Mongolia, Part II: Should One Tempt the Wrath of Khan?
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This article follows Worldview’s earlier report on Mongolia and presents the recent performance of Mongolian equities, currency, and interest rates. One of the challenges of investing in Mongolia is that data is harder to come by than for many other emerging markets, and so this presentation will not be able to perform the full sets of analysis that have traditionally been a part of Worldview articles. For example, MSCI does not keep an index, total return or otherwise, on the Mongolian market. We do, however, take what data is available use it in the most meaningful ways available.
The Mongolian Stock Exchange was created to assist with the privatization of state enterprises during the transition from the Soviet-style command economy after 1990. Citizens were issued vouchers signifying ownership shares in public companies and allowed to exchange them for cash and/or acquire more through licensed brokerages. In 1995 secondary trading was legalized.
Figure 4 shows Mongolia’s total stock market capitalization in USD from year-end for 1995–2008, along with the local-currency MSE Top 20 index from January 4, 1999 to September 10, 2010. Even the quickest glance catches why Mongolia has captured investors’ attention—a meteoric 10-fold rise in about 18 months from 2006–2008, as well as an apparent resumption of impressive growth in the second half of 2009. Clearly, any portfolio manager or trader would have liked to capture a piece of that action and would wonder if there is more to come. Certainly the economic fundamentals discussed earlier are auspicious, and the trend looks promising.
Figure 4: Growth of Mongolia Stock Index and Cap
Source: MSETOP via Bloomberg (accessed 13 Sep 2010); Market Capitalization: World Bank via TradingEconomics.com (accessed September 10, 2010). Note: MSETOP index is a local currency index; total market capitalization is in USD.
Over the period for which we have data, the MSETOP delivered an annualized capital gains return of approximately 22%, with a 26% annualized standard deviation. Using a risk-free rate of 3% over the last ten years gives a Sharpe ratio of about 0.75, which is attractive for the time frame. These figures leave out dividend returns (for which we have no index-level data), which should improve the returns without substantially increasing risk.
A closer examination reveals the challenge, however. At the start of 2006, the entire market capitalization was only about $45 million USD. While the growth rates are impressive, the entire market is still very small. The most recent data point, at $406 million in 2008 (possibly as high as $650 million at the time of writing) makes the point that the entire Mongolian stock market capitalization is still smaller than the smallest company in the S&P 500 index. This means that large and even moderate sized portfolios cannot enter this market without taking on serious liquidity risk. For most institutional investors, this point alone will prohibit entry because even a tiny allocation is likely to move the market and/or break position limits. However, for smaller portfolio investors prepared for a bumpy ride, this might be an advantage. Certainly, the possibility of a 100% return in 12 months is worth taking on at least some risk.
A comparison of market capitalization growth rates in China and Mongolia in Figure 5 show that the two track each other fairly closely. China’s stock market is more than 5000x the size of Mongolia’s, but they do grow and shrink more or less in sync.
Figure 5: Mongolian Stock Market Capitalization Growth Rates
Source: World Bank, via TradingEconomics.com (accessed September 10, 2010).
Figure 6 shows the exchange value of the Mongolian tögrög (MNT) versus the US Dollar, Euro, and Chinese Yuan. The figure shows the value of 1000 MNT in foreign currency so that higher values on the chart represent strength and lower values show weakness. What is immediately apparent is that the exchange rate has been remarkably stable (at between 1100 and 1200 MNT/USD) for most of the decade.
Figure 6: Value of Mongolian Tögrög in Other Currencies
The extremely smooth USD exchange rate results from Mongolia’s central bank policy targeting exchange rate stability, a not-uncommon policy for export-oriented countries. Even though China is Mongolia’s largest trading partner, it is interesting that the central bank targeted currency stability vis-à-vis the US Dollar. Presumably this is because of the dollar’s greater liquidity, its utility as a reserve asset, and the fact that Chinese currency policy also targeted a stable dollar exchange rate throughout most the same period.
The figure shows that the tögrög has been slowly weakening through most of the decade, which is not surprising, given Mongolia’s struggles with inflation. The currency devalued by about 30% at the height of the financial crisis, and has since recovered about half of the loss. At present, the tögrög has been on a mild strengthening trend, and robust Chinese growth along with a supportive central bank policy suggests that the currency will most likely strengthen until it reaches the previous 1100–1200 MNT/USD range, at which time the central bank may reconsider its exchange rate targeting policy.
