First steppes for Mongolian derivative market

Mongolia's derivative market is in it's infancy - but the promise of future returns is luring international banks to Ulan Bator.

With nearly a quarter of the population living on less than a $1.25 a day and a history of instability in its financial sector, Mongolia isn't an obvious spot to find an investment bank. But for ING's man in Ulan Bator, Howard Lambert, the opportunity is clear: the bank has been creating bespoke products for clients to gain exposure to Mongolia's currency, the tugrik, and they have been earning fat returns.

"We were the first bank to structure a derivatives product to sell to international investors and give exposure to the currency. One hedge fund made 15% a year net on coupon and another 14% appreciation on the currency, which gives you equity-style returns," he says.

So far Lambert, ING's head of corporate and investment banking for Mongolia, has had a clear run at the Mongolian market - until earlier this no other international investment bank had a presence on the ground, but this is changing. Emerging market specialists Standard Chartered opened an office in Ulan Bator earlier this year - they declined to be interviewed for this article.

And in February Goldman Sachs bought a 4.8% stake in Ulan Bator-based Trade & Development Bank (TDB) - and it's easy to see why investment banks are interested in the North Asian State. In March TDB issued a five-year bond at 5.75% on the international market, raising $580 million.

This cheap offshore funding can then be swapped into tugrik (1 US$ =1,305 tugrik), says Tsengel Tumurbat, Ulan Bator-based head of research at Asia Pacific Securities. "TDB can lend that out at 10-11% in Mongolia so banks are very profitable at this time," he says. The underlying reason for this bout of international interest is resources - Mongolia has copper, coal, gold and uranium reserves on a par with international commodities powerhouses Kazakhstan and Australia.

Last year the domestic economy expanded by 17% - double that of its southern neighbour China - and this growth is about to get turbocharged by two mining developments.

Oyu Tolgoi, on the border with China, will be one of the largest copper and gold mines in the world when it comes online later this year, while Tavan Tolgoi's 6.4 billion tonnes of deposits make it one of the world's largest coal mines and it is expected to increased production from 16 million tonnes in 2012 to 40 million tonnes a year by 2020. The IMF predicts this single facility will flip Mongolia's current account from deficit to surplus as it does so.

As these large currency flows start moving across borders it means firms will have to start looking at forex risk, and how to manage it, according to Lambert.

But the country's capital markets and market infrastructure are playing catch-up to a runaway economy. The interbank market is in a nascent form and so derivatives tools to hedge risk are not yet available. "Mongolia only has a spot forex market and almost no interbank market," says Lambert.

Tugrik troubles

There may not be an active domestic bank market but there is no shortage of currency volatility. The Mongolian tugrik fell 40% against the dollar in 2008 before rebounding and it seesawed again last year, moving from 1,191 on March 31 but sliding to 1,436 by mid-January. This is partly explained by the country's sizeable trade deficit - much of which is due to the cost of the heavy-duty mining machinery required for mining projects like Tavan Tolgoi and Oyu Tolgoi.

But it's also due to the climate: according to Lambert as winter temperatures plummet to -40C, Mongolians hoard dollars to buy imported goods. Mines also stop producing and spending at mines reduces dramatically so dollar inflows fall. This seasonal affect assisted in driving the currency to these levels between August and December 2011.

But, according to Tumurbat, despite this weather-induced currency volatility, while companies were unhedged when the markets were volatile, they view it as part and parcel of doing business in Mongolia. "As companies can't hedge this risk yet it becomes part of the operating expenses," he says. In any case Lambert says a lack of experience with derivatives means companies only want to hedge their currency risk when it is falling - and hence very expensive to hedge, if that is even possible.

"Companies would say I need to now hedge my currency when it's losing 5% per day. Nobody wants to offer a hedge and get in the way of that steaming locomotive. The flipside is that when the currency plateaus at 40% depreciation from the start of the year, foreign investors want exposure to the currency and clients onshore don't want to sell the currency," he says.

