Opportunities Abound for the Nimble Investor

Global Finance, Nov 2004 by Iskyan, Kim

RUSSIA

Russia's economy has posted some impressive results recently. Investors should beware, however, as the numbers may not tell the whole story.

Hasual readers of the business press over the past year could be forgiven for thinking there is only one major company in Prussia. The long-running soap opera of the socalled Yukos affair has so dominated headlines that it has virtually eclipsed all other news. But there's actually been a lot more to Russia recently than Mikhail Khodorkovsky and Co. As with much of Russia, the signals are confusingly contradictory and paint the picture of an economy that is, on the one hand, expanding robustly and, on the other hand, crippled by capital flight and seismic shudders in the banking sector.

Developments on the macroeconomic front continue to be resoundingly upbeat. After expanding by 7.3% in 2003-its fifth consecutive year of posting growth above 4.5%-the Russian economy is on pace to grow by at least 6% in 2004. Most estimates suggest that Russian GDP will grow by at least 5% a year through 2010. Industrial production grew by 7% last year and is on target to grow almost as much in 2004. Inflation is falling, from 12% last year, and will likely fall below 10% in 2004. Foreign reserves, at around $90 billion, have increased more than eight-fold since 1999. Russia has a current account balance of around 11 % of GDP and had a positive trade balance of some $60 billion in 2003. The Ministry of Finance reported a budget surplus equivalent to 3.4% of GDP for the first half of 2004.

Russia has strong commodities prices to thank for much of its prosperity: Roughly three-quarters of the country's exports are composed of fuel (oil and gas) and metals. But there's more to Russia's growth than oil. Growth in consumer demand and capital spending remains strong, with retail turnover jumping \ 1% and fixed investment growing 13% over the first five months of 2004, according to Russian government statistics agency Goskomstat. The nominal average dollar wage per month, according to Moscow-based investment bank Renaissance Capital, leapt from $85 in 1999 to $227 in June this year.

Meanwhile, Russian President Vladimir Putin is using some of his substantial political capital to push through a series of reforms that strip away large segments of the system of social benefits that are a carryover from the Soviet era, in favor of a more transparent and market-oriented approach. Other elements of the broad Putin reform program, such as administrative reform, power-sector reform and long-anticipated changes to the shareholding structure of government gas giant Gazprom, are moving forward, albeit slowly.

Storing Up Problems

But there are deep fissures in Russia's seemingly sturdy macroeconomic façade. Perhaps most concerning is capital flight, which threatens to undermine Putin's key achievements of stability and economic growth. Alexei Moisseev, an economist at Renaissance Capital, argues that Russian authorities are in effect encouraging capital flight. "What the Russian authorities are doing is really quite counterproductive," says Moisseev. "They're shooting themselves in the foot and potentially laying the groundwork for problems further down the road."

Confidence in domestic investment has been seriously eroded by the Yukos affair, while the Central Bank of Russia's contradictory aims of a weak ruble and low inflation are resulting in capital leaving the country. After an outflow of $3.9 billion in the first half of 2003, Moisseev estimates that $10.1 billion fled the country over the same period in 2004. That's a lot of money for a country that experienced foreign direct investment of just $1.1 billion in 2003.

The figures carry echoes of previous crises. One of the hallmarks of Russia's financial crisis in 1998 was sunny optimism on the part of foreign investors at a time when locals were running for the exits. Recent evidence suggests that foreigners again aren't as concerned about deterioration in the Russian investment environment as domestic Russian investors. Within the past few months, a few high-profile purchases-by Heineken of two Russian breweries, by European tobacco firm Altadis of a local cigarette maker and by BNP Paribas of Russia Standard Bank, for example-indicate that many foreign investors consider Russia an attractive investment destination. Perhaps most significantly, US oil major ConocoPhillips is seeking to buy up to a 25% stake in LUKoil, Russia's second-largest oil producer. Mean-while, although Russian shares are down 25% from early April 2004 all-time highs, they're still up 8% over the past year-and up more than 15-fold since all-time lows in late 1998. Unfortunately, there may be little room for upside, since, excluding key underperformersYukos and Sibneft, the Russian market is near all-time highs. And "valuations of the rest of the oils," which comprise roughly two-thirds of total market capitalization, "are far from screaming buys on either a historical or comparative basis," says Caius Rapanu, senior analyst at Nikoil investment bank. "Should LUKoil be valued close to the same EV/EBITDA level as the supermajors? I don't think so," he adds.