Rio's $5.3 bln go-ahead fuels hopes of end to Mongolia's hangover

* Oyu Tolgoi extension could help energize investor confidence

* Will improve Mongolia's prospects, but will take time to kick in

* Economy seen growing less than 1 pct this year - ADB (Updates with external debt detail in paragraph 11)

By Terrence Edwards

ULAANBAATAR, May 9 (Reuters) - Rio Tinto (LSE: RIO.L - news) 's long-awaited approval of a $5.3 billion extension for its giant Oyu Tolgoi copper mine is fuelling hopes of a revival at last for Mongolia, battered by a slowdown in neighbouring China that has left it deep in debt.

Oyu Tolgoi, one of the world's largest undeveloped copper projects, has been a bellwether for Mongolia since its discovery more than a decade ago. But as discussions with the government stalled in 2013 and prices collapsed, Rio put the flagship project on the backburner - and confidence in Mongolia crumbled.

Rio's decision to go ahead with the costly and complex expansion is a bet on copper's recovery for a miner that badly needs to recalibrate its iron ore-heavy portfolio.

Mining executives, government officials, diplomats and analysts say it is also a potentially game-changing boost for Mongolia that could spark the unblocking of other projects and restore investor trust, key steps for the country to meet debt repayments due from 2017.

"This is a vital vote of confidence in Mongolia," said David Paul, chief executive of Aspire Mining, which is raising money to study a rail line for its Ovoot and Nuurstei coking coal projects in the country's north.

The Oyu Tolgoi expansion could also be key to winning over the public - in some cases reluctant to compromise with foreign investors - to deals on troubled Tavan Tolgoi, Mongolia's largest coal project, and the Gatsuurt gold mine owned by Centerra Gold (Other OTC: CAGDF - news) .

The parliamentary speaker blocked a $4 billion investment deal for Tavan Tolgoi last April on the day investors including China Shenhua Energy, Japan's Sumitomo and Ulaanbaatar-based Mongolian Mining Corp were to sign.

Centerra Gold mine has been waiting on an investment deal for Gatsuurt since 2010.

"We do believe the project will enhance Mongolia's economic growth prospects by establishing the country as one of the largest sources of high-grade copper globally," said Andrew Fennell at Fitch Ratings, which downgraded Mongolia to B in November. "However, near-term pressures remain."

According to Fitch, Mongolian sovereign and sovereign-guaranteed entities face a combined $1.1 billion of external bond maturities in 2017 and 2018 - before extra cash from the underground mine begin to flow. First (Other OTC: FSTC - news) production is due in 2020.

Rating agencies have repeatedly downgraded Mongolia since it issued Eurobonds in 2012. According to the International Monetary Fund, its sovereign spreads are among the highest of all frontier economies; data from Fitch rank Mongolia, with its $12 billion economy, as having one of the highest net external debt ratios in its global portfolio.

RESOURCES HANGOVER

Mongolia is recovering from a crippling hangover.

It (Other OTC: ITGL - news) was the world's fastest growing economy in 2011, according to the World Bank. At the peak of the boom, Ulaanbataar was teeming with hopeful expatriates and sushi bars, promises of luxury hotels and even a Louis Vuitton boutique all jostled for a slice of the newfound wealth.

The capital is now instead dotted with unfinished skeletons of buildings where financing ran out: an incomplete Hilton Hotel and dozens of office buildings in the business district.

This year, as miners pull away from frontier projects, the economy will grow less than 1 percent, and as little as 0.1 percent, according to the Asian Development Bank.

The country badly needs to restart stalled projects if it is to cope with ballooning external debt - pegged at $21.6 billion at the end of 2015 by the central bank - and avoid default.

At the high-profile weekend celebrations at the Oyu Tolgoi mine, Mongolia brushed off worries of further hiccups and promised consistency for a project that will employ some 3,000 more people with its expansion - 95 percent of them Mongolian.

"We are partners, like husband and wife, and sometimes you have problems," said Prime Minister Chimed Saikhanbileg.

Despite some lingering political opposition, he promised the outcome of Mongolia's legislative elections next month would not change the approach for a project that is vital for the country's future.

"Mongolia needs to see a sustained pick up in foreign direct investment," said Anushka Shah, analyst at Moody's. "And that will come from greater policy predictability." (Additional reporting by Sonali Paul in MELBOURNE and Umesh Desai in HONG KONG; Writing by Clara Ferreira Marques; Editing by Richard Pullin)