Ben Aris in Moscow -

Equity outlook

• Bric stock market rallies running out of steam, Russia's just starting

• Russian stocks returned 20% in 2010 and will do better in 2011

• RTS likely to pass all-time high of 2400 in 2011, rising by at least 15-25%

• Russian stocks were cheapest in world in 2010 and unless market corrects up, will become even cheaper in 2011

• Big international investors overweight Russia for 2011

• US is set to release a series of QEs, little of which will be absorbed by the US economy and much of which will end up in global emerging market (GEMs), driving asset prices higher

Investing into Russia equities is easy: you only need to ask yourself: "Will Russia have a crisis this year?" If the answer is "no", then you should invest and you will get at least a 20% return (from the index).

In 12 of the last 15 years, Russia's equity market has been amongst the three best performing markets in the world. The trouble is that in the other three years - crisis years - it is in the bottom three worst performing markets in the world. Russia's equity market remains extremely volatile and vulnerable to external shocks - more than any of the other Brics.

Asking the same question at the start of 2010 would have also returned an answer of "no crisis this year" and Russia has had a good year, returning about 20% over the year. 20% is the minimum that Russia returns in a non-crisis year and this was clearly a disappointment, as almost all the investment banks in Moscow were predicting the RTS index would end 2010 at about 2000, when it actually looks like finishing closer to 1700.

The reasons for the "underperformance" are obvious: a combination of the summer fires that destroyed a third of the crop and knocked 1-2% off GDP growth, and the rolling sovereign debt crisis in the West.

While the external conditions remain unstable (will Spain have a crisis?), the internal conditions are improving steadily, especially consumer spending and borrowing. So on first principles, the RTS should do better than it did in 2010.

Russian stocks are so cheap that several banks and funds have started to overweight Russia for 2011. UniCredit has been a fan of Russian stocks for most of the year, while HSBC and Goldman Sach's chief economist, Jim O'Neill, both said in December they were overweight Russia. HSBC Global Asset Management said it had Russia as its biggest overweight position in emerging markets, predicting 2011 returns would outstrip the 10-30% gains it expects from broader emerging equities.

• Earnings vs P/E ratios and RTS forecasts

Part of the reason the RTS should outperform is the fact that Russian stocks were the cheapest in the world at the time of writing, trading at a price/earnings (P/E) ratio of just under 8x.

This is the same ratio as they were trading in the mid-1990s: in other words, Russian equities have gained no benefit from the fact that the economy has transformed out of all recognition over the last 15 years, with almost every indicator - size of the economy, average incomes, size of international currency reserves, stock market capitalisation, external debt, export volumes, etc -increasing 10-fold.

Russia is today more-or-less a normal country, yet the equity valuations are the same as when it was a post-collapse economic basket case in the mid-1990s. This is nonsense.

Moreover, the nine-month forward forecast for P/E's based on aggregate corporate earnings projections suggest that the P/E ratio will fall to 6.3x in 2011, so the already dirt cheap stocks will get even cheaper.

This is highly unlikely, as despite Russia's terrible international image, the 1990s showed that even when the problems are massive and there is no foreseeable end to the chaos investors were still willing to buy super cheap stocks at P/E ratios below about 7x simply because the downside is so limited, while the upside gets bigger and bigger.

This "cheapness" effect alone will probably drive the RTS up to the 2000 level to keep P/E ratios at about 8x, taking the RTS to where it should have been in 2010 had it not been for the fires. The gains will probably come during the annual spring rally that usually ends just before Easter.

In 2011, Russian indices will grow by 15-20%, forecasts a head of the Investment Management Department at Raiffeisen Capital, Igor Kobzar. Analysts at VTB Capital forecast that the RTS Index will reach 2200 points by mid-2011. All told, there is a very good chance that the RTS will pass its all-time high of 2487.92, set on May 19, 2008 in 2011.

• Investors overweight Russia, other Brics out of steam

Despite being rubbished by the press and a middling performance in 2010, most international investors were being pulled into Russia and overweight going into the holidays in expectation of a pick up in the annual Russia spring stock market rally.

But they were also being pushed out of the other Brics as strong rallies all three of the other markets look like they have run out of steam, while Russia's rally remains strong.

Michael Kahn, a mutual fund analyst, produced a series of charts in an article on Barron's that highlights price trends all three of the other Brics has described an "M" double top and failed to break through resistance - except in Russia.

