Russia 2011-2014

By bne IntelliNews February 25, 2011

Ben Aris in Moscow -

At the start of last year, the press was filled with op-eds calling for the "R" to be removed from the acronym Bric. At the start of this year investors pulled $10bn out of equities of emerging markets, including China, India and Brazil, yet Russia was the only Bric market to take in fresh cash - over $250m worth around St Valentine's Day. Russia, it seems, has gone from being a troll to the sweetheart of portfolio investors.

Part of the interest in Russia is simply that it largely missed out on the 2010 rally in emerging markets, but part is also due to its robust economic health and the boost that the economy got from rising commodity prices, which caught everyone, including the Russian government, by surprise. Indeed, Russia watchers have pointed out that January's sell-off had more to do with sentiment than statistics. "If you look at the macroeconomic picture, there are few countries in the world that have stronger fundamentals than Russia," says Roland Nash, chief investment officer at Verno Capital. "There is nothing fundamentally wrong with the economy and if anything, by squeezing out all the leveraging, the crisis has left Russia's companies in an even more robust shape than they were before."

Eye of the beholder

Perceptions of Russia have always had a hard time keeping up with reality, which is in turn obscured by the country's appalling image in the press and the volatility of its market. Yet over the last two decades, Russia has gone from basket case to emerging European power, while the population have progressed from simply surviving to shopping.

"During its various booms, the last of which came to an abrupt end in September 2008, that perception gap has narrowed (at the height of the credit boom, Renaissance Capital ran an informal "hotel index" that tracked how many rooms were free in Moscow's top hotels, which regularly dropped to zero as investors flooded into Moscow to look for business or extend cheap credits). But that gap can stretch out to several years following the worst of Russia's many crashes and, once again, the gap today between what is actually happening and how the outside world perceives Russia is wide.

In the summer of 2008 just before the financial crisis struck, Russia was actually on the brink of becoming the largest consumer market in Europe. The economy took a hit that reversed a roughly 7% economic expansion in the autumn of 2008 into a 7% contraction by February 2010, but now the country is staging a strong comeback that has been gathering momentum since December. The government is forecasting mild growth of 4% for most of the next three years, whereas most economists are already predicting at least 5% growth for this year.

Another problem with people's perceptions is the time scale. As Russia's economy is still very dependent on oil prices, the short term remains very unpredictable - as the recent crash proved yet again. Yet over the longer term, the country has made steady progress (with some huge detours) towards converging with the developed world. Indeed, on a per-capita basis, Russia is already by far the richest of the four Bric countries, with average incomes more than twice those of the next wealthiest country. According to a UN report released at the end of last year, Russia is already a "high human development" country, ahead of Brazil in the same category, and well ahead of China and India, which are both classed as "medium human development" countries along with the likes of Turkmenistan and Gabon. In fact, on many scores, like education and literacy, Russia is already on a par with Western Europe, according to the UN.

This idea of the inevitable march towards convergence is at the core of the whole Bric concept introduced by Goldman Sach's Jim O'Neill, which was backed by a February report from PriceWaterhouseCoopers (PWC) saying Russia would be one of the five biggest economies in the world in the next three years, pressing on the heels of Germany, China and the US. "The old world order is sure to be changed by a new one during the next four decades," PWC said in its report, "The World in 2050".

In 1999, Putin boasted that by 2015 Russians would be as rich as the Portuguese - Western Europe's poorest economy - despite at that time the average Russian income being only 9% of the average in Portugal. Putin's bold assertion was widely derided, but since then Russia has grown so fast that average incomes are now 60% of those in Portugal and show no sign of slowing down, while incomes in Portugal are going backwards. If the two economies keep growing at the pace they have over the last decade, Russia's income per head would overtake not only Portugal's in 2014, but also Japan's.

Aftermath of the crisis

Still, there is a lot of work to do, but Russia has made a good start on climbing out of the hole it fell into in 2008.

Nearly all of Russia's most important sectors reported strong growth in 2010, albeit the volumes of production and sales still remain well below those of the 2008 peaks.

Currently, both domestic and foreign investors are taking advantage of the reduced valuations and a rebalancing of the economy is in full swing. With cheap assets and plenty of cash about, Russia saw over 3,000 mergers and acquisitions last year - almost 10 times as many deals as in the much larger Chinese economy. And with an average deal size of $10.5m, these deals are mostly private sector, whereas in somewhere like China, with an average deal size of $166m, the deals tend to be amongst state-owned enterprises, according to Thompson Reuters.

Likewise, despite a sharp fall in foreign direct investment (FDI) since 2008, over the last four months there have been several huge investments by strategic investors into the Russian economy. Overall, FDI in 2010 was about $40bn, half of the 2008 peak, but while the volumes are down, the size of the deals is going up as strategic investors take the plunge and commit to Russia. BP's $1.5bn share swap with state-owned Rosneft represents a major commitment to Russia by the oil major. Even more significant was PepsiCo's $3.8bn deal to take over dairy firm Wimm-Bill-Dann, the biggest deal in Russia's recent history, which at a stroke makes PepsiCo the largest food producer in Russia.

The banking sector is already spluttering back into life. "There is not really much opportunity in Russia, as the bank debts were quickly restructured and they were not under much pressure to sell," says Andre Andrijanovs, an emerging market credit analyst at Exotix, a London-based fund that specialises in emerging market distressed assets. "Now the banks are over-liquid and sitting on their preferential loans waiting for lending to resume."

Picking up the pace

In the past, Russia's economy grew despite, rather than because of, its government. The inflow of petrodollars pays for a lot of machinery and consumer goods, but the state has been very slow to push through badly needed reforms. Waste is legion, corruption rife and good management scarce in Russia's corporate world, but businesses flourishes because there is so much cash sloshing about. "Why does a cup of coffee cost so much in Moscow?" wondered Yulia Laterniya, a well-known political commentator in her column. "Because the system works so badly."

This crisis has been another "never again" moment for a government that became complacent with $150 per barrel oil. Going into the crisis, the Kremlin clearly thought its $600bn was enough to buy the country out of hardship, but it soon became clear that it wasn't.

Moreover, for the first time in eight years smaller business was put under pressure and made an issue of efficiency, which in turn highlighted poor government and led to rising social tension. This has made the government nervous and reinvigorated its reform drive; there is a popular myth that there is no reform in Russia, whereas in fact the state has had a string of successes.

The first big change came in the retail sector, which amounted to little more than freeing prices. Telecommunications was the first big set-piece reform that required deregulation and privatisation of a state-owned monopoly. Russia's mobile phone sector has flourished to the point where it looks like that of any other developed country in the world.

But nowhere is the success of reforms and Russia's ability to attract investment better demonstrated than in the auto sector. Nearly every major foreign manufacturer in the world has a factory in Russia and foreign brands are so ubiquitous that you have to look hard to find the classic Soviet brands, the Lada and Volga, on the streets of Moscow today. The crisis crushed the car market, but output bounced back and doubled on the year to 1.2m units in 2010, the Economic Development Ministry said in January, though that's still far short of the 1.65m cars made in only the first six months of 2008. However, the market is expected to recover steadily and once again become the largest car market in Europe by 2015, predict industry experts.

There is more of the same in the works. The Kremlin launched a major push to remake the pharmaceuticals sector at the end of 2010, and, like the automotive sector, will mix billions of dollars of subsidies together with protective tariffs that are designed to encourage the world's largest producers to set up locally. The growth of the drug sector is already outpacing that of the economy as a whole, with 2011 expected to see it expand 12% to RUB733bn, up from the 6% growth last year, and maintain this pace for several years, according to Russia's DSM Group.

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