Ben Aris in Moscow -

While Western Europe is once more staring into the abyss of sovereign default, Russia is expecting to see the strong growth that was originally forecast in the second half of 2010 (but was delayed by the fires in the summer) finally arrive in the first half of 2011.

Russia is recovering from the crisis well, but even leading officials admit that the state is carrying the can, while the private sector and consumers are still recovering from the shock of the 2008 collapse. How quickly this confidence returns - and it's likely to take another two years until it's completely restored - will be as important, if not more so, for the rate of growth than oil prices in 2011.

The government is under pressure. Thanks to the budget deficit, rising imports, and a shrinking current account, it has to make reforms work over the next two or three years, or else it will face a another bout in the "periodic devaluation trap," argues Deputy Economy Minister Andrey Klepach.

The trap is set

Thus far the state has been unable to come up with anything better than pumping more investment into the economy through the large state-owned enterprises, which - without the private sector and consumers - is what drove the less than spectacular recovery in 2010. Nowhere is this more clearly illustrated than by the budget's break-even oil price, which was running at $110 at the end of 2010, up from (the still extremely high) $70 pre-crisis. This is not a sustainable policy; or at least it condemns Russia to a boom-bust cycle that follows commodity prices swings.

On the upside, the Russian capital markets should do well in 2011, with the RTS likely to outperform other emerging markets. FDI and investment should both pick up simply because they lag the crisis by at least a year, and 2010 was the low point in the cycle. Domestic production should also pick up as, while imports soared in 2010 putting the current account under pressure, the statistics show that most of this was down to companies re-tooling ahead of the next super-cycle and recovery of domestic consumer demand.

On the downside, inflation and the deficit remain a problem. The pressure on the current account, added to a $90 ceiling on oil prices has economists worry that the dwindling current account surplus could turn negative by the end of 2011, which may lead to a mild devaluation of the rouble.

However, these problems are fairly mild and it means that the Finance Ministry will have to go to work for once, rather than simply organising how to spend the huge flood of petrodollars that used to pour into Russia's coffers.

At least the Kremlin appears to realise the scale of the problem and what will happen if they fail. "The economy is now starting a new phase of growth," says Klepach. "There will be big qualitative changes [in the structure of the economy] otherwise the economy will not be competitive and we will not be able to escape the periodical devaluation trap."

State-led rescue

On the face of it, the pace of economic growth is picking up fairly well, with 2010 expected to see expansion of around 3.8%, while the deficit has fallen further and faster than anyone expected (the end of year estimate is 3.5%-4% of GDP). Meanwhile, with about $500bn in reserves, Russia's public finances are amongst the most robust in the world.

On closer inspection, however, the official numbers look disappointing, with the private sector moribund. The government's results may paint a rosy picture in the European context of bailouts and spiking credit default swap (CDS) spreads, but the blanks in between are a cause for concern. Whilst the state and state-owned business have enough money and momentum to keep nudging the economy out of the deep hole it fell into in 2008, everyone is still waiting for consumer and small business confidence to return to the point where Russians start to shop again and businesses start to invest.

"Russia enjoys a very low debt/GDP ratio of about 10%, so we can borrow and remain reluctant to cut spending. The deficit is projected to be 4.8% this year, 3.6% next year before falling to zero in 2015," Deputy Finance Minister Dmitry Pankin told delegates at a December conference. "We are not under a lot of pressure and we can continue fiscal stimulation, as there is no danger of solvency problems."

Russia should have a good 2011 then, with much of the strong growth that was expected in the second half of 2010 arriving in the first quarter of 2011 instead. Both consumer and corporate confidence were knocked sideways by the fires in the summer of 2010, but by the fourth quarter they were both growing as evidenced by the gathering momentum of bank lending.

As for the result at the end of 2011, much depends on the external environment, but at the same time the key will be how well the government performs in pushing through real, and more importantly effective, reforms. The state's first challenge will be to move the core of economic growth out of the state-owned sector and into the private sector, which wont be easy.

