Step by step: The exchange is expected to grow rapidly in the coming years

In recent years the Mongolian Stock Exchange (MSE) has experienced solid growth, fuelled by capital inflows and foreign investment, in line with emerging economy bourses around the world. At the same time the market is constrained a by shortage of information and low liquidity. Like other frontier economies, Mongolia is in the midst of a long-term programme to modernise and scale up its securities platforms until they are on par with global standards. A recently established partnership with the London Stock Exchange Group (LSEG) and a number of upcoming dual listings are expected to improve the visibility of the Mongolian market.

EXPECTED SUCCESS: Unlike some other young bourses in developing countries, the MSE will likely see consistent success in the coming years. The exchange may not offer the best emerging-market returns every year, as it did in 2010, but investors worldwide have taken notice of its strengths. These include Mongolia’s economic potential as it continues to develop, initial public offerings (IPOs) fuelled by the mining sector and the privatisation of state companies, the added bonus of local-currency appreciation and, perhaps most importantly, the country’s proximity to China.

Because foreign investors are not allowed to buy or hold Chinese stocks, over the past decade portfolio investors have worked to find securities that will mimic Chinese securities. Mongolian stocks fit the bill. China wants resources; Mongolia is China’s neighbour and has some of the world’s last pure deposits of several crucial minerals, including gold, industrial metals such as copper, and energy-sector inputs including coal and, potentially, oil.

CHALLENGES REMAIN: Taking into account these assets, the incentive to invest in Mongolia is clear and the barriers are minimal, with Mongolian brokers being quite accessible to customers. However, the exchange’s size makes investing large amounts a challenge, as only a few stocks can be bought in large quantities. Uncertainty about liquidity – whether there are enough buyers, sellers and stocks to make trading fast and easy – is also a concern.

Transparency is also a major issue for the exchange. Markets thrive when information is easy to access, and for now the MSE does not fit that description. Data and statistics are outdated, unavailable, or sometimes contradictory. Even something as basic as measuring the benchmark MSE Top 20 Index is no simple task. For example, when the index was experiencing the fastest growth in the world 2010, international media and economic research posted total growth figures at 121%, 115% and 132%.

Underneath the obvious strengths and weaknesses at the MSE are a host of other structural problems, including a lack of custodian services and an abundance of companies whose stocks rarely trade and whose executives do not comply with reporting requirements. These are key bits of financial infrastructure required for crucial investing roles, and they are often lacking.

The Mongolian authorities are acutely aware of these challenges. The country’s leadership also understands that investors around the world are watching and eager, and that getting the MSE into shape would likely play a major part in boosting overall economic growth in the future. With this in mind, Mongolia’s master plan for its stock market goes beyond the usual plan in developing countries in which mutual funds are revitalised by corporatisation, privatisation and global strategic partners, often with a major foreign exchange in a consulting role.

PARTNERSHIPS: The MSE recently partnered with the LSEG, but the collaboration is more intensive than most such alliances. The LSEG has a three-year contract to actively manage the MSE – a creative and unique partnership that officials hope will speed up the development process by protecting reforms from entrenched interests, political interference or a plodding bureaucracy. In the spring of 2011, executives from LSEG arrived in Ulaanbaatar to put their plan in motion. They have three years to show progress, as an extension of the LSEG-MSE partnership is a possibility, but not yet certain.

GAINING CAPITAL: Mongolian companies need capital, in fact likely more than can be generated on the local capital markets. This may explain why there is a growing Mongolian presence on key foreign bourses. The challenge for the MSE is to capture as much of this business locally as possible.

Indeed, several companies are considering listing abroad as well as domestically. Chief among this group is Erdenes, a mining firm, which is expected to seek an IPO in London and Ulaanbaatar. Erdenes and other locally owned mining companies are expected to raise between $10bn and $20bn in the next several years, according to figures provided by the Trade and Development Bank (TDB), the country’s largest commercial lender. Foreign mining companies that come to the country are expected to establish a local listing as well, as the Mongolian government wants their support in the process of building up the local stock exchange. Outside of the mining sector, local companies will likely come to market for $3bn to $5bn in the coming years, according to information from the TDB.

SIZE & SCOPE: The MSE was established in 1991, when the collapse of the Soviet Union compelled Mongolia to switch from a communist to a capitalist economy. The country decided to privatise state assets through the creation of a stock market. As in Russia, many citizens initially did not understand the concept, and the small minority that did scooped up shares at low prices and ended up forming the Mongolian version of Russia’s class of oligarchs. The MSE was the world’s smallest exchange until 2010, when the Laos Stock Exchange opened its doors.

Market capitalisation reached MNT2.27trn ($1.8bn) in late November 2011, and is widely assumed to be in the midst of a long and large expansion. As of late 2011 market capitalisation was equal to around 18% of GDP, which indicates relatively low penetration even by emerging market standards. In neighbouring Kazakhstan, for example, the corresponding figure is 43%. Mongolia often uses Kazakhstan as a benchmark to measure itself against, as both are resource-rich economies, though development in Kazakhstan began several years earlier and therefore its experience is often interpreted as a possible predictor for Mongolia.

