EMEA Emerging Markets Research25 March 2011

Developed and Emerging Market Growth, Inflation and Policy Challenges in 2011, with Special Emphasis on Russia

Michael MarreseAC

EMEA EM Economics and Strategy(44 207) 777 4627(44-207) 777-4627michael.marrese@jpmorgan.com

Anatoliy Shal(7 495) 937-7321

t li h l@janatoliy.a.shal@jpmorgan.com

J.P. Morgan Securities Ltd.

See the end pages of this presentation for analyst certification and important disclosures. J P M d d k t d b i ith i d i it h t A lt i t h ld b th t th fiJ.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Summary and conclusions Part 1Summary and conclusions – Part 1

Global growth to slow in 2011 to 3.3% from 3.8% in 2010 due to: the supply shortages and higher energy prices as a consequence of the Japanese earthquake and tsunami; fiscal

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consolidation among some DM countries; and globally tighter monetary policy. The US has opted for two years of fiscal stimulus, rather than addressing its unsustainable underlying structural fiscal deficit.

2011 will be a year of par growth for DM (2 3% compared to 2 3% annually during 2002-2007

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201 2011 will be a year of par growth for DM (2.3% compared to 2.3% annually during 2002 2007

and 2.5% last year), while EM is forecast to grow 6.0% (compared to 7.0% annually during 2002-2007 and 7.2% last year). The disappointment surrounding DM is that unemployment remains unacceptably high in the US, Japan and peripheral Europe. Moreover, social contracts are being negotiated in a disappointing direction in DM.

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Enormous differences across EM, depending mostly on interdependence with Asia. The output gaps of Asian EM mostly closed by mid-2010, while Brazil’s closed in early 2010. Except for Argentina (gap closed well before 2009), most Latin countries will see their output gap disappear in 2011. Mexico will lag. For EMEA EM, most output gaps will be positive

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d sappea 0 e co ag o , ost output gaps be pos t ethroughout 2011, with exceptions in Israel, Poland and Turkey.

DM headline consumer price inflation in 2011 is expected to be 2.3%oya in 4Q11 (compared to 1.6% in 4Q10). EM headline consumer price inflation is forecast at 5.7%oya in 4Q11 ( d t 5 6% i 4Q10) d i bl ti i I di Chi I d i K B il

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M (compared to 5.6% in 4Q10), and is problematic in India, China, Indonesia, Korea, Brazil, Mexico, Egypt, Turkey, Russia, and parts of Eastern Europe.

Asset price inflation and/or excessive credit extension to the private sector have caused monetary policy tightening in much of EM Asia (including China), Brazil, Chile, Peru, Israel,

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y p y g g ( g ), , , , ,Turkey, Serbia and Georgia.

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Summary and conclusions Part 2Summary and conclusions – Part 2

DM countries have much worse fiscal and debt figures than EM countries (slide 29),

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which implies the need for prolonged DM fiscal consolidation. This is a factor likely to constrain DM growth this year and beyond.

Global imbalances—in terms of current-account balances (slide 24) and massive financial account movements given widening interest rate differentials between DM and

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201 financial account movements given widening interest rate differentials between DM and

EM—have become less of a major problem in part because Japanese retail investment abroad is being repatriated back to Japan and in part because China’s current account surplus is narrowing rapidly.

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On the negative side for EM (slide 29), political risks remain high as recent turmoil in the Middle East and North Africa has demonstrated. Moreover, ease of doing business is

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nf Middle East and North Africa has demonstrated. Moreover, ease of doing business is relatively poor, corruption perception indices are high in selected EM countries, and the young in EM countries often are discouraged by high unemployment rates.

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Global growth and inflation 2010 2012EGlobal growth and inflation, 2010-2012E

Real GDP and inflation forecasts

2010 2011 2012 1Q11 2Q11 3Q11 4Q10 4Q11Real GDP (%oya) Real GDP (%q/q, saar) Consumer prices (%oya)

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2010 2011 2012 1Q11 2Q11 3Q11 4Q10 4Q11USA 2.8 2.9 2.9 2.5 3.5 3.5 1.2 2.5United Kingdom1 1.3 1.7 2.7 2.8 2.0 2.5 3.4 3.8Germany 3.5 3.3 2.2 4.5 2.5 2.5 1.6 2.3France 1.5 2.3 2.4 3.5 2.0 2.5 1.9 2.1Italy 1.1 1.4 2.1 1.5 1.5 2.0 2.0 1.9

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Italy 1.1 1.4 2.1 1.5 1.5 2.0 2.0 1.9Spain -3.7 -0.1 1.0 1.0 1.0 1.5 2.3 0.7Japan 4.0 0.9 2.8 1.2 -1.0 2.0 0.1 0.4China 10.3 9.4 9.0 8.7 8.8 9.0 4.7 3.3Korea 6.1 4.2 4.6 5.0 4.0 5.5 3.6 3.2Malaysia 7.2 5.1 4.4 5.2 5.1 5.4 2.0 3.7

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yIndia 8.5 8.0 8.7 7.9 8.4 13.2 9.2 8.5Brazil 7.5 4.0 3.8 3.9 4.8 4.9 5.6 6.1Mexico 5.5 4.5 3.5 2.0 8.0 2.5 4.2 3.7Russia 4.0 4.5 5.0 3.5 3.0 3.5 8.2 9.7South Africa 2.8 3.7 3.8 3.6 3.7 4.0 3.5 5.9

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nf Turkey 8.3 4.5 5.0 - - - 9.1 11.3Poland 3.8 4.0 4.2 3.5 4.0 4.5 2.9 2.9Israel 4.7 4.5 4.0 4.5 4.5 4.5 2.5 3.8Saudi Arabia 3.8 5.3 4.8 - - - 6.1 6.2United Arab Emirates 2.2 3.6 3.8 - - - 2.7 3.1

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M Nigeria 3.8 4.0 4.2 - - - 3.1 3.6Global 3.8 3.3 3.6 3.4 3.4 3.7 2.7 3.2Developed markets 2.5 2.3 2.7 2.5 2.3 2.7 1.6 2.3Emerging markets 7.2 6.0 6.0 5.8 6.2 6.4 5.6 5.71. FY 2011/2012

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Population distributions among major DM and EM countriesPopulation distributions among major DM and EM countries

Population distributionsPopulation in millions, % in each age group

EM Countries in general have younger populations than DM countries. In EMEA EM, Russia and Poland have relatively older populations (older than even that ofTotal Median 0-14 15-59 60+

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have relatively older populations (older than even that of the US), while South Africa and Turkey have relatively young populations. Turkey’s population is particularly young relative to that of EU countries.

The structure of China’s population is changing

population age 0 14 15 59 60

Germany 81 44.9 13.3 60.2 26.4

Japan 126 44.8 13.2 55.8 31.0

UK 63 40 0 17 3 60 1 22 5

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p p g grapidly given the relatively low share of its population aged 0-14 years. China’s aged 0-14 year old cohort is 17.6% of its total population compared to: India’s 29.7%; South Africa’s 28.6%; Mexico’s 28.3%; Turkey’s 26.5%; Brazil’s 26.2%; and the USA’s 20.1%. China’s median

UK 63 40.0 17.3 60.1 22.5

France 65 39.9 18.5 58.5 23.1

Russia 139 38.7 15.2 66.2 18.7

Poland 38 38 5 14 7 65 4 20 0

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Brazil s 26.2%; and the USAs 20.1%. China s median age and its +60 cohort are projected to rise rapidly, which will be yet another reason (along with rapid growth in nominal and real wages) for China’s current-account surplus to narrow rapidly (slide 24).

Poland 38 38.5 14.7 65.4 20.0

US 313 36.9 20.1 61.4 18.6

China 1,337 35.5 17.6 69.1 13.2

Brazil 203 29.3 26.2 63.7 10.0

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nf Among DM countries, the US has a relatively young population. For example, the median age for the US is 36.9, whereas it is 44.9 for Germany, 44.8 for Japan, 40.0 for the UK, and 39.9 for France. The provides the US with an advantage with regards to potential real GDP growth.

