Russia: Steady for 2011-12

July 2011 Julia Tsepliaeva (+7495-7856022) Yury Eltsov (+7495-2258940)

Growth Optimism: consensus at 4-5% for the medium term

Chart 1: Economic Growth and Oil Prices Chart 2: Industrial Output and Investment

Source: FSSS, Bloomberg, BNP Paribas

Source: FSSS, BNP Paribas

We remain bullish on oil prices, expecting Brent to average USD112125/bbl and thus maintain our forecast for annual GDP growth of 5-5.2% in 2011-12. (EE Consensus forecast was 4.6% as of May 2011.) Expectations for a strong harvest add to our optimism for this year. Sizable capital outflow limits upside opportunities.

Although industrial growth slowed in Q2 2011 owing to base effects, we expect it to outperform GDP growth. Investment rebounded strongly in Q2; we expect growth of 8% and 6.5% in 2011 and 2012, respectively, on the back of government efforts.

High oil prices are essential for stronger growth. We expect oil prices to remain favourable for Russia (USD 111/bbl and USD 123/bbl (Urals) in 2011 and 2012 respectively). We are bullish on the pace of recovery, expecting 5% in 2011 and 5.2% in 2012. We expect growth to average 5% in the medium term. Consensus range for economic growth: 4-5% (4.6% according to Mays EE survey). The government remains the main engine of modernisation and the biggest single investor in the economy. Its role is gradually increasing.

Chart 3: Industrial Growth Breakdown

Source: FSSS, BNP Paribas

Manufacturing remains the main beneficiary of higher oil prices. Domestic demand is playing a key part in the sectors rebound. We see manufacturing growth at 9% and 6.7% in 2011 and 2012, respectively. We expect growth in the raw material sector to be sluggish at c.2% y/y, stymied by high tax pressure.

04/07/2011

Consumer Universe: Improving

Chart 4: Retail Sales and Services Volumes Chart 5: Income and Wages

Source: FSSS, BNP Paribas

Source: FSSS, BNP Paribas

In H1 2011, retail growth was solid at 5% and driven by credit growth, which accelerated to 16.3% y/y in Jan-May. Income and wage growth is likely to pick up in H211 and stimulate further acceleration. We expect private consumption to grow at an annual pace of 5-5.2% in 2011-12.

Although the trend in real wages and incomes was not particularly impressive in H1 2011, we expect acceleration to 5+% on the back of government social policy. Forthcoming parliamentary and presidential elections are leading to a new wave of populist measures.

Consumption recovered significantly in 2010 and we expect the growth to be sustained. We see retail sales and services sales growing 5% a year in 2011-12. The parliamentary and presidential elections of 2011-12 entail a high probability of a new wave of populism, boosting consumption and incomes this year and next. We expect further qualitative and quantitative improvements in the labour market. We are particularly optimistic on hidden unemployment, with a significant decline likely on the back of economic recovery and stabilisation. The latter is essential to boost consumer spending.
Source: FSSS, BNP Paribas

Chart 6: Unemployment

As expected, the unemployment rate continued to decline in Q211, reaching 7.2% of the economically active population in May. The drop in hidden unemployment is boosting consumer optimism. We expect further decline to 6.5% and 6.3% by end-2011 and end-2012 respectively.

04/07/2011

Monetary Policy: tightening on the back of recovery

Chart 7: Inflation and Money Supply Chart 8: CPI Breakdown

Source: CBR, FSSS, BNP Paribas

Source: FSSS, BNP Paribas

Money supply growth is likely to stay around 30% y/y through end-2012 on the back of high oil prices and sterilisation operations by the CBR. Monetary factors are becoming increasingly important for inflation. Transmission mechanisms are gradually improving, boosting the role of CBR policy.

Food inflation remains high, but we expect a good harvest to cool it down. We see a risk of fuel prices accelerating in Q411, pushing CPI inflation up. Nevertheless, core inflation is slowing on the back of monetary tightening and the rouble appreciation of H111.

