This is bne's Russia chairman’s newsletter, a selection of forward looking stories on development in eastern Europe and the region. Feel free to request topics or ask questions:

editor@bne.eu

Contents: Top Story

EU increasingly split on Russian sanctions Pain but no disaster in store for Russia in 2015

Politics – the good

Navalny defies house arrest with impunity Russian officials to switch to performance pay scale Russia to blacklist corrupt officials Putin signs personal bankruptcy bill into law Navalny's party of progress to run in Duma elections Duma deputies who spend more than a month abroad to be striped of powers Rostelecom's former boss pays back golden parachute

Politics – the bad

Duma passes "undesirable" company ban law Russia and Belarus among worst in Freedom of speech index

Russian opposition Bolotnaya demonstrator appeals 4.5yr sentence with ECHR

Politics – the ugly

Payment of $50bn to ex-Yukos shareholders awarded in Hague due Putin's buddy gets $3bn bridge project to Crimea job

Polls, mood, sociology Putin re-election a foregone conclusion for most Russians Sberbank CIB Ivanov Consumer Confidence shows collapse in Russian consumer confidence Russians becoming more hostile to West Only 3% of Russians think the west is meddling in Ukraine Majority of Russians are willing to give up western food if sanctions are extended Half of Russians stand for developing relations with China - poll Russia should ignore western criticism

The best thing Yeltsin did was quit says poll

Banks and Finance

Bank overview Capital adequacy ratio remains a major problem. Russia's DIA sets eligibility criteria for bank recapitalization EBRD to make a loss in 2014 due to Russian crisis CBR reshuffles staff, indicates new policies Trust bank bailed out, accused of asset-stripping MasterCard Agrees to Move Payment Processing to Russia

Economics

Ruble crashes below 71 to the dollar on 2% interest rate cut Oil price scenarios for 2015 How much does Russia have to repay this year? Real incomes and consumption take it on the chin Russia's $20bn anti-crisis plan launched Capital flight sets new record high in 2014 Richest Russians repatriating assets following new tax law

Russia down graded to junk Russia’s deteriorating labour market demographics Oil is a big part of small economies Ruble oversold but fears lead to re-dollarization of economy EBRD says Russia's economy is less diversified than in Soviet times MACROECONOMIC WRAP Russia's EconMin estimates 2014 growth at 0.5%-0.6% Russia finishes 2014 with under $400bn reserves Russia will only spend $40bn of reserves in 2015 The weak ruble will fuel inflation Investment down, to be hit by devaluation in 2015 Industrial production spikes in December, outlook poor Ruble fair value undermined by lack of confidence Trade balance and current account positive under any oil scenario Real disposable incomes fall in 2014, to hit retail turnover in 2015 Russian households buy FX, send money overseas

International banks lending to Russia down by fifth in 2014 BUDGET WRAP Russian federal budget in good shape in 2014 FinMin to cut all spending except military by 10%

Infrastructure

Russia urged to spend on infrastructure but multiplier effect open to question Russian port turnover growth slows on falling oil exports Russia and China to launch $13bn joint long-range passenger aircraft project China to Build $242bn Railway to Russia Aeroflot and SCA sign agreement for additional 20 SSJ-100s

Turkish Stream construction to start 2016 but capex is a concern

ECM

Moscow stock prices tanked last year Food Retail stocks a winner from crisis in 2015 Government ready to transfer 23.9% of Bashneft to local government

DCM

Russian distressed bonds up tenfold as sanctions bite Russia’s foreign debt declines by $80bn in the fourth quarter of 2014 China's leading credit rating agency upgrades Gazprom to AAA Rosneft places second ruble bond issue

Sectors

Russia’s gas output tumbles in 2014, as Gazprom produces 100 year production lows Russia sets oil output record ahead of uncertain 2015 Falling oil price bring lower export duties Russian car sales to crash in 2015 Real estate market results in 2014 Asian investors make up tenth of Russia's commercial real estate

Russia's biggest oilfield services deal sees Schlumberger pay $1.7bn for stake in Eurasia Drilling Russia slashes meat import as domestic production soars

Top Story EU increasingly split on Russian sanctions With European growth faltering and fears causing a total economic meltdown of the Russian economy that no one wants the European Union's commitment to sanctions on Russia is faltering. At least eight EU countries are openly supporting not renewing EU economic and financial sanctions when they automatically expire between May and June this year. The discussion is also likely to continue at the upcoming G7 meeting in June where Germany and Japan are expected to clash with the US, calling for an easing of sanctions while Washington is expected to argue for leaving them in place. France has been the most vocal in the call for an end to sanctions on Russia, which is now under severe economic pressure due the crashing oil prices, which dropped to below $45 per barrel on January 15 from over $100 for most of last year. French President Francois Hollande floated the prospect of scaling back sanctions on Russia on December 19, becoming the first major European leader to offer to ease the Kremlin’s economic pain.

Most recently the EU’s foreign policy chief Federica Mogherini suggested EU should restart trade and finance with Moscow in a policy paper that was leaked to the press on January 15. While Brussels said last year trade between the Customs Union and the EU were incompatible (mainly due to differences in quality norms) the same is not true for the EU and the Eurasian Economic Union (EEU), which came into being on January 1. The situation has been further complicated by the results of the Greek election in January as victory of the new anti-austerity government Syriza coalition has threatened to vote against any increase or renewal of sanctions on Russia. As the EU needs a unanimous vote Greece effectively has a veto and may use this as a bargaining chip in its debt negotiations. Pain but no disaster in store for Russia in 2015 If the average price of oil in 2015 is $60 then Russia's economy will contract by 4.3% and the ruble will be RUB56.4 to the dollar, say analysts at Renaissance Capital in a note released on January 20 exploring different oil price scenarios.

Oil prices have fallen from an average of more than $100 in 2014 to hover at about $50 at the time of writing, but a great deal of uncertainty remains over the average price it will settle at this year, ranging from the low $20s to a return to $100 by 2016, depending on who you talk to. While Renaissance Capital believe that $60 oil is the most likely price, it went on to speculate that if oil averages $80 the GDP contraction will only be 1.7%; however, if oil averages $40, then the contraction will be 7.2%. "Russia is facing a new and challenging environment given the drop in oil prices and Western sanctions. With oil at $60/bl, we expect Russian GDP growth to fall by 4.3% in 2015E after increasing by 0.6% in FY14E. Domestic demand is likely to drop significantly, while we see no government and central bank policy boost for growth. However, low unemployment, a lower level of de-stocking, and gains from a weaker currency limit the downside," according to the note written by economists Oleg Kouzmin and Charles Robertson. The outlook is brighter for 2016, according to Renaissance, with positive growth of 2% with average oil at $80, but no change to the economy if oil remains at $60 next year as well. There was no estimate of growth at $40 oil in 2016, suggesting the bank, like Russian President Vladimir Putin, believes that oil prices are likely to start recovering in 2016.

The price of oil will also affect the "dollarization" of the economy. One of the remarkable trends following the collapse of the ruble's value in December was how little foreign exchange the average Russian bought, preferring to put their money in fixed assets like apartments and luxury cars. In the 1990s Russian typically held a large part of their savings in foreign currency, but with almost a decade of a stable or appreciating currency, faith in the ruble has increased. That may change now: sustained low oil prices could lead to a re-dollarisation of the economy, says Renaissance. "After the recent ruble spike, we expect confidence in the national currency to soften, which would increase dollarisation to the 25%-30% level and the ruble “fair value.” The ruble would look stronger if oil prices appreciate, but could weaken considerably with oil prices staying at $40/bl or below and dollarisation going towards 50% in the mid-term, in our view," the economists said. The Central Bank of Russia's (CBR) decision to allow the ruble to float freely has had a beneficial effect on Russia's trade balance and the majority of commentators are predicting that Russia's current account surplus will increase this year as a result of devaluation and its affect on imports. "The current account (C/A) surplus reaches $53bn in our base case (3.8% of GDP), as imports drop due to a weaker currency and a

contraction in domestic demand," say Kouzmin and Robertson. This prediction is more moderate than Fitch, which forecasted last week a rebound in the current account surplus of $72bn (5.3% of GDP) in 2015 as imports shrink. The free floating ruble and its ability to track oil prices down will serve as a significant cushion for the federal budget and, as a result, spiralling federal budget deficits is not one of the problems the government has to deal with. "At nearly any oil price, the budget deficit is likely to be capped by around 2% of GDP, in our view. This is positive for long-term sustainability, but we think implies limited support for the economy in challenging times, which is in line with our growth forecasts," says Renaissance. The ability of the ruble to move in step with oil prices will also allow the CBR to preserve its cash pile if

it is willing to allow the ruble to fall in line with oil prices. The reason previous crises were so expensive (Russia spent $200bn on defending the ruble in 2008 and still had a 30% devaluation) was that the CBR was forced to try and keep the ruble inside an exchange rate corridor, which was only widened slowly. Renaissance also have a much lower estimate for debt redemptions than many commentators, putting this year's bill at $75bn. Other commentators believe the redemption bill for this year is about $100bn, with some putting the number as high as $150bn. Taken all together, Renaissance's estimate is that Russia's international reserves will fall only mildly this year from $388bn on January 1 to $345bn by the end of the year, or $43bn – dramatically down from the $124bn the state spent in 2014, according to the investment bank.

Politics – the good Navalny defies house arrest with impunity Opposition blogger and de facto leader Alexei Navalny defied his house arrest by cutting off his ankle transmitter and joining a public demonstration. He was arrested but given a symbolic fine and is now effectively free from house arrest, continuing to appear in public. The European Court of Human Rights also said in January that it will consider his complaint over a recent conviction. Navalny has vehemently railed against the guilty verdict handed

down against him and his brother Oleg on December 30, accusing the court of violating a number of procedural rules in its handling of the case. Navalny and his brother were both sentenced to 3 1/2 years, though the anti-corruption campaigner was given a suspended sentence while his brother was immediately taken into custody to serve out his term in a penal colony. Russian officials to switch to performance pay scale Russian officials pay will be switched to a performance pay scale by December 2017, according to reports.

A new contractual system will be introduced based on criteria for assessing officials’ efficiency in their performance within their competencies and those that don’t meet norms will have their salary docked. There are currently 1,729 officials in the Presidential Executive Office, who received the highest monthly salary as of late 2014 – about RUB216,000 a month ($3,315). The lowest salaries are for the Federal Archives Agency, whose staff of 51 each received about RUB53,000 ($815) a month, in the Ministry of Crimean Affairs – RUB40,000 ($615) and in the Ministry of North Caucasus Affairs – RUB38,000 ($580). Russia to blacklist corrupt officials State officials caught taking bribes will have their names included in an official blacklist that will bar them from public office or service in the future, according a proposal by the Labour Ministry. Technically any official that has been dismissed from their positions on the basis of a “loss of trust” due to corrupt activities will be include. However, the scheme is unlikely to work as few corrupt officials that are caught are actually dismissed using the "lost of trust" criteria. And no decision has been made on whether the list will be made public.

