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OPPORTUNITIES IN: RUSSIAN CAPITAL MARKETS BY BEN ARIS


OPPORTUNITIES IN: RUSSIAN CAPITAL MARKETS Ben Aris


The author Ben Aris arrived in Moscow in October 1993 as a young freelance reporter two weeks before Boris Yeltsin sent the tanks onto the streets as part of his show down with the Communist-dominated Duma, plunging the country into a violent constitutional crisis. He spending just over two years travelling throughout the region living and working in many of the former Soviet republics and regions of Russia – including stints in Central Asia and the Baltic States – he arrived back in Moscow in 1996 in time for Yeltsin dramatic re-election as president of the Russian Federation. Over the next eight years Ben had a ringside seat to rise of the oligarchs – interviewing most of them as they built their empires – and reported the first stock market boom for the international press, only to see it collapse again in the 1998 financial crisis. As the third longest serving foreign correspondent in Russia, Ben has interviewed most of Russia's leading lights and seen first hand the changes the country has gone though since the fall of the Soviet Union. By 1999 Ben was Moscow bureau chief for the Daily Telegraph and covered the two Chechen wars and the appearance of Putin. However, as the economy began to grow strongly again in 2000 he switched his focus back to business as contributing editor for the Banker and a regulator contributor to the Wall Street Journal and other leading business publications. Ben continues to write regularly for most of the mainstream press, but in 2003 Ben moved to Berlin as acting bureau chief for the Guardian before leaving to found his own online publication www.businessneweurope.eu , which specializes in covering business, finance, economics and politics in Eastern, Central and Southeastern Europe. He is married with three children.

© Thomson Financial 2007 The contents of this publication, either in whole or in part, may not be reproduced, stored in a data retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without written permission of the publishers. Action will be taken against companies or individual persons who ignore this warning. The information set forth herein has been obtained from sources which we believe to be reliable, but is not guaranteed. This publication is provided with the understanding that the author and publisher shall have no liability for any errors, inaccuracies or omissions of this publication and, by this publication, the author and publisher are not engaged in rendering consulting advice or other professional advice to the recipient with regard to any specific matter. In the event that consulting or other expert assistance is required with regard to any specific matter, the services of qualified professionals should be sought. First published 2007 by Thomson Financial Group, Aldgate House, 33 Aldgate High Street, London EC3N 1DL, UK Typeset by: Claire Taylor and Nicola O’Hara Printed and bound by: Ikon Office Solutions, Berkshire, UK


CONTENTS Chapter 01 01 The Russian macroeconomic situation Introduction Economic indicators Rates of growth Economic drivers of growth Oil Consumer spending Personal income Construction Financial services Investment Russian oligarchs and the Kremlin's nine commandments for big business State involvement The nine commandments The BRIC prediction Current financial situation International reserves and debt State funds Stabilisation Fund State Investment Fund State Venture Capital Fund State Future Generations Fund Inflation SInterest rate control Ruble appreciation, currency controls and de-dollarisation Currency flows Money supply and dollars The federal budget Oil and economic expansion Trade and the balance of payments Political events Politics and fiscal loosening Oil price scenarios Chapter 02 23 The banking sector Overview Initiating sector reform Russian bank sector fundamentals Bank reform 2004 mini-crisis Deposit insurance Sector consolidation Foreign ownership of Russian banks Subsidiaries rather than foreign branches A new mega-regulator Bank sector growth Consumer credit Car loans Credit cards Mortgages The regions The future role of banks Sector challenges Falling capital adequacy Non-performing loans CBR acts to curb NPLs

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Home credit bites the bullet Devaluation and currency risk Exposure to equities Investing in banks Portfolio investments Private equity investments Chapter 03 39 Equities – market composition and performance Background RTS development Inception to October 1997 October 1997 to October 1999 October 1999 to today Summary RTS performance under Putin RTS composition The dominance of blue chips Growing state share of the index IPOs Diluting the index Opening up new sectors Pricing challenges Owners’ motivations IPO pipeline congestion Banks Utilities Small companies Impact on liquidity Stock exchange trading The main exchanges Trading volumes The OTC market Russia as an emerging market Russia's rising index weightings International investment flows into Russian equity Stock valuations and P/E ratios Traditional market drivers The seven year boom Liquidity Oil prices The effect of oil on liquidity Ruble appreciation Bank sector liquidity The tax schedule Foreign investment in Russian funds Foreign capital inflows Domestic consumption Domestic investment – the new market driver Investment growth Investment structure Sources of investment capital Investment pitfalls State investment programmes Power Defence Nuclear Market volatility The links between GEMs Electricity

Banks Fixed-line telcos Consumer Sell-off cycles Seasonal factors Chapter 04 73 Bonds Background Economic recovery Rating Russia Corporate governance issues Local ratings agencies Bond market development Bond market structure Rising turnover in all sectors Inflation and interest rate challenges MosPrime Challenges to MosPrime development Lessons from Russia’s first ever corporate bond default Sovereign bonds Sovereign Eurobonds Paris club redemptions Aries bonds Spread performance Influences on spread compression Russian debt becomes a defensive asset Domestic sovereign bonds Government debt strategy The OFZ market Domestic bond ownership Corporate ruble bonds Market development Secondary market trading Currency liberalisation Corporate Eurobonds Bank borrowing of Eurobonds The rise of bank Eurobonds Municipal and other bonds Broadening the borrowing base Other debt instruments Credit-linked notes Veksels Asset-backed securities and mortgages Obstacles to expansion Russia Railways' Red Arrow SPV Bonds and real estate Ruble Eurobonds Chapter 05 101 Securitisations Background Market beginnings Growth prospects Domestic securitisations Chapter 06 105 Syndicated loans Background Leading borrowers Leading lenders


The influence of state-owned enterprises Chapter 07 109 Mergers and acquisitions Background Sector changes in M&A Steel Aluminium Telecoms Banks Utilities Mobile phones Supermarkets Transaction structure Lending constraints LBOs Chapter 08 115 Private equity funds Background Market opportunities New target areas Oligarch funds and the rise of the minigarch The new investment class Sources of private equity capital Future challenges The main Russian private equity funds Troika Capital Partners Alfa Capital Partners East Capital Firebird Management Baring Vostok Capital Partners Prosperity Capital Management Mint Capital Chapter 09 123 Venture capital Background Home-grown venture capital Early successes Early funds Russian Venture Company State telecoms venture fund Regional venture capital funds Chapter 10 127 Pension funds Background Pension reform Pension reconstruction Pension market structure Chapter 11 131 Mutual funds Russian investment in mutual funds Current investment preferences and future projections Chapter 12 133 Derivatives Background Legal developments OTC trading

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Table 2.1: Russia's top 30 banks,as of September 2006 (US$) Table 2.2: Top Russian consumer loan providers, 2006 (%, US$m) Table 2.3: Top Russian car loan providers, 2005, 2006 (US$m, %) Table 2.4: Top Russian credit card issuers, 1H2006 (US$m, %) Table 2.5: Russian deposits and loans, 2002–10E (US$bn, %) Table 2.6: Retail loans – bank share, 2005, 2006 (RUBbn, %) Table 2.7: Significant foreign M&A deals with Russian banks, 2004–06 (US$m) Table 2.8: Russian banks’ stock exchange performance, 2006 (US$m,%)

2004–Sept 2006 (US$, %) Table 3.8: Worst IPO performers, 2004–Sept 2006 (US$, %) Table 3.9: IPOs trading below initial price, Sept 2006 (US$, %) Table 3.10: RAO UES – Projected IPOs, 2007 Table 3.11: Proposed IPOs, 2007 (US$m) Table 3.12: Growth in trading of the individual segments on MICEX, 2006 (%) Table 3.13: Equity trading – average daily volumes, Mar 2006, Mar 2007 (US$, %) Table 3.14: Emerging markets funds – Russia weightings, 2006 (%) Table 3.15: Russian indices, by sector, Mar 2007 (%) Table 3.16: RTS, GEM and oil price performance, 2000–06 (%) Table 3.17: Weekly inflows to Russia, GEM and BRIC funds, 2006–Feb 2007 (US$m) Table 3.18: Russian share price performance and P/E ratio, Jan 2007 (US$, %) Table 3.19: Oil export revenue, 2000–06F (US$) Table 3.20: Oil exports, 2000–06F (m bbl/d) Table 3.21: Energy stocks related to oil price scenarios Table 3.22: Tax payment calendar, 2007 Table 3.23: Inflows to Russia, GEM and BRIC funds, 2006–Feb 2007 (US$m) Table 3.24: Investment breakdown and growth, by sector, 1Q2006–3Q2006 (%) Table 3.25: Sources of investment financing, 2005, 2006 (%) Table 3.26: RTS cycles, 2003–06 (%) Table 3.27: RTS rallies, year-end and new year, 2000–05 (%) Table 3.28: RTS returns, 1997–2007 (%)

Table 3.1: Market breakdown, by sector, Nov 2006 (%) Table 3.2: Top Russian stocks, Jan 2007 (US$bn) Table 3.3: Ownership of Russian equities, 2003, 2006 (%) Table 3.4: Annual value of Russian IPOs, 1996–2007E (US$m) Table 3.5: Forecast IPO issuance, 2007 (US$m) Table 3.6: Performance of IPOs issued in 2006–Jan 2007 (US$, %) Table 3.7: Top IPO performers,

Table 4.1: Russian external debt, 2006–08E (US$bn) Table 4.2: Emerging markets international bond issuance, 2001–2Q2006 (US$bn) Table 4.3: State-owned banks – lending capacity, 1H2006 (US$m) Table 4.4: Current Russian ABS issues (US$m) Table 4.5: Russian retail banking structure, 2004–1H2006 (US$bn) Table 4.6: Mortgage loan market, 2005–06 (US$m, %) Table 4.7: Mortgage market

FORTS MICEX Derivatives Market Section Russian derivatives trading in London List of tables and figures Table 1.1: Russian GDP by production and use, 2005, 2006 (RUBbn, %) Table 1.2: Russian GDP growth by sector, 2006 (% y-o-y) Table 1.3: Russian budget law and execution, 2003–07 (% GDP) Table 1.4: Russia's main trading partners outside the CIS, 2006 (US$bn, %) Table 1.5: Russian external trade, 2004–06 (US$bn) Table 1.6: Russian economic performance under President Putin, 2000–06 Table 1.7: Public trust in Russian politicians, 2006 (%) Table 1.8: Duma election, Dec 2003 – Share of popular vote (%), number of seats Table 1.9: Brent oil prices – Forecasts and implications


leaders, 1H 2006 (US$m, %) Table 4.8: Bonds connected to real estate borrowing (RUBm, US$m, %) Table 4.9: Ruble Eurobond issues, 2005–06 (RUBbn) Table 5.1: Russian ABS ratings Table 7.1: Russian acquisitions of foreign steel assets, 2003–06 (US$) Table 7.2: Top 10 Russian M&A transactions, 2005–06 (US$m) Table 12.1: FORTS trading volumes, 2005, 2006 (RUBm) Table 12.2: RTS trading volumes, by instrument, 3Q2006 (RUBbn) Figure 1.1: Growth of Russian GDP, 2001–10F (US$bn, %) Figure 1.2: Russian consumer market dynamics, 1999–2006E (US$bn, %) Figure 1.3: Average Russian monthly wage (year-end estimate), 2000–08F (US$) Figure 1.4: Russian population demographics and financial statistics (2006) Figure 1.5: Individual Russian client wealth, 2006 (US$) Figure 1.6: World’s largest economies, 2006–07 Figure 1.7: Top holders of foreign exchange reserves (US$bn) Figure 1.8: Russian Stabilisation Fund growth, Jan 2004–Apr 2007 (US$bn) Figure 1.9: Russian inflation, 2003–09F (%) Figure 1.10: Russian Federal budget revenues and expenditures, 1998–2007E (% GDP) Figure 1.11: Oil price – Brent quarterly average, 1Q2006–4Q2007F (US$/bbl) Figure 1.12: Russian exports, by sector, 2006 (%) Figure 2.1: Sberbank’s share of the Russian deposit market, 2003–06 (%) Figure 2.2: Russian loans market growth, July 2004–July 2006 Figure 2.3: National household loans markets, 2006 (% of GDP) Figure 2.4: Indicators of banking sector capital adequacy (H1 standard), 1999–2006 (%) Figure 2.5: Banking liquidity indicators, Jan 2002–July 2006 (%)

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Figure 2.6: Growth of nonperforming consumer loans, July 2004–July 2006 (%) Figure 3.1: RTS index, Sept 1995–Oct 1997 Figure 3.2: RTS index, Oct 1997–Oct 1998 Figure 3.3: RTS index Oct 1999–May 2007 (%) Figure 3.4: State voting stock in top 20 RTS companies, 2000–06 (%) Figure 3.5: Global emerging markets – country weightings, Sept 2006 (%) Figure 3.6: P/E ratios, by sector, 2007E Figure 3.7: Money supply vs equities, 2000–07 Figure 3.8: Equities vs oil prices, 2003–07 Figure 3.9: Russian exports, imports and oil price, 2000–09F (US$) Figure 3.10: Breakdown of worldwide oil and gas reserves, 2006 (%) Figure 3.11: Russian banks – excess reserves, 2003–07 (RUBbn) Figure 3.12: Russian net private capital inflows, 1998–3Q2006 (US$bn) Figure 3.13: Russian stock movements, Jan–Feb 2007 (%) Figure 3.14: Fixed investment and stock exchange sector movements, 2004–06 (%) Figure 3.15: RTS index, Jan 2005–Mar 2007 Figure 4.1: Russian bonds – sector breakdown, Dec 2006 (%) Figure 4.2: Russian bond growth, by sector, 2003–06 (% CAGR) Figure 4.3: Bond holder distribution, 1999–1H2005 (%) Figure 4.4: Bond maturities, 2002–1H2005 (%) Figure 4.5: Bond distribution, by sector, 1999–2005 (%) Figure 4.6: Primary market bond issues and redemptions, 2002–1H2005 (RUBbn) Figure 4.7: Bond trading on secondary market, 2002–1H2005 (RUBbn) Figure 4.8: Distribution of state debt, 2004–08E (%) Figure 4.9: Outstanding federal bonds (OFZ vs GSB, traded vs non-traded), 2006–08F (US$bn) Figure 4.10: Russian Paris Club debt – breakdown by country, Jan 2006 (%)

Figure 4.11: EMBI+ spread, 2006 (bp) Figure 4.12: Correlation between sovereign bonds and oil prices, 2000–06 (%) Figure 4.13: Russia’s beta, 1Q2004–3Q2006 (bp) Figure 4.14: Russian domestic bond ownership, 2006 (%) Figure 4.15: Bank shares of bond issuance, by segment, 2006 (%) Figure 4.16: Top corporate borrowers, 2006 (US$bn) Figure 4.17: Bond deals, 2001–Nov 2006 Figure 4.18: Bond market breakdown, by sector, 2006 (%) Figure 4.19: Russian Eurobond market 2001–07E (US$bn) Figure 4.20: Russian corporate bond issuers, Nov 2006 (%) Figure 4.21: Eurobond and CLN distribution, by type, Nov 2006 (%) Figure 5.1: Russian securitisation, by asset class, 2006 (%) Figure 5.2: Securitisation in Russia, 2003–06 (US$m) Figure 6.1: Russian syndicated loans market, 2001–06 (US$bn) Figure 6.2: Russian syndicated loans market, by sector, 2005, 2006 (%) Figure 6.3: Russian syndicated loans, by sector, 2002–06 (%) Figure 7.1: Russian M&A transactions, 2005, 2006 (US$m) Figure 7.2: Russian M&A transactions, by sector, 2005, 2006 (US$m) Figure 8.1: Russian private equity investment, by sector, 2005 (%) Figure 8.2: Private equity investment, by stage, 2005 (%) Figure 8.3: Private equity investment, by Federal District, 2005 (US$m, %) Figure 8.4: Sources of private equity capital, Russia vs India, 2006 (US$bn) Figure 8.5: Russian IPOs, 2000–06, rebalanced (US$bn) Figure 11.1: Growth of Russian domestic mutual funds, 2000–06 (RUBbn) Figure 12.1: FORTS trading volumes, Sept 2001–Sept 2006 (RUBbn)


CHAPTER THE RUSSIAN MACROECONOMIC SITUATION

01

Introduction Russia is a country in transition and so the macroeconomic environment directly impacts both investors and domestic businessmen's lives. Having been in serious trouble for most of the 1990s, the Russian economy is now in the rudest health, which in turn has inspired confidence among domestic businessmen, who are returning flight capital home to capitalise on ballistic rates of growth. Russia boasts some of the best macroeconomic fundamentals of any country in the world. It is now the third richest country in the world in terms of gross hard currency reserves, which are enough to pay for more than a year of imports. The government regularly runs a 7% budget surplus, while tax revenues continue to rise. Foreign debt has fallen from around 90% of GDP in 1997 to less than 6% by the start of 2007, making it the least indebted country of any industrialised nation, while inflation fell to single figures in 2006 for the first time in modern history, ending the year inside the government's self imposed target of 9%. But the most important change has been that the life of the average Russian has become more predictable. After seeing their life savings hyper-inflated away in the early 1990s and then losing them again in two bank crises and several currency reforms, since President Vladimir Putin took office in 2000 average incomes have octupled to about US$400 a month by the start of 2007 and continue to rise at about 10% a year in real terms. Consumer spending accelerated with the advent of consumer credit in 2001 and life has become noticeably better for most people. The ‘feel good factor’ is feeding through to booming consumer spending, investment, increased small business activity, the appearance of financial products such as mutual funds, a slow recovery in birth rates and political stability, which is what most businessmen that lived through the Yeltsin-years still crave. However, not all is perfect. The Central Bank of Russia (CBR) is still struggling to contain inflation and prevent the ruble from appreciating too fast on the back of the flood of petrodollars, but lacks the tools to carry out an effective monetary policy. At the same time, while fixed investment is growing, economists say it is not growing fast enough. Unless the government can continue its reforms to the financial system and make Russian banks more efficient as financial intermediates, the current economic growth will stall and Russia could go the way of Latin America in the 1970s and 1980s.

Economic indicators Rates of growth In 2007, Russia entered its seventh year of strong growth, with an economy worth more than US$1trn – if the (rapidly shrinking) share of the grey economy is taken into account – up from US$196bn at the end of 1999. GDP growth has surprised on the upside almost every year since Putin took power in 2000. GDP growth has averaged at least 6% since 2000 and the economy has tripled in size in dollar terms since Putin took the helm (see Figure 1.1). Analysts have consistently under-estimated the rate of Russia's growth, partly because they have under-estimated the progress of reforms put in place by the Kremlin. While politically motivated attacks on companies such as Yukos catch the headlines, the bulk of the economy is allowed to operate without any state interference and the extremely open trade regime means Russian companies have to compete on more or less even terms with foreign competition, which has also been driving reforms and restructuring.

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Figure 1.1: Growth of Russian GDP, 2001-10F (US$bn, %) US$bn 2,000

Russian nominal GDP Real GDP % change

% growth, yoy 30 25

1,600

20 1,200 15 800 10 400

5

0

0 2001

2002

2003

2004

2005 2006E 2007F 2008F 2009F 2010F

Source: Business Monitor International, RosStat

Russian GDP growth for 2006 was a slight disappointment. Economists were predicting 7% growth for the full year 2006, but the final result, released in February, came in at 6.8% – still better than the 6.4% for 2005. Analysts say that even this good result is less than Russia is capable of, as red tape and state interference is still cutting some 3–4% off growth rates. For its part the Kremlin seems happy with the trade-off between control and growth. The reason is that Russia enjoys a significant ‘comfort factor’ in the form of oil revenues. Putin got lucky with the oil prices – which averaged over US$67 a barrel in 2006 – that fuelled a boom from about 2000 and lifted the economy out of the abyss it fell into during the 1998 financial crisis. But, despite the growth, the economy is not yet diverse enough to repeat the performance should the price of a barrel of oil tank in 2007. According to the Ministry of Economic Development and Trade, Russia's economy should grow by 7.5% in 2007, driven by oil prices, consumer spending and increasing domestic investment. UBS Brunswick said in its 2007 strategy paper: "We see real GDP growth accelerating slightly to 7.5% from 2006 estimated growth of 7%, driven by investment and construction as, flush with cash, Russia becomes one big building site."

Economic drivers of growth There is an unresolved debate among economists covering Russia as to the contribution of consumption to growth, against that of oil. When Putin took over in 2000, the initial rapid growth – GDP expanded 10% in 2000, the biggest gain on record – was driven by oil prices that recovered from a low of US$10 a barrel to about US$25 and "primed the pump" for growth in the following years by providing badly needed liquidity, according to the World Bank. However, in the last few years, domestic consumption has played a growing role in economic growth. What is not clear is the relative importance to the economy of consumer spending opposed to oil prices.

Oil After the fast growth in the first years of the new century, oil sector production slowed and output only increased by 2.5% in 2006. Actual oil production rose 2.1%, after turning in doubledigit returns for most of the first years of Putin's rule. Alfa Bank's chief economist, Natalia Orlova, argues that all this growth is being fuelled by the liquidity flowing into the economy from the oil and gas sector, and estimates that oil revenues indirectly accounted for 63% of the value of the economy in 2006. However, consumer spending is clearly driving the recovery and investment is increasing in large swathes – especially in light industry.

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This debate will not be resolved unless oil prices collapse and the ideas can be tested. The consensus is that Russia's economy is still very dependent on oil, but that each year that passes shifts the centre of gravity towards the consumer.

Consumer spending Retail turnover was up 13% in 2006, to RUB8.6bn and has been growing in double digits for six straight years. Consumer spending has increased massively in the last seven years, from US$90bn in 1999, equivalent to 45% of GDP, to an estimated US$290bn by the end of 2006, or 31% of GDP, as shown in Figure 1.2 (RUB26.1 = US$1). While spending as a proportion of proportion of GDP has been shrinking, the telling numbers are in the changing distribution of spending. At the beginning of the 1990s food dominated the spending of the average Russian, but this has fallen steadily, from 56 kopeks in every ruble in 1999 to 40 kopeks by 2006, while total spending has more than tripled (CAGR 19.2%).

Figure 1.2: Russian consumer market dynamics, 1999–2006E (US$bn, %) 1999

2006E

19%

13%

41%

US$90bn 31%

US$290bn

CAGR = 19.2%

F&B

56% 40%

Non-food Services

Source: RBA Research

Personal income Personal incomes were up 10% in 2006, compared to 11.1% in 2005. The nominal average monthly wage was RUB10,700 in 2006, 24.5% up, compared to 2005. In real terms, salaries in Russia went up 13.5% over the year and have octupled since Putin took office in 2000 (see Figure 1.3). Russian real disposable income was up 10% in 2006 and the average per capita income was up 20.5% on the year, to RUB14,757 per month by the end of December 2006, according to Rosstat (the Federal State Statistics Service). Russia’s robust economic growth is bringing with it a growing danger of social unrest; sociologists say that if the difference between the income of the top 10% of the population is more than 10 times the income of those in the bottom 10% of the population, this fuels resentment that can spark popular protest. Russia still has some breathing space and if the Kremlin is successful in its drive to diversify the economy – and especially in its efforts to promote small and medium-sized enterprise – then this danger can be nipped in the bud. But the difference in these two incomes is already seven-fold and continues to creep up. The disparity in personal incomes again widened slightly in the first quarter of 2007. The topearning 10% of the population accounted for 30% of overall cash incomes in the first quarter of 2007, compared with 29.7% in the first quarter of 2006 and 29.6% in the first quarter of 2005. The lowest-earning 10% accounted for just 2% of income in the period, compared to 2% in the first quarter of 2006 and 2.1% in the first quarter of 2005.

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Figure 1.3: Average Russian monthly wage (year-end estimate), 2000–08F (US$) US$ 500

400

300

200

100

0 2000

2001

2002

2003

2004

2005

2006

2007

2008

Source: Aurora

Figure 1.4: Russian population demographics and financial statistics (2006) Segment

% Population

A

5%

>2,000

B

6%

1,000-2,000

C

Households (m) A B C D

400-1,000

30%

59%

D

Moscow/St Petersburg 1.25 1.65 3.00 2.95

<400

16 Largest cities 0.65 1.20 6.00 2.95

A = Credit cards (Gold, Platinum), auto insurance, asset management, mortgages, remote banking B = Credit cards, term deposits, auto, mortgages, personal loans, insurance products C = Payments, deposits, POS loans, Visa Instant, cash loan Source: McKinsey

4

Monthly income per household (US$)

Other regions 0.60 0.15 6.00 23.50


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Figure 1.5: Individual Russian client wealth, 2006 (US$) No of HNW individuals

Total assets

56

US$500m+

US$90bn

87

US$100-500m

US$19bn

240

US$35-100m

US$22bn

960

US$20-35m

US$29bn

2,957

US$25-20m

US$30bn

UHNW

Aspiring HNW

4,300

Totals 190bn

US$

Source: Finans Magazine 2005, Scorpio Partnership, Citigroup Own Estimates

One worry from rising incomes is that the rich are getting richer faster than the poor are getting less poor. The gap between Russia's richest 10% and the poorest 10% has widened to a multiple of seven, according to a study at the end of 2006. Experience shows that a difference between the top and bottom-tier salaries of more than 10 times tends to cause social instability. The proportion of ‘well-off and rich’ Russians with incomes higher than RUB20,500 per month went up last year from 8.5% to 9.2%, according to the Living Standards' research and Citibank. In general, the wealth of the country is starting to trickle down as more and more Russian businesses start to flourish. In the 1990s wealth distribution was simple: a huge block of the population on starvation wages and a small block of super-wealthy oligarchs. However, following five years of strong growth, the shape of wealth distribution has been transformed into the more traditional pyramid shape. This remains a pyramid with very steep sides, but thanks to the emerging middle class the gradient has been falling steadily (see Figures 1.4 and 1.5). The key question is whether consumer spending has built up enough momentum not only to prevent another financial crisis if oil prices collapse, but to fuel Russia's ongoing growth.

Construction After natural resources and consumer spending, construction is the biggest contributor to economic growth and has been expanding fast in the last two years, being the fastest growing sector in 2006. Construction accounted for 15% of the economy in 2006, according to Rosstat and grew by a robust 14% over the year. According to preliminary data, the real estate boom in Moscow, where apartment prices were up over 70% in 2006, seems to have reached its peak. However, real estate prices (especially residential) in the regions are still growing and will continue to do so for at least another year.

Financial services Banks are the fourth largest contributor to growth, accounting for 10% of the economy. However, the financial sector is growing very fast and total assets of the banking system expanded by 37% in 2006 (see ‘Russian bank sector fundamentals’, Chapter 2).

Investment Low investment is the Achilles heel of the otherwise sparkling Russian economy. Russia's fixed investment totalled RUB4.5trn (US$173bn) in 2006, or about 19% of GDP, according to Rosstat. However, the World Bank view is that emerging markets need to maintain fixed investment levels of over 20% if they are to sustain economic growth. Peter Westin, chief economist at MDM Bank, said in a paper last year that as Russia emerges from the simple ‘catch-up’ stage of recovery, where most growth comes from filling empty seats on production lines, the country is starting on a new phase of growth where investment is key. At the end of 2006, levels of investment in Russia could either follow the experience of Latin America, where initial fast growth stalls and leads to

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stagnation, or it could follow the experience of the so-called Asian Tigers in the 1980s and boom. The key in these two scenarios is that Latin America was investing about 20% of GDP a year, whereas SE Asian countries were investing about 25% of GDP. The good news is that domestic fixed investment began to take off in 2006 and is expected to be a major contributor to growth in 2007. Russia's fixed investment was up 13.5% in 2006 compared to the previous year, according to Rosstat, the fastest growth since 2000 and easily beating out the Economic Development and Trade Ministry start-of-year forecast of 11.3%. And it was accelerating towards the end of the year, when the December-to-December gain in fixed investment was up 16.5%. Russian GDP statistics are given in Table 1.1 and sector growth details in Table 1.2. Arkady Dvorkovich, the Head of the Russian President's Expert Department says: "There are many unsettled problems in the manufacturing industry. The most important problems are a low competitiveness of products compared with import goods and the peak load of industrial capacities in some sectors. As far as extractive sectors and the distribution of electric power, gas and water are concerned, these sectors have problems with the infrastructure rather than with the demand. It will hardly be possible to settle them within a short period of time." (See Chapter 3 for more on equity drivers.)

Table 1.1: Russian GDP by production and use, 2005, 2006 (RUBbn, %) GDP by production, nominal, Rb bn GDP Extraction of raw materials Manufacturing Construction Trade Transportation & IT Operations with real estate GDP by production, real, YOY, % GDP Extraction of raw materials Manufacturing Construction Trade Transportation & IT Operations with real estate GDP by use, nominal, Rb bn GDP Consumption households Gross investment gross capital formation Net exports GDP by use, real, YOY, % GDP Consumption households Gross investment gross capital formation Net exports Source: Rosstat

6

1Q06

2Q06

3Q06

2005

2006

5,722 520 800 201 1,134 501 404

6,343 650 980 315 1,153 590 475

7,224 642 1,103 420 1,214 628 545

21,615 2,070 3,568 1,034 3,616 1,902 1,829

26,621 2,375 4,362 1,356 4,484 2,258 2,254

5.5 1.7 4.6 1.6 11.0 4.0 4.3

7.4 3.5 7.1 12.3 10.1 7.9 8.9

6.5 3.8 6.3 14.5 6.6 7.9 8.5

6.4 0.9 5.7 10.6 9.9 6.8 11.8

6.7 2.1 4.9 14.0 8.7 9.4 5.6

5,722 3,892 2,734 786 720 934

6,343 4,147 2,970 1,172 1,083 956

7,224 4,440 3,222 1,787 1,355 861

21,615 14,360 10,626 4,350 3,848 2,932

26,621 17,728 12,880 5,416 4,795 3,372

5.5 8.5 10.7 13.4 5.8 -11.7

7.4 9.6 12 14.6 13.6 -12.3

6.5 9.5 11.7 13.4 12.4 -27

6.4 9.7 12.7 7.2 8.3 -12.8

6.7 9.0 10.7 13.2 13.7 -14.3


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Table 1.2: Russian GDP growth by sector, 2006 (% y-o-y) Construction Fishing Hospitality Financial services Transport and telecommunications Trade Real estate Administrative and military spending Manufacturing Healthcare and social services Electric power, natural gas and water Mineral resources Education Agriculture, hunting, forestry

14.0 12.0 11.2 10.4 9.4 8.7 5.6 5.0 4.9 3.8 2.6 2.1 1.8 1.7

Source: Rosstat

Russian oligarchs and the Kremlin's nine commandments for big business Among the first things President Vladimir Putin did on taking office in March 2000 was to attack oligarchs Boris Berezovsky and Vladimir Gusinsky, driving both into self-imposed political exile. In July he called the first of his so-called oligarch meetings and laid down the informal rules by which oligarchs could retain their companies and work in his Russia. For the next three years oligarchs were nervous, afraid that they too would come under the Kremlin's scrutiny and lose their assets; fears that were only reinforced when the tax authorities arrested Yukos oil company owner, Mikhail Khodorkovsky, and eventually bankrupted the company and jailed Khodorkovsky for eight years. At the time, it appeared that the Kremlin was about to launch a pogrom against the oligarchs, but in hindsight it appears more likely that Khodorkovsky was simply being punished for interfering in politics. Between 2004 and today, Putin has held several more meetings with the oligarchs and the rules have become very clear. The Kremlin has moved beyond simply leaving the oligarchs in peace if they keep their noses out of government affairs, to actively co-opting them into its long term strategy to make Russia a ‘great power’ again. One-on-one meetings between Putin and business leaders have become a regular feature of big business life, where the owners ‘explain’ their strategy to Putin. According to off-the-record remarks made by businessmen at these meetings, Putin has vetoed initial public offering (IPO) plans but will throw the weight of the Kremlin behind any oligarch who wants to buy assets such as phone companies in other countries. The idea is to create a series of Russian national champions on the global, not just national or regional, market.

State involvement The Kremlin has not only deliberately blurred the line between business and politics, but Putin is attempting to remove it altogether. Russia is unusual in that senior government officials sit on the board of nearly every significant state-owned company. In the same way the one-on-one meetings with Putin give the president a de facto say in the running of almost all of Russia's two dozen significant private corporations, the Kremlin is attempting to turn the concentration of assets in the hands of the Yeltsin-era oligarchs to its advantage, and so far the projects the state is pushing the oligarchs at havae been profitable and to their mutual advantage. A concrete example is the state's fluffed attempt to place US$8.8bn worth of Sberbank shares at the start of 2007. The marketing campaign was botched and CEO Andrei Kazmin confused investors with a series of contradictory remarks in the run-up to the sale. In the end, the Kremlin was forced to turn to the oligarchs to bail out the flotation, who spent an estimated US$4bn on shares.

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It was the second time in seven months that the Kremlin had botched an important stock issue: the historic Rosneft IPO in July 2006 worth US$10.6bn was actually more of a private placement after international investors shunned the sale because of perceived political risk. Oligarchs and international oil companies wanting to work in Russia also bailed out this IPO.

The nine commandments These events are not one-offs, but part of the new paradigm Putin is developing to govern relations between big business and the state. Alfa Bank's chief strategist, Chris Weafer, has laid down the new rules in a tonguein-cheek "nine commandments" for the oligarchs. "A significant amount of the domestic sourced funding that supported both the Rosneft IPO and the recent Sberbank equity issue has almost certainly come from a large group of Russian billionaires and the companies controlled by them. It actually is a very neat mechanism for the state to use the funds owned by these people to help advance the state's industrial ambitions. Of course, so far these have also been profitable investments for those investors," says Weafer. The oligarchs represent a very substantial pool of capital – of the order of US$40bn, according to some estimates – that the state is expected to tap into again as the IPO programme continues, and especially if international investors remain nervous about Russian companies as an asset class. In 2000, at the first oligarch meeting, Putin laid down the first three laws: 1. Stay out of politics. 2. Pay your taxes. 3. Operate within the law. In late 2003, at another meeting with business leaders, there were two new commandments added to the list: 4. Wealthy individuals should use their wealth to help improve Russia and in support of state objectives. 5. Businesses in strategic sectors should work to further the state's plan for industrial and economic development. At the 2006 meeting with the Russian Association of Industrialists and Entrepreneurs – known as the RSPP in Russian, an organised lobbying group to represent big business interests to the Kremlin – Putin elaborated on rule 5 and also added a new commandment: 6. Companies operating in the natural resources sector should plan to shift from exporting unprocessed material and now invest in downstream processing, so as to increase the value-added segment of natural resource exports. To the list above Weafer adds three more rules that have become apparent in the last year: 7. Foreign strategic investors are allowed to invest in strategically important companies or projects, but only up to a maximum of 49%. 8. For more ‘sensitive’ companies and projects in ‘strategic’ sectors, that limit is reduced to a maximum of 25%. 9. International companies that offer reciprocal investment opportunities outside of Russia will increasingly be favoured as strategic partners for the Russian state-controlled companies. Undoubtedly we will see a 10th commandment sometime in 2007. There is a role for foreigners in this paradigm and the newest commands relate to them as well as to big Russian business. A key part of this public-private partnership between the Kremlin and domestic business is to attract foreign know-how, management skills and, most importantly, access to new markets to the emerging Russian national champions. Although the Kremlin was in the process of marking out which are Russia's strategic sectors at the start of 2007, foreigners will even be allowed to invest into these sensitive sectors, albeit as minority investors.

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The Kremlin is setting up a series of national champions, in the hope of reviving the battered aviation and automotive sectors among others, into which all the state's holdings are gathered. Funding for investment and expansion will come from offering shares in these holdings to investors in a series of IPOs. But a key element of this strategy is to attract a ‘foreign expert partner’ who is offered a minority stake in a national champion. By the start of 2007, the most advanced of these national champions was the state-owned United Aviation Company that unites Russia's planemakers and design bureaux. EADS holds a 5% stake in jet planemaker Irkut, which is the core asset in UAC and is the expert partner. However, the Kremlin is finding it hard to implement the plan, as European politicians are resisting Moscow’s attempt to increase is concurrent 5% stake in EADS, held by state-owned bank VTB, for political reasons.

The BRIC prediction Jim O’Neill at investment bank Goldman Sachs coined the term BRIC (Brazil, Russia, India, China) in 2003 to sum up his prediction that these four countries would provide most of the global growth in the next two decades. O'Neill calculated that the Chinese economy could overtake Germany and Britain in four years in US dollar terms, before outstripping Japan by 2015 and then the US, to become the world’s biggest economy by 2040. Putin famously set Russia the task of overtaking Portugal in his state of the nation speech in 2002, a task Russia has already completed, as well as overhauling Italy in terms of the value of the economy. Finance Minister Alexei Kudrin predicted in February 2007 that Russia would catch up with France in 2031–32 and with Germany in 2037–38 in terms of GDP. At current growth rates, Russia is already set to become the world's 10th largest economy by the end of 2007 (see Figure 1.6). However, economists remain sceptical whether Kudrin's projections can be met, as they assume the state successfully carries off all the reforms it plans and Russia maintains the heady growth rates it currently enjoys.

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Figure 1.6: World’s largest economies, 2006–07 GDP, current prices, US$bn

15,000

12,000

9,000

6,000

Mexico

Korea

India

Brazil

Russia

Spain

Canada

Italy

France

UK

China

Germany

US

0

Japan

3,000

GDP per capita based on purchasing-power-parity (PPP)*

50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000

2006

5,000 Mexico

Korea

India

Brazil

Russia

Spain

Canada

Italy

France

UK

China

Germany

US

Japan

2007

0

*PPP (current international dollars): a theory stating that over the long term the exchange rate between two currencies adjusts according to currencies’ relative purchasing power. Source: IMF forecasts

Current financial situation International reserves and debt High oil prices have been a massive boon for Russia and allowed the state to build up the third largest currency reserves in the world – equivalent to over a year's imports, where 3–4 months of import cover is the norm (see Figure 1.7). In the summer of 1998, Russia's gross international reserves (GIR – hard currency and gold) fell to a mere US$9.1bn. By the end of 2006 Russia's GIR topped US$300bn. Ratings agency Fitch estimates Russia's GIR will reach US$370bn by the end of 2007. And the government has shown great prudence with its windfall oil money. Rather than ploughing it into various white elephant projects, the state set up the Stabilisation Fund on 1 January 2004. This accumulates the federal budget's extra revenues from progressive oil export taxes on Urals blend oil prices exceeding US$27 per barrel. The Stabilisation Fund has followed the same path as Russia’s GIR, as shown in Figure 1.8, and had reached US$87.5bn as of 1 January 2007 and crossed the US$100bn mark by the start of February 2007. According to Fitch, it is expected to rise to US$135bn by the end of 2007. This fund is ring-fenced from Duma deputies who can only tap it to subsidise the budget when oil prices fall below US$27. Once the fund exceeds RUB500bn (US$19.2bn) excess funds become available to the Ministry of Finance and can be used exclusively for paying down sovereign debt.

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Figure 1.7: Top holders of foreign exchange reserves (US$bn) US$bn 1,200 1,000 800 600 400

France 1

Germany 1

Hong Kong 2

1 End of December, 2 end of January, 3 January 26 2007 Source: Hong Kong Monetary Authority

Singapore 2

Korea 2

Taiwan 3

Russia 3

Japan 2

China 1

1

0

India 3

200

Figure 1.8: Russian Stabilisation Fund growth, Jan 2004â&#x20AC;&#x201C;Apr 2007 (US$bn) US$bn 120

Stabilisation fund, US$bn

100 80 60 40

Jan 07

Mar 07

Sep 06

Nov 06

Jul 06

May 06

Jan 06

Mar 06

Sep 05

Nov 05

Jul 05

May 05

Jan 05

Mar 05

Sep 04

Nov 04

Jul 04

May 04

Jan 04

0

Mar 04

20

Source: Finance Ministry

The windfall petrodollar revenue has allowed the Russian government to pay off almost all its international debts early, including the debts Russia inherited from the Soviet Union. In 2006, Russia paid off US$22bn of debts to the Paris Club of sovereign creditors ahead of schedule. In the mid-1990s, Russia's debt was around US$165bn or about 80% of GDP, and was 75% of GDP when Putin took office in 2000. By the start of 2007, Russia's sovereign foreign debt was US$52bn, or 5.2% of GDP, the lowest ratio in all the global emerging markets. Russia has now completely paid off its debts to the Paris Club, the IMF and the World Bank. The level of foreign debt in relation to GDP was 31.3% as of May 2007, compared to 50.9% at the start of 2000. Government foreign debt fell sharply during this period, while foreign debt in the private sector grew. However, the relationship of Russia's foreign debt to GDP is at an "absolutely healthful" size, Finance Minister Kudrin said in May. At the same time, Kudrin said that it is more the quality of administration of borrowed funds than their size that is a cause for concern. The main question is whether companies will receive the necessary return and the expected yields from the borrowed funds, the minister said. Russian banks' and companies' external liabilities grew 50% to US$260.7bn, whereas the cumulative debt of Russia's government institutions and monetary regulation bodies was less than one-fifth that amount as of 1 January 2007 (down to US$49bn from US$82.1bn). Foreign debt at Russian banks doubled to more than US$100bn in 2006, which is more than 10% of Russian GDP, according to Kudrin.

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Foreign borrowings by the non-financial sector increased 27% to US$159.5bn: however, the relationship to GDP dropped slightly to just over 16.2%, he told the State Duma in presenting the draft federal budget for 2008–10 in May. Russian banks, however, are borrowing more than ever and increased the amount of credits drawn from international capital markets to US$48.5bn in 2006 from US$19.2bn in 2005. This suits the companies that prefer to borrow in rubles and the banks, which can borrow abroad more cheaply. Standard & Poor's predicts that domestic credits will increase almost 40% in the next three years, from 30.8% of GDP in 2006 to more than 50% by 2009. At the same time, the amount of money Russian banks had on deposit in foreign banks rose from US$150bn to US$220bn over 2006, according to United Nations Conference on Trade and Development.

State funds The Russian government has set up four funds in all since the stabilisation fund was set up in 2004. With so much money flowing into the state coffers, the problem has been what to do with all the free cash.

Stabilisation Fund The Stabilisation Fund is a piece of prudent money management, building up reserves in good times in anticipation of the bad. However, it quickly took on a second function, as it is one of the more effective money sterilisation tools the CBR has to help hold back ruble appreciation against the dollar and euro. However, once the fund passed the US$19bn mark the state began thinking about how to make best use of the excess revenue. The Duma was torn over what to do with these surplus revenues. There was a strong lobby, headed by Prime Minister Mikhail Fradkov, that wanted to use the excess cash to fund a drastic cut in taxes – and especially VAT, which accounts for a third of the state's tax revenue. This debate is ongoing and VAT is likely to be cut from 18% to 15% in 2008, slashing some RUB400bn (US$15bn) from the state's tax revenues.

State Investment Fund The more conservative faction at the Finance Ministry carried the day and the second fund to be established was the State Investment Fund – a special fund that will be used to finance big infrastructure projects, like building new hydro-power stations, upgrading roads and rail, and modernising the ports – all assets that have been barely touched since the fall of the Soviet Union 15 years ago. By the middle of 2006, the first projects had been allocated to receive finance from the State Investment Fund, but instead of the state simply doling out money, each of these projects has been done in partnership with a private investor. Companies and regions have to raise a significant part of the financing before they can apply to the State Investment Fund commission for financing to complete the project. The State Investment Fund runs in parallel to a series of ‘national programmes’ headed by First Deputy Prime Minister and deputy head of the presidential administration, Dmitri Medvedev. These are high profile and well-funded programmes designed to put social services like health and education back on track. Likewise, some of the money has been ploughed into a series of federally-owned banks designed to support this investment effort, including: the Roseximbank, an export promotion agency; the National Development Bank, which will oversee and organise big infrastructural investment projects; and Rosselkhozbank, which is financing the agricultural sector. All these programmes are part of Putin's pubic-private partnership policy. Alive to the failings of the Soviet Union's central planning, the Kremlin is trying to involve professional managers and commercial interests wherever it can to ensure efficient, profit-motivated management of all these projects. This usually takes the form of a strategic partner and the sales of shares and IPOs are offered as the incentive for private concerns to come in on the project – in addition to attractive financing terms.