Money supply growth is likely to accelerate above 30% y/y in 2011 on the back of economic growth and solid dollar inflows. The CBR is absorbing extra dollars from the market to prevent rouble appreciation and is printing roubles. Slowing food inflation and expectations of a good harvest should gradually pull CPI inflation down. However, we expect inflation to remain above the official target range 6.5-7.5% (BNPP forecast: 8.5% y/y at end-2011, 9.4% 2011 average). In 2012-13, we see inflation slowing further, paving the way for the refi rate to be cut to 8% by end-2012. We expect the CBR to become less aggressive in its tightening in 2011 and start easing in 2012 as inflation slows.

Chart 9: Policy Rates of the Central Bank

Source: CBR, BNP Paribas

Solid rouble liquidity (on the back of petrodollar inflows) keeps money market interest rates negative in real terms. The CBR is likely to maintain its refi rate close to zero in real terms.

We expect the CBR to refrain from tightening in the coming months as inflation risks are declining. Nevertheless, we see one more hike (of 25bp) in Q4 2011 as a response to accelerating fuel inflation. We expect new hikes in reserve requirements of perhaps 2-3pp in H211.

04/07/2011

Banking Sector: strong dynamism

Chart 10: Lending & Deposit Rates Chart 11: Credit Expansion

Source: CBR, BNP Paribas

Source: CBR, BNP Paribas

As expected, monetary tightening has not significantly affected lending rates. They continue to decline, in particular in the retail sector, reflecting growing confidence in the stability of the financial sector. Deposit rates are likely to rise marginally but will remain strictly negative in real terms through 2012.

Credit growth jumped to 17.2% y/y in Q111 and c.2% m/m in May, strengthening our forecast of 20+% in 2011. Retail credit is growing faster than corporate credit and is being boosted by pre-election wave. The NPL ratio continues to decline and should be c.12% at the end of 2011.

The recovery in the banking sector has accelerated in 2011. Credit growth is exceeding expectations, particularly in retail. However, structural weaknesses remain: there are too many banks in the system (above 1,000) and banking supervision is still inadequate. Dollarisation of the system remains at appropriate levels (hard currency denominated loans account for 26% of the total portfolio while the share of foreign-currency deposits stands at 23%). The banking sector is likely to benefit from wider access to global capital markets in H211. More issuance is expected. Consolidation of the sector is likely (minimum capital requirement raised to RUB 180mn from 1 Jan 2012). State-owned banks are likely to improve their positions further.
Source: CBR, BNP Paribas

Chart 12: Banking Deposits

Deposit growth has slowed in 2011 (rates are not enticing) and is very unlikely to outperform credit growth this year as a whole. The loan-to-deposit ratio dropped in 2010 and seems to have stabilised at c.100%. Short-term deposits continue to dominate the deposit structure.

04/07/2011

External Balances: capital outflow as the main surprise of 2011

Chart 13: Balance of Payments Chart 14: Net Capital Flows

Source: CBR, BNP Paribas

Source: CBR, BNP Paribas

We expect the current account surplus to rise to USD 75bn (4.1% of GDP) in 2011. Although the rebound in imports should be strong, the high level of oil prices is boosting exports. However, the current account surplus is likely to decline to zero by 2014. Net FDI is chronically low.

Sizable net capital outflow of c.USD 34bn was a negative surprise for Russia in January-May this year. Capital outflow is also likely in Q411 on the back of uncertainty associated with elections. We forecast net capital outflow of US 30bn this year, reducing the gains from high oil prices.

Chart 15: External Debt

Chart 16: External Debt Payment Schedule

Source: CBR, BNP Paribas

Source: CBR, BNP Paribas

Gross foreign debt reached 32.5% of GDP in 2010 but is unlikely to exceed 40% in 2011-15 due to higher economic growth. State-owned companies and banks remain the most aggressive borrowers and we expect more measures by the government to rein them in.

The foreign debt payment schedule for 2011-12 is supportive of rouble appreciation. However, payments are scheduled to spike in Q411 to USD 34.5bn. In combination with capital outflow stimulated by elections, this is creating pressure on the rouble.

