bne:Chairman's Monthly List — December 2014 by Ben Aris

This is bne's Russia chairman’s newsletter, a selection of forward looking stories on development in eastern Europe and the region. Feel free to request topics or ask questions: editor@bne.eu

Contents: Top Story Deep recession for Russia in 2015 Ruble likely to rise into $70s in first half 2015 Growth is around the corner, says Putin

Politics – the good Sistema's Vladimir Evtushenkov freed from house arrest Putin slashes penalties for small scale bribery Capital amnesty for returning money proposed Profits of foreign-registered Russian firms are aimed to get under Russian taxation LGBT Activist Compensated After Russian City Bans Gay Pride Parade NGOs get off foreign agents list, but barred from election monitoring

Politics – the bad EU not ready to talk free trade with Russia as cases mount in WTO Foreign Agent NGOs barred from election monitoring

Politics – the ugly Russia's former defence minister summoned to court over corruption case First Sentence Handed Out in Russia's Anti-Corruption Police Scandal One in three Russian officials corrupt Siberian editor of independent news agency beaten

Polls, mood, sociology Despair ye not, all you entering the emerging markets Three out of four of Russians feel happy All love for Russia lost in Ukraine Russians bullishly patriotic despite fatalism Order more important than human rights for Russians Eight of ten Russians support Putin despite crisis, war Half Russians consider Putin to be source of power Kremlin sceptical of truth of TI's corruption perceptions ratings

Russians Belarus, Kazakhstan most successful CIS countries

First budget spending cuts, non-oil budget

West to blame for collapse of Soviet Union

Effect of falling oil prices on the budget

Banks and Finance Banking overview

Russian government could double deficit in 2014 to 0.9% to recapitalize banks

Bank capital adequacy problems

Macro economic wrap

Trust Bank gets $1.9bn bailout, enters DIA administration

Gross international reserves & RUB

CBR rate hike to hurt bank margins and growth in 2015 EU eases sanctions on Russian bank in Europe to stave off European banking crisis Number of indebted borrowers rising

China to Russia's rescue, dollar loosing reserve role Belarus-Russia trade to reach almost $39bn in 2014 Russia's savings dilemma

Infrastructure

Russia's FinMin to suggest granting 10% of National Welfare Fund to banks

Russia's RDIF, India's IDFC to invest $1bn in joint infrastructure projects

Dollar denominated mortgage holders in trouble

Russia's Sukhoi Civil Aircraft seeks quarter of global passenger plane market

Sberbank hikes mortgage rates and increases down payments

Container turnover continues to fall in November

Economics How much did devaluation cost? GDP forecasts and oil price scenarios Russia launches $100bn debt bailout programme Incomes and inflation

Russia's Finance Ministry: use 10% of NWF to fund infrastructure via banks Gazprom opens subsidiary for Turkish pipeline Russian government bails out Transaero airlines

ECM

CBR to cut rates in first quarter 2015 (if conditions allow)

Equities outlook in 2015 and oil

Stability in 2015 at the consumersâ&#x20AC;&#x2122; expense

Evraz delays IPO of Evraz North America due to oil price slump

Budget outlook for 2015

Moscow Exchange shareholding may be limited to 10% maximum stakes

Mysterious buyer of massive Rosneft bond likely to be state banks

Russian stocks - Keep Calm and Carry On

S&P could downgrade Russia's rating to speculative in January

Cabinet approves the sale of a 19.5% stake in Rosneft MSCI could exclude Russia from Emerging Markets index if capital controls introduced All SOEs must pay 25% of net income as dividends Russian government stake in Bashneft might not be sold within the next three years Tinkoff Credit Systems Bank may delist from LSE

DCM Debt redemption in 2015 Russian corporate hard currency bonds under pressure from ruble collapse Russian regions' could face a tough 2015 as debt grow

Sectors Car sales down just 1.1% in November thanks to weak ruble, but poor 2015 outlook Car sector was already hurting before the ruble meltdown Devaluation helps housing and hotels but hurts offices and warehouses Law changed on Russian oil sector taxation Rosneft to become second largest Russian gas producer Russia sold $13bn worth of weaponry in 2014 Apple products sell out as ruble crashes

Top Story Deep recession for Russia in 2015 The mood amongst Russia watchers is as black as it has always been in the midst of one of Russia's major crises. The forecasts for 2015 are almost – but not unanimously – bleak. The crash of the ruble by 10% in a day on December 15 and the subsequent 650-basis-point hike in overnight rates by the Central Bank of Russia (CBR) bring to 17% consigned Russia to a deep recession of a 4.5% contraction, according to the CBR statement following the rate hike. What happens next will all depend on where oil prices settle (Brent oil was $60 a barrel at the time of writing) and how much of the CBR's $420bn in hard currency reserves it burns up managing the exchange rate in an effort to stave off a crisis-inducing panic. Uralsib said in its 2015 outlook that if the ruble continues to tumble, then "Russia would experience economic deterioration on the scale seen in the early 1990s." But this has to be balanced by Russia macro fundamentals, which remain fairly solid, whereas in the 1990s the country was bankrupt. There is one glimmer of hope for the economy in 2015, largely championed by Evgeny Gavrilenkov, chief economist at Sberbank and an economist of formidable power, who cannot be

written off lightly. He is arguing that the problem is the lack of stability in the ruble/oil prices, rather than the level they fall to. If both stabalise quickly, then the devaluation of the ruble will lead to a surge in import substitution investment and give the Russian economy a shot of vitality that will keep growth positive in 2015. The OECD agrees, saying in November: “Russia would fall into recession if oil prices continue to decline, but sustainable import substitution could provide some boost for the economy." Gavrilenkov told bne IntelliNews in December that in his trips to the regions, the bank's rich clients there were borrowing and actively investing into import substitution production, and these will get a boost from the increasingly cheap ruble. There was a noticeable upswing in industrial production and manufacturing in the last months of 2014 and agricultural in particular expanded by 16.6% in November, so the idea is not ridiculous. Without doubt, the devaluation of the ruble comes with some beneficial effects, as was clearly seen in 1998 (the last time the mood was this black), which led to a surprisingly fast rebound (GDP grew by 10% in 2000, still a record). Really, the debate is over

how strong these effects will be – and that comes down to your view on where oil prices will settle and how the political problems Russia is facing will play out. Triple whammy crises Russia was suffering from three simultaneous crises as 2014 came to a close. The first and most obvious was the military standoff between Russia and the West over Ukraine and the political crisis that led to tit-for-tat sanctions that have wounded Russia's economy. The financial sanctions imposed in the autumn have in effect cut off all Russia's leading banks and corporates from cheap, long-term international funds. The second was the tanking oil price and associated ruble/dollar exchange rate, which came moreor-less out of the blue. Russia's currency had been losing value all year, but the declines accelerated alarmingly in the last months of year as oil prices dropped below $70 and then $60 in the space of a few weeks. The outlook for oil prices in 2015 remains subdued (see commodities section), but a consensus seems to be that oil will stabilize at about $70, or possibly lower. The third, and least obvious, but probably the most significant, is a domestic investment crisis; Russian companies are not investing in their production and fixed investment has been flat or negative for several years. Without investment the economy will stagnate and incomes will

gradually fall, undoing the sense of prosperity that Russian President Vladimir Putin has been able to deliver in his 14 years in office – both of which were already visible by the end of 2014. The results of this crisis of confidence amongst domestic businessmen are manifest everywhere, including a drum-tight labour market, soggy GDP growth, falling real income levels and cheapening ruble. Going into 2015 and economists in Russia were almost universally pessimistic, predicting at best stagnation, at worst recession. "Our base case… assumes virtually no economic growth in Russia for the next two years," says Uralsib. "Russia has faced neither stagnation nor stagflation in the post-Soviet period. This presents a serious challenge to corporate capex plans and policies, as well as the overall investment attractiveness of Russian capital markets."

Chances for resolution to the political crisis It is pointless writing a detailed analysis of the chances for a resolution to the political crisis, as the situation is far too fluid and the two sides have dug their heels in too deep. Moreover, the fact that both sides – the Ukrainian government and the Russian government – are fighting each other by using military militia (Ukrainian "volunteers" on one side and "holidaying" Russian soldiers or separatist rebels on the other) introduces a wildcard, as was seen by what appears to be the accidental shooting down of the

commercial MH17 commercial flight by pro-Russian rebels. Neither side fully control their combatants; they can encourage them to fight easily enough, but they can't order them out of the field with any certainty of being obeyed. bne IntelliNews' view is that a political compromise will be found, maybe as soon as in the first half of 2015, as both Russia's and Ukraine's economies are in deep trouble and neither can afford a protracted conflict. But sanctions could easily be in place for years. Certainly, the liberals in the Russian government in charge of economic planning assume sanctions are not going anywhere any time soon. Economic Development Minister Alexey Ulyukayev said in an interview that he expects sanctions to remain in place until 2017. Russiaâ&#x20AC;&#x2122;s earlier macroeconomic forecast assumed that the sanctions would be lifted in 2015, Ulyukayev said. The issue is to find a compromise on the key points: Russia is insisting on a "100% guarantee" that Ukraine won't join Nato, and that its strategic and commercial interests are taking into account in any deal with the EU; Ukraine (and the EU) is insisting Russia withdraw its support for fighters in the eastern Donbass region and Russia stop interfering in Ukraine's internal politics. The forces pushing the two sides towards a deal include first and foremost this is not an ideological confrontation, the main difference with the Cold War conflict. Russia

now shares the capitalist ideology with its opponents and everyone, including the EU, want to go back to doing business and making money. Secondly, no one can afford a protracted standoff. The pain of the conflict is hurting everyone really badly. Ukraine was on the cusp of collapse in December and desperately needs to start the process of reform. Russia economy is slowing and the financial sanctions imposed in September 2015 have proven to be extremely effective and are really hurting the Russian economy. It can not grow or develop while cut off from the international capital markets irrespective of how much money the Chinese lend the Kremlin. Europe too is sliding back into recession and is still in the middle of the Eurozone crisis, although reporting on this has been pushed into the background in 2014. It is squandering scarce political and financial resources on the dispute that it needs to spend at home to fix its own problems. Globalisation was the phenomena of the naughties and the showdown has split Europe into blocs again, but this bucks the historical trend for further and deeper global integration. While the politics have become divided, the underlying business relations remain integrated and continue to function: German businesses already in Russia (6,500 companies, ten-times the rest of Europe) are still earning profits and investing into what is already the second biggest consumer market in Europe, which remains their most

profitable market in Europe. And as was noted above, Russia can't develop without access to the capital markets in London and New York. That leads to a mismatch between the political rhetoric and business interests. The politics have mostly been couched in terms of the ideal that countries have an inalienable

right to chose their partners, but ignores the realpolitik that small or weak countries have to take the interests of their larger/more powerful neighbours into account. Business doesnâ&#x20AC;&#x2122;t give a fig for ideology and will go where the markets are rich.

Ruble likely to rise into $70s in first half 2015 During his annual press conference on December 17 Russian President Vladimir Putin said that the current currency crisis would only last "at worst" for two years, and the recovery could begin possibly as soon as the first quarter of 2015. At first glance this sounds like talking down the crisis in order to calm frayed nerves, but a little closer and Putin could well be right. The collapse of the ruble on December 15 was not so much the collapse of the currency, as a collapse in the oil prices: in the space of two months oil tumbled from over $100 a barrel to a low point of about $58, before stabilising at around $60. Given that approximately half Russia's budget revenue is derived from oil taxes any fall in the oil price is bound to reduce the value in the ruble. The value of the ruble tracks the oil price more-or-less 1:1. The Russian budget is hurting as a result of the falling oil prices â&#x20AC;&#x201C; but then so is everybody who produces

oil. As bne showed in a recent bne:Chart about half of the world's oil producers now need more than $100 oil to balance their budgets, and the biggest producer, Saudi Arabia, needs $99.2 to accomplish the same. Even Qatar, which needs the least, still only breaks even at $71, putting a floor on the fall in the oil prices. After the instability caused by the panic selling in December subsides it seems like oil prices will recovery slowly to at least the low $70 level in 2015. "The situation on the global oil market will stabilize soon," Energy Minister of the United Arab Emirates Suhail al-Mazrui said on December 21 at the tenth Arab Energy Conference, reports TASS. He noted that the dramatic fall in oil prices had impacted the economic situation of Arab oil producing countries and called to pool efforts to work out measures aiming to stabilize the energy market and this way consolidate positions of the OAPEC (Organization of Arab Petroleum Exporting Countries) states on the global oil market, adding OAPEC

fully supported OPEC’s decision to give some time to the oil market to stabilize. Recent estimates of break-even oil prices have painted a worrying picture for Russia’s fiscal future following a sharp decline in spot prices. Oil prices have lost 20% of their value this year and threaten to bring Russia's economy to its knees. Or do they? While Russia's new three-year budget breaks even with oil prices of $100, how does this stack up against other petrol producers around the world? According to Deutsche Bank's figures, all but three of the countries included in its estimates can expect to record a budget deficit for 2014, with their break-even prices sitting far higher than last week’s two-year low of $84 a barrel. But with a break-even price of $100.10, Russia will have to gamble on the further decline of the ruble against the dollar to ease the burden of the fall in spot price. The ruble has already fallen by some 20% since January. The budget estimates for oil prices are

denominated in dollars, but the revenue it receives from oil taxes are paid into the budget. That means if oil prices fall, so long as the ruble/dollar exchange rate also falls, the budget receives more rubles and as budget spending is set in nominal rubles unadjusted for changes in the exchange rate, the devaluing ruble can compensate for the falling price of oil - at least as far as running a federal budget deficit is concerned. A longer-term prognosis predicts that Russia runs a deficit of 2.5% if oil prices remain around the $80 mark and the ruble value stays in line with current trends, forcing the Ministry of Finance to dip into its foreign exchange reserves. Yet Russian reserves are the equivalent of some 25% of GDP and so the state has plenty of wiggle room compared most other major oil producers. With reserves amounting to only 1.4% of GDP and a break-even price of $162 – nearly double current prices – Venezuela, for example, is in a lot more trouble than Russia.

