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Russian economy: The flight of the Russian phoenix

Guy Norton
8th January 2008

Willi Hemetsberger, head of global markets at UniCredit Markets and Investment Banking in Vienna, admits: "At the time it was hard to see how Russia would get itself out of the crisis." Few people can have had such a baptism of fire as Hemetsberger, who joined Bank Austria Creditanstalt, now part of UniCredit Group, the day that the Russian government gave up the fight to defend the rouble and pay back tens of billions of rouble-denominated government bonds. But as Hemetsberger explains, even during the darkest hours of mid-August 1998 there was confidence that Russia would not remain an economic basket case for ever. "It was always clear that Russia was potentially a very rich country, but that it had to sort out its political, legal and regulatory framework to achieve that potential," he says.

Until the dawn of the new millennium it was far from certain that the country would achieve that goal. Peter Halloran, chief executive of fund management company Pharos Financial Group, says: "In 1999-2000 Russia was still pretty much a binary bet, which either would or wouldn’t come off."

One factor that hurt the country most of all in 1998 was the price of oil falling below $10 a barrel. With the oil price having tested the $100 a barrel mark in recent months it’s easy to claim that Russia has simply benefited from the growing global demand for oil. "The recovery in the oil price has clearly helped Russia a lot," says Halloran at Pharos. "But in 1998 nobody knew where oil prices would go." And as Halloran points out, in countries such as Nigeria, Venezuela and Iraq high oil prices have not delivered the widespread economic benefits that they have in Russia. The clear difference is that in recent years Russia has benefited from the type of political stability that has been lacking in many other oil-rich nations. Any discussion about Russia’s economic recovery inevitably revolves around the emergence of one key figure, Vladimir Putin, Russia’s president since 2000 and the man widely credited with restoring the country’s pride in itself. "Patriotism was completely lacking in the 1990s in Russia," says Halloran at Pharos. "Everything that happened was driven by a handful of oligarchs who acted in their own best interests and not in the country’s." Traditionally, pride is regarded as one of the seven deadly sins, but in terms of nation building a sense of pride is essential. Doubts about Putin’s democratic credentials notwithstanding, Halloran says that he has restored a sense of self-belief to Russia that was sadly lacking in the late 1990s. "More than anything else, Putin wants Russia to be a great nation," he says.

Halloran says that when Putin took power in 2000 he stopped the rot by going back to basics and centralizing political and economic power. "He put an end to personal fiefdoms in the regions."

Hans Holzhacker, chief economist for Russia at UniCredit, agrees that Putin’s centralizing policy has paid dividends. "Centralization has been positive from a fiscal point of view in that there is much more economic predictability and that has helped to gain the support of the population." Although the Kremlinization of the Russian economy will not win Putin any plaudits from free marketeers, Holzhacker says it plays well in Russia. "I don’t think that Russian will ever subscribe to a totally liberalized economy," he says. "State control would never be re-established in a Gosplan-type way," referring to Soviet-era style economic planning.

Holzhacker cautions that overcentralization has its dangers as well, however. "If we have overcentralization the cost would be increased cronyism and corruption, and that could endanger the long-term efficiency of the economy," he says. Halloran at Pharos acknowledges that despite the greater democratization of economic participation there is still a danger that the good work of the past few years could be undone. "Russia is still controlled by a relatively small group of people who act without many checks and balances and could make a foolish decision."

"The big goal is aligning our regional footprint. The Russian banking sector is still underdeveloped compared with the likes of Kazakhstan and Turkey"Leonid Vakeev, UralSib

It’s a danger that Putin himself has acknowledged in recent weeks. Addressing the heads of Russia’s Chamber of Commerce and Industry at a meeting in early December, he said: "We are not planning to have state capitalism. It is not our choice or our way of development." The government would see to it that state corporations do not suppress other businesses, he vowed, by creating a purely market environment for them.

Leonid Vakeev, executive director at UralSib, one of the country’s leading financial services groups, says that the big difference between 1998 and the present day is that there is much more confidence in the country’s economic destination. "Everyone is convinced that Russia is now on the right path," he says. "Both Russian and foreign business people feel comfortable with the situation in the country."

It’s a measure of the turnaround in Russia’s economic fortunes that it is now attracting the attention of the very biggest players from the US, its one time ideological foe. In recent months leading US retailer Wal-Mart announced that it was looking to set up shop in Russia in 2008, and Citi, which has been hammered by losses in the sub-prime mortgage market in the US, recently announced that it would add further bulk to its banking network in Russia.

Open to investment

Holzhacker at UniCredit believes that despite any short- term political tensions between Russia and the West, Russia will remain receptive to such investment. "Russia welcomes FDI as long as it’s not in economically strategic areas such as energy, where it has a vested interest to remain in control. It’s good for it to have access to foreign capital on both a strategic and portfolio investor level in other areas."