Turkey 79 28.5 26.5 64.1 9.3

Mexico 114 27.1 28.3 62.3 9.4

India 1,189 26.2 29.7 62.0 8.4

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South Africa 49 25.0 28.6 62.9 8.6Source: US Census estimates 2011

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US 2011 Economic Outlook: Continuation of fiscal stimulus – Part 1

We forecast US growth in 2011 of 2.9%, compared to 2.8% last year.

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This 2011 growth forecast benefits from: all Bush tax cuts being extended; the payroll tax holiday; and accelerated depreciation. 2011 will be a year of extended fiscal stimulus.

Near-term headwinds include the fiscal contraction of state and municipal governments, higher i d t t t ti t Aft t t f h h

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201 energy prices, and a stagnant construction sector. After tax support for house purchases

evaporated, home sales have slumped (slide 9). Distressed home sales as a share of all US home sales has stayed at about 30% (slide 10). New home sales have been stuck at low levels.

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y We forecast 2.5%q/q saar real GDP growth this quarter, rising to 3.5% in 2Q11. Business surveys and more timely weekly readings on initial jobless claims are pointing to an upturn in employment growth. The 4-week weekly average of jobless claims has dropped from 418,500 in the week of the February labor market survey to 386,500 in the week of the March labor market survey

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US corporate profits are up. Capex surveys suggest businesses will spend.

On aggregate, state and local government budgets are in balance. Yet further belt tightening is

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US 2011 Economic Outlook: Continuation of fiscal stimulus – Part 2

The CPI is up to a 3-month run rate of 1.8% saar, including the surge in air fares. The core PCE i i d i f b 1 3% i h h h h h F b

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PCE price index is forecast to be up 1.3% saar in the three months through February.

Import prices are also accelerating, up 1.4% saar in February and 6.9%oya. The price of imported manufactured goods has also accelerated.

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201 US unemployment rate will remain high for many years, averaging 8.4% in 2012.

Fed on hold throughout 2011, and we do not expect another round of quantitative easing after QE2.

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Tremendous contrast between expansion of corporate borrowing and the de-leveraging by the household sector. Non-financial corporate debt increased 4.5% q/q saar in 3Q10, the third consecutive quarterly increase, and the financing gap rose to US$127.9 billion at an annual rate. Yet households are still paying down both mortgage debt and consumer credit.

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p y g g gAccording to the latest data, household debt service has fallen below 12% of household disposable income, from a high of almost 14% in 2007 (slide 7).

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US consumers have been adjusting as their debt burden declines

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US household wealth

US consumers have been adjusting as their debt burden declines

US household debt service ratio%% of disposable income

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Historic average

14.0

12

13

14

500

550

600

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10

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80 84 88 92 96 00 04 08400

450

52 56 60 64 68 72 76 80 84 88 92 96 00 04 08

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25130.2

120

140

Household debt% of disposable income

Household debt% of household and nonfinancial corporate assets

Source: J.P. Morgan Source: J.P. Morgan

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10

15

20116.1

Historic Average

60

80

100

120

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0

5

52 56 60 64 68 72 76 80 84 88 92 96 00 04 080

20

40

52 56 60 64 68 72 76 80 84 88 92 96 00 04 08

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Source: J.P. Morgan Source: J.P. Morgan

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US household saving rate has risen and US labor costs have fallen

US saving rate

US household saving rate has risen and US labor costs have fallen

%, sa

US employment cost index

%oya

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12

14

7

8y

Benefits

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8

10

5

6

Compensation

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4

6

3

4p

Wages/salaries

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2 1

2 Wages/salaries

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M 080 85 90 95 00 05 10

002 03 04 05 06 07 08 09 10 11

Source: J.P. Morgan Source: J.P. Morgan

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US home sales have slumped as tax support faded

US housing turnover

US home sales have slumped as tax support faded

Single-family home sales per householdEnd of Federal tax support

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0.07

0.08 End of Federal tax support (end-April 2010)

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0.05

0.06

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0.03

0.04 Historical average

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0.01

0.02

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0.0068 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Source: J.P. Morgan

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US shadow housing inventory a risk to house prices

Distressed sales and home prices

US shadow housing inventory a risk to house prices

%oya %

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40

45

15

20LoanPerformance House Price Index Distressed sales as % of all home sales

y

Case-Shiller House Price Index

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25

305

10

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15

20

-5

0

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5

10

-15

-10

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M 0-202006 2007 2008 2009 2010 2011

Source: J.P. Morgan

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E ro area 2011 Economic O tlook Underpinnings and Risks Part 1Euro area 2011 Economic Outlook: Underpinnings and Risks – Part 1

After more than a year of Western European recovery, Euro area growth has slowed. Euro area GDP rose 1 1%q/q saar in 4Q10 with German growth (1 5%) higher relative to the rest of the region (slide

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rose 1.1%q/q, saar in 4Q10, with German growth (1.5%) higher relative to the rest of the region (slide 12). Euro area ex Germany composite PMI remains weak relative to Germany’s PMI. Euro area ex-Germany domestic final sales have stagnated, while Germany’s domestic final sales have risen sharply over the past year. Slide 14 summarizes our view of a three-speed European recovery: rapid in Germany; solid in Western Europe (ex. Germany); and slow in peripheral Europe.

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y p ( y) p p p

Euro area IP (ex. construction) rose 0.3%m/m in January, construction output rose 1.8%m/m, while exports to outside the Euro area climbed to 3.6%m/m. We expect a further strengthening of IP in February, with modest gains in construction output as well. We see the Euro area’s export prospects as bright

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y as bright.

In Greece, fiscal and structural progress remains impressive, yet the 2009 fiscal deficit was 15.4% of GDP and the forecast for the 2010 fiscal deficit is 9.4%. We forecast that Greece would need a 6.5% of GDP permanent primary fiscal surplus post-2013 if it were to keep its public debt to GDP stable at

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nf 158% (slide 15). For Ireland, the yield to maturity on its 10-year government debt has risen from 5.70% on September 1 to 9.89% on March 23 (well after the IMF/Euro area/ECB offered Ireland a EUR67.5bn financial support package). We estimate that Ireland would need a 3.1% of GDP permanent primary surplus post-2013 if it were to keep its public-sector debt to GDP stable at 135%.

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Funding stress for Greek, Irish and Portuguese banks on the whole has remained high, and these banking systems have not issued any debt (other than short-term) so far in 2011.

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E ro area 2011 Economic O tlook Underpinnings and Risks Part 2Euro area 2011 Economic Outlook: Underpinnings and Risks – Part 2

Spain in a number of ways has de-coupled from Greece, Ireland, and Portugal, and its 10-year i ld t t it d 40b t 5 21% f J 18 t M h 23

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yields to maturity narrowed 40bp to 5.21% from January 18 to March 23.

Our growth forecasts for Germany have been revised up because German households have become increasingly confident about the future and in part because German export growth has remained strong Now we see German GDP up 3 3% this year (compared to Euro area growth

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of 2.2%).

The Euro area has begun to see growth in bank loans to households and non-financial companies (slide 15).

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p ( )

One upside risk to Euro area growth is that European households have scope to lower their saving rate as public-sector saving in the Euro area increases (slide 16).

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nf We expect the ECB to raise its main policy interest rate 25bp to 1.25% in early April. Note that the Euro area business surveys in February were at a level far above that consistent with the ECB staff’s growth forecast.

