are defined as banking, media and telecommunications and mining. The FIL is ambiguous and leaves a lot of discretion in the parliamentary approval process. If foreign shareholding exceeds 49% of an asset and the amount of the investment at the time is to exceed MNT100 billion (approximately US$75.0 million), then parliamentary approval is required. In the case of state owned entities (SOE) there is no minimum threshold and all proposed investments from SOE’s require parliamentary approval. In addition, if a foreign entity wants to acquire one third or more of the shares in an investment in a strategic sector, then the MNT100 billion limit is not applicable and cabinet approval for the investment is required regardless of the value.


The proposal by Chalco, announced on April 2, 2012 of a C$8.48-per-share bid for a controlling interest in SouthGobi Resources, retrospectively fulfilled all of the criteria applicable to the law’s remit in terms of size, in that Chalco was considered an SOE and in the strategic importance of coal mining. SouthGobi Resources is one of the largest coal producers in Mongolia and owns four major projects in the country, of which one, the Ovoot Tolgoi Mine is only 40 km from the Chinese border (See Map in Figure 1).







Resource nationalism has always been a feature in Mongolian politics, but it has been growing in strength. The passage of the ambiguous FIL is only one facet of this. There have also been a number of inconsistent decisions taken by regulatory bodies along with incidents of harassment of officials of foreign owned companies all of which have created a climate of uncertainty. For example, the Mongolian Parliament passed the FIL on 17 May just weeks before Chalco’s offer to acquire control of SouthGobi Resources, and just before the law was passed the Mineral Resources Authority of Mongolia (MRAM) announced on April 16 a request to suspend the exploration and mining licences at a number of SouthGobi’s projects in the country including the operational Ovoot Tolgoi coal mine. This occurred while the Mongolian government sought to clarify the conditions of the proposed takeover and although no suspension has taken place, the announcement has caused significant economic damage by inducing other government officials to grant permits needed to conduct operations. SouthGobi Resources have now curtailed operations at the mine and have confirmed that no production mining has taken place since June 30 and that the suspension would continue throughout the third quarter. SouthGobi Resources has also noted that during the period customers were reluctant to enter into new sales contracts partly due to the uncertainty about the company’s mining licences.


SouthGobi’s financial statements to shareholders show that for the three months ended June 30, 2012, the Company produced 0.27 million tonnes of raw coal in contrast to production of 0.87 million tonnes for the three months ended June 30, 2011. This has hit SouthGobi’s profitability sharply. The company recorded net income of C$0.2 million for the three months ended June 30, 2012 compared to a net income of C$3.1 million for the three months ended March 31, 2012. The company has also had to suspend uncommitted capital expenditures and exploration expenditures to preserve its financial resources due to a number of factors of which one was uncertainty in the regulatory environment. [7] 



SouthGobi seeks arbitration

There are a limited number of defensive steps available to international investors when they are subject to domestic legislation or regulatory decisions which interfere with their property rights within a country. Certainly, there is no redress from the multinational agreements monitored by the World Trade Organisation although there is an international arbitration procedure sponsored by the World Bank when a country is a signatory to a Bilateral Investment Agreement (BIT). Mongolia has signed 37 BITs, one of which is with Singapore which came into force in January 1996. On July 5 of this year, SouthGobi’s management resolved as a last resort to file a Notice of Investment Dispute with the Mongolian government using this treaty. This particular BIT is relevant because the Singapore registered company SGQ Coal Investment Pte. Ltd., is a wholly owned subsidiary of SouthGobi which owns the operating subsidiary SouthGobi Sands LLC. The Notice concerned a number of issues including SouthGobi’s management’s frustration with the MRAM’s failure to execute the pre-mining agreements (PMAs) associated with exploration licences of the company, for which valid PMA applications had been lodged in 2011. Given that SouthGobi has spent a significant amount of time and money to develop these mines, the failure to implement the agreements is equivalent to an expropriation of SouthGobi’s investment in the affected areas. In addition, the Notice raised issues concerned with the harassment of SouthGobi’s officials involved as witnesses in a MRAM corruption investigation and the announcement of the suspension of operating licences following the political furore on Chalco’s bid to acquire control in SouthGobi.


