30 August 2011

EQUITY RESEARCH STRATEGY AND ECONOMICS

MACROECONOMICS
Oil or Nothing
Macroeconomic variables and their correlation* with the oil price
Oil price correlation with: Exports Imports Budget revenues International reserves Average wage Average income Correlation coefficient 0.97 0.91 0.93 0.91 0.90 0.90

Russias economy in barrels of oil. While official data may suggest that Russias oil sector accounts for a rather small share of the economy, unless measured using tax revenue, most macroeconomic indicators exhibit a very strong correlation with the oil price. In light of Russias dependence on the latter we have evaluated certain aspects of the countrys economy in terms of barrels of oil equivalent. We conclude by outlining our revised economic forecast. On the back of a worsening global economic outlook we now expect the Russian economy to grow 3.6% this year and 4.0% in 2012. Beyond 2012 we do not see expansion above Russias potential growth rate (around 4%) with a growing budget deficit our main concern. A barrel equivalent reading provides insight into the value of production growth. While we acknowledge the limited value gained from assessing economic variables such as GDP, fixed investment, retail sales and wages in terms of barrels of oil equivalent, we nevertheless observed a telling trend: a healthy pace of growth across each variable in barrels of oil equivalent in 2000-04 vs the years both before and after that period. In 2000-04, the world oil price rose 100%, but more importantly Russia expanded crude production by 50%. While the oil price has continued to rise, output growth has almost totally stalled, hence giving some cause for concern. Budget deficit the most worrying feature. Our barrel of oil equivalent approach reveals an even more pronounced impact when we examine the budget. Looking forward, using our oil analysts average price forecast of $102/bbl in 2011 and $89/bbl from 2012 implies a widening in the deficit in the coming years. Expressed as a percentage of GDP, we estimate the deficit may expand from 0.7% in 2011 to 4.1% in 2015. Alternatively, expressed in terms of barrels of oil, under these assumptions the deficit rises from 128.6mn barrels in 2011 to 1.3bn barrels in 2015. Downbeat forecast for oil production growth emphasises economic vulnerability. One solution would be to produce and export more oil (which we acknowledge would require growth in global oil demand in order to be oil-price supportive). However, according to our oil teams assessment, Russias crude oil production growth prospects for the forecast period are not encouraging. We estimate that under our production growth forecast for 2011-13, around 3% of the deficit (expressed in barrels of oil) would be covered, while for 2014-15 our projection implies that crude oil output growth would cover just 1.5% of the deficit. A different approach is to set the expected deficit in barrels of oil equivalent against expected aggregate oil production. Using the same oil price and output assumptions outlined above, we calculate that this year the deficit in barrels of oil would be equal to 3.5% of total oil production. For next year the deficit would jump to 11% and then to over 20% in 2013 and more than 30% of total barrels of oil produced by 2015. Our estimates suggest that Russia remains extraordinarily vulnerable to the oil price and the lack of growth in oil output is aggravating the situation.

Retail sales 0.89 *Correlation based on monthly data for Jan 2001 July 2011 (June 2011 for exports and imports) Source: Rosstat, Ministry of Finance, CBR

Budget deficit in bbls of oil as a percentage of the total number of barrels of crude oil produced

Source: Ministry of Finance, Bloomberg, Aton estimates

Fiscal deficit coverage provided by growth in oil production (%)

Source: Ministry of Finance, Bloomberg, Aton estimates PETER WESTIN +7 (495) 213 03 41 peter.westin@aton.ru ANDREW RISK +7 (495) 777 6677 (ext. 2641) andrew.risk@aton.ru SERGEY KOLOKOLOV +7 (495) 777 6677 (ext. 2671) sergey.kolokolov@aton.ru For professional investors only. This document has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Please refer to important disclosures and analyst certification at the end of this document

Oil or Nothing
With Russias economy so heavily dependent on oil, global crude prices remain the most important variable for forecasting. In simple terms, if you get the oil price right, you are likely to come pretty close to getting your economic forecast right, too.

