Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

The world’s first simultaneous three-exchange IPO is expected to be confirmed this week, from an unlikely quarter – a Mongolian coal mine.

The listing of Erdenes Tavan Tolgoi, which owns the vast Tavan Tolgoi mine, and the broader development of that mine in coming years, is potentially transformative for the Mongolian economy. The backers and bankers of the IPO, which is expected to raise $3 billion or more, have been choosing between the exchanges of Mongolia, Hong Kong and London for the listing. Emerging Markets understands that after a series of presentations by the three exchanges in Ulaan Baatar on Friday, it is set to announce a role for all three, with the only question being the precise role that London plays: a primary listing or a global depositary receipt issue. “It’s not decided yet,” says somebody close to the deal. “But it would be very surprising if any of the exchanges were excluded now.”

The listing, likely to take place later this year or the first quarter of 2012, will cast light on global appetite for emerging Asian capital. In the past year Asia has been a magnet for international debt and equity flows, then appeared to repel them again at the turn of the year, and more recently has attracted them again. If a single-asset frontier market coal listing can attract billions of dollars across three exchanges, it will clearly demonstrate that risk appetite remains.

Further barometers of Asia sentiment will appear in the coming days. Last night Renren, the Chinese social networking platform, was due to price an IPO on the New York Stock Exchange of up to US$743.20 million, having considerably increased  its planned listing size despite having recorded a US$64 million net loss in 2010 and no profit in 2009 either.

It should also become clearer how much money Shanghai Pharmaceuticals is likely to raise in a Hong Kong IPO expected to price on May 12. This deal, currently being roadshowed by global coordinators Credit Suisse and Goldman Sachs, has already attracted cornerstone investments from Pfizer, Temasek, Guoco and BOCGI, and based on initial guidance could raise as much as HK$17.3 billion (US$2.22 billion).

While those deals appear to show very positive momentum towards Asian equities, an alternative view is suggested by Yuanda China Holdings, which designs curtain walls of buildings such as Beijing’s Watercube Olympic swimming facility. This IPO was due to price in Hong Kong last Friday, but the company has instead said it plans to alter the terms of the deal and may reduce both the size of the deal and its price.

On the debt side, last Thursday’s US$2.5 billion 10-year global bond from the Republic of Indonesia suggested great appetite for Asian sovereign debt. The bond – half of which was sold to US investors, according to sources, and almost a quarter to Europe – epitomizes global demand for Indonesian debt which has led to foreigners holding more than 30% of government bonds. While this inflow underlines Indonesia’s recent success story, it is also starting to alarm policymakers who fear the foreign capital fleeing again.

Probably the most striking new debt deal to move forward this week will be a planned US$500 million exchangeable from the Pakistan state, which will convert into shares of state-owned oil and gas company OGDC. Look out for more on this in later editions of Emerging Markets.

Fancy a Mongolian mining company? No? How about a nice Lithuanian bank, or a Kazakhstan gas utility? OK, my final offer: KenGen. What do you mean you don’t know KenGen? It’s Kenya’s most successful electricity company. Durr.

Frontier markets, as stock markets like these are known, require greater savvy and experience than dealing with the most grizzled of used-car salesmen. This is, no doubt, where some of the most extraordinary gains will be made: the emerging star companies of tomorrow in the emerging star countries of tomorrow. But they take the idea of risk and reward to a whole new level – particularly on the risk side of the ledger.

You may not know it, but the countries you are exposed to are dictated more than anything by a group of people sitting in an office on Pine Street, New York. This is MSCI, and it is one of the leading providers worldwide of stock market indices. One of its most well-known ones is the MSCI Emerging Markets, and it is against this index that most emerging market fund managers – including those selling such funds in Australia – are benchmarked.

Consequently, most emerging market funds tend to mirror the geographical allocations of the MSCI index fund quite closely; when a market enters or leaves the index, a lot of capital tends to flow in or out with it as emerging market portfolio managers rebalance their holdings accordingly. The table below shows the 26 nations that make up the index today; even if you don’t hold an emerging markets fund yourself, the chances are your super fund will have at least a modest allocation to it, and it is because of MSCI’s decisions that you probably have an exposure to Brazil but not Argentina, to Hungary but not Croatia, and to Morocco but not Tunisia.

“The definitions to a large extent are given to us as fund managers by the index providers, particularly MSCI,” says Peter Taylor, investment manager for Asian equities at Aberdeen Asset Management in Singapore. (Taylor’s investment decisions affect the emerging market and Asia funds sold by Aberdeen in Australia.) “They have a process and criteria, and under those, some markets are defined as developed, some as emerging, and some as frontier.”

