The sparse population, landlocked location and extreme climate make developing Mongolia’s transportation and logistics infrastructure a prominent challenge. Deciding how to allocate the state’s limited resources is a complex question at a time when spending is needed in so many areas in order to remove the bottlenecks holding back economic growth. The state’s growing capacity to tackle these issues, the new availability of capital and the willingness of developmental institutions to help are combining to ease constraints.

NECESSITY: As they stand, those issues are severe enough to crimp economic growth. According to a 2011 UNDP report, as of 2008 transportation costs accounted for 18% of the country’s average world price for exports and 11% for imports.One example of transportation and logistics preventing profitable activity is in dairy products. There are plenty of cows in the country, thanks to herders who maintain a traditional semi-nomadic way of life, and those cows produce more than enough milk to meet domestic demand. However, that milk cannot be reliably transported to markets. It goes to waste while more expensive milk is imported from elsewhere. Housing is another example. There is a shortage of lower-income and middle-income housing, but the expense of imported materials makes large-scale building difficult. This perpetuates the housing deficit and pushes up real estate values, and subsequently goods and services prices throughout the economy.

CAPACITY CONSTRAINTS: “Transport bottlenecks are also contributing to increasing lead times for import shipments and negatively impacting the transport sector,’’ according to the World Bank’s quarterly report on the country published in October 2012. “Transport capacity constraints are likely to prove a significant impediment in implementing the massive road building and social housing plans announced by the government and private sector housing development plans.’’ Current usage statistics are another way to gauge the growth. Freight carried by rail, air and road jumped 39.7% in 2011 to 44.09m tonnes, up from 29.42m in 2010. The number of passengers carried over these networks was up 18.1% to about 296.2m, from around 250.7m in 2010, according to the National Statistical Office of Mongolia 2011 Yearbook.

RETURNS FOR INVESTMENT EXPECTED: The number of vehicles in the country, as measured by the total that have passed technical inspections by the Vehicle Inspection and Regulatory Agency of Mongolia, surged to 312,542 in 2011, up 22.8% from 254,486 in 2010.

That growth, lost opportunities past and present logistical obstacles make clear that the return on investment in transportation infrastructure for Mongolia will be significant, whether it is measured directly or through tangential effects.

That is one reason why development agencies such as the Asian Development Bank (ADB), World Bank, Millennium Challenge Corporation and others, keen to get see their investments make an impact, are eager to help build transport networks.With Mongolia’s international standing and creditworthiness improving, it is eligible for concessional and non-concessional aid, which means larger programmes and more spending on the sector. The Mongolian government has also created a development bank of its own, the Development Bank of Mongolia (DBM), which raised $580m in an international bond sale in March 2012. Some of the proceeds are earmarked for transportation spending.

The signature project for transportation is the state’s railroad plan, which will turn mineral deposits across the country into feasible mining sites by removing transportation costs as an obstacle. It will also create a potential industrial hub in the country, open up export routes, and connect disparate areas such that domestic distribution will be a more realistic proposition.

Mongolia is also hoping to add an airport in Ulaanbaatar to meet increased demand, and continue a road-building programme to connect remote villages.

DISTANCE & DENSITY: The transportation challenge is more than a function of distances, however. In the capital city, Ulaanbaatar, density is a challenge, as a city designed in the 1950s to accommodate 250,000 people struggles to cope with the needs of its current population of 1.3m people. There are approximately 170,000 cars in the city and some 120,000 property titles, according to R2 Research, a real-estate-focused investment and research firm based in the city. Natural urbanisation is compounded in Mongolia by a recent series of harsh winters, which have driven many herders into the cities looking for work, as their herds have died. The combined stress of these factors on Ulaanbaatar and its transportation network has given rise to a challenge that can no longer be overlooked..

MINING’S ROLE: The transport sector grew by 3.1% in the second quarter of 2012, according to the World Bank’s quarterly update. That compares with 14.1% in the first quarter. These statistics are heavily skewed by the development of Oyu Tolgoi, the massive mixed-minerals deposit that is one of the country’s flagship economic activities of any sort. The mine is expected to account for a third of GDP by the time it reaches full production in 2020, and building it accounted for about 70% of imports in 2011. Facilities are now complete there, and therefore growth in several economic areas including transport is likely to fall, to be replaced either in the short term or in the long run by other activities. Transportation and machinery imports fell by 29% and 8% on a year-on-year basis in parts of the third quarter, according to the statistics.

