25 August 2014

Vladimir Miklashevsky Economist, Trading Desk Strategist Danske Bank Markets, Research + 358 10 546 7522 vladimir.miklashevsky@danskebank.com In Twitter on Russia and RUB: @vmiklsuomi

Russian economy: landing softly

Important disclosures and certifications are contained from page 15 of this report.

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Economic growth approaching zero

Economic growth in Russia has slowed further, posting 0.8% y/y growth in Q2 14 versus 0.9% y/y in Q1 14. GDP saw a 0.2% y/y contraction in July 2014. Our 2014 GDP forecast remains -0.3% y/y due to a surge in geopolitical risks, which have introduced both supply- and demand-side shocks. Yet, in July, consensus for 2014 GDP growth was at 0.5% y/y decreasing from an expectation of 2.2% in February 2014.

Net capital outflows slowed down to USD25.9bn in Q2 14 versus USD48.8bn in Q1 14 (excluding banks’ FX operations). Yet, the amount remains extremely high and we expect net capital outflows to reach USD120bn in 2014.

Fixed investment growth is still disappointing: it increased just 0.5% y/y in June, falling for the first five months of 2014. Construction improved 1.2% y/y in June, staying negative in H1 14 despite strong residential construction data: 30.2% y/y growth in H1 14. As supply-side shocks and tightening monetary policy are set to have a further negative impact on fixed investments in 2014-15, we see some upside risks in 2015-16 arising from giant state projects such as the gas line deal with China and plans to invest additionally into infrastructure.

Source: Bank Rossii, Bloomberg, Danske Bank Markets

-60

-50

-40

-30

-20

-10

0

10

20 Russian private sector's capital net

flows, USD bn

Other sectors

Banks

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RUB: weak, but not enough

Source: Macrobond, Reuters EcoWin, Danske Bank Markets (both

charts)

Despite the nominal weakening of the rouble (-9% against the USD and -5.5% against the EUR YTD as of 22 August 2014), high inflation ensured real appreciation of the rouble as inflation in trade partner countries is lower on average: in January-July 2014, the rouble’s REER surged 1.4%.

In practice, the real appreciation means that

Russian companies continue to lose their international price competitiveness but Russian consumers are still able to consume more and more foreign goods.

An increasing monetary base is adding up to inflation, although not significantly, and weighing on the RUB. At the same time, growing money supply is helping the Russian economy through better liquidity and expectations of lower rates in 2015.

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RUB: floating freely...on the horizon

Source: Bank Rossii, Danske Bank Markets

• Bank Rossii has made another firm step towards a free floating currency in 2015. On 18 August, the rouble’s trading band against the dual currency basket was widened by two roubles to nine. This is the first widening in two years. The central bank is abolishing FX interventions within the range, aiming to complete the shift to free float by the end of 2014. • The Russian central bank surprisingly hiked its main rates by 50bp on 25 July 2014 to curb accelerating inflation and support the RUB. We do not expect Bank Rossii to lower the key rate in coming months. The next rate decision is due to be published on 12 September. We expect rates to be unchanged. We believe that a 50bp rate hike is possible in H2 14 if CPI accelerates further on the food import ban.

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*RUBBASK (45%EUR+55%USD)

upper border

lower border

RUB's trading band vs. the dual currency basket

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Inflation climbs up on weak rouble and geopolitics

Inflation disappointingly accelerated in H1 14, climbing from 6.1% y/y in January 2014 to 7.8% y/y in June 2014, which is outside Bank Rossii’s target range (5-6%). Some relief has been seen in July as slow food price rises due to summer period pushed CPI to 7.5% y/y. The main impact has come from inflationary expectations due to the rouble’s fast nominal weakening (-7.2% against the dual currency basket from early January 2014 to late July 2014) and the deteriorating geopolitical situation, which has caused a ‘sanctions war’ between Russia and some developed economies.

We have raised our 2014 Dec/Dec inflation outlook by 0.6% pp to 6.8% y/y and continue to see upside risks as continuing food imports ban may push prices quicker.