Frontier is actually quite an odd term, because it doesn’t always mean what you might think it means: poorer countries with no established stock markets. In fact, if you look at the table showing the constituents of the frontier markets, it includes some of the richest countries in the world, such as Kuwait, Bahrain and the United Arab Emirates; these have not been promoted to more widely tracked indices mainly because of a lack of easy access to their stock markets, or a lack of maturity or depth within those markets. Also, some frontier markets have stock exchanges almost as old as Australia’s: the Colombo Stock Exchange in Sri Lanka traces its history back to 1896.

“The term ‘frontier markets’ captures a broad universe,” says Taylor. “There are things that you might consider real frontier markets – Central Asia, Mongolia, Papua New Guinea, Pacific islands – where there is an insignificant stock market or sometimes no stock market at all, with the bigger companies listed elsewhere. Then there are what you might think of as the emerging markets of tomorrow: places like Vietnam, Sri Lanka, Bangladesh, Pakistan, and outside Asia places like Nigeria, Kenya or Romania. They may have their difficulties but are sizable countries with a decent number of listed stocks already that could potentially make the leap in the next few years.” And a third category is the wealthy Gulf states. “’Frontier markets’ is not strictly an income level cut-off. If a market has certain types of controls or access problems, it won’t meet MSCI’s criteria to be in the emerging market index. That’s why you have a country like Kuwait defined as a frontier market where it is far richer per capita than, say, India.”

Frontier funds covering all these bases do exist, but they are rare and little marketed in Australia. Franklin Templeton, for example, whose fund manager Mark Mobius has long been a standard-bearer for unloved markets, runs the Templeton Frontier Markets Fund out of Singapore and has so far garnered US$299.13 million under management tracking the MSCI Frontier Markets Index. Its biggest geographical positions are, in this order, Nigera, Qatar, the UAE, Vietnam, Saudi Arabia and Kazakhstan. Its biggest picks, while household names in their own countries, are little known outside them: MTN Group, a South African telco; Kazmunaigas Exploration Production, a Kazakhstan gas company; Saudi Basic Industries, a chemical, fertilizer, plastic and metals producer; Industries Qatar; and United Bank for Africa, which is headquartered in Lagos, Nigeria.

Other funds might pursue a specialist opportunity. In Australia, AMP Capital developed the Vietnam Real Estate Opportunity Fund, for example, investing in direct property there, although funds like this tend to limit access to sophisticated or institutional buyers rather than general retail.

Since few pure frontier funds exist, investors are more likely to get exposure to the frontiers when emerging market fund managers decide to dip their toes in the water of markets outside their benchmark, whether in expectation that those countries will eventually be promoted into true emerging markets and hence become part of their mandate, or simply because they think there are good returns there. In this respect, emerging markets fund managers are most interested in the chunk Taylor labelled the emerging markets of tomorrow, and this is perhaps where the biggest opportunities might lie for bold investors too. “We are quite bullish on prospects for both Vietnam and Sri Lanka long-term,” says Peter Sartori, founder of Treasury Asia Asset Management. “We think it will take longer than many people expect for both markets to become more mainstream or institutional – we expect it is five years away rather than one to three years – but it will likely happen.”

Managers differ on which markets they think offer the real opportunities. “There are a decent number of interesting stocks, particularly in markets like Sri Lanka and Kenya, which have a very long tradition of equity markets,” says Taylor.  “We find more interesting companies in Nigeria and Sri Lanka than we find in Vietnam. Vietnam is everybody’s favourite exotic market, but it’s not a place we find a lot of good companies, whereas places like Nigeria and Sri Lanka have had listed companies forever, with subsidiaries of multinationals listed there, and the local banks.” Aberdeen pursues these opportunities particularly through an Asian small caps fund – this holds stocks in places including Sri Lanka and Pakistan – and to a lesser extent in its broader emerging market funds too.

If you’ve noticed Sri Lanka keeps popping up in this story, that’s a useful point to consider. What’s really changed in Sri Lanka for everyone to be talking about it? It’s not that its companies, which have been around for more than a century in many cases, have become suddenly better – it’s because a crippling civil war has ended. Fund managers with a really long-term view will look at macro considerations like this in deciding whether exposure to a market might eventually make sense. “There has been a tremendous increase of interest in Sri Lanka but it’s got nothing to do with it graduating [to an emerging market definition – which, by MSCI, it still hasn’t],” says Taylor. “People were dismissive of it because of civil war, and suddenly it’s become exciting. We’ve been invested in Sri Lanka forever and that was not a set of investments that have performed very well for many years but suddenly it’s come good: all our stocks have been two or three baggers in the last 18 months.” That is, they’ve doubled or trebled.