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Sources of capital in Russia: show me the money

Kingsmill Bond of Troika Dialog

Russia's net capital outflow could amount to $25bn in 2010, Deputy Economic Development Minister Andrei Klepach told reporters on the sidelines of a banking forum in December. Russia is likely to receive net capital inflow in 2011, Klepach said, adding that capital inflow could start in December 2010.

Troika summarizes assets and liabilities for households, companies, the government, banks, institutions and foreigners, and examines the nature of the debt and equity markets to identify unusual aspects of the Russian capital markets.

• Foreigners are the key source of long-term capital

Foreign investors are the providers of financial capital for the equity (75%), Eurobond (70%) and syndicated loan (100%) markets, and provide 44% of the total financial capital in Russia. Foreign perception is therefore arguably as important for the equity market as local reality.

• The principal source of domestic capital is deposits

Deposits make up 82% of identifiable domestic financial capital, and are intermediated by the banks into domestic loans, with little available for long-term investment.

• Russia has limited institutional capital

The total size of the Russian pension system is 3% of GDP, mutual funds are 1%, and insurance funds are 1%, a fraction of what we see in Eastern Europe. If Moscow is to develop as a financial centre, it will be necessary to stimulate the growth of this capital, a financial deepening process we have seen elsewhere.

• Corporate debt is already high

Given the lack of depth elsewhere in the markets, investors should be relatively cautious about corporate debt, which amounts to 48% of GDP.

• Foreigners will be key to new capital provision

As most deposits are recycled by the banks into loans, and institutional capital growth is low, foreigners will be the principal source of capital for the coming wave of debt and equity issuance. As the current account is shrinking, and debt capital is not so easy to attract as before, this should lead to better corporate governance and higher rates.

• Beware the money illusion

In theory, the government, oligarchs and homeowners control assets with tremendous value. However, the lack of domestic capital means that valuations are suspect, and these assets cannot be realized easily. Investors should thus avoid capital raisings that are not accompanied by very clear standards of corporate governance.

• Who owns the equity market?

Of the free float of around $250bn, we can identify $120bn in assets held by foreign long-only funds, but only $4bn held by Russian mutual funds, $19bn by the banks, $10bn by pension funds, and perhaps $25bn by retail. The rest is held by oligarchs or hedge funds.

• Where is household wealth?

We calculate that 84% of household wealth is in property, 12% in deposits, and just 4% in all other financial assets.

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• Reforms work!

In fact, investors would be well advised to ignore all the talk about the cheapness of Russian stocks - it is a constant theme of any presentation by fund managers talking about Russia. The cheapness of Russian stocks is a red herring. Better to focus on the earnings of companies.

Russia has never re-rated and is unlikely to re-rate in the near future. Russian stocks rise on their earnings and as GDP/capita income in Russia (between $15,000 and $18,000 adjusted for PPP, depending on who you ask) is by far the highest of any of the Brics, not only are Russians by far the richest of all the emerging market populations, but their incomes are rising by far the fastest.

This feeds through into strong earnings growth, especially (but not only) for consumer-orientated companies. This increase in earnings alone has been enough to drive the RTS up by over 750% in the last decade - four times more than the Shanghai Index (up 190% over the same period), the second best performing market in the world. And China's gain includes a re-rating, as Chinese shares traded at a P/E of 15.1x as of October against Russia's pathetic 7.5%.

But while the overall Russian market has not re-rated, individual stocks in some sectors have. Companies in sectors that have reformed are rising so fast that they look pricy now. For example, leading regional supermarket chain Magnit saw earnings increase by a third during the worst of the crisis in 2009 and its stock is currently trading at 30x. The same is true, to a lesser extent, for the other retailers such as X5.

Retail companies have proven a highly popular target for fund managers and have mostly hugely outperformed the rest of the economy. However, this is because the sector has been a beneficiary of real reform, in that with it being a high-volume, low-margin business, it and the reforms are largely apolitical - the state didn't need to do more than free prices and provide access to capital, both of which happened shortly after the collapse of Communism.

However, there have been real, state-led reforms in other sectors and, surprisingly, the same massive outperformance by stocks of the representative companies can be seen. For example, independent gas producer Novatek's stock was trading at a P/E ratio of 20.1x in November, which has also been a major beneficiary of the partial liberalisation of the gas market. Gazprom and Sberbank are other obvious examples.

