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Is this crisis really that bad? Well, at this point - yes it is. The economic data coming in at the moment is truly shocking. But what investors really want to know is, will things get worse? The answer to this question is up in the air, but a growing (albeit still small) number of voices are saying we are at, or near, the bottom, while bond spreads suggest the worst is over.

There is still very little clarity and much depends on how well the US deals with its own problems. The Russian government has become more pessimistic than it was in December and announced in the last week of January that it had downgraded its economic growth forecast for 2009 to minus 0.2% if oil remains at an average of $41 per barrel - ie. the Russian economy will contract for the first time in a decade. This is against the 2.4% of growth the state was predicting only a month ago (assuming oil of $50). Nearly every economic indicator you care to name is at some record low, or has fallen with record speed, and other analysts are predicting even worse results for this year.

However, a few optimists are sticking their heads above the parapet. Their argument goes: all this pain is inflicted from the outside and there is nothing fundamentally wrong with Russia - once the money starts flowing again, the bounce back should be strong and rapid.

Presidential economics advisor Arkardy Dvorkovich is in this camp and said on January 20 that he thought Russia's economy had almost reached bottom. "Of course, we have not passed through the depths of the crisis yet," Dvorkovich said, adding that, "demand on world markets will continue falling for several months. However, the economy may begin to recover in May-June due to investments in new technologies and new production."

Prime Minister Vladimir Putin was more pessimistic, saying he expects the economic crisis in Russia to end by the latter part of this year or early 2010. "We believe that we will really feel the positive tendencies in late 2009-early 2010. We are hoping that in some industries positive tendencies will be seen as early as in the middle of this year," Putin said in an interview with Bloomberg ahead of the Davos conference.

However, everything depends on what you mean by "recovery": Dvorkovich is talking about the start of the process, Putin about the end.

Still, equity investors clearly have yet to be convinced. The RTS fell below the psychologically important 500 mark last week (down from an all-time high of 2487.92 set on May 19, 2008 to 2003 levels), making Russian equities the cheapest in all of the emerging markets. At these prices, some analysts are starting to argue that it doesn't matter what happens to the world economy as share prices can only go up.

"Russian equities are now trading at a forward [price/earnings ratio] of 3.0 times. That is by far the cheapest amongst major emerging markets. This is a great entry point for traders looking for a bear market rally and investors looking to build a long-term portfolio. Such cheap valuations cover the risk of earnings downgrades and the timeline uncertainty," Chris Weafer, chief strategist at UralSib, said on January 26.

The big CEESE

So if everything is so cheap, why is no one buying? The short answer is no one has any money to spare, or if they do, they are hanging onto it just in case things get worse. Pessimism rules: Europe has finished an unprecedented eight-year boom, so everyone expects the bust to be equally dramatic and prolonged.

To see just how good we had it, the two charts below plot GDP in cash dollar terms for all the countries in Western Europe versus Central and Eastern Europe/Southeast Europe (CEESE) since the fall of the Soviet Union.

The first thing that jumps out at you is the phenomenal growth of the 15 countries in the EU starting in about 2001. In the aftermath of the 1998 crisis, low interest rates fuelled a rocket of growth across the whole continent, but the big countries of France, the UK and Germany accounted for the largest gains.

The second chart zooms on the same data to compare the biggest economies in east and west. While Germany and the UK grew fast, Russia put in a sprint finish and was building up some real momentum until the crisis hit: GDP rose from $85bn in 1992 to a whopping estimated $1,778bn as of the end of 2008, according to the International Monetary Fund. But the surprise winner in this race was the bigger CEESE region, which saw GDP rise from $535bn in 1992 to an estimated $4,687bn as of the end of 2008 - growing twice as fast as Russia.

In January, the international press made hoopla of the fact that China's economy overtook Germany's to become the third-biggest economy in the world (after the US and Japan). Yet no one seems to have noticed that the big CEESE region overtook Germany two years ago in 2006 and is one of the fastest-growing regions on the planet, streaking ahead of the rest of Europe as all the smaller markets in the Balkans, Central Asia and Eastern Europe came into their own.