Putting Oil in Context: The Contribution to GDP

Estimating the energy sectors proportion of GDP with accuracy is a tricky process. Based on official data, mineral extraction, which is part of industrial production and includes oil extraction, amounted to a mere 10% of GDP in 2010. However, this is measured in terms of value added in domestic prices, which are lower than world market prices. For example, crude oil is a very low value-added product. Furthermore, looking solely at extraction does not capture the value created by the refining of crude oil. Moreover, the figure of 10% does not reveal the full extent of the oil and gas contribution to GDP given that services to the energy industry comprise a significant proportion of several other economic sectors (notably transportation and trading), a fact that is not reflected in extraction figures. Estimates by the World Bank and the OECD in studies aimed at including all areas linked to oil and gas put energy as a share of GDP closer to 25%. Measured in terms of federal budget revenue collection, the oil and gas sector accounts for about 45% of revenue. We can derive a simple approximation of the oil sectors contribution to GDP by first multiplying the annual number of barrels produced in Russia with the average oil price to arrive at a theoretical value of the oil produced and sold. Why theoretical? First, we do not capture the value added but rather the final price, while a share of crude oil produced is sold for refining. Furthermore, oil is sold at a discount to the world market price domestically, and the same is true for exports to the CIS. Currently about one-quarter of crude oil produced is consumed domestically and just over 10% of total crude oil exports go to the nations of the former Soviet Union. Nevertheless, this likely underestimated value still amounts to around 20% of GDP. Figure 1: Value of Russian oil production at world market price as share of GDP
30% 25% 20% 15% 10% 5% 0% 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: Info TEK, Rosstat, Bloomberg, Aton estimates

Still, although according to official data the oil sector seems to account for a rather small share of the economy (unless measured using tax revenue), most macroeconomic indicators show a very strong correlation with the oil price.

Figure 2: Macroeconomic variables and their correlation* to the oil price

Oil price correlation to: Correlation coefficient Exports 0.97 Imports 0.91 Budget revenues 0.93 International reserves 0.91 Average wage 0.90 Average income 0.90 Retail sales 0.89 *Correlation is based on monthly data for Jan 2001 July 2011 (June 2011 for exports and imports) Source: Rosstat, Ministry of Finance, CBR

While it may not be surprising that exports are strongly correlated to the oil price, given that oil and oil products account for 50% of exports (or 65% if we include exports of natural gas), we see that imports are also highly correlated with the oil price. We believe this is related to the strong correlation between the oil price and domestic demand-related indicators, such as wages, income and retail sales. In other words, this correlation is a product of oil revenues reaching the country and then trickling down into the economy, and in turn supporting domestic consumption and hence demand for imports. The strong correlation between budget revenues and the oil price is also not surprising given the high tax burden placed on the oil industry.

Russias Economy in Barrels of Oil

In light of Russias dependence on the oil price we have evaluated certain aspects of its economy in terms of barrels of oil equivalent. Admittedly, this exercise is of limited usefulness, especially when measuring indicators such as GDP and fixed investment in terms of barrels of oil equivalent. Additionally, it does not solve the biggest issue in forecasting economic development that is, it does not provide a tool for predicting the oil price. At the same time, we believe this approach offers an insight into the Russian budget, in particular highlighting the need for creating incentives for the oil industry to invest in generating production growth. For the most part, therefore, we view this method as simply a different way of looking at things and hope our clients find it enlightening, something which is perhaps rare in the current market environment. Measuring the economy in terms of number of barrels of oil (here we used the average oil price expressed in roubles) shows that based on our 2011 nominal GDP estimate of RUB52.7trn and our 2011 average oil price forecast of $102/bbl, Russias economy is worth 17.8bn barrels of oil. This is well below the peak of 22.5bn barrels in 1998. While GDP at that time stood at RUB2.6trn, the average oil price was a mere $12/bbl.

