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Strategy

CIS

Strategy

Equity Research

17 September 2010

RussiaGlobal trends, o implications

Important disclosures are found at the Disclosures Appendix. Communicated by Renaissance Securities (Cyprus) Limited, regulated by the Cyprus Securities & Exchange

Commission, which together with non-US afliates operates outside of the USA under the brand name of Renaissance Capital.

Roland Nash

+7 (495) 258-7916

[email protected]

Anton Nikitin+7 (495) 258-7770 x7560

[email protected]

l cal



17 September 2010 Strategy Renaissance Capital

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Introduction - Implications of volatility 3 Russia – Dancing to a global tune 5

Influencing the domestic economy 5 The deterioration of Russia’s social security system 9 From over- to under-investment 9 The end of the subsidy 11 Russia – Well positioned to take advantage ofglobal trends 12 Low debt 12 Currency mismatch 13 Private sector borrowing 14 Natural resources: Exponential growth in demand, linear growth in supply 14 Diversifying the economy – duraki i dorogi 17 Breaking natural resource dependency 18 Macroeconomic efforts to diversify the economy away from oil 18 Microeconomic efforts to diversify the economy 19 Improving the legislative and administrative backdrop 20 Infrastructure 22 Efforts to drive investment fall into four categories 22 Reform dependent private sector initiatives 22 Public-private-partnerships (PPPs) 23 Financial sector reform 25 Sberbank 26 Will it be effective? 26

Conclusion 27 Disclosures appendix 28

Contents



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Renaissance Capital Strategy 17 September 2010

In 12 of the past 15 years, Russia’s equity market has either been among the best

five or worst five performing markets globally. Over the 2008 global credit crisis,Russia’s economy shifted from 8% growth in 2007, to 8% contraction in 2009 to a

likely 4% growth in 2010, the biggest shift in growth among large economies

globally. This excessive volatility in both asset markets and the economy is

destabilising and a major reason for the historic discount of equity assets to global

emerging market peers. In this report, we examine the reasons for Russia’s

particular tendency towards volatility, the attempts by the government to smooth out

the business cycle and the longer-term consequences of both the volatility and the

attempts to fix it.

The two most important factors influencing the Russian economy are both set

independently of Russia. For both the price of natural resources and the cost of

capital, Russia is a price-taker. A managed exchange rate regime transfers external

volatility directly onto the internal economy. Inflexible labour and capital markets are

unable to adequately adjust, forcing Russia through an exaggerated boom-bust

cycle.

In this sense, OPEC, the Chinese government and the US Federal Reserve have

as much influence over Russia as the Kremlin or the oligarchs. For a country of

Russia’s size and geopolitical ambitions, this is not a sustainable position. The

disequilibrium will either be solved through a reform programme which diversifies

Russia’s economy away from commodities and international capital, or through

further destabilising crises.

The implication for asset markets depends on the external environment. In the near

term, the reliance on global trends will likely play in Russia’s favour. With low debt,restructured balance sheets, and better costs, Russian firms and banks look well

positioned to take advantage of the low global interest rate environment and strong

medium-term outlook for natural resource prices.

If interest rates remain low and commodity prices rise over time, Russia can enjoy 4-

6% economic growth over the next few years, and the equity and housing markets

can again become among the best performing globally. The country has

deleveraged and restructured in preparation for the next upswing. In this sense, as

we discuss in this report, Russian equity is among the best value means to play the

emergence of the new engines of global growth in Asia, South America, Africa and

the Middle East.

But as in the past, any economic or financial growth will only be partially due to

productivity gains in Russia. Much of it will be for reasons outside of Russia’s

control. High growth will prove no more sustainable than in the past. Indeed, the

more successful Russia looks over the next few years, the bigger the bust is likely to

be the next time there is a shift in international sentiment in commodity or financial

markets.

Moreover, the impact of outside influence is getting bigger. One of the most

important stabilising influences of the past 20 years has been the infrastructure

inherited from the Soviet period. Russia was effectively able to subsidise transition

through running down its Soviet-era inheritance. Cheap electricity, gas, housing and

transport mitigated the economic impact of transition. Twenty years of under-

investment and a decade of economic recovery has left Russia’s infrastructure

increasingly inadequate to the demands of the economy.

Implications of volatility




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To their credit, the government and the Kremlin recognise the inherent structural

weaknesses in the economy. An under-appreciated reform programme, which wediscuss in this report, is focused on diversifying the economy away from natural

resources and building a financial system capable of intermediating capital. But it is

not clear whether the speed of reform will be adequate relative to the scale of the

problem. Relative to the volatility in commodity and financial markets, the impact of

reform may be lost in the noise.

In Oct 2010, Russia will mark two decades since Boris Yeltsin announced his

intention to implement “shock therapy”. Russia now has an economy which is

capable of delivering productivity gains, improving living standards and growth

based on resource allocation driven by market-derived pricing signals. There is an

ambitious reform programme in place to create an economy with a stable and

prosperous middle class by 2020. But while the financial sector remains inadequate

at intermediating domestic savings and the economy relies on natural resources,

success will be ultimately out of Russia’s hands.

Figure 1: Excessive market volatility – Russian equity market performance 1996-2010

1996 1997 1998 1999 2000 2001 2002 2003

1 China A: 250 Russia: 100 Korea: 98 Turkey: 247 China B: 136 China B: 74 Pakistan: 122 Thailand: 1342 China B: 205 Turkey: 87 Finland: 95 Russia: 153 China A: 58 China A: 65 Czech Republic: 40 Turkey:1223 Russia: 139 Panama: 59 Greece: 94 Finland: 150 Costa Rica: 33 Russia: 35 Indonesia: 38 Brazil: 1024 Budapest: 133 Hungary: 54 Costa Rica: 86 Cyprus: 123 Nasdaq: 25 Costa Rica: 11 Russia: 33 Argentina: 985 Venezuela: 98 Mexico: 52 Nasdaq: 81 Nasdaq: 97 Dow: 20 Austria: 0.5 Hungary: 28 Russia: 70