It is not just Russia’s access to capital that will play an important role in the future of the Russian economy, says Holzhacker. The willingness of other countries to open their markets to Russian companies will also be significant. "The question of Russian access to the European Union and the spectre of EU protectionism is a major issue that has to be confronted," he says, adding that expansion into international markets will play a key role in the development of corporate Russia. In this context the concurrent rise in the economic importance of China and India is a valuable counterbalance to Russia’s often-troubled economic relations with Europe and the US.

"The secular rise of China and India has permanently altered the global petroleum balance," says Eric Kraus, manager of the Nikitsky Fund, one of several Russian hedge funds established in recent years to take advantage of the booming Russian economy. "Massive industrial growth in the developing countries is the primary driver subtending Russia’s economic resurgence, and is not likely to reverse in the coming decades." Holzhacker adds: "Emerging Asia is very important for commodity prices and Russia’s political leverage with Europe over oil and gas supplies." Russia’s ability to play off demand for oil and gas from China and India against that from Europe will play a key role in its economic future, he says.

"Russia will not be independent of oil and gas prices for the foreseeable future," he says, adding that ensuring a geographically diverse market for its production will be of key importance. "We’re seeing buoyant growth in the non-oil and gas sectors of the economy but Russia needs to improve production of oil and gas to help support those developments."

All market participants agree that the greatest long-term challenge for Russia is ultimately to reduce its dependence on commodities and develop a more diversified economic base. "Russia has always been more than just an oil and gas play," says Hemetsberger at UniCredit. "And it has a good idea of where it wants to go in terms of implementing industrial and economic policy."

One of the key policy announcements in 2007 by the government centred on infrastructure development, which is seen as a priority if Russia is to sustain high levels of growth. Key players have already positioned themselves to take advantage. Leading Russian investment bank Renaissance Capital, for example, has teamed up with global infrastructure specialist Macquarie Bank to develop infrastructure advisory and fund management opportunities in Russia. "It is estimated that up to $200 billion will be spent on infrastructure in Russia over the next five years or so, excluding the oil and gas sector," says Alexander Pertsovsky, global chief executive of Renaissance Capital. "While the government will provide most of the funding, there is an expectation that the private sector will support this development with the additional funding required."

Worn-out infrastructure

Renaissance Capital infrastructure analyst Eduard Faritov adds: "The required investment is very large. However, economic growth at current rates will not be sustainable without increased investment into the infrastructure – more than half of Russia’s railways, roads and airports are fully depreciated."

He adds that in 2006 Russia invested only 1.04% of its GDP in road reconstruction and maintenance. By comparison, Italy spent 4.8% of GDP on roads infrastructure and the UK 4%, Even in poorer countries such as Belarus and Mongolia, spending was higher, at 2.2% and 1.6%, respectively. "We estimate that $560 billion is required to build the extra 451,000 kilometres of roads needed to bring density of roads in Russia to 50% of the level of Canada – a country with one-third the population density of Russia – by 2020," says Faritov.

Dennis Gaevski, head of capital markets at Bank of Moscow, says that just one landmark infrastructure project – the 2014 Winter Olympics in Sochi, southern Russia – will generate at least $60 billion in investment and that a key challenge for banks is to identify and help fund the companies that are best positioned to win contracts for such a politically prestigious event.

If Russia is to attract the funds necessary to support infrastructure development and economic diversification, market participants say that it will need to improve corporate governance across the board. Although the most notorious examples of robber baron capitalism seen in the 1990s have largely been abolished under Putin, Halloran at Pharos says: "Corporate governance is still one of the risks in Russia." He adds that the government is playing its part in improving affairs. "The state’s role in public companies has generally been a positive one and has had a stabilizing effect on corporate governance in the country. Corporate governance is largely a question of self-interest – people need to realize that part of the price of accessing capital markets is improving corporate government standards." Kraus at Nikitsky adds: "The cumulative success of Russian IPOs in the west means that more and more managers see this as a realistic exit, which gives them an incentive to be more investor-friendly."

Access to international capital markets and foreign portfolio investment in Russia has had an undoubted positive effect – Russia’s stock market capitalization, for example, has soared to more than $1.2 trillion, compared with less than $200 billion at the start of the decade – there are downsides as well; the country is now more sensitive to changes in global stock market movements and investor sentiment.

Pertsovsky at Renaissance says that despite very strong economic fundamentals, Russia is sharing the pain of the tightening of global liquidity. "Why? This happened precisely because of Russia’s success in becoming a fully integrated member of the global financial system." He adds that with more than $450 billion in reserves and a stabilization fund of $130 billion and growing, there are few countries better able to withstand a liquidity crunch than Russia. Although the country is fully integrated with the global financial system, its economy is still firmly independent and self-sufficient.