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State Venture Capital Fund The most recent addition to the family is the Russian Venture Capital (RVC) Fund. Some US$500m has been earmarked from the State Investment Fund to finance about a dozen venture capital funds that are intended to create from scratch a venture capital industry in Russia and at the same time unleash Russia's intellectual capital. (For more on this, see below.) The state is basing the RVC Fund on Israel's experience, where the state put in US$200m of seed capital and raised US$8bn in private funding for venture capital products. Three companies were awarded the first venture fund tender in May and gained access to the RVC Fund. The winners were the fund set up by Russia's VTB bank jointly with the European Bank for Reconstruction and Development (EBRD), the fund established by Bioprocess Capital, a Russian pharmaceuticals group, and Israeli Tamir Fishman Group's fund with Russian partners.

State Future Generations Fund The next fund in the works is a state social fund that will be used to make ad hoc payments in the social sphere, such as one-off payments to pensioners. This latest fund is slated to appear in the second half of 2007 and the government says it will eventually be worth 10% of GDP.

Inflation Despite Russia's impressive macroeconomic fundamentals, there are still some nasty problems to fix. One of the most difficult is curbing inflation, which has been stubbornly high. After the government missed its self-imposed inflationary target of 10% in 2005 with an end-ofyear 10.9% inflation rate, the Kremlin was buoyed by coming inside the 9% target in 2006 – the first time in modern history that the Russian economy has enjoyed inflation in single digits (see Figure 1.9). Hitting the target is important, as one of the components that drives inflation is the expectation of rising prices, so missing targets is in itself inflationary. The government has been holding down inflationary tariff hikes to prices for essential services such as gas and electricity in recent years as an administrative means of containing inflation. However, economists say that in the last few years the drivers of inflation are increasingly crossing over to the market where the state has no ability to reduce inflation by administrative means. Traditionally, the CBR's only monetary policy tool has been intervention in the foreign exchange (FX) market as a way of injecting cash into the financial system. The CBR has used this tool to pursue the twin policy of reducing inflation and holding back ruble appreciation against the dollar. However, economists say that it is impossible to control these two variables with only one tool – and a crude one at that.

Interest rate control The race is now on between the CBR and the growing economy. The CBR is working towards bringing inflation down to the point where its overnight interest rates are greater than inflation and so ‘turn on’ the traditional tool of central bank money management – interest rate hikes. It is a slow process, as hiking interest rates fast affects liquidity in the still fragile banking sector and could spark another bank crisis, but economists say the CBR is within a year or so of making the key overnight interest rates a real tool of monetary policy. (For more on this, see the Chapter 4.) The CBR was off to a good start in the first month of 2007, with inflation rates coming in significantly under target. On the back of this good news the government has revised its inflation projections and expects inflation to be 8% over 2007, 7% in 2008, 6.8% in 2009 and 6.5% in 2010. A testament to the robustness of Russia's economic growth is the fact that the state has begun to raise tariffs more quickly, as the priority shifts from containing inflation to creating badly-needed investment capital for the likes of Gazprom and United Energy Systems, which provide Russia with its essential gas and power. In December 2006, the government announced a plan to gradually deregulate gas and electricity tariffs for industrial customers. The domestic price of gas will rise from US$44 per thousand cubic metres at the end of 2006 to US$125 by 2011, according to Andrei Klepach, the head of the macroeconomic forecasting department at the Ministry of Economic Development and Trade. These figures may be revised upwards again, Klepach said in the first week of January. "A new mechanism of regulation of the power market is required. If no such mechanism is found, inflationary risks are likely to increase greatly." Analysts were surprised by the accelerated increases in tariffs, coming in an election year.

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Figure 1.9: Russian inflation, 2003–09F (%) Inflation, % 20

RUB per US$1 32

30

15

28 10 26 5

24

Ruble/US$ ratio, ave 22

0 2003

2004

2005

2006E

2007F

2008F

Inflation

2009F

Source: Ministry for Economic Development & Trade

Ruble appreciation, currency controls and de-dollarisation The ruble has almost become a hard currency in the last few years and has been appreciating in value rapidly. Real ruble appreciation in 2006 was 7.6%, inside the CBR target of 9% and well below the 10.5% real appreciation the national currency saw in 2005. Economic Development and Trade Minister German Gref says that the ruble will appreciate by 4–5% in 2007 and will start losing ground to the dollar by 2010, according to the Ministry's forecasts. The average annual rate of the ruble will be RUB26.1 to the dollar in 2007 and 2008, RUB26.4 to the dollar in 2009 and RUB27 to the dollar in 2010, says the Ministry. While the growing value of the ruble is a problem for the authorities, the fact that the bulk of Russia's exports remains raw materials means that Russian firms have yet to suffer much pain from the rising value of the ruble. The increasing value of the ruble is also sucking in increasing amounts of imports, but the value of exports still exceeds imports by a handsome margin. The Kremlin accelerated plans to make the ruble a fully convertible currency in 2006, removing the last of the currency control restrictions on 3 July 2006. Foreign investors willing to buy assets denominated in the Russian currency will not be subject to any regulatory restrictions, such as interest-free deposits with the CBR, and will not have to deal with the complicated system of multiple accounts that had been previously in place.

Currency flows According to the currency control legislation, introduced in 2003, the CBR has the right to introduce restrictions (in the form of reserve requirements) to defend the balance of payments' stability and preserve the country's international reserves. This aims to limit 'hot money' flows and prevent the destabilisation of the local market in the event of turmoil in world capital markets. Effectively, this implies additional taxation on external capital transactions. By the start of 2007 Euronext, the European stock exchange, had set up a system to allow clearing of ruble-denominated deals, in preparation for the ruble entering the international FX markets – although by the end of February not a single deal had been transacted. Probably the best testament to the growing confidence in the ruble is the almost wholesale dedollarisation of the Russian economy. Holding hard currency has always been a typical hedge against inflation (and a capital offence in Soviet Russia). The US government was forced to fly plane-loads of US$100 bills to Russia in the 1990s to keep up with the demand for cash. However, at the end of 2006 the Russian public converted US$7.7bn worth of dollars into rubles and deposited them in bank accounts, setting a new monthly record. Economists say that the process of de-dollarisation began in about March or April in 2006 and had been gathering momentum all year.

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The rate of growth of hard currency deposits was essentially zero in 2006, according to UBS, while domestic deposits grew at 60% year-on-year and the share of foreign currency deposits declined from 30% to 23% of total bank deposits in the first nine months of 2006. Furthermore, according to the balance of payments figures, US$10.6bn of cash dollars left Russia in 2006, compared to US$1bn in 2005. The net demand for foreign currency in 2006 ranged from zero to US$1bn a month, while in 2005 the demand for foreign currency was US$2–3bn a month. The euro accounts for a quarter of foreign currency purchases and 15% of sales. The remainder is almost completely in dollars.

Money supply and dollars 2006 saw a record net inflow into Russia of US$41.6bn in capital – repatriated funds by domestic investors and burgeoning amounts of foreign investment – compared to the net inflow of US$1.1bn in 2005. The pace is likely to slow considerably this year, but is still a lot better than in the past; the Finance Ministry is predicting inflows of US$15bn in 2007. Russia's money supply is intimately linked to the flows of foreign currency, as the CBR still uses the FX markets as its main tool of monetary policy. The money supply increased sharply in 2006; however, economists were surprised that this did not fuel higher inflation, which actually decreased. While the CBR stepped up its attempts at sterilisation (through its deposit window, the issuance of its own paper – the OBRs – and an increase in the reserve requirement for foreign currency borrowing in October) reserve money grew by 41% y-o-y in 2006, funding about US$45bn of the reserve build-up, compared to a growth rate of 22% y-o-y in 2005. UBS said in January: "Somehow surprisingly, this rapid expansion has not led to an increase in inflation. In fact, inflation has continued to decline and the CBR managed to achieve its end-year inflation target of 9% y-o-y. It has been helped by relatively slow growth in administrative prices but the rising demand for the ruble is the main reason for the falling rate of price increases in our view." The de-dollarisation is also contributing to keeping inflation down, despite the continued rapid rise in the money supply. "The fact that the demand for money must have grown substantially is also borne out by the fact that nominal interest rates have hardly changed," says UBS.

The federal budget The government ended 2006 with whopping budget surplus of 7.3% of GDP, or slightly less than RUB2trn. Federal budget revenues came to RUB6.3trn, while expenditures were RUB4.3trn. In 2005, the federal budget surplus was at RUB1.5trn, or 7.2% of GDP, while federal budget revenues amounted to RUB5trn and spending was at RUB3.6trn. Budget data can be seen in Table 1.3. The Federal Tax Service collected RUB3trn in taxes for the budget in 2006, the Federal Customs Services collected RUB2.9trn and the Federal Property Management Agency collected RUB69.8bn. Other federal government agencies collected RUB343bn for the budget in 2006. Among the fastest rising tax revenues was corporate profit tax, which was up 40% in 2006 to RUB1.7trn. One of the slowest risers was VAT, which was up only 4.1% last year to RUB924bn – but as VAT contributes a third of budget revenues by itself, this slow rise is more a function of the fact that reforms to the tax collection system have concentrated on the efficiency of VAT collection above all else. Federal budget revenues and expenditures as a percentage of GDP are shown in Figure 1.10. The situation is improving in the regions, too. Of Russia's 88 regions (two were merged in 2006) 16 are now running at a profit and net contributors to the budget – almost all oil producing regions – and a dozen regions rely on federal funds for their budget needs. The rest are muddling through on local taxes and federally-sponsored programmes. Financial aid from the federal government to the regions between January and October 2006 was nearly RUB440bn, with average transfers equalling 14.6% of regional budget revenues.

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The donor regions in 2006 were: the city of Moscow, the city of St. Petersburg, the Yamal-Nenets, Nenets, Agin Buryat, and Khanty-Mansi autonomous districts, the Perm, Komi Republic, Tyumen, Samara, Lipetsk, Vologda, Sverdlovsk, Leningrad, Yaroslavl, Chelyabinsk, and Orenburg regions, according to the Regional Development Ministry. Moscow dominates, accounting for 70% of regional contributions to the federal budget.

Oil and economic expansion Both the growth of the Russian economy and the importance of oil can be seen in the price of oil needed for the budget to break even. In 2000, the price of a barrel of oil had to be US$14 or more to generate enough tax revenue for the budget to break even, according to Alfa Bank. In 2006, the break-even price of oil had risen to an estimated US$39 per barrel. In both years, the actual price of oil was well above this level, and the Kremlin is confident as it has a wide comfort zone against the US$62.3 average first quarter price band which oil has been trading at through to the start of 2007. Even bankers' long-term forecasts for oil predict prices of the order of US$45. Price movements and forecasts for Brent oil are given in Figure 1.11.

Table 1.3: Russian budget law and execution, 2003–07, (% GDP) Budget law 2003 Federal budget revenues 18.5 Federal budget non-interest expenditures 15.8 Budget surplus 0.6 Oil price forecast (US$) 21.5 Inflation foecast 12.0 GDP growth forecast 4.4 Budget execution Federal budget revenues 19.4 Federal budget non-interest expenditures 16.1 Budget surplus 1.6 Oil price(US$) 27.2 Inflation 12.0 GDP growth 7.3

2004 17.9 15.5 0.5 22 10.0 5.2

2005 17.8 15.0 1.5 28 8.5 6.3

2006 20.7 16.7 3.2 40 8.5 5.8

2007 22.3 17.0 4.8 61 8.0 6.0

20.4 15.1 4.3 34.2 11.7 7.2

23.9 15.4 7.5 52 10.9 6.4

24.1* 14.5* 8.9* 65* 9.5* 6.6*

24.0* 17.0* 6.5* 65* 9.5* 6.4*

Note: Alfa Bank’s forecasts on oil prices, inflation and GDP growth; oil prices forecasts are currently under revision * Budget execution for 1H06 Source: Finance Ministry, Internet Securities

Figure 1.10: Russian Federal budget revenues and expenditures, 1998–2007E (% GDP) % to GDP ratio 24

20

16

12 Federal budget revenues, % GDP Federal budget expenditures, % GDP 8 1998 Source: RosStat

16

1999

2000

2001

2002

2003

2004

2005

2006E

2007E


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Figure 1.11: Oil price – Brent quarterly average, 1Q2006–4Q2007F (US$/bbl) US$/bbl 75

70

65

60

55

50 1Q06

2Q06

3Q06

4Q06

1Q07

2Q07

3Q07

4Q07

Source: Raiffeisen

Trade and the balance of payments Russia continues to enjoy a very strong positive balance of payments. The trade turnover with foreign countries other than the CIS increased 28.7%, to US$371.4bn in 2006, while trade turnover with the CIS countries was up 25.4%, to US$64.7bn, according to figures released in January 2007 by the Federal Customs Service. The EU is the largest economic partner of Russia, accounting for 53.2% of trade turnover in 2006 and 52.1% in 2005. The CIS countries accounted for 14.8% (15.3% in 2005) and Asia made up the remaining 7.8% (7.8% in 2005). Russia’s main trading partners outside the CIS in 2006 are shown in Table 1.4. Imports were up 45% to US$115.7bn in 2006 and while the absolute value of imports remains less than those of exports, the rate of growth of imports was higher than exports for the first time in recent years, rising 37.7% against the 25.5% increase of exports over the same period. Russian external trade details are shown in Table 1.5 and the composition of exports in 2006 in Figure 1.12. UBS said in January: "The current account surplus has peaked as imports continue to outpace exports. In dollar terms imports grew by 34% y-o-y in 2H06 compared to 25% in 1H06, an acceleration that we attribute to the rapid increase in investment spending." Some 40% of imports in 2006 were heavy machinery, which Peter Westin, chief economist at MDM bank, says is a good sign and indicates that Russian industry is tooling up for more growth. However, experts say that the Federal Customs Service's statistics overstate the real growth rates of imports because of corruption, leading to significant amounts of unregistered trade. "The European Union is Russia's main partner in the sector of registered trade. The greatest increase of imports was registered in this direction, because the ruble grew stronger against the euro significantly," says Igor Belyakov, an analyst at the Expert Economic Group. The Middle East is now an insignificant trade partner and the US is only a minor partner.

Table 1.4: Russia's main trading partners outside the CIS, 2006 (US$bn, %) Country Germany The Netherlands Italy China Turkey United States Poland Britain France Switzerland Source: Russian tax service

17

Trade (US$bn) 42.9 38.5 30.8 28.6 17.0 15.3 14.9 14.0 13.5 13.4

Increase on 2005 (%) 30.1 45.1 31.4 41.0 35.6 40.7 30.9 26.9 37.5 14.7


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Table 1.5: Russian external trade, 2004–06 (US$bn) Dec 05

Oct 06

Nov 06

Dec 06

2004

2005

2006

24.5 13.9 10.6

24.9 15.7 9.2

25.6 16.2 9.5

30.0 19.4 10.6

183.2 97.4 85.8

243.6 125.3 118.3

304.5 163.9 140.7

28.3 31.7

20.6 35.2

15.2 33.7

16.8 35.7

34.8 28.0

32.9 28.7

25.0 30.8

US$bn Exports Imports Trade balance YoY, 3-mma, % Export Import

Note: The CBR makes its own estimates, making more use of the flows of money than the goods flow recorded by Federal Customs. Both these sets of numbers can be different from Rosstat’s, which uses a third methodology. On the whole, the Federal Customs numbers are the most widely used, but in areas such as measuring foreign direct investment the differences can be up to 20%. Source: CBR

Figure 1.12: Russian exports, by sector, 2006 (%)

23% 35%

Oil Gas Metals

3%

Equipment 6%

Chemicals Forestry 5%

Other 14%

14% Note: Data for Jan–Oct 2006 Source: RosStat, Russian Customs

Political events A crucial year for politics, 2007 will see elections for the lower house of parliament, the Duma, in December 2007 and Presidential elections three months later, in March 2008. The Kremlin is expected to tighten its stranglehold over the Duma and Putin has repeatedly said he will stand down; he is constitutionally barred from running for a third term. While fighting ahead of the Duma and presidential elections represent a real political risk, all of Russia's investment banks expect the transition of power to be smooth and believe Putin's promises that his successor will continue the same policies as his administration. Despite being demonised by the Western press, Putin remains enormously popular with an approval rating that topped 80% in January 2007. Looking at his record over the last six years since he took office, it is not hard to understand why. Life under Putin has got noticeably better for nearly everyone in Russia, as shown in Table 1.6.

Table 1.6: Russian economic performance under President Putin, 2000–06 President Putin’s record GDP per capita (US$) Government debt (%GDP) Stabilisation Fund (US$bn) FX reserves (US$bn) New external debt (%GDP) RTS equity index Sovereign rating (FCIDR) Source: Fitch

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End 2000 1,784 63 0 28 50 143 ‘B’

End 2006 6,750 10 90 304 -4 1,911 ‘BBB+’


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Table 1.7: Public trust in Russian politicians, 2006 (%) Most trusted politicians President Putin Dmitry Medvedev, First Deputy PM & Head of Gazprom Sergei Shoigu, Emergencies Minister Sergei Ivanov, First Deputy PM & Defence Minister Boris Gryzlov, Speaker of Duma and Head of United Russia

% 46 17 12 9 9

Source: Levada Center

Analysts are expecting Putin to introduce his chosen successor to the public sometime in the second half of 2007, who will probably be made Prime Minister at the same time. At present, the identity of the presidential candidate is a matter of pure speculation. The two First Deputy Prime Ministers, Dmitry Medvedev and Sergei Ivanov, are the obvious front-runners, who are both close confidents of Putin. But political analysts all agree that a dark horse could emerge very late in the race; however, according to an opinion poll in December, about half of Russians intending to vote will vote for anyone Putin dubs as a successor, enough to give the candidate victory in the first round of the elections. The politicians who the electorate place most trust in are shown in Table 1.7. Analysts at UBS sum up the received wisdom: "Theoretically, with both the executive and the legislature up for grabs, there should be the potential for a change in regime. However, we, like the bulk of analysts, see the chances of a real change as being close to zero: with Putin's popularity still sky-high and democracy ‘managed’, the questions are more second-order ones about who is promoted and whether there is any modest change in effectiveness and style." The Duma election should return the pro-Putin ‘Party of Power’ – United Russia – with a majority, with the only unknown being the exact size of its majority.

Table 1.8: Duma election, Dec 2003 – share of popular vote (%), number of seats United Russia Communist Party LDPR Homeland/Rodina Union of Right Forces/SPS Yabloko Agrarian Party Pensioners Party Russia re-birth Party Green Party Others Against all parties

Share of vote 37.09 12.70 11.60 9.10 4.00 4.30 3.70 3.10 1.90 0.40 6.50 4.80

Duma seats* 310 47 33 28 0 0 0 0 12 0 0 0

*Note: 19 Deputies are independents Source: Alfa Bank Research

The only drama in the elections will all come from the tail-end of the race, seeing which of the also-rans can muster the recently increased 7% of the vote threshold needed to get into the Duma. Battling it out for second will be the newly formed left-leaning (and Kremlin-backed) ‘A Just Russia’, which will go up against the waning Communists. After almost a decade of loyally serving the Kremlin's interest (and providing Russia-watchers with a lot of entertainment) Nationalist Vladimir Zhirinovsky's LDPR will all struggle to get over the 7% hurdle, as will the liberal parties on the right, which are a spent political force. Details of the last Duma elections are given in Table 1.8. The major themes of the election look set to be social equity and nationalism, suggesting the big policy question will be the extent to which policy drifts in this direction in 2008, says UBS. However, Alfa Bank thinks that the election campaign could produce some fireworks in the form of an anti-corruption drive – something that is high on almost all Russians' list of moans. "The election theme is expected to be an increasingly high profile campaign against corruption in state agencies and amongst law enforcement officials. It is possible that we may see some very high profile anti-corruption event in 2007 as the government looks to address the country's poor investment image and reflect voter concerns," says Alfa Bank.

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Politics and fiscal loosening Maybe the biggest danger from the upcoming elections is the fact that the government is likely to loosen the purse strings and boost social spending, which will put pressure on inflation and ruble appreciation. Fitch said in a note in January: "The IMF forecasts that the general government non-oil deficit could widen to 8.3% of GDP in 2007 from 4.3% in 2004, and Fitch forecasts that the federal government surplus will narrow to 3% in 2007 from 7.5% in 2006. By the end of January a significant loosening of fiscal policy was already clearly underway as money supply grew 48% month-on-month, twice the normal rate.â&#x20AC;?

Oil price scenarios There is a consensus among economists covering Russia that domestic growth is extremely robust and almost all the dangers are external. Several banks have tried to forecast what would happen to the equity market if oil prices were to fall precipitously. However, oil would have to fall a long way and stay low for more than a year to do any real damage to the economy. The government is expecting to spend about US$156bn this year. Even if the price of oil dropped to zero and so wiped out two-thirds of the state's revenue, the whole year's spending would be covered by the US$100bn in the Stabilisation Fund. With a less drastic fall, the fact that Russia's sovereign debt is now so low as a proportion of GDP, the state could afford to borrow its way out of trouble for several years. UBS carried out the most comprehensive study in December 2006, looking at scenarios with the average price of oil at US$40, US$50, US$59 (UBS' base case) and US$67 (the base case in 2006). See Table 1.9 for details. Below US$40: The real economy would start to be affected in a serious way only with oil prices below US$40. The reason is that, at that point, both the budget balance and the current account would turn negative. UBS says it is impossible to guess how the state would react to such a scenario. "Would it open the coffers of the stabilisation fund and start spending from it? Would it start supporting the ruble from a depreciation, etc? Given this ambiguity, the uncertainty of investing in Russia would, in our view, start rising more rapidly. This is not that we would see a crisis but uncertainty and sentiment would be sufficiently affected to cause companies to take a more defensive attitude. Consumption driven by credit creation would also be affected negatively, reducing domestic demand growth further," says UBS. At US$40: UBS says the net private inflows would fall from their 2006 level to US$30bn. The case for a currency appreciation would be far less obvious and fewer investors would place such a bet, hurting the bonds market. "Still, we do not think that the CBR would depreciate the ruble ahead of the election just at a time when the population at large has shifted its deposits and cash into rubles," says UBS. Above US$40, but below US$60: UBS says the main impact would be in the nominal sphere. â&#x20AC;&#x153;Real growth would marginally fall, we believe, to 6% rather than the 7.5% of our base forecast. "More notable would be the impact on nominal GDP growth. Depending on the oil price Russia's GDP in dollar terms would grow by between 8% and 26% and this rather large range implies that not only oil stocks are sensitive to the price of Brent but also domestically oriented stocks," says UBS.

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Table 1.9: Brent oil prices â&#x20AC;&#x201C; Forecasts and implications Oil price, Brent Exports Imports Current account Current account Net private sector capital inflows Net payment of government debt Change in reserves Reserves Budget surplus Unsterilised reserve build/ money creation* Reserve money growth M2 CPI RUB/US$ exchange rate GDP Real GDP growth US$ GDP growth Source: CBR, GKS, Bloomberg, UBS

21

2004 US$/bbl 38 US$bn 183 US$bn 97 US$bn 61 % GDP 10.3 US$bn -8 US$bn 7 US$bn 45 US$bn, eop125 % GDP 3.4 US$bn 33

2005 55 244 125 84 11.1 1 23 61 182 7.5 28

2006E 65 302 163 96 9.8 42 30 107 303 7.4 65

% yoy 24 % yoy 36 % eop 11.7 Rb/$ eop 27.8 US$bn 590 % yoy 7.2 % yoy 35

22 39 10.9 28.8 759 6.4 29

41 49 9.0 26.4 974 7.0 28

2007E 40 250 190 10 1.0 30 10 30 335 0.5 35

50 275 195 30 2.7 40 10 60 365 2.9 38

59 305 200 55 4.6 50 10 95 400 4.6 51

67 335 205 75 6.1 55 10 120 425 6.1 55

20 28 6.0 26.5 1,050 6.0 8

25 30 6.5 26.0 1,100 7.0 13

30 35 7.5 25.0 1,204 7.5 22

35 45 8.0 24.0 1,230 8.0 26

2008E 62 325 240 35 2.5 60 5 90 490 3.5 46 20 30 6.0 24.5 1,402 7.5 17


CHAPTER THE BANKING SECTOR

02

Overview Russia's financial sector is almost completely populated by banks, which are the main players on the capital markets. Private pension funds, insurance companies, mutual funds and other forms of institutional investor have yet to appear in any great number. As equities are almost the only assets in Russia that produce a positive real return, most of the banks have become active participants in the equity capital market, which in turn is sensitive to the ebb and flow of liquidity in the banking sector. As bank reform only really took off in about 2004, the banking sector, while growing fast, remains rough and ready. The monthly and annual tax payments are written large on banks’ liquidity flows and can be seen in the rhythms of the equity markets as the interbank market remains under-developed and other financial instruments normally used to smooth the flows of liquidity in the bank system are still rudimentary or simply non-existent.

Initiating sector reform However, since 2004, financial sector reform has gone to the top of the Kremlin's agenda and while reforms to the administrative and social spheres have largely stalled, those to the financial sector are progressing rapidly. Why did the Kremlin finally turn its attention to the financial sector? President Putin is very concerned that Russia does not become simply another petro-economy and the word ‘diversification’ has become a mantra in Russia's political circles. Bank reform is designed to tackle Russia's fundamental problem. On one side, there are the raw material producers that are swimming in money; in 2006 roughly US$10bn a month flowed into Russia, or about 1% of GDP. On the other side, there is a plethora of small and medium-sized enterprises that are seeing massive demand from consumers, who are enjoying rapidly rising incomes, but are starved of cash and unable to raise investment capital. In the middle is the banking sector that is unable to carry out its traditional role of facilitating the flow of money from one side to the other. The push to fix the bank sector was timely, as the first real benefits of economic transiton began to make themselves felt and consumers began to make use of bank services. Although average incomes are low, as the average Russian was gifted their apartment in the early 1990s and no-one had any debt to speak of, analysts say that the average Russian had the same spending power as the average Swede, as IKEA found out to its surprise when it opened its first store in Moscow in 2000; the store is now one of the highest earning in the world in terms of spend per square metre. Following the advent of consumer express crediting in 2001, the entire sector took off. Companies have followed the people and everyone is borrowing hand over fist to pay for expansion – be it in terms of the quality of life or production capacity.

Russian bank sector fundamentals The number of credit institutions in Russia fell by 46 in 2005, to 1,253 as of 1 January 2006, according the Central Bank of Russia (CBR). Of these, 924 banks were listed in the register of participants of obligatory deposits insurance system, which means they have a full bank licence and can accept deposits from retail customers. In January, Russia's Minister of Finance, Alexei Kudrin, boasted: "Our banking system is increasing faster than any other banking system in the world." Banking experts agree with him. "It is evident from the preliminary analysis that the last year was one of the most successful years in the history of the Russian banking system. The progress of the Russian banking system stands in close relation to the positive dynamics of Russia's macroeconomic indicators, including the reduction of inflation, the acceleration of the growth rates of GDP and its increased monetization", said Kudrin.

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The capitalisation of the banking sector increased by RUB224bn (US$8.6bn) in 2006 and the assets of the sector were up by RUB3.6trn to RUB13.4trn – that is, by 37% year-on-year. And Russia's 30 largest banks increased their net profit 42% on the year in 2006 to RUB279.7bn (US$10.7bn) rubles as of 1 January 2007. At the end of 18 months of frenetic acquisitions in the bank sector, the number of financial organisations with 100% foreign capital increased from 41 to 52 in 2006 and the number of financial organisations with some foreign capital in their equity increased by 136 to 153. Among the most significant banks, foreigners bought or bought into Rosbank, Impexbank, Promsvyazbank and the Bank of Moscow.

Table 2.1: Russia's top 30 banks, as of September 2006 (US$) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Bank Sberbank Vneshtorgbank Gazprombank Bank of Moscow Alfa Bank UralSib Rosbank Raiffeisen International Moscow Bank MDM Rosselkhozbank Russky Standart Promstroibank Promsvyazbank Citibank Petrokommerts Homos-bank Ak Bars VTB–24 MPB Zenit Transkreditbank ING Bank Eurasia Impexbank Vozrozhdeniye Khanty-Mansiisky Bank BIN-bank Globex MBRR Soyuz

Assets (US$bn) 109.3 27.8 19.1 11.3 9.7 9.5 7.8 6.5 6.3 5.9 5.5 5.0 4.9 4.7 4.6 3.6 3.2 3.1 3.0 3.0 2.8 2.3 2.2 2.2 2.1 2.0 2.0 2.0 1.8 1.8

Profit before taxes (US$m)* 1,865 433 507 129 79 195 26 111 104 91 48 262 104 122 22 111 43 30 22 6 34 50 19 10 38 15 19 16 7 8

Ruble figures converted into dollars *Latest figures available Source: Interfax Center for Economic Analysis

Bank reform The replacement of CBR governor Viktor Gerashchenko with Sergei Ignatyev in May 2002 marked the turning point for Russia's bank sector. Gerashchenko, a former Soviet-era Gosbank apparatchik, simply tried to avoid a crisis, while banks got rich from speculating against inflation or in government bonds. Ignatyev began the process of supervising the sector and making the prudential rules stick.

2004 mini-crisis The CBR's efforts to reform the bank sector have been multifaceted, but it started by stamping out the rampant reporting of ‘virtual capital’ in the sector. In an effort to win custom, banks regularly artificially inflated their capital by making soft loans to related party companies that would then buy shares in the bank. The result was the amount of cash in the bank remained the same, but the bank’s capital was increased by a fresh injection of capital into its equity. At the height of this scam in 2002–03, about a quarter of the Russian banking sector’s capital was thought to be make-believe. The CBR has countered, by first forcing banks to reveal their ownership and Ignatyev actually started closing banks for breaking the rules in 2004, sparking a mini-banking crisis.

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In May 2004, the CBR exercised the newly-enacted anti-money laundering laws to withdraw the licence of Sodbiznesbank – the first time any bank licence had ever been withdrawn. Bankers were spooked. A blacklist quickly circulated of small and medium-sized banks that market participants thought the CBR was about to close down, which caused the interbank market to collapse as bigger banks cut off smaller banks. As small banks have few resources of their own, they depend on borrowing on the interbank market for their liquidity to fund what transactions they do, and dozens of small banks quickly found themselves in real trouble. Things got worse when professional rivals took advantage of the panic to attack their rivals and spurious newspaper reports that Alfa Bank, one of Russia's top five commercial banks, was in trouble started a run on deposits, forcing the owners to fly in US$800m in cash to shore up confidence in the bank. The CBR acted quickly and restored confidence within a few weeks and the only real casualty was the top 20 Guta bank, which was taken over by state-owned VTB, Russia's second largest bank (named Vneshtorgbank at the time). Indeed the Kremlin took advantage of the crisis to bolster VTB's position: instead of bailing out wobbly banks directly, the CBR chose to grant VTB a US$800m loan which it used to buy up loan portfolios of troubled banks and so increase its position in the market, as well as launching its retail operations with the acquisition of Guta Bank's extensive branch network.

Deposit insurance The 2004 mini-crisis turned out to be a useful slap on the wrist for Russia's bank sector. It did little real damage, but galvanised both the Kremlin and the Duma into action, while bolstering both Ignatyev's reputation and the CBR's authority. Following 2004, the CBR will act to close down banks that break the rules on a monthly basis. Bankers routinely ignored CBR instructions in the past; as long as their pro forma documents were in order there were few consequences. Now, if the CBR orders a change, bankers take it seriously. This change in environment has also contributed to the decision by many bank owners to sell out. The mini-crisis pushed the Duma into rushing through the deposit insurance laws in December 2004. These are the cornerstone of the CBR's plans to restore confidence in the bank sector from consumers who have been robbed of their life savings three times since 1991 by bank crises. Personal savings have been rising steadily over the last seven years, from 7.6% of GDP in 1999 to 12.8% at the end of 2006, but this still represents a low savings rate as Russians remain wary of the banking sector. All of Russia's 1,400 banks (at the end of 2006) were forced to re-apply for their general licence if they wanted to offer services to retail customers. In effect, the entire sector was re-licensed. Analysts were hoping the CBR would take the opportunity to close down hundreds of banks, as Russia is clearly over-banked. They say that Russia only needs about 300 banks and the 1,000 smallest banks account for about 5% of the total banking assets, while the five largest banks (three of which are controlled by the state) control 43.8% of total assets as of the end of 2006. The 20 biggest banks account for 73.8% of total assets and the 50 largest banks hold just under 90% of all bank assets. Afraid of moving too quickly and causing a systematic meltdown of the sector, in the end the CBR let just under 1,000 banks into the deposit insurance system from the total of 1,400.

Sector consolidation But the re-licensing was not a failure. The CBR forced banks applying for the scheme to declare their beneficial owners. The result was a bank system that looked very similar, but the CBR managed to significantly increase the transparency of the sector – to the regulators at least – and increase its authority as a regulator; over the following year the CBR withdrew the licences of over 50 banks as it slowly cracked down on malfeasants. At the same time, the sector has been consolidating on its own. While banking capital as a proportion of GDP has remained steady at about 45% for the last two years, the actual capital of banks has grown by over 30% on average. The biggest banks are growing even faster – the capital of a few leading banks doubled last year. The upshot is that assets are becoming more and more concentrated in the leading banks.

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Analysts say that as the smaller banks start to find it harder and harder to make profits, in the face of the competition from the bigger banks on one hand and more stringent supervision by the CBR on the other, the consolidation of the sector that began in about 2004 will continue and pick up pace in the coming years. At the same time, the shift towards competition in the market-place to win the business of increasingly choosy retail clients is undoing another traditional element in the Russian bank sector – Sberbank's virtual monopoly of the retail business. The successor to the Soviet Savings Bank, in 1991 Sberbank held about eight out of every 10 rubles on deposit. However, as the commercial banks grow and roll out increasingly attractive products for both consumers and companies, they have steadily been eating into Sberbank's domination (see Figure 2.1). It remains what one banker called, "an 800lb gorilla sitting in the Kremlin's living room", but the power of the bank is diminishing steadily and forcing the Sovietera behemoth to compete and beef up its own services.

Figure 2.1: Sberbank’s share of the Russian deposit market, 2003–06 (%) % 70 66.9 65 62.9 59.6

60

55

54.0

54.1

53.8 50 1 Jan 2003

1 Jan 2004

1 Jan 2005

1 Jan 2006

1 Oct 2006

Source: Deposit Insurance Agency

Foreign ownership of Russian banks With domestic reforms in hand, the Kremlin introduced the second plank of its reform of the financial sector – foreign competition. Putin's administration has been criticised for its "creeping statism" and it is true that the Kremlin took advantage of the mini-crisis in 2004, as mentioned earlier, to bolster VTB's position in the market and gift it with what is now a fast-growing, retail operation. However, at the same time the restrictions on foreign banks have been significantly eased, the ruble has been made fully convertible and the restrictions on foreign ownership of bank assets have been almost completely removed. It is a strategy the Kremlin is applying to almost every area: build up a state-owned national champion to represent the state's interests in the sector, but bring in foreign competition to ensure these entities have to compete and so are reasonably efficient. Foreign banks’ share in the capital of the Russian banking sector was capped at 25% of total banking capital in the mid-1990s, but this restriction was removed in 2006 (foreign bank ownership actually never got beyond 15% of total capital). In December 2006, the government made it even easier for foreign banks to buy their Russian peers by removing the ‘blessed share’ system – analogous to the Kremlin's decision to remove the so-called ring fence around Gazprom's locally traded shares. In both cases these were special rules that restricted foreign ownership of shares. Under the old rules, foreigners had to get the CBR’s permission to acquire shares in a Russian bank, while Russian residents only needed the CBR's permission when purchasing more than 20% (but had to notify the CBR when acquiring smaller stakes). Under the new rules, both foreigners and Russians need to inform the CBR if they buy more than 1% of a bank's shares, and seek permission when acquiring a stake larger than 10%. The changes simplify the investment process for foreigners by shortening the time required to exercise purchase orders and decreasing costs.

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The change will not make much difference to portfolio investors as there is really only one bank traded – Sberbank, which always had plenty of pre-blessed shares for foreigners to buy. However, with a wave of bank IPOs in the wings in 2007 the rule change was a significant preparation for bringing more foreign money into the sector. It should also be noted that while the scheme liberalises foreigners' ability to buy and sell bank shares, the CBR has also lowered the threshold for seeking permission for major transactions in bank shares – for both foreigners and Russians – from 20% to 10% as part of its campaign for tighter supervision of the sector. The Kremlin is clearly now keen to encourage more foreign competition in the banking sector as a way of whipping its own banks into shape. By October 2006, foreign banks accounted for 12.6% of total banking sector capital, up from 9.3% at the start of the year. (See also ‘Investing in banks’ later in this chapter.) But it is also clear that the Kremlin wants to remain the dominant force in the sector, largely through its ownership of the two dinosaurs of VTB and Sberbank.

Subsidiaries rather than foreign branches The government attitude to foreign participation the bank sector has softened notably; however, Russia scored a coup with the terms for World Trade Organisation (WTO) membership signed in November 2006, as it became one of the only member countries that successfully beat off American demands to allow foreign banks to open branches in Russia (which are subject to the prudential supervision of their home central banks) rather than Russia-registered subsidiaries (which are subject to the CBR's supervision). The difference in the two forms of ownership is important, as a branch of a foreign bank can tap its parent bank at home for loans and so borrow funds much more cheaply than its Russianowned competitors. However, a Russian legal entity, even if it is owned by a foreigner, is governed by the CBR and so is subject to the same regime and carries the same country risks as its Russian competitors, so the cost of capital is roughly the same. Despite the liberalisation of the Kremlin's attitude to foreign banks in its home market, it has reserved the right to change its mind. A protocol on banking rules, prepared by the Economic Development and Trade Minister, German Gref, says: "Russia permits 100% foreign ownership of banks, broker and investment companies. Russia retains the right for limitation of new direct foreign investments in the banking and insurance sectors if the share of foreigners there exceeds 50%."

A new mega-regulator The possible next stage in the reform to the financial sector could be a meta-reform: the creation of a mega-regulator that would unite all the different bodies responsible for governing the various branches of financial operations. The CBR is the mainstay of the financial system and governs the banking system, but at the start of 2007 there were another seven bodies with the right to demand information and with some administrative power over the banking system: 0 0 0 0 0 0 0 0

Central Bank of the Russian Federation (CBR); Federal Financial Markets Service (FFMS); Deposit Insurance Agency (DIA); Federal Service for Financial Monitoring (FSFM); Federal Tax Service; Federal Anti-monopoly Service (FAS); State Pension Fund; Federal Customs Service.

Banks deal with the CBR on a daily basis, but all these bodies make occasional demands on banks in connection with their other duties. And bankers complain that each one has its own set of rules and requires its information in a different format. This system is riddled with contradictory demands and norms. Currently, banks resolve these conflicts through a process of mediation with the respective authorities. However, this costs both time and money.

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The Kremlin has been debating introducing a mega-regulator to unite responsibility for all these sectors for years. At the time of writing the prospects for the appearance of a mega-regulator were improving as the state begins to unite competing regulatory authorities. The most advanced example is the move to create a central depository. At the start of 2007 two companies, the Depository Clearing Company (DCC) and the National Depository Company (NDC), were responsible for clearing and settling trades on the two main stock exchanges: the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX). Custodians have long been calling for the two companies to be united, which would save money and reduce unnecessary counterparty risks, but the initiative got caught up in a turf war between the two exchanges, as the DCC is owned by the leading market participants on the Russia Trading System (RTS), whereas the NDC is majority-owned the CBR, which is unwilling to give up this informal mechanism of supervising the stock market. However, at the time of writing it looked increasing likely the two companies would be united. Once this battle is out of the way, the state will move on to similar battles to unite the other regulatory bodies. It will probably take years (if it is completed at all), but it is clear the liberals in the government are pushing hard to simplify the regulatory system.

Bank sector growth All these reforms have paid dividends. The process is far from over, but at the end of November German Gref said that Russia's banking sector was approaching an optimum position. Bank sector assets grew by 39% in 2006 and are expected to rise by another 35% in 2007, according to Troika Dialog. Banks' capital as a proportion of GDP has risen steadily from 39.8% in 1999 to 45.1% at the end of 2006; however, both this share of GDP and the absolute total banking sector capital of US$463bn as of 1 October 2006 mean the Russian banking sector remains small by international standards. Retail lending remains the engine of growth; sector-side retail lending growth was 85% in 2006 and is expected to end 2007 up 65%. On the liability side, strong economic growth led to corporate deposits rising by 35% in 2006 and these are expected to rise another 32% in 2007, according to Alfa Bank. But it is consumer lending growth that is really on fire. Russia’s retail loan market grew by 91% year-on-year to US$78.4bn, or 8% of GDP, by the end of 2006 and is expected to hit 10.2% of GDP by the end of 2007, according to Alfa Bank. This segment also became highly specialised last year, with mortgage and car loans now accounting for 27% of total retail lending. Their share in 2004 was just 15%. Consumer loans have more or less doubled every year since Bank Russky Standart (Russian Standard Bank) pioneered the idea of small express unsecured credits in 1999. There is no sign of a slow-down as it is clearly still very early days. Loans to households are only 4% of GDP, compared to 10–20% in the Central European countries and about half in Western Europe, as shown in Figure 2.3. Sberbank's researchers believe that the amount of consumer loans will have increased 4.2-fold by the end of 2012 to a total of RUB9trn (US$345bn).

Consumer credit While the pace of growth of consumer credit began to slow in 2006, this was simply because Russians were switching to new forms of borrowing. The share of personal loans – loans provided for unspecified purposes – dropped from 70–75% in 2004–05 to 60% in the first half of 2006 and this trend is expected to continue, albeit more slowly. Likewise, the banks are beginning to specialise; in the 1990s all banks aspired to being universal banks, but in the last two or three years a group of specialist retail banks have emerged to claim a significant part of the consumer finance business – none of which are state-owned. Commercial banks commanded 83% of the consumer finance business (as opposed to personal loans) by July 2006 (see Table 2.2).

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Sberbank boasts the largest retail portfolio, at US$21bn, and announced its intention to focus on the mortgage market, which represents 20% of the bank’s portfolio. It does not plan to expand into the auto loans and consumer finance markets, as it considers them too risky. The bank launched a pilot credit card project in 2006 but cancelled it because of problems with controlling bad debt. Sberbank is likely to concentrate on its personal loans business and leave the consumer finance business to the specialists. Numbers are US$m

Table 2.2: Top Russian consumer loan providers, 2006 (%, US$m) Russian Standard Home Credit and Finance Rosbank Investsberbank Finansbank

Market share % 37 20 13 7 6

Portfolio as of July 1, 2006 (US$m) 1,600 840 580 300 250

Source: Company reports, Alfa Bank estimates

Car loans Booming car loans are causing horrendous traffic jams in Moscow and increasingly in the other regional capitals. The car loan segment totalled US$9bn at the end of 2006. As expected, this sector was not a top performer, with market share remaining at a flat 11%. This niche is still dominated by Rosbank, with 16% market share, although Russian Standard Bank greatly increased its penetration in this segment in 2006 (see Table 2.3).

Table 2.3: Top Russian car loan providers, 2005, 2006 (US$m, %) Auto loans Banks portfolio, 2005 Rosbank 837 MDM 298 Rusfinans 150 Russian Standard 99 Raiffeisen 417 International Moscow 240 UralSib 282 Gazprombank 98

Market share 2005 % 22.4 8.0 4.0 2.7 11.2 6.4 7.6 2.6

Auto loans portfolio, 1H06 1,191 616 234 247 504 356 307 161

Market share 1H06 % 19.9 10.3 3.9 4.1 8.4 5.9 5.1 2.7

Auto loans portfolio, 2006 1,408 873 843 656 600 580 398 225

Market share, 2006 % 15.6 9.7 9.3 7.3 6.6 6.4 4.4 2.5

Source: RBC, CBR, Alfa Bank Research

Credit cards The banks' drive to capture retail customers began with campaigns to issue debit cards to their biggest corporate customers (which has had a side-effect of reducing tax avoidance by increasing transparency through the decrease in the use of cash to pay wages) but the first true credit cards have only just appeared. The use and volumes were up threefold in the first half of 2006, to US$4bn from US$1bn at the end of 2005. Again it was consumer credit pioneer Russian Standard that is leading the charge (see Table 2.4). Most of the other banks with retail aspirations are at least six months behind ‘the Vodka Bank’ – so called as its owner Rustam Tariko also owns the Russky Standart premium vodka brand.

