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OUTLOOK 2012: Russia muddling through (Part 1)
Ben Aris in Moscow - Business New Europe - bne.com - 12.20.11 - JRL 2011-229

[Charts can be found here: www.bne.eu/storyf3142/OUTLOOK_2012_Russia_muddling_through_Part_1]

Intro ­ muddling through 2012

In the five years bne has been writing a Russia outlook report for the coming year, never have the prospects been so uncertain. The complications are multifarious, but can be split neatly into external and internal problems. The most obvious obstacle is the ongoing sovereign debt crisis in Western Europe, which is stymieing growth by depressing exports and investment flows. The prospect of a meltdown in the EU would have serious consequences for the Russian economy, although that said, its economy is in a much better position to withstand the shock than it was in 2008.

At home, despite a deceptively strong economic performance in 2011 and rapid recovery, the economy is more vulnerable to fluctuations in oil prices than it has ever been. On top of that, political risk returned to Russia on December 11 after a 30,000-strong street protest ­ the largest since the fall of the Soviet Union. Further out, while Prime Minister Vladimir Putin has declared he will run for the post of president in March (and will almost inevitably win) Russia's medium- to long-term development strategy remains unclear; with growth forecasts stuck at 4% or less for the next few years, Russia badly needs a new development model and it is by no means clear that Putin can deliver.

Having said that, the leading investment banks all predict more-or-less the same thing for Russia in 2012: a poor and volatile first quarter of the year with growth, investment and stock markets picking up and gathering momentum in the second half of year ­ barring a train wreck in the rest of Europe. The details will be determined by how both the external crisis resolution and the internal politics play out. "The hope for investors in Russian assets is that the [European] crisis does come to a head in early 2012 and that a new base of valuation and risk reference can then be established. Until that happens, none of the traditional 'reference points of relative valuation' can be trusted because current assumptions, eg. earnings growth, will certainly change. To a large extent, 2012 is the undiscovered country," says Chris Weafer, head of strategy at Troika Dialog in his 2012 outlook.

Bankers on the whole are optimistic that Europe (and hence Russia) will manage to muddle through the first half of 2012 without toppling into the abyss. However, even under the various "nuclear winter" scenarios of Europe's collapse, most banks still see Russia growing by a bit more than 2% and doing reasonably well. "The outlook is based on a muddle through scenario for the Eurozone (no financial collapse but weak growth) and a modest slowdown elsewhere, with global output around 3.5-4.0% and an oil price of $90-100," says Marcus Svedberg, chief economist at East Capital in a fairly typical summary. "We acknowledge that there are risks on the downside, especially in the Eurozone, and that Eastern Europe will be affected if these risks materialise. At the same time, we believe the long-term growth outlook remains solid, even though growth will stay below trend in the near term."

Internally, there is a sharp divide in the possible dominant drivers of the Russia story. A battle will be fought between the rising income and retail story, which is essentially apolitical vs. the cloying bureaucracy, corruption and wrong-headed gigantism of Kremlin policy. Russia has reached another of those crossroads it is always traversing: the economy has reached a level of sophistication where simply increasing state spending can no longer produce growth. Indeed, upping the state's presence will be increasingly detrimental to growth from here on in and there lies the road to stagnation.

Still, despite the pall that hangs over the international capital markets, Russia's economy was picking up steam in the second half of 2011 as the banking sector and consumer confidence (and spending) recovered. It was not quite the boom it should have been, but the economic momentum is widely believed to continue into 2012 barring external train wrecks and continues to relentlessly improve. "2012 will see Russia join the World Trade Organization, set up the long-awaited central depository, and Gazprom will likely start to pay attractive dividends. Russia is slowly starting to look like a normal market, and that should drive down the discount," says Citigroup strategist Kingsmill Bond.

Return of political risk?

Politics has made a comeback in a big way following the Duma elections and street demonstrations in December. Popular protests and the public booing of Putin (for the first time in 12 years) unsettled investors. While the big demonstration went off quietly investors were left asking: is political risk in Russia back?

bne's take on a possible "Russian Spring" is that if it happens, it will probably be the most civilised revolution of any recently witnessed. A combination of relative affluence, low unemployment, rising income levels, reasonably strong GDP growth and a government with lots and lots of cash will combine to soothe the people's anger. But more than anything else, the Russian protest is being led by the middle class, the very people that Prime Minister Putin has enfranchised with the economic growth of the last decade and half, who are not natural rioters.

Equity markets probably overreacted to the demonstrations in December 2011, but the political environment is likely to remain confused until after the March 4, 2012 presidential elections. Few doubt that Putin will be reinstalled as president as promised, however, how it is done and what Putin can offer to placate a public that is becoming increasingly tired of him will colour his next term in office.

As the new president will not be inaugurated until May 7 (and then he must appoint a new prime minister by May 21) there is also unlikely to be much clarity until about June. At the time of writing Moscow was full of rumours that the kremlin was planning a major reform initiative. Some of the scenarios being discussed included: Medvedev will be sacked as Prime minister in 2012 and replaced by a strong liberal such as former finance minister Alexei Kudrin, who announced that he will form a new political party in the middle of December; there will be a major reshuffle of the Cabinet; and some oligarchs will be ousted or even jailed as part of a make over and as a fob to the anti corruption campaign.

Still, despite the speculation over Putin's growing authoritarian tendencies, it is important to remember that it was the PM himself who launched Russia's first attempt in 2001 at economic reform with the so-called "Gref Plan" at a time when no-one believed in it. The economic benefits that followed have convinced everyone in the Kremlin that some sort of reforms are needed and worthwhile, so we see no reason to believe the reforms will stop or even slow. The only issue is one of pace and what the focus will be.

Citi's Bond summed up the consensus view on politics well in his outlook note:

* The return of political risk: We believe that the market is only now starting to price in the return of top-level political risk for the first time in 12 years, and that developments in Russia will lead to more short-term downside.
* The protests are likely to continue: Russia is unusually well-educated and wealthy to endure a system characterized by so much corruption. Now that the spark has caught the tinder of discontent, we expect more protests.
* The government reaction is likely to be populist: We believe that the government is likely to indulge in populism to attract votes rather than reform to improve the long-term situation. We anticipate more friction with the West, more government spending, and a postponement of liberal policies. There is also the risk of attacks on unpopular oligarchs and higher taxes on rentier companies.
* The threat to the reset: It is standard policy for regimes under pressure to seek out a foreign enemy. We believe that the conflict of words between Prime Minister Putin and US Secretary of State Clinton may escalate further.
* The ruble is likely to weaken: We expect more ruble weakness as a result of the political uncertainty and the relatively significant role played by foreigners in providing long-term capital to Russia.
* The metals and mining sector is most at risk: We see risk to companies that are beneficiaries of the current rentier system or controlled by oligarchs.
* Regulated companies are also at risk: The government may elect to postpone again electricity price rises and to force oil companies to lower their domestic prices.
* Potential beneficiaries: Retailers are the most obvious potential beneficiaries of higher government spending.

Predicting growth numbers for 2012 has been made impossible by the uncertainties that are wracking Europe: Moscow's investment bank forecasts have covered the spectrum of possibilities.

Inside the country, growth and confidence will be driven by Kremlin policy initiatives. However, with presidential elections in March, some clarity on policy is unlikely to appear before the start of the third quarter, although at the end of 2011 analysts were saying the pressure from the protests could cause the Kremlin to offer a new reform agenda earlier as part of their efforts to placate the dissenters. Just how ambitious this plan will be remains moot, with most observers erring on the side of "steady but not spectacular."