04/07/2011

Fixed Income: markets have stabilised

Chart 17: Exchange Rates
9 Y ld(% ie )
Gazp1303

Chart 18: Corporate Eurobonds

AlfaBank12 EUCHEM12 Gazp1407 VIP18 Gazp3402

MTS20 VEB20

SberBank13 TRANSNEFT1403 Evraz15 Tatfondbank12 Luk1706 Tneft18 Gazprombank14 VTB15 AlfaBank13 RURAIL17 Evraz13 Alrosa14 RussAgrBank14N

Russia28

Russia20

Russia18

3 0 2

Russia15

Duration (years) 6 8 10 12 14

Source: CBR, BNP Paribas

Source: CBR, BNP Paribas

We are neutral on the rouble in H211 after its strengthening in JanuaryMay 2011. Although high oil prices and the solid current account are pushing the rouble up, risks of higher capital outflow are curbing the move. The CBR is tolerating rouble fluctuations and continuing to gradually liberalise the FX regime.

Corporate Eurobond yields look favourable in comparison with the domestic debt market. We expect more issuance from first- and second-tier companies in H211-12. We expect the average maturity of foreign debt to gradually increase from five years to seven.

Chart 19: Ru30 Yield & Ru30UST10 Spread

12 900 800 10
8.0

Chart 20: OFZ Benchmark Yield

Russia-30 Yield (%)

8

700 600 500

7.8

7.6

Russia OFZ Benchmark (%)

6 400 4 300 200 2 100

7.4

7.2

7.0

Russia-30 - UST10 Spread (b.p., RHS)

0 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 0
6.8 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11

Source: Bloomberg, BNP Paribas

Source: Reuters, BNP Paribas

The spread between Russian sovereign debt and US Treasuries is currently 130-140bp. We expect this to compress to its all-time low of 8090bp in the coming 12 months. High oil prices, Russias low debt burden and modest refinancing needs underpin our optimism.

We see some upside for Russian government domestic debt on the back of the less aggressive monetary tightening we expect in H211 and the states low financing needs. Corporate yields are very tight to the sovereign curve, reducing investors interest in the market.

04/07/2011

Fiscal Performance: prudence returns, driven by oil

Chart 21: Budget Performance Chart 22: Budget Revenues

Source: MoF, CBR, BNP Paribas

Source: MoF, EEG, BNP Paribas

Russia is likely to enjoy a balanced budget in 2011-12, although the risk of new hikes in public spending remains high as the election season approaches. As the dependence on oil prices has increased, the budget is unlikely to remain balanced in the coming years.

The oil-price threshold for balancing the Russian budget has shot up from USD 18.5/bbl in 2000 to USD 120/bbl (our forecast) in 2012. Oil revenues account for 53% of federal budget revenues. We expect a non-oil deficit of 11.7% of GDP in 2011, which is high.

Chart 23: Government Debt

Chart 24: Sovereign Wealth Funds

Source: MoF, CBR, BNP Paribas

Source: MoF, BNP Paribas

Gross government debt remains modest at little more than 8% of GDP and is unlikely to rise substantially in 2012-13. The governments financing needs are falling. We do not expect new Eurobonds in the rest of 2011-12. Domestic debt issues by the government are not affecting corporate borrowers.

A balanced budget reduces financing needs. The Reserve Fund is likely to be replenished by USD 3-5bn in 2011-12. Further, the government is unlikely to touch the National Wealth Fund in 2011-13. This important financial cushion reduces fiscal risks in the medium term.

04/07/2011

Political Situation: elections hold some intrigue

Chart 25: Public Approval Ratings of President Medvedev and PM Putin (%)
62 57 52 47 Medv edev 42 37 32 27 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct Jan 09 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Putin

Chart 26: Preferred Candidate for 2012 Presidential Elections (%)

100 90 80 70 60 50 40 30 20 10 0 Jun 10 Sep 10 Dec 10 Mar 11 Medvedev Putin Neither Medvedev or Putin Both Medvedev and Putin

Source: WCIOM, BNP Paribas

Source: Levada Centre, BNP Paribas

We expect the current ruling group to retain control following the upcoming elections. Although we expect 5-6 candidates to participate in the presidential race in March 2012, only PM Putin and President Medvedev would stand a chance of winning. We put the probability that Putin and Medvedev will both stand next March at 20%. We think the probability that Putin will return to the presidency at more than 80%. A single decision-making locus and high oil prices are likely to make the next presidency stronger than the current one. The next president will have to accelerate structural reforms. Differences between Medvedev and Putin would likely be seen in terms of methods with a larger role for the government and state corporations in the event of a Putin victory.