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Remarkably positive indicators for German households

130 20

Consumption across the Euro area

Remarkably positive indicators for German households

German consumer confidence% balanceIndex, 1Q02=100

Greece

11

110

115

120

125

-10

0

10

France

Spain

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95

100

105

02 03 04 05 06 07 08 09 10-40

-30

-20

00 01 02 03 04 05 06 07 08 09 10 11

Italy

Germany

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8020

German retail confidence% balance

German household fears about unemployment% balance

Source: J.P. Morgan Source: J.P. Morgan

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20

40

60

-20

-10

0

10

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-20

0

00 01 02 03 04 05 06 07 08 09 10 11-50

-40

-30

00 01 02 03 04 05 06 07 08 09 10 11

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Source: J.P. Morgan Source: J.P. Morgan

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A h d E

120

A three speed Euro area recovery

Euro area economic sentimentInx, sa, 100 is post-1990 average

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110

120Germany

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100

Core, ex Germany

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90Periphery

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70

80

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M 7007 08 09 10 11

Source: J.P. Morgan

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E G i id f i

Euro area bank lending

Euro area: Growing evidence of monetary traction

%oya

11

15

20y

Nonfinancial corporate loans

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10

Household loans

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5

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0

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M -52000 2002 2004 2006 2008 2010

Source: J.P. Morgan

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S f E h h ld i d bli i i k

6

Financial positions of Euro area sectors

Scope for Euro area household saving to moderate as public saving picks up

% of GDP, 4-qtr moving sum

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4

6

Household

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2External

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-4

-2Corporate

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8

-6Government

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M -82000 2002 2004 2006 2008 2010

Source: J.P. Morgan

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The extent of the fiscal journey in the periphery of the Euro area

The achievement of debt sustainability in 2013

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Primary position 2010 Gross debt peakJPMorgan

estimate of equil primary position

Journey from 2010 Government objective for primary position

Greece -3.7 158.0 6.5 10.2 5.9

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Spain -7.3 70.2 1.1 8.4 0.1

Portugal -4.4 86.6 2.1 6.5 1.9

Italy -0.3 119.2 4.1 4.4 2.6

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France -5.0 87.4 2.2 7.2 -0.1

Germany -1.3 80.0 1.5 2.8 0.5

UK -7.4 85.5 2.1 9.5 1.9

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nf Source: J.P.Morgan. The JPMorgan estimate of the equilibrium primary position is based on a regression of the primary position on the level of gross debt for eight Euro area countries over the period 1997-2007 (Bel, Fr, Ger, It, Neth, Port, Sp and Au). The equation is primary position = -2.72 + 0.055*gross debt. No additional risk premia has been added for very high levels of debt. It does not matter much if the analysis is done in terms of net debt.

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E id f b k f di i h E i h

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Use of ECB refinancing by country

Evidence of bank funding stress in the Euro area periphery

% of liabilities Greece

11 15

20 Greece

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15

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5

10

Portugal

Ireland

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5

Spain

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M 02008 2009 2010 2011

Source: J.P. Morgan

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European bank redemptions likely to be heavy in 1H11

160

Quarterly European bank funding needs for 2011-2012

European bank redemptions likely to be heavy in 1H11

€bn

11 24 7

10.1

12.8 21.6

120

140

160 Senior Subordinated Government Guaranteed

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2324.7

16.8

21.3

26.70.7

50.8

13.9

80

100

120

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102.1 107.1

6 8

107.6

77 3

20.915.3

9

6 740

60

80

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53.5

77.3

50.6

23.2

13.4

6.7

0

20

40

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M 0Q1'11 Q2'11 Q3'11 Q4'11 Q1'12 Q2'12 Q3'12 Q4'12

Source: J.P.Morgan

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Japan 2011 Economic Outlook: Underpinnings and Risks – Part 1

In light of a catastrophe that is larger than any other since the end of WWII, the BoJ has been injecting liquidity aggressively into the banking system and the Bank expanded the

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been injecting liquidity aggressively into the banking system, and the Bank expanded the size of its asset purchase program to JPY10trn (2% of GDP), from JPY5trn. The G-7 has conducted coordinated USD purchases against JPY since Friday March 18.

The direct damage from the earthquake and tsunami is expected to be at least 3% of

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The earthquake and tsunami will likely pull down growth in 2Q11 (to -1.0% saar from +2.2%), but we expect a rebound in 2H11.

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Labour productivity has risen, contributing to the surge in profit of Japanese manufacturing firms. In fact, Japanese corporate profits have recently exceeded US corporate profits (measured in USD). Given yen strength and the abundant cash of Japanese firms, we expect Japanese firms to increase overseas investment, especially in EM.

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The supplementary budget is expected to be at least 2.0% of GDP, financed with JGB issuance, a temporary hike in the consumption tax, and use of contingency budgetary funds.

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Japan 2011 Economic Outlook: Underpinnings and Risks – Part 2

CPI deflation continued in 2010, recording -0.7%y/y. We expect the rate of over-year-ago decline in core (ex fresh food) CPI to increase again in February after falling 0 2%pt in

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decline in core (ex fresh food) CPI to increase again in February, after falling 0.2%pt in January. We still believe that the underlying pace of the CPI’s exit from deflation will be very gradual.

The BoJ established its asset purchase plan and is expected to keep its virtual zero rate

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201 policy until it judges that price stability has been achieved (so at least through 2012).

Fiscal consolidation is an urgent issue. Yet JGB yield remains low at 1.3%. The natural disaster and the uncertain political situation dim the prospects of near-term fiscal consolidation 94% of JGBs are held by Japanese investors

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y consolidation. 94% of JGBs are held by Japanese investors.

Once Japan’s current account falls into deficit, non-residents will need to finance Japan’s fiscal deficit. Unless the market is convinced of Japan’s fiscal discipline, bond yields will rise markedly. In 2011, Japan is projected to have a 2.8% of GDP current-account surplus.

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The consumption tax rate is now 5%, but in order to avoid much higher government borrowing costs in say 3-5 years time, that rate will likely increase steadily.

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China 2011 Economic Outlook: Underpinnings and Risks – Part 1

The Chinese economy’s momentum turned up significantly in 4Q10, with real GDP rising 12 7%q/q saar (our estimate) following 9 9%q/q saar expansion in 3Q For 2010 we forecast

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12.7%q/q saar (our estimate), following 9.9%q/q saar expansion in 3Q. For 2010, we forecast that GDP rose 10.3%.

For 2011, we forecast 9.4% growth mostly on the basis of domestic demand growing at a brisk pace. We expect local governments to start new projects early next year. This

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target, is likely to coincide with solid private consumption growth and the gradual fading of the inventory drag. Note that we revised down our 1H11 forecast modestly in light of the downward revisions we have made in our forecasts for 1H11 US and Japanese growth. Historically a 1% age point change in US GDP growth (with its associated impact on the

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y Historically, a 1%-age point change in US GDP growth (with its associated impact on the global economy) leads to about a 5%-age point change in China’s export growth.

Chinese policymakers have turned their attention toward inflation, which we expect to rise 5.3%oya in March, and to remain elevated through mid-year. The PBoC announced on

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nf March 18 that the reserve requirement ratio for financial institutions’ yuan deposits would be raised 50bp effective from March 25. This is the third hike in 2011, after six hikes in the RRR last year. The RRR for small and medium banks to 18.0% and for large banks to 20.0% (compared to the historical high of 17.5% in mid-2008). These policy changes, we believe, are designed to cool the housing market manage inflation and prevent overheating

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M are designed to cool the housing market, manage inflation, and prevent overheating.

We expect policymakers to continue with their multi-front approach. We look for continued monetary normalization in coming quarters, including more RRR hikes, interest rate hikes, and further CNY appreciation.

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China 2011 Economic Outlook: Underpinnings and Risks – Part 2

Yes, gradual currency appreciation will continue. Yet, Chinese officials argue that their low value added exporters (textiles and footwear) have little room to raise prices Should these

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value-added exporters (textiles and footwear) have little room to raise prices. Should these low value-added exporters lose market share, unemployment would rise swiftly, according to Chinese officials.

China’s M2 money supply growth eased in February, rising 15.7%oya, compared to 17.2%

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201 growth in January. That growth was the slowest in %oya terms since July 2010.

Seasonally adjusted M2 rose a moderate 0.8% m/m in February, following no growth in January.

With regard to the risks to growth policy dynamics this year we believe that the Chinese

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y With regard to the risks to growth-policy dynamics this year, we believe that the Chinese government still places the maintenance of stable economic growth as a high policy priority, hence is not keen to over-tighten in 2011.