Table 2.4: Top Russian credit card issuers, 1H2006 (US$m, %) Bank Russian Standard Home Credit and Finance Citibank Investsberbank

1H06 portfolio, US$m 3,100 220 130 130

Market share % 78 6 3 3

Source: Company reports, Alfa Bank estimates

Mortgages However, the really big gains will be in the mortgage market, which is still in its infancy but already a US$6bn business that is expected to grow 10–20 times in the next decade.

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Figure 2.2: Russian loans market growth, July 2004–July 2006 Mid–2004=100 400 350 300 250 200 150

Loans to corporate Loans to individuals

100 1 Jul 2004

1 Jan 2005

1 Jul 2005

1 Jan 2006

1 Jul 2006

Source: CBR data and IFC calculations

Figure 2.3: National household loans markets, 2006 (% of GDP) % 60 50 40 30 20 10 0 Russia

Slovakia

Czech Poland Hungary Estonia Germany Euro-zone Republic

Source: Central Bank of Russia

Table 2.5: Russian deposits and loans, 2002–10E (US$bn, %) 2002 Deposits Retail deposits % increase % of GDP Corporate accounts % increase % of GDP Loans Retail loans % increase % of GDP Corporate loans % increase % of GDP Total loans/GDP Source: Troika Dialog estimates

30

2003

2004

2005

2006E

2007E

2008E

2009E

2010E

33 44 10 34 15 10

52 57 11 47 37 10

71 38 12 71 52 12

96 35 13 103 44 14

142 48 14 164 60 16

190 34 16 226 38 19

234 23 18 279 24 22

292 25 21 351 25 25

358 23 23 426 22 28

4 42 1 51 28 15 16

10 127 2 81 60 18 20

22 119 4 117 45 19 23

41 84 5 148 26 20 25

83 103 8 221 49 22 30

138 67 12 295 34 25 37

196 42 16 354 20 28 44

271 38 20 431 22 31 51

357 31 23 513 19 33 56


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Table 2.6: Retail loans – bank share, 2005, 2006 (RUBbn, %) Retail loans All banks Sberbank Other big state-owned banks Consumer finance banks Big private banks Foreign banks Other banks

Market share YE 2005 100 44.6 3.4 9.3 7.1 3.8 31.8

2005 % growth 91.3 79.6 184.8 135.9 137.0 194.9 57.7

Volume 2006/H1 (RUBbn) 1,522 559 61 133 116 57 596

Market share 2006/H1 100 36.7 4.0 8.7 7.6 3.8 39.2

2006/H1 % growth 28.6 18.9 52.2 20.8 37.1 26.1 37.5

Source: CBR data and IFC calculations

The regions Finally, the banking action is rapidly moving into the regions of Russia. Moscow dominates the economy and the Moscow-based banks are by far the largest, but it was the smaller banks in the regions making small loans to their local clients that were growing the most quickly by 2006. While Moscow-based banks still lead in areas such as foreign currency loans, the capital has seen its share of total ruble loan lending fall from 38% at the start of 2002 to just 25% by the middle of 2006, and this trend is continuing. The banking sector also shows well the rising role of the regions in Russia's economy, as Moscow’s dominance is being eroded. While the total capital of banks based in Moscow dwarfs that of the regional players, the situation is reversed when looking at the volume of small credits made to private individuals. Here, Moscow-based banks have seen their share of the loans business fall from 41% as of 1 January 2002 to 25% as of the middle of 2006. Thanks to all this good news, the CBR is starting to sound happy. In 2006, it issued one of its most upbeat annual ‘Review of the banking sector’ reports ever. The central bank predicted in the next few years Russia's economy can "expect to receive the large-scale capital investments it needs as Russia's banks finally begin to play the tradition role of financial intermediary."

The future role of banks All this growth is good news for the Russian economy as it means banks are starting to fulfil their role as financial intermediators. For most of the last 15 years companies have funded almost all their expansion from retail earnings; bank loans as a proportion of invested capital were stuck at about 4% of the total. More recently, companies have been making use of other forms of financing that have become available, such as the ruble bond market which reappeared in 2001 after being destroyed by the 1998 financial crisis. However, analysts are predicting that 2007 will be the year that investment becomes a major economic driver and banks are playing a growing role in this process, but their ability to lend will be quickly capped by their lack of resources. The Russian bank sector remains highly fragmented and their customers who need loans to the order of several billion dollars dwarf even the biggest state banks. Bank lending is growing much faster than the rise in assets: between 1999 and 2006 bank credits to non-financial institutions as a share of GDP rose from 13.8% to 25.3%. Following the 1998 crisis banks did not trust companies and lent mainly to related parties; however, in the last few years lending has becoming increasingly commercial as banks look for true customers. The total domestic credits to GDP ratio is about 31%, which is still two-fifths of the average in Western Europe and suggests that unless the rate of growth of the last four years picks up significantly the saturation point is still some 15–20 years away. However, for the first time in Russia's modern history, companies are looking to finance the bulk of their investment plans from debt rather than their own resources and want long-term credits on a large scale. This growing demand for credit has already led to a growing tide of Russian bank Eurobond issues and accounts for the increasing interest in IPOs.

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Sector challenges Falling capital adequacy The CBR says that Russian banks are working at an optimum level at the moment as their risk adjusted capital adequacy – the ratio of their capital against the amount they have lent – is about 10%, which is considered to be an ideal: banks have lent as much as is safe, but have sufficient cash in reserve to be able to deal with surprises, such as the 2004 mini-crisis. However, capital adequacy has been falling by about 1% a year since 2003 and clearly this ideal will not last very long; this year some banks will be forced to stop lending so fast, limited by the amount of capital they must keep in reserve. Under CBR prudential rules banks must keep at least 10% of their capital in reserve. So far, no Russian bank has been forced to stop lending, or reduce the rate of growth of its lending (although this has already happened to one major bank in Ukraine), but this is not far off. Capital adequacy (unadjusted for risk) reached 14.8% in October 2006, down from a peak of 20.3% as of 1 January 2003, and shown in Figure 2.4. At the same time, banks' liquidity is falling – a combination of CBR policy and the hard lending action of recent years. (See Figure 2.5, and Chapter 3.) The answer is for owners to inject more equity into their banks and as banking is a sector with such obvious potential, owners’ attitudes have changed drastically in the last three years so that the oligarchs have begun investing in banks, but this trend has been limited to the top two tiers which make up the leading 50 or so banks.

Figure 2.4: Indicators of banking sector capital adequacy (H1 standard) 1999-2006 % 25

20

15

10

5

0 1 Jan 99 1 Jan 00 1 Jan 02 1 Jan 03 1 Jan 04 1 Jan 05 1 Jan 06 1 Oct 06 Source: Vnesheconbank

Figure 2.5: Banking liquidity indicators, Jan 2002–July 2006 (%)

Source: VEB

32

1 Jan 2002

1 Jul 2006

Ratio of highly-liquid assets to cumulative assets

25.3%

14.7%

Ratio of liquid assets to cumulative assets

40.8%

26.8%

Ratio of liquid assets to demand liabilities (H2 standards)

70.6%

52.2%

Ratio of client funds to cumulative loans

120.7%

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Non-performing loans A much more serious problem than falling capital adequacy is the rapid rise of non-performing loans (NPLs). This problem is made more worrying as, despite the CBR’s closer supervision of the bank sector, the owners of banks are adept at hiding bad debt. While both bankers and the regulator agree that the problem is not yet so bad as to cause real concern, the clear upward trend in the number of NPLs is a genuine worry. A race is on between banks' proclivity to hide their bad debts and the CBR's ability to make banks report the true size of NPLs. NPLs are probably the biggest risk facing Russia's bank sector today. At current levels, NPLs are not destabilising and would not be, even if the sector received another shock as it did in 2004. But the clock is ticking and the rise of bad debt is potentially destabilising. Eric Kraus, manager of the Nikitsky Fund, sums up the issue: "There is no way a bank that is seeing credits double every year and is at the same time branching out into new product areas every six months can do proper risk management. But we will only know how bad the problem is when the next bank crisis arrives." Russians are borrowing from banks for the first time and an increasing number of Russians are getting into trouble. At the same time, in their rush to build up market share there is anecdotal evidence that banks are prepared to bend the rules in order to win new customers: after Raiffeisen International bought top-20 retail bank Impexbank in 2006, Russian daily Kommersant reported the Austrian management had to ditch three out of four consumer loans as they did not meet the bank's risk criteria. The CBR says that according to officially reported figures 2.63% of all consumer loans were nonperforming in the third quarter of 2006 (see Figure 2.6). This is in itself nothing to worry about but all Russia's bankers are watching this trend closely. Industry experts believe the real number is closer to 5–6%, against the typical delinquency rate of 4–5% in the US, according to the American Bankers Association. Even if the problem is getting worse, the newness of the business means a collapse of the consumer credit business will only do limited damage. Total household credits amounted to 5.6% of GDP in 2005 against an average 16% of GDP in Central Europe, the Balkans and the Baltic states. This implies that non-performing household loans currently amount to between 0.2–0.3% of GDP, which economists say is a manageable level. "The danger is not in the number, which is low," says Michele Perhirin, CEO of MDM Bank. "It is the trend that is obviously the worry. Also you can be sure that the real numbers of NPL are in reality much higher than this, although no one can say by how much. Russian banks have a habit of moving their NPL off balance sheet." The extent of the problem will only be made clear if Russia goes through another severe bank crisis. At the moment even a nasty crisis would probably not bring the consumer credit specialists down, as typical annual real interest rates are an extraordinary 50%-plus and in many cases over 100% a year. "Only when the tide goes out will we actually know who has been swimming naked," says a senior executive at Vneshenconombank.

Figure 2.6: Growth of non-performing consumer loans, July 2004–July 2006 (%) % 3.0

2.5

2.0

1.5

1.0

NPL corporate NPL individuals

0.5 1 Jul 2004 Source: CBR

33

1 Jan 2005

1 Jul 2005

1 Jan 2006

1 Jul 2006


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CBR acts to curb NPLs The CBR is working hard to head off the problem of NPLs before it gets out of hand. In January 2007, it ordered banks to advertise their real effective interest rates to consumers, rather than their nominal rates. Two new rulings have been introduced: Central Bank Directive No. 1759-U "On the Introduction of Changes to Central Bank Regulation No. 254-P of March 26, 2004, On the Procedure for Forming Reserves by Credit Organizations against Possible Losses on Loans, Loan Debt and Equivalent Debt" and Letter No. 175-T "On the Determination of the Effective Rate on Loans Provided to Individuals." Banks load loans with hidden charges and add-ons that drive the rates up from a typical nominal rate of 29% a year to between 90% and 124% a year in 2006, according to the CBR. Credit cards are a better deal, but here too the banks are massively overcharging with real rates of almost 60% a year against a declared rate of 28%. Large, long-term credits with collateral have the best rates. Car loans cost a real rate of about 25%, against the declared rate of 13%. The CBR was spurred into action as it says that NPLs are rising at 9% a month, outstripping the rise in the volume of consumer loans of 5% a month in 2006. The bank is sketchy on the details, but it has been reported that the CBR believes the proportion of NPLs in some small retail banks is up to a third. CBR Deputy Chairman, Gennady Melikyan, said the CBR was hoping to reduce the risks of default and was acting in the interests of the Russian consumer. This is the first time the CBR has ordered banks to reveal their real effective interest rates to consumers. The CBR has issued similar warnings in the past, but only as advisories, which were largely ignored by the industry. The CBR's move will only turn up the heat on an increasingly competitive business. The margin on retail loans fell from 16–17% in mid-2005 to 13% as of August 2006, according to Russian bank rating agency RusRating.

Home credit bites the bullet The most high profile bank to have problems with bad debt was Home Credit Finance Bank, owned by the Czech financial group PPF and the second biggest provider of consumer credits after Russian Standard (Russky Standart). In the first half of 2005 it was unique among the consumer finance banks after it reported a net loss of RUB195m (US$6.9m) in a rising market. The bank had been expanding rapidly – too rapidly as it turned out – and NPLs rose to 27% of its gross loans, against 12% in 2004. Even Russian Standard has run into trouble. At the end of August 2006, Russia's premier bank rating agency, RusRating, downgraded the consumer wunderkind one notch because of "high credit risks of the leading consumer lender and the decrease of profitability in the sector." However, ratings agency Standard & Poor's, which rates the banks’ many bond issues, said that rising NPLs are still nowhere near big enough to threaten the bank. "With the share of overdue debts of 5–10% and an effective interest rate of 50–60%, profits cover absolutely all Russky Standart's risks," an analyst at Fitch Ratings said. Home Credit also played down its problems with NPLs. In its defence the bank said that these bad debts were technical defaults: the number includes payments that were a month overdue and the bank recovers much of this money fairly easily. However, Home Credit was forced to increase provisions for bad debt by 60% for the first nine months of 2005 and "sharply tighten" the origination and collection procedures. The parent group injected RUB5bn into the bank to support it, as well as writing down RUB3.5bn in the fourth quarter of 2005 to ease the pressure. The rescue operation worked. By September of the following year the bank was again earning healthy profits. Reported net profits increased to RUB184m (US$7m) for the first nine months of 2006, winning back almost all the ground lost over the same period the year before. The bank also had a good full year, seeing the volume of its consumer loan growth increase by 20% over the same period to a total of RUB37.5bn.

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Devaluation and currency risk Exposure to currency risk brought down the banking sector in 1998 when the ruble was cut to a quarter of its value against the dollar on 17 August. However, it was not the devaluation per se that did the damage, but margin calls on the forward contracts Russian banks had signed with foreign investors into the bond market. The Yeltsin administration was financing a 7â&#x20AC;&#x201C;8% budget deficit for most of the 1990s with the now infamous GKO ruble-denominated sovereign bonds. In the run-up to the crisis the government was paying up to 20% a month. The CBR was holding the ruble in a slowly depreciating trading band and to protect themselves against the possibility of a devaluation, foreign banks signed forward contracts with Russian banks that locked in an exchange rate at the time their bonds matured. When the ruble devalued these contracts came due and left Russian banks with a bill of an estimated US$40bn, which they were unable to pay. Almost all the Russian banks defaulted, on the grounds that a forward contract was a type of gambling and as such Russian banks were not liable to pay if the foreign banks lost their bet. This ruling was to have profound repercussions on the development of the derivatives market. (See also Chapter 12.) Russia's banks have learnt their lesson. The negative real interest rates have limited foreign investment into sovereign bonds and with over US$300bn in gross international reserves against the approximately US$9bn of reserves the CBR had on the eve of the crisis, another devaluation looks very remote. Banksâ&#x20AC;&#x2122; exposure to currency risks has tanked in the last seven years. Liabilities in foreign currency have fallen from 35% of total bank sector liabilities to 0.6% of the capital value of the 30 largest banks as of October 2006, according to Vnesheconombank.

Exposure to equities As the only security in Russia that delivers a positive real return, Russia's banks have been investing heavily into the stock market. The rise of the investments in equities made by banks tracks almost exactly the rise of the leading RTS index, rising from RUB200bn at the start of 2002 to about RUB1.5trn by the end of 2006. Another stock market crash like that of 1998, where the collapse of the market wiped 40% off share values in a matter of months, would hurt banks but not kill them â&#x20AC;&#x201C; Vnesheconombank estimates a repeat of the 1998 falls on the stock market would wipe out 10% of current banking capital.

Investing in banks Given its obvious appeal, how can investors get exposure to the Russian banking sector? The short answer is: with great difficulty. The main entry to Russia's banking sector in 2006 has been through the acquisition of banks. Strategic investors have been buying Russian banks since 2004 and the action became frenetic in 2006 with half a dozen big deals. However, these investors have been paying a heavy premium for entering at such a fashionable time: the cost of a bank has risen to about 3.5 times the bank's book value, well over twice what strategic investors paid for banks in Central Europe in the 1990s. The main mergers and acquisitions (M&A) by foreign banks are detailed in Table 2.7.

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Table 2.7: Significant foreign M&A deals with Russian banks, 2004–06 (US$m) Target Rosbank Rosbank Investsberbank IMB Impexbank Monchebank Delta Credit KMB Bank Delta Bank

Acquirer SocGen SocGen OTP Unicredit Raiffeisen DnB NOR SocGen Banca Intesa GE Cons. Finance

Date Sep 06* Jun-Sep 06 Jul 06 Jun 06 Feb 06 Oct 05 Aug 05 Apr 05 Aug 04

Deal value (US$m) 1,700 634 477 395 550 21 c. 100 90 c. 100

Stake acquired 30 20 96 23 100 97 100 75 100

BV, US$m 1,385** 1,385** 129 477 188 10 47 32 24

Implied PBR 4.1 3.4 3.8 3.5 2.9 2.2 2.2 3.7 4.2

Note: *Option excercisable any time before YE08; **YE06 forecast BV, assuming 25% earnings growth and US$460m raised in a new share issue Source: Company data, Interfax, Renaissance Capital estimates

Private equity investment into banks took off in 2006 with the establishment of the first fund dedicated to investing into banks. And several more funds were in the works by the start of 2007. Despite sporting over 1,200 banks, there is only one listed bank in Russia of any weight: Sberbank, which is also one of Russia's blue chip stocks. Banking IPOs were due to begin in 2006, but the global sell-off in May 2006 convinced the banks in the pipeline to delay.

Portfolio investments Investors have warmed to bank stocks as the leading banks are clearly going to do extremely well on the back of the sector's increased role in the economy. However, only six banks are listed and the only really liquid bank stock on the market is Sberbank, which accounts for a bit more than 6% of the entire market's capitalisation. As enthusiasm for banking built in the last decade, Sberbank has seen its share price rocket: between 2000 and the start of 2007 Sberbank's capitalisation has risen over 1,000% and its stock price rose 163% in 2006 alone, against the market's over all rise of 71% for the year. There are a few alternatives to Sberbank, but all of them are illiquid and have a relatively small capitalisation. Table 2.8 gives details of listed Russian banks. The most popular newcomer in 2006 was Vozroshdenie Bank (also known as V-bank) that has been listed for years. In 2006, the bank issued more equity in a private placement that saw the price rise from US$27 a share in the middle of the year to about US$41 by the year-end. St Petersburg-based Promstroibank is another rare example of a listed bank. However, the bank was bought by VTB in 2006 and investors were waiting to see what sort of swap rations VTB was going to offer minority shareholders ahead of merging the bank into the state-owned giant. A second question hanging over this bank is whether VTB will create a single share before or after its own IPO slated for May 2007. There was supposed to be some fresh supply of new bank stocks in 2006, but the pioneer Rosbank, which was supposed to hold Russia's first true banking IPO in June 2006, floating 20% of the bank, bailed out at the last moment because of poor market conditions. Rosbank sold the stake to French bank Société Générale, which has an option to increase this stake to 30% by the end of 2008. This year is due to see two really big issues of bank shares. In February, Sberbank successfully placed US$8.8bn worth of shares in a second placement to raise money to boost its capital. However, the Kremlin made a ham-fisted effort of the issue and was forced to turn to the oligarchs to bail out the bank, who reportedly bought US$4bn worth of the new shares. The big event in 2007 was the IPO of VTB, which placed 22.5% of its stock to raise US$8bn in May. The IPO was a real success, raising almost double the initial expectation of US$4bn, and demand was so strong among Russian investors – especially retail investors – that 65% of the issue was sold in London and 35% on the Russian exchanges, against the 30% that was initially slated to be sold on the domestic exchange. The government said the long-term plan is to reduce the state's stake in the bank to 50% plus one share by 2010.

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The two issues will suck US$12bn out of the market and make other issues more difficult. Gazprombank, the financial arm of the state-owned gas monopolist Gazprom, has already delayed its IPO until 2008. However, momentum for bank IPOs is building and should hit its stride sometime in 2008.

Table 2.8: Russian banks’ stock exchange performance, 2006 (US$m,%)

Sberbank Sberbank pref UralSib Bank Bank of Moscow Rosbank Promstroibank Vozrozhdenie Bank RTS

Share price performance, 2006 163.4 163.4 99.4 154.6 13.6 68.2 87.0 70.7

MCap US$m 65,550 2,865 9,025 5,825 4,797 2,333 1,209 —

Free float % 36 100 3 6 3 25 25 —

Free float US$m 23,755 2,865 226 349 144 583 302 —

Estimated 30-day ADT foreign ownership US$m 20-25 115.10 — 117.33 1 0.09 4 0.73 2 1.02 10-15 2.00 18 0.31 — —

100-day ADT US$m 90.20 72.23 0.06 0.34 0.54 0.99 0.25 —

Note: as of close on Dec 29, 2006 Source: Bloomberg, Troika Dialog estimates

Private equity investments Falling capital adequacy has led to a round of private equity deals in 2006, where private investors are able to buy 10–15% of a bank's equity. Given the ballistic rate of growth in the banking sector, few owners are willing to sell majority or even blocking stakes in their banks. But an increasing number are more than happy to sell smaller stakes in return for capital to continue their expansion. One of the first funds set up to capitalise on this trend was Swedish fund managers East Capital, which established the closed-end East Capital Financial Explorer fund at the start of 2006. The fund has a life of seven years (with a possible three-year extension) and raised US$350m. By the start of 2007, East Capital had already distributed US$200m, buying stakes in banks across the CIS, but mostly in Russia. "We set up the fund as there is a lack of opportunity to invest into the banking system as there are very few listed banks," says East Capital's CEO, Karine Hirn. "But most bank owners in Russia are not ready to sell yet. They can see that if they wait a few more years then they can get a much better deal. However, they need capital and they are interested in co-operating to get the most value out of their assets so they are willing to sell small stakes." More recently, Renaissance Capital launched a similar fund at the start of 2007, and many of the leading funds investing in the region, such as Firebird Management LLC, were taking stakes in regional up-coming banks in the middle of 2006 and have seen their investment almost double in six months.

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CHAPTER EQUITIES – MARKET COMPOSITION AND PERFORMANCE

03

Background Russia's stock market was created in the early 1990s as a function of privatisation; if you have private joint stock companies where the owners have shares in these companies then you need a market on which to buy and sell these shares. Like everything else in Russia's economy, privatisation broke every enterprise and market into its constituent pieces and much of the history of Russia's equity market has been about the process of putting all these pieces back together again into corporations. The Russia Trading System (RTS) was itself set up in 1995 to consolidate the separate regional exchanges used to list newly privatised local companies into a united trading floor that covered the whole country. It quickly became the default trading system (technically, it was not an exchange but a venue for organised over-the-counter, or OTC, trading of shares) and the RTS index remains the default reference index although its rival exchange, the Moscow Interbank Currency Exchange, or MICEX, has long since overtaken the RTS in terms of the volume of organised trading.

RTS development The exchange has provided investors with an exciting time. Huge profits have been earned from investments in Russian equities, but investors have needed a strong stomach as the Russian market has been through at least two crashes and remains highly volatile. The development of the Russian stock market can be roughly divided into three eras.

Inception to October 1997 Trading opened on 1 September 1995, with the RTS index set arbitrarily at 100. In the early days volumes were thin so that an investment of US$1m was enough to send the index soaring. It took about a year for investors to build up any interest in the index. Most were waiting to see what happened in crucial elections in which the already ill Boris Yeltsin was competing with the resurgent Communist Party for job of President. It was in this period that the emerging oligarchs, who grabbed most of Russia's industrial jewels in the notorious loans-for-shares deal at the end of 1995, clubbed together to rescue Yeltsin's flagging popularity and ensure his return to office in early 1996. Yeltsin’s re-election, or rather the overwhelming defeat of the Communists was the starting signal for the RTS, which began to rise quickly. With the prospect of a return to socialism behind them, investors concentrated on Russia's enormous potential and began to invest. The first test came on 11 October 1994, a day that became known as Black Tuesday, after the value of the ruble on interbank exchange markets plunged by 27%, which sent the stock market reeling. It took investors nearly another year to regain their confidence, but by the start of 1997 optimism returned with the rise of the so-called young reformers, who promised to push liberalisation and privatisation of the economy. In general, the macroeconomic picture was improving and both oligarchs and foreign companies selling their wares on the expanding Russian market – thanks to an overvalued ruble – were making fortunes. The performance of the index in its initial years is shown in Figure 3.1.

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Figure 3.1: RTS index, Sept 1995 - Oct 1997 700 600 500 400 300 200 100

1/9/97

1/7/97

1/5/97

1/3/97

1/1/97

1/11/96

1/9/96

1/7/96

1/5/96

1/3/96

1/1/96

1/11/95

1/9/95

0

Source: RTS

October 1997 to October 1999 The RTS hit its zenith on 6 October 1997, when the index reached 571.6, after which investors began to loose their nerve. The problem was with the ruble. As the Central Bank of Russia (CBR) slowly gained control over inflation the exchange started to settle and Russians were encouraged when the exchange rate remained at roughly six rubles to the dollar for most of 1997 – the manifestation of stability in an exchange rate-obsessed society emerging from years of hyper-inflation. However, the CBR's efforts to keep the ruble inside a slowly falling trading band meant the currency was overvalued and the mispricing of the currency had sucked liquidity out of the system, leading to a massive and ongoing non-payment crisis. With no cash in the economy, the state could not raise taxes, companies had no money for investment and the population was living on IOUs. The government, struggling to fund a deficit running at 7–8% a year, issued short-term rubledenominated bonds – the GKOs, paying up to 20% a month at the peak – in an effort to attract money. And then Russia had some bad luck. Although the economy was in a mess, interest rates on GKOs were falling steadily and reforms were going ahead, albeit slowly. Then a crisis in Asia brought oil prices down to US$10/bbl (per barrel). It was an external shock that the Russian economy was in no position to weather and the weak financial system collapsed, ending with a double whammy of default on domestic debt and devaluation of the ruble on 17 August 1998. As far as the stock market was concerned, the financial crisis came at the end of the falling stock market, while the beginning of the fall was started by a sell-off in Asia that spread around the world. The RTS reached its nadir on 5 October 1998, when the index dropped to an all time low of 38.5309 (see Figure 3.2).

Figure 3.2: RTS index, Oct 1997 - Oct 1998 700 600 500 400 300 200 100

Source: RTS

40

6/10/98

6/9/98

6/8/98

6/7/98

6/6/98

6/5/98

6/4/98

6/3/98

6/2/98

6/1/98

6/12/97

6/11/97

6/10/97

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October 1999 to today In the summer of 1999, the ailing Yeltsin plucked an unknown KGB colonel from obscurity and made him Prime Minister. The man was Vladimir Putin, who came to office just as Chechen terrorists killed more than 300 Russians by blowing up their apartment blocks while they slept. Then in a shock announcement on New Year's Eve Yeltsin resigned, making Putin the acting President. By March of 2000, Putin was installed in the Kremlin as Russia's second ever President. Putin started his new job with a lot of luck. Oil prices soon recovered to about US$25 and put the budget into profit. But more importantly, devaluation created a fairer value for the ruble and suddenly the economy was awash with cash. Moreover, oil companies found that their domestic costs had been cut to a quarter, while their revenues were rising. The flood of petrodollars primed the pump and in 2000 Russia's economy surprised everyone by growing 10%. This was the twilight of the oligarch era and it took investors several years to get used to the idea that not only had Russia's economy recovered from the crisis (in about 18 months) but that it was actually now growing strongly and on the path to sustained recovery. The rise of the RTS was to a large extent driven by historically low interest rates in the rest of the world; unable to earn decent returns elsewhere, investors flooded into emerging markets and Russia had a good story to tell. The problems in this period were all political. The RTS dived in the summer of 2003, when the Kremlin opened its assault on oil major Yukos â&#x20AC;&#x201C; at this time the most valuable company in Russia with a market capitalisation of over US$30bn â&#x20AC;&#x201C; with the arrest of deputy chairman Platon Lebedev. The market fell again when Yukos owner Mikhail Khodorkovsky was arrested in October 2004. Investors were afraid of a pogrom against the remaining oligarchs, but once it failed to appear the index resumed its rapid growth and the RTS nearly doubled in both 2005 and 2006. The party finally came to an end in May 2006, when fears of interest rates hikes in America ended about eight years of high risk tolerance and a lake of global liquidity. The RTS still managed to put on a 71% gain in 2006, despite a sell-off in May that wiped 25% of the market's capitalisation in a week, as the Russian growth story had become ever more convincing. However, investors were reminded of the new global liquidity threats in March 2007 when a selloff in China sparked another global selling bout. Clearly, the benign conditions of the preceding eight years were over, but at the time of writing it is unclear which will win out: Russia's ongoing growth or the damping effect of the tightening of global liquidity and problems in the industrialised nations of the world.

Figure 3.3: RTS index, Oct 1999 - May 2007 Index 2,500

2,000

1,500

500

1/4/07

1/4/06

1/10/06

1/4/05

1/10/05

1/4/04

1/10/04

1/4/03

1/10/03

1/10/02

1/4/02

1/10/01

1/4/01

1/10/00

1/4/00

1/10/99

0

Source: RTS

Summary In the first period described above, the growth of the RTS index was driven by the improving political situation, despite the poor state of the economy, of which investors were reminded on Black Tuesday.

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In the second phase, the fall of the RTS was tipped into steeper decline by the Asian crisis, which span out of control because of the sorry state of the domestic economy, despite the improving domestic political situation. In the third phase, the recovery of the RTS was driven by the rapidly improving economy, but knocked back by the decaying political situation and the rise of the hardliners in the Kremlin, the so-called Siloviki, or ‘men of power’ connected to the security services. As the Russian stock market moves into its fourth phase, which started with the sell-off on 12 May 2006, economists agree that there are very few problems with the domestic economy. Although there is significant political risk associated with the March 2008 presidential elections, when Putin is due to step down, the main dangers to the continued growth of the Russian stock market are entirely external. Here the main difference is that while the Asian crisis of 1997 was enough to knock the Russian market off its feet, it is clear that a China crisis, or some other external problem, will not be able to do as much damage to the now robust Russian economy.

RTS performance under Putin Having started with an index value of 100 in September 1995 and a market capitalisation of a few hundred million dollars, the Russian stock market has really only come into its own under Putin. The total value of all traded Russian companies broke through the US$1trn barrier on 30 November 2006, as the RTS index soared from an all-time low of 38 in October 1999 to a new alltime high of 1,921.9 on the last day of trading in 2006. Even this astronomical gain in value leaves the stocks on the Russian exchanges at a 20% discount to their global emerging market peers, say analysts. "Russian equities have not had a single 'down' year since the beginning of the millennium, with 2006 being the sixth consecutive year of positive returns for the key Russian indices (although 2004 was almost pushed into negative territory by the Yukos affair). Moreover, it became the fourth year out of six with returns in excess of 50%", said Deutsche Bank UFG in its 2007 strategy report. The arrest of senior executives of oil major Yukos in 2003 and 2004 and the eventual bankruptcy of the company – the so-called ‘Yukos affair’ – badly shook investors' confidence in Russia and caused big sell-offs on the market. Investor confidence eventually recovered, as the Kremlin continued to roll out a series of investorfriendly measures such as dropping the ring-fence around Gazprom at the start of 2006 then selling off a big chunk of state-owned oil major Rosneft. In addition, reforms to the market infrastructure continue undeterred. But more than anything it has been the returns to be earned from the RTS that has been the strongest argument. Investments into Russian equities saw a 250% return between the market lows at the depths of the Yukos crisis in July 2004 and the end of 2006.

RTS composition Natural resources companies dominate the make-up of the RTS index and rising values have increased their share of the weighting. However, it appears that the blue chips may have peaked and are starting to give way to the rising share of state-owned companies as well as a groundswell of small companies, as a tide of IPOs starts to break in Russia (see IPO section below).

The dominance of blue chips The make-up of the RTS reflects the youth of the market, Russia's natural resource wealth and the gains that valuations have made in recent years. Oil, gas and metals company shares dominate total RTS market capitalisation and the importance of oil has only increased in the last few years as the value of a barrel of oil has gone from US$25 to over US$70. Oil and metal companies were always the most valuable on the market, but in recent years their valuation has climbed to the point where they swamp the index changes (see Table 3.1).

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The result is that, in the last three years, the RTS index has become less useful as a litmus test of the state of Russian equity market. For example, at the end of the 1990s there were a handful of stocks worth more than US$10bn but the liberalisation of just Gazprom's stock to allow foreign investors unfettered access to the domestically traded shares has seen the company's market capitalisation soar to about US$250bn (as of January 2007) – or about a quarter of the entire value of all Russia's companies listed on all exchanges. Likewise, all of Russia's oil stocks have made massive gains in recent years, yet there are only six stocks (as of the end of January 2007) in the exclusive US$30bn market cap club, all of them oil companies except Sberbank and UES, which between them make up over half of the entire market capitalisation of the Russia's publicly traded companies (see Table 3.2).

Table 3.1: Market breakdown, by sector, Nov 2006 (%) Oil Gas Metals Telecoms Electricity Financials Consumer Manufacturing Total

% of total market* 35.5 30.7 8.7 7.3 7.0 6.6 3.0 1.2 100.0

*Based on closing prices on November 30 Source: DataStream, Alfa Bank Research

Table 3.2: Top Russian stocks, Jan 2007 (US$bn) Gazprom Rosneft LUKOIL Sberbank TNK-BP UES

US$bn 246.0 96.0 66.0 44.7 35.0 48.0

Source: RTS (as of 25/01/2007)

Growing state share of the index Maybe the most noticeable change in the composition of the index in the last two years has been the state's rapidly growing presence. The Kremlin has been roundly criticised for its ‘backdoor’ re-nationalisation of the so-called strategic sectors, such as oil and gas companies. The state is now the biggest shareholder in Russia, commanding a bit less than two-fifths of all shareholder equity in the country, as shown in Table 3.3 and Figure 3.4. In value terms, the state is now by far the most exposed to the equity market, with an estimated exposure of US$352bn. That is 4.5 times greater than the money in the Stabilisation Fund and represents almost 40% of GDP. Shares and IPOs have moved to the front of the Kremlin's grand plan of reforming the economy and are at the core of Putin's private-public partnership philosophy. While the international press has been quick to pick up and lambast the Kremlin's efforts to reassert control over key money-making sectors, in parallel with this centralisation the Kremlin's reforms to deregulate the stock market infrastructure and lift controls on share ownership have gone largely unreported. This dual approach was best illustrated by the changes in 2005 to Gazprom's ownership structure. In a complicated asset swap the state-owned gas giant transferred some 14% of its treasury shares to the Kremlin, raising government ownership from 38% to 50.5% and so giving the Kremlin direct control over the company.

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However, at the start of January 2006 the Kremlin lifted the so-called ring-fence – special rules that prevented foreigners from directly owning the companies’ locally traded shares – and the value of the company soared. The Kremlin followed up in July of the same year with the historic IPO of state-owned oil major Rosneft which raised US$10.6bn, and in March 2007 raised another US$4.4bn with a second placement of shares in retail banking behemoth Sberbank. VTB, the second biggest bank in Russia, floated 22.5% of its stock to raise US$8bn in May 2007 and state-owned diamond monopolist Alrosa has announced plans to launch an IPO. Indeed, a central tenet of the development plan of all the state's national champions that were being set up in 2006–07 is an IPO, not only to raise investment cash, but more importantly to bring in an expert partner or strategic investor that can provide the crucial management skills and technical know-how. The state's growing role in the stock market obviously has positive implications for both the development of the capital markets and corporate governance, as the state is now a major stakeholder.

Table 3.3: Ownership of Russian equities, 2003, 2006 (%) Mid-2003 20.0 38.0 17.0 25.0 100.0

State ‘Management & insiders’ Strategic Industry investors Free float Total

Feb 06 29.6 21.2 20.4 28.8 100.0

Nov 06* 35.2 22.0 15.4 27.4 100.0

*Based on closing prices as of end November 2006 Source: Company reports, Alfa Bank Research

Figure 3.4: State voting stock in top 20 RTS companies, 2000 – 06 (%) % 50 38.9

40

30

20

18.1 10.8

10

0 Jan 00

Jan 04

Dec 06

Source: Company data, Aton estimates

IPOs In the 10 years between the founding of the market in 1995 and 2005 Russia saw just 11 IPOs, which raised a total of US$1.3bn (if flotations on international markets are included). This method of fund raising really took off in 2005 before gathering momentum in 2006, when 15 companies floated raising US$17.7bn. This was an excellent result, even if the US$10.6bn that state-owned oil company Rosneft raised is counted out of the tally. Table 3.4 details the IPOs between 1996 and 2006. And the pace is expected to continue to quicken in 2007. Analysts say that, at the start of the year, some 90 companies had expressed an interest in an IPO and expect them to raise something like US$30bn (see Table 3.4).

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Table 3.4: Annual value of Russian IPOs, 1996–2007E (US$m) Period 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 excl. Rosneft Rosneft 2006 total 2007 possible

No. of IPOs 1

Total raised, US$m 111

— — 1 1

— — 52 323

— 2 1 5 12 13 1 14

— 220 14 620 4,926 6,999 10,656 17,659 30,000

Source: Alfa Bank Research

Diluting the index Russia's IPOs are already making a mark on the composition of the market and starting to dilute the natural resources companies' dominance of the RTS index. Two years ago, the 10 largest names accounted for 85% of the value of the market. Currently, the 10 largest names account for 69%. The top 15 names used to account for 94% of the total market value at end-2004, while currently they account for 76%.

Opening up new sectors Over the last decade, portfolio investors have been happy to invest into Russia's raw materials producers, simply because they have been so cheap when compared to their peers around the world. However, after the market gains of the last three years this is no longer true; indeed some Russian steel and oil companies were trading at a slight premium to their emerging market peers. At the same time, the Russian story changed from simply ‘catch-up’ by the extractive industry valuations to the boom in consumer-orientated business, and these companies were all but absent from the universe of publicly listed companies. Because of the fast growth of consumer companies such as supermarkets and their inability to raise investment capital from traditional sources, these companies have also been among the vanguard of Russian IPOs. (Table 3.5 shows potential IPO issuance for 2007 and the sectors which are forecast to see most activity.) While the capitalisations of these companies pales in comparison to their raw materials cousins, the distribution of stocks by sector on the RTS is already more diverse and will continue to diversify in the short term, allowing investors to build a more representative portfolio.

Table 3.5: Forecast IPO issuance, 2007 (US$m) Sector Construction Consumer, food, retail Electricity Financials IT & Media Leisure Manufacturing Metals Oil Real estate Telecom Transport Total Source: Alfa Bank Research

45

No. of possible IPOs 3 25 5 10 5 4 12 13 4 2 2 6 91

Cash to be raised (US$m) 600 3,000 6,000 11,000 550 100 2,200 3,800 1,400 300 300 750 30,000

% of total 2.0 10.0 20.0 36.7 1.8 0.3 7.3 12.7 4.7 1.0 1.0 2.5 100.0


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Pricing challenges The first round of IPOs enjoyed the novelty factor and also the fact that investors were keen to get away from the traditional oil and gas stocks. Early IPOs were up to 20 times oversubscribed and consequently very aggressively priced. Only five of the 25 Russian IPOs between 2004 and the start of 2007 have performed better than the RTS. An IPO portfolio in that period would have gained 48%. A similar investment in the RTS would now be 86% higher, while equal investments in Gazprom would today be 185% better off. Of the 15 issues in 2006, including the private placing of a 10% block of equity by the owners of Wimm-Bill-Dann Foods, six were trading below the issue price as of January 2007, while three more performed less well than the RTS index in the same period. The best performing IPO since 2004 has been Open Investments, the real estate company that is part of oligarch Vladimir Potanin's empire. The continuing surge in the value of Russian real estate – residential prices were up 70% in 2006 – and the fact that Open Investments occupies an exclusive niche in the stock market, have supported its price. The company represents the only direct way for portfolio investors to get exposure to the real estate market. The next best performer, with an IPO value of almost US$1bn and far bigger than Open Investments, was the independent gas producer Novatek. The rapid rise in oil and gas prices has strongly supported the investment outlook for the company during this period. But the main reason why this IPO was so successful was that it was very deliberately priced to succeed, as the owners accepted a discount in order to ensure not just a successful IPO exercise, but also a successful post-IPO market, according to analysts at Alfa Bank. With equity investments so heavily weighted on the side of the oil and gas sector and the consumer sector so obviously on fire, anything that floated that was not a natural resources producer was significantly overbid. Consequently, buying Russian IPOs in the last two years has been a poor investment when compared only to the RTS index performance. The various performances of IPOs are shown in Tables 3.6 to 3.9. The almost doubling of supply (more than doubling, if Rosneft's de facto private placement is excluded) will take all the froth off the market and turn the tables from a sellers’ market to a buyers’ market in 2007. The return of risk aversion will only add to this trend. With the first flush gone, bankers say that Russian companies are going to price their shares more aggressively from 2007 to ensure the success of their flotations.

Table 3.6: Performance of IPOs issued in 2006–Jan 2007 (US$, %) Comstar-UTS Trader Media East Razgulyai Veropharm Magnit Cherkizovo CTC Media Rosneft TMK OGK-5 Sistema-Hals Chelyabinsk Zinc Severstal Raspadskaya Mine Wimm-Bill-Dann Total Prices as at close January 26, 2007 Source: DataStream, RTS

46

Total raised (US$m) 1,062.00 650.00 144.00 140.00 368.00 251.00 381.00 10,656.00 1,084.00 459.00 432.00 324.00 1,222.00 317.00 165.00 17,655.00

IPO price (US$p/s) 7.25 13.00 4.80 28.00 27.00 15.25 14.00 7.55 5.40 0.09 10.70 167.50 12.50 2.25 37.50

Current price* (US$ p/s) 8.70 9.78 4.40 37.00 36.10 13.40 21.70 8.93 8.70 0.13 13.20 160.00 12.77 1.93 61.00

Gain/loss (%) 20.0 -24.8 -8.3 32.1 33.7 -12.1 55.0 18.3 61.1 43.3 23.4 -4.5 2.2 -14.2 62.7


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Table 3.7: Top IPO performers, 2004–Sept 2006 (US$, %) IPO date 16/11/04 20/07/05 31/05/06 28/04/06 10/05/06

Company Open Investments Novatek CTC Media Magnit Cherkizovo Group

IPO price (US$ p/s) 49.75 16.75 14.00 27.00 15.25

Current price* (US$ p/s) 178.00 49.00 21.60 34.00 14.30

Performance* (%) 257.8 192.5 54.3 25.9 -6.2

RTS% (same period) 138.8 109.6 8.8 -4.1 -8.7

Note: *prices as at September 7, 2006 Source: RTS, Bloomberg, Alfa Bank Research

Table 3.8: Worst IPO performers, 2004–Sept 2006 (US$, %) IPO date 05/12/05 22/03/05 29/10/04 22/04/05 17/11/05

Company IMS Group Khelb Altaya Mechel Severstal-Auto Amtel-Vredestein

IPO price (US$ p/s) 3.30 0.90 21.00 15.10 11.00

Current price* (US$m p/s) 1.90 0.78 21.10 18.50 4.80

Performance * (%) -42.4 -13.3 0.5 22.5 -56.4

RTS % (same period) 144.9 135.6 139.4 123.6 56.6

Note: *prices as at September 7, 2006 Source: RTS, Bloomberg, Alfa Bank Research

Table 3.9: IPOs trading below initial price, Sept 2006 (US$, %) IPO date 14/07/06 10/05/06 07/02/06 25/04/06 22/03/05 13/02/06 05/12/05 17/11/05

Company Rosneft Cherkizovo Group Comstar UTS Veropharm Khelb Altaya Trader Media East IMS Group Amtel-Vredestein

IPO price (US$ p/s) Current price * (US$m p/s) 7.55 7.51 15.25 14.30 7.25 6.70 28.00 25.00 0.90 0.78 13.00 8.60 3.30 1.90 11.00 4.8

Loss (%) -0.5 -6.2 -7.6 -10.7 -13.3 -33.8 -42.4 -56.4

Note: * prices as at September 7, 2006 Source: RTS, Bloomberg, Alfa Bank Research

Owners’ motivations Why have IPOs now? There are two motives for owners to sell stakes in their companies now. The first is to raise investment capital to continue their fast expansion. For example, in the supermarket sector competition is so fierce for the dwindling market share that owners are willing to forego the anticipated share value appreciation for the ready cash to build more stores today. December 2005 was a key month for Russian owners, as the RTS crossed the 1,000 milestone for the first time, rising 83% over the year. The following year was the sixth in a row of strong growth and reached a tipping point where cost of equity finance was on a par for the first time with the alternatives such as bank loans of bond issues. With economic growth running at over 6% for five years, everyone is desperate for investment capital. “There are big opportunities for companies with access to equity capital markets and the cost of equity finance has fallen from the thousands of percent to about 10-11% now versus the 7–8% it costs to borrow or issue bonds,” says Charles Ryan, chairman and CEO of United Financial Group. “In other words, the difference is small enough to make equity financing an attractive alternative, especially since so many companies are now quite highly leveraged. A lot of sectors here are ripe for consolidation and equity is a powerful weapon in negotiating the terms [of acquisition or merger],” says Ryan. The second reason is many owners simply feel the fast growth phase is coming to an end and want to cash out. Fears of what will follow after Putin steps down as President in March 2008 are catalysing this desire to secure the huge gains made in recent years. Analysts estimate that about half of the IPOs in 2005 and 2006 were motivated by owners wanting to monetise the fortunes they had made on paper ahead of the regime change in the Kremlin.

