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Budget expenditures – will common sense prevail?

August 19, 2009

The following overview is based on materials prepared by Troika Dialog’s Research Department: “Russia Economic Monthly” and “Strategy Monthly”

Current SituationThe latest data suggest that the second half of 2009 will bring better results than the first half. Improvements are already evident on the labor market: unemployment dropped to 8.3%. As a reminder, as recently as April this figure exceeded 10%.

According to July reports, inflation remained close to 0.6%, allowing the Central Bank of the Russian Federation to make further cuts in interest rates, setting refinancing rates at 10.75%. According to our expectations, inflation may drop significantly in August (deflation is also possible) and total approximately 10.5% for the year. Money supply increased by 2.3% in June, an important figure which may indicate increased demand for rubles and improvements in the banking sector.

On the whole, the economic situation is developing in line with our expectations voiced in previous materials, so we will reiterate our forecast that GDP this year will drop 5%, followed by 5% growth in 2010.

The ruble and oil

The federal budget deficit in July amounted to R202.1 bln ($6.4 bln). The deficit was financed with funds accumulated in recent years (including the Reserve Fund). The Central Bank continued sterilizing surplus ruble liquidity emerging from budgetary channels by reducing lending to the banking system. For example, the volume of collateral-free loans in June dropped by R81.7 bln (from R685.9 bln to R604.2 bln). Nevertheless, the Central Bank seems to be encountering challenges while sterilizing ruble liquidity, which is already evident on the currency market.

In July-August, volatility on the currency market increased considerably. The ruble is now basically in free float (as indicated by stability in gross foreign currency reserves), and market participants are setting the exchange rate on their own. As a result, the ruble has become quite sensitive both to changes in the oil price and to heightened interest in dollar assets at the global scale.

In the two and a half months of summer, the ruble exchange rate against the dual-currency basket fell by 6%, even though oil prices in mid-August were even higher (about $70 per barrel) than end May ($65 per barrel). In our view, the ruble weakening is connected with the budget deficit.

On the whole, the budget deficit has become a serious threat to stability on the currency market. As a result, during the traditional period of increased government expenditures (i.e. the end of each quarter and in December, when monthly budget expenses typically reach their peak), heightened volatility in the ruble exchange rate is to be expected.

In focus – the budget deficit

The government has approved the main parameters of the federal budget for 2010–2012. The forecasted oil price of $55–57 per barrel appears reasonable, while budget revenues, as anticipated, will gradually rise from R6.6 trillion rubles in 2010 to R8.1 trillion in 2012. However, it is planned to keep expenditures near their current level (R9.7 trillion annually). As a result, a significant budget deficit of 7.5% of GDP in 2010 may subsequently lower to 3.0% of GDP in 2012.

Given the government’s plan, the Reserve Fund will likely be exhausted by end 2010. In addition, it is planned to borrow up to $20 bln annually, attract internal loans and make use of the Sovereign Wealth Fund. We believe these are dead-end policies that eventually will be changed.

The budget deficit appears to be the main threat to macroeconomic stability in 2010, while the oil price as before will influence all the country’s economic processes, so it is worth examining the different scenarios that might unfold depending upon these two factors.

First scenario – the yearly average oil price is close to $70 per barrel. If so, no considerable threats will arise, or, more precisely, there won’t be any need to initiate any changes in macroeconomic policy. It will remain possible to spend budgetary funds without there being any risk of a serious budget deficit. Under such an outcome, the issue of reducing expenses will be felt less acutely.

Second scenario – the yearly average oil price is $55 per barrel or lower. Russia lived under such an oil price in 2005 and 2006, when GDP growth exceeded 6% annually, although the level of expenditures was less than half of that outlined in current plans. If the government opts not to reduce expenses, the deficit will inevitably be monetized, presenting a destabilizing factor. Exacerbated inflation and increased currency risks are to be expected.

In the event of a lower oil price, we predict that the government will choose to lower state expenditures, which may be called the third scenario of possible outcomes.

Such a scenario is likely to include the following principles: preserving social obligations; reducing expenses relating to support for inefficient sectors of the economy; using money previously earmarked for state corporations; replacing direct government expenditures with conditional ones (guarantees on loans, etc.). We see indications that the upper echelons of power are beginning to realize the inevitability of this scenario. In particular, such indications include the Russian President’s dubiousness regarding the efficiency of state corporations, as evidenced by the recently-initiated examination into financial activity of such corporations and proposals on the expediency of this type of legal entity.

At present, Russia is not a member of the group of developed countries; in order to join this group, and to become one of the drivers of global growth, the country needs to slash excessive and inefficient spending, which in turn will slow inflation and reduce interest rates, and, in the long-term, will lead to stronger growth.

The current market situation

In July, the Russian market grew by just 3%, remaining a bystander to the rally on global trading platforms.

In our view, the main driving force behind the Russian market remains the direction of the oil price, rather than events in the country’s economic and political lives or risk appetite among international investors. According to our imperial dependence model, under an oil price of $70 per barrel the RTS index should amount to 1200 points. This means the market has the potential for growth under the existing level of oil quotes.

However, it would be erroneous to assert that oil quotes will hold at their present levels, so we believe that the current market environment is favorable to tactical purchases only. In addition, investors are advised to bear in mind the high market volatility, which is largely due to the altered market structure, as well as a prevailing speculative mood among Russian investors operating therein.

Market structure: the Russians are returning

In the past year the structure of the Russian equity market has changed considerably. At present, Russian investors are setting the conditions; residents’ share in turnover on local equity markets has reached a record level of 74%.

The market has changed considerably in recent months: residents have made their return – individuals and institutional investors alike. In addition, an increase in the volume of deals completed by retail investors occurred largely due to an increased number of new and active investors.

In fact, foreign investors account for just one-fourth of turnover in Russian corporate stock. Moreover, foreign investors generally trade securities in the 25 biggest companies, which account for 90% of foreigners’ investments and market turnover.

The market structure has changed: it became far more speculative, as shown by sharp growth in stock churn.

Stock churn indicates how many times per year any particular company’s stock in free circulation changes ownership. Churn of the entire volume of stock located in free circulation on the Russian market reaches some seven times per year, which is twice as high as one year ago. This is considerably higher than analogous figures in developed markets (one-half to two-thirds lower) and most emerging markets. Particularly high churn is observed in portfolios belonging to retail investors – 20 times per year. This creates increasingly favorable conditions for a speculative rally, similar to the recent surge in Sberbank stock. Investors are advised to exercise caution with stocks in which heightened speculative activity is observed.

Under longer-term investments, preference should be given to securities from those issuers capable of generating yield higher than the market average. We have already written about three pertinent qualities: active work involving China, capabilities to generate large cash flows, and undervaluation relative to peers. Another important factor is ownership structure: companies controlled by several shareholders who are independent of one another will treat minority shareholders favorably, while their stock, in our opinion, will outstrip the market.

We recommend that investors pay attention to companies where control is either split up or located in the hands of management, while the divergence of interests between major proprietors in all likelihood will prevent ‘offending’ minority shareholders. Among such companies we include LUKOIL, VimpelCom, NOVATEK and CTC Media. The second most attractive option is buying securities in companies known for favorable treatment of minority shareholders on the part of a controlling oligarch or a particular government structure. MTS and Sberbank are good examples.


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