We expect the tight monetary policy, freeze in tariffs for industrial consumers and slow economic growth to push inflation down further in 2015-16. However, the weak rouble may add some upside pressure to import prices.

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Consumer’s fairy tale is over for now

As we expected, the consumer sector growth is slowing further down. Accelerating inflation together with weakening RUB and tightening monetary policy are seizing purchasing power of Russian households.

In H1 14, retail sales growth slowed to 2.7% y/y versus 3.9% y/y in H1 13. Yet, July’s figure improved a bit to 1.1% y/y from June’s 0.7% y/y, which was the weakest growth since January 2010. Car sales dropped 23% y/y in July, its weakest since February 2010. We expect private consumption growth to expand moderately in 2014, but to turn negative in 2015 as demand-side shock affects the consumer.

As we expected, real wages grew more slowly this year: 3.4% y/y in H1 14 versus 5.4% y/y in H1 13. July expansion was just 1.8% y/y, the poorest since the February 2011 drop. Nominal average monthly wage has risen to RUB32,715 in July 2014, but regional differences are large. We expect real wage growth to stay low in 2014 on risks of raising inflation.

Unemployment continued to slow, remaining at a record-low 4.9% for the third month in a row and supporting private consumption. However, the scarcity of the labour force due to weak demographics continues to curb long-term economic growth.

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-11

-6

-1

4

Consumer confidence index

consumer confidence index

appetite for large purchases

Source: Rosstat, Danske Bank Markets

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Non-performing loans are growing at alarming rate

As interest rates for consumer debt remain high (weighed average annual rate for consumer loans under one year in roubles was 28.1% and in USD 12.3% in June 2014), low growth of real wages has put more debt servicing burden on Russian households.

We see the current situation as challenging for Russia’s monetary policy makers: the central bank has to manoeuvre taking into account many things: health of banking system, rouble’s soft weakening, capital outflows, slowing economic growth and poor fixed investments performance by Russian corporations. Yet, Bank Rossii has stated that its main goal is inflation targeting.

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Residential construction expands on a steady path

• In H1 14, residential construction expanded 30.2% y/y to 29.4m square meters versus 7.5% y/y in H1 13.

• Mortgage stock is traditionally low in Russia: only 15.4% of all consumer loans issued in 2013 (14.3% in 2012) were mortgages, as high rates impose limits. The average rate for RUB mortgages was 12.2% as of 1 July 2014.

• In 2013, RUB mortgage loan issuance grew 31% y/y (in 2012, RUB mortgage loan issuance grew 54% y/y versus 97% in 2011). In January-June 2014, loans issued grew 43% y/y. We expect mortgage loan issuance growth to slow further in 2014-15, as banks are tightening conditions and real income is set to grow moderately.

• FX loans are just a tiny part of the stock: 1.1% in 2013, 1.4% in 2012 and 2.7% in 2011 of all mortgage loans issued.

• In 2013, the average payback of RUB mortgages was 176 months (versus 180 in 2012). As high rates prevail, Russian consumers seek to pay back their loans as quickly as possible. The share of mortgages paid in advance was 31% of stock issued in 2013.

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0 %

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6 %

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10 %

12 %

14 %

16 %

18 %

0%

10%

20%

30%

40%

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70%

80%

90%

100%

FX exposure in loans is decreasing

Source: Bank Rossii, Danske Bank Markets

Mortgage loan and rate development in Russia

Source: Bank Rossii, Danske Bank Markets

RUB

FX 0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Corporate RUB and FX loans, % of total

corporate loans

RUB

FX

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Oil price risk to weigh on Russian budget

• The Russian budget saw a 2.2% of GDP surplus in January-July 2014 as the average oil price being USD106.8/bbl during the period. This is far more than budget’s break-even oil price for 2014 (USD101/bbl). Thus, the budget stayed balanced from one month to another due to high energy prices and increased tax collection. Oil and gas revenues continue to exceed income from non-energy sources.

