Vladimir Tikhomirov of Uralsib -

Three months ago when we published our previous macro forecast, we were hoping to see a much faster stabilization in Russia's economic performance than suggested by June-July statistics. While the release of the latest data has required a downward revision of some of our earlier macro estimates, our strategic view on Russia's economy remains unchanged: we continue to believe that the economy will begin to show growth later this year, and that it will likely be moderate.

Despite our view that the next 1-2 months will see increased turbulence on the markets from potential problems within the banking sector, we are confident that there will not be anything resembling the crisis suffered by the Russian and global economies in autumn 2008 in terms of its scale.

KEY CHANGES TO OUR FORECAST

Lower growth in 2009, but higher in 2010. The GDP growth rate for 2009 was downgraded from a contraction of 2.8% YoY to a drop of 5.8% YoY. We also downgraded our 2009 industrial output forecast from a negative of 6.7% YoY to a contraction of 7.9% YoY. In 3Q09, we project a much more modest contraction in GDP (down 3.8% YoY), while in 4Q09 we expect a recovery of 1.2% YoY in the Russian economy. We have also upgraded our growth forecast for 2010 from 4% to 4.2% YoY, due to higher government spending plans, higher real incomes, stronger oil prices and a lower base factor.

Higher incomes ... We have upgraded our 2009 forecast for real income growth (to a drop of 1.2% YoY (versus the previous forecast of a 4.4% YoY fall) due to two factors: 1) the Russian government is on track to fulfill all of its social promises made before the crisis, while 2) the rebound in the ruble rate has helped to push up average real incomes.

... but lower retail sales. The unexpectedly strong real incomes will not contribute to a significant increase in retail sales, as consumers' behavior patterns are likely to be oriented towards economizing rather than spending, and most consumers will be unable to spend on expensive items. This means that while the lower-priced segment of the retail market is likely to see continued growth, sales in the higher-priced segment as well as overall revenue in the retail sector are unlikely to recover until at least the end of 2010. We now project a decline of 4% YoY in retail trade volumes in Russia this year (previously we forecasted a marginal decline of 1.1%).

Forecasts for ruble rate and inflation unchanged. Over the next 1-2 months we expect to see increased volatility in the ruble rate, but we believe the ruble will gradually stabilize into a narrower range between RUB35- 37/basket. The ruble should trade at RUB31/$ by the end of 2009 and at RUB33/$ by the end of next year. In our view, inflation is likely to remain in the double digits through the end of 2009 (12.2% YoY in December), and by the end of 2010 CPI could gradually fall to 9.8% YoY.

NO SECOND WAVE OF RECESSION

Recovery will be slow ... We believe fears of a repeat of the crisis that Russian and global economies experienced in 2008 are unfounded, although this does not mean that the return to growth will be smooth or fast.

On the contrary, we expect recovery to be gradual and volatile, with some important sectors such as construction and some segments of retail and the services industries to continue to lag for some time.

... and banks likely to experience more pain ... We would also not be surprised to see further growth in volumes of non-performing loans (NLPs) and/or bad assets in the banking sector in the next few months. However, we do not expect these developments to evolve into a new wave of crisis, as we believe that, this time around, central bankers, corporate leaders, and policy makers in Russia and globally are better prepared for a possible build-up of problems than they were last year.

... but counteraction has already been taken. In addition, since the start of 2009, we have seen active implementation of various anti-crisis programs in many economies, which we expect will significantly help to dampen the negative effects of a new build-up of problems in the banking sector and in economies at large, should they occur.

CREDIT MARKETS WILL START TO UNFREEZE SOON

Excessive debt leverage ... The core development in the current crisis was the rapid and overwhelming freeze on credit markets, which quickly translated into a build-up of problems in non-financial sectors of the global economy. In Russia, these effects were much more pronounced than in many other parts of the world due to massive growth in leverage of its banking and non-financial sectors in the years preceding the crisis.

... accelerated the slide of the economy. Difficulties in debt restructuring have forced many Russian companies to cuts their investment programs dramatically, which in turn has led to sharp changes in the country's economic growth paradigm. During the twelve months to early 2009, Russia's GDP growth rate collapsed from 8.5% YoY to a drop of more than 10% YoY, which was accompanied by a fall in fixed investment from growth of over 20% YoY at the start of last year to a contraction of 20% in mid- 2009. These abrupt changes were largely the result of the closure of global and domestic credit markets to Russian borrowers.