Growth is around the corner, says Putin "Growth is inevitable and imminent," Putin promised Russians who tuned into the president's annual press conference. He predicted that the poor economic situation would last up to two years in the "worst case scenario" but recovery could start as soon as the first quarter of next year â&#x20AC;&#x201C; it would depend on what happened to the price of oil. Putin predicted that the global economy would inevitably return to growth and this would drive up the price of oil, lifting the value of the ruble with it. The whole of the first half hour of the press conference was dedicated to the discussion of economics in unusual detail for this annual preChristmas jamboree. Putin struck an upbeat tone, stressing that Russia has plenty of reserves, that the fall in the oil prices was temporary and that things would be back to normal soon â&#x20AC;&#x201C; depending on what happened with the "external factors." While stressing that Russia has adequate government reserves of RUB8.4 trillion rubles ($142bn), Putin admitted that the collapse of the oil price was driving Russia's current woes â&#x20AC;&#x201C; and that oil prices could fall further. "We must not waste our reserves on the market but give loans to the market, via things like repos. These instruments can be issued for a month, a week or a day. And

this money will be repaid, so it is a way to offer access to the reserves. It has been done correctly but maybe could be done faster," said Putin. And he went out of his way to assure the millions of Russian tuning into the event that while there had to be budget cuts to take into account the new realities (without specifying what would be cut) social payments, pensions and state employee pay would not be cut. The government said even before the December 15 plunge of the ruble by 10% that it will cut spending by 10% - the first nominal cut in budget spending since Putin took office in 2000. The obvious place to make these cuts is in defence spending, which has ballooned in the last two years and currently accounts for about a third of total budget spending. But given Putin's siege mentality that he has been showing during his confrontation with the west, it is likely that the president will find every way possible to avoid cutting the re-armament programme that he regards as a fundamental national security issue. Putin added that another 25% of Russia's problems were the result of sanctions and painted a picture of East-West confrontation where Russia must stand up for its national security interests. He described Russia as a bear that

"they" wanted to "sit quietly and eat honey" and chain up. "If [the West] takes out the bear's fangs and claws it will not be able to do anything. It's just a stuffed animal. We are trying to maintain our security interests," said Putin earnestly. Putin didnâ&#x20AC;&#x2122;t blame everything on oil and Nato's aggression, but conceded that his government has also failed to carry through on the obvious need to diversify the economy. Putin fended off a question blaming Russia's legendary bureaucracy for the economic problems. "You think Russian bureaucracy is bad? You should see the bureaucracy in the EU. Compared to that Russian bureaucracy is not a problem," Putin said. "Our problem is that everyone wants to invest into energy as that is the most profitable. No-one is investing into high tech." He suggested that this crisis might be the goad that Russia needs to finally put in the deep structural reforms that Russia needs in order to flourish. Prior to the press conference, Economic Minister Alexey Ulyukayev said in an interview that Russia could grow by 2%-3% a year if it made these reforms. Putin returned to the theme of promoting the business environment as the way to diversify the economy. "We need to provide a friendly business environment for

entrepreneurs, we need more innovation, to diversify the economy, regional development, to stop using police/courts for business disputes," said Putin. However, Putin has consistently failed to follow through with effective reforms. His line is belied by the recent renationalisation of privately-owned oil major Bashneft, which has seriously undermined confidence amongst both Russian and foreign investors.

Politics â&#x20AC;&#x201C; the good Sistema's Vladimir Yevtushenkov freed from house arrest

and earned its shareholders large profits mainly from high dividend payments.

Investors sighed a breath of relief after Russian President Vladimir Putin announced London-listed Sistema BoD Chairman and majority shareholder Vladimir Yevtushenkov would be not only released from house arrest in the middle of December but was also invited to Putin's private Christmas party for leading businessme n and top government officials.

Yevtushenkov promised to sign an undertaking to appear, meaning he will be required to meet with investigators as well as appear in court at appointed times and also provide notification of any change in address.

The head of the multibilliondollar conglomerate is heavily owned by international portfolio investors, who were afraid that Yevtushenkov was going to become a second Mikhail Khodorkovsky (who was incidentally also released by presidential fiat exactly a year earlier at the same press conference â&#x20AC;&#x201C; Putin's annual meet the press affair). Despite being an oligarch that came to prominence thanks to his association with former Moscow mayor Yuri Luzhkov, Yevtushenkov is generally regarded as a straight shooter and in particular turned the oil producer Bashneft around

Yevtushenko's house arrest was recently extended and supposed to last until March 16, 2015. The rationale behind the extension, according to Interfax, was that the criminal investigation against Yevtushenkov was ongoing, and he should remain under house arrest to prevent him from pressuring potential witnesses or fleeing. Also, the period of investigation was extended until April 28, 2015. Putin slashes penalties for small scale bribery Russian President Vladimir Putin introduced new legislation to slash penalties on small scale bribe givers partly because "no one pays the fines anyway," a presidential envoy said.

A bribe under RUB25,000 ($366) is currently punishable with fines of between 25 and 50 times its size. But a bill drafted by the office of Putin now proposes to bring the fine's lower threshold to 10 times the bribe's size. The minimum fine for bribe-givers in such cases will be brought down from 15 to five times the bribe's size, according to the bill, which passed the first of three readings on Tuesday. For corrupt officials taking bribes of up to RUB150,000 ($2,200), the fine's lower threshold is to be slashed from 20 to 10 times a bribe's size. The time frame for paying will also be extended from 30 to 60 days, and from three to five years for those whom the court has allowed to pay in installments. Graft can also be punished with set fines, community service and jail time, all of which would also be reduced in accordance with the bill. The bill does not affect bribes that are larger than RUB150,000. Only between 15 and 20 percent of fines imposed over lesser bribes are actually paid, presidential envoy Garri Minkh said earlier in comments carried by the TASS news agency.

Capital amnesty for returning money proposed Russia will hold a amnesty for flight capital that returns to Russia and deposited on Russian banks accounts â&#x20AC;&#x201C; no questions asked and no tax charged, president Vladimir Putin proposed in December. With capital flight expected to reach $120bn in 2014 and roughly the same amount to leave in 2015, the Kremlin is looking for ways to return cash home. No one is sure how much Russian capital is squirrelled away off-shore but it certainly runs in the hundreds of billions of dollars. Profits of foreign-registered Russian firms are aimed to get under Russian taxation The Duma approved tax law changes in December designed to restrict the common practice of offshoring profits of Russian companies by sending e.g. dividends and loan interest to companies in countries with low tax rates. The long-recognised problem has recently faced more vocal demands to promptly rectify the situation, including from Russian President Vladimir Putin himself. The amendments require Russian firms and private individuals to pay taxes in Russia on the profits of their foreign-registered corporations if they own at least 50% of the company. Starting in 2016, the minimum ownership cap falls to 25%.

Amendments include also some more detailed conditions, like that the foreign tax jurisdiction will still be recognised in certain circumstances, e.g. when at least 80% of the earnings of the foreignregistered company are generated through business activities in the local economy. Deputy finance minister Shatalov said the reforms would add about RUB20bn (€360m) a year to the federal budget. Next year’s federal budget revenue estimate was about RUB15.1 trillion rubles (€270bn). LGBT Activist Compensated After Russian City Bans Gay Pride Parade Well known gay rights activist Nikolai Alexeyev won an award of RUB3000 ($55) from a court in Kostroma, which ruled a gay rights parade and two LGBT protests he was trying to hold should have gone ahead. The local authorities were ordered by the court to pay moral damages to Alexeyev, who has become the public face of the gay rights protest movement. The decision was the first time in a decade that Alexeyev, the founder of the Moscow Gay Pride movement, has been compensated for moral damages in regards to his LGBT rights activism in Russia. Homosexuality was only made legal in 1996 and under the Russian constitution every citizen has the right to assembly. However, while the courts always

make a point of offering political protests an alternative revenue to requests help in the centre of the capital (usually in the middle of nowhere) the Russian courts have usually flat our denied gay pride marches anywhere in any city with impunity – a clear violation of the constitution, which is why the Kostroma ruling is so surprising. In 2013, the country adopted legislation banning the promotion of non-traditional sexual relations to minors. NGOs get off foreign agents list, but barred from election monitoring Good news and bad for Russia's NGOs in December: the Justice ministry introduced a procedure that would allow foreign-funded NGOs from the "foreign agents" list; but that the same time they have been barred from monitoring elections. The move comes days after President Vladimir Putin conceded that there were shortcomings in a controversial 2012 law requiring NGOs that engage in vaguely defined "political activity" and accept funding from abroad to register as a "foreign agent" with the Justice Ministry. NGOs can get off the foreign agent list if they if they pass an unscheduled audit, RIA Novosti reported. However, the concession comes with a ban on getting involved in politics and particular acting as election monitors.

Politics – the bad EU not ready to talk free trade with Russia as cases mount in WTO “Trade from Lisbon to Vladivostok: yes, it’s a beautiful vision,” said Cecilia Malmström, the new EU trade commissioner, at parliamentary meeting in Brussels in December. “But I don’t think it’s a vision that will materialise in the very short term. Russia has occupied an independent country. The situation is escalating. Entering into trade agreements with Russia does not feel appropriate." That statement was made the same day the EU’s foreign policy chief, Federica Mogherini, met with the US trade representative, asking him to include a chapter on energy in the ongoing transatlantic trade and investment partnership (TTIP) negotiations. Geopolitical considerations run high in current EU trade policy, and the TTIP is increasingly seen as a political necessity. The TTIP could trigger US exports of crude oil and shale gas to Europe, and ease the continent’s dependence on Russian fuel. This dependence is seen as Europe’s Achilles’ heel in its political relations with Russia. However, signals are conflicting as German Chancellor Angela Merkel has also suggested that the EU can do a trade deal with the Eurasian

Economic Union (EEU), the Russian-lead trade club. The resolution of this debate will go a long way towards the possible resolution of the current political crisis. Echoing the tones of Germany’s 1970s Ostpolitik, which aimed to bring East and West together through closer economic integration, Merkel, who is under pressure from certain business groups and parts of public opinion to become more conciliatory with Moscow, recently told the German parliament in Berlin: “We are ready for talks between the Eurasian [Economic] Union and the EU on trade." Business favours the idea. Frank Schauff, CEO of the Association of European Businesses (AEB) in Moscow, told Borderlex: “One large, single economic space [between the EU and Russia] makes sense.” And talking to the EEU “would be positive if issues like technical regulations and technical standards are harmonised with the EU,” he added. The Russians want a deal. In 2010, Russian President Vladimir Putin offered the EU to establish a common economic space stretching from Europe’s westernmost capital to Russia’s easternmost city in Asia, at a time when he was establishing a Customs Union with Kazakhstan and Belarus. The

Eurasian Economic Union (EEU) came into being on January 1, 2015. Russia’s desire to include Ukraine in the EEU – a project conceived as a rival to the EU and its Association Agreement plans with Ukraine, Moldova and Georgia – has been one of the main triggers of the crisis in Ukraine. Yet Brussels and Moscow are still far from this goal. Trade is the EU’s exclusive competency. If Berlin were to press Brussels hard for a trade deal now, it could not, alone, change Brussels’ current firm stance and current unwillingness to engage with the EEU, although there is evidence that the issue is being debated within the bureaucracy. Brussels-Moscow negotiations towards a follow-up treaty to their 1997 Partnership and Cooperation Agreement were suspended last March, immediately after Russia annexed Ukraine’s Crimean peninsula. The new treaty would have included a free trade agreement. A trilateral dialogue initiated last summer between Ukraine, the EU and Russia over how to handle a potential negative fall-out for Russian exports of Ukraine’s Association Agreement with the EU is now moribund. Foreign Agent NGOs barred from election monitoring Russian NGOs that classified as "foreign agents" are barred from acting as election monitors, the

Russia's Justice Ministry ruled in December. Any NGO that receives funding from abroad has to registered with the government and then in paced on the "foreign agent" registry. However, Russian President Vladimir Putin has recently hinted that he will soften the rules due to a general outcry at the law. The Justice ministry has submitted a new procedure that would allow non-governmental organizations to remove themselves from the federal register if they appeal as well as passing a snap inspection. Putin said during his annual press conference on December 17 that there were shortcomings in a controversial 2012 law.

Politics â&#x20AC;&#x201C; the ugly Russia's former defence minister summoned to court over corruption case Russiaâ&#x20AC;&#x2122;s former Defence Minister Anatoly Serdyukov, who has been the most high profile victim of Russian President Vladimir Putin's anticorruption drive, was summoned to the Presnensky Court of Moscow to testify again in the arms agency Oboronservis corruption case. The former defence minister was to be questioned on December 23, but the court meeting has been postponed already twice due to illness of defendant Yuri Grekhnyov who was taken to hospital on December 22.

by the Kremlin stopped short of jailing him. His former assistance and alleged lover, the former head of the property relations department of the Russian Defence Ministry Yevgeniya Vasilyeva has been charged with embezzlement of Oboronservis funds during the sale of the company property and jailed. She was found guilty of inflicted damage on the state in excess of $57mn. Serdyukov's has been used as a warning to other top officials of the dangers of stealing from the state and his renewed questioning is probably simply a message that even if you are not jailed you remain at the mercy of the Kremlin if you steal from the state. First Sentence Handed Out in Russia's Anti-Corruption Police Scandal Russia's corruption-busting Interior Ministry's Main Directorate for Economic Security and AntiCorruption has been caught up in a string of corruption scandals all year and saw its first member sentenced for graft in December. The Moscow City Court judged that a former anti-corruption official was guilty of graft and sentenced him to five years in prison for bribe-taking, tampering with evidence and taking part in a criminal organization.

Serdyukov was sacked in November 2012 and investigated

The sentence comes on top of a string of scandals that lead to the arrests of several senior officers in

the Interior Ministry's Main Directorate for Economic Security and Anti-Corruption. Analysts have suggested that the arrests are also due to an internal power struggle with the Federal Security Service (FSB) over the control of economic crime investigations. Russia's business ombudsman Boris Titov has tried to keep the FSB out of his anti-corruption fight but was overruled by Russian President Vladimir Putin in December, who said the state security services must be consulted in drawing up new anti-graft rules and retain a role in investigations. One in three Russian officials corrupt One in three Russian officials are corrupt, according to the head of Russian National Anti-Corruption Committee Kirill Kabanov, speaking in an interview in December. "About 30% of officials â&#x20AC;Ś are corrupt," said Kabanov said in an interview, adding that a growing problem is the growth of "corrupt business" specifically created to extract money from the state. "Unless we eliminate corrupt business itself, the fight with corrupt officials is just mowing the lawn. The more you mow, the more professional the people who engage in corrupt business become," Kabanov said.

Siberian editor of independent news agency beaten There was fresh outrage as yet another independent journalist was assaulted in Russia in December. Yevgeny Mezdrikov, the editor in chief of the independent Taiga.Info news portal was assaulted by two unknown assailants on December 8 just hours after the website suffered a DDoS attack, reports local press. Mezdrikov was hospitalized with a broken nose after being attacked in the portal's offices in the centre of Novosibirsk. The attack was linked by co-worker to Mezdrikov's critical reporting on local affairs in Siberia. In separate news the online TV station Dozhd (TV Rain) has almost been forced off the air after Kremlin pressure lead to its cable network contracts being cancelled. Currently the station is being shown only online and is run from an apartment.

Polls, mood, sociology Despair ye not, all you entering the emerging markets Life is tough in emerging markets, but the bne Despair Index, which we introduced in 2011, and reflects life in the bottom third of society, shows that life is not as tough as you would expect: measuring to Spain Russia and it transpires that

not only is it far lower than in all of the other emerging markets it's also lower than the EU average. All in all Russian seem to be a lot happier and more optimistic about the future the most of the EU and on a par with their compatriots in the UK and Germany.

The Despair Index is built on the better-known Misery Index, which is simply the number you get when you add together inflation and unemployment. Traditionally the misery index has been taken as a shorthand form to show how societies are coping during economic downturns.

emerging markets very well, so we added to the equation poverty. Shortly after the collapse of the severe union rushes despair index shut up to around 2,500 -- think about the size of that number for a second: thatâ&#x20AC;&#x2122;s the sum of inflation+unemployment+poverty.

