Mongolia's national parliament building at Sukhbaatar squareReuters

Moody's has cut Mongolia's foreign currency bond rating, citing the country's strained external liquidity position and saying that foreign exchange reserves would further deplete unless the country takes help from its big neighbour China.

The Mongolian tughrik, which has been on a declining trend since 2011, has touched a new record low of 1840 against the US dollar following the rating action.

The tughrik has fallen more than 10% so far this year and weakened more than 35% since April 2011, indicating the severity of the foreign exchange crisis Mongolia is facing. See the chart below.

The foreign currency government bond rating has been downgraded to B2 from B1 with outlook negative. The government's issuer rating as well as senior unsecured rating have also been downgraded to B2.

Moody's has also downgraded the rating of the government-owned Development Bank of Mongolia to B2 from B1 with outlook remaining negative.

"Reserves would most likely be lower, were it not for the Bank of Mongolia drawing down on a bilateral swap facility with the People's Bank of China," the statement showed.

Expansionary monetary and fiscal policies have added to demand pressures, fuelled inflation, and heightened spillover risks to the banking system and the balance of payments, the rating agency said.

Liquidity Position

Mongolia's total foreign reserves have fallen rapidly, to $1.6bn in May 2014 from $2.2bn at the start of the year, in spite of a narrowing current-account deficit, Moody's said.

The rating agency notes that the sharp pace of deterioration comes as foreign direct investment (FDI) has more than halved from levels last year.

"The investment regime remains unpredictable, suggesting that FDI will remain subdued at least over this year. Further ahead, instability in the investment regime threatens to dampen the development of the mining sector."

External Debt

Mongolia's rising external debt repayment burden was compounded by the decline of official foreign-exchange reserves to a low level. The development of Mongolia's mineral resources will play an increasingly important role in this context.

Moody's External Vulnerability Indicator — which gauges the adequacy of reserves with respect to maturing external debt obligations over the next year — has risen to an estimated 130% in 2014 and will increase further to 196% in 2015, significantly above a prudent 100% threshold for systems that are heavily dependent on foreign creditors, the rating agency said.

Expansionary Policies

The central bank's pursuit of expansionary monetary policies since 2013, including liquidity injections to banks, low-cost mortgage loans, and support to the construction and real estate sectors, has boosted demand, Moody's said.

Inflationary pressures continue to build in the country, while credit is still growing at a rapid pace, the rating agency said.

"This increases pressure on the balance of payments, raising the risk of capital flight, and further weakens the external payments position. Given regulatory forbearance in the provision of credit and weakening asset quality, there could also be spillover risks for the banking system."

Mongolia's currency falls to record