Transparency International ranks Russia 136th out of 175 countries in its latest Corrupt Perceptions Index, released in December. The Interior Ministry has proposed changes to the Criminal Code toughening penalties for fraud. The ministry is seeking to reduce by six times the damage caused as a result of a large-scale fraud. The criminal code has seven articles on fraud, with penalties varying between up to five and up to 10 years. Damage in fraud cases is considered serious when it exceeds RUB250,000 ($3,940 at the current exchange rate) and major if it exceeds RUB1mn ($15,775). However, under four articles, including on corporate fraud, large and very large-scale damage amounts to RUB1.5mn ($23,662) and RUB6mn ($94,645), respectively. Putin signs personal bankruptcy bill into law President Vladimir Putin on Monday signed a bill on personal bankruptcy, under which an individual can be declared bankrupt upon a creditor’s request if the total amount of debt exceeds 500,000 rubles (about $9,600), into law. The document has been posted on the government’s legal information website. The law stipulates a three-year deferment for debtors with a stable income. Otherwise, a court will declare the borrower bankrupt and distribute the property among the creditors. Borrowers would be able to file for bankruptcy themselves.

The right to file bankruptcy lawsuits would be also given to creditors or authorized agencies, in which case borrowers would be able to say that they cannot honor their obligations irrespective of the debt amount. The property of bankrupt individuals would be included in the bankruptcy estate for subsequent auction. Creditors’ claims that are not satisfied due to a shortage of auctioned assets would be considered redeemed. Upon the end of settlements with creditors, bankrupt individuals would be discharged from any subsequent liability. The law also says that creditors and the deceased individual’s heirs can file a lawsuit to declare the said individual bankrupt. Navalny's party of progress to run in Duma elections Opposition blogger and anti-corruption Alexei Navalny says his Progress political party intends to run in Russia's 2016 Duma parliamentary elections and called for protests and rallies if the government fails to register the party's application. Navalny said there was a "very high" stymie the registration. "There is no other way to achieve participation in them [elections], aside from taking to the streets in protest," Navalny was quoted as saying by the Noviye Izvestia newspaper.

Navalny came second in the race for Moscow mayor in 2013, taking 27% of the vote and nearly forcing the Kremlin-backed incumbent, Sergei Sobyanin, into a run-off. Duma deputies who spend more than a month abroad to be striped of powers Russian Duma deputies who go overseas and spend more than a month abroad could be stripped of their powers, according to a new draft law introduced by Communist party deputy Ivan Nikitchuk, the first deputy chair of the Russian State Duma Committee for Natural Resources. Deputies that want to spend more than a month overseas will have to seek formal permission and give a valid reason. The law is part of Russian President Vladimir Putin's de-offshorisation campaign and plays to growing nationalist sentiment. The draft follows laws that ban deputies from owning property abroad, foreign bank accounts or dual citizenship. Rostelecom's former boss pays back golden parachute The former president of state-owned telecommunications giant Rostelecom, Alexander Provotorov, paid back a RUB200mn ($3.3mn) golden parachute payment he received after being sacked 2013, despite a court ruling saying he could keep the money. Minority shareholders in the company objected to the payment in court as excessive but the court ruled to allow the payment.

However, Provotorov said in December said he would return the money as it was the "only right solution."

He kept another RUB30mn ($480,000) paid separately equal to salary owed from the months remaining on his contract.

Politics – the bad Russia and Belarus among worst in Freedom of speech index Russia and Belarus did worse in the "Reporters without Borders" annual freedom of speech rating released in January. Russia ranked 148th out of 180 countries, behind Ukraine (127th) but ahead of Belarus (157th). Among the post-Soviet countries Estonia performed the best taking 11th position. “Russia (148th) might have been lower in the index had it not been for the stubbornness and resistance shown by its civil society. But the authorities keep on intensifying the crackdown begun when Vladimir Putin returned to the Kremlin in 2012 and are exporting their model throughout the former Soviet Union. From Ukraine (127th, unchanged) and Azerbaijan (160th) to Central Asia, Russia’s repressive legislation and communications surveillance methods are happily copied. Moscow also uses UN bodies and regional alliances such as the Shanghai Cooperation Organization in its efforts to undermine international standards on freedom of information,” the authors commented on the rating.

Duma passes "undesirable" company ban law Russia's Duma passed a bill in the first reading that will ban any "undesirable" foreign companies or organizations. The targets any foreign entity that "presents a threat to the defence capability or security of the state, or to public order, or to the health of population." It can also ban companies on moral grounds. Russian opposition Bolotnaya demonstrator appeals 4.5yr sentence with ECHR Russian opposition activist Sergei Udaltsov, who was sentenced to 4.5 years in prison for organizing the Bolotnaya Square protests in central Moscow in May 2012, filed an application with the European Court of Human Rights (ECHR), his attorney Violetta Volkova told RAPSI on Tuesday. Udaltsov claims his “detainment, his placement under house arrest and the subsequent restraint on his freedom during the inquest,” was unlawful and politically motivated.

Politics – the ugly Payment of $50bn to ex-Yukos shareholders awarded in Hague due As of January 15, the July 2014 decision of the Hague Permanent Court of Arbitration to award the ex-shareholders of Russia's formerly largest oil producer Yukos comes into effect. The period during which the award of $49.8bn ruled by the court could be paid voluntarily is over, and as of January 15 1.89% annual interest penalty will accumulate on the award. At the same time, sources of Vedomosti business daily said that no such compensation was planned in the federal budget for 2015. Tass cited the justice minister Alexander Konovalov as saying that it was too early to say whether Russia will or will not pay the compensation. Russia has appealed the decision in the end of 2014. However, the appeal itself is not sufficient to lift or postpone the rewards due, according to BFM.ru. In fall 2014 there were unconfirmed reports that ex-Yukos shareholders are preparing property claims in Germany, as well as in Great Britain, Netherlands, France, and the US, should Russia fail to pay the award. Shortly after, Russian State

Duma passed a law that would allow nationalizing foreign property in Russia to compensate the damage of Russian companies and citizens under “unlawful” court rulings in these foreign countries. This law can be potentially used to compensate the companies in cases such as claims of Yulkos shareholders. In July, the Hague Permanent Court of Arbitration awarded a total of $49.8bn damages to three former shareholders in Yukos in connection with the bankrupting of Yukos in 2004-2005, as a result of which the Yukos assets were renationalised and acquired by state-owned Rosneft, now Russia's largest oil company. Yukos was run by oligarch Mikhail Khodorkovsky, a political opponent of Russian president Vladimir Putin, who was sentenced on organized crime charges to 10 years in jail. He was released early in December 2013. Putin's buddy gets $3bn bridge project to Crimea job Russian Prime Minister Dmitry Medvedev signed off on an order granting a RUB228bn ($3.3bn) contract to build a bridge between Russia's mainland and the recently annexed Crimea to one of Russian President Vladimir Putin close personal friends Arkady Rotenberg and his Stroygazmontazh company.

"Today a government order is to be published, which approves Stroygazmontazh as the only performer of the contract to build a bridge across the Kerch Strait," a few sources familiar with the situation told Kommersant. Representatives of Medvedev and Kozak refused to comment on the

situation, and the Transport Ministry only said they "prepared a draft order and submitted it to the government." Rotenberg told Kommersant that the final cost has not been decided but a figure of RUB228.3bn ($3.3bn) is the current estimate.

Polls, mood, sociology Putin re-election a foregone conclusion for most Russians Despite being three years away, the next Russian presidential election will see Vladimir Putin re-elected in a landslide, according to a study by the independent Levada Centre. The results of the poll, published on January 15, found that if a general election were to take place this weekend, Putin would eclipse all other potential runners, with 55% of those surveyed opting for the current president, as the first bne:Chart below shows.

Communist party leader Gennady Zyuganov placed a very distant second, with a mere 4% of respondents saying that they would vote for him. Russia’s current economic hardships if anything have stoked up a latent sense of nationalism that has allowed Putin to emerge as the best option for many Russians. A further poll by Levada shows that 72% of respondents believe that relations with the West and Nato have gotten worse in 2014, compared with only 29% in 2013.

Sberbank CIB Ivanov Consumer Confidence shows collapse in Russian consumer confidence State-owned Russian retail bank Sberbank's monthly consumer index shows that consumer confidence has collapsed following the sharp devaluation of the ruble in December.

"The tenth tracker indicates a sharp drop in the consumer confidence index from the third quarter of 2014 level of –7% to –24% in the fourth quarter of 2014," the bank said in its report. A similar poll conducted by the state statistics agency Rosstat looking at consumer confidence data for the fourth quarter of 2014, came to the same conclusion:

consumer confidence dropped 11 ppt to negative 18% during the quarter, which only slightly exceeds the 4Q08 level. Sberbank launched the "Ivanov index" (the Russian equivalent of the surname Smith), an independent poll that tracks consumer sentiment, two years ago as a way of keeping tabs on consumer spending, savings and confidence across the country. Results were terrible across the board. The index of country wealth over the past 12 months plunged from –19% in the third quarter to –51% in the last quarter of last year. "Rising inflation, dimmer employment prospects and sharp ruble depreciation were the main contributors. This also dragged down personal wealth expectations over the next 12 months," Sberbank said. Sberbank said that the survey suggested that after a rush to lock up cash in things like cars and apartments in December the majority of Russians are not planning to make big ticket purchases this year. Reduced wealth means Russian have also become a lot more price

sensitive: the share of price-sensitive customers rose to 73% in December, up from 69% in September. The consumer is also trading down to buy cheaper (typically Russian-made) goods: 60% of respondents are trying to save on staples. In discretionary spending, dining out is the main victim, with 70% of respondents cutting back on restaurant visits, followed by entertainment (63%) and vacations (50%). However, despite some economies, life for the Ivanovs has not changed that much. The survey found that nearly half (46%) of respondents kept their family consumption budget unchanged in terms of structure and ruble value (implying lower consumption in real terms). "One fifth of respondents began to build up food inventories, which could weaken demand in the first half of this year. Given that a higher share of these one-off purchases were made in non-organized retail, modern retail should be more resilient and its market share growth will accelerate in 2015," the bank concluded.

Russians becoming more hostile to West As tensions ratchet up half of Russians (47%) have become more hostile to the west and believe that the country's top foreign policy should be to strengthen ties with China, up from 21% that believed the same thing a year ago, according to a recent poll from the Levada Centre. Second place went to the CIS countries (12%), followed by Western Europe (8%), the United States (4%) and the Islamic countries bring up the rear with 1%. The desire to be friends with America has fallen by more than half; the same time last year 9% of Russians thought that Russia should be friends with America. Only 3% of Russians think the west is meddling in Ukraine Only 3% of Russians think the west is meddling in Ukraine, according to a poll by the state-owned VTsIOM pollster, despite the heavy state propaganda. Half said there was civil war in Ukraine, 17% genocide and the same amount described the situation as anarchy. About a quarter of Russians (26%) say that there is a "rather high probability" that Russia will launch military activity in the region. Another 10% is "convinced that a war between the countries is already under way."