"If we do get that crisis-rebuild scenario in Europe and elsewhere, then the case for Russian market out-performance in second half of 2012 and into 2013 will be boosted by the fact that the next government is expected to take a more proactive and pragmatic route to improve investment in the economy, and the reform agenda should proceed at a steady, albeit modest, pace," says Weafer.

GDP drivers for 2012

While portfolio investors concentrate on oil prices as the bellwether for the Russian stock market, it is domestic investments, construction and household consumption that actually drive growth, accounting for some three-quarters of the economy. All of these factors are due to increase in 2012 and construction growth was already well underway by the end of 2011.

The economy will get a further boost after the government cuts social security taxes that it realises were hiked too high at the start of 2011 and ate into incomes, thus holding back consumer demand.

* Consumer demand

By October, household consumption had already recovered all the ground lost in the crisis, increasing by 8.8% on year, which is only moderately lower than the 9.2% year-on-year reading registered in the preceding month, according to Deutsche Bank. Consumption is already above pre-crisis levels and expected to grow at the same rate or higher in 2012. Indeed, the rise in consumption was so strong in the last months of 2011 that Deutsche Bank says the end of year GDP numbers may be revised up from over 4% to 7% in the New Year. "The Russian economy has been surprisingly resilient to global turmoil, as the oil price is holding up well and a renewed credit crunch has been avoided for now," say analysts at Danske.

The bne consensus growth (assuming oil prices of about $100) is for 3.72% in 2012, in a range from 2.8% to 5.0% - a wide spread. Much will depend on where oil prices actually settle and how the Eurozone crisis unfolds. The government's own estimate is exactly on the consensus, predicting 3.7% of growth in 2012 as its baseline assumption for the budget, assuming $95 oil. "If the stagnation in Europe gathers momentum showing a near-zero growth rate, the reaction of the markets, both commodity and oil ones, may be more nervous. The oil price of about $80-90 is the price at which the Russian economy will be adequately protected despite a slower growth rate. In this case, our estimate may be about 2.5-3.0% instead of 3.7% provided for in the basic scenario," Deputy Economic Development Minister Andrei Klepach said in November.

Consumption will be also be supported by recovering consumer crediting. Pre-crisis, the volume of loans to the consumer were growing at over 50% a year, however in 2009-2010 the crediting business came to a standstill and Russians spent their time repaying their old loans. However, by 2011 credits to consumers had restarted and were increasing by 25% on year, according to Danske. Shopping is a powerful engine of growth, as at end of the day Russians remain underleveraged and still want all the material goodies that westerners take for granted. Retail credit was growing at 15% in the second half of 2011 and is expected to grow at 20% in 2012, according to Danske.

* Fixed investment

Fixed investment is another key factor for the speed for Russia's growth and was rapidly accelerating in the last quarter of 2011. Deutsche Bank pointed to the "emphatic" growth of investment as an important factor for economic performance in 2012: investment growth was picking up all year starting at 5.3% in January-October and was set to end the year at 6%, but on a month-on-month basis was accelerating towards the end of the year, running at 8.6% in October and is expected to continue to increase in 2012, partly driven by the construction sector which had returned to health in the last quarter of 2011.

"Our view is that fixed investment growth is likely to benefit in 2012 from a combination of lower capital outflows, further recovery in construction as well as the implementation of large-scale infrastructure projects associated with the preparations for APEC summit in 2012 and Sochi Winter Olympics in 2014. Starting from next year, a notable increase in infrastructure spending is also projected for the 2018 Soccer World Cup," say analysts at Deutsche Bank.

The key element of the increase in investment is the invisible infrastructure boom that started in 2008: from a low of $7bn of spending in 1999, the Kremlin has been spending a massive $100bn a year spending on infrastructure since 2008 ­ equivalent to a third of the budget spending ­ and intends to keep this up for at least another five years. Likewise, similar amounts are being spent on re-equipping the military.

bne believes that the bankers are underestimating the impact this infrastructure spending will have on the economy. Much of it is linked to sports events (such as the Sochi 2014 Winter Olympics and the World Cup in 2018) so the spending comes with a framework, a set of fixed goals, international scrutiny and hard deadlines ­ all of which are fairly novel concepts for government spending and should conspire to make this some of Russia's more effective investments. At the same time, big reforms in other sector, notably automotive, are also starting to bear fruit. "In 2012, industrial growth will concentrate in budget-financed military sectors. Consumption is likely to remain the primary driver of GDP at 3-4%. However, household spending is generally a lagging business-cycle indicator, and we forecast it to support economic growth in the beginning of 2012, but the aftermath of the slowdown to affect consumption by second half of 2012, after less generous budget spending following the presidential elections of March 2012. Furthermore, Russia plans to increase military spending by $640bn over the next 10 years," says Citi's Bond.

Russia needs investment growth of over 25% to produce long-term sustainable growth, but averaged just 20% between 2000 and 2010. Obviously investment fell away after the blitz hit in 2008 to next to nothing.

In 2011, fixed investment was recovering again and growing by 8% year on year by the end of the year, and the hope is this rate will be maintained and improved on. This is one of the areas where Putin's 2024 policy plan will make a big difference: boosting investment needs to be at the core of the programme.

* Construction

Construction was amongst the hardest hit of all Russian sectors, but thanks to banks bailing out developers because they were unwilling to take the huge losses on the loans, the economic recovery has led to a rapid recovery in the real estate sector.

Construction was the third largest contributor to Russian growth pre-crisis. The sector has also been supported by the change of mayor in Moscow, as all construction permits have been frozen until 2013 while the new administration sorts through the mess left by Yuri Luzhkov.

Tellingly, the most activity has been in the warehouse sector where real estate agents are reporting best-ever results as multinationals are running short of space to house their imports. But prices in the residential and especially the office market are already above their long-term trend prices (counting out the bubble in 2007 and 2008). Moscow was voted the "most attractive market in Europe" by Cushman & Wakefield in December.

On balance bne expects that the Russian economy, if left to its own devices, could grow faster than expected thanks to the recovery of crediting, consumption and the massive state spending on infrastructure and the military.

Need for a new economic model

In October, Putin boldly told investors at the VTB Capital investor conference that Russia will grow by 6-7% in 2012. "4% is not good enough. We shall aim higher on the back of domestic demand, an improving investment climate and greater investment efficiency. The ultimate goal is to diversify the economy and create hi-tech jobs." He went on to list the priority sectors: nuclear, biotech, nanotech, communications and space, and said that investments would increase to 25% of GDP.

No one believes he can do it. This rate of growth (and investment) is double the bne consensus forecast for 2012 and to pull it off Russia would have to completely change its economic model. Several investment banks highlighted the need for a new model and Aton Capital even produced a whole report asking whether Russia is headed into a cul de sac because of the unsolved structural issues like low investment and poor demographics.

The problem is the game has changed but the Kremlin seems to still be playing by the old rules. In the first phase of transition, a state needs to take the lead, as it is the only economic agent with sufficient resources to kick start business. Spending on infrastructure and other big projects both inject cash into the system and also build a framework in which new business can operate. However, in the second phase the continued presence of the state in the economy increasingly hinders the development of private enterprise and the state needs to move from push to "nurture," improving the rules that allow a level playing field for companies to slug it out in the market place.

