Ben Aris in Moscow -

A consensus emerged from all the 2009 strategy papers issued by Russia's investment banks at the end of 2008: this downturn is nasty, but it is temporary.

Global prices for commodities have plunged and the international capital markets are in deep freeze. Russia's economy was brought to a shuddering halt in the autumn of 2008. Industrial production fell off a cliff in November and within a few months over 100,000 people had lost their jobs. Some fear that, at a stroke, Russia's investment- and consumer-led growth has been destroyed, while the oil revenues that were paying for it will disappear. Despite all these problems, the underlying convergence story remains intact and analysts are expecting the Russian economy to bounce back strongly in the second half of 2009

BAD START, GOOD FINISH FOR 2009

All of Russia's investment banks agree that the first half of 2009 is going to be terrible. However, they almost all agree that in the second half of the year Russia should start to recovery.

Despite the global slowdown, Russia is expected to be one of the few islands of growth left in the global economy by the end of 2009. The timing of this recovery and return of confidence isn't clear and as 2008 draws to a close, two big questions remain open: where will the price of oil settle in 2009? And can the government manage a controlled devaluation of the ruble without causing yet another bout of instability?

Renaissance says in the preamble to its 2009 strategy paper: "In 2009, Russia's markets will outperform when the historic levels of disorder in global finance begins to ease. The breakdown in global markets is fundamentally a consequence of structural weaknesses in developed economies. When the liquidity being created globally to combat the crisis begins to feed into risk assets, emerging markets in general, and Russia in particular, will benefit disproportionately."

Uralsib makes a similar point, arguing that Russia's lack of integration into the global market gives it a measure of protection from the global slowdown, while the momentum of the internal growth built up in the last years will be pushing the economy towards recovery. But this recovery is not certain.

UniCredit says in its strategy report: "We see two major factors shaping investors' attitudes toward Russia over the next 12 months - oil prices and the ruble exchange rate. Without at least some stability in both of these factors, we believe the Russian markets will be unlikely to sustain a rally, even in the short term."

Clearly, if the oil price remains at the sub-$50 per barrel that it was at the end of 2008, then the value of the ruble will have to fall some 15-20% and until this happens, investors will stand on the sidelines as an uncontrolled devaluation could inflict a fresh round of chaos on the economy. However, analysts agree that the issue of finding a new value for the ruble will be resolved early in 2009 and set the stage of the subsequent rally.

UBS sums up what most of the investment banks are saying in its strategy: "In our view, Russia is a special case in the emerging markets block. Markets have sold off heavily and the [central bank] has lost $115bn of reserves (net of valuation changes) since August, but from a macro point of view it is actually quite difficult to find much wrong with Russia. Yes, the economy will slow down, given less available foreign money and, yes, the economy was overheating and inflation had increased, and, finally, Russia is indeed a commodity-based economy that is experiencing a negative terms of trade shock. Still, none of this, in our view, can explain the reserve loss or the way markets have sold off."

STATE AID

With the international capital markets in flames, the Russian state will play a key role in determining the impact of this crisis on Russia's performance in 2009. The state has been quick to offer a huge amount of support and promised over $200bn for 2009. Then in December, Prime Minister Vladimir Putin has announced that the government will directly support 1,500 companies that produce about 85% of Russia's GDP. The initial list will include 300 names that will be expanded in 2009. The main criteria to get on the list are to have a turnover of RUB15bn-16bn, employ more than 4,000 people and be the major employer in the city (Russia has a lot of cities with just one large plant or mine and no other alternatives).

It remains to be seen if this is enough, or even if it is, if it can be delivered efficiently enough to make a difference. Moreover, throwing money at the economy will have to be accompanied by a major stepping up of reforms and a loosening of the state's control over key sectors.

FIRST-HALF SLOWDOWN

"A fixed exchange rate has exposed industry to the full force of the global crisis. The two standard deviation shock to both the oil price and credit markets has left Russia's credit and payment system dysfunctional. Without a functioning financial system, the economy is seizing up. The contraction in output over the winter will be severe," says Renaissance. "The economic outlook in the first quarter, and possibly first half, is shocking. In the fourth quarter, finance stopped flowing, goods stopped being delivered, investment plans were cancelled and much of the economy simultaneously started hording dollars. The average decrease in capex in 2009 forecast by our sector analysts is 30%. From growth of 8% in the first half of 2008, year-on-year output could shrink as much as 5% in the first half of 2009."

Growth will now almost certainly be negative quarter on quarter in the first quarter of 2009, with the situation believed to stabilise in the second quarter as the beneficial effects of devaluation start to kick in. VTB Capital says in its strategy paper: "We are still in crisis mode, with fear firmly rooted, but no crisis lasts forever, and in line with our previous views, we believe that we are perhaps at the final stages of the financial crisis [as of the end of 2008]. As soon as the blaze is put out - whether this time around or another quarter down the line - the wall of newly created dollars will start seeking better returns."

"Sound familiar? Where will it find them? Dollar-denominated commodities are the first natural choice, and we would expect those with good economics behind them to do particularly well." VTB says. "Soft commodities in the first place: while people might stop driving during a recession, they are unlikely to stop eating. Then, of course, our closely watched commodities complex. By the time the global economy starts picking up, supply will be short again courtesy of today's price action."

• non-payment crisis

Business was frozen in October as companies simply stopped making payments and the longer this goes on, the more damage it will do. Enough damage has already been done to make sure the first one or two quarters of 2009 will be bloody awful.

The further up the value chain, the worse the problem. Retail has been hit by the cessation of consumer credit. Non-payments in steel are as high as 40%. Cash collection in coal companies fell as low as 20%.

At the same time, in November, Rostat was reporting that wage arrears surged, which will feed through to falling retail sales (still strong in October 2008) and so slow one of the main engines of growth. "A combination of government growling and generous liquidity injections are gradually freeing up the payments system. But there is two months' worth of non-payments, which need to be restructured. The short-term impact will be large," says Renaissance.

• capex

Longer lasting on companies' performance will be the impact of the cuts to capex programmes. Russia was not investing enough before the crisis hit and now the problem is worse. Companies immediately cut spending plans for 2009 and it could take a whole year or longer until Russia returns to the 20%-plus growth in fixed investment it needs to ensure long-term growth.