–1 Tel Aviv: (4) Philippines: (61) China A: (45) Austria: (8) Thai: (52) Nasdaq: (46) Philippines: (30) United Kingdom: 27 –2 Chile: (16) Malaysia: (65 China B: (49) Switzerland: (9) Indonesia: (55) Brazil: (51) Israel:(31) US: 26 –3 Nikkei: (16) Korea: (70) Venezuela: (50) Ireland: (14) Korea: (56) Cyprus: (54) Brazil: (33) Netherlands: 24 –4 Korea: (32) Jakarta: (72) Turkey: (52) Panama: (16) Cyprus: (68) Finland: (56) Turkey: (36) Malaysia: 23 –5 Thailand: (36) Thailand: (76) Russia: (85) Belgium: (18) Nasdaq: (82) Turkey: (64) Argentina: (50) Finland: 16

2004 2005 2006 2007 2008 2009 20101 Colombia: 125 Egypt: 167 Russia: 65 China: 179 Ghana 20 Brazil: 132 Mongolia: 1872 Egypt: 118 Colombia: 102 China: 58 Ukraine: 135 Tunisia 3 Russia: 120 Ukraine: 423 Hungary: 87 Russia: 83 Venezuela: 58 Slovenia: 96 Venezuela (7) Singapore: 109 Thailand: 394 Czech Republic: 76 Czech: 65 Argentina: 57 Croatia: 80 Morocco (17) Ukraine: 99 Indonesia: 385 Austria: 69 Turkey: 64 Peru: 53 Brazil: 72 Slovakia (23) Sri Lanka: 89 Chile: 35

–1 Russia: 4 Venezuela: (28) Thailand: (3.2) Estonia: (4.2) Vietnam (69) Kenya: (9) Italy: (20) –2 Finland: 3 Ireland: (10) Korea: (1.3) Japan: (5.3) Russia (72) Kuwait: (14) Portugal: (20) –3 Peru: (0.1) Portugal: (9.49) Turkey: (5.5) Sri Lanka: (7) Serbia (80) Slovakia: (17) Slovakia: (22) –4 China: (0.2) Taiwan: (9.45) Israel: (5.9) Ireland: (18) Bulgaria (80) Bahrain: (21) Greece: (34) –5 Thailand: (4) Spain: (3.7) New Zealand: (5.8) Venezuela: (27) Ukraine (84) Nigeria: (37) Venezuela: (38)

Source: Bloomberg

Figure 2: Excessive economic volatility – Russian YoY growth compared

Source: Rosstat

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From among the fastest growing....

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Influencing the domestic economy

The two most important inputs into the Russian economy are the cost of capital and

the price of natural resources. Most of the major shifts in both financial markets and

the economy over the last decade (and arguably longer) can be explained by one or

the other, or more commonly, both of these variables (see Figure 3). Russia is a

price-taker in both.

Figure 3: Financial market and economic v olatility

Source: Bloomberg

Being a price-taker for the cost of capital and the cost of natural resources is not

unique to Russia. Few countries have control over the cost of natural resources and

all countries with open capital accounts must choose between controlling their

currencies and controlling their domestic interest rate environment.

But Russia is arguably the most exposed of any large country globally, for six

reasons.

1. Russia is the world’s largest producer and exporter of natural

resources. Taking just hydrocarbons, Russia has net exports roughly 50%

greater than the next biggest (Saudi Arabia) and three times more than

Norway and Australia in third and fourth place (see Figure 4). Russia is

also a major exporter of metals, minerals and agriculture. Changes in

commodity prices can therefore have a very large impact on the value of

Russian economic output.

Figure 4: Net hydrocarbon exporters, mn toe*

* The numbers are calculated by taking the production minus domestic consumption of oil, gas and coal, measured in millions of tonnes of oil equivalent.Source: BP, Renaissance Capital estimates

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Russia – Dancing to a globaltune




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2. Russia has a population size and an economic complexity which

requires a diversified economy. Relative to the size of the economy,there are many countries where the commodity sector plays a larger role

(see Figure 5). But Russia has the population size and economic

complexity that it cannot rely solely, or even mainly, on natural resources.

Russia cannot be like Saudi Arabia (population 25mn) or Norway

(population 5mn) because its economy and population are too big relative

to the size of its natural resource sector. Russia has a population of

142mn,of which only 800,000 work directly with natural resources (see

Figures 6 and 7). It also remains, despite the past 20 years of relative

decline, one of the world’s foremost industrial and technological powers1.

Russia therefore faces a unique set of circumstances. It is the world’s

largest natural resource economy, but it cannot rely on them if it is to

deliver sustainably improving living standards for the vast majority of the

population.

Figure 5: Hydrocarbon production, economic si ze and population

Source: BP, IMF

Figure 6: Industrial producti on by sector*

*This is a picture only of industrial production. Around 60%of the economy is services.Source: State Statistics Committee

1This may see a contentious claim. But the nuclear and space industries, second only to the

US, are enough on their own to justify the point. In lazar, aeronautics and ballistics, Russiaremains a world leader.

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5. The banking sector remains a poor intermediator of capital. The

banking sector is unable to provide adequate financing to small andmedium-sized firms and households. As with rouble debt markets, this is

improving (see Financial sector reform below, page 26), but the size of the

mortgage market relative to the size of the economy indicates how poorly

the Russian banking sector intermediates capital (Figure 9). An ineffective

banking sector encourages Russians to use the international financial

system to intermediate funds. Russians tend to hold savings outside of

Russia, and use international banks to assess lending risk.

Figure 9: Mortgage loans as a percentage of GDP

Source: Central Banks data and Renaissance Capital estimates

The open capital account and weak domestic banking sector have

combined to encourage the effective outsourcing of much of the

intermediation of capital within Russia to the international financial system.

This clearly increases Russia’s vulnerability to changing global risk

perception, as was so vividly illustrated by the 2008 financial crisis.

6. Monetary authorities de facto target the nominal exchange rate. There

continues to be a fierce debate over whether the Central Bank of Russia

(CBR) should target the nominal exchange rate or inflation. In theory, the

CBR is moving towards inflation targeting. In practice, however, while the

exchange rate remains the most politically sensitive financial variable in

Russia, the CBR will continue to limit fluctuations in the exchange rate,

accumulating reserves in good times, and spending in bad. Exchange ratetargeting is therefore a function of a weak financial system. While the CBR

targets the exchange rate, the rouble is unable to adjust to outside shocks,

forcing internal prices to make the adjustment. A managed exchange rate

directly imports international volatility into the domestic economy.