Former Prime Minister Mikhail Fradkov launched a sweeping reform of the bank sector in 2004. "Bank reform is at the top of the political agenda," he told the Duma that summer to widespread disbelief. However, the reform went ahead and has transformed the sector, sending stocks like Sberbank soaring.

The chart below, produced by Renaissance Asset Managers, shows the difference between the bank sector share price set against an RTS indexed at 100 in 1999 to flatten out the bumps in the over all equity market and focus on relative performance of the banks against the index.

Indeed, in every case where the government has launched a major set-piece reform, the value of the most representative stocks in that sector has soared over the index. What is so surprising is that this pattern is repeated in a range of what should be disparate sectors.

For example, while commentators poo-poo Russia as an investment destination, the Kremlin has successfully attracted nearly every major automotive manufacture to various car-clusters in St Petersburg and Kaluga, which are well developed and recently have started to developed secondary production, like making car parts. Russia was (briefly) the largest car market in Europe in the summer of 2008 and will surely overtake Germany again in the next few years. Once again, the shares of listed carmakers have massively outperformed.

And the same chart can be drawn for the telecom and power sectors, which have also been beneficiaries of big reforms. Moreover, these charts match the chart that maps share prices and earnings. Clearly, as earnings are expected to recover in 2011, the share prices will start rising strongly again.

The fly in the ointment is that almost none of these reforms are finished. Indeed, most of them are only half done (think of the completely free mobile phone sector versus the saga over privatising the state-owned fixed-line monopoly of Svyazinvest), so detractors always focus on what has not been done and write off the entire reform effort. These charts show that investors should look at the other side of the coin and see what has been achieved and then find the companies that will stand to benefit from liberalisation. "That there is a no reform in Russia is a myth," says Plamen Monovski, CIO of Renaissance Asset Managers. "There is widespread reform, but it is incomplete and usually only the best companies in the sector have reaped the benefit in the form of higher valuations. However, these valuations are not random events. They are part of an ongoing process that if anything will accelerate from here."

Going into 2011, the Kremlin has launched a major effort to "modernise" the economy. This means a new wave of reform in new sectors that should produce a new batch of representative companies that should massively out-perform the index. The state has specifically named the following sectors for attention:

Agriculture

Pharmaceutical

Coal

Roads

Rail

Meat processing

Timber

Finally, in light of the impact of these reforms (on stock prices anyway), we have to qualify the statement that "Russia has never re-rated." It has, but only at the level of individual companies, or at a stretch a few sectors like banks and retail.

However, as we go forward these beacons of outperformance will become more numerous and more people will notice that they are appearing in an increasing number of disparate sectors. So at some point they will all link up - and then Russia will finally re-rate after waiting two decades for people to notice its best companies are actually doing really well.

Will this happen in 2011? Almost certainly not. The next big trigger for a possible reassessment of Russia comes with the 2012 presidential election, when the Kremlin is hinting that it will move much faster on liberalisation - both political and economic.

Bonds outlook

• Emerging market bonds in general outperformed, but Russia performed less well than the other Brics in 2010

• The government intends to finance most of the budget with RUB1500bn a year of bond issues on domestic market from 2011 as the reserve fund will run dry in 2011

• As one of the most creditworthy countries in the world at the moment, Russian bonds are well received and yields have already fallen to levels below pre-crisis levels

• Russian corporates are borrowing hard from international markets (the government is going to avoid the international market as much as possible in 2011) and corporate external debt is rising fast

• However, borrowing is limited to the best companies, which as a result of the crisis have much less leverage than pre-crisis.

Global emerging market (GEM) bonds were among the best performing assets in 2010. Corporate bonds and bonds in local currencies did especially well. The sovereign debt crisis in the West coupled with the extremely low interest rates in the GEMs was driving investors' interest in bonds with strong fundamentals and high yields. GEM bond funds saw record inflows with assets growing by 42% in 2009, rising from €44.5bn to €63.2bn, and a further rise of 53% this year, to reach €96.4bn by the end of July, according to Lipper.

Russian bonds paid well in 2010, delivering (as of December 10) a 8.3% dollar return on sovereigns, a 13.8% dollar return on corporate Eurobonds and a 12.2% ruble return or a 9.0% dollar return on local corporate bonds. While still remaining a top performer among GEM bonds in the last decade, in 2010 Russian bonds underperformed other major GEM markets.