However the misery index doesn't capture what's going on in the

But the index quickly fell off to more reasonable levels in the 1990s and after Russian President

Vladimir Putin took over in 2000 not only did the index fall to be on a par with most developed markets, Russian despair fell below that of all of the leading industrial markets during the boom years: 2007 inflation fell into single digits that is for the first time; poverty also dropped down into the early teens; and finally unemployment has fallen to a record post-Soviet low in single digits. Against that western countries have been surprisingly unsuccessfully stamping out property, and the Euro crisis has increased unemployment into double digits in many of the European Union countries. Details of despair In 1994, the US scored 8.7 by this measure, with inflation at a comfortable 2.7% and unemployment at a not-too-bad 6.1%. Compare in the same year Russia’s unemployment of 13% and astronomical inflation of 412%, which was a result of the opening-up of ex-Soviet markets and the ‘shock therapy’ methods employed to kick-start their economies. Since then, the landscape has transformed dramatically, with many ex-Soviet nations and their neighbours enjoying a quality of life and economic growth that

would have been unimaginable a generation ago. While nominal wealth may still be lagging behind that of their Western counterparts, many emerging market nations are enjoying growth and relative purchasing power that can go toeto-toe with many Western nations. Indeed, Poland now has a GDP (PPP) higher than that of the Netherlands and each of the Scandinavian countries. Take for example the US 2012 median income of just under $31,000. The median Czech income was less than half that, at $14,000, yet the percentage of its population living under the national poverty line was only 8.6% in 2013. Data released in November showed that nearly one in five households in the US – a country set to record a 2014 GDP of over $17tn – is receiving state assistance in the form of food stamps, with over 15% of the population living below the national poverty line. The bottom line is that in developed markets such as the US, the post 2009 crisis has been eating into the income of the middle class: in America average wages have been falling by approximately $1000 a year for the last eight years. In contrast in Russia incomes have stored some

16 fold since Putin took over. As bne IntelliNews put it last time it calculated the Despair Index: “What does it matter if the prices of iPods are rising at 10% a year if you do not have enough money to put food on the table?” The point here is that the nominal wealth of a low-earning American household does not equate to prosperity when compared to a nominally-lowerearning emerging market counterpart. Unlike the Despair Index, the more-established Misery Index does not reflect this. 2015 is going to be a difficult year as for the first time in a decade and a half real incomes are going to fall. Already the uptick in inflation – expected to finish 2014 at 10% and almost certainly to go into the early teens in 2015 – has impacted the despair index; just in the second half this year rising inflation due to food price hikes has already progresses slightly behind Germany and the US. Despite the speculation that Russia's economic slowdown could spark a so-called coloured revolution, bne's view is before this can happen despair in Russia must overtake that in the EU and then some. The lines were converging

as 2014 came to an end, but if the expected rebound in oil prices materialises Russian despair will be assuaged. Find an interactive version of this chart here: http://www.bne.eu/content/story/b nechart-despair-not-ye-emergingmarket-brethren Three out of four of Russians feel happy A decade of income growth, the return of political stability, and the increasing normalcy of life means that three out of four (76%) of Russians feel happy, with only 17% unhappy, according to a poll by the state-owned Russian Public Opinion Research Centre (VTsIOM). Young people are particularly happy: 88% of respondents said they felt happy compared to 64% of pensioners and 61% amongst the working classes. 40% of respondents said the family and relatives gave them joy. 14% of people said they felt happy because their relatives and they themselves were healthy. "I have all required for happiness," respondents (12%) said.

11% of respondents link their prosperity with good job, 4% link it with high salaries and 4% with housing, the VTsIOM said. All love for Russia lost in Ukraine Russian President Vladimir Putin may have won the battles in East Ukraine but he has definitely lost the war for hearts and minds in Ukraine, which suggests that he will also fail to achieve his longterm goals to keep Ukraine out of EU and maybe even Nato. A poll released by Gallup on December 15 concludes that the support there was for the Russian leadership in Ukraine has fallen by 90% in the last year: just 5% of respondents in the survey say they have a positive view of the Russian administration under Putin, down from 43% a year earlier (The poll excluded the Crimea). The poll should worry the Kremlin as traditionally the Russophile eastern half the country has shown high ratings for the Russian leadership for most of the last decade. Now the disapproval of the Kremlin is uniform over the whole country, Gallup found. "The drastic change in approval is not that surprising, given Russia's backing of pro-Russian separatists and its gas dispute with Ukraine, but it marks a full divorce from Ukrainians' generally high approval ratings of Russian leadership over the past decade," Gallup said in it report. "Importantly, ratings have declined sharply across all of Ukraine - including the country's

typically more Russian-leaning South and East, where 57% approved in 2013 and 12% approve today. In Ukraine's Central and North and Western regions, current approval is 1% and 2%, respectively." While the western perspective is that Ukraine has definitely turned from Russia to Europe, the poll reflects the local view that Ukraine is on its own; the Maidan protests began as a call to join Europe, but quickly morphed into a more fundamental call to break the oligarch-client system and end endemic corruption. These are the same values espoused by Europe, but Ukrainian's feel let down by Europe, which has offered little other than rhetorical support in a fight that has cost 4,000 Ukrainian lives so far. The approval of the German leadership amongst Ukrainians, which has been fighting the good fight on Europe's behalf, has also fallen by 7% over the same period to 41%. The majority of Ukrainians (55%) think it is unlikely that the EU would intervene in the event of armed conflict between Ukraine and Russia, and about half (49%) think it is unlikely that the US would get involved, Gallup found. Russians bullishly patriotic despite fatalism A recent poll by Russiaâ&#x20AC;&#x2122;s Levada Center has shown that the majority of Russians are resigned to having little in the way of democratic freedoms despite feelings of

national pride being overwhelmingly high. As the bne:Chart shows, when asked if they believe they can “personally influence political and economic life” in Russia, 67% of respondents either completely or mostly disagreed with the statement. In spite of this, 69% said that they feel “free” living in Russian society.

much sway over the running of their country while registering emphatically nationalistic responses to other questions. When asked if people should support their country even when it is in the wrong, exactly 50% of respondents said they should, and 64% of those polled believe that Russia is “better than the majority of countries”.

The results of the poll paint a confused picture, with respondents seemingly willing to live without

See an interactive version of this chart here: http://cf.datawrapper.de/VrHwz/3/

Order more important than human rights for Russians

civil right freedoms: the vast majority says order is more important than human rights with 29% taking the opposite view, with another 9% saying the question

After having lived through the chaos of the 1990s, Russians put more store in order than human or

was difficult to answer, according to the independent Levada Centre. Freedom of speech and freedom of religion also rank well below order but below human rights. 75% of respondents cited the right to life as the most important right, followed by the right to free education, medical aid and pensions with 64%, and the right to privacy and a home with 50%. The right to a well-paying job in one's specialty came next, with 43% â&#x20AC;&#x201D; followed by the right to own property, with 39%. The right to free speech was cited as the most important by only 30% of respondents, and freedom of religion by only 22%. Another 20% cited the right to information as the most important, and 19% cited the right to elect representatives in government. Eight of ten Russians support Putin despite crisis, war Eight out ten (81% )said they strongly or somewhat approve of the way Putin is handling his job, an AP-GfK poll found in December, up sharply by 20% from the same survey in 2012. The presidency and the military are the country's most trusted institutions, according to the poll, with three out of four Russians saying they trust the presidency and two out of three expressing faith in the military.

A similar poll by the independent Levada Centre came to a similar conclusions with 74% saying they support Putin. Half Russians consider Putin to be source of power Half of all Russians consider Russian President Vladimir Putin to be the main source of power in Russia, according to a poll from VTsIOM, whereas only 23% understand that the constitution guarantees that the people are the bearers of sovereignty. The number of Russians that understand the people are the source of power is up slightly from 19% that understood this in 2005. Another 11% believe the parliament is the source of power in Russia. Another 3% believe the source of power in Russia is some "higher force." However, Russians are clearer on the structure of their political system: 72% knew that Russia is a federative state vs 67% in 2005. Kremlin sceptical of truth of TI's corruption perceptions ratings The Kremlin said it was sceptical of the veracity of the widely quoted corruption perception rankings produced by Berlin-baesd corruption watch dog Transparency International, Sergey Ivanov head of the presidential administration said in December. â&#x20AC;&#x153;I am sceptical, if not extremely sceptical, about such ratings that

can be simply invented,” he said. “Transparency International’s rating is not a rating of corruption, it never even sets such a goal, it only analyses perception of corruption by some experts no one knows." At the same time, Ivanov said the Kremlin “is very attentive to serious sociological agencies, including foreign ones.” Ivanov cited a separate survey on corruption conducted by Ernst & Young that found corruptions risks in Russia had considerably decreased to be below the world’s average. Russians Belarus, Kazakhstan most successful CIS countries Russians see Belarus and Kazakhstan as the most successful countries in the Commonwealth of Independent States (CIS), according to VTsIOM. In what will be a surprise for westerners Russian see the more successful of the two as Belarus (66%) vs the oil rich Kazakhstan (45%), against the results of 2013 (50% and 35% correspondingly). Belarus' poor political profile in the west is less of an issue in the east and Belarus has been seen since Soviet times as the home to highly skilled workers. Ukraine has lost its position in the top-three: if in 2013 some 21% of the respondents considered it to be successful, in 2014 the figure plummeted to 2%.

Belarus has the best relations with Russia among all the CIS member states (65%), followed by Kazakhstan (46%), Armenia (7%), Azerbaijan (6%), Kyrgyzstan (3%), Moldova (3%), Uzbekistan (3%), Turkmenistan (3%), and Tajikistan (2%). Ukraine place in the hearts of the populations of the other CIS countries has also faded with only 3% of the respondents believe the Russia-Ukraine relations are strong enough, while in 2013 the figure stood at 18%. West to blame for collapse of Soviet Union The majority of Russians blame a "conspiracy" of hostile Western powers for the collapse of the Soviet Union, a poll from the Levada Centre found in November. The number of Russians who blamed the Soviet Union's demise on the West had risen to 28% from 16% seven years ago, the Levada Centre found. Just over half (54%) questioned regret the fall of the Soviet Union. Another 28% don’t miss it. In a more sophisticated question with multiple answers asking what the cause of the collapse of the USSR was, the most popular answer was the "irresponsible" deal between then-Russian leader Boris Yeltsin and his counterparts from the Soviet republics of Ukraine and Belarus to signed a dissolution agreement on December 8, 1991 in Belarus

that was the death knell of the union, said 30% of respondents. Other explanations have seen little change in popularity in surveys conducted over the past seven years with 19% blaming public discontent with the policies of the Soviet government and Mikhail

Gorbachev, slightly down from 21% in late 2007, the Levada Centre found, which is also the western academic explanation for what actually happened.

Banks and Finance Banking overview As the year came to a close Trust bank needed a RUB100bn ($1.9bn) bailout and state-owned banks VTB Bank and the Agricultural bank have also been asking for money to recapitalize. However, with over RUB1 trillion ($16bn) in reserves in the Deposit Insurance Agency, currently the authorities have plenty of reserves to cope with the pressure put on the sector by December's sharp ruble devaluation and no banking sector crisis is expected in 2015 as the year starts. But Russia's banks are having a hard time of it. They have been in the front line in 2014. Firstly, the Central Bank of Russia (CBR) killed off their most profitable business, consumer lending, at the start of the year to pop a ballooning consumer credit bubble. As of the end of 2014, about one in five Russian banks were making a loss and few retail orientated banks were making money. The number

of profit-making credit institutions (including those whose profit is zero) decreased 18.6% to 646, according to the Bank of Russia's statistics as of November 1, 2014 year-on-year â&#x20AC;&#x201C; and the same is expected in 2015. However, the fall in the profits of banks fell at a slower pace, which suggests the banking business is becoming more concentrated in the top banks. The profit of Russian banks for eleven months of 2014 fell 11.7% year on year to reach RUB781bn. Total net profit of state banks was RUB416.7bn for three quarters of 2014 versus RUB394.7bn for the same period in 2013. In particular, net interest and commission income of state banks increased 21.3%. This increase together with profits from operations with foreign currency allowed the state banks not only to make up for nearly double growth of net expenses for provisions, but also to cover losses from operations with securities.

The financial sanctions on a handful of state-owned banks made the entire Russian banking sector toxic, cutting it all off from the international capital markets. Banks were left to fund their business the traditional way â&#x20AC;&#x201C; by raising deposits.

The CBR published benchmark rates for capping unsecured consumer loans for commercial banks in Q1/15, under a law that was passed in the end of 2013 over increased concerns about overheating in unsecured crediting sector.

The upshot is that while asset growth continues and were up by 22% in 2014 to RUB70 trillion, profits have fallen to an estimated RUB750bn for 2014, or down by a quarter year-on-year. At the same time the lack of funding means banks have been dipping into their own capital to fund operations and the sector's capital adequacy rate has fallen from about 20% in the boom years to 12.4% by the end of 2014, but still above the mandatory minimum of 10%.

The CBR has been worried about a possible consumer credit boom and so capped the main interest rates banks can charge. It calculated that rates on POS-loans will not be allowed to exceed 55%, credit card loans 35%, and new car lease rate 20%. Before the outbreak of the Ukrainian crisis, the International Monetary Fund (IMF) mission to Russia listed rapid growth (3040%) of the unsecured retail credit sector as one of the main risks to the short-to-mid-term outlook.

Non-performing loans (NPLs) are ticking up, especially in retail loans, but are still on the order of 5% of total loans and well within the manageable range.

Funding costs are expected to continue to grow, but these costs should to some extent be passed on to clients in the form of higher rates on loans (further slowing the economy), which was already happening at the end of 2015.

The banks remain well capitalised, the state has offered significant support and no one is expecting a financial crisis in 2014. But the banking sector is doing little more than treading water and cannot contribute to economic growth until its funding problems are solved. Lending and deposits growth for the sector should remain around 10% in ruble terms in 2015, as Russian companies will need to refinance through the domestic banking system as long as the international wholesale markets remain closed.

The banks have proven to be resilient in the current environment and 2015 will see them grind out more, albeit modest, growth. Their return on average equity (ROAE) will be depressed and organic capital generation will be subdued, making recapitalization a necessity for some banks. The CBR, for its part continues to close smaller and iffy banks at a pace of about 50 a year -- a process that has gone smoothly â&#x20AC;&#x201C; and will continue to whittle way at the deadwood banks in 2015. "Even if

our pessimistic scenario of low oil prices and a weakening economy and ruble fails to materialize, we could see certain banks fail to meet capital requirements, thus raising the general level of uncertainty and apprehension in the sector," says Andrew Keeley, a banking analyst with Sberbank.

nominal terms in October compared to 10% year-on-year for retail), and the share of funding from the CBR rose to 9.2%, a new post-2009 high in 2014.

In a desperate move to stop the ruble sliding, the CBR hiked interest rates by a surprise 150 basis points in late October. The move didn't work and the ruble continued to slide, but one of the knock-on effects is that analysts are expecting bank deposits to rise in 2015 as a result of the higher interest rates on offer.