Figure 3: GDP, 1995-2012E (in bn bbls)

Billions 25 23 21 19 17 15 13 11 9 7 5 1995 1998 2001 2004 2007 2010

Figure 4: GDP, 1995-2012E (RUBbn)

Billions
70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1995 1998 2001 2004 2007 2010

Figure 5: Oil price ($/bbl, Urals Med)

160 140 120 100 80 60 40 20 0 2006 2007 2008 2009 2010 2011

Source: Bloomberg, Rosstat, Aton estimates

Real GDP is calculated by adjusting nominal GDP by inflation, or the GDP deflator, which in simple terms is a combination of growth in consumer and producer prices. When we divide nominal GDP with the average oil price we get real GDP adjusted for the change in the oil price, i.e. an alternative measure of real GDP, or what we call the barrel equivalent of real GDP. Plotting the change in real GDP as well as GDP adjusted for oil price inflation since 1995 (based at 100) shows that since that time, real GDP (using the GDP deflator) has advanced 80% (2011 estimate). Real GDP, adjusted for the oil price, is actually down 4% compared to the 1995 level. While at first this may seem a product of the rise in oil prices since 1999, a closer examination reveals that the sharp drop in the oil price in 1998, followed by a sharp rise in 1999 and 2000, largely explains the underperformance of the barrel equivalent real GDP. In fact, rebasing both real GDP and GDP adjusted for the oil price to 1999 shows a very similar path for both variables (Figure 7). Figure 6: Growth in GDP: real vs real bbl equivalent, 19952011E (1995=100)
200

Figure 7: Growth in GDP: real vs real bbl equivalent, 1999-2011E (1995=100)

190 170

150

150 130 110

100

50

90

Real GDP
0 1995 1997 1999 2001

Real GDP (bbl equivalent)

2003 2005 2007 2009 2011

70 50

Real GDP

Real GDP (bbl equivalent)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Rosstat, Bloomberg, Aton estimates

We also recalculated fixed investment, retail sales, personal income and wages in terms of barrels of oil. In Figures 8 to 11, we set growth in real terms for these indicators against growth in the barrel equivalent. While one could question the value of this exercise, the charts reveal very healthy growth rates in all variables (as well as GDP, as shown above) in barrels of oil equivalent in 2000-04 compared to the years before and after that period. In 2000-04, Russia expanded crude production by 50% and the world market oil price rose 100%. While the oil price has continued to rise, output growth has almost totally stalled, which raises concerns. The impact is even more pronounced when examining the budget in terms of barrels of oil, which is discussed in more detail in the following pages.

Figure 8: Growth in fixed investment: real vs bbl equivalent, 1995-2011E (1995=100)

250 200 150

Figure 9: Growth in retail sales: real vs bbl equivalent, 1995-2011E (1995=100)

300

Fixed investment Fixed investment (bbl equivalent)

250 200 150

Retail sales Retail sales (bbl equivalent)

100 50 0 1995 1997 1999 2001 2003 2005 2007 2009 2011

100 50 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: Rosstat, Bloomberg, Aton estimates

Figure 10: Growth in per capita income: real vs bbl equivalent, 1995-2011E (1995=100)
250 200 150

Figure 11: Growth in real wage: real vs bbl equivalent, 19952011E (1995=100)
300 250 200 150

Real disposable income Income per capita (bbl equivalent)

Real wage Real wage (bbl equivalent)

100 100 50 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 50 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: Rosstat, Bloomberg, Aton estimates

When it comes to the budget, translating values into barrels of oil becomes more interesting in our view. In Figure 12 we plotted federal fiscal revenues and expenditures in barrels of oil, while Figure 13 shows the resulting balance expressed in barrels of oil. We have included our budget forecast to 2015 using a flat oil price forecast of $89/bbl from 2012 onwards, as provided by Atons oil team.

Figure 12: Budget revenue and expenditures in bbls of oil

Millions 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1995 1997 1999 2001 2003 2005 2007 2009 2011E 2013E 2015E

Figure 13: Federal budget balance in bbls of oil (mn barrels)

Millions 1,500 1,000 500 0 -500 -1,000 -1,500 -2,000 1995 1998 2001 2004 2007 2010 2013E Source: Ministry of Finance, Bloomberg, Aton estimates

