8 March 2009

Truth Beauty and Russian Finance ~ (Yet another) Year of Living Dangerously Russia in the Global Crisis

Recently, we were asked to contribute a paper on the impact of the global economic crisis upon Russia. Whilst T&B sees a number of signs of stabilization in Russia – a phenomenon painfully missing virtually anywhere else – both the speed and the severity of the global meltdown is simply breathtaking. Russia is climbing back up the rock-face, but it is climbing up through an avalanche…

It is thus a risky business issuing bullish calls for any economy – we see growing evidence for a gradual stabilization in Russia – most recently, at 40.6 the VTB Purchasing Manager Index (PMI) while still clearly recessionary, has improved for the second month running – from 33 in December to 35 in January; inventories of finished goods have declined quite substantially, one of the conditions for a resumption in manufacturing activity. As of this writing, the rouble has stabilized, and after the spectacular recovery in the Eurobond market, the rouble bond market is now steadily improving, with bids for first and second tier assets at yields around 20%.

Life lacks spice if not spent far out upon a limb, so we will risk making fools of ourselves with a series of predictions: the S&P will hit our target of 650 (now just 50 points away) sooner rather than later – but will then stabilize (hope, not evidence). Oil prices have probably bottomed. Chinese resource demand is coming back. The RTS equity market bottomed around 500 last October and

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -1 -

does not want to go any lower (current quote: 540) but we would expect it to trade within a reasonably narrow range for the immediate future. The best near term investment opportunities now include Russian Eurobonds, and for the adventurous, selected rouble bonds.

In brief – we have seen a fair number of swallows – we begin to suspect that they may a springtime make. That said, the downside risks are obvious: if we are faced with a true meltdown of the global economic, financial and trading systems, then any predictions regarding Russia in isolation should not be relied upon. If the disaster scenario were to eventuate, we suspect that our readership would have other, more immediate preoccupations – the procurement of food, water, and a dry cave in which to sleep – rather than blaming us for a missed call or two.

(Another) Year of Living Dangerously – Russia and the Global Crisis

Whilst the economic impact upon Russia of the initial phases of the global economic crisis exceeded rational expectations formulated based upon the secular shift in economic activity towards the emerging markets, in fairness, the sheer havoc triggered by the collapse of the serial US asset bubbles is unprecedented; in retrospect, the current crisis will be seen to have represented the fundamental inflection point in secular shift in the global balance of economic power away from the old economies of the West.

For now, innocent bystanders need beware. As in every financial crisis, the initial disruption was both panicked and non-selective; both babies and bathwater were pitched out of windows as financial entities went into survival mode. Then, as the crisis matures, markets begin to increasingly differentiate between those companies or countries faced with the threat of imminent demise, as opposed to those which have become oversold beyond any rational valuation, and thus, offer compelling opportunities for the adventurous. We think that the contagion effect in Russia was front-loaded, i.e. that the worst effects were felt in late 2008, and that a period of stabilization is now at hand.

The Three Horsemen of the Apocalypse – and the Missing Stallions

Three principal mechanisms account for the transmission of the global economic crisis to the Russian economy; in order of decreasing importance, these are the global credit contraction, the collapse in commodities prices, and the reversal of investment flows. These shocks have been of a magnitude unprecedented in modern economic history, and especially, occurred with extraordinary rapidity, with in particular credit going from bounteous to almost non-existent virtually overnight.

For structural reasons, the emerging markets – not excluding Russia – were highly exposed to a sudden failure of global capital markets. Since conditions will almost certainly continue worsening during the course of 2009-2010, legitimate questions can be asked regarding the economic survivability of several emerging countries, in particular of Eastern Europe. As regards Russia, on the other hand, it appears that most of the damage has already been felt, and absent a complete collapse in the global trading system or commodities markets, we would expect to see stabilization not far from the current levels.

We will first consider the three essential factors driving the crisis, as well as the near-term outlook for each, before turning to the mitigating factors, i.e. those areas where Russia is relatively immune to contagion effects.

1. Credit While Russia was initially able to shrug off the first phases of the global crisis, the disastrous decision to allow a disorderly failure of Lehman Bros sent global financial markets spiralling into crisis mode. The desperate rush by banks to repatriate capital led to the sudden withdrawal of all credit – regardless of the ultimate creditworthiness of the borrower. The Russian corporate sector, largely funded in the international capital markets, proved to be dangerously exposed.

