The structural conditions for Mongolian manufacturing remain challenging for 2013, despite potential in a few niche segments such as food processing for local markets and cashmere products for exports.
The move into mass production, however, faces the same perennial constraints: Mongolia has a small domestic market, poor infrastructure, a growing minerals sector competing for labour and capital, and its neighbours, China and Korea, are world leaders in low-cost mass production. At the same time, Mongolia is an open economy, with low tariffs and limited non-tariff barriers. As such, foreign goods can easily enter from countries with economies of scale Mongolia cannot match.
In 2011 manufacturing value added as a percentage of GDP was only 7%. This compares with China’s 30% and Thailand’s 36%. The reality of the situation is not lost on the government, and the prospects for manufacturing, especially of high-tech consumer items or even low-cost assembly line products, is well understood. “It is hard for Mongolia to compete with China and Japan,” said M. Bayanmunkh, director-general of the heavy industry policy implementation and coordination department at the Ministry of Industry and Agriculture.
BLANKETS & BUTTER: It has not always been this way. During the socialist era, Mongolia had a thriving manufacturing sector that grew as the Soviet Union worked to industrialise the economy.
The country produced significant quantities of paper, matches, soap, leather goods, textiles, furniture, blankets, shoes, alcohol, flour, canned meat, sausages and butter. In 1989, manufacturing value added was almost one-third of the country’s total GDP.
When the Soviet subsidies were withdrawn, however, it all collapsed. Factories were abandoned and looted, workers returned to the countryside in a mass migration in search of subsistence incomes in herding and professionals shifted to retail and wholesale. In real dollar terms, manufacturing has never recovered, and the total value added for the sector in 2011 was just half of what it had been at the conclusion of 1989.
Despite the great odds against the development of industry locally, it has returned as a priority. The government and the people see good reason to maintain the manufacturing base. It can act as a hedge against commodity prices and help the country balance an overdependence on mining.
As well, it can keep more value at home, provide a wide range of jobs, promote increased self-sufficiency and also be the source of some export revenues. Mongolia has no illusions about being another China, nor does it want to be. But, it is aware that a manufacturing base is important and that steps can be taken to promote and preserve it.
INTERNATIONAL STANDARDS: Mongolia is open and free, and has access to global markets for both capital and capital goods, which should enable it to spur domestic manufacturing. There is no reason why it cannot have factories producing what is needed at home.
The beverages subsector is a good example of Mongolia’s potential. It accounts for half of the manufacturing sector’s nearly 10% contribution to GDP, and most investments in the sector were made in the last decade. Coca-Cola is the largest of the foreign manufacturers; it established a bottling plant in 2002 with its local affiliate, MCS Coca Cola, and saw years of volume growth in excess of 50% annually.
In 2008, having reached capacity ahead of schedule in its first plant, Coca Cola introduced more international standards and invested another MNT25.4bn ($22m) in a second facility. Pepsico, which had until then been absent from the market, responded by partnering with GN beverages in 2010 to bottle and distribute its products in Mongolia. The facility appears to have been successful enough to garner a $6m long-term loan from the Overseas Private Investment Corporation in 2012, allowing GN to build another bottling plant. Tiger is another foreign entrant to the market.
The Singaporean beer company built a $20m brewery in 2007, again with MCS, in the hopes of capitalising on changing tastes for a population raised on vodka.
The locally-owned beverage industry, meanwhile, is dominated by APU. Founded in 1924, the maker of beer, vodka and drinks was all but abandoned after the end of socialism. Over the next 20 years it was rebuilt and became a market leader, selling half of all beer and vodka consumed in the country. Rather than simply rehabilitating itself to local standards, it chose to invest in its physical plant, using equipment imported from Germany, Italy and Austria. It also uses raw materials from abroad in production.
AIMING HIGH: Mongolia may never have its own Sony or even its own Huawei, however, it is a growing and dynamic economy that can support high-quality manufacturers of goods for local consumption and limited international distribution. A number of companies have already recognised the potential and made relevant investments. For example, Just Agro, part of the Just Group, gained Hazard Analysis and Critical Control Points certification in 2012, which will bring local meats to global standards and should result in higher sales and margins domestically as well as opening possible overseas markets in developed economies.
A virtuous circle is in fact developing. Demand is increasing, with companies in possession of more funds to invest in plants, equipment and training. That improves quality, leads to still more demand and in some cases results in exports. Retailers such as Nomin are noticing that consumers are not only buying more, but that they want better products, and this is also driving investment into more modern plants and equipment and motivating local enterprises to be more competitive.
For decades, consumers were willing to make post-collapse compromises. They now feel that they can have more of what they want, regardless of the country’s location and latitude. Milk is a good example. Such is the high demand for fresh milk that companies like APU are scrambling to find ways to make more. The market no longer wants or needs so much powdered milk.
