The Tavan Tolgoi coal mine in southern Mongolia.Eight hundred years after Genghis Khan, Mongolia is back in the news. Nicknamed “Mine-golia,” it is enjoying the largest energy and raw-materials boom on the planet. Today, Mongolia boasts the world’s third-largest copper mine, as well as one of the largest coal mines.

In the first quarter of 2012, Mongolia’s economy grew at an average annual rate of 16.7 percent, double the pace of growth in neighboring China. The growth rate was nearly as high for all of 2011. And the boom—which also includes a gold rush—has been going on since 2007.

With the boom, however, came the “resource curse”—also known as the “Dutch disease”—in which the mining sector drives prices up and crowds out employment in other sectors. Both wages and prices have skyrocketed.

And now Mongolia is threatened by another disease related to natural wealth: resource nationalism. Though dominated by the supposedly promarket Democratic Party, its parliament earlier this year pushed through a half-baked law on investment in “strategic sectors” that violates every free-market rule in the book.

The law imperils Mongolia’s relatively high score in the Index of Economic Freedom. Published annually by The Heritage Foundation and The Wall Street Journal, the most recent index ranked the Mongolian economy as the 81st freest in the world. Its overall rating was just below the regional average.

Yet the new law endangers foreign investments. And without foreign investment, Mongolia’s mineral boom may turn into doom. Wages will dwindle, and political unrest may ensue.

The new natural-resources law mandates that foreigners can hold only minority stakes in mineral, banking and media ventures. This is similar to provisions prevailing in neighboring Russia.

The law further requires that government clerks must approve any transaction or management decision that affects over one-third of such corporation’s shares, or “impacts market prices of Mongolian mineral products for export.” It also provides broad “national security” regulatory powers to the government.

The underlying reason for this retreat from market liberalism is the mistrust and dislike of neighboring China. After brutal wars and Genghis Khan’s conquest of the Celestial Empire, China defeated the Mongols and ruled them for centuries. Today, however, it is the largest market for Mongolian mineral exports, including coal.

At the same time, geography is destiny. Exports of coal via Russian ports would require thousands of miles of railway and would be uneconomical. The Singapore-based SouthGobi Sands Company, in the desert near the Chinese border, could develop Ovoot Tolgoi, one of the largest coal mines in Mongolia. The easiest export route would be a short railroad to ship coal to energy-starved China.

Yet the Mongolian government recently scuttled a SouthGobi deal with the Chinese Aluminum Company (Chalco), which was willing to buy majority stake of SouthGobi. The new strategic-sector law all but killed the promising project. The government also launched a dubious corruption investigation, which shut down all mining by SouthGobi in the Ovoot Tolgoi project.

Given Mongolia’s small population (2.7 million), its landlocked location between two former imperial masters (Russia and China), and its longstanding fear of foreigners, the rising tide of resource nationalism is understandable.

But the strategic-sectors law is a case of overkill. China is and will remain the principal market for Mongolian coal and other raw materials. In fact, Mongolia is in a privileged position, as it is near the largest manufacturing economy in the world. This location gives it a competitive advantage over Australia and other raw-materials exporters.

Even if Mongolian coal were sold to Japan, which is busy shutting down its nuclear sector, and to Korea, the commodity would need to move via Chinese railroads to be competitive. Beijing, however, may balk at allowing such massive export shipments to clog its heavily used railroads, or would charge very high transportation tariffs, particularly if Mongolia refused to allow some Chinese ownership of coal mines.

Solutions do exist. Creative interpretation of the law could assuage fears of Chinese state-owned enterprises, which Mongolian president Tsakhia Elbegdorj has expressed. The appropriate ministries could interpret the law on strategic enterprises as allowing majority foreign ownership of Mongolian-registered corporations. Thus, a Mongolian corporation would control a majority stake in a project and be subject to Mongolian law—but may be controlled by foreign owners. Another option might be to allow a foreign company's investment project to have long-term management control.

To encourage vital foreign investment, governments must harmonize their laws with the need for economic development—especially when half-baked laws scare international business. The government of Mongolia needs to demonstrate the will to settle quickly with foreign investors who took it to international arbitration and must signal by deeds, not words, that Mongolia is truly open for business.

In the longer term, the parliament may consider softening the strategic-sectors law, allowing, for example, multiple foreign owners, with combined ownership going above 51 percent. Today, the law is just too vague, onerous and punitive. It will scare foreign investors and hurt ordinary Mongolians.

After all, many countries, such as Australia, boast 90 percent foreign ownership of extractive industries—and thrive. The key is a transparent, modern and investor-friendly legal and regulatory system.

With these new safeguards in place, Mongolia may one day do as well as Australia.

Ariel Cohen, Ph.D., is senior research fellow in Russian and Eurasian Studies and International Energy Policy at The Heritage Foundation.