Russia has reached this second phase and the Kremlin needs to come up with a new model for the economy and do things like invest heavily in R&D and education. But there is no sign that it will give up its predilection for setting up huge state champions. And spending on education in the 2011-14 budget, already at subpar levels, has actually been cut. Pundits are waiting to see what change the 2012 presidential election will bring and Putin's comments above show that at least he is aware of what needs to be done so positive surprises can't be ruled out. "If Russia were to succeed in unleashing forceful structural reforms, we believe GDP growth rates of 5% to 6% would easily be possible over the longer term. The marginal productivity of investment in a market-friendly environment would be very high, delivering a big boost to economic activity, and this would surely get foreign investors excited as well. So in this sense, while we remain cautious on reforms we hope to be surprised positively by Mr Putin and his team after the presidential elections are out of the way in March 2012," says Reinhard Cluse of UBS.

Inflation

Of all the macroeconomic parameters, the government has had the most success with inflation, which is expected to end 2011 at about 6% - its lowest level since 1992 ­ and will fall another two points in the next three years.

This success is partly due to the economy slowdown, but more to the change in policy at the Central Bank of Russia, which has begun to release its grip on the ruble and is in the processes of finally switching over to inflation targeting. The capital outflows in 2011 also eased inflationary pressures, which have led to money supply (M2) increasing by about 7% in 2011, down from 31% in 2010. For 2012-14, the CBR expects a modest, by Russian standards, growth in the money supply of 13-20%. "CPI inflation is likely to decelerate to about 6% in the beginning of 2012 from just below 7% in December 2011 as a result of postponed adjustment of state-regulated prices. 2012 stable or declining oil prices should help to slow down PPI down, which will restrain the CPI growth, counterbalancing the boost from inflation from currency depreciation, provided wage growth remains moderate (about 10-11%). If oil prices rise, we should see greater CPI growth," says Kingsmill Bond of Citi.

The battle with inflation will impact the utility sector the most. The sector was supposed to go over to the so-call RAB method of calculating tariffs based on a company's assets and investment programme. However, the state effectively suspended the programme in February 2011 once it realised this would lead to 15%-plus tariff hikes in an election year. Once the presidential elections are passed, this reform may be put back in place.

Instead of the average 10-15% tariff growth in recent years, average tariff growth for 2012 was be 6.5-7.5% for electricity, 7.5% for gas, 6% for rail freight, 10% for passenger rail transportation, and 4.9% for household utilities in 2011.

State finances

* Budget deficit

Russia was supposed to run a deficit until 2015 following the 7% economic contraction in 2009, but by October the budget was already back in the black to the tune of RUB1.4 trillion and is estimated to end the year at 1% of GDP.

Likewise, the reserve fund was supposed to run dry by the end of 2011 as funds were to be used to plug the hold in budget spending. Instead, the fund took in RUB600bn ($20bn) and ended 2011 with an estimated RUB1.6 trillion in the kitty.

While Russia's fiscal crisis has receded faster than anyone dared hope, because of heavy spending the budget will remain under more pressure than it is used to going forward ­ and this will only increase in the coming years. Pre-crisis, the budget broke even at an oil price of $21 in 2007, but this had risen to $115 by the end of 2011. Russia is a lot more vulnerable to oil prices than it has ever been before. As a rule of thumb, UBS says that for each $10 change in oil price the budget balance price changes by 1% to 1.5% of GDP.

Estimates of the budget deficit for 2012 vary widely, ranging from the state's -1.4% to Deutsche Bank's -0.4%. Again everything will depend on what happens outside Russia and to the price of oil. UralSib says if the Urals oil price drops to an average of $60/bbl instead of the $100/bbl currently planned in the budget, the budget deficit will reach 6% of GDP instead of 1.6% of GDP the bank is forecasting.

"Given DB's positive oil price outlook for 2012, the current account is likely to continue to exhibit a strong surplus, while in the fiscal sphere a moderate deficit may emerge at the federal level. The escalation in fiscal commitments (most notably in the defence sector) may sustain the level of the non-oil budget deficit at high levels, leaving the federal budget vulnerable to declines in oil prices," say analysts at Deutsche Bank.

There is no clarity on this score, but having said that, Russia's deficit has managed to surprise on the upside every year since 2009 and everything needed to allow it to surprise on the upside again in 2012 is in place.

Still, a modest budget deficit will be fairly easy to finance and with $80bn of scheduled debt to refinance, the Ministry of Finance has already said Russia would probably offer a Eurobond in the New Year without specifying how much (see below). Russia has plenty of scope to tap debt markets: its debt/GDP ratio is currently at less than 11% and its the entire foreign debt is covered dollar for dollar by the country's foreign exchange reserves.

Despite the relatively good performance of the budget in the short term, there are mounting concerns for the medium term due to the rising social, infrastructure and military spending as well as rising imports. The Russian economy is moving into a new phase of tighter budgets where the huge surpluses it has enjoyed until now will slowly disappear in the next years. The government will have to improve its efficiency while economic expansion will be harder to maintain and increasingly important to balancing the budget.

* Oil

As ever, the wild card for next year is what will happen to the oil prices. Still barring another global meltdown, all of the investment banks and the international financial organisations are predicting oil prices will stay in the $95-$100 range following on from the average $109 oil cost in 2011.

Oil production has been declining in recent years and the state has become more interested in reducing demand at home by encouraging energy efficiency as a way to maintain energy supplies. The IEA forecasts that Russian oil production will soon go into decline and natural gas production will only grow at about 1% a year over the coming decades, assuming $30bn a year is invested in both oil and gas production. However, the state is revving up to boost investment into the sector: Rosstat reports that investment in the oil and gas sector reached $40bn in 2010, its highest point in a decade, and more of the same is to follow.

Russia will require $1.5 trillion for developing the extraction of oil before 2035, International Energy Agency chief Maria van der Hoeven said in November.

"The Brent price, and therefore Urals, has outperformed other commodities and equities in 2011. This is due to tight supply, demand skewed toward the still-robust developing world and a higher risk premium as a result of instability across the Arab world. Oil will not be able to avoid a decline with the EU recession and slower global growth in 1Q12. But the same factors that held the price relatively well in 2011 are still in place. This will not prevent Russian market weakness in 1Q12 but should still ensure a favorable domestic economic platform for second half of 2012," says Weafer.

* Tax take to rise

With Russia expected to run deficits on a regular basis in the near future, the talk has started about raising taxes. The Kremlin has plenty of room for manoeuvre as taxes in Russia are amongst the lowest in Europe.

However, the first thing the Kremlin will do in 2012 is cut social security tax. Many of the problems caused in the first half of 2011 were due to an overly zealous hike in these taxes from 26% to 34% of the wage bill that cause real incomes to fall and hurt consumption. The Kremlin realized its mistake in the summer and has promised to reverse this change.

Capital investment and incomes were strongly hit in 2011 following the social security tax increase: in the first half of 2011 capital investments decelerated to 2.7% year-on-year growth (vs. 6.0% in 2010) and real incomes contracted 1.2% year-on-year (vs. 4.3% growth in 2010).

The mandatory social security contribution of employers is due to drop from 34% of wage bill to 30% and this change is supposed to remain in force until 2013. However, the government has also introduced a 10% social security tax surcharge for wages in excess of RUB512,000 per annum, which will mostly affect the financial and natural resource sectors.

"Finding an appropriate rate for the employers' contribution has been a thorny topic within the cabinet. On one hand, the government wants to support entrepreneurship by keeping the mandatory contribution as low as possible, but on the other hand social security contributions are insufficient to cover the actual costs of the system," the Bank of Finland said in a report on taxes.

In the meantime, Russia will hike some of the more obvious taxes it has left untouched until now to bring them in line with the rest of Europe. Alcohol and tobacco duty hikes have already been approved for the 2012-14 budget, with the largest increase for vodka. Petrol taxes will also increase ahead of inflation, but part of this money will be used to fund the road fund that will pay for automotive infrastructure projects.

The extraction fee (resource use tax) for natural gas is significantly lower than the extraction fee on crude oil. This gap will be narrowed by doubling the current resource use tax on natural gas by 2014.

However, analysts are expecting the lion share of the big tax increases only to come in in the summer after the presidential elections are passed.

On the flip side the government is thinking about ways to use tax breaks more intelligently to promote important sectors. The finance ministry was due to finish a review of the tax code at the end of 2011 and recommendations for changes to the system will be presented in the summer of 2012.

The ministry's assessment shows that the overall value of tax breaks granted to firms in 2010 amounted to around RUB700bn (€17bn), an amount equivalent to about 10% of combined federal and regional tax revenues. Of that, about RUB170bn constituted temporary relief on the resource use tax granted to oil and gas producers, RUB100bn was for property and another RUB100bn for depreciation on corporate profit tax.

* Privatisation

In 2011, the government re-launched its privatisation programme with the twin goals of getting the state out of the economy and raising some money for the budget. The crisis prevented most of the sales from happening, but a SPO of 10% of VTB Bank and the auction of a controlling stake in First Rail Cargo company both got out of the door.

Under a president Putin, the privatisation programme may slow, as it was very much Medvedev's baby. Putin's circle -- mostly Siloviki -- are also not keen on the idea of selling off the state's crown jewels: Deputy PM Igor Sechin suggested in December that the government would not bring SPOs to the market at a price lower than the original IPO, which was quickly rejected by other ministers, but the possibly of miring the whole programme in argument is real.

The sales that are currently slated to go through in 2012 include Sberbank (a 7% stake), and another VTB stake (10%), with a total valuation of around $6bn. Both of these sales are very likely proceed irrespective of Putin's attitude to the programme. The managers of VTB in particular are very keen to completely privatise the banks as quickly as possible.

Rosneft is another company where the government wishes to sell a stake of around 10% (worth just under $7bn), and which may take place in 2012.

Apart from the companies included in the 2010 programme, the state is planning to greatly expand the list of stocks to be sold. Russian Railways had originally announced plans for an IPO in 2011, but is now targeting an issue in 2013. Initially the sale may be for 25% and with further sales over the following years. Reports also suggest that the state will sell its full stake in the following companies, retaining only a golden share.

* Current account and trade balance

Russia has been running a comfortable trade surplus, but as the economy continues to recover the combination of lower commodity prices externally and rising demand sucking in imports internally will continue to pull the surplus down.

Russia's current account surplus increased 37.7% on the year to $84bn in January-October, Central Bank of Russia (CBR) Chairman Sergei Ignatyev said in November, but the surplus is expected to disappear entirely by 2014 according to the Ministry of Economic Development and Trade. As a result, the dependence of Russia's economy on the inflow of private capital is to increase, Deputy Economic Development Minister Andrei Klepach says.

"A decrease in commodity prices and weaker global demand for commodities in 2012 will lead to only 0.5% year-on-year growth in export revenue to $522.bn in 2012. Imports will outpace exports due to real ruble appreciation: we expect that imports will grow by 9.9% year-on-year to $342.7bn in 2012. Thus, the trade balance will decrease to $179.6bn in 2012 from $201.0bn in 2011," says UralSib.

2011 also saw the return of capital flight in the face of the uncertain political future: an estimated $85bn left Russia in 2011 ­ the largest outflow since 1994, excluding 2008 ­ but bankers and the government are predicting capital flight will slow with bank estimates ranging from between $20bn to $40bn.

* FDI and investment

Investment into Russian remains very low by comparison to its peers in Central Europe, but was recovering strongly in the second half of 2011.

Russia's level of FDI as a share of GDP rose fairly steadily from 2002, peaking at 4.5% of GDP in 2007, but since then the level of FDI has dropped, reaching less than 3% of GDP in 2010. The average for 1994-2010 was 1.9% of GDP, significantly below the average for post-communist countries and the BRICs.

Investments for the ten months of 2011 equalled $36bn and foreign direct investment was up even more, by 43% in October year-on-year to $11.8bn, nearly half of which ($4.7bn) arrived in the third quarter alone.

Of the FDI a third went into manufacturing as direct investment continues to diversify away from extraction, which still takes another third of the investment (down from 54% at the start of 2011).

While the total FDI still only represents about 1% of GDP ­ far to small to affect the capital account ­ one of the changes noticeable in 2011 was the entry into the Russian market of several multinational retailers.

The game started in December 2010 when America's PepsiCo paid $3.8bn for a 66% stake in Wimm Bill Dann, to become Russia's single biggest dairy producer overnight. Over the course of the year a string of similar deals and direct investments were announced adding up to over $10bn of commitments according to bne's estimates.

It seems while investors are still taking a wait and see attitude, the truly big multinationals are increasingly committing to the Russian market; with growth in the traditional markets likely to be poor for at least five years these companies are moving into the large Russian consumer market which is still growing strongly and will do for years to come.

* Ruble

The value of the ruble is intimately tied up with price of oil and which way capital is flowing ­ in or out ­ but that relation broke down in 2011 due to a sharp pick up in capital flight.

Under the basic "muddle through spring, pick up in second half" scenario most banks expect the depreciation the ruble in 2011 to reverse in the second half of the year. Deutsche Bank for example expects the ruble to appreciate towards RUB28/dollar, which is roughly in line with the other banks.

The capital flight partly caused by the rising political uncertainty. An estimated $85bn left Russia in 2011. Capital outflow in 2012 is expected to slow to $20bn-$40bn before reversing in the second half of the year.

* Interest rates

While reducing inflation was the top priority in 2011, in 2012 the focus of the CBR will be to support economic growth. As inflation continues to fall, the CBR has plenty of room to manoeuvre and at least one rate cut of 25 bps is expected in 2012. A rate cut would also support the banking sector, which was struggling with liquidity problems at the close of 2011, which would also boost growth.

* WTO

The last hurdles for Russia's accession to the WTO at the end of December and Russia should go into 2012 as a paid-up member. The long-term benefits should be significant, though the impact of accession in the short term will be small as Russia has lost most of its comparative advantages over the 18-year long negotiating process.

"WTO entry in 2Q12, while not having any significant short-term impact, will nevertheless establish an increasingly important timetable for companies to become more competitive," says Weafer.

The main benefit is that membership imposes external rules and standards on Russia and will push Russian companies into becoming more productive and competitive; Russia's main problem is bad management, according to a World Bank study. Turkey and most of the Central European countries found that joining the EU (or trying to) brought not only more trade, but as important was the adoption of EU standards which made business more transparent and productive.

"WTO membership will therefore create a framework or a time clock for the next government's agenda to create greater efficiency and diversification in the economy, just as the 2018 FIFA World Cup will provide a timetable for improvements in key parts of the nation's infrastructure," says Weafer.

The short term impact includes:

* A fall in the average tariff ceiling from 10% to 7.8%. One third of tariffs will be at their final level immediately on accession; a quarter more will be put in place in three years.

* The beef tariff will fall from 65% to 15% and pork from 65% to zero.

* The foreign equity limitation on telecoms will be eliminated in four years.

* Foreign banks will be allowed to establish subsidiaries

* Foreign companies will be able to engage in distribution.

* Quantitative restrictions such as quotas, permits or bans will be eliminated. Russia will apply all its laws and regulations governing transit of goods in accordance with GATT and WTO.

* Government procurement: government agencies will award contracts in a transparent manner.

* The government will eliminate all industrial subsidy programmes so that subsidy provided is not contingent upon exports.

* Producers and distributors of natural gas will operate on the basis of normal commercial considerations. Households are exempted.