SECOND-HALF PICK UP

No one expects an economic recovery to begin before the end of the second quarter of 2009, but most expect a good second half.

"In the third quarter, we expect the benefits of devaluation to become increasingly evident, along with the first signs of improvement in the global economy. Demand for metals should start to pick up as the de-stocking process comes to an end, in turn driving up metals prices. The oil price should also start to recover as demand stabilises and the effect of financial market disturbances on commodity prices is no longer felt. Infrastructure projects should also be up and running at this stage," says Renaissance.

However, this recovery is contingent on oil prices recovering to over $50 per barrel. Analysts are divided on the importance of the price. The government has been saying that the economy will function happily at a price of $50 (the amount assumed by the budget) thanks to the reserve fund, but all the main investment houses in Moscow are assuming an oil price of around $70 for the second half of the year.

UniCredit says: "Russia needs an average crude price of $75 per barrel in 2009 to avoid a recession; if this happens, we believe investors would return. Under this scenario, the effects of the oil price recovery would be compounded by the positive effects of moderate devaluation of the ruble, helping the Russian economy to pass through the crisis relatively easily."

Renaissance is expecting Russia to repeat its rebound from the aftermath of the 1998 crisis, predicting negative growth in the first quarter becoming growth of 5% in the third quarter of 2009. By the final quarter of the year Russia's economy could be humming along again at 7% on quarter, according to Renaissance.

Renaissance says: "By this time, growth should be driven by private consumption and investment (the latter through both government and private funding). Sector-wise, we expect to see the strongest recovery in the mining, transport and manufacturing sectors."

"But perhaps the most remarkable facet of the value destruction of the past six months is that the medium-term investment thesis underpinning Russia remains more or less intact. There is some possibility that the giant emerging economies will choose to turn away from market-based economics. But that chance remains small. More likely, they will emerge from what is fundamentally a developed world financial crisis relatively stronger," says Renaissance.

In contrast with many developed countries, Russia's return to the growth path will be unencumbered by the need to deleverage a large volume of household debt, and this should support a rapid recovery of private consumption, argues Renaissance.

However, things will be tougher for corporates, which still face the challenge of rolling over their debt. But here the Russian government can make a huge difference and has already stepped up to the plate. "We firmly believe that, as a result of government policy and a turnaround on the global markets (both financial and commodities), the mood mid-year will be drastically different from now," concludes Renaissance.

2010 AND BEYOND

Because of the convergence story there is no doubt that demand for commodities will recover. If Russia and the rest of the emerging universe were developed economies, then this downturn of the business cycle could go on for years. As the convergence story supplies a positive upward pressure on growth that is independent of the global business cycle dynamics, arguably these economies will bounce back sooner than the developed world. But the issue is all one of timing and how bad the international crisis is.

"The medium-term commodity picture remains one of rapidly growing demand and increasingly expensive supply," says Renaissance.

The potential of the medium term is captured by the economic forecasts from the IMF. While the fund has a poor record of forecasting Russia's growth it has still upgraded its estimates of the relative size of the Russian economy measured in dollars and predicts Russia will have the fifth-largest economy in the world by 2013.

MACRO

GDP FORECASTS

Deputy Economic Development Minister Andrei Klepach says in December the economy could contract by as much as 0.5% in 2009 under a pessimistic scenario, but the base projection foresees growth resuming by mid-2009 and reaching 2.4% for the year assuming an oil price of $50 per barrel. The ministry expects the major growth drivers to be continued investment demand expansion at 1.4% and real growth of disposable income of 2.5%, but predicts industrial output to fall 3%.

The government also expects the ruble to fall to RUB30.8/USD-RUB31.8/USD, assuming a USD1.25/EUR exchange rate, implying another 5-6% devaluation from the end of 2008 level. The ministry expects inflation to stay in double digits, reaching 10-12% despite slowing growth and falling commodities prices.

Renaissance says the crash in capex and spending means the growth could crash from 8% in the first nine months of 2008 to -5% in the first half of 2009. "Given the very high growth rates in the first half of 2008, recovery is only possible in the third quarter of 2009 and only likely in fourth. But when it happens, it is likely to be rapid," says Renaissance's Roland Nash.

GDP growth forecasts for 2009

Government 2.4%*

Alfa 0% to -5%

Renaissance 4%

Uralsib 4.3%

Unicreidt 2.5%

IMF 3.5%

Fitch 2.5%

* assuming oil price of $50

key factor: EXCHANGE RATE

The ruble will have to be devalued to accommodate the new lower oil prices. Most of the banks agree that the average exchange rate for 2009 will be between RUB30-31/USD from the RUB24.9/USD average in 2008.

But the question for 2009 is if the Central Bank of Russia will let the ruble float freely. It may be forced to, as the state cannot go on spending money at the rate it was at the end of 2008.

UniCredit says: "We believe that by end-2008 the CBR could spend another $50bn-60bn of reserves in addition to the $50bn issued to refinance external debts [to support the ruble]. This would put Russia's total international reserves at roughly $350bn, or just $200bn-220bn net of the amount needed to continue ruble support, which we think is close to the critical level of reserves for the central bank. As a result, we believe the CBR will decide to let the ruble float, opening the door for a devaluation of some 15% next year."

The Russian economy is linked into the global economy through two main channels: commodity prices and financial markets, and both went sour at once in the middle of 2008. "Russia's effectively fixed exchange rate system means that any adjustment to an external shock cannot be offset by a shift in external prices. As a result, domestic prices must do all the heavy lifting. Given that Russia's internal capital and labour markets are not efficient, the adjustment involves very large costs. The tremendous movement in asset prices and the explosion in non-payments across the economy are effectively the attempt by markets to adjust to the external shocks in the absence of a flexible exchange rate or efficient domestic capital and labour markets," says Renaissance.

The upshot of this change is that the cost of money in Russia went from being very negative in real terms, to money becoming prohibitively expensive.

One of the main tools that the government will use in the first half of 2009 to fight the dramatic slowdown in the economy will be to loosen its control over the exchange rate, and it was already doing so at the end of 2008. But this will be a tricky task of letting the ruble devalue "not too fast, not too slow." Fast unsettles the population and hurts the banks; slow burns up hard currency reserves at a rapid rate.

