Russia 100204 Basic Political Developments

FT.com: A volatile oil price is the only serious risk for Russia

By Kingsmill Bond

Published: February 4 2010 02:00 | Last updated: February 4 2010 02:00

Since the middle of 2008 the Russian market has tracked the oil price. The rule of thumb that the Russian RTS index is the oil price times 20 has been the somewhat uninspiring reality.

Given that both price/earnings multiples and index earnings are oil-price dependent, there were good reasons for this link in a world where oil prices and markets were volatile. But greater oil price stability should encourage investors to look afresh at Russian markets as a high-growth, low-debt story, linked to the Asian boom. Provided oil stays near current levels, we expect the RTS index to end the year at 2,000, up nearly 40 per cent from today and still 20 per cent below its peak.

A good starting point is that the market and the currency are cheap. When oil was $70 a barrel, we forecast a 2010 price/earnings ratio of 8.4, and a price to book ratio of 1.1; across a series of sectors from oil to base metals to retail, Russian stocks trade at a 20-30 per cent discount to their emerging market peers. It was not always thus. The market has in the past traded at a premium to emerging markets and at p/e multiples in the low teens. Meanwhile, the rouble trades at two-thirds of its purchasing power parity fair value, and the country runs a large current account surplus.

Russia has tremendous growth potential, as penetration levels for most goods and services are well under half those in western Europe; mortgage penetration for example is 3 per cent of GDP and only 20 per cent of people have cars. For those companies that have been able to seize the opportunity, the rewards have proven tremendous, and Russia now boasts the largest markets in Europe for mobile subscribers, beer and white goods. Meanwhile Russia is the world's greatest repository of natural resources, and Russian companies are blessed with colossal amounts of commodities, valued at a fraction of their global peers.

Lacking as it is in capital, Russia is a high return market, with returns on equity (ROE) before the crisis of nearly 20 per cent, and an ROE over the cycle that we estimate at 16 per cent. This has been one of the foundations for the superb performance over the last decade, when the Russian market was up eightfold, the best performer among major markets.

Contrary to the various scare stories you may have heard during the crisis, debt levels are low in Russia. Government debt and household debt are both under 10 per cent of GDP, bank loans to GDP are 39 per cent, and in the recent McKinsey study of the global credit bubble, Russia stands out for its extremely low level of total debt to GDP (71 per cent), half that of China and a quarter that of developed markets. Consequently, Russia will not be held back by the deleveraging facing other markets.

And into this relatively benign mix comes a catalyst that we believe will electrify the story in 2010 - disinflation. For the first time since the end of the Soviet Union, inflation has now fallen into single digits for an extended period. From 13 per cent in 2008, inflation fell to 9 per cent in 2009 and is currently running at about 6 per cent, where we think it will end the year. The government will thus be able to continue to cut the cost of money, and we anticipate a further 150 basis points of rate cuts this year. All of this leads to growth: in 2010, we expect loan growth of 20 per cent, GDP growth of at least 5 per cent, and earnings growth of 41 per cent.

There are a number of other factors that we believe will help the story. The modernisation programme being pushed by both President Medvedev and Prime Minister Putin will, over time, yield results in economic diversification, greater power for the courts, and a more modern administration; Russia continues to shift its centre of gravity to the growth markets of the east with the building of pipelines and infrastructure; and relations with the west continue to improve.

The usual counter to a positive stance on Russia is to cite transparency, corporate governance, and corruption. On transparency, the environment has changed radically in the last few years, with Russian companies adopting international accounting standards and disclosure. On corporate governance, a number of high-profile cases such as Mechel, Vimpelcom or Uralkali were favourably resolved over the last year; in a world of Madoffs and Enrons, Russia is perhaps no worse than its peers. Corruption remains a problem and a drag on growth, albeit an issue that the government is seeking to address.

Fears of a new cold war were always far-fetched given Russia's new capitalist direction, and we are likely to see much less concern about this given a new government in Ukraine and more accommodating US policy.

The main issue that should concern investors is the oil price, given that the rouble, government finances, and profits are heavily dependent upon this. Below $60 a barrel the market gets nervous, and more than $30 a barrel the whole macroeconomic framework looks fragile. This is the main tail risk.

By Alex Nicholson and Paul Abelsky

Feb. 3 (Bloomberg) -- Russia needs to do more to ensure its banks are sound, the International Monetary Fund said, signaling the country’s efforts last year to stress test its financial industry weren’t sufficient to renew confidence and credit flows.

“What we have recommended is for the central bank to make a comprehensive assessment of the status of the banking system,” Odd Per Brekk, the IMF’s Russia representative, said in an interview yesterday. “What’s important here is to lay the basis for the banking system to restart credit expansion, because that has not really happened yet.”

Russia stress-tested all its banks last year and a number of the 100 biggest lenders fell short of capital adequacy requirements, Bank Rossii First Deputy Chairman Gennady Melikyan said in October, adding that capital shortages may start to appear by April. The test results weren’t made public beyond policy maker comments. Fitch Ratings on Jan. 22 raised its outlook on Russia’s BBB grade, in part because bank risk had receded, though the service warned of “uncertainty” over banks’ ability to provide adequate credit.

Delinquent debt in the world’s biggest energy exporter may climb to 20 percent of total lending this year, based on international definitions of non-performing assets, Deutsche Bank AG analyst Bob Kommers said on Jan. 28. He says investors are “underestimating the risks and overstating the recovery potential.” Delinquencies could peak at about 25 percent of total lending this year, Fitch estimates.

‘Big Issue’

VTB Group, Russia’s second-largest lender, is among banks that have a “big issue with asset quality,” according to Kommers. Russian bank lending grew 0.2 percent last year, Bank Rossii First Deputy Central bank Chairman Alexei Ulyukayev said last month. He forecast growth of 20 percent this year.

Banks’ non-performing consumer loans were at 6.4 percent as of November, according to Bloomberg calculations based on data from the central-bank, which Kommers says uses a more narrow definition for bad loans and doesn’t take into account restructured debt. Central bank Chairman Sergey Ignatiev said on Nov. 18 banks’ non-performing loans were “near the peak.”

The economy is showing signs of recovering from a record 7.9 percent contraction last year as demand for its commodities rebounds. Policy makers are trying to extend that growth to the domestic economy, to ensure the recovery lasts.

Sustainable Recovery

“What you want to see is that private sector demand picks up in Russia, to actually take over the lead in sustaining the recovery,” Brekk said. “The net export numbers for 2009 were encouraging in terms of external demand, but the private domestic sector also needs to come in so that you can sustain the recovery.”

The State Statistics Service estimates that net exports, or exports minus imports, grew 58 percent last year while household spending fell 8.1 percent.

Russia’s recovery is “fragile,” Deputy Economy Minister Andrei Klepach said yesterday. “The quality and stability of the revival raises questions,” he said.

For Related News and Information: On Russian banks: TNI RUSSIA BNK Russian loans stories: TNI RUSSIA LOANS Russian economic statistics ECST RU Emerging-markets monitor: EMMV