The combination of a very large natural resource export sector together with a weak

and open financial sector with a managed exchange rate and relatively inflexible

internal markets makes Russia uniquely exposed to international volatility.

Moreover, it is getting worse.

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The deterioration of Russia’s social security system

Russia (and the CIS more generally) inherited from the Soviet period an economic

infrastructure which has been perhaps the most important reason why the bust and

boom of the past 20 years has not resulted in more social tension. Cheap housing,

electricity, gas, water and low direct taxes (either through under-payment in the

1990s, or low rates since the income tax rate was decreased to 13% in 2001)

compensated households for the sudden rise in the cost of consumer goods, the

rapid decline in real incomes and the inflating away of savings which hit Russia at

either end of the 1990s. Russia has been able to effectively borrow down the over-

investment of the Soviet period to pay for transition. On our estimates, subsidy from

Soviet-era infrastructure was worth $280bn over the past 20 years, not including

public sector housing. To put that number into perspective, the government’s

Stabilisation Fund at its peak in 2008 reached $225bn

From over- to under-investment

While the quality of investment during the Soviet period was low, the quantity was

high. For much of the post-war period, households effectively subsidised industry as

would-be consumption went into investment. Investment rates ranged between 30%

and 40% of GDP during the 1950s, 1960s and 1970s (see Figure 10), and then

collapsed in the 1990s to 15% of GDP. It has started to recover over the last decade

towards 20% of GDP.

Figure 10: Investment rates since 1950, % national income

Source: State Statistics Committee

The 40% collapse in the economy during the 1990s then further decreased the

demand on the Soviet-era infrastructure. Therefore by 2000, Russia had an

infrastructure which was actually large relative to a smaller economic output, despite

the under-investment during the previous period. Thanks to over-investment by the

Soviets and economic collapse in the 1990s, Russia has been able to under-invest

in infrastructure for the past two decades.

The exact scale of the subsidy is difficult to quantify, but it is clearly large. Figures

11a to 11e make an attempt at valuing the bigger bits of Russia’s infrastructure as it

was inherited from the Soviet period, together with the rates of investment sincethen. The state statistics committee provides an estimate of how depreciated public

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sector assets were in 1992. Assuming a rate of amortisation of 4% and adding back

the investment into infrastructure, we came to an estimate for the subsidy of runningdown infrastructure in the range of $280bn over the past 20 years. This does not

include housing or local public services.

Figure 11a: The Soviet subsidy - oil pi pelines1990 2010

Transneft pipe, ‘000km 46 51Price of pipeline*, $mn/km 1.8Initial depreciation level 40%Depreciated replacement cost, $bn 49.7Depreciation 20 years** 39.7Maintenance capex 20 years ***, $bn 4Additions, ‘000km 5Additions, $bn 9Subsidy $bn 26.7*assuming average price of new construction in Russia over the past five years**assuming 4%depreciation pa*** assuming $200mn capex per year

Source: Rosstat, Renaissance Capital estimates

Figure 11b: The Soviet subsi dy - gas p ipelines1990 2010

Gazprom pipe, ‘000km 144 165Price of pipeline* $mn/km 1.5Initial depreciation level 38%Depreciated replacement cost, $bn 133.9Depreciation 20 years** 107.1Maintenance capex 20 years ***, $bn 30Additions, ‘000km 21Additions, $bn 31.5Subsidy, $bn 45.6*assuming average price of new construction in Russia over the past five years**assuming 4%depreciation pa*** assuming $1.5bn capex per year


Figure 11c: The Soviet subsidy - rail system1990 2010

Railways, ‘000km 87 87Price*, $mn/km 2.5Initial depreciation level 45%Depreciated replacement cost, $bn 119.6Depreciation 20 years** 95.7Maintenance capex 20 years ***, $bn 40Additions ‘000km 0Additions, $bn 0

Subsidy, $bn 55.7*assuming average price of new construction in Russia over the past five years**assuming 4%depreciation pa*** assuming $2bn per year




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Figure 11d: The Soviet subsidy - road system1990 2010

Roads, ‘000km 700 933Price*, $mn/km 2Initial depreciation level 50%Depreciated replacement cost, $bn 700Depreciation 20 years** 560Maintenance capex 20 years***, $bn 40Additions ‘000km 233Additions, $bn 466Subsidy, $bn 54*assuming average price of new construction in Russia over the past five years**assuming 4%depreciation pa*** assuming $2bn capex per year


Figure 11e: The Soviet subsidy - utility sector km Replacement cost, $/km

Regional grid km 2,000,000 60,000Federal grid km 126,000 1,000,000

MW $/MWGeneration, kWt 141,000 1,000,000Additional, kWt 54,000 3,000,000Depreciation level 1990 41%Depreciated replacement cost, 1990, $bn 329Depreciation level 2009 60%Depreciated replacement cost*, 2009, $bn 220Total subsidy, $bn. 109* Assuming replacement cost of$1,500/KWt of fossil generation, $3,000/KWt of hydro, $1mn of federal grid and $60.000/km of regional grid


The end of the subsidy

As the economy grows and under-investment takes its toll, this effective subsidy is

rapidly coming to an end. The economy grew at an average pace of 5.4% per year

from 1999 to 2010 (including the contraction in 2008). It is now, in real terms, 17%

bigger than it was in 1991. At the same time, Russia has been under-investing into

infrastructure. Rates of investment below that of amortisation mean that Russia has

an infrastructure which is now worse than it was at the end of the Soviet period, with

an economy which is bigger. Figure 12 illustrates the point using the example of

power generation. In the mid-1990s, Russia had 25% spare capacity in power

generation. If it wasn’t for the 2008 crisis, current spare capacity would be well

below the minimum reserve margin of 8%. It is only a matter of time before Russia

will not be able to generate sufficient power to meet demand.

Figure 12: Spare capacity in pow er generation

Source: Rosstat, Unified Energy Systems, Renaissance Capital estimates.