All the banks agree that the authorities will have to take a much more flexible approach to foreign exchange policy in 2009. How and how fast this is done will be a key driver for the economy through the remainder of the year.

Exchange rate forecasts 2009

Government RUB30.8/$-RUB31.8/$

Renaissance RUB30.5/$*

UniCredit RUB31/$**

UniCredit RUB35/$***

* oil at average of $75

** oil at average of $70

*** oil at average of $50

key factor: OIL SCENARIOS

Clearly, the price of oil will be another of the key determining factors for 2009. Oil ended 2008 at an average price of $96, according to Finance Minister Alexei Kudrin, and there is no way it will come anywhere close to that in 2009.

Most banks are assuming oil will be at $75, which is an acceptable price that allows growth, a balanced budget and no balance of payment deficits. Investment would return and Russia would pass through the crisis with limited damage.

"Russia needs an average crude price of $75 per barrel in 2009 to avoid a recession; if this happens, we believe investors would return. Under this scenario, the effects of the oil price recovery would be compounded by the positive effects of moderate devaluation of the ruble, helping the Russian economy to pass through the crisis relatively easily," says UniCredit.

Analysts are confident of this price because of the demand and supply argument above, but also because the budgets in the Middle Eastern countries also only balance at $50 or more, and so this will enforce discipline on the Opec members when it come to making price-supporting production cuts.

"The real trouble begins if oil stays at an average of $50/bbl," says UniCredit. "We see a high risk of recession and devaluation in this case. We admit that given the current level of oil prices, an outlook of $50 or even lower is not unrealistic, as is an even more pronounced devaluation of the ruble."

At $50 oil, UniCredit predicts: "real GDP growth to slow to just 0.5%, with investment demand slipping into negative territory and contracting by some 3%; a heightened risk of sharp devaluation; unemployment rising sharply; the banking sector facing serious problems; and redistribution of property, spreading to large businesses, as corporate default risks intensify sharply even among blue-chip companies.

UBS is amongst the most pessimistic banks on oil prices in 2009, but even this bank predicts an oil price of $60, before recovering to $70 in 2010.

Highlighting the confusion, Fitch believes oil prices in 2009 could average around $80 per barrel if Opec is able to effectively defend this price through sustained production cuts. "This would result in Russia's net export earnings averaging around $400bn in 2009, which is still quite high relative to historical averages," the agency says in a December report.

Despite the uncertainty over the oil price, the main takeaway is that almost all the experts are expecting oil to be comfortably above the key $50 level and so Russia should suffer only a mild version of this crisis.

INFLATION

Until the crisis hit inflation was the big problem for Russia. However, the fall of oil prices means that inflation has receded.

The sharp decline in industrial production that started in November 2008 was accompanied by falling producer prices. The PPI dropped a record 8.4% on month, bringing producer prices to only 4.4% year-on-year in November. Some analysts speculate there could be some producer prices deflation. This has never happened to Russia before; the only time the year-on-year PPI has been negative was in August 1998.

That says inflation will still be high and the amount of cash injected into the economy by the government will keep the level high. But the problem with inflation in Russia is not expected to be as bad in the developed world.

Government 10-12%

Renaissance 12%

Uralsib 10.5%

WEAKENING DOLLAR

Currently investors small and big are selling assets and going into cash - the dollar. However, for Russia to recover investors need to start moving out of dollars back into other assets. Some analysts believe there is a bubble forming in the dollar's value and the expectations it will weaken are widespread.

A falling dollar to the ruble will have several beneficiary affects on Russia's economy.

• it will improve the competitiveness of the ruble without the CBR having to adjust the exchange rate, which is the symbol of Russia's economic health. However, most of Russia's costs are in euros.

• a falling dollar will help commodity prices and in particular will support the oil price which also has a big psychological impact on the economy.

• a falling dollar will also remove the incentive to trade out of assets into dollars and this will contribute to the resumption of crediting and so help fix the broken payment system.

INDUSTRIAL PRODUCTION

Russia's industrial output fell off a cliff in November 2008, according to Rosstat, contracting by 7.5% year-on-year (8.7% on month), well ahead of the market expectations of a 1.5% year-on-year drop. The fall was led by a 10.3% year-on-year drop in manufacturing and a 9.3% decline in regulated goods.

The industrial production data crystallizes the fears of a dramatic slowdown in production for 2009. As 2008 ended railway transportation had plummeted 20% year-on-year, while there were record lows for the manufacturing and services PMIs, as well as the output declines in the metals and automotive sectors. The size and speed of the decline in output is striking and indicates that the economy has very little resilience to negative shocks.

Some analysts argue that the economic momentum built up in recent years means it will not be so hard to get the ball rolling again once liquidity returns. However, every day manufacturing idles the more difficult it will be. At the end of 2008 it was still not clear exactly how much damage has been done.

TRADE BALANCE

Russia will still have a trade surplus in 2009, but will face a current account deficit, Deputy Economic Development Minister Andrei Klepach said in December.

The country's trade surplus is expected to amount to about $18bn next year the ministry's forecasts. Russia's exports are expected to fall to $303.1bn, while imports are expected to decrease to $284.7bn. In 2008, exports were an estimated $469.1bn, while imports are planned at $292.5bn.

CAPITAL MARKETS

EQUITIES

Russia went into 2008 as a safe haven in an increasingly unstable world, but by the end it was a pariah. In an awful year for financial markets globally, Russian equity was among the hardest hit of any market.

The whole Russian market (which provides investors with exposure to one of the largest world economies, including 25% of gas reserves, the biggest oil reserves outside Opec, and the third-largest hard currency reserves in the world) is down from over a trillion dollars to $300bn - less than the market capitalization of a single US oil major, ExxonMobil. And UniCredit points out that the Russian market is now worth only 17% of the country's GDP, which is substantially lower than other key emerging markets, such as Brazil (24%), Turkey (37%), China (39%), and Poland (48%).