Revenue, in mn bbl Expenditure, in mn bbl

Thus, using our oil analysts forecast of an average oil price of $102/bbl in 2011 and $89/bbl from 2012 implies a widening of the deficit in the coming years. Expressed as a percentage of GDP, the deficit could expand from 0.7% in 2011 to 4.1% in 2015. Alternatively, expressed in terms of barrels of oil, under these assumptions the deficit could rise from 128.6mn barrels in 2011 to 1.3bn barrels in 2015. In theory, the deficit could be reduced by producing and exporting more oil (which we acknowledge would also require growth in global oil demand in order to be oilprice supportive). However, according to our oil teams assessment, Russias crude oil production growth prospects for our forecast period are not encouraging. We estimate that the production growth in our forecast for 2011-13 would cover around 3% of the deficit expressed in barrels of oil, while for 2014-15 our projection implies that growth in crude oil output would cover just 1.5% of the deficit. A different approach is to set the expected deficit in barrels of oil equivalent against expected aggregate oil production. Using the same oil price and output assumptions outlined above, we calculate that this year the deficit in barrels of oil would be equal to 3.5% of total oil production. For next year the deficit would jump to 11% and then to over 20% in 2013 and more than 30% of total barrels of oil produced by 2015.

Figure 14: Level of coverage of fiscal deficit provided by growth in oil production (%)
4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2011E 2012E 2013E 2014E 2015E 1.4% 1.8% 3.4% 3.1% 3.2%

Figure 15: Budget deficit in bbls of oil as a percentage of the total number of barrels of crude oil produced
40% 35% 30% 25% 20% 15% 10% 5% 0% 2010 2011E 2012E 2013E 2014E 2015E Source: Ministry of Finance, Bloomberg, Aton estimates 3.5% 10.6% 20.4% 21.5% 26.8% 33.7%

Both the budget and the current account have become more dependent on oil in recent years. For example the oil price at which the budget balances in 2011 is $110/bbl, on our numbers, and $107/bbl for 2012. Also, as shown in Figure 16, the non-oil fiscal deficit, derived by excluding federal revenues related to crude oil and oil products, could amount to 11% of GDP this year. Although we estimate it may fall slightly in 2012 (based on our forecast of $89/bbl) it is still far greater than the nonoil deficit seen prior to 2009. The same is true for the current account. While we expect a surplus of 5.6% of GDP this year, excluding exports of oil and oil products pushes the current account into a deficit of 9.3%/GDP, reaching 10%/GDP by 2013.

Figure 16: Fiscal balance: general and non-oil (%/GDP)

10% 7.4% 5.4% 5% 0% -5% -10% -15% -11.1% -13.1%-12.9% 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E -1.8% -2.3% -5.4% -9.6% -9.8% -9.6% -9.6% 4.1% Balance Non-oil balance

Figure 17: Current account balance: general and non-oil (%/GDP)

15% 10% 5% 0% -5% -5.3% -10% -15% 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E Source: Ministry of Finance, Bloomberg, Aton estimates -7.4% -8.4% -8.1% -9.2% -9.3% -9.7% -10.0%-10.0% -9.8% 9.6% 5.9% 6.2% Balance 5.6% 4.0% 4.8% Non-oil balance

-6.0% -4.0% -0.7% -1.8% -3.2% -3.6% -4.1%

2.6%

0.9%

-0.1%

-0.7%

Atons strategy and oil teams have written extensively on the problems facing the Russian oil industry (for example, see Russian Oils: Strangled by Taxes, 26 May 2011, and Russian Equity Strategy: Underweight the Heavyweights, 16 June 2010). Figures 18 and 19 demonstrate the problems facing the oil industry. After a period of sharp contraction in oil production in the 1990s, related to underinvestment, capital flight and a general destruction of value, growth resumed after the 1998 crisis. As the oil price rose, capital that had left the country started to return and investment surged. However, this was short-lived, as the government imposed high taxes on the oil sector in 2002-04, destroying the incentive to invest. Little has been done to tackle this problem and the outlook for the next five years, according to Atons oil team, is for a further slowdown in crude output growth.

