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RUEHLMC/MILLENNIUM CHALLENGE CORP WASHINGTON DC 0370

UNCLAS SECTION 01 OF 03 ULAANBAATAR 000773 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE PASS DOC/ITA, USTR, USTDA, OPIC, AND EXIMBANK 
STATE FOR EAP/CM, EB/TPP, OES/IHA 
USAID FOR ANE CALISTA DOWNEY 
 
E.O. 12958: N/A 
TAGS: PREL EINV ETRD EMIN MG
SUBJECT: Mongolia's New Golden Hoard: Five Months After New Tax, 
Unsold Stockpiles Amount to 12% of the Economy 
 
 
SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET DISTRIBUTION. 
 
¶1.  (SBU) SUMMARY: Six short days in May saw the abrupt passage by 
Mongolia's State Great Hural (parliament) of a windfall profits tax 
on gold and copper in a process utterly lacking in consultation with 
stakeholders foreign or domestic and the public.  Just as Mongolia 
looks to large foreign investments to develop its mineral wealth, 
prospective investors have been given a rude lesson in the 
unpredictability of Mongolia's business environment.  While no 
foreign firms have yet pulled out, all are warily watchful, and many 
have modestly scaled back exploration and development.  A glaring 
technical defect in the new gold tax appears to make it 
uncollectible (the government is still arguing with itself), but 
those producing gold have largely stopped selling.  The decline in 
gold sales amounts to over 12% of the annual GDP.  There may be 
knock-on effects as miners cannot repay banks and suppliers, 
although some creative end runs around the law appear to be 
emerging.  END SUMMARY. 
 
Six Days in May 
--------------- 
 
¶2. (SBU) In a mere six days in May, the State Great Hural (SGH) 
passed a windfall profits tax (WPT)in an effort to: 1) assuage 
wide-spread public fears that Mongolia was being stripped of its 
mineral assets, and, 2) to increase revenues for new social spending 
on pensions and children.  The legislative process that birthed the 
WPT differed from anything the Embassy and businesses had ever 
encountered.  Crucial to its quick passage was the strong support of 
Speaker Nyamdorj, who ensured the bill moved along in record fashion 
in a system where legislation can take years to go from idea to 
passage.  While it was clear the bill was on a fast track, Nyamdorj 
surprised nearly everyone by scheduling a vote on the bill late on a 
Friday afternoon, at least a week before anyone thought a vote might 
come.  MPs normally open about legislation refused to share with 
Emboffs copies of the draft bill, and they categorically refused to 
discuss any aspect of it.  Many MPs privately agreed that the bill 
was bad, and that the process of approval was deeply flawed. 
However, most of these MPs, rightly or wrongly fearing a populist 
backlash, refused to act against it, either abstaining or voting for 
it.  After visibly hesitating until the last moment, President 
Enkhbayar opted not to veto the bill, but publicly criticized the 
haste and lack of transparency which characterized in its passage. 
 
The Taxing Details 
------------------ 
 
¶3. (SBU) The WPT imposes a 68% tax on the profits from gold and 
copper mining respectively.  For gold, when the price hits US$500 
per ounce, the tax kicks in on the portion of sales proceeds 
exceeding that threshold; for copper, the threshold is US$ 2,600 per 
ton.  Mining industry sources claim that the 68% tax rate, when 
combined with other Mongolian taxes, makes the effective tax 100% on 
all proceeds above the two threshold prices.  Boroo Gold, a 
Canadian-invested company which opened a large gold mine in 2004 is 
exempt from the tax under its stabilization agreement; another gold 
mine under discussion between the government and the company may 
also be made exempt.  In theory, the WPT proceeds are set aside in a 
special fund for a combination of social welfare expenditures and a 
reserve fund.  In reality, before any money drifted into the fund, 
heady back-of-the-envelope calculations of projected WPT proceeds 
were used to justify sharp increases in child money payments by the 
government and MPs of all parties eager to throw money at voters in 
advance of the 2008 elections. 
 
Whoops! 
------- 
 
¶4. (SBU) As drafted and passed, the WPT on gold is impossible to 
implement due to a technical glitch resulting from the hasty 
consideration and passage of the bill.  As introduced, the bill only 
taxed copper.  The tax on gold was added during the brief debate 
which preceded the SGH's unexpected late Friday vote.  As passed, 
the WPT requires the Tax Authority of Mongolia (TAM) to use the 
 
ULAANBAATA 00000773  002 OF 003 
 
 
price of gold on the London Metals Exchange (LME) to set the tax. 
However, no such price is available as the LME does not trade in 
gold.  TAM has attempted to remedy this mistake by using other gold 
price mechanisms -- for example, using Bloomberg's daily reports on 
the price of gold.  However, the Ministry of Justice and Home 
Affairs has refused to allow the use of pricing mechanisms other 
than that specified in the WPT law. 
 