Bank capital adequacy problems

Corporate deposits continued to grow twice as fast as retail deposits (24% year-on-year in

CBR introduces raft of temporary measures to support the banking sector in the wake of ruble crisis

The Central Bank of Russia (CBR) temporarily relaxed requirements for revaluation of securities and FX assets in the last week of December, as several banks would not meet their capital adequacy ratio (CAR) requirements of at least 10%. CARs are under pressure across the sector and will be the main issue for banks in 2015.

Capital: Among the other measures include a temporary moratorium on the recognition of negative revaluation losses for securities portfolios, allowing banks to use 3Q14 exchange rates for the recognition of FX assets, widening the range of instruments through which the CBR provides forex liquidity and providing support to the central counterparty on the Moscow Exchange, if necessary. The measure means banks will not have to post losses that could eat into local capital ratios and also offsets the negative impact of the recent massive rate hike. The CBR and government are preparing a recapitalization package for banks for 2015, without any details given, although in December it was already decided to allocate 10% of the National Wealth Fund to banksâ&#x20AC;&#x2122; sub debt. Media reports suggest it may proceed via direct sub debt provisions from the CBR (Vedomosti sources) or via banks issuing prefs to the Deposit Insurance Agency, which in turn will be capitalized by OFZ issuance (up to RUB1 trln, according to Kommersant). FX liquidity: The CBR will launch FX refinancing backed by illiquid assets (rule 312- P), which will help banks raise additional FX liquidity and refinance corporate FX loans. The total amount of FX corporate loans to domestic borrowers is about $110 bn. Assuming a similar ratio to that which we currently see for parallel ruble refinancing, this could imply around a 20% ratio of 312-P financing to total loans, meaning around $20bn in refinancing.

Loan and deposit rates: the CBR decided not to enforce its full credit cost regulation in 1H15 and widened the potential deviation of maximum deposit rates from the market average from 2 ppt to 3.5 ppt. This will be positive for consumer lenders. The CBR recently introduced regulations that cap what banks can charge interest on consumer loans. On the corporate side, there was an easing in provisioning requirements; for example, those regarding loan restructuring involving a change in currency. Credit risk: In certain cases when the financial position of a borrower has deteriorated (e.g. impact of sanctions or force majeure) or a loan is restructured due to redenomination of its currency, the CBR will allow banks not to charge additional provisioning under local accounts. Deposit insurance cover: was doubled from RUB700,000 to RUB1.4m ($23,300 at RUB60/$1) to reassure depositors that their savings were safe and nip any potential bank runs off in the bud. New measures will primarily help banks fulfil CAR requirements. Banks estimate that the dollar's 50% gain against the ruble since the end of September may have inflated RWAs by 11% and shaven off around 1 ppt from the sector N1 CAR ratio (versus 12.2% as of October). Negative securities revaluation would have added to this. In November, for example, when OFZs were flat and the RTS lost

11%, the sector reported a negative securities revaluation of RUB68bn ($1.5bn) in its Russian accounting standards data, the third-biggest revaluation this year. The RTS index has already dropped 26% so far this December, while OFZs have lost around 15%, so the impact could have been pretty significant. Without these measures, it could have been hard for some banks to meet capital requirements. The regulator has expressed its commitment to supporting the stability of the financial system, and we believe these measures will ease pressure on banks╒ capital, especially for the banks whose N1.0 CAR ratios were approaching the minimum level of 10%. The question that remains is how long the moratorium on negative revaluation for securities and FX assets will last, and where the brink is after which the easing of requirements will begin to dangerously distort the picture. However, the new measures do solve some immediate issues, as it would have been hard for the banks to adjust their asset structures by the end of 2014. Trust Bank gets $1.9bn bailout, enters DIA administration The CBR announced on December 23 that it has placed leading commercial bank Trust Bank into administration in an attempt to tackle’s the bank’s financial difficulties. The bank was given a RUB30bn ($1.9bn) loan by the Deposit

Insurance Agency (which has been appointed as the temporary administrator) to support the bank’s liquidity position. Russian banks are under pressure and the state has put RUB100bn ($10bn) aside to support the sector. In addition state-owned VTB Bank and the Agricultural bank have asked for help; between them these three banks could eat up the entire RUB100bn allotted to the sector. However, the Deposit Insurance Agency has a war chest of RUB1 trillion in funds to deal with problems in the sector and analysts speculate that the DIA will take over more struggling banks and organize their sale to other Russian banks in keeping with the regulators efforts to consolidate the sector. At end third quarter of 2014 Trust Bank was the country’s 32nd largest bank by assets (RUB231bn) and the 15th largest retail deposit bank (RUB133bn), according to Interfax. The bank was set up by oligarch Mikhail Khodorkovsky in the naughties but is now is ultimately controlled by three private individuals and has a network of 10 branches and 240 outlets. According to CBR Deputy Governor Mikhail Sukhov, a run on the bank in the last week of December drained more that RUB3bn of its liquidity and caused it to fail. Moreover, the regulator identified “a hole” in the bank’s capital of “tens of billions of rubles,” which

compares with its total regulatory capital of RUB29bn and with an official N1.0 capital ratio of just 10.8% at the start of December. During the temporary administration, the bank will operate as normal (though it will take some time to meet all deposit withdrawal requests) while the Deposit Insurance Agency carries out due diligence. The CBRâ&#x20AC;&#x2122;s ultimate goal is to sell the bank to a strategic investor (likely to be another Russian bank). Several Russian banks (BIN Bank and MDM Bank, for example) have already expressed an interest in taking over the bank. CBR rate hike to hurt bank margins and growth in 2015 On December 15 the Central Bank of Russia (CBR) dramatically hiked rates by 6.5% that will hurt an already struggling banking sector in 2015.

The CBRâ&#x20AC;&#x2122;s November sector data showed corporate loans growing 4.6% month-on-month and 1.5% month-on-month net of the ruble's 19% month-on-month decline against the dollar. Corporate lending: Corporate loans grew 4.6% m-o-m in nominal terms and only 0.9% if adjusted for the massive ruble depreciation. Year-on-year growth bankers estimate, net of the ruble effect, was around 13.5% in November, close to the October level. Though the extremely high rates will probably not last too long, the sector will need to adjust the pricing on all products sooner or later. Corporate loan rates should rise, though demand could wane, or banks themselves could choose not to take on credit risk at such rates to avoid ending up with COR at 2008-09 levels.

Retail loans: were weak, again climbing 1.0% m-o-m in November (0.7% adjusted for FX), with YTD growth of 14% as of December 1. The retail portfolio grew 15.9% year-on-year, slightly slower than the 16.6% growth posted in October. Sberbank outperformed the rest of the sector in corporate lending (6.3% versus 3.6%) and was in line with other banks in retail loan growth (1.0%).

Retail deposit rates will also adjust in 2015 due to the December rate hike, but at a slower pace than corporate rates, as the government is keen to shield the population from the pain of the currency collapse. For retail lending, the duration of the mortgage portfolio will constrain the rate of re-pricing. For unsecured loans, the CBR will likely abandon full credit cost control.

Loans overdue ratio was flat month-on-month on the corporate side at 4.2%, while the situation in retail continued to worsen, with

another 10 bps month-on-month increase raising the overdue ratio to 5.9%.

Retail deposit growth remained sluggish at just 2.3% month-onmonth, which translates into a 1.6% month-on-month contraction minus the revaluation effect. On a year-on-year basis, retail deposits

posted 11.3% growth, or just 2.5% net of revaluation. The sector's monthly ROAE came in at just 8% for the second month in a row, as Sberbankâ&#x20AC;&#x2122;s profit was again very low.

Corporate deposits: increased 6.3% m-o-m (only about 1% when adjusted for FX). Sberbank underperformed the rest of the sector in retail deposit growth in

The CBR rate hike will be felt on all levels, from NIM to asset quality and has already made interbank money very expensive, and a repricing in corporate funds is soon to follow. Bankers see NIM coming under material pressure, as the margin

November (1.7% versus 2.8%, respectively), while it increased its retail deposit rates again in early December.

between borrowing and lending interest rates converge, especially for the state banks, which rely the most heavily on CBR funding. Assets: increased 6.2% m-o-m in November, implying growth of 26% y-o-y and 24% YTD as of December 1.

EU eases sanctions on Russian bank in Europe to stave off European banking crisis The European Union relaxed the restrictions on the subsidiaries of Russian banks in Europe on borrowing and raising finance in a pre-emptive move to stave off a potential European banking crisis.

Russia' biggest banks - Sberbank, VTB, Gazprombank, Vneshekonombank and Rosselkhozbank â&#x20AC;&#x201D; were all included in a financial sanctions regime in July that severely restricts their ability to borrow on the international capital markets that has hobbled their ability to work.

As the Russian economy teetered on the edge of meltdown in the middle of December the EU seem to decide it had pushed things too far and was making noises about backing off. The goal of sanctions was to pressure Russia and not collapse economy completely. Everyone suddenly realised that destabilising Russia is in no one's interests â&#x20AC;&#x201C; especially not in the interests of Europe.

"This should not be viewed as an effort to ease sanctions on Russia â&#x20AC;&#x201D; but rather protecting the stability of the EU banking sector against backdraft from sanctions on Russia," said Timothy Ash, an emerging markets analyst at Standard Bank in London, in a note to clients.

The EU said that European subsidiaries of Russian banks are no longer restricted to raising loans for a maximum of 30 days and can borrow for longer provided, the "documented objective [is] to provide emergency funding to meet solvency and liquidity criteria," according to amendments published in the Official Journal of the EU.

The number of borrowers who received a new loan despite serious problems with the repayment of existing overdue debt is rising fast to 2.8% of the total number of the Russian people who received a loan in the third quarter of 2014 to versus 1.7% in the same period a year earlier, according to the United Credit Bureau.

Number of indebted borrowers rising

The problem for unreliable borrowers is not that their debt is growing but the banks are becoming increasingly selective about who they lend to. Still, the vast majority of borrowers are still managing to service their debt, even if this number is falling slowly too: the number of borrowers who defaulted on none of existing loans fell from 87% in the third quarter of 2013 to 81% in in the same period in 2014, the credit bureau said. Russia's FinMin to suggest granting 10% of National Welfare Fund to banks At a meeting with president Vladimir Putin on Tuesday December 9, Russia's ministry of finance is going to suggest of granting up to 10% of sovereign National Welfare Fund (NWF) to country's largest banks, Kommersant daily reports, citing unnamed sources familiar with the ministry's drafts. Reportedly the ministry is going to suggest granting state subordinated loans for financing strategic projects to banks with capital of over RUB100bn. 10% of the NWF currently amounts to about RUB400bn ($7.4bn). Notably, according to previous reports two state banks VTB and Gazprombank have already secured RUB350bn worth of state support: RUB250bn in subordinated loans and RUB100bn in direct capital injections, respectively.

At the same time most recently Vladimir Putin ordered the government and the central bank to re-capitalize the â&#x20AC;&#x153;systemicallyâ&#x20AC;? important banks until February 1 2015, a definition allowing privately owned banks to also receive state support. Vedomosti business daily recently reported, citing unnamed highranking government officials, that Russian private banks are asking the government for support from the NWF along with the stateowned banks. Reportedly banks that have already received substantial support in 2008-2009 (RUB4094bn worth of loans for 17 state-owned and private banks) are again requesting subordinated funding. Among the past recipients of state support are private banks such as Alfa Bank, Svyaz Bank, Russian Standard, SKB, Zenith, and others. Reportedly, the banks might demand the conversion into capital of the loans received in 20082009, to be repaid by 20% annually as of 2015, similarly to what was allowed to Russia's largest bank state-controlled Sberbank. Dollar denominated mortgage holders in trouble Russians that took out a cheaper mortgage loan have found themselves in deep trouble after the ruble lost half its value at the end of 2014. The only good news is the prudence of Russian banks means the number of people caught on the wrong side of the fall of the ruble is relatively low.

The temptation to borrow in dollar, euro- or Swiss franc-denominated mortgages, which are significantly cheaper than local currencydenominated loans, has plunged people across CEE into a debt nightmare since the 2008 crisis began. However, the Russian natural prudence and faith in their own appreciating currency means only 25,000-150,000 foreign currency-denominated loans were taken out. However, after the Central Bank of Russia (CBR) prime rate was hiked to 17.5% in December even those with regular ruble mortgages are feeling the pinch. Mortgages took off in 2008 and have been doubling in volume every 18 months since. In September for the first time ever the mortgage business of the

state-owned banks, Sberbank and VTB, outstripped their uncovered consumer credits business which became less profitable as mortgage. Mortgage has been growing faster than any other loan type in 2014, partly as prudential reserves associated with the lending are much lower than say consumer credits. Russians like owning physical assets in crisis times and new mortgages soared in the first half of 2014. But the overall penetration of 3%-4% of GDP remains very low. The stock of mortgages was $3bn in April 2014 and was growing by 33% per annum, says Rencap. Russian home ownership is about 80% and one of the highest in Europe, but about the same proportion of Russians say they want to move.

Sberbank hikes mortgage rates and increases down payments Sberbank raised mortgage rates by an average of 200 bps at the end of December and also increased down payment requirements. The bank has also stopped offering mortgage products under two programs, Construction of Your Home and Suburban Housing, both targeted at single-home purchases. The more popular mortgage products for apartments (over 80% and 90% of the Moscow metropolitan and St Petersburg metropolitan markets, respectively), both in the secondary and primary housing market, are now offered at 14.516.0% with the average down payment increasing to 20% (from 10-15% previously) for regular mortgage products, supported by income statements, and to 50% (from 40% previously) for loans not requiring verification of income. This is bad news for the housing market. Mortgage rates have entered “hardly affordable” territory, and the circa 30% of the housing market that depends on mortgages will see a significant fall in demand. The primary market, important for public homebuilders, is likely to see a more profound effect as mortgages account for a higher share (>40%) of pre-sales. With mortgages becoming prohibitive, both in terms of rates and down payments, homebuilders

will only be able to sustain sales by replacing banks’ consumer financing, but that entails a strong balance sheet to begin with and a much stronger requirement on working capital, which most homebuilders are unlikely to afford. Turning to banks for long-term financing for the purpose of replacing banks’ consumer financing is likely to be pointless as homebuilders will simply be passing on the higher cost of capital to their customers. There is likely to be a decline in home sales in 2015, which may put pressure on housing prices in some regional markets, depending on the supply/demand balance; out of the three biggest markets, Moscow remains the safest in this respect.

Economics How much did devaluation cost? It has been suggested that the devaluation of the ruble had reduced the dollar value of the Russian economy from $2.1 trillion at the start of 2014 to $1.4bn at the end, knocking down from 8th largest economy in the world to 13th, or on a par with Spain. This is equivalent to a 34.6% contraction. However, this calculation is simplistic at best. It done simply recalculating the ruble value of the economy using the exchange rates at the start and end of the year ($2.1 trillion times RUB32/$1 in January 2014 to give a ruble value, then dividing by RUB53/$1 rate in December to convert back to dollars = $1.4 trillion, or a $700bn worth of value destruction.) The calculation fails to take into account the fact that Russia exports some $500bn worth of goods (mostly oil and gas) a year where the devaluation calculation above works in reverse increasing the value of exports to $700bn in ruble terms.