Note that if nominal wage growth continues to accelerate faster than inflation, then this will

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Global imbalances 2010 2012Global imbalances, 2010-2012

Real GDP and inflation forecasts

2011 Nominal GDP(US$ billion) 2010 2011 2012 2010 2011 2012

Current account (% of GDP) Fiscal balance (% of GDP)

11

(US$ billion) 2010 2011 2012 2010 2011 2012USA 15246.7 -3.2 -3.6 -3.6 -8.8 -9.8 -7.5United Kingdom1 2475.8 -2.2 -1.8 -1.9 -10.2 -7.7 -5.7Germany* 3358.2 6.1 5.8 5.2 -3.7 -2.7 -1.8France* 2590.8 -1.8 -1.8 -1.8 -7.7 -6.3 -5.8Italy* 2054 9 -2 9 -2 7 -2 6 -5 0 -4 3 -3 5

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201 Italy 2054.9 -2.9 -2.7 -2.6 -5.0 -4.3 -3.5

Spain* 1366.1 -5.2 -4.8 -4.6 -9.3 -6.4 -5.5Japan 6031.1 3.6 2.8 2.2 -7.9 -7.7 -7.4China 7071.1 5.0 3.5 3.3 -2.1 -1.9 -1.8Korea 1122.8 2.8 1.5 1.0 -0.5 0.5 1.0Malaysia 252 6 14 7 13 0 10 9 -5 6 -5 2 -4 5

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Malaysia 252.6 14.7 13.0 10.9 5.6 5.2 4.5India 1885.0 -2.7 -2.6 -2.0 -5.2 -4.8 -4.1Brazil 2382.8 -2.3 -2.9 -3.7 -3.0 -2.3 -1.1Mexico 1205.4 -1.0 -1.5 -1.8 -2.6 -2.4 -2.0Russia 1853.2 4.9 4.5 2.9 -4.0 -0.5 0.2South Africa 396.8 -2.8 -4.0 -5.0 -5.3 -5.2 -4.6

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Turkey 816.2 -6.5 -7.3 -6.6 -3.6 -2.6 -1.7Poland 563.3 -3.3 -4.2 -4.5 -7.9 -6.0 -4.5Israel 243.5 3.5 3.0 2.5 -3.7 -3.0 -3.0Saudi Arabia* 476.0 6.7 15.6 12.1 1.8 12.8 7.6United Arab Emirates* 255.1 5.4 8.1 7.2 -2.4 14.8 8.4

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Source: J.P. Morgan

Nigeria 233.0 1.9 7.2 8.5 -6.1 -6.0 -4.51. FY 2011/2012 *Official and IMF forecasts.

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Weak narrowing of current account imbalances and major policy challenges

In the July 2010 Banca D’Italia Occasional Paper “The Role of Macroeconomic Policies in the Global Crisis”, four Banca D’Italia economists argue that with a set of very different economic policies during 2002-2007 in various parts of the world, the global financial economic crisis thereafter would h b h k d h li d

11

have been much weaker and shorter lived.

They argue that (p. 28) “….,had monetary and supervision policies been less expansionary in the United States, had policies enhancing potential output growth been implemented in Japan and Europe, and had policies conducive to rebalancing towards domestic demand been pursued in

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Europe, and had policies conducive to rebalancing towards domestic demand been pursued in emerging Asian economics, in combination with enough exchange rate flexibility to maintain domestic balance, the pattern of current accounts would have been considerably more balanced and US housing prices would have grown at a much slower pace. For the United States, the cost of these policies would have been lower output and temporarily higher inflation, but the loss in

t t (l th 3 t i t b l th b li i 2006) i h lf bi th t t l

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y output (less than 3 percentage points below the baseline in 2006) is half as big as the output loss at the trough of the recession (6 percentage points relative to the pre-crisis trend in 2009Q2). All in all, the slower US growth could be viewed as an insurance premium for avoiding the costs of the recession and the subsequent large increase in public debt in order to offset the weakness in private demand and the effects of financial sector de-leveraging. For the other major economies

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p g g jthe rebalancing of global demand, through a shift towards greater reliance on domestic demand in China and an increase in potential output growth in Europe and Japan, would have compensated the slowdown induced by tighter US monetary and supervision policies, helping markedly to mitigate the international distortions that facilitated the build-up of the crisis.”

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The authors conclude that: “The importance of achieving a major rebalancing of global demand through policies aimed at a more sustainable pattern of growth has not been reduced with the crisis.” In other words, the major global economic actors—each for country-specific reasons—have not learned the value of cooperation.

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Weak narrowing of current account imbalances and major policy challenges

For 2011, the USD value of the forecast current-account surpluses of Germany, Japan, China, Korea, Malaysia, Russia, Israel, Saudi Arabia, U.A.E., and Nigeria equals US$868

11

billion, which is 1.46 times the estimated current-account deficits of the USA and the UK. Note that the current-account surpluses of the above 10 countries is estimated at 4.8%, 4.0%, and 3.4% of their combined GDP for 2010, 2011 and 2012 respectively.

On slide 27 many EM countries have found their currencies appreciating in nominal terms

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201 On slide 27, many EM countries have found their currencies appreciating in nominal terms

tremendously versus USD, and have begun to implement policies to counter further nominal appreciation.

On slide 28, J. P. Morgan estimates that during the period January 2000 through February 2011 CNY i t d i l ff ti t 20 5% ( d t l ti t t EM

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y 2011, CNY appreciated in real effective terms 20.5% (modest relative to most EM countries), and actually has depreciated 1.4% in real effective terms since the bankruptcy of Lehman in September 2008.

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EM FX appreciation has challenged policymakers

Change over one year versus USD as of March 25, 2011

EM FX appreciation has challenged policymakers 11

11.6711.16

10.219.65

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8.558.10

7.31

5.955.32 5.15 4.85 4.80

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y 4.12 3.77 3.412.54

1.97 1.93

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-0.31

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Source: Bloomberg

SGD CLP CZK MYR ZAR BRL TWD THB HUF PHP MXN IDR RUB CNY PLN COP KRW PEN INR TRY

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Emerging Markets real effective exchange ratesEmerging Markets real effective exchange ratesReal Effective Exchange rate% change (positive denotes appreciation)

At end-February 2011, BRL, COP, ZAR and SAR stood out as having appreciated significantly more since September 2008 in real effective terms than other EM currencies. Since September 2008, TRY, UAH, KRW, PLN, MXN and ISK have depreciated in real effective terms the most.

DM

Jan 2000- Feb 2011 Change

Sep 2008- Feb 2011 Change

Big Mac Index Under (-) or over (+) valuation against the dollar1

11

Countries such as Brazil have become increasingly aggressive in fighting both nominal and real appreciation by implementing capital controls. This practice is likely to spread in part because the Fed’s policy of additional quantitative easing could lead to further USD weakness, imported inflation via higher commodity prices and additional inflows into EM. If capital inflows continue at the recent pace then Indonesia Thailand and Korea are

DM Change Change against the dollar1

USD -18.1 -0.4EUR 13.3 -9.2 29.1JPY -15.8 19.8 5.4CHF 10.8 18.9 82.7AUD* 45.1 12.4 2.9NZD* 35.1 11.9 -3.8CAD 1.7 1.8 12.7

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201 inflows continue at the recent pace, then Indonesia, Thailand and Korea are

most likely to act with controls of some sort, in our view.

In the EMEA EM region, South Africa has begun to adjust policy, in a sensible manner, to counter the rise in its exchange rate. South African authorities have increased the offshore upper investment limit for local fund managers by 5% points. South African authorities have already substantially

CAD 1.7 1.8 12.7LatamBRL 125.5 20.1 41.8COP* 20.4 13.9 17.7CLP* 30.0 0.9 -10.5MXN 8.6 -5.4 -30.5EMEA EMCZK* 53 6 -2 6 -8 0

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managers by 5% points. South African authorities have already substantially raised the maximum offshore exposure limits for individuals. Moreover, both the government and the SARB have increased allocations to purchase foreign currency. We continue to view it as unlikely that South African authorities will impose a tax on portfolio inflows.

EU countries such as Poland, Hungary and the Czech Republic are least

CZK 53.6 2.6 8.0EGP* -7.5 0.3 -6.7HUF* 21.5 -1.1 -10.7ILS* 6.9 -0.1 3.5ISK2** -28.1 -5.3 40.0KWD 3.9 -0.3 -KZT -18.4 -1.6 -LVL2** 2.7 -1.1 -13.0

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g y plikely to increase FX intervention, in our view. Although CE-3 currencies have appreciated versus the dollar, moves versus the euro have been negligible (the bulk of foreign trade takes place with EU countries). We believe that policymakers in the region will not fight gradual real FX appreciation and that intervention will only be used to dampen the volatility or rapid repricing of CE-3 currencies. Stronger CE-3 currencies would help to i)

LVL 2.7 1.1 13.0PLN* 20.0 -10.2 -30.3RON 90.0 -1.8 -RUB 135.2 8.2 -35.6SAR* -5.8 9.2 -28.4SKK 24.3 -5.0 -TRY* 10.5 -16.7 4.3UAH* 6 6 -15 1 -50 7

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M rapid repricing of CE 3 currencies. Stronger CE 3 currencies would help to i) ease the burden on FX mortgage holders - mainly in Hungary, ii) reduce debt to-GDP ratios - also in Poland, and iii) reduce upside risks to inflation.