Even if corporates suddenly took an interest in hedging they would be stymied by issues on the local banking sector - chiefly the absence of an active interbank lending market. There are currently 14 local banks in Mongolia, but they rarely lend to each other, according to Hyung Ju Lee, financial sector specialist, East Asia department at the Asian Development Bank in Manila.

The collapse of domestic players, Anod Bank and Zoos Bank, in 2009 is only the latest in a series of financial problems to hit the local banking sector and has left confidence in interbank lending at a low.

"In principle they can do all kinds of transactions but real transactions often don't happen. The problem is huge counterparty risk. In the last two decades Mongolia had several financial crises so commercial banks are very careful in trading with each other," says Lee. Instead they rely on the central bank for funding via the central bank bills (CBBs) auction.

These instruments are short dated and range from one week to six months. The auction is exercised every week but liquidity is shallow and pricing isn't very stable, according to Lee. This overreliance on the central bank is a barrier to the creation of derivatives like swaps and forwards as banks are unable to offset their risk in the market.

A further challenge in creating hedging structures is knowing where the risk-free rate lies in Mongolia for the tugrik. A Libor equivalent in Mongolia, the Ulan Bator bank offered rate (UBBOR) has emerged but is not yet a tradable rate, according to ING's Lambert. It is based on banks making contributions to come up with an implied UBBOR rate but it is not possible to lend or borrow at that rate.

"UBBOR gives a sense of what is going on - if contributors are nervous about the market then they will mark UBBOR up and if they are confident with the market they will mark it down. As it's not a rate you can trade on it is slightly spurious. This is more a question of interbank liquidity than anything else. If there was interbank activity at UBBOR rates then UBBOR would be a significant component of pricing credit and forward products," says Lambert.

Instead of CBBs, the policy rate and deposit rates are used as pricing indicators and bonds issued last year can be used as single, one-time points on the curve, says Lambert. But this brings its own issues due to the nascent state of the country's capital markets.

Hedging closer

"There's no secondary market and no recent issues so for last year's SME project bonds which were issued at 8% by the Ministry of Finance, are they still at 8%? With no secondary trading it is difficult to say." Clients for a tugrik hedging programme certainly exist. A coal miner getting paid in USD or RMB with fixed costs in tugrik (and therefore affected by its appreciation) or a company that imports diesel and petrol from Russia and has costs in dollars but has revenue in the local currency could both utilise tugrik hedging.

But Lambert says there are issues in offering a forex swap due to the poor credit quality of Mongolian firms, as marking such trades to market in such a volatile market can exceed the size of the credit line. Mongolian Mining Corporation, which had a recent bond issue, was rated B+ by S&P on March 14, 2012, and Golomt Bank, one of Mongolia's largest banks, was rated Ba3 by Moody's on November 9, 2011.

"You can't run a $50 million credit line with some Mongolian companies as the size of the company doesn't justify the credit. But there is an opportunity and we are chipping away at the rock face."

In theory ING could warehouse the risk but it would mean taking naked exposure on the currency for a period of time. An Isda with a daily margining collateral agreement doesn't yet exist in Mongolia. Companies need to have standard documents covering transactions that allow for margining on a frequent basis so that they stay within a bank's risk tolerance.

For international investors looking to gain access to the tugrik there are only a few options, according to Lambert. They could deposit money at an onshore bank but settlement is a problem because of difficulties in buying the local currency - and given the spate of insolvencies in the Mongolian banking sector this approach is not without risk.

Alternatively investors could purchase a Ministry of Finance local currency bond but these are very illiquid as there is no secondary market and it would necessitate opening accounts on the Mongolian Stock Exchange and with a local broker.

Or investors could make a local currency loan, but as it is unsecured there is high credit risk. Lambert says ING has been creating bespoke products for clients to gain exposure to the tugrik. He says most clients are European real money and some have been pension funds and hedge funds but he was unable to provide examples or numbers of institutions engaged in the trade.