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -2 -

This fragility was a direct consequence of the “Kudrin System” whereby, so as to forestall the development of “Dutch Disease” and hyperinflation driven by massive commodity export revenues, under FM Kudrin Russia moved to capture the windfall profits of the oil producers, accumulating massive Forex reserves while reducing the sovereign debt load to trivial levels. Given the perceived limits to the ability of the Russian financial system to absorb and allocate investment capital, the government invested oil export revenues into G7 assets, essentially leaving it to the global investment banks to intermediate these reserves back into the Russian economy.

Deprived of domestic options for financing business expansion, working capital or Capex, the Russian corporate sector by necessity turned to the global banks and capital markets for funding. Given that until October 2008 the international banks were both highly liquid and increasingly desperate for credit-worthy borrowers, they willingly provided increasing volumes of finance; the counterpart to burgeoning sovereign Forex reserves was thus the rapidly-growing indebtedness of the Russian corporate sector.

Had the onset of the global crisis been delayed by a further 24 months, it is likely that the Russian private sector would have found itself disastrously over-indebted. In the event, whilst the gross indebtedness of the Russian corporate sector has been rather alarmingly estimated at some $500 billion, this ignores the huge offsetting foreign assets held by the corporate sector. Estimated debt service and redemptions for 2009 are approximately $110bn, the vast majority of which have already been funded by issuers purchasing USD on the local market; indeed, many of the obligors, in particular the banks, have been actively buying back their outstanding Eurobonds, which have performed very strongly over the past few months.

The Washington Consensus Strikes Again…

We would argue that the crisis was exacerbated by the premature, politically-motivated decision to fully integrate Russia into global financial markets, embracing total liberalisation just as the Western system spiralled into an asymptotic bubble trajectory, asserting Russia’s newfound economic stability by dismantling all capital controls. Unfortunately, whilst controls are relatively ineffective in preventing outflows, at the time outflows were not the problem; the problem was an excess of hot money looking for short term trading opportunities and where controls had been relatively effective was in discouraging the inflow of foreign hot money.

In the event, with the capital account thrown open, the “global carry trade” got underway in earnest; hedge funds piled into short-term rouble assets, given the perceived one-way rouble exchange rate risk, as well as local interest rates which, while negative in real terms, were well above the dollar cost of funding. These inflows, coupled with a strongly positive trade account, obliged the Russian Central Bank to run an inappropriately easy monetary policy so as to slow rouble appreciation; along with torrential capital inflows, this pushed domestic real interest rates into deeply negative territory – resulting in inflation, excessive currency valuation, and a serious misallocation of resources. Furthermore, since virtually all of the currency inflows were short term, they made no useful contribution to much-needed infrastructure investment or Capex; of course, when global risk tolerance collapsed, there was a violent reversal of capital flows, leaving the CBR to a desperate and ultimately unsuccessful attempt to preserve popular confidence in the currency and banking system by seeking to hold the rouble at an unsustainable level.

Perspectives –

Despite the occasional public calls for capital controls by hardliners in the Russian government, the Central Bank is fully aware that the time for currency controls is when the money is pouring in – when the cash pours out, controls prove extremely porous. Indeed, by triggering precautionary capital flight, they generally prove counterproductive, especially in a country as skilled as is Russia in the evasion of administrative controls. As recently affirmed by Mr. Putin himself, for now, the game will continue to be played by the old rules.

Perhaps the most successful aspect of the anti-crisis package has been the shoring up of the Russian banking system. There have been no disorderly bank failures; the level of popular and corporate bank deposits has been broadly maintained; and while NPLs are rising (and recent

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -3 -

changes in CBR bank reporting regulations certainly have not enhanced clarity), their absolute levels do not threaten Russian macroeconomic stability.

At present, global credit markets have begun to recover, and indeed, a few top-rated Russian entities have managed to raise substantial new finance, while a larger number have successfully negotiated roll-overs of their existing credit lines.

By cutting back on the systematic official (non-bank) support for Russian companies faced with foreign debt maturities, the government is encouraging these to continue to seek negotiated arrangements with their foreign creditors – who may find it in their own best interests to maintain a cooperative relationship with their solvent but illiquid borrowers. Given that those companies able to do so took advantage of the stepwise rouble devaluation to purchase foreign currency sufficient to meet their 2009/2010 obligations, any defaults on foreign bonded debt will likely be confined to a couple of very minor issuers. On the other hand, we would not expect Russian corporates to gain meaningful access to global capital markets in the foreseeable future.

