OREANDA-NEWS. The rapid depreciation of the Mongolian tugrik - which has plunged more than 20% since end-June - underscores the country's strained external liquidity and escalating refinancing risks, says Fitch Ratings. Fitch believes the currency volatility reflects deep short-term external liquidity constraints and economic challenges, while immediate solvency risk is mitigated by the fact that the sovereign does not face significant external bond maturities until at least early 2017.

The tugrik's plunge reflects significant short-term economic challenges, including weak public finances, external liquidity risks, and a deteriorating near-term growth outlook. Fitch, which cut Mongolia's sovereign rating to 'B' in November 2015, has long highlighted strained external liquidity as a core challenge for the country. Its foreign reserves of USD1.3bn at end-June were broadly consistent with levels reported over the past two years, but headline reserves obscure Mongolia's extensive use of a CNY15bn bilateral swap facility with the People's Bank of China in that period.

Mongolia will continue to face heightened external liquidity risks in the short term, which have been exacerbated by loose policy settings in recent years. Refinancing risks also remain high, though Mongolia does not face significant external bond maturities in the immediate period - a sovereign guaranteed USD580m Development Bank of Mongolia bond comes due only in March 2017 and a USD500m sovereign bond is due in January 2018. A recent hike in benchmark rates by 450bp to 15% on 18 August is a sign that policy priorities may have moved towards stabilising these ongoing pressures after a number of key personnel changes at the Bank of Mongolia following parliamentary elections earlier this summer.

Public finances are also a key challenge. Mongolia already exhibits general government debt levels well above its 'B' rated peers, and recent public statements from the authorities suggest 2016 fiscal performance has fallen exceptionally far from a commitment to stick to a 4% budget deficit ceiling made under the recently implemented Fiscal Stability Law. This underscores the challenges the authorities face in addressing the country's weak public finances amidst a deteriorating growth outlook, but also highlights a weakness in the credibility of Mongolia's broader economic policy framework, exacerbated by uncertainties posed by the recent change in government.

Fitch continues to believe the ongoing development of the USD6bn Oyu Tolgoi underground copper mine will significantly enhance Mongolia's long-term growth prospects, and may eventually help ease the country's external liquidity and fiscal pressures. Still, the more pressing short-term challenge is whether the newly formed government can implement credible and coherent economic policies that increase confidence in the country's basic economic stability, a prerequisite to alleviating the country's ongoing refinancing risks.

Banks' loan quality will remain under pressure with the system-wide NPL ratio likely to easily exceed Fitch's earlier expectation of 9% by end-2016 (end-1H16: 8.6%) if the interest rate hike fails to stop the tugrik's depreciation. In addition, salary-backed loans could become more vulnerable if the authorities implement the announced significant salary cuts for staffs at state-owned enterprises and government agencies. Lenders with large retail exposures such as State Bank (B-/Stable) and Khan Bank (B/Negative) could therefore also see their impaired retail loan ratios rise, while the pressure on XacBank (B/Negative) stems mostly from its larger corporate and foreign currency loans.

The immediate impact from the interest rate hike on the banks' pre-impairment profitability could be mildly positive, while the impact on their liquidity should remain containable as these lenders can rely on deposits and bilateral funding.

Fitch maintains its Negative rating Outlooks on the banks whose ratings are not support-driven to reflect the pressure on asset quality from the weakening operating environment. Our banking sector Outlook has been Negative since December 2013.