This will be the year of rest and rally

Global prices for commodities have plunged and the international capital markets are in deep freeze. Russia's economy was brought to a shuddering halt in the autumn of 2008. Industrial production fell off a cliff in November and within a few months over 100,000 people had lost their jobs. Some fear that, at a stroke, Russia's investment- and consumer-led growth has been destroyed, while the oil revenues that were paying for it will disappear. Despite all these problems, the underlying convergence story remains intact and analysts are expecting the Russian economy to bounce back strongly in the second half of 2009.


All of Russia's investment banks agree that the first half of 2009 is going to be terrible. However, they almost all agree that in the second half of the year Russia should start to recovery.

Despite the global slowdown, Russia is expected to be one of the few islands of growth left in the global economy by the end of 2009. The timing of this recovery and return of confidence isn't clear and as 2008 draws to a close, two big questions remain open: where will the price of oil settle in 2009? And can the government manage a controlled devaluation of the ruble without causing yet another bout of instability?

Renaissance says in the preamble to its 2009 strategy paper: "In 2009, Russia's markets will outperform when the historic levels of disorder in global finance begins to ease. The breakdown in global markets is fundamentally a consequence of structural weaknesses in developed economies. When the liquidity being created globally to combat the crisis begins to feed into risk assets, emerging markets in general, and Russia in particular, will benefit disproportionately."

Uralsib makes a similar point, arguing that Russia's lack of integration into the global market gives it a measure of protection from the global slowdown, while the momentum of the internal growth built up in the last years will be pushing the economy towards recovery. But this recovery is not certain.

UniCredit says in its strategy report: "We see two major factors shaping investors' attitudes toward Russia over the next 12 months - oil prices and the ruble exchange rate. Without at least some stability in both of these factors, we believe the Russian markets will be unlikely to sustain a rally, even in the short term."

Clearly, if the oil price remains at the sub-$50 per barrel that it was at the end of 2008, then the value of the ruble will have to fall some 15-20% and until this happens, investors will stand on the sidelines as an uncontrolled devaluation could inflict a fresh round of chaos on the economy. However, analysts agree that the issue of finding a new value for the ruble will be resolved early in 2009 and set the stage of the subsequent rally.

UBS sums up what most of the investment banks are saying in its strategy: "In our view, Russia is a special case in the emerging markets block. Markets have sold off heavily and the [central bank] has lost $115bn of reserves (net of valuation changes) since August, but from a macro point of view it is actually quite difficult to find much wrong with Russia. Yes, the economy will slow down, given less available foreign money and, yes, the economy was overheating and inflation had increased, and, finally, Russia is indeed a commodity-based economy that is experiencing a negative terms of trade shock. Still, none of this, in our view, can explain the reserve loss or the way markets have sold off."


With the international capital markets in flames, the Russian state will play a key role in determining the impact of this crisis on Russia's performance in 2009. The state has been quick to offer a huge amount of support and promised over $200bn for 2009. Then in December, Prime Minister Vladimir Putin has announced that the government will directly support 1,500 companies that produce about 85% of Russia's GDP. The initial list will include 300 names that will be expanded in 2009. The main criteria to get on the list are to have a turnover of RUB15bn-16bn, employ more than 4,000 people and be the major employer in the city (Russia has a lot of cities with just one large plant or mine and no other alternatives).

It remains to be seen if this is enough, or even if it is, if it can be delivered efficiently enough to make a difference. Moreover, throwing money at the economy will have to be accompanied by a major stepping up of reforms and a loosening of the state's control over key sectors.


"A fixed exchange rate has exposed industry to the full force of the global crisis. The two standard deviation shock to both the oil price and credit markets has left Russia's credit and payment system dysfunctional. Without a functioning financial system, the economy is seizing up. The contraction in output over the winter will be severe," says Renaissance. "The economic outlook in the first quarter, and possibly first half, is shocking. In the fourth quarter, finance stopped flowing, goods stopped being delivered, investment plans were cancelled and much of the economy simultaneously started hording dollars. The average decrease in capex in 2009 forecast by our sector analysts is 30%. From growth of 8% in the first half of 2008, year-on-year output could shrink as much as 5% in the first half of 2009."

Growth will now almost certainly be negative quarter on quarter in the first quarter of 2009, with the situation believed to stabilise in the second quarter as the beneficial effects of devaluation start to kick in. VTB Capital says in its strategy paper: "We are still in crisis mode, with fear firmly rooted, but no crisis lasts forever, and in line with our previous views, we believe that we are perhaps at the final stages of the financial crisis [as of the end of 2008]. As soon as the blaze is put out - whether this time around or another quarter down the line - the wall of newly created dollars will start seeking better returns."