Table 1: Putin and Medvedev: Comparison Points

Comparison points Putin Medvedev GDP doubling + Diversification Modernisation Economy Tax Code Police Reform Land Code Military Reform Reforms Aquatic Code Judicial Reform Budget Code Labour Code Debureaucratisation Reform Reforms on agenda Banking Reform (still little progress) Pension Reform Anti-corruption Measures State Corporations Acceleration in Govt. participation in Privatisation economy Tough rhetoric Restrained rhetoric Foreign Arena United Russia (70% of Duma Potentially: A Just Party Support seats) Russia (8.4% of Duma seats)

Source: BNP Paribas

04/07/2011

Capital Flows: outflows as political developments gain prominence

Chart 27: Capital Outflow (USD bn) Stoked by Political Developments: 1994-2007 Chart 28: Capital Outflow (USD bn) Stoked by Political Developments: 2008-2011

Source: CBR, BNP Paribas Source: CBR, BNP Paribas

The evolution of capital flows, results of the parliamentary election in December and changes within the ruling group will all have an influence on the presidential election. Each presidential election sees USD 15bn in terms of capital outflow the quarter before. Russia is hosting a lot of international events in 2012-18, boosting foreign investment. We expect the government to continue its efforts to attract more investment and improve Russias image in the eyes of foreign investors during the next presidency.

Chart 29: Net FDI (% GDP) Since the Beginning of Transition

Source: CBR, BNP Paribas

04/07/2011

10

Russia: Economic and Financial Forecasts

Year 09 C o m po ne nt s o f G ro wt h GDP (% q/q) nsa GDP (% q/q) sa GDP (% y/y) GDP (USD bn) P rivate Co nsumptio n P ublic Co nsumptio n Fixed Investment Expo rts (% y/y) Impo rts (% y/y) Industrial P ro ductio n Savings Ratio (%) -7.9 1 225.8 -4.8 -0.5 -1 6.2 -4.7 -30.4 -1 .0 1 1 8.8 4.0 1 465 2.7 0.7 6.0 1 .1 1 25.4 8.2 1 8.0 5.0 1 825 5.0 0.3 8.0 1 0.1 20.5 5.6 1 8.6 Year 09 Inf la t io n & La bo ur CP I CP I (2) Unemplo yment Rate (%) 1 .8 1 8.8 8.2 6.9 8.8 7.5 9.4 8.5 6.9 Year E xt e rna l T ra de Trade B alance (USD bn) Current A cco unt (USD bn) Current A cco unt (% GDP ) Net FDI (USDbn) Net FDI (% GDP ) 09 11 1 .6 49.5 4.0 -7.2 -0.6 1 0 1 .4 51 71 .1 4.9 -1 0.5 -0.7 1 (1) 1 1 50.0 75.0 4.1 5.0 0.3 Year 09 F ina nc ia l V a ria ble s Gen. Go v. B udget (% GDP ) Gro ss Go v. Debt (% GDP ) (2) -6.4 7.5 -3.9 7.9 0.0 7.8 Year 09 Int e re s t & F X R a t e s Official Interest Rate (%) 3-M o nth Rate (%) USD/RUB
(2 )

201 0 1 (1) 2 5.2 2045.8 5.2 3.0 6.5 0.5 1 5.0 4.5 21 .0 1 (1) 3 4.8 5.0 1 .3 6.0 0.5 1 5.0 4.1 21 .0 Q1 -1 5.0 1 .0 3.5 0.1 1 .8 -4.1 1 8.5 1 0.7 9.5 1 2.4 Q2 8.0 0.7 5.0 4.6 0.7 5.3 3.9 20.8 1 0.9 1 9.9 Q3 1 0.9 -1 .0 3.1 6.7 0.2 7.2 9.5 34.8 6.4 1 8.8 Q4 2.7 3.7 4.5 392.3 0.0 0.5 9.8 1 2.3 35.3 6.5 20.7 Q1(1) -1 5.3 0.6 4.1 41 .2 1 3.5 0.5 -0.8 1 .0 1 1 2.0 5.9 1 7.0

