Sunday, June 20, 2010

Questionable Democracy – In ? We Trust

Mongolian President, the Honorable Ts. Elbegdorj addressed the Fair Mineral Development Roundtable hosted under the auspices of his office and the World Economic Forum this week. Would that more heads of state have the ability to articulate sovereign and public interest with the clarity and pragmatism evidenced in his remarks! Rarely have I seen as concise and unqualified a statement from a public servant than the remarks made by the Hon. D. Zorigt, Member of the State Great Hural and Minister of Mineral Resources and Energy when commenting on the mineral laws of Mongolia. In both instances, the refreshing clarity centered on the stated recognition that “best practice” laws drafted over the last 20 years, in consultation with foreign interests, have exposed Mongolia to significant disadvantage. Only now are Parliament members and the public and private sector realizing the full extent to which the laws were drafted to favor mineral and energy extractors to the detriment of the public interest.

For readers of InvertedAlchemy, the irony will not be lost that, during the same time as my meeting with the leaders of Mongolia, BP’s CEO was foundering in his testimony before Congress on the nature of liability and responsibility of the extractive industries when things go poorly. Further, the government of Australia is fanning populist flames to support their proposed revised tax scheme on mining companies which, according to analysts from Morgan Stanley, will jeopardize many future developments. And, I’m currently writing this entry from Papua New Guinea where the Prime Minister (yes, the same one that’s been heralded as a hero for his REDD campaign to placate CO2 polluters) pushed through an amended environmental law that greatly reduces accountability for polluting the sea. It’s almost beyond belief that the government of Papua New Guinea, under the glaring light of the BP global brand debacle, would choose such poor timing to make rules less stringent.

Four years ago, I stated that my analysis of the global markets indicated that by 2010, the U.S. dollar would be in such weak condition and the euro would be inadequate to pick up the slack so as to open the possibility of a move by China to push a commodity basket-backed reminbi. Well, the International Herald Tribune today, Friday, June 18, 2010 loudly confirmed that analysis. Chinese leaders are warning the G20 not to bring up currency at the upcoming meeting or face “serious global economic consequences”. The U.S. and Europe have finally awakened (albeit, too late) to the error in the Jack Welch era out-sourcing wave. You see, the “we’ll always be the innovator” thesis that justified the risk of outsourcing manufacturing assumed that resource scarcity would be controlled by Western markets. However, quite suddenly, the tables are turning. Beryllium, cobalt, copper, gallium, indium, germanium, gold, graphite, magnesium, platinum, tantalum, tungsten, and uranium – all minerals that were safely controlled by post-Bretton Woods arrogance are now controlled by China, Russia, Congo, Brazil, Mongolia and others who were left out of the club for the last 50 years. It would not be surprising to see China reinstate a gold or hybrid metal standard as it seeks to manage its risks on dollar and euro historical exposures. And when a key infrastructure development project to what could be the world’s largest gold / copper operation in Oyu Tolgoi in South Gobi, Mongolia is a 105km road to the Chinese border, it doesn’t take a PhD in geopolitics or economics to realize that commodity control is about to take a serious and unquantifiable turn.

It was, however, at the Ulaanbaatar roundtable this week, when I saw galvanized a series of critical information failures which led many in the roundtable to revert to basic questions about the adequacy of representational democracy in countries rich in minerals and energy resources. Questions of nationalization vs. “free-market” were met with NGO mistrust in the transparency of asset dispensation. “Trust” and gold, copper, and coal, seemed to make poor bedfellows.

I will summarize five themes where I observed situations in which the “wrong” questions and assumptions gave rise to heated debate around the “wrong” answers.

First, lack of understanding of the cost of equity. As presented in the meeting, the Mongolian government purchased equity in the Oyu Tolgoi LLC (“OT”) mining operation. The equity was purchased with debt which is running up interest well in advance of any productivity. Not unlike several of the Papua New Guinea and other national cases where we’ve seen government equity purchases debt financed by the likes of the Commonwealth Development Corporation, the European Investment Bank, and the World Bank and its sister organizations, the belief is that somehow equity means benefit sharing. Nothing could be more misleading. Few things could do more harm with respect to mal-aligning public expectations and actual outcomes. Mongolia’s interests are in the LLC operator – not in the corporations which will manage the profits and see their stocks rise on the back of the country’s extracted wealth. Ivanhoe Mines and Rio Tinto – and their shareholders – will see their stock price appreciate many times while the LLC remains an illiquid debtor / operator. Everywhere I went, I heard the public perception that Mongolia was going to start reaping the benefit for its equity far sooner than possible. And remember, if their shares ever do have value, the first beneficiary is the debt financiers, not the people.