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While the situation is not quite so dire elsewhere, public sector infrastructure will

become an increasingly significant drag on economic growth without investment.Investment will only happen if either the cost of the service is increased to a level

which reflects economic cost or if the government invests directly. Either way, the

era of cheap, subsidised infrastructure is closing.

As we explain below, the government, to its credit, recognises the issue and is

attempting to promote investment into infrastructure (see Infrastructure , page 23).

But in the interim between a decent infrastructure built and while households are

having to pay economic rents, the economy is most exposed to outside shocks. The

social infrastructure which has cushioned Russia from the worst of international

volatility is degrading to the point where it is unable to provide that service any

longer. The increase in tariffs is the most obvious manifestation of that.

Russia – Well positioned to take advantage of globaltrends

From an international perspective, Russia looks to be among the best positioned

markets to take advantage of the major medium-term global trends. It has a low debt

economy, producing goods for which there is an excellent long-term demand outlook

and limited competition, within a stable political regime which is promoting

investment through an open capital account at a time when large structural

challenges will likely force the West to hold the global cost of capital at historically

low levels for a sustained period.

Low debt

The flip-side of 20 years of under-investment is low debt. Taking together private

sector and public sector, Russia as a country has low levels of debt relative to both

the developing and the emerging world (see Figure 13).

Figure 13: Total Russian debt vs developed and emerging peers*

Source: Economic Intelligence Unit, Bloomberg, Central banks and BIS

Most of the debt is private sector corporate loans , while the public sector is a net

saver if the Stabilisation Fund is included. The split between private and public debt

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is a result of policy decisions reflecting experience from the late 1990s when the

decrease in the oil price to $10/bbl pushed the over-leveraged government intodefault. Beginning in 2001, the government has been consciously over-taxing the oil

sector in order to save the oil price windfall while decreasing private sector taxation

and opening up Russia to international financial markets by lowering capital

controls. The intended result was to free the international financial sector to allocate

capital. By over-taxing natural resources and not spending the windfall, the

government hoped to both pull the public sector out of the economy and to

encourage investment into the non-resource economy (see Diversifying the

economy page 19 below). The macro-policy set was both remarkably pro-market

and often under-appreciated.

Unfortunately, the 2008 financial crisis revealed that the private sector had also

made mistakes in its decisions on borrowing and capital allocation. Currency and

duration mismatch caused severe financial dislocation which contributed

substantially to the size and speed of the economic downturn when funding was

withdrawn by the international financial system in the late summer of 2008.

As a result of the financial crisis, the Russian private sector was forced to

restructure its collective balance sheet, and cut back costs which had accumulated

over the previous decade of economic boom. Having saved the oil price windfall, the

public sector proved able to step in to replace financing. Coming out of the crisis,

Russia’s private economy looks considerably better positioned than it did pre-crisis.

Currency mismatch

The banking sector has greatly decreased its forex exposure during the crisis. In

early summer 2008, total foreign liabilities of the banking sector stood at 20% of total

assets. By early this summer, foreign liabilities had fallen to less than 10% (see

Figure 14). The decrease in foreign liabilities makes the banking sector less

exposed to a sharp devaluation of the rouble. Greater immunity against downward

movements in the currency makes it easier for the CBR to allow the rouble to

fluctuate, insulating the domestic economy from outside shocks.

Figure 14: Foreign Liabilit ies/Total assets of the banking s ector

Source: CBR

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Private sector borrowing

The private, non-banking sector was forced to find alternative means of refinancing

international loans. Collectively, firms did this through cutting costs, borrowing from

the rouble market and seeking new financial partners (see Figure 15 and 16). From

rising 10-25% annually between 2001 and 2007, producer prices declined 7% in

2008 as firms sought to cut costs. Equally, 2009 was the record year for rouble bond

issuance, jumping from $18bn in 2008 to $28bn.

Figure 15: Prod ucer Pric e Index, 2000-2010

Source: State Statistics Committee

Figure 16: Rouble bond issuance

Source: Renaissance Capital estimates

New financial partners effectively meant the government (through Sberbank and

VTB) and, where possible, new countries away from the traditional Western financial

markets and banks. This has profoundly changed the shape and orientation of the

Russian (and CIS) economy. After several years when Western financial markets

feared the creep of the Russian government into the private sector, ironically it was

the sudden withdrawal of Western financing which sent the private sector scurrying

back into the arms of the Russian government. The government has been struggling

ever since to push it back out of the public sector.

Natural resources: Exponential growth in demand, linear growth in supply

Russia is, of course, the world’s largest producer of natural resources. Figure 17shows quite how significant Russia is as a primary producer.

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Figure 17: Russia – the world’s central bank of natural resourcesProduction Reserves

Russia % of Global Russia % of GlobalOil, mn bpd/bn bbls 9.6 12 79.5 6Gas, bcm/bn boe 656.2 23 280.5 24Nickel, metric tonnes of nickel content 320,000 20 6,600 10Platinum, ounces 980 16 82,137 12Palladium, ounces 2,668 41 308,991 44Gold, metric tonne 162 7 3,000 7Timber, mn m³/bn m³ 184 6 82 23Fresh water na na 4,262 15Land Mass na na 17,075 11

Source: BP, LME, CIA, World Bank, Renaissance Capital estimates

The position as the world’s leading producer of natural resources is a well-

recognised double-edged sword, both by the investment community and by the

Russians themselves. The easy rents accruing from resources create all sorts of

economic distortions from corruption to crowding out. But there are two facets of a

natural resource producer which should be less controversial, because they are

internally consistent.

First, it ties Russia inescapably to the fate of the large emerging economies. It is

surely impossible that the 3bn people of China, India and Africa can enjoy high

growth without demand for commodities growing. Figures 18a to 18c show the per

capita growth in oil, gas and coal consumption of several emerging countries since

the 1960s. The experience of Japan, Korea and Taiwan has been remarkably

similar at different times and through different oil price environments. It seems that

the shift in living standards experienced by successful emerging economies requires

a remarkably similar increase in energy consumption. So far, China and India havefollowed more or less the same pattern of per-capita energy consumption growth as

Japan in the 1960s and 1970s, and Korea and Taiwan in the 1970s and 1980s.