We remain of the view that the currency pegs in Bulgaria, the Baltics and the GCC will hold. We also believe that if a eurozone government restructured its government debt, the eurozone itself would remain intact.

UAH 6.6 -15.1 -50.7ZAR 13.0 9.3 -24.8

Other EMCNY 20.5 -1.4 -41.2INR 1.2 3.4 -KRW -12.2 -14.6 -18.3Source: J.P.Morgan based on PPI. KZT and LVL data lag by one month.1. Source: The Economist as of 15 Oct 10, *22 Jul 10 or **13 Jul 09.

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g ,,2. Source: Central Bank, based on CPI.

28

Debt fiscal and structural indicators 2011Debt, fiscal and structural indicators 2011

Debt, fiscal and structural indicators 2011

Nominal GDP (US$ Total debt2

% of GDP

Gross public debt

Debt held by residents2 (% of

General govt revenue (% of Gross borrowing

needs (% of GDP)

Ease of business

Corruption perceptions

11

NOT UPDATEDUSA 15246.7 358.3 96.0 66.1 32.0 12.8 5 22United Kingdom1 2475.8 535.0 83.5 66.0 40.9 12.0 4 20Germany* 3358.2 293.1 79.6 46.0 42.9 10.7 22 15France* 2590.8 331.0 87.9 33.0 49.8 11.0 26 25

billion) % of GDP (% of GDP) gross public debt) GDP) needs (% of GDP) 2011 2010

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201 Italy* 2054.9 306.5 118.4 48.0 45.7 14.0 80 67

Spain* 1366.1 393.1 69.0 56.0 37.0 11.6 49 30Japan 6031.1 797.4 204.6 95.4 33.3 8.3 18 17China 7071.1 43.6 17.4 99.6 17.9 4.7 79 78Korea 1122.8 - 44.7 - 31.4 0.0 16 39

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y Malaysia 252.6 142.2 54.8 84.0 24.0 11.7 21 56India 1885.0 - 79.5 94.0 23.7 10.0 134 87Brazil 2382.8 - 61.2 90.0 34.5 11.4 127 69Mexico 1205.4 - 33.8 75.0 23.6 35.8 35 98Russia 1853.2 90.0 8.9 87.0 36.0 0.9 123 154S th Af i 396 8 40 3 82 0 30 2 9 0 34 54

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nf South Africa 396.8 - 40.3 82.0 30.2 9.0 34 54Turkey 816.2 91.6 44.5 89.0 33.6 11.0 65 56Poland 563.3 141.6 54.0 74.6 38.9 10.3 70 41Israel 243.5 220.0 78.0 97.0 38.0 6.6 29 30Saudi Arabia 476.0 35.0 11.0 100.0 46.9 11.0 11 50United Arab Emirates 255 1 75 0 22 0 76 0 31 0 21 6 40 28

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Sources: J.P. Morgan, OECD, IMF, World Bank Doing Business Report 2011 (out of 183 countries) and Transparency International Corruption Perception Index 2010 (out of 178 countries). 1. FY2010/11, government debt is for the total public sector. 2. Latest available figure or J.P.Morgan estimate - Total debt is the sum of household debt, financial and nonfinancial corporate debt and government debt; but excludes unfunded government pension liabilities.

United Arab Emirates 255.1 75.0 22.0 76.0 31.0 21.6 40 28Nigeria 233.0 - 16.9 - 26.0 - 137 1341. FY 2011/2012. 2. Latest available data. *Off icial and IMF forecasts.

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EM fundamentals

EM sovereign spreads trade well inside peripheral Europe and US states

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The EM output gap has closed, but remains substantial for DM

EM unemployment rates have declined, but DM unemployment rates still remain just below their peak

EM FX reserves are more than double those of DM

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EM public-sector debt ratios are less than half those of DM debt ratios

EM economies will make up 50% of global GDP by 2017

Chi d I di di t J P M ti t ill b th l t i i th t d d d B il i

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y China and India, according to J.P. Morgan estimates, will become the largest economies in the next decade, and Brazil is to become the world’s fifth largest economy

EM per capita income has tripled over the past decade in PPP terms

Oil demand by emerging markets is surpassing that of developed markets

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More that 50% of China’s exports are now directed to EM countries; Latin America’s exports to China have doubled since 2005; Brazil is now exporting more to China than to the USA

Many EM commodity exporters are net external creditors (Brazil, Chile, Venezuela, GDD, Kazakhstan, Russia, Nigeria, M l i ) Chi T i d Th il d

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EM fixed income total market capitalization is approaching US High Grade and is more than three times higher than US High Yield

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Russia: High oil prices to offset lack of reforms in the near term

Outlook

• Growth in 2010 was 4%, after the almost 8% GDP contraction in 2009. Last year, the economy was affected by a major heat wave and drought, which lowered GDP by almost 1%-age point. However, we also believe that Russia’s potential growth has declined from 5-6% in the previous decade to 3 5% 4% d t b th i d hi d l i t i th

Main macroeconomic forecasts for Russia

2008 2009 2010e 2011f 2012f

Real GDP growth (%) 5.2 -7.9 4.0 4.5 5.0Real consumption (% change) 8.5 -5.4 2.1 3.1 5.1

Key forecasts: Higher growth and inflation as oil climbs higher

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3.5%-4% due to both worsening demographics and slow improvements in the business climate. But higher oil prices are to fuel domestic demand and to push growth to 4.5% or above in 2011.

• Due mostly to the surge in food prices, inflation has been accelerating since July 2010, and is to return to double-digits in 2Q11. Strengthening domestic demand and a shrinking output gap start lifting core inflation up. Excise tax hikes and the long term strategy to bring regulated prices to

Real fixed investment (% change) 10.4 -15.7 3.5 11.5 12.5Real exports (% change) 0.6 -4.7 11.1 6.0 4.9Real imports (% change) 14.8 -30.4 25.4 19.0 16.5

Nominal GDP (US$ bn) 1665 1233 1477 1912 2154

Inflation (% change, Dec/Dec) 13.3 8.8 8.8 8.8 7.5Inflation (annual average %) 14 1 11 7 6 9 9 7 7 5

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201 Excise tax hikes and the long-term strategy to bring regulated prices to

cost-recovery levels add to inflation too.

• With more signs of demand-pull inflation and CPI approaching 10%, we expect the CBR to hike the overnight deposit rate 125bp this year to prevent a rise in inflation expectations. This will be combined with gradual increases in reserve requirements.

Inflation (annual average %) 14.1 11.7 6.9 9.7 7.5

RUB/Basket of 0.55USD+0.45EUR (eop) 34.7 36.1 34.9 32.5 33.0RUB/USD (eop) 29.4 30.3 30.5 26.8 28.0RUB/USD (avg) 24.9 31.7 30.4 27.6 27.9

Federal cash fiscal balance (% GDP) 4.1 -5.9 -4.0 -0.5 0.2Reserve Fund (FX holdings, US$ bln) 137 60 25 43 73

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y • Inflation pressures are also likely to be partially offset by a stronger ruble in 2011, though the CBR will try to limit appreciation. The CBR will increase the flexibility of its exchange rate policy in the medium-term.

• High current account surpluses have been supported by rising commodity prices and will fuel near-term ruble appreciation. However, CA is likely to shrink in the medium-term given that the revival in import demand is to be

( g )National Well-being Fund (FX holdings, US$ bn) 74 77 74 81 81

Current account balance (US$ bn) 102 49 73 86 62Current account balance (% GDP) 6.1 4.0 4.9 4.5 2.9Capital / financial account balance (US$ bn) -148 -46 -36 -20 -15Capital / financial account balance (% GDP) -8.9 -3.7 -2.4 -1.0 -0.7Foreign exchange reserves* (US$ bn) 426 439 479 573 617

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nf only partially neutralized by firming commodity prices.