• We expect a deficit of 0.6% in 2014 and less than 1% of GDP in 2015, as the weakened rouble helps to cover increased expenditure. The budget deficit could be financed by oil funds as external borrowing has been challenging due to increased yields on geopolitical woes and rating cuts.

• The budget suggests that in 2014 and 2015, GDP is set to amount to RUB74trn and RUB83trn and inflation to not exceed 5%. The budget’s break-even oil price levels are USD97/bl, USD101/bl and USD104/bl for 2013, 2014 and 2015.

• However, as the average Brent price declined to USD104.4/bbl as of 20 August, we see downside risks for increases in budget revenues.

Source: Macrobond, Danske Bank Markets

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Foreign direct investments to Russia

Source: Bank Rossii, Danske Bank Markets

0

100,000

200,000

300,000

400,000

500,000

600,000

Dec-09 Dec-10 Dec-11 Dec-12

Total inward FDI accrued (USDm)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

Dec-09 Dec-10 Dec-11 Dec-12

FDI accrued by country of origin (USDm)

Denmark Norway

Finland Sweden

Source: Bank Rossii, Danske Bank Markets

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Russian stocks: more fundamentals, less geopolitics

• H1 14 has been a very challenging period for Russian stocks. The strong start of the year was ripped out in March 2014 as geopolitical situation around Ukraine escalated further. As with other global indices, Micex was strongly driven by geopolitics. Yet, later in May 2014, investors pushed geopolitical fears aside and started buying stocks at levels cheaper than before.

• Since the bottom levels in March 2014, Russian stocks have gained 17.2%. Yet, the Micex stock index growth remains 3.6% negative from its top levels in January 2014.

• We see that currently the main focus has shifted more to fundamentals from purely geopolitics. However, we see that unique tragic events may stop the current buying anytime. However, we advise not to underestimate geopolitical risks.

Source: Bloomberg, Danske Bank Markets

Russian stocks seeing accelerated demand on dips

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Scandinavian stocks with Russian exposure

Source: Bloomberg, Danske Bank Markets

Company Sector Performance, %, y/y,

as 7 Jan '14

Rockwool Construction 54.6

Modern Times Media 43.6

Tikkurila Construction 36.4

TeliaSonera Telecoms 17.0

Fortum Utility 14.7

STOXX Nordic Index 14.4

Nokian Renkaat Auto 10.2

Oriola-KD Pharma 8.2

Carlsberg Consumer 3.7

Aspo Industrial -6.6

Oriflame Consumer -6.9

Scania Auto -7.8

YIT Construction -15.7

Stockmann Retail -16.5

Company Sector Performance, %, y/y,

as 22 August '14

Scania Auto 42.1

Fortum Utility 26.5

Aspo Industrial 16.5

STOXX Nordic Index DKXF Index 14.3

TeliaSonera Telecoms 7.6

Tikkurila Construction 6.9

Oriola-KD Pharma -1.3

Rockwool Construction -5.8

Carlsberg Consumer -6.0

Modern Times Media -15.0

Stockmann Retail -25.0

Nokian Renkaat Auto -29.7

Oriflame Consumer -30.7

YIT Construction -32.4

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Macroeconomic and FX forecasts for Russia

Source: Macrobond, Rosstat, Danske Bank Markets

2013 2014 2015 2016

GDP (% y/y) 1.3 -0.3 -1.8 0.5

CPI (% y/y) 6.8 6.8 4.8 4.0

Private consumption (% y/y) 4.0 1.2 -2.2 2.2

Fixed investments (% y/y) -2.0 -3.7 -3.0 0.3

Unemployment (%) 5.6 5.5 6.1 6.0

Current account (% of GDP) 2.0 1.0 0.1 0.1

Russia

Credit rating:

S&P: BBB- (negative)

Currency regime:

Managed peg versus dual

currency basket – 45% EUR and

55% USD (freely convertible)

Inflation target:

5% in 2014, 4.5% in 2015

(December-on-December basis)

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Disclosures

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of this research report Is Vladimir Miklashevsky, Economist, Trading Desk Strategist.

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Date of first publication

See the front page of this research report for the date of first publication.

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