2. Commodities Although the Russian government has long been cognizant of the risk posed by excessive dependency upon the global commodity cycle, in practice, this dependency has proved exceedingly difficult to break. Russia is by nature a major exporter of energy, minerals, as well as an increasingly important force in the global agricultural commodities market. Thus, during the commodity up-cycle, cash pours in, driving currency appreciation, inflation, and crowding out non-commodity economic activity. The down-cycle of course is marked by rapid economic deceleration, credit squeeze, and deflation.

To date, the most successful attempts at industrial diversification have involved Russian exporters moving up the commodity value-added chain, e.g. from export of iron ore and slab steel to high- value added speciality steels; from natural gas to fine chemicals; from pulp and lumber to coated paper and furniture.

Tacit the occasional nanotechnology fantasy, the development of domestic manufacture has been most successful as regards import substitution – including food products, building supplies, and especially, the domestic manufacture of foreign automobile marques. For the latter sector, Russia’s politically-motivated exclusion from the WTO has proved a blessing in disguise, sheltering the domestic market for foreign car manufacturers established in Russia.

Perspectives -

For the foreseeable future, Russia’s relative correlation with the commodity cycle should be taken a given. There is no clear consensus as regards medium-term price trends in global commodity markets, although we suspect that market participants may have swung from excessive bullishness to unjustified pessimism. While economic activity in the West will almost certainly continue to decline, this will be at least partially offset by resource-intensive government mandated infrastructure spending.

Nevertheless, the continuation of the Chinese growth miracle now constitutes the sole realistic hope for avoiding a prolonged recession/depression. Quite fortunately, one would do well to discount much of the pessimism in the press as regards the ability of China to reflate. Whilst China is faced with the daunting task of reorienting export-driven manufacturing activity towards a huge and deeply undersupplied domestic market, it benefits from a high degree of political centralization and is thus able to rapidly implement radical policy directives; after a decade of contracyclical fiscal and monetary policy, China has a huge stock of ammunition – a combination of a deep budget surplus and the world’s largest currency reserves.

The first, encouraging signs of resumed Chinese demand include a modest rebound in global iron ore, coke and steel prices. Similarly, having collapsed by an unprecedented 90% last year, the Baltic Dry Index, the primary index for global bulk shipping costs, has more than doubled on growing Chinese demand. With agricultural production having collapsed in numerous geographical locales

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -4 -

due to accelerating climate change as well as the drying up of agricultural credit, export grain prices should rebound within the next 18 months.

The key question is, of course, the oil price. It seems likely that a bottom was found in late 2008, with Brent repeatedly bouncing off of the $40 level on Brent since last December. Whilst the market has focused on demand destruction, destruction of supply has been neglected – at current prices, numerous marginal oil sources, from Canadian oil sands to deep-water offshore drilling, US stripper wells, much Kazakh production, and most alternatives including biofuels become economically unsustainable. OPEC is showing remarkable discipline, and there are modest signs of cooperation among some non-OPEC oil producers.

Meanwhile, the great oil fields are declining at variable rates – Indonesia is now a net importer, Mexican production is collapsing, and whilst the terminal phase in North Sea production has been delayed, the final slope of this decline will be extremely sharp. Although new oil sources will continue to be found, the easy oil has already been drilled, and marginal production will be feasible only at prices closer to the 65-85$ range where we see oil prices ending the year.

As regards the demand side, although it is a fair bet that the United States will never again import as much oil as it did in 2007, the US is no longer the top source of incremental demand. Amazingly, in January – for the first time in history – Chinese consumers bought more cars than did Americans (and it should be noted that American automobile sales are net-net replacement purchases, while Chinese sales represent new cars on new roads).

3. Capital flows Foreign investment capital has flowed out of all emerging markets, with global capital markets closed to Russian (indeed, to all EMEA) equity offerings since October 2008; they look to remain so for the foreseeable future. As regards debt markets, only the top-rated borrowers can raise new money – and this is considerably more expensive than in the past.

While some very alarming numbers have been reported for Russian capital flight, in fact, much of this has simply been Russian entities purchasing dollars/Euros, either to fund upcoming debt maturities and bond buy-backs, or simply for wealth preservation. Correspondent accounts with the Central Bank of Russia have surged as the Russian corporate sector has switched reserves into foreign currencies; despite the currency shift, these reserves remain available to their Russian owners.

As regards FDI, at least until recently, the vast majority of foreign companies doing business in Russia have been highly profitable – when polled, a majority confirmed their intention to maintain or increase their investments in what remains a secular growth market. We would contrast this with the situation in China, where despite a more charitable treatment in the press, one would be hard- pressed to name 5 Western companies making money on their domestic operations.