Performance of sovereign Eurobonds of GEM countries

Russia was punished by investors for lower economic growth compared with other major GEM economies. Foreign investors point to this year's budget deficit that is likely to persist for another three years as a major concern. Consequently, foreign flows to Russia were limited in 2010 and were much less compared with other GEMs. For that reason, the ruble is finishing the year 3% weaker to the dollar despite a much higher oil price, Russia's positive current account and Russia's close to $500bn FX reserves - the third largest currency reserves in the world after China and Japan.

Russian officials point out that Russia has no solvency problem (its debt/GDP level is less than 10%) and for that reason the state has decided to take some leverage - quite limited by international standards - to invest in the upgrade of Russia infrastructure and stimulate domestic economy. "We are not under a lot of pressure and we can continue fiscal stimulation as there is no danger of solvency problems," Dmitry Pankin, deputy economics minister, said in December.

• Borrowing is focused on the domestic market

The bulk of financing for the deficit will come from borrowing starting in 2011. Here the state has made room for international borrowing, but intends to raise the bulk of the money from the domestic market. "We have in the budget $7bn per year of external borrowing - as a maximum, but I think we will borrow less," says Pankin.

The state returned to international bond markets in April with its first sovereign debt issue in a decade, raising $5.5bn that was intended as benchmark for companies that followed the state into the market. The state says it will continue to provide liquid instruments and manage this benchmark.

The bulk of the borrowing will be from the domestic market: the government plans to raise RUB1500bn per year over the next three years from the internal market. Excessive domestic liquidity concentrated in the Russian banking system is fuelling a strong local demand for bonds. Sberbank alone has accumulated more than $40bn in bonds (both corporate and government bonds).

Corporates have followed suit, tapping the pool of liquidity in the bank sector to raise funds. In 2009 alone, there were 174 issues that raised just over RUB1 trillion, twice as much as in the previous year. The Russian domestic bond market is now large, liquid and more diversified than the Eurobond segment of the market.

Compared to the other GEMs, the Russian domestic bond market is one of the largest and has an important advantage. There are no restrictions on foreign capital flows. Russia is often compared to Brazil in terms of local rates. However, apart from three euro-fungible Brazil sovereigns (16s, 22s and 28s) denominated in BRL and yielding from 8.4% to 9.7%, all other investments in Brazil local bonds are subject to 6% tax on foreign inflows, which make Brazil local bonds less attractive compared to Russian bonds.

Local yield curve of BRIC countries

• Bond market diversifying again

When the bond market was born in 1999, the only sector issuing bonds was the energy one. However, the market quickly diversified over the next 10 years. Russia is widely viewed as a simply hydrocarbon play, however, it surprises on the depth and breadth of companies that have issued bonds and offers a diverse universe for the investor. Indeed, Russia's bond market today looks very similar to those of the developed market in terms of what is on offer.

The sovereign share of the total outstanding bonds has continued to fall steadily from 61% in 2005 to 33% in 2010, and the bond market is more diverse in 2010 than it was in 2008 - and this is despite the flood of issues from the state, which has significantly ramped up its borrowing on the domestic market to finance the budget deficit.

Despite a common belief that oil and gas dominate the market, energy companies only account for 8% of the local market, while banks are the largest non-state issuer with 16%. The sovereigns still account for the lion's share of outstanding issues, while municipal and regional bonds add with another 13%. However, the entire industrial gamut of bonds is on offer, with metals and mining, telecom, transport, utilities and others amongst the most active issuers with 4-6% of the total each in 2010.

On the corporate front, Russian companies' Ebitda margins remain high, while their debt/Ebitda levels are not high by international standards. During the crisis, most companies have also improved their debt profile by reducing short-term debt and replacing it with long-term financing, better matching FX risks through more borrowing in the local market, and becoming more balanced in general in terms of growth plans.

M&A & FDI

Global companies seeking a foothold in fast growing countries pushed deal making in emerging markets above that of Europe for the first time ever in September.

Emerging market targeted M&A volume was up by more two-thirds to $575.7bn (€441bn) as of September, while European volume has increased by barely 20% to $550.2bn, according to data from Dealogic.