Second, lack of understanding about “local investment”. Like many other cases around the world, the OT investment agreement called for significant employment and contracting revenue to come to the citizens and Mongolian corporations. However, if one examines how much of the billions of dollars that are being “invested in the country” are actually building wealth for Mongolia, the numbers tell a very unfortunate, tiredly predictable story. Chinese, Korean, Russian, European, Japanese, and American companies will see their revenues rise as they contract services and supplies. Further, much of the “local” attributed expenditures are actually the employment of expatriate consultants and contractors engaged in projects for community benefit. Their compensation (usually at a salary plus hardship premium) is often attributed to country benefit even though the actual compensation flows out of the country. OT made a laudable commitment of up to 90% local employment which represents a larger commitment than most. For this, they are heartily commended. Mongolia could have been better served by asking for a proportion of compensation – not body count – as the local labor force typically represents a miniscule fraction of the expat executive compensation. Body counts are one thing; actual compensation is the true economic metric.

Third, lack of visibility regarding corporate structure and accountability. In every country where we’ve worked, neither the local level nor national government seems to take sufficient time to understand how far removed their subsidiary corporate counter-party is from the actual control of profits and operating decisions. While the media and general public hear about the multi-national entity whose name is attached to the project, there is a general lack of clarity on the fact that neither the listed company’s nor the capital provider’s success in the broader market have any bearing on the direct benefit flowing to the country. Board decisions, control of disposition of assets, and allocations of revenues to generate dividends are typically made well outside the operating corporate structure in which the country has participation.

Fourth, lack of capital markets visibility. The money to be made in mining is far removed from the mine. The promise of the “largest” gold and copper mine creates wealth in public equities like Ivanhoe, BHP, Rio Tinto, and others in listed share price appreciation – not their balance sheet. Infrastructure finance benefits bond issuers and traders through fees and commissions on trades – not in-country businesses or the public. Once in production, it is commodity traders – not the suppliers – who make the most traded wealth. Yet time after time, countries are lured into believing that somehow their ownership is going to create a pathway to wealth creation. In the absence of the ability to participate in equities and bond liquidity-based trading, countries are saddled with debt-financed, encumbered equity, operating liabilities and pro rata financial obligations, and very disillusioned citizens.

Finally, lack of market-appropriate tools. Most countries have little more than license, royalty, and tax as means to capture some benefit for the loss of extracted minerals or energy. When they realized that they’ve been disadvantaged, they revert to the globally unpalatable (though popularly expedient) actions like nationalization of licenses on producing properties. And if they raise taxes, demand more royalty participation, or nationalize incompletely considered and illegitimately granted licenses, they are penalized as not being stable business environments thereby diminishing standing for foreign investments and partnerships. All too often, the rule of law is eclipsed (as it has recently been in Papua New Guinea) by expediency where the short term empty promise of benefit concedes lax regulatory environments where public interest is subordinated by misinformed public officials to placate unethical demands from corporations.

Against these challenges, most paths lead to the decision to succumb by a few public sector officials who are co-opted for their own personal gain while they abandon the public interest they’ve been elected to promote. Corruption, beginning with multi-national corporations who see uninformed governance as a weakness to exploit, is a frequent utility in this expediency-driven model.

Could there be a different path? Would it be possible to get it right?

Yes. Countries and their mineral and energy ministers could demand that the counter-party in benefit sharing be the listed company or demand a equity tracking benefit that would allow for monetization of the early equity appreciation immediately post announcement of resources and immediately post the granting of production licenses. Countries could demand that they are compensated on the applicable market appreciation in the equity, bond, and commodity markets attributable to their market contribution. Countries could demand that their counter-party signatories be the senior listed company (the holding interest) rather than the shell subsidiaries from which benefit can be easily shielded. Countries could set compensation and contract REVENUE requirements rather than relying on the antiquated body-count requirements. Countries could demand the implementation of Trade Credit Offset equivalent programs for competitively bid contracts where local businesses could be nurtured and grow into scalable suppliers and partners with capacity building, training, and technology transfer. And, are you ready for this? Investors could actually demand that the companies in which they invest are held accountable for misleading and unethical business behavior including fraud in negotiating, contracting, and environmental and community accountability.

What has been historically labeled as sovereign risk could be cured by actually placing indemnity issuers in mineral and energy rich countries so that the financial incentives of contract stability are actually aligned with all actors. By linking financial and risk management business – required by any multinational corporation’s shareholders to the country in which business is being done – economic literacy and benefit can grow and the operating environment can be stabilized.

And, it’s important that we get this right. You see; if we don’t actually take responsibility across the board – investors, corporations, and countries – we will galvanize a public response that is already fueled with mistrust built on expectation misalignment and abusive experience. Democracy is not possible when the public is not informed of all the facts. Those who promote democracy but insist on the preservation of secrecy and willful ignorance are simply insuring their own demise and accelerating the same. If we’re going to see constructive international market development in the coming years, the only thing we’ve got left is an attempt to innovate ethics into our capital markets. If we don’t, expedient actors who are resource hungry will innovate their own model and we all will be the poorer.


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Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave