Aton Capital in Moscow -

We view the rapid increases in Russian labour costs as a major economic challenge for Russian companies and the economy in general. We forecast labour cost increases will seriously diminish Russia's competitive advantage of relatively cheap labour and cause a deceleration of gross profits in the economy.

Over the past three years, labour costs in Russia rose by almost 50% in inflation-adjusted terms. In dollar terms, wage increases were even higher. Thus, in June, average gross wages in Russia reached $530/month, about 30% higher than in June 2006. As a result, the average Russian worker now earns about $6,000 a year, which is very reasonable by major emerging market standards.

We expect real and nominal labour costs to continue to rise quickly throughout the forecast horizon. Thus, in 2007 we expect real wage growth to exceed 15.1%, with average annual nominal wages forecast to reach $520/month. We also expect the average nominal wage to almost double to above $1,000 by 2011, reaching $1,668 in 2015.

Labour cost increases are already affecting corporate profits by eating into profit margins; and we expect their importance to increase in the future. We think this particularly affects companies in labour-intensive sectors such as retail, banking, mining, telecommunications and industrials. On the other hand, sectors such as electricity production and distribution, metals processing and consumer goods should be affected to a much smaller extent, mostly because of the low share of personnel costs.

We believe the rapid increase in labour costs is driven by a demographic squeeze and high demand for labour in Russia. As a result, we think all positive macro developments in the Russian economy likely to be accompanied by even faster real wage growth.

In our view the only sustainable long-term solution to the labour cost problem in Russia is an increase in labour productivity. Despite all the economic reforms that took place in Russia over the past 15-20 years, the Russian economy remains largely labour intensive, as labour productivity in Russia lags far behind both the developed world, and most other Central and Eastern European countries.

Therefore, we believe effective labour policies and labour productivity enhancements could become important factors determining corporate profitability in the future. We also think another increasingly important company characteristic could be management's ability to resolve labour disputes and maintain good relationships with trade unions.

Not so cheap anymore

Rising wages has revived the labour movement, which was all but non-existent in Russia just a few years ago. Even though strikes and legal labour disputes are still uncommon, there was an increase in occurrences of organized labour demands over the past year. Most importantly, strikes demanding wage increases usually affect successful companies, which tend to already have the highest wages. For example, in 2007 collective action took place in the Russian production facilities of Heineken, Ford, leading Russian auto manufacturer Avtovaz and major cement producer Evrocement. In all cases, workers demanded substantial pay increases of over 20-25% (over 100% in Avtovaz' case) on top of already relatively high wages in their localities.

As a result, we think that Russia should no longer be viewed as having an abnormally cheap labour force. We expect average gross nominal monthly wages in Russia to reach the current levels in Eastern Europe in 2010-2012 and approach Portugal's current level in 2014. Moreover, wage growth in rapidly growing sectors is almost certainly to exceed average growth rates, which should make certain types of Russian employees more expensive than their European counterparts. Overall, we believe that within the next several years Russia's competitive advantage of relatively cheap labour will continue to diminish.

Wage inflation is starting to seriously affect company profits, especially those with high growth rates. For example, in 2006 major Russian retailers such as Pyaterochka and Magnit increased their sales by 45.1% and 58.8%, respectively. Their labour costs, however, jumped by 67.8% and 68.1%, which increased the weight of labour costs in total sales by 1.1 percentage point and 0.5 point, respectively. Higher labour costs were also at least partly responsible for earnings below forecasts at a variety of other Russian companies - from telecom and media companies, such as Rambler and CTC Media, to oil and gas majors. We expect the negative influence of labour cost on profits to increase in the future as sales expansion growth starts to decelerate due to a high base effect.

On the macroeconomic level, we expect high labour cost growth to cause significant redistribution of Russian national income from the corporate sector to the population. As a result, increasing the share of employees' wages could squeeze the economy's gross profits from over 40% of GDP in 2007, to less than 30% by 2015.

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