Market capitalisation on the MSE has been steady for the past two years, as there have been no IPOs since July 2008, when the direct reduced iron producer Khukh Gan entered the market. Causes of the IPO drought have included the international economic downturn and regulatory uncertainty in the mining sector, as a 2006 windfall tax on profits slowed exploration and production until the government removed the measure in 2011. There were, however, several secondary offerings during this period, including several from mining company Sharyn Gol and Hai Bi Oil, a local coal company that also focuses on oil production. Overall, funds raised through 2011 totalled MNT62.52bn ($48.8m), according to figures from CLSA, an Asia-Pacific-focused investment bank.

STRUCTURE: The Mongolian State Property Committee, a state agency that holds various government-owned enterprises, currently owns the bourse. The MSE was an equities-only exchange, the country’s first bonds were issued in 2010. However, a new trading platform, brought in at the end of 2011, does not support bond trading. The market regulator is the Financial Regulatory Commission, which was created in 2006 to regulate all financial services.

As of November 2011 the MSE hosted 336 stocks, but fewer than 20 were considered adequately liquid. Based on CLSA research, in early 2011 just three stocks had a daily trading value above $20,000. According to data from the LSEG, 20 listings account for about 85% of market capitalisation. In the last week of trading of 2011, 71 equities were active and 657,500 shares were traded on the stock exchange.

COAL CONCENTRATION: The MSE is dominated by coal mining stocks. The largest listing by market capitalisation is Baganuur, which operates the oldest coal mine in the country and contributed the most – 29% – to the market’s 2010 surge. In the top five listings, only APU, a local beverage producer, operates outside of the mining sector.

Key coal stocks include Shivee Ovoo, Sharyn Gol and Tavan Tolgoi, the latter of which is often misidentified because it shares its name with another, larger coal deposit that is also due to list soon. Small Tavan Tolgoi, as the currently listed firm is known, made the second-largest contribution to the 2010 rise, at 19%. Beyond coal, the largest contributors to growth in 2010 were APU, Mongolian Telecom and the country’s biggest stockbroker, BD Securities.

In general, the MSE remains a very inaccurate representation of the country’s economy. Most investors prefer the makeup of a stock market to mimic that of the overall economy so that investing in an index is akin to investing in an economic narrative.

However, in Mongolia there is a huge representation of mining companies and, unlike almost every other market worldwide, no bank stocks. The country’s lenders have not listed because several years ago two banks that had sold shares closed down. The IPOs were not the direct causes of these institutions’ downfall, but the financial sector remains cautious nonetheless. As the exchange continues to develop, banks – which will likely need large capital increases in order to service the growing economy in the coming years – are expected to begin to list. For now, however, lenders are more open to debt financing or listing on international markets.

Following the success of equities in 2010, the bond market grew substantially in 2011. Of the total $172m in government bonds outstanding as of October 2011, about $150m had been offered in the preceding three months. A corporate bond market is in the very early stages of development, with a few companies offering bonds jointly in Mongolia and in a foreign market. Local meat supplier, Just Agro, offered a “meat bond” in the second half of 2011 valued at MNT30bn ($23.4m), the largest bond in the country’s history and the first to be offered in three years.

Since 2010, the number of securities brokers has flourished in anticipation of additional market activity. As of October 2011 there were 63, including BD Securities, TDB Capital, Monsec, the Capital Market Corporation, Northernsec, Eurasia Capital, Frontier Securities and Mongolian investment bank MICC. Commissions and fees generally amount to about 2.5% of a transaction. An analysis by Eurasia Capital showed $210m in fees generated by brokers and other securities firms in the past two years, including listings overseas. That number is expected to increase markedly as the market expands.

One compelling argument for setting up a brokerage in the country is a law mandating that Mongolian citizens must get 10% of any IPO. The law is meant to encourage Mongolians to participate in the stock market. Recent statistics show a steady increase in accounts: from June to October 2011 an average of 10,500 new accounts opened monthly. The high was 12,156 accounts in August and the low was 9608 in June, according to Frontier Securities.

Many areas of the MSE are currently in flux. In 2012 Mongolia’s parliament is expected to debate a new comprehensive law for capital markets. After 13 of 14 relevant laws were reviewed, a final draft was prepared for parliament to vote on, according to G. Saruul, the chief regulatory officer of the MSE.

OUTSIDE HELP: When the MSE and LSEG announced their partnership in April 2011, outsiders raised their eyebrows at the nature of the deal. Essentially, the MSE had outsourced management of the exchange, with LSEG executives currently in control of the day-to-day operations of the MSE. They also have a remit to implement the plan that has been set out to reform the exchange. This goes beyond the more common consultancy role usually played by the expert partner in similar deals.