Perspectives –

The best news here is that the situation cannot further deteriorate – capital raising simply cannot fall below zero! Indeed, it could be argued that, unlike long-term foreign direct investment which has clearly been beneficial, the opening of the Russian market to speculative foreign capital flows has reliably proved disastrous; Russia may well do best when forced to rely primarily upon her own internal resources.

And the Missing Horsemen:

Unlike many of its emerging market peers, Russia is relatively immune to miscellaneous scourges facing the developing economies, and which threaten a number of Latin American (Mexico, Argentina), EMEA (Ukraine, Georgia, the Baltics, Hungary) and Asian (Indonesia, Thailand, Philippines, Korea) countries with economic collapse:

• Plunging global demand for manufactured goods © Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -5 -

Russian exports are primarily in the commodities sector – and the main driver here is likely to be Chinese industrial activity. Manufactured exports are limited to military (a growth sector in troubled times), nuclear power generation, and relatively cost-effective heavy industrial machinery (turbines, power generation, etc.) suitable for the needs of the developing countries – where at least some infrastructure spending is likely to be maintained.

• Inability to fund the current account deficit due to collapse in remittances/bond markets/exports Russia has no indispensible import requirements, being self-sufficient in all major commodities and basic foodstuffs. In a worst-case scenario, Russia could survive without Mercedes motorcars and French cheese for an unlimited period. Remittances are a negative item on the balance sheet, and the Federal government has virtually no foreign debt to refinance.

• Political instability With due respects, reports of Russian political unrest are laughable. Whilst a number of EMEA governments are breaking under the stress, Russia remains remarkably quiet. We would note that the Western press, always desperate for bad news as regards Russia, has been recycling a single demonstration by Vladivostok used car dealer for nearly three months now… Those of us who lived through the 1998 crisis were stuck by the total absence of popular protest – as the crisis worsened, people returned to their dachas to plant potatoes. Perhaps the experience of seventy years of collectivist rule durably chilled the popular enthusiasm for revolution.

As regards the international context, the crisis has diminished any Western ardour for confrontational politics, the opening of new military fronts, or expensive missile systems; a substantial improvement in US-Russian relations is thus to be expected. Similarly, some of Russia’s neighbours, previously fixated upon comprehensible but perhaps outmoded historical grievances, will now have far more important matters to attend to – in the current climate, even modest Russian investment capital flows will likely receive a warm welcome.

• Economic fragility Despite claims by the western kommentariat that the Russian politico-economic system lacks flexibility, in fact, it is far more flexible than that of most developed economies. Downward adjustment of wages and staffing levels can occur virtually overnight, with production simply halted until inventories are reduced to the desired level – as indeed happened during the January 2009 period (resulting in industrial production numbers which were dramatic but quite misleading).

In summary, while our readers are undoubtedly familiar with the inefficiencies of the Russian economy, this does have a silver lining: no manufacturer in his right mind would attempt to set up a just-in-time supply chain in Russia. After 20 very eventful years, like an old Lada automobile, much of the local industrial fabric is relatively inefficient, but at least, admirably fault-tolerant.

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -6 -

Although we would expect to see further discouraging numbers through the first half of 2009, the period of maximal stress was apparently reached in October-November 2008; after a sharp rouble devaluation, successful support for the banking sector, and the recycling of official Forex reserves into the corporate sector, the increase in non-payments which mushroomed out in Q4 2008 has been almost entirely reabsorbed.

Although our view is temporarily unfashionable, we continue to expect a gradual differentiation between the potentially high-growth BRICs countries and the old economies of the West. Those wishing to predict the timing of a Russian rebound would do well to keep a close eye on Chinese growth trends. Whilst the financial disruption in Russia has been severe, the financial system has survived the stress test, and policy of both the Central Bank and the finance ministry are broadly appropriate. Over the next couple of years the opportunities in financial markets will likely match those enjoyed by investors in the 1998 post-crisis period.

This message is provided for informational purposes and neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any investment funds, securities or any options, futures or other derivatives related to such securities.

Investment in emerging markets bears a high degree of risk, and is not suitable for all investors. This report is based upon information we believe to be reliable, however it is provided solely as an intellectual exercise, and no investment decisions whatsoever should be based upon it, in full or in part. In particular, investing in securities, including Emerging Markets securities involves a great deal of risk and investors should perform their own due diligence before investing.

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