Figure 18a: Per capita consumpt ion of oil barrels per year, various countries 1965-present

Source: BP, IMF, CIA

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Figure 18b: Per capita consumption of gas, tonnes of oil equivalent per thousand people


Figure 18c: Per capita consumption oil coal, tonnes of oil equivalent per thousand people


Barring a revolutionary and so far absent change in technology, consumption of

energy and commodities will have to increase if the populations in high growth

economies are to continue the process of catch-up towards living standards enjoyed

in the OECD. Currently 17% of the world’s population living in the OECD consume

50% of its total energy. Assuming no further increase in demand for energy in thedeveloped world, and that growth in per-capita energy consumption in China, India

and Africa follows the same pattern as that of Japan between 1965 and 19852, then

energy consumption growth will be the equivalent of current Chinese consumption

every decade, or current Indian demand every three years (see Figure 19).

2 This would assume a slowdown in the growth of energy consumption of the last decade.Average per capita energy consumption in India has growth by 3.5% per person per annumover the last decade, and by 8.1% in China.

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8001,0001,2001,4001,6001,8002,000

1965 1970 1975 1980 1985 1990 1995 2000 2005




17


Figure 19: Path of demand increase for energy, mnt of oil equivalent*

* Assumes all energy consumption remains constant at 2009 levels except that for India, China and Africa which grow at the same average per-capita rateas Japan grew (4.3%) between 1965 and 1985. This would imply a slowdown in energy consumption rates from that of the last decade.Source: BP, IMF, CIS

This growth rate in energy demand is presumably impossible given the supply

constraints and environmental concerns which have emerged over the past two

decades of rapid growth in these economies. But the limiting factor looks likely to be

price, not a shift down in the demand curve

As the foremost producer of natural resources globally, Russia must benefit from

this continued one-way move in the terms of trade. If China, India and Africa grow,

then so must Russia. In this sense, Russia is simply the cheapest way to gain

exposure to the emerging market growth story.

Second, it removes the risk of a sudden spike in commodity prices. As a commodity

producer, Russia is obviously exposed to a sudden down-swing in commodity

prices. Equally, however, there is no risk to Russia of any sudden increase in

commodity prices, clearly quite the opposite. For anybody buying into the long-term

growth offered by the new emerging giant economies, presumably the major risk is

not of a sudden decrease in commodity prices, but rather the opposite. Russia is

hedged against the risk of resource shortage.

It therefore seems an odd argument that Russia should be priced at a major

discount to the rest of the emerging world because it is a natural resource producer.

The common argument used to explain the discount is that Russia is a price-taker

on its major product and therefore a discount is justified because there is lessvisibility on future earnings streams. Today’s low P/E can be tomorrow’s high P/E

depending on events outside of the company’s control. But there seems no good

reason why the risk to an exporter of price volatility is greater than the risk to an

importer. To be sure, Russia is a high beta economy, as we explain in this report,

but not because (or not only because) it is a natural resource producer.

Diversifying the economy – duraki i dorogi

Longer-term stability depends on breaking the exaggerated boom-bust cycle. To do

so requires establishing an economy capable of weathering outside shocks, whichmeans creating a measure of independence from variables which are outside of

Russia’s control. As the external variables are natural resources and the cost of

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,00020,000

1 9 6 5

1 9 6 8

1 9 7 1

1 9 7 4

1 9 7 7

1 9 8 0

1 9 8 3

1 9 8 6

1 9 8 9

1 9 9 2

1 9 9 5

1 9 9 8

2 0 0 1

2 0 0 4

2 0 0 7

2 0 1 0

2 0 1 3

2 0 1 6

2 0 1 9

2 0 2 2

2 0 2 5

2 0 2 8

US

Africa

China

India

Total World




18

capital, the two sets of necessary reforms are 1) diversifying the economy away

from natural resources; and 2) creating a financial sector capable of intermediatingdomestic savings into the domestic economy.

The government recognises the need for these reform initiatives and is making

progress on both.

Breaking natural resource dependency

Since 2004, one of the central guiding principles of reform has been to diversify the

economy away from oil, and natural resources more generally. Broadly speaking,

reform has broken down into macro and micro. The macro-reform has been

successful, and under-appreciated, while the micro has been slow and, so far,

inadequate.

Macroeconomic efforts to diversify the economy away from oil

There have been several consistent policy initiatives undertaken by the Ministry of

Finance and the CBR since 2000.

Over-taxing the oil sector, while decreasing taxation in the rest of the

economy. Since 2001, Russia has been creating one of the most onerous

tax systems globally for upstream oil. Effective tax rates take 93% of the oilprice above $30/bbl. Taxes are all at the upstream level, with taxation

lowered as the oil moves up the value chain. At the same time, taxation in

the rest of the economy is remarkably low. In 2001, Russia lowered the

income tax rate to 13% and the profit tax to 24%. In 2009, the profit tax was

lowered further to 20%. It is often noted by the investment community that

high tax rates discourage investment into the oil sector. This is perhaps not

unintentional.

Pulling the public sector out of the economy. Between 2002 and 2008,

the Ministry of Finance was actively attempting to reduce spending as a

percentage of revenues and run large budget surpluses. Russia only began

running deficits when private sector demand ran into a wall following thecrisis of 2008. In 2007, when the private sector borrowed $150bn from

abroad, the federal government ran a budget surplus of $50bn. When the

private sector was forced to pay down debt in 2009, the government ran a

deficit of $60bn (see Figure 20a). The Ministry of Finance has therefore

been running a classic counter-cyclical fiscal policy. The size of the

surpluses and deficits reflects the scale of adjustment needed by an

economy so susceptible to boom-bust. As Russia pulls out of recession,

and starts growing, it will be a major test of the Ministry of Finance whether

it will be able to rein in spending and recommit to the austerity followed

earlier last decade. So far, the signs are somewhat concerning. The non-oil

deficit continues to widen.



19


Figure 20a: Public sector saving, priv ate sector borrowing


Opening up the capital account. Since 2006, Russia has had a fully

liberalised capital account regime. In combination with running large budget

surpluses, opening up the capital account encouraged the private sector to

borrow from abroad.

