Russia: The Investment Case

1
April 2004
Russia The Investment Case
Critical Transition Period
Chris Weafer Chief Strategist Alfa Bank, Moscow
2
Putins three-phase strategy

Putin has been very consistent in setting out his
goals. The long-term goals are doubling of
GDP within ten years diversified growth
drivers in the economy broad-based wealth
distribution The evidence suggests it is pursuing
a three-phase approach 2000-2003 stabilizing
the economy and political reorganisation 2003-200
4 clampdown on media,the oligarchs and
parliament 2004-2008 delivery especially on
economic goals
3
Roughly where it wants to be today

Preparation phase (2000 2003) stabilized the
situation from the crisis period rebuilt fiscal
reserves now has complete control of economic
policy from the Oligarchs restored domestic
confidence country has greater international
credibility government now has a very reliable
support base in the legislature long-term
economic goals have been clarified
Entering its second term, Putins government is
able to set out realistic economic objectives
with confidence it has a high level of necessary
support and funding to see them progressed.
4
Focused on change
Growth over the past five years has come from a
combination of high export earnings from natural
resources and the capital investment made in
these industries. Government now wants to
prioritise investment into the industrial sectors
in the hope that future economic growth will come
from a mixture of natural resources and rising
domestic consumption. The state intends to adopt
a more interventionist role by means of
industrial policies and budgetary measures to
shift growth emphasis and financial resources
from the natural resource industries to other
sectors.

A high risk strategy that involves deliberate
capping of growth in the most successful part of
the economy to try and stimulate growth in the
lagging sectors.
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Mechanism for change
Budget Raising the federal budget tax take by
3 bln annually or raising the States profit
share to 80 (from 50 currently) Industrial
policies Creating growth incentives for Small
Mid-sized Enterprises (SMEs) is one of the
stated key objectives Reforms The main priority
is administrative reform, further simplification
of taxation, and the fight against corruption
Targeting Russian investors Russian business
and individuals have about 250 bln in off-shore
accounts (years of accumulated capital flight).
Attracting that back is a higher priority than
FDI over the next two years.

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Sustainable or speculative growth?
To be successful Ability to legislate
efficiently and speedily Budget changes and
industrial policies that are realistic and instil
confidence (in Russian business and owners of
250 bln of accumulated capital
flight) Extraordinary success in reducing
bureaucracy and fighting corruption Preserving
the attractive investment climate that Putin has
regularly referred to, and maintaining the
alignment of interests inside government and
between government and business Establishing a
favorable monetary environment that supports
growth in the domestic industries Reducing the
grey economy (est. at 40 of total)
If not, then the steady build-up of liquidity
will instead increasingly go to speculative areas
of the economy, and the next inevitable crisis
will be similar to that of Southeast Asia in 1997.
7
Moscow Center back in charge
United Russia party controls legislative agenda
and has chairman and deputy chairman roles in all
Duma committees Government-aligned parties now
have a 75 share of Duma votes Big business now
fully aware of its supporting rather than
dictating role
Pyramid of Power (2000)
Pyramid of Power (2004)
The only question for investors is whether
the government will continue trying to persuade
inward investment or increasingly rely on a
Sword of Damocles approach
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Reform agenda

The reform agenda for the next government (as
stated by German Gref) is
Administrative To reduce bureaucratic
interference in business and cut corruption
(costs business over 30 bln p.a. 10 of
GDP and 80 is at the municipal and
regional government level) Broad economic
structural reforms To push for core economic
objective of broadening the economy and
creating wealth distribution Stimulate growth
in SMEs Legal and judicial system Education and
communal housing Financial infrastructure
(banks) Now delayed again and with Sberbank
likely to be exempted until 2009hence
unlikely to work Military reforms WTO
accession Wealth creation and distribution
.
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Investment case...now shifting

Was based on cheap assets getting less cheap as
investment risk declined Investment risk declined
as economy was bolstered by high export revenues,
growth in investment in natural resources, and
rising investor confidence Large corporations
moved out of the restructuring phase (associated
with high corporate governance risk) to business
development phase Internationalization of Russia
- both corporate and political During this period
(from late 1998) equity and debt prices have
risen by over 1,300
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Investment case going forward