"Sound familiar? Where will it find them? Dollar-denominated commodities are the first natural choice, and we would expect those with good economics behind them to do particularly well." VTB says. "Soft commodities in the first place: while people might stop driving during a recession, they are unlikely to stop eating. Then, of course, our closely watched commodities complex. By the time the global economy starts picking up, supply will be short again courtesy of today's price action."

o non-payment crisis

Business was frozen in October as companies simply stopped making payments and the longer this goes on, the more damage it will do. Enough damage has already been done to make sure the first one or two quarters of 2009 will be bloody awful.

The further up the value chain, the worse the problem. Retail has been hit by the cessation of consumer credit. Non-payments in steel are as high as 40%. Cash collection in coal companies fell as low as 20%.

At the same time, in November, Rostat was reporting that wage arrears surged, which will feed through to falling retail sales (still strong in October 2008) and so slow one of the main engines of growth. "A combination of government growling and generous liquidity injections are gradually freeing up the payments system. But there is two months' worth of non-payments, which need to be restructured. The short-term impact will be large," says Renaissance.

o capex

Longer lasting on companies' performance will be the impact of the cuts to capex programmes. Russia was not investing enough before the crisis hit and now the problem is worse. Companies immediately cut spending plans for 2009 and it could take a whole year or longer until Russia returns to the 20%-plus growth in fixed investment it needs to ensure long-term growth.


No one expects an economic recovery to begin before the end of the second quarter of 2009, but most expect a good second half.

"In the third quarter, we expect the benefits of devaluation to become increasingly evident, along with the first signs of improvement in the global economy. Demand for metals should start to pick up as the de-stocking process comes to an end, in turn driving up metals prices. The oil price should also start to recover as demand stabilises and the effect of financial market disturbances on commodity prices is no longer felt. Infrastructure projects should also be up and running at this stage," says Renaissance.

However, this recovery is contingent on oil prices recovering to over $50 per barrel. Analysts are divided on the importance of the price. The government has been saying that the economy will function happily at a price of $50 (the amount assumed by the budget) thanks to the reserve fund, but all the main investment houses in Moscow are assuming an oil price of around $70 for the second half of the year.

UniCredit says: "Russia needs an average crude price of $75 per barrel in 2009 to avoid a recession; if this happens, we believe investors would return. Under this scenario, the effects of the oil price recovery would be compounded by the positive effects of moderate devaluation of the ruble, helping the Russian economy to pass through the crisis relatively easily."

Renaissance is expecting Russia to repeat its rebound from the aftermath of the 1998 crisis, predicting negative growth in the first quarter becoming growth of 5% in the third quarter of 2009. By the final quarter of the year Russia's economy could be humming along again at 7% on quarter, according to Renaissance.

Renaissance says: "By this time, growth should be driven by private consumption and investment (the latter through both government and private funding). Sector-wise, we expect to see the strongest recovery in the mining, transport and manufacturing sectors."

"But perhaps the most remarkable facet of the value destruction of the past six months is that the medium-term investment thesis underpinning Russia remains more or less intact. There is some possibility that the giant emerging economies will choose to turn away from market-based economics. But that chance remains small. More likely, they will emerge from what is fundamentally a developed world financial crisis relatively stronger," says Renaissance.

In contrast with many developed countries, Russia's return to the growth path will be unencumbered by the need to deleverage a large volume of household debt, and this should support a rapid recovery of private consumption, argues Renaissance.

However, things will be tougher for corporates, which still face the challenge of rolling over their debt. But here the Russian government can make a huge difference and has already stepped up to the plate. "We firmly believe that, as a result of government policy and a turnaround on the global markets (both financial and commodities), the mood mid-year will be drastically different from now," concludes Renaissance.


Because of the convergence story there is no doubt that demand for commodities will recover. If Russia and the rest of the emerging universe were developed economies, then this downturn of the business cycle could go on for years. As the convergence story supplies a positive upward pressure on growth that is independent of the global business cycle dynamics, arguably these economies will bounce back sooner than the developed world. But the issue is all one of timing and how bad the international crisis is.

"The medium-term commodity picture remains one of rapidly growing demand and increasingly expensive supply," says Renaissance.

The potential of the medium term is captured by the economic forecasts from the IMF. While the fund has a poor record of forecasting Russia's growth it has still upgraded its estimates of the relative size of the Russian economy measured in dollars and predicts Russia will have the fifth-largest economy in the world by 2013.