A combination of over-taxing the oil sector, decreasing taxation in the rest of the

economy, large budget surpluses and an open capital account is consistent with

providing the right macro-incentives for the non-hydrocarbon sectors of the economy

to borrow, invest and grow.

It is not surprising that there was such a large private sector borrowing spreebetween 2006 and 2008 (see Figure 20a). The domestic economy needed capital

and was willing to pay, the government was crowding-in investment (the budget

surpluses were saved in dollars, but the fixed exchange rate meant that rouble

money supply grew rapidly), and firms were free to borrow from international

markets.

With the oil sector over-taxed, this should, and did, lead to a non-oil sector boom.

The problem was that both the lenders (international banks and capital markets) and

the borrowers (Russian firms) proved poor at allocating capital effectively, which

was at least partly the fault of the inefficiency of the Russian economy at the micro-

level.

Microeconomic efforts to diversify the economy

The microeconomic reform effort is the litany of heroic reforms which are habitually

listed by commentators and government as necessary to improve the business

environment to the level which encourages investment and drives the competition

needed for improved competitiveness and productivity. They can be split into three

parts.

-200

-150

-100

-50

0

50

100

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Net foreign borrowing (banks and corporates), USD bn. Government budget deficit/surplus, USD bn.




20

Improving the legislative and administrative backdrop

Russia is a notoriously difficult place to operate a business. The bureaucracy has

the reputation of being corrupt and inefficient. Regulation is deemed anachronistic

and opaque. According to Transparency International, Russia is perceived to be the

146th

most corrupt country in the world, just better than Sierra Leone and

considerably worse than Nigeria.

Figure 20b: Corruption Perceptions Index, 2009Countr y Ranking 2009 (out of 180)

New Zealand 1Switzerland 5UK 17US 19South Africa 55

Brazil 71China 79India 84Nigeria 130Pakistan 139Russia 146Sierra Leone 146

Source: Transparency International, 2009

Russia is indeed a difficult and frustrating place to do business. The bureaucracy is

large and laws and regulation have not kept up with the speed of change in the

underlying economy. There is little stable about Russia’s legal and institutional

framework.

But it is mistaken to believe that the government has always been slow to pursue areform programme. Indeed, in tax, budget, judicial, financial and administrative

reform there has been a lot of activity, arguably too much. Codes have been drawn

up, legislated and, increasingly, implemented, particularly in the golden period of

Russian reform between 2000 and 2004. Figure 20c lists the major reforms in each

of these broad areas.

Figure 20c: Major reforms undertaken since 2000Reform area Achievements Year implemented

Tax reform

Tax laws codifiedTurnover taxes (ex. road tax) and sales tax abolishedVAT and profit tax lowered (to 18% from 20% and to 20% from 35%, respectively)Flat personal income tax at 13% introducedPayroll tax reduced to 26% from 35.6%

2001-20062000

2002, 2004, 200820012004

Budget reform Government savings funds created and clear usage rules setAll government accounts transferred to Federal TreasuryThree-year budget planning introduced

200420022008

Financial reform

Capital controls abolishedDeposit insurance scheme launched (and successfully tested in 2008-2009)IFRS reporting for banks imposedMost notorious minority shareholder (mis-) treatment issues solved (dilution, refusal to register, etc.)Fully funded pension reform launched (though stalled)

20062004

2003-20062001-2004

2002

Judicial system reform

Massive increase in salaries and improvement in status of judgesImposing of a right to be tried by a juryAdoption of post-Soviet Criminal, Criminal procedures, Arbitration procedures, Civil, Civilprocedures, etc. CodesInternet-based tracking of arbitration cases imposed

2000-20072004

2000-2002

2008

Administration reformNumber of activities, which require licensing, cut to less than 100 from 2,000Ability of state controlling bodies to inspect businesses severely limited and strict rules imposedTaxation and accounting streamlined for SME’s, implied tax introduced

2002, 20082008, 2009

2002

Property rights Land, Urban and Forest Codes imposed, zoning requirements streamlined, private ownership and afree sale of land, including agricultural, allowed – for the first time in history of Russia. Propertyregistration improved, taxes streamlined, some (inheritance) – abolished

2002-2006




21


The reform record is not bad, especially when considering the country which the

then-president inherited in 2000 following the economic, political and social collapseof the 1990s.

Russia still has a long way to go in creating a user-friendly business environment

which would rank alongside countries in the OECD. But enough has been done, and

is being done, to remove bureaucracy, corruption and red tape as the over-riding

reasons why Russia fails to live up to its economic potential. Reform, generational

change across all levels of government, pressure from the private sector and a

growing middle class are all gradually wearing away at the bureaucratic deadweight

on the economy.




22

Infrastructure

As discussed above, investment into infrastructure is becoming increasingly

necessary as under-investment over the past 20 years together with rapid economic

growth leaves current infrastructure inadequate to the demands of the economy.

Very large numbers have been targeted by the Federal government. Perhaps the

most often quoted is the $1trn over the following decade announced in 2008. At the

time, that was roughly 5-7% of expected GDP over the period. In 2009,

infrastructure investment was 2% of GDP. It is clear that under-investment is

becoming a barrier to further economic expansion.

Efforts to drive investment fall into four categories

Private sector initiatives. At the individual level, there is already investment taking

place into infrastructure. Ownership of housing and access to financing is

encouraging investment into residential housing. In fact, investment into housing

construction was among the fasting growing investment categories between 2000

and 2008 (20% per annum).The need for investment remains vast. Despite an

income per head of $8,000 per annum, Russians have an average living space in

square metres of 20, approximately the same as in Moldova, Europe’s poorest

country with an income per head of $3,000 per annum (see Figure 21). If financial

markets become better at delivering capital to where there is demand, then there is

little doubt that investment into housing will boom across Russia.

Figure 21: Square metres of ho using per head

Source: Rosstat, UNECE

Reform dependent private sector initiatives

Across a range of public sector utilities, the government has recognised that it has

neither the financial fire power nor the allocative ability to invest appropriately. It

wants to bring in the private sector to provide the financing, and recognises that

investment will only come when services are priced at a level which reflects the cost

of production. But equally, the government is nervous about shifting the economic

cost from the utilities themselves (through unfinanced amortisation) to theircustomers.