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IPO pipeline congestion The IPO pipeline for 2007 and 2008 is already filling up quickly as more and more companies come to market either to take cash off the table or raise badly needed investment capital to fund ongoing expansion.

Banks By far the largest category of IPOs in 2007 will be from the financial sector, with major issues expected from state-owned retail banking behemoths Sberbank and VTB. Sberbank raised a total of US$8.8bn in its secondary public offering (SPO) on 22 February 2007, as opposed to the intended US$12.3bn (a target which included around US$3.3bn from the CBR). This made it the second largest share sale in Russia's history, after the IPO of Rosneft last year. Shares were sold at RUB89,000 (US$3,394), or a 4.3% discount to previous day’s closing price of US$3,545 on Moscow's dollar-denominated RTS exchange. As a result, the government reduced its share in the bank to 55%. Foreign investors owned about 20% of the bank prior to the SPO. Oligarchs used their pre-emptive rights to up their stake and owned about 12% of the shareholders capital prior to the offer. In all, oligarchs and the CBR bought over half the SPO in a 24/35% split, according to analysts’ estimates. The rest was bought by international investors, with Russian retail investors accounting for minimal amounts. A total of 3.5m new shares were issued. VTB raised US$8bn with an IPO in May, well above the target of US$4.5bn. The third big bank to float will be Gazprombank – this has been delayed and will probably IPO in early 2008.

Utilities The other industry targeting a substantial IPO issuance is the electricity sector. The state-owned utilities operator United Energy Systems said in January it hopes to hold around 15 IPOs this year in the electricity sector, which will raise between US$10–15bn. Table 3.10 assumes (as of February 2007) a total issue of US$6bn though 2007, while the CEO of UES has said that his ambition is to raise up to US$10bn via multiple generation and transmission company IPOs.

Table 3.10: RAO UES - Projected IPOs, 2007

OGK-1 OGK-2 OGK-3 OGK-4 OGK-5 OGK-6 TGK-1 TGK-3 TGK-4 TGK-5 TGK-7 TGK-8 TGK-9 TGK-10 Kuzbass- energo TGK-12 TGK-13

M.cap., (US$m)

EV/Capacity, (MW)

New shares placement, % of persent equity

5,022 4,019 4,301 5,306 4,162 3,392 3,497 6,384 1,715 1,216 n/a 1,664 2,028 n/a n/a n/a

546 473 517 616 492 461 562 659 561 501 n/a 452 690 n/a n/a n/a

– – 61.00 46.80 25.03 – 64.01 40.70 – 36.60 – – 64.46 – – –

RAO UES board approval – – Approved Approved Approved – Approved Approved – Approved – – Approved – – –

Source: Company’s information, Trust estimates

Small companies Analysts expected smaller issues to come early in January, so as to avoid being squeezed by the large issues planned in the banking and electricity sectors later in the year, but 2007 got off to a slow start with a modest US$1.2bn of issues in the first month. At the time of writing there was another US$15bn of proposed issues by companies that have confirmed an interest in an IPO, but have yet to start the formal process, as listed in Table 3.11.

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Table 3.11: Proposed IPOs, 2007 (US$m) Companies that are currently in the process of an IPO to be completed in early February: GV Gold US$200m Sitronics US$500m Polimetall US$500m Companies that have announced their intention to raise, but which have yet to start the formal process: MMK US$1.6bn Companies that announced their ‘plan’ to issue in 2007 but have not indicated any timeframe: EMALyans (power equipment) US$100m RESO-GARANTIYA (third largest insurer) US$100m and 150m Rosneft May ‘at some point’ sell an additional 25% of its equity by way of public issue Source: Alfa Bank

Impact on liquidity The heavy IPO schedule also means that liquidity is tightening and some investors will have to sell their stakes in other companies if they want to buy into the new issues. The two big IPOs so far – Rosneft and Sberbank – had little impact on liquidity as the Kremlin fluffed the marketing of both issues. Rosneft was dogged by the additional problems raised by Yukos' former owners threatening to hound the company with legal actions: Rosneft's main production subsidiary is Yuganskneftegaz, which it won at a controversial bankruptcy auction in December 2004 from the now defunct Yukos. Shareholders in Yukos claim the state illegally appropriated the subsidiary and the threat of legal action was enough to dissuade most international portfolio investors from taking a punt on Rosneft. The upshot was both flotations were more like private placements after the Kremlin strong-armed oligarchs and strategic investors into buying into them. However, the raft of genuine IPOs on the way is likely to suck some liquidity out of the market and depress the growth of the RTS index this year. Just how big this effect will be remains unclear.

Stock exchange trading Daily trading volumes used to be in the millions; now they are in the billions. The entire market capitalisation of Russia's six main exchanges was about US$100m in 1995; now it is over US1trn. The returns that can be earned on the Russian stock exchanges are impressive but the rise in daily trading volumes give a better idea of the growing interest in Russian stocks and who is investing into Russia's equity.

The main exchanges Russia has six exchanges in all but the confusingly named Moscow Interbank Currency Exchange (MICEX) and the Russian Trading System (RTS) dominate the action – neither of which started life as a stock exchange. The RTS market was launched in 1995 as a by-product of privatisation: if you created privatelyowned joint stock companies you had to have a stock market to trade these stocks on. MICEX began life in 1991 as the platform for interbank loans and later became first the platform for bond trading before adding equities. As the RTS was the original platform for buying and selling shares, most investors in Russia still tend to quote the RTS index as a measure of how equity investments into Russia are faring. Since MICEX began equity trading it has sped away from the RTS in terms of exchange-based trading and now accounts for 90% of all securities transactions in Russia – greatly helped by the fact that it has always been home for Gazprom's listed shares, which is now 10 times bigger than any other company in Russia, with a market capitalisation just short of US$300bn at the start of 2007, or accounting for a third of the market capitalisation of all Russian shares on its own. However, the RTS remains the home of OTC trading – the trading of small companies' stock through informal dealer networks – and following reforms passed in 2006, began posting the prices and volumes of all of its OTC trading in February.

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Analysts were surprised by the first day's results, which showed the volume of OTC deals on the RTS was nearly US$1bn, compared to US$1.7bn on the formal exchange that day, which shows that a much more robust and vibrant market exists in Russia's second and third-tier stocks than was previously known.

Trading volumes In January 2007, MICEX reported that total volume of trading in all markets of the MICEX Group in 2006 was to RUB52trn (US$1.9trn), twice as much as the RUB26.5trn (US$932.2bn) of share transactions in 2005. At the same time the average daily volume on MICEX was RUB210bn (US$7.8bn), up from a few million dollars in the mid-1990s. Trading in stocks accounted for 39.2% of the total volumes in 2006 (up from just under a quarter in 2005), or RUB14.9trn (US$550bn), while the average daily volumes for trading in just shares was up to RUB82.5bn (US$3.1bn), just under four times more than in 2005. Some of this growth was simply due to the fact that a lot of companies listed their shares: since the beginning of 2006, the number of securities traded on MICEX grew by 44%, while the number of issuers whose securities are admitted to exchange-based trading grew by 40%. Details of the expansion of trading on MICEX are given in Table 3.12. The volumes are now big enough to make MICEX one of the 20 biggest exchanges in the world. Stephen Jennings, CEO of the Renaissance Capital Group, said in January that Russia is the best developing market in the world. He believes that despite current problems Moscow will eventually become Europe's second largest financial centre. London is the financial capital of Europe, Jennings said. But Moscow will surge ahead of Frankfurt, Paris and Milan in all segments of the financial market. "We cannot now imagine the scale of change," he said, "as the process will last not five or even 10 years, but 15â&#x20AC;&#x201C;20 years."

Table 3.12: Growth in trading of the individual segments on MICEX, 2006 (%) Corporate securities market Foreign exchange unit Government securities market Derivatives market

320 150 160 480

Source: MICEX

There are still many problems with the equity capital market infrastructure, but MICEX President, Alexander Potemkin, listed among the major achievements of 2006 the following: 0 The launch of trading in Gazprom shares on MICEX following the removal of the ring-fence in January 2006, Rosneft's IPO in July which is traded on MICEX, the start of trading in mortgage securities; 0 The development of collective investments, the doubling of the number of individual investors working on MICEX; 0 Raising the liquidity of the exchange-based currency market by improving the parameters of traded instruments and optimising the tariff policy; 0 Organising the service of the Bank of Russia's lending operations (collateral crediting) and the launch of a new segment of the government securities market: government savings bonds; 0 The launch of interest-bearing futures on the exchange-based derivatives market; 0 The beginning of the work of The National Clearing Center within the MICEX Group, which organises settlements and clearing for transactions in the MICEX orderly markets. (For more on new products being offered by the exchanges see Chapter 12.)

The OTC market Analysts were given an insight into the nature of Russia's stock market when the RTS started to publish OTC trading statistics in March 2007.

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They were surprised by the robust nature of the OTC trade, which suggests investment activity with small and medium-sized enterprises is much greater than they suspected. The total average trading volume in all Russian equities at the start of 2007 was around US$6bn a year, with local bourses accounting for 67% of this and another 6% being on the new futures market. However, the OTC average trade volumes were US$1.6bn at the start of March, much more than analysts had expected (see Table 3.13). This result changes the balance between the two main exchanges, as although MICEX dominates the formal trading, the RTS is the preferred venue for OTC trades. On the first day of reporting the OTC trades at the end of January 2007 the RTS saw 1,445 deals worth RUB10.15bn (US$400m) whereas MICEX had only three deals worth RUB257,648 (US$10,150).

Table 3.13: Equity trading - average daily volumes, Mar 2006, Mar 2007 (US$m,%)

RTS-Official RTS-OTC MICEX Gazprom Total domestic bourses LSE NYSE Total foreign bourses FORTS Total daily average

Average daily, last week % of total 52 – 1,588 – 2,453 – – – 4,093 67 1,204 – 485 – 1,689 27 360 6 6,142 100

Average daily, previous week 106 1,298 2,998 – 4,393 1,197 471 1,668 428 6,489

% of total – – – – 68 – – 27 7 100

Average daily, last year 51 – 1,227 200 1,478 444 176 620 152 2,250

% of total – – – – 66 – – 27 7 100

Note: As of first week in march Source: RTS, MICEX, Bloomberg, Alfa Bank research

Russia as an emerging market In the 1990s, Russian investors were a specialist breed of adventurers in a highly unpredictable market. However, over the last decade investing into Russia has moved slowly towards the mainstream and Russian companies are being included in an increasing number of international indices that in turn are bringing in more investment. One of the effects of the steady flow of IPOs of the last two years and new equity issuance is to push the value of the total market higher, but it has also increased the availability of equities for portfolio managers around the world, as about half of the IPOs, in terms of value, have taken place on international markets. In 2006, the share of Russian stocks in the global emerging markets (GEM) and other international funds increased sharply, from 6.3% of the GEM universe to 10.0% at the end of the year, as shown in Table 3.14. Russia’s position in the league of individual GEM countries is shown in Figure 3.5.

Table 3.14: Emerging markets funds - Russia weightings, 2006 (%) End Dec 05 End Jan 06 End Feb 06 End March 06 End April 06 End May 06 End June 06 End July 06 End Aug 06 End Sep 06 End Oct 06 End Nov 06 End Dec 06 Source: Emerging portfolio fund research

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GEM 6.30 6.60 6.80 7.00 7.67 8.00 8.70 8.70 9.10 8.85 9.22 9.67 9.99

East Europe 38.70 40.00 40.30 40.80 41.70 43.10 44.40 44.20 45.10 45.80 44.00 45.90 44.60

EMEA 12.00 16.40 16.50 17.00 18.80 18.80 24.90 27.10 27.60 30.80 30.60 31.60 31.70

International 0.28 0.33 0.23 0.27 0.27 0.27 0.35 0.39 0.36 0.34 0.36 0.39 0.37


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Figure 3.5: Global emerging markets – country weightings, Sept 2006 (%) % 18 16 14 12 10 8 6 4 2 Korea (South) Brazil Taiwan Russia South Africa China Mexico India Thailand Turkey Malaysia Indonesia Chile Israel Hong Kong Poland Egypt Philippines Argentina Pakistan Morocco Venezuela

0

Source: Emerging portfolio fund research (EPFR)

Russia's rising index weightings The weighting of Russian stocks in Morgan Stanley's influential emerging market index, the MSCI, has also been rising in the last two years. This index is important, as many investors into GEMs use the MSCI index to measure the performance of their funds – increasing Russia's weighting usually means a greater allocation of money for investment into Russian stocks. The key event for the MSCI index was the fall of the ring-fence around Gazprom's shares, when special rules that precluded foreign investors from buying locally-listed shares were removed at the start of 2006. The MSCI included Gazprom in its index in May and made the company the biggest stock in the GEMs overnight, overtaking Korea's Samsung, with a market capitalisation of US$250m. The performance of the Russian equity market is made more difficult to follow as the mark-ups of the various indices are very different, a function of the companies that are included into each. The traditional index has been the RTS, but the trading volumes (on organised markets) on the MICEX are bigger. Oil and gas play a much larger role in the RTS than the MICEX index. And the MSCI index has an even stronger oil and gas bias, as shown in Table 3.15. This bias towards Russia's strong suits meant that all the indices gave a pretty good picture of how the Russian equity market had been developing in recent years, since oil and gas stocks have been the main focus of attention. However, since the middle of 2006, when there was a massive switching out of these commodity stocks into the shares of companies with exposure to the domestic consumer spending story, none of the indices has given a very good picture of the state of play on the market. The bottom line is: "stock picking has become important", according to most bankers.

Table 3.15: Russian indices’ weight, by sector, Mar 2007 (%) Sector Oil and gas Metals and mining Fertilisers Banking Telecommunications Electric utilities Retail and consumer goods Media Conglomerates Automotive Defence Transportation

RTS (since 15 March) 53.4 12.7 0.4 15.3 8.2 7.0 1.8 0.2 – 0.5 0.2 0.3

Source: RTS, MICEX, Bloomberg, Deutsche Bank research estimates (prices as of February 2007)

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MICEX 32.9 13.0 – 18.4 10.5 13.8 – 0.4 – 0.4 – 0.3

MSCI (since 1 March) 64.6 8.6 – 10.8 9.6 4.7 0.5 – 1.2 – – –


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International investment flows into Russian equity The flows of international investment into the Russian market have been rising steadily in the last two years, as the nearly doubling of the market for three years in a row attracted more and more attention. However, of the BRIC countries, Russia has attracted the least attention. Russia was classed as one of the BRIC (Brazil, Russia, India, China) countries by Jim O’Neill, an economist with investment bank Goldman Sachs, who coined the term BRIC in 2003. He calculated that the Chinese economy could overtake Germany and Britain in four years in US dollar terms. But of the four, Russia suffers from a consistently bad press that fails to acknowledge much of the progress that has been made over the last five years, especially in the financial sector. It has outperformed all the other BRIC countries for several years, although both China and India did better in 2006. Likewise, over the last six years Russia's stock market outperformed the global emerging market index as well as the price of oil, which conventional wisdom says is the main driver of the market. See Table 3.16 and also ‘The effect of oil on liquidity’ below.

Table 3.16: RTS, GEM and oil price performance, 2000-06 (%) 2000 2001 2002 2003 2004 2005 2006*

RTS –18.2 81.5 38.1 58.0 8.3 83.3 57.8

GEM –31.9 –4.8 –8.0 51.7 22.4 33.3 23.7

Oil-Brent –13.0 –11.7 51.7 0.0 33.4 51.9 10.0

Note: *2006 year to close on November 30 Source: DataStream

The international investment inflows peaked at the start of 2006 when retail investors in America joined the party, but have fallen substantially since the global markets were routed in May 2006 by fears of US interest rate hikes, and have not really recovered. Since the price of oil peaked in August 2006, the flow of new money into Russian dedicated equity funds has slowed markedly and portfolio managers have stopped increasing their weighting in Russia with new money. The increase in the weighting with GEM is due to the market performance in December 2006, when Russian equities outperformed the GEM average by a factor of two. Looking at the trends in the flows into funds that report investment movements on a weekly basis (see Table 3.17), in 2006 the allocation of new money to country-specific funds within the BRIC category of countries was 7.4% into Russia. That was the lowest allocation within this category. In November and December, the new allocations were relatively small, and in January 2007 the net total taken into Russia-dedicated funds was only US$22.3m. Most of the fresh inflows into the BRIC countries in 2006 and the first few months of 2007 went to India and China – the ‘it’ GEMs.

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Table 3.17: Weekly inflows to Russia, GEM and BRIC funds, 2006 – Feb 2007 (US$m)

January February March April May June July August September October November December 2006 - year January ‘07 February ‘07***

Russia & CIS 321 464 281 138 –57 –716 826 193 –72 110 29 110 1,629 22 55

China* 786 1,442 1,207 1,569 539 –600 4,758 299 295 670 1,743 2,806 15,514 1,642 –675

India 299 577 701 519 –544 –505 1,252 220 168 48 123 –150 2,708 57 40

Russia % of BRIC** 19.10 15.20 11.40 6.00 –25.70 26.20 10.30 21.30 –19.70 13.10 1.50 3.90 7.40 1.30 –

Brazil 278 573 283 81 284 –915 1,221 194 –25 10 27 41 2,052 35 96

GEM 2,502 1,793 304 343 384 –2,219 2,055 100 –956 704 377 –149 4,470 822 31

BRIC 360 1,296 1,468 857 –7 82 3,615 32 –106 –19 –58 569 7,925 195 124

Note: *China includes both China and Greater China funds] ** Russia as a % of Russia, China, India and Brazil country specific funds *** Month to February 21st Source: Emerging portfolio fund research

Stock valuations and P/E ratios The market capitalisation of Russia's stock market has trebled since the start of Putin's second term of office in 2004 and some stocks such as Gazprom and Sberbank have seen their share price increase about 1,000-fold over this period. So are Russia's shares now at fair prices, or even over-valued? Looking at the price of equity to earnings (P/E) ratios for different sectors suggests that on average Russian stocks are still trading at about a 20% discount to most of their emerging market peers, but that the years of 100% returns are over. Peter Westin, chief economist with MDM Bank, says: "The aggregate P/E for the Russian market remains in the middle of the consensus range for emerging market peers. Similarly, on a growthadjusted basis, Russian valuations are close to peers' valuation trends." However, the higher P/E ratios are not uniform and the fads for oil stocks that gave away to a fashion for telecoms and retail-orientated stocks are clear from the detailed lists (in Figure 3.6 and Table 3.18). Again the bottom line is that there is still a lot of untapped value in the market, but investors can no longer sit on their hands and wait for Russian shares to ‘catch up’ with their emerging market peers; now it is necessary to go and look for undervalued companies.

Figure 3.6: P/E ratios by sector, 2007E Developed markets Emerging markets 13.1 13.4

Banks-Russia

13.9 14.0

Fixed-line telcos Russia

20.0 15.5

14.8

Mobiles-Russia 10.1 Miners-Russia 8.3

Steels-Russia Oil & gas-Russia

54

17.2

14.1

Retailers-Russia

Source: MDM estimates, Datastream

15.0

6

8

9.8 9.9

11.9

9.6 10.0 9.3 10

17.3 16.0

13.5 12

14

16

18

20

22


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Table 3.18: Russian share price performance and P/E ratio, Jan 2007 (US$, %) Price* US$ (p/s) RTS 1,863.30 Amtel-Vredestein 4.70 Pharmacy chain 36.6 59.50 AvtoVAZ 74.00 Bank of Moscow 70.00 Baltika 44.60 Bashkirenergo 1.60 Bashneft 15.5 Celtic resources 2.80 CenterTelecom 0.74 Chelyabinsk pipes 3.84 Chelyabinsk zinc 16.65 Cherkizovo group 13.38 Comstar-UTS 8.70 CTC Media 21.68 Evraz 27.10 Gazprom-local 10.82 Gazprom ADS 43.30 Gazpromneft 4.60 Golden Telecom 52.10 Highland gold 3.40 Irkut 1.01 Irkutskenergo 0.83 Kalina 45.80 Krasnoyarskaya GES 3.13 Lebedyansky 75.00 LUKOIL 79.70 Magnit 36.10 Mechel 26.87 MGTS 25.00 Mosenergo 0.21 MTS 53.53 Norilsk nickel 162.25 Novatek ADR 56.50 NLMK 2.44 Novosibirkenergo 63.00 NTMK 2.10 OGK-3 0.14 OGK-5 0.13 Open investments 240.00 Polyus gold 49.70 Power machines 0.19 Promstroibank 1.76 Razgulyai group 4.40 RBC 11.30 Rosneft 8.93 Rostelecom 7.60 Sayano-Shushenskaya GES 1.24 Sberbank 3,500.00 Seventh Continent 26.00 Severstal 12.77 Siberia Telecom 0.11 Sistema 31.30 Sistema Hals 13.20 South Telecom 0.17 Surgutneftegaz 1.24 Tatneft 4.37 TNK-BP Holding 2.30 TMK 35.00 Transneft pref 2,355.00

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Last week (%) 2.8 –3.1 4.4 4.3 9.4 2.1 6.7 0.0 –3.4 –1.3 5.2 8.8 7.0 1.2 1.7 6.5 0.9 0.9 –1.1 3.3 13.3 1.0 7.9 –1.5 –0.6 0.0 1.8 2.8 7.2 2.0 5.0 7.8 1.7 –1.9 10.4 26.0 0.0 2.1 4.0 2.1 10.2 2.2 0.0 6.0 2.7 0.0 3.4 1.6 2.6 –0.4 14.5 8.3 –0.9 –0.8 0.6 0.8 0.9 0.4 9.4 7.5

Month (%) 0.6 2.2 6.3 8.8 59.1 3.7 10.3 –3.1 –6.7 –2.6 19.3 0.3 –2.3 2.4 –10.8 9.3 –5.1 –7.3 5.5 13.0 9.7 2.0 6.4 –5.2 –1.6 –6.3 –7.1 4.6 8.8 2.5 5.0 11.1 7.7 –9.9 5.2 21.7 –0.9 24.3 2.4 11.1 2.5 9.2 –1.7 11.7 0.9 –2.4 3.0 3.3 12.9 0.8 15.0 3.7 1.3 0.0 1.8 –15.1 –5.4 –6.9 7.7 6.3

Year to date (%) –3.1 2.2 2.1 8.8 62.8 0.8 10.3 –3.1 –9.7 –1.3 16.4 –2.1 –2.3 3.6 –9.7 5.5 –5.9 –5.9 0.9 11.2 6.2 –2.4 7.1 –11.1 –0.6 –6.3 –9.4 1.1 5.5 2.5 4.5 6.7 3.3 –11.0 3.8 26.0 –3.7 16.7 4.0 11.2 0.8 1.9 –4.9 10.0 1.3 –2.4 –0.7 0.0 1.4 –2.6 14.0 –1.3 –2.2 –0.4 –3.9 –19.0 –5.4 –11.4 0.0 2.6

12 months (%) 39.3 –53.0 83.1 54.2 194.7 20.5 131.9 10.7 –31.7 19.4 172.3 – – – – 41.1 34.9 – –2.7 75.4 –32.0 17.4 69.4 11.7 56.5 4.2 2.3 – –2.3 22.0 28.0 43.1 85.4 101.8 47.6 125.0 15.1 – 115.0 – – 72.7 37.5 – 61.4 – 223.4 74.2 128.6 2.4 14.3 33.7 25.2 – 15.3 –10.1 5.0 –28.1 – 0.0

P/E** 0.1 9.4 52.9 8.3 32.6 15.9 – ≠– – 26.1 26.5 – – – – 9.6 10.6 – 11.2 18.1 22.9 10.6 – 13.5 – 13.2 7.6 28.6 11.1 15.2 – 13.2 10.1 24.5 11.4 – 11.2 – – – 33.1 – 28.1 – 23.9 16.3 30.1 – 22.9 22.9 – 12.1 19.8 30.9 11.1 7.8 6.2 – –


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Table 3.18: Russian share price performance and P/E ratio, Jan 2007 (US$, %) (Cont.)

UES Ufa Refinery Ufaneftekhim UralSib Uralsvyazinform Veropharm VimpelCom Volga Telecom Volzhskaya GES Vortkinskaya GES Vozrozhdenie VSMPO Vyksa Pipes Wimm-Bill-Dann X5 Retail Group YUKOS Zagorskaya GAES Zeiskaya GES Zhigulevskaya GES

Price* (US$ p/s) 1.12 1.85 3.10 0.03 0.07 37.00 85.00 6.45 0.41 0.72 63.00 299.00 1,354.00 61.00 27.00 0.59 0.02 0.36 0.29

Last week (%) 8.7 0.0 –1.6 –2.9 13.2 16.4 8.0 8.4 5.1 6.7 –1.6 1.4 4.2 7.7 –0.6 25.3 2.9 5.9 3.6

Month (%) 13.0 8.8 –1.6 9.7 10.6 23.7 9.7 14.2 7.9 2.9 21.2 2.0 5.0 6.6 6.7 22.9 0.0 2.9 3.6

Year to date (%) 3.7 8.8 –1.6 6.3 11.5 16.5 7.7 6.6 8.2 35.8 10.5 2.0 –3.3 –8.3 3.8 13.5 0.0 3.2 1.4

12 months (%) 120.0 –7.5 –15.1 17.2 92.1 – 78.9 61.3 55.9 72.2 106.6 52.1 96.2 143.0 70.9 –66.3 – 127.8 68.6

P/E** 21.5 – – 19.6 13.0 – 21.0 10.5 – – 22.2 17.0 – 21.5 20.2 – – – –

Note: *As at close January 26 ‘07 ** Based on 2007 earnings forecasts Source: Alfa Bank research, DataStream

Traditional market drivers Traditionally, the oil price has been the main driver of valuations on the Russian stock market and it remains the most important factor. However, more recently, as the economy grows and the size of the Russian stock market capitalisation grows, several other factors have come into play. The performance of other emerging markets is having a greater impact on the Russian market; domestic consumption is becoming a major economic driver and is making itself felt on the equity market; and growing domestic investment is going to be a driver.

The seven - year boom A combination of extremely low interest rates in the industrialised markets and high commodity prices driven by the strong growth of emerging markets combined to create near perfect conditions for the emerging market stock markets. Unable to earn much of a return in the traditional markets, international investors have piled into the emerging markets en masse and sent valuations soaring in a seven year-long investment binge. During the sweet spot for emerging markets investors became almost immune to risk. A telling example was the spread on the yields between Russian sovereign Eurobonds and the benchmark US treasuries, which was falling steadily at the start of 2006. However, in May 2006 the party seemed to come to an end after the US federal reserve upped interest rates to 5.25% on treasury bonds and the fear of further rate hikes sent emerging market investors running for the door. Then a year later a sell-off in China, coupled with the first round of rate hikes in nearly a decade by the Bank of Japan, sparked another sell-off around the world. Clearly, the seven years of benign external conditions are coming to an end and emerging markets are going to face competition again from more traditional and safer investment options in the industrialised counties of the world. However, during these good years many of the emerging markets, including Russia, have made great strides forward. The question is what balance investors will strike in this new more competitive environment when choosing between investment destinations. Or put another way: to what extent have the emerging markets emerged? While the rise of the RTS clearly mirrors the rise in oil prices since 1999, more recently the index has also become more closely correlated to the performance of other global emerging markets.

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Liquidity The lack of institutional investors and the speculative, short-term mentality of most of the domestic investors mean Russia’s stock market remains very sensitive to liquidity in the financial system. In turn the liquidity is dependent on the price of oil, the strength of the ruble's appreciation and the tax schedule, among other things. The leading role of banks among the domestic investors also makes the RTS more dependent on liquidity flows. In Figure 3.7 the rise of the RTS follows the rise in money supply, which is being fuelled by incoming petrodollars. However, the relation breaks in 2004 during the mini-bank crisis, when the interbank market collapsed and smaller banks suddenly experienced a sharp liquidity squeeze. The market was further unsettled in that year by an escalation of the Yukos affair, but once these nerves passed the market quickly caught up with money supply in 2005.

Figure 3.7: Money supply vs equities, 2000–07 Inflation, % 400

RUR per US$1 2,500

350

Money supply RTS Index

2,000

300 250

1,500

200 1,000

150 100

500 50 0 1/1/00 1/4/00 1/7/00 1/10/00 1/1/01 1/4/01 1/7/01 1/10/02 1/1/02 1/4/02 1/7/02 1/10/02 1/1/03 1/4/03 1/7/03 1/10/03 1/1/04 1/4/04 1/7/04 1/10/04 1/1/05 1/4/05 1/7/05 1/10/05 1/1/06 1/4/06 1/7/06 1/10/06 1/1/07 1/4/07

0

Source: DataStream

"We saw through 2006 that when liquidity conditions tighten in Russia, the rising cost of borrowing slows market activity and generally hurts prices as traders are forced to close positions. The major driver of liquidity in 2007 will be budget revenues based on oil flows and the Finance Ministry's actions to balance sanitising flows to the Stabilisation Fund and increase the monetary base", says Alfa Bank.

Oil prices A sudden fall in oil prices is widely seen as the biggest stumbling block for the Russian economy, as the equity market and the price of oil are clearly linked – a correlation demonstrated in Figure 3.8.

Figure 3.8: Equities vs oil prices, 2003-07

2,500

90

RTS index Brent crude US$

80

2,000

70 60

1,500

50 40

1,000

30 20

500

10

Source: DataStream

57

1/4/07

1/1/07

1/10/06

1/7/06

1/10/06

1/4/06

1/1/06

1/7/05

1/10/05

1/4/05

1/1/05

1/7/04

1/10/04

1/4/04

1/1/04

1/10/03

1/7/03

1/4/03

0 1/1/03

0


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This correlation is partly due to the predominance of oil stocks in the index, but also because of the impact of oil prices on most of Russia's economic indicators. High oil prices increase money supply and liquidity as the CBR attempts to sterilise hard currency flowing into the economy, which can be seen in Russia's trade balance. The rising price of oil has been the biggest contributor the rising liquidity on the Russian market over the last six years. Revenues earned from the export of oil have risen from US$39bn in 2000 to just under US$160bn a year, estimated for the end of 2006 (see Table 3.19).

Table 3.19: Oil export revenue, 2000â&#x20AC;&#x201C;06F (US$) Exports, m bbl/d 4.1 4.6 5.1 5.7 6.4 6.8 7.1

2000 2001 2002 2003 2004 2005 2006F Total

Average urals, US$ /bbl 26.5 22.9 23.8 27.2 34.6 50.5 61.2

Total revenue, US$bn 39.6 38.5 44.5 56.8 80.1 124.6 158.6 542.7

Source: Customs Data, DataStream, Alfa Bank research

Table 3.20: Oil exports, 2000â&#x20AC;&#x201C;06F (m bbl/d) Crude 2.89 3.21 3.73 4.21 4.75 4.96 5.10

2000 2001 2002 2003 2004 2005 2006F

Products 1.2 1.4 1.4 1.5 1.6 1.8 2.0

Total 4.1 4.6 5.1 5.7 6.4 6.8 7.1

Source: Customs Data, Alfa Bank research

Figure 3.9: Russian exports, imports and oil price, 2000-09F (US$)

US$ per barrel

US$bn 500

Export, US$bn (Lhs) Import US$bn (Lhs) Urals price, ave, US$/barr (Rhs)

400

60

300

40

200 20 100

0

Source: Ministry of economy and trade

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2000

2001

2002

2003

2004

2005

2006F 2007F 2008F 2009F

0


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Figure 3.10: Breakdown of worldwide oil & gas reserves, 2006 (%) Share of worldwide gas reserves

Share of worldwide oil reserves

4.1%

5.0% 9.5% 3.4%

8.0% 61.9%

40.1%

Middle East

8.3% Russia

8.5%

4.0%

5.6%

8.9%

Other Europe & Euasia South & Central America Asia Pacific Africa

6.2%

North America 26.6%

Source: BP statisical review of World energy

The dangers from a fall in oil prices do not seem to be exorbitant, say analysts. Brent blend oil prices averaged US$67/bbl over 2006, but the consensus for 2007 is that prices will almost certainly fall. UBS has a long-term average price of US$41, while the Economic Development and Trade Ministry sees oil falling to US$58 in 2007 and declining to US$48 by 2009 (Figure 3.9). An analysis of the likely development of oil prices in the next years is beyond the scope of this report, but most Russian analysts and the government are assuming that OPEC is striving to maintain a price floor of US$55/bbl. High oil prices have had dramatic effects on share price performance, and while the relation between oil and the RTS is breaking down, if oil sticks to an average price of US$60/bbl, then UBS says the RTS could end 2007 at a stunning 3,200. UBS said: "While we see the economy robust for all oil prices above US$40/bbl, with 75% of the market oil and gas stocks the price of oil is key. If it were to fall to US$40 or below, the market would hurt. If though something like our house US$67/bbl average occurs we could see long-term oil-price expectations rise. With US$60 long-term we see end-07 RTS fair value of 3,200." The effect of falling oil prices has been diluted by the size of the economy and the diversification gains already made: in 1990s a US$1 fall in the price of oil would have shaved about 0.8â&#x20AC;&#x201C;1% off GDP growth. Today, the same US$1 fall in oil prices cuts 0.2% off GDP growth, according to Fitch. A fall to US$40 would be painful, but would not upset the apple cart and the RTS could still see some modest gains. Deutsche Bank UFG mapped out the effect of several oil price scenarios on the biggest stocks in its 2007 strategy, shown in Table 3.21.

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Table 3.21: Energy stocks related to oil price senarios Current Base case Conservative A Conservative B Conservative C Conservative D Stock Price (US$) TP (US$) Upside (%)TP (US$) Upside (%)TP (US$) Upside (%)TP (US$)Upside (%)TP (US$)Upside (%) LUKOIL 80.39 105.00 31 102.73 28 100.68 25 98.60 23 96.48 20 TNK-BP Holding 2.30 2.40 4 2.34 2 2.29 0 2.24 –3 2.18 –5 Gazprom Neft 4.57 4.00 –12 3.89 –15 3.78 –17 3.67 –20 3.56 –22 Rosneft 8.98 9.45 5 9.38 4 9.30 4 9.23 3 9.15 2 Surgutneftegaz, ord. 1.25 1.03 –18 1.02 –18 1.00 –20 0.99 –21 0.98 –22 Surgutneftegaz, pref. 0.90 1.03 14 1.02 13 1.00 11 0.99 9 0.98 8 Tatneft 4.40 4.20 –5 4.12 –6 4.02 –9 3.92 –11 3.82 –13 Bashneft 15.75 16.30 4 15.74 0 15.22 –3 14.69 –7 14.16 –10 Gazprom 10.82 10.70 –1 10.53 –3 10.36 –4 10.20 –6 10.03 –7 Novatek 56.50 67.50 19 67.27 19 67.06 19 66.85 18 66.63 18 Oil price, Brent 2007F 61.00 55.00 50.00 45.00 40.00 2008F 54.00 51.10 47.90 44.70 41.30 2009F 49.00 47.40 45.90 44.30 42.60 2010F 44.00 44.00 44.00 44.00 44.00 Source: Bloomberg, Deutsche Bank research estimates

While Russia's production and export have been rising fast over the last decade, it is still a pricetaker and once the greatest beneficiary of the high prices. Despite the Kremlin's best efforts to diversify the economy, oil will remain an important source of income as Russia holds the second largest reserves of oil in the world, after Saudi Arabia. It also holds the second largest reserves of gas. However, the Kremlin's strategy is not to squander this resource and since Putin took office the state has effectively capped oil production by limiting access to pipelines and is going slow on plans to build new pipelines. The strategy going forward is to keep production increases to a minimum and instead create more free gas for export by improving energy efficiency at home, as the legacy of the Soviet economy is that Russian industry is one of the most wasteful in the world. The motive for the cap on production is that oil already produces significant trade balance surpluses and the CBR is struggling to sterilise the incoming petrodollars. The Kremlin is afraid of suffering from the so-called Dutch disease, where petrodollars quickly drive up the value of currency making it difficult for domestic industry to compete in export markets. While the ruble has been appreciating strongly, economists say that Russia has not yet caught the Dutch disease; however, they warn that the pressure from the rising ruble is increasing and this problem is a real danger.

The effect of oil on liquidity Despite the obvious increased diversification of the Russian economy since Putin took power, there is a real debate among analysts over the importance of oil to both the economy and the stock market's performance through its effect on liquidity. Alfa Bank's Chief Economist, Natalia Orlova, wrote about this in a note entitled ‘Oil Price Vulnerability Back on the Agenda’ (26 October 2006) in which she illustrated the inter-relationship between oil and the monetary base. One of the important conclusions was that, without some flexibility to the government's current approach to the Stabilisation Fund, should the oil price average US$50/bbl in 2007 rather than US$60/bbl then the CBR's reserves would only rise by US$40bn rather than the expected US$100bn. In that case, the Stabilisation Fund would only receive an extra US$40bn rather than the expected US$60bn. That would also mean zero allocation to the monetary base and a severe liquidity squeeze. The fiscal growth that has sustained economic growth through the last several years would disappear. On the other side of the fence, some argue that the relation between oil price and the RTS index is breaking down. Certainly, since the end of 2006 when oil prices began to fall thanks to an unseasonably warm winter, the RTS continued to rise despite a sharp adjustment in the price of a barrel of oil (see Figure 3.8). The proponents of this argument believe that Putin's cap on oil and his ‘Nine commandments to business’ (see Chapter 1) have already moved the stock market's centre of gravity towards the consumer sector, which depends on the domestic engine of consumer spending and is relatively immune to what is happening on international commodity exchanges.

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At the same time, the RTS is becoming more correlated with what is happening in other GEMs. This is a function of Russia's increased weighting in indices such as the Morgan Stanley MSCI index and the rising amount of foreign portfolio investment since Russia was awarded a hat-trick of investment grade ratings by the leading ratings agencies in 2005. As international traders are increasing their position in Russian stocks as part of their GEM portfolios, a sell-off in one market, as with the rout of China's stocks in February 2007, will have a greater impact on the performance of Russian stocks as traders sell Russia to cover loses in China. "Since [2000] the best correlation that the RTS has shown is with the trend in the emerging market asset class. Of course, short-term price dips and spikes in the oil price have an immediate knee-jerk reaction in the market because of the heavy weighting of the oil majors, but increasingly it is the direction of the GEM asset class that is driving the market. The main reason is because while local investors now dominate daily market activity, the base direction of net buying or net selling comes from the main holders of the free float in the equity market, i.e. international fundsâ&#x20AC;?, says Alfa.

Ruble appreciation The second factor determining liquidity, after oil, is the strength of the ruble, also likely to be heavily influenced by the oil price in 2007. A strong ruble, especially relative to the dollar, will result in higher speculative inflows. That will increase the amount of liquidity in the banking system and reduce the cost of borrowing. If the ruble were to weaken, then the opposite would result. However, while falling oil prices would reduce liquidity in the banking sector it would also reduce ruble appreciation and reduce the inflationary pressure that would make it easier for the government spend some of its petrodollar windfall of recent years and so maintain growth. This balance of mitigating circumstance would be maintained down to about US$40/bbl, when the state's budget surplus would disappear and force the government to start borrowing to fund the spending gap, so here too the government has significant room to manoeuvre. Despite lacking sufficient monetary tools to properly control the exchange rate, the CBR has managed to deftly keep both inflation and ruble appreciation in check in 2006. The real effective rate (REER) of ruble appreciation in 2006 was 7.6%, well within the CBR's target of 9% for the year, and well below the 10.5% the ruble gained against the dollar in 2005. The CBR got off to a good start in 2007, as the REER was 2.8% for the first two months of the year and analysts expect it to be even lower for the rest of this year as the CBR needs to intervene less in the foreign exchange markets as inflation is curbed. Still, the ruble will continue to strengthen, as economists believe it remains overvalued. The Economist's Big Mac index, released in February, suggests the ruble is overvalued by 43%. The danger is if the CBR abandons its policy of gradual ruble appreciation, Russia's exporters will be hit by higher prices and domestic producers will suffer from cheaper imports that, combined, could smother Russia's economic growth â&#x20AC;&#x201C; the so-called Dutch disease. So far, economists investigating the situation say that Russia is not yet suffering from the Dutch disease, but time is running out and the CBR needs better tools to manage monetary policy if it is to avoid this problem. In the meantime, a strengthening ruble will suck in more money form speculative investors, which could accelerate the appreciation of the currency's value. "We expect that the generally strong ruble will attract increased (and speculative) capital flows into the country, and that should provide a good base for liquidity to support market activity. But the oil price is again the key," said Alfa. "The ruble is more likely to establish a closer correlation with the price of oil in 2007 than it has in the past. The reason is that starting from January global foreign exchange traders will be able to settle ruble trades via the Euroclear system. The fact that this has not been an option historically is one of the reasons why the global FX market has had relatively little influence on the direction of the ruble." Following the lifting of the last currency controls last year the ruble is a fully convertible currency and can, in theory, be traded by forex deals. Euronext has already set up a system to handle ruble deals; however, by the start of March it had yet to see a single trade.

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Bank sector liquidity As equities are the only asset in Russia that are earning positive real returns, Russian banks are big players in the equity market and consequently the liquidity in the banking sector has a dramatic effect on the performance of the equity market. The interbank market has been hit several times by turmoil in recent years. The mini-banking crisis in 2004 saw the interbank market stall after big banks cut off small banks, fearing a round of closures and collapses, and only recovered slowly in 2005. Then the interbank market was hit by another bout of volatility in the second half of 2006 as a result of the unstable capital flows. Declining oil prices in the third quarter of 2006 stimulated ruble depreciation and hit the ruble liquidity of Russian banks. Total liquidity in banks declined to US$29.3bn in this period from the high of US$36.3bn reported in August 2006. The interesting point is that, despite the liquidity increase as of end-November 2006, the tense liquidity situation on the local interbank market persisted until December and overnight rates did not decline to 4% until 5 December. They remained above this level in January 2007 despite the usual jump in liquidity in the second half of December. These swings in bank liquidity were reflected in the equity market, which suddenly surged at the end of 2006 as the liquidity suddenly increased to set a new all time high of 1,921 on the last day of trading on 29 December 2006. The rise and fall of excess bank reserves are shown in Figure 3.11.

Figure 3.11: Russian banks - excess reserves, 2003 - 07 (RUB bn) RUB bn 1,000

Total excess reserves Total excess reserves, 12month average

900 800 700 600 500 400 300 200 100 0 2003

2004

2005

2006

2007

2008

*defined as balances of bankâ&#x20AC;&#x2122;s NOSTRO accounts at the CBR and time deposits of the CBR Source: CBR, Deutsche Bank research estimates

The tax schedule As Russian banks have few tools with which to manage their liquidity, the tax schedule is clearly reflected in the liquidity of the bank system. Most companies defer tax payments at the end of the year for tax reasons and so liquidity piles up in the banks, which in turn invest this excess cash in equities. The sharp sell-off in the first week of January 2007, where the market lost 15% in the first days of trading, was partly driven by bad news from the US and on the oil markets, but also because of the release of this fiscal overhang that sucked liquidity out of the banking sector. Also, a fall in oil prices usually hits the bank sector about three months later, as it takes this long for the effect of falling prices to work its way through the oil sector production and delivery schedules before cash starts to dry up in the bank sector. At the same time, lower oil prices mean less pressure on the ruble and fewer interventions by the CBR on the forex markets, which also reduces liquidity. The tax schedule, then, is an important driver of the performance of the RTS and is given in Table 3.22.

