5 Jan 2011
Russia in 2011 – Old Politics, New Economics
In the year before elections, Russia will be all about avoiding the unexpected in 2011. Stability in politics means the avoidance of confrontation, whatever the theatre between Prime Minister Putin and President Medvedev. In economics, though, stability requires change. The 2008 crisis was a regime-threatening wake-up call that the economic model of the 2000s left Russia inherently vulnerable to events outside of its control. Prosperity and failure were in the hands of international markets which could send the Russian economy into a tailspin and with it, the whole carefully constructed political compact. The next wave of economic change in Russia will be all about implementing the lessons learned. The search for a new economic model will inevitably offer both risk and opportunity. On the one hand, Russia needs to change if it is to finally embark on a sustainable medium-term growth path and some of the changes will unlock tremendous value, just as they have done several times before in the last 20 years of Russian transition. On the other, several of the more important positive underpinnings to the argument for Russia may be undermined in the drive for change. The period of careful management of Russian budget finances, for instance, is likely behind us.
Here are our top 10 trends to watch for in 2011.
1.The return of politics. Politics will likely spasm into life ahead of Duma elections in December 2011 and Presidential elections in March 2012. But it will be largely theatre – managed politics for a domestic and international audience. Separating noise from reality will be a key-driver of equity outperformance in 2011. One of the bigger themes is likely to be nationalism. In an election year, politics will be managed to divert attention away from the more intractable economics and to galvanize support for the incumbents. Against creeping criticism of bureaucracy, corruption and stagnation, the ruling elite have impeccable credentials at being Russian.
2. Tax threats and the search for a new paradigm. In the aftermath of crisis, Russia is searching for a new economic paradigm. The budget surplus, private-sector borrowing paradigm of 2001-2008 was broken by the humiliation of the economic collapse of 2009. The government is searching for an alternative. Whether it is modernization, Moscow City, High-Tec, Skolkovo, Titanium Valley, PPPs or infrastructure investment, it involves an increased role for government and a bigger budget. In the run-up to elections, it is a very useful stick and carrot to talk change in taxation. Promises to cut taxation in the oil sector and threats to increase taxation elsewhere can bring the oligarchs to heal. Actual implementation will likely wait until 2012, but barring another big bump up in the oil price, any decrease in oil-sector taxation will likely be more than matched by increases in taxation among the remaining commodity producers.
3. A burst of reform. When it comes to reform in Russia, it pays to be skeptical. But with expectations at knuckle-dragging levels, 2011 may actually prove to be a year of positive surprises. Whisper it quietly, but Russia may finally make it into the WTO in 2011. Despite the rhetoric in Washington and Brussels, it is politics on both sides that has kept Russia from entry. Now, for the first time since the bizarre martyrdom of Mikhail Khodorkovsky, both Europe and the US are pushing a positive agenda with Russia. Moscow is coming out of its post-Georgia grump and the political stars are aligned. Privatization, too, looks likely and, with the right amount of squinting, that can play well internationally. Add to that some success with banking reform, pension reform, public-private-partnerships, judicial reform and changes at some of the state monopolies, and 2011 could be a year of surprising progress.
4. Match-Making National Champions. The heavyweights of Russian industry have been lumbering around each other for years. Tie-ups between Rosneft and Surgut, Gazprom and TNK, LUKoil and a state company, Uralkali and Silvinit, Alrosa and Norilsk have all been rumoured. With the cost of capital low, companies wanting to raise funding, valuations punctured, commodity prices rising and state owned banks puffed up with new investment banking arms, the likelihood of consummation will be rising in 2011.
5. The Emergence of International Champions. Russia’s national champions are being encouraged out onto the international stage, and a pre-election desire to diversify away from Russia, may result in Russian companies stepping out of their comfort zone. Rosneft wants to expand in the near abroad and Middle East, Novatek is looking for international partners to build out its Siberian assets, Sberbank is looking outside Russia’s borders, LUKoil and others have ambitions to tap Asian capital markets. While business expansion westwards has proven politically difficult, burgeoning emerging-emerging investment may provide more fertile opportunities. Russia likes investment relationships led from the Kremlin. Russia prefers dealing with Germany and Italy than with the USA or UK within developed countries. The Middle East, Africa, South America and Asia offer more opportunity for companies to follow the Kremlin’s lead. Where Vimpelcom has led, others may well follow.
