Indicators point to improved prospects for resolution of Mongolia's Oyu Tolgoi dispute but underlying risks persist

Turquoise Hill Resources, which owns 66% of Oyu Tolgoi LLC and is itself a 51%-owned subsidiary of Rio Tinto, announced on 22 September that the government had reduced the amount of tax Oyu Tolgoi was being called upon to pay from approximately USD127 million to USD30 million. In a statement, Turquoise Hill said that the ruling was "welcome" but that "aspects… require further clarification". When the dispute emerged in June, Turquoise Hill stated publicly that the broader dispute over Oyu Tolgoi would not be resolved before the tax dispute (see Mongolia: 26 June 2014: Failure to resolve Oyu Tolgoi dispute highlights increased downside risk for Mongolia's economy and investment environment). Given that the government's tax claim against the Turquoise Hill subsidiary appeared to violate the 2009 Oyu Tolgoi Investment Agreement, it also raised the prospect of a move to international arbitration – something that would severely delay the resolution of the broader dispute.

On the same day, the company announced the completion of its feasibility study for the second phase expansion of the Oyu Tolgoi mine. The announcement is significant because the government and Rio Tinto have both made the completion of the study a prerequisite for the resolution of the dispute. Coming so soon after the announcement of the reduction of the disputed tax bill, this suggests a concerted effort on both sides to move to a broader resolution.

Positive indicators reflect changing attitudes among political leadership and public

The motivation behind the tax authority's decision to present Oyu Tolgoi LLC with the tax bill earlier this year, during the sensitive negotiation process over the second phase of the project, remains unclear. IHS sources in Ulaanbaatar, discussing the issue earlier this month, tended to reject the theory that the tax dispute was engineered by the Mongolian government as a way of strengthening its bargaining position in the broader dispute. Instead, one source noted that many foreign companies were being presented with relatively small tax demands following audits by the tax authorities as a way of generating increased revenue. It is possible that rather than being specifically targeted, Oyu Tolgoi was one of many companies being targeted this way and it simply received more attention given its prominence. Another source believed that the audit was initiated at the unofficial direction of one of Prime Minister Norovyn Altankhuyag's opponents with the aim of embarrassing him at a time when the delay in moving ahead with the project is a key political issue. Both explanations are plausible in the Mongolian context and although neither can be independently corroborated, they share an underlying assumption that is important to understanding the Mongolian business environment. This is that the lack of co-ordination between state agencies, ministries, and politicians can lead to delays and disputes emerging even when the top political leadership firmly support a project, as well as creating the opportunity for the politicisation of state agencies.

In general there has been a shift in attitudes towards foreign investment, and Oyu Tolgoi in particular, among the population and the political class. In an 8 September address, Altankhuyag explicitly connected the politicisation of foreign investment with the depreciation of the Mongolian currency and the consequent rise in the cost of living. A survey of public opinion in Mongolia published in April showed that 20.8% of respondents identified inflation as the main issue that concerned them, up from 14.6% the year before. As such, it is unlikely that the 2016 election campaign will see a repeat of the last election campaign in 2012, when Mongolian parliamentarians rushed through the Strategic Entities Foreign Investment Law (SEFIL), a piece of legislation which contributed to the sharp downturn in foreign investment and which senior Mongolian policymakers now openly describe as a mistake.

Government instability and capacity issues have the potential to undermine progress

However, notwithstanding this positive shift, there remain significant institutional challenges to the resolution of the broader dispute and the second phase of the mine. In part this is down to capacity issues within the Mongolian bureaucracy. Oyu Tolgoi is a large, technically challenging project. The recent feasibility study puts the cost of the second phase expansion at USD5.4 billion, which when compared to Mongolia's estimated 2014 GDP of USD11.3 billion highlights the scale of the project. More broadly, the Mongolian authorities continues to face capacity constraints and business legislation and regulation is often inconsistently applied.

The risk of government instability also has the potential to delay negotiations. The government's popularity has declined to the point where the potential for a change of government was being discussed openly in Ulaanbaatar earlier this month. Altankhuyag announced a reshuffle on 8 September in a move that was likely to have been aimed at forestalling a more serious challenge to his position. This is most likely to come from within his own Democratic Party (Ardchilsan Nam: AN) or from one of his coalition allies. In contrast, the opposition Mongolian People's Party (Mongol Ardyn Nam: MAN) is likely to see the continuation of an unpopular AN government as in its interests. Even without a marked deterioration in government instability, political considerations have the potential to cause further delays. For example, the commencement of copper shipments from the first phase of Oyu Tolgoi was repeatedly delayed by the AN-led government ahead of the 2013 presidential elections, in part at least to prevent any negative coverage of the project from affecting the re-election campaign of AN candidate President Tsakhiagiin Elbegdorj (see Mongolia: 21 June 2013: Oyu Tolgoi exports likely to commence following Mongolian election after second delay).

Outlook and implications

The reduction in the tax bill and the completion of the feasibility study suggests that the prospects for a resolution of the Oyu Tolgoi dispute have improved since the tax dispute emerged in June. This dispute has come to define Mongolia's reputation as a destination for foreign investment. Resolving it would mark the first step towards restoring confidence in Mongolia. Conversely, the longer the dispute persists the greater the long-term negative impact on Mongolia's investment environment is likely to be.

In June, IHS assessed that the end of September was the earliest likely date for a resolution to the dispute. The next session of the Mongolian parliament begins on 1 October and is due to run to 10 February 2015. Prime Minister Altankhuyag stated on 8 September that his government would resolve the Oyu Tolgoi dispute during this session. The Lunar New Year festival, Tsagaan Sar, commences in mid-February and if the dispute has not been resolved before this it is likely that the festivities will preclude any movement on the government side for several weeks. However, given ongoing factional infighting within the ruling party and its coalition partners, and the capacity and co-ordination issues within the government bureaucracy, there is a significant risk of further, unexpected delays to a resolution of the dispute emerging. In this context, an absence of major public statements from either side over the next several weeks would, counter-intuitively, be a positive indicator for the resolution of the dispute.