The concept of a "blue sky country" has become almost a cliche in presentations about Mongolia, the world's fastest-growing economy last year. The phrase, which evokes the Montana-like landscape of the steppe, paints a picture of sunny investment horizons in this frontier democracy rich in coal, copper and gold.
But visitors to this city, the capital of Mongolia, seldom find a blue sky today. It is smoggy, and soot rains down from the hills, as the poorest residents burn cheap brown coal to stay alive through the winter.
The investment prospects of Mongolia, a darling of the emerging markets, are similarly shifting.
In May, the Parliament passed a law that restricted foreign investment in the country's most attractive asset, its mineral deposits. The government is also taking aim at a crucial deal with the multinational mining giant Rio Tinto, a pact that many see as the foundation of the country's recent economic growth.
Now, the underlying fundamentals of the country look increasingly shaky. Mongolia faces a financing crunch, as investment dollars flowing from abroad have fallen. And revenue from coal, the country's main export, has dropped along with Chinese demand.
"There are a series of elements that have built up less-than-welcoming attitudes to Mongolia at a time when the macroeconomic situation is deteriorating," said John P. Finigan, the chief executive of Golomt Bank, the country's second-biggest bank.
Mongolia's star rose — and is now falling — with the fortunes of one company: Rio Tinto, the country's largest investor.
In October 2009, Rio Tinto and Ivanhoe Mines, a Canadian exploration company, negotiated a deal with the Mongolian government about developing Oyu Tolgoi, the crown jewel of the country's mining sector and the world's biggest new source of copper. The copper and gold mine would cost more than $10 billion to build, and the potential investors wanted assurances. Under the so-called Oyu Tolgoi Investment Agreement, taxes and royalty payments to the government would be fixed for 30 years. At the time, it was considered "the initiation of a new stage in Mongolia's history," said Oliver Belfitt-Nash, an analyst at Monet Capital, a Mongolian investment bank.
The agreement set off a boom.
Rio Tinto spent billions of dollars to buy out Ivanhoe's stake in the project and build the Oyu Tolgoi mine. Investors followed, encouraged by the cooperation between a multinational corporation and a coalition government. Some investors financed smaller mines. Others imported mining equipment or Hummers to sell to newly minted millionaires. Skyscrapers rose in central Ulan Bator.
The impact of this spending was significant in this country of only three million people. Last year — when capital expenditures on the Oyu Tolgoi mine peaked — Mongolia's gross domestic product increased by 17.5 percent, according to the International Monetary Fund. It was the fastest-growing economy in the world.
(Read More: Mongolia Strikes It Rich, But at What Cost?)
But optimism has fizzled since May. That month, Mongolia passed the Strategic Foreign Investment Law, which states that Parliament must approve foreign takeovers of assets in strategic sectors like mining and banking.
In Ulan Bator, the law was widely seen as a torpedo aimed at one deal, Chalco's takeover of SouthGobi Resources, a coal mining company. Chalco, China's largest state-owned mining company, agreed in April to buy a controlling stake in SouthGobi Resources, a Rio Tinto subsidiary, for $926 million. The next month, Chalco walked away, citing regulatory uncertainty.
Both foreign investors and local businessmen have complained about the law's lack of clarity. The rules set up the potential for severe regulatory delays, as politicians from all parties intervene in the deal-making. The government has not yet specified how the law would work in practice, but it has already affected transactions beyond the SouthGobi acquisition.
"We haven't made any new investments," said an executive at an financial company with extensive holdings in Mongolia, who spoke on the condition of anonymity. It "is a horrible law. It is very menacing and unclear. At a time when investors are scared of allocating capital anyway, it's definitely had a negative impact."
In the months after the law's passage, foreign direct investment plunged. In September, investment flows from abroad dropped 44 percent compared with the same month in 2011, according to data from the central bank.
The commodity markets are partly to blame for the financing crunch. Prices for coal and copper, the country's main exports, are lower this year.
But government policies have only worsened the problem. Ovoot Tolgoi, a large coal mine owned by SouthGobi Resources, has suspended its operations for the last six months after the failed deal with Chalco.
Tavan Tolgoi, the state-owned coal mining company, did not export coal for three months this summer. In the run-up to elections in June, the government raided the company's treasury to pay for cash handouts to the populace.
(Read More: Mongolia to Grow at 20% in 2012: Fund Manager)
The ruling party eventually lost the elections. And the policy left Tavan Tolgoi so starved for money that it could not afford to transport its coal to Chinese markets, according to a company official who spoke on the condition of anonymity because of the political nature of the matter.
The combination — the weakness in the mining industry coupled with the government actions — has hurt the country's finances. The International Monetary Fund expects that Mongolia will face a fiscal deficit of 900 billion tugrik, or $643 million, in 2012, and several policy makers in Ulan Bator expect it to widen next year.
The situation has left the government scrambling to make up the gap, putting the Rio Tinto deal directly in the cross hairs.
Last month, the Parliament approved a budget for 2013 that tries to renegotiate the Oyu Tolgoi Investment Agreement with Rio Tinto. The budget calls for 446 billion tugrik, or $319 million, of extra income from the Oyu Tolgoi mining project next year. This revenue would come from new royalty payments that are up to four times as high as in the original deal. The budget legislation refers to "when the amendment is made," as if it were already a done deal.
"We believe the recent surge in government support to renegotiate" the deal with Rio Tinto "is to meet the proposed budget deficit," Dale Choi, an analyst at Origo Partners, a private equity investor in Mongolia, said in a note last month. But revising the deal "would undoubtedly adversely impact both near- and longer-term economic growth and Mongolia's sovereign risk profile in the global financial markets."
The changes in the budget could threaten Rio Tinto's returns. Significantly higher payments to the government could make the project uneconomical, prompting the company to freeze new investment and start international arbitration.
So far, Rio Tinto and its partners have spent more than $6 billion building Oyu Tolgoi, a vast complex that gleams with state-of-the-art equipment in the Gobi Desert. But the investors have not seen a dollar in profit because the mine will not start producing copper until next year. A spokesman for Rio Tinto declined to comment.
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The two sides are in a standoff. The mining minister said at a news conference in October, "We have a strong need to renegotiate the investment agreement. If Oyu Tolgoi keep refusing, we will work until they understand and accept the changes." But the company is unwilling to accept the tax and royalty amendments proposed in the budget, said a person with knowledge of the situation. Low-level discussions between the company and the government are under way, according to people on both sides, who declined to be identified.
Now, Mongolia faces a tough choice.
The country needs the money to plug the hole in the budget. The Rio Tinto deal has also become politically toxic, and the government needs to please many members of its coalition who campaigned and won seats by opposing the agreement.
But foreign investment — the lifeblood of the economy — could dry up if Rio Tinto pulls back.
Even as pessimism about the economy and investment policy deepens in Mongolia, outside investors continue to buy into the country's "blue sky" future. Last week, Mongolia sold $1.5 billion of sovereign bonds amid strong demand.
In New York, Singapore and Hong Kong, a Mongolia delegation showed a PowerPoint presentation that featured photographs of the wide-open steppe. The first slide reads: "Mongolia: The Country with Unmatched Growth Potential."
But within Mongolia, some are wondering whether such claims match the reality.