Mongolia’s Khan Bank – Exciting Frontier Market Exposure via Japan

For this month’s focus piece, we travel away from the Middle East to another exciting frontier market being boosted by China’s rise – Mongolia. The country’s breakneck economic growth has been largely fueled by commodities since the 90’s. The country has vast copper and gold reserves, and the mining sector is still at a nascent stage. China imports the lion’s share of these commodities as it seeks to feed its industries – particularly electric vehicle manufacturing. As with every frontier market, this young democracy is not immune to political and economic risks. However, we have identified a rare opportunity to gain access to this relatively closed stock market through the majority Japanese-owned and highly profitable Khan Bank, which dominates the local banking sector with USD 4.3 billion in assets and a 78% market share.

A New Asian Tiger Roaring Ahead in the Commodities Boom?

From humble agricultural and pastoral roots and decades of stagnation as a Soviet satellite state, Mongolia’s economy has exploded since the 90s in a resource bonanza driven by the extraction of copper, coal, and gold. The country’s GDP per capita has more than tripled since 1990, with impressive gains in health and education to boot. Some commentators have even described Mongolia as a “wolf economy” or a “new Asian tiger.” While Mongolia’s fledgling democracy is not without the usual issues of corruption, it has been praised as an outlier in a region with few similar systems. We see the key catalysts for Mongolia’s sustained growth as surging commodities prices and a relatively friendly environment for foreign investors.

China’s insatiable demand for copper is set to only grow with Beijing’s drive to boost electric vehicle use. This bodes well for Mongolia, as China already buys 84.3% of the country’s exports as of 2021. Mongolia is estimated to have the 11th largest copper reserves in the world, a figure only set to grow as more foreign companies join the likes of Rio Tinto in exploration efforts, as disputes between the Australian mining giant and Ulan Bator appear to be in the rear-view mirror. In recent years the country has made significant gains in its balance of payments. Despite a concurrent rise in imports, as of 2021 Mongolia boasts a trade surplus of USD 2.4 billion, likely led by increasing commodity prices. This is up from trade deficits reaching over USD 2 billion in the pre-2015 era. The rush of money into the economy can only be good news for local banks, particularly for Khan Bank which dominates the country’s banking sector.

However, only 6.4% of the population is employed in mining and Euromonitor has pointed out significant opportunities for diversification, particularly in agribusiness and tourism. Furthermore, between 2021 and 2040, the urban population is expected to increase by 31.9% to account for 73.9% of the total. This will provide increased income potential and boost the consumer market, and yet again, consumer banking. Additionally, the construction sector could also benefit significantly as it participates in government tenders for infrastructure and housing projects – a key policy goal being to house the 3.2 million people (or half the population) who live in informal housing. The country’s youthful population presents an opportunity, if the government is able to boost job creation then this offers a growing consumer base. Both job creation and housing will be a priority for any future democratically-elected government if they wish to avoid popular unrest – the resultant boost to consumer banking bodes well for Khan Bank.

An expanding workforce and worsening housing shortage will likely lead to significant infrastructure spending

Key weaknesses in the country’s economy appear to be debt, inflation, and vulnerability to external shocks. Despite commitments to the IMF to reduce the fiscal deficit, with 90.0% of public debt denominated in foreign currency, the country is exposed to exchange rate depreciation. The COVID-19 pandemic has led to a deterioration in public accounts, with declining revenues and stimulus packages aggravating the already precarious situation. Improving commodities prices may help Ulan Bator balance its books and return to a budget surplus, as was achieved in 2019. The COVID-19 era showed that the government would dig deep into its pockets to appease the public, in the longer term it is likely to use an improved budget surplus to make the aforementioned improvements to housing and the job market.

Mongolian Equities Outperform but Remain Elusive to Foreign Investors

What piqued our interest in exploring Mongolia this month was how well the domestic market performed in 2021. The Mongolian Stock Exchange (“MSE”) became the world’s best performing market having soared 130%. This is not the first time Mongolian stocks have performed well. It is noteworthy that the benchmark jumped 400% in 2007 and 138% in 2010, but also fell for five straight years from 2012 to 2016.