6. The return of borrowing. Russia is under-leveraged relative to most of the emerging world and all of the developed world. Banks have restructured non-performing loans and are looking to expand their balance sheets. Interest rates of 6-12% (depending on credit-rating) are again roughly equal to inflation (8%). Sberbank began net lending again in the final six months of 2010. All of the pieces are in place for lending to resume again, and it is likely to take off in 2011. But borrowing is likely to be different from the last cycle. Many of those sectors which were able to borrow in 2004-2008 (real estate, construction, transport, metals) are the only sectors of the economy over-leveraged at the beginning of this cycle. In 2011, it is likely to be the government, households, retail and perhaps even SME lending which rises rapidly.
7. Shaking up state-owned companies. Something is changing in the state-owned companies. Before the 2008 elections, there was a major reshuffling of Russia’s power ministries. This time, it might well be the turn of Russia’s power companies. There is some disappointment at the inability of larger companies to attract investment, and German Gref has illustrated at Sberbank what a change in management can achieve. The retirement of Sergei Bogdanchikov from Rosneft in 2010 may be repeated by similar changes at Gazprom, Surgutneftegas and Transneft in 2011. New management may result in either better relations with investors or better favours from the government. Gazprom, Transneft and VSMPO can benefit, just as Sberbank and Novatek have done in 2010.
8. Rouble-Yuan reserve currency swap. It may not happen in 2011, but at some point the economics of the world’s largest commodity producer and the world’s largest commodity consumer holding some of their reserves in each-other’s currencies will become too compelling to ignore. Both Moscow and Beijing have been critical of the US policy to print its way out of trouble. Both governments have been looking to diversify their investment portfolio away from dollars. Both want to eventually generate seigniorage and have longer-term ambitions to be at least regional substitutes for the dollar. Both governments have been trying hard over the last five years to overcome the large political barriers and got on with building an economic relationship between the two countries. Russia would love to see commodities priced in roubles, and when pipelines are opened into China, trade between the two countries could be priced in local currency. In mid-December 2010, the Yuan started trading in Moscow. To the extent that currency reserves are a hedge against future uncertainty, it makes eminent economic sense for these two commodity super-powers to hold each other’s currency in their reserve portfolios. Progress in financial and economic relations between China and Russia can be a major driver of improvement in Russia in 2011.
9. Capital flight and the return of the Russians. Russia is awash with liquidity, yet Russian money is the dark mass missing from the equity market. Capital flight and its reversal can be major drivers of Russian asset markets in 2011. Banks have over RUB2 trillion sitting with the CBR earning less than 3% interest, so any uncertainty tends to cause money outflow. 12-18 months ahead of elections, is traditionally the time when capital moves out of Russia. Roughly USD20 bn has been removed from Russia in the last three months of 2010, the largest sustained period of capital flight since the 2008 crisis. If history is any guide, though, money tends to return in the months leading up to elections. Electoral uncertainty dissipates as it becomes clear how the power landscape is shaping up, and therefore who to support. Threats earlier in the year turn to forgiveness in the second half, and a post-electoral programme emerges through the grapevine. Roughly USD150 bn were moved out of Russia in late 2008 and 2009. This year’s USD80 bn current account surplus has not fed into reserves, suggesting much of that has left through the capital account. When Russians return, therefore, it can prove a major boost to markets.
10. Russian equity markets hit new highs by end 2011. At the time of writing, Russian equity remains the furthest of any large market from its pre-crisis highs. MSCI-Russia is still 45% below the levels it reached in the summer of 2008, compared to most of EM at less than 10% off previous highs. But Russia equity is also by far the cheapest of any market globally. It is cheap relative to other markets, earnings growth, debt, the relative size of the economy, history and when broken down by sector. With lending likely to resume, both monetary and fiscal policy loose, investment picking up and interest rates negative in real terms and against a backdrop of high commodity prices and low international cost of capital, Russian equity could well enjoy one of its traditional blow-out years in 2011.