Credit markets could start to thaw in 4Q09. We believe that this situation is likely to start improving in 4Q09, when we expect global creditors to start becoming more receptive to new loan requests; companies should find it easier to restructure their debts, and investment volumes should gradually start to pick up.

A RISE IN DOMESTIC DEMAND

Demand fell on credit-market closure, state-spending cuts, and changes in consumer behavior. Limited access to credit for corporate and individual borrowers was one of the main reasons behind the dramatic fall in domestic demand. The two other factors were (1) a curbing of most statefunded investment programs, which, as a result of the crisis has, become overwhelmed by the rapid growth in demand for spending on social issues, and (2) changes in the behavioral patterns of Russian consumers, who have shifted from excessive spending to economizing.

Domestic and global demand will start to improve soon. We do not expect miracles, and would not be surprised to see demand remaining suppressed for quite some time in the future. However, this does not mean that demand will remain at its current low levels. On the contrary, we forecast that corporate and consumer demand in Russia will gradually start to pick up within the next few months. This process will be driven by stabilization in the Russian and global economies. There are already a few promising signs of change: over the past three months, the unemployment rate in Russia has dropped from 9.5-10% to 8-8.5%; after falls of 9-10% YoY in late 2008 and early 2009, real incomes have recently recovered, with YoY growth rates in April-June hovering around -1/+1% YoY; funding from the government's anti-crisis programs has finally started to filter through to the wider economy, which has led to a recent improvement in production orders in some key sectors of Russian industry (i.e. manufacturing and construction materials).

NO BIG DIP IN OIL PRICES

Oil unlikely to trade below $40/bbl ... Based on our scenario of a gradual improvement in global demand and a moderate recovery in the world's largest economies, we believe the chances of another big slump in energy prices to be low. While market volatility could easily push oil prices down from their current levels, we would be surprised to see these prices hitting their December 2008 lows, and consider it highly improbable that oil prices could stay at such low levels for a protracted period of time.

... which means that risks to Russia's future growth are more on the upside. With its high dependence on commodity exports, the low oil price risk is likely to remain subdued for Russia in the coming months. Moreover, in our view, the chances are high that in the coming months and years, oil prices could average significantly above current official forecasts, which could lead to higher budget revenue and better growth rates in the economy than that forecast by state planners.

RUBLE WILL NOT COLLAPSE

Administered devaluation ... Russia has an administered currency, which means that any major changes in the ruble exchange rate could be triggered by market movements to the same extent that they could come from policymakers' decisions. This is a major risk factor for investors, particularly due to the lack of transparency and consistency regarding actions undertaken by Russia's monetary authorities. A year ago, when Russia entered the crisis, the country's top leaders were publicly upbeat about the ruble's fortunes, but just two months into the crisis, their attitude had totally reversed. The result was the so-called 'gradual devaluation' of the ruble, which was unprecedented in the length and the size of the speculative effect that it created.

... has increased currency risks. The heritage of this devaluation is likely to remain embedded in investors' minds for quite some time, and is likely to trigger new waves of anxiety about the prospects for Russia's currency whenever the market mood changes. However, despite the clear difficulties in forecasting the future movements of regulated currency rates, we believe that in the coming months, the chances of the ruble breaking out of the trading corridor that was set by Russia's central bank are close to zero.

CBR's currency corridor unlikely to be breached ... The corridor set by the CBR is quite wide: it ranges from RUB26 to RUB41 to the euro/dollar basket. The upper limit of the basket (RUB26/basket or RUB22/$ at a $1.41/EUR rate) is unlikely to be breached any time soon, even if, for some reason in the future, oil prices return to their peak levels of mid-2008. In early February 2009, the ruble was trading very close to the lower limit of the basket (RUB41/basket or RUB34.6/$), and if we see growth in bearish sentiment among investors, a return to this level is quite possible in the next one-two months. But even if this happens, we do not expect the ruble to weaken further unless we see a major turn for the worse in the global economy, financial markets, and investor sentiment.