Strong and unified central control that allows
for a successful implementation of mechanisms
designed to achieve economic goals Backing
investment in domestic industries will expand
investment opportunities in these industries and
will sustain higher earnings growth that will, in
turn, justify higher valuations Preservation of
the attractive investment climate (and all that
this implies as regards, e.g. legal protections)
continues to boost liquidity as investment risk
perception remains low Final upgrade to
investment grade in mid-2004 and the start of
sovereign debt restructuring in the latter half
of 2004 Commitment to WTO entry in late 2005
(albeit long compliance grace period) Continued
internationalization of Russias biggest
businesses (and JVs inside Russia) Global
investment themes continue to focus on emerging
markets and commodities i.e. steady inflows
into portfolios investing in these areas. High
level of investment liquidity (including
domestic) in Russia and continuing small
free-float boosting equity valuations beyond
current condition fair values.
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Problems

Bureaucracy This is acknowledged as one of the
major problems to be tackled. The appointment of
Fradkov as the new Prime Minister, and the
restructuring of government, underlines the fact
that this is one of Putins priorities.
Corruption Costs small business about 35 bln
annually (10 of GDP) and is regularly cited as
the main obstacle to growth and reason for large
grey economy. Monetary policy Strength of
ruble, rising monetary base (over 30 p.a.) and
actual cost growth (much higher than official
inflation) hurt growth prospects in domestic
industries. Maintaining confidence How to
maintain consumer and investment confidence
during the transition phase especially if
there were to be an oil price correction.
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What investors are waiting for

• Structure of next government
• Putins continued commitment to creating the
  attractive investment climate that he has
  referred to in the past
• An end to the YUKOS/Menatep case especially as
  it may affect minority investor rights
• Capital flows will Russian businesses and
  investors respond by bringing capital back?
• Budget mechanism specifics on how the
  government plans to restructure the growth
  drivers in the economy
• Action on administrative reform, corruption and
  start of Gazprom reform

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Investment Case Monitor
Catastrophic Events that, if they were all to
turn negative, would destroy the investment
case over the 1-3 year review period. Critical Ev
ents or assumptions that are an important part of
the investment case. Cautionary Events or
factors that, while not yet critical, may
increase in importance and then have the
ability to affect the outcome of the
investment case.

• Catastrophic events Overall outlook still
  positive
• Oil price below 12 p/bbl Putins
  effectiveness terrorism in major cities
• Critical event Neutral outlook on balance
• Asset valuations bank reform progress
  elections outcome economic growth
  external shock free float of stocks on equity
  market investment climate investment
  liquidity investment grade monetary policy
  MSCI Index oil price tracking too high or
  too low for growth oligarch risk
  YUKOS/Menatep risk

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Investment Case Monitor
Based on a continuous monitoring of events that
will determine whether the assumptions supporting
our investment case in 2004 prove correct or
not. Split into three categories, with the
results of the Catastrophic and Critical events
determining the overall stance. The ICM was last
updated in mid-December (after the Duma
elections) with an overall neutral result but
with a tendency towards positive. This
indicated a medium-term favorable backdrop for
the stock and bond markets.
RTS and Investment Case Monitor Updates in 2003
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Investment themes in 2004
Domestic theme equities Second-tier stocks that
should see both earnings growth and higher
ratings if the governments economic plan
succeeds initial boost on expectation. State
involvement Companies like Gazprom and Sberbank,
which both suit the theme of economic transition
and are supported by state equity
involvement. Natural resources Portfolio
investors likely to focus on second-tier oils and
pipe manufacturers at least until uncertainties
(i.e. taxes, Menatep, oil price, etc) are
resolved. Sovereign debt No risk of default or
delayed debt service and with the probability of
extensive debt replacement issues (to reduce
annual service bill) starting in 2H04 Private
equity Into industries that are targeted for
growth under the governments economic plan.
Manufacturing, services and consumer sectors now
account for less than 4 of equity market
capitalization but 50 of GDP.