Deputy Economic Development Minister Andrei Klepach says in December the economy could contract by as much as 0.5% in 2009 under a pessimistic scenario, but the base projection foresees growth resuming by mid-2009 and reaching 2.4% for the year assuming an oil price of $50 per barrel. The ministry expects the major growth drivers to be continued investment demand expansion at 1.4% and real growth of disposable income of 2.5%, but predicts industrial output to fall 3%.

The government also expects the ruble to fall to RUB30.8/USD-RUB31.8/USD, assuming a USD1.25/EUR exchange rate, implying another 5-6% devaluation from the end of 2008 level. The ministry expects inflation to stay in double digits, reaching 10-12% despite slowing growth and falling commodities prices.

Renaissance says the crash in capex and spending means the growth could crash from 8% in the first nine months of 2008 to -5% in the first half of 2009. "Given the very high growth rates in the first half of 2008, recovery is only possible in the third quarter of 2009 and only likely in fourth. But when it happens, it is likely to be rapid," says Renaissance's Roland Nash.

GDP growth forecasts for 2009
Government 2.4%*
Alfa 0% to -5%
Renaissance 4%
Uralsib 4.3%
Unicreidt 2.5%
IMF 3.5%
Fitch 2.5%
* assuming oil price of $50

key factor: EXCHANGE RATE

The ruble will have to be devalued to accommodate the new lower oil prices. Most of the banks agree that the average exchange rate for 2009 will be between RUB30-31/USD from the RUB24.9/USD average in 2008.

But the question for 2009 is if the Central Bank of Russia will let the ruble float freely. It may be forced to, as the state cannot go on spending money at the rate it was at the end of 2008.

UniCredit says: "We believe that by end-2008 the CBR could spend another $50bn-60bn of reserves in addition to the $50bn issued to refinance external debts [to support the ruble]. This would put Russia's total international reserves at roughly $350bn, or just $200bn-220bn net of the amount needed to continue ruble support, which we think is close to the critical level of reserves for the central bank. As a result, we believe the CBR will decide to let the ruble float, opening the door for a devaluation of some 15% next year."

The Russian economy is linked into the global economy through two main channels: commodity prices and financial markets, and both went sour at once in the middle of 2008. "Russia's effectively fixed exchange rate system means that any adjustment to an external shock cannot be offset by a shift in external prices. As a result, domestic prices must do all the heavy lifting. Given that Russia's internal capital and labour markets are not efficient, the adjustment involves very large costs. The tremendous movement in asset prices and the explosion in non-payments across the economy are effectively the attempt by markets to adjust to the external shocks in the absence of a flexible exchange rate or efficient domestic capital and labour markets," says Renaissance.

The upshot of this change is that the cost of money in Russia went from being very negative in real terms, to money becoming prohibitively expensive.

One of the main tools that the government will use in the first half of 2009 to fight the dramatic slowdown in the economy will be to loosen its control over the exchange rate, and it was already doing so at the end of 2008. But this will be a tricky task of letting the ruble devalue "not too fast, not too slow." Fast unsettles the population and hurts the banks; slow burns up hard currency reserves at a rapid rate.

All the banks agree that the authorities will have to take a much more flexible approach to foreign exchange policy in 2009. How and how fast this is done will be a key driver for the economy through the remainder of the year.

Exchange rate forecasts 2009
Government RUB30.8/$-RUB31.8/$
Renaissance RUB30.5/$*
UniCredit RUB31/$**
UniCredit RUB35/$***
* oil at average of $75
** oil at average of $70
*** oil at average of $50

key factor: OIL SCENARIOS

Clearly, the price of oil will be another of the key determining factors for 2009. Oil ended 2008 at an average price of $96, according to Finance Minister Alexei Kudrin, and there is no way it will come anywhere close to that in 2009.

Most banks are assuming oil will be at $75, which is an acceptable price that allows growth, a balanced budget and no balance of payment deficits. Investment would return and Russia would pass through the crisis with limited damage.

"Russia needs an average crude price of $75 per barrel in 2009 to avoid a recession; if this happens, we believe investors would return. Under this scenario, the effects of the oil price recovery would be compounded by the positive effects of moderate devaluation of the ruble, helping the Russian economy to pass through the crisis relatively easily," says UniCredit.

Analysts are confident of this price because of the demand and supply argument above, but also because the budgets in the Middle Eastern countries also only balance at $50 or more, and so this will enforce discipline on the Opec members when it come to making price-supporting production cuts.