0 10 20 30 40 50 60 70

Moscow

RussiaMoldova

ChinaHungary

CzechUK

FinlandAustria

GermanyFrance

DenmarkUS



23


The compromise is effectively an experiment in tariff reform in the electricity sector.

Electricity generation and distribution is just reaching the level when, if investment isnot forthcoming, it will act as a drag on economic growth. The investment

requirement is vast. Numbers range between $250bn to $1trn over the next 20

years. Tariffs are therefore being liberalised throughout the sector, with the hope

that it will stimulate investment.

If it does, then it is likely that the government will roll out a similar programme across

the rest of public sector utilities, from water to gas.

Public-private-partnerships (PPPs)

Much noise was made several years ago about the potential for PPPs to bring

private sector money and discipline to public sector infrastructure investments. The

legislative framework was defined in 2005 by two pieces of legislation, one aimed at

federal projects and one encouraging regional governments to create their own

incentives3.

Since 2005, a whole range of projects have been mooted for financing through

PPPs. By 2008, six had reached the stage where they were had signed, or were

close to signing, financial and construction agreements (see Figure 22).

Figure 22: The most advanced PPPsProject Description Size Consortium Stage of development

Pulkovo Airport PPP Modernising St Petersburg's main international airport EUR1.1bnEUR400mn of equity provided by VTB(58%), Fraport AG (Frankfurt airport)(36%) and EUR716mn loan financing.

Financial close, Apr 2010. Tobe completed by late 2013

Moscow-St. PetersburgPPP

The first 43 km of the motorway linking Russia's twomain cities

RUB60bn($2.1bn)

RUB29bn loan from VEB and Sberbank;RUB10bn of state backed bonds;

RUB23bn from federal govt.

Financial close, Apr 2010. Tobe completed by late 2013

Moscow-Minsk PPPThe first 20 km of the Moscow-Minsk motorway which

will be part of the pan-European transport corridor,Berlin-Minsk-Moscow-Nizhni Novgorod

RUB27bn($0.9bn)

Bond financed, RUB8bn, maturity 2027issued

Financial close, Apr 2010

Western High-SpeedDiameter highway

A toll eight-lane motorway linking St Petersburg, andspecifically the port, to the federal road system

$643mn of bondsSt Petersburg City government and the

Federal govt.To be completed by 2015

Orlovsky TunnelA six-lane motorway under the Neva, linking the two

banks of St. Petersburg. Expected 60,000 vehicles dailytraffic. Toll financed

RUB48bn($1.7bn)

Private investor, city budget, RussianInvestment Fund*

To be commissioned in 2015

Nadzemny Express30 km high speed light railway line across St Petersburg

out to Pulkovo airport$1.3bn Five consortia were short-listed in 2008 No financial close

Source: Macquarie – Renaissance Capital

Clearly the ambition to implement PPPs is large, but the execution has so far been

poor. Despite all the noise over the last five years, no money has yet been actually

invested. Of the projects signed, only one has equity participation, and the debt

participation in the remaining projects all require federal government guarantees.

There are several reasons why progress has been slow.

The financial crisis. Some of the financing agreements behind the biggest

PPPs were signed in the summer of 2008. The timing could not have been

worse. When Russian sovereign spreads widened out from 80 bpts to 400

3 ’The Federal Russian Law on Concession Agreements’ was passed in July 2005 and the‘Law on the Participation of St Petersburg in Public Private Partnerships’ was passed in Dec2005.




24

bpts, there was clearly not going to be much enthusiasm for untested,

several decade-long financing for Russian infrastructure projects. Theappetite for Russia-risk is only just returning to the levels where financing

can again become available

The scale of the projects. Infrastructure needs a lot of funding, and the

government wanted to create some headlines. Even so, the smallest of the

mooted infrastructure projects is nearly $1bn. Given the history of foreign

investment into Russia, it was always going to be challenging to raise $1bn

in project financing on an untested government sponsored scheme outside

of natural resources.

The legislation. The two headline pieces of legislation underpinning PPPs

are not entirely consistent. While the St Petersburg legislation is

considered to be the more flexible of the two, it is not clear how it stands in

relation to the Federal legislation.

The insistence on rouble financing and Russian legislation. It is perhaps

not unreasonable that the federal government insists on using only Russian

law to underpin the PPP agreements, and that financing must be in

roubles. However, it does mean an added layer of risk for international

participants, already baulking at the scale of the projects in the aftermath of

the 2008 financial crisis.

In conversations with investment funds raised to invest into PPPs, it is clear that

most are waiting for a successful example to emerge before committing. It is likely

that a pilot-project will need to be seen through to completion before the fundsraised for investing into PPPs will be released on the scale hoped for by the

government.

Public sector investments

The most problematic hole in infrastructure is those projects which rely entirely on

government spending. This is not because the government lacks the financial

muscle, but rather because it lacks the bureaucratic ability to make the investments.

There are several reasons for this. First, Russia’s underpaid, demotivated and

sprawling bureaucracy outside of central government is not capable of making majordecisions on infrastructure. Second, the Finance Ministry recognises that a major

proportion of any financing provided for a public sector project leaks out of the

system. It has been estimated that building a kilometre of road in Russia is roughly

two times as expensive as building the same kilometre of road in Germany, and five

times as expensive as in China ($3mn in China, $8mn in Germany and $15mn in

Russia)

Third, and perhaps most insurmountably, even with the most efficient of

bureaucracies, it is difficult to justify the economics of many public sector

infrastructure projects across a country as vast as Russia. Building a transport route

between two large cities in China or India creates obvious economics. In Russia, the

country is so sparsely populated that the economics become a lot more difficult to

justify. In theory, a transport link between China and Europe across Russia makes

eminent sense. In practice, this would be a road or rail system stretching across



25


eight time zones – roughly the same distance as from Moscow to New York. The

costs involved are vast, and the economics are uncertain, particularly when thevolatile cost of Russian capital is factored in.

Indeed, it is possibly true that only a regime as blind to economics as the Soviets

would ever build a land-based transport system across Siberia at all. Since the

break-up of the Soviet Union, there has been a further exodus out of Siberia into

European Russia.