Currently, we do not see much respite across markets, when the global economy is grappling with supply chain constraints, inflationary headwinds, and COVID-19 restrictions, and valuations remain stretched in face of an inbound recession. The MSE has fallen 22% year-to-date in-line with major market benchmarks and despite this, we do see specific opportunities that can potentially prevail in this environment and are also fundamentally sound in the longer run.

The MSE is only 30-years young and currently home to 179 stocks. There are very few foreign investors given uncertain policy outlook and sluggish commodity prices. Foreign investment accounted for less than 2% of trading. With no easy way of gaining access or exposure to this frontier market, we look towards companies across developed markets that can serve as a proxy to Mongolia. We found that there are only a handful (investable) globally, but we like Japan-listed HS Holdings Co., Ltd. (8699.T, “HS”).

Khan Bank’s Meteoric Rise and Investments from Japan

Interestingly, Khan Bank (formerly, the Agricultural Bank of Mongolia) is one of Asia’s unheard turnaround stories, from insolvency in 2000s to becoming the country’s largest commercial bank, with strong liquidity, funding, and loan book, with over 530 branches catering to 78% of the country’s 3.2 million population.

In the context of the country’s turbulent emergence from the Soviet era, the bank was burdened by bad loans from being obliged to prop up state-owned enterprises, and subsequently was placed in receivership in 1999. In the meantime Hideo Sawada (the namesake of HS Holdings), an extremely successful Japanese travel industry entrepreneur, was making made in-roads into Mongolia. As part of a re-structuring, Khan Bank was re-capitalized and nationalized by the Mongolian government with support from an American management team. The bank broke even within 4 months and in 2003, it was auctioned off to HS for USD 6.76 million. At today’s prices, HS’s stake in the bank is worth approximately USD 250 million.

HS is a Japanese conglomerate with a market capitalization of USD 301 million. HS owns various domestic and international assets, but most importantly, it holds 60% stake of Khan Bank (through two entities, see below), which had become the largest commercial bank in Mongolia with USD 4.3 billion and USD 414 million in assets and equity, respectively, in 2021. Khan Bank also earned USD 93.9 million net profit after tax last year. Khan Bank constitutes around 50% of HS’s book value of assets and about 80% of its earnings.

Potential Khan Bank IPO as a Catalyst for HS

There are currently no publicly traded banks in Mongolia, but as per Q3-Q422, the country’s major commercial banks are required to go public under a new law to diversify shareholding. There has been talk of the Mongolian government making its banking sector go public for over a decade. There are a myriad of reasons why it didn’t happen earlier, including the sector being much smaller back then; the Khan Bank IPO looks slated for June 2022 based on the amended Banking Law of Mongolia.

With the challenges facing Mongolia’s economy and poor wider market sentiment, there may not be significant interest in frontier market IPOs. Thus, the bank may come to market at a modest valuation, but for an acceptable price through the parent. The Japanese conglomerate will own <50% shortly, which serves as a catalyst for its investment.

While the banking sector may not necessarily be the best place to invest under the current macro climate, we are bullish on the longer-term growth of the economy and think this is a neat way to play at it, while HS, as a proxy to Khan Bank, is inexpensive relative to frontier banking peers.

Sources:

https://www.fsa.go.jp/en/glopac/assets/participants/current/17th_mongolia.pdf

https://www.worldbank.org/en/country/mongolia/overview#1

https://www.gisreportsonline.com/r/mongolia-oyu-tolgoi/

https://www.policyforum.net/mongolias-path-to-economic-revival/

https://kbknew.khanbank.com/files/3566da57-f8a9-4b4a-98d1-c1c7b73ada58/21%20A1.4%20AFS%20Khan%20bank.pdf

https://www.khanbank.com/mn/personal

https://khanlex.mn/khanlex-pick-up-mandate-on-khan-bank-ipo/

https://khanlex.mn/publications/proposed-amendments-to-the-banking-act-of-mongolia-may-lead-to-landmark-reforms/

https://khanlex.mn/ipo-in-mongolia-1-brief-regulatory-overview-and-2-legal-considerations-for-bank-ipos-2/

https://www.nytimes.com/2003/10/21/business/in-mongolia-a-tilt-toward-a-free-market.html