"They want to benefit from high interest rates on the underlying risk-free rate but also as longterm investors they want high growth and exposure to the currency appreciation story."

Lambert says ING is offering different structures such as being long currency risk or both credit and currency risk. Much depends on the type of credit the investor wants exposure to - corporates or banks, for example. Tenor and currency being used to convert to tugrik are also factors that have an impact on pricing.

Last stage

"We implied a risk-free rate using a proxy - the CBB rate and the deposit rate - and then form a view of where we think the riskfree rate should be," he says. "We then apply a credit rationale to see what a borrower - corporate or bank - should pay as a credit spread over the risk-free rate.

The last stage is to build the tenors and yield curve from these reference points and then find a client to take on the risk at the given points." He adds that the structures are effectively funded forwards and so far they are going out to three years in local currency and the shortest is one year - 12 to 18 months is typical. Clients are predominantly pension funds and hedge funds that want to be long the currency and want to find assets to match their longer-term liabilities.

"With the high interest rates in Mongolia, discounting movement in the currency, if you fund at Libor or Euribor you can make some good returns. Clients are putting in .05% of their portfolio - for them it's not much and in meetings with investors they can say they are developing into Mongolia."
Time to take stock

Unlike most of its Asian peers Mongolia doesn't operate capital controls, and allows international investors free access to its domestic stock market.

But, given the country isn't even included on MSCI's Frontier Market Index - despite the presence of countries such as Pakistan and Jordan - its domestic stock market is undeveloped.

But this is changing. One of the most significant initiatives underway in Mongolia on the investment front is an agreement signed in April 2011 between the Mongolian state property company, which owns the Mongolian stock exchange (MSE), and the London Stock Exchange (LSE), to modernise the MSE. This would entail managing the exchange using the LSE's Millennium IT trading platform.

"The idea is to help develop market structure and securities law so moving from pre-funded trading to T+3 which is standard in all modern economies," says a spokesman at the LSE in London. The scope of potential products will also include derivatives such as equity options and ETFs.

"We are also helping to broaden the number of tradable asset classes to ETFs and derivatives. At present there is no futures market. They need to have a stable base of well-traded companies before a futures market can be delivered," says the spokesman.

The impetus for the new stock exchange is to bring confidence to investors, especially foreign investors, and to allow the big new coal, telecom and banking companies to list on an exchange with the latest trading infrastructure.

"Putting in place fully electronic trading and a much stronger backbone to the system, we hope will improve liquidity and trading volume," says the LSE spokesman. Currently Mongolia's stock exchange trades for just two hours a day with a mix of voice and computer trading.

It has more than 300 stocks listed - a by-product of privatising state-owned companies - yet only 30 are actually trading, according to Lee at the Asian Development Bank. It also has other challenges as many of the listed stocks are 90% owned by a handful of private investors making them very illiquid.

"The market lacks liquidity so investors don't buy from the Mongolian stock exchange but they go and buy a portion of the company directly from the owners. Many companies' stocks are concentrated so often 90% of companies are owned by about five individuals and just 10% is floating on exchange," says Asia Pacific Securities' Tumurbat.

He adds that regulations are in train stipulating that at least 30% of a company must be free floating on exchange. But according to some, the most important step is creating transparency from more stringent reporting standards on listed companies, which will in turn lead to better and more accurate valuations of companies and encourage investors to buy shares in Mongolian companies.

"With improved valuations, better transparency and more traders, people holding major stakes could be tempted to sell shares. The new rules should improve transparency and reveal more information about companies," says Dosbergen Musaev, chief economist at Eurasian Securities in Ulan Bator.

When the new stock exchange is launched later this year and as exports increase, large inflows of foreign currency will make their way into Mongolia potentially destabilising the tugrik and Lee believes derivative tools could help to mitigate the risk.

"As Mongolia has a flexible exchange rate there is a market need to manage forex risk. If other conditions are in place such as appetite to take counterparty risk, there is also a potential to develop a derivatives market," he says.

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