"Our rough calculations suggest that the market is pricing in a scenario in which the Russian economy collapses during a long global recession, with oil prices at $30/barrel, a crisis in the financial system, a massive drop in reserves, the inability of both the Russian government and corporates to pay their debts, and substantial devaluation of the ruble. While we cannot fully exclude this scenario, we believe its probability is fairly low at the moment," says UniCredit.

The current low valuations for Russia are typical of investors' sentiment towards the country, as they have always had a "love-hate" relation with it. The issue with investing into Russia has always been one of timing more than anything else.

Roland Nash, head of research at Renaissance says: "Over the last 12 years Russia has either been amongst the best performing equity markets in the world or in the worst. So you have to ask yourself a simple question: which one of the two do you think it will be in for 2009?"

All the major banks are expecting a strong gain in equity prices in 2009 and the predictions run from between 80% (UniCredit) through 100% (UniCredit) to over 200% (Renaissance) contingent on what happens to oil prices and the value of the ruble. The universal consensus is if oil settles at around $70 in the summer of 2009 these gains will be realised.

Several banks recommend equity investors to watch the yields on the bond markets as a lead indicator of when equities are about to recover, as falling yields in 1999 preceded a rally in equities in the last big crisis.

For any sustained recovery in equity markets, two necessary conditions must apply. First, there must be some relief in global risk markets. Second, commodity prices, particularly oil, must stabilise.

• PE ratios

Russian equities were oversold in the midst of the crisis - there is little debate on this point. While developed markets equity prices fell by about 40% Russian equities are down by 75% or more. This has left Russian assets terrifically cheap on an asset basis. Even on a cash-flow basis at $40/barrel oil, Russia is trading on a 2009 P/E of 7.9x, according to Renaissance estimates.

Even before the crisis struck in September, Russia was amongst the cheapest markets in the world on a P/E ratio.

• end of year target for RTS

All the investment banks struggled to set a target level for the RTS at the end of 2009, as there are so many unknowns that go into the calculation this year. Best they could do was make some conditional statements, but all agreed on a level of around 1000-1100 - providing there was no fresh train wreck along the route.

Renaissance says: "We see the RTS reaching 1,100 by the end of 2009, which is 75% upside from current levels [in December 2008], and still less than half of where it was in June 2008."

Uralsib says: "The trading range in the first half of 2009 is again likely to be very wide, possibly between 500 on the downside and 1,200 on the upside... How the market closes out the full year will depend on how the global economy performs, how oil and other commodities trade and how investors perceive investment risk in Russia."

Troika says: "At $55 oil, a 20% devaluation and a 16% cost of equity, our end-2009 RTS Index target is 1,000. However, there are clearly huge variables surrounding this; a global depression would see the index at 350, while a rapid bounce in global growth would take it back to 1,500.

FIXED INCOME

Despite the massive widening in spreads at the end of 2008, Russia doesn't have a debt problem and Russia is underperforming its lower-rated peers.

As with the Russian equity market, which is now demonstrating the weakest performance of all GEMs, Russian Eurobonds have fallen farther than their peers.

The Russia-30 spread to underlying US Treasuries widened to almost 1,000bp, whereas it fluctuated in the 120bp-200bp range until August, while the composite JP Morgan EMBI Plus Index benchmark spread increased to 760bp from its 200-day moving average of 350bp. Turkish indicative 2030 Eurobonds are now trading with a 625bp spread, and Brazil-2040 at 600bp, even though both countries' sovereign ratings are lower than Russia's.

UniCredit says: "Yields on corporate bonds seem excessive, even in light of deteriorating credit quality. Russian corporate debt - including the quasi-sovereigns - suffered even more than the sovereign Eurobonds."

The bank says that the double-digit yields on quasi-sovereign bonds - as of December: VTB-12 yielded 21.6% at the end of 2008 vs. 7% at the beginning of the year, Gazprom- 2013 yields went to 16.9% vs. 6%, Transneft-14 yields 19.4% vs. 6.45% - have been over done.

"These companies have an implicit (and sometimes explicit) state guarantee, as well as boasting strong cash flow, even in the current commodity price environment," says UniCredit.

Russia's external leverage is high - total external debt was almost $530bn as of July 1, 2008 (according to the Central Bank of Russia) with the CBR's foreign reserves at $565bn - but the country's position looks comfortable in comparison to Turkey (reserves of $117bn vs. total external debt of $284bn as of July 2008) or Brazil (reserves of $197bn vs. total external debt of $214bn as of October 2008), according to analysts at UniCredit.

Renaissance says: "Rather than a debt problem, Russia has a solvency problem. Simply put, in August Moscow was flooded with international bankers competing to provide funding to Russian entities. By October, the only financiers visiting were those trying to get their money back."

As of the middle of 2008, debt was 60% of GDP and UBS estimates the total leverage is 75.6% as of the end of 2008. Compare this to the US debt of 350% of GDP. Typically, post crisis the debt markets are amongst the first to recovery as the macro conditions stabilize and improve.

Russia's public sector debt is negligible. External debt stood at $36bn, or 2.3% of GDP after second quarter 2008. Domestic debt stood at 5.1% of GDP and in fact there is arguably a shortage of domestic sovereign bonds, says UBS. Debt servicing is already manageable and will get easier over the next few years.

Russia has considerable private sector external debt ($490bn after the second quarter of 2008), but putting this into perspective quickly reveals that this is not really all that large, says UBS.

The banking sector had gross external debt of $203bn in the second quarter 2008, which is large compared to a deposit base of $520bn in the same period. However, the loan to deposit ratio was only 111%, hardly displaying large external leverage. The reason is that there is a large difference between net and gross liabilities to foreigners for Russian banks. Net liabilities of Russian banks (subtracting assets) were only $87bn after the second quarter and this number was down to 70bn in the third.

UBS thinks it is probably at best $50bn (3% of GDP) after the recent de-leveraging and Russian banks' purchase of their own bonds. Thus, unlike in many other EMEA countries there is very little net external leverage in the Russian banking system and instead domestic credit is largely financed by domestic deposits. The corporates also have considerable external debt $290bn, of which UBS believes about 40% resides in the oil sector (mainly Gazprom and Rosneft).

Domestic leverage is also very low. Bank loans only amount to 40% of GDP and household debt was a meagre 9% of GDP in the second quarter, the lowest of any major economy covered by UBS analysts.