Correctly calling the end of a civil war with any accuracy is clearly beyond most of us, but there are other similar factors that are easier to see coming: the world is getting more interested in Mongolia as transformative mining deals (including a vast mine backed by Rio Tinto) get closer to completion, which should lead to greater foreign involvement, faster economic growth and a more developed stock market, for example.

Still, in unpredictable places, these transformative economic moments can go both ways. “People think of emerging markets as a one way bet, but that’s not the case: you do have some emerging markets that go in the wrong direction.” The two key examples at the moment are Pakistan and Argentina, both of which in the recent past have been investment darlings – Pakistan in particular, which for a brief time was a poster child of foreign investment and privatisation before the political and security situation worsened. Both those markets now languish in the frontier indices rather than the emerging market ones, with a consequent loss of interest from international capital. Similarly Kazakhstan was for several years considered a barometer for the emergence of Central Asia, and attracted a lot of attention as it liberalised its banking sector – which pretty much went broke in the financial crisis, taking a lot of foreign money with it.

No Australia-based investor in their right mind would seek to buy a stock listed in Ulaanbaatar or Lagos without a great deal of prior knowledge, but there are other ways of getting exposure to odd parts of the world through a single stock. To stick with the Mongolia example, more and more of the world’s most powerful investors – such as Temasek, Singapore’s sovereign wealth fund, and China Investment Corporation, its equivalent in Beijing – are trying to get a foothold in companies and mining interests there in expectation of growth. One of the companies that sovereign funds have bought into, South Gobi Resources, has since been listed in Hong Kong, which can be easily reached by Australian investors and is a well-governed exchange. (It’s worth noting, though, that the stock has crashed 30% since listing, although the rest of the market is well down too.) You don’t even have to go that far to get exposure to some frontier markets: here in Australia, Lihir Gold gets most of its revenue from a gold mine in Papua New Guinea, and much of the remainder from Cote d’Ivoire. A great many mining companies, BHP Billiton and Rio Tinto included, have some exposure to the frontier mining idea.

It’s also very easy for Australian investors to invest in the USA, and doing so gives you access to the greatest range of exchange-traded funds (ETFs). These behave like buying a single share, but they reflect the performance of an entire index. Providers in the US such as Vectors, PowerShares and Claymores offer frontier ETFs, or ETFs tracking particular areas such as the MENA area, which means Middle East and North Africa. Examples are the Claymore Frontier Markets ETF (whose New York Stock Exchange symbol is FRN), PowerShares MENA Frontier Countries ETF (on Nasdaq, code PMNA) or Market Vectors Africa ETF (NYSE, NFK). Be aware that an ETF gets you exposure to the dross as well as any diamonds that might be found, and also that buying an ETF in America from Australia also exposes you to currency movements. iShares, the biggest provider of international ETFs sold in Australia, covers several individual Asian emerging markets in its Australia-listed products (Taiwan and Korea, for example), but for more far-flung stuff you have to go to their New York-listed products too: they have ETFs for Peru, Chile and South Africa, for example.

Otherwise, real frontier investing tends to be the preserve of private equity players who bring chunks of daring institutional money together to put into very new markets with a long-term timeframe. Examples are Altima Partners, the former Deutsche bank equity special situations group which peeled off from the bank in 2004 and has since launched funds including the Central Asia Fund, covering Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Tajikistan, Turkmenistan and Kazakhstan; the Dubai-based private equity specialists Abraaj Capital, which runs the Abraaj/BMA Pakistan Buyout Fund alongside a local Pakistan bank; and a group called Acap Partners, run by a former McKinsey staffer called Pierre van Hoeylandt, who runs a truly frontier-spirited entity, the Afghanistan Reconstruction Fund. It takes big money and immeasurable patience and risk appetite to participate in these sorts of ventures.

Generally, though, the idea of wanting to get in early to markets that will grow in importance, liquidity and influence is sound enough, and allied to the broader trend of Asian or emerging market growth. “Asia ex-Japan has only been on the radar for most Australian institutions for the last five years,” says Sartori. “It will definitely remain on the radar and will continue to grow in importance as the region continues to grow relatively stronger than elsewhere in the world and Asia gets larger in global indices. The frontier markets will contribute to this, but are a few years away from being more meaningful.”

BOX: The Middle East

The Middle East, which for investors is chiefly the big oil-rich markets of the Gulf Cooperation Council (GCC), is an odd case. Massively wealthy, their stock markets do not appear in global indices because by and large their markets either lack suitable access for foreign money, or because they are too small or immature. Saudi Arabia’s market doesn’t even make it into the frontier index because foreigners cannot buy Saudi shares (although they can create the effect of doing so synthetically with new investment structures).