In the year before elections, Russia will be all about avoiding the unexpected in 2011. Stability in politics means the avoidance of confrontation, whatever the theatre between Prime Minister Putin and President Medvedev. In economics, though, stability requires change. The 2008 crisis was a regime-threatening wake-up call that the economic model of the 2000s left Russia inherently vulnerable to events outside of its control. Prosperity and failure were in the hands of international markets which could send the Russian economy into a tailspin and with it, the whole carefully constructed political compact. The next wave of economic change in Russia will be all about implementing the lessons learned. The search for a new economic model will inevitably offer both risk and opportunity. On the one hand, Russia needs to change if it is to finally embark on a sustainable medium-term growth path and some of the changes will unlock tremendous value, just as they have done several times before in the last 20 years of Russian transition. On the other, several of the more important positive underpinnings to the argument for Russia may be undermined in the drive for change. The period of careful management of Russian budget finances, for instance, is likely behind us.
Here are our top 10 trends to watch for in 2011.
1.The return of politics. Politics will likely spasm into life ahead of Duma elections in December 2011 and Presidential elections in March 2012. But it will be largely theatre – managed politics for a domestic and international audience. Separating noise from reality will be a key-driver of equity outperformance in 2011. One of the bigger themes is likely to be nationalism. In an election year, politics will be managed to divert attention away from the more intractable economics and to galvanize support for the incumbents. Against creeping criticism of bureaucracy, corruption and stagnation, the ruling elite have impeccable credentials at being Russian.
2. Tax threats and the search for a new paradigm. In the aftermath of crisis, Russia is searching for a new economic paradigm. The budget surplus, private-sector borrowing paradigm of 2001-2008 was broken by the humiliation of the economic collapse of 2009. The government is searching for an alternative. Whether it is modernization, Moscow City, High-Tec, Skolkovo, Titanium Valley, PPPs or infrastructure investment, it involves an increased role for government and a bigger budget. In the run-up to elections, it is a very useful stick and carrot to talk change in taxation. Promises to cut taxation in the oil sector and threats to increase taxation elsewhere can bring the oligarchs to heal. Actual implementation will likely wait until 2012, but barring another big bump up in the oil price, any decrease in oil-sector taxation will likely be more than matched by increases in taxation among the remaining commodity producers.
3. A burst of reform. When it comes to reform in Russia, it pays to be skeptical. But with expectations at knuckle-dragging levels, 2011 may actually prove to be a year of positive surprises. Whisper it quietly, but Russia may finally make it into the WTO in 2011. Despite the rhetoric in Washington and Brussels, it is politics on both sides that has kept Russia from entry. Now, for the first time since the bizarre martyrdom of Mikhail Khodorkovsky, both Europe and the US are pushing a positive agenda with Russia. Moscow is coming out of its post-Georgia grump and the political stars are aligned. Privatization, too, looks likely and, with the right amount of squinting, that can play well internationally. Add to that some success with banking reform, pension reform, public-private-partnerships, judicial reform and changes at some of the state monopolies, and 2011 could be a year of surprising progress.
4. Match-Making National Champions. The heavyweights of Russian industry have been lumbering around each other for years. Tie-ups between Rosneft and Surgut, Gazprom and TNK, LUKoil and a state company, Uralkali and Silvinit, Alrosa and Norilsk have all been rumoured. With the cost of capital low, companies wanting to raise funding, valuations punctured, commodity prices rising and state owned banks puffed up with new investment banking arms, the likelihood of consummation will be rising in 2011.
5. The Emergence of International Champions. Russia’s national champions are being encouraged out onto the international stage, and a pre-election desire to diversify away from Russia, may result in Russian companies stepping out of their comfort zone. Rosneft wants to expand in the near abroad and Middle East, Novatek is looking for international partners to build out its Siberian assets, Sberbank is looking outside Russia’s borders, LUKoil and others have ambitions to tap Asian capital markets. While business expansion westwards has proven politically difficult, burgeoning emerging-emerging investment may provide more fertile opportunities. Russia likes investment relationships led from the Kremlin. Russia prefers dealing with Germany and Italy than with the USA or UK within developed countries. The Middle East, Africa, South America and Asia offer more opportunity for companies to follow the Kremlin’s lead. Where Vimpelcom has led, others may well follow.