* The Russian Federation will use international standards for the development of technical regulation.

Keywords: Russia, Economy, Business, Investment, Trade - Russia News - Russia

 

[Charts can be found here: www.bne.eu/storyf3142/OUTLOOK_2012_Russia_muddling_through_Part_1]

Intro ­ muddling through 2012

In the five years bne has been writing a Russia outlook report for the coming year, never have the prospects been so uncertain. The complications are multifarious, but can be split neatly into external and internal problems.

The most obvious obstacle is the ongoing sovereign debt crisis in Western Europe, which is stymieing growth by depressing exports and investment flows. The prospect of a meltdown in the EU would have serious consequences for the Russian economy, although that said, its economy is in a much better position to withstand the shock than it was in 2008.

At home, despite a deceptively strong economic performance in 2011 and rapid recovery, the economy is more vulnerable to fluctuations in oil prices than it has ever been. On top of that, political risk returned to Russia on December 11 after a 30,000-strong street protest ­ the largest since the fall of the Soviet Union. Further out, while Prime Minister Vladimir Putin has declared he will run for the post of president in March (and will almost inevitably win) Russia's medium- to long-term development strategy remains unclear; with growth forecasts stuck at 4% or less for the next few years, Russia badly needs a new development model and it is by no means clear that Putin can deliver.

Having said that, the leading investment banks all predict more-or-less the same thing for Russia in 2012: a poor and volatile first quarter of the year with growth, investment and stock markets picking up and gathering momentum in the second half of year ­ barring a train wreck in the rest of Europe. The details will be determined by how both the external crisis resolution and the internal politics play out. "The hope for investors in Russian assets is that the [European] crisis does come to a head in early 2012 and that a new base of valuation and risk reference can then be established. Until that happens, none of the traditional 'reference points of relative valuation' can be trusted because current assumptions, eg. earnings growth, will certainly change. To a large extent, 2012 is the undiscovered country," says Chris Weafer, head of strategy at Troika Dialog in his 2012 outlook.

Bankers on the whole are optimistic that Europe (and hence Russia) will manage to muddle through the first half of 2012 without toppling into the abyss. However, even under the various "nuclear winter" scenarios of Europe's collapse, most banks still see Russia growing by a bit more than 2% and doing reasonably well. "The outlook is based on a muddle through scenario for the Eurozone (no financial collapse but weak growth) and a modest slowdown elsewhere, with global output around 3.5-4.0% and an oil price of $90-100," says Marcus Svedberg, chief economist at East Capital in a fairly typical summary. "We acknowledge that there are risks on the downside, especially in the Eurozone, and that Eastern Europe will be affected if these risks materialise. At the same time, we believe the long-term growth outlook remains solid, even though growth will stay below trend in the near term."

Internally, there is a sharp divide in the possible dominant drivers of the Russia story. A battle will be fought between the rising income and retail story, which is essentially apolitical vs. the cloying bureaucracy, corruption and wrong-headed gigantism of Kremlin policy. Russia has reached another of those crossroads it is always traversing: the economy has reached a level of sophistication where simply increasing state spending can no longer produce growth. Indeed, upping the state's presence will be increasingly detrimental to growth from here on in and there lies the road to stagnation.

Still, despite the pall that hangs over the international capital markets, Russia's economy was picking up steam in the second half of 2011 as the banking sector and consumer confidence (and spending) recovered. It was not quite the boom it should have been, but the economic momentum is widely believed to continue into 2012 barring external train wrecks and continues to relentlessly improve. "2012 will see Russia join the World Trade Organization, set up the long-awaited central depository, and Gazprom will likely start to pay attractive dividends. Russia is slowly starting to look like a normal market, and that should drive down the discount," says Citigroup strategist Kingsmill Bond.

Return of political risk?

Politics has made a comeback in a big way following the Duma elections and street demonstrations in December. Popular protests and the public booing of Putin (for the first time in 12 years) unsettled investors. While the big demonstration went off quietly investors were left asking: is political risk in Russia back?

bne's take on a possible "Russian Spring" is that if it happens, it will probably be the most civilised revolution of any recently witnessed. A combination of relative affluence, low unemployment, rising income levels, reasonably strong GDP growth and a government with lots and lots of cash will combine to soothe the people's anger. But more than anything else, the Russian protest is being led by the middle class, the very people that Prime Minister Putin has enfranchised with the economic growth of the last decade and half, who are not natural rioters.

Equity markets probably overreacted to the demonstrations in December 2011, but the political environment is likely to remain confused until after the March 4, 2012 presidential elections. Few doubt that Putin will be reinstalled as president as promised, however, how it is done and what Putin can offer to placate a public that is becoming increasingly tired of him will colour his next term in office.

As the new president will not be inaugurated until May 7 (and then he must appoint a new prime minister by May 21) there is also unlikely to be much clarity until about June. At the time of writing Moscow was full of rumours that the kremlin was planning a major reform initiative. Some of the scenarios being discussed included: Medvedev will be sacked as Prime minister in 2012 and replaced by a strong liberal such as former finance minister Alexei Kudrin, who announced that he will form a new political party in the middle of December; there will be a major reshuffle of the Cabinet; and some oligarchs will be ousted or even jailed as part of a make over and as a fob to the anti corruption campaign.

Still, despite the speculation over Putin's growing authoritarian tendencies, it is important to remember that it was the PM himself who launched Russia's first attempt in 2001 at economic reform with the so-called "Gref Plan" at a time when no-one believed in it. The economic benefits that followed have convinced everyone in the Kremlin that some sort of reforms are needed and worthwhile, so we see no reason to believe the reforms will stop or even slow. The only issue is one of pace and what the focus will be.

Citi's Bond summed up the consensus view on politics well in his outlook note:

* The return of political risk: We believe that the market is only now starting to price in the return of top-level political risk for the first time in 12 years, and that developments in Russia will lead to more short-term downside.
* The protests are likely to continue: Russia is unusually well-educated and wealthy to endure a system characterized by so much corruption. Now that the spark has caught the tinder of discontent, we expect more protests.
* The government reaction is likely to be populist: We believe that the government is likely to indulge in populism to attract votes rather than reform to improve the long-term situation. We anticipate more friction with the West, more government spending, and a postponement of liberal policies. There is also the risk of attacks on unpopular oligarchs and higher taxes on rentier companies.
* The threat to the reset: It is standard policy for regimes under pressure to seek out a foreign enemy. We believe that the conflict of words between Prime Minister Putin and US Secretary of State Clinton may escalate further.
* The ruble is likely to weaken: We expect more ruble weakness as a result of the political uncertainty and the relatively significant role played by foreigners in providing long-term capital to Russia.
* The metals and mining sector is most at risk: We see risk to companies that are beneficiaries of the current rentier system or controlled by oligarchs.
* Regulated companies are also at risk: The government may elect to postpone again electricity price rises and to force oil companies to lower their domestic prices.
* Potential beneficiaries: Retailers are the most obvious potential beneficiaries of higher government spending.

Predicting growth numbers for 2012 has been made impossible by the uncertainties that are wracking Europe: Moscow's investment bank forecasts have covered the spectrum of possibilities.

Inside the country, growth and confidence will be driven by Kremlin policy initiatives. However, with presidential elections in March, some clarity on policy is unlikely to appear before the start of the third quarter, although at the end of 2011 analysts were saying the pressure from the protests could cause the Kremlin to offer a new reform agenda earlier as part of their efforts to placate the dissenters. Just how ambitious this plan will be remains moot, with most observers erring on the side of "steady but not spectacular."