Russian M&A hit a three-year high in the last quarter of 2010 as companies took advantage of a drop in dollar borrowing costs and weak competition to buy bigger market share. Deals involving Russian companies reached $33.8bn as of the start of October, the most since the last three months of 2007 and three times the level in the same period in 2009. This compares with $37.7bn of deals in China and $8.2bn in Brazil. And this was before PepsiCo spent $3.8bn to buy dairy producer Wimm-Bill-Dann in December.

Clearly, the crisis of 2008 will catalyse a shift of the world's economic centre of gravity towards the east. The GEMs will be big winners from the 2008 meltdown - Russia too, only it will take a little longer than the others.

It has been fascinating to watch this story unfold over the last year or so. All the talk at Davos in February was about the need to move into the "fast moving economies" (the moniker that is slowly beginning to replace the "emerging markets" that have mostly now emerged).

However, despite the obviousness of the idea there was little action. . Foreign direct investment (FDI) in 2010 has actually fallen and M&A levels were depressed for most of the year. At the same time, equity sales people in Moscow report that while they have a great story to tell as Russian stocks have not been this cheap for a decade, they couldn't even get people in London or New York to pick up the phone.

Rosstat published foreign-investment statistics in November showing total foreign investment decreasing 13.2% on year in September and 24.1% on year in the third quarter, bringing the figure to $47.5bn over the year to September. FDI was down 28.6% on year in the third quarter, and will end the year at around $35bn or less. Investments classified as "other" - of which more than 90% were credits received by Russian companies abroad - decreased by 23.6% on year.

The problem was that traders and investors were so busy trying to sort the mess on their own books that they had no time to think about making new and (time-consuming) risky investments. However, as 2010 draws to a close, most of the mess has at least been contained in bin liners for later disposal and investors were starting to look about for things to do.

The same is true for strategic investors. As it takes between six months to a year to plan and implement a big FDI, much of the slowdown in 2010 can be attributed to the horrible year everyone had in 2009. So FDI should, on principle, start to pick up again in 2011, driven by Russia's recovering consumer confidence and subsequent rising retail sales.

Clearly more strategic foreign investors are on the way to follow the growing number of success stories that include Ikea (Sweden), Metro (Germany), Auchan (France) and most recently PepsiCo (US) - all of which are in retail and also represent the most active countries in Russia.

Russian consumer in starring role as box office take tops $1bn in 2010

Russia's film distribution market grew by up to 40% in 2010 to finally breach the $1bn revenue threshold, becoming the fifth biggest in the world, according to the website Kinobusiness.com. The news is yet another sign of the healthy growth in Russian consumer spending.

Analysts are still calculating the final figures for the year - the Russia and CIS box office year runs from December 1 to November 30 - but the website said at the end of November that it's expected to total around $1.05bn. Russian distributors dominate the Commonwealth of Independent States space, whilst Russian revenue accounts for around 97% of the total. The numbers do not include Ukraine, which is not a member of the CIS. (It never ratified the CIS charter).

The data represent a strong recovery from last year, when receipts retreated to $736m from $831m in 2008. That said, the rouble's rapid fall that year played a significant role, and according to analysts at Nevafilm, local currency box office revenues still grew 13%.

The news offers another illustration of the strength of the Russian consumer, both through the crisis and as the recovery builds momentum. Whilst the global economic crisis softened consumer spending, the damage was far from critical. For the most part, it was the corporations that bore the brunt, whilst average Russians merely tightened their belts a little.

Since the start of 2010, they've been loosening them once more - a factor that investors are increasingly recognising. Russian consumer names such as supermarket chain X5 have remained confident, which finally closed a $1.7bn acquisition of the Kopeika grocery chain in December. The generous premium that PepsiCo paid for its $5.4bn acquisition of Wimm-Bill-Dann also in December, and the extremely strong IPO performance from mail.ru in November, prove that foreign heads are also being turned at last.

Little wonder, say analysts, as these firms are being forced to hunt for growth abroad in the face of stagnation in their home markets. Goldman Sachs' Jim O'Neill in December called the consumer in the Bric nations, "the key investment of our lifetime."

On the back of that, the Russian consumer is spending more on entertainment. PricewaterhouseCoopers forecasts in its report, "Global Entertainment & Media Outlook 2010-2014", that the Russian entertainment and media (E&M) market will expand at a compound annual growth rate of 9.3%.