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Table 3.22: Tax payment calender, 2007 Month January

Date 15

February

22 25 29 15

March

20 26 28 15

April

20 26 28 16

May

20 25 28 7 15

June

21 25 28 15

July

20 25 28 16

August

20 20 25 30 6 15

September

20 27 28 17

October

20 25 28 15

November

December

22 25 29 6 15 20 26 28 17 20

63

Specific tax paid Unified social tax for December 2006 Payments to pension fund for December 2006 VAT for December 2006 and quarterly payments Unified production tax for December Profit tax Unified social tax for January Pension fund payments for January VAT for January Unified production tax for January Profit tax Unified social tax for February Pension fund payments for February VAT for February Unified production tax for February Profit tax Unified social tax for March and 1Q07; final payments for 2006 Pension fund payments for March and 1Q07; final payments for 2006 VAT for March and quarterly payments Unified production tax for March Profit tax Pension fund final payments for 1Q07 Unified social tax for April Pension fund payments for April VAT for April Unified production tax for April Profit tax Unified social tax Pension fund payments VAT for May Unified production tax for May Profit tax Unified social tax Pension fund payments VAT for June and quarterly payments Unified social tax payments for 1H07 Unified production tax for June Profit tax Pension fund final payments for 1H07 Unified social tax Pension fund payments VAT for July Unified production tax for July Profit tax Unified social tax Pension fund payments VAT for August Unified production tax Profit tax Unified social tax for September and 9M07 Pension fund payments VAT for September and quarterly payments Unified production tax Profit tax Pension fund final payments for 9M07 Unified social tax Pension fund payments VAT for October Unified production tax Profit tax Unified social tax Pension fund payments VAT for November

Amount due, RUB bn 20 60 171 90 63 25 60 119 85 63 25 60 130 85 272 30 75 137 85 78 10 30 60 113 80 190 150 80 119 80 190 40 65 138 20 80 190 15 25 65 146 80 242 80 70 149 80 190 45 65 142 85 190 40 40 65 120 85 222 60 65 140


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Table 3.22: Tax payment calender, 2007 (continued) Month December

Date 25 28

Specific tax paid Unified production tax Profit tax

Amount due, RUB bn 90 190

Source: Garant, Russian treasury, Alfa Bank research

Foreign investment in Russian funds For the first five years of the Russian stock market's life, foreign portfolio investors were by far the largest investors. However, following the 1998 financial crisis, Russian investors have played an increasingly important role and today hold about half of the free float of traded shares. This means that Russia remains vulnerable to external shocks and as the Russian market grows in size it is moving ever more in step with other GEMs (see ‘The links between GEMs’ below). A sell-off in one market will cause traders to take profits in other markets to cover losses and so a rout on the Shanghai exchange will cause a sell-off in Moscow. The nature of international portfolio investors has changed in the last three years and, following the hype about emerging markets, several BRIC funds started marketing to retail investors, hoping to catch the wave of rising asset valuations bringing in significant amounts of fresh capital. 2005 was a record year for allocation of new money, with US$20.3bn flowing into GEMs, and between January and May 2006 more than US$30bn came in. Whereas US retail investors typically had 10% of their money invested abroad in 2004, this jumped to 70% by the end of 2005, with a significant proportion going to GEM funds. However, retail investors are quick to withdraw their investments and as the global equity markets sold off hard in May 2006, over the next three months investors pulled out US$16.9bn from GEM funds. Money slowly returned after the first scare passed and GEMs reported a net inflow of US$18bn by the end of 2006; however, the bulk of this net flow is going to China and China regional funds, which so far have taken in US$7.5bn of new money in 2006 according to Emerging Portfolio Fund Research. The rebalancing of the important MSCI index (see section above on index weightings) and especially the inclusion of Gazprom in the index, brought in more new money as traders adjusted their portfolios to reflect Russia's increased importance in the index. However, Aton Capital estimates this rebalancing could be worth as little as US$1–2bn, which is "an important contribution, but hardly a major market driving force for the trillion dollar Russian equity market." While this episode shows that Russia's equity market is now more prominent on international investors' radars, it has yet to cause the kind of enthusiasm that China's equity market enjoyed in 2006 (see Table 3.23).

Table 3.23: Inflows to Russia, GEM and BRIC funds, 2006 – Feb 2007 (US$m) Month Full year 2006 Last month Dec 6 Dec 13 Dec 20 Dec 27 Dec 31 Jan 10 Jan 17 Jan 2007 Feb 2007

Russia & CIS 1,628.1 38.7 64.0 –1.7 6.5 2.9 –26.2 –13.5 22.3 36.5

China* 15,514.2

India 2,708.3

Brazil 2,053.4

470.5 508.4 724.7 438.9 663.2 693.5 60.6 1,641.8 –627.7

–59.0 –121.9 10.5 –4.5 24.7 28.3 –78.4 56.9 20.8

0.0 10.6 24.7 5.8 0.0 24.8 –43.1 34.7 69.2

*China includes both China and Greater China fund categories **Russia as a % of Russia, China, India and Brazil country specific funds Source: Emerging Portfolio Fund Research

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Russia % of BRICC** GEM 7.4 4,469.6 8.6 13.9 –0.2 1.5 0.4 –3.6 – 1.3 –

–843.7 672.2 –23.1 –423.1 468.7 584.9 –81.0 821.7 331.8

BRICC 7,925.1 24.2 12.8 91.6 68.0 371.9 97.0 –29.5 195.3 1.0


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Foreign capital inflows Another source of fresh capital arrives indirectly via the burgeoning foreign investment market. Russia has been a net exporter of capital for almost all of the last decade, but 2006 saw a boom in foreign direct investment (FDI), as shown in Figure 3.12. At the end of January 2007 Russia's Finance Minister, Alexei Kudrin, reported that Russia's net capital inflow soared to US$41.6bn from US$1.1bn in 2005, which was the first year of positive inflows since the fall of the Soviet Union in 1991. In 2007 inflows will moderate, says Kudrin, but the Ministry of Finance is still expecting net inflows of capital to top US$15bn. Moreover, the CBR Governor, Sergei Ignatyev, says there is plenty of room to surprise on the upside as the state is organising at least two big share placements – VTB and Sberbank – that could bring in this amount by themselves.

Figure 3.12: Russian net private capital inflows, 1998 - 3Q2006 (US$bn) 30

By banks By non-banks Total

20 10 0 –10 –20 –30

1998

1999

2000

2001

2002

2003

2004

2005

3Q06

Source: CBR

Domestic consumption Much of the turmoil on the international equity capital markets is being driven by fears of a slowdown of the US economy, but one unanswered question is to what extent consumer consumption in the emerging markets of India, China and Russia will compensate for the possible American recession. While the consensus is that these markets – individually or combined – are not big enough to compensate for an anaemic US, they have become big enough to cushion the blow. To what extent domestic consumption has immunised Russia's stock market against external shocks remains moot. Deutsche Bank's Asian economists argue that, while Asian demand is not yet big enough to outweigh a US recession, it is enough to keep commodity prices in the mid-cycle range. And with over US1trn in hard currency reserves, China's appetite for commodities will continue for the meantime. Russia is in a similar position, with over US$300bn in reserves which will buffer the economy from a slow down in the outside world. Portfolio investors certainly believe that the consumer story offers some protection from a cooling of the global economy. Following the sell-off in May 2006, portfolio investors switched en masse out of traditional commodity stocks and into consumer-oriented stocks in the belief that the consumer spending locomotive has a lot further to run on the back of rising consumer credits. Figure 3.13 shows the most recent stock market trends. Alfa Bank is typical of the banks in that it adjusted its model portfolio to favour more consumeroriented stocks, while maintaining a position in Russia's strongest suits of raw materials. Alfa Bank decreased its weighting of blue chips oil and metal companies in its model portfolio for 2007 from 60% to 50% and increased its weighting of mid-cap companies – mostly consumer-oriented – to 40% from 30%, but it has maintained the small-cap, low-liquidity companies share at 10%.

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Figure 3.13: Russian stock movements, Jan - Feb 2007 (%)

Irkutskenergo (IRGZ) AO MOSENERGO (MSNG) 26.4 Wholesale Generation Company -3 (Republic of Buryatia) (OGKC) 25.3 Severstal (CHMF) 22.1 NMLK (NLMK) 21.3 NORILSK NICKEL (GMKN) 18.8 RAO UES (EESR) 15.7 Polyus Gold (PLZL) 11.8 Mobile TeleSystems (MTSS) 11.4 Baltika Brewery (PKBA) 8.7 Rostelecom (RTKM) 7.6 7.0 Savings bank of the Russian Federation (Sberbank) (SBER) 0.6 RTS Index –1.4 Rosneft (ROSN) –2.2 Sibneft-Omskoilproduct (SIBN) –2.6 Tatneft (Republic of Tatarstan) (TATN) –6.6 Gazprom (GAZP) –8.5 LUKOIL (LKOH) –11.5 Novatek (NVTK) –17.3 Surgutneftegas (Common Stock) (SNGS) –22.3 Surgutneftegas (Preferred Stock) (SNGSP) –30 –20 –10 0 10 20 30 %

49.7

40

50

60

Source: Bloomberg

Domestic investment – the new market driver Oil and consumer spending are well established as economic drivers, but the new vector in the Russian economy this year is domestic fixed investment. Domestic investment was gathering a head of steam in 2003, but the Yukos affair effectively stopped it short as oligarchs cancelled investment programmes while they waited to see if they would hang onto their assets. Now the brouhaha of the crushing of Yukos is almost over, investment is poised to be the factor that allows Russia's economy to surprise on the upside once again.

Investment growth Fixed investment in 2006 was 18% of GDP, against the median 26.5% for the 10 new members of the EU, which is "sufficient for moderate growth but too small to expect successful diversification away from fuels and metals in the near future," according to Renaissance Capital. The World Bank recommends emerging market economies to maintain an investment rate of at least 20% of GDP to sustain growth and of over 25% to facilitate fast growth and diversification. However, investment was accelerating by the end of 2006 and there is a wide consensus among investment banks and government officials that 2007 will see an investment boom. "Investment growth has been volatile in the past, but the current recovery appears more firmly based, reflecting rising public investment, strong private sector balance sheets, easier access to financing from capital inflows and bank credit growth, tightening capacity utilisation and good growth prospects. Growth in 2006 was also supported by government measures such as profit tax depreciation allowance changes, VAT reimbursements and lower import duties. The new law on special economic zones could also provide a fillip", Fitch said in a report in December 2006. Most of Russia's investment banks point to the rapid progress being made by Russian banks and the fact that many of Russia's companies are approaching full capacity utilisation as an indication that the economy will enjoy an investment boom this year that will accelerate growth. UBS said: "In many ways 2007 looks set to be very similar to the past few years... However, in one important sense next year will be somewhat different: 2007 will be the year in which domestic investment was seen to have taken off and, probably, as an extended period when strong, investment-led growth commenced." "What makes us confident of this? Capacity constraints are being hit in all sectors; both domestic and international funds are readily available; asset prices are no longer dirt cheap, so gains must come from growth; and confidence is abundant. We conclude that Russia is on the threshold of a construction and investment boom."

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Having hovered around 14–15% of GDP for the last few years, fixed investment growth rates yearon-year took off in the second half of 2006 to hit about 19% by the end of the year. The growth was even faster in some sectors, such as construction, which saw investment rate growth of 21% towards the end of 2006 on a three-month moving average basis, as can be seen in Figure 3.14. "The impetus for this acceleration comes from the boost to fixed investment. Having taken the backseat to consumption over the last three years, investment leaped strongly in autumn 2006: year-on-year fixed investment growth was above 15% for three consecutive months," says the bank, arguing that Russia is moving into a new investment-driven cycle of growth. "Thus, we expect to see a virtuous cycle of investment and demand growth emerging, which will greatly enhance the quality of Russia's economic growth. The stories most closely tied to the 'new capex cycle' paradigm are rapid financial deepening and domestic energy reform," say the bank's analysts.

Figure 3.14: Fixed investment and stock exchange sector movements, 2004 - 06 (%) % yoy 25

Industrial production Investment Construction

20 15 10 5 0 –5

Jan 04

Jan 05

Jan 06

Source: Rosstat

Investment structure Consumer-oriented companies have caught the headlines as the fast growing and most dynamic sector, but the structure of investment is still biased towards the natural resources sector, which accounted for 45% of total investment growth in the first three quarters of 2006. For manufacturing, year-on-year investment growth was only 6% in the first three quarters, according to Rosstat (see Table 3.24). The economy needs to diversify and a vibrant bank sector is the key to allowing companies to invest, but it is still early days in the diversification odyssey.

Table 3.24: Investment breakdown and growth, by sector, 1Q2006 – 3Q2006 (%) Q106-Q306 Total Natural resource extraction Manufacturing Agriculture Electricity, gas an water supply Construction Retail Transport Communications Real estate State admin and social services Source: state statistics service

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Growth (yoy) 12 29 6 43 1 6 0 15 4 4 15

% total 100 19 18 4 7 4 3 21 5 11 9


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The state entered in 2006 as a major source of investment and is set to play the leading role in 2007 (see below). The reforms to the power sector and the massive US$118bn spending programme announced by United Energy Systems are big set piece state-funded investment projects, but nearly every infrastructural sector – roads, rail, ports, navigation systems, etc – now has a large state investment programme. Many of these are grouped under the title of ‘national programmes’ and funded by the State Investment Fund (see Chapter 1) but the oligarchs have also been roped into the effort and are investing in the same sectors as the state under the Kremlin's public-private partnership scheme. Aton Capital highlights the potential of infrastructure, as the Kremlin turns to dealing with the transport bottlenecks and rebuilding the physical underpinnings of the economy. "We believe the next several years will witness large-scale investments in Russian infrastructure assets, as the country effectively needs to rebuild itself in order to sustain the economic growth of recent years", says Aton.

Sources of investment capital For most of the last decade, retained earnings have been by far the biggest source of investment capital available to growing companies. However, after three years of fast growth the banking sector is playing an increasingly important role, although it is still only stepping off square one (see Table 3.25). Foreign investors have also become a major source of investment capital, providing almost as much as the entire Russian bank sector in 2005 and 2006. And there is still plenty of growing room: Russia has received a cumulative per capita FDI of US$61 between 1989 and 2005, compared to the CEE (Central and Eastern Europe) average of US$2,714, according to the EBRD (European Bank for Reconstruction and Development).

Table 3.25: Sources of investment financing, 2005, 2006 (%) Q1-Q3 (% total) Own funds Loans from enterprises Budget and off-budget funds Bank loans Other o/w foreign financing

2006 45 6 18 9 22 7

2005 48 8 19 7 19 5

Source: state statistics service

Investment pitfalls Investment has been booming, but this is not to say that Russia has become a safe place to invest. Fitch identifies the main dangers for investment as: 0 The state has been increasing its ownership of the economy and creating national champions. Its relatively poor track record in managing companies suggests that rent-seeking could increase while corporate governance, competition, efficiency and output growth could weaken; 0 A draft law has been tabled that would limit foreign investment to 50% of companies’ shares in seven designated ‘strategic’ sectors (natural resources extraction, natural monopolies, weapons, nuclear, space, aerospace and special equipment); 0 The state has shown itself to be aggressive in the pursuit of its goals and liable to skate over the law. The Yukos affair increased the uncertainties of doing business. A more recent example was the pressure from state authorities on the foreign companies owning the Sakhalin II oil and gas project under a production sharing agreement that persuaded them to sell 50% plus one share to Gazprom. The impact on investors’ confidence of the Yukos affair is clearly visible in the investment statistics in 2004 and 2005; 0 Assassinations as a business tool made a reappearance in 2006. The daily slayings of the 1990s had largely disappeared over the last six years. Among those killed were figures from banking, oil, the media and Andrei Kozlov, the first deputy chairman of the CBR, who was trying to crack down on money laundering; 0 Corruption remains pervasive. According to Transparency International’s Corruption Perceptions Index, Russia’s score and rank improved only marginally to 121st (out of 163) in 2006 from 126th (out of 158) in 2005, which is the worst of any investment-grade country.

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State investment programmes Since the fall of the Soviet Union the state has played a relatively small role in investment, as it kept spending as low as possible as part of the campaign to bring down inflation. However, the hardest part of the battle to reduce inflation is almost over and 2007 should mark a watershed as the state begins to spend some of the hundreds of billions of dollars of windfall oil revenues. This money will be pumped into the economy using a variety of means, but the State Investment Fund is the main vehicle, with other investment funds such as the Fund for Future Generations and the state-owned Russian Venture Capital Fund also accounting for significant investment (see Chapter 1) of about US$7bn in 2007. Apart from these organised programmes to support targeted sectors and goals, the two main state investment projects are targetting power and the army.

Power The supply and demand of power are evenly matched and Russia desperately needs to build new generation capacity or face blackouts. The state-owned United Energy Systems (UES) utility operator will spend US$118bn over the next five years to build 41GW of new generating capacity.

Defence After more than a decade of neglect the state has decided to build up its conventional armed forces again, as well as investing into the military-industrial complex. Russia is the second biggest arms exporter after the US and earned a record US$6bn from arms exports in 2006. Altogether, the Kremlin plans to spend a reported US$178bn on equipping the armed forces and investing into arms production over the next five years.

Nuclear In March the government allocated US$38bn to build more nuclear power stations. Russia currently sports nine nuclear plants, but as part of the Kremlin's grand plan to develop its energy resources it plans to build 40 new nuclear power stations over the next 20 years. The first phase of the programme will run to 2015 and includes increasing nuclear power generation by 50â&#x20AC;&#x201C;100%.

Market volatility The Russian stock market is very volatile. The country has yet to develop domestic institutional investors such as pension funds and insurance companies that invest long-term and provide some stability to prices. Domestic banks dominate domestic portfolio investments and their desire to hold equities is a function of the liquidity flows in the banking sector, which is itself volatile. The Russian retail investor has discovered mutual funds, which attracted a record RUB400bn (US$15bn) in 2006. However, few of these investors are putting money away to supplement their pensions and tend to use the funds as a proxy with which to play the market. Leading domestic mutual fund managers say that investors typically invest for six months and redeem their investment if it rises. Russia scored a hat-trick of investment grades from the main ratings agencies in 2005 which have brought in more big international investors with a longer-term perspective, but the number of them and amount they have committed remains limited. Much of the investment remains fairly speculative and the growing number of hedge funds invested in Russia can also destabilise the market in times of turmoil.

The links between GEMs The Russian stock market put in almost five years of uninterrupted growth until May 2006 when fears of interest hikes in the US sent the RTS index down by 25% in a week. The market recovered to finish 2006 up more than 70% but then at the start of March 2007 a sharp 9% sell-off in China sent the markets tanking again: the index fell from its freshly set all-time high of 1,965 on 25 February to just over 1,700 (see Figure 3.15).

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Figure 3.15: RTS index, Jan 2005 - Mar 2007

2,100 1,900

–30%, 25d May 06

1,700

–12%, 5d Feb 07

1,500

–12%, 14d Sep 06

1,300

–11%, 9d Mar 06

1,100 900

–15%, 13d Oct 05

700 500 Jan 05

Jul 05

Jan 06

Jul 06

Jan 07

Source: Bloomberg, UBS

Eric Kraus, the manager of the Nikitsky Fund blames the speculative nature of investment into Russia for driving some of the volatility. "The experience of May 2006 and [previous sell-offs] has taught us that even though fundamentals were first rate, and the risks to the overall story low, technical issues can drag down asset prices in violent ways", says Kraus. "Specifically, the fact that the marginal buyer is often now a hedge fund, and hedge funds with no appetite for performance volatility (for fear of seeing outflows from fund-of-funds/investors unwilling to countenance it), means lots of ‘stop-lossers’ about. With real money accounts often finding less inflows or even outflows when things turn down, and often fully, or close to fully invested before the storm breaks, there are few marginal buyers to meet the loss-stopping sellers. This breeds more selling and more violent price falls. Saying when this will stop from a fundamental perspective is mixing apples and oranges." Both these sell-offs show that the link between the RTS and the GEMs has become more important; during the China-induced sell-off oil rose from US$55/bbl to over US$60 for the first time that year, which shored up the index and cushioned the fall, but did not send the index upwards as fast as it would have done two years earlier. Analysts were quick to dub this link "the butterfly effect" – where a sell-off in one GEM affects all the stock markets of all big emerging markets the same day. The value of Chinese equities is similar to the total in Russia, or just over US$1trn, or less than 3% of the total value of global equities. But what it has done is allowed US economic concerns and the fear of a sudden unwinding of the yen carry trade to take centre stage again. These sell-offs have introduced an element of volatility into the market as it is not clear where the GEM markets, and Russia in particular, will go in the short to medium term. The benign conditions that supported the catch-up of most of Putin's term of office have come to an end, but investors are now asking if domestic growth is strong enough to power through a global economic slowdown, if it comes, or whether a recession in the US would take the edge off high commodity prices and suck the liquidity out of emerging markets which would sell-off as a result. The answer to this question will only be provided over the next year. However, the Russian growth story will continue and the braver investors will attempt to weather this recent bout of nerves that hits the Russian market periodically. Alfa Bank recommends the following sectors as defence plays to park money until the picture becomes clearer.

Sector strengths Electricity Momentum is continuing in industry reforms, and a sizeable part of the equity to be raised will come either from strategic investors or domestic sources. UES is still the best proxy for these changes, but it is also one of the most liquid blue chips and therefore will not buck a major selloff. Moscow City and Moscow United Distribution are the cheapest in P/E terms, while OGK-5 and UES both have good upside based on DCF target price.

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Banks Growth in the domestic economy will mostly be unaffected by any global problems, or at least not in 2007. Sberbank is now in a strong position, having secured almost US$9bn of additional capital at the start of 2007, so it has enough funding to sustain strong growth via lending expansion this year. Sberbank and Vozrozhdenie Bank are the best valued sector plays.

Fixed-line telcos Siberia Telecom, Volga Telecom and Uralsvyazinform are all trading at a cheaper 2007 P/E than the market average. Volga and Siberia also have among the highest upsides to target price. A good hedge strategy would be to go long both Volga and Siberia while shorting the most expensive stock in Alfa Bank’s coverage universe, Rostelecom.

Consumer Because a domestic consumer theme was favoured through most of 2006, the pure consumer stocks, such as food producers and retailers, are now expensive. None have 2007 P/E ratios below the market average, and only Lebedyansky has upside to the 12-month DCF-based target price greater than the market average. X5 Retail Group is the next best with 14% upside.

Sell-off cycles Sell-offs occur regularly in the Russian market and it is no place for the weak of heart. Typically, when a sell-off starts it lasts for a few weeks and the index can drop by as much as a third. However, thanks to the benign conditions of recent years, the market has always recovered over the next 10–20 weeks. This cycle of sell-and-bounce-back has been in place almost unbroken since the start of the market's post-1998 financial recovery (see Table 3.26).

Table 3.26: RTS cycles, 2003 – 06 (%) Start 02/07/03 17/03/07 20/10/03 19/11/04 12/04/04 28/07/04 06/10/04 21/12/04 11/03/05 17/05/05 04/10/05 19/10/05 27/02/06 13/02/06 06/05/06 13/06/06 11/08/06 25/09/06

Finish 17/07/03 20/10/03 19/11/03 12/04/04 28/07/04 08/10/04 20/12/04 10/03/05 15/05/05 04/10/05 19/10/05 27/02/06 10/03/06 06/05/06 13/06/06 11/08/06 25/09/06 30/11/06

Loss (%) –18

Gain (%) 52

–25 63 –34 34 –21 21 –12 64 –16 72 –12 30 –30 34 –12 22

Weeks 2 13 4 21 13 10 10 11 9 19 2 18 2 8 5 8 6 9

Source: DataStream, RTS

Many of the sell-offs in the Russian markets have been provoked by politics, such as the arrest of Yukos owner Mikhail Khodorkovsky, or external shocks such as falling oil prices. However, there is a clearly definable seasonality to the rallies and sell-offs. Typically, the market rallies from the late autumn until just before Easter and then sometime between March and April there is a sharp correction of some 10% or more. Historically, the first two months of the year have accounted for most of the year's returns (see Tables 3.27 and 3.28).

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Table 3.27: RTS rallies, year-end and new year, 2000 – 05 (%) 2000 2001 2002 2003 2004 2005

December, % 1.1 14.8 –0.6 6.9 0.5 6.3

December - mid January, % 20.2 29.1 –4.3 15.2 4.7 26.5

Source: RTS, DataStream

Table 3.28: RTS returns, 1997 – 2007 (%) RTS index 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average ** 2007

Jan-Feb* % 65.5 –22.9 27.9 1.8 17.8 13.6 4.1 15.8 9.6 30.2 – 0.6

Year % 97.9 –85.2 197.4 –18.2 81.5 38.1 58.0 8.3 83.3 70.7 – ?

Jan-Feb as % of full year return 66.9 26.9 14.1 N.M 21.8 35.7 7.1 190.4 11.5 42.7 28.4 –

*2007 data as of February 23, 2007 **Excluding 2000 and 2004 Source: Bloomberg

Seasonal factors None of the investment banks has satisfactorily explained the reason for this behaviour, although it seems likely that as the same phenomena have been noted in other markets in the West it is related to factors such as holidays, and the need to close positions to book profits ahead of quarterly performance checks is the reason. And in Russia the weather and the long holidays exaggerate this phenomenon. The Russian Orthodox Church still celebrates Christmas and New Year according to the Julian and not the Gregorian calendar: Christmas falls on 7 January and New Year on 13 January. Russia has normal working days on 24 and 25 December. Moreover, Easter is a far more important religious festival for Orthodox believers than Christmas, which is a bit of a non-event in Russia, so the impact of the Easter holidays is much larger. The holidays and weather have a profound impact on Russia's work rhythm. Typically, the entire country comes to halt on 31 December as Russians celebrate the ‘New New Year’, and business does not really get going again until the start of February, after the Orthodox ‘Old New Year’. Many Russians choose to leave for a hot holiday in January and very little work happens in the first month of the year. The next big holidays are in May, running from May Day through to 8 May (International Women's Day, Russia's answer to St Valentine's Day), when the country takes another universal break to welcome in spring. Finally, work stops again in July and most of August as Russian schoolchildren are given a threemonth summer holiday to make the most of the warmth and families decamp to the ‘dacha’ or country house that all Russians have. The country starts up again on 1 September, the day all the schools reopen, which is also about the time when the market starts its end-of-year rally.

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Background The local bond market started life as one of many scams designed to dodge the currency control restrictions set up in the wake of the 1998 financial crisis to keep dollars in the country as the CBR strove to rebuild its reserves. Foreign investors found the money they had invested into the domestic sovereign bills, or GKOs, was trapped in special accounts. But once the CBR allowed investors to use this money to buy domestic bonds and then allowed them to sell these bonds and repatriate the profits, foreign investors began to retrieve their trapped cash. “Corporate bonds were a non-market mechanism when they were first introduced in 1999. They were simply a scam designed to allow money trapped on special ‘S’ accounts [at the CBR] after the financial crisis of 1998, to leave the country”, says Dmitri Volkov, MDM’s director of domestic capital markets. “The first real ruble bonds were only issued in the summer of 2000.” Over the last two years the flow of money reversed as these bonds became attractive investments in their own right and Russia’s ruble-denominated corporate bonds grew fast, allowing the country’s fastest growing companies to tap into a pool of otherwise inaccessible liquidity trapped in the fragmented banking sector. Today the bond market continues to grow rapidly in size and liquidity. In 2006, the total amount of Russian issuances topped the US$100bn mark for the first time, with US$74bn outstanding on the domestic market and a daily trading turnover of US$500m by the end of that year. Corporate bonds had grown to 45% of the local market as of December 2006 (see Figure 4.1), and now represent not only the largest but also the most dynamically growing market segment (Figure 4.2). The government was about to issue new local bonds in 2007, supporting the Ministry of Finance's OFZ bonds as a benchmark. Banks, retailers and power sector companies will remain the most active borrowers on the market in the medium term.

Figure 4.1: Russian bonds – sector breakdown, Dec 2006 (%)

Corporate Sub-federal 45%

45%

10% Source: Cbonds

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Figure 4.2: Russian bond growth, by sector, 2003–06 (% CAGR) 90 80 70 60 50 40 30 20 10 0 Corporates

Sub-federal

Federal

Source: Cbonds

In the 1990s Russia financed a whopping 7–8% budget deficit with bonds, the notorious GKO that paid yields of 20% on three months bonds at their nadir. At the same time, external debt was up over 100% until the whole house of cards came down on 17 August 1998 when the government defaulted on its debt.

Economic recovery Devaluation of the ruble at the same time turned out to be a blessing in disguise. The overvalued ruble and the sky-high inflation of the 1990s led to banks speculating against inflation and caused a complete collapse of the payment system. The longer you could held onto cash which was converted into dollars, the bigger the profits. Devaluation put an end to this scam and resulted in the economy being remonetarised, which allowed small and medium-sized enterprises to take off once workers were being paid again in cash. Fortuitously for Putin, oil prices also quickly recovered from their nadir of US$10/bbl and once they passed US$14 in 2000 the budget went into profit, as oil tax revenues were enough to cover the government's expenditure. The financial crisis radically transformed the nature of the Russian economy and started a virtuous circle of spending, investment and growth. Since 2000, Russia has been awash in cash and the state has prudently made the most of the windfall to pay off all its external debt and build up not only its hard currency reserves but also to create the Stabilisation Fund to subsidise the budget should oil prices fall again. By the start of 2007 Russia's external debt (sovereign and corporate) had fallen to under 10% of GDP from a mid-1990s high of about 80% of GDP. Nowhere has this transformation of the health of Russia's public finances been more clearly seen than in the bond market, where the spread between Russia's sovereign Eurobonds and the benchmark US Treasury bills (T-bills) fell consistently until 2006, when it approached zero. The corporate bond market reappeared in 2001 when domestic companies, enjoying the fruits of the start of a consumer boom, started to look for ways to raise money to fuel their ongoing expansion. Since then, bonds have been getting bigger and longer as companies, municipalities and the state build out their yield curves. Russian debt was compared to Mexico, but now South Africa is used as a comparison.

Rating Russia Russia scored a hat-trick of investment grade ratings in 2005. Corporate governance has improved dramatically among those companies that are eyeing the possibility of an eventual IPO or sale to a strategic investor. The problem is that not all companies see the merit of going public and these companies remain as opaque as ever. There are concerns even with the more transparent companies. Natasha Page, head of Fitch Ratings’ Moscow office, says: “The problem is that no matter how much you know about a company in a big group, usually you have no clear of idea of what else is in the group.” The danger is that one of an oligarch’s businesses goes bust and he turns to the other companies in his holdings for cash and brings several unrelated companies down in the process.

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There is already a precedent for this. During the worst of the 2004 mini-banking crisis, one of Russiaâ&#x20AC;&#x2122;s well-known commercial banks started to have liquidity problems after nervous customers began withdrawing their money. The owners injected cash brought in from offshore accounts, but also raided their various retail operations for cash to pump into the bank â&#x20AC;&#x201C; literally emptying the tills in their shops. In its most recent report on corporate governance, Standard & Poor's (S&P) found that in 2006 Russian companies made only modest improvements to their corporate governance: S&P's transparency index rose from 50% in 2005 to 53% last year, which measures the performance of 50 big Russian companies.

Corporate governance issues Once Russian companies wanting to IPO can clear the corporate governance hurdles imposed by international stock exchanges they stop making any more improvements. Still, this is a significant improvement on the opacity of Russian companies in the 1990s. It means that most of the leading Russian blue chips can already boast western standards of corporate transparency. S&P also noted that the most improvement has been with disclosure of ownership. Yukos' owner, Mikhail Khodorkovsky, kicked this trend off in 2002 as the first Russian blue chip to fully declare who owned how much of the company, and saw his share prices soar as a result. Still, there is plenty of room for improvement. The issue in Russia is not the level of transparency, but the number of companies willing to go down the corporate governance path: just under 90% of big Russian companies remain the private property of their owners. Last year 34% revealed their ownership structure compared to 28% in 2005, says S&P, but an equal number of owners are continuing to hide behind opaque company structures. Progress towards better corporate governance is what you would expect to find in the most modern industries, which have high capital needs and produce low margins. In general, the telecoms sector is the most transparent and the engineering sector the least, while the most progress in improving transparency was made in the fast moving consumer goods sectors, such as food and retailers. "In addition to the increased confidence that the YUKOS affair was a one-off case, the drive of Russian companies to meet the informational needs of international investors appears to be the main motive for improvements in ownership disclosure," S&P said in its Transparency and Disclosure report in November. "In many cases, this comes in connection with completed or planned IPOs. While the regulatory requirements associated with listings on international exchanges continue to set standards for disclosure, market-based disclosure incentives play an increasing role. This role is demonstrated by progress among companies that are not exposed to stringent regulatory requirements."

Local ratings agencies There are two main ratings agencies in Russia. Interfax provides lists of bank information and rates banks according to assets, capital etc. However, the only true domestic bank rating agency is RusRatings, which was founded by the former Thomson BankWatch Russian manager, Richard Hainsworth and provides customers with in-depth western style ratings of the leading Russian banks.

Bond market development The development of the bond market over the last five years has been a story of steady growth and diversification. Big banks were the first buyers of bonds in 2001 but over the next few years they were increasingly joined by medium-sized banks attracted by the high yields; banks invested into the bonds which were earning negative real returns, as to leave deposits in cash loses even more money from inflation. However, the diversification process stopped in 2003 when investors became worried by the worsening investment climate. This was the year the Kremlin arrested Yukos shareholder Platon Lebedev and it seemed as if the Kremlin was about to launch a campaign to re-nationalise the oligarchs' assets.

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Things became even more uncertain in 2004 when Russia was hit by a mini-banking crisis following the closure of Sodbiznesbank (see text box below). The state took the opportunity to increase its presence in the banking sector after state-owned VTB received a US$800m loan from the CBR and bought out the portfolios of wobbly smaller banks rather than the CBR issuing stabilisation loans directly to troubled financial institutions. However, most of the other indicators were not affected by these problems. Maturities have continued to lengthen, although they remain short by developed market standards (Figure 4.4). And the number of sectors represented in the bond market continues to increase (Figure 4.5). Energy companies were the first round of borrowers, but as their incomes soared on the back of rising oil prices they have all but disappeared from the bond market to be replaced by companies from sectors such as transport, chemicals and telecoms. At the same time, both the number and size of primary issues and the trading on the secondary market have increased steadily (Figures 4.6 and 4.7).

Figure 4.3: Bond holder distribution, 1999–1H2005 (%) % 100 Largest banks

90 80

Medium and small banks, investment companies

70

Institutional investors

60

Other entities and individuals

50 40 30 20 10 6 m 2005

2004

2003

2002

2001

2000

1999

0

Source: MDM Bank

Figure 4.4: Bond maturities, 2002–1H2005 (%) % 100 <1 year

90 80

1–2 years

70

2–3 years

60

>3 years

50 40 30 20 10

Source: MDM Bank

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2004

2003

2002

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Figure 4.5: Bond distribution, by sector, 1999–2005 (%) % 100 Energy

Telecommuniactions

Other

Construction/mortgage

Metallurgy

Chemical and petrochemical

50

Banks

Motor industry

40

Transportation

Machine building

First tier

Electric power

Food industry

Pulp and paper

90 80 70 60

30 20 10 2005

2004

2003

2002

2001

2000

1999

0

Source: MDM

Figure 4.6: Primary market bond issues and redemptions, 2002–1H2005 (RUBbn) 40 35

Primary market supply, RUB bn

30

Redemption volume, RUB bn

25

Issues placed

20 15 10 5

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul

0 –5

1999

2000

2001

2002

2003

2004

2005

Source: MDM

Figure 4.7: Bond trading on secondary market, 2002–1H2005 (RUBbn)

140

OTC turnover, RUB bn

120

Exchange turnover, RUB bn

100

Number of trasactions (Rhs)

20,000 18,000 16,000 14,000 12,000

80

10,000 60

8,000 6,000

40

4,000

20

2,000

2002 Source: MDM, NDC, CBONDS.INFO

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Apr

Oct

Jan

Jul

Apr

Jan

Oct

Jul

Apr

Oct

Jan

Jul

Apr

Jan

0 2005

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Bond market structure In 2006, a total of 239 bonds were placed and 26 issues of municipal and regional bonds worth a total of RUB540bn (US$20.7bn), which was double the number and value of issuances in 2005. From the issuers’ perspective, the structure of the market has changed little year-on-year. The banking sector made up 38% of the total issuances, trading companies accounted for 14% and energy companies were the third biggest group, with 10% of the total in terms of value. Among the largest corporate borrowers were Vneshtorgbank with RUB15bn, oil major LUKOIL with RUB14bn, the federal network company UES with RUB11bn, state-owned gas giant Gazprom with RUB10bn, and the state-owned Russian Railways with RUB10bn, as well as Gazprombank, the subsidiary bank of the gas monopolist with RUB10bn. Moscow City and the Moscow region retained their leading positions among the municipal bond issuers, borrowing RUB30bn and RUB12bn, respectively. (Moscow City and St Petersburg City are the only two cities in Russia, which are classed as ‘regions’ in terms of the administrative structure of the country.) The number and size of issues has more or less been doubling every year since 2001 and the tide of issues means the Russian fixed income market continues to deepen and become more liquid, with several bonds, such as those from Gazprom, Sberbank and Moscow City acting as effective benchmarks in their respective niches.

Rising turnover in all sectors MICEX, which dominates bond trading, saw the turnover of corporate and municipal securities reach RUB3.71trn and the turnover on the OTC market reach RUB663bn. The value and turnover of sovereign ruble bonds is rising too, with the CBR estimating the face value of all outstanding sovereign bonds to be more than RUB837bn. The government policy of paying down its international debt early has had a profound affect on the domestic ruble bond market. The state paid off US$22.3bn of international debt early in 2006 – payments which are clearly seen in the Stabilisation Fund figures for the year – and resulted in an upgrade to investment grade by all three of the main ratings agencies, which translated into cheaper borrowing across the board and only fuelled the fire of issuances. At the same time, the fixed income market got a fillip from the government's decision to lift the last of the currency controls in 2006 and make the ruble a freely floating currency. More investors followed the ruble into the domestic bond market as currency risk was reduced, attracted by the double gains from high yielding bonds and strong ruble appreciation. According to MICEX, the monthly turnover of non-resident investments into non-government bonds increased from RUB19.6bn at the start of 2005 through RUB52.8bn at the start of 2006 to finish that year at RUB249.4bn. Analysts are not sure if these exponential gains will continue in 2007 and once again point to oil prices as a significant contributing factor determining the direction of the market this year.

Inflation and interest rate challenges With inflation running at over 10% and bond yields in the order of 8% in recent years, Russia's fixed income instruments have been earning negative real returns, which has stymied the development of the debt market. The CBR has been trying to control both inflation and ruble appreciation by interventions on the foreign exchange market, but without a working bond market where bonds earn positive real returns the CBR's interest rate policy is not an effective tool for fine tuning economic growth. The CBR has been moving Russia slowly towards the point where overnight interest rates will have an impact on the market and so give the CBR another badly needed tool of economic management. The point where the overnight rate exceeds inflation and so ‘turns on’ interest rates as a tool of monetary policy is approaching. However, the CBR is going slowly to prevent a sharp squeeze on liquidity and so spark another mini-banking crisis, as in 2004. At the end of January 2007, the CBR took advantage of the successes in the fight with inflation in 2006 to lower the refinancing rate from 11.0% to 10.5% – still more than the average rate of inflation in 2006 – making the real interest rate, adjusted for inflation, 1.522%, according to Troika Dialog.

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As the CBR has set a (realistic) inflation target of 8% for 2007, economists are expecting more rate cuts, with the refinancing rate falling to 10.0% or even 9.5% by the end of the year. It has also been developing a REPO market, which analysts expect to eventually become the cap on interest rates. At the start of 2007, the minimum REPO rate of for overnight refinancing was 6%, against the 8% inflation expected by the end of 2007. "Refinancing operations are still not in great demand, as the interest rate is significantly higher than the rate of REPO operations. However, both rates tend to converge, so we expect the refinancing mechanism to be switched on once this happens. The timing will depend on oil prices; the lower the price, the sooner that domestic economy crediting will become a major driver of ruble liquidity injection," says Evgeny Gavrilenkov, chief economist at Troika Dialog. Most economists agree that the CBR will continue to hike interest rates slowly up from the CBR's 3% overnight rate at the start of 2007, which will serve as the lower boundary for the time being. At the same time, the REPO rates will gradually become the cap to bound the upper limit; at the start of 2007 the CBR held the minimal rate for the REPO rates at 6% for overnight deals and 9% for three months. However, in both cases the changes will be very gradual. In parallel, the CBR introduced a new CBR bond in February that will be used to soak up liquidity; Sberbank is expected to buy most of the issue.

MosPrime In April 2005 the EBRD launched the Moscow Prime Offered Rate, otherwise known as the MosPrime Rate, to create a benchmark interest rate that would underpin the development of more sophisticated capital market transactions such as interest rate swaps by providing a realisable benchmark yield curve that was widely accepted by market participants. The inaugural bond to use the rate was the EBRD’s own RUB5bn, five-year ruble-denominated bond that was issued in May 2005. MosPrime has been a big success. Since the launch of the rate the EBRD has floated a total of three ruble-denominated bonds worth RUB17.5bn that contributed to building out the curve, and MosPrime has become widely adopted by the market as the benchmark. More recently, in February 2007 EBRD launched a RUB2bn 5-year fixed-rate ruble-denominated Eurobond swapped to MosPrime. And in March 2007 juice-maker Lebedyansky issued the first ever RUB1.5bn corporate bond with a coupon linked to MosPrime. The rate has become the defining yield curve for the money-markets time deposits offered by the top tier of Russian banks to their peers. The rate is calculated for a range of periods up to six months and at least six banks contribute to the reference rate tables that go into calculating the rate, which are drawn from the approved banks: ABN AMRO Bank, Citibank, Gazprombank, International Moscow Bank, Raiffeisenbank Austria, Sberbank, VTB and WestLB Vostok Bank. “We created the MosPrime rate to create the curve and allow the development of a three-month floating rate which people can believe in,” says Isabella Laurent, a senior banker at the EBRD who was the architect of the rate. The rate has been particularly popular among mortgage lenders who were previously offering fixed-rate mortgages, denominated in dollars. As the volume of mortgage credits is more than doubling every year and hit a total of US$6bn of outstanding credits by the end of last year, the EBRD had the mortgage lenders in mind when they launched MosPrime. “The bank doesn’t believe that it is healthy for the country if mortgage lenders are lending at a fixed rate in dollars. The volumes are now growing bigger. Next on the list of things to do is improve the payment system and rules that cover collateral are still not clear”, says Laurent.

Challenges to MosPrime development The MosPrime rate was founded on the EBRD’s three bonds. The first two were for RUB5bn, with the most recent floated in May 2006 for RUB7bn. As the EBRD is a triple-A lender, these bonds very effectively define the floor for interest rates and so make an ideal basis from which to calculate interest rate spreads for the rest of the market. However, there is still a lot to do. The legislation covering areas such as interest rate swaps is still a work in progress and despite a lot of discussion over the derivatives laws, these are still not complete. And unfortunately the Kremlin has taken the opportunity to introduce some protectionist measures in the laws. For example, while interest rate swaps are now covered in the newly-

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approved reforms to the legal code covering financial transactions, the law says that it will only recognise deals that involve a Russian bank. A Russian interest rate swap deal that involves only foreign banks is treated by Russian law as a ‘bet’ – even if one of the banks is Russian, but registered offshore. These caveats have already driven some of these deals offshore, where they are covered by UK law. “It is protectionism, driven by a desire to control the market,” says Laurent. “If the laws are too prescriptive then the market will go offshore and some of it already is.”