Figure 18: Growth in Russian crude oil output

12% 10% 8% 6% 4% 2.4% 2% 0% -2% 0.1% -1.0% 1998 2000 2002 2004 2.2% -0.6% 2006 2008 2.2% 2.2% 1.2% 0.3% 0.4% 0.7% 0.6% 11.0% 9.1% 7.7% 6.1% 8.9%

Figure 19: Periods of Russian crude output growth

10% 8% 6% 4% 2% 0% -2% -4% -6% -8% 1990-99 2000-04 2005-10 2011E-15E -5.6% 1.7% 0.4% 8.5%

0.1%

2010 2012E 2014E

Source: InfoTEK, Aton estimates

Regarding the equity market, it is no secret that the oil price has a great influence on Russian equities given that oil and gas stocks comprise 49% and 52% of the RTS and MICEX indices, respectively.

Figure 20: MICEX and the oil price: A close relationship

2,500 2,000 1,500 1,000 500

MICEX, lhs Oil price, $/bbl, rhs

160 140 120 100 80 60 40 20

0 0 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Source: Bloomberg

However, by transforming the index market cap of MICEX into barrels of oil equivalent and setting it against the index market cap in dollar terms, we reveal an interesting pattern. Since 2006, market caps expressed in dollars and barrels of oil have diverged sharply on four occasions, with barrels of oil equivalent seemingly the leading indicator and the index in dollar terms lagging by around two-to-six months. We believe this can be interpreted in the following way: as the market cap in barrels of oil equivalent rises ahead of the index, this suggests that the equivalent number of barrels of oil which could be purchased with the index market cap has become relatively cheaper, i.e. more barrels for your buck. As the index catches up, it reaches a point where the number of barrels of oil that can be purchased with the index market cap (i.e. the relationship between the stock price and oil price) is no longer as attractive, leading the index market cap to follow the barrel equivalent lower.

Figure 21: MICEX and barrel of oil equivalent index market cap
Millions 12,000 10,000 8,000 6,000 4,000 2,000 400 200

Index MktCap (mn bbl of oil), lhs Index MktCap ($bn), rhs

1,000 800 600

0 0 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Source: Bloomberg, Aton estimates

Economic Outlook Revised Downwards amid Global Deterioration

We last revised our economic forecast in Sep 2010 when we had a rosy outlook for 2011-12, especially given that 2010 was a disappointing year economically as the base effect from the 7.8% GDP drop in 2009 did not materialise. We looked for a shift in the base effect to occur in 2011. The reality is that over the past six months global conditions have taken a turn for the worse. Domestically an oil price above $100/bbl has created reform paralysis while apparent political concerns ahead of the Dec 2011 elections have sparked

massive capital outflows. The latter has occurred despite an advance in the oil price, which should in theory lead to greater demand for roubles. Figure 22: Russian net private capital outflow ($bn)
60 50 40 30 20 10 0 -10 -20 -30 -40

-130.2 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 Source: CBR

A worsening global picture We do not expect to see markets fully stabilise in the next few months. One of the key reasons is the substantial debt repayments facing EU countries this year as shown in Figure 23: and Figure 24:. France and Italy have to make the greatest repayments with the toughest months being September and October. Our fixed income team expects a further jump in CDS spreads around this time, which in our view is likely to be accompanied by volatility on equity markets.

Figure 23: Breakdown of scheduled 2011 debt repayments for major EU members by month (bn)
160 140 120 100 80 60 40 20 Aug Sep Oct Nov Dec

Figure 24: Breakdown of remaining 2011 debt repayments for major EU members by country (bn)
500 450 400 350 300 250 200 150 100 50 IRE POR GER BEL SPA ITA FRA Total

FRA BEL IRE

ITA GER

SPA POR

Dec Sep

Nov Aug

Oct

Source: Bloomberg, Aton estimates

In addition to sovereign stress in Europe, there are increasing concerns about a global recession. Recent economic data out of the US and Europe in particular has been disappointing. This has led economists to start downgrading the global outlook, led by downgrades of developed economies. Although the Bloomberg consensus outlook for Eurozone GDP has actually risen over the past six months or so, this is largely a function of a positive outlook for Germany. That said, the recent (Aug 2011) preliminary reading for German 2Q11 GDP growth of 2.8% came in below consensus (3.2%) and may become the turning point for downgrades of German and subsequently Eurozone GDP growth.