Conversely, more than half of Russians do not think Russia will go to war with Ukraine: 33% said it was unlikely, and 21% said it was impossible. Majority of Russians are willing to give up western food if sanctions are extended Eight out of ten Russians are willing to give up western food if sanctions are extended or prolonged, according to a recent poll by the Sociology Institute of Russia's Academy of Sciences. Another 55% said they were willing to forego foreign holidays to the US or Europe and 51% said they would not save using foreign currency. Only 10% said they would accept a wage freeze Half of Russians for deepening relations with China Just under half of Russians (47%) believe that Russia should deepen its ties with China in the long-term period, the Levada Centre found in a poll. CIS countries ranked second (12%), Western Europe came third (8%) and the United States a distant fourth (4%), with Islamic countries bring up the rear. China has soared up the polls from 21% of respondents prioritized Beijing as Russia's partner a year ago. Much of China's gains have been made at the cost of the CIS and Europe, down from 28% and 20% a year ago respectively.

Russia should ignore western criticism More than half of Russians (57%) believe that western criticism should be ignored, up from 50% two years ago. The overwhelming majority of Russians (87%) believe that the West is now hostile to Russia with only 8% disagreeing with this interpretation. Naming the motivation for the criticism respondents chose: "the West does not wish Russia well and the criticism is hostile" (43%) and "the West sees Russia as a rival and tries to weaken it" (40%). Another 46% believed that the west is trying to grab Russia's natural wealth and 43% believe the west fear's Russia's military might.

Three out of four Russians believe the best thing Yeltsin did was quit The best thing former president Boris Yeltsin every did for Russia was to quit his job say 73% of the respondents in a poll from the state-owned VTsIOM. Yeltsin's administration remains hugely unpopular in Russia: 59% believe Yeltsin's presidency had a mostly negative impact on the country, with people older than 50 being the most critical (70%). However, 85% say that Yeltsin's best decision as president was to hand over power to then-Prime Minister Putin. The majority (65%) believe that Yeltsin's take over of the presidency in 1991 was legitimate, but only one in three believe he acted in the interest of the people with another 20% believing he acted in the interest of the oligarchs.

Banks and Finance Bank overview December was surprising in the relatively modest retail deposit withdrawals despite the collapse of the currency against the dollar, which speaks well for the system’s resilience, though December is typically seasonally very strong. However, analysts say that the sector lost about RUB589bn ($9bn) but just how this happened has not clear yet. Dollarization of lending: About a third of sector corporate loans and a quarter of retail deposits are now FX-denominated. The bank sector finished the year with corporate lending growth of around 12% net of the revaluation effect (versus nominal growth of 31%), while the share of FX loans was up to 32% from just 23% a year ago. Retail loans rose 14% year-on-year or 12% year-on-year net of revaluation, with the share of FX loans remaining low at 2.7% (versus 2.4% in December 2013).

FX mortgages are a separate matter, as despite their low share in mortgage lending (3.7% in November), the CBR's recommendation of restructuring them into ruble loans at the the third quarter of 2014 exchange rate would lead to significant one-off losses for some players. Assets: Assets rose 9% month-on-month, implying growth of 35% year-on-year for 2014. Stripping out ruble depreciation, the sector’s balance sheet increased some 18% last year, which is still a strong expansion. Loans: Corporate loans increased 5.3% month-on-month, but this falls to just 1.0% when accounting for ruble depreciation. Retail loans were flat. This means corporate loans rose 31% for the full year while retail loans climbed 14%, but when adjusted for FX changes, growth was the same at 13%. Sberbank outperformed the rest of the sector in both corporate (36% versus 28%, respectively) and retail lending (22% versus 10%).

NPLs: The overdue loan ratio (which incorporates only the overdue portion of a loan) was flat

for corporate and retail in December.

Deposits: Retail deposits increased 2.6% month-on-month but fell about 0.7% if adjusted for ruble depreciation. Given all the tumult in December, this is really not a bad result. In 2014, however, on a FX-adjusted basis, retail

deposits dropped 2.5% year-on-year. Corporate funds on an FX-adjusted basis increased 3% month-on-month and were up 18% year-on-year in 2014.

Sberbank underperformed the rest of the sector in retail deposit growth (6% versus 13%, respectively) but was well ahead in corporate deposits and accounts (62% versus 36%). Revaluation also inflated the share of FX in retail deposits to 26% in

December compared to 17% at the end of 2013. Net of revaluation, retail deposits fell around 2% year-on-year and corporate deposits rose 13% year-on-year (with nominal growth of 9% and 41%, respectively).

Capital adequacy ratio remains a major problem. As of 1 January, 13 out of the top 50 banks by net assets had an N1.0 CAR ratio below 12%, but still over the mandatory minimum of 10%.

27 banks with capital exceeding RUB25bn will be able to apply for the OFZ recapitalization program and increase their capital by up to 25%, while smaller banks and players focused on unsecured retail lending are in a less favorable position and will likely need to rely primarily on their shareholders for capital replenishment.

Russia's DIA sets eligibility criteria for bank recapitalization via OFZ The government has already decided to help three banks with recapitalisation: state-owned VTB Bank and Russian Agricultural bank, as well as privately owned Trust Bank. But another RUB1 trillion ($15.3bn) has been set aside to help recapitalise another 27 banks. This money will not be given to everyone and the state is putting on strings that effectively mean the cash will have to be used in directed lending to sectors the government deem 'strategic.' The Deposit Insurance Agency (DIA) is in charge of dishing out the dosh and set the eligibility criteria for bank recapitalization; RUB830bn has already been allotted to the banks which will

receive 25% of their own capital as of 1 January as fresh capital. Prime Minister Dmitri Medvedev said the recapitalization scheme would not be designed to rescue troubled banks (a separate process), but rather to ensure that banks are adequately capitalized to continue lending to the real sector. Amongst the conditions to qualifty for the extra capital:

• a bank needs to have at least RUB25bn of capital, which means only about 30 Russian banks qualify;

• a bank has to ensure stable

growth of lending to priority sectors of the Russian economy (12% per annum on a three-year horizon has been mentioned);

• a participating bank must match 50% of the amount received from the DIA, either externally (via shareholder capital contribution) or internally (via retained earnings). If it is unable to secure this upfront, it needs to cut top management pay and dividends;

• a bank that is heavily exposed to retail lending are excluded; non-secured retail loans must not exceed 40% of a bank’s assets;

• other eligibility conditions

are pretty standard and include participation in the deposit insurance scheme and compliance with CBR requirements.

Deputy Finance Minister Alexei Moiseev said that VTB, Gazprombank and Russian Agricultural Bank are likely to be eligible for the scheme too. Analysts are happy with this plan as it has illustrated the Russian government’s quick and decisive action to shore up the capital position of systemically important banks. "Combined with liquidity support measures, this could help prevent a significant credit crunch," says Sberbank. Separately the state bought RUB40bn ($720mn) worth of shares in state-owned Gazprombank, which is one of the banks on the EU and US's sanctions list, to support its capital. Likewise, Russian Prime Minister

Dmitry Medvedev signed an order to give the country's second-biggest bank VTB Bank a RUB100bn ($1.7bn) capital injection. VTB Capital increases its dominance of Russian investment banking business VTB Capital increased its market share of the investment banking market in Russia in 2014 (M&A, ECM and DCM) to 22.01% in 2014 from 14.87% in 2013, Thomson Reuters reports. VTB Capital increased its share of Russia-targeted M&A fees from 16.32% to 23.59%, increased its share of Russian ECM fees from 13.51% to 14.9% and increased its share of Russian DCM fees from 13.84% to 24.1%. EBRD to make a loss in 2014 due to Russian crisis The collapse of the Russian ruble will probably lead to a loss for the EBRD in 2014. The bank was set up in 1991 to finance growth in emerging Europe and has lost money on five times since then, most recently in 2008 and 2009. A quarter of the banks investments are in Russia. The European Bank for Reconstruction and Development will probably report its first loss since the global financial crisis due to turmoil in Russia and Ukraine, the development bank's Vice President Andras Simor said in January.

Simor said a fall in the value of its Russian equity investments due to the ruble's slide as well as provisions against other losses in both countries meant an overall loss for 2014 was likely. The EBRD has suffered only five annual losses since it was created in 1991 originally to invest in the former Soviet bloc countries of eastern Europe, most recently in the crisis years of 2008 and 2009. Russia remains its biggest area of activity with €5.8bn euros invested in the country in the form of equities, project loans and other forms of financing. Ukraine is third biggest, behind Turkey, with €3bn. CBR reshuffles staff, indicates new policies The appointment of a new deputy governor to the Central Bank has raised the prospect of shifts in Russian monetary policy as the country continues to grapple with a currency crisis that saw the ruble lose a third of its value against the US dollar over the last two months. Dmitry Tulin was rehired by the Central Bank of Russia (CBR) in January to take over responsibility for monetary policy from Deputy Governor Ksenia Yudayeva, who sees her role trimmed to macroeconomic forecasting. Analsyts see the technocrat Tulin's appointment as indicative of new policies at the regulator.

US-educated Yudayeva, who joined the Central Bank less than 18 months ago, has been criticized for the inactivity of the CBR in the midst of the ruble crash in December. CBR governor Elvira Nabiullina tried to play down the change at the top. "I particularly want to emphasize that we are preserving the strategic and tactical benchmarks of monetary policy," Nabiullina said, according to the Russian RBC news website. Tulin worked for 10 years in the Soviet Central Bank and served as deputy governor at post-Soviet Central Bank between 1991 and 1994 and again between 2004 and 2006. He also worked at the International Monetary Fund, accounting firm Deloitte and VTB. Trust bank bailed out, accused of asset-stripping Privately owned Trust bank was the only Russian bank to nearly go bust during the collapse of the ruble in December and took a RUB99bn ($1.54bn) bailout payment from the Central Bank of Russia (CBR). However, the regulator said a week later they suspected the former owners of the bank had stripped it of asses through lending schemes worth hundreds ofmns of dollars. The CBR has now lent the bank a total of $2.4bn to protect the lender from bankruptcy. Trust Bank was originally set up by Yukos owner Mikhail Khodorkovsky

and is known to the Russians as the face of American actor Bruce Willis in its advertising. As much as RUB28bn ($430m) would also be loaned over six years to Otkritie Bank, which will oversee Trust Bank's rescue, making it the second-largest bank bailout in Russia's history. MasterCard Agrees to Move Payment Processing to Russia Credit card company MasterCard says it will transfer its card processing to inside Russia to comply with the need to service an alternative local state-owned

system, as Russia prepares to launch its own domestic payment settle system. Russian authorities have obliged foreign card companies, which have stopped providing services for some Russian banks subject to Western sanctions, to move Russian processing to the local system or pay a hefty security deposit. The deadline for companies to switch to the local system is the end of March.

Economics Ruble crashes below 71 to the dollar on 2% interest rate cut The ruble crashed to below RUB71 against the dollar following a surprise interest rate cut by Russia's central bank on January 30. The central bank announced a 2% cut in the key policy rate, from 17% to 15%, “taking into account the changing balance of risks between consumer price inflation and economic slowdown". It believes that the economic contraction of 3.2% in the first half of 2015 on the year should contain inflation.

