Fitch Ratings - Hong Kong - 15 May 2023: 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

Strong Growth, External Vulnerabilities: Mongolia's ratings are underpinned by favourable medium-term growth prospects and high per capita income relative to 'B' rated peers. The ratings are constrained by the country's high reliance on external funding and commodity exports to China amid high external debt and low foreign-exchange reserves. Mongolia scores well on World Bank Governance Indicators relative to 'B' peers, but has suffered from political volatility around issues of resource nationalism.

Growth Rebound: We forecast real GDP growth of 5% in 2023, similar to 2022, on stronger mining activity and steady domestic demand. Growth will likely accelerate in 2024. Coal exports are rebounding after China's removal of border pandemic controls. Export capacity will rise further once cross-border rail links become fully operational in the next one-two years. The strategic Oyu Tolgoi copper mine's underground phase started production in March 2023, although most of the volume gains will only come from 2025. Other mining and infrastructure projects could support medium-term growth.

External Finances Stabilising: The export rebound is helping rein in the current account deficit (CAD), which we expect to shrink to about USD1.7 billion-1.8 billion (about 9% of GDP) in 2023-2024, from about USD2.3 billion (over 13% of GDP) in 2022. We expect inflows of FDI to cover the CAD. Official foreign-exchange (FX) reserves recovered to USD3.7 billion in April 2023, from a trough of USD2.7 billion in August 2022, while bank deposit dollarisation stabilised at 37% of total deposits in March 2023, having risen from 24% at end-2021.

External Finances Remain Precarious: Net external debt, at 160% of GDP in 2023 will be around 6x the 'B' median, although over 30% of this is intercompany lending (FDI), and over 20% is the government's bilateral and multilateral loans on concessional terms, both of which we expect will continue to be stable sources of funding. Reserve coverage ratios, though improved, remain weaker than the 'B' median. Gross reserves are supported by about USD1.7 billion in swap liabilities to the People's Bank of China, which we expect to be rolled over, and similar amounts of FX liabilities to domestic banks.

Maturity Management: Just over USD150 million in government external debt is due in the rest of 2023, with the proceeds of a USD650 million issuance in January mostly used to repay and exchange bonds maturing in May. The Development Bank of Mongolia (DBM) has set aside reserves to repay a JPY30 billion (USD220 million) government-guaranteed bond in December. The government is authorised to guarantee DBM bonds maturing in October (about USD437 million outstanding), which we assume will be used to roll them over. Government external debt maturities in 2024 are USD680 million.

Narrow Fiscal Deficit: We forecast general government fiscal deficits at under 1% of GDP in 2023-2024, after a surplus of 1% of GDP in 2022, reflecting our expectation that higher spending will offset the boost to revenue from the mining sector and inflation. Last year's fiscal outturn marked a significant turnaround from the 3% of GDP deficit in 2021. The government originally budgeted a deficit of under 2% of GDP in 2023, but has since raised its projection for mining revenue by over 1% of GDP.

Underlying Fiscal Stance Expansionary: We estimate that the non-mineral primary deficit will remain at around 11%-12% of non-mining gross value-added (GVA), down from 21% in 2020, but 4pp-5pp worse than in 2017-2019, largely a result of increases to pensions and child support payments legislated in a 2022 supplementary budget, costing over 3% of GDP (5% of non-mining GVA). In our view, there are no credible fiscal anchors, and impetus for fiscal consolidation will be limited in the run-up to legislative elections in June 2024.

Commodity Dependence, Risks: The outlook for external finances is highly sensitive to commodity revenues, which account for 90% of total external receipts and 30% of government revenue. For example, a 10% shortfall in coal volume relative to our baseline would imply a USD500 million (4% of GDP) hit to the CAD in 2023 and a USD100 million hit to government revenue.

Debt Declining; Sizeable Contingent Liabilities: Government debt edged down to 60% of GDP in 2022 from about 61% of GDP in 2021 on strong nominal growth and an improved fiscal balance. We expect debt to continue on a downward path broadly in line with the 'B' median, reaching about 55% of GDP by 2024, including DBM debt assumed to be rolled over with a government guarantee. However, the government has significant potential contingent liabilities, including unguaranteed state-owned enterprise debt of over 15% of GDP and the Bank of Mongolia's (BOM) negative equity position of about 7% of GDP.

Inflation Peaking; Monetary Stance Mixed: We expect headline inflation to average 12% yoy in 2023, from an average of over 15% in 2022, before moderating to 9% in 2024, slightly above the BOM's 4%-8% target. Full normalisation of trade with China and lower global commodity prices should exert a downward pull on inflation, although international sanctions on Russia are still leading to elevated import costs.

The BOM raised its policy rate to 13% in December, bringing cumulative hikes in 2022 to 700bp. However, the impact of this could be blunted by nearly MNT3 trillion (6% of GDP) in liquidity injections from the redemption in central bank bills in 2022. Government-approved customs exemptions for diesel and gasoline imports in 2Q23 appear to run contrary to the BOM's moves to tighten policy.

Banking System Stable: Non-performing loans have remained steady at about 10% of total sector loans, although underlying asset quality issues may be masked by high nominal growth, ongoing subsidised lending programmes and a moratorium on mortgage repayments, which only ended in December 2022. The BOM completed an asset quality review of domestic systemically important banks (D-SIBs), and three of the five D-SIBs have already launched IPOs to reduce shareholder concentration, meeting a BOM requirement to do so by June 2023.

ESG - Governance: Mongolia has an ESG Relevance Score 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 have in our proprietary Sovereign Rating Model. Mongolia has a medium World Bank Governance Indicator ranking at the 47th percentile.

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.

- Public Finances: Significant increase in the budget deficit or the government debt/GDP ratio.

- Structural Features: Political instability and/or major policy shifts 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: Strong and sustained economic growth and export without the emergence of imbalances, and the maintenance of a favourable business environment conducive to robust FDI inflows.

- Public Finances: Sustained reductions in the 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.

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

- Structural: -1 notch, to reflect lingering risk of political volatility around issues of resource nationalism, which could negatively impact foreign investment and mining sector exports.

- Macro: +1 notch, to reflect Mongolia's strong medium-term growth prospects, which are not fully reflected in the current SRM output and are stronger than that of peers.

- External Finances: -1 notch, to reflect Mongolia's vulnerability to external shocks, given its dependence on commodity exports to China, as well its high external financing needs and debt in the context of relatively low foreign-exchange reserves.

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 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 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 a 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, visitwww.fitchratings.com/esg.