So far, the consensus view seems to be that the emerging market universe will be able to maintain the earlier-forecast growth rates. Nevertheless, we believe that GDP growth downgrades for emerging economies are likely on the horizon, although we expect that, as was the case in 2008-09, most emerging markets will see healthy growth rates relative to the developed world. Figure 25: Bloomberg consensus 2011 GDP growth: downgrades underway (%)
4 3 2 1 0 -1 Aug-10 US Germany UK Eurozone Japan

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11 Source: Bloomberg

From a wider perspective, our view is that on some levels the current global environment is more precarious than in 2007-08: Banking system: The sub-prime crisis brought most US banks to the verge of bankruptcy while European banks also suffered huge losses. In addition, the loss of credibility meant that once a semblance of normality returned, banks could not borrow as they once did and heightened third-party risk froze financial markets and severely impacted the global economy. Currently, in both the US and Europe, banks have recapitalised and are less dependent on short-term borrowing. That said, in Europe many banks remain vulnerable due to sizeable exposure to heavily indebted nations, mainly in the south of Europe. The European Central Bank (ECB) as a lender of last resort remains a key lifeline. Policy tools: In 2008, the G7 countries were quick to loosen monetary and fiscal policy in order to stem the crisis by offering financial support to ailing banks and supporting national economies through investments and lowering taxes. This was very much a coordinated response. Since then sovereign debt in both Europe and the US has ballooned and the space for additional stimulus measures is likely limited, while in many countries harsh austerity measures are needed. The level of political coordination is also questionable with signs of major divisions. In the US this mainly comes down to internal politics, while in Europe the division is spread across EU member countries. Central banks: When the sub-prime crisis hit in late 2007 the Fed Funds rate was at 4.75% and the ECB rate stood at 4.0%. As the US and European economies plunged into recession the US Fed and the ECB lowered policy rates to between 0-1% and initiated a wave of emergency funding for banks, coupled with purchases of securities. Currently, the Fed Funds rate stands at 0.25% (and is set to stay at that level until mid-2013) and the ECB rate is 1.5%. Over the past couple of years the Feds balance sheet has increased from approximately $1trn to $2.8trn and the Fed has expressed scepticism about further security buybacks. Before the ECB began to support Italian

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and Spanish bonds recently, it had already bought 74bn worth of bonds from other countries, leading to questions about the banks independence. Hence the availability of monetary policy tools has probably largely been exhausted.

US vs Europe - pulling in different directions: Investors are also battling a conflicting environment in which the US and Europe, two of the worlds major economic zones, have contrasting policy needs. In the US, the question revolves around further nearterm stimulus efforts, while in Europe tightening measures are in focus after a period of moves aimed at revitalising the economy during the 2007-08 crisis. China: As the global economic cycle slowed in 2008, the Chinese government responded by increasing investment and offering cheap domestic financing. One result was a sharp recovery in commodity prices, benefitting not just emerging markets but also the exporting industries in the developed world. China was also financing the US deficit by continuing to buy US Treasuries. China is now dealing with an overheated economy and higher inflation. This may imply that a new round of stimulus measures is unlikely, at least until inflation is under control and economic growth has reached a sustainable level. Russia - economic slowdown amid a deteriorating global backdrop: To recap on a few points: prior to the 2008 downturn Russias potential GDP growth was approximately 6% and the non-oil budget deficit (the estimated budget deficit when excluding revenue from the oil and gas sector) amounted to 4% of GDP, based on our estimates. Currently, we believe Russias potential growth rate is 4% at best while the non-oil deficit is currently a massive 12% of GDP, so the Russian economy has become more sensitive to the oil price. A deteriorating global outlook has severely undermined the foundation for growth in Russia and we forecast economic growth to remain sluggish for the next few years, despite an increase in our long-term oil price forecast from $79/bbl to $89/bbl. As a result, we expect GDP to expand 3.6% in 2011 and slightly improve to 4% in 2012. Figure 26: GDP growth (%)
10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 2006 2007 2008 2009 2010 2011E 2012E

Figure 27: GDP per capita ($)

16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 2006 2007 2008 2009 2010 2011E 2012E Source: Rosstat, Aton estimates

Within GDP we see consumption maintaining a leading role with retail sales expanding 5.8% this year and an estimated 6% in 2012. This segment should gain an extra boost from a probable hike in pre-election spending. However, we believe fixed investment growth will remain sluggish at a mere 4.3% in 2011, rising to 5.4% in 2012.