"Despite a debt/GDP ratio less than one-fifth of the level in the US and a better medium-term growth story, Russian debt is already trading at default levels. Any evidence that most Russian companies will not default should help bring down spreads," says UBS.

Still, while the overall picture is not bad, many Russian companies paid little attention to managing their debt while they were growing fast. This carelessness has come back to bite selected companies. And even if the level of debt should be management, the maturity structure of some companies debt causes big problems.

Finally, even if the company is not in debt, often their controlling shareholder is and these people are milking their companies for cash to meet their other obligations. Because of the poor corporate governance often it is not clear what exposure companies have to other companies in the shareholder's group.

UniCredit lists a number of state and quasi-state bonds as the best options to capitalise on the inevitable recovery of bond yields as the rally gathers strength in the second half of 2009.

• state to the rescue

Renaissance says: "Since the private sector stopped lending, the public sector has attempted to fill the gap. The firepower available to the public sector should be more than adequate to meet the funding requirements of the private sector. In even the worst-case scenario, when capital markets remain completely closed to Russian corporates, Russia would still 'only' leak $100bn in each of the next two years at average oil prices of $50. This is a large sum, but Russia has more than enough reserves."

• defaults

Between 2001 when the bond market reappeared and 2007 there were no defaults in Russia. In November there was one default every two days all month - almost exclusively of third-tier companies. So far there have been no defaults of second- or first-tier companies and none are expected for the time being - but a few second-tier companies have come close.

• post default

In the third-tier universe, recoveries are likely to be low, and smaller bondholders will find themselves at a disadvantage, say Renaissance analysts.

Renaissance writes: "Recent cases also reveal another interesting pattern. It is often borrowers themselves (ie. their shareholders) that hurry to initiate bankruptcy procedures. Since bankruptcy is an effective way of shielding the borrower from any creditors' claims, including payments on the issued bonds, it offers a good alternative to any efforts to satisfying creditors' claims, even if this is possible. Also, we cannot help feeling that some of these bankruptcy filings resemble the notorious 1990s practice of controlled bankruptcies initiated with the sole purpose of ensuring creditors get as little as possible - effectively abusing bankruptcy procedures to gain favourable restructuring terms."

GROWTH OF DOMESTIC FINANCIAL MARKETS

One of the positive changes the crisis will have is to accelerate the switch from tapping international capital market for money to using the domestic savings to finance business.

Russia boasts one of the highest savings rates in the world of 30% of GDP, second only to China, and this money is enough to finance the massive outlay on infrastructure, say Troika analysts.

However, until the crisis hit Russian companies were mainly borrowing from international capital markets as the money was cheaper and longer. Cut off from this source of capital, Russian companies will now have to turn to internal resources to raise capital. The government needs to step up to the plate with hard work to accelerate the switch and happily the Kremlin already launched exactly this programme at the start of 2008. However, it will take time to make this change.

Renaissance says: "Over time, the spread between the return paid to savers and the return generated from borrowers (which currently accrues largely to the developed world financial community) will incentivise that intermediation. The current crisis will likely catalyze that process, and indeed, the investment by governments long of dollar savings into their domestic economies is part of that process."

However, in the short term a return to some kind of normalcy in the international capital markets will be key factor in overcoming the crisis and getting companies back to work. Most Russian banks are confident that the massive injections of capital into western markets will feed through into the global economy sometime in the second half of 2009 and allow at least a restructuring of debt to take into account the new realities. Russia is supposed to do very well from this process as it remains one of the strongest and most appealing emerging markets.

SECTORS

OIL SECTOR

With current oilfields maturing and demand expect to rise over the medium term, the falling production will push oil price up again. Production from the fields that currently supply global demand will start falling from as soon as 2010. Even new developments currently in development will not be enough to meet anticipated demand in the next five to ten years. In other words oil prices are unlikely to stay low for long.

Prices will be supported by falling Russian production in 2009. Deputy Economics Minister Andrei Klepach says at the end of December oil production will decline 1.7% in 2009 to 9.60m b/d (from 488 to 480m tonnes), unlike gas production, which will increase 0.8% on year to 670bn cubic metres.

Forecasts from the International Energy Agency (IEA), the US Department of Energy's Energy Information Administration (EIA) and Opec now average 0.2% demand growth in 2008 (lower than the July 2008 estimate of 1.0% and the December 2007 estimate of 1.9%). The three agencies now envisage 2009 demand growth of 0.3% vs the 1.5% forecast by EIA in May 2008.

However, while demand is being destroyed so is supply. Capex amongst the Russian companies expected to fall by a bit less than 20% in 2009, which will lead to a fall in production of a bit more than 1%.

The IEA stated in its recently released 2008 World Energy Outlook that the projected increase in global oil output hinges on adequate and timely investments. It estimates 64mmbpd of additional gross capacity (equivalent to 74% of current global crude output) needs to be brought on stream between 2007 and 2030, with some 30mmbpd of new capacity needed by 2015. There remains a real risk that underinvestment will cause an oil-supply crunch in that timeframe, with sharply lower visibility for post-2010 capacity additions.

Like the other sectors most of Russia's investment banks predict a recovery of the oil sector in the second half of 2009 when prices begin to rise again. This will also be the point when the various government measures, like tax cuts, start to kick in.

UralSib says: "We believe April-September will be the best time to invest in Russian oil stocks, as the sector should by then be benefiting from a better macroeconomic outlook and improved investment climate in the sector, which will create strong buying opportunities for investors."

The bank highlights the following key changes in the second half of the year but warns that oil stocks may fall further in the first half of 2009:

• the government revisiting the question of taxation on the sector, including mineral extraction tax (MET) and export tax formulas;

• price declines in other sectors (metals, concrete, services) and lower fuel prices will likely have picked up and duly reflected in lifting and direct refining costs;

• oil price stabilization, with the impact of Kudrin's scissors disappearing;

• stabilization on the debt markets, which will open up new funding opportunities;

• ruble depreciation against the US dollar, though inflation will remain stable.

oil price predictions:

Rencap $70

Uralsib $70-$75

Unicredit $75 2009

METAL SECTOR

Uralsib believes that commodity prices were close to bottom at the end of 2008, as the spot prices are below the cash production costs of the high cost producers. Evidence of this is the wide spread capacity closures in all extractive industries worldwide and the bank expects commodities to remain under pressure through the first half of 2009.