• 2010 capital account suffered US$38bn of net non-bank outflows as Russian companies and oligarchs diversified abroad, clearly unsatisfied with the risk/reward profile of the business climate. Approaching elections are likely to maintain export of domestic capital elevated. However, inflows of foreign capital may strengthen this year: privatization of state assets will

Foreign exchange reserves* (US$ bn) 426 439 479 573 617Total external debt (US$ bn) 481 467 483 511 530External debt/GDP (%) 28.9 37.9 32.7 26.7 24.6

Memo: Urals crude oil price 95.1 61.3 78.2 102.0 108.0Source: Rosstat, CBR, Minfin, J.P.Morgan estimates* Including fx assets of the Reserve Fund and the National Well-being Fund

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M attract portfolio inflows, while Russian companies may borrow more externally, as domestic rates are rising. Investors’ perception about Russia’s business climate may also improve in 2011, if Russia enters the WTO. Still, the capital account is likely to remain net negative and volatile.

• The fiscal deficit is expected to fall sharply on higher oil prices. However, the non-oil deficit will shrink only gradually in the next few years. Fi i f th d fi it h ld t b bl th k t hi h il i

— Oil prices. — Closure of international credit markets.— Irresponsible fiscal policy, driven by electoral cycle and slower

economic growth environment

Macro outlook most sensitive to:

g g

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ed Financing of the deficit should not be a problem thanks to high oil savings and low debt levels. Ample domestic liquidity will help domestic borrowings, while Eurobond issuance is likely to be limited.

economic growth environment.

31

Russia: Ambitious privatization plan marks a change in policies

Privatization to reopen in 2011-15

Partial privatization of up to 850 enterprises for 2011-13 adopted on 17 Nov 2010. While the announcements sounded impressive, this is not a big change from the last few years, when privatization lists were also long (for instance, 547 entities were to be privatized in

Privatization of top companies in 2011-15Name State Privatization scheduleVTB 85.5% 10% in 2010, 10% in 2011, 15.5%-1 in 2012Sovkomflot 100% 25% in 2011, 25%-1 share in 2012-13

% %

Privatization of top companies in 2011-15

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we e also lo g ( o sta ce, 5 e t t es we e to be p vat ed 2009, 957 in 2008). But track record of recent years’ privatization is poor (bar chart).

However, a special list of 10 large state-owned companies (table), which will be offered for privatization in the next several years, marks a real change in the government’s policies. For these 10

i th t t ill fi t ff l i it t k i t

United grain company 100% 100% till 2012Rushydro 57.97% 7.97%-1 in 2011-13FSK 79.11% 4.11%-1 in 2011-13Sberbank 57.58% 7.58%-1 in 2011-13Rosneft 75.1% 25%-1 till 2015

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201 companies, the state will first offer only minority stakes, reserving at

least 50% of state ownership. However, Minister of Finance Alexei Kudrin expects the state’s share may be lowered to 25% after 2015 (this has not been confirmed by Russia’s top political leadership yet). In addition, the Ministry of Finance is urging regional governments to enhance privatization as well (by making privatization one

i t t bt i f d l t f )

Rosagroleasing 99.9% 49.9%-1 in 2013-15Rosselhozbank 100% 25% till 2015Russian Railways 100.0% 25%-1 after 2013Source: Ministry of Economy

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y requirement to obtain federal transfers).

During 2011-13, the government is anticipating RUB 1 trillion ($33 billion) in privatization revenue, mainly from selling stakes in the top ten companies. We anticipate greater privatization revenue.Some privatization may take the form of swapping government stakes for stakes in other companies (i.e. non-money transaction), which

40

50Plan Actual

Recent years' privatization plans were unambitious and poorly executedRUB billion

Recent years’ privatization plans of the government were unambitious and poorly executed

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p ( y ),may be of interest for national champions (Rosneft, Russian Railways). Privatization revenues are meant to help finance the budget deficit. However, Finance Minister Kudrin has already suggested to create a special sovereign fund to save these revenues.

Russia sold the first 10% VTB stake in Feb-11 (for $3.3bn). 0

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M Renewed privatization efforts, in our view, are constructive, even though the state does not want to lose control over its national champions. Privatization should help improve corporate governance, deepen Russian stock market, in some cases attract new strategic investors, improve Russian image abroad and, ultimately, reduce Russia’s elevated state participation in the economy. We note,

Source: Ministry of Finance, Ministry of Economy

2005 2006 2007 2008 2009

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p p y ,however, that the recent oil rally may slow the privatization process as cash constraints are not binding anymore.

32

Russia: Very close to WTO accession

One step closer to benefit from WTO membership

Russia has been trying to join WTO since 1994. The already very long negotiations were further dragged out when Russia declared that it would join WTO within a newly created customs union with Kazakhstan and Belarus in 2009, which followed PM Putin’s regrets

100120140

Restrictions against Russian exportsunits

Total number of restrictions

Restrictions against Russian exports

11

a a sta a d ela us 009, w c ollowed M ut s eg ets about the unconstructive position of the West in negotiations. These plans were, however, abandoned and the new, crucial, impulse to the process was given after President Medvedev’s visit to the US in the summer of 2010. All key outstanding issues with the US were resolved by September, and with the EU by November. At the moment, Russia and WTO are at the middle of editing the 0

20406080

100

Antidumping measures

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, gworking party report. It is thus now possible that Russia will enter WTO in 2011, if remaining issues with agricultural subsidies are overcome and an agreement is reached with Georgia.

A precise evaluation of the impact of WTO entry on the Russian economy is difficult, but the implications look positive. World B k h gg t th t WTO i ight i R i ’

Export restrictions by sectors

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Fertilizers, 7

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y Bank research suggests that WTO accession might increase Russia’s GDP by 3.3% and consumption by 7.8% in the medium-term, with much of the impact coming from an increase in FDI into skill-intensive services sectors as well as from imports of manufacturing machinery. As restrictions on foreign ownership of financial businesses and import duties on investment-related goods have already been lowered somewhat since the time of that research

Metals, 28Other, 46

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nf already been lowered somewhat since the time of that research, actual mid-term gains are likely to be lower. In the long-term, if benefits of improvements in Russia’s business climate are realized, the WTO entry may boost Russia’s GDP level by 11%, according to WB.

Russia’s WTO accession to affect growth via several channels. S f h Mi i f E

Agricultural products, 7Chemicals,

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gExtraction of raw materials should benefit from lower trade restrictions, though this is likely to be at least partially offset by net losses in agriculture, light industry and perhaps in a few other manufacturing industries. Consumers could win from lower prices, and the economy as a whole looks set to benefit from a better competitive environment and lower barriers for investment. Most

Source for charts: Ministry of Economy

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33

Russia: Potential growth declined from 5-6% to 3.5-4%

Outlook

We estimate that Russia’s potential growth will slip from 5-6% in the last decade to 3.5-4% in the coming years, affected by weaker demographics, tighter financial conditions, and a shift in government priorities.

6

%y /y

Potential growth estimates

HP-filter estimate

Potential growth: slowed from 5-6% to 3.5-4%

11

gove e t p o t es.

Demographic decline: Russia’s working-age population is set to fall about one million a year over the next decade, with no signs of welcoming immigration. The pension to wage ratio jumped from 25% in 2008 to 37% in 2010, which should reduce economic incentives to postpone retirement (55 years for women and 60 for

th iti l t t i th i ) 3

0

3Production function estimate

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201 men; authorities express reluctance to raise the pension age).