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Figure 28: Growth in industrial production, fixed investment and retail sales
30% 20% 10% 0% -10% -20% 2006 2007 2008 2009 2010 2011E 2012E Source: Rosstat, Aton estimates

Industrial production

Fixed investment

Retail sales

Lower commodity prices and a slowdown in economic activity have led to a certain easing in headline inflation, though it still stood at 9% YoY in July 2011. At the same time, core inflation has not budged and lower unemployment and a reduced output gap are likely to continue to put pressure on inflation at the core, in our view. That said, we expect to see headline inflation coming down further, reaching 7.4% YoY by YE11. Lower headline inflation coupled with a slowdown in economic growth, both domestically and globally, suggests the CBR is unlikely to tighten further. Hence we see the refinancing rate remaining at 8.25%, with perhaps a 25 bpts hike in 4Q11.

Figure 29: Inflation and the refinancing rate

16% 14% 12% 10% 8% 6% 4% Jan-08

Figure 30: Unemployment rate

10% 9% 8% 7% 6% 5%

CPI
Jul-08 Jan-09

Refinancing rate
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

4% Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Source: Rosstat, Aton estimates

We forecast the federal budget to run a minor and manageable deficit of 0.7% of GDP in 2011. Of greater concern, however, is our projection for the non-oil deficit, which we see potentially running at 11% of GDP before dropping to 10% in 2012. These levels suggest that the budget remains highly vulnerable to movements in the oil price. The same is true for the current account, which we believe will remain in surplus both this year and next, but turn to a deficit in 2014, under the assumption of a flat oil price of $89/bbl. Nevertheless, like the budget, the non-oil current account is in deficit to the tune of 10% of GDP.

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Figure 31: Fiscal and current account balance (%/GDP)

15% 10% 5% 0% -5% -10% 2006 2007 2008 2009 2010 2011E 2012E Source: Rosstat, Ministry of Finance, CBR, Aton estimates

Fiscal balance

CA balance

Recent rouble movements have also posed a conundrum. Historically, a higher oil price has led to a stronger currency, which has led to increased demand for roubles domestically and an inflow of capital from abroad. This in turn has provided significant benefits for the monetisation of the economy and the banking system. However, over the past 15 months the oil price (Urals Med) has risen more than 60% while the CBR has reported a net private capital outflow of approximately $40bn over the same period. The oil price plays a vital role in determining the exchange rate. Figures 32 and 33 show the strong correlation between the oil price and the exchange rate. At the same time, Figure 33 highlights a shift in this relationship in late 2008, implying that currently, a given oil price corresponds to a weaker rouble than seen prior to Dec 2008. Figure 32: Oil price and the RUB/$ exchange rate
140 120 100 80 60 40 20 0 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11

Figure 33: Oil price and exchange rate: A shift in relationship

0.039 0.037 0.035 0.033 0.031 0.029 0.027 0.025 160 140 Oil price ($/bbl) 120 100 80 60 40 20 0 20 25 30 RUB/$ exchange rate 35 40 Jan 2001 to Nov 2008 Dec 2008 to Aug 2011

Oil price ($/bbl), lhs

$/RUB, rhs

Source: Bloomberg, CBR, Aton estimates

While the current oil price stands at $110/bbl, Atons oil team is expecting it to drop to around $90/bbl by YE11, which would likely put further pressure on the rouble. We expect a RUB/$ rate of 29.9 by the end of this year. Given that our oil team forecasts the oil price to remain at a similar level ($89/bbl) in 2012, we currently estimate a marginally unchanged exchange rate of RUB29.6/$ by YE12. Finally, a look at liquidity reveals a rather comfortable position. It is no secret that excess liquidity resulting from rising commodity prices has been part of Russias fundamental story over the past ten years or so. We forecast money supply growth to remain healthy with M2 expanding by 19.7% in 2011 and 22.9% in 2012.

