The start of 2010 brings economic recovery . .. As expected, since the beginning of 2010, the Russian economy has started to show clear signs of recovery. According to preliminary estimates from the Economy Ministry, in 2M10 Russian GDP grew by a solid 4.5%YoY, which is a welcome change from the 7.9%YoY slide in GDP recorded in 2009. However, the overall picture in the economy still remains rather mixed: some important sectors show a strong and sustainable recovery, while other key areas continue to remain under pressure. We believe that this situation is likely to change towards mid-year, when we expect all major sectors of the Russian economy to be on firm recovery track. We reiterate our 2010 GDP growth forecast of 5.5%YoY.

… led by exporters and discount domestic producers. The positive trends in the Russian economy have some important implications for investors. At this stage, growth is predominantly driven by rising external demand that favors export industries (oil and gas, metals, and coal) as well as by a gradual pick-up in domestic consumer demand for cheaper goods and services. These trends support local agricultural and food producers, retail discounters, utilities, telecoms and some consumer-oriented sectors of the manufacturing industry. As the economy continues to recover, we expect to see solid improvements on balance sheets within the banking sector and a rise in activities of a much broader spectrum of domestic companies, ranging from housing construction to heavy machinery and on to services industries. Continued strengthening of the ruble coupled with a relatively low inflation environment are likely to further boost the attractiveness of investments in Russian stocks and bonds.

Growth driver #1: commodity prices. The recovery in the Russian economy thus far was driven by three main factors. The first one is external, and is linked to a rapid rise in commodity prices that was accompanied by increased demand on global markets for Russia’s major export goods, such as metals, oil, natural gas and coal. This, in turn, boosted production levels in Russia’s mining sector and led to fast growth in cargo volumes. These two sectors have quickly restored their output volumes since October 2009. The increase in exports has also supported public revenue flows, and allowed the government to avoid spending from its Reserve Fund during the first two months of 2010.

Growth driver #2: real income growth ... One major distinction between the current crisis and previous ones that Russia has experienced lies in the fact that this time around a slump in the economy did not cause any significant social consequences. On the contrary, last year – even during the most difficult months of 1H09 – real incomes among the Russian population continued to grow at an average of 2.3%YoY in 2009 and at 4.8%YoY in 2M10. This happened despite a rise in the unemployment rate and mass cuts in salaries by many private-sector companies at the peak of the crisis. Growth in real incomes primarily came as a result of rises in public wages and pensions along with the predictable and protracted process of ruble depreciation (the latter allowed many Russians to switch their savings from rubles into FX and, therefore, to post gains from the devaluation process).

… that was partially offset by a rise in savings rate. This continued growth in real incomes has formed the second-most important growth driver for the Russian economy. However, its effect thus far has been significantly weakened by a major rise in the savings rate, itself a traditional reaction to the crisis. On the eve of the crisis in 1H08, the savings rate in Russia averaged 7.7%. As the crisis spread, it started to grow rapidly reaching an average of 15.2% in 2H09 and a peak of 20.5% in December 2009. However, as the recovery process becomes firmer, we expect the savings rate to drop, and this should boost consumer demand in Russia later this year. There is already evidence of this: in January 2010, the savings rate dropped to a pre-crisis level of 5.6%, which has lead to growth in domestic agricultural and food output, prompting the start of a recovery in retail sales, housing construction, and on the real estate market.

Growth driver #3: public sector spending and tariff reforms. The third growth driver is political. The growth in real incomes stemmed largely from a significant increase in public salaries and pensions that had been planned by the government before the crisis, and which was implemented right through the depths of the crisis. In addition, another government decision – to go ahead with hikes in energy and utility tariffs and with liberalization of the electricity sector – has played a key role in boosting output in the utilities’ industry.