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Special report: Mongolia: Capital markets struggle to make headway

Hampered by a lack of liquidity and trading activity, capital markets have been slow to evolve, despite government efforts to create a sympathetic regulatory environment

Mongolia's capital markets are at an embryonic stage despite being more than two decades in the making, with only a small number of stocks and corporate and government bonds changing hands with any frequency.

The country burst on to the global capital markets stage in November 2012 with a whopping $1.5 billion sovereign bond issue – the equivalent of one-fifth of GDP – but the momentum from that initial leap forward has since fizzled.

Companies listed on the local stock exchange have been denied or are unable to avail themselves of the opportunities to access capital offered by issuing depository receipts or dual listing.

Analysts say that, together with a lack of domestic investors, this has produced a vicious cycle in which the lack of trading activity creates low liquidity making investors even less willing to trade – ensuring institutional investors stay away.

The capital-hungry resources sector is almost entirely funded from overseas through listings on exchanges elsewhere, in North America, Australia and Hong Kong, syndicated loans from global banks and development bank loans, and bond sales.

Size limits

Corporate banking is well developed, with the larger banks providing most services from lending, trade financing and leasing to cash management, treasury and guarantees. Given that the largest bank has assets of only about $2.85 billion, corporate loans are small by international standards, restricted to around $50 million maximum. The small size of the banking sector effectively precludes banks’ direct participation in the resources sector: a single project like Oyu Tolgoi could swallow more than half of the assets of Mongolia’s entire banking system. According to Fitch Ratings, given the current weakness of the mining sector, that is probably a good thing.

Clemente Cappello, founder and CEO of Sturgeon Capital, says Mongolian banks can gain exposure by targeting lending to suppliers, or suppliers of suppliers, of the large companies developing multi-billion-dollar projects. “Unfortunately, the high cost to domestic banks of raising capital, at least 10%, is ultimately going to be paid by the customer. If you’re a large corporate you can probably access foreign funding, which will be very much cheaper, so there is no way of competing against international banks on the ultra-large loans. What they can do is have high margins on the smaller loans in spaces where they have a lot of clients. That’s where they can make money.”

Until recently, corporate banking has been the main focus. Investment banking exists, but with domestic IPOs, debt offerings and private placements few and far between, demand is insufficient to spur growth. The basics without which institutional investors cannot invest, such as custodian services and delivery-versus-payment, are not yet available. Trades are pre-funded with settlement and depository functions handled by the state-owned Clearing House & Central Depository.

“If you’re a large corporate you can probably access foreign funding, which will be very much cheaper, so there is no way of competing against international banks on the ultra-large loans”

Clemente Cappello, Sturgeon Capital

“Investment banking as a sector is really quite small,” says TDB president Randolph Koppa. “We have a capital markets company, TDB Capital, which has a brokerage licence, it has an underwriting licence and it can do advisory service.

“We were joint lead manager of the government’s sovereign bond issue and have advised on syndicated loan arrangements in the capital markets. We’ve also had a couple of mandates and probably have a couple of potential mandates to underwrite IPOs when the exchange is properly functioning and conditions are more favourable. But capital markets activity has been pretty modest in the last couple of years. We’re really geared to be the leader in corporate lending activity.”

Indirect route

Institutional investors’ current exposure to Mongolia is mostly restricted to indirect portfolio plays on resources companies listed overseas or private equity investments in unlisted Mongolian companies in hopes of an IPO, acquisition, merger or recapitalization. The government has redressed the lack of an enabling regulatory and legal framework, blamed for restricting the capital-raising opportunities available to Mongolian companies – but to little avail.

Analysts warn Mongolia will struggle to make headway while doubts persist over whether the government will stay the course with its pro-foreign investment agenda and liquidity levels are such as to make it almost impossible to exit equity positions.