It also ignores the fact that the state debt of RUB1 trillion also becomes cheaper thanks to devaluation, but as Russia has only $50bn of external debt the $15bn increase in the cost of this debt due to devaluation is negligible. Adding in this factor and Russia's economy contracted, in dollar terms, to $1.88bn, or only 4.5%. Finally in reality most of Russia's trade is actually with Europe and denominated in euros not dollars. Part of the rubles rapid fall against the dollar has been due to the rapid rise of the dollar against all world currencies. Given that oil export revenue is earned in dollars, but Russia's imports have to be paid for in euros, then ironically Russia is one of the winners in the rapid rise in the dollar's value. If the change in the economy's value over 2014 is recalculated in euro terms (RUB49.2/â&#x201A;Ź1 in January vs RUB62.6/â&#x201A;Ź1 in December) then Russia's economy has only lost 3.1% of its value due to the currency crisis and is still the eight largest economy in the world.

See an interactive version of this chart here: http://www.bne.eu/content/story/bnechart-flippant-claim-russia-spain-widemark GDP forecasts and oil price scenarios The fall of the ruble in the last months of 2014 was down to the fall in the oil price. The ruble lost 50% of its value against the dollar in 2014 (although a lot less against the euro, which is Russia's main trade exchange currency, due partly to the dollar's strong outperformance). The Central Bank of Russia (CBR) predicted that the collapse of the oil prices and the subsequent fall of the ruble condemned Russia to a 4.5% contraction in 2015. Danske Bank was more pessimistic, predicting a 11.3% contraction in the first quarter and a 7.9%

average contraction for the full year, whereas Uralsib predicted simply that "Russia will return to the 1990s" as a result of the crisis. This seems a bit extreme to us as even in the depths of the 2008 crisis Russia's economy only contracted by 7%, driven by the total shock as it came at the end of at least three years of a boom and was catalysed by the short-term debt held by leading companies. This time round there has been no panic and the debt profile has improved enormously. Plus the depth of the devaluation will provide some stimulus in the form of import substitution â&#x20AC;&#x201C; although this will be more limited than in

previous crises. And give the oil prices could well recovery to at least $70 (see related article) the upside for positive surprises still seems greater than the downside for negative surprises at the time of writing. But everything will depend on what happens to the oil price: the need of middle east producers to have oil over $100 to balance their budgets is off set by the global economic slowdown â&#x20AC;&#x201C; in Asia and Europe in particular â&#x20AC;&#x201C; that will kill demand for oil. In December, the Economic Development Ministry presented its new macro forecasts for 2015, incorporating a downgrade in oil price expectations from $100 per barrel to $80. "The new oil price of $80-90 per barrel is most likely to stay over the medium or even longer term," Siluanov told Russia's upper house of parliament in November. However, within a week even $80 looked hopelessly optimistic. Oil plunged through the $70 mark and was at $60 at the time of writing. Oil prices have been losing about $10 a month for the last three months, leading some investment banks to introduce a $40 oil scenario in their 2015 outlooks. The plunging price of oil has made forecasting what will happen to Russia's economy in 2015 impossible, so most banks were issuing scenarios. While it lies outside our competence, bne IntelliNews finds

the argument that there is a floor at $70, as this is a price that will see many marginal US shale producers and fields close, and remove 2mn-4mn barrels a day of production and so stabilise prices. However, we donâ&#x20AC;&#x2122;t expect this mechanism to kick in until the second half of 2015, so the rest of winter and spring months could be very uncomfortable. Also it should be noted that December was clearly marked by panic, as the usual rule of thumb linking oil and the ruble had broken down: usually each $10 movement of oil prices down shaves RUB2 off the exchange rate to the dollar. This means that at $70 the ruble should be about RUB42, whereas in the middle of December it was RUB53 and at $60 oil the ruble fell to RUB66 to the dollar at the time of writing, whereas the rule of thumb should put the rate in the late 40s. It seems probable that during the panic on the currency markets the pendulum swung too far and the ruble rate to the dollar will recover next year. CBR Governor Elvira Nabiullina said that speculators were to blame for 8 to 10 percentage points of the currency's 49% depreciation since January. She predicted that the Russian currency will rise again in 2015. "The ruble will appreciate significantly next year, given an overshoot effect and a rise in oil prices," she said, referring to official forecasts of the Central Bank.

Oil risk scenarios for Russia in 2015 Oil price (Brent $/barrel)

105

100

1.7

1.0

0.3

-0.4

-1.7

-3.1

-4.4

-5.8

RUB/$, annual average

38.6

39.7

40.4

42.1

43.2

44.7

46.5

48.3

Inflation, annual average

6.9

7.1

7.4

8.0

8.7

8.5

8.2

8.1

-0.4 -0.7 -1.0 -1.5 Source: Renaissance Capital estimates

-1.9

-2.6

-3.3

-3.9

Real GDP growth YoY

Budget balance, % GDP

Russia launches $100bn debt bailout programme

December to get its companies over the hump.

Unable to refinance their debt on international capital markets Russia's leading banks and companies are turning to the state for help. The Kremlin launched a $100bn bailout programme in

Banks and companies owe a total of $600bn in foreign debt, of which $100bn-$150bn is due in 2015 according to various reports. The pressure on Russian corporate finance has endangered Russia's

investment grade rating: credit rating agency Standard & Poorâ&#x20AC;&#x2122;s said in December there was at least a 50% chance it would cut Russia's status to BBB- or "junk" status. "We are reviewing our assessment of Russiaâ&#x20AC;&#x2122;s monetary flexibility and the impact of the weakening economy on its financial system," S&P said. The rate cut is not a given as despite the problems the government's reserves are sufficient to comfortably cover the corporate external debt in 2015 and probably 2016 as well. In addition about half of the money owed is owed by state-owned Rosneft and Gazprom, both of which earn dollars from their exports and so should be able to repay their own debts; this problem is not one of refinancing debt so much as managing cash flows against a debt repayment schedule that has been changed by their lack of access to international capital markets. With an average price of $60 per barrel of oil in 2015 that would result in Russia's export income from crude dropping to $95bn, from $174bn in 2013. Moody's ratings agency said that it expected Russia's GDP to contract by 5.5% in 2015 and 3% in 2016, under the effect of the plunge in oil prices and the ruble's slide. Russia has already spent about $96bn of its foreign exchange and gold reserves trying to prop up the value of the ruble.

Incomes and inflation The main impact from the 2014 currency crisis will be to depress incomes for the first time in nearly a decade, with far-reaching consequences. Inflation was already soaring before the meltdown on the currency market in December is bound to make the problem worse: food prices are driving inflation and just food prices were up 7-times more than those in Europe in October. In the short-term many analysts are expecting a spike in prices in January-February as a result of the re-rating of the currency; many retailers have held off increasing prices to off set the soaring inflation and rocketing exchange rate dynamics on imports as they sell off inventory. However, in the New Year they will have to adjust prices to match the new realities and that could mean 10-30% price hikes in both the first two months of 2015. The impact on incomes in 2015 is expected to be significant before recovering in 2016. Real wages were already falling at the end of 2014. Nominal wages rose 0.5% y-o-y in November, while real disposable incomes declined 4.7% y-o-y.

The falling ruble will feed inflation, which is the main macroeconomic problem for 2015, together with the lack of investment. The CBR has had to abandon its mid-2014 target of 5% inflation and was resigned to inflation soaring to at least 12% in 2015, probably more. As companies are squeezed, the real wages growth stalled in mid2014 and turned negative for the first time in almost 14 years at the end of 2014. "Accelerating inflation, the risk of new rate hikes and the lack of aggressive social spending will weaken retail trade growth in 2015," says Alfa's Orlova.

Even during the crisis years after 2008, incomes continue to rise at about 10% a year. However, companies are increasingly being squeezed between the rising cost of borrowing and lower sales. A very tight labour market, with unemployment at historic lows, means they had to continue to increase wages, but this situation is clearly unsustainable. And the government can't help; social payments in 2015 will only be increased 5.5% year-on-year, less than inflation, which will undermine retail trade growth and depress consumption.

"Real wage growth has been much faster than productivity growth since the early 2000s, which has reduced the competitiveness and profitability of Russian firms. But this cannot continue indefinitely and wage growth will have to readjust to a much weaker pace of productivity growth," says Londonbased consultants Capital Economics. The mismatch between wage growth and slow growth in productivity has finally caught up with Russia and kicking in now. Moreover this comes just as Russian households' ability to

borrow has been constrained. A consumer credit boom that came to an end at the start of 2014 and now households are deleveraging as they borrowed too much. "Householdsâ&#x20AC;&#x2122; balance sheets are starting to look stretched and, at the same time, structurally high inflation and persistent capital outflows will keep domestic monetary conditions tight," says Capital Economics. The pain of the slowing economy and rising inflation was already starting to make itself felt before the December 15 meltdown; the unemployment rate grew in

November for the third consecutive month, to 5.2% from 5.1% in October. These are still extremely low numbers, however, this trend will probably accelerate in 2015 but it remains more a symptom of the economic problems rather than a

problem in its own right. Unemployment has been at a record low of about 4.9% and is expected to rise to around 5.5% in 2015, well off European levels of joblessness.

CBR to cut rates in first quarter 2015 (if conditions allow)

2015,” Ulyukayev told journalists. He said “for a quarter, banks still have an opportunity to maintain previous rates on loans or ones close to them."

The Central Bank of Russia (CBR) will cut interest rates in the first quarter of 2015, if the economic conditions allow, Russian Economic Development Minister Alexey Ulyukayev said at the end of December. “I believe the rate is at an extremely high level, and it needs to be cut within the first quarter of

The Russian Central Bank’s board of directors decided overnight into December 16 hiked rates by 6.5 percentage points — from 10.5% to 17% annual interest in a desperate attempt to halt the precipitous fall of the ruble.

However, the rate hike is a growth killer for the already anaemic economy, which is now expected to go into a deep recession this year. The last hike of the Russian Central Bank’s key rate was the sixth in 2014. On March 3, the bank raised it from 5.5 to 7%, on April 25, to 7.5%, on July 25, to 8%, on October 31, to 9.5% and on December 11 to 10.5%. The Finance Ministry’s main proposals for 2015 include an increase of the budget’s deficit to 3.5% of the GDP, indexation of social and regional spending by RUB0.5 trillion and spending of more than 70% of the current amounts of the Reserve Fund. Stability in 2015 at the consumers’ expense The recent spike in the key rate to 17% will affect the growth outlook in 2015. Anecdotal evidence suggests that the short-term three-month commercial lending rate has spiked to 35%, while the deposit rate at commercial banks is 15-20%. Lending is profitable again, but the high prices are expected to squash growth of lending to between 2% and 5% in 2015, down from around 15% in 2014. Alfa bank expects only exporters and the largest borrowers will be able to continue borrowing at the current interest rate level, and cut its corporate loan growth forecast to 5% year-on-year in 2015.

Alfa also expects a very sharp deceleration in retail loan growth to 2% year-on-year, with shorterterm segments such as consumer loans shutting down completely due to the high interest rate level even before the rate hike. Given that further borrowing is no longer an option, households are expected to spend RUB2 trillion (equivalent of 5% of annual household consumption) just on debt servicing. The upshot is the lack of credit will whack which consumption is expected to drop 10% in real terms in 2015. The two key differences with 2015 vs. 2009, when consumption dipped only 3.6% year-on-year, are (1) the lack of support for household income from the budget, as state social spending, including public salaries, pensions and other social payments, was up 22% in 2009; and (2) higher pressure from debt servicing, which was equivalent to only 3% of consumption in 2009. The seemingly stable 1-2% consumption growth seen in 2014 is misleading as it was financed by burning through savings rather than representing a sustainable pattern. The fast contraction in consumption should trigger a drop in imports, which Alfa expects to reach 40-50% in 2015 given the import ban and devaluation effect.

Budget outlook for 2015 The biggest impact on Russia from the falling ruble is its affect on the budget. Oil tax revenues (and to a much lesser extent, taxes on gas exports) make up well over half of the budget revenues. Russia's Federation Council approved the federal budget for 2015-2017 on November 25 that assumes deficits for each of the next three years. In 2015, budget revenue will stand at RUB15.1 trillion and spending at RUB15.5 trillion. However, on December 15 the government announced it would cut the budget spending by 10% because of the economic slowdown, which should leave the budget flat in 2015. "If approved, this will mean spending of RUB14.0 trillion in 2015, or flat year-on-year, instead of the previously drafted 11% year-on-year increase to RUB15.5 trillion; and this cut would first of all be positive for budget stability: under our base case RUB48/$ exchange rate assumption, the 2015 breakeven [price of oil for the budget] could be as low as $80/bbl. Secondly, it would show much needed support for the CBR in its inflation-targeting efforts, being a long-term positive macro development," says Natalia Orlova, chief economist at Alfa Bank. It should be noted that while a $100 minimum oil price for the budget to break even is widely quoted, this ignore the appreciatory effect on Russia's dollar-denominated exports a devaluation of the ruble that actaully increases the number of rubles the budget receives. Accounting for this effect, the breakeven price falls with the falling ruble. While depreciation is still painful â&#x20AC;&#x201C; largely by pushing up the rate of inflaton â&#x20AC;&#x201C; a falling oil is not per se a disaster for the federal budget, as long as the ruble falls in step. Since the ruble was floated in November 2014, the Russian economy has become a lot more flexible and able to absorb these external shocks. While details were not available, if the budget spending cuts are made, then it will be the first year-on-year budget spending cut in about a decade; in the boom years, budget spending was increased by about 20% a year, although more recently increases were below the level of inflation. In 2016, revenue will amount to RUB15.8 trillion and spending to RUB16.3 trillion. In 2017, revenue will amount to RUB16.55 trillion and spending to RUB17.1 trillion. GDP is expected at RUB77.50 trillion in 2015, RUB83.21 trillion in 2016, and RUB90.06 trillion in 2017.

Inflation will amount to 5.5% in 2015, 4.5% in 2016, and 4.0% in 2017. Russia will borrow RUB1.28 trillion on domestically, but the annual $7bn of borrowing on foreign markets in 2015 has already been cancelled. Borrowing of RUB1.09 trillion in 2016, and RUB1.23 trillion in 2017 is planned after that.

First budget spending cuts, non-oil budget Almost a third of Russia's budget is targeting increased spending on the military. Russia will take defence spending to 3.8% of GDP â&#x20AC;&#x201C; well ahead of Nato's obligatory 2% of GDP spending, but still behind the US' 4%-plus spending. The liberals in the government are not happy with this setup and Alexei Kudrin quit as finance minister over the issue. But Putin has committed himself to a complete revamp of Russia's military and is willing to sacrifice growth and badly needed investment for this end. A key change to Russia's budget for the last few years is that while spending increased each year by about 20% in the boom years, more recently the increases have slowed to 5%. In 2015, for the first time in a decade the government is looking to cut spending by about 5%. This more than anything has caused the economy to slow and will lead to even more slowing. Part of those cuts will come in the form of cuts to public sector workers, which make up a quarter of the workforce (more if you include those connected to, but not directly on, the public payroll), who have been enjoying pay rises well above the rate of inflation for most of the last decade. However, pay rises for civil and government worker are now rising below the rate of inflation, which will feed through to lower consumption and retail turnover.