Over the past few years, domestic manufacturing has been growing rapidly, suggesting a significant and sustainable recovery in the sector. In 2011 milk production was up 119%, bread 110%, ketchup 402%, camel-wool blankets 169%, beer 127%, notebooks 114% and electric wire 857%, according to data published by Infomonglia. As per World Bank statistics, total manufacturing value added was up 32% in 2011 over 2010. And in the first 11 months of 2012 industrial output (which includes mining) was up 7.2% on year, according to the National Statistical Office.
After so many years, manufacturing is beginning to regain the ground lost after the economic collapse of the 1990s. It is still below its peak, but private money is beginning to compensate for the lack of Soviet subsidies, and the economic case for a manufacturing base has improved. Mongolians, meanwhile, are returning to urban areas as part of the consuming class.
CONCERNS: While decline in manufacturing may finally have ended, many factors stand in the way of a continued rebound. Inflation is eating away at wages, which is reducing the buying power of consumers and could start to put pressures on margins. While the gross numbers may suggest prosperity, the real adjusted numbers – with prices rising roughly 15% a year – show a mixed picture. The cost of capital is also a concern. While lending rates have fallen over the past decade, they are still running 18-24%, making it difficult for local companies to finance their businesses and compete with countries with lower rates, such as China. While the economy is booming, manufacturers are going to continue to feel constraints on investment and expansion.
Mining is both positive and negative for light manufacturing. On one hand, it will provide significant direct funding for industry, as people with mineral wealth seek investments, as the government deploys its tax revenues and as workers spend more freely as their incomes increase. On the other hand, mining may also hurt manufacturing. It has the potential to crowd out factories in the financial markets as mining will likely offer higher returns, and could suck up labour, push up wages and skew the demands of the labour market.
Indeed, staffing is already a problem. Mongolians are often unwilling to take the toughest of factory jobs, and North Korean labourers have been imported to do the work. As the government begins to distribute more mineral wealth to its citizens via subsidies and higher paying jobs, matters look set to get somewhat worse. Few Mongolians in a booming economy will want to work in factories for factory wages.
TOP PRIORITY: Manufacturing is a priority for the government. As with agriculture and education, it is an area towards which the state must deploy its mining wealth in order to balance and even out the country’s economic growth and create a steady stream of earnings for the future. Manufacturing is also directly relevant to the mining sector and certain manufacturing capabilities need to be developed to service that industry.
Building materials is one such industry to mention. As the mineral booms resulted in the construction of infrastructure and buildings, demand for cement exploded. The World Bank estimates that the construction sector grew some 130% in the first quarter of 2011 and that cement sales doubled between 2009 and 2011.
For the government, industry is most important for the value it adds and keeps in the country. Authorities are aware of the fate that awaits the nation if resources are simply shipped elsewhere. The country will make money, but the greatest share of the profits will go to those who process the materials. This will expose Mongolia to the full brunt of the commodity cycle. The downturns directly hit those dependent on the sale of raw materials, whereas those who both mine and use the raw materials can benefit somewhat from falling prices. Mongolia is realistic about what it can do, but it would like to get a piece of the high-margin business.
“It’s a bit hard to produce finished goods,” said Bayanmunkh. “But we want at least to add value.”
CASHMERE VALUE CHAIN: The country has long been trying to encourage more cashmere manufacturing at domestic factories. After the economic collapse in the 1990s, order broke down and herders started to sell their wool directly to Chinese traders. This route to market has remained the rule, and it is estimated that about half of all raw cashmere leaves the country before being processed, mainly in China. Some local manufacturers that lack spinning capacity will then import cashmere yarn from China from which to make garments.
To improve the value chain, the government and foreign donors have made loans to local companies so they can upgrade their production facilities. In 2011 the European Bank of Reconstruction and Development (EBRD) provided a $5m loan to Gobi, the cashmere company, to improve quality and increase capacity. The funds were to be used to purchase spinning, knitting, linking, weaving and finishing equipment. The EBRD also lent $800,000 to Ezio Foradori, a local company that specialises in cashmere garments. The money was to be used for expansion and to improve quality. The hope was that the company would be able to sell its products in the West under its own name.
The Mongolian government has offered loans as well. In June 2011 parliament passed a resolution approving the issue of MNT300bn ($240m) in bonds and the loaning of MNT100bn ($80m) of the proceeds to cashmere companies. Of the rest, MNT150bn ($120m) would go to small and medium-sized enterprises and MNT50bn ($40m) to herders. The government is in part focussed on getting, or regaining, some of the value chain that is in China so that cashmere does not have to do a round trip, Mongolia-China-Mongolia.
“The government policy is to support and provide assistance to companies that do spinning,” said B. Battsetseg, senior officer at the department for policy coordination of light industrial policy implementation at the Ministry of Industry and Agriculture.
CAPITAL FOR CASHMERE: The 2008 Asian Development Bank (ADB) Rural Development Project also supported the cashmere industry. The $49.7m programme backstopped 50% of loans made by banks to local agricultural businesses for the purpose of enhancing the sector’s value chain and provided grants for infrastructure development. A total of 13 companies received loans, including those involved in wool and cashmere production, leather processing and meat processing. The sense is that it is primarily the shortage of funds at reasonable rates that stands in the way of these companies succeeding and becoming competitive, and that making the right investments would allow them to take more of the market (see analysis).