6. The return of borrowing. Russia is under-leveraged relative to most of the emerging world and all of the developed world. Banks have restructured non-performing loans and are looking to expand their balance sheets. Interest rates of 6-12% (depending on credit-rating) are again roughly equal to inflation (8%). Sberbank began net lending again in the final six months of 2010. All of the pieces are in place for lending to resume again, and it is likely to take off in 2011. But borrowing is likely to be different from the last cycle. Many of those sectors which were able to borrow in 2004-2008 (real estate, construction, transport, metals) are the only sectors of the economy over-leveraged at the beginning of this cycle. In 2011, it is likely to be the government, households, retail and perhaps even SME lending which rises rapidly.
7. Shaking up state-owned companies. Something is changing in the state-owned companies. Before the 2008 elections, there was a major reshuffling of Russia’s power ministries. This time, it might well be the turn of Russia’s power companies. There is some disappointment at the inability of larger companies to attract investment, and German Gref has illustrated at Sberbank what a change in management can achieve. The retirement of Sergei Bogdanchikov from Rosneft in 2010 may be repeated by similar changes at Gazprom, Surgutneftegas and Transneft in 2011. New management may result in either better relations with investors or better favours from the government. Gazprom, Transneft and VSMPO can benefit, just as Sberbank and Novatek have done in 2010.
8. Rouble-Yuan reserve currency swap. It may not happen in 2011, but at some point the economics of the world’s largest commodity producer and the world’s largest commodity consumer holding some of their reserves in each-other’s currencies will become too compelling to ignore. Both Moscow and Beijing have been critical of the US policy to print its way out of trouble. Both governments have been looking to diversify their investment portfolio away from dollars. Both want to eventually generate seigniorage and have longer-term ambitions to be at least regional substitutes for the dollar. Both governments have been trying hard over the last five years to overcome the large political barriers and got on with building an economic relationship between the two countries. Russia would love to see commodities priced in roubles, and when pipelines are opened into China, trade between the two countries could be priced in local currency. In mid-December 2010, the Yuan started trading in Moscow. To the extent that currency reserves are a hedge against future uncertainty, it makes eminent economic sense for these two commodity super-powers to hold each other’s currency in their reserve portfolios. Progress in financial and economic relations between China and Russia can be a major driver of improvement in Russia in 2011.
9. Capital flight and the return of the Russians. Russia is awash with liquidity, yet Russian money is the dark mass missing from the equity market. Capital flight and its reversal can be major drivers of Russian asset markets in 2011. Banks have over RUB2 trillion sitting with the CBR earning less than 3% interest, so any uncertainty tends to cause money outflow. 12-18 months ahead of elections, is traditionally the time when capital moves out of Russia. Roughly USD20 bn has been removed from Russia in the last three months of 2010, the largest sustained period of capital flight since the 2008 crisis. If history is any guide, though, money tends to return in the months leading up to elections. Electoral uncertainty dissipates as it becomes clear how the power landscape is shaping up, and therefore who to support. Threats earlier in the year turn to forgiveness in the second half, and a post-electoral programme emerges through the grapevine. Roughly USD150 bn were moved out of Russia in late 2008 and 2009. This year’s USD80 bn current account surplus has not fed into reserves, suggesting much of that has left through the capital account. When Russians return, therefore, it can prove a major boost to markets.
10. Russian equity markets hit new highs by end 2011. At the time of writing, Russian equity remains the furthest of any large market from its pre-crisis highs. MSCI-Russia is still 45% below the levels it reached in the summer of 2008, compared to most of EM at less than 10% off previous highs. But Russia equity is also by far the cheapest of any market globally. It is cheap relative to other markets, earnings growth, debt, the relative size of the economy, history and when broken down by sector. With lending likely to resume, both monetary and fiscal policy loose, investment picking up and interest rates negative in real terms and against a backdrop of high commodity prices and low international cost of capital, Russian equity could well enjoy one of its traditional blow-out years in 2011.