However, the reduction of production means that if there is any sort of economic recovery in the second half of the year, there could be a shortage of supply, which will send prices back up again.

The bugbear in this argument is the shortage of supply and debt load of some companies could make their recovery more difficult.

Steel: Russia's steel sector ended 2008 operating at 50% capacity utilization after the demand-chain collapsed. The complete halt of the credit system together with a massive global de-stocking was a knock out blow for the steel sector.

All the banks agree that 2009 will be a terrible year for metal companies and there is little hope that there will be much pick in the second half of the year. Renaissance estimates 2009 will be the worst year for global apparent steel demand since 1974, at 12% year-on-year; then it took two years for demand to recover. Steel costs are set to fall 25% in 2009, say Renaissance, and it seems the steel industry has successfully adjusted to survival mode.

Ferroalloys and nickel weak: Stainless demand has collapsed as much as steel's, if not slightly more. The outlook for ferroalloys worsened towards the end of 2008 and prices for 2009 look as though they will be below $1/lb, representing a 50%-plus reduction on third-quarter levels. Likewise, nickel prices look as though they will have little impetus to break out of the current range of $4.50-6.80/lb.

Gold: has been volatile but VTB Capital analysts like it as a hedge against the potential weakening of the dollar. There have already been reports that China is increasing its gold reserves and each 1% increase to China's reserves is equivalent to 21% of the global annual gold supply. Polyus Gold is the favourite stock in this sector.

BANK SECTOR

• NLPs

"Russia's crisis is the mirror image of the American one," Uralisib's CFO Konstantin Vaysman told bne in London. "Theirs started with toxic debt and then turned to a liquidity crisis; ours started with a liquidity crisis in September and now the toxic debt is going to come."

The rapid slowdown in the Russian economy will hit the banking sector hard in the first half of 2009 as previously solid debt begins to go bad. The biggest danger to the otherwise relatively robust bank sector is the rising proportion of non-performing loans (NPL).

Corporate loans started to sour at the end of 2008. Overdue corporate loans also rose sharply in October, up by RUB51bn (€1.39bn) to 1.6% of gross loans against RUB20bn in September, according to the most recent central Bank of Russia results released at the start of December.

"The outlook for the next 3-12 months is now very vague. Visibility is poor and the asset quality of the banks is deteriorating fast," David Nangle, Renaissance's senior bank analyst says at the start of December.

No one knows how far the NPLs will rise, but it is possible to make some educated guesses about the different types of lending. Analysts believe that mortgages will be the least affected with NPLs on the order of 1-2%. Banks with a strong retail focus will see NPLs rise to the red line level of 5% or more. And the banks in most danger are the consumer finance specialist, which will see NPLs rising to over 10% of their portfolio, says Nangle.

• Growth to slow

Sector growth is all about funding, and most key funding sources have been hit. Retail deposits will slow as incomes are expected to fall in 2009. Corporate deposits will suffer from disappearing credit and a slowing economy. And wholesale funding has all but disappeared. The state will have to set in to replace some of these sources of capital, but state lending will be aimed at state banks. Renaissance forecasts sector asset and credit growth of 10% and deposit growth of 6% in 2009.

• Consolidation

Consolidation of the banking sector was well under way by the end of 2008. The consensus is the number of banks in Russia will fall from 1200 in 2008 to about 800 in 2009. However, some sources say that the CBR is hoping to reduce the total number of banks to about 300 in the next few years.

The state banks were the first to start buying banks in September 2008 as a way of bailing out those in trouble, but the state is expecting all strong banks to participate. Indeed, each of the top 200 banks would have to buy an average of three banks if the number is to fall to a total of 300.

• Bankruptcies

There will also inevitably be a wave of bankruptcies in the bank sector in 2009 as economic conditions tighten and the cost of credit rises. The regulators have repeatedly said that not all banks will be rescued.

On November 20, the Deposit Insurance Agency set quantitative criteria for a bank to be rescued: the agency is to rescue a troubled bank if its retail deposit base is more than $4bn for a federal, or $1bn for a regional bank, although there could be certain exceptions.

UniCredit estimates the total number of banks satisfying this criteria at around 200-300. However, the DIA has enough capital to cover only 5% of the total Russian deposit base. Therefore, it cannot afford to allow all banks below the top 200 to go bankrupt - they control around 8% of the total Russian deposit base - unless the government boosts its capital. We therefore think that the agency may not be very strict with this quantitative requirement.

• Listed banks cheap

As of the end of 2008, all of Russia's listed banks were valued by the market below their estimated 2008 shareholders' equity and were trading below 1.0 on 2008 Price/Book value.

Uralsib argues that these prices assume major problems for the banking sector, but points out that almost no one expects any of the major 200 banks to go bust. "Russian banks do not warrant such low valuations as the major players in particular are benefiting from state support which is mitigating risk. For this reason we believe the shares of the most liquid banking names are well set for a strong rebound in 2H09," says Uralsib.

RETAIL SECTOR

In November, Rosstat reported that wage arrears had doubled in November alone to R7.8bn (~$300m), or around 2% of Russia's total monthly salaries. At the same time some 80,000 Russians lost their job in November and unemployment is expected to climb rising from 6.3% of the work force in 2008 to 7.4% in 2009, according to the Ministry of Economic Development and Trade forecasts. The total number of jobless in Russia will swell to an average of 5.4m in 2009 from 4.6m in 2008, the ministry predicts, while the ranks of registered unemployed are likely to grow to 2.8m in 2009 from 1.65m in 2008.

As a result real income growth will slow dramatically in 2009 to 0.5% year-on-year vs. an estimated 7.6% year-on-year in 2008, says Uralsib.

A slowing economy and the cessation of consumer credits will impact the consumer sector. Moreover a weakening ruble will hurt companies in this sector: all their revenues are in rubles, but 10-40% of costs are dollar denominated, which will wipe 35-60% off their earnings, estimates Renaissance. "We forecast zero consumer credit availability in 2009. Given our expectation of 4.7% real wage growth in 2009 and the current liquidity crisis, we do not expect banks to start providing affordable loans to consumers next year."