Markets reacted immediately, with the ruble plummeting in value against the dollar, to cross the RUB71 to the dollar mark, its weakest value for six weeks. “The central bank is comfortable still with the ruble continuing to take the strain” from low oil prices, Western sanctions, weak growth, and lack of reforms," says Tim Ash of Standard Bank. Clearly the central bank is concerned about killing off growth by having the cost of borrowing too high. At the same time, the central bank is said all along that it believes that interest rates and monetary factors have no effect of

inflation, which is largely been driven by external sources. On December 15 the central bank introduced the 17% rate – hiked up from a previous rate of 10.5% - as an emergency measure to stem a collapse in the value of the ruble, but at the cost of potentially throttling Russia's economic prospects. The same week the Ministry of Economics produced a forecast for a 3% contraction in economic growth in 2015, significantly less than the consensus forecast for between 4% and 5% contraction this year. Oil price scenarios for 2015 Its all about the oil in 2015: what price oil settles at will determine the performance of the economy. As it is not clear at all where oil will go – the range of predictions is

between $20 and $100 – most banks are offering scenarios, however, the consensus seems to be an expectation of around $50-$60 average price in 2015. The consensus for 2015 is Russian GDP growth will fall by 4.3% and the ruble to average RUB56.4/$1 if Brent crude oil at $60/bl. Domestic demand is likely to drop significantly, with the government unable to do much to boost demand. But the blow will be cushioned by low unemployment, a lower level of de-stocking, and gains from a weaker currency that limit the downside, says Rencap. "If oil prices go up to $80/bl, growth falls by only 1.7%, but if they bottom at $40/bl in the next 12 months, we see growth turning more negative (-7.2%)," according to Rencap.

How much does Russia have to repay this year? How much does Russia have to repay this year to international creditors? The question is key as cut off from the international capital market by sanctions dollars leaving Russia to meet maturing corporate debt obligations are a major drain on the country's resources. The CBR released a fresh foreign debt repayment schedule at the end of January: the principal

amount of non-public debt due this year was increased to $108.1bn, from $98.8bn expected three months ago, with the bulk of the difference coming from the corporate side. State and CBR payments are estimated at $2.6bn; interest payments total $23.2 bn. The peak of private debt maturities falls in February and March, with $15.2bn and $16.5bn due, respectively. The first quarter of 2015 volumes are the highest overall ($36.1bn).

Russia reduced its debt by $130bn in 2014 and is likely to reduce its debt again by just under $100bn in 2015. Due to alternative sources of funding the Central Bank of Russia (CBR) is not expected to spend more than $30bn of reserves to pay off debt and a total of $40bn-$50bn all together, assuming oil prices stabilise at about $60.

The sovereign debt is trivial and fell from $61bn in 2014 to $41bn as of January 1. The Russian government can pay its debts out of its lunch money. If the corporate debt is included then the numbers become more significant. The official headline amount of debt coming due in

2015 at $120bn, but economists believe that this number is overstated by as much as 40%. "They include low-risk transactions within multinationals or between parent companies and their subsidiaries, Russian financing done through offshore vehicles, and trade loans from China. Our estimate is $75bn for 2015. This figure lowers gradually for each subsequent year, but we cautiously assume it also amounts to$75bn for 2016E," said Rencap in a note. $75bn is the same amount as Fitch estimates as Russia's current account surplus, so in theory the external debt could be complete covered by cash earned from trade. However, the state will not be called on to cover all the debt. Russia's banks having been paying off debt of some $10bn a year in 2012 and 2013, although that jumped to an estimated $40bn in 2014 when Russia was cut off from the international capital markets. However, as the ruble was already devaluating slowly thought out 2014 banks took the opportunity to build up significant hard currency reserves offshore by speculating on the ruble/dollar exchange rate. Indeed, banks were scolded as "speculators" by Russian President Vladimir Putin in December for borrowing CBR funds and using the money to play the FX market rather than lend to companies. Rencap recons banks foreign assets are higher than their foreign liabilities: "There are different

estimates depending on methodology, but foreign assets of Russian banks exceeded their foreign liabilities by $70bn or $40bn as of the end of October 2014, according to various CBR statistics and our estimates, which will bring in $28bn for Russia." The debt situation is also made easier by the fact that around a quarter of Russian external debt is denominated in rubles, which is important when trying to calculate the future amount of Russian external debt, which accounted for 60% of Russia's reduction of $130bn in external debt in 2014 to about $600bn as of the start of 2015. Analysts estimate that Russia's total external debt will decline by nearly $100bn in 2015 – although its share of GDP will increase due to the recession: Debt will decline to $519bn as of the end of 2015 (38% GDP), which compares with $594bn as of 2014 year-end (32% GDP), according to Rencap. In the other non-extreme scenarios, the outstanding amount of the Russian external debt might differ from $534bn (34% GDP) to $492bn (47% GDP), with oil prices at $80/bl and $40/bl, respectively. a Real incomes and consumption take it on the chin Ruble weakness will severely hurt real incomes and private consumption in 2015, which have been the main economic engines of growth in recent years.

Although there is still a lot of money left in the Reserve Fund, the government does not have enough resources to support real incomes to the extent it did in 2009, when, in spite of the severe recession, real incomes grew 3%. The government will raise the salaries of state employees in nominal terms, meaning salaries will shrink in real terms. The government plans to increase pensions in 2015 in line with the level of inflation in 2014, implying zero growth in real terms (inflation forecast for 2015 is 9.4%). In the private sector entrepreneurial incomes are expected to contract sharply due to a steep drop in corporate profits (the share of net profits in GDP is forecast to fall to 8-9% versus the 14.4% average in 2004-07). In all real incomes are expected to drop 8.2% in 2015, causing an 8.7% contraction in retail trade volume, says Rencap. Russia's $20bn anti-crisis plan launched The government published an anti-crisis plan in January that includes

RUB1.3 trillion ($20bn) of economic support in 2015, of which RUB552bn ($8.5bn) is to be financed via the federal budget. Social spending is slated to expand by RUB296bn ($4.5bn), while support for regional budgets will increase by RUB160bn ($2.4bn). Banking system recapitalization and VEB’s financing will total RUB550bn ($8.6bn), which will be financed via the National Wealth Fund. This transaction will be treated as an investment for the fund, so it will not officially reduce it or impact the budget. Finally, the state will provide guarantees on up to R230bn in financing for select investment projects, and this will also be a non-cash transaction (at least in the initial stages). The government is still discussing the possibility of cutting its currently planned expenditures for 2015 by 10%, or RUB1.5 trillion. Thus, implementing the anti-crisis plan would not necessarily imply an increase in total expenditures (RUB15.5 trillion) this year if it is offset by reduced spending elsewhere.

Capital flight sets new record high in 2014 Capital flight nearly tripled in 2014 to its highest level ever of $151.5bn, up from $61bn in 2013 and exceeding the previous record of $133.6bn set in 2008 during the global financial crisis. Capital flight in 2015 is expected to remain at the same level. Part of the flight is due to the fact that Russia has been cut off from the international capital market by sanctions. Some $50bn of capital flight is simply due to Russian companies paying down debt that they cant roll over or refinance. The exodus of capital is contributing to the fall of the ruble which is down by 50% from its 2014 start of RUB32 to the dollar and is currently trading at about RUB65.

The Central Bank of Russia (CBR) has put a brave face on capital flight and is predicting $118bn will leave this year. But with $72.9bn leaving in the forth quarter alone quintuple the amount that left a year earlier in the same period, economists are sceptical that capital flight will fall this year. Richest Russians repatriating assets following new tax law Russia's richest businesspeople are reported to be repatriating assets in response to a new law decreeing that Russian-owned offshores be treated as Russian tax residents – or as a sign of support for President Vladimir Putin. A new law on so-called 'foreign controlled companies' entered into force at the start of the year, which equates offshores used in Russian tax optimisation schemes to Russian tax residents, a move made possible by increased

international information sharing by tax havens. The law is part of a programme of 'de-offshorisation' launched by the Kremlin in 2012 on the re-election of Vladimir Putin as president. As a result, owners have started to de-offshorise their businesses – but the jury is out on whether this is because of the change in law, or because they sense it is the way the political wind is blowing and want to be seen supportive of the Kremlin. According to sources quoted by Bloomberg, Russians could be holding as much as $1 trillion in safe havens such as Switzerland and Cyprus. Russia down graded to junk Russia was downgraded to junk by Standard & Poor's on January 26 in the latest of a series of downgrades from all the main ratings agencies. Russia was lowered one step to BB+, putting it below investment grade for the first time in a decade. The decision came as the US and European Union warned that Russia may face further repercussions from the war in Ukraine. Russia may lose $20-30bn from its investment rating downgrade by S&P, Economic Development Minister Alexey Ulyukayev said in an interview. S&P’s rating is one step below Moody’s Investors Service and Fitch Ratings, which both knocked the sovereign’s credit score to the

lowest investment grade this month, but have yet to mark Russia to junk. The cost of insuring Russian debt against default is the fifth-highest globally after jumping 113 basis points this month to 589, near the riskiest in almost six years. The contracts climbed 33 basis points before the S&P decision. However, some bond investors say the prices now make the risk-reward look attractive: five-year credit-default swaps suggest a 34% probability of default, according to CMA, but that is set against Russia’s international reserves, excluding gold, which are still the eighth-biggest globally, according to data compiled by Bloomberg. Russia’s deteriorating labour market demographics Russia’s population has stopped falling, but the labour pool is still shrinking. In the post Soviet period, Russia suffered an unprecedented peace-time collapse in its population, but, contrary to many well-publicized predictions, the rate of decline moderated in 2006 and population growth was recorded in 2013 and 2014. But the labour workforce will continue to fall by as much as 10% over the next decade. The legacy of the 1990’s is that Russia now faces a period when the available workforce may shrink by between 7% and 10%, or between 5mn and 7mn people, on a cumulative basis, over the next ten years.

