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Winning Moves, Winning Strategies

LOOKING DOWN THE TRACK

Understanding the ways in which the political climate and changes in Russia will impact

investors both local and foreign




Winning Moves, Winning Strategies

SPEAKER

Alexei Yazikov

Head of Research

Aton Capital




Winning Moves, Winning StrategiesWinning Moves, Winning Strategies

Oil or Nothing: Oil is the lifeblood of the Russian economy

Oil & Gas contribution to budget revenues Ave. annual net FDI as % of GDP, 1994-2010, BRIC countries ($bn)

Source: Bank of Russia, EBRD, Aton estimates

2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E0

100

200

300

400

500

0%

10%

20%

30%

40%

50%42%

47%

37%

47%

41%

48% 46% 46% 45%

Budget ($bn, LHS) O&G (% of total, RHS)Oil (% of total, RHS)

2005 2006 2007 2008 2009 2010E

2011E

2012E

2013E

0

500

1,000

1,500

2,000

2,500

3,000

0%

2%

4%

6%

8%

10%

12%10.0%

10.9%

8.7%

10.6%

7.6%8.3% 8.1% 7.8%

7.5%

GDP ($bn, LHS) O&G (% of total, RHS)Oil (% of total, RHS)

• Russia’s economy remains heavily dependent on the Oil & Gas sector – over the last six years the sector accounted for 44% of federal budget revenues and 9.4% of GDP. This leaves Russia exposed to the global economic cycle and boom-bust periods

• In 2003-08 the country experienced one of the fastest 5-yr periods of growth ever, but in 2009 it recorded one of the largest slumps in economic activity in the world. While Russia currently seems to be in good shape, the situation could quickly deteriorate as the current financial crisis escalates

• Downbeat forecasts for oil production growth in the coming years underline Russia’s economic vulnerability





• With rising budget spending on the agenda (in both the run-up to the elections and their aftermath), the fiscal deficit is likely to rise significantly

• Russia’s next president will inevitably shift his focus towards the nation’s economic performance as the main determinant of popular support

• Without deep structural reforms and modernisation, Russia’s economic prosperity will be at risk

• Reforms are therefore not dependent on the political will of the ruling elite: they are a practical necessity. Any pragmatic leader needs to accept the path of reform or face the risk of popular unrest.

What causes frustration or anxiety in your life? Unreasonably high cost of living 67Low availability of medical services 53Widespread corruption 49High level of crime 48Influx of Migrants 41Deplorable state of education system 39Moral decay of society 39Weak protection of property 36Limited career opportunities 35State of pension system 35Increasing intolerance in society 27

Absence of an independent judiciary 26

Growth of Russian nationalism, xenophobia 16

Authoritarian regime 15Restriction of media freedom 14

Source: Levada Centre, Novaya Gazeta

Structural reforms are necessary





Russia: gross and net FDI, 1994-1Q11 ($bn) Net FDI into transition economies 1994-2010 ($bn)

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

1Q11

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Net FDI Gross FDI

Total gross FDI in the period: $274bn

Net FDI – $37bn

Kyrg

yzst

anSl

oven

iaAz

erba

ijan

Arm

enia

Alba

nia

Geor

gia

Esto

nia

Latv

iaLit

huan

iaBe

laru

sTu

rkm

enist

anCr

oatia

Slov

akia

Russ

iaHu

ngar

yBu

lgar

iaUk

rain

eRo

man

iaKa

zakh

stan

Czec

h Re

pPo

land

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

Net FDI remains very weak

• FDI is vital for an economy in transition: it brings considerable benefits such as the transfer of technology and management know-how as well as potential access to export markets. FDI can help close the technology gap with developed countries. FDI has also been a major component of success for countries that have been able to diversify away from natural resource dependence (Sweden, Finland, Canada, and to some extent Australia).





Russia’s FDI is one of the lowest

Net cumulative FDI per capita 1994-1Q11 ($bn) Average annual net FDI as % of GDP, 1994-2010 ($bn)

Source: Bank of Russia, EBRDRu

ssia

Slov

enia

Bela

rus

Ukra

ine

Pola

ndLit

huan

iaRo

man

iaKi

rgizs

tan

Croa

tiaAl

bani

aHu

ngar

yLa

tvia

Slov

akia

Turk

men

istan

Esto

nia

Arm

enia

Czec

h Re

pGe

orgi

aKa

zakh

stan

Bulg

aria

Azer

baija

n

-2%

0%

2%

4%

6%

8%

10%

12%

Azer

baija

nRu

ssia

Kyrg

yzst

anSl

oven

iaBe

laru

sUk

rain

eAr

men

iaAl

bani

aGe

orgi

aTu

rkm

enist

anRo

man

iaLit

huan

iaPo

land

Latv

iaHu

ngar

yKa

zakh

stan

Slov

akia

Croa

tiaEs

toni

aBu

lgar

iaCz

ech

Rep.

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

• Political risks, poor investment climates and widespread corruption were the key contributing factors to low FDI in the region. Nevertheless, Kazakhstan and Azerbaijan have been more successful in attracting FDI with investment climates little better than Russia’s.

• Low FDI can be partly explained by the fact that most investments were geared towards domestic consumption – this differs significantly from foreign investments into EU accession countries.





FDI: Russia not a solid BRIC

Net cumulative FDI per capita 1994-1Q11, BRIC countries ($bn)

Avg. annual net FDI as % of GDP, 1994-2010, BRIC countries ($bn)

India Russia China Brazil0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

87258

830

1,566

Russia India Brazil China0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.2%

0.7%

2.1%

3.5%

Source: Bank of Russia, EBRD

• In our view, the main reason for low FDI comes down to poor corporate governance: transparency and protection of property rights are the keys to attracting FDI. While many would argue that Russia is hardly unique vs its peers in terms of weak governance, a state-dominated economy and other socio-economic issues, the figures above speak for themselves.

• In one of its reports, the OECD rightly noted that if a country wants to attract foreign investment, it needs to make its investment climate and business environment attractive for domestic players as well.





Net FDI in BRIC countries 1994-1Q11 ($bn) Annual net private capital outflow, 1994-2010 ($bn)

Source: Bank of Russia, EBRD

Russia India Brazil China0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

36,916103,226

302,631

1,113,851

-150

-100

-50

0

50

100

-14 -4-24-18-22-21-25-15 -8 -2 -9 0

41

82

-134

-57

-22-49Total Net Outflow 1994-2011

$300bn

Which side of the trade you are on?

• Capital flight remains an issue for Russia with the net total outflow amounting to over $300bn since 1994. • While portfolio investors were putting money into Russia in the first half of this year, domestic businessmen were

actively taking money out, de-facto selling their own country. This can serve as an ‘insider trading’ test for the attractiveness of Russia and poses the question to potential investors – which side of the trade do they want to be on?





• In many respects, Russia now resembles the classic business case of a large struggling company where the absence of a coherent strategy and eternal conflicts of interest between board, management committee and the remaining stakeholders lead to the lack of cooperation between divisions, inefficient use of available resources, poor corporate governance, high staff turnover and shambolic financial performance.

• While this description may be dispiriting, even small incremental changes in the way the company (country) is run can have a disproportionate effect on its investment attractiveness and hence its market capitalisation.

• Therefore, we continue to believe that the ‘upside’ for Russia’s stock remains huge and this alone justifies the risk of an investment.

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