Slower capital stock growth: Apart from cyclical forces and increased capital destruction from sharp declines in capital utilization in the recent recession, it will be affected by:

• Limited state investment: prioritizing social stability over i f d l

-395 00 05 10 15

Output gapWith economy growing 4-5% a year, output gap may remain negative for a few more years

flatio

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y infrastructure development

• A shift in real interest rates from negative to positive: a combination of wiser monetary policy and higher demand on domestic private savings (public savings fell)

• Reduced capacity of the corporate sector to increase

10

20

% of potential GDP

Output gap

Based on HP-filter estimate

negative for a few more years

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nf leverage: reached 57% of GDP by 2009

• Little improvements in business environment to attract FDI

Slower productivity growth:

• Lack of reforms to improve business environment, increase competition

-20

-10

0

95 00 05 10 15

Based on production function estimate

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• Infrastructure bottlenecks

• Lower R&D spending as % of GDP, as state cut development spending during the crisis

• Lower (though still vast) potential for convergence with DM

Sources for charts: J.P.Morgan

95 00 05 10 15

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34

Russia’s fiscal accounts: 2011 financing should not be a problem

The recent deterioration in public finances is likely to present the government with the challenge of fiscal consolidation in the years to come. In 2009, the federal budget recorded a deficit of 5.9% of GDP, which was a significant swing from the 4.1% surplus in 2008. This was partly because of sharply lower oil revenues, but tax cuts, a shrinking tax base, and more spending have also led to a deterioration in the non-oil balance (headline

5

10% GDP

Federal budget balance

Total balance

Federal budget balance% GDP

11

spending have also led to a deterioration in the non-oil balance (headline cash balance excluding oil and gas revenues).

Future consolidation is likely to be gradual, as the stimulus was mostly delivered as social spending and tax cuts, which will be hard to reverse. The authorities have been trying to maintain the status quo and to stop the decline in their popularity ratings through social expenditure—which makes an

-15

-10

-5

0

95 97 99 01 03 05 07 09 11

Non-oil balance

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decline in their popularity ratings through social expenditure which makes an exit strategy more difficult, in our view. One example demonstrating the extent of this populist response to the recession was the decision to raise state pensions by 45% in 2010.

The adopted 2011 budget assumes only a moderate growth is social outlays(6.5% for state wages, 9% for pensions). But we expect that the election cycle

Federal budget, main items% of GDP

2007 2008 2009 2010e 2011f 2012f

Revenues 23.4 22.4 18.8 18.5 19.9 20.2il & 8 7 10 6 7 6 8 5 9 6 9 4

Federal budget, main items% of GDP

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( g , p ) p ywill make authorities revise social spending up during 2011.

Higher oil prices are helping to cut headline deficit. We expect that with Urals at $102/bbl, the deficit will shrink to virtually zero in 2011, down from 5.9% in 2009 and 4% in 2011. However, non-oil deficit will only decline to around 10% of GDP from the 2009 peak of 13.5%.

oil & gas revenues 8.7 10.6 7.6 8.5 9.6 9.4non-oil revenues 14.7 11.8 11.1 10.0 10.3 10.8

Expenditures 18.0 18.3 24.6 22.5 20.4 20.0Interest 0.4 0.4 0.5 0.6 0.7 0.9

Budget balance 5.4 4.1 -5.9 -4.0 -0.5 0.2Primary balance 5.8 4.5 -5.4 -3.4 0.3 1.1

Memo: non-oil balance -3.3 -6.5 -13.5 -12.5 -10.1 -9.2

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Deficit financing should not face many problems in 2011-12. Taking into account debt maturities, Russia’s public sector borrowing requirements are estimated to be at around $20bn in the next two years (Urals at $102-108/bbl). After much of 2009 and 2010 financing needs were covered by the Reserve Fund, the MinFin is likely to opt to tap the domestic bond market and

Memo: Urals crude price 69.5 95.1 61.3 78.2 102 108Source: Minfin, J.P.Morgan estimates

Public sector borrowing requirements and financing, US$ billion2010 2011 2012

Deficit -59 -9 5

Borrowing requirements and financing, US$ billion

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M to start accumulating the Reserve Fund again in 2011-12. Given the low level of deficit and increasing volume of pension savings managed by VEB, the market should easily absorb the (limited) supply. We thus expect that Russia will issue not more than $3-5bn of Eurobonds in 2011 (Russia issued $5.5 billion in Apr-10, and RUB 40bn of RUB-denominated Eurobonds in Feb-11).

Maturities -12 -17 -20Total financing needs -71 -26 -15

Domestic debt 29 27 30External debt 9 4 4Privatization, etc. 2 9 9R F d th d it 31 14 28

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ed Reserve Fund, other deposits 31 -14 -28Total financing 71 26 15Source: MinFin, CBR, J.P.Morgan estimates

35

Russia: Labor market is tightening fast

Labor market slack has been decreasing faster than expected. By winter 2010/11 unemployment declined to about 7% (seasonally adjusted), down by almost 2%pt from the crisis peak. In addition to continued improvement in headline unemployment, indicators of hidden unemployment are declining too. Number of employees in unpaid leave and working part-time has more than halved

8

9

% (sa by J.P. Morgan)Unemployment rateUnemployment rate

11

has more than halved.

Rapid tightening of Russia’s labor market has been at odds with the very sluggish economic recovery. For example, Okun’s law signaled slower improvement (chart). One of key reasons for a relatively fast decline in the unemployment rate is a shrinking economically active population, a decade-long demographic trend, which started in 2010. That the number of older

5

6

7

2005 2006 2007 2008 2009 2010

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long demographic trend, which started in 2010. That the number of older people leaving the work force exceeds number of young new entrants is a consequence of the WWII demographic wave and low fertility in the 1990s. This new trend is not being fully offset by immigration (and the recent upsurge of nationalism is unlikely to help it in the near term).

Tightening labor market may result in higher core inflation. That the

y = -0.17x + 0.62234

4Q change in unemployment rateOkun's law: Russia (1995-3Q2010) Okun’s law: Russia (1995-3Q2010)

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g g y gunemployment rate has reached the 7% sa mark is a worrisome sign, as we estimate that 6.5%-7% should be the level of “non-accelerating inflation rate of unemployment” (NAIRU). The Phillips curve suggests that the strong disinflation effect of labor market slack is running its course (though some slack remains in capacity utilization in a number of sectors). Should labor markets tighten further and the unemployment rate fall below 6.5% sa

-3-2-1012

15 10 5 0 5 10 15

3Q10

2Q10

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nf markets tighten further and the unemployment rate fall below 6.5% sa (unlikely until 2012), this would become a strong inflationary force. In fact, private sector wages have already begun to accelerate in 2010.

However, this effect is likely to be postponed due to payroll tax hike, which should limit wage inflation in early 2011. The payroll tax rate was increased from 26% to 34% in 2011 (wages of up to $15,000 a year are

-15 -10 -5 0 5 10 15GDP growth, %oya

1 0

2.01Q change in oya core inflation rate, %-pt Change in core inflation vs. unemployment (1Q02-3Q10) Change in core inflation vs. unemployment (1Q02-3Q10)

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( g p $ , ytaxed). Research suggests that the tax increase could be reflected in lower wage growth. Given the very high flexibility of wages and work week in Russia, while employment flexibility is relatively low, (as in Germany, not the US), the ultimate pass-through of the tax increase onto wages can be high. This also raises the hope that the pass-through of costs to consumers via price increases may be limited 3 0

-2.0

-1.0

0.0

1.0

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ed via price increases may be limited.

Source: Rosstat, J.P. Morgan estimates

-3.05 6 7 8 9 10

Unemployment (lagged 2q), %

36

Russia: Inflation expectations taken off

Cost pressures and increasing capacity utilization have recently significantly boosted firms’ intentions to raise prices. This should keep near-term producer price inflation elevated. Firms’ short-term price expectations usually quite quickly translate into actual prices (within 5-6 months).

80

90

100Diffusion index (sa by J.P. Morgan)

Russian Economic Barometer, 3-month outlook for output prices

11

More positively, plans for wage increases remain moderate, being restrained by the increase in payroll tax from early 2011.

Households’ price expectations seem to be adaptive and, following the cost-push CPI shock, have moved up. If unaddressed by monetary policy, high inflation persistence will be maintained (most empirical studies find 40

50

60

70

92 94 96 98 00 02 04 06 08 10

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201 high inflation inertia in Russia).

Economists’ long-term expectations have remained stable and even moved down in recent quarters, despite the sharp rise in headline inflation. To be sure, the decline in five-year inflation expectations, which do not seem to be affected by contemporary inflation rates, perhaps

fl t t l th h i di ti f CBR’ t li b t l

-90

-85 15

20% bal (sa by J.P. Morgan)

Households' 12-month price expectations (Rosstat) vs. actual inflation% q/q saar

Expectations

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y reflects not only the changing direction of CBR’s monetary policy, but also the expected slowdown in inflation of regulated prices (natural gas, utilities, transport), as price disproportions diminish.