Lessons from Russia’s first ever corporate bond default Judging the risk and hence the price of Russia's ruble bonds is difficult, as since the 1998 crisis there has been one default on a bond. Sodbiznesbank failed to pay the coupons on its corporate bond in May 2004. However, this was seen as an exception, as the bank was the first ever to have its licences revoked by the CBR on money laundering grounds, which sparked the mini-bank crisis that summer. Bond traders actually welcomed the default, as they were worried by the growing enthusiasm for Russian corporate debt. The failure of Sodbiznesbank to honour its obligations was seen as a timely reminder of the risks associated with bond issues. Prior to Sodbiznesbank's default there had been one technical default, when the corporate issuer simply forgot to pay the coupons. A second technical default was caused after Gazprom took back control of the Sibur petrochemical company, which went into a technical bankruptcy as part of a corporate control battle back in 2000. Sibur had issued two bonds, but Gazprom stepped in and paid them both off, avoiding a default. However, the fears of default should be taken seriously, as Russian companies have been borrowing heavily to finance their expansion in a rising market. Most bonds have a maximum maturity of three years, whereas they are being used to finance investment projects with a typical payback of five to eight years. The issuers are assuming that they can roll over the bonds at least once and so far as yields have fallen continuously this has not been a problem. But the mismatch between the maturities of corporate bonds and the projects they are being used to finance is one of the potential threats to Russia's growth. If there is a nasty external shock that increases yields again, then companies will find that previously profitable investment projects are made unprofitable by the increased cost of borrowing and could lead to a wave of defaults.

Sovereign bonds Flush with money, the state has been paying off its debt early and is not expected to issue new Eurobonds for the next few years. In the 1990s the state borrowed most of the money it needed to fund its deficits from international markets, but the share of foreign borrowing in the state debt portfolio has been falling steadily and is expected to pass parity in 2007, as shown in Figure 4.8.

Figure 4.8: Distribution of state debt, 2004–08E (%) % 100 90 80 70 60 50 40 30 State domestic debt

20

State external debt

10 0 01/01/04 Source: Finance Ministry, Troika Dialog estimates

80

01/01/05

01/01/06

01/01/07E

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Sovereign Eurobonds Russia's sovereign Eurobonds have rapidly gained in creditably over the last eight years, but as the government is unlikely to issue more Eurobonds in 2007 or 2008 the sovereign Eurobond market is on the verge of extinction. Eurobonds were the only instrument that the government did not default on during the 1998 financial crisis, but servicing of the bonds was suspended for five years and in the first years the bonds were traded at a very deep discount. However, since about 2000, the spread between the yields on Russia's Eurobonds and the benchmark US T-bills has rapidly converged as Russia's macroeconomic fortunes have improved. Russia's Eurobonds enjoyed a re-rating in the middle of 2005, as the spread between them and US T-bills fell from about 280bp in the summer of 2004 to 130bp by the end of August 2005, and was in a trading band of between 95bp and 135bp for most of 2006, where it is now expected to stay. The Yukos fracas spooked portfolio investors, but largely passed the bond market by, which was more focused on Russiaâ&#x20AC;&#x2122;s outstanding macroeconomic results and the upgrade to investment grade by the three major ratings agencies at the start of 2005. This episode was a classic example of the mixed picture that is painted for Russia-watchers, as equity investors ran for the hills while bond traders were opening the champagne. Investors into Russia's sovereign bonds were attracted by the double-plus of high yields in an otherwise lacklustre global market and ruble appreciation. Brokers report that the enthusiasm for Russian bonds means that foreigners are diving into the uncharted waters of second and third-tier junk bonds, but even in these risky investments yields are down below 11% â&#x20AC;&#x201C; slightly less than inflation. Although Russia's sovereign Eurobonds are now seen as rock solid investments, thanks to the more than US$300bn the state has in reserves, the government is unlikely to issue any more debt for the time being and has been paying down what debt it has. In 2006, the state paid off most of its debt to the Paris Club of commercial creditors early and further reduced the amount of sovereign debt. With the small and dwindling supply, investors have turned their attention to bonds from the state-owned companies as quasi-sovereign bonds, which have also seen their spreads over US T-bills fall dramatically in the last two years or so.

Figure 4.9: Outstanding federal bonds (OFZ vs GSB, traded vs non-traded), 2006â&#x20AC;&#x201C;08F (US$bn) US$bn 60

US$bn 60

50

50

40

40

30

30

20

20

10

10 0

0 2006

2007 OFZ

2008F GSB

2006

2007 Traded

2008F Non-traded

Source: Minfin, Cbonds, ING estimates

Paris club redemptions Modern Russia started life taking over the debt of the Soviet Union, not just for Russia but all the countries that now make up the CIS. Most of this debt was owed to the so-called Paris Club of commercial debtors and much of it was the non-tradable type of debt. This meant that there was no market mechanism available to clear the debt, which had to be settled through bilateral negotiations.

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With money piling up in the coffers, the reserves in the Stabilisation Fund exceeded Russia's entire external debt of US$75.2bn in the middle of 2006 and the Kremlin made clearing this debt a priority. Once agreement had been reached with the Paris Club, Russia had then to agree terms with each member of the Club in bilateral negotiations. Many countries pointed to Russia's extremely high oil revenues and wanted some kind of premium to the debt principal, while the Kremlin naturally wanted after a pari passu approach, assuming similar conditions for similar deals (the 2005 redemption did not include any premium). A compromise was finally found. The debt was divided into two parts, one with a fixed rate and one with a floating rate. Russia agreed to pay a premium (US$1bn in total) to holders of debt in the first group, thus theoretically compensating these creditors for the lower cash flow of previous years (compared to the floating-rate debt). Germany was the main beneficiary of this solution; the larger creditor in the club (around 42% of the total), Germany received US$700m with the rest being divided between the UK, France and the Netherlands. In the end, all of the Paris Club members took Russia up on the offer, including Switzerland, which had rejected the 2005 deal. On 20 August 2006 Russia's Finance Ministry transferred US$23.7bn to creditors (US$21.3bn for the principal sum, a US$1bn premium and US$1.4bn in regular redemption payments). The early redemption of the Paris Club debt is equivalent to a saving of US$7.7bn in interest payments, most of which will be transferred to the State Investment Fund between 2007 and 2009. At the same time, Russia reached an agreement on the redemption of Soviet-era debt to several non-Paris Club countries (among them Kuwait and Turkey), and the Finance Ministry finished another round of swaps of Soviet-era 'commercial' debt for sovereign Eurobonds. The composition of Russia’s external debt is shown in Table 4.1, and the Paris Club creditors are given in Figure 4.10.

Table 4.1: Russian external debt, 2006-08E (US$bn) Paris Club Non-Paris Club countries Former COMECON “Commercial” debt IFO Eurobonds MinFins Others Total

01/01/06 25.2 3.5 2.1 1.1 5.7 31.5 7.1 0.3 76.5

01/04/06 24.4 3.5 2.0 1.1 5.6 31.2 7.1 0.3 75.2

01/07/06 24.3 2.9 2.0 1.1 5.5 31.2 5.7 0.2 72.9

01/10/06 1.9 2.9 2.0 1.1 5.4 30.9 5.7 0.2 50.1

01/01/07E – 2.7 2.0 0.5 5.4 31.1 5.3 0.2 47.2

Source: Finance Ministry, Troika Dialog estimates

Figure 4.10: Russian Paris Club debt – breakdown by country, Jan 2006 (%) 12%

9%

Italy Japan

43%

US 8%

France Austria

8%

Others Germany

6% 14% Source: Finance Ministry

82

01/01/08E – 2.2 1.7 0.5 5.1 27.8 4.6 0.2 42.1


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Aries bonds Russia's decision to redeem the Paris Club debt early faced one obstacle. In 2004, the German government was facing a budget crisis and, strapped for cash, repackaged some Russia's debt to the Paris Club into so-called Aries bonds. This effectively locked up part of Germany's share of Russia's debt to the Paris Club. The bonds were not very successful. They were issued with a 200bp spread over Russia's sovereign bonds, but this spread disappeared by the second half of 2005 and was negative by 2006. During negotiations in 2005 on redemption of the first part of Russia's Paris Club debt, the German government rejected outright any possibility of the debt locked in Aries bonds being included in the deal, suggesting that Russia would not be able to pay down its Paris Club debt in full. At end-2005, however, Gerhard Schroeder was replaced as chancellor by Angela Merkel, who had not been involved in the Aries deal. The new German authorities were ready to compromise. Counterparties reached an agreement on a premium, the Aries bond was shifted from Russian to German debt and Russia was able to redeem the debt in full.

Spread performance International investors’ decreasing aversion to risk, as low global interest rates made bond investors hungry for returns, looms large over the spread between Russian sovereign and quasisovereign bonds and the benchmark US T-bills. However, while spreads narrowed to under 100bp, Russia’s bonds have preformed less well than the bonds of many of its emerging market peers. As a class, emerging market bonds boasted a positive performance in 2006, with the spread of the EMBI+ (the Emerging Markets Bond Index Plus), the widely accepted proxy for emerging markets as a whole, tightening from 245bp at end 2005 to 198bp by December 2006. Most of the tightening had occurred by early May 2006, though when emerging equity and fixed income markets were both in the spotlight during a global sell-off, the EMBI+ spread was already at an all-time low of 175bp. In the wake of the equity markets sell-off, the emerging market bonds spread increased by over 50bp. Although they did tighten again, they have been range-bound since and have failed to return to pre-sell-off record low levels (see Figure 4.11).

Figure 4.11: EMBI+ spread, 2006 (bp) 260

240

220

200

180 EMBI+ spread, bps 160 Jan 06

Mar 06

May 06

Jul 06

Sep 06

Nov 06

Source: Bloomberg

The tightening of Russia bonds against US T-bills has been driven by the sparkling macroeconomic results, the growing pile of cash in the CBR's coffers and the Kremlin's policy of paying down debt early.

Influences on spread compression Meanwhile, external factors contributing to the tightening of spreads were mainly driven by international investors’ growing appetite for risk (or blatant disregard for risk, depending on your standpoint) and the general growth in credibility of the whole emerging market story. These markets, after half a decade of strong growth, are increasingly becoming ‘emerged’ markets; Russia's hat-trick of investment grade ratings won in 2005 is testament to the improving stability of the market.

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At the same time, unlike equities, the correlation between the performance of Russia's sovereign bonds and oil prices has been low and is getting lower as Russia's macroeconomic health continues to improve (as shown in Figure 4.12). Oil prices would have to fall to under US$38/bbl and stay there for the budget to be affected. Troika Dialog says there was no measurable correlation at all between the spread between Russia's sovereign bonds and oil prices in the last six months of 2006. This means that bond investors at least no longer see Russia as a commodity play.

Figure 4.12: Correlation between sovereign bonds and oil prices, 2000–06 (%) 60 40 20 0 Six-month rolling correlation between weekly changes in Russia’s 30’s spread and weekly returns of Brent price

-20 -40 -60 2000

2001

2002

2003

2004

2005

2006

Source: Bloomberg, Troika Dialog

Despite this progress, Russia's higher grade bonds have underperformed its emerging market peers. The Russia 30 Eurobond spread (which matures in 2030) traded within a relatively narrow range throughout 2006, and barely changed from 115bp at the end of 2005 to 112bp at the end of 2006. Likewise, the spread between the EMBI+ and EMBI+ Russia decreased by 42bp over the course of 2006 to about 83bp by the start of 2007. Russia has been among the laggards in terms of spread performance, ahead of only Indonesia, Egypt, Turkey and South Africa in the EMBI+ universe. In total return terms, the Russia 30 gained only 3.2% in 2006, which is much less than the EMBI+ Index's return of 9.2%, and substantially behind most high-yielding names, such as Brazil (up 15.1% in 11m06).

Russian debt becomes a defensive asset Analysts say that Russia's sovereign debt is now a defensive play, as global markets are unsettled by the changing investment environment. Russian debt fundamentals have positively affected the country's spread and although spread compression was one of the main themes of 2006, investors were still attracted by the country's shining economic fundamentals. Countries that managed to reduce their debt significantly saw their outstanding debt perform better in 2006. While countries such as Russia that have achieved substantial debt reduction did not see their spreads tightening meaningfully during the recovery following the May 2006 sell-off, the positive fundamentals mean that spreads are also unlikely to widen dramatically during a downturn in the market. Troika Dialog analysts support this view, by arguing that Russia's beta, or correlation to international markets, has been falling in recent years, as shown in Figure 4.13. "The beta of weekly changes in the EMBI+ Russia spread on weekly changes in the EMBI+ spread over the past six months [to the end of 2006] was only 0.44, supporting the view that Russia is a defensive asset. Russia's beta rose to 0.85 in February 2006, when emerging markets performed well, but came off during the May-June sell-off of that year and later during range-trading," the bank said in a report. "In the context of emerging markets, Russia looks like one of the main safe havens with its strong and improving debt indicators, defensive characteristics as a recently underperforming debtor and low beta. A potential correction on commodity markets should also have little major effect on Russia's external debt, in our view," say Troika's analysts. "The Russian budget will be in surplus in 2007 even if the price of oil drops to US$37–38/bbl (Urals). Investors seem to be properly factoring this in, as the Russian spread ignored a substantial fall in oil price in the last part of 2006. In fact, there has been no correlation between changes in Russia's sovereign spread and the oil price over the last six months of 2006, which shows that investors are now looking at Russia not only as a commodity proxy. We expect this correlation to remain weak."

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In general, Troika observes that bond funds prefer countries with higher spreads; however, Russia is the exception and funds were overweight in Russian bonds, when compared to its weighting in the emerging market indices, attracted by its solid fundamentals.

Figure 4.13: Russia’s beta, 1Q2004–3Q2006 (bp) 1.2 1.0 0.8 0.6 0.4 Six-month rolling beta of weekly changes in EMBI+ Russia spread on changes in EMBI+ spread, bps

0.2 0.0 1Q04

3Q04

1Q05

3Q05

1Q06

3Q06

Source: Bloomberg, Troika Dialog

Domestic sovereign bonds After the 1998 financial crisis the domestic sovereign bond market became something of a backwater. The state's policy of paying down debt early and the budget surpluses enjoyed by the Ministry of Finance mean the state has issued only enough bonds to keep the market alive, rather than tapping domestic investors as a source of capital. And the Ministry of Finance has all but ceased issuing short-term bonds, which were the staple diet of the market in the 1990s: none were issued in 2006 and the Ministry says it has no plans to issue any in 2007 either. The lack of bond issues is reflected in the secondary market, where liquidity is thin and the turnover in bonds is limited, largely because the biggest buyer on the market is the state pension fund, which tends to hang on to its bonds.

Government debt strategy However, 2005 marked a change of phase, as the Ministry of Finance began to increase the amount of bond issues, not so much as to raise capital, but to develop the bond market as part of its strategy to develop interest rates to the point where the CBR could use the overnight rates as a method of monetary control. The state borrowing in the form of bonds was up by a fifth in 2006 to just over RUB1trn of federal loan bonds issued by the Finance Ministry, the so-called OFZ. These come in a variety of flavours: the OFZ-AD has a sinking fund provision and accounted for 65% of the government's borrowing in 2006; the OFZ-PD has a fixed yield and accounted for 20%; and the OFZ-FK has a fixed coupon rate and made up 9.2%. In addition, the government issued RUB52bn worth of GSO-FPS bonds, a savings bond that made up just over 5% of the total. Over 2006, the government's debt policy aimed at substituting external borrowings with local debt and the development of the local federal bond market. The government ran a budget surplus of over 7% of GDP in 2006 and expects to have a surplus of more than 4% in 2007, so it barely needs to borrow. The government has scheduled the placement of three new bond issues in 2007, maturing in three (OFZ 25061), five (OFZ 26199) and 11 years (OFZ 46021). On the whole, these are expected to further improve the liquidity of OFZ bonds and strengthen their position as a benchmark for ruble bonds. In 2006 the government introduced new securities – GSB (government saving bonds) – in order to provide pension funds with securities to invest in, and thus improve liquidity in, traded sovereign bonds – OFZs.

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In 2006, local sovereign bonds outstanding increased by US$9.5bn, including US$2bn raised via the GSB placement. In 2007, ING expects total bonds outstanding to increase by another US$9.1bn, including US$3.1bn of new GSBs. By the end of 2007, ING says the total amount of traded federal bonds will reach US$39.3bn, up US$6.1bn for the year. This estimate is based on the government's plans to place US$8.5bn of OFZs in 2007 and the redemption schedule of traded bonds as of the start of 2007.

The OFZ market The big bond story of 2005 was the recovery of the domestic sovereign bond market – the OFZ and to a lesser extent the MinFins (Ministry of Finance Bonds) – that has lain moribund since the 1998 financial crisis. OFZs are ruble-denominated bonds issued by the Ministry of Finance with maturities of between one and 30 years, OFZs pay annual, semi-annual or quarterly coupons; coupon payments may be fixed or variable; interest income is not subject to income tax. MinFins are Russian treasury bills, denominated in US dollars and issued on behalf of the Ministry of Finance. The rally took off at the start of August 2005 and sent prices up 6% in two weeks, just as the RTS passed its all-time high. The longest maturity bonds were leading the charge: the yield on the OFZ 46018 bond, which matures in November 2021, saw its face value rise by 5.8% over the first two weeks of August and its yield fell below 8% for the first time in the market’s history. The OFZ had been trading on a par with Gazprom and City of Moscow’s benchmark domestic bonds, which are still in high demand from foreign investors. Gazprom issued its cheapest ever RUB5bn four-year bond in August with a yield of just 6.95%, well below lead manager Renaissance Capital’s expected yield of 7.25–7.36% and about 150bp less than comparable bonds from the likes of the Russian Railways corporation. Russian bond traders say the Gazprom bond was as cheap as an OFZ and driven artificially low by foreign demand. The other major event in this asset class was the issue of the first 30-year OFZ, which fills in the missing box at the long end of the yield curve. The OFZ market has been de facto closed to foreign investors, due to special reserve requirements forcing them to freeze a portion of their ruble assets for 12 months with the CBR, without interest. These restrictions were removed as of 1 July 2006, when the ruble became a fully convertible currency, opening the doors to the OFZ market (as well as to all other financial markets) and reinstating the OFZ as the key benchmark curve on the local market, which was lost in 1998 after the financial crisis. The OFZ are becoming particularly popular among foreign investors and hedge funds, which appreciate their low risk and were switching out of corporate bonds into the state bonds as the rally built up some momentum. Traders said everyone was getting into the game by the middle of the month, including small banks that are not normally players on the bond markets. The rally in the OFZ was due to a change in policy by the Ministry of Finance in 2005. The government issued eight times more domestic debt in 2006 than the US$1.1bn it plans to raise abroad – mainly from the EBRD and World Bank for structural reforms – and is willing to pay a bigger yield premium to bring in the investors.

Domestic bond ownership Foreign investors are thought to hold about half of the domestic bonds outstanding. Numbers are sketchy, however, as most foreign investors have bought via one of the Russian-registered legal entities, so their investment shows up in the statistics as banks, which are the single biggest players on the domestic market with a 60% share (see Figures 4.14 and 4.15). The second largest class is institutional investors, which hold around 36% of total domestic debt securities. This class comprises the State Asset Management Company (Russian acronym: GUK) and insurance companies, mutual funds, non state pension funds and other asset management companies, and has grown significantly over the last two years, increasing its market share. This process has been influencing the market's development and pricing, since institutional investors enjoy essentially free funding and are thus indifferent to the state of the money market and currency exchange rate, and depend mostly on the inflow of funds under their management.

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Figure 4.14: Russian domestic bond ownership, 2006 (%) 15.2%

Asset management companies State asset management companies

27.4%

Investment houses 12.5%

Insurance companies Non-state pension funds Mutual funds

3.1% 3.4% 2.8% 1.7% 1.1%

24.8% 8.1%

Others Russian banks Sberbank Banks registered in Russia, subsidiaries of foreign banks and investment funds

Source: Banks, Central Bank, National League of Asset Managers, NAUFOR, Interfax, Troika Dialog estimates

Figure 4.15: Bank shares of bond issuance, by segment, 2006 (%) % 40

30

20

Sovereign bonds

10

Regional bonds Corporate bonds

0 Russian banks Note: Sovereign bonds include OBRs Source: Companies, Central Bank, Interfax, Traoika Dialog estimates

Sberbank

Banks registered in Russia, subsidiaries of foreign banks and investment funds

Corporate ruble bonds In April 2000, a string of big Russian companies, led by diamond producer Alrosa, began to issue the first post-crisis ruble bonds. Both the number of issues and issuers ballooned rapidly, but the first bonds were more of a dodge to release money trapped in special accounts at the CBR following the government's default on its debt in 1998 rather than an investment. However, the market quickly became real and the first round of corporate bonds, issued by the obvious blue chip companies, was soon followed by second and third-tier companies. The breakdown of the top issuers in 2006 is indicative of the changing shape of the Russian economy. While the state-owned companies still dominate â&#x20AC;&#x201C; with railways, Russia's second largest and state-owned bank, VTB, and Gazprom being the three biggest single issuers of bonds â&#x20AC;&#x201C; the presence of Rosbank (RSB), the leading retail bank from the non-state banks, and the state-owned refinancing agency AIZhK in the fifth and sixth slots highlight the growing importance of the consumer in the economy (see Figure 4.16).

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Figure 4.16: Top corporate borrowers, 2006 (US$bn) 2.0

1.5

1.0

0.5

0.0 RZD (transport)

VTB (Banks)

Gazprom (oli & gas)

FSK (utilities)

RSB (banks)

AlZhK (financials)

Source: Cbonds

The corporate ruble bond market is the fastest growing of all the borrowing forms on offer and is a function of the growing cash pile in Russiaâ&#x20AC;&#x2122;s otherwise fragmented banking system (see Figure 4.17). Companies are also paying greater attention to the domestic securities market, because the ruble's appreciation has forced many of them to switch their exposure to local currency to avoid a currency mismatch, which is very important for those that focus on retail. For example, this is one reason why retail chains favour ruble bonds to Eurobonds for public borrowings.

Figure 4.17: Bond deals, 2001â&#x20AC;&#x201C;Nov 2006 No. of deals 250

200

150

100 In Eurobonds 50

In CLNs In ruble bonds

0 2001

2002

2003

2004

2005

11m 06

Source: Troika Dialog

Figure 4.18: Bond market breakdown, by sector, 2006 (%) 3%

2% 2%

5%

29%

5% 6%

7%

9% 8%

88

Transport

Trade

Food

Oil & gas

Construction

Electricity & utilities

Chemicals

Telecoms

Agriculture

Machinery

Other

Metals & mining 8%

8% Source: Cbonds

Banks and financials

8%


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Market development Russia's corporate domestic bond market took off in 2001 and doubled in size nearly every year both in terms of size of bond issued and the volume of total bonds issued. Both the number and volumes of bonds issued in 2006 doubled. A total of 290 corporate and municipal bonds were issued over the course of the year with a total value of RUB543bn (US$20.9bn), according to agency CBonds. A sector breakdown is given in Figure 4.18. The domestic ruble-denominated bond market remains an attractive form of financing for most companies and a convenient way to tap into the growing pool of liquidity in the otherwise fragmented banking sector. The driving force of the market remains companies' huge demand for investment capital. By the end of December 2006, total corporate bonds outstanding hit US$34.3bn, and exceeded the outstanding volume of federal bonds (US$33.3bn) for the first time. Banks have become the biggest issuers and Gazprombank was the most active in 2006, tripling the number of domestic bonds it issued year-on-year. VTB was next, raising RUB52bn (US$2bn). Rosbank was Russia's most active commercial bank on the domestic fixed income market, with RUB40bn (US$1.5bn) of issues in 2006, putting it in third place overall. The 10 largest bonds accounted for a quarter of the total issues. Banks account for 29% of the total outstanding bonds as of the start of 2007 â&#x20AC;&#x201C; three times more than any other single sector. The rapid growth of retail lending and the growing bank loan portfolios will continue to feed demand for bonds for the foreseeable future. Corporate bond issuance is not expected to slow. The total volume of major corporate bond placements due in 2007 was estimated at US$8bn at the start of the year and it is likely to increase through the year. The largest bond supply is expected to come from banks (US$3.1bn), retailers (US$1.6bn) and the power sector (US$1.3bn). Even as the established companies become more leveraged, or tap other sources of financing, such as IPOs or syndicated loans, there is a never-ending stream of fresh issuers as the mediumsize companies increasingly come to market to raise money. And in 2007 there will be huge demand from the power sector, as the privatisation of state-owned utilities company UES moves into full swing. UES says that it needs to spend US$118bn by 2010 on building new generating capacity and upgrading existing infrastructure, a substantial proportion of which will be financed by debt, including bond issues. In 2006 the first in this wave of powerbonds were issued by the generating companies OGK-5, OGK-3, HydroOGK, and MOESK.

Secondary market trading The trading on the secondary market is growing as both the liquidity and depth of the market increases. As of the start of 2007 the total trading volume on the local market is US$500m per day, with corporate bonds accounting for 80% of turnover. In 2006, the average trading volume of corporate papers doubled to US$400m and is likely to grow further, along with the growing number of good quality and large issues. As a share of total debt outstanding, the monthly average turnover of local debt remains around 15%, which means that over a one-year period local bonds have changed hands roughly twice (compared to three to five times for municipal bonds). This sort of ratio is generally evidence that trade intensity is growing at the same pace as the volume of the market. At the same time, the relatively low liquidity of federal bonds in comparison to their total debt outstanding is a result of pension funds' significant long positions in sovereign papers. Foreign hedge funds own about half the debt, as the yields plus ruble appreciation are attractive. However, this means the market is volatile as ruble appreciation will slow if oil prices fall.

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Currency liberalisation After the 1998 financial crisis, the CBR imposed a strict regime of currency controls as it tried to rebuild its reserves. Exporters were forced to sell the majority of their repatriated dollar earnings, while foreign investors unfortunate enough to be holding Russian debt at the time of the default saw their money frozen in special Saccounts which they could not touch. Over the next eight years these controls have gradually been lifted as the CBR's hard currency reserves were quickly replenished by soaring oil prices. The process was completed on 1 July 2006, when the last of the currency controls was lifted and the ruble became a fully convertible currency – six months earlier than originally planned. The current ‘Law on Currency Regulation and Control’ empowers the monetary authorities to regulate the flow of capital by ordering a freeze on part of sums entering or leaving Russia, and the CBR has made wide use of these powers since 2004. Liberalisation of the currency market will, in the long term, affect many areas of the Russian economy. Its greatest effect, though, will be on the ruble debt market, particularly state debt. Following the financial crisis of 1998, the monetary authorities assumed tight controls on capital entering the fixed income market. If the corporate debt market is now fairly free from constraints, the sovereign debt market has, until very recently, been very heavily regulated. Between 1999 and 2004, non-residents were barred from investing new funds in OFZs. The introduction of S-accounts provided access again to this market, but part of any funds invested has still had to lie in reserve with the CBR for 12 months without any interest accruing. The proportion was initially set at 20% of the total investment (3% for investments in corporate and municipal paper). In 2005 the rate was reduced to 15%, and then 7.5% (for non-state debt, it was reduced to 2% and then 1%). Foreign investors are still very wary of Russia's financial markets. Many ruled out entirely the possibility of investing in OFZs, while the reservation system was still in force. Since the abolition of all restrictions on 1 July 2006, foreign investors' attention has thus naturally drifted towards sovereign debt. Foreign capital made up around 12–14% of the corporate and municipal debt markets by the start of 2007, and around 5% of the OFZ market, even accounting for investment by foreign bank subsidiaries registered in Russia, which will likely be the main source of interest in the next few years. The balance has also been tipped towards state debt over the previous benchmark, the City of Moscow bonds, after the capital reduced the number of its primary placements in 2005 since the city budget was in surplus. This was the case, too, in 2006 and Moscow began to actively buy back short-term paper in both 2005 and 2006. Although volumes of this debt did grow, the rate of growth lagged far behind market demand. Hence, many turned their gaze back to OFZs, the natural base market which had lost its benchmark status after the 1998 crisis.

Corporate Eurobonds Gazprombank was the first to issue a Eurobond after the 1998 crisis, but other Russian blue chips were quick to follow. The Eurobond market is almost double that of local bonds outstanding, with more than 90% denominated in US dollars, and also provides access to a much wider and more diversified investor base. At the same time, the amount of corporate Eurobonds exceeded outstanding sovereign issues for the first time in 2006, largely driven by the insatiable appetite for capital of the Russian financial sector issuers (see Figure 4.19). In all, Russian corporate issuers raised about US$25bn in Eurobonds and credit-linked notes (CLNs) on the international markets in 2006.

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Figure 4.19: Russian Eurobond market 2001â&#x20AC;&#x201C;07E (US$bn) US$bn 80

60

40

20

Outstanding amount of Sovereign Eurobonds Outstanding amount of non-government Eurobonds

0 2001

2002

2003

2004

2005

1H06

2H06E

2007E

Source: Troika Dialog

This rapid growth has already made Russia the second largest issuer of international corporate bonds in the emerging market universe, second only to South Korea, as shown in Table 4.2.

Table 4.2: Emerging markets international bond issuance, 2001â&#x20AC;&#x201C;2Q2006 (US$bn) South Korea Russia Mexico Brazil Malaysia

Dec 01 19.4 0.5 21.1 12.5 9.9

Dec 02 20.0 3.5 17.9 10.6 9.6

Dec 03 20.3 9.5 16.4 13.7 8.2

Dec 04 22.5 15.1 14.6 10.7 7.3

Dec 05 25.4 22.5 18.4 10.8 6.4

Jun 06 26.3 25.3 18.2 12.7 6.2

Source: BIS, Troika Dialog

Gazprom remains the biggest issuer of international debt securities. Even without its subsidiaries, Gazprom Neft (former Sibneft) and Gazprombank, bonds issued by the corporation make up 14% of the market. The biggest issuer among the banks was also a quasi-sovereign state-owned bank, VTB (formerly Vneshtorgbank), with a market share of 8% (see Figure 4.20).

Figure 4.20: Russian corporate bond issuers, Nov 2006 (%) 6% 38% 8% Sovereigns and MinFins Non-quasi-Sovereign Other quasi-Sovereign

13%

VTB (incl. Mosnarbank) Gazprom

27% Source: Troika Dialog

In all, the share of quasi-sovereign Eurobonds (excluding CLNs) make up about 60% of all corporate Eurobond issues as of the end of 2006, a ratio that has remained remarkably stable in the last few years. In 2007, refinancing needs will increase for corporate Eurobond issuers. Russian issuers redeemed US$3.7bn of debt securities in 2006 and are expected to redeem US$7.7bn in 2007 and US$8.8bn in 2008, the bulk of which is expected to be refinanced with new issues.

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Bank borrowing of Eurobonds Banks have been among the most active issuers of bonds as they raise capital to channel into the growing loan portfolio. Many of the biggest banks have been turning to the international capital markets, where the resources have longer maturities at lower prices than is available on the domestic market. Banks borrowed US$25bn of Eurobonds and CLNs in 2006 – a record. A breakdown of Eurobond and CLN distribution is given in Figure 4.21. The state banks dominate the banking sector and have the most resources available. The government has regularly called on the leading state-owned banks to support politically motivated projects with credits.

Figure 4.21: Eurobond and CLN distribution, by type, Nov 2006 (%) 2%

5%

3%

4%

44%

Corporate Eurobonds Banking Eurobonds ABSs Banking CLNs

42%

Corporate CLNs Ruble Eurobonds

Source: Troika Dialog

In Russia, the maximum credit exposure allowed by law to one borrower is 25% of the bank's equity. While the CBR could theoretically waive breaches of this regulation (and has done so in the past), such a waiver would be politically difficult to maintain for long, as it would lead to disputes centred on the Eurobond covenants of the leading state-owned banks' Eurobonds. Given the equity of the largest 10 state-owned banks, they could lend up to US$2.5bn to one borrower, based on aggregate Russian Accounting Standards equity as of the end of the first half of 2006 (see Table 4.3). While the amount of short-term funding that Russian state-owned banks can attract is virtually unlimited, the sources of long-term funding are restricted to selling liquid assets and borrowing from international banks and on international capital markets. Renaissance Capital estimates the maximum that state banks can borrow is US$3–4bn within a timeframe of two to three months.

Table 4.3: State-owned banks – lending capacity, 1H2006 (US$m)

VTB VTB-Retail Sberbank Gazprombank Evrofinance-Mosnarbank Bank of Moscow Russian Development Bank Rosselkhozbank Promstroibank VEB* Aggregate

Equity 1H06, RAS, US$m 2,811 505 1,129 2,115 243 1,103 229 568 640 826 10,171

Maximum exposure to one borrower 703 126 282 529 61 276 57 142 160 207 2,543

*VEB - FY05 IA5 data. VEB has a special legal status, does not possess a banking licence, and is thus not subject to CBR regulations. We make an assumption, however, that it would not lend substantially more than 25% of its 1A5 equity to one borrower. Source: Bank data, Renaissance Capital estimates

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The rise of bank Eurobonds The first bond of any kind to be issued post-crisis was by Moscow City. The first commercial bond to be issued post-crisis was from Rosneft in November 2001, which was a US$150m five-year bond with a coupon rate of 12.75%. This was followed by Gazprombank in December 2001, with a US$200m two-year bond at 9.75%. Gazprombank took another gamble and broke the ice again in 2004, uncertain of how international capital markets would receive a Russian Eurobond. But its four-year US$300m Eurobond – technically a reopening of its US$750m Eurobond offer from October 2003 – was one-and-a-half times oversubscribed, with a low yield of 7.25%. As many investors see Gazprom as little more than the ‘Ministry of Gas’, the company’s bank enjoys a sound standing with investors but it also boosted the confidence of other banks and companies. Russia-watchers were following the issue closely, afraid that the Kremlin’s political bludgeoning of one-time portfolio investors’ darling oil company Yukos had permanently dented Russia’s investment climate. Despite the arrest of Yukos owner Mikhail Khodorkovsky, the enthusiasm for Gazprombank’s bond showed investors were taking President Putin at his word and saw the whole fracas as a oneoff political fight, rather than the beginning of the end of liberal reform. Alfa Bank was the first of the commercial banks to issue a Eurobond in November 2002, a threeyear US$175m bond with a 10.75% yield. Alfa’s issue was shortly followed by MDM’s three-year US$125m bond, also at 10.75%. With yields over 10%, Eurobonds are not a very effective source of capital for Russian banks, which last year could raise funds more cheaply from foreign trade credit agencies or on the domestic market. But all the banks were interested in building up a credit history and bringing down the cost of borrowing in anticipation of Russia's strong economic growth and a rising demand for cheaper, longer-term money. Even retail giant Sberbank could not resist and, having ignored the bond market for most of the last decade, placed a three-year US$1bn Eurobond at Libor plus 1.75% – by far the largest and cheapest Russian bank Eurobond ever issued. By 2005, most of the leading 20 banks had issued Eurobonds, which have now become a major source of financing for consumer-oriented banks such as Russian Standard (Russky Standart) and Rosbank, both of which have large retail portfolios.

Municipal and other bonds Russian regions were banned from selling bonds after the 1998 crisis unless they paid off previous ones. Moscow City has become a monster in this business (as it was during the final days of Imperia Russia) and is the de facto benchmark. In 2006, the sub-federal sector of the local bond market saw its lowest growth in the last four years. The total volume of traded bonds increased US$1.06bn in 2006, compared with US$1.16bn in 2005 and more than US$1.5bn in the prior two years. The slowdown was due to the falling appetite for debt by the Moscow City government, which has been the biggest issuer of debt in recent years and accounted for 37% of the whole sub-federal bond market as of the start of 2007. Like the federal government, the city is flush with cash as it achieved a strong budget surplus and good liquidity in 2006. Hanging on the wall of the Moscow City Debt Committee offices is the bond certificate from the city’s first ever international offering. In 1908, the city fathers raised £188,956 in London with a 5% note, to pay for a new tram system, improvements to the city’s water supply and money to build 10 new schools. Just under 100 years later, the city government issued another bond, this time Russia’s biggest and longest regional note, for much the same purposes. Moscow City bonds are by far the strongest and most liquid of Russia’s regional bonds and with over 50 issues under its belt since 1992 its fixed income paper has established such a strong reputation that its notes have become a benchmark for other regional issues.

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Broadening the borrowing base The 1998 crisis briefly interrupted the flow of bonds, but the city returned to the market cap in hand in 2000 and concentrated on rebuilding its reputation, and the city's bonds enjoy the same rating as sovereign bonds. More than 30 regions have been given permission by the Ministry of Finance to issue bonds, but only a dozen have issued paper; Moscow alone accounts for more than half the outstanding volume of regional bonds. Having built up a lot of experience, the city organises much of its own issue and does not bring in banks as underwriters, instead relying on an informal â&#x20AC;&#x2DC;underwriters clubâ&#x20AC;&#x2122; of bankers which has grown from four members in 2000 to 23 today. The City of Moscow does not plan any further bond placements in 2007 as the budget surplus is expected to continue. This deprives the sub-sovereign market of its benchmark bond and will also reduce the liquidity of this section of the market. In the meantime, Moscow is trying to support interest in its bonds, proposing to exchange shortterm issues with low liquidity (Series 31, 42, 40, 43, 29, 36) for more liquid bonds with longer durations (Series 47, 38, 39, 44). However, as the Russian growth story is increasingly moving into the regions, analysts are expecting other regions to step up to the plate and borrow on the sub-federal market, going part of the way to replacing Moscow City in the market. During 2006, many of the key rated sub-federal issuers received credit rating upgrades and are expected to take advantage of the falling cost of capital this implies for their bond issues. Among the key regions to receive upgrades were: Bashkortostan, Irkutsk region, Krasnoyarsky Krai, Komi Republic, St. Petersburg, Sverdlovsk region, Tatarstan, HMAO, and YANAO. Others were assigned ratings for the first time and will form a second wave of bond issues in the medium term, including: Karelia, Kirov region, Nizhniy Novgorod region, and Ryazan region.

Other debt instruments As the sovereign and corporate bond markets develop, Russian banks are beginning to roll out more sophisticated products to take better advantage of the growing demand for debt.

Credit-linked notes Russia has over 30,000 registered legal entities, but the problem with the Eurobond market, and to a lesser extent the domestic corporate bond market, is that it is accessible to a relatively small universe of larger companies. In about 2005 the first CLNs appeared â&#x20AC;&#x201C; short-term, high-yielding paper that was sold as a speculative investment to high net worth individuals in the first pass at the market. Many companies are using CLNs to provide short-term financing for expansion or as working capital, but they are also seen as a short cut to building up a credit reputation that will make issuing corporate rubles easier and cheaper to organise.

Veksels The so-called veksel promissory notes are still actively traded on the secondary debt market, but the volumes are shrinking as companies move over to more recognisable bonds. Veksels are unregulated promissory notes (from the German word wechsel, or trade) that were heavily used by companies in the 1990s, as everyone was strapped for cash. The absence of a functioning payment or settlement system meant most of the economic activity was done in terms of barter or by using promissory notes in what academics Barry Ickes and Clifford Gaddy dubbed the "virtual economy." Gazprom's veksels were the gold standard in this market and made up about one-third of the veksels in circulation as companies actively bought and sold these notes to cover their obligations. However, veksels are now a dying breed after Gazprom decided to stop offering the notes in 2004 as part of reorganising its debt and moving from short to long-term financing.

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In 2003, veksels accounted for just under half of all the outstanding corporate debt instruments on the domestic market, while corporate bonds made up only 16% of the total. By the end of 2006, the share held by veksels had fallen to nearly nothing while corporate bonds made up 45% of the total outstanding bonds. Despite the decline in the use of the veksel they remain popular with smaller and regional companies. As these notes are unregulated they are simple and cheap to issue. Also, as veksels have been in use since Soviet times, managers are very familiar with their use and the market infrastructure to support them is well developed. Issuing corporate bonds, by comparison, is expensive and bureaucratic but carries less risk. There is still a market in veksels, which tend to carry higher yields because of the risks involved and can be very profitable. The Denholm Hall Group estimates that there was US$15bn worth of veksels outstanding as of the end of 2006. This is a niche market but it made the notes one of Russia's top performing investment vehicles in 2005. As veksels are all traded over the counter in rubles they offer investors exposure to fast growing small and medium-sized enterprises that is hard to get otherwise.

Asset-backed securities and mortgages Owning a comfortable apartment is close to most Russians' hearts after the nightmare of finding accommodation in Soviet Russia, and most Russians are still living in their Soviet-allocated apartments that were gifted to the population in the 1990s as part of the first round of privatisation. IMS, a leading Russian market research company, estimates that over two-thirds of Russians are unhappy with their current housing and want to move.

Table 4.4: Current Russian ABS issues (US$m) Gazprom 20 Rosbank 09 Soyuz Bank 10 HCFB 12 Russian Standard 12 Alfa Bank 11 Red Arrow 12 VTB 34 City Morgage Bank 33 MDM Bank 13

Date of issue 23/07/04 02/02/05 27/07/05 09/12/05 27/03/06 28/03/06 30/03/06 05/07/06 10/08/06 17/10/06

Amount issued, (US$m) 1,250 300 50 150 380 350 507 88 73 430

Maturity 01/02/20 24/09/09 10/08/10 10/05/12 12/01/12 15/03/11 30/06/12 18/05/34 15/09/33 23/10/13

Securitisation Gas supply contracts Card payment claims Auto loans Consumer loans Consumer loans Diversified payment rights Lease receivables Mortgage loans Mortgage loans Auto loans

Source: Troika Dialog

Mortgage lending first appeared around 2001, but really only took off in about 2003. The average length of a mortgage credit is 15â&#x20AC;&#x201C;25 years and interest rates were about 11% at the start of 2007. According to a survey by the Russian business magazine Profil at the end of 2006, the average mortgage is repaid in five years, so 8â&#x20AC;&#x201C;10% of the banks' total mortgage portfolio is redeemed early every year. The introduction of the laws to underpin asset-backed securities (ABS) will cause the biggest change in the domestic capital market in the next few years as it opens up the mortgage business. ABS volumes grew from US$1.8m at end-2005 to US$3.9bn at end-November 2006 (including the Gazprom 20, which is not a classic securitisation) and ABS comprised 7% of the total nongovernment Eurobond market as of the end of 2006. Of the US$2.1bn worth of ABS issue in 2006, US$1.6bn was issued by banks. However, the single biggest issue was made by Russian Railways via an SPV named Red Arrow (the name of the express train that runs from Moscow to St Petersburg, see also text box below) which issued RUB13.73bn (US$526m) of ruble-denominated ABS, backed by the lease receivables of the Russian Railways. This was the first public securitisation of lease payments in Russia, and arguably the most interesting deal on the Russian ABS market in 2006. Details of current ABS issues can be seen in Table 4.4.

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Table 4.5: Russian retail banking structure, 2004–1H2006 (US$bn) US$bn Mortgage Auto loans Consumer finance Credit cards Personal loans Total retail loans

2004 0.9 2.5 1.8 0.5 16.3 22.0

2005 3.0 4.5 3.0 1.0 29.5 41.0

1H2006 6.2 6.0 4.5 4.0 35.0 55.7

Source: RBC rating, Company reports, Alfa bank estimates

Mortgages have been growing exponentially since the pioneer Delta Credit Bank introduced the first a few years ago, but lending really picked up momentum in 2005 and has been doubling every year since. The market tripled in 2006 to reach a total of US$12.4bn, or about 1.3% of GDP, up from US$4bn at the end of 2005, and is expected to at least double again in 2007. Mortgage growth was around US$2.5bn in the first half of 2006, accelerating remarkably in the second half to end the year at US$6bn. Alfa Bank says that this accelerated growth was due to a palpable slowdown in real estate prices in the fourth quarter of 2006, after spiking by nearly 50% in the first half of the year. Housing prices have been increasing very fast in recent years and put on another 70% in 2006 alone; however, real estate experts say they believe the market is nearing its top and expect the rate of increase of prices to slow in 2007. Although Sberbank remains the largest player with a US$5.8bn loan portfolio, its market share dropped significantly from 63% in 2005 to 47% in 2006. In 2006, growth was increasingly fuelled by outsiders, such as Moskommertsbank and KIT Finance, both of which are now in the top five lenders, with respective portfolios of US$599m and US$409m. Russia's state-owned bank, VTB, the second-largest bank in the country, is leading the growth after its mortgage portfolio increased by 270% in 2006 to reach US$875m by the end of 2006 (see Tables 4.6 and 4.7).