"If we do get that crisis-rebuild scenario in Europe and elsewhere, then the case for Russian market out-performance in second half of 2012 and into 2013 will be boosted by the fact that the next government is expected to take a more proactive and pragmatic route to improve investment in the economy, and the reform agenda should proceed at a steady, albeit modest, pace," says Weafer.

GDP drivers for 2012

While portfolio investors concentrate on oil prices as the bellwether for the Russian stock market, it is domestic investments, construction and household consumption that actually drive growth, accounting for some three-quarters of the economy. All of these factors are due to increase in 2012 and construction growth was already well underway by the end of 2011.

The economy will get a further boost after the government cuts social security taxes that it realises were hiked too high at the start of 2011 and ate into incomes, thus holding back consumer demand.

* Consumer demand

By October, household consumption had already recovered all the ground lost in the crisis, increasing by 8.8% on year, which is only moderately lower than the 9.2% year-on-year reading registered in the preceding month, according to Deutsche Bank. Consumption is already above pre-crisis levels and expected to grow at the same rate or higher in 2012. Indeed, the rise in consumption was so strong in the last months of 2011 that Deutsche Bank says the end of year GDP numbers may be revised up from over 4% to 7% in the New Year. "The Russian economy has been surprisingly resilient to global turmoil, as the oil price is holding up well and a renewed credit crunch has been avoided for now," say analysts at Danske.

The bne consensus growth (assuming oil prices of about $100) is for 3.72% in 2012, in a range from 2.8% to 5.0% - a wide spread. Much will depend on where oil prices actually settle and how the Eurozone crisis unfolds. The government's own estimate is exactly on the consensus, predicting 3.7% of growth in 2012 as its baseline assumption for the budget, assuming $95 oil. "If the stagnation in Europe gathers momentum showing a near-zero growth rate, the reaction of the markets, both commodity and oil ones, may be more nervous. The oil price of about $80-90 is the price at which the Russian economy will be adequately protected despite a slower growth rate. In this case, our estimate may be about 2.5-3.0% instead of 3.7% provided for in the basic scenario," Deputy Economic Development Minister Andrei Klepach said in November.

Consumption will be also be supported by recovering consumer crediting. Pre-crisis, the volume of loans to the consumer were growing at over 50% a year, however in 2009-2010 the crediting business came to a standstill and Russians spent their time repaying their old loans. However, by 2011 credits to consumers had restarted and were increasing by 25% on year, according to Danske. Shopping is a powerful engine of growth, as at end of the day Russians remain underleveraged and still want all the material goodies that westerners take for granted. Retail credit was growing at 15% in the second half of 2011 and is expected to grow at 20% in 2012, according to Danske.

* Fixed investment

Fixed investment is another key factor for the speed for Russia's growth and was rapidly accelerating in the last quarter of 2011. Deutsche Bank pointed to the "emphatic" growth of investment as an important factor for economic performance in 2012: investment growth was picking up all year starting at 5.3% in January-October and was set to end the year at 6%, but on a month-on-month basis was accelerating towards the end of the year, running at 8.6% in October and is expected to continue to increase in 2012, partly driven by the construction sector which had returned to health in the last quarter of 2011.

"Our view is that fixed investment growth is likely to benefit in 2012 from a combination of lower capital outflows, further recovery in construction as well as the implementation of large-scale infrastructure projects associated with the preparations for APEC summit in 2012 and Sochi Winter Olympics in 2014. Starting from next year, a notable increase in infrastructure spending is also projected for the 2018 Soccer World Cup," say analysts at Deutsche Bank.

The key element of the increase in investment is the invisible infrastructure boom that started in 2008: from a low of $7bn of spending in 1999, the Kremlin has been spending a massive $100bn a year spending on infrastructure since 2008 ­ equivalent to a third of the budget spending ­ and intends to keep this up for at least another five years. Likewise, similar amounts are being spent on re-equipping the military.

bne believes that the bankers are underestimating the impact this infrastructure spending will have on the economy. Much of it is linked to sports events (such as the Sochi 2014 Winter Olympics and the World Cup in 2018) so the spending comes with a framework, a set of fixed goals, international scrutiny and hard deadlines ­ all of which are fairly novel concepts for government spending and should conspire to make this some of Russia's more effective investments. At the same time, big reforms in other sector, notably automotive, are also starting to bear fruit. "In 2012, industrial growth will concentrate in budget-financed military sectors. Consumption is likely to remain the primary driver of GDP at 3-4%. However, household spending is generally a lagging business-cycle indicator, and we forecast it to support economic growth in the beginning of 2012, but the aftermath of the slowdown to affect consumption by second half of 2012, after less generous budget spending following the presidential elections of March 2012. Furthermore, Russia plans to increase military spending by $640bn over the next 10 years," says Citi's Bond.

Russia needs investment growth of over 25% to produce long-term sustainable growth, but averaged just 20% between 2000 and 2010. Obviously investment fell away after the blitz hit in 2008 to next to nothing.

In 2011, fixed investment was recovering again and growing by 8% year on year by the end of the year, and the hope is this rate will be maintained and improved on. This is one of the areas where Putin's 2024 policy plan will make a big difference: boosting investment needs to be at the core of the programme.

* Construction

Construction was amongst the hardest hit of all Russian sectors, but thanks to banks bailing out developers because they were unwilling to take the huge losses on the loans, the economic recovery has led to a rapid recovery in the real estate sector.

Construction was the third largest contributor to Russian growth pre-crisis. The sector has also been supported by the change of mayor in Moscow, as all construction permits have been frozen until 2013 while the new administration sorts through the mess left by Yuri Luzhkov.

Tellingly, the most activity has been in the warehouse sector where real estate agents are reporting best-ever results as multinationals are running short of space to house their imports. But prices in the residential and especially the office market are already above their long-term trend prices (counting out the bubble in 2007 and 2008). Moscow was voted the "most attractive market in Europe" by Cushman & Wakefield in December.

On balance bne expects that the Russian economy, if left to its own devices, could grow faster than expected thanks to the recovery of crediting, consumption and the massive state spending on infrastructure and the military.

Need for a new economic model

In October, Putin boldly told investors at the VTB Capital investor conference that Russia will grow by 6-7% in 2012. "4% is not good enough. We shall aim higher on the back of domestic demand, an improving investment climate and greater investment efficiency. The ultimate goal is to diversify the economy and create hi-tech jobs." He went on to list the priority sectors: nuclear, biotech, nanotech, communications and space, and said that investments would increase to 25% of GDP.

No one believes he can do it. This rate of growth (and investment) is double the bne consensus forecast for 2012 and to pull it off Russia would have to completely change its economic model. Several investment banks highlighted the need for a new model and Aton Capital even produced a whole report asking whether Russia is headed into a cul de sac because of the unsolved structural issues like low investment and poor demographics.

The problem is the game has changed but the Kremlin seems to still be playing by the old rules. In the first phase of transition, a state needs to take the lead, as it is the only economic agent with sufficient resources to kick start business. Spending on infrastructure and other big projects both inject cash into the system and also build a framework in which new business can operate. However, in the second phase the continued presence of the state in the economy increasingly hinders the development of private enterprise and the state needs to move from push to "nurture," improving the rules that allow a level playing field for companies to slug it out in the market place.

Russia has reached this second phase and the Kremlin needs to come up with a new model for the economy and do things like invest heavily in R&D and education. But there is no sign that it will give up its predilection for setting up huge state champions. And spending on education in the 2011-14 budget, already at subpar levels, has actually been cut. Pundits are waiting to see what change the 2012 presidential election will bring and Putin's comments above show that at least he is aware of what needs to be done so positive surprises can't be ruled out. "If Russia were to succeed in unleashing forceful structural reforms, we believe GDP growth rates of 5% to 6% would easily be possible over the longer term. The marginal productivity of investment in a market-friendly environment would be very high, delivering a big boost to economic activity, and this would surely get foreign investors excited as well. So in this sense, while we remain cautious on reforms we hope to be surprised positively by Mr Putin and his team after the presidential elections are out of the way in March 2012," says Reinhard Cluse of UBS.

