Not all of eastern Europe is in the process of joining the EU. Indeed, much of the continent holds out no hope of joining in the foreseeable future at all. Chief among those, of course, is Russia. Granted, the former primer minister of the UK, John Major, once remarked that he saw no reason why the world’s largest country could not join the EU eventually, but only as far as the Ural Mountains. But Moscow, not surprisingly, seems unwilling to sacrifice Siberia just to cosy up to Brussels.

Nor does there seem to be any reason for Moscow to do so. Simon Kukes, the new CEO of the embattled Russian oil major Yukos, said recently that Russia is poised to overtake Saudi Arabia as the world’s largest exporter of oil. It already holds that position for natural gas. The Saudis, nervously, have been trying to get Russia to sign up to Opec, but the Kremlin is not biting. For the first time in a long while, Moscow feels confident enough to stand alone.

Confidence, as they say, breeds confidence, and that certainly seems to be the case today in Russia. Unshaken by two tragedies in the Russian capital in the space of a week – first a terrorist bomb in the metro, then the collapse of a leisure centre – domestic and foreign investors alike are keeping stock and bond markets at record highs.

Indeed, investors seem unflappable. The market’s plunge after prosecutors’ initial investigation into Yukos and the arrest of its former CEO, Mikhail Khodorkovsky, last autumn has all but been forgotten. Similar, though so far lower key, investigations – into mobile-phone operator Vympelcom, banking and insurance conglomerate Alfa Group and oil major Sibneft (and Chelsea FC) owner Roman Abramovich – have been brushed aside, as investors remain convinced that the attack on Yukos was a one-off. Concern over anti-democratic irregularities in December’s parliamentary elections, or indeed in this month’s upcoming presidential elections, has likewise failed to give pause.

Only one thing seems to matter now: oil prices. Oil and natural gas account for some 58% of Russia’s exports, and thus to a large degree account for the country’s whopping $60bn trade surplus and $39.1bn current account surplus. Those are numbers even China, the giant among emerging markets, cannot match. With oil still strongly above $30 a barrel, industry experts are talking of a shift in the long-term average. If that turns out to be true, Russia’s economy could stay buoyant for a long time.

For the moment, according to Anton Khmelnitsky, head of equities and Russian specialist at Brunswick Asset Management, all of Russia’s numbers look excellent. GDP growth reached 7% last year, and looks to hit at least 6% this year. But that is not all oil money. Industrial production in general grew by 10% in 2003, while the money supply grew some 45%, despite falling inflation. The result, Khmelnitsky said, is excess liquidity of some 20%, which is more than domestic capital markets can absorb.

“That money is going into real estate and finding its way into primary assets,” he says. “We’re seeing M&A and strategic consolidation. It is spilling over into other sectors. We’re likely to see more consolidation in other sectors, especially metals and aluminum. We’re seeing more consumer-driven growth than in the past. The current account should continue to rise. Imports should increase. And the strong rouble is great, because debt shrinks and reserves grow.”

For those willing to get in on the game, the result is some very attractive returns. Russia-only funds are by far and away the best performing in the emerging Europe category, and some of the best among emerging markets as a whole (see table). And the opportunities are expanding. Whereas Russia has generally been seen as a place to play with commodity stocks – oil, metals and the like – the market appears to be deepening, according to Elizabeth Hebert, director of Moscow-based Pallada Asset Management.

“Look at the domestic corporate bond market,” she says. “Yields right now are at 10% in roubles. Estimates are that the rouble will strengthen by 5-17% by year end. That’s a very attractive return.”

Bond markets, however, are subject to capital controls that can be onerous, and anyway are crowded with domestic investors. Another opportunity – though not for the faint-hearted – is mid-cap stocks. Pallada’s mid-cap fund was the best performing in Russia last year, returning 96%. Still, opportunities are limited.

“It requires a high level of confidence and commitment,” Hebert says. “There are a lot of mid-cap companies that are listed but that don’t trade. There is the potential for the market to broaden. When you start to look at IPOs, the government has done nothing to develop that market. It’s easier for companies to issue bonds.”

But that may soon change. Consolidation in various sectors is underway, and some of that will result in “significant IPOs by year end,” Khmelnitsky says.

“We are extremely excited about steel and aluminum,” he says. “We are not going to see any time soon a flurry of IPOs. The older companies still have to go through ownership structure changes. And the newer companies have to reach critical mass. But retail companies have EBITDA margins of 13-14%. They are among the most profitable in the world. But you need to reach $500m to $1bn in sales before it makes sense to sell out. A few of these companies will eventually realise that they will need access to international capital markets to compete.”

When that happens, Russia may at last become something more than a commodity play. In the meantime, though, investors still have to like the commodity story if they are going to invest heavily in Russia. Despite announcements of major government initiatives, corruption and criminality remain rampant and the courts and other democratic institutions remain weak. What is more, Khmelnitsky points out, in the world’s second largest oil exporter some 30 million people – or one fifth of the population – live on less than $100 a month. In the end, if Russia is to enjoy the success of its western neighbours, resolving that problem peacefully and democratically will be key.
SG

Printer friendly version

Email this article to a friend