Vasily Vysokov, president of Rostov-on-Don's progressive Centre-Invest Bank, put his finger on the problem saying: "We shouldn't increase the rate of growth of a bad economy, but use the crisis to change the nature of the economy and its direction. State support takes money out of the pockets of those that work well and puts it in the pocket of those that work badly."

External environment

Control over Russia's economic health in 2011 is to a large extent out of its hands and depends on what happens in the rest of the world. While bne doesn't have an in-depth view on Western economies, clearly the crisis is not over in Europe and the US, as nearly all the countries in this group have to work out large debt and deficit problems that will certainly take several years to deal with, if not longer.

This makes the external environment very unpredictable and has already negatively affected Russia's stock and bond markets, with issues being cancelled throughout 2010 because of Europe's, not Russia's, problems.

While 2010 was the year that the first round of sovereign debt problems hit (with Greece almost defaulting at the start of the year and Ireland experiencing a close shave at the end), there's bound to be more of the same next year. However, like any aftershock, the size of the quakes should become smaller over 2011 (although also like aftershocks there's always the chance of the odd big secondary shock that does more damage).

Deutsche Bank predicts in its outlook: "We expect the euro area to be defined once again by the rolling sovereign debt crisis in 2011. We do not expect markets to improve until the countries for which there are genuine questions of financial sustainability are offered EU-IMF aid to finance their adjustments. After Greece and Ireland, we believe this likely only means Portugal."

"Spain will have to do more to differentiate itself, but a stronger recapitalisation of the banking sector coupled with structural reforms can keep Spain in the market and out of the EU-IMF umbrella. The ECB may need to lend more assistance to make sure markets remain functional."

"We are revising up our euro area GDP forecasts for 2010 and 2011 by 0.2pp to 1.7% and 1.2% respectively. Despite the upward revision, we continue to envisage a slowdown into 2011. We expect euro area inflation to rise above 2% in the coming months and to average above 2% in 2011."

Having said all this, it could have been a whole lot worse and the Eurozone and US are growing (and Germany is actually doing better than at any time since unification), which provides a foundation on which CEE countries can build their own recoveries.

For Russia this lackluster external environment means the government is not quiet earning enough to pay for its own spending, and this is probably the best driver to force the Kremlin to push hard on reform. Indeed the results of 2011 for Russia will depend to a large extent on how successful the Kremlin is at instigating effective reform rather than the usual suspects like oil prices and inflation.

Macro

• GDP outlook

Russia's economy is growing, but growth remains very fragile. It bounced back in the last part of 2009, and this growth extended into the start of 2010. Then it began to falter, and was slowing even before it was knocked sideways by the fires over the summer. More fundamental domestic-based, consumption-led growth only started to appear in the last months of 2010.

"The growth of the Russian economy was almost exhausted in the first quarter of 2010, but then it started to recover in September," according to Klepach. "At the start of 2010, the key drivers of the economy were all external and supported by the recovery of oil prices which goes hand in hand with [the growth in] Russia's GDP. So in September, we saw the start of a third wave of growth and expect that growth for the full year will be about 3.8%."

Klepach paints picture of a state-led recovery in 2010. "In the fourth quarter, we saw the start of a pick-up in investment, which was faster than expected: we were expecting 2.5% [increase in the rate of investment year-on-year], but in October saw 5.5-6%. Much of this investment was going into energy and into the metal and engineering sectors. But it is hard to get a clear picture of what is happening in investment, as the state is also investing heavily under state programmes."

Faster growth is possible in 2011, but the speed depends on the return of confidence amongst both consumers and businesses. At this point the outlook looks good on both scores as bank lending to both classes was recovering well in the last quarter of 2010.

• GDP forecasts for 2011

The official estimate for Russia's economic growth in 2011 is 4%, but the band of estimates on what it will actually be varies widely from 3.5% to over 5%.

The newly launched Rencap-NES macro research team are more cautious about Russia's prospects for 2011 than those from the government and many international financial organisations, arguing that everything depends on the government's success in carrying out reforms.