Inflation

Of all the macroeconomic parameters, the government has had the most success with inflation, which is expected to end 2011 at about 6% - its lowest level since 1992 ­ and will fall another two points in the next three years.

This success is partly due to the economy slowdown, but more to the change in policy at the Central Bank of Russia, which has begun to release its grip on the ruble and is in the processes of finally switching over to inflation targeting. The capital outflows in 2011 also eased inflationary pressures, which have led to money supply (M2) increasing by about 7% in 2011, down from 31% in 2010. For 2012-14, the CBR expects a modest, by Russian standards, growth in the money supply of 13-20%. "CPI inflation is likely to decelerate to about 6% in the beginning of 2012 from just below 7% in December 2011 as a result of postponed adjustment of state-regulated prices. 2012 stable or declining oil prices should help to slow down PPI down, which will restrain the CPI growth, counterbalancing the boost from inflation from currency depreciation, provided wage growth remains moderate (about 10-11%). If oil prices rise, we should see greater CPI growth," says Kingsmill Bond of Citi.

The battle with inflation will impact the utility sector the most. The sector was supposed to go over to the so-call RAB method of calculating tariffs based on a company's assets and investment programme. However, the state effectively suspended the programme in February 2011 once it realised this would lead to 15%-plus tariff hikes in an election year. Once the presidential elections are passed, this reform may be put back in place.

Instead of the average 10-15% tariff growth in recent years, average tariff growth for 2012 was be 6.5-7.5% for electricity, 7.5% for gas, 6% for rail freight, 10% for passenger rail transportation, and 4.9% for household utilities in 2011.

State finances

* Budget deficit

Russia was supposed to run a deficit until 2015 following the 7% economic contraction in 2009, but by October the budget was already back in the black to the tune of RUB1.4 trillion and is estimated to end the year at 1% of GDP.

Likewise, the reserve fund was supposed to run dry by the end of 2011 as funds were to be used to plug the hold in budget spending. Instead, the fund took in RUB600bn ($20bn) and ended 2011 with an estimated RUB1.6 trillion in the kitty.

While Russia's fiscal crisis has receded faster than anyone dared hope, because of heavy spending the budget will remain under more pressure than it is used to going forward ­ and this will only increase in the coming years. Pre-crisis, the budget broke even at an oil price of $21 in 2007, but this had risen to $115 by the end of 2011. Russia is a lot more vulnerable to oil prices than it has ever been before. As a rule of thumb, UBS says that for each $10 change in oil price the budget balance price changes by 1% to 1.5% of GDP.

Estimates of the budget deficit for 2012 vary widely, ranging from the state's -1.4% to Deutsche Bank's -0.4%. Again everything will depend on what happens outside Russia and to the price of oil. UralSib says if the Urals oil price drops to an average of $60/bbl instead of the $100/bbl currently planned in the budget, the budget deficit will reach 6% of GDP instead of 1.6% of GDP the bank is forecasting.

"Given DB's positive oil price outlook for 2012, the current account is likely to continue to exhibit a strong surplus, while in the fiscal sphere a moderate deficit may emerge at the federal level. The escalation in fiscal commitments (most notably in the defence sector) may sustain the level of the non-oil budget deficit at high levels, leaving the federal budget vulnerable to declines in oil prices," say analysts at Deutsche Bank.

There is no clarity on this score, but having said that, Russia's deficit has managed to surprise on the upside every year since 2009 and everything needed to allow it to surprise on the upside again in 2012 is in place.

Still, a modest budget deficit will be fairly easy to finance and with $80bn of scheduled debt to refinance, the Ministry of Finance has already said Russia would probably offer a Eurobond in the New Year without specifying how much (see below). Russia has plenty of scope to tap debt markets: its debt/GDP ratio is currently at less than 11% and its the entire foreign debt is covered dollar for dollar by the country's foreign exchange reserves.

Despite the relatively good performance of the budget in the short term, there are mounting concerns for the medium term due to the rising social, infrastructure and military spending as well as rising imports. The Russian economy is moving into a new phase of tighter budgets where the huge surpluses it has enjoyed until now will slowly disappear in the next years. The government will have to improve its efficiency while economic expansion will be harder to maintain and increasingly important to balancing the budget.

* Oil

As ever, the wild card for next year is what will happen to the oil prices. Still barring another global meltdown, all of the investment banks and the international financial organisations are predicting oil prices will stay in the $95-$100 range following on from the average $109 oil cost in 2011.

Oil production has been declining in recent years and the state has become more interested in reducing demand at home by encouraging energy efficiency as a way to maintain energy supplies. The IEA forecasts that Russian oil production will soon go into decline and natural gas production will only grow at about 1% a year over the coming decades, assuming $30bn a year is invested in both oil and gas production. However, the state is revving up to boost investment into the sector: Rosstat reports that investment in the oil and gas sector reached $40bn in 2010, its highest point in a decade, and more of the same is to follow.

Russia will require $1.5 trillion for developing the extraction of oil before 2035, International Energy Agency chief Maria van der Hoeven said in November.

"The Brent price, and therefore Urals, has outperformed other commodities and equities in 2011. This is due to tight supply, demand skewed toward the still-robust developing world and a higher risk premium as a result of instability across the Arab world. Oil will not be able to avoid a decline with the EU recession and slower global growth in 1Q12. But the same factors that held the price relatively well in 2011 are still in place. This will not prevent Russian market weakness in 1Q12 but should still ensure a favorable domestic economic platform for second half of 2012," says Weafer.

* Tax take to rise

With Russia expected to run deficits on a regular basis in the near future, the talk has started about raising taxes. The Kremlin has plenty of room for manoeuvre as taxes in Russia are amongst the lowest in Europe.

However, the first thing the Kremlin will do in 2012 is cut social security tax. Many of the problems caused in the first half of 2011 were due to an overly zealous hike in these taxes from 26% to 34% of the wage bill that cause real incomes to fall and hurt consumption. The Kremlin realized its mistake in the summer and has promised to reverse this change.

Capital investment and incomes were strongly hit in 2011 following the social security tax increase: in the first half of 2011 capital investments decelerated to 2.7% year-on-year growth (vs. 6.0% in 2010) and real incomes contracted 1.2% year-on-year (vs. 4.3% growth in 2010).

The mandatory social security contribution of employers is due to drop from 34% of wage bill to 30% and this change is supposed to remain in force until 2013. However, the government has also introduced a 10% social security tax surcharge for wages in excess of RUB512,000 per annum, which will mostly affect the financial and natural resource sectors.

"Finding an appropriate rate for the employers' contribution has been a thorny topic within the cabinet. On one hand, the government wants to support entrepreneurship by keeping the mandatory contribution as low as possible, but on the other hand social security contributions are insufficient to cover the actual costs of the system," the Bank of Finland said in a report on taxes.

In the meantime, Russia will hike some of the more obvious taxes it has left untouched until now to bring them in line with the rest of Europe. Alcohol and tobacco duty hikes have already been approved for the 2012-14 budget, with the largest increase for vodka. Petrol taxes will also increase ahead of inflation, but part of this money will be used to fund the road fund that will pay for automotive infrastructure projects.