"The real trouble begins if oil stays at an average of $50/bbl," says UniCredit. "We see a high risk of recession and devaluation in this case. We admit that given the current level of oil prices, an outlook of $50 or even lower is not unrealistic, as is an even more pronounced devaluation of the ruble."

At $50 oil, UniCredit predicts: "real GDP growth to slow to just 0.5%, with investment demand slipping into negative territory and contracting by some 3%; a heightened risk of sharp devaluation; unemployment rising sharply; the banking sector facing serious problems; and redistribution of property, spreading to large businesses, as corporate default risks intensify sharply even among blue-chip companies.

UBS is amongst the most pessimistic banks on oil prices in 2009, but even this bank predicts an oil price of $60, before recovering to $70 in 2010.

Highlighting the confusion, Fitch believes oil prices in 2009 could average around $80 per barrel if Opec is able to effectively defend this price through sustained production cuts. "This would result in Russia's net export earnings averaging around $400bn in 2009, which is still quite high relative to historical averages," the agency says in a December report.

Despite the uncertainty over the oil price, the main takeaway is that almost all the experts are expecting oil to be comfortably above the key $50 level and so Russia should suffer only a mild version of this crisis.


Until the crisis hit inflation was the big problem for Russia. However, the fall of oil prices means that inflation has receded.

The sharp decline in industrial production that started in November 2008 was accompanied by falling producer prices. The PPI dropped a record 8.4% on month, bringing producer prices to only 4.4% year-on-year in November. Some analysts speculate there could be some producer prices deflation. This has never happened to Russia before; the only time the year-on-year PPI has been negative was in August 1998.

That says inflation will still be high and the amount of cash injected into the economy by the government will keep the level high. But the problem with inflation in Russia is not expected to be as bad in the developed world.

Government 10-12%
Renaissance 12%
Uralsib 10.5%


Currently investors small and big are selling assets and going into cash - the dollar. However, for Russia to recover investors need to start moving out of dollars back into other assets. Some analysts believe there is a bubble forming in the dollar's value and the expectations it will weaken are widespread.

A falling dollar to the ruble will have several beneficiary affects on Russia's economy.

o it will improve the competitiveness of the ruble without the CBR having to adjust the exchange rate, which is the symbol of Russia's economic health. However, most of Russia's costs are in euros.

o a falling dollar will help commodity prices and in particular will support the oil price which also has a big psychological impact on the economy.

o a falling dollar will also remove the incentive to trade out of assets into dollars and this will contribute to the resumption of crediting and so help fix the broken payment system.


Russia's industrial output fell off a cliff in November 2008, according to Rosstat, contracting by 7.5% year-on-year (8.7% on month), well ahead of the market expectations of a 1.5% year-on-year drop. The fall was led by a 10.3% year-on-year drop in manufacturing and a 9.3% decline in regulated goods.

The industrial production data crystallizes the fears of a dramatic slowdown in production for 2009. As 2008 ended railway transportation had plummeted 20% year-on-year, while there were record lows for the manufacturing and services PMIs, as well as the output declines in the metals and automotive sectors. The size and speed of the decline in output is striking and indicates that the economy has very little resilience to negative shocks.

Some analysts argue that the economic momentum built up in recent years means it will not be so hard to get the ball rolling again once liquidity returns. However, every day manufacturing idles the more difficult it will be. At the end of 2008 it was still not clear exactly how much damage has been done.


Russia will still have a trade surplus in 2009, but will face a current account deficit, Deputy Economic Development Minister Andrei Klepach said in December.

The country's trade surplus is expected to amount to about $18bn next year the ministry's forecasts. Russia's exports are expected to fall to $303.1bn, while imports are expected to decrease to $284.7bn. In 2008, exports were an estimated $469.1bn, while imports are planned at $292.5bn.



Russia went into 2008 as a safe haven in an increasingly unstable world, but by the end it was a pariah. In an awful year for financial markets globally, Russian equity was among the hardest hit of any market.

The whole Russian market (which provides investors with exposure to one of the largest world economies, including 25% of gas reserves, the biggest oil reserves outside Opec, and the third-largest hard currency reserves in the world) is down from over a trillion dollars to $300bn - less than the market capitalization of a single US oil major, ExxonMobil. And UniCredit points out that the Russian market is now worth only 17% of the country's GDP, which is substantially lower than other key emerging markets, such as Brazil (24%), Turkey (37%), China (39%), and Poland (48%).