201 1 Q2 (1) 8.9 1 .6 5.0 5.0 0.5 6.2 1 0.0 20.0 5.6 1 9.0 201 1 Q4 8.1 8.8 7.2 Q1(1) 9.6 9.5 7.6 Q2 (1) 9.7 9.7 6.8 201 1 Q4 36.4 14.1 3.6 -3.0 -0.8 Q1(1) Q2 (1) Q3 (1) Q4 (1) 48.2 36.8 32.5 32.5 31 .8 7.7 -1 .0 -0.2 20.5 4.6 0.0 0.0 201 1 Q4 Q1 Q2 201 1 Q4 7.75 4.1 0 30.4 Q1 8.00 3.96 Q2 (1) 8.25 3.50 Q3 (1) 8.25 3.70 Q4 (1) 8.50 4.00 Q1(1) 8.50 4.00 Q3 Q4 Q1(1) 1 .4 1 2.4 3.0 0.6 1 .4 1 2.3 3.0 0.6 Q3 (1) 9.3 8.8 6.6 Q4 (1) 8.8 8.5 6.5 Q1(1) 8.3 8.2 6.5 Q3 (1) 1 .9 1 0.0 6.0 5.5 0.0 1 .5 1 8.0 25.0 5.6 1 9.0 Q4 (1) 1 .5 2.6 4.8 6.0 0.0 1 5.0 1 .5 1 25.0 5.3 1 9.5 Q1(1) -1 5.6 0.3 4.5 461 .0 4.8 2.0 5.0 0.5 1 4.0 3.5 1 9.5

201 2 Q2 (1) 1 0.0 2.6 5.5 5.1 2.0 6.0 1 .0 1 4.4 4.5 20.5 Q3 (1) 1 .9 1 0.0 5.5 5.5 4.0 7.0 0.5 1 5.5 5.0 22.0 Q4 (1) 1 .2 2.3 5.2 5.5 4.0 8.0 0.0 1 6.0 4.9 22.0

1 0

1 (1) 1

2342 330.0 358.0 384.2

446.1 478.8 488.9

500.1 536.7 548.0

201 0 1 (1) 2 8.1 7.8 6.4 1 (1) 3 7.7 7.5 6.2 Q1 7.2 6.4 8.8 Q2 5.9 5.8 7.4 201 0 1 (1) 2 1 0.0 1 35.0 1 .7 1 .0 1 0.5 1 (1) 3 90.0 1 5.0 0.6 1 5.0 0.6 Q1 46.5 33.3 10.1 -2.2 -0.7 Q2 39.2 18.0 5.0 -2.0 -0.6 Q3 29.2 5.7 1.5 -3.3 -0.9 Q3 6.2 7.0 6.8

201 2 Q2 (1) 8.1 8.1 6.5 201 2 Q1(1) Q2 (1) Q3 (1) Q4 (1) 30.0 30.0 30.0 20.0 1 0.0 2.2 2.5 0.5 1 0.0 2.0 1 .5 0.3 201 2 Q2 (1) 201 2 Q2 (1) 8.50 4.20 Q3 (1) 8.25 4.40 Q4 (1) 8.25 4.50 Q3 (1) Q4 (1) 8.0 1 .5 4.5 0.8 7.0 1 .3 2.5 0.5 Q3 (1) 8.0 8.0 6.3 Q4 (1) 7.9 7.8 6.3

1 0

1 (1) 1

201 0 1 (1) 2 0.0 8.2 1 (1) 3 -1 .0 9.0 Q1 Q2 201 0 1 (1) 2 8.25 4.50 1 (1) 3 8.00 4.00 Q1 8.25 4.50 Q2 7.75 4.00 Q3 7.75 3.80 Q3 -

1 (1) 0

1 (1) 1

1 0 7.75 4.1 0

1 (1) 1 8.50 4.00

8.75 7.05

30.20 30.40 27.30

27.60 27.80 29.00 30.20 30.60

28.40 28.00 27.50 27.30 27.90 28.00

28.1 27.60 0

Fo o tno tes: (1 Fo recast (2) End P erio d ) Figures are year-o n-year percentage changes unless o therwise indicated So urce: B NP P aribas

04/07/2011

11

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