"Economic growth in Russia will continue to disappoint in 2011. The research team anticipates that economic growth will be 3.5%, more or less unchanged from 2010. With the oil price approaching $90/barrel, and much of the rest of the emerging world enjoying strong recovery, economic growth at below 4% for Russia should be considered disappointing. Sustainable medium-term growth in Russia can rise from the current 3-4% to 6% with the right structural reforms," the Rencap-NES team said in their inaugural report.

Economic growth in emerging Europe could accelerate to 3.2% in 2011 after growth of 1.8% for the region in 2010, but this hinges on a sustained global recovery and stability in financial markets, the World Bank said in December.

At bne we believe that the GDP will pick up a bit faster, ranging from 4%-5%. Bank lending clearly shows that consumer confidence is rising, with retail loans growing faster than any other type of lending. We are also encouraged by the jump in the import of equipment - which made up most of the import gains this year - as it suggests that while companies are more-or-less treading water at the moment, they are spending this quiet time to retool and so clearly expect domestic demand to recover.

Growth was driven in the boom times by the virtuous circle of spending-profits-investment-wage rises. Currently this wheel is idling, but once it starts turning again it will push things forward quickly. It is the compounding effect of the relentless rise of per capita income, which multiplies itself the faster it rises - and per capita income in Russia is amongst the fastest rising amongst all the emerging markets.

• Impact of World Cup win

Russia will host the 2014 Winter Olympics in Sochi, an F1 World Championship race, and successfully won the bid to host the 2018 FIFA World Cup in December. Fund managers were ecstatic at this sporting hat trick, which is forecast to lift GDP growth rates by 1%-2% on its own, not to mention the intangible benefits.

Firstly, at least $10bn will need to go into bringing the country's infrastructure up to international standards. As these events are so prestigious the Kremlin is going to bend over backwards to do a good job. Russia has been directly challenged by China success in hosting the last summer Olympics, and more recently the World Expo, winning acclaim for both by spending billions. The Shanghai Expo brought in a record 72m visitors - and that is the point: these events are supposed to be a coming-of-age party.

In Russia the roads, bridges, rail, airports, ports and sports facilities will all be brought up to world-class standards. "This will substantially increase productivity, employment and increase economic growth. Historically, large infrastructure spending has tended to add a 1-2% non-cyclical layer to trend growth. On the back of this and high commodity prices, Russia can re-join the club of the high-growth countries in the world," says Elena Kolchina, head of Renaissance Asset Managers fixed income fund.

Secondly the Kremlin is clearly using these events to impose some discipline on its regional development plan. Moscow and St Petersburg dominate the Russian economy, accounting for at least a third of the country's GDP. The Sochi 2014 Olympics was a test run of using a major sports event to provide a plan to develop the local economy and infrastructure. The World Cup will extend the programme to another 14 cities, all except Yekaterinburg in the European part of Russia, where 80% of the population live.

Probably the most important direct benefit is that not only does the Kremlin want to make the investments, it now has to, and to a fixed deadline with outside inspectors to check the quality of the work. Russian reform has been constantly plagued by too much talk, too much stealing and not enough action.

Can the 2018 World Cup turn that around? There's not a lot of form to go on. There have been lots of reports that the development in Sochi is not going well, and there is a lot of overspending and stealing. So far the only big international event Russia has hosted is the Eurovision Song Contest a couple of years ago, but that went very well indeed, with the organisers saying it was the best ever event (not that many papers bothered to report these comments). So on balance we are inclined to give the Kremlin the benefit of the doubt.

Finally the incidental benefits are mainly connected to having hundreds of thousands of normal people wandering around in Russia. A large part of Russia's bad image is connected to the sheer ignorance about what Russia is like. Germany found that it earned a huge amount of credit from hosting a hugely successful World Cup in 2006, an experience which counteracted much of the residual animosity many Europeans still feel towards Germany.

While the western press constantly paints a picture of Russia as a fascist police state populated by paupers and under a perennial blanket of snow, for those of us who actually live here, the people are intelligent, hospitable in the old school style, and fun. The experiences of these visitors will go a long way to improving Russia's image, as the contrast with what is written in the press will be so stark - especially for those that visit the southern parts of Russia.

