By Alex MacDonald

LONDON--Proposed changes to Mongolia's mining law threaten to undermine the economic viability of its fledgling mining sector, with negative consequences for the entire economy and future investment in the country, business leaders and investors warned.

The legislation, which includes a requirement for existing miners to relinquish stakes in projects to indigenous groups, marks a departure from the free-market principles that have benefited the country since the 1990s, The Business Council of Mongolia, the country's largest business group, said in a four-page open letter to Mongolia's president last week.

Mongolia has seen foreign investment in mining wane after it introduced a new law last year that restricts foreign ownership in strategic sectors such as mining. Politicians have also made at least two unsuccessful attempts to change the terms of a mining agreement signed in 2009 to develop the massive $6 billion Oyu Tolgoi gold and copper project. The project is expected to account for about a third of the country's economy by 2020.

The legislation, if approved in its current form, will "halt current minerals exploration and development in Mongolia and greatly discourage any future investment," The Business Council of Mongolia, which has more than 250 members, said in its open letter. It also threatens the development of the nation's largest coal reserves, Tavan Tolgoi, the council said. Mongolian state-owned Erdenes-Tavan Tolgoi Co. owns rights to develop those reserves and has been seeking to raise up to $3 billion via a public share offering that has already been delayed several times.

The draft law, which would replace the one signed in 2006, proposes several measures that would give the Mongolian government a firmer grip over its mineral resources while raising concerns about ownership rights and possibly lead to higher taxation. The legislation would require that mining companies hand over a stake of at least 34% in their existing projects to indigenous groups. It would also require companies to mine lower ore grades even if they're not profitable, said Luke Lesley, head of mining at London-listed Origo Partners PLC (OPP.LN), a private equity group that owns stakes in various Mongolian mining companies.

The draft law also raises concerns about security of license tenure and fails to identify a dispute resolution process or body given overlapping powers between different ministries and local government, Mr. Lesley said. The Council also said was unclear whether the government may be able to apply the draft law retroactively to existing projects. Mining companies that currently operate in Mongolia include globally diversified miner Rio Tinto PLC (RIO), operator and major shareholder of the Oyu Tolgoi project through Turquoise Hill Resources Ltd. (TRQ.T), Peabody Energy Corp. (BTU), and Erdene Resource Development Corp. (ERD.T). None of them were immediately available or able to comment.

"Both domestic and foreign investors have unanimously and unambiguously responded negatively to these amendments," the U.S. embassy in Mongolia said in a report about investment climate published Tuesday. "They argue that the amendments grant the government broad and vague discretionary authority to revoke exploration and mining rights without meaningful checks on these powers; and impose taxes and fees, development obligations, and production, management, and employment practices that may render commercial mining impossible in Mongolia," it noted.

"It makes it very hard to raise money for any of these projects with all of this lack of clarity," Mr. Lesley said.

Businessmen and investors are also concerned that the draft law may fall foul of political posturing ahead of the presidential elections in May. The draft legislation is "almost certainly politically motivated," said Mr. Lesley. "Both of the main parties are looking at popular measures that could be put to the electorate."

Last year, politicians pushed through a law that restricts foreign ownership in key strategic sectors such as mining. The law was passed just before parliamentary elections in June in response to voter concerns that Mongolia may be compromising its sovereignty by giving foreigners too large of a stake in its key sectors. But since the elections, the government has been considering relaxing some of those rules in order to make it more business friendly.

The draft legislation on mining is currently open to consultation until Jan. 18, according to Origo. Both the Business Council of Mongolia and Origo said they have submitted comments.

Origo expects the draft law will be submitted to parliament for a vote in April in order to approve the law ahead of the presidential elections.

"Passage of the Draft Law in its current form is likely to damage Mongolia's brand as an investment destination," the Business Council said, noting that it would lead investors in all sectors of Mongolia's economy to re-evaluate the country's sovereign risk profile. The end result could repel rather than attract foreign direct investment, the Council said.

Write to Alex MacDonald at alex.macdonald@dowjones.com

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