First steppes for Mongolian derivatives market


First steppes for Mongolian derivatives market

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First steppes for Mongolian derivatives market

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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 year 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).

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 turbo-charged 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, one of the world’s largest coal mines, is expected to increase 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, hitting 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 effect assisted in driving the currency to these levels between August and December 2011.

But, according to Tsengel Tumurbat, head of research at Asia Pacific Securities in Ulan Bator, 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.

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