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#21 - JRL 7187
The Electronic Telegraph (UK)
May 19, 2003
Investors ride their luck with Russian roulette
Ben Aris in Moscow discovers Russia's economic health is much improved, but the risks remain

Ratings agency Fitch upgraded Russia to one notch below investment grade last week, but thanks to its fast economic growth, bond traders are already pricing Russian debt as if the country was a fully functioning market economy.

While the rest of the world struggles to stave off recession, Russia has gone from strength to strength. President Vladimir Putin said in his state of the nation speech on Friday: "Russia credit rating is now at its highest level in history. We have some of the biggest companies in the world in their sectors, and they are expanding and starting to offer serious competition to those of other countries."

Mr Putin pointed out that the Russian economy has grown by 20pc over the past three years, its first robust growth for three decades, and called for a doubling of economic output by 2013.

"This is realistic, though very difficult," Mr Putin said. "The doubling of the GDP is a large-scale task. It will require a deep analysis, including of the existing approaches to economic policy," he said.

The financial crisis of 1998, when Russia became one of the few countries in history to default on domestic debt and the rouble was devalued, was the turning point. Prior to devaluation of the rouble, companies could not compete with imports and the government failed to collect taxes from impoverished firms.

With the rouble cut to a quarter of its value against the dollar on August 17, 1998, imports disappeared overnight and domestic producers stepped gleefully into the pounds 20 billion hole.

Shortly after coming to power in May 2000, Mr Putin pushed through a radical tax reform that slashed income taxes to a flat rate 13pc and later cut corporate profit taxes to 24pc. Under Boris Yeltsin the government consistently ran a 7pc to 8pc deficit funded by issuing a never-ending stream of treasury bills, the notorious GKOs, but under Mr Putin the budget has been in surplus since March 2000. Admittedly, this is partly down to good luck as his presidency has coincided with high oil prices and the government receives about half its revenues from oil.

"Putin has provided the forceful leadership that for the first time has forced Russia to carry out reforms when the cotton is high," says Charles Ryan, the chairman of United Financial Group, a Moscow-based investment bank. "In the past they only thought about reforms when the country was in deep trouble." Macroeconomic growth has averaged 6pc a year, but things have gone more slowly at the company level. The lack of reforms to things like bureaucracy and the judicial system has held back foreign direct investment to about $4 billion a year.

"Direct investment into Russia is still pathetic," says Ryan. "The paradox is that FDI was higher before the crisis than it is now. The reason is the lack of reforms mean that investors prefer debt to equity as it offers better protection against the shenanigans. Last year's FDI was stuck at about $4 billion, but counting in debt and investment was up to about $20 billion."

However, interest in Russia seems to have reached critical mass and just two big investments since the start of the year have smashed all records. BP announced a $6.5 billion deal to buy half of Russia's fourth biggest oil company Tyumen Oil in January, the single biggest investment into Russia and more than all foreign investment for the previous three years taken together.

BP was badly burnt in 1999 after it spent $500m on a 10pc stake in Russian oil major Sidanco, only to see it put into bankruptcy in 1999. Sidanco lost control of its main production subsidiary and BP had to write off hundreds of millions of dollars. BP's decision to take a second stab at investing in Russia has been an enormous vote of confidence and catalysed several other deals.

At the end of April Russia's biggest oil company, Yukos, rushed through a merger with fifth largest oil company, Sibneft, in a $15 billion union that catapulted the new company over the likes of British BP, US ChevronTexaco and French TotalFinaElf into the number two slot in the hydrocarbon universe, in terms of reserves.

The two companies had already tried to merge in the spring of 1998 and were still talking about tying the knot but the creation of TNK-BP forced Yukos chief executive Mikhail Khodorkovsky's hand; Yukos had to act quickly or see Sibneft snapped up by one of the international oil majors, all of whom were actively sniffing at Sibneft's skirts.

And only five days ago Royal Dutch/Shell smashed the investment record again, by announcing it had secured $10 billion of financing to build a gas liquefying plant on the remote far eastern island of Sakhalin.

"Investors are coming to Russia because of the Russian economic story and because they are looking for an acceptable return in an otherwise gloomy global investment climate," says Marcus Hopkins, the head of banking at Moscow Narodny Bank in London. "But we have been surprised at the speed of Russia's development."

Oil companies have been driving Russia's growth and rising production has helped put the country on a solid financial footing. After the break-up of the Soviet Union, oil production collapsed from a high of 11m barrels a day to languish at about 6m barrels a day for most of the 1990s. Following the crisis, oil production began to recover again and has reached about 8m barrels a day over the first quarter of this year.

Production increases are running at an average of 8pc to 10pc a year and the leading companies have been putting in double-digit gains for the last two years.

"Russia's comparative advantage is in the export of raw materials and commodities are much more profitable than manufacturing," says Peter Boone, head of research at Brunswick UBS Warburg. "And the companies are taking this money and reinvesting into Russia, whereas they used to whisk it abroad to offshore havens."

The 1998 crisis sparked when international oil prices fell to $10, but rising production means that government already can collect enough tax revenues to cover expenditures even if oil prices fall dramatically.

"The cost of finding and producing a barrel of oil in Russia is $5, so even if the price falls to $15 [from the current $25 a barrel] there will be less money and less investment, but it won't kill the economy," says Boone.

Production increases means that the state-owned export pipeline system is already working at full capacity and the leading oil companies have been forced to club together to propose building two new large export pipelines - one to China and another to north-western port of Murmansk that would open the American markets to Russian oil.

Oil companies have also fuelled the recovery of the stock market and account for half the RTS (Russian Trading System) market capitalisation.

Portfolio investors in Russia have had a white-knuckled rollercoaster ride as they watched the RTS index crash from its all-time high of 572 on October 6 1997 to its all-time low almost exactly a year later of 38 on October 5 1998. But as Russia has recovered over the last four years the RTS has clawed back most of the ground lost and the market closed at 437 last week, up by more than a quarter since the start of the year.

The economic growth has already trickled down to other sectors of the economy and is being driven by a consumer boom. Small and medium-sized companies are taking over as the economic engine.

Last year Russian companies raised about $1 billion in corporate eurobonds but this year they have already issued more than $3 billion of bonds. And the domestic rouble bond market has doubled every year since 2000. Their next move is to float on foreign exchanges: 25 Russian companies have already announced plans to float shares on the London stock market within three years.

However, investing in Russia remains risky. The rule of law is still far below western standards and the country is extremely exposed to the fluctuations of the oil price. The bureaucracy is legendary.

The central bank is also struggling to keep inflation in single digits. Mr Putin pointed out in Friday's speech that most of the economic growth has been fuelled by the high international oil prices of the last few years and that reform is still going too slowly.

"In last year's speech, Putin highlighted specific objectives for the coming year," says Chris Weafer, head of research at Alfa Bank in Moscow.

"One year later, little has changed. In fact, as regards his stated objectives, there has been no change. Russia's economic health is much improved, but the risks are still pretty much the same as they have ever been."

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