“They’re trying to create an infrastructure that’s more conducive to trading and especially institutional interest but unfortunately there’s just too many other outstanding issues right now where I don’t really see a strong pick-up in capital markets in the near term,’’ says Calvin Wong, analyst at Quam Asset Management in Hong Kong. “Certainly they’re moving in the right direction. In terms of policies and regulations they’re trying to create a more liberal market and to create liquidity but it really is being held back by how slow the government moves. There’re a lot of issues still outstanding especially with the mining sector and licensing. Obviously, Oyu Tolgoi is still outstanding and there are various macro factors causing currency weakness, increased risk of overleveraging the economy and inflation.

“The best chance of a strong rebound is international equities of Mongolian companies. The liquidity is better and there are more institutional investors within those companies, and perhaps on the sidelines looking at these companies, so they would be more sensitive to certain triggers such as the resolution of the Oyu Tolgoi dispute.”

Liquidity lacking

The Mongolian Stock Exchange (MSE) was formed in 1991 as a means for the government to privatize hundreds of state-owned enterprises it inherited from the socialist era by issuing shares to all citizens. Secondary trading began only in 1995 but volume and turnover were low and no new companies were listed because of the lack of legal, underwriting and regulatory frameworks. Despite moving to electronic trading and market capitalization spiking to an all-time high in 2011 of MNT2.20 trillion ($2 billion at that time), low liquidity has been a persistent problem plaguing MSE’s efforts to become a world-class exchange.

Trading began to take off in 2005 led by volume which peaked in 2008. Equity volume and trading value more than doubled between 2010 and 2012 but even at its historical peak in 2012, trading value was just MNT144.7 billion ($83 million at the time). Last year, the value of equities traded tumbled to MNT97.6 billion, according to data from MSE. Volume slumped from 133.8 million shares in 2012 to 65.8 million for 2013, a situation not helped by the fact that only around a third of the stocks of the 249 companies listed actually trade. In March this year, trading virtually dried up before rebounding in April when 11.7 million shares of 79 companies were traded with a value of MNT3.15 billion. The three most actively traded companies – property developer Mongolia Development Resources, ready-mix concrete producer Remicon and logistics firm Bayankhairkhan – accounted for 13% of volume.

 “Certainly they’re moving in the right direction. In terms of policies and regulations they’re trying to create a more liberal market and to create liquidity but it really is being held back by how slow the government moves”

Calvin Wong, Quam Asset Management

While there was an IPO as recently as April, when local construction company Merex raised $1.5 million, there has been only one other listing since 2008.

The bond market is even slimmer, with zero turnover in both government and corporate bonds in the first four months of this year. In 2013 there was just one government bond transaction on the exchange, worth MNT1 billion. In 2012, the most recent year for which corporate bond trading data is available, 1.8 million bonds worth MNT19.61 billion were traded though the exchange.

Building an infrastructure

The government has placed strong emphasis on creating an infrastructure to foster sustainable development of the country’s capital markets with institutional investors clearly in its sights.

Wide-ranging new legislation – the Securities Markets Law and the Investment Fund Law – came into force in January. The changes allow MSE to adopt a new clearing, settlement and custody environment based around the T+3 global standard, paving the way for institutional investors and overseas funds to invest.

Dual listing – both of domestic listed firms overseas and of overseas firms on the MSE – is now permitted and the range of tradable securities that may be issued has been expanded to include options, futures and depository receipts. The minimum proportion of outstanding shares firms are permitted to float has been raised to 25% and financial statements must now be filed in both English and Mongolian.

However, the dual listings and arrival of global custodian banks and institutional investors have yet to materialize.

Quam Asset Management’s Wong says that the changes are all-important because a functioning and free capital market further down the line will not be possible without them. But he warns this type of market is a considerable period of time away. “Institutions aren’t going to suddenly say ‘oh now we can trade options and futures, let’s increase our Mongolian allocation’. There are too many things that need to be fixed before it’s a legitimate investment opportunity for institutional investors, especially larger funds.

“Annual turnover on the MSE is the size of one trade for a big fund. Even if you can get into positions over time, getting out is a big issue. It’s really not an investable market for a lot of people. I wouldn’t buy options on Mongolian equities because there’s no real tangible and predictable return I can earn. With the regulations on financial reporting and the current trade participants within the market it’s too hard to play as a pure equity investor.” 

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