Bilateral investment treaties are agreements between two states under which each undertakes to promote and protect investments made in its territory by people and companies from the other state. They generally promote a number of key rights and principles including freedom from expropriation or nationalisations of investments made by nationals of the other state in its territory. They also intended to promote the right to fair and equitable treatment for investors which obliges contracting states among other things to maintain a stable legal and regulatory framework. SouthGobi’s filing of the Notice of Investment Dispute triggers the dispute resolution process under the BIT which gives the Mongolian Government six-months to satisfactorily resolve the dispute through negotiations. If negotiations are not successful, or if the Mongolian government fails to negotiate, SouthGobi will be entitled to commence conciliation/arbitration proceedings under the auspices of the International Centre for Settlement of Investment Disputes (ICSID) based in Washington which was established by a Convention which came into effect in 1965. The number of cases filed with the ICSID) has risen steadily in the last decade and 25% of all cases ever registered deal with oil, gas and mining. The details of any conciliation or arbitration proceedings will be confidential, but since 62% of all cases are settled by the tribunal simply filing and proceeding with the notice by SouthGobi provides the Mongolian government with sufficient time to take effective steps to solve its dispute or risk moving the disagreement to the scrutiny of an international body which emit a dangerous signal to international investors at the expense of Mongolia. This could be disastrous. The dependence of Mongolia’s economic growth on attracting foreign direct investment is extremely high and the country is vulnerable to any reversal in inwards capital flows.


The way forward

There are several ways out of the impasse that threatens SouthGobi’s coal mining investments, but also Mongolia’s future attractiveness to foreign investment, particularly from China. In the short term, even though Chalco have dropped the bid to acquire control over SouthGobi, the company should continue with its Notice of Investment Dispute since while production is suspended economic damage is continuing. Now that a Chalco tie-up is over it’s time to release the announcement of the suspension of licences as well as allowing progress to occur with SouthGobi’s application process for its pre-mining licenses in its adjacent properties.


In the medium term, it seems that some of Mongolia’s politicians are not aware of the dangers facing their country’s continuing prosperity from the FIL which requires amendment. It was rushed through by Mongolian legislators spurred on by the Chalco bid. While the principles of self-protection on which it is based are understandable, politicians need to understand that although the priorities of governments and the objectives of foreign investors can differ, their interaction is of fundamental importance to economic growth. Governments should be concerned with increasing welfare for the benefit of their citizens, while investors are primarily concerned with maximising the long-term value of their investment for the benefit of shareholders. Excessive and uncertain regulation impedes FDI activity and is associated with higher corruption which benefits the regulator and not the country.



From the perspective of the objectives of Mongolian government the most important issue is that the resources generated from the exploitation of minerals support the state’s fiscal needs from a mixture of royalties and other forms of taxation. Given the domestic opportunity cost of capital in Mongolia, the weakness of government finances and the lack of savings insufficient resources will be generated from restricting foreign ownership. From the perspective of international investors, ownership is important only insofar as it allows initial heavy expenditures to be recouped sufficiently to earn a rate of return attractive enough compared to alternatives. This is a function of time and the value of the resource mined.


It would be instructive for Mongolia’s lawmakers to consider the case of the negative impact arising towards Indonesia from regulations aimed at cutting foreign investment in new mining projects to 49% amending relatively more liberal legislation passed in 2009. Foreign investors had been allowed to own up to 80% of the equity in a mining project, but the new regulations envisage a forced sale of 20% of equity to domestic investors after six years from the start of the project and a staged reduction down to 49% after ten years. [8] This legislation ignores the fact that foreign investors may have earned an inadequate return on capital after these time periods which implies a form of expropriation of their property.


