UniCredit in Russia -

Between May 1-26, prices in Russia rose by 1.2%, which brought headline inflation in May to 15% on year, a level last seen in December 2002. In our EMEA strategy report Pouring oil on choppy waters of November 30, we suggested inflation above 15% could be one of 10 surprises in 2008 (a second, oil at $120/bbl, has already materialized).

Despite the accelerating rise in prices, we would reiterate that inflation alone does not pose an immediate threat to Russia's ongoing economic expansion: the pace of nominal wage and disposable income growth by far outpaces any measure of inflation, leaving plenty of room for real expansion in consumption. Moreover, the substantial price increases allow companies to step up the transfer of rising production costs on to consumers, thus opening the door for further profitability improvements.

This is particularly relevant for sectors with direct exposure to consumer markets, such as retailers, consumer goods, utilities, and particularly food producers. The latter are likely to benefit most of all, as the majority of price increases are concentrated among the foods group of goods, and should directly increase producers' revenues.

At the same time, surging inflation should trigger a further tightening of monetary policy, which should further worsen the wholesale funding picture for Russian banks. In turn, this could slow the overall growth of the sector and put pressure on banks' profits, thus endangering share prices. This situation could be further aggravated by a slowdown in deposit growth: inflation by far outstrips any interest on deposits, implying a real decline in the value of savings.

Continued real growth

Nominal wage and disposable income growth by far outstrip inflation dynamics. Despite the increasingly ugly data flow, we do not believe the existing level of inflation poses an immediate threat to the current consumption boom in Russia, as the recent acceleration is predominantly demand-driven, meaning its real effects should be limited. Thus, nominal wages and disposable incomes in Russia continue to rise at rates that far outpace inflation, pushing real growth into high double-digit territory on top of already high inflation readings.

We also expect existing pressures on the Russian labour market to continue to fuel strong nominal wage growth, which we forecast to top 24% in 2008 and continue in strong double digits over the next several years.

Moreover, the continued growth of nominal incomes is leading to significant increases in wealth for increasingly large layers of the population, creating a rapidly expanding middle class. Thus, according to our estimates, the number of people with disposable income over $1,000/month has nearly tripled in just three years, from barely 10m in 2005 to exceed 28m in 2007. We expect this trend to continue into the future, due to the combination of robust economic growth and the Russian demographic squeeze. This leads to radical changes in the structure of consumption, as an increasingly large share of the Russian population moves away from near-subsistence models of consumption, thereby creating a boom of demand for higher-quality, higher valued-added goods. We would also emphasize that this process of real consumption growth and improvement looks to continue despite considerable increases in food prices - we believe the story of the emerging Russian middle class is still largely in the initial stages of development.

We see rising inflation as beneficial for companies exposed to domestic consumer demand, such as food producers and retailers such as X5 Retail Group, Magnit, and Dixy. These companies are set to benefit the most from the buoyant expansion of nominal as well as real demand. Thus, substantial price increases, which are mostly concentrated among the foods group of goods, directly boost company revenues, but also enable them to transfer continued production cost increases onto consumers without compromising healthy profit margins. Moreover, the companies now have a wide-open opportunity to benefit from price dynamics, since the Russian government has lifted all price freezes on politically sensitive food items in May.

We expect to see similar positive effects the utilities and gas producers. Thus, strong acceleration of headline inflation makes it increasingly easier for industries to lobby for double- digit tariff indexations in the future. As an example, we would point to the recent approval of a highly aggressive long-term energy tariff indexation plan by the government, which is an integral part of an overall upbeat outlook for these sectors.

Anti-inflationary response, real fallout in savings to slow banking sector development High inflation and long-lasting negative interest rates should have an adverse effect on the real value of savings, which could seriously undermine the dynamics of domestic savings.

The latter could negatively affect the national banking system's domestic deposit base growth, and thus slow growth potential for the whole sector. Moreover, the Central Bank of Russia (CBR) is also likely to intensify its anti-inflationary efforts with further tightening of monetary policy. It has already hiked the key overnight direct repo rate twice this year, and we expect it to proceed with another two or three 50-basis-point hikes in 2008, bringing the rate to 7.0-7.25% on overnight loans. We also expect the CBR to tighten reserve requirements (which it has already done twice this year, in an attempt to control massive capital inflows - the primary driver of monetary expansion, due to the de-facto fixed exchange rate regime).

Overall, we think that the CBR's anti-inflationary efforts could further intensify problems with wholesale funding for Russian banks and should further increase competition, potentially pushing for sector consolidation around banks with access to liquidity - either domestic market leaders (most likely with government support) or foreign banks with easy access to ample external financing.

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