Investors Back Mongolia Despite Rio Mine Dispute

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Renewed unease about sovereign and regulatory risk in Mongolia - triggered by a dispute between the government and mining giant Rio Tinto over the Oyu Tolgoi copper and gold project - is on the rise but shouldn't erode confidence among longer term investors in the mineral-rich nation, said experts.

Rio and the Mongolian government held "productive" talks this week and agreed on a temporary budget for the $6.6 billion mine, according to a statement released Friday by Rio Tinto subsidiary Turquoise Hill Resources. Talks will continue this month though both parties made "progress" on issues related to costs, operating budget, project financing and management fees.

(Read More: Rio Tinto Posts Loss; New CEO to Cut Costs)

Oyu Tolgoi – which will represent almost a third of Mongolia's economy when in full production - is expected to reach commercial output by the end of June 2013. But development has been setback by wrangling over taxes and ownership of the project.

Fears over 'resources nationalism' are overshadowing the narrative with some investors fearing Mongolia's government may be revising mining contracts and the regulatory framework to extract a greater share of the royalties. "The amber light warning is still lit regarding sovereign risk although not blinking," said Jim Dwyer, executive director of the Business Council of Mongolia in Ulan Bator.

Though the government seems to be upping the ante with the dispute, Thomas Byrne, Moody's senior vice president and Asia-Pacific manager of the sovereign risk group, told CNBC that Mongolia's 'B1' rating "suggests default is not imminent."

In a related development earlier this week, the Mongolian government announced that it had annulled mining licenses held by Canada-listed Entre Gold for areas immediately surrounding the Oyu Tolgoi license.

(Read More: Miners in Mali Dodge Conflict, Risks 'Manageable' for Now)

Investor sentiment "definitely has been hurt" by the high-profile dispute in Mongolia, said Katie Jung of Mongolia Asset Management in London. But like the divisive debate over the tax increases and spending cuts needed to avoid the U.S. going off the "fiscal cliff," too much was at stake to let Oyu Tolgoi fail and "pulling out of the whole project will cost too much and will be too painful" for both parties, she added.

"This type of dispute is expected when big money is involved and suddenly people start smelling real tangible wealth," Jung said in comments emailed to CNBC. "What started out as an idea in the middle of the Gobi desert is soon going into real production. The Mongolian government is feeling pressure from the local population who increasingly feel that Mongolia is selling its wealth too cheaply."

Longer term investors, however, are unlikely to alter course, she said, and "far-sighted investors might use this opportunity to buy Mongolian assets on weakness."

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Chris MacDougall, managing director at Mongolian Investment Banking Group, added: "We feel that co-dependency and economic opportunities will far outweigh any protective sentiment allowing for 'business as usual' to resume mid-to-late summer."

June Elections Key

Mining analysts and investment managers identified presidential elections in Mongolia this June as a key reason explaining why the government appeared to be playing up national and strategic interests in the Oyu Tolgoi dispute.

"There is a lot of posturing going on as politicians seek to look tough in the eyes of the population," said Gavin Wendt, a senior resource analyst at Mine Life in Sydney. "Australia is a great example of politicians pandering to vested interest groups as they talk about 'securing a fair share' of the windfall profits from the resources boom. Mongolia's politicians are no different."

(Read More: Australia Investment in New Mine Projects at Record High)

Ultimately, Wendt said, pragmatic governments recognize that they have to engage with mining companies, "and vice versa." In Oyu Tolgoi's case, "there does appear to be some case for modifications to the current agreement, with a significant level of cost blow-outs…this provides the perfect opportunity for Rio and the Mongolian government to formulate a slightly revised deal - which at the end of the day makes them both look like winners."

The Oyu Tolgoi dispute has overshadowed an announcement by Mongolia's President Tsakhia Elbegdorj this week that the Draft Minerals Law will not be heard in parliament until after the June elections.

"We maintain our core view that post-election Mongolia will play host to a very different political and investment environment than that leading up to the June presidential election," Mongolian Investment Banking Group's MacDougall said.

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"With the Draft Minerals Law being postponed beyond the election date and the Strategic Foreign Investment Law still awaiting changes we strongly believe that the climate will be both open and supportive to business."

Until investors get the political certainty that comes with a legislative framework, "the market will remain deflated until the second-half of the year and projects requiring capital will not be able to progress until investor trust is regained," MacDougall warned.