Alfa Bank -

We upgrade our 2007 GDP growth forecast to 7% based on better-than-expected industrial growth in 1Q07 (7.9%).

We expect the continuing consumption boom to boost the retail lending market to $125 bln by 2008. Strong economic growth should also help to control inflation, now expected at 7.5% for the year.

The economic results for 1Q07 have been very impressive, leading us to upgrade our GDP growth target to 7% for the year:

Russian economic growth accelerated to 7.9% in 1Q07, driven by the strong manufacturing and commodity extraction sectors.

Dynamic growth should help to keep inflation at 7.5% for FY2007.

Households consume 85% of disposable income: The real disposable income level of the Russian population is back to the 1991 level and is increasing by 10% p.a. Considering that savings did not increase in previous years and around one-third of savings has in the past been allocated to the purchase of real estate, the Russian population in coming years will be more likely to borrow than to save in Russian banks.

We project that the retail lending market will reach $125 bln by 2008: The mortgage and credit card markets are expected to be the driving forces behind banking sector growth this year. While concerns remain about bad loans in Russia, we believe that with total retail at 8% of GDP, this is not a serious threat. Retail loans represent just 20% of total loans, and their contribution to banks' net profit is still very modest. Thus, the retail market has not yet grown large enough to become a serious threat to banking stability.

Economic growth accelerated in 1Q07

The first set of economic results for 2007 has proven very positive. According to the Cabinet's preliminary estimates, GDP grew by 7.9% in January-March 2007 vs. the 6.7% reported for FY2006. We attribute this strong growth to an acceleration in investment growth, which jumped to 20% y-o-y in the closing months of the previous year.

The response to increased investment pushed output in local industries.

Industrial production increased 8.4% y-o-y in 1Q07, and the manufacturing sector went up 14.5% y-o-y after having reported a modest 2.8% increase a year ago. Manufacturing sector growth is driven by the production of railway, agricultural and other equipment, which reflects Russian state companies' higher capital expenditures.

In the meantime, local companies operating in the consumer markets, i.e.

targeting private consumers, are facing very strong competition from imports.

While in 2006 local demand went up by 7.4 ppts in real terms (see figure 1), only 0.6 ppts were from sales of locally produced goods, while import growth covered 92% of the increase. In 2004-2005, the share of import consumption in total consumption growth represented around 50-60%. In other words, Russian enterprises' potential to benefit from the local consumption boom is shrinking.

One positive development was the acceleration of oil sector production by 4.2% y-o-y in 1Q07. Extraction of crude has been the main driving force behind this acceleration. For the last two years, commodity extraction companies reported only 1.3-2.3% growth y-o-y. We believe this is the result of the improvement of operations at the Yukos companies, which in previous years had posted declining output due to the uncertainty behind their ownership. Additionally, we believe that the increase in commodity extraction reflects top officials' general understanding that a squeeze in the trade balance is on the horizon. In order to maintain a positive trade surplus, Russia has to increase crude extraction and volumes of crude exports. This is completely in line with recently emerging claims that the tax regime for oil companies will be eased in order to stimulate investments into production.

Very strong GDP and industial growth will clearly help decelerate inflation. CPI in 1Q07 increased by 3.4% contrary to the 5.0% seen in 1Q06. While our initial 2007 inflation target was 8%, we now believe that 7.5% is more likely. We also raise our GDP growth target for this year from 6.5% to 7.0%.

The Cabinet's dilemma

The upcoming presidential elections have resulted in intensifying discussions about next year's tax policies. Commodity producers are increasing pressure on the Cabinet for tax relief after 2008. In the meantime, it is obvious that the non-commodity sector also needs support to protect its position against import growth.

Commodity producer lobbying is focused on the need to increase oil production, which requires significant CAPEX. Russia's ambitious plans to increase exports to new markets like China call for an increase in oil extraction and higher infrastructural expenditures. The commodity extraction sector currently indicates 4% growth y-o-y but insists on fiscal support for investment projects. Given that oil companies are still important political players, the promise to ease oil taxation could become a part of the presidential campaign.

The recently announced three-year fiscal plan does not provide any obvious room for the Cabinet to maneuver. An expected decline in oil prices will result in lower tax collection from the fuel sector, which could halve in three years, from 11.9% of GDP in 2006 to 6.2% of GDP by 2009. However, this decline is due not to a decline in tax burden, but to the declining contribution of the fuel sector to GDP. According to the Cabinet, the commodity sector's share in total GDP will decline from the current 21% to 15% by 2010. Fiscally speaking, this drop will be offset by a minor increase in local tax collection, going up to 13.1% of GDP in 2009 from the current level of 11.3% of GDP. Cabinet efforts to keep the expenditures-to-GDP ratio close to 17% will help to keep a small surplus in the budget; however, we believe that the fiscal deficit is not an acceptable option.

This means that any reduction in commodity sector taxation leaves no space for a decrease in tax burden on the rest of the economy, which is already suffering from competition with imports. Thus, the Cabinet faces a tough dilemma of choosing between the need to stimulate economic diversification and the intention to maintain a strong position on international commodity markets.

Another plausible option for resolving the situation could be the stimulation of higher energy efficiency. In past years Russian energy efficiency improved slightly due to strong GDP growth. However, it is still half that of developed countries, which consume 0.1-0.2 '000 toe/GDP PPP versus 0.4 in the case of Russia (see Figure 4). To resolve the energy efficiency issue, Russia needs to accept a period of fast tariff growth, which is not politically acceptable at this time. A delay in raising tariffs until after the 2008 election means that all discussions about possible tax burden cuts must be postponed even further.