"Moreover, the only major risk factor to Russia from economic slowdown in the US is through commodity prices. But the weakening dollar is helping to push up commodity prices. So, in that sense, Russia acts as a natural hedge to any US slowdown."

Pertsovsky says that another important trend that will help support equity performance is the evolution of the asset management industry in Russia. "Interest rates in Russia will remain negative in real terms, encouraging depositors to shift savings into real assets. Less than 5% of Russian GDP is currently invested in mutual and pension funds compared with over 100% of GDP in the US." Growing domestic funds will help further boost liquidity on the Russian equity market, where daily turnover has risen from less than $100 million in 2000 to more than $10 billion this year – four times the average daily turnover in Turkey and more than twice that of France.

Not only is the size of the market increasing, so is its sophistication. With increasing numbers of western and Russian banks offering equity derivatives on a growing number of second-tier and third-tier stocks in addition to Russian blue chips there is a much more developed market infrastructure in Russia than there was in 1998.

"Derivatives only really got going 18 to 24 months ago when the western investment banks started to pile into Russia in force and brought the know-how with them," says Halloran at Pharos. Hemetsberger at UniCredit, which is one of the banks looking to increase its share of the burgeoning derivatives market, says: "There are now lots of liquid stocks where you can play both on the long and the short side of the market." Halloran says that given the tendency of emerging markets to overshoot on the upside, the emergence of shorts as a viable hedging instrument is a particularly positive development. "Shorting is good for any market, it prevents stocks from getting mispriced too quickly." Pertsovsky at Renaissance, which has linked up with RBS to develop a range of derivative products, believes the pace of development will increase further in 2008. "The market that will develop more than any other over the next 12 months will be derivatives," he says. "The liberalization of the capital markets last year and rouble convertibility are stimulating demand for increasingly sophisticated financial intermediation. We are already seeing significant growth in the appetite of Russian banks and corporations for structured derivative solutions to better manage their liabilities and foreign exchange flow. In addition, Russian domestic equity derivative volumes have matched the fast-growing cash market at times. We expect these trends to continue."

Although energy stocks still dominate the equity market in Russia – accounting for more than 50% of the composition of the RTS index for example – market participants expect to see a broadening of the universe of companies that come to market, especially from sectors that are linked to the rise in the importance of the Russian consumer.

In a recent report, Russia in a global context: crouching tiger, hidden value, Kingsmill Bond, chief strategist at Russian investment bank Troika Dialog, highlights the fact that many domestic-driven plays are barely represented in the make-up of the RTS, yet are likely to grow by 20%-plus a year over the next five years and should prove relatively immune to any global crisis. "We believe that, over the next few years, domestic stocks will act as the driver of outperformance for the market. As the credit crunch plays out, we believe that global growth and risk plays will struggle, while the market will actively search out and re-rate the high-growth domestic story." Bond says that within the domestic play, Troika Dialog recommends exposure to low penetration sectors such as banks, property, retail and broadband. Meanwhile, growing average spend levels will also support higher penetration areas such as mobile telecoms, media, automotive and consumer goods.

Private equity boom

One of the key supporters of the Russian consumer play to date has been the private equity industry, which has boomed in recent years as investors have sought to identify up-and-coming companies that are likely to attract either the attention of trade buyers or will eventually be able to list on the public equity markets. Companies such as Mint Capital, a private equity firm established in 2000 with backing from Boeing and fast-moving consumer goods group Oriflame, typify the more pioneering end of the market, with a diversified portfolio of investments in such relatively exotic companies as Mone, a hairdressing and beauty salon chain, and confectioner Fruzhe, which produces luxury chocolates.

"Your average Russian consumer is not going to stop spending because of problems in the US sub-prime mortgage market"Ben Wikening, Mint Capital

But as Mint Capital partner Benjamin Wikening explains, both companies are strongly positioned in the premium ends of their respective markets and both are therefore well placed to take advantage of the increasing spending power of the Russian consumer. He adds that strongly rising income levels in Russia mean that the country’s consumer companies are unlikely to be adversely affected by the recent economic travails in the US. "Your average Russian consumer is not going to stop spending because of problems in the US sub-prime mortgage market," he says.

Gaevski at Bank of Moscow says that the fallout from the credit crunch is likely to create opportunities in the still relatively young, fast-growing financial services sector in Russia. "Now is a brilliant time for private equity investment in financial services in Russia as the owners of smaller banks and insurance companies need funds to develop their networks to capture growth but don’t really have the access to the debt markets given tightened liquidity and increased risk aversion following global credit crunch." So to beat the US sub-prime blues the message from Russia is a clear one – invest in a regional shopping centre that houses banks, hairdressers, luxury sweet shops and mobile phone stores and you won’t go far wrong.

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