“The shortage of capital is one of the bottlenecks for all the companies except those in mining,” said Ya. Narmandakh, project coordinator of the Agricultural and Rural Development Project. “We hope that this company can now compete with Chinese cashmere,” added D. Bagaajav, business advisor for the ADB project, referring to one of the loan recipients.
FABLESS: Some new areas are also being explored. Though its location and poor transportation infrastructure make Mongolia ill situated for the development of much manufacturing, it does have some advantages that might make it an appropriate place for other industries. For example, because the fibre-optic cable running from Asia to Europe goes through Mongolia, the country has some of the best internet connections in the region. This could make it an appropriate place for fabless manufacturing, the design and sale of computer hardware, and the outsourcing of the actual manufacturing. It is a model that eliminates the parts of the process that are particularly difficult to do in Mongolia and leaves that which can be done there. Fabless manufacturing has attracted the interest of the government because it calls for investment into design capabilities and allows the country to immediately utilise those capabilities despite the significant transportation bottlenecks that exist.
PROCESSING INDUSTRIES: The primary focus for the country and its government with respect to manufacturing is the development of the resources processing industry. By building up this sector, it hopes to keep raw materials from being extracted and exported wholesale to other markets and hopes that the profits and better jobs that come from working higher up the value chain will remain in the country. The Sainshand Industrial Complex is the main project of this kind. It designed to process the resources taken out of Oyu Tolgoi and Tavan Tolgoi (see analysis).
Another such project is the rehabilitation of the Darkhan Metallurgical Plant. The Darkhan region, north of Ulaanbaatar towards the Russian border, was the major industrial centre of the country during the socialist period. The establishment of facilities there began in 1961 with help of the Soviet Union, Hungary, Poland, and Czechoslovakia. A cement factory, a steel factory and a leather processing plant were built, as were a number of food production units.
The area also has significant iron ore deposits. For this reason, the government has been planning to invest about MNT100bn ($79.2m) through 2015 upgrading the steel factory. Exporting ore, which is processed overseas and returned as finished product, makes no sense, according to the government.
The main problem with large-scale industrialisation comes down to economics. While it may make sense to process more materials locally, such as finished steel products, major investment will be needed. The cost of developing Sainshand is estimated at $9bn-11bn. Darkhan is currently using 40-year-old Japanese technology and can make only the most basic products. A major capital investment programme is needed if it is going to compete successfully with imports from abroad. While Mongolia should have a good stream of cash flow from mining operations, it will still need to raise capital from the international markets.
AFTER OYU TOLGOI: After the contract disputes with Oyu Tolgoi, this will be a key challenge. Even before the attempt to renegotiate the agreement, the prospects for foreign investment in manufacturing were not great. Mongolia is an open and democratic country, so in some respects it is an attractive place for foreign investors to concentrate their work.
In the World Bank’s “Doing Business” series, Mongolia ranked 76 out of 185 in 2013, up from 88. Starting a business jumped 56 places in a year, from 95 to 39. It now takes 12 days to form a company. Registering a property and investor protection also improved considerably. Enforcing contracts was 29, as it was in 2012.
Still, weaknesses remain. In the trading across borders category, the country is ranked 175, in dealing with construction permits 121, and in getting electricity 169 (it takes 126 days to get connected). Mongolia is thus still a challenging place to do business. Corruption is another cause for concern. In Transparency International’s Corruption Perception Index it ranked 94th.
The legal framework, meanwhile, may hold back the planned mega-projects. While basic contracts are enforced and investors are protected, some of the investments are sizeable and will require a measure of public and private cooperation. This will be a challenge. The disagreement on Oyu Tolgoi has damaged confidence, and the relevant statutes are largely untested.
The Law on Concessions became effective in 2010, and it is a global best practices document, drafted using UN and European models. It includes all the basic internationally known structures, and it is open and flexible. Almost anything can be done on either a public and private basis. Still, legal practitioners note that the stability of the legal environment must be considered by investors regardless of how good the law may look.
OUTLOOK: If Mongolia gets the basics right, it can have a strong and healthy industrial sector. Domestic demand is climbing. Quality is improving. Interest rates have, over the long term, been falling.
Moreover, foreign investors, while for a time cool on the country, are nevertheless still interested and willing to consider commitment to Mongolia. As for the government, it appears ready to invest in the sector to guarantee that the economy does not become completely dependent on commodities.
It is possible that the country’s industrial sector will thrive over time. If the programme to improve cashmere manufacturing and the investments to raise the quality of meat production work, exports of manufactured goods could become a meaningful part of the economy. Merchandise exports have already doubled in two years. As long as laws are enforced and Mongolia keeps moving up the rankings, anything is possible.
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