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Evolution of the economyreal GDP growth
Nobody in charge Declining production of oil, gas
and other commodities
Oil/gas volume and price growth Devaluation
benefits Productivity gains Tax reform Investment
Source State Statistics Committee
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Structure of economy
Source Goskomstat
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Economy today
Debt no longer a threat
Foreign debt now 27 of GDP (from 78 in 1999)
while net
debt is much less than 10 of GDP No longer
vulnerable to oil price Budget can balance at
17 p/bbl with minor tweaking Stabilization fund
Over 15 bln in
accumulated budget surpluses and
privatization sale proceeds (all separate from
Central Bank reserves) is now
available and growing
Healthy Forex Reserves
Positive Trade Balance
Source State Statistics Committee
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Alfa Bank - Investor Confidence Index
Constructed with the help of the New Economics
School, the AB-ICI is a leading indicator of
investor intentions in Russia and captures not
just stock market activity, but also a broad
range of economic macro trends, direct investment
and banking activity.
The Index declined a little after the start of
the Menatep investigation, but is now tracking
sideways in a holding pattern while the next
moves are awaited.
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Oil still drives growth
Economy earned 180 bln from oil export sales
over the past five years Over 50 of federal
budget tax receipts come from the oil gas sector
Underlying GDP growth and high oil effect
2000 2001 2002 2003E Reported GDP growth,
y-o-y 8.3 5.1 4.7 7.0 Oil price
effect, y-o-y 2.8 1.5 1.5
3.0 Base GDP growth 4.5 3.6
3.2 4.0
Based on 20 p/bbl oil average
Source State Statistics Committee, Alfa Bank
estimates
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Monetary policy still out of sync
Monetary policy Ruble is too
strong for domestic sectors while the CBR
struggles to control the rate of
appreciation in the face of
strong export revenue repatriation. Inflation
Official inflation rate is falling but does not
capture all costs (anecdotal evidence suggests
actual cost growth is 25 p.a.) Currency
mismatch Russia is a dollar revenue
earner (exports, budget revenues) but
increasingly exposed to the euro on the cost
side, directly (50 of imports, mainly
consumer goods) and indirectly as the public
moves to a euro base. California
disease Government is worried that budget cost
growth reflects rising annual budget revenues
from the oil gas sector. Stated aim is to
establish a more stable base of tax revenue
that does not rely on high oil and gas export
prices.
Source State Statistics Committee, Alfa Bank
estimates
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Key Numbers