There is a precedent here too. When Scotland's national football team played a friendly against Estonia in the early 1990s, 40 Scottish football-fans made the trip and only 20 went back - the rest stayed and married local girls. When the next friendly was played about two years later 400 Scottish fans made the trip - and 200 went back. Today many of the bars and restaurants in Tallinn belong to Scots and many of the local girls speak English with broad Glaswegian accents.

Inflation outlook

After falling to record lows of about 4% in the summer of 2010, inflation has begun to rise towards the end of 2010, and is expected to climb to about 8%-8.5% - slightly (but not a lot) higher than Russia's comfort zone.

Much of the increase was caused by a one-off hike in food prices after a third of Russia's crop burnt in the summer. Food prices were up 12.6% in November year-on-year, but CPI excluding food was flat at 5.7%. However, as the snow began to fall towards the end of the year, the CBR admitted that monetary factors were also starting to play a role.

Because of that, the central bank is likely to reverse the string of cuts seen in 2010, and hike rates early in 2011. Deputy chairman Alexei Ulyukaev says the CBR expects inflation to start declining in 2Q11.

Meanwhile, whilst it has talked a lot about switching from FX control to inflation targeting, the CBR is not there yet. The floating RUB/basket band was expanded again in October, but a fully floating ruble is still at least two years away. The CBR is still intervening, but the whole show has become a bit hazier.

Firstly, it has not made it clear where the boundaries of the trading band are - "the market knows," said Ulyukaev in November. Secondly, the CBR is trying to intervene as little as possible and has gone months in 2010 when it didn't buy a single dollar.

The interventions could be better thought of the CBR acting when 'speed traps' are triggered. Analysts from UralSib say: "Our understanding of the mechanics of the range is as follows. There are a series of thresholds (call them 'speedtraps') each associated with a certain level of cumulative intervention by the CBR. We believe that these thresholds and associated limits of intervention are as follows:"

Ulyukaev has also made a number of important statements on the conduct of Russia's monetary policy, including his claim that the CBR likes FX volatility as it allows its rates to become true policy rates. This statement well coincides with the regulator's Monetary Policy Guidelines draft for 2011-2013 and the plan to narrow the interest rate corridor in the medium-term.

Budget deficit

The reappearance of the deficit since the start of the crisis is the other major macro problem the government has to deal with. Economic Development Minister Elvira Nabiullina said that in 2011 the official budget deficit forecast is 5.3% of GDP, although it's more than likely to come in significantly below this level: between 3.5% and 4%. (It was 2.2% in November 2010).

Indeed, after some sweaty palm moments at the start of the year that predicted an 8% deficit, the funding gap has come down much faster than anyone could have hoped. Indeed, in December Goldman Sachs was predicting that the government could actually clear the deficit in 2011 if it was lucky.

The main issue for the Ministry of Finance is how to fund the deficit of around RUB1.5 trillion ($50bn) for 2010. The government intends to use three sources: its reserve funds, privatisation and its borrowing programme.

• Reserve funds

The government has enough money left in the Reserve Fund and National Welfare Fund ($40bn and $90bn respectively, as of December 2010) to completely finance the deficit in 2011 and 2012.

In keeping with the prudent management of its reserves, the state has decided to spend $15-20bn of the Reserve Fund to support the budget at the end of 2010 (when most allocations are made), and use the rest in 2011 (which will exhaust the fund), but to leave the National Welfare Fund untouched. The rest of the shortfall will be financed from the privatisation and borrowing programmes.

• Privatisation

The budget calls for income of RUB300bn ($10bn) a year from privatisations, over the next three years, while the total could go up to $50bn if the market conditions are good, says Pankin.

During this first round of the programme, the state will keep controlling stakes in the companies its sells, but after 2015 it's possible that the controlling stakes will be sold too, according to officials.

"Everyone accepts that the state is not an efficient manager and so selling these companies will make them more efficient - that is the main goal. The secondary goal is to get a good price," says Pankin.

• Borrowing programme

The budget has a provision for $7bn of international borrowing over the next three years, however, the state has made it clear it will borrow as little as possible overseas.