The change can be seen in the non-oil budget deficit â&#x20AC;&#x201C; the deficit that Russia would have if you magically made all the oil disappear. The non-oil deficit is a much better way of understanding Russia's spending habits. The government uses oil income to subsidize the rest of the economy, but in the boom years limited this to a non-oil deficit of about 4% (headline surpluses were large and positive). During the 2008/2009 meltdown the non-oil deficit ballooned out to 13% of GDP and even the headline deficit became negative. The liberals in the government want to return to a 4% non-oil deficit but the military spending is keeping this deficit closer to 10% of GDP. Putin is pushing the envelope and spending as much as he thinks he can get away with to modernize the military as fast as possible, at the risk of destabilizing the economy. This represents a big change in the way the country is run. Rather than prudentially using the oil revenues to build up reserves, Putin has chosen to treat the headline deficit as the key number, not the non-oil deficit as was the case under Kudrin. Policy is now geared to keeping the headline deficit slightly above zero.

Effect of falling oil prices on the budget Falling oil prices have made predicting the budget performance very uncertain, but falling oil prices also have much less of an effect on budget revenues than first appears. As the oil price assumption in the budget is set in dollars, but the spending is set in nominal rubles, if the ruble falls against the dollar, then the amount of rubles created for the budget when the government converts its oil tax dollar revenue actually increases. So as long as the ruble's fall at least tracks the oil price fall, the budget is not badly affected. And that is what happened in December. Instead of causing a deficit, Russia was expected to end the year with just under 2% of GDP surplus. However, these rubles are worth a lot less and this dynamic also leads to surging inflation and slower growth, which will inevitably affect the state's finances and cause a deficit. "In the event current levels of the ruble/oil remain in place ($/RUB50.0 and $70/bbl), the budget deficit is likely to increase from 0.6% GDP to 1.3% GDP with the dollar-denominated breakeven oil price reaching the $85/bbl level," Deutsche Bank said in its 2015 outlook. "Overall, the sensitivity of the budget to oil prices remains high. The non-oil deficit increased significantly from 2009 after an abrupt fall of oil prices and subsequent increases in social outlays. Since 2011, the breakeven oil price fluctuated within the range of $100-$115/bbl in 2011-2014. At the same time, in ruble terms, the oil prices remained at the level of RUB3,500/bbl in 2012- 2013." Deutsche Bank made a sensitivity study that compares combinations of oil prices and ruble exchange rates to product a budget deficit/surplus. Roughly speaking, any oil price above $85 with a dollar/ruble exchange rate below RUB55/$ will produce a surplus and anything below/above that will lead to increasingly large deficits.

Russian government could double deficit in 2014 to 0.9% to recapitalize banks Russia's government could recapitalize banks through an issue of RUB1tn ($16.5bn), according to the ministry of finance's amendments to the 2014 federal budget, issued at the end of 2014. According to the amendment, Federal Deposit Insurance Agency (ACB) will get a mandate to increase capitalization of commercial banks, while the government will inject RUB1tn into the capital of the agency. The funds will be financed from the federal budget and will increase the deficit in 2014 from projected 0.4% to 0.8%, finance ministry's Maxim Oreshkin told Reuters in December. This will be reportedly a â&#x20AC;&#x153;non-cashâ&#x20AC;? support scheme, under which the ministry of finance will capitalize ACB with RUB1tn worth OFZ federal bonds,

which ACB in turn will pass to banks in exchange for subordinated bonds or preferred shares. Reportedly, the mechanism is going to be used for â&#x20AC;&#x153;healthyâ&#x20AC;? banks and not for bail-outs.

Macro economic wrap Industrial production Industrial production contracted 0.4% y-o-y in November, but import substitution and devaluation affects were already visible in several sectors. The on going ruble weakening and accelerating inflation clearly caused domestic demand to deteriorate in November, the decline in industrial output should not be overdramatized. Industrial output grew 2.8% y-o-y in November 2013 (the best monthly result in 2013), so the base effect was negative for this November. The calendar effect also had a negative impact, as there were only 18 working days in November this year compared with 20 in the same month last year. Raw materials extraction expanded 2.5% y-o-y which is getting a boost from devaluation as costs are in rubles, but revenues in dollars. The supply and redistribution of electricity, gas and water rose 7% (mainly on the back of colder weather) and the manufacturing sector contracted 3%. The base effect was extremely strong in the manufacturing sector, as the turnout in November 2013 was a record 4.8% growth. Although the November figures were weak, over 11m14, the performance remained dynamic as the import substitution effects are already visible. Industrial output climbing 1.5% y-o-y, versus growth of just 0.4% in the year- ago period. Manufacturing grew 1.9% over 11m14 (versus 0.4% growth in 11m13).

Capital investment contracting The real crisis in Russia is not the collapsing currency at the end of December 2014, but the lack of fixed investment, which has been absent for several years now due to the uncertainties of Putin's politics, both domestically and

externally. If nothing is done to improve the domestic investment environment â&#x20AC;&#x201C; first and foremost for domestic investors â&#x20AC;&#x201C; then Russia will doom itself to stagnation. Externally the conflict with the West and the prospects of a war have made domestic business nervous, but internally the de facto renationalization of Bashneft, a privately owned oil company that the state took over in December, has undermined confidence in property rights and also acted as a deterrent to investment. Capital investment has been negative almost all year. It contracted 4.7% year-on-year in November (November is a short work month and usually has especially bad numbers) and was down 2.8% over the first eleven months of 2014. Investment shrank all year, bar one month in the summer. Uralsib predict a 3% contraction in capital investment in 2014 and an even deeper contraction in 2015 due to massive capital outflows, the high level of uncertainty surrounding the Russian economy and ruble weakness.

Russian inflation accelerates above 9% year-on-year in November The lack of fixed investment is a slow moving crisis, but the immediate impact of the devaluation/rate hike in December 2014 on the economy for

2015 will be in the inevitable spike in inflation that follows. Inflation in November was already the highest since June 2011 before the ruble crashed. The growth in inflation accelerated in November to 1.3% month-on-month and surged to 9.1% year-on-year from 8.3% year-on-year in October. Economists are now expecting a 15%-30% jump in prices at the start of 2015 as retailers readjust to the new ruble exchange rate and then at least 12% inflation in the first quarter but the first quarter could turn out to be the peak for the year if oil prices do regain some ground, as we and several investment banks believe. Where inflation ends the year will depend entirely on where the oil prices settle. Governor of the Central Bank of Russia (CBR) Elvira Nabiullina believes that oil prices will recover and intends to cut rates as soon as possible. Food items and services accelerate most on the back of Russia's self-imposed sanctions on EU goods. Price growth accelerated in all sub-segments yearon-year in November, with food alone up 2% month-on-month in November to reach 12.6% year-on-year versus 11.5% year-on-year in October. Prices for services rose 1.2% month-on-month in November due to the start of the heating season and growth accelerated to 8.7% year-on-year in November from 7.6% year-on-year growth in October. The price of non-food items grew 0.6% month-on-month for the third consecutive month and growth accelerated to 5.9% year-on-year in November from 5.7% year-on-year in October.

Trade and current account balance The brightest spot in the Russian economy at the end of 2014 was that the devaluation has further improved its trade balance and the country was running a triple trade/current account/federal budget surplus â&#x20AC;&#x201C; pretty much the only major economy in the world to do so. The devaluation of the ruble killed off imports while exports remained strong.

Russia's foreign trade turnover decreased 3.4% over the first ten months to $665bn, but the foreign trade surplus was up by 5.2% to $180.8bn and should finished the year at over $200bn. Russia's current account doubled in size in the second half of 2014 and was expected to be $60bn by the end of 2014, or 3% of GDP. "Currency weakness is likely to prompt the population to spend less on imports; thus, we expect a significant reduction in imports of goods and services next year. We expect the CA balance to improve to 5.5% GDP in 2015E gradually declining to 4.9% GDP in 2017E," Deutsche Bank said in its outlook.

Russian retail sales expand in November Retail sales rose 1.8% y-o-y in November, while food retail contracted 1.7% y-o-y and non-food retail grew 4.8%. Following the collapse of the ruble on December 15 there was a stampeded across the entire Commonwealth of Independent States (CIS) to snap up goods priced in rubles. The demand was so high (as the prices were so low) that several retailers, including the Apple Russian online store and several car manufacturers, closed their doors. The shopping binge will lead to a spike in December's retail numbers, but they will also almost certainly lead to a complete collapse in retail numbers for the first few months of 2015, if not the entire quarter. Shame, as retail had been doing relatively well prior to the dislocation. The rise in non-food retail in November was mainly due to an increase in inflation expectations for imported goods on the back of the already weakening ruble. The populace rationally increased purchases in this segment, which supported retail sales. Over 11m14, retail sales were up 2.2% y-o-y, and should end 2014 at around 2% over the full year. Analysts expect retail turnover to be flat for all of 2015, as inflation is accelerating, which is having a negative impact on real incomes.

Gross International reserves & RUB Russia's gross international hard currency reserves fell below $400bn from a pre-crisis peak of $600bn, in the last days of 2014 as the Central Bank of Russia (CBR) attempted to quell a currency crisis panic. The CBR spent a total of $80bn in 2014 defending the ruble and could spend the same again in 2015. Despite some scaremongering by certain publications, Moody's confirmed that Russia has sufficient reserves to cover its external debt redemptions in 2015, the ratings agency said in a report entitled: "Foreign Exchange Reserves Decreasing but Sufficient to Cover 2015 External Debt Needs," just in case the conclusion wasn’t clear. The Central Bank of Russia (CBR)'s gross foreign reserves were $414bn as of December 1, 2014, which "is more than sufficient to cover the country's external debt payment obligations through 2015, which amount to roughly $130bn across government, banks and corporate debt," Moody's said in the report. Moreover, in a pointed rebuttal to arguments put forward by both the

Economist magazine and analyst Anders Aslund, the reserves are sufficient "even if you exclude the $172bn of reserves counted as the central bank reserves that come from the government's two special savings Funds -- the National Wealth Fund (NWF) and Reserve Fund (RF)." In addition Aslund and others suggested Russia's $50bn-odd in gold reserves is not liquid, but given the global bullion market is worth some $2.5 trillion – twice the size of the UK gilts market – this suggestion is risible. While both the rainy day funds funds have specific purposes and so in theory are not available to the CBR to spend on the FX markets or use to repay foreign debt, for example, they still can be transferred to the CBR in times of crisis and added to the reserves if things got really bad, Moody's argued. Moody's notes that, according to official data, central bank FX sales to support the ruble dropped from $29bn in October to around $1bn in November after the ruble was freed and the central banks adopted a new strategy of preserving reserves and allowing the ruble to fall freely if needed.

China to Russia's rescue, dollar loosing reserve role China has ridden to Russia's rescue during the currency meltdown and is expanding its role as alternative to the IMF. It is also working with Russia to break what Russian President Vladimir Putin dubbed the "dictatorship of the dollar." China expanded a $24 billion currency swap program to help Russia weather its worst economic crisis since the 1998 default, but as also provided $2.3 billion in funds to Argentina since October as part of a currency swap, and lent $4 billion to Venezuela, which has found itself in similar straights to Russia following the fall of oil prices. At the same time Russia and China have expanded mutual settlement of local currencies in their international trade. In 2008 China settled none of its international

trade in yuan; in 2014 it settled a quarter of its trade in yuan and Russia is one of its biggest trade partners. At the same time Russia has been selling off its US T-bills and increasing the share of yuan in its reserves mix. However, to truly move away from the dollar as a key part of Russia's reserve make up will take decades. Belarus-Russia trade to reach almost $39bn in 2014 According to the preliminary data, Belarusian-Russian trade turnover will total about $39bn in 2014, which is slightly lower than in 2013, writes BelTA citing Ambassador Extraordinary and Plenipotentiary of Russia to Belarus, Alexander Surikov. There are several reasons for the trade turnover to decrease. Among

them is a fall in oil prices and the recently-worsened purchasing power of the Russian market, the Ambassador said. He added that in 2014 the two countries were able to regulate the issue related to the duties on light oil products. â&#x20AC;&#x153;It is a milestone event,â&#x20AC;? he stressed. The surplus of Belarus' foreign trade in merchandise and services totaled $797.7mn in JanuaryOctober compared to deficit of $1.4bn seen in January-October 2013, the National Bank of Belarus has announced. In JanuaryOctober, Belarus' foreign trade totaled $73.3bn, 2.5% down y/y. Belarus' export rose by 0.5% to $37bn while import shrank by 5.4% to $36.3bn. In JanuaryOctober, the deficit of merchandise trade totaled $1.1bn versus $3.3bn a year ago. Russia's savings dilemma Savings are the natural funding base of investment. The rate of savings in the Russian economy has been on a continuous decline since 2012. Based on desired longterm economic growth of 3-4% per annum, banks estimate that the Russian economy was underfunded this year by about 5% of GDP, or RUB3.8 trillion. This is clearly visible on the bond market where the total amount outstanding in 2014 contracted not only on the corporate Eurobond market (which could be attributed to the sanctions), but also on the local bond market, where corporate issuers returned over RUB150bn net to creditors in 10M14. It has become practically impossible for

Russian companies to raise ruble financing longer than two years. Even the Russian government has been unable to place significant volume of long-dated bonds this year. CBR cannot be a source of long money for the economy, but is playing this role at the moment. Whatâ&#x20AC;&#x2122;s the deal with the savings? Domestic savings are now the only source of funding for investment projects within Russia. 2011 resembles Russia's long-term norm. As can be seen from the chart, periods of active savings accumulation generally correspond to periods of rapid economic growth. The accumulation of savings rate must be at least 3-4% in order for the country not to lag the developed world. In 2011, after the trough of 2008-09, Russia's GDP growth stabilized at 4.3%, with the ratio of savings to GDP at 32.9%, slightly below the levels of 2006-07 (which were among the most economically successful years in Russia's history). But since 2012 the savings rate has constantly declined, together with GDP growth. The S/Y ratio was 28.5% in 2011 and banks expect it to move further down to 27.7% in 2014. Why are people reluctant to save in rubles? The answer is obvious: they are worried about both the volatility of the forex rate, which relatively often wipes out the value of ruble instruments in dollar

terms, and high inflation, which constantly erodes the value of

ruble assets in relation to domestic prices.

Infrastructure Russia's RDIF, India's IDFC to invest $1bn in joint infrastructure projects

Russia's Sukhoi Civil Aircraft seeks quarter of global passenger plane market

The Russian sovereign wealth fund, Russian Direct Investment Fund (RDIF), and India's Infrastructure Development Finance Company (IDFC) agreed to invest up to $1bn in bilateral projects in the two countries during Russian President Vladimir Putin's visit to India in December.