Investors should note that in a relatively undiversified extractive economy like Mongolia’s, inflation targeting is an unusually challenging task. Capital tends to flow to the extractive industries, resulting in underinvestment and higher prices in consumer sectors, leaving the central bank in a dilemma of targeting exchange rates to help exporters access capital or target inflation to alleviate consumer distress. So far, Mongolia has shown a preference for currency stability.
In the Soviet-influenced period, Mongolia’s government often used 20-year bonds (mostly purchased by the Soviet Union) to manage its finances, but the intense inflation experienced during the transition to a market economy forced the government to fund itself almost entirely with short-term paper, typically 3–6 month bills, with only a smattering of longer-term notes. This habit has continued to today, in part because the specter of inflation still persists and long-term bond investors face substantial risks on top of inflation. As a result, Mongolia, like many emerging markets, does not have a well-defined yield curve, and most interest rates in Mongolia are built off of ongoing short-term interest rates.
Figure 7: Declining Deposit and Lending Interest Rates
Source: World Bank, via TradingEconomics.com (accessed September 10, 2010).
Figure 7 shows the trend of declining interest rates over the 15 years from 1993 to 2008. The main driver of the improved interest rate environment has been falling inflation, as shown by the dotted red CPI inflation line. Real deposit rates have been below 10% since 1999, and real lending rates under 30% for much of the same period, averaging about 25% overall.
These rates are still fairly lucrative on the surface, but they represent both credit risk and the risk of returning inflation. Indeed, rising inflation in 2007 and 2008 crimped real interest rate spreads substantially (from 12% to 7%), so the high nominal rates primarily represent interest rate and inflation risk. After accounting for inflation, deposit-lending spreads have averaged about 21% in real terms over the entire 1993–2008 period, and this has narrowed to about a 15% average over the last decade. It is also true that Mongolian debt tends to be short term, both by tradition and necessity, and so returns come mostly from fees and interest payments and comparatively little from capital gains. If the country is able to bring inflation down reliably, longer-term debt instruments may become more common.
Mongolia’s equity markets have dazzled emerging markets investors with growth rates that outpace even China’s, and the economic fundamentals underpinning that performance appear to be reliable for the foreseeable future. Even if China’s exports decline somewhat due to ongoing global recession, its internal demand will provide Mongolia with large markets for its raw materials for some time to come. Mongolia’s main challenge will be to see if it can diversify its economy to reduce dependence on the extractive sectors, stave off inflation, and improve business transparency, data availability, as well as reduce corruption.
However, with a total market capitalization well under a billion dollars, it will be difficult for institutional investors to take advantage of this dynamic, and retail investors will find it difficult to access the right instruments to enter the market. That leaves direct investors, small and mid-scale private equity firms, and the high-net-worth market as the most likely investors who can benefit from the dynamics in Mongolia.
The impressive performance in 2005–2007, combined with the apparent resumption of that trajectory in 2010 will no doubt attract a great deal of speculation and investors driven by momentum and chasing returns. This will likely produce a very bumpy ride in Mongolia, but the risk should still be well compensated for those who can stomach the volatility. Investors should, as always, be aware that the exceptionally high rates of return that have generated all of the recent excitement are almost certainly much higher than what investors should expect over the long term, but a small exposure held and compounded over time should still generate good results for a portfolio.
The Mongolian tögrög is presently on a strengthening trend, following a 30% devaluation during the financial crisis. The central bank is likely to continue letting the tögrög strengthen until it returns to its recent historical range of 1100–1200 MNT/USD. In interest rates, the resurgence of inflation in Mongolia in 2007–2008 has hurt lenders. The global deflationary environment has mitigated this somewhat in 2009–2010, but the intense demands on the resource extraction sector does mean that the inflation threat is stronger here than might otherwise seem.
In any case, expect to hear more about Mongolia in the news as the global economy heals and investors search new sources of growth in emerging markets. The connection to China makes for an attractive narrative, and large investors attracted to small markets mean that the numbers coming out of Mongolia are likely to be eye-popping in both directions.
–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.