Russia needs more migrants and a later retirement age. One way this may be addressed is through a combination of continued migration from Central Asia, which continues to have high population growth rates, and by raising the country’s current retirement age. The Eurasian Union, assuming it continues to expand, will facilitate the former while there appears to be no political appetite for the latter. Reducing the currently sizeable state workforce, accounting for some 20% of the country’s total 75mn workforce, and having an effective re-training and re-location program would help enormously. So far there is zero indication that this is a possibility. The tight labour market is keeping wage growth high. he shrinking workforce demographic will have a negative impact on the economy and on the federal and regional budgets. The state has already raided the future pension pot and FEWER tax payers and fewer economically active people will have to carry a growing number of retirees. In 2012 the number of Russians aged between 15 and 29 accounted for 22% of the population, down from 34% in 2009. This total may drop to 18% in ten years time. Russia already has 38mn pensioners or 9mn more than those aged 16 or younger. Oil is a big part of small economies Russia's dependence on oil is well known as about half its exports revenues and federal budget

revenues are earned from oil. What is less well known is that in terms of its share of Russia's economy, oil plays a relatively subdued role. Oil and gas production account for a mere 14% of GDP. If you added in ancillary connections due to state-owned oil company spending and investment then the importance rises to about 25%, according to Goldman Sachs analysts. However, this is on par with Norway where oil and gas account for 10% of GDP and about the same as Russia if the ancillary spending is included, according to research by the Bank of Finland. In this sense Russia already has a well-diversified economy and gives it the possibility to recover from the oil price crash driven slowdown by turning to the promotion of the rest of the economy. Compare the oil share in Russia's GDP with the main oil producers: oil accounts for 70% of GDP in the Republic of Congo and around 50% for some of the Gulf States: Kuwait, Saudi Arabia and Iraq. Other noteworthy countries include Venezuela at about 25% of GDP and Brazil at 3%, about on a par with Canada, according to Goldman Sachs. For the UK and US (which rank 54th and 55th globally), oil revenue accounts for only about 1% of GDP. A simple back of the envelope calculation that directly translates a decline in oil prices into a proportional decline in GDP suggests that, given a 60% decline in oil prices (which is roughly the

size of the decline in front-month WTI crude oil over the last six months), nominal GDP in Kuwait and Saudi Arabia would decline by

more than 25%, whereas Russia is expecting a 4%-5% decline in 2015.

Ruble oversold but fears lead to re-dollarization of economy Investment banks say the ruble is oversold and should more closely reflect fundamentals in a note released in mid-January, but its exchange rate forecasts are noticeably weaker. If oil prices average around $60 in 2015, Rencap estimates the ruble might average around RUB56.4/$1. As of January 20 the price of oil was $50 and the ruble was RUB65 to the dollar. During the worst of the crash in December the ruble hit RUB80 briefly and that has undermined confidence and will fuel a re-dollarization of the economy.

"First, and most obvious, the average-year exchange rate for 2014 has changed, which also pushes up our future exchange rate forecasts. But second, and most important, we suggest that after the recent ruble collapse, especially with the ruble going to RUB80/$1 for a few hours on 16 December 2014, confidence in the national currency has softened in Russia, which could lead to increased dollarization of the Russian economy," Rencap said in a note. The 2008-2009 shock saw the level of dollarization rise from 15% to 20%. Rencap says that this latest ruble crash, will, as in 2008-2009, push that level of dollarization

higher again – perhaps up to the 25-30% level. The dollarization of the Russian economy was up already from around 20% previously to an estimated 30.5% (+/-1%) as of the end of 2014. In this

environment the underlying “fair value” for the ruble becomes weaker as there is a semi-permanent lower bid for the currency, due to this rise in demand for dollars.

EBRD says Russia's economy is less diversified than in Soviet times Russia's economy is now less diversified than it was during the Soviet Union, Suma Chakrabarti, head of the European Bank for Reconstruction and Development (EBRD) said in January. "Research that we carried out in 2012 showed that Russia was less diversified than it was during the Soviet Union. And its even less diversified now," the bank head told journalists.

During the period of rising oil prices from the late 1990s the Russian economy became increasingly reliant on the energy sector. Over half of government revenue now comes from taxes on oil and gas, leaving the country vulnerable to last year's drop in oil prices.

While this is true it skips over the fact that the Russian economy is now more than five-times larger than it was in 1991 - with almost all the growth due to the expansion of the oil and gas sector.

MACROECONOMIC WRAP Russia's EconMin estimates 2014 growth at 0.5%-0.6% Russia's ministry of economic development estimates the 2014 GDP growth at 0.5%-0.6%, deputy minister Alexei Vedev said in January, noting that this was the revised forecast for 2014. Most recently, the World Bank projected Russia's 2015 GDP contraction at 2.9% vs. an estimated 0.7% growth in 2014, assuming $60/barrel average oil price forecast. The informal forecast by Russia's ministry of economic development and its central bank expect 3% and 4.5%-4.7% GDP decline in 2015, respectively, given average $60/barrel oil price. Currently the official forecast by the ministry of economic development remains for a 0.8% contraction at $80/barrel oil price. However, the finance ministry is already basing some of its unofficial fiscal estimates at oil price of $50/barrel. In January, Fitch Ratings said that the Russian economy in 2014 will contract by 4% in 2015, at an average of $70/barrel oil price in 2015, vs. a previous estimate of 1.5% recession. Throughout 2014, geopolitical crisis, weak oil and ruble volatility have placed Russia’s GDP growth expectations for 2014 in the range of 0%-0.7% vs. previous 2%-3%. In 2013 Russian economy expanded by 1.3% vs. the original official forecast of 3.3% growth.

Russia finishes 2014 with under $400bn reserves Central Bank of Russia (CBR) FX/gold reserves dropped by $10.4bn to finish 2014 with reserves of $388.5bn as of December 26. That is nearly a $100bn of reserves were lost in 2014 with over half of that being spent in just December during the currency volatility. FX/gold reserves had fall by only $30bn between January and the beginning of November, when the CBR gave up automatic interventions on the currency market and effectively free floated the ruble. More than half the fall in reserves came in just December ($72bn) amid extreme currency market volatility and ruble decline, due to CBR's extraordinary interventions and introduction of additional FX liquidity instruments. The $361bn of FXRs held by the Central Bank of Russia (CBR) as of December 1, is more than sufficient to cover about $130bn worth of

government, banking, and corporate external debt through 2015, says Moody's. Central Bank of Russia Reserves ($bn)

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Jan-14

Dec-14*

Total Reserves 427.08

436.267

479.379

498.649

537.618

509.595

498.926

388.500

Forex 406.205

402.778

432.948

441.162

473.11

456.447

444.149

Na

Gold 14.533

22.753

35.788

44.697

51.039

39.99

41.715

Na

Source: Central Bank of Russia (CBR) Russia will only spend $40bn of reserves in 2015 Russian investment bank Renaissance Capital predicts that Russia's international hard currency reserves will fall by only $40bn in 2015, after they dropped by $124bn in 2014. "We assume that the CBR and the government will maintain a cautious stance in reserve spending, pencilling in $345bn of reserves for the end of 2015 in our base case [that assumes an average oil prices of $60]," the bank said in a note, down from the $388bn Russia had as of January 1. That still covers nearly 18 months of Russian imports and remains a comfortable cushion. First, the CBR is likely to spend some part of reserves to support debt redemptions and the ruble, mainly done on a reversible basis (i.e. via REPO and swap deals for providing dollar liquidity). "This implies that reserves might be partially restored, as soon as sanctions are (hopefully) lifted and the CBR closes these deals," the bank said. Second, due to lower oil prices, the Ministry of Finance would probably spend some of the Reserve Fund ($89bn as of 1 December 2014) to cover budget deficit, and that the Central Bank of Russia (CBR) would sell these dollars from the Reserve Fund on the market. Rencap gives four reasons support what is a very optimistic view compared to other estimates. • the Russian economy has alternative sources to pay off external debt, apart from international reserves; • the CBR is unlikely to heavily defend the ruble as preserving reserves has become the top priority;

• the government is expected to make significant budget spending cuts, preventing a widening of a budget deficit and has already announced it will lop 10% off all spending except military; • spending from the (the other reserve fund) the National Welfare Fund (NWF, $80bn as of 1 December 2014) would not necessarily lead to a decline in Russian international reserves. "This spending is mainly ruble-denominated. At first stage, the Ministry of Finance would sell the NWF dollars to the CBR to buy rubles to spend. At the second stage, we think that the CBR might postpone the selling of these dollars on the market. Hence, we would see only a redistribution of the share that the CBR and the government own in Russian international reserves. So the scheme would be different for the Reserve Fund and NWF spending," says Rencap.

The weak ruble will fuel inflation In December, month-on-month inflation came in at 2.6% – the highest monthly rate since January 2002, when it reached 3.1%. For the full year, inflation was 11.4%. The weak ruble will fuel inflation which is expected to hit 16% year-on-year in April, before easing in the second half of the year. Imported goods account for around 44% of Russia's retail trade nad consumer inflation was already rapidly accelerating by August 2014 as the ruble slide slowly all year in 2014.

Inflation was only boosted by the ban on most food imports from Europe in August, and reached 11.4% year-on-year by the end of the year. The CBR's dramatic rate hike to 17% will not have a big impact on inflation say analysts, as inflation is now being driven primarily by the depreciation of the ruble. The CBR is expected to start cutting rates as soon as the acute stage of the financial crisis is over. VTB says key rate may be cut to 14-15% this summer and 11-12% by the end of the year. Sberbank calculates that each 10% drop in the ruble adds roughly 1.5 ppt to consumer inflation within the following 3-4 months, suggesting that inflation should continue to rise in the first quarter of 2015 before peaking at 15.9% year-on-year in April. "After that, inflation should start to ease, although there could be a small uptick in July due to the more aggressive indexation of regulated tariffs (compared to the tariff indexation in July 2014)," says Sberbank. "Provided the weather this summer will not be extreme, we expect inflation to decrease to 9.4% by the end of 2015 and to just 4.6% by the end of 2016."

Investment down, to be hit by devaluation in 2015 Capital investments fell for the second consecutive year, down 2.5% in 2014 and 0.2% in 2013. There is no prospect for fixed investment to increase this year which will also undermine growth prospects. According to Rosstat, machinery and equipment (most of which is used for investment purposes) make up about 50% of Russian imports. Since machinery and equipment account for around 40% of capital investment, a sharp contraction in investment imports could contribute around 10-12 ppt to a forecast 28.2% drop in investment in 2015 on a sharp reduction in corporate profits, prohibitively high interest rates and the uncertainty surrounding Russia's economic growth prospects, according to Sberbank. Some manufacturing segments moderately benefit from the import substitution caused by the weak ruble (food production, petrochemicals,

resins and plastics, metals and some segments in light industry and machine and equipment production), but investment-related segments (construction materials, vehicles and heavy machinery, wood processing) remain under serious pressure. Industrial production spikes in December, outlook poor Industrial production accelerated to 3.9% year-on-year growth in December and grew 1.7% last year, due to the 2.1% expansion in the manufacturing segment, which was well ahead of expectations. "The spike was apparently caused not only by the calendar effect of an additional working day, but also the strong performance across various manufacturing sectors, both investment and consumption-focused," says Dmitry Dolgin of Alfa Bank. "The December and 2014 industrial output dynamic indicates that the current situation differs from 2008, when the drop in the oil prices and pressure on the financial market translated into a sharp deterioration of the industrial output trend. That said, uncertainties regarding external demand, local oil downstream taxation this year and the expected decline in consumer demand will be risk factors for the industrial trend this year." In particular, import substitution was the major driver for development in 2H14. Output in the food industry, clothes, pulp, chemicals, metals, televisions and video monitors soared in 2014. Machinery output, meanwhile, was encouraged by Russian Railways’ investment program. Besides, the retail boom at year end helped passenger car production (up 12.7% year-on-year in December but down 9.7% for the year). Despite the good production data, cargo turnover shrank 3% year-on-year in December and declined 0.1% last year, after growing 0.6% in 2013. The construction figures were also quite weak (negative 2.7% year-on-year in December and negative 4.5% last year), due to the weak investment activity. Agricultural growth accelerated to 4.2% year-on-year in December and grew 3.7% last year. Ruble fair value undermined by lack of confidence In 2014 alone, households transferred as much as $20bn abroad, indicating a newly emerged confidence issue. Unless the government addresses the issue of trust, high net capital outflow will keep the ruble in the RUB60-70/$ range, which is weaker than its fair value.