The bulk of the money - the budget calls for RUB150bn a year for three years - will be raised from the domestic market. (for more see the bond's section below).

Consumption

"The second key question for the growth in 2011 is what will the consumer do? Incomes are still rising, but they are rising half as fast as they did pre-crisis. However, we expect that lending will increase," said Klepach.

Consumers, not oil, are now the key driver of economic growth in Russia and they have been pretty depressed for most of 2010. However, the indicators suggest that people were starting to cheer up as the year came to a close.

There have been several structural changes affecting the way consumers think and act. Unemployment dropped faster than expected in 2010, but all in all sectors are now employing less people, even though those people are paid more than before the crisis. Meanwhile, whilst real incomes continued to rise throughout the last two years, this has not fed through into an increase in retail turnover in 2010.

"The change in consumption is not reflected in these numbers and has remained more or less flat and well below government forecasts: retail turnover growth won't reach the government's forecast of 5% this year," says Klepach, estimating the number will end the year closer to 2%.

Before the crisis, increases in income were reflected and multiplied in retail turnover results, so that, for instance, an approximate 5% increase in income turned into a 15%-plus increase in retail spending. Even though real incomes have risen over the last two years - this year incomes are up some 5% - retail sales growth has lagged.

This strongly suggests that Russian shoppers are still feeling shell shocked by the crisis, and have changed they way they buy. Instead of leveraging their ever-increasing incomes to buy on credit (which multiplies retail turnover very quickly), they are saving until they can buy goods in cash.

Companies can't invest unless they have rising sales, as Russian private industry is now suffering from overcapacity, while the state is doing all the investment. Klepach admitted as much. "The key drivers for 2011 are all the natural monopolies' plans [for investment] - nothing is expected from the private or SME sectors - so the state is leading the recovery," Klepach said. "The investment plans by Gazprom alone will have a huge impact, while investment in other sectors is still minimal."

Current account and trade balance

Imports surged in 2010, putting the current account under pressure, and more of the same is expected in 2011. Indeed, what sales increases were seen were mostly going to imports, which have been rising fast.

"The growth of internal demand is mapped to imports," said Klepach. "Now the ratio of import/export production is worse than before the crisis. While food imports have fallen or remained stable due to protectionist measures, in the durables and investment sectors the sensitivity to imports is enormous, and their gain is enormous. Joining the WTO will not help and won't slow the growth of imports - in fact it will do quite the opposite and exacerbate it."

This is bad news. If this trend continues, then the value of the rouble will come under more pressure. Elina Ribakova, economist for Citigroup, says: "The bottom line is that once you are running a current account deficit, someone has to agree to finance it. If Russia does not make itself attractive to foreign investors, they will not agree to finance its current account deficits and that will mean exchange rates will have to depreciate enough to slow down imports."

If there is no change in the current trends, then Russia will face another bout of devaluation of the rouble to bring it into line with new structure of the economy. "In 2012, rouble appreciation will stop and there will be a devaluation shake up. This happens every few years," said Klepach. "Or we will have to dramatically open our economy to foreign investors and get a steady flow of investment."

The good news is almost all of the rapid rise in imports has gone to capital goods - new machines for companies. This suggests that although sales are low, companies are retooling to increase their share of domestic production for when confidence recovers. This suggests the uptick - when it comes - could go faster than expected.

Outlook for the ruble

The rouble underperformed other commodity currencies this year. The main reason was that foreign capital inflows were limited due to unpopularity of Russia compared to other BRICs, while capital outflows increased.

However, through 2010 we also saw the peak of repayments on external loans obtained by Russian companies in the crisis year of 2008. Most companies preferred to reduce debt, as post-crisis business plans are less aggressive. At the same time, many external loans were refinanced in the domestic market as companies are managing FX risks more closely. As a result, net capital outflow from Russia in 2010 may reach USD30bn.

Next year the capital account should improve and the current account remain positive. Increased global risk appetite and attractive valuations of Russian assets (both equities and bonds) which underperformed this year should attract higher foreign portfolio flows.