The result of these pessimistic predictions is banks all focused on the food producers and supermarkets as the best bets in the retail sector. Magnit proved to be the most popular company.

TELECOMS SECTOR

The mobile telecom stocks are relatively well positioned in a slowing economy, as the bulk of their revenue is for basic services. The example from other countries that have entered a slowdown earlier than Russia is that basic mobile activity holds up relatively well, say analysts at Uralsib.

TRANSPORT SECTOR

This is one of the sectors that will fare worst from the crisis. Russia's airliners have enjoyed double-digit growth rates in 2007 and in the first 10 months of 2008, fuelled by rising incomes and growing business activity. However, the economic downturn will likely bring an end to this growth in the first half.

Most of the banks are predicting that passenger traffic will fall about 10% for all the main airlines in 2009 and no recovery to the sector is likely before 2010. Moreover even when the traffic picks up again, cash flow problems will delay a return to strong profits for a while longer.

REAL ESTATE AND CONSTRUCTION SECTOR

"If history repeats itself (in line with other economic slowdowns, eg. Asia 1997/1999) then this will be the last sector to recover." Uralsib says. "The price of real estate, both commercial and residential, will fall a lot more than already seen. The market will likely reach a bottom in the second quarter. "

All analysts see more problems for the sector throughout 2009. Prices are expected to keep falling and the developers will have the toughest job convincing banks to finance new projects of all the companies in any sector. The problem is deals came to a complete halt at the end of 2008 making it impossible to value developments and so work out what the risks for financing are. As a result banks simply stopped lending and won't start again until some clarity on the prices for property emerges.

Uralsib forecasts that 2009 office rental and residential sales volumes will be down 40%, rental sales will fall 15% and residential sales will shrink by 20%. The optimistic scenario is the sector will stabilize in late 2009 and prices will begin to grow again, albeit modestly.

UniCredit worries that credit will be in such short supply developers will be struggling to just finished the projects they have started.

"We are skeptical about the industry's ability to complete even the 39mn sqm of current uncompleted housing. We estimate that approximately 10m sqm could be completed using government support, 4.6m sqm using bank loans, and 6.1m sqm using money from buyers. The total of 20.7m sqm means that almost an equal amount - approximately 18.3m sqm - of housing would lie uncompleted, without the financial resources to complete them. Where the $22bn needed to do so might come from, especially in the current environment, is unclear," UniCredit says.

"Even under the optimistic scenario, we expect housing construction volume to fall to 52m sqm in 2008F, 37m sqm in 2009F, and 41m sqm in 2010F (this year's financing deficit should depress 2009F and 2010F results). We project total construction volume, including non-residential (commercial) and building infrastructure, falling 14% this year to 73m sqm, and another 28% in 2009F to 52m sqm, but in 2010F we expect the sector to begin recovering, with volumes rising by 10% to 57m sqm. The pessimistic scenario could throw the industry back to its 2000 levels when, following Russia's 1998 default and the resultant financial crisis, builders delivered about 30m sqm. In both scenarios, we expect similar trends in the commercial segment," the bank says.

UTILITIES SECTOR

All the banks agree that power consumption will be low in the first half of 2009, as power is generally taken as a proxy for economic activity, and likewise it will recover in the second half.

Growth in utilities will be supported as the liberalisation of the sector will continue and stocks in this sector will bounce in the second half of the year as a result.

Uralsib says: "From 1 July 2009 the share of the liberalized market will increase from 35% to 50%. This development will be particularly positive for the more efficient generation companies. In addition to market liberalization we expect global demand to recover on the back of central bank liquidity injections, and electricity consumption will likely increase toward the middle of 2009. This should result in higher wholesale electricity prices, which will drive up earnings estimates and the shares in the second half."

CORPORATE ISSUES

CORPORATE GOVERNANCE

Corporate governance was already decaying by the end of 2008 and as the state takes up a larger role as the source of funding for business it will probably decay further in 2009.

"In the meantime, the negative financial trends of 2008 put governance mechanisms of many companies to the test. There are increasing pressures on companies and banks to engage in related party lending to support affiliated entities in distress, potentially against the interests of external investors. Also, to many large investors, the liquidity squeeze increases the appeal of exploiting legal loopholes to circumvent their obligations before minority investors, such as avoiding mandatory buy-out procedures in takeovers. The fact that several large investors were able to do so without facing legal recourse highlights the remaining weaknesses in legal and regulatory infrastructure," Oleg Shvyrkov of S&P said in a report in December.

Renaissance argues that one of the drivers of decaying corporate governance is big companies will have to switch from private finance to public sources, which by definition are less efficient. "When the immediate discount applied to Russian assets because of the global financial dislocation is finally removed, the medium-term cost is therefore likely to be a one-off decrease in efficiency within Russian corporates. Corporate governance - never Russia's strong suit - will likely be left permanently damaged by the crisis," says Renaissance.

The problems with corporate governance are especially apparent in the bond market. Some companies are playing up their distress in order to get bondholders to sell out of bonds at big discounts. In other cases they are actively looking to explore loopholes to wiggle out of their obligations completely. One option is to transfer assets into shell companies where creditors cannot touch them; these so called "bridge" structures were extremely popular following the 1998 crisis. (see Bonds: post default, above)

The problems highlight the lack of transparency amongst the corporates in Russia as many of these scams can be operated with impunity. "Another concern relates to the fact that many Russian companies are satisfied with attaining moderate governance standards in the absence of specific national regulations and in view of the relatively mild governance requirements that most international exchanges present to foreign issuers. This usually involves bringing transparency up to the minimum standards of international exchanges, setting up an investor relations function and appointing a limited number of independent directors to the board," says Shvyrkov.

HOW TO PLAY THE RECOVERY

Actually this is pretty easy. It is more than likely the recovery will follow the path of other crises.

• Bonds first

The first asset class to recover are bonds. The spreads have widened to fantastic levels and as confidence on the macro stability of the country returns the first thing to move is spreads on bonds. Moreover investors are attracted to bonds by the relative solidity of fixed income in quality names and also by the regular coupon payments that hand them cash in a time of want.

