Fitch Ratings - Hong Kong - 28 May 2020: Fitch Ratings has affirmed Mongolia's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B'. The Outlook is Stable.

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

KEY RATING DRIVERS

Mongolia's commodity-dependent economy is facing a sharp slowdown in GDP and export growth, deterioration in the public finances and an erosion in external buffers this year due to the coronavirus shock. Nevertheless, the affirmation of the rating with a Stable Outlook reflects Fitch's assessment that the impact of the shock will be largely temporary, with the economy rebounding strongly and government debt/GDP starting to decline again in 2021. Significant downside risks are captured at the 'B' rating level, and Mongolia's strong structural factors combined with expected access to financing from multilateral and bilateral creditors provide support to the sovereign ratings.

Fitch forecasts the economy to contract by 2% in 2020, before rebounding to 7.9% in 2021. Our baseline assumes demand from China, which accounts for around 90% of Mongolia's exports, will pick up during the second half of this year. This is underscored by a gradual improvement in China's industrial production and investment spending since April. At the same time, downside risks to Mongolia's growth outlook remain amid uncertainty on how the pandemic develops globally, as well as the speed of China's recovery.

Real GDP fell by 10.7% yoy in the first quarter, driven in large part by measures to prevent the local spread of the coronavirus. This included a temporary suspension of coal exports to China during February and March, tight restrictions on international flights and railways, and strict social-distancing measures. Mongolia has seen relative success in containing the coronavirus, with 141 officially reported cases.

Fitch forecasts a budget deficit of 7.1% of GDP in 2020, up from a 1.4% surplus last year. Our forecast is wider than the government's baseline of 2.5%, due mainly to our view that the revenue decline will be more severe. In March, the authorities unveiled an economic stimulus package valued at around 13% of projected 2020 GDP. However, this includes reordering of expenditure priorities, and Fitch estimates that measures that will add directly to the budget deficit are around 4% of GDP. Key fiscal priorities include select infrastructure projects, as well as fiscal and tax relief measures. The risk of a sharp rise in pre-election spending ahead of parliamentary elections on 24 June, as was the case in 2016, has thus far not materialised, and Fitch now anticipates fiscal restraint to remain broadly intact.

Fitch projects that the fiscal deficit and growth contraction will drive up the general government gross debt (GGGD) to around 70% of GDP by end-2020, from 65% of GDP in 2019. We expect GGGD to resume its downward trend in 2021 and decline to 57% by 2024, below the current 'B' median level of 60%. Prior to the coronavirus outbreak, Mongolia had made significant progress in reducing public debt from 93% of GDP in 2016, underpinned by strong budget outcomes aided by robust growth and supportive commodity prices.

We forecast foreign-currency reserves (USD4.1 billion in 1Q20) to decline to USD3.1 billion by end-2020, equivalent to 4.1x current-external payments. The sovereign faces no marketable external bond maturities until April 2021, after a USD500 million private-sector external bond carrying a government guarantee matured in May 2020. Fitch forecasts the current account deficit to widen to 14.7% of GDP in 2020 (4.6% of GDP net of FDI, or USD645 million), before narrowing to 11.9% in 2021. Nevertheless, reserves are low and a rating weakness, particularly in view of a substantial step up in amortisation in 2021-2023.

IMF staff have completed discussions on a USD99 million loan under its Rapid Financing Instrument (RFI) to help meet the country's budgetary and balance of payments needs, and we expect IMF board approval in early June. In completing the discussions, IMF staff noted Mongolia's progress in reducing public debt and accumulating reserves under the three-year Extended Fund Facility (EFF) that expired on 23 May. The Asian Development Bank (ADB) has also recently approved new loans and a grant worth USD233 million in budget support and project financing. The authorities are also exploring a possible follow-on program to the EFF, as reflected in the IMF's media statement following staff discussions on the RFI.

The Mongolian parliament unanimously passed a resolution last November requiring the government to review ways to improve the Oyu Tolgoi investment agreement. Fitch believes this underscores the longstanding strained relations between the government and Rio Tinto over taxation, delays and other aspects of the large-scale copper mining project, as well as the potential for heightened political volatility around resource nationalism. However, Fitch does not believe this will lead to a material disruption in Oyu Tolgoi's development, given the significant implications this would have for Mongolia's macroeconomic stability, and the considerable investment that Rio Tinto has already deployed into the country.

Mongolia's rating is supported by World Bank Governance Indicators (WBGIs), GDP per capita, and World Bank Doing Business rankings that are stronger than the 'B' range median. GDP growth potential is high. However, net external debt is high at 176% of GDP at end-2019.

Fitch has a negative sector outlook on Mongolian banks, which reflects our expectation that the pandemic will put additional pressure on banks' asset quality. The banking sector non-performing loan ratio stood at 10.9% as of end-April 2020. A combination of the Bank of Mongolia cutting interest rates by 200bp so far in 2020, slower credit growth than previously expected and a higher credit-loss provision is likely to put pressure on banks' profitability.

ESG - Governance: Mongolia has an ESG Relevance Score of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the WBGIs have in our proprietary Sovereign Rating Model. Mongolia has a medium WBGIs ranking in the 53th percentile, reflecting a recent 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.

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 to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- 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.

- Structural Features: -1 notch, to reflect uncertainty ahead of forthcoming parliamentary elections and strained relationships with major foreign investors, which increases the risk of political and economic shocks.

- Macroeconomics: +1 notch, to reflect Mongolia's strong medium-term growth prospects. The committee introduced a new positive notch because it believes strong medium-term growth prospects are not reflected in the current SRM output. The SRM output has fallen by one notch since the last review mainly owing to the impact of the coronavirus shock on GDP growth, which Fitch believes will be temporary and which would otherwise add excessive cyclicality to the rating.

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.

RATING SENSITIVITIES

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

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

- A reduction of fiscal deficits that puts GGGD/GDP back on a downward trajectory after the increase in 2020 related to the coronavirus shock.

- 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.

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

- Evidence of heightened external financing stress, for example if official multilateral and/or bilateral inflows are not forthcoming or in the event of a marked decline in foreign reserves.

- Failure to reduce the budget deficit and stabilise the GGGD/GDP ratio after the increase in 2020 related to the coronavirus shock.

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

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Public Finance 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.