So the main issue with rejuvenating Russia’s public infrastructure is the age old one,

identified by Gogol in 1842, of dorogi i duraki , roads and fools. The difficulty is in

economically justifying the building of infrastructure across a country as vast and

sparsely populated as Russia, and the absence of a bureaucracy capable of dealing

with the challenge. These issues are unlikely to be resolved within any reasonable

investment time horizon.

Assuming a modicum of international financial stability, there will be large

investment going into Russia’s infrastructure, mostly through private initiative. But

there will likely remain large holes in some parts of public sector infrastructure,

which are likely to act as a long-term drag on growth.

Financial sector reform

Russia has both large excess supply of savings at the macro-level and large excess

demand for savings at the micro-level. The current account surpluses generated bythe natural resource sector tend to be invested into foreign assets despite the better

returns on offer in Russia.

The failure to intermediate savings within Russia and the reliance on external

funding make Russia dependent on international risk perception. They are major

reasons for the exaggerated volatility in Russian asset markets.

The CBR and government are fully cognisant of the issue. But they are torn between

two objectives. On the one hand they want to reform the financial sector, on the

other, they do not want to create any instability. The institutional memory of the

1990s is still strong, and the government does not want to undermine what fledgling

confidence has been created over the last decade.

The solution which appears to have been adopted is to reform the banking system

by reforming the main state-owned banks. Between them, Sberbank and VTB

dominate the banking sector (Sberbank alone controls 48% of household deposits

and 30% of the assets in the banking sector). If they can become the link between

the supply of savings and the demand for capital from households and SMEs, then it

will help solve one of the main inefficiencies in Russia.




26

Sberbank

Sberbank, under CEO German Gref, the well-respected reformer who headed up

the Economics and Trade Ministry between 2000 and 2007, is undergoing a total

overhaul of its business. The process is gradual, but there are real signs of success.

In his three years in charge, Gref has changed top management, bringing in a

Western-trained Russian group who are actively reforming the bank. The most

public change has been in corporate governance, where the bank has made

significant progress. Quarterly IFRS reporting, management roadshows and an

active investor relations department is a big improvement from the practices of

previous management.

As with reform elsewhere, the 2008 crisis has delayed the implementation and

impact of the reforms at Sberbank. But as Russia pulls out of the crisis, there are

growing signs of change. In March, Sberbank launched its retail credit factory, and

retail loans have been growing by 1% per month since. Credit cards have at last

been rolled out in 2010. Most encouragingly, Sberbank is switching its focus away

from providing funding to large, generally government related corporate and towards

higher margin retail consumers and SMEs. The transition will take time, but it is

clearly in progress.

Will it be effective?

Financial sector reform, private investment into infrastructure and ongoing attemptsto improve the business climate are all examples of an under-appreciated reform

momentum in Russia. Diversifying the economy away from natural resources and

strengthening the domestic financial system will gradually make Russia more

independent of global commodity prices and the international cost of capital.

Eventually, Russia should be able to define its own economic policy framework and

decrease the exaggerated tendency towards boom-bust.

It remains a question, however, whether Russia will be given the opportunity to

pursue a gradualist reform agenda. Volatility in natural resource prices and the cost

of capital risks overwhelming any attempt at domestic reform. One of the reasons

why progress on reforms has received such little attention in recent years is

because of the exaggerated market volatility. Any Russian policy has simply beenlost in the noise of global volatility.

Russia is currently in a good position. Its companies and banks are relatively strong

following two years of crisis. The economy has very l ittle debt. The global outlook on

the cost of capital and the price of natural resources is probably good. The

government seems intent on pursuing reforms.

But this period won’t last forever. Unless Russia is able to use this window to lessen

the economy’s dependence on external factors, both the economy and politics will

remain inherently unstable.



27


Russia looks to be well positioned to benefit from global economic recovery driven

by high growth emerging markets. Over the past two years, firms and banks havebeen forced to restructure balance sheets, cut costs and find new customers. The

economy as a whole is underleveraged and, in particular, the public sector and

households are virtually debt free.

In addition, the government is embarking on a reform programme designed to attract

investment and improve public sector infrastructure. While a degree of scepticism is

warranted given the slow pace of reform over the past five years, there are concrete

signs of progress in some of the most difficult areas, including tariff reform, judicial

reform and tackling corruption.

But the main reason for optimism is that Russian assets will benefit from a low

global cost of capital and rising commodity prices. A combination of the developed

world holding down interest rates and the developing world pushing up commodity

prices is a very good backdrop for Russian assets.

As has been the case for at least the last decade, the main determinant of success

in Russia lies outside of Russia. As a price-taker for the cost of capital and the price

of its largest product (natural resources), Russia relies on global markets to fix its

main economic inputs. A managed exchange rate translates external volatility into

internal price changes, and inflexible capital and labour markets adjust only with

difficulty, leaving Russia exposed to an exaggerated boom-bust cycle.

The key to smoothing the economy and asset markets through the cycle are reforms

to diversify the economy away from natural resources and to create a more effective

means of intermediating domestic savings into the domestic economy. The need toattract capital is becoming more acute as Russia’s domestic public and private

sector infrastructure deteriorates. The timeline for reform is a function of how much

longer economic growth can be supported with current rates of investment.

Twenty years on from the start of Boris Yeltsin’s shock therapy, global recovery is

driving the early growth phase of Russia’s next business cycle. With global growth

being driven by the large emerging economies in Asia, Latin America and Africa,

Russia offers some of the best value exposure to some of the most important trends

in global markets. The speed of recovery is largely outside of Russia’s control. The

sustainability of recovery depends on escaping the boom-bust cycle.

Conclusion




28

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Disclosures appendix



29


Renaissance Capital equity research distribution ratingsInvestment Rating Distribution Investment Banking Relationships*Renaissance Capital Research Renaissance Capital Research

Buy 161 40% Buy 5 71%Hold 61 15% Hold 2 29%Sell 16 4% Sell 0 0%Under Review 12 3% Under review 0 0%Suspended 0 0% Suspended 0 0%Restricted 0 0% Restricted 0 0%Unrated 151 38% Unrated 0 0%

401 7

*Companies from which RenCap has received compensation within the past 12 months.NR – Not RatedUR – Under Review



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