1998 1999 2000 2001 2002 2003
2004F 2005F GDP bln 275 187
251 312 355 440 507
600 y-o-y, -4.9 5.4 8.3
5.1 4.7 7.0 6.5
5.0 Industrial prod. y-o-y -6.2 11.0
11.9 5.2 3.7 6.8 5.0
4.6 Fixed investment, y-o-y -12.0
5.3 17.7 8.5 2.6 12.0
6.0 4.0 Current account, bln 1.0
20.8 46.3 34.8 31.7 39.0
21.0 9.0 Trade balance, bln 17.1
35.8 60.7 49.6 45.3 55.0
43.0 35.0 Ruble/1 rate, year-end 20.7
27.1 28.1 30.1 31.8 29.3
29.0 31.0 Exchange rate, y-o-y change
245 31.0 3.7 7.1 5.7
-7.9 -1.0 6.9 CPI, change
y-o-y 84.5 36.5 20.2 18.6 15.0
12.0 10.3 12.0 CBR reserves,
bln 12.2 12.5 28.0 36.6 47.7
76.9 90.0 100.0 Foreign debt,
bln 148 145 144 135 122
119 110 99.0 of GDP
54.8 77.5 57.4 43.5 34.4
27.0 22.0 16.5 Oil Price - Brent
p/bbl 13.1 18.2 28.9 24.7
25.2 28.8 26.0 20.0
- Urals p/bbl 11.9 17.3
26.5 22.9 23.0 27.2
24.5 19.0
Source Government agencies and Alfa Bank
estimates
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Oil revenue disbursement ..in billions
2000 2001 2002 2003E 2004F Total declared
revenue 50.5 53.3 60.6 79.7 81.6 Essential
op. costs 18.7 18.9 22.7 28.2 34.6 Availabl
e Profits 31.8 34.4 37.9 51.5 47.0 .used
for.. Capex for growth 5.9 9.6 8.8 9.8 9.2
Corporate tax 3.6 3.4 3.0 3.9 4.4 Other
taxes 7.2 9.9 14.9 21.1 19.7 Dividends 1.5
3.1 2.8 5.2 3.2 Retentions
other 13.6 8.4 8.4 11.5 10.5
Source Company reports and Alfa Bank estimates
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Actual corporate tax deducted
2000 2001 2002 2003E YUKOS 12.4 15.5 12.9
12.8 LUKoil 19.3 30.9 32.3 18.1 Surgutnef
tegaz 29.9 25.1 24.0 24.0 Sibneft 10.4 9.2
12.3 16.7 Tatneft 20.7 30.5 24.9 24.0 TN
K Intl 9.8 20.6 14.3 24.0 Industry average
19.2 22.9 21.3 19.1 24.0
Source Company reports, Alfa Bank estimates
25
Oil revenue disbursement ( of Available
profits)
2000 2001 2002 2003E 2004F Available
Profits 31.8 34.4 37.9 51.5 47.0 .breaks
down.. Capex for growth 18.6 27.9 23.2 19.0
19.6 Corporate tax 11.3 9.9 7.9 7.6 9.4 Oth
er taxes 22.6 28.8 39.3 41.0 41.9 Total tax
take 34.0 38.7 47.2 48.5 51.3 Dividends 4.7
9.0 7.4 10.1 6.8 Retentions
other 42.8 24.4 22.2 22.3 22.3
Source Company reports and Alfa Bank estimates
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Stock Market Basics
Equities Capitalization at 223.3 bln for all
equities RTS 153.7 bln Ten largest stocks
account for 82 of total value
Volume activity in all equities
Last five trading days 17-02 18-02 19-02 20-02 24-
02 (all figures in US million) RTS 23 17 11
25 30 Gazprom 135 102 73 121 128 MICEX
402 368 336 305 638 ADRs
London 174 211 134 54 335 ADRs New
York 212 161 146 88 167 Note Feb. 20
was the day before a three-day weekend. On
Feb. 24 the president dismissed the
government.
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Structure of equity market (as of February 25th,
2004)
Sector weightings Total RTS Oil 46.1
64.2 Gas 21.3 0.0 Telecoms 9.4
4.5 Metals 8.8
12.3 Utilities 8.6 12.0 Financials
3.0 4.1 Consumer 1.6
1.2 Manufacturing 1.2 1.6
Largest equities Gazprom 45.3 bln YUKOS 32.4
bln LUKoil 22.9 bln Surgutneftegaz 21.2
bln Sibneft 15.7 bln Norilsk Nickel 14.8
bln UES 12.6 bln MTS 8.8 bln Sberbank 6.3
bln Severstal 4.0 bln
Source DataStream, Bloomberg, Alfa Bank data
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Ownership of market
Management 53.6 bln 24.0 Connected
insiders 42.2 bln 18.9 Total
insiders 95.8 bln 42.9 Strategic
investors 36.2 bln 16.2 Government 32.4
bln 14.5 Regional governments 1.3 bln
0.6 Free-float 57.6 bln 25.8 Total equity
market 233.3 bln 100
Free-float was over 30 at the start of 2003
Sources DataStream, RTS, FCSM filings, Alfa Bank
estimates
29
Russian oil in the global context
Russia currently accounts for 40 of global
reserves outside of OPEC and North America
Top 10 Largest Oil Reserves (bln barrels)
bln barrels of world Saudi Arabia 261.8
23.8 Iraq 112.5 10.2 UAE 97.8
8.9 Kuwait 96.5 8.8 Russia 91.0
8.2 Iran 90.0 8.1 Venezuela 77.5
7.0 United States 30.4 2.8 Libya 29.5
2.7 Mexico 27.0 2.5
Source IEA, OPEC, BP, Alfa Bank estimates
30
Russian gas in the global context
Reserves Production Exports Russia 1,680
56.7 19.1 Canada 60 17.8 10.0 Norway
77 6.3 5.9 Algeria 160 7.8
5.3 Turkmenistan 71 5.1
3.8 Netherlands 62 6.7 2.9 Malaysia
75 4.9 2.4 Qatar 508 2.8
1.8 Australia 90 3.3 1.0 Note
trillion cubic feet billion cubic feet per
day
Source BP, OPEC
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