The state-owned Russia's Sukhoi Civil Aircraft plans to occupy 2025% of the world's market for medium-range aircraft with its Sukhoi Superjet 100 (SSJ-100) planes within 10 years, Senior Vice President Yevgeny Andrachnikov said in December. The devaluation of the ruble has only improved the companies chances.

â&#x20AC;&#x153;Our top priority is to start implementing certain projects that will allow us to restore historical importance of cooperation between Russia and India. Together with the IDFC, we will invest $1bn in bilateral projects in Russia and India, half a billion of US dollars each," he said, adding that there is a wide range of projects, from toll roads and airports to hydropower projects in India.

â&#x20AC;&#x153;Our markets are, no doubt, the southeast Asia: China as the largest market, India holding the second place, Indonesia. Of course, there are the Middle East, Africa, Latin America," he said, adding that in the current circumstances the company does not plan to enter the US market," Andrachnikov said.

Sukhoi Civil Aircraft can offer competitive leasing prices due to a new instrument of state support, guarantees for the remaining value, which envisages compensation if a plane's market value at the moment of sale is less that it was forecasted by a leasing agreement. Container turnover continues to fall in November Container turnover in Russia drops 6.1% year-on-year. According to the Association of Trade Sea Ports, throughput at Russian ports dropped 6.1% year-on-year to 434,017 TEU in November, with Global Portsâ&#x20AC;&#x2122; (GLPR LI â&#x20AC;&#x201C; Hold) container turnover declining 9.7% year-on-year to 195,401 TEU. Container turnover has been in decline since August. Overall, container turnover in Russia was on the rise in January-July, but the

positive trend was broken in August, and turnover has been on the decline for four consecutive months. Turnover at Global Ports followed the market pattern, while turnover at its main terminals declined both in the Baltic and in the Far East. However, the turnover at its container terminal in Ust-Luga kept growing in November, albeit, from a low base. Import-driven model suffering in the current macro environment. The November data showed weak container flow due to shrinking demand, which was in turn due to ruble depreciation and the weaker purchasing power of customers. In the next few months, container traffic in Russia will probably continue to contract, with turnover at Global Ports, which controls nearly half of the market, following the general trend.

Russia's Finance Ministry: use 10% of NWF to fund infrastructure via banks The Finance Ministry has proposed allocating up to 10% of National Wealth Fund (NWF) assets to banks with capital in excess of RUB100bn via long-term subordinated debt. Those funds will be included in the recipient banks’ supplementary (Tier 2) capital and have to be used to finance designated infrastructure projects. This amount, which totals roughly RUB395bn, is below the previously discussed 20% allocation limit. Among banks that fulfil the criterion of R100bn in capital for receiving this funding, only VTB and Gazprombank have expressed an interest thus far. The former has requested up to R250bn and the latter around R100bn, which, combined, is close to the proposed limit. However, these amounts could be reduced if needed. Gazprom opens subsidiary for Turkish pipeline Russia's largest natural gas producer and pipeline exports monopolist Gazprom announced creating a subsidiary for construction of a new pipeline to Turkey that will replace the previously mooted South Stream pipeline that bypasses Ukraine. The head of state-controlled Gazprom Alexei Miller toughened his rhetoric regarding cancelling the South Stream pipeline project in favour of the a new pipeline to Turkey with the same annual capacity of 63bn m3 annually.

Miller told the press that Gazprom is going to change its strategy in Europe, no longer delivering the gas to end-consumers utility companies, and instead selling the gas at hub on the border of Turkey and Greece. It is not clear how serious this project is or if it is just a negotiating tactic by Russia. The Turks too have flip flopped on the issue as Ankara also doesn’t want to become a Russian energyvassal. Russian government bails out Transaero airlines The Russian government issued a RUB9bn guarantee note to struggling private airline Transaero in December as the travel industry has been amongst hardest hit by the devaluation as Russians cancelled their now expensive foreign holidays en masse. Russian Prime Minister Dmitry Medvedev signed a government resolution on a RUB9bn ($164.8mn) guaranteed support to Transaero, Russia’s second largest air carrier in terms of traffic. The state guarantee will cover up to 100% of Transaero's liabilities on a three-year loan from stateowned Bank VTB. The money is to finance the company’s operating activities. The guarantee-secured liabilities mature after January 1, 2017 and so will have no impact on the budget.

Russiaâ&#x20AC;&#x2122;s third largest airliner, Utair, is also in trouble and has also asked the government for help. Its overall debt to banks has soared to RUB13bn rubles ($214mn). The company published its streamlining

program expected to achieve breakeven operation in 2015. Its fleet of aircraft will be cut by 40%

ECM Equities outlook in 2015 and oil The oil price is the other wild card in 2015. The rule of thumb in the past is that the RTS should be 20times the price of oil, but a bne study found that averaging the multiple over the entire history of the Russian stock market, the actual ratio is closer to 15.61-times the price of oil. At the time of writing in midDecember, the price of oil was $67.70 per barrel, which gives a theoretical RTS index value of 1056.8, against the actual RTS value of 898.95 and a MICEX value of 1,533.50. However, this rule has broken down somewhat in the closing months of 2014. In the past the MICEX and RTS indices were roughly the same, but the two have diverged as the RTS is a dollar-denominated exchange and MICEX ruble-denominated; devaluation has caused the RTS to fall faster than normal whereas the MICEX has seen gains. This rule is far from perfect. In bad times the ratio of oil prices to the

RTS Index value has fallen into the low teens and in boom times it has climbed as high as 30-time the price of oil. However, the ratio has been much less volatile than the RTS Index itself. Despite the terrible news, the actual ratio of oil prices to the RTS Index was 13.26 in the middle of December. This is bottom of the range for the oil/prices ratio; the last time the ratio was below 13 was in September 2008, following the Lehman Brothers collapse, where it sank to 10.8 in October 2008, before slowly recovering to 20 again by the end of 2009. The average oil/price ratio over the last five crisis years has been much higher at 16.5, despite all the horrendous news, which would imply a fair value for the RTS Index in December of 1,117 with $67.7 oil, or an increase of 5.7%. However, if oil returns to $80, as predicted by the 2015 budget, the RTS Index should trade at 1,320, or an upside of 25% from December's levels (assuming a crisis-years average multiple of 16.5 from between September 1, 2009 and September 1, 2014).

For comparison, Uralsib's base case scenario, which assumes oil at $102 and a stagnating economy, it forecasts an RTS index of 1,190 for end-2015, barely above the level of December 2014. This would leave the RTS Index inside the 1,100-1,400 range

where it has been trading for most of the last three years and so doesnâ&#x20AC;&#x2122;t seem unlikely. However, for stock prices to break out of this range oil price would have to return to close to $100 and the Kremlin would have to make some convincing structural reforms before investors took a bigger punt on Russian stocks.

Evraz delays IPO of Evraz North America due to oil price slump Evraz has delayed the IPO of Evraz North America (Evraz NA), its North American business, due to the recent slump in oil prices (down 44% YTD), which negatively affected the potential valuation of the unit. The sources cited stated that if the oil price stabilizes, the IPO may still be conducted in 2015. To recap, Evraz filed the registration statements with the SEC for the IPO at end September with plans to place a 25-35% stake. Evraz NA is the largest producer of rails and LDPs in the

NAFTA countries, with a respective market share of 39% and 47% in 2013. In 1H14, Evraz NA sold 1.3mn tonnes of steel products (17% of the group total), earning $129mn in EBITDA (12% of the group total) with a 9% margin. Moscow Exchange shareholding may be limited to 10% maximum stakes Duma deputies are considering introducing a 10% cap on any single shareholding (direct or indirect) in Moscow Exchange, according to today’s Vedomosti. The limit would come as part of an amendment to the “Law on the Securities Market,” which is

currently due for its second Duma reading of three required to pass. Also, any acquisition of a more than 5% stake would have to be preapproved with the Central Bank. The rationale for the limits cited in the report is to ensure the independence of the exchange as a systemic operator of the financial market’s infrastructure and to respect the interests of all stakeholders and market participants. Russian stocks - Keep Calm and Carry On Sberbank offered the following rational of why portfolio investors should consider buying Russian stocks in January. The argument is simple: this crisis has either created a historic buying opportunity similar to January 2009 (when the RTS fell to 500 before recovering to 1500 the same year) or the end of the Russia story for a decade. Why buy Russian assets? Deep value and a history of massive overshoots make Russia fertile ground for nimble investors. Although the key drivers are deteriorating today, there are catalysts that could spark a major rerating in 2015: a bounce in oil, a deal on Ukraine or major domestic policy moves. • Global FX/rates. Divergent monetary policy cycles will dominate in 2015. While the Fed will contemplate higher interest rates from mid-year, the ECB is set to adopt sovereign QE as early as 1Q15. A key aim would be to drive

the EUR lower. We believe that it will be successful. • Global bonds. We see the global environment remaining benevolent for hard currency fixed income instruments in 1Q15, although less so later in the year. As a result, we expect high-grade names to outperform high-yield peers. We also expect to see some normalization of curve slopes. • Global equities. In an environment of a strong $and weak commodity prices, we expect to see continued outperformance from the US market and from those emerging market commodity importers with a reform story. • Oil. Markets have been shaken by OPEC’s refusal to even attempt to support oil prices, hence volatility is warranted and the low $60s/bbl cannot be ruled out. In the medium term, however, there is likely to be an attractive buying opportunity. • Gold. The bearish influence from an ever strengthening $is expected to fade, hence gold price prospects for 1Q15 are likely to be driven by supportive fundamentals, thereby leading to a moderate recovery. • Metals. The base complex is likely to continue spinning apart as specific fundamentals overwhelm general trends. We expect nickel to outperform copper and aluminum. In PGMs, palladium remains our top pick. • Russian equities. We assume a drift down with oil in 1Q15, and a bounce as oil prices find a trough

and move to a more sustainable level. Within the market, we like the metals and mining sector now, the oil and gas sector when oil troughs, and domestics when there is rapprochement in Ukraine. • Russian Eurobonds. Spreads of hard-currency Eurobonds from high-grade Russian issuers have widened significantly on the back of the negative political backdrop and the decline in oil prices. However, these bonds remain fundamentally safe and now offer appealing risk/return ratios. • Russian FX/rates. The perfect storm of 2H14 is set to extend into early 2015, with a $/RUB test of 60 not to be ruled out. Some semblance of stabilization may emerge toward mid-year, but the scope for a far lower $/RUB is limited. • Ruble bonds. Pressure from foreign debt payments, a weak RUB and limited liquidity provisioning will keep local bond yields in the double digits. We do not expect an improvement until 2Q15, with policy rate cuts likely to follow in 2H15 and ease the pressure. Cabinet approves the sale of a 19.5% stake in Rosneft The Russian government approved the privatization of a 19.5% stake in Rosneft for 2015 at a total price of at least RUB420bn ($8.5bn), translating into RUB203/share ($4.1/share) at RUB49.2/$. The government’s order says the price should not be lower than the

2006 IPO price, but does not specify the currency. Earlier reports also suggested that the price could not be lower than the 2006 IPO price of $7.55/share, and Rosneft’s management supported this minimum. Technically, RUB203/share translates into $7.55/share if the exchange rate effective during the IPO is used, RUB26.9/$. Since Rosneft closed at RUB234/share ($4.74/share) in December, the IPO price in dollars would suggest a 59% premium, making the sale of the stake in the market at the IPO price virtually impossible in the next 6-12 months. However, the sale could take place at a premium to the current market to a strategic investor, such as a state-controlled Chinese or Indian company. MSCI could exclude Russia from Emerging Markets index if capital controls introduced New York based index provided MSCI said it might exclude Russia from its Emerging Markets benchmark index, should Russian authorities introduce restrictive measures on the capital or currency markets. Currently capital controls remain a remote possibility as Russia still has some $400bn in reserves and some $100bn-$150bn of debt repayments in 2015: countries only impose capital controls when they run out of reserves.

All SOEs must pay 25% of net income as dividends On December 9, during his meeting with the government, President Vladimir Putin reiterated that state owned enterprises should be paying out 25% of their net income in the form of dividends. Putin said that discipline in this area was lacking among state-owned enterprises (SOEs). While SOEs must pay 25% of profit (under Russian accounting standards) by law many of the biggest companies â&#x20AC;&#x201C; especially the banks â&#x20AC;&#x201C; have negotiated special exemptions. Those exemptions have been nixed and all SOEs will be expected to pay dividends in 2015. Still, there is no word on forcing companies to switch from Russia to international IFRS accounts, which would significantly increase their reported profits, although this switch remains the plan. Russian government stake in Bashneft might not be sold within the next three years The government stake in Bashneft, which belonged to Sistema and was nationalised in December, might not be sold within the next three years, according to Olga Dergunova, the head of the Russian State Property Fund. The state might enter the BoD of the company, according to Kirill Molodtsov, the deputy minister of energy. There is no decision on potential changes in management yet.

If Bashneft remains a statecontrolled entity, it would be unlikely to pay less than 25% of IFRS net income in the form of the dividends say bankers. Tinkoff Credit Systems Bank may delist from LSE "TCS Could Delist Securities from the London Stock Exchange", Oleg Tinkov, CEO of Russia-based Tinkoff Credit Systems Bank (TCS) told journalists at the end of November. "If the stock looks as it does at the moment, we reserve the right to delist the shares and turn the bank private," he said. Depositary receipts of Cyprusbased TCS Group Holding, a parent company of TCS Bank, were sold on the London Stock Exchange (LSE) in October 2013 wth a market capitalisation of over $1bn. IPO was ten-times oversubscribed but euphoria quickly cools and the share price has been falling hard since to a fifth of the IPO price.

DCM Debt redemption in 2015 Falling oil prices has raised concerns as to whether Russia can meet its debt obligations. At 13% of GDP Russia's sovereign debt is extremely modest, but corporate debt is higher at about 33% of GDP, or $731bn as of June 2014. Of this three-quarters is denominated in foreign currency (Russia introduced rubledenominated Eurobonds a few years ago), which become more expensive to service the further the ruble falls. Growth of the external debt was driven mainly by the increase in long-term obligations, though short-term debt was growing faster after the ruble devaluation began in February and the conflict with Ukraine began in March. Debtors have been anticipating the sanctions and have been building up reserves of cash in 2014 so can meet their payments in 2014 and 2015 without much help. Moreover, about half of the debts owed are owed by Rosneft and Gazprom, both of which earn dollars from exports and so can finance their repayments out of their cash flows. Maturity: However, corporates owe a lot less than they did in 2008 and the average loan maturity has also increased dramatically, with half

the outstanding debt having a maturity of two years or more as of December 2014. Breakdown by type of debtor: The largest component of debt is attributable to banks and other non-government sectors, which together owe more than $650bn to foreign lenders, 17% of which is short-term, and much of which (46%) is attributable to stateowned banks and enterprises. Banks alone have $192bn external debt (about 10% of GDP), up from $170bn in 2008, and from $18bn in 1998. Companies directly under Western sanctions account for about 60% of the debts due. Repayment schedule: $35bn of debts were due in December, but another approximately $150bn is due in 2015. However, with the new freely floating ruble and the significant reserves, Russia should have no problem covering its debt in 2015. More than half of this debt ($90bn) is owned by just two state-owned companies, Rosneft and Gazprom, both of which earn hard currency for their exports and both of which are able to pay their debts out of their cash flow, so this will have no impact on the CBR's reserves. The current account surplus of about $60bn should be enough to cover the rest.