UniCredit says: "We believe the risk premium implied by yields on many Russian Eurobonds is excessive, notwithstanding justified concerns about credit quality deterioration. We find sovereign and high-quality corporate Eurobonds attractive investments in their own right. We also would expect them to recover first - as they did in 1998-1999 - thus acting as a leading indicator for equities."

Favourite names include: Transneft, Gazprom and Rosneft.

The bank giants Sberbank and VTB are also obvious, however, there is more concern on these names due to the potential rising in non-performing loans in the bank sector.

Further down the road the most attractive companies include: Evraz, TMK, NLMK and Uralkali.

• Then Equities

Next to recover is equities and clearly the valuations are very now; Renaissance estimates equity prices could stage a 200% rally within the next 18 months, and this would mirror the recovery of prices in the 1998 crisis.

Amongst the favourite names in the equity world are either those with a strong balance sheet or government backing, including: MTS, VimpelCom, Gazprom, Rosneft and Lukoil.

• FDI last

Direct investment will be the last to recovery.

POPULAR CRISIS STOCKS

• oil and gas

Gazprom appears to offer the best risk-return trade-off in the sector. Like last year, everyone loves Gazprom and says this stock will do well regardless of what happens in 2009. Renaissance says: "We estimate a three-year EPS CAGR of 4% (vs an average of -6% for the oils), mostly driven by growth in domestic end-user and transportation tariffs. Contrary to the oil sector reforms, we think domestic gas price liberalisation is much more likely in a low-oil-price environment. We also estimate Gazprom would be one of the sector's biggest beneficiaries of rouble devaluation, with a 14% upgrade in 2009 dollar EPS on a 20% weaker rouble, on our estimates."

Surgutneftegas remains an attractive consolidation play - Renaissance and UniCredit like this one: Although this year's changeover in the political cycle had no effect on the clarity of the company's ownership or balance sheet structure - contrary to our expectations - we believe Surgutneftegas may prove the most resilient of all Russian oil stocks in the downturn. This is mostly related to its alleged $23bn cash pile, of which 80% is says to be held in foreign-currency deposits. RENAISSANCE

Gazprom Neft is Uralisib's top oil pick. Gazprom Neft has a geographically well-diversified network of filling stations, a developed lubricant, airplane and bunkering business and is in a healthy financial position URALSIB

Lukoil. Uralsib and UniCredit like this one: We like Lukoil for its developed domestic downstream operations, promising gas business, international upstream and downstream diversification, and healthy financials. URALSIB

• retail

Magnit - UniCredit and Uralsib like this one: Russia's second-largest food retailer is well prepared for the slowing consumer spending to come. It has the best balance sheet in the sector and no dollar debt. Its price-sensitive product range should sell well in a downturn and help it win market share from more expensive competitors. URALSIB

X5 Retail Group- domestic consumer play, likely to further solidify and expand leadership position, Alfa Group seems to be doing well politically. UNICREDIT

• telecoms

MTS -- UniCredit and UralSib like this one: After Gazprom, the mobile phone companies are amongst analysts most favourite stocks as their revenues are the least likely to be affected by an economic slowdown. Uralsib says: "Mobile services are much more resilient that other parts of the consumer sector during a downturn, especially basic voice services. The company will generate strong cash flows and will pay a big dividend to its major shareholder (AFK Sistema) and to minorities. Its debt position is much better than that of VimpelCom." URALSIB

Comstar UTS- several banks like this one: steady cash flow generator, low multiples, potential target for MTS UNICREDIT

• metals

Polyus Gold. Uralsib, Troika and UniCredit like this one: The best Russian equity proxy for the gold price. The price of gold is expected to rise as investors buy into it as a haven in the midst of financial turmoil, dollar weakness and general economic uncertainty through the first half. URALSIB

NLMK- strong balance sheet, lowest cost in the industry, good political connections UNICREDIT

• real estate

Raven Russia. Russia has a massive shortage of class A warehouse space, even with the expected cooling of economic activity over the next two quarters. The company is on course to add 900,000 sqm of new space by 2010 to bring its total space to 1.2 mln sqm. The company pays a dividend equivalent to a 17% yield and will raise this to a yield equivalent (based on the current share price) of 20% by 2010. URALSIB

• utilities

RusHydro. Unlike other generators, OGK-4 and RusHydro are not facing the problem of rising non-performing loans and bad debts. They are the most efficient operators in the industry, with good balance sheets and cash flows for 2009 based on tariff increases. URALSIB

Moscow Integrated DisCo- strongly depressed, consolidation completed, access to end-consumer cash flows, potential target for Gazprom. UNICREDIT

• banks

Sberbank -- UniCredit and Uralsib like this one: Russia's largest bank is the best option for investors looking to take positions ahead of a possible recovery in the equity markets in second half as it is a major recipient of government funds ($20 bln in subordinated loans) and does not bear as much risk as VTB or other private banks. URALSIB

• fertilisers

Uralkali. This is a typical example of a deep-value stock. While the market is still concerned about possible fines for infrastructure damage invoked by the mine collapse, we believe that current valuations of less than 2.0 times this year's earnings already account for this risk. The company is the only exporter in Russia that is able to influence the global price for its commodity. This makes Uralkali a unique stock in an environment of falling commodity prices. TROIKA

RECESSION AND DEPRESSION: WHICH IS WHICH?

Moody's

December 19, 2008

Although recession is often defined in 'technical terms' as two consecutive quarters of negative growth, this definition is not necessarily helpful, nor in fact particularly meaningful. Two quarters of very mild contraction of output followed by a significant rebound is less damag-ing than a single quarter of sharp contraction followed by a sluggish recovery, or even, for that matter, a longer period of barely positive economic growth. Negative growth has also a very different meaning for a country whose trend (potential) growth is 4% and for a country whose trend growth is 2%.

More fundamentally, the notion of a recession is related to the concept of an economic cycle, and designates the trough of the cycle. A recession refers to a substantial deviation of economic output below its trend, resulting in accumulation of spare capacity, downward pres-sure on prices and - perhaps the most relevant indicator for indivi