Roland Nash of Verno Capital -
2012 is shaping up to be a year of change in Russia. Both the economic and the political models that have underpinned the country for a decade have stopped working. The economy seems incapable of delivering the rate of improvement in living standards that can justify the political sacrifices. A new generation of Russians used to the relative efficiency of the private sector are fed up with bureaucratic incompetence and a self-serving government. There might be an attempt to fix the existing models; more likely they will need to be replaced. Perhaps the biggest question facing Russia in 2012 is whether Prime Minister Vladimir Putin is capable of delivering Russia from the failures of Putinism.
Below we lay out our top-10 trends to watch for 2012.
1. Not the Arab Spring
It will likely prove a common mistake in 2012 to conflate the protests in Russia with the coloured protests of the region or the Arab Spring. The Russian protests are different. Few people are protesting about anything very big. Very few want to see any kind of revolutionary change in Russia. The Communist leader, Gennady Zyuganov, who had consistently polled as the most popular opposition leader, effectively ruined his election chances by comparing the Russian protests to those of the Orange Revolution in Ukraine. The protestors were grossly offended by the comparison. Most people are fed up with a very wide range of relatively minor complaints. Poor schooling and deteriorating health care; petty corruption and an ineffective police force; endless traffic jams while government officials breeze through in imported Audis with blue flashing lights. While the economy boomed, these inconveniences were overlooked. Following four years of economic turmoil, people are ready to do more than privately complain. But they do not want to see wholesale change. The Russian protests, and attempts to deal with them, must be understood in a Russian context. The likely frequent failure to do so will generate market volatility, and opportunity, in 2012.
2. Putin post-Putinism I - the politics of managed liberalism
It will only be after his return to the presidency in March that Putin will likely unveil his vision for Russia. Before then, politics will be a mix of populism and opportunism, and it may not look pretty. After the presidential elections in March, Putin faces a choice. He can either blame the popular dissatisfaction with managed democracy on too little democracy, or too little management. The fear is that he decides it was too much freedom and the failure of control which led to protests. Anti-US rhetoric plays well in Russia, as does a stronger hand over the near-abroad. Fewer people trust the West than trust Putin. It is possible that the likely pre-election lurch towards nationalism and populism becomes the new normal in Russia. The hope is that he recognises that generational change and the success of ending the chaos of the nineties and raising living standards has led to the point where Russians demand more accountability from government and more oversight over government. Decentralisation of some powers, fairer elections and political pressure on bureaucratic elites are more effective ways to hold on to power. The most visible sign of change could well prove to be a managed liberal party - the sponsorship of a liberal movement which is opposed to nationalism and bureaucratic incompetence but not to Putin.
3. Putin post-Putinism II - The economics of failed Kudrinism
Despite the political demands of the recent protests, the top-three concerns for Russians remain inflation, unemployment and living standards. The protests themselves are unlikely to have happened at all (at least not now) if economic growth had continued at the same pace as between 2000 and 2008. Generating rapid, widespread economic growth is the best way to contain the political protests. The problem facing policymakers is that the model which generated growth between 2000 and 2008 stopped working with the economic crisis of 2008. Over-taxing the oil sector, decreasing taxes elsewhere, not spending and holding real interest rates well below zero for long periods generated extraordinary (and unsustainable) economic growth for nearly a decade. The last four years have demonstrated the failure of what was, essentially, Kudrin's economic policy. In the future, the government is going to have to play a larger role, which means increased government spending, a more active economic policy and a lot of failed national projects. The need for public investment into social infrastructure and the inability of the government to spend effectively is perhaps the most under-appreciated cost of the incompetency of Russia's bureaucracy.
4. New faces, old loyalties
It is already clear that there will be a major overhaul of the personnel across government. Several big-hitters have already fallen victim to the electoral transition, including Alexei Kudrin and Vladislav Surkov, two of the principal architects of Putinism. Others will surely follow. The easiest and best way to show that Putin is reacting to the demand for change is to bring in new faces to government. This will likely prove easier from the Kremlin than from the White House. As president, Putin will be less reliant on the ministers than he is as prime minister. But equally, Putin has tended always to keep only a small number of people close to power, and to reward loyalty even above competence. The dynamic between the need to change the current power structure and loyalty to a chosen few will likely create political tension. Kudrin, for instance, may well be brought back into power perhaps as Prime Minister. But that would undermine the agreement Putin has with Medvedev, permanently tarnishing Putin's reputation as somebody who sticks to his promises.