In any case, Russia's companies and banks have spent 2014 year building up hard currency reserves and according to Moody's are already in a position to meet their obligations. JP Morgan estimates Russian banks have accumulated $292bn in foreign assets as of December 2014. Moody's drove the point home in a report issued on December 5 entitled "Foreign Exchange Reserves Decreasing but Sufficient to Cover 2015 External Debt Needs." "According to official data, the Bank of Russia (CBR)'s [foreign currency reserves] (as of 1 December 2014) are at $361bn. This is more than sufficient to cover the country's external debt

payment obligations through 2015, which amount to roughly $130bn across government, banks and corporate debt," Moody's concluded. "That assumption holds even when excluding the $150bn of FXRs counted as the central bank reserves that come from the government's two special savings Funds â&#x20AC;&#x201C; the National Wealth Fund (NWF) and Reserve Fund (RF). While these two Funds have specific mandates and are therefore unlikely to be used either to intervene in the foreign exchange market or to finance the government's external debt payments, like the CBR's own reserves, the amounts placed in the central bank contain liquid, marketable assets, that can be utilized if required."

Russian corporate hard currency bonds under pressure from ruble collapse

ruble have put enormous pressure on Russian corporate bonds denominated in hard currency.

Western sanctions, collapsing commodity prices and the falling

Russiaâ&#x20AC;&#x2122;s 10-year sovereign bond yields have also been hit, and

climbed to a new five-year high of 12.4% as investors continue to exit the countryâ&#x20AC;&#x2122;s financial markets in mid-December.

The yield spreads over US T-bills has almost doubled in the last year, rising 100bp in just December. However, defaults remain unlikely as analysts believe most companies have been building stockpiles of dollars throughout the year to pay down debt in a crisis. Russian regions' could face a tough 2015 as debt grow According to Moody's, Russian regions will increase spending on social welfare, healthcare, education and utilities, which will push up operating expenses by 67%, in line with inflation, but leave many of them running deficits that will be have to covered by central government.

"We expect that Russian regions' spending growth will lead to a combined deficit of 8-10% of total revenues in 2015. Meanwhile, budgetary flexibility is low given already constrained capital expenditure, which limits opportunities to prevent fiscal deterioration," says Vladlen Kuznetsov, lead analyst at Moody's on Russian regions. "In addition, persistent financing deficits have led to growing regional debt, which we project will increase by 20-25% in 2015, at a time of decreasing debt affordability." Standard & Poor's was more pessimistic saying that the debts of Russia's local and regional governments will amount to 35% of current incomes in 2015 and will continue growing in 2015-2017. "Although the government supports small LRGs in refinancing

their debts and gives them budget loans, the support is not enough, the agency said, and it will only delay the problem until 2017. In 2016-2017, LRGs expenses on servicing and redeeming the debt may increase to 18% of incomes." Russian regions' debt structure is gradually moving towards private sector debt, mostly bank loans, reflecting reduced availability of soft loans from the central government. While in Moody's view regions' debt affordability is still manageable, it is trending down as Ukrainian geopolitical tensions have led to a significant tightening of Russian credit markets, leading to rising borrowing costs. Regions are increasing in to increasing problems and already have high debt repayments in 2015 but will face elevated refinancing risks due to the crisis. Overall, the regions' interest service costs will remain below 2% of total revenues on average in 2015. Loans from state-owned banks and from the Federal Government will continue to absorb regions' financing needs, although their capacity will gradually decline. The poor growth outlook for 2015 will only add to the fiscal pressures on the regions, further tightening credit availability and hitting the unreformed regions disproportionately; weaker economic growth will weigh on revenues, mainly through a decline in corporate income tax, and other revenue streams, such as personal

income and property tax, will grow more slowly. Despite regional governments' greater needs, the federal transfers they receive are likely to remain broadly unchanged in 2015 compared with 2014, given the weak national GDP. Mysterious buyer of massive Rosneft bond likely to be state banks Russia's largest oil company, stateowned Rosneft, placed RUB625bn ($11bn) of bonds on December 11, apparently with private buyers, leaving the market baffled as to their identity. Experts argued that the bond was purchased by state banks, in particular Russia's second largest bank VTB, which will use them as collateral for refinancing loans from Russia's central bank. In other words the bond placement was a scheme to finance the company using state funds indirectly and support the state banks at the same time without affecting the value of the ruble by using the hard currency reserves. The state bank may pledge the bonds acquired as security for dollar liquidity from the Central Bank, which would then be provided to Rosneft as a currency swap. Apparently confirming this version, the central bank on December 11 announced a three-year auction for RUB700bn to be held on December 15. Rosneft has to pay down $6.9bn of foreign debt on December 21, $7.3bn on February 13, 2015, and

must repay up to $29.7bn by the end of financial year 2015, debts arising from the purchase of oil major TNK-BP in March 2013. It had previously said that it would replace some foreign debt with ruble borrowings. Other analysts argue that Rosneft has sufficient hard currency funds to pay down its debts. Rosneft currently has $16bn in cash, and is expecting significant prepayment from China on future oil supplies, which could be as much as $15bn in the first quarter of 2015. Rosneft also hopes to get funds from Russia's sovereign fund, the National Welfare Fund, for major investment projects, in particular in Russia's Far East. Sources from the National Welfare Fund denied it

had participated in the December 11 ruble bond issue. S&P could downgrade Russia's rating to speculative in January S&P made the decision to place Russia’s rating (BBB-) under review at the end of December with the outlook negative. The agency will reassess their view of Russia’s monetary flexibility as well as the impact of the weakening economy on the country’s financial system. The review is expected to be completed by end January. According to the agency’s methodology, such a step implies a 50% chance of a downgrade within 90 days.

Sectors Car sales down just 1.1% in November thanks to weak ruble, but poor 2015 outlook New passenger car and LCV sales fell just 1.1% y-o-y in November to 229,439 units, according to the Association of European Businesses (AEB). To support automakers, Russia earmarked RUB10bn ($186mn) in September to fund incentives for new vehicle purchases until the end of this year and the programme was extended with a

second dollop of RUB10bn in December. The two factors behind improving sales (in m-o-m terms) are the most recent wave of ruble weakening and nice discounts offered through year end under the government’s scrappage program. Given that sales were flat y-o-y in 1Q14 during the first wave of ruble depreciation (and a lack of government subsidy programs), the most recent, and even more dramatic (the ruble lost 12% against the dollar in November),

exchange rate moves are actually the key reason why people are rushing to buy new cars, so that they can beat the ruble price hikes that many dealers have already announced, especially for imported models.

($/RUB over 50) and the New Year’s rush, as well as the 11.6% y-o-y decline in car sales in 11m14, mean a full- year drop of 12% seems a little too pessimistic. However, the outlook for 2015 still looks soft.

Although the cash-for-clunkers program is also supportive – mostly for highly localized domestic producers (AvtoVAZ, GAZ and UAZ) – its net contribution cannot be measured. The relatively positive outlook for December on the back of an even weaker ruble

According to Vedomosti, the government will extend its cashfor-clunkers program by allocating R10bn in 2015 (the same as the initial subsidy under the 2014 program, to which it added R2.9bn in December).

Car sector was already hurting before the ruble meltdown The meltdown of the ruble on December 15 lead to several major car producers halting sales and suspending operations until some stability returns to the Russian currency. Japan's Nissan Motor Co and French partner Renault SA stopped taking orders in late December for some cars in Russia and said they would raise prices on others if the ruble's plunge continues.

General Motors Co., Audi and Jaguar Land Rover also temporarily stopped selling cars in Russia in the crisis week, deciding that taking a timeout from the market was the best way to deal with the ruble’s collapse. GM suspended sales to dealers on December 16 to “manage its business risk” in light of the volatility of the ruble. GM didn’t set a date to resume wholesale deliveries, but will deliver Chevrolet, Opel and Cadillac cars

that have already been purchased at the agreed-prices. Other players still in the game will raise prices dramatically. Nissan had already raised prices 5-8% due to weakening of the currency earlier in the year. Audi also halted sales in Russia on December 16. Volkswagen AG has also suspended production but will restart after it sets a new price list. Russia is Nissan's fifth-largest market and the Nissan-Renault alliance have been gaining market share. The JV hoped to triple sales in the coming three years, but those plans are in danger now. BMW AG, one of the few carmakers that discloses its ruble exposure, may lose 100mn euros ($123mn) to 150mn euros in earnings in the fourth quarter if the ruble loses half its value, Ellinghorst estimated. Daimler AG, Volkswagen, Renault SA and Hyundai Motor Co. probably face an even larger impact, the analyst said. Devaluation helps housing and hotels but hurts offices and warehouses The 40% devaluation of the ruble by the middle of December was having a mixed impact on the real estate sector: housing and hotels are expected to get a fillip, whereas offices and warehouses will be hurt by the fall in the value of the ruble. Housing has been an immediate beneficiary as Russian middle classes rushed to take out

mortgages and buy apartments as a way of tying up their spare cash in an asset that will hold its value even if the ruble continues to tank versus the dollar. This has been going on since May when the first devaluation fears swept the country and lead to a significant spike the purchase of foreign exchange. Since then the population have been steadily buying other big ticket items that are easy to resell like posh cars and top end white goods. That has supported the construction of residential property, which is expected to top 85-87mn square meters of new residential space this year -- an alltime record. Likewise the collapsing ruble has meant this year and even more so next year, Russians will stay at home or inside the Commonwealth of Independent States (CIS) for their summer holidays where devaluation is less noticeable. That is creating demand of middle of the range hotel space. The economic slowdown has adversely affected the office market which experts say is now oversaturated. Currently there is one meter of office space for each Muscovite, which experts say means demand has met supply. Rental rates have already begin to fall as a result: Class A office space rates have dropped from $800 to $710 per square meter per year this year and for Class B offices slumped from over $490 to $430, according to Knight Frank. And the

decline is expected to continue over the next two years. The same story is being told in warehousing where demand for space has slumped due to a slow down in retail turnover. The fourth quarter of this year saw a record delivery of new warehouse space just as demand fell. Rental rates in prime locations have already decreased from $135 per square meter per year in the first half of this year to $125-130 in the third quarter. The warehouse vacancy rate has aalso risen and is expected to reach 10% by the year's end, reports the Moscow Times. Law changed on Russian oil sector taxation In mid-November, the Duma approved major revisions of the tax and duty scheme for crude oil and petroleum products. The amendment shifts the taxation emphasis from exports to production. The changes will come into force gradually over the next three years. During that time, export duties on crude oil, diesel fuel and gasoline will go down 70%. The mineral extraction tax on crude oil production correspondingly will go up 70%, and there will be an over 500 % increase in the extraction fee for by product gas condensate generated from oil drilling. One of the aims of the changes is to increase federal budget revenues. It is estimated that the reform should boost budget revenues by about 250 billion rubles (€4.5bn) a year starting in 2016.

The tax structure reform will reduce earnings of oil refiners, because the domestic price they pay for crude oil will rise as a consequence of higher mineral extraction fees. The losses to refiners will be offset, however, through the corresponding drop in export duties on petroleum products. Igor Sechin, CEO of state-owned Rosneft, strongly opposes the reform, which he fears will endanger e.g. Rosneft’s planned Nakhodka oil refinery. Russia severely taxes the oil sector, and taxes are based on the global price of crude oil. It is estimated that about 70 % of the oil export price goes to the federal budget through various fees, duties and taxes. The system does not encourage companies to modernise their production facilities or make new investments. Russia has been encouraged to adopt international practices, i.e. taxation based on corporate earnings instead of the value of production. Rosneft to become second largest Russian gas producer The government has set up Rosneft to compete with Gazprom on the gas market in the same way VTB Bank was created to compete with Sberbank and so introduce some competition in the sector. Rosneft will become Russia’s second largest gas producer in the mid-term, according to CEO Igor Sechin: “In the last two years Rosneft has established a massive gas business, has become Russia’s third largest gas producer, built effective gas marketing, tripled its

production and formed a competitive portfolio of gas projects. We see the potential of becoming Russia’s second largest gas producer in the mid-term,” Sechin said. He also said the Rosneft sees implementation of effective mechanisms for monetizing oil and gas reserves, including the development a long-term resource supply system, as its priority. Russia sold $13bn worth of weaponry in 2014 Russia exported $13bn worth of weaponry in 2014, Vladimir Kozhin, the presidential aide for militarytechnical cooperation, said on December 17, making Russia the world's second biggest arms exporter after the US. "We have so far exported weaponry worth $13bn while the current portfolio of foreign arms orders is worth over $48bn,” Kozhin said, cited by Sputnik. Kozhin said that the last few months of 2014 had been hard for Russia, adding that despite this Moscow "can afford to behave the way it does" which means acting independently and being confident in the future — even though many in the world "can't stand looking at it." According to Kozhin, the work of Russia's defense industry is the basis for the country's confidence. Russia is the world's second biggest arms exporter after the United States and sold a total of $15.7bn worth of weapons abroad

in 2013, according to official reports. Apple products sell out as ruble crashes During the nadir of the rubles crash on December 15 when the ruble crashed from RUB53 to the dollar to RUB80 at its low point Russians rushed to stores the latest Apple products were emptied from the shelves. For a few days Apple products were about third cheaper in Moscow than they were in London. Sales of the latest gizmos via the Apple site sword until the company closed access, saying it was an able to set prices. Sales were not just driven by Russians taking advantage in the collapse of the value of the currency but also from neighbouring countries such as Armenia Kazakhstan and Belorussia, where similar scenes of electronic stores being gutted of the goods could be seen. The spike in sales was exacerbated by the free availability of electronic goods in online stores, especially Russian stores which are well developed. A purchase made by credit or debit card instantly locked in the exchange rate of the moment whereas in previous crises punters actually had to schlep down to the store to take advantage of cheap prices, at least giving shop owners a few hours to write new price tags. By December 16 Apple have halted online sales only three weeks after increasing the price of this latest iPhone six by about 25% to take in

the previous slide of the ruble. By that weekend iPhone 6s were not to be found in Moscow and Apple Air computers had also disappeared as well as the latest version of the iPad. However older models of things like the iPad or iPad Mini were still available. Punters were targeting the latest releases partly to buy a must-have accessory but secondly to tie up the money in goods that would be easy to sell later on should the collapse of them will continue. The battle hardened exchange-rate savvy Russian consumer has long ago developed a tactic of investing free cash into fungible electronic goods, cars and, in this crisis, has added apartments to the list, in order to preserve the value of the savings in times of currency instability. The collapse of the currency is caused a nightmare for retailers who are facing big losses and apple is not the only company to have suspended sales. Several leading international car produces also stop sales until some stability returns. Other retailers like German supermarket chain Metro began repricing goods every two days to keep up with the ruble's collapse.