"Our rough calculations suggest that the market is pricing in a scenario in which the Russian economy collapses during a long global recession, with oil prices at $30/barrel, a crisis in the financial system, a massive drop in reserves, the inability of both the Russian government and corporates to pay their debts, and substantial devaluation of the ruble. While we cannot fully exclude this scenario, we believe its probability is fairly low at the moment," says UniCredit.

The current low valuations for Russia are typical of investors' sentiment towards the country, as they have always had a "love-hate" relation with it. The issue with investing into Russia has always been one of timing more than anything else.

Roland Nash, head of research at Renaissance says: "Over the last 12 years Russia has either been amongst the best performing equity markets in the world or in the worst. So you have to ask yourself a simple question: which one of the two do you think it will be in for 2009?"

All the major banks are expecting a strong gain in equity prices in 2009 and the predictions run from between 80% (UniCredit) through 100% (UniCredit) to over 200% (Renaissance) contingent on what happens to oil prices and the value of the ruble. The universal consensus is if oil settles at around $70 in the summer of 2009 these gains will be realised.

Several banks recommend equity investors to watch the yields on the bond markets as a lead indicator of when equities are about to recover, as falling yields in 1999 preceded a rally in equities in the last big crisis.

For any sustained recovery in equity markets, two necessary conditions must apply. First, there must be some relief in global risk markets. Second, commodity prices, particularly oil, must stabilise.

o PE ratios

Russian equities were oversold in the midst of the crisis - there is little debate on this point. While developed markets equity prices fell by about 40% Russian equities are down by 75% or more. This has left Russian assets terrifically cheap on an asset basis. Even on a cash-flow basis at $40/barrel oil, Russia is trading on a 2009 P/E of 7.9x, according to Renaissance estimates.

Even before the crisis struck in September, Russia was amongst the cheapest markets in the world on a P/E ratio.

o end of year target for RTS

All the investment banks struggled to set a target level for the RTS at the end of 2009, as there are so many unknowns that go into the calculation this year. Best they could do was make some conditional statements, but all agreed on a level of around 1000-1100 - providing there was no fresh train wreck along the route.

Renaissance says: "We see the RTS reaching 1,100 by the end of 2009, which is 75% upside from current levels [in December 2008], and still less than half of where it was in June 2008."

Uralsib says: "The trading range in the first half of 2009 is again likely to be very wide, possibly between 500 on the downside and 1,200 on the upside... How the market closes out the full year will depend on how the global economy performs, how oil and other commodities trade and how investors perceive investment risk in Russia."

Troika says: "At $55 oil, a 20% devaluation and a 16% cost of equity, our end-2009 RTS Index target is 1,000. However, there are clearly huge variables surrounding this; a global depression would see the index at 350, while a rapid bounce in global growth would take it back to 1,500.


Despite the massive widening in spreads at the end of 2008, Russia doesn't have a debt problem and Russia is underperforming its lower-rated peers.

As with the Russian equity market, which is now demonstrating the weakest performance of all GEMs, Russian Eurobonds have fallen farther than their peers.

The Russia-30 spread to underlying US Treasuries widened to almost 1,000bp, whereas it fluctuated in the 120bp-200bp range until August, while the composite JP Morgan EMBI Plus Index benchmark spread increased to 760bp from its 200-day moving average of 350bp. Turkish indicative 2030 Eurobonds are now trading with a 625bp spread, and Brazil-2040 at 600bp, even though both countries' sovereign ratings are lower than Russia's.

UniCredit says: "Yields on corporate bonds seem excessive, even in light of deteriorating credit quality. Russian corporate debt - including the quasi-sovereigns - suffered even more than the sovereign Eurobonds."

The bank says that the double-digit yields on quasi-sovereign bonds - as of December: VTB-12 yielded 21.6% at the end of 2008 vs. 7% at the beginning of the year, Gazprom- 2013 yields went to 16.9% vs. 6%, Transneft-14 yields 19.4% vs. 6.45% - have been over done.

"These companies have an implicit (and sometimes explicit) state guarantee, as well as boasting strong cash flow, even in the current commodity price environment," says UniCredit.

Russia's external leverage is high - total external debt was almost $530bn as of July 1, 2008 (according to the Central Bank of Russia) with the CBR's foreign reserves at $565bn - but the country's position looks comfortable in comparison to Turkey (reserves of $117bn vs. total external debt of $284bn as of July 2008) or Brazil (reserves of $197bn vs. total external debt of $214bn as of October 2008), according to analysts at UniCredit.

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