Table 4.6: Mortgage loan market, 2005–06 (US$m, %) Bank Sberbank VTB Moskommertsbank DeltaCredit KIT Finance UralSib Gazprombank Raiffeisen

Mortgage portfolio, 2005 2,487 229 2 183 9 90 79 160

Market share 2005 (%) 63 5.8 0.1 4.6 0.2 2.3 2.0 4.0

Mortgage portfolio, 1H06 3,717 334 107 275 83 187 n.a. 186

Market share Mortgage 1H06 (%) portfolio, 2006 57.2 5,841 5.1 931 1.6 599 4.2 421 1.3 409 2.9 395 n.a. 306 2.9 268

Market share 2006 (%) 47.0 7.5 4.8 3.4 3.3 3.2 2.5 2.2

Source: RBC, CBR, Alfa Bank Research

Table 4.7: Mortgage market leaders, 1H2006 (US$m, %)

Sberbank VTB Group DeltaCredit UralSib Raiffeisen Absolut bank Zapsibcombank Banque Société Genéralé Vostok

Portfolio as of 01/07/06 3,717 334 275 187 186 134 134 117

Portfolio as of 01/01/06 2,487 119 190 90 159 46.3 n.a. 70.7

Average loan size 22,700 99,600 n.a. 29,800 112,900 79,700 36,300 107,300

Market share % 60 5 4 3 3 2 2 2

1H06 TD growth (%) 49 181 45 108 17 189 n.a. 65

Source: RBC-rating, Company reports, Alfa Bank estimates

The growth of mortgages is partly due to the Kremlin's policy of promoting home ownership, which hopes to repeat the US experience where they acted as a sort of social cement; the idea is that if people own their own homes and have to meet payments, they tend to have more stable lifestyles.

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There are three primary types of operator in the emerging lending market: Universal Commercial Banks, the Federal Housing Lending Agency and regional agencies. Banks have been increasing their portfolio but until the final approval of an ABS law in 2006 lending was constrained by the banks’ limited capital. Since the end of 2006, it is possible to package and sell mortgages (on the domestic market) in a security that allows banks to refinance their borrowing and so offer new deals.

Obstacles to expansion What is still missing is the establishment and operational reliability of a central credit bureau and a risk insurance system. Another major drawback of the current system is the relatively low level of income within large parts of the population. Russia does not have a specific securitisation law for cross-border transactions. Federal Law No.152-FZ, On Asset-Backed Securities, expressly provides for the true sale of assets and the issue of ABS, but only to a domestic special purpose vehicle (SPV). An offshore SPV does not benefit from the provisions of the legislation. Any securitisation under Russian law must therefore rely on the general provisions of Russian Federal law to carry out a true sale. The transaction can only proceed once legal opinions are able to confirm that the essential components of a true sale have been achieved under the transaction documents. There is, however, some degree of uncertainty as to the grounds on which such an assignment may be challenged. For example, it is not clear at this stage of the development of the legal framework, whether any potential challenge on grounds of an ‘undervalue’ could be launched (primarily due to a lack of analogous transactions). In addition, there is some debate regarding the precise character and application of the relevant rules and principles, as none of these rules have been tested.

Russia Railways' Red Arrow SPV Under the Red Arrow deal, SPV Red Arrow bought rolling stock and leasing agreements from three companies that provided leases to Russian Railways, and funded the purchase by issuing Red Arrow bonds. The papers were securitised by the underlying rolling stock and lease payments. However, the recourse to the underlying rolling stock was given little importance by the rating agencies in assessing the bonds' credit quality, as there could be legal difficulties in enforcing the claims if Russian Railways were to default, partly because there is no legislative precedent for the securitisation of leases in Russia. So the credit quality was determined primarily by Russian Railways' ability to service the payments on the lease contracts and Red Arrow's paper is rated at the same level as Russian Railways' bonds. Like most ABS, Red Arrow bonds are divided into three tranches, with one senior tranche (class A) and two junior tranches (class B, which is subordinate to class A, and class C, which is subordinate to both). The outstanding amounts are RUB12.57bn for tranche A, RUB1.11bn for tranche B and RUB122m for tranche C. Coupon payments on each tranche are made on a quarterly basis. In addition to coupon payments, there are scheduled amortisation payments on tranches A and B. There is a possibility of the early redemption of tranches B and C. Cash flows on Red Arrow are paid from Russian Railways’ lease payments. Each cash flow from the lease agreements consists of payment of part of the principal and interest, plus the VAT on both sums. The VAT rate was 18% as of the start of 2007 and cash flows from the lease agreements exceed scheduled payments on the paper's tranches. These excess funds are used for early redemption of tranches B and C. Tranche B is the first that can be redeemed. When tranche B is repaid in full, the remaining funds can be used for early redemption of tranche C. Tranche A is not eligible for early redemption, unless the lease agreement is terminated ahead of schedule. If there are funds left over on the maturity date after all the tranches have been paid in full, they will go to holders of the class C paper. The Red Arrow paper does carry the risk of a change in VAT rate, as payments on lease agreements are dependent on this rate at the moment of payment. And this is a real risk as the government is debating reducing the VAT rate to 15% in the first half of 2007. If VAT drops significantly, there may not be enough funds for the scheduled payments on the bonds. Assuming a constant VAT rate over 2007–12, lease payments would fall short of scheduled payments on all three tranches, though only if VAT were below 5.7%.

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Bonds and real estate Construction is now the third biggest contributor to economic growth and the advent of mortgages means that the sector is unlikely to slow for several years. In all, real estate prices have grown 253% in the primary market and risen 288% in the secondary market between 2000 and 2005, while inflation was only 189% over the same period. Construction companies are increasingly turning to the bond market to raise money to finance developments, as shown in Table 4.8.

Table 4.8: Bonds connected to real estate borrowing (RUBm, US$m, %) Issue Glavmosstroy-2 Mirax-1 Mirax-2 Mirax-8 SU-155 PIK-5 LSR LSR-Invest Adamant-1 Adamant-2 HORUS 07 Open Investments Don Stroy ZUN-1 (LenspecSMU) ZUN-2 (LenspecSMU)

Amount RUB4,000 RUB1,000 RUB3,000 US$100 RUB1,500 RUB1,120 RUB1,000 RUB2,000 RUB500 RUB2,000 US$50 US$150 US$150 RUB1,000 RUB1,500

Coupon (%) 11.50 11.50 10.99 9.70 10.50 10.20 11.00 10.70 13.10 11.25 9.88 9.13 10.00 11.25 11.69

Put 20/09/07 None None 23/01/07 None 22/05/07 22/03/07 03/06/08 None 24/05/07 None None 01/11/08 05/05/08 28/07/08

Maturity 17/03/11 19/08/08 17/09/09 27/02/08 30/03/07 20/05/08 20/03/08 08/12/09 05/06/08 20/05/10 30/05/07 09/11/07 01/11/10 22/04/10 20/01/10

Price (%) 100.88 101.05 100.63 100.19 100.09 99.65 100.02 100.00** 100.25 99.86 100.00 100.50 100.25 100.00 99.90

YTW (%) 10.52 10.48 10.99 9.72 10.58 11.45 10.68 – 12.64 12.06 10.01 8.71 10.22 11.36 11.61

TRUST MO MO MO MP MO MP MO MO MP MP MP MP MO MP MP

*MP – Market Perform, MO– Market Outperform, MU – Market Underperform **-<<What if market...>> Source: MICEX, Bloomberg, TRUST

Tens of billions of dollars are being poured into real estate by banks and oligarchs, funded out of their own resources. At the end of last year, construction was contributing 15% to GDP growth, according to Trust Bank in Moscow, or US$113bn in 2005, the latest figures available. In an effort to keep up with demand, companies are leveraging up to finance the construction frenzy. Construction companies issued four CLNs worth a total of US$450m and 18 ruble bonds worth a total of US$850m in 2006. Residential real estate is the main source of growth and is expected to drive the sector for at least the next decade. The volume of residential construction grew by 44% between 2000 and 2005, or 7.5% a year, which is on a par with GDP growth over the same period. However, in 2006, residential growth rates accelerated to 12% as 48m square metres were added with a market value of US$60bn, according to Trust Bank. That is about an extra one square metre per person – Putin reiterated this in his state of nation speech in April – for every adult in the country against the average of 20.8 square metres they currently inhabit – less than half the European average. The government estimates that there is a deficit of 1.7bn square metres that will take 16 years to build at current rates of construction.

Ruble Eurobonds Ruble Eurobonds made their debut in 2005, with the issue of a RUB2.5bn bond by the Russian Bank for Development (owned by telecoms conglomerate AFK Sistema) in the form of CLNs. The market expanded rapidly in 2006 with seven new issues worth a total of RUB41.4bn (US$1.6bn) with four of them in the form of CLNs (see Table 4.9). As elsewhere in the fixed income market, banks dominate the issues and are likely to continue to dominate going forward. The ruble Eurobonds are especially attractive for foreign investors as they are settled and cleared by Euroclear, whereas foreigners buying ruble-denominated bonds on the Russian exchanges are exposed to the greater counterparty risks of dealing with the National Depositor Company, the dominant bond depository, as well as being liable to both Russian capital gains and interest taxes. Buying ruble Eurobonds avoids both these problems.

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Demand for these bonds is being fed by higher yields and the expectation of more ruble appreciation. And as the ruble is now a fully convertible currency and Euroclear has already set up the mechanisms for settling deals in rubles (although no deals had been yet done at the time of writing) this segment of the market is expected to grow once ruble-denominated settlements appear. Clearstream has set up similar systems in anticipation of the appearance of ruble currency trading.

Table 4.9: Ruble Eurobond issues, 2005â&#x20AC;&#x201C;06 (RUBbn) VTB 09 Red Arrow Expobank 07 (CLN) Russian Bank for Development 06 (CLN) Rosbank 09 Renaissance Capital Bank (CLN) Soyuz Viktan 07 (CLN) Bank of Moscow Source: Cbonds

99

Date of placement 07/04/06 30/03/06 30/03/06 31/03/05 22/09/06 27/07/06 27/02/06 17/11/06

Maturity 13/04/09 30/06/12 30/06/12 29/12/06 30/09/09 27/07/07 27/02/07 25/11/09

Amount, (RUBbn) 10.00 13.73 1.40 2.50 7.00 3.50 0.75 5.00

Coupon rate (%) 7.00 8.38 11.75 7.60 8.00 10.50 11.50 7.25


CHAPTER SECURITISATIONS

05

Background Russian banks have jumped feet first into the securitisation business, where loans to consumers are repackaged into reduced-risk bonds and sold off to international investors. Securitisations are a consequence of the ballooning volumes of retail lending in 2004 and the need to find cheap ways of refinancing this lending. The traditional problem for organising asset-backed securities (ABS) in Russia has been the lack of a clear distinction between loans provided by a bank and those provided by a non-financial institution, or SPV. Previously it has been impossible to transfer loans from one type of entity to the other. Nothing has changed materially to the rules, but the judicial system has decided to accept the principle of asset transfers between banks and SPVs, although the legal concepts underpinning the issue are still fluffy and untested. The volume of securitisations has grown exponentially over the last 18 months. A handful of deals in 2005 got the ball rolling, when a few pioneering banks raised US$300–400m by securitising their hard currency credit card receipts and retail credit portfolios, selling the bonds on to international investors before reinvesting the money back into the market in the form of more loans. Russia is unusual in that the types of securitisations have expanded very rapidly, whereas in other emerging markets banks have stuck to the simple forms of securitisations such as receipts of foreign credit cards. The first ruble-denominated credit portfolios were securitised in 2006 and by December of that year a total of 11 transactions had been completed, generating US$2.5bn worth of deals. Russian banks need the money, but foreign investors, mainly Europeans, want exposure to the booming retail sector almost as much. The early deals were necessarily offshore, as Russian law simply did not exist to create the Special Purpose Vehicle (SPV) that is the core of a securitisation deal.

Market beginnings The second-tier Soyuz Bank, which belongs to aluminium tycoon Oleg Deripsaka, set the standard with a securitisation of receipts from car loans at the end of 2005, issuing a bond that was rated significantly better than the bank. The bank floated a US$49.8m Eurobond in London backed by receipts from a 4,000 car loan portfolio worth between US$60–80m. The car loans were transferred to Russian Auto Loan Finance B.V., a Netherlands-registered SPV, which then issued three tranches of bonds. JP Morgan will act as cash manager and Russian Standard Bank will act as the back-up servicer. The bond’s legal packaging impressed the ratings agencies so much that Moody’s granted it an extremely high (by Russian standards) rating of Baa3 – an investment grade rating – which is significantly higher than the bank’s own sub-investment grade rating; Moody’s does not rate Soyuz at all, but the bank was given a CCC+ rating from Standard & Poor's in August. Investors bought the senior tranche that carries the least risk, which made up 88% of the total, paying 1.75% over Libor, a cost of capital that is significantly cheaper than the bank could raise for itself. The deal is doubly impressive as Soyuz bank is a relative newcomer on the scene, having emerged from a series of restructurings to bank entities associated with insurance giant Ingosstrakh after 1998. The bank is now part of the Basic Element aluminium group, headed by oligarch Oleg Deripaska, and only got into the car loan business in 2004. Soyuz’s ABS is not Russia’s first securitisation. Rosbank securitised external credit card payments from foreigners using their cards in Russia and Gazprom securitised gas export receipts last year, but both these bonds were awarded lower ratings of, Ba3 and BBB-, by Moody’s.

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“The Soyuz issue was ground-breaking as it was the first to securitise cash flows inside Russia. It was doubly impressive as the structure received an extremely high rating,” says Alexey Boulgakov, a debt analyst with Aton. Details of this and other early securitisations are given in Table 5.1. Soyuz was soon followed by the bank considered the main force behind Russia's consumer credit boom, Russian Standard Bank (Russky Standart), which pulled off the first securitisation of rubledenominated consumer loans. Following that, Russian Standard organised the first rubledenominated car loan securitisation and will follow up with ruble-denominated credit card receipts and mortgages.

Table 5.1: Russian ABS ratings Amount US$50m €127m €350m US$350m US$88m US$73m US$430m €255m

Soyuz Bank 10 HCFB 12 Russian Standard 12 Alfa Bank 11 VTB 34 City Mortgage Bank 33 MDM Bank 13 Russian Standard 17

Rating (senior tranche) –/Baa3/– –/Baa2/– BBB/–/– –/Baa3/– –/A1/BBB+ –/Baa2/– A–/Baa1/– A–/Baa1/–

Issuer’s rating B–/B1/– B/Ba3/– B+/Ba2/– BB–/Ba2/BB– BBB+/Baa2/BBB+ –/–/– B+/Ba2/BB– B+/Ba2/–

Rate (senior tranche) 1mLIBOR+175 1mEURIBOR+250 1mEURIBOR+165 3mLIBOR+160 1mLIBOR+160 1mLIBOR+160 1mLIBOR+100 1mEURIBOR+115

Source: Troika Dialog

So far, all the securitisations have involved consumer credit in some form, but the big innovation in 2006 was the passage in July of amendments that created mortgage-backed securities (MBS), which the experts believe will be a US$10bn business within a few years. Russia's second biggest bank, VTB, was quick to follow up with the first US$500m securitisation of mortgages, and the most recent deal was an issue from Gazprombank subsidiary Sovintradebank, which issued an offshore MBS. However, almost all consumer lending products are now being securitised. Russian Standard's Leonid Zolotaev says the bank has mandated the securitisation of its ruble-denominated credit card receipts and will do the same for mortgages in 2007; credit card lending is now the fastest growing segment of retail lending, overtaking unsecured personal loans in volume for the first time over the first six months of this year.

Growth prospects Moody's David Mumzhui says Russia is unusual in that there is already a wide array of securitisation asset classes on offer (see Figure 5.1), whereas other emerging markets tend to develop only one product – like credit card receipts – before moving on to the next.

Figure 5.1: Russian securitisation, by asset class, 2006 (%) 2% 10% Future flow 31% Auto 13% Lease receivables Consumer loands RMBS (Residential mortgage-backed securities) Other 18%

26% Source: Moody’s

The rapid development of Russian securitisation, as seen in Figure 5.2, is a reflection of the lack of international banks in the Russian banking sector, which dominate in Central Europe after the sector was largely sold off in the 1990s and so the local subsidiaries have little problem raising cheap capital from their parents to refinance their credit portfolios.

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By contrast, in Russia there are about 50 international banks registered, but collectively they account for only 14.4% of the total assets of the banking sector, leaving most of the running to the Russian banks, which have limited access to capital. With no sign of a slowdown in consumer borrowing, and more and more banks launching plans to refinance their consumer loans portfolios via securitisation, the only question about the growth in 2007 is whether it will be fast or very fast. "The Russian banks are interested in securitisation because they are interested in the liquidity. In Russia we have an expanding retail market which needs funding and we have a relatively low savings rate," says Tim Nicholle, deputy head of structured finance for UniCredit Group. "The difference between what people on the street are saving and what they are borrowing has to come from somewhere. And that's where we come in; the international capital markets are providing the liquidity."

Figure 5.2: Securitisation in Russia, 2003–06 (US$m) US$m 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2003

2004*

2005

2006

*Excludes Gazprom’s US$1.25bn future flow deal Source: Moody’s

Bankers believe that the volumes of Russian securitisations will rise to US$4–6bn in 2007 with a typical deal size of US$300–500m. Until now, Russian banks have turned almost exclusively to European banks to buy their securitised assets, but as the deal sizes approach US$1bn, which is expected by about 2008, then Russian banks will be forced further afield to the US and Asian financial markets. In reality, the volume of deals is probably much higher than the official figures. The estimates for the 2007 volumes are extrapolations of publicly announced securitisations, but Moody's estimates there will be another US$2–3bn of securitisations that will remain as private transactions and so unreported. Securitisations are not a panacea to Russian banks' shortage of capital as they are still a very expensive product. Soyuz Bank's ground-breaking securitisation was small – a US$50m issue – but the bond received a considerably higher rating than the bank itself could command and so significantly reduced its borrowing costs. However, Soyuz CEO, Stuart Lawson, warns that the cost of putting the deal together was high, so there is no point doing a one-off securitisation; better to create a structure that can be used reused, he says.

Domestic securitisations Next on the agenda is to create a domestic securitisations market. One of the problems Russian banks face is that despite the growing pool of liquidity among Russian banks, the sector remains highly fragmented and most of the major industrial companies dwarf the banks. Domestic securitisation is a simple way for Russian banks to tap into this pool of liquidity. A bill that will create the legal framework for domestic securitisation is planned to go before the Duma in 2007, according to Russia's Federal Service for Financial Markets (FSFM). The law is needed, as setting up SPVs that are key to making securitisations work is impossible under current legislation due to shortcomings in the rules covering collateral. Banks transferring cash flows from the underlying assets of ABS would also be required to transfer the cash to investors in case of a default, unless otherwise stipulated by investors' contracts with the issuer, says the FSFM deputy director, Vladimir Gusakov.

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CHAPTER SYNDICATED LOANS

06

Background This business is booming and volumes have been doubling every year for the last four with no sign of a slowdown. The funds of external investors are playing an increasing role in their source base of Russian banks. From 1 January 2002 to 1 October 2006, the volume of interbank credit attracted from non-resident banks increased 12-fold, from US$3.3bn to US$39.5bn, according to VEB. These volumes make Russia the biggest user of syndicated loans in the emerging market universe, borrowing twice as much as China, which was in second place in 2006. Russia was already the biggest borrower on the syndicated credit market in 2004, raising a total of US$13.6bn according to the World Bank, ahead of Brazil in second place with US$9.8bn. However, Russian appetite for debt meant that it pulled ahead in 2005 when Russian companies borrowed US$40.1bn, or twice as much as Chinese companies (US$18.5bn) and significantly more than Mexican (US$18.2bn), Brazilian (US$13bn) and Indian corporations (US$12.2bn). However, the figures from 2005 are skewed by the two jumbo event-driven loans for Gazprom and Rosneft, which totalled US$13.1bn and US$7.6bn respectively. The rate of borrowing has slowed in the last year, partly because other forms of financing are becoming available and partly because the Kremlin has become very aggressive in the rates it demands. The total volume of Russian syndicated loans barely changed from 2005 to 2006 and was down marginally to US$38.5bn from US$40.1bn in this period (see Figure 6.1). Commodity sectors still dominated in 2006, although financial and telecoms sectors took a more important share of the market (see Figure 6.2). Relationships have also become more important as yields declined. Syndicates were more top-heavy as the proportion of retail investors and pure asset-taking participants declined.

Figure 6.1: Russian syndicated loans market, 2001â&#x20AC;&#x201C;06 (US$bn) Acquisition related financing

US$bn 45

Value

40

No of issues

35 30 25 20 15 10 5

30

48

2001

2002

62

74

111

2004

2005

133

0 Source: Citigroup

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Figure 6.2: Russian syndicated loans market, by sector, 2005, 2006 (%) 2005

2006 15%

18%

68% 32% 8%

3% 6%

4%

Oil & gas Metals & mining

4%

Finance

1%

8% 33%

Transport Telecomms Other

Source: Citigroup

Leading borrowers The volume of syndicated loans has been growing exponentially since the business reappeared in 2001 following Russia's financial crisis in 1998. The first round of borrowers was comprised of the big oil and gas companies, which remain large borrowers, but they have since been joined by companies from across the industrial spectrum. More recently, as with other types of borrowing, the banks have become increasingly active as they look for ways to finance their growing loan portfolios. At the same time, Russian domestic companies are increasingly happy to turn to the domestic banks to borrow as, with the strong appreciation of the ruble, they are becoming more concerned about exposure to foreign exchange risks. Bank borrowing through syndicated loans reached critical mass in about 2005, when the spreads on this type of borrowing fell dramatically thanks to Russia's improving macroeconomic fundamentals; both real and perceived risk had fallen dramatically, while the interest rates remained very attractive for lending banks. Banks account for about one-third of syndications as of the start of 2007, with companies from the fuel and energy sector accounting for about a quarter of the total by value (if the handful of state mega-deals in 2006 are excluded from the tally). In 2005, only Russia's top 20 banks could access the international capital markets, but by the end of 2006 the next 30 banks were also becoming active takers of syndicated facilities. Russian banks turned to syndications as both the cheapest and the fastest way to replenish their coffers as domestic lending took off. The spread between falling interest rates on the international markets and what they could charge on the domestic market meant this remained an attractive business. Over the last five years interest rates for Russian borrowers abroad fell from an average of 430bp over Libor to 180bp over Libor a year, while inside Russia the rates fell from 11.6% to 8.7% a year for dollar-denominated loans. At the same time, the average term of credit abroad grew from one to three years, while on the domestic market the average credit term grew from 18 to 24 months. The state also became one of the biggest consumers of syndicated credit in 2005, as the Kremlin needed billions of dollars to reassert its control over the oil and gas sector. Gazprom drew an unsecured syndicated credit worth more than US$13bn to buy Roman Abramovich's oil company Sibneft, and Rosneftegaz, a holding company controlled by Rosneft acting on the Kremlin's behalf, borrowed US$7.5bn from Western banks for the acquisition of 10.74% of Gazprom shares. These two loans alone accounted for a quarter of the year's total volume of syndicated loans. State-owned banks have also been big users of syndicated facilities, but over the last two years increasing numbers of second-tier banks have entered the market. Lenders were initially attracted by the state-owned banksâ&#x20AC;&#x2122; quasi-sovereign status, but as the banking sector is clearly on fire they are now tempted by the faster-than-average growth the best of the regional banks are enjoying or the new breed of niche players that have appeared in the financial sector, such as consumer-orientated banks. By the end of 2006, the pace of growth had slowed as the margins had been squeezed. Interest rate compression of international loans had gone about as far as it could, while competition at home meant the margins from on-lending to the domestic customers was less profitable than it had been.

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However, the banks will remain big borrowers in 2007. The state banks and companies dominated the syndication business in 2006: Vnesheconombank raised US$500m at a record low 30bp over Libor and Gazprom raised a US$1.5bn loan at 55bp over Libor in April. However, commercial banks will up the ante in 2007; UralSib plans to raise just under US$1bn in 2007 and MDM bank has said it wants to raise US$3bn in syndications in 2007, to name but two.

Figure 6.3: Russian syndicated loans, by sector, 2002â&#x20AC;&#x201C;06 (%) % 100

Oil & gas

90 FI

80 70

Metals

60

Other

50 40 30 20 10 0

2002

2003

2004

2005

2006

Source: Dealogic Loanware

Leading lenders The profile of international banks participating in the syndicates lending to Russian companies and banks has been changing fast in the last few years, once the business really began to pick up and the number and type of borrowers diversified. A few banks dominated the syndicated loans business, but since Russia scored a hat-trick of investment grades form the main agencies in 2005 the Asians have suddenly become big players, to the point where banks such as VTB are specifically marketing themselves to the Asian lenders. Recently, the first Russian banks have opened offices in Asia. The rates that Russian banks can borrow at have been falling steadily but there is still a big difference between the rates charged to commercial banks and those enjoyed by the quasisovereign state-owned companies. Given the tight pricing now demanded by leading Russian borrowers, the format of bank groups is changing. They are smaller and are dominated by the major international banks, as well as some smaller banks that have, or are looking for, relationships in Russia. Tightly-priced deals require a significant sales effort from the borrowers. For example, the Bank of Moscow borrowed US$20m in the middle of 2006 in a typical small loan that is part of the process of building up an international credit history with lenders. The bank raised funds at 220bp over Libor, slightly better than the average 240â&#x20AC;&#x201C;370bp over Libor which most commercial banks pay. However, in the same year the state-owned banks VTB, Vnesheconombank, Gazprombank and Sberbank all raised money through syndications and paid at the rate of 30â&#x20AC;&#x201C;100bp over Libor.

The influence of state-owned enterprises Part of the reason for this change is that syndicated lending has been politicised. At the start of 2006 it was clear that several large state-owned enterprises would IPO within two years or so. The first to go was the Rosneft US$10.4bn IPO in July 2006 and the state began demanding better prices on its syndications, dangling the prospect of some of the IPO work in exchange. Rosneft had become very aggressive in negotiations and in April 2006 some Western banks backed out of negotiations for a syndication, refusing to make the interest rates cuts demanded by the state-owned oil company. In March, Rosneft had sent a request to its foreign creditors, including ABN AMRO, Barclays Capital, Dresdner Kleinwort Wasserstein, J.P.Morgan, Deutsche Bank and Citibank, asking them before 11 April to reduce their floating interest rates to 65bp above Libor on loans totalling US$3.1bn. In particular, Rosneft wanted the banks to retroactively cut interest rates on a US$2bn

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loan taken out in 2006 at an interest rate of 180bp above Libor, and a US$800m loan taken out in December 2004 at 200bp above Libor. In late 2004, Rosneft had raised record loans to finance its US$9.35bn purchase of Yuganskneftegaz, a former subsidiary of oil company Yukos. At least two banks pulled out of the syndication rather than agree to the new terms, although the rest reportedly made the concessions demanded and indeed the same group of banks ended up organising the Rosneft IPO. There are several more IPOs still in the works, such as VTBâ&#x20AC;&#x2122;s IPO slated for the second half of 2007 and Gazprombank is due to IPO in the first half of 2008. This linking of investment bank work with the raising of syndicated loans has dramatically affected both the rates and the make-up of syndicates for the state banks. Typically, the state banks command rates of about 150bp less than purely commercial borrowers and the syndicates willing to make these loans have fallen from over 50 participating banks to a dozen or so big names.

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CHAPTER MERGERS AND ACQUISITIONS

07

Background Russia's 1998 financial crisis turned into the biggest buying opportunity that Russia's leading businessmen have ever enjoyed. While foreign investors had fled the country en masse, it only took a year for Russia's richest businessmen to see that assets were massively undervalued and they ventured back into the market. There are tales of businessmen picking up entire factories for as little as US$60,000, but oligarch Roman Abramovich got the ball rolling following his purchase of the PAZ bus factory in 1999. What was unusual about this deal was not the low price he paid for one of the biggest producers of buses in the country, but that rather than pulling government strings to fix a privatisation auction, the preferred method of privatisation in the 1990s, he simply bought the shares on the open market. Over the next two years, businessmen started snapping up companies in what turned into a wave of acquisitions. By 2002, fuelled by recovering oil prices, it was clear that Russia's economy was rebounding strongly from its nadir and the nature of these deals began to change as businessmen started building up integrated nationwide companies to compete in the various sectors. By around 2004, these emerging conglomerates were starting to compete head-to-head as the leading rivals in each sector started to do battle for market share. At the same time, valuations had risen so high that oligarchs started weeding out their non-core assets and cashing in on the huge gains they had made over the previous five years. There were plenty of willing buyers, as other firms looked to add production facilities to their growing businesses. At the start of this decade Russia's economy could be described as a ‘Soviet sandwich’ – the two bread and butter sectors earning most of the money were oil and gas at the top of the economy and food processing at the bottom. The middle was characterised as a pink greasy sausage of unreformed Soviet-era industry. Russia’s privatisation turned every single factory, shop and warehouse into an individual company like so many pieces of Lego. After six years of strong growth, sectors are beginning to consolidate as the strongest companies buy out their less ambitious peers. Sectors such as meatpacking are still at the beginning of this process; others, such as steel, are already almost completely in the hands of half-a-dozen rival conglomerates. Today, this process of consolidation is still going on. The bread and butter sectors have expanded in size and range, but the big change is that throughout the sausage in the middle there are seeds of growth as the leading companies have become profitable. In some sectors several companies have emerged as leaders and are starting to battle for customers. In others, the sector is dominated by a single company that is snapping up all the smaller ones. And in a very few sectors, such as steel, the sector has progressed to the point where the conglomerates are beginning to merge as they move out to compete on the global markets as true multinationals.

Sector changes in M&A All in all, the Soviet sandwich has become a lot more appetising and this change is being driven by the frenetic pace of mergers and acquisitions (M&A). Below are some sketches of a few representative sectors.

Steel Around six companies emerged from the chaos of the 1990s to lead the steel sector and built up vertically integrated companies, producing everything from coal through ore to specialist steels. The steel sector has been one of the first in Russia to move overseas, as the leading companies began to buy assets abroad (see Table 7.1). In 2006, the steel sector attempted to become the first Russian industry to integrate into the global economy with a merger between Alexei Mordashov's Severstal Steel and the European producer Arcelor, which ultimately failed.

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Table 7.1: Russian acquisitions of foreign steel assets, 2003 – 06 (US$) Deal Amount (US$) Comparative valuation Acquisition of Rouge Steel (SNA) 285m Severstal: by severstal in 2003 EV/EBITDA (04) =4 Rouge: EV/EBITDA (04) =3 Acquisition attempt of Stelco by 900m Severstal: Severstal in 2004. Not successful EV/EBITDA (05)=4 Stelco: EV/EBITDA (05)=8 Acquisition of Vitkovice Steel by 240m Evraz: Evraz in 2005 EV/EBITDA (05) =3 Vitkovice: EV/EBITDA (05) =2.5 Buyout of Lucchini by Severstal 51% for Severstal: from Mordashev in Q306 550m EV/EBITDA (07E) =4 Lucchini: EV/EBITDA (07E) =4 Merger of Severstal and Arcelor. – Severstal: 2nd offer in 2Q06. Not successful EV/EBITDA (07E) =3 Arcelor: EV/EBITDA (07E) =6 Establishment of JV between 50% for NLMK: NLMK and Duferco in 4Q06 800m EV/EBITDA (07) =4 JV: EV/EBITDA (07) =3 Bid for Oregon Steel by Evraz 2.3bn Evraz: in 4Q06 EV/EBITDA (06) =5 JV: EV/EBITDA (06) =7

Target description Rouge comprises all stages of steel manufacturing except for coke production. Steel output 2.5 mtpa Comprises all stages of steel production and includes mining assests. Output 4.7 mtpa Steel production from purchased pig iron and rolling it out into thick sheet. Output 0.87 mtpa 4 mtpa of longs and speciality steels. No mining assets

Impact on acquirers value Positive

Negative

Positive

Slightly negative to neutral

In order to obtain approval Negative from Arcelor board, Mordashev valued Severstal at ridiculous US$10 per share 4.5 mtpa of rolled products Neutral, not consilidated with 2.1 mtpa of own slab production 1.5 mtpa of flats, pipes and rails with 0.8 mtpa of own slab production. Projected output growth

Negative in S.T., but may be positive in L.T.

Source: Company data, TRUST estimates

Aluminium Only two aluminium companies emerged from what has been called the ‘metal wars’ – Russian Aluminium and SUAL. These two merged at the end of March with Swiss company Glencore's aluminium assets, to become Russia's first true multinational and the biggest aluminium producer in the world, with assets in over a dozen countries.

Telecoms The state led a reorganisation of the fixed line telecoms sector at the start of the decade, which saw the 88 regional telecoms providers merged into seven super-regional companies. A massive reorganisation, this process barely got a mention in the international press and went amazingly smoothly. Since then, the long distance sector has been reformed and thrown open to competition and the first players are already taking their places.

Banks There have been relatively few bank acquisitions or mergers so far, given the sector is badly overbanked and ripe for consolidation. Part of the reason is mergers in the banking sector need special permission from the CBR, which has been promising to simplify the rules for years but has yet to act. The first significant acquisition was Rosbank's US$200m take over of 1st OVK in 2004, the rump of the failed SBS Agro Bank, which made Rosbank the biggest commercial retail bank in Russia.

Utilities The power sector set out on a similar restructuring to the telecoms sector in 2006, which is being driven by the state. The main thrust of the reform is to break up the regional ‘energos’, which control both the production and transmission of power, into their respective parts. Some 300 companies are being created in all, from which about 50 power companies are expected to emerge over the next few years. Foreign utility companies are expected to play a significant role in this process.

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Mobile phones Three main players emerged from the 1990s to operate at a national level: VimpelCom, Moscow TeleSystems (MTS) and Megafon. Over the last five years these companies have bought up almost all of the smaller regional players and provide a national service. Over the last few years they have also moved aggressively into the countries of the ‘near abroad’, as Russians refer to the countries of the former Soviet Union, and are significant players in almost all these markets. And since the start of 2006 they have begun to go further afield. VimpleCom's owner, the Alfa Group, bought a stake in Turkey's biggest provider, Turkcell, a deal which is being disputed. Russia's mobile phone companies are hoping to move into markets such as Vietnam and China with the Kremlin's help.

Supermarkets Organised retail only came into its own in the aftermath of the financial crisis. The competition between the major chains is fierce and has already led to the first big merger in 2006 between two of the leading companies – Perekrestok and Pyaterochka, to create X5 – in an effort to pull clear of their rival companies. With French companies Auchan and Carrefour entering Russia and WalMart poised to follow, there will probably be more deals of this sort ahead and the threat of foreign competition on top of aggressive Russian rivals means mergers are very likely.

Transaction structure The total dollar value of M&A transactions increased by 76% in 2006 over 2005, while the number of deals increased by 4%, according to Citigroup, making 2006 a record year (see Figure 7.1). In all there were 345 transactions worth $63.5bn, according to latest figures from Ernst & Young. The comparison between these figures and those of Citigroup show the dynamic nature of the M&A market and also the fact that not all deals are reported immediately. M&A volumes have been doubling almost every year since the economy began to pick up a head of steam at the start of this decade and are now approaching mature levels. M&A deals accounted for 4.5% of GDP in 2005 against the 8–10% of GDP average in industrialised countries, but were worth the equivalent of 6.5% of GDP by the end of 2006, according to Ernst & Young. The Russian market also became more transparent, as the share of disclosed transactions almost doubled to 57% in 2006, although about half of these were trans-national deals, a growth of 90%. Foreign companies bought US$14.5bn worth of assets in Russia in 2006, or three times more than in 2005. Russian companies slowed a bit, buying only US$9.8bn worth of assets abroad, compared with US$10.3bn in 2005.

Figure 7.1: Russian M&A transactions, 2005, 2006 (US$m) Value, US$m 40,000

Number of deals

Value (US$m)

285

Number of transactions 30,000

20,000

283

19,398

280

275 34,081 271

10,000

270

0

265 2005

Source: Citigroup

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Figure 7.2: Russian M&A transactions, by sector, 2005, 2006 (US$m) 2005 Value, US$m

Number

5,000 4,500

Value (US$m)

80

Number

70

4,000

60

3,500 3,000

50

2,500

40

2,000

30

1,500

20

1,000

10

500 0 Others

Trade

Telecom.

Oil & gas

Mining

Metals

Mach. eng.

Mass media

Food

Finance

Catering trade

0

2006 Number

Value, US$m 14,000 12,000

Value (US$m)

80

Number

70 60

10,000

50 8,000 40 6,000

30

4,000

20

2,000

10 Others

Trade

Telecom.

Oil & gas

Mining

Metals

Mach. eng.

Mass media

Food

Finance

0 Catering trade

0

Source: Citigroup

As elsewhere the numbers are slightly misleading, as the state entered the M&A market in a big way in 2006 with a couple of mega-deals as the Kremlin began retaking control of the ‘strategic sectors’. More tellingly, two-thirds of all deals were conducted between two Russian parties. The largest numbers of M&A deals were made in trade and the services (17%, or four times more than in 2005), commodities (8%), telecoms (9%), mechanical engineering (10%), and food (14.5%), which testifies to the consolidation process going on in all industrial weight categories. Unsurprisingly, the most valuable deals were in the fuel and energy sector (20% of the total) and metallurgy (19%). These figures are according to Ernst & Young, whose categories are slightly different to Citigroup’s, on whose data Figure 7.2 is based. Gazprom's acquisition of a 75% stake of oil major Sibneft for US$13.1bn was easily the biggest single deal in 2006, closely followed by RusAl's decision to merge with SUAL, worth $10.2bn and completed in March 2007. Of the eight remaining top-10 deals, which accounted for just over half of Russian M&A deals in 2006 by value, the average deal size varied between US$0.5bn and US$3.5bn. The average value of the remaining M&A transactions was nearly US$200m in 2006, up from US$120m the previous year and US$75m the year before that. Among the more important domestic deals were: the merger of the Perekryostok and Pyaterochka supermarket chains; Novolipetsk Steel’s acquisition of VIZ Steel, the second-largest Russian producer of electrical-grade steel, and coking coal producer Altai Koks; and LUKoil’s takeover of Primoryeneftegaz and the Khanty Mansiysk Oil Corporation.

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Most of the trans-border deals involved banks: of the biggest were the acquisition of Russia’s Impexbank by Austrian banking group Raiffeisen, and the acquisition of a stake in Rosbank by French bank Société Générale. Foreign acquisitions accounted for 35.4% of all transactions by value and were worth US$4.7bn. Analysts forecast that the volume of M&A deals will increase by a quarter in 2007, with most of the deals coming from the metals and mining, power and financial sectors.

Lending constraints One of the most important factors containing the growth of the value of the deals is that Russian banks are already running up against the prudential caps on their ability to lend money to finance the bigger deals. Russian bank loans to a single customer are capped at 20% of the bank’s capital, putting a de facto credit limit on deals financed by a single domestic bank of about US$100m. The two state-owned giants, Sberbank and Vneshtorgbank, can lend a maximum of US$200m. Beyond this, deals typically go overseas and are financed by syndicated loans among international banks. However, with the capital of the biggest banks doubling at the moment, their lending capacity is not running far behind the rising demand for capital by big corporations.

Table 7.2: Top 10 Russian M&A transactions, 2005 – 06 (US$m) Transaction

Industry

Value (US$m)

Acquired stake (%)

Jurisdiction Jurisdiction Acquisition of the acquirer of the target method

Gazproms acquisition of Sibneft The acquisition of ZAO Polyus by its shareholders Rosneftagaz’s acquisition of Gazprom shares

Oil & gas Mining

13,101 12,867

72.68 100.00

Russia Russia

Oil & gas

7,136

10.70

Russia

The acquisition of Odmurtneft by Sinopac TNK-BP’s acquisition of SIDANCO (BP) Evraz Group’s acquisition of Oregon Steel The acquisition of Nelson Resources by LUKOIL Alfa Group’s acquisition of Turkcell

Oil & gas Oil & gas Metals Oil & gas Telecom

3,500 2,546 2,088 2,000 1,602

96.90 2.00 90.87 100.00 13.22

China Russia Russia Russia Russia

PKN Orlen’s acquisition of Mazelklu Nafta Pyaterochka’s acquisition of Perekrestok

Oil & gas Retail

1,500 1,477

n/a 100.00

Poland Russia

Russia Russia

Divestiture Acquirer is an investor group Russia Share acquisition Russia Divestiture Russia Stock swap USA Tender offer Kazakhstan Divestiture Turkey Share acquisition Lithuania Divestiture Russia Divestiture

Source: Citigroup

LBOs Leveraged buy-outs (LBOs) are a classic form of M&A deal, but a recent innovation in Russia and almost all of those reported in 2006 involved foreign companies. About a quarter of all M&A deals concluded in 2006 were LBOs, worth a total of US$11.6bn. The three largest LBOs were worth more than US$2bn each: the Bank of China issued a credit to Chinese company Sinopec for the acquisition of Udmurtneft for US$3.56bn; Polish PKN Orlen borrowed €1.6bn from international banks for the purchase of an 84.4% stake in Mazeikiu Nafta from Yukos for US$2.34bn; and Russian Evraz Group drew a syndicated credit worth US$1.8bn organised by Credit Suisse and UBS for the purchase of American Oregon Steel Mills for US$2.3bn. All of these deals had raised at least 70% of the financing through borrowing, using the purchase company as collateral. As the scale of investments on the slate for 2007 is as big as those in 2007, analysts are expecting a lot more LBOs. For example, each of the mobile phone operators can raise about US$9–12bn to finance ongoing foreign expansion, while Rosneft will have to borrow tens of billions of dollars to finance the rest of the Yukos assets that are due to be auctioned in 2007. Dealmakers will also be forced to find sophisticated ways to finance deals as the cost of companies is also going up fast. For example, mobile phone operator MTS paid US$315 per subscriber in the acquisition of Kuban GSM in 2002, but regional operators cost over US$500 per subscriber by 2005 and over US$800 per subscriber in neighbouring countries.

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CHAPTER PRIVATE EQUITY FUNDS

08

Background Private equity is booming in Russia, but while foreign investors dominate the private equity business in most of the markets of Central and Eastern Europe, in Russia it is the Russian businessman who swamps all other sources of private equity funds. Poor corporate governance, a weak judicial system and political instability have put most foreign investors off and only a handful of firms are actively targeting private equity investments in Russia. However, the few that are operating funds have all proven to be spectacularly successful. Anecdotal evidence suggests that in the last 18 months foreign investors have overcome their fears and the volumes suddenly picked up at the start of 2006, but even this up tick has not been enough to keep pace with the growing domestic enthusiasm for private equity investment.

Figure 8.1: Russian private equity investment, by sector, 2005 (%) 6.5% 0.4% 4.9%

0.1% 0.4% 2.0%

31.2%

4.0%

7.9%

Communications

Energy

Other

Financial services

Consumer market related

Industrial equipment

Light industries

Chemicals and materials

Medical/health related

Biotechnology

Computers related 20.9% 21.6% Source: Russian Private Equity & Venture Capital Association

Market opportunities Private equity investors say the range of target companies is broadening rapidly, but funds remain spoilt for choice. Funds like Barings Vostok Capital say they review up to 300 potential deals a year but actual invest in only five of them. Companies looking for money report that the funds can drive an extremely hard bargain as there are few alternatives. "There are lots of companies looking for capital, particularly as local debt markets are not well organised for small ones, and international markets are inaccessible", says Richard Sobel, CEO of Alfa Capital Partners, who still sees private equity as the best way to invest in the Russian economy. Private equity funds are limited by the number of potential targets with a combination of high levels of transparency, good management teams and high growth prospects. Returns have been exceptionally good in recent years, with firms making several times their money. Portfolio company growth rates stand at around 25â&#x20AC;&#x201C;30%, according to industry sources. The director of one firm says the main constraint on private equity is the limited length of the funds, as some portfolio companies are growing so well that he is disinclined to sell them. The place where most opportunities are to be found is in the industries that did not exist at all in Soviet Russia, such as retail, financial services, distribution, media and information technology, which are still relatively young and so growing very fast. The distribution of investment equity by industry sector in 2005 is shown in Figure 8.1. "Basically all kinds of consumer services are good examples. In many industries strong growth has attracted a lot of players and we are now seeing active consolidation. Both growth and consolidation offer good opportunities for PE investors", says Ulf Persson, managing partner at Mint Capital.

