UralSib in Moscow -

Planning greater diversity. The government's declared economic priority under President Dmitry Medvedev is to more actively use the financial resources built up during Vladimir Putin's presidency and the high revenue stream coming from commodities to give the economy a more broad range of drivers and risks. At present we can see a more healthy balance in the make-up of GDP as incremental growth is coming from new industries. But this does not present a fully accurate picture. The financial resources upon which much of the current growth is based are heavily dependent on commodity industries, and the state acquired a dominant role in these industries during Putin's presidency. Russia now needs to accelerate the use of these resources to create genuine diversity in the economy while the favourable commodity price backdrop persists. This would involve not only spending effectively to promote growth in new industries and repairing and extending the country's infrastructure, but also following through with Medvedev's promise to reduce the role of the state in the economy. This would be no easy task given the entrenched position that the state-connected companies now have in key sectors of the economy.

Danger is in a delay. We believe there is a real danger that the government will not make sufficiently fast progress in this favourable commodity price environment and will later be faced with a worst-case scenario of declining growth and commodity cycle downturn.

Growth to come from new industries. Should the government's policies and strategies prove effective, the potential reward - not just for the overall economy, but also for equity investors - will be huge. The current structure of the stock market reflects the main influences in the economy, commodities. The value of companies in the oil, gas and metals sectors represents 66.6% of the total value of all listed Russian equities. This structure reflects the economic priorities of the Putin administration. Now that we are shifting to creating sustainable and balanced economic growth, we should also see the equity market structure change to reflect this. This will mean more consumer and manufacturing companies listing and more rapid growth in their valuation as their sectors of the economy grow faster.

Consumer, manufacturing and real estate companies currently account for less than 10% of the value of all listed Russian equities. We expect this figure to eventually rise to around 50% contingent on the next phase of the government's economic plan proving successful.

Potential for sustainable growth depends on political will. Russia's current economic growth pattern is becoming increasingly vulnerable and unsustainable, in our view. Our analysis of GDP output dynamics demonstrates that even a renewed surge in commodity prices would be unlikely to halt the development of negative trends in many areas, primarily in sectors producing goods. We believe the resolution to this problem lies in the political arena, not the economic. Political will is required to change the role of the state from principal wealth redistributor to economic growth promoter. We believe the government needs take several difficult decisions, for example to revise the current taxation system, promote true competition, break up the monopolies and, more importantly, endeavour to reduce state interference in the economy. So far, we have seen exactly the opposite - the state becoming larger and more paternalistic - which is making it ever harder to overhaul the economic growth pattern.

COMMODITY PRICES + TAXES = CONSUMER DEMAND AND GDP GROWTH

Half of GDP is generated by trade, manufacturing and tax collection. Almost half of value-added production in Russia is generated in three areas: retail and wholesale trade, the manufacturing industry, and net tax collection. These three areas had a combined share of 48.9% in Russian GDP in the first quarter. Over the past five years the share of trade in gross GDP output has become smaller while the share of the other two areas has increased. The contribution of taxes to GDP rose from 12.5% in the first quarter of 2003 to 14.4% in the first quarter in 2008 on the back of peaking commodity prices and the introduction of a higher tax burden on the resource sector in 2004. The increased tax take has allowed the state to increase social spending and investment, which in turn has helped to boost domestic output of manufactured consumer and capital goods: The share of the manufacturing industry in GDP increased from 14.6% in 1Q03 to 16.2% in first quarter. However, the expansion of value-added output in these and other sectors reduced the share of trade in GDP from a high of 20.9% in the first quarter of 2003 to 18.3% five years later.

Global commodity prices boost share of resource industry in GDP. The fourth most important contributor to value-added output in Russia is the resource industry, which in the first quarter accounted for 9.4% of GDP - a significant increase on its share five years previously (6.2%). However, the rising share of the resource sector was to a large extent the result of the rapid increase in global commodity prices rather than the consequence of significant gains in domestic productivity. According to official data, between 2002 and 2007 Russia's resource industry (which includes oil, gas, metals and mining) increased output volumes by 22.5%, while its value-added output rose by 23.2%. The only other sector in which production growth by volume lagged that of value-added output during the same period was agriculture, which has also gained significantly from the recent huge rises in global soft commodity prices.

Consumer boom driving up value-added output in the financial sector. The contribution of the financial services sector to GDP has also risen significantly: In 2003 the financial sector accounted for 3.2% of GDP, but five years later that share had risen to 4.4%. This rise was supported by massive gains in real incomes (up 68.8% in 2002-07), construction output (up 94.3%) and retail sales volumes (up 82.5%).

GDP shares of transport, agriculture and utilities fall. In five years, the transport and communications sector posted the largest decline as a share of GDP (9.6% vs. 7.5%). Two other sectors also saw declining shares in the same period: agriculture (from 2.9% to 1.9%) and electricity generation and utilities (from 4.4% to 3.5%). The negative productivity trends in these sectors were compounded by a lack of reforms (agriculture, railroads, road construction), uncertainties associated with restructuring (utilities) and market saturation (telecommunications).

PREVIOUS GROWTH FACTORS WEAKENING

Trade, industry and taxes account for 60% of GDP growth. A breakdown of GDP growth by sector gives a slightly different picture. In the first quarter more than 60% of GDP growth was delivered by three sectors (trade, manufacturing and the resource industries) and net tax collection. In the first quarter trade became the largest contributor to GDP growth with a share of 18.7%. The manufacturing industry - the leading GDP growth contributor in 2007 - dropped to second place with a share of 16.6%. Despite almost stagnant physical production levels in the resource industry (output rose by just 0.7% on year in the first quarter), this sector accounted for 13% of GDP growth, which was almost purely down to the recent surge in global commodity prices. The same factor also helped to boost the contribution of net taxes to from 11.8% of GDP growth in 2007 to 12.2% in the first quarter.

Construction, real estate contribution to growth shrinks. A combination of peaking house prices, slowing income growth and tighter credit conditions has led to decrease in the share of the construction and real estate sector in Russian GDP growth. In the first quarter, construction accounted for 6.8%, down from 7.5% in 2007, while real estate accounted for 7.4%, down from 9.7% in the previous year. Over the past five years the contribution of the transport and communications sector has almost halved, from 11.1% in 2003 to 5.8% in the first quarter.

Consumer sectors lead in value-added output. Our analysis of changes in the structure of Russian GDP in constant prices shows that in the five years to the first quarter the largest gains in value-added output were recorded by the consumer sectors. A recalculation of real value-added output by sector based on 2003 prices puts the construction industry, with a growth rate of 98% in 2003-08, well ahead of all other sectors. The retail and wholesale trade sector comes second, with a growth rate of 68%, followed by financial intermediation (67%), the financial sector (64%) and net tax collection (54%). Overall, between 1Q03 and 1Q08 Russian GDP in constant 2003 prices expanded by 40%, but growth in all sectors of the real economy lagged behind: value-added output rose by 34% in the manufacturing sector, 16% in the resource sector, 4.2% in the agricultural sector, and by a mere 2.2% in the utilities sector.

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