Fitch Ratings - Hong Kong - 18 May 2022: Fitch Ratings has affirmed Mongolia's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B' with a Stable Outlook.

A full list of rating actions is at the end of this rating action commentary.

KEY RATING DRIVERS

Structural Strengths, External Vulnerabilities: Mongolia's ratings are underpinned by governance indicators and per capita income that are strong relative to 'B' peers, and favourable medium-term growth prospects. The ratings are constrained by the country's high reliance on external funding, narrow economic base predominately focused on commodity exports to China, and recurring bouts of political volatility.

Near-Term Growth Remains Subdued: Fitch forecasts growth will remain subdued this year at 1.2%, following 1.4% in 2021, despite elevated commodity prices and the re-opening of international borders after achieving high Covid-19 vaccination rates. However, coal exports and other merchandise trade have been severely disrupted by ongoing closures of the border with China, Mongolia's largest trading partner, under the former's "dynamic zero Covid" policy.

Fitch expects border disruptions to ease in 2023, although further downside risk to growth could emerge if trade disruptions with China are more prolonged. Global economic spill-overs from the war in Ukraine and supply bottlenecks from import disruptions with Russia and China are leading to inflationary pressures, which will weigh on real incomes and private consumption.

Favourable Medium-Term Growth Prospects: Fitch projects GDP growth will accelerate to 6.3% in 2023 and 6.8% in 2024, as headwinds from trade disruptions and the war in Ukraine wane, and China's demand for Mongolia's key commodity exports remains reasonably buoyant. Mongolia also has the potential to harness its generous natural resource endowments, as the underground phase of the Oyu Tolgoi (OT) mine becomes operational, and improved cross-border infrastructure connectivity unleashes more economic benefits for the country.

Progress in OT Development: The recent agreement over the strategic OT mine, in which the government holds 34%, indicates easing of strained relations between the government and foreign investors over project delays, cost overruns and taxation. We believe the agreement bodes well for the continued development of the underground phase, with potential positive spill-overs to Mongolia's export receipts, fiscal accounts and foreign-investor sentiment. However, recurring bouts of political volatility over resource nationalism weigh on the rating.

Sizable Budget Deficits: Fitch forecasts the budget deficit to widen to 4.4% of GDP in 2022 (B median: 4.7%), from an estimated 3.0% in 2021, as we assume that revenue growth will be lower than the government's baseline expectations. We forecast the budget deficit to narrow to 3.7% in 2023 on stronger revenue collection as Mongolia's economic recovery gains traction. Part of the pandemic-related social welfare spending, including an increase in child money allowance (an average of 3.1% of GDP for 2021-2022), will be maintained.

Quite High Public Debt: We forecast general government debt to increase by about 4.3pp to 65.3% of GDP by end-2022, broadly in line with the projected current 'B' median of 65.9%. About 95% of government debt is denominated in foreign currency, exposing it to shocks. Our baseline expects Mongolia's favourable medium-term growth prospects and its nascent pre-pandemic record of keeping fiscal outturns in line with approved budgets will put public-debt dynamics on a modest downward trajectory.

Vulnerable to External Shocks: Fitch expects tighter global financing conditions and geopolitical spill-overs to exacerbate Mongolia's weaker external finance profile. We project Mongolia's current account deficit in 2022 to widen to 16.3% of GDP and its net external debt burden to be large at 167% of GDP. Dependence on external marketable debt raises its vulnerability to shifts in international investor sentiment. However, Mongolia's access to external financing from multilateral and bilateral creditors provided an important cushion throughout the pandemic.

Low Reserves, Looming External Maturities: We project foreign-currency reserves at USD3.6 billion by end-2022, equivalent to about 3.2x current external payments. Foreign reserves remain low in view of the around USD1.1 billion in public external debt maturing in 2023-2024, excluding contingent liabilities under the Development Bank of Mongolia (DBM).

The DBM faces significant asset-quality pressures and has a combined USD733 million (4.1% of projected 2023 GDP) in external bonds maturing in late 2023, including a JPY30 billion (1.3% of GDP) Samurai bond carrying a government guarantee. The government has instructed the DBM to explore potential early payment of its outstanding Samurai bond obligations, which if successful, would reduce contingency liability risks for the government.

Rising Inflationary Pressure: The Bank of Mongolia (BOM) raised the benchmark policy rate by a cumulative 300bp in 1Q22 to 9% in response to geopolitical spill-overs, trade disruptions and high inflation. Fitch forecasts headline inflation to average 14.2% in 2022 before slowing to 10.8% in 2023, still well above the BOM's target of 4%-8%.

Banks' Asset-Quality Risks: Banks have provided soft loans to support employment, businesses and housing programmes under the MNT10 trillion economic stimulus package, which also fuelled inflationary pressure, in Fitch's view. Strong loan growth should support banks' profitability, but it could also mask NPL recognition and understate asset-quality issues, especially from high inflation pressure.

ESG - Governance: Mongolia has an ESG Relevance Score (RS) of '5[+]' for Political Stability and Rights and '5' for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Mongolia has a medium WBGI ranking at the 50th percentile, reflecting a recent track record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate institutional capacity, established rule of law and a moderate level of corruption.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

- External Finances: Heightened external stress, which may be evident from restricted access to external-financing sources or a marked decline in foreign reserves, potentially as a result of prolonged border disruptions with China.

- Public Finances: Failure to reduce the budget deficit and stabilise the government debt/GDP ratio.

- Structural Features: Political instability sufficient to significantly disrupt strategic mining projects or FDI inflows.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

- External Finances: The accumulation of larger foreign-currency reserve buffers and the implementation of a debt-management strategy that lowers refinancing risks and improves external debt sustainability.

- Macroeconomic: A resumption of stronger economic growth and export trends without the emergence of imbalances, and the maintenance of a favourable business environment conducive to robust FDI inflows.

- Public Finances: Narrowing of the budget deficit consistent with a declining government debt/GDP ratio.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Mongolia a score equivalent to a rating of 'B' on the Long-Term Foreign-Currency (LT FC) IDR scale.

In accordance with its rating criteria, Fitch's sovereign rating committee decided not to adopt the score indicated by the SRM as the starting point for its analysis because the SRM output has migrated to 'B', but in our view this is potentially a temporary deterioration. Consequently, the committee decided to adopt 'B+' as the starting point for its analysis.

Fitch's sovereign rating committee adjusted the output from the adopted SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:

- Structural Features: -1 notch, to reflect recurring bouts of political volatility around issues of resource nationalism, which could negatively impact the business environment and increases the risk of economic shocks.

- Macroeconomic: +1 notch, to reflect Mongolia's strong medium-term growth prospects, which are not reflected in the current SRM output.

- External Finances: -1 notch, to reflect high vulnerability to external shocks, given the country's narrow economic base, which is exposed to commodity prices and developments in China, moderate level of foreign-currency reserves, substantial amortisations on external marketable debt, and high net external debt ratios.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Mongolia has an ESG Relevance Score of '5[+]' for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As Mongolia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

Mongolia has an ESG Relevance Score of '5' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Mongolia has a percentile rank below 50 for the respective Governance Indicators, this has a negative impact on the credit profile.

Mongolia has an ESG Relevance Score of '4[+]' for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As Mongolia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

Mongolia has an ESG Relevance Score of '4[+]' for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Mongolia, as for all sovereigns. As Mongolia has record of more than 20 years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.