The extraction fee (resource use tax) for natural gas is significantly lower than the extraction fee on crude oil. This gap will be narrowed by doubling the current resource use tax on natural gas by 2014.

However, analysts are expecting the lion share of the big tax increases only to come in in the summer after the presidential elections are passed.

On the flip side the government is thinking about ways to use tax breaks more intelligently to promote important sectors. The finance ministry was due to finish a review of the tax code at the end of 2011 and recommendations for changes to the system will be presented in the summer of 2012.

The ministry's assessment shows that the overall value of tax breaks granted to firms in 2010 amounted to around RUB700bn (€17bn), an amount equivalent to about 10% of combined federal and regional tax revenues. Of that, about RUB170bn constituted temporary relief on the resource use tax granted to oil and gas producers, RUB100bn was for property and another RUB100bn for depreciation on corporate profit tax.

* Privatisation

In 2011, the government re-launched its privatisation programme with the twin goals of getting the state out of the economy and raising some money for the budget. The crisis prevented most of the sales from happening, but a SPO of 10% of VTB Bank and the auction of a controlling stake in First Rail Cargo company both got out of the door.

Under a president Putin, the privatisation programme may slow, as it was very much Medvedev's baby. Putin's circle -- mostly Siloviki -- are also not keen on the idea of selling off the state's crown jewels: Deputy PM Igor Sechin suggested in December that the government would not bring SPOs to the market at a price lower than the original IPO, which was quickly rejected by other ministers, but the possibly of miring the whole programme in argument is real.

The sales that are currently slated to go through in 2012 include Sberbank (a 7% stake), and another VTB stake (10%), with a total valuation of around $6bn. Both of these sales are very likely proceed irrespective of Putin's attitude to the programme. The managers of VTB in particular are very keen to completely privatise the banks as quickly as possible.

Rosneft is another company where the government wishes to sell a stake of around 10% (worth just under $7bn), and which may take place in 2012.

Apart from the companies included in the 2010 programme, the state is planning to greatly expand the list of stocks to be sold. Russian Railways had originally announced plans for an IPO in 2011, but is now targeting an issue in 2013. Initially the sale may be for 25% and with further sales over the following years. Reports also suggest that the state will sell its full stake in the following companies, retaining only a golden share.

* Current account and trade balance

Russia has been running a comfortable trade surplus, but as the economy continues to recover the combination of lower commodity prices externally and rising demand sucking in imports internally will continue to pull the surplus down.

Russia's current account surplus increased 37.7% on the year to $84bn in January-October, Central Bank of Russia (CBR) Chairman Sergei Ignatyev said in November, but the surplus is expected to disappear entirely by 2014 according to the Ministry of Economic Development and Trade. As a result, the dependence of Russia's economy on the inflow of private capital is to increase, Deputy Economic Development Minister Andrei Klepach says.

"A decrease in commodity prices and weaker global demand for commodities in 2012 will lead to only 0.5% year-on-year growth in export revenue to $522.bn in 2012. Imports will outpace exports due to real ruble appreciation: we expect that imports will grow by 9.9% year-on-year to $342.7bn in 2012. Thus, the trade balance will decrease to $179.6bn in 2012 from $201.0bn in 2011," says UralSib.

2011 also saw the return of capital flight in the face of the uncertain political future: an estimated $85bn left Russia in 2011 ­ the largest outflow since 1994, excluding 2008 ­ but bankers and the government are predicting capital flight will slow with bank estimates ranging from between $20bn to $40bn.

* FDI and investment

Investment into Russian remains very low by comparison to its peers in Central Europe, but was recovering strongly in the second half of 2011.

Russia's level of FDI as a share of GDP rose fairly steadily from 2002, peaking at 4.5% of GDP in 2007, but since then the level of FDI has dropped, reaching less than 3% of GDP in 2010. The average for 1994-2010 was 1.9% of GDP, significantly below the average for post-communist countries and the BRICs.

Investments for the ten months of 2011 equalled $36bn and foreign direct investment was up even more, by 43% in October year-on-year to $11.8bn, nearly half of which ($4.7bn) arrived in the third quarter alone.

Of the FDI a third went into manufacturing as direct investment continues to diversify away from extraction, which still takes another third of the investment (down from 54% at the start of 2011).

While the total FDI still only represents about 1% of GDP ­ far to small to affect the capital account ­ one of the changes noticeable in 2011 was the entry into the Russian market of several multinational retailers.

The game started in December 2010 when America's PepsiCo paid $3.8bn for a 66% stake in Wimm Bill Dann, to become Russia's single biggest dairy producer overnight. Over the course of the year a string of similar deals and direct investments were announced adding up to over $10bn of commitments according to bne's estimates.

It seems while investors are still taking a wait and see attitude, the truly big multinationals are increasingly committing to the Russian market; with growth in the traditional markets likely to be poor for at least five years these companies are moving into the large Russian consumer market which is still growing strongly and will do for years to come.

* Ruble

The value of the ruble is intimately tied up with price of oil and which way capital is flowing ­ in or out ­ but that relation broke down in 2011 due to a sharp pick up in capital flight.

Under the basic "muddle through spring, pick up in second half" scenario most banks expect the depreciation the ruble in 2011 to reverse in the second half of the year. Deutsche Bank for example expects the ruble to appreciate towards RUB28/dollar, which is roughly in line with the other banks.

The capital flight partly caused by the rising political uncertainty. An estimated $85bn left Russia in 2011. Capital outflow in 2012 is expected to slow to $20bn-$40bn before reversing in the second half of the year.

* Interest rates

While reducing inflation was the top priority in 2011, in 2012 the focus of the CBR will be to support economic growth. As inflation continues to fall, the CBR has plenty of room to manoeuvre and at least one rate cut of 25 bps is expected in 2012. A rate cut would also support the banking sector, which was struggling with liquidity problems at the close of 2011, which would also boost growth.

* WTO

The last hurdles for Russia's accession to the WTO at the end of December and Russia should go into 2012 as a paid-up member. The long-term benefits should be significant, though the impact of accession in the short term will be small as Russia has lost most of its comparative advantages over the 18-year long negotiating process.

"WTO entry in 2Q12, while not having any significant short-term impact, will nevertheless establish an increasingly important timetable for companies to become more competitive," says Weafer.

The main benefit is that membership imposes external rules and standards on Russia and will push Russian companies into becoming more productive and competitive; Russia's main problem is bad management, according to a World Bank study. Turkey and most of the Central European countries found that joining the EU (or trying to) brought not only more trade, but as important was the adoption of EU standards which made business more transparent and productive.

"WTO membership will therefore create a framework or a time clock for the next government's agenda to create greater efficiency and diversification in the economy, just as the 2018 FIFA World Cup will provide a timetable for improvements in key parts of the nation's infrastructure," says Weafer.

The short term impact includes:

* A fall in the average tariff ceiling from 10% to 7.8%. One third of tariffs will be at their final level immediately on accession; a quarter more will be put in place in three years.

* The beef tariff will fall from 65% to 15% and pork from 65% to zero.

* The foreign equity limitation on telecoms will be eliminated in four years.

* Foreign banks will be allowed to establish subsidiaries

* Foreign companies will be able to engage in distribution.

* Quantitative restrictions such as quotas, permits or bans will be eliminated. Russia will apply all its laws and regulations governing transit of goods in accordance with GATT and WTO.

* Government procurement: government agencies will award contracts in a transparent manner.

* The government will eliminate all industrial subsidy programmes so that subsidy provided is not contingent upon exports.

* Producers and distributors of natural gas will operate on the basis of normal commercial considerations. Households are exempted.

* The Russian Federation will use international standards for the development of technical regulation.