“It is a very broad strategic partnership,” said Kh. Altai, the CEO of the MSE. “First of all, the LSEG is involved in the daily management of MSE, second, the LSEG will bring in its technology and IT infrastructure, Millennium IT, and third, together with our colleagues from London, we are working to improve the rules and regulation of the capital markets.”

With LSEG executives at the wheel, the long-term plan for the MSE first calls for a new trading platform. The Millennium IT system, which is currently in use at the LSEG, was expected to be installed and operational by 2012. The new platform implies an evolution in trading, as the settlement of trades will now happen within three days, or on a T+3 basis in market terms, instead of immediately. That means once a trade is agreed on the involved parties have three days to swap shares for money. Though this may sound slower than the current system, T+3 is the global standard because it gives each side time to come up with the money after the trade has been completed, which is more attractive than Mongolia’s current T+0 system, which requires buyers to prefund their exchange accounts before trades go through. Because most investors do not want their money to be locked up (earning no interest) while they decide which shares to buy on the MSE, the need to pre-fund an account serves as a disincentive.

“The LSEG is bringing in definitions of issues that have not been addressed before and is pushing us to think about how they will be regulated,'' said S. Narantuguldur, the managing director of Khan Investment Management, one of the first Mongolian equity funds established overseas, focusing exclusively on Mongolian stocks.

The plan includes establishing market-support organisations such as custodians and clearing houses, membership rules for brokers, as well as lining up insurers and pension funds to play the role of institutional investors. Additionally, rules and regulations are expected to be overhauled, and Mongolians working in the relevant government agencies will be trained. This last initiative will include MSE employees, as well as those at the Financial Regulatory Commission and other related institutions.

NEW RULES: Although the new capital markets law is currently in flux, the LSEG’s Damitha Cooke told OBG that the bulk of the most pressing changes could be implemented through regulations instead of through the new law, which implies a faster pace of reform. Cooke also said the development of a secondary market for bonds is on the agenda.

Once the basic building blocks of a healthy capital market are in place, the MSE is expected to look to privatise by 2014 or 2015, Bill Gorman, a former LSEG executive, said in June 2011. This would be followed by a period of expansion of trading into options, derivatives, exchange-traded funds and other advanced tools. It remains unclear how the relationship between the MSE and the LSEG will progress once the current three-year contract expires. According to Saruul, the LSEG has offered to buy a stake in the exchange and the government is considering this.

UPCOMING OFFERINGS: According to recent LSEG projections, the existing market capitalisation of slightly under $2bn could potentially reach $45bn in the next few years on the back of a few key IPOs, including those for Tavan Tolgoi and Oyu Tolgoi, the sites of the country’s largest mining projects, as well as the IPOs of several other smaller mining companies, the state airline and the state telecommunications firm. By early 2012, the MSE is expected to have boosted listing requirements, modernised procedures for IPOs, and perhaps to have cut down on the number of listed firms that trade rarely, all moves that would increase the bourse’s efficiency.

The main event in 2012 is expected to be the IPO of Erdenes-Tavan Tolgoi. The company’s parent, Erdenes MGL, is a government agency tasked with the development of the country’s 15 largest mines and is in need of capital to carry out this mandate. Consequently, the company plans to launch separate public offerings for each of the mines as they progress.

The first project, at Tavan Tolgoi, will mine the world’s largest undeveloped coal deposit. Nearly half (49%) of the site has been awarded to a consortium of private firms, with the other half being retained by Erdenes MGL. Initial production at Tavan Tolgoi has started, but capital will be required to get to the expected production of 15m tonnes per year.

The plan to offer the IPO on the London exchange reflects the perception that Mongolia is too small to be able to capitalise such a project alone. The joint listing also ties in with the MSE-LSEG management contract. While there were plans to float the company’s shares on the Hong Kong exchange, this has been dropped, due to the government’s plan to give citizens shares ahead of listing, which contravenes Hong Kong’s regulations. In the future, IPOs are likely to come from mining companies as well as from the government, which has earmarked some 50 state-owned enterprises for eventual privatisation.

OUTLOOK: The MSE is small, but the bourse has attracted interest from outside the country. Hong Kong listings, such as the Mongolian Mining Corporation, are gaining popularity, as are stocks such as Ivanhoe Mines, the Canadian-listed company that is developing the Oyu Tolgoi copper and gold deposit. New funds are also emerging: the Khan Mongolia Equity Fund was launched in August 2011 to capitalise on growth opportunities in equities, for example, and Asia Pacific Investment Partners has been raising funds to issue an IPO for its Mongolian investment company, which has plans to develop a property fund, a cement factory and a finance company.

With keen interest from emerging-markets investors worldwide, Mongolia expects rapid development in its capital markets. If the MSE proves that it can keep up with internationally renowned bourses, it seems likely that global investment cash will contribute to substantial growth in the coming years.

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The Report: Mongolia 2012

Capital Markets chapter from The Report: Mongolia 2012

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