Long-term conversion

There are two forces at work in the CEESE region. The first is the business cycle. Clearly, Western Europe is now paying the price for the "irrational exuberance" of the boom and will pay for several years. As CEESE is inexorably linked to the world financial system, this downward turn of the economic wheel has spilled over into Central and Eastern Europe, dragging the CEESE region down with it.

But underlying this normal business cycle is the process of convergence that has been driving the CEESE's amazing growth since about 2000. This force for growth remains unaffected by the current bust, as putting in place things that are simply missing drives it. Just because there is an economic downturn, doesn't mean these missing things are no longer needed. Continuing to put them in place will continue to produce extra-ordinary growth.

Western governments are reaching for Keynesian-style spending on infrastructure to kick-start their economies, but most of the basic infrastructure was built long ago. In the east, most of this work has yet to be started; Russia, for example, has no motorway system to speak of and only 2% of new roads have been added to the highway system since 1991. Infrastructure spending was already on the agenda; now it has an extra impetus. And thanks to the reserves that many countries in the region have built up, they have the money to pay for this work. As the convergence story reasserts itself, the CEESE region will go back to its strong growth. The only question is when.

In the short term, things like oil prices will determine just how this process plays out. However, in the long term, all the commodity prices that support many of the CEESE economies will have to go up. The era of cheap oil is over and, as bne argued in its cover story "Back to Basics" in November, food prices are also on the up as the world isn't producing enough to feed all the new hungry mouths. Construction, a big economic driver, has taken a hit, but Russia needs to build two new cities the size of Moscow - enough to house the entire population of the Czech Republic three times over - just to bring its average residential area up to the level of Moldova, according to Renaissance Capital. The bottom line is that 3bn new consumers have joined the global community of 6.5bn since 1991 and all of them want everything we are used to in the West.

No one wants to stick their neck out at the moment and call the bottom, as more surprises are possible. But in recent weeks optimistic predictions have become more common. Typical is a Moody's Investors Service report released in January calling the crisis "temporary."

"The current turmoil in the financial markets has evolved from a crisis that was initially largely confined to sophisticated western financial systems, to a crisis that can be characterized as a global 'sudden stop'," says Pierre Cailleteau, team managing director of Moody's Global Sovereign Risk Group. "Moody's key assumption is that international financial integration is not unraveling - rather, the current shortage of foreign currency funding in the world economy, in its current extreme form, is temporary."

Banks like Troika Dialog have also started releasing notes underlining Russia's, and the rest of the region's, long-term potential. Of course, it is easy to accuse investment banks of talking up their books (as they surely are), however, the logic of convergence remains.

Part of the reason that Eastern Europe's macro numbers continue to suck is because almost all the currencies in the region have been forced to adjust to the new realities - which means devaluation. Russia's currency has fallen by some 40% in the last five months, Ukraine's by over 60% and this month the Kazakh authorities finally admitted they will probably have to devalue the tenge by about 10% in the first half of this year. While currency values are changing, there is little incentive to invest, as returns on speculating against devaluation are more or less certain.

That process of re-valuation is nearly finished - both the ruble and hryvna were said to be stabilizing by the end of January - so in theory money now has an incentive to look for something more productive to do. And once money starts flowing again growth will return.

All of this can be written off as wishful thinking, but falling bond spreads over US treasury bills are one piece of concrete evidence strongly suggesting that the Russian economy is about to bottom out.

Bond spreads are a leading indicator of both crisis and recovery. If 1998 is anything to go by, spreads above 1,500 basis points (bps) are usually immediately followed by a rout on equity markets (as happened in September last year as well). But spreads fall back to earth a lot faster than equity prices can recover. Typically, bond spreads fall several months before equity prices start to climb, and equity prices climb several months before the real economy begins to recover.

In January, the spread of the Russia 30 Eurobonds were falling from mid-December 1,130-bp levels to 900 bps, but still have a long way to go before they return to the levels under 100 bps that were seen in 2006. Likewise, spreads on the leading corporate bonds were returning to earth: the yield on pipe-maker TMK 09 bonds have fallen a stunning 2,700 bps from peak levels and steelmaker Serverstal's 2009 bonds have recovered from 3,600 bps to its normal 500-bp level.

Based on the experience of the last crisis, the action on the bond market suggests that Dvorkovich's and Putin's start-to-end timetable for the recovery isn't far off the money.

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