MOSCOW BLOG: Russia - from unloved to unbowed

By bne IntelliNews January 28, 2011

bne -

Is the "unloved Bric" going to emerge as a safe haven in 2011? Russia is off to an flying start this year and analysts expect momentum to build from here.

The Russian stock market was up 23% in 2010, but soared 18% in December alone. Having shunned Russian equity for most of 2009, when the leading RTS index lost about three-quarters of its value from its peak in September 2008 to trough six months later, investors have started to pile back in, as the gains in the other Bric stock markets appear to have run out of steam.

Flows into emerging market equity funds recorded net inflows in 33 of the past 34 weeks, but Russia took in its biggest inflow in three years in the middle of January. Increasingly, portfolio investors have nowhere else to go if they want to make the big returns they have enjoyed in emerging markets since the crisis struck. Likewise, Renaissance Capital predicts that Russian IPOs will triple this year as Russian companies return to the equity markets to raise fresh capital.

Equity investors have already caught the Russia bug, but institutional fixed-income investors in the UK and US, such as pension funds and insurers, are also looking to invest in emerging markets with their higher yields, falling risk and appreciating currencies. And there is plenty to buy: the Russian government has returned to the debt market after a 10-year hiatus to finance the budget deficit with $7bn in hard currency borrowing and another RUB1.7 trillion ($56bn) of ruble borrowing written into the budget this year.

The Russian economy is also doing well. The government raised its 2011 estimate for GDP growth to 4% in January, but analysts almost universally predict growth will top at least 5% this year - not bad for a middle-income country. Strong growth "opens up good opportunities for us to become a safe haven again amid the problems in Europe and the ongoing stagnation in the USA," says Elena Matrosova, director of the Center for Macroeconomic Research at BDO Group in Russia.

Foreign investment is returning. The all-important foreign direct investment topped $40bn - regaining the 2006 level - after a terrible year in 2009, but still half of the $80bn recorded at the 2008 peak. However, while the volume of investment is down, the size of the deals is going up: BP invested $1.5bn in a tie-up with state-owned oil major Rosneft; clearly, BP has an eye on the huge untapped oil reserves in the Arctic in a world where the discovery of new reserves is lagging behind oil production. More significant was PepsiCo's takeover of Wimm-Bill-Dann, Russia's biggest dairy maker, also for $1.5bn in 2010 - the biggest takeover deal in Russia's modern history. Like BP, Pepsi is eyeing Russia's massive untapped resources, except in this case it is the 142m strong consumer market - half as big again as the German market, the second biggest in Europe.

Unexpectedly strong oil prices (topping $90 in January) have meant the state finances in 2010 did a lot better than expected, with the budget deficit coming in at 3.8% at the end of 2010 - a lot better than the 6-7% expected at the start of the year. The numbers were so strong that Deputy Prime Minister and Finance Minister Alexei Kudrin said in January that Russia wouldn't in fact spend all of its rainy-day reserve fund this year contrary to expectations.

However, the key number is the state's external debt, which is a ridiculously low 17% of GDP - against the triple digits that most developed world economies are sporting. Put another way: for each dollar of external debt the economy has (including corporate debt), the state has $1.20 of cash reserves.

Port in a storm

With the effects of the global fiscal stimulus waning and the next stage of the sovereign debt crisis unfolding, new storm clouds are gathering and safe havens are likely to be in great demand this year.

In Europe, Spain and Portugal have to raise tens of billions of euros this year simply to roll over existing debt - it is not clear that they will manage it (although both cash-rich Russia and China have said they will buy their bonds if the price is right).

In the US, things are looking even worse. Investors fled municipal bonds in December, driving up the cost of borrowing and driving state after state into deficit. Currently, well over half of the 50 states are unable to meet their obligations and the government is due to pass a bill enabling them to go bankrupt - no American state has ever gone bust.

Russia was briefly hailed as a safe haven as the world began reeling from the US subprime mortgage crisis in 2007, but following Lehman Brothers collapse in September 2008, its weaknesses - such as the huge corporate indebtedness of Russia's biggest firms - were exposed and the economy was brought to a standstill.

The crisis has squeezed Russian debt dry and this time round if there is a fresh credit crunch, Russia is much better equipped to deal with it. Indeed, a safe haven image becomes a self-fulfilling prophesy, as the more money you attract, the better you are able to weather the storm. It is already clear that the biggest danger Russia faces this year is inflation, driven up by the arrival of "hot money" from the developed world and asset price bubble as investors find they have few places to go.

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