5. A public-sector Khodorkovsky
Putin's first period as president can be split in two around the arrest and prosecution of Mikhail Khodorkovsky. Before Khodorkovsky, it was unclear who controlled Russia's resource industries, and therefore who held the purse strings. After Khodorkovsky, there was no such ambiguity. Whatever one thinks of the arrest, the total destruction of Russia's most powerful man took, and demonstrated, tremendous political strength. It was also enormously popular. In today's Russia, the biggest domestic threat to the political power of the Kremlin is the vast waste and inefficiency of Russia's bureaucracy and state-owned industries. The total emasculation of a powerful person within the public sector would be the loudest signal that the new presidency marks a new era, and it would be equally as popular as the arrest of Khodorkovsky.
6. Borrowing from the credibility of international institutions
One of Russia's most obvious weaknesses is a lack of institutional credibility. The rule of law, the independence of the judiciary, the competence of law enforcement, the standard of corporate governance and an accountable government are all questionable. This leads to uncertainty, corruption and under-investment. The long-term solution is to build domestic credibility. A shorter-term fix is to tie Russian institutions to international counterparts and leverage off their existing credibility. WTO membership achieves this in trade negotiations. Listing on major exchanges in New York and London does the same for corporates. Committing to host the Asia-Pacific Economic Cooperation (Apec) summit in 2012, the Winter Olympics in Sochi in 2014 and the World Cup in 2018 secures the momentum for domestic investment in infrastructure. Expect to see more of the same in 2012.
7. Economic Growth Independent Of The Oil Price
One of the unsung successes of 2012 has been the more flexible ruble. Allowing the ruble to depreciate may have raised ruble borrowing costs, but it has been more than compensated by the improvement in competitiveness and the preservation of international reserves. The flexible ruble has done its job at providing some insulation from global volatility. While the Russian growth remains vulnerable to either a sudden global financial crisis or a collapse in commodity prices, the flexible ruble means that, barring extremes, economic growth should be predictably between 3% and 5% for 2012.
8. Consolidation and internationalization of state-owned industries
There is something rotten in the state-owned industries. In a period when they should be driving the much-needed domestic investment boom, the state monopolies continue to be tremendously wasteful, as responsible for capital flight as they are for generating growth. The politics of recent months has demonstrated the risk of not tackling the endemic mismanagement. Some notable progress has been made over the last few years. Management change at Sberbank remains the poster-child for both addressing the issue and for the potential benefits. Gazprom and Transneft are being persuaded to recognize the need for an improved relationship with the market if they are to raise the funds for their investment programmes. Early in Putin's next presidency is the best time to accelerate the pressure for change. Further management change and deeper consolidation among state enterprises is a trend to watch in 2012. A continuation of the internationalization of national champions is another.
9. Trouble in the near abroad
The good news about Ukraine is that it has long experience with surviving crisis. Apart from a brief one- or two-year period after the Orange Revolution, Ukraine has been in crisis for the past two decades. But with per-capita income now less than that of China, the budget surviving on a drip-feed from the IMF, most of the business and political elite focusing on removing assets from the country and the economy amongst the most exposed to Europe, Ukraine looks as vulnerable as it ever has done. In Kazakhstan, the political stability of the last 20 years has relied on the health of the president, Nursultan Nazarbayev, who will turn 72 in 2012. The recent reshuffle among the country's elite suggests a jostling for position among the potential succession candidates. While a political "Spring" in Kazakhstan remains unlikely, the country looks as vulnerable to global downturn as it has at any time. Within the CIS, Russia's relative strength is rising. With Europe preoccupied and China a rising power in Central Asia, 2012 may prove a year when Russia increases its special relationship with the near abroad.
10. Russian equity in a sweet spot?
Tension in Iran, Iraq, Bahrain, Syria, Yemen, Egypt and Nigeria together with uncertainty over the outlook for global economic growth makes it as likely that oil prices will rise as fall. The ruble is 10% cheaper than a year ago. The combination of high oil prices and a depreciated ruble is ideal for earnings. Russian companies are, for the first time, paying out retained earnings to shareholders. Equities are as historically cheap on a 2012 P/E basis both in absolute terms and relative to emerging market peers as at any time in the last decade. Political tension in Russia has exacerbated global fears of impending crisis leaving the market pessimistic about the outlook. Cheap stocks, great earnings outlook, companies recognizing the need for improved relations with investors and widespread pessimism just might be a sweet spot for Russian equities heading into 2012.
Roland Nash is CIO of Verno Capital
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