Ruble is also under pressure in the medium term from regular capital flight and Russian companies paying off their foreign debts, which will run to $75bn-$100bn this year (see related piece). Alfa Bank estimates show that ruble elasticity with respect to oil over the past few months was approximately equal to 0.3, meaning that each 10% drop in Brent caused the ruble to depreciate 3% on average. The ruble elasticity has varied considerably over the last decade due to changes in CBR policy, but in any case, Alfa's Orlova can say with a high degree of certainty that it is currently between 0.2 and 0.4. Thus, in a more stable geopolitical situation, and in the absence of sanctions, a 57.6% decline in the price of Brent would have caused the ruble to depreciate only 16-18%, which is about in line with the recent dynamics of other floating oil currencies such as the Norwegian krone, the Mexican peso and the Nigerian naira. The remaining 27-29% of the ruble's depreciation since June 2014 can be attributed to payments on foreign debt and, to a lesser extent, the other factors mentioned above. Trade balance and current account to be positive under any oil scenario Russia's current account surplus widened to $10.5bn in the fourth quarter of 2014, up from $6.4bn in the third quarter of 2014, bringing the annual positive balance to $56.7bn ($34.1bn in 2013). The fast pace of the rubles devaluation which has crushed imports, the money earned from oil exports irrespective of the price of oil, means that Russia will run a positive trade and current account surplus in 2015 under almost any oil price scenario. Increased capital outflow stimulated depreciation of the ruble and a contraction of imports, which fell 9.8% to $308bn. So despite the almost 9% contraction in oil prices to around $100/bbl Brent (the annual average figure for 2014), which drove the decline in nominal exports (down 5.7% to $493.6bn), the trade balance actually widened to $185.6bn in 2014 versus $181.9bn in 2013. The balance of services, income payments and wages also improved last year. The 40% ruble devaluation seen in 2014 will cut imports 40-50% in 2015, meaning that the current account this year will not be less than last year’s $57bn. Given the expectations of $130-140bn in capital outflows in 2015, the current account surplus could widen to $75bn, as the volume of Russian exports (72% of which is fuel and energy products) is relatively irresponsive to exchange-rate shocks.

Real disposable incomes fall in 2014, to hit retail turnover in 2015 Real disposable incomes contracted 7.3% year-on-year in December and dropped 1% last year after growing 4% in 2013. Retail trade growth surged to 5.3% year-on-year growth in December as consumers rushed to buy durable goods due to inflation fears driven by the collapse of the ruble; non-food spending surged to 10.5% year-on-year. The sequential pace of non-food retail sales was an eye-opening 90% (SAAR), the highest on the record. This chimes with banking data, which saw a significant outflow of retail deposits in December (up to RUB800bn SA) as households hurried to purchase imported goods and hard currency amid extreme FX volatility. However, retail trade growth decelerated to 2.5% last year from 3.9% in 2013. The unemployment rate rose for the fourth consecutive month, to 5.3% in December from 5.2% in November. Russian households buy FX, send money overseas Similar to 2008, the demand for FX from the population increased and bought $34bn, up from the $25bn bought in the 2008 crisis. A material deterioration was, however, observed at the household cross-border transaction level: personal net capital transfers abroad accelerated to $5bn per quarter in 2014 vs. ~$2-3bn per quarter for the previous three years. Unlike FX cash purchases, analysts see this trend as irreversible, and persisting rumours of capital/FX controls may keep the preference for individual capital outflow high this year, too. International banks lending to Russia down by fifth in 2014 International banks lending to Russia was down in 2014 by $11bn, or 19%, to $196bn according to the Bank for International Settlements. Lending

to Ukraine was down more by $7bn in the year to the end of September, or 28%, to $17.7bn, the BIS data showed. BUDGET WRAP Russian federal budget in good shape in 2014 The Finance Ministry has reported a strong rise in budget expenditures in December, which reached R3.2 trillion. This brought the annual figure to R14.8 trillion. As annual revenues were R14.5 trillion, the balance had a deficit of R328bn, or 0.5% GDP. Meanwhile, the Finance Ministry included into the expenditures RUB1 trillion transferred in OFZ to the Deposit Insurance Agency. This money will be used by the agency to recapitalize the banking system. Currently, the transfer is in non-cash form. Banks can later use the OFZ as collateral with the CBR and thereby monetize the issuance. As a result, cash budget expenditures from this process will not appear for either end 2014 or later transactions. Cash expenditures were RUB13.8 trillion, in which case the budget ran a solid surplus of RUB672bn, or 0.9% of GDP. Interestingly, cash expenditures were 1% below the initial target so the final 2014 breakeven oil price would be at around $93/bbl Brent, or even lower, according to Sberbank's chief economist Evgeny Gavrilenkov. FinMin to cut all spending except military by 10% Russia's finance minister Anton Siluanov said all budget spending will be cut by 10%, except for military in 2015. He also noted that this should be coupled with harder optimization efforts in order not to “burn” the sovereign reserve funds. Should such spending cuts and optimization be implemented, the federal budget deficit in 2015 is not going to exceed 2%-3% of GDP, Siluanov estimated. This is higher then the most recent forecasts by the Central Bank of Russia (CBR) that in December expected a 1.3% deficit for 2015 vs. 0.6% actually budgeted. The non-oil and gas budget deficit was forecast at 9.7% of GDP. For 2014 the federal budget deficit is estimated at 0.4% of GDP, but was going to double to 0.8% due to non-cash RUB1 trillion support to the banking sector. Siluanov did not specify on which oil price his budget deficit forecast is based, but he did note separately that at an oil price of $50/barrel the

budget will lose about RUB3 trillion. He also said that spending of the intra-budgetary Reserve Fund will exceed the planned RUB500bn, but the RUB4.95 trillion fund should not be spent in one and a half years.

Infrastructure Russia urged to spend on infrastructure but multiplier effect open to question This is a bean counter crisis in Russia. There have been no significant bankruptcies, no bank runs, no defaults, debt remains low and the budget is still in the black. The main victims so far have been tourist agencies as Russians en masse cancel their now increasingly expensive foreign trips. Rather than dealing with a firestorm, the challenge the Russian government faces is what to spend its (albeit smaller) surplus on to help drag the economy out of recession this year and maybe next. Infrastructure! ratings agency Standard & Poor's answered in a report released on January 13. One of the quirks of the Russian budget is that because the government prices spending in rubles but earns about half a trillion dollars a year in dollars from oil taxes, the state is one of the biggest beneficiaries of devaluation. And there is no better place to spend that money than on roads, railways and airports to lift a spluttering economy, according to John Maynard Keynes in his now

legendary book, “The General Theory of Employment, Interest and Money”, published in 1936 during the Great Depression. “Thus public works even of doubtful utility may pay for themselves over and over again at a time of severe unemployment, if only from the diminished cost of relief expenditure,” Keynes wrote. The US might have had its economic forecast upgraded by the World Bank on the same day as the S&P report came out to 3.2% from 3.0%, but global growth is now predicted to expand by just 3% this year and 3.3% in 2016, after predicting in June growth of 3.4% and 3.5%, respectively. "With global infrastructure investment needs now in the tens of trillions of dollars – figures that are essentially incomprehensible to most of us – it's easy to see the problem as insurmountable. The result is that too often, we forget that even a relatively small increase in spending on infrastructure can yield outsized returns – especially if investments are executed in a wise, targeted way," S&P said in the introduction to its report, “Global Infrastructure Investment: Timing Is Everything (And Now Is The Time)”.

Panama effect The reasons infrastructure spending helps are two-fold. First is the relief it brings in the short run by boosting aggregate demand (economic output), putting pay in pockets and chickens in pots. Second, in the longer run infrastructure is an economic multiplier: S&P estimated that each dollar spent on infrastructure in the Eurozone will produce $1.4 worth of economic growth in the following three years. A study by International Monetary Fund economists last year came to a similar conclusion: a one%age point increase in infrastructure spending leads to a 0.4% boost to output in the first year and a 1.5% increase four years out. For a country like Russia that is facing a deep recession – estimates vary from Fitch Ratings's forecast of 2.9% to senior fellow at the Peterson Institute for International Economics Anders Aslund's estimate of an 8-10% contraction – the effect of infrastructure spending would be even more dramatic. Following several generations of underinvestment in infrastructure, simply improving transport could produce the kind of effect that the Panama Canal had on international shipping when it opened. And as luck would have it Russia plans to massively increase infrastructure spending; prior to the 2008 crisis, the Kremlin rolled out a $1 trillion infrastructure investment programme. Since the 2008 crisis, this number has been greatly reduced; on January 15 the

Kremlin said it would cut all spending, except defence, by 10%. But the government continues to talk about pumping hundreds of billions of dollars into infrastructure and is working on issuing infrastructure bonds to finance it. Low multiplier A glaring omission from the S&P report is any mention of what happens if Russia spends on infrastructure. Despite discussing Russia's BRIC peers, S&P gives no estimate for Russia's multiplier effect. Given S&P estimated the multiplier for the other members of the BRIC quartet at between 2.0 and 2.5 times, Russia presumably has a similar number. But omitting estimates of Russia's multiplier perhaps has something to do with the size of it being a contentious subject. In their book, “Russia After The Global Economic Crisis”, Aslund, self-exiled top Russian economist Sergei Guriev and fellow of the Centre for Strategic and International Studies Andrew Kuchins wrote: "Most recent detailed studies put the size of the multiplier at 1, ie. GDP increases only by a dollar in response to a dollar increase in government expenditures." The problem is that all the benefit is eaten up by corruption and accrues to the oligarch lucky enough to win the contract, rather than to the economy as a whole. Russia is not alone in this problem; consultants McKinsey & Co. estimated in 2013 that even in the developed world infrastructure projects could generally be completed at two-thirds of current

costs if they are evaluated, planned and executed more carefully. However, in a worrying sign that nothing has changed in Russia, on January 14 the Kremlin announced that the winner of a tender worth billions of dollars to build the Kerch bridge to link mainland Russia with the newly annexed Crimea peninsula was Russian President Vladimir Putin's former judo partner and the billionaire Kremlin insider Arkady Rotenberg. Examples of demonstrably expensive infrastructure investments in Russia abound. "As we argued earlier, it is better to withdraw subsidies from inefficient enterprises and spend these funds for direct support of Russians suffering from the crisis," the academics argue in their book. Will Russia's infrastructure spending make a positive difference? Now we will find out. The Kremlin has no choice but to make reforms and reduce corruption if it is to avoid a Latin American-style decade of stagnation. Long-term Russia watchers are hoping that Putin will replace Russian Prime Minister Dmitry Medvedev with the well-respected former finance minister Alexei Kudrin to oversee the process. But more likely Putin will simply hunker down and spin out Russia's cash reserves for as long as he can. Keynes himself foresaw the essence of this problem: “The difficulty lies, not in the new ideas, but in escaping from the old ones,

which ramify, for those brought up as most of us have been, into every corner of our minds." The future is probably not as bleak as Russia hawks like Aslund make out, as the Kremlin has already taken its first faltering steps towards cracking down on corruption and begun the process of making structural reforms. Medvedev, speaking at the Gaidar forum on January 15, stated: "Russia needs to completely transform its economic model." Keynes argued that ultimately it is hard to get the infrastructure spending completely wrong because ordinary people aspire to a better life and will find a way to cope, even if it takes time. "This [Great Depression] is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life… and will soon learn to afford a standard higher still. We were not previously deceived. But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time," Keynes wrote in the “Nation and Athenaeum” published in 1930.