LEAD MINISTRY: The Ministry of Roads and Transportation (MoRT) is the government agency for transport and logistics. It’s departments are responsible for much of the nation’s transport oversight. The Department of Road Policy Implementation and Regulation oversees road building and maintenance, while the Department of Road Transportation Inspection and Registration supervises road transport firms. The Mongolian Civil Aviation Authority (MCAA) regulates air travel, while rail and maritime transport are regulated by the Department of Railway and Sea Transportation Policy Implementation.

The two largest railway companies are UB Railway, which is the current owner and operator of most existing railroads in the country, and Mongolian Railways, which was created in 2008 to part to fulfil the long-term vision for rail transport. MIAT is the flagship airline, and a privatisation of 49% was announced for 2013, though it was the still subject of debate at time of press.

REGULATION: Investors in the transportation and logistics sector have been paying close attention to the legal regime for large-scale projects in Mongolia in hopes of gauging the true potential and bankability of its economic environment. The government has been working to add clarity to its regulatory regime, and has made progress to the extent that foreign investors are more willing now to participate in long-term infrastructure deals than in the past. The 2010 Concessions Law clarifies how public-private partnerships (PPPs) are to be handled by clearly spelling out the obligations and guarantees that will come from government. Developing countries short on the capital needed to build their own infrastructure projects have increasingly looked to structure PPP deals to entice private-sector investment in recent years – Indonesia for example has formed several government bodies to promote PPPs and attract investors, and has created a list of shovel-ready projects. Mongolia fits in with this global trend of solving capital shortages through PPPs, but the country is a relatively new option for foreign investors, in particular outside the mining sector.

Mongolia has yet to establish itself as a reliable and safe country in which to invest, which will likely act as a deterrent to some outsiders. The hope is that three projects in particular help get the country past that stage, and that could boost outside interest in building transportation infrastructure.

The first is Oyu Tolgoi. If the country and its majority partner in the mine, Rio Tinto, manage to settle their differences over how to split the proceeds, then the mine will provide revenue to the country to make it a more bankable investment destination and also an example of its reliability as a partner to for-profit foreign firms that are interested in domestic projects.

The second is an electricity plant locally known as CHP5 (Combined Heat and Power Plant Number 5), which would be built using the PPP structure. Negotiations with a consortium of foreign and local investors were ongoing as of late 2012. “If they get this right that will really put Mongolia on the map for PPPs,’’ Shane Rosenthal, the deputy country director at the ADB’s Mongolia mission, said.

Finally, the Sainshand Industrial Complex Project will contribute to diversification, offering a range of value-added products in mining and metallurgy.

FACILITATING AGENCY: Another key government body is the DBM, which was created in 2011. With so much needed – a new airport for Ulaanbaatar, massive road and rail expansion, and perhaps even a revival of riverine systems – outside funding will be necessary. Its bonds pay a yield of 5.75% and mature after five years, according to the DBM.

There are plenty of ideas for what to do with this money, and one of the more popular ones has been to use it for railroad construction. There is also an intent to raise more funds in the future. So far, $107m has been committed to two transportation-sector goals: $100m to build a railroad from the site of the major coal deposit in the country, Tavan Tolgoi (TT), to the border with China; and $7m in support for Mongolia’s state airline, MIAT.

Other disbursements from the total have included MNT40bn ($28m) for concessionary mortgages and MT50bn ($35m) to support small and medium-sized enterprises. The rest as of late October 2012 was in short-term notes with the local lenders Trade and Development Bank and Khan Bank, and was expected to be used for road construction. The DBM told OBG that all of the money would be disbursed by the end of 2012.In late November Mongolia succeeded in raising $1.5bn in a two-part bond offering as part of a $5bn debt-issuance programme approved by the Great Khuraal. Tapping international markets is a key aspect of Mongolia’s plans to address its transportation and logistics issues, as well as other infrastructure problems and a housing shortage, all of which are issues exacerbated by the mining boom under way and serve now as impediments to broad-based economic growth.