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To ascertain whether domestic liquidity conditions will remain favourable, we use Marshallian K (developed by the economist Alfred Marshall). Marshallian K shows the difference between the change in money supply and the change in money demand (we use GDP as a proxy for money demand), allowing us to estimate a countrys liquidity position. A reading above zero is representative of money supply growing faster than money demand. Since 2000, the Marshallian K calculated for Russia has been in positive territory: money supply growth has exceeded growth in money demand. This has been underpinned by capital inflows and a strengthening rouble (both linked to high commodity prices). However, following the economic downturn of 2008-09 excess liquidity dried up. Nevertheless, our forecast indicates that excess liquidity will remain, although at a slightly lower level than in 2010 and weakening further in 2012. Figure 34: Money supply growth
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% 2006 2007 2008 2009 2010 2011E 2012E 0.0 2004 2005 2006 2007 2008 2009 2010 2011E 2012E

Figure 35: Marshallian K points to excess liquidity

M2, Average
2.5 2.0 1.5 1.0 0.5

M2, Dec/Dec

Source: Rosstat, CBR, Aton estimates

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Figure 36: Key macroeconomic indicators: historical and forecast

Nominal GDP (RUBbn) GDP ($bn) GDP per capita ($) Real GDP growth, (%) Industrial output growth (%) Fixed investment (%) Real retail sales (%) SOCIAL INDICATORS Real disposable income (%) Real wage (%) Average wage ($/month) Unemployment (% ILO) PRICES CPI growth (% Dec/Dec) PPI growth (% Dec/Dec) TRADE Exports ($bn) Imports ($bn) Trade balance ($bn) Current account ($bn) Current account ratio (%/GDP) Oil price ($/bbl, Urals Med, aop) FEDERAL BUDGET Revenues (%/GDP) Expenditures (%/GDP) Fiscal balance (%/GDP) MONETARY INDICATORS Gross international reserves ($bn) M0 (RUBbn eop) M0 growth (%) M2 (RUBbn eop) M2 growth (%) M2/GDP (% average) EXCHANGE RATES RUB/$ (eop) RUB/$ (aop) Real appr.(+) / depr.(-) RUB/$ (%) Real appr.(+) / depr.(-) RUB/, (%) 29.4 24.9 -8.9 -4.9 30.2 31.7 5.7 3.6 30.5 30.4 6.2 29.9 29.0 6.3 29.6 29.8 5.8 427 3,795 2.5 13,493 1.7 33.1 439 4,038 6.4 15,698 16.3 34.0 479 5,063 25.4 20,012 27.5 38.4 547 5,988 18.3 23,952 19.7 41.7 597 7,651 27.8 29,425 22.9 46.2 22.5 18.3 4.1 18.9 24.9 -6.0 18.5 22.5 -4.0 21.0 21.7 -0.7 19.4 21.2 -1.8 471.6 291.9 179.7 102.3 6.2 95 303.4 191.8 111.6 49.4 4.0 61 400.4 248.7 151.7 89.3 6.0 78 513.7 308.8 204.9 102.5 5.6 102 476.8 375.6 101.1 50.6 2.6 89 13.3 -7.0 8.8 13.9 8.8 16.7 7.4 7.0 6.8 5.0 1.9 11.5 693.8 6.4 1.9 -2.8 592.4 8.4 4.3 4.2 694.6 7.5 2.1 4.5 814.5 6.4 4.0 5.0 897.2 6.3 2008 41,277 1,661 11,697 5.2 2.1 9.8 13.5 2009 38,786 1,222 8,641 -7.8 -10.8 -17.0 -5.5 2010 44,939 1,480 10,504 4.0 8.2 6.0 4.4 2011E 52,653 1,816 12,932 3.6 5.1 4.3 5.8 2012E 58,950 1,982 14,164 4.0 5.1 5.4 6.0

15.2 4.7 4.2 Source: Rosstat, CBR, Ministry of Finance, Bloomberg, Aton estimates

1 5

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