Russian port turnover growth slows on falling oil exports Turnover at Russian seaports grew 5.7% year-on-year in 2014. According to the Association of Trade Sea Ports (ASOP), throughput at Russian ports grew 5.7% year-on-year to 623mn tons in 2014.

Coal turnover rose 15.1% year-on-year to 116mn tons, Oil product turnover grew 14.5% year-on-year to 128mn tons, Fertilizer turnover increased 13.7% year-on-year to 15mn tons, Ferrous metal turnover grew 5.9% year-on-year to 23mn tons Grain turnover grew nearly 62% year-on-year to 30mn tons.

However, oil (the largest cargo type by tonnage) turnover dropped 9.8% year-on-year to 187mn tons and container turnover declined 1.3% year-on-year to 5.2mn TEU in 2014. Turnover kept growing in December, up 3.0% year-on-year, driven mainly by coal and oil

products. However, transloading of crude oil at Russian seaports continued to decline due to flat oil production and increased production of oil products. Due to shrinking domestic demand, container turnover was also under pressure, down 6.3% year-on-year to 419,000 TEU in December.

Russia and China to launch $13bn joint long-range passenger aircraft project Russia and China may invest $13bn into a joint long-range passenger aircraft project, the president of Russia's United Aircraft Corporation (UAC) told journalists Thursday, Sputnik reported.

According to Yury Slusar, the jumbo jet will be built in cooperation with the Commercial Aircraft Corporation of China (Comac) and financed by the two sides on an equal basis. A working group established earlier is expected to prepare the aircraft's preliminary design this year, the UAC head noted.

Slusar said the plane will undergo its first test flight in 2021 and is expected to go into production in 2025. China to Build $242bn Railway to Russia China plans to build a 7,000km high-speed rail line from Moscow to Beijing at a cost of 1.5 trillion yuan ($242bn) as Russia works to boost ties with its eastern neighbour amid Western sanctions, news agency Bloomberg reported Thursday. The proposed route would take passengers from China's capital to Moscow via Kazakhstan in just two days, Beijing's city government said in a social media post. The current rail route between Moscow and Beijing takes about a week and requires several transfers. Aeroflot and SCA sign agreement for additional 20 SSJ-100s Aeroflot and Sukhoi Civil Aircraft (SCA) have signed an agreement for an additional 20 of the latest Sukhoi Superjet 100 aircraft. Aeroflot will receive the additional SSJ-100s in full specification, able to accommodate 87 passengers in a spacious dual-class configuration (12 seats in business and 75 in economy) and with a flight range of 2,400 km. The new aircraft will fly on short-haul domestic routes operated by Aeroflot Group subsidiaries, where

the Superjet 100 has already proved highly effective. Aeroflot Group’s domestic traffic increased 23.6% year-on-year in November 2014. The new aircraft are expected to make a significant contribution to the Group’s future growth. Turkish Stream construction first phase ready in 2016 but capex is a concern Gazprom says the first phase of Turkish Stream will be ready by the end of next year. The first line of the new pipeline, with capacity of 15.75bcm, might be finished in December 2016. Altogether, the company plans four lines with total capacity of 63bcm. Bankers worry where the money is going to come from to pay for the construction. Also while the first 16bcm of gas will be easy to sell, the eventual additional 57bcm of gas will be tougher to place. Turkey might participate in the construction of the onshore part of the proposed pipeline. The cost of construction of the offshore part is EUR10-12mn/km ($11.2-13.5mn) or $10-12bn for the entire offshore part. Gazprom CEO Alexei Miller met with Turkey’s Energy Minister Taner Yildyz in Ankara, where Miller stated that Gazprom intends to finance the construction of the 660km undersea part with its own funds, while Turkey’s Botas will assist in laying the 250km onshore section of Turkish Stream.

Gazprom is looking to cease gas transit via Ukraine in 2020, when its contract with Naftogaz expires.

ECM Moscow stock prices tanked last year The Moscow Exchange’s RTS index fell 43 % last year from a high of 1,388 points to 791 points. The steepest drop came in December on the sharp drop in crude oil prices, even if the index has recovered somewhat thereafter. The Moscow Exchange last year was among the poorest performing emerging market stock exchanges. The RTS Index has not seen such lows since spring 2009. Russia and all EM squeezed through the holidays Russia continued to suffer outflows throughout the holiday lull but in relative terms, the first three weeks of January saw a deceleration in outflow growth. EM funds in general continue to be squeezed versus injections for DM. All EM funds also saw net redemptions in the past three weeks, totaling $6.1bn (0.15% of AUM). Over one year, all EM funds have seen 3.2% of AUM withdrawn, or $24.4bn. Meanwhile, EPFR Global press releases indicate

that DM funds saw inflows during the period. Turkey remains the only market in BRICST to be lagging Russia in one-year terms as a%age of AUM, though its decline has been cut from 7.8% three weeks ago to 5.1% in the most recent data. Overall, Russia’s performance can be said to have been better than that of emerging markets combined in the past three weeks. However, market closures and low volumes, and the drop in Brent, suggest the outperformance is less likely to be the result of some kind of trough in withdrawals than due to a lack of attention and liquidity. In terms of 2014 as a whole, all EM funds saw 3.1% of AUM withdrawn ($24.0bn), while Russia redemptions were 3.8% ($2.0bn). Food Retail stocks a winner from crisis in 2015 Food inflation peaking in 2015, slower wage growth and declining retail lending should cause food retail sales to drop 2.4% in real terms this year, but revenues are set to soar and devaluation deliver

several re-rating benefits to their shares. Sales growth should be supported by traffic gains from smaller chains, while procurement scale will push margins to new highs and prohibitive borrowing rates will ease competition for new locations. Sberbank predicts aggregate revenues increasing 26% in 2015, boosting EBITDA 30% in ruble terms.

Valuations are also very attractive. The sector market cap slid 33% in 2014 (amid 40% ruble depreciation) and is now trading at a 2016E EV/EBITDA of 7.4, implying a 30% discount to EM peers, versus 15% a year ago. Provided no further major depreciation hits the ruble, the sector’s performance will be driven by multiples re-rate and earnings growth (at a 21% CAGR starting from 2016, versus 10% for EM peers).

Government ready to transfer 23.9% of Bashneft to local government The Republic of Bashkortostan has asked to receive the shares in Bashneft expropriated from Sistema and the Bureau of Federal Property Management is ready to hold 50% plus one share of Bashneft and transfer 23.9% to the Republic of Bashkortostan, Vedomosti reports. The shareholder’s agreement has been prepared by the federal government, as was done with Sakha-Yakutia in regards to the Alrosa case.

At this point it is impossible to evaluate the effect the transfer would have on the company’s financials. But it is a positive sign the intention of the regional government to finance the budget from dividends, but the decision-making process might become more complicated, and hence less efficient. A sale of a stake to Bashkortostan may trigger a buyout offer to minority shareholders, although it seems the republic wants to receive the asset gratis. Anyway, if the minorities are not forcibly parted from their shares by then (still a remote possibility), the

question for them is whether they are better off with the Federal Property Fund or the regional authorities at the helm. The problem with having the company run out of Ufa is that there will be a temptation to make

it serve all kinds of local needs – such as build up another bloated a services unit or start constructing a refinery in order to generate jobs. Tatneft's experience is instructive here.

DCM Russian distressed bonds up tenfold as sanctions bite One in five global bonds in distress currently are Russian with yields at least 1,000 basis points above Treasuries as of January 16, up from about five notes on December 1, according to Bloomberg. The biggest contributors were lenders OAO VTB Bank and Vnesheconombank, both under US and European Union sanctions. Russian companies are struggling after they were cut off from foreign capital and the central bank tripled interest rates to 17% in December, before reducing it to 15% in January. State-run VTB and Vnesheconombank account for about 43% of Russia’s $44 billion of distressed debt

Russia’s foreign debt declines by $80bn in the fourth quarter of 2014 The Central Bank says Russia’s total foreign debt declined from $679bn to $599bn over the fourth quarter of 2014. This has extended the deleveraging trend set in the third quarter of 2014 (debt was $732bn on July 1). Over the last six months, Russia’s foreign debt has dropped by $133bn, estimates Sberbank CIB. The bulk of the reduction last quarter was again due to currency revaluations, as the ruble lost 31% of its value against the dollar, and the euro depreciated 4%. With 23% of debt denominated in rubles and 10% in euros as of end the third quarter of 2014, currency adjustment reduced the dollar debt value by $51bn, most of this coming from the ruble side. As a result, the ruble share in total foreign debt slid to 17% as of January 1. This was mainly offset

by the dollar share rising from 63% to 68%, estimates Sberbank CIB. As of January 1 Russia’s foreign debt remains well covered. Stripping out the ruble part ($106bn) and inter-company debt ($131bn) leaves $363bn, versus $386bn in CBR reserves, putting the coverage ratio above 1. China's leading credit rating agency upgrades Gazprom to AAA China's leading credit rating agency upgraded state-owned Gazprom's long-term credit outlook to AAA for both local and foreign currencies with stable outlook. "The ratings reflect Gazprom's extremely strong wealth creation capability, and the very low degree of deviation between its available repayment sources and wealth creation capability. Quite a few of Gazprom's core indicators are among the best in global integrated oil and gas industry," the Dagong Global rating agency said in a press release on February 2. Dagong said that the sanctions imposed by the West on Russia over have had little affect on the company which continues to earn hard currency from the export of gas and can meet its debt obligations from its cashflow. "The sanctions imposed by the US and EU as well as the short-run deterioration of the Russian economy impose little impact on the repayment capacity of Gazprom. The local currency

repayment capacity and foreign currency repayment capacity are both extremely strong," Dagong said in its press release. Rosneft places second ruble bond issue Rosneft placed a RUB400bn of ruble bonds on January 28, setting the coupon rate at 11.9%, which is considerably below market value. This is the second bond issue in as many months. In December the company raised over RUB625bn ($11bn) with a domestic issue that some say caused the ruble to collapse because if sucked so much money out of the market. VTB is speculated to be the buyer of the bond. Rosneft would clearly like to refinance its mostly foreign-currency debt with ruble debt, as the company has taken a heavy hit since the massive ruble devaluation in 2014, with the related FX loss dragging down its bottom line. The company needs to repay $7.1bn by February 13 and a total of $19.5bn in 2015, it would prefer to retain its foreign-currency cash for debt repayment purposes (especially since it must now sell part of its foreign currency revenues to the market) while borrowing in rubles to cover tax payments (MET, VAT and excise taxes were due yesterday), as well as to cover some operating expenses.