The $580m raised in March 2012 was considered by many Mongolia’s first sovereign bond denominated in dollars and sold overseas, and therefore a benchmark for the country. A previous $75m debt sale in June 2010 is considered a private placement, and not a standard-setting event for Mongolian debt. A concern that has arisen since the DBM sale in March 2012 is how the money has been used. Mongolian politicians have made conflicting statements about the targets of the money, and as of October 2012 there was concern that too little had been disbursed. Given that interest payments to bond holders amount to $33.3m annually, investors in future bonds may be keen for confirmation that the money will be used in ways that create more revenue for the state, allowing for the debt to be paid back in full by the maturity date of March 15, 2017, and establishing the government as a responsible steward of the country’s finances. Sitting on it – reinvesting it in timed deposits at local banks, for example – would not be considered a wise use of the money, said one senior foreign finance executive based in Ulaanbaatar, or encouragement for foreign investors to snap up Mongolian bonds the next time. “The question is how close investors are going to look at what the government is doing,’’ the executive told OBG. “On the one hand, you want to see that they are using the money wisely before they go to the markets another time. On the other hand, investors may not really pay attention to how fiscally responsible the government is. Europe and the US are shaky, so that helps bonds from developing markets.’’ RAIL NETWORK: UB Railway, which owns most existing railroad assets and a portion of the rolling stock in the country, is half-owned by Russian Railways, as a result of a government-to-government agreement signed when Josef Stalin ruled the USSR. Russia continues to exercise a degree of influence over railroads in Mongolia – the US-based development agency Millennium Challenge Corporation (MCC). The MCC proposed to pay for railroad rehabilitation as part of its current development focus in Mongolia, for example, but thanks to Russian pressure Mongolia rejected that offer. Mongolia’s tracks are built to the Russian gauge of 1520 mm apart instead of the standard gauge of 1435 used in China. That means that rail cargo passing between Mongolia and China must stop at the border so wagons can be lifted from one set of wheel bogies to another, a process that can take several hours and substantially increases costs.

Additional rail capacity is considered the key to unlocking Mongolia’s economic potential, both for the ability to export minerals and to import other goods. The state approved a master plan in 2010 that has evolved since then, but what is most likely is that any expansion is tied to an agreement to further develop TT, a collection of coking coal deposits in the southern Omnigovi province. Getting this coal to market would require rail capacity, but Mongolia has a longer list of capital-intensive needs than it does capital, and so an international consortium with stakes in the coal deposit may help to bring aboard partners with the cash needed to build more (see analysis).

ROAD LINKS: As of 2011 there were a total of 7633.4 km of roads in the country, up from 6734.4 km in 2010, according to the National Statistical Office of Mongolia (NSOM). Of those totals, 4063.4 km were paved in 2011 and 3105.6 km were paved in 2010. The country’s international road connections are all part of the Asian Highway Network, which is an ongoing project of the UNESCAP to use existing highways where possible and also build new ones where necessary in order to link Asian countries together and with Europe.

In Mongolia there are three routes that are part of this network. Asian Highway 3 (AH3) runs from UlanUde south through Ulaanbaatar and then south-east to Beijing and the Chinese Pacific coast, roughly following the path of the Trans-Siberian Railway. Both it and AH4 are spurs of AH6, which bisects Russia before turning south for the Korean Peninsula and ultimately Hong Kong. AH4 goes south from Novosibirsk, through Khovd, the economic centre for Western Mongolia, and then continues south into China, through Urumqi, and then south-west toward Pakistan. A32, meanwhile, is an east-west road within Mongolia, running from Khovd, through Ulaanbaatar, to Sumber in the east of the country. According to the UNESCAP website there are plans to extend it further into China. A total of $26bn has been invested in the project across 32 Asian countries, resulting in a network of 141,000 km of roads. Because of the role these routes play in promoting trade and cooperation they are a popular target for funding from development agencies, with two of the more prominent ones operating in Mongolia being the ADB and the MCC. Of the ADB’s $667.3m of total loans in Mongolia, $264.63m, or 31.5%, have come in the category of transportation and information and communications technology, according to bank data on the country. That includes major roads, such as a plan to upgrade stretches of AH4, but also smaller ones – building feeder roads to connect individual villages to the existing network, for example. One of the larger projects to date from the ADB is a bus rapid transit system for Ulaanbaatar to run along Peace Avenue, the city’s only artery road. The MCC’s spending is also focused on transportation: the $88.4m earmarked for a 174-km stretch of the Trans-Siberian Highway accounts for 31% of $284.9m it has promised Mongolia. These projects are intended as supplements to the government’s multiple road-building programmes, such as the $3.75bn New Up Building plan, which calls for 5500 km of roads and 900 km of highways. Others involving road building include the 2007-21 National Development Strategy; the Transit Mongolia Programme, which covers 2008 to 2015; the Mongolian Road Master Plan (2008-20); and MoRT’s investments.What is unclear, however, is funding. In October 2012 the government approved a list of road projects to be financed with DBM money. According to market research from Eurasia Capital’s Ulaanbaatar-based office, most of those involved were already part of the state budget, which raises the question of whether the DBM’s money is to be used for normal government activities or for additional development.