Perhaps the key point in the box office numbers is that the Russian consumer appears increasingly willing to pay more for better quality facilities. By far the biggest factor in the film market's growth was higher ticket prices. Through the year, cinema audience numbers only actually increased by 14.9%.

This trend should help PwC's forecast that the Russian box office will continue to grow at a similar rate to the overall E&M rate, to the point where it will account for 63% of the total receipt growth in all CEE countries, and peak at $1.78bn by 2014.

The spanner in the works, however, is the devastating effects of the crisis on real estate development, which looks likely to slow growth.

Modern multiplexes are the biggest driver of the move to quality and consequent rise in ticket prices, with more than half of Russia's modern screens now housed in retail and entertainment developments. These modern screens have benefited as Hollywood blockbusters such as Avatar and Shrek Forever After demanded 3D presentation.

According to Nevafil, the share of multiplexes in the total number of modern screens in Russia was until recently increasing at a rate of at least 30% per year, but by mid-2010 this figure fell for the first time to 23.8%. However, the worst effects of the crisis on development aren't expected until the second half of 2011.

Looking at the longer term, that seems likely to prove little more than a temporary irritation, with developers already trying to get new projects off the ground to take advantage of the coming supply shortfall. Given the momentum in box office revenues, multiplexes appear bound to remain keen anchor tenants for malls.

Banking sector

The banking sector was kicked in the goolies by the crisis, but has bounced back and come out the other side in much better shape than anyone could have hoped. The bank sector is one of the first set to outperform in 2011.

Alexei Ulyukaev, first deputy chairman of the Central Bank of Russia (CBR), offers a more positive picture of the sector for 2011. Non-performing loans, capital adequacy ratios and liquidity in the sector are all extremely strong. More importantly, he pointed to a recovery in lending, with consumer lending growing the fastest. "We expect lending to growth by 12% by the end of 2010," said Ulyukaev, "which if you take out 8% inflation, is a real increase of 3%, but retail lending is growing faster than corporate."

Private banks are increasing lending faster than the state banks, which is good news, as they have been "more realistic about the state of the economy than the state banks," says Ulyukaev.

He also says that banks were in robust health and that the lower-than-expected bad debt levels will give the bank sector a capital boost in the new year. Bankers feared that NPLs would top 30-35% at the start of the crisis and spark a systemic crisis, but by the close of the year had flattened out at only 6.5% of total sector credits, according to the CBR. "The need to increase bank capital will be solved organically, as reserves [set aside to deal with bad debt] are at a historical high and next year some of this money will be transferred to boost the capital base," said Ulyukaev.

• New banking growth cycle in 2011

Russian banks are about to enter a phase of renewed profit growth. During the crisis, banks provisioned heavily in the expectation of a large increase in NPLs, but as the economy has stabilised the level of bad debt has been more benign than feared.

From the start of 2011, banks will start releasing some of these provisions and giving the sector's capital a 20% boost that should allow the growth of lending and profits to be faster than the trend growth going into the end of 2010. And the first round of banks have already begun this process.

Bankers in Russia all remember the financial crisis of 1998 well, which wiped out the top tier of household names almost overnight. As a result, they took a very conservative stance in 2008 to lending and debt provision. Russian banking capital adequacy ratios in December are already the envy of their western peers. With the sector NPL down to about 6% as the year closes and falling, shifting provisions into profitable activity, should boost returns on equity starting in the first quarter of 2011.

It will still take several years for banks to completely work through their NPL issues, but in 2011 a broad-based recovery for Russian banking sector is expected to begin and start building momentum.

• Comparison with Emerging Market Peers

Russian banks provide greater returns on equity (ROE) than most of their emerging market peers, with Sberbank right at the top of the list. High margins and low risk costs has driven Sberbank to the top of the forecast list for best performing stocks in 2011. Sizeable loan loss provision recoveries as asset quality improves will drive Sberbank's impressive performance.

Sberbank is also likely to be able to reduce bad debt provisions faster than other banks, and we estimate that Sberbank will be able to recover around 80% of the loans currently categorised as non-performing between 2011 and 2013 - much better than the average post-crisis 50-60% recovery rate.

Sberbank is the only bank among emerging market peers with an expected 0% risk cost in 2011. In addition, the bank continues to enjoy one of the highest margins among emerging market peers despite our conservative assumption of a further 23-basis-point contraction in ruble terms.

