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Long-Term Rating On Mongolia Lowered To #B+# On Weaker External And Debt Outlook Stable

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Standard & Poor's--29 Apr--Standard & Poor's
OVERVIEW

Mongolia's external and debt profiles have weakened.We are lowering our long-term sovereign credit rating on Mongolia to 'B+' from 'BB-'.At the same time, we are affirming our 'B' short-term sovereign credit rating on Mongolia. We are also lowering our transfer and convertibility assessment on Mongolia to 'BB-' from 'BB'.The stable outlook weighs possible faster improvements in the business environment and fiscal management against potential shocks in external demand and slower-than-expected foreign direct investment inflows.

RATING ACTION

On April 29, 2014, Standard & Poor's Ratings Services lowered its long-term sovereign credit ratings on Mongolia to 'B+' from 'BB-' and affirmed the 'B' short-term rating. The outlook on the long-term rating is stable. At the same time, we lowered our transfer and convertibility assessment on Mongolia to 'BB-' from 'BB'.

RATIONALE

We lowered the long-term rating on Mongolia to reflect the country's weakened external and debt profiles. Weak inflow of foreign direct investment (FDI) and lower exports contributed to a sharp decline in the country's gross official foreign exchange reserves over the past year. These trends weakened Mongolia's external balance sheet beyond what we had expected earlier, resulting in increased external risk over the next three years and highlighting Mongolia's exposure to shifts in FDI. Meanwhile, off-budget spending also raised government debt above levels we had expected previously. Mongolia's external risk is high. We project the country's external financial needs to be about 119% of the sum of current account receipts and usable reserves on average over 2014-2016. Mongolia's volatile terms of trade add another layer of external risk to this country, where minerals dominate exports. Moreover, as the country's external liabilities increased sharply, Mongolia is more exposed to the shift of FDI. However, as foreign investors become more attracted by the country's business-friendly laws, and as cross-border transportation improves, we expect FDI and exports to rise again. We forecast increases in exports and FDI as helping the gross official foreign exchange reserves rebound 50% by 2016 from the end of 2013 and lowering the narrow net external debt gradually to 83% of current account receipts by 2016, from 101% in 2014. Mongolia's governance and policy effectiveness is weak, in our view. The government's more business-friendly investment law approved late October 2013 has been slow in attracting foreign investors, in our opinion, because of Mongolia's past record in policy shifts. However, we believe the government is likely to improve policymaking and implementation over the next three years, which will benefit investments and the economic ties with neighboring countries--Mongolia's key export destinations and sources of FDI. However, the absence of a majority party in parliament may constrain the extent of improvements. Mongolia's fiscal flexibility is weak. We expect the Fiscal Stability Law that was implemented 2013 to lead to a gradual strengthening of fiscal discipline without cutting fiscal spending in a disruptive way. Accordingly, we project the average yearly increase in general government debt to be about 4% of GDP over 2014-2016, provided the government draws down some bank deposits to finance its fiscal deficit. The government's fiscal flexibility is constrained because of its significant reliance on the volatile mining sector for revenue and the notable shortfall in basic services and infrastructure across the country. Mongolia's underdeveloped economy, with a low GDP per capita, constrains the government's revenue base and its room to maneuver policy to support its creditworthiness in a downturn. We estimate the country's GDP per capita at US$4,071 in 2013. Mongolia's strong growth potential offsets some of the weaknesses in its sovereign creditworthiness. We expect the long-term trend growth of GDP per capita in Mongolia to be 8.4% in 2014. Mongolia's monetary policy puts economic growth ahead of keeping inflation low, in our view, which limits the country's monetary flexibility for attenuating economic or financial shocks down the road. The parliament can effectively define monetary policy, indicating the central bank's lack of independence. Inflation in 2013 exceeded the central bank's target of 8%. We expect inflation to be about 10% over the next three years. The country's general government debt is largely neutral to the sovereign creditworthiness, although the debt profile has become much weaker than we expected. We estimate the net general government debt to be about 37% of GDP at the end of 2014, gradually improving to about 34% by 2016. Meanwhile, we expect the interest expense of general government to remain below 5% of revenue over 2014-2016.

Our local currency rating on Mongolia is equal to the foreign currency rating, because of the central bank's lack of independence in its monetary policy. The transfer and convertibility assessment reflects our opinion that the likelihood of the sovereign restricting access to foreign exchange needed by Mongolia-based non-sovereign issuers for debt servicing is slightly lower than the likelihood of the sovereign defaulting on its foreign currency obligation.

OUTLOOK

The stable outlook weighs possible faster improvements in the business environment and fiscal management against potential shocks in external demand and slower-than-expected FDI inflows. The government may also tap bilateral or multilateral support in response to external shocks, which supports the sovereign creditworthiness. We may lower our rating if the pace of improvement in policymaking and implementation falls significantly short of our expectations for the promotion of FDI and exports, resulting in much higher external risk than our projection.

We may also lower the rating if the government resorts to stronger fiscal spending and fast credit expansion in response to further external shocks, thus worsening the fiscal profile and increasing the risk of correction in the financial system. We may raise our rating on Mongolia if the government strengthens its policymaking and implementation, leading to significantly faster improvement in its fiscal and external profiles.

In accordance with our relevant policies and procedures, the Rating Committeewas composed of analysts that are qualified to vote in the committee, withsufficient experience to convey the appropriate level of knowledge andunderstanding of the methodology applicable (see 'Related Criteria And

Research'). At the onset of the committee, the chair confirmed that theinformation provided to the Rating Committee by the primary analyst had beendistributed in a timely manner and was sufficient for Committee members tomake an informed decision.

After the primary analyst gave opening remarks and explained therecommendation, the Committee discussed key rating factors and critical issuesin accordance with the relevant criteria. Qualitative and quantitative riskfactors were considered and discussed, looking at track-record and forecasts.The chair ensured every voting member was given the opportunity to articulatehis/her opinion. The chair or designee reviewed the draft report to ensureconsistency with the Committee decision. The views and the decision of therating committee are summarized in the above rationale and outlook.


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