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New target areas Funds are already branching out as the frenetic pace of growth is throwing up new possibilities. Prosperity Capital, another big Russia-specific fund, launched the Voskhod fund (Sunrise) in October 2006 that takes a slightly different tack to the vogue consumer story. It assumes the Russian economy has gone through a fundamental change in the last two years. By seeking out companies that are growing thanks to reform and restructuring rather than simply catering to ballooning consumer consumption, it is targeting the companies that service the main economic drivers such as metal and oil producers rather than supermarkets and food producers. The fund's manager, Mattias Westmann, argues that although Russian retailers are growing fast now they will not be able to stand the competition from the big international retailers that will eventually enter the market and so will only be good medium-term investments. However, the service companies are likely to have decades of good growth. Another consequence of the lack of private equity fund activity and the huge demand is that the existing funds, spoilt for choice, tend to invest into well-developed companies that are almost certain to succeed and hunt for expansion capital, which accounts for just under two-thirds of all private equity investments. Seed capital for start-ups gets almost nothing and late-stage developed companies are left entirely to fund further expansion from their own retained earnings, or via other instruments such as debt, according to the Russian Private Equity & Venture Capital Association and shown in Figure 8.2.

Figure 8.2: Private equity investment, by stage, 2005 (%) 6.7% 4.9% 62.2%

Expansion Buyout

26.2%

Seed & start-up Early stages Later stages (0%)

Source: Russian Private Equity & Venture Capital Association

Another indicator that it is still very early days for Russia's private equity is the fact that the deals are very concentrated among the big urban populations, with Moscow taking the lion's share: the Central Federal District (where Moscow is located) accounted for 72.8% of all private equity investments in 2005, whereas the Far East Federal District took in only US$2.8m, or 1.1% (see Figure 8.3). This will change in the next few years, as the regional cities are now growing faster than the Central District and the centre of commercial gravity has already moved to the regions. In all, Russia has a total of 13 cities with populations of more than 1m people, including Moscow and St Petersburg.

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Figure 8.3: Private equity investment, by Federal District, 2005 (US$m,%)

Central US$180m 72.8% South US$3.6m 1.5%

Far East US$2.8m 1.1%

North West US$33m 13.5% Volga US$7m 2.9%

Ural US$12.6m 5.1%

Siberia US$8m 3.2%

Source: Russian Private Equity and Venture Capital Association

Oligarch funds and the rise of the minigarch Foreign investors typically dominate private equity investments in other emerging markets, with the locals accounting for up to 10% of the funds under management. In Russia, domestic high net worth individuals not only invest more than the foreigners, but it is the foreigners that only account for 5% of the total under management. Rich Russians have their core businesses in hand and the more successful have turned these businesses into cash cows. A few years ago they began investing in interesting projects on a whim, but increasingly the high net worth individuals are treating their private equity projects as a serious second business. While they spend most of their energy on running their core businesses, they are looking for funds or professional managers to invest in prospective companies in attractive sectors as a secondary line in which they play the role of financial rather than strategic investor. It is a form of insurance. As business becomes more political again, these oligarchs are looking for ways to diversify out of their main business and have been pouring money into private equity investments. One of the most famous examples is GMC (Group Menatep Capital), a private equity fund owned by Mikhail Khodorkovsky and other main shareholders of oil major Yukos. At the time this management company was created, Khodorkovsky was the richest man in Russia and the founders poured several hundred million dollars into the fund. The managers were drawn for the most part from Russian bankers that Khodorkovsky had come across in the course of his work at Yukos who had prepared various structured and equity products for the company, although he also hired a few foreign nationals with fund management experience. The brief was to "invest into anything and everything except oil", which is typical. The fund was very successful and became a major force in the Polish telecoms market among other things. Few of Russia's high net worth private equity investors are as organised as this, but the amount of money these few have earmarked for private equity investments make them a serious force in the business.

The new investment class A few rungs down the ladder and there are several thousand Russian businessmen who are worth over US$100m; domestic private equity funds have begun to target this group as a major source of money. These ‘minigarchs’ are increasingly happy to pass their money on to professional managers and due to the general improvements in corporate governance – many minigarchs have made their money in ‘new economy’ sectors which tend to be less corrupt – their money tends to be ‘whiter’ than the wealth created in the 1990s, so fund managers have less risk accepting it. "In the last three years the rate at which the oligarchs are making private equity investments slowed after the Yukos affair and they have become more subdued," says Michael Calvey, managing director of Barings Vostok Capital Partners (BVCP). "This has created an opportunity for the 50–100 smaller industrial groups. They see this as their time to become serious players and they are growing aggressively."

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Minigarchs are entrepreneurs who have built up a strong business that contains 5–10 companies with cash flows of the order of US$50m. With the bank sector's capital growing by over 40% a year, these minigarchs now have access to substantial credit, which allows them to finance deals of US$20–40m – enough to buy a factory or successful publishing company. There are few Russian institutional investors and those there are consist almost entirely of the likes of state-owned banks, such as Sberbank, VTB and Gazprombank, which are also making proprietary private equity investments. But these banks are also the main source of funds for minigarch investors.

Sources of private equity capital Russian money being invested into domestic industry has massively distorted the normal structure of private equity investments. Everywhere else in the emerging market universe it is international private equity funds that dominate the business. In Russia, the private equity investments made by high net worth individuals swamp all other sources of funds. Foreign managed private equity funds raised an estimated US$1.5bn in 2006, or about 5% of the market, mainly from foreign institutional investors. However, domestic money dwarfs the international investment. There are no reliable statistics available but experts believe Russian businessmen have about US$40bn invested in private equity investments, as of the start of 2007. Foreign private equity investment is growing fast, but domestic private equity investments are growing just as fast and it is unlikely that the foreign share will get over 10% of the total in the next five years, believes Calvey. Despite the healthy returns reported by the existing firms, international groups have also been reluctant to enter Russia, with investments in Europe and other markets perceived as less risky than Russia. Carlyle, the Washington DC-based giant, opened a Moscow office in 2004, but shut up shop abruptly last year, having only made one modest investment. Paul Murphy, a partner with Ernst & Young in Moscow, says that despite the lack of activity from global funds to date, the chances of their arrival on the market will increase as acquisition targets become larger and cross their minimum investment threshold. Several large funds paid visits to Russia in 2006 to check the lay of the land, including the US-based firm Texas Pacific Group (TPG) and the UK-based firm Gartmore. In 2006, the sector broke down into three broad sections according to the Russian Private Equity & Venture Capital Association: 0 Large funds – 11 funds and seven fund management companies with a total of US$2.5bn under management, with between US$151m and US$800m in each fund; 0 Medium-sized funds – 27 funds and 20 fund management companies with a total of US$1.9bn under management, with between US$51m and US$150m in each; 0 Small funds – 41 funds and 33 fund management companies with a total of US$0.5bn under management, with between US$5m and US$50m in each. However, this still only accounts for US$4.9bn of the estimated US$40bn of total private equity investment in Russia. In other words, high net worth Russians have some US$35bn in unorganised private equity investments. In most emerging markets private equity is evenly spread between the three main sources. However, Russia is unusual as private domestic capital massively outweighs other sources of capital. Comparing India and Russia, which are at similar stages of development, in Figure 8.4 highlights the anomaly.

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Figure 8.4: Sources of private equity capital, Russia vs India, 2006 (US$bn) 40

7.5

5

5

Domestic Russian PE capital & “Oligarchs”

Domestic Indian PE capital & “Oligarchs”

Global buyout & VC funds (Russia allocation)

2 Global PE & VC funds (India allocation)

Russian dedicated PE funds

Indian dedicated PE funds (institutional foreign capital)

3

*Liquid or “investable” private equity capital Source: Baring Vostok, Baring India

Future challenges BVCP's Calvey warns that the best investing years may already be over. "The last six years will come to be seen as the best investment period of our lifetimes", he says. "It's easier to go from (sales of ) US$50m to US$100m than from US$500m to US$2.5bn. One reason for the growth was consolidation in many industries, but you can only do this up to 100%, and then have to grow organically", he says. Maybe the biggest stimulus to the growing interest is the multiplying number of exits available for the private equity investor. For most of the last 15 years the only possible exit was a sale to a strategic investor. With the volume of M&A over US$50bn a year there is an expanding number of Russian and international buyers. At the same time, the ballooning number of IPOs gives a viable alternative. And the advent of leveraged buy-outs (LBOs) and the first management buy-outs (MBOs) appearing provide a third alternative. The rapid growth in the number and size of Russia's IPOs is widely quoted, but strip out the natural resources sector, the state company IPOs and telecoms giant AFK Sistema, which raised US$1.5bn at the start of 2005, and the growth of Russia's IPOs has been much more even, rising from US$0.4bn in 2000 to US$3.8bn in 2006, according to Russia Partners, a fund run by Richard Sobel (see Figure 8.5). The mega-IPOs have helped bring about the development of the IPO market, but underlying these extraordinary events the IPO market is following a normal course of development, with an increasing number of companies coming to market from increasingly diverse sectors making it increasingly easy to float any type of company.

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Figure 8.5: Russian IPOs (exâ&#x20AC;&#x201C;Natural Resources and Sistema), 2000â&#x20AC;&#x201C;06, rebalanced (US$bn) US$bn 20

15

10

5

3.8 1.9 0.4

0

2000

0.4

0.2 2001

2002

2003

2004

2005

2006

2007 YTD

Source: Investment bank research

Improved M&A options have created their own problems for private equity firms. Target companies also have more choices for attracting investment than simply selling to buy-out firms. Calvey of BVCP says company owners are becoming more reluctant to sell with these expanding alternatives: bank financing is cheaper than before, and debt capital will be more accessible than in the past, meaning private equity will be seen as an increasingly expensive alternative. Another issue is the reluctance of owners of rapidly growing businesses to sell shares while they still see several years of potential upside, a factor that in turn is pushing up valuations. "Strong Russian managers are not quick to sell their businesses", says Alfa Capital's Sobel. "They want a financial partner but don't want to give up control." Despite all the progress, making private equity investments still involves cutting deals with individuals and Calvey says that corporate governance is still a concern; BVCP likes to maintain a controlling stake in their companies. "In a raging bull market corporate governance is usually pretty good," says Calvey. "The problems appear once the market turns, then the incentives for founding owners deteriorate and you can expect more serious problems for minority shareholders. If you have a controlling stake, you can control the cash flow and so if sentiment turns sour it is still possible to make money." And at some point the Russian raging bull will run into a wall. Calvey says that after six straight years of extraordinary growth, investors into Russia are bound to get ahead of themselves. "It will not happen in the near future, but at some point we are expecting the market to overshoot and there will be a correction â&#x20AC;&#x201C; probably a very serious one," says Calvey.

The main Russian private equity funds Russia has always tempted foreign investors, as the huge potential of a country with 150m citizens that is stuffed with raw materials is obvious. But few have taken the plunge, as the risks of doing business in Russia were more than obvious. Still, a few brave souls decided that the rewards outweigh the risks and set up private equity firms in the 1990s. The brief description of the funds below is not meant to be exhaustive, but contains some of the best known names and highlights the different strategies being adopted by fund managers to deal with the very real risks of doing business in Eastern Europe.

Troika Capital Partners Troika launched the Russia New Growth Fund in December 2006 and attracted a US$35m investment from the EBRD and raised a total of US$370m. Troika is one of the most experienced asset management companies in Russia and makes most of its money from investment banking and its mutual fund business, having a total of US$3.5bn under management by the start of 2007. Troika Capital Partners, the private equity arm of the group, was set up in 2005 in conjunction with Temasek Holdings of Singapore, which has a total of US$80bn under management around the world. The Russia New Growth Fund targets companies predominantly in the industries whose development is tied up with an increase in consumer demand, such as retail trade, financial services, consumer services, and related sectors. The fund looks to buy blocking and controlling equity packages in these companies.

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Alfa Capital Partners A franchise set up in partnership between the fund's managers – Richard Sobel is a doyen of Russian capital markets – and the main shareholders in the Alfa Group, Alfa Capital Partners is a hybrid of an oligarch fund and a purely commercial private equity fund. The fund has had some notable success in new economy sectors and is responsible, among other things, for launching the Russian language MTV.

East Capital The Stockholm based East Capital is now one of the largest of the Eastern Europe funds, with about US$3bn under management as of the start of 2007. The company was originally launched aimed at Scandinavian retail investors in 1997 as a specialist fund targeting Central, Eastern and Southeast Europe, but has grown and expanded massively since then. It provides a range of mutual fund products that target its various markets. In 2004, it launched the first of the Bering fund series that make private equity investments into Russia, Ukraine and more recently the Caspian region. And in November 2006, East Capital launched the East Capital Explorer Financial Institutions Fund. While the minimum requirements for the Bering fund is of the order of US$50,000 to US$75,000 and so still accessible to well-off retail investments, the Explorer fund had a threshold of US$1m and was the first fund aimed specifically at institutional investors. The fund buys minority stakes in up-and-coming banks across the region, but mostly in Russia, and has been a huge success as it launched about six months before the fever for Russian banking assets had broken out.

Firebird management The New York-based Firebird manages four Former Soviet Union equity funds: Firebird Fund LP, Firebird New Russia Fund LLC, Firebird Republics Fund LLC, and Firebird Avrora Fund LLC. The Firebird Fund and Firebird New Russia Fund have returned 60.8% and 50.4% respectively over the last year and are 90% invested in Russian equities. The biggest funds are the Firebird Republics Fund and Firebird Avrora Fund (which is only one of the four funds still open to new investors as of the start of 2007), with over US$650m under management in each. Like most investments in Russia, these two funds are hunting for opportunities in the regions and returned 69.1% and 50.5% over 2006. The Firebird funds had a total of US$2.8bn under management as of the end of 2006. About US$1.9bn of this is in these four funds, but Firebird also has two global funds – Firebird Global Fund I and II. The fund does not have a clearly defined strategy but rather invests into both listed companies or buys private equity stakes – the bottom line is its managers are constantly travelling in the region looking for opportunities wherever they may be.

Baring Vostok Capital Partners BVCP was founded in 1994 and is one of the pioneers of Russia's private equity market. BVCP set up one of the very first funds buying into Russian companies when it was still not clear if Russia was going to stick to the road of democracy and market economics. BVCP has stakes in about 25 companies from across the industrial spectrum, including independent oil producers, retailers, financial services and media. It has raised and invested some US$800m, and was in the process of closing a fourth fund in the first quarter of 2007. Since inception, the fund has distributed over US$1.1bn to investors from 28 realised investments with an average multiple of invested capital of 4.5 times and 40% IRR (internal rate of return). BVCP funds owned 17 businesses at the start of 2007 with US$815m in revenues, US$237m in net income and 8,264 employees. Revenue growth in 2006 was 71% over 2005.

Prosperity Capital Management Another pioneer among the Russia-specific funds, Prosperity launched a private equity fund called Vosktok (Sunrise) in October 2006 to invest into companies and sectors currently restructuring and investing for growth – sectors other than raw materials. The new fund is focused on the internal value created by the ongoing restructuring rather than the external valuation creation from growth. Russia has gone from having lots of macro problems to lots of micro ones – but even those are being fixed by entrepreneurs and a state that is taking responsibility, says Mattias Westmann, the fund's manager.

Mint Capital Scandinavian private equity firm Mint Capital founded its first fund in 2001 and was fully invested in 2005. There are seven investments in the Mint I portfolio and the firm is expecting the first exits from this fund in 2007. The first fund is primarily invested in software, media and technology. A second fund was raised in 2005 and Mint II is making expansion stage investments in rapidly growing companies that are generally in the US$10–100m revenue bracket in such industries as media, consumer goods and services, financial services, and retail. The second fund has so far made two investments – a payment services company and a retail operator.

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CHAPTER VENTURE CAPITAL

09

Background Venture capital, as it is understood by Western investors, does not exist in Russia. Rich Russian businessmen are investing huge amounts of money into new ventures and domestic private equity activity dwarfs that of organised foreign funds, but with so many opportunities available to existing businesses few businessmen have bothered to take on the additional risks of starting entirely new business in high risk sectors. This is all about to change in 2007, once the Kremlin pumped in US$500m of seed capital to create a venture capital business from scratch. In addition to oil and minerals, one of Russia's biggest assets is its intellectual capital; the Soviet Union had many failings but its university system produced world-class scientists and engineers. Much of this potential has been lying fallow for most of the last 15 years and the state-sponsored Russian Venture Company is designed to realise this potential by providing money to scientists with good ideas. Kremlin officials have done their homework and Krill Dmitriev, head of the Russian Private Equity and Venture Capital Fund Association (RPEVCA), says he has been in high demand recently: “Venture capital is in its infancy, but there is a lot of excitement over the government programme which could be a great help.” The curiosity of foreign venture capital funds has been piqued and several funds were flying into Moscow in 2006 to find out more about the Kremlin's programme. Dmitriev has been active in bringing together Western venture capitalists with top government officials, who met in September 2006 with Minister of Science and Technology, Andrei Fursenko, and Russia’s economic guru German Gref to explain what they need to make venture capital funds work. “What Gref is trying to figure out now is if venture capital can be used to transform the Russian economy”, says Dmitriev.

Home-grown venture capital Dmitriev estimates the amount invested into traditional early-stage ventures will reach US$200m this year, up from US$140m in 2006, but he says that since the Kremlin has pushed venture capital funds to the top of the agenda he expects it to turn into a US$3bn business within three years. So far, virtually none of Russia’s venture capital money has come from dedicated venture capital funds that are systematically looking for big returns from small companies at a very early stage of development. Most venture capital is from big domestic companies investing into new technologies on the fringe of their main R&D projects. For example, Norilsk Nickel has been funding research into hydrogen cells and oil company Yukos backed a study into ways to change gas into oil. The small number of private equity firms working in Russia also dabble in start-ups, but most of the venture money is invested by oligarchs or minigarchs – businessmen who have made US$100m or so and are backing small projects as much for fun as for the return. “There are a lot more projects than there are venture capital funds and almost no-one was looking at start-ups a few years ago. It is a fund manager’s market and they are spoiled for choice”, says Viktor Frumkin, co-director of Bridgetown Foods, which makes croutons (a popular Russian snack food) and eventually went into business after raising money from the leading private equity fund Baring Vostok Partners several years ago.

Early successes Even so, the Cold War legacy means that Russia still boasts world-class scientists and there have already been several successes.

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Russian companies have been very active in software development and a sizable chunk of the research departments of leading global software companies, such as Microsoft, are staffed with Russians. The Russian company Paragraph is a world leader in technology to read handwriting, and AB software has produced some of the best software for optical character recognition. And much of the software that runs mobile phones around the world is now developed in Russia. According to First Deputy Prime Minister, Dmitry Medvedev, the Russian software market was worth RUB361bn (US$13.8bn) at the end of 2006, of which hardware accounted for RUB212bn (US$8.16bn) and services for RUB91bn (US$3.5bn). "The offshore software market is now worth about US$2bn and grows by 70–80% a year", Medvedev said in March 2007. “At the same time, Russia's domestic software market is worth about US$30bn." More recently, Russian entrepreneurs have been moving into biosciences, where the Soviet Union was also a world leader thanks to the efforts it put into germ warfare.

Early funds Venture capitalism is a new idea in Russia. The problem is not that Russian science is not an eligible candidate for venture capital – it is – but that there is more opportunity than money in Russia’s increasingly vibrant economy. “The main problem for Russian venture capitalism is you can still get much better returns from private equity investments. Why take on the technology risks if you can still earn 80–90% a year from more certain private equity investments?” says Dmitriev. Mint Capital is probably the first true venture capital to set up in Russia, focusing on high-tech start-ups in 2000 with US$21m under management. The biggest Russian venture capital fund is probably Alfa Group’s Russkiye Tekhnologii (Russia Technologies), which teamed up with the Israeli Infinity Venture Capital to form RT-Infinity Venture Partners in July 2006 to look for opportunities in Russian high-tech start-ups and small firms. Russkiye Tekhnologii has only been around for three years and looked at 500 projects in the hightech sector but invested in only eight projects. However, it provides a rare example of a Russian technological development that has been turned into a commercial project when it began exporting a new highly efficient motor to India for use in mopeds.

Russian Venture Company Russia will launch a series of state-backed venture capital funds in 2007, as part of the Kremlin’s efforts to revive the intellectual might that made the Soviet Union a superpower. President Putin has personally spearheaded the effort and told government officials at the end of last year to “create a venture fund, any fund, just do it quickly.” The project to set up the Russian Venture Company (RVC) was formally announced in January 2006 and since then industry the government has roped in professionals to make sure that the US$800m earmarked for the effort by the Kremlin is not squandered. The RVC is the third major fund set up by the Russian government in the last two years and, rather than start from scratch, the Kremlin decided to base the fund on the assets of Construction Division 1 of the Federal Atomic Energy Agency, which is (if you think about it for a minute) probably the closest thing the Russian government has to a venture capital structure. After the fall of the Soviet Union, Russia’s well-financed defence-oriented programmes have collapsed. Most of Russia’s scientists were employed in the military-industrial complex and, while the country still has a lot of gifted and experienced scientists, there is a total lack of market mechanisms for identifying promising projects and providing them with capital to bring products to the market. "The Russian Venture Company will become a Fund of Funds which will accumulate RUB15bn (US$560m). Up to RUB5bn will be allocated to the company in 2006, up to RUB10bn will be allocated (to the company) in 2007", Gref said in August. "We aim to attract more than RUB30bn (US$1.12bn) to the Russian high-tech sector by the end of 2007.”

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There are actually a whole series of venture capital funds being set up. The VCR is the flagship and will be run on a fund-of-funds basis – Gref will oversee the creation of around 10 funds with US$50m of state money in each. The government will contribute 49% of the capital, with the remaining 51% being raised from private investors. As it is in the minority, the government plays no role in the investment decision-making process. Professional fund managers under the supervision of independent directors will manage each fund. "Venture capital investment can only be done with the participation of the private sector. The fewer the bureaucrats that get involved, the better", Gref said. The private managers are the key to the success of the venture. All of Russia’s asset management companies have been vying for the job of managing a fund and the Kremlin has whittled the list down to about a dozen well-known names. Managers will be paid 2% of the portfolio they manage as a fee, as well as 20% of the returns they make.

State telecoms venture fund While market participants welcome the RVC plan as optimal they are less happy with the state’s telecoms fund. Set up in parallel to the RVC, the Ministry of Telecoms, under Leonid Reiman, will be allocated another US$300m which it can invest directly into companies working in the telecoms sector. “The point of the RVC’s fund-of-funds structure is to remove bureaucrats from the investment decision process. Not only are they by definition the worst people to make this sort of decision, you also lay yourself open to the problems of vested interests and corruption. The structure of the telcoms fund is fundamentally flawed”, says a Western banker involved in the talks. Reiman has been dogged by allegations of following self-serving polices and has been accused of being the ultimate beneficial owner of Russia’s third largest mobile phone company, Megafon, during a money laundering probe by German investigators earlier this year, an accusation he has always strenuously denied.

Regional venture capital funds In addition to the federal funds the first regional venture capital fund has already appeared. At the start of October 2006 the Moscow Venture Fund began to accept financing applications from projects. Managed by Alliance Rosno Asset Management, which is part of an insurance group controlled by the Alfa Group, the fund received its first tranche from a total of RUB2bn (US$77m) in financing for such funds from the state over the summer. In total, the federal government will contribute RUB200m (US$7.5m), the Moscow city government another RUB200m and the remaining RUB400m is being placed by private investors. Rosno has set the minimum investment in a project at RUB10m (US$375,000) and the maximum at RUB120m (US$4.5m). It hopes these projects will return at least 30% each. The company says that 75% of assets will go into early stage projects, with 15% invested in companies that have just started work and the last 10% for small companies that want to expand. Other funds have also been registered by the Federal Service for Financial Markets (FSFM) in Tatarstan, the Perm and Krasnoyarsk Krai and the Tomsk region and are supposed start receiving finance by the end of the year.

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CHAPTER PENSION FUNDS

10

Background The Russian government is in a bind, as contributions to the state pension fund do not cover outgoings. Domestic pension funds are by far the biggest segment in the managed money market, although the bulk of this is raised through workers’ obligatory contributions to the State Pension Fund (SPF) as part of the social taxes. The volumes under management in mutual funds are less than one-thirtieth of the money in pension schemes: there was about RUB400bn invested in mutual funds at the end of 2006. As in other European countries, the Russian post-war baby boomers are coming up to retirement and the bulge in demographics means that whereas the contributions of two workers used to support one pensioner, the ratio will fall to one-to-one in the coming decade. Moreover, the problem is particularly acute in Russia, as the collapse of the Soviet Union hit birth rates hard as well as sending death rates up. It was only in 2006 that birth rates began to recover as Russia's economy emerged from the chaos of transition. Russia desperately needs to reform its pensions system, and attempted to do so in 2003 by allowing workers to transfer part of their mandatory contributions to the SPF to privatelymanaged pension funds – the so-called ‘investable’ part of their contributions. At the same time, 55 special asset management funds were registered that can invest part of workers’ social taxes in the hope of creating more resources for tomorrow’s retirees. In all, there are 56 pension funds if you include the state-owned bank Vnesheconombank (VEB), which is charged with managing the non-investable part of workers’ pension contributions. However, the reform was botched, hijacked by the oligarch-controlled pension funds, and the state had to enforce the closure of many of these funds at the end of 2006 as it attempted to clean up the mess it had made with its half-baked reform. The pension industry is only just emerging, but as the average Russian's horizon stretches out from ‘tomorrow’ to several years they are beginning to think about preparing for old age.

Pension reform There was nothing really wrong with the plan, but as with so much of reform in Russia the key is in the implementation. At the start of February 2004 the SPF announced that a disappointing 2% of Russians had chosen to move their investable money to one of the companies – well down on the 10% who it had been hoped would take part – or about RUB1bn (US$30m); a fraction of the total RUB90bn (US$3bn) in the SPF which remains in the state fund and is managed by VEB. The chairman of the SPF, Mikhail Zurabov, claimed that the poor showing was due to citizens being insufficiently informed about private management companies, either in terms of their credit quality or track records. However, independent fund managers in Moscow say the whole process was hijacked by the big pension funds under the control of the leading domestic conglomerates. Of the money collected, management companies controlled by the government of Tatarstan took a quarter of the total and 10 companies associated with either the big banks or the leading industrial groups took nearly all the rest. “Pension reform has got off to a disastrous start. There was a respectable blueprint that would have qualified funds with track records and transparent structures, but it was changed at the last minute”, says Elizabeth Hebert, CEO of Pallada Asset Management, which has been operating funds since 1992 and was one of the authorised 55 pension firms. “We ended up with 55 management companies, most of them unknown, that have no requirement to disclose their owners. Threequarters of these companies are owned by groups and will invest into their related companies.”

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In one of the more galling examples, the authorities decided to disqualify the local subsidiary of Dresdner Bank, which has two years’ experience of fund management in Russia. However, the pension authorities accepted an application from a company called the Management Company of Pension Funds that was registered the day before the deadline for submission of licence applications closed. The reason for the ‘Brand X’-style name of this company became clear the day after the results of the selection process were announced and the same company, one of those to qualify, was advertised for sale on the internet for US$1m and sold to the Tatarstan regional government. In the end, the authorities registered any company that applied for the special permission to administer pension funds and made no attempt to weed out the weak (or often paper companies) from strong companies with proven records. The campaigning to attract workers to funds was further mired by some of the management companies (legally) offering company managers a US$1 bounty on each worker they persuaded to sign over their investable portion to them, according to fund managers. An estimated 40% of applications were from employees of one of the leading financial-industrial groups.

Pension reconstruction Since the reform, the pressure on both government and employers to fix the mess has been growing. With the advent of consumer credit in around 2001 employees have been increasingly refusing to sign up to the payment scams companies use to dodge social taxes, including pension payments, as they need a ‘white’ income to raise credits from banks. With mortgages now taking off this pressure will increase dramatically. At the same time, Russian companies are faced with a desperate shortage of experienced managers. Salaries are rising fast and are on a par with Western levels in some industries. While still unusual, companies are starting to introduce perks such as pensions to tempt good employees to work for them. Russia’s Health and Social Development Ministry has also submitted a proposal that would drastically change pension reform procedures. The idea is to exclude a saving component from mandatory pension insurance. The money currently managed by VEB would go to pay off the SPF's deficit instead, while the population would be forced to transfer their pension schemes to private companies. If the proposal is adopted, then from 2008 the transfers to VEB of the investable part of a worker’s contribution would no longer automatically go to VEB if the worker did not specify a private company to manage their money and give it to private companies instead. The draft law was submitted to the government that would allow it to invest some of workers’ investable funds with private companies and the law could be in place by the end of 2007. In essence, Zurabov is attempting to encourage the nation to move their pensions to private companies. The purpose is to make the pension market two-level, starting from 2013. The first component will be the PAYG (pay as you go) system, which will be controlled by the government. The second will be represented by private pension savings, independent from the government and encouraged by tax benefits but stripped of all state guarantees at the same time.

Pension market structure Investment savings managed by the 56 management companies, including VEB, increased 52% in 2006 to RUB276.4 (US$10.6bn). The year previously the total funds under management grew even faster, albeit from a low base, and were up 86.9% year-on-year. According to the Interfax-100 ranking of pension savings management, in the period from first quarter 2004 to fourth quarter 2006, VEB accounted for 96.6% of all pension funds under management. In other words, the amount of investable funds in the care of non-state run funds has grown from about 2% in 2004 to 3.4% of the total. The concentration of savings managed by private management companies also increased slightly: the share of leading management companies in terms of the volume of savings managed, increased from 80.1% to 81.4%.

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Unsurprisingly, the privately-run companies are proving to be far more effective managers of funds than VEB. Analysts also say that younger people coming into the market are a bit more savvy than their parents and are more likely to choose private funds. VEB's share of fresh money from the Russian Pension Fund was 87.1% in 2006, and only 12.9% was earned revenue, a worse performance from 2005 when the breakdown was 82.4% and 17.6%, respectively. On the other hand, of private management companies’ fresh money, 67% was from new customers and the remaining 33% was from earned profit, better than in 2005 when the respective breakdown was 71.1% and 28.9%. The stock markets’ association, the National Association of Stock Market Participants (NAUFOR), estimates that the money private pension funds will have under management will rise from US$10bn in 2005 to US$440bn by 2015, at which time NAUFOR estimates one-third of the economically active population will use the services of a brokerage company in some form. The biggest pension funds in Russia are still the funds associated with the biggest companies, and the biggest of them all is Gazfond, which belongs to gas monopoly Gazprom. In the 1990s, Gazprom's management used their pension fund like a huge slush fund to finance their business activity. But in 2005 it began to revamp its pension fund and stop the abuse. Likewise, in January 2005 LUKOIL chairman, Vagit Alekperov, ordered a makeover of LUKOIL’s pension fund, Russia’s second biggest, saying he wanted to see his oilmen retire with “an honourable and sufficient” pension at the end of their careers. Other industrial groups, such as Interros and oil major Surgutneftegaz, have also been shedding the bad habits of in-house pension fund abuse, say analysts, but maybe the most advanced of all is utilities monopoly UES, which boasts one of the best corporate pension schemes of the government-controlled companies.

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CHAPTER MUTUAL FUNDS

11

Boris Yeltsin kicked off the pension reform by creating laws for mutual funds in 1996, known as PIFs in Russia. Just under 100 funds were set up, just as the RTS hit its peak, but the industry shrivelled and died in 1998 as the stock market sold off continuously over the next year until it crashed and burned in the financial crisis of August 1998. “Many funds closed but most went into hibernation,” says Elizabeth Hebert, CEO of Pallada Asset Management, which has been operating funds since 1992. “These are vehicles tested by fire – they have a seven-year track record and now are starting to pay off as people are looking for an alternative to simply investing into cash dollars stuffed under the mattress.”

Russian investment in mutual funds Investment in mutual funds has been surging in the last two years. Although the mutual fund business was all but destroyed by the 1998 financial crisis, it has come bouncing back. At the end of 2006 there was a total of US$10.6bn of pension fund money under management, including the obligatory contributions to the State Pension Fund (SPF), while the amount in domestic mutual funds doubled to RUB400bn (US$15.4bn). Only 2% of Russians invest in mutual funds, but these numbers suggest that those Russians who are starting to invest prefer the shorter-term horizon of mutual funds to pension funds. However, the prognosis for the sector is extremely good. The market players’ organisation, NAUFOR, published a report in December 2006 that estimates 21m Russian, or 15% of the population, will have investments worth US$290–360bn in the domestic equity capital markets by 2015. Over this period, market capitalisation is expected to rise from the current US$1trn to US$2.94trn, says NAUFOR, with foreign investors accounting for US$300bn.

Sector revival While international investors were withdrawing money in the aftermath of the May 2006 sell-off, Russian small investors started buying into the weakness in June, bringing the total under management to a new record of RUB300bn from RUB233bn at the start of the year, cushioning the blow and marking the start of a turn-around. "What was remarkable about the sell-off in May and June is that Russian investors started buying and the [domestic mutual funds] took some of the edge off the sell-off by considerably increasing their equity holdings. The Russian funds seem to be very confident about the long-term prospects of the Russian market", says Peter Westin, chief economist at MDM Bank. "[Domestic mutual funds] have turned into a major player on the Russian markets." By the end of 2006 PIFS had more than RUB600bn under management – partly thanks to the 70% growth the Russian stock market had put in over the year – of which just over RUB150bn was in opened funds, Inflows in the first quarter of 2007 suggest this rate of growth should be maintained, according to Deutsche UFG strategist Georgy Kartashov, with weekly figures revealing average monthly inflows of RUB3bn over the period. “Only once we reach US$100bn is it likely to slow down,” he says. Domestic mutual fund growth is shown in Figure 11.1.

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Figure 11.1: Growth of Russian domestic mutual funds, 2000–06 (RUBm) Assets (RUBm) 500,000

700

Number of funds

600 400,000 500 300,000

400 300

200,000

200 100,000

100 0

0 2000

2001

2002

2003

2004

2005

2006

Source: Investfunds

Current investment preferences and future projections A survey conducted by MICEX and the 'Salvador D' agency released in September 2006 found that just under half of Russians still have almost no contact with the financial sector and the vast majority have no experience of dealing with stocks. Only 2% of Russians polled said they had bought or sold shares; Russia's emerging middle class is thought to account for about 15% of the population. In answer to the question of what they would do if they were unexpectedly given a large amount of money, 32.4% of people said they would put it in a Sberbank deposit account, 20% would start their own business, 14% would keep the money at home, 6.7% would buy shares, 5.8% would buy gold (gold prices have soared in the last two years) and 3.8% would deposit the money with a bank other than Sberbank. Analysts and investment banks said the NAUFOR report quoted earlier, called ‘Ideal model of the stock market of Russia for the middle term’, was probably too optimistic in its projections, but no-one is denying that the size of the mutual fund industry is expected to grow by thousands of percentage points over the coming decade.

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CHAPTER DERIVATIVES

12

Background Derivative trading was first introduced on the St Petersburg exchange in 1992 but never took off. After the 1998 financial crisis investors lost interest in derivatives as the legal basis underpinning them was destroyed by the legal battles brought by international banks trying to get Russian banks to honour forward currency exchange contracts widely used prior to the crisis. However, after these legal problems were resolved in 2006, the derivatives market exploded, reflecting growing investor interest, high market volatility and the steadily expanding number of issues traded. The two main exchanges – MICEX and the RTS – have both set up derivatives platforms which are expanding as interest rises, although the RTS is the dominant derivates exchange. At the same time, there is also a brisk OTC trade in equity derivatives, as all leading international and Russian investment banks have built substantial derivatives desks, and these trading volumes continue to increase as well. "Activity in the derivatives market is growing very substantially, and we expect to see this segment grow even faster in 2007. Currently most activity is in options giving exposure to the RTS Index as traders look for ways to increase market leverage while others look to hedge market uncertainty. That activity will grow in 2007 as nervousness over political change and the sustainability of future growth inevitably increase", says Alfa Bank.

Legal developments Until 2006, the same laws that govern Russian casinos covered derivative products. Unable to write meaningful contracts the derivative business was small, but following the changes to the laws the market has blossomed. The problems started with the devaluation of the ruble in August 1998. As the ruble at the time was not a freely-traded currency, but was kept within a well-defined trading band by the CBR, most Russian banks saw these contracts as money for old rope and built several tens of billions of dollars of exposure. When the ruble actually lost about three-quarters of its value in a day, the Russian banks wormed they way out of these obligations by arguing that derivative products were a form of betting and they were not liable for the punters’ losses, an argument accepted by the courts which set a precedent. That changed in July 2006, when the Duma accepted the first laws to put derivative trading on a proper legal footing in the first of three readings. This is an ongoing process and the legal basis for derivate trading is far from finished, but traders are confident that it the process is in its final stages. Futures for deliverables – such as grain and oil – already enjoyed some protection, as Russian law saw these deals as sales contracts that are covered by the civil code. But more sophisticated products for non-deliverables – such as an option to buy a stock at a set price in a month’s time – were in a legal limbo that effectively treated them the same way as betting on the fall of a ball on a roulette wheel. However, the passage of the long-mooted derivates law ran into problems in December 2006 when the upper house of parliament, the Federation Council, shot the law down. The upper house objected to changes to Article 1062 of the second part of the civil code, which deals with gambling; quite sensibly, the law says that gamblers are not entitled to legal protection if they lose. The new bill proposes new clauses to the bill to cut derivatives out from the rest, giving judicial support for any ‘bet’ that meets the following critieria: 0 Such claims arise out of transactions that oblige a party or the parties to pay monetary funds;

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0 The amounts of such claims are determined based on the fluctuation of prices for goods or securities, in the exchange rate of a particular currency, variable interest levels, inflation figures (or any values dependent on any combinations of the above), or any other circumstances stipulated by legislation that may or may not come into effect; 0 At least one party to the transaction is a legal entity licensed to engage in banking or to act as a professional on the securities market or, if applicable, a legal entity licensed to execute transactions on an exchange. The Federation Council vetoed the bill on 27 December 2006, saying the definition of the transactions were unclear – the word ‘derivative’ does not actually appear in any of the amendments – and did not agree to the limitation of an individual’s rights based on the place of an agreement. Russian senators sent the bill back, asking for something a little more specific that defines derivatives so that they can be explicitly included in the civil code. At the time of writing, the lawmakers were thrashing through the options to find a workable formula, but given that Putin has been personally pushing for the development of Russia's exchanges, few doubt that the issues will be resolved.

OTC trading Due to weak regulation of the OTC derivatives market in Russia, most OTC trading is conducted by non-Russian legal entities and is governed by English law. Troika Dialog has been a pioneer of the futures market, after it set up one of Russia's first dedicated futures and options desks at the start of 2005. Chief trader, Georgy Mirel, says that option deals remain simple and opaque as most are OTC, but the market is growing very fast. “Most options are still a plain vanilla market. Some 90% of the deals are simply futures calls. The more exotic products will come, but there are still a lot of clients out there that are thinking about derivatives but have yet to test the market”, says Mirel. The problem with OTC is that it is very hard to get a fix on what price the market is setting for trades, so the first thing Troika did was to put two-way buy-sell prices on a screen so investors could judge at what level they wanted to price their options. “Before we did this there was no firm pricing,” says Mirel. “Transparent prices are what triggered the real-time trading in options.” Volumes traded on Troika’s options desk have grown exponentially. Since the bank launched its services it has seen volumes more than double in 12 months to several hundreds of millions of dollars, and it expects them to continue to double each year for at least another two years.

FORTS Future Operations on the Russian Trading System (FORTS) has emerged as the main derivative trading platform and is the most liquid market-place for futures and options on Russian equities and the RTS index. Having grown exponentially over the last four years, average daily trading volume on FORTS is now US$500–600m (see Figure 12.1 and Table 12.1). The most traded equity derivatives include futures and options on blue chip stocks such as LUKOIL, Gazprom, Norilisk Nickel, Rostelecom, Surgutneftegas and UES, as well as on the RTS index (see Table 12.2). The RTS already has diesel futures in 2007 and is planning to roll out a wide range of new products this year, including aviation fuel and weather derivatives and a number of corporate bond futures, including futures for bonds issued by Russian Railways and gas giant Gazprom, some time in January–June 2007, according to RTS CEO, Oleg Safonov. The RTS launched future trading of oil and gold to the existing dozen blue chips, interest rates and index products in June 2006, but on the first day a total of 5,342 contracts were signed, worth US$3.4m. Gold trading produced a similar result.

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No-one expects Moscow to become a new hub for oil and precious metals trading overnight. RTS vice-president, Roman Goryunov, told journalists at the launch session for oil and gold futures trading that the RTS would be happy if 100,000 contracts were signed by the end of the year after averaging about 2,500 contracts a day in the months after the launch. This is compared to the average 35,000 contracts for Brent trading on the oil futures market in London, where the basic contract unit is 1,000bbl rather than Russiaâ&#x20AC;&#x2122;s basic unit of 10bbl per contract.

Figure 12.1: FORTS trading volumes, Sept 2001â&#x20AC;&#x201C;Sept 2006 (RUBbn) Rbn 16

Rbn 80

Average daily turnover (Lhs) Open positions (Rhs)

14

70

Sep 06

Apr 06

Nov 05

Jun 05

0 Jan 05

10

0 Aug 04

20

2 Mar 04

4

Oct 03

30

May 03

6

Dec 02

40

Jul 02

50

8

Feb 02

60

10

Sep 01

12

Source: RTS, Aton estimates

Table 12.1: FORTS trading volumes, 2005, 2006 (RUBbn) 11M06 2005 Growth

Trading volume, Rbn 2,416 589 310%

Trading volume, m contracts 81 48 69%

Source: RTS, Aton estimates

Table 12.2: RTS trading volumes, by instrument, 3Q2006 (RUBbn) Number 1 2 3 4 5

The most popular exchange-traded instruments in Russia Gazprom, common shares UES, common shares LUKOIL, common shares Futures and options on the RTS index Norilsk Nickel, common shares

Total 3Q06 exchange trading volume, Rbn 986 758 425 220 212

Source: RTS, Aton estimates

MICEX Derivatives Market Section The total volume of trading in the MICEX Derivatives Market Section in 2006 came to RUB894.3bn (US$33.1bn), nearly a five-fold increase on the previous year. The average open RUB/USD contract in the MICEX derivatives market was US$1.52bn. MICEX added futures on interest rates of the interbank money market (MosIBOR and MosPrimeRate) products last year, which got off to a good start with a total volume of RUB3.6bn. To promote the development of the derivatives market, MICEX widened the range of traded instruments by launching trading in futures and options on the MICEX Index and other stock assets and improving the risk management system.

Russian derivatives trading in London Derivative trading of Russian stocks was also launched in London in December 2006. The EDX London launched its Russian derivatives service, the Russian IOB Equity Derivatives Service, offering equity and index derivatives based on Russian Depositary Receipt instruments.

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There are standardised futures and options available for regular trading and clearing on four main Russian blue chips â&#x20AC;&#x201C; LUKOIL, Gazprom, Surgutneftegaz, and Norilsk Nickel â&#x20AC;&#x201C; while tailormade contracts are available on 10 major Russian London-listed names, as well as on the FTSE Russia IOB Index. The introduction of transparent London-based trading in Russian equity derivatives, in addition to FORTS and OTC markets, should further increase the depth and liquidity of the derivatives market, say bankers. Despite being launched just as Christmas was emptying trading floors, the new platform was generating 1,200 contracts a day, a volume that doubled in the first month of the new year. The total value traded in single Russian Depositary Receipts derivatives by the end of January 2007 was US$152.7m, with US$49.8m traded in index derivatives, on 28,670 contracts. Although these figures are minute in comparison with other derivative exchanges (last year the Chicago Mercantile Exchange traded an average of 1.76m contracts a day), analysts say the growing number of Russian listings on the LSE is likely to significantly increase trading volumes. Part of the rationale for the LSE to launch the product is that some of Russia's biggest companies are already listed on the LSE and a total of US$20bn worth of new issues is expected in 2007, half of which is expected to end up on the LSE. In 2006, 10 Russian companies joined the ranks of Russian companies to list on the LSE, including oil company Rosneft and steel giants Severstal and TMK, bringing the total to 19 Russian companies listed in London. The Russian service has already attracted some leading Russian banks to join the EDX in anticipation of growing volumes. Commercial banks UralSib, Renaissance Capital and Troika Dialog had already signed up by January and 11 more Russian banks were in the membership process at the end of January.

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IFR Opportunities in Russian Capital Markets 2008