Sberbank is expected to generate an ROE of 28.2%, the highest result among emerging market peers (average ROE of CEEMEA banks amounts to 14.7% and to 16.9% for global EM banks).

Meanwhile, VTB is one of the least leveraged banks of its emerging market peers. Its strong capitalisation will allow the bank to make acquisitions, as Russia's banking sector consolidates over the coming years. Citi says VTB Group will generate an ROE of 14.6% next year, in line with CEEMEA banks (14.7%), but lower than the wider EM peer group (16.9%). VTB's forecast cost-to-income ratio and risk cost are similar to peers.

Meanwhile, mid-cap Vozrozhdenie's ROE has been battered by the bank's lack of efficiency. Despite strong fee generation capacity and higher margins than many emerging market peers, the mid-cap bank's performance is dragged down by poor cost/income and cost/equity ratios. Indeed, the bank's profitability would be best in class if was able to better control costs.

• Lending picking up already

Corporate loan growth in October showed positive monthly growth for the seventh consecutive month, rising 0.5% on month. Loans growth slowed slightly from August (+1.2%) and September (+2.9%), but the general trend remains firmly upward.

Meanwhile, loan growth to households climbed to 10.2% year-to-date in October, rising 1.7% on the previous month.

According to the CBR, outstanding bank loans reached RUB21600bn at the beginning of November. This corresponds to about half of total GDP, so changes in bank lending are a significant growth driver. Bank lending to households and firms feeds through into the real economy through consumption and investments at a brisk pace.

Overall lending growth is likely to reach 15% by the end of the year, says Danske Bank, led by the household sector. Average lending rates to the private sector are finally falling to affordable levels of below 10%, boosting demand. By next year, bank lending could grow as much as 30% on year.

Citibank also updated its sector loan growth forecasts for 2010 and 2011 in September and introduced medium-term estimates. It expects corporate loans to grow 12% and retail loans to expand 13% this year, bringing the total loan growth to 12% (up from 10% previously). In 2011, its forecast corporate and retail loan growth is at 17% and 21% respectively. Based on our medium-term GDP forecast of 4.5%, it sees lending growth at around 17% in 2012-13.

• Confidence in bank sector recovering

A recovery in confidence is going to be a key driver for 2011 and the public's confidence in the banking sector has already begun.

Personal deposits with Russian banks could grow 27-28% in 2010, Mikhail Sukhov, head of the CBR's licensing and financial recovery department, said at a forum in November. Sukhov also pointed to the improvement of Russian banks' financial state and said the majority of banks were expected to return to operating profit this year.

The Global Reputation Index ranking of leading Russian banks, according to research carried out by Romir, found the top banks regain a surprisingly high reputation for stability relatively fast.

Thanks to their implicit state guarantee, the state-owned banks Sberbank and VTB stand head and shoulders above the private banks, but the leading commercial banks including Alfa Bank and Rosbank, also enjoy the population's confidence.

Rated business reputation of the largest banks in Russia:

1. Sberbank - 71 points

2. VTB - 62 points

3. Alfa-Bank - 58 points

4. Rosbank - 55 points

5. Raiffeisenbank - 54 points

6. Uralsib - 53 points

7. Bank of Moscow - 52 points

8. Russian Standard - 51 points

9. Promsvyazbank - 51 points

10. Home Credit - 47 points

11. Unicredit - 46 points

12. Gee And Money Bank - 37 points

13. OTP Bank - 35 points

source: Romir

However, the crisis has also changed Russians attitude to borrowing. Rates have also been held down, making it cheaper to borrow across the board, which will underpin growth in lending as bank loans have never been so accessible to so many businesses. As of the end of October, average market rates on classical unsecured consumer loans in rubles ranged from 21% to 25%, while the rate offered by the top-20 banks fell from 31% to 27%.

The crisis has shaken up the banking sector and market shares that were established pre-crisis were up for grabs again during the uncertainty post-crisis. As a result, banks have begun slashing rates to win new customers as competition has become fierce.

Romir's research found that for 77% of respondents to its survey, the interest rate on the loan was the most important factor when choosing a loan programme. The second most important factor was the possibility to pay off the loan early, but only 5% of the respondents chose that. No one pointed to the term of consideration of a loan application.