There are funds that do invest exclusively in these markets: one of the biggest is the Schroder Middle East Fund, sold within its International Selection range, whose biggest positions are in Turkey, Saudi Arabia, Kuwait, the UAE and Qatar. “The long-term case for investing in the region remains strong,” says Rami Sidani, fund manager at Schroders in Dubai. “Middle Eastern countries are at a relatively early stage in their development and have strong growth potential. While many of these countries continue to benefit from oil and gas riches, they are investing in new products and skills to diversify away from reliance on energy exports. The region has a young, fast-growing population which should also contribute to a more rapid economic development.”

But emerging markets managers often consider the Gulf’s position in frontier indices an anomaly given that, as highly wealthy states, their future growth profile is likely to be quite different to a Vietnam or Sri Lanka.

In any event, MSCI has been talking for some years about adding some Gulf markets to the emerging markets index; Kuwait, the UAE and Bahrain are the ones that are most frequently mentioned, even though Saudi Arabia has much the biggest market in the region by market capitalization. It will be an interesting day when it happens, because calling Kuwait an emerging market – with its high performance luxury cars, bounteous oil revenue and soaring per capita income – seems just as odd as calling it a frontier.

You had to go a long way in September to find anyone who thought it was a good idea to launch a US$300 million debt programme. Specifically, you had to go to an upstairs side-room of the State Palace in Ulaanbaatar, Mongolia. In world capital market terms you can’t get much further off the beaten track than that.

Here, on September 10, Khan Bank CEO J Peter Morrow announced that his bank was growing so aggressively and successfully that it needed international funding to keep up. And if that seemed a contrarian sentiment at the time – this was the week Lehman Brothers’ share price began its final plunge towards bankruptcy – then Morrow certainly wasn’t alone. The following day ING, the sole lead on the global medium term note programme for Khan Bank, formally opened its first office in Ulaanbaatar. And that night, crowds of foreign bankers and investors were treated to a show of contortionists and throat singers at a party celebrating the launch of a whole new Mongolian investment bank, by Eurasia Capital Management, which earlier this year launched a Mongolia-dedicated fund.

To judge the mood in Ulaanbaatar, it was as if nobody had heard of the credit crunch or the crisis on Wall Street. So what’s so special about Mongolia?

Chiefly, the fascination with Mongolia comes down to mining. Although the commodities boom has flagged recently, the last few years have been a very good time to be a quarry for the world. Mongolia has commodities in abundance: 100 billion tons of coal reserves (ranking fifth in the world, and with the largest reserves of coking coal), 1.5 billion barrels of oil reserves, 8% of the world’s potential copper, and plentiful gold, silver, uranium and other minerals.

This bounty prompts Tim Condon, ING’s chief economist and head of research for Asia, to note: “Mongolia’s rich resource endowment should make it Asia’s fastest growing economy.” It’s already right up there, as the attached chart shows: GDP growth was 8.4% between 2002 and 2006, 9.9% in 2007, and 10.2% in the first half of 2008. Even allowing for a slowdown in the second half, the official growth forecast for 2008 is 8.7%. That, notes Randolph Koppa, president of the Trade and Development Bank of Mongolia, “is now on par with Asia’s strongest: China, India and Vietnam.”

But has Mongolia blown the advantage of its natural resources? These opportunities have been well-known to foreign investors for years yet the biggest mines look no closer to getting underway than they did then. Take Oyu Tolgoi, which ought to be the poster-child of Mongolian mining. Discovered in 2001, it is being developed by Ivanhoe Mines and Rio Tinto in the South Gobi, and when completed is expected to produce an average of a billion pounds [lbs] of copper and 330,000 ounces of gold a year over 35 years. Peak production rates, reached about six years after initial production, would be higher still, creating one of the world’s largest copper and gold producers.

The impact of Oyu Tolgoi on a small economy should be extraordinary. It is expected to be a $4 billion build-out taking place over 25 months, suggesting spending of $160 million a month; it’s likely to involve 10,000 people, with a permanent staff of 5,000 when the mine is built, most of them Mongolian. Ivanhoe has stated that the mine should produce an average increase of 34.3% in Mongolia’s real GDP up to 2043, as well as an average increase in nationwide employment levels of 10.3%, nationwide real per capita disposable income of 11.5%, and a total contribution of US$7.9 billion to the government. (Quite what those figures would end up being depends in part on the final negotiated agreement.)

And Oyu Tolgoi’s not the only mine: also on the table is Tavan Tolgoi, a $2 billion project to mine the world’s biggest coking coal deposit, and a number of smaller projects.

Yet getting on for a decade after their discovery, the investment agreements to get them going beyond the exploration stage are still not in place. The problem is, the sheer scale of the potential windfall to Mongolia has prevented it from ever being realised, so severe are the consequences of botching the mining agreements. Before anything can move forward, revisions have to be passed to Mongolia’s mining law, designed to ensure the state participates in the benefits of its own minerals.