¶5. (SBU) Still, TAM has tried to collect the gold tax, ordering both 
Mongol Bank (the central bank) and those private banks authorized to 
purchase gold to withhold the tax at point of sale.  The private 
banks have refused to collect the tax, noting the defect in the law. 
 TAM has called on gold miners to pay the tax voluntarily, a call 
miners have rejected. 
 
Fear and Loathing in the Land of Gold 
------------------------------------- 
 
¶6. (SBU) Combined with amendments to the Minerals Law passed in July 
(amendments which allow the government to take equity stakes in 
"strategic deposits" with compensation and implementation details 
still murky), the WPT has caused severe damage to confidence in the 
mining industry in the GOM's credibility.  While this attitude is 
especially vivid for those with current or potential copper or gold 
mining projects, the lack of transparency and slipshod fashion in 
which the bill was rammed through have sharply raised perceptions of 
political risk among all firms.  One mining source noted that 
calculating costs on large scale copper and gold mines have become 
that much more difficult with a government so quick to change the 
rules of the game, and added that these sorts of moves made 
financing extremely difficult and expensive to obtain. 
 
¶7. (SBU) However, investors are not yet leaving.  Miners tell us 
that they will wait and look at how the WPT and the new mining law 
are implemented.  Wary, most are scaling back exploration and 
development to avoid being caught out if the GOM alters the rules 
again. 
 
¶8. (SBU) For their part, both Democratic and Mongolian Peoples 
Revolutionary Party MPs regularly assure Western investors that they 
will not suffer from the law's new taxes, and talk about revising 
portions of the law or revoking it entirely.  However, SGH Speaker 
Nyamdorj recently told a TV audience that the SGH will not revoke 
the gold tax, and repeated calls for the miners to pay it 
immediately. 
 
Gold Sales Way Down 
------------------- 
 
¶9. (SBU) The law has had unpleasant unintended consequences for the 
GOM.  First, gold purchases by both Mongol Bank and private banks 
are down 40% to 75%, and may decline further as the year progresses. 
 Gold miners tell us that they are mining and smelting gold at the 
same pace as last year, but that they refuse to sell through the 
formal channels.  Mongol Bank reports gold purchases down nearly 50% 
from last year.  By late September 2005, the bank had purchased 
nearly 14 metric tons of gold.  By late September 2006, the bank has 
only purchased about seven metric tons -- most before May's passage 
of the WPT.  Trade and Development Bank's (TDB) CEO (protect) 
reported that his bank's purchases down some 75% from four metric 
tons for all of 2005 to one metric ton as of the end of August. 
 
¶10. (SBU) Overall, gold purchases to date are down some 12 metric 
tons of gold -- US $227 million at current prices.  For an economy 
of about US $2 billion per year, the missing gold represents some 
12.5% of the GDP.  For Mongol Bank, which counts on these revenues 
to cover foreign exchange needs, the loss is more acutely felt.  The 
bank has urgently assured miners that it will purchase without 
withholding the tax at point of sale.  However, the bank notes that 
the tax might have to be collected later. Producers have not 
responded to these calls. 
 
Hoarding and Creative Solutions 
-------------------------------- 
 
ULAANBAATA 00000773  003 OF 003 
 
 
 
¶11. (SBU) But if the producers are not selling gold into the system, 
what are they doing with it?  Are they smuggling it out?  The answer 
seems to be no, as sources at customs and from the business 
community report no large-scale attempts to send hundreds of kilos 
into China or Russia.  Rather, businesses report hoarding of gold 
dust and bullion.  For businesses dependent on gold revenues, the 
lack of ready cash squeezes their ability to cover payrolls and 
debts to banks and equipment suppliers.  TDB is concerned that some 
gold miners may default on loans to cover seasonal mining costs, 
although TDB may accept gold in lieu of cash payments. 
Specifically, miners have worked out a temporary solution with TDB 
and selected banks.  Rather than sell the gold outright, the miners 
deposit it with the bank and then take out loans secured with gold 
present at the banks.  Apparently, there has been no attempt by 
firms to take loans out on their entire annual output, but only to 
cover operational costs alone.  The interest and other transaction 
costs -- say for defaulting and turning over the gold to the bank -- 
are less than the 68 percent tax. 
 
Collateral Damage 
----------------- 
 
¶12. (SBU) The local Caterpillar (CAT) dealer (protect) reports 
similar arrears from his customers, who were advanced equipment in 
lieu of payment, and now lack the cash to pay for it.  The CAT 
dealer reports that he, too, has been offered gold for trucks but 
has been somewhat leery of taking it.  Both CAT and TDB have deep 
pockets to ride out the temporary storm but many other local 
suppliers and small banks, treading on thin financial ice, living 
from payment to payment, may find themselves squeezed by the 
temporary suspension of US$225 million in the economy. 
 
¶13. (SBU) Also, one wonders what the impact on the general economy 
if 12 metric tons of gold flooded the Mongolian market in so short a 
period.  Because gold is purchased in US dollars, the available 
supply of US currency in Mongolia might not meet the demand, causing 
unintended distortions as other merchants had to face higher 
exchange costs to cover the dollar-denominated costs of their 
imports. 
 
MINTON