AIR TRAFFIC: Mongolia has 23 airports, 14 of which have paved runways. There were 8590 domestic flights in 2011, up 27.3% from 6748 in 2010 and almost double the total of 4321 in 2009, according to NSOM data. Passengers carried on both domestic and international routes reached 574,000, up from 398,200 in 2010. The freight total reached 2109.2 tonnes, more than double the 988 tonnes recorded in 2010. The flagship carrier is MIAT, which was founded in 1954. It flies to Moscow, Berlin, Beijing, Seoul and Tokyo, and has code-share arrangements with Korean Air and Aeroflot. It is expected that a 49% stake will be privatised in 2013, according to B. Byambajav, the director of the Department of Strategic Policy and Planning at the MoRT. However, details have not yet been announced.

MIAT no longer handles domestic traffic, as carriers such as Eznis Airways, Aero Mongolia and Mongolian Airlines have filled that niche. Mongolian Airlines is flying to Hong Kong and Tokyo, and others are flying to neighbouring Russia and China. Mongolian Airlines plans to go further, however, with service to European capitals. New routes are opening up with Mongolia’s economic growth – in 2012 Turkish Airlines began service from Istanbul on a route that also stops in Bishkek, Kyrgyzstan (see Tourism chapter).

Demand is being driven by two main factors – the mining industry and Mongolians’ increasing spending power. As of late 2012 about 45% to 50% of revenue came from the mining sector, according to Aero Mongolia. Domestic growth is driven by the incremental rise in wealth across the country, and increasingly people from outside Ulaanbaatar are flying to the capital for shopping trips. “With the rise in middle income the demand for domestic flights is increasing steadily and airline operators need to adapt to more frequent travel patterns,’’ said Aero Mongolia CEO G Munkhbaatar. “Prices are also expected to decrease.” Efforts in the country to diversify fuel sources will help airlines with costs. According to Munkhbaatar, a tonne of jet fuel costs $1100 in China and $1350 in Mongolia. “Fuel prices are determined by Russian supply,’’ he said. “The government needs to be more active to diversify the source of fuel. China and Kazakhstan could be viable options.” Fuel was regarded as the biggest risk to cash-flow management in the sector.

AIR ADDITIONS: Chinggis Khan International Airport (ULN) is the hub, located south-west of the capital city. The airport is outdated and lacks the capacity to handle the anticipated increase in traffic. A new airport is on the agenda, and the Japan International Cooperation Agency extended a soft loan of JPY28.8bn ($362.9m) for that purpose. Local media reported the terms as lasting for 40 years, but interest-free for the first 10 years, with a 0.2% interest rate to be charged thereafter. A site has been chosen in the Hoshigt Valley in Tuv Province, and construction is slated to begin in April 2013. It is expected to be completed in 43 months. Government policy thrusts for the air market include a liberalisation in which MIAT will lose favourable conditions; it already no longer has a monopoly on international routes. The MCAA is overseeing a switch from propeller-based aircraft to jet-powered, and is spending $500,000 a year on pilot training. Looking toward the future, airlines are thinking of improving the cargo market, and MIAT is renovating an old building on the airport grounds to create a cargo terminal. The logistics market in Mongolia is in its infancy, with few services available. Even basics like warehouse space, large-scale fuel storage and parking garages in downtown Ulaanbaatar are lacking. Several private-sector efforts are under way, such as a logistics centre from DHL and another plan from the Mongolian Logistics Association. The group hopes to establish a logistics park in Choir, which is south of Ulaanbaatar on the Trans-Siberian Railway. It is aiming to gain control of a disused military airstrip nearby, renovate it and establish facilities including fuel-storage tanks, office and warehousing space, and fuel-delivery services. Legal obstacles include the lack of a law for freight forwarding, said A. Munkhbold, the president of the association.

OUTLOOK: Although obstacles present themselves across the range of transportation options, the negotiations over TT and their implications for railroad building are perhaps the most key. Those negotiations had been stalled for much of 2012, in large part because the parliamentary election of June 2012 made it difficult for the country’s politicians to take major decisions. Once the elections were settled, then Oyu Tolgoi became a focus for parliamentary debate. Mongolian politicians were promising a deal on TT by the end of 2012, but one was not imminent as of early December. Despite the challenges, a new injection of funds is set to keep new projects on track. A $1.5bn financing scheme, the Chinggis Bond, is intended to support a raft of large projects, including four for the transport sector: 1800 km of new railroad, in addition to a railway project planned along the south of Bogd Khan Mountain, new aircraft for MIAT, and hard-surface roads between the six provinces and the capital.