... unless oil stays below $40/bbl. In our view, in order for the ruble to set new lows, oil prices should break downwards through $40/bbl and stay there for at least a few weeks. It is only then that the CBR would be under pressure to decide whether it should continue supporting the currency at the expense of the country's international reserves, or let the ruble go down further. Since we view a scenario of extremely low oil prices as unlikely, we do not anticipate any moves in the ruble rate outside the basket's corridor in the near future.

Calls for new devaluation ... Apart from market sentiment, another factor that could affect the CBR's currency policy is politics. In recent years, powerful voices in Russia could be heard almost every month calling for a new devaluation of the currency. Their most common argument is that such a move would automatically increase domestic producers' competitiveness and, therefore, provide much-needed help to the economy.

... likely to fall on deaf ears. However, we remain confident that these arguments will not affect the behavior of Russia's currency decision-makers, as politicians are well aware of the extremely negative fallout that a possible new wave of currency devaluation would create. Thus, they know that if the ruble's stability were to be broken, this would cause a new wave of capital flight from Russia, would hit the deposit base of Russia's banks (which were already weakened by the crisis), could lead to a closure of credit markets to the majority of Russia's corporate borrowers, and would significantly undermine the image of Russia's top politicians as guardians of stability.

KEY CHANGES TO OUR FORECAST

Lower growth in 2009, higher in 2010. Our forecast for the GDP growth for 2009 has been downgraded from a negative of 2.8% YoY to negative 5.8% YoY. We also downgraded our 2009 industrial output forecast from a negative of 6.7% YoY to a negative of 7.9% YoY. According to preliminary data from Rosstat, Russia's GDP output contracted 10.4% YoY in 1H09. To a large extent this sharp fall in GDP was driven by a collapse in investment inflows, which resulted from the effective closure of the global credit markets and curbs in government spending. We believe that the decrease in GDP volume was actually lower than the numbers reported by Rosstat, because, as the crisis developed, a significant portion of economic activity has moved to the informal sector, which is poorly covered by statistics. For 3Q09, we predict a much more modest contraction in GDP (down 3.8% YoY), while in 4Q09, we expect the Russian economy to return to growth (1.2% YoY). We have also upgraded our growth forecast for 2010, from 4% to 4.2% YoY, due to bigger state-spending plans, higher real incomes, more supportive oil prices and a lower base factor.

Higher incomes ... We have upgraded our forecast for growth in real incomes in Russia. In 2009, we expect real incomes to fall by 1.2% YoY (our previous forecast was a 4.4% fall YoY), and in 2010 we predict incomes will grow by 2.6% YoY. Two factors have prompted us to change this forecast.

First, in 2009 the Russian government fulfilled all of the social promises made before the crisis, during the election campaigns of 2007 and 2008.

This means that despite the crisis, state salaries and pensions are growing at rates that significantly exceed inflation. Second, the rebound in the ruble rate following its depreciation has also helped to push up real incomes. As a result, in 6M09 real incomes have actually risen 0.5% YoY, which is in stark contrast to the 1998 crisis, when six months after the crisis began, real incomes had fallen over 23% YoY.

... but lower retail sales. We believe that the unexpectedly strong real incomes will not contribute to a significant increase in retail sales for two reasons: (1) even if the crisis were to end soon, consumers' behavior patterns are likely to be oriented towards economizing rather than spending, as fears of a second wave in the crisis will not recede quickly; (2) consumers ability to spend on expensive items (cars, real estate) will continue to be undermined by the lack of access to credit, as banks are also likely to pursue conservative policies in the aftermath of the crisis. This means that while the lower-priced segment of the retail market will continue to boom, sales in the higher-priced segment are not likely to recover until the end of 2010 at the earliest.

Forecasts for ruble rate and inflation unchanged. Over the next 1-2 months we would not be surprised to see higher volatility in the ruble rate, which could be driven by instability on the global markets as fears of a second wave in the banking sector start to grow. However, towards the end of the year as markets stabilize, the ruble should gradually stabilize into a more narrow range of between RUB35-37/basket. We believe the ruble will trade at RUB31/$ by the end of 2009 and at RUB33/$ by the end of next year. In our view, inflation is likely to remain in double digits throughout the remainder of 2009 (12.2% YoY in December) and by the end of 2010 CPI could gradually fall to 9.8% YoY.

Vladimir Tikhomirov is senior economist at Uralsib

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