Compared with Mongolia, however, the new regulation in Indonesia only applies to new projects and does not retrospectively impact on projects for which capital expenditure has already been committed. In general, however, arbitrary limits on foreign ownership at 49% do not balance the satisfaction of the desire for domestic participation in strategic industries while continuing to encourage foreign capital. There is a need for solutions which recognise the relative risks caused by differences in the scale of capital investment applied by domestic and foreign investment partners, the risks from regulatory delays and finally from the market price of the mineral extracted. This can be accomplished through a number of mechanisms. China, for example, uses the equity joint venture (EJV) as an institutional form to control foreign investment in strategic sectors. Like wholly foreign-owned enterprises, EJVs are independent legal persons with limited liability under PRC law.

EJVs are established on the principle of strict proportionality—dividends and shares in the residual assets of the JV after dissolution are distributed strictly in proportion to the parties' contributions to the JV's registered capital. Representation on the JV's board of directors and board of supervisors also tends to be allocated in proportion to the registered capital contributions. In the case of an EJV form ultimate ownership is less important as equity shares can reflect economic reality in terms of the contribution of investors. Applying the same format to Mongolia, a Chinese investor could have 60% or more of a mining vehicle with a residual for domestic investors which could take the form of income generating convertible debentures for example, with the terms depending on project length or mineral prices.


Mongolia on the Cusp

Unfortunately, with the FIL in place, Mongolia looks set to apply a more simplistic solution to foreign ownership questions. According to provision 6.2 of the FIL, all applications for foreign transactions will need to be initiated to get approval from the Government and/or the Parliament.   The application will be first reviewed by the Ministry of Economic Development then possibly by a small committee of other ministers which will then go to the entire cabinet for review.  Another problem is that the minister of Economic Development is N. Batbayar, is an anti-foreign investment champion who wants the Mongolian government to take a major stake in the Oyu Tolgoi copper and gold project which could contribute up to a third of Mongolia’s GDP.


Alongside the problems with Chalco’s bid to control SouthGobi, the forces of resource nationalism in Mongolia are gearing up for a potential fight over Oyu Tolgoi, which will send further even more worrying signals to the global investment community. The Oyu Tolgoi mine is located 550 km southwest of the capital Ulan Bator (See Map in Figure 1) and is estimated to be one of the three largest copper and gold deposits in the world. Turquoise Hill Resources and Rio Tinto will have invested around US $6 billion into the mine by the time the first phase of construction is complete and mining starts next year. An agreement made in 2009, which granted 66% of the project to Turquoise Hill Resources allowed the Mongolia state to increase its stake in this major project from 34%, but only 30 years after it had gone into operation allowing time for a competitive rate of return to be earned. However, elections in June have produced a coalition government where some politicians are openly pushing a resource nationalist agenda. In a petition to the prime minister a group of 24 MPs called for the enforcement of a parliamentary resolution that the Mongolian government should own 51 percent of the Oyu Tolgoi project once foreign partners recoup their start-up investment. Mining Minister Ganhuyag Davaajav told the Mongolian Odriin Sonin newspaper that his government would seek to raise its current stake in Oyu Tolgoi, as part of a mining action "action plan" that has not yet been finalised. Following a heated Parliamentary debate the Mongolian Prime Minister Altankhuyag Norov told that the government action plan did not specifically name Oyu Tolgoi, “but we said that all investment agreements in the mining and energy sector need to be reviewed carefully."  The report also said Altankhuyag intended to subject the Oyu Tolgoi agreement to a full and transparent parliamentary hearing and resolve the debate "once and for all".  Given these calls and the SouthGobi experience it is essential for the future welfare of Mongolia’s citizens that an informed debate is opened on the benefits of foreign ownership that will generate more light than heat.



[2]  Australian Coal Export Forecast to 2015,

[5] The World Bank defines FDI as is net inflows of investment to acquire a lasting management interest (10% or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments. This series shows total net, that is, net FDI in the reporting economy from foreign sources less net FDI by the reporting economy to the rest of the world.

[8] See Indonesia to Pare Foreign Investors' Mining Stakes, Wall Street Journal, March 7, 2012.