Although ruble debt ends up being more expensive than Rosneft’s foreign debt portfolio (mostly raised to finance the TNK-BP acquisition), converting foreign currency debt into rubles within the

context of sanctions and very unstable ruble would allow the company to protect its bottom line from enormous paper losses as in 2014.

Sectors Russia’s gas output tumbles in 2014, as Gazprom produces 100 year production lows Russia’s gas output dropped 4% in the year as Gazprom saw its production squeezed by a reduction in exports, stagnant domestic demand and continued output growth from independent producers. Deliveries to non-FSU customers dropped at least 14 bcm in a year that was bookended by two relatively warm winters. Gazprom lost another 12 bcm in sales to Ukraine, which accounted for almost the entire drop in deliveries to the FSU.

Domestic gas consumption seems to have eased by roughly 1-2 bcm, to about 346 bcm (full numbers are not out yet), and this accounts for the 28 bcm of output reductions for Russia as a whole. Gazprom’s own number tumbled by 44 bcm to its lowest level this century, as independent producers of natural gas, foremost among them Novatek affiliates SeverEnergia and Nortgas, injected an extra 16 bcm into the system. The independents should do one better in 2015, adding at least 20 bcm of production, with almost all of that growth coming from SeverEnergia.

Russia sets oil output record ahead of uncertain 2015 Russia set a new record oil production producing in December with the strongest monthly increase in the year bringing production to 10.6 million barrels a day – a record and making Russia the biggest oil producer in the world. The currency crisis may lead to Russia's oil production falling by 1mn, Deputy Prime Minister Arkady Dvorkovich said at Davos. Russia has no plans to cut production to support the price. "If the oil [price] stays at $50 for a long time, of course some projects will become less attractive and a small output decline may start. But we will not cut production on purpose," Dvorkovich told Reuters. "We could lose at maximum a 10th of output but more likely 300,000-400,000 bpd. There are no grounds for a bigger decline," he said on the sidelines of the World Economic Forum in Davos. The crisis is already hitting the major producers, the combined output of which dropped fell in the

same month by 5 kbpd month-on-month. The surge in the overall production almost singlehandedly the work of SeverEnergia. The near-simultaneous launch of the first and second stages of the company’s condensate-rich Urengoiskoye field boosted the country’s output by over 30 kbpd. Next year, SeverEnergia’s liquids output should grow by over 100 kbpd. In the year as a whole, Rosneft posted the greatest drop in output among the major producers. Lukoil’s numbers, however, were skewed by the Samara-Nafta acquisition about halfway through last year; without that, its output would have declined at a similar rate as Rosneft’s, as its South Khylchuyuskoye field is heading toward extinction. Lukoil is now contemplating cutting drilling by as much as 20% in 2015, or as much as it did in 2009. The clear production growth champion last year was Bashneft. Its Burneftegaz acquisition aside, the company still posted output growth of over 5%, or about 1mn tonnes, largely on the back of the Trebs and Titov development.

Falling oil price bring lower export duties As oil prices plunge, the silver lining for Russia's oil producers is they are also dragging down oil duties that could lead to some companies to boost sales and new fields to have no duties on export at all. Russia's oil export duty is expected to fall to $112.9 per ton in February after lower oil prices and changes in tax laws, a move that will spur sales abroad. There could also be a zero export rate for oil produced at newer fields in eastern Siberia and fields operated by LUKoil in the Caspian Sea, according to the Finance Ministry. Russian car sales to crash in 2015 Sales of cars in Russia will crash by about 25% in 2015, says the closely watched forecast from the Russia-based Association of European Businesses (AEB), but the fall will not be as big as in 2009 when they halved.

Car sales recovered somewhat in 2014 after the Russian government restarted its cash for clunkers scheme, subsiding loans on new car purchases if buyers traded in an old car. Russian car and light commercial vehicles (LCV) sales rose 2.4% year-on-year to 270,653 units in December, reports VTB Capital, but that still lead to an over all fall in sales of 10.3% or 2.5mn units in 2014, according to AEB. The December uptick was driven by the rapid devaluation of the ruble as Russians scrambled to convert their free cash into some sort of fixed asset that would hold its value in a time of crisis, but could be easily sold again when things calmed. The boost in sales from the devaluation effect is expected to evaporate as soon as this month. "The auto market is sliding into a double-digit decline [in 2015], in our view," VTB Capital analysts said in a note released on January 15.

Car producers have done their best to catch up with the falling ruble value and have introduced significant ruble-denominated price hikes in the last few weeks that will only add to the downward momentum in sales. "The first quarter of 2015 will be especially challenging given that it will take time for consumers to get used to new price levels along with the unfavourable base effect (first quarter of 2014 was relatively strong) and the pull-forward demand in late 2014. According to AEB, Russia's car and LCV sales will fall 24% to 1.89mn in 2015, while our forecast implies a 15% drop to 2.1mn," VTB Capital said in its note. Russia's flagship brand, the Lada, made by AvtoVAZ did worse than the rest of the sector in 2014, despite being a big beneficiary of the cash-for-clunkers scheme. Sales of Ladas fell 9% year-on-year to 35,315 units in December and 15% to 387,307 units in 2014. Russian consumers are now almost entirely focused on foreign brands after a decade of income growth and easy access to credit. However, as Russia's premier Russian brand with 81% of its components made locally, AvtoVAZ is well positioned to outperform in 2015, say analysts, as it will be much less affected by the devaluation than its competitors. Under the new investment deal for duties reduction struck at the start of last year, most of the foreign manufacturers with factories in Russia still import some 40% of their parts from abroad. Moreover,

Avtovaz, which is now owned by the Renault-Nissan joint venture, is planning to launch a new model, the Lada Vesta, in the autumn of 2015. Real estate market results in 2014 Last year was tough for the Russian real estate market as annual investment volume reached $3.5bn, according to JLL analysts’ calculations down 57% year-on-year. This number reflects particularly weak Q4 investment volume of $609m; a decreased of 81% year-on-year. The market moved in line with the macroeconomic environment driven by a weaker oil price and a higher cost of debt. According to preliminary estimations of JLL analysts, investment volumes into the Russian real estate market will not exceed $3.0bn in 2015, which would be the lowest level for the last 10 years. During this year the investment market will be driven by the availability of financing, so the influence of this factor will be constraining in nature. Therefore we predict an increase of acquisitions with the use of equity. Market uncertainty, especially the high volatility of ruble exchange rate, will be a constraint for real estate investment deals, according to JLL experts’ opinion. Since the commercial real estate cycle requires a good understanding of future prospects, potential buyers need stability, and are unwilling to

take on risk by buying in a declining market. Prime yields continued to react to the current market situation. In Q4, rates in Moscow for prime assets with operating income and debt in place both nominated in foreign currency increased by 50bps to 10.0% and 10.25% for offices and shopping centres respectively. For warehouses rates are at 11.75%. According to JLL analysts’ expectations, more expensive and unavailable debt financing will likely lead to further capitalization rate increase through 2015. In 2014 foreigners invested $830m in Russian real estate market, down 78% year-on-year. The main reason of such a decline is the closure of large deals in 2013 (for example, Metropolis SC). The share of foreign investors decreased to 24% in 2014 compared to 45% in 2013. According to JLL analysts’ estimates, local players will continue to dominate on the Russian market in 2015, and the share of foreign capital will not exceed 20%. JLL experts expect office assets to be in most demand – the share of office deals could reach 50-70% of total transactions volume, compared to 77% in 2009. The share of retail deals could reach 15-20% (13% in 2009). The rest will be distributed among warehouses, hotels, multifunctional centres and residential. During the current period of uncertainty Moscow assets

continued to be the most attractive for investors, accounting for 82% of total investment volume in 2014 compared to 84% in 2013. The share for St. Petersburg accounted for 9% in 2014 (vs 6% in 2013), Russian regions attracted 9%. JLL analysts expect this trend to continue – investor interest will be focused on the most stable Moscow assets. Asian investors make up tenth of Russia's commercial real estate Asian investors now account for a tenth of all investment into Moscow's commercial real estate sector investing $8.1bn in in 2013 and $8.8bn in 2012, according to real estate consultancies Cushman & Wakefield and Jones Lang LaSalle, from nowhere in 2010. At the same time investors from Europe and the US are withdrawing. European capital accounted for just 9% of total investment last year, down from 29% in 2013. Meanwhile Russian investors' share rose from 71% in 2013 to 81% in 2014. Russia's biggest oilfield services deal sees Schlumberger pay $1.7bn for stake in Eurasia Drilling Leading global oilfield services provider Schlumberger will acquire a 45.65% stake in its largest Russian counterpart, Eurasia Drilling Company, the US company announced on January 20. Schlumberger said it would pay $22 per share, bringing the total

cost of the acquisition to approximately $1.7bn, and there is a call option for Schlumberger to buy out the company entirely within three years. The acquisition is Russia's biggest ever oilfield services deal and comes despite the backdrop of collapsing oil prices and Western sanctions against Russia, including those on the oil industry. Eurasia Drilling's GDRs on the London Stock Exchange surged by 70% on publication of the news, to $20 from the closing of $12 on January 19, though still well down from the $42 they were trading at in January 2014. “The agreement extends the successful long-term relationship enjoyed by the two companies within the strategic alliance signed in 2011, which has enabled deployment of a range of drilling and well engineering services to customers in the Russia land conventional drilling market,” Schlumberger said in a statement. Some observers in Moscow suspect that Rosneft CEO Igor Sechin has his fingers in this particular pie. Russia slashes meat import as domestic production soars Russia slashed its meat imports by a quarter in 2014 as domestic production soared to fill the gap created by the collapse of the ruble. Russia’s Federal Customs Service said domestic meat import from non-CIS states by 25% between

January and November 2014, while imports from CIS states was up 13% in the same period. Domestic production rose by a whopping 6%, particularly the production of pork. These numbers exclude trade in meat with Belarus and Kazakhstan, which are now part of the Eurasian Economic Union (EEU) and have open borders with Russia. Russia also had a bumper harvest, bringing in a record 105.3mn tonnes of grain in 2014, Agriculture Minister Nikolai Fyodorov said in January. Poultry purchases from non-CIS states plummeted by 15.7%, butter — 8.5% down, cheese and curd — 34.5% down over the same period. Domestic cheese output rose by 14.1% in 2014 as a whole, poultry product output hiked by 7.8%, sunflower oil — by 21.5% up and sugar — 6.5% up. Fish production dropped by four%, flour — 1.6% down and milk — 1% down, according to official numbers. The Russian government has committed RUB185bn, or just under $3bn, to promote the development of the agricultural sector in 2015, according to Russian Prime Minister Dmitry Medvedev