To add to the picture, the fact that long-term interest rates have been relatively stable (after a pickup in 2H10, they have fallen in February) suggests that market expectations are perhaps more or less in line with

-80

-75

-70

-65 0

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10

02 04 06 08 10

CPI

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nf suggests that market expectations are perhaps more or less in line with those of professional forecasters. However, the recent fall could have been aided in part by the increased pressure of excess liquidity on short-term rates and by diminished expectations of aggressive policy tightening.

All in all, the recent rise in inflation expectations is calling for some monetary policy response though the fact that long-term expectations of

8

9%, Dec/Dec (dotted line original series, solid line seasonally adjusted by JPM)

Professional forecasters' inflation expectations (Development Center)

3 years ahead

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04 05 06 07 08 09 10 11

5 years ahead

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Source: Rosstat, REB, Development Center, J.P. Morgan

04 05 06 07 08 09 10 11

37

Russia: The CBR is opening a tightening cycle

After the rate hike at the start of 2009 to stop ruble devaluation, the Russian central bank had been gradually easing monetary policy through May 2010. Key rates were cut 10 times in 2009 (-425bp) and 4 times in 2010 (-100bp).

However, rising cost-push inflation and growing evidence of building

12

14%pa

CBR policy rates and interbank overnight rate

Interbank O/N

CBR policy rates and interbank overnight rate

11

inflation expectations pushed the CBR to open the hiking cycle already in Dec-2010, earlier than we and the market expected. The CBR started the normalization of its monetary policy with hiking its overnight deposit rate from 2.5% to 2.75% and 1-week deposit rate from 2.75% to 3%. Other policy rates, including the auction-based 1-day repo rate (5%) and the signalling refinancing rate (7.75%) were left unchanged.

4

6

8

10

Repo O/N

Refinancing rate

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refinancing rate (7.75%) were left unchanged.

The CBR surprised the market with a new policy mix in January by leaving its policy rates unchanged, but increasing the required reserve ratio (RRR) by 50-100bp. The CBR thus joined some other EM central banks in employing unconventional ways to tighten monetary policy amid record-low interest rates in the G-4. The press release made it clear that the key reason for not

0

2 Depo O/N

2008 2009 2010 2011

R i t l di thl d h

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p yhiking was the threat of increased capital inflows, which are already being attracted by increased commodity prices.

This was followed by a broader than expected tightening step in February, when both interest rates and reserve requirements were hiked. Not only the overnight deposit rate was increased by 25bp to 3%, which was

7

89

40

50

60%

Reserve requirements vs. lending growth%oy a

Loan growth

Reserve requirements vs. lending growth

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nf anticipated by consensus, but also the auction-based repo rates and the (signalling) refinancing rate were increased by 25bp. In addition, the reserve requirement ratio (RRR) was increased by 100bp on liabilities to non-residents (to 4.5%) and by 50bp on other liabilities (to 3.5%), the second such step this year. Given the large amount of excess liquidity in the system, the increase in reserve requirements should not have much impact on either the level of 2

34

56

0

10

20

30

Average RRR

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q pliquidity, hence money market rates, or on the pace of lending growth, in our view. It will likely take a series of RRR hikes and a few deposit rate hikes to affect banks’ lending policies.

We expect the CBR to hike overnight deposit rates by 125bp this year, which, given the CBR’s currency concerns, should be delivered gradually

Source: CBR, J.P. Morgan

01

-20

-10

03 07 09 1105

Dev

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ed during the year and be combined with further RRR hikes and narrowing of the interest rate corridor.

38

Russia: Balance of Payments adding to appreciation pressuresBalance of payments

Current account remains strong despite fast growth in imports. Key reason for this is firm commodity prices. With the $102/bbl Urals crude assumption we expect Russia’s current account to reach 4.4% of GDP in 2011. In the medium term, however, stronger domestic demand and real ruble appreciation will continue to drive imports higher. In 2012, we expect CA to shrink to below 3% of GDP.

Balance of paymentsUS$ billion, flows, positive sign for fx inflows, unless indicated otherwise

2007 2008 2009 2010f 2011f 2012fCurrent account 76 102 49 73 86 62

% of GDP 5.9% 6.1% 4.0% 4.9% 4.5% 2.9%Non-oil CA, % of GDP -11.0% -12.5% -11.5% -12.1% -12.7% -14.0%

Merchandise trade balance 131 180 112 149 176 163

11

Capital outflows intensified in 2H10, after capital account strengthened in 1H10. Financial and capital account recorded a deficit of $3.4 billion in 3Q10, which was followed by $23 billion in 4Q10. The outflows were apparently driven by export of domestic capital. Russian businesses having become more expansionary abroad led to intensified outward FDI flows, while record low domestic interest rates resulted in companies reducing external indebtedness

Exports 354 472 303 398 491 534 Imports -223 -292 -192 -249 -315 -371

Services balance -20 -25 -20 -27 -34 -37 Factor income balance -32 -49 -40 -45 -52 -59 Current transfers -3.5 -3.1 -2.5 -4.1 -4.1 -4.1

Capital and financial account 1 73 -148 -46 -36 -20 -15 % f GDP 5 6% 8 9% 3 7% 2 4% 1 0% 0 7%

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201 domestic interest rates resulted in companies reducing external indebtedness.

Weak institutional environment and lack of structural reforms also suggest FDI inflows are likely to stay contained over the long-term.

Capital account shortfall is likely to shrink substantially in 2011, from 2.4% to 1.0% of GDP, we expect. However, capital account is to remain volatile.

% of GDP 5.6% -8.9% -3.7% -2.4% -1.0% -0.7%

Foreign direct investment, net 8 18 -7 -8 -5 -1 Portfolio investment, net 8 -34 -3 4 9 6Other investment, net 79 -121 -19 -24 -13 -9 Net errors and omissions -12 -9 -1 -5 -5 -5

(+) denotes increase 149 -45 3 37 65 45Change in intern'tl reserves,

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But inflows of foreign capital are likely to strengthen in 2011. Privatization f t t t d hi h dit i t tt t tf li i fl

(+) denotes increase 149 -45 3 37 65 45% of GDP 11.5% -2.7% 0.3% 2.5% 3.4% 2.1%

Average Urals oil price, US$/bbl 69.5 94.8 61.3 78.2 102.0 108.0Nominal GDP, US$ billion 1300 1665 1233 1477 1912 2154Real GDP, % change oya 8.5 5.2 -7.9 4.0 4.5 5.0

Memo:

1. Including net errors and omissions, not including change in international reserves.

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nf of state assets and high commodity price are to attract more portfolio inflows. This may be further supported if Russia enters WTO this year, which appears likely. At the same time, an increase in domestic interest rates—the result of higher inflation and tighter monetary policy—may shift the balance between domestic and external borrowing and lead to an increase in external debt.

Combined with a still-strong current account surplus this should result in

10 9% GDP, 4q ma

Private capital flows vs. output gap% of potential GDP

Private capital

Capital flows tend to be pro-cyclical

Source: CBR, JPMorgan.

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-5

0

5

-6

-3

0

3

6p

Output gap

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We expect the ruble to reach 33.0/basket by mid-2011.Source: Rosstat, CBR, J.P. Morgan estimates

-15 -995 01 03 05 07 099997

39

Russia: Macroeconomic fundamentals

Russian economic data and forecasts2002 2003 2004 2005 2006 2007 2008 2009e 2010F 2011F 2012F

Real GDP growth (%) 4.7 7.3 7.2 6.4 8.2 8.5 5.2 -7.9 4.0 4.5 5.0 Gross domestic investment contribution -0.4 2.7 2.3 2.8 5.3 7.2 4.6 -15.2 6.7 7.3 6.6 Gross consumption contribution 6.4 6.3 6.6 7.9 6.6 7.9 6.2 -4.1 1.6 2.3 3.8 Net external demand contribution -1.4 -2.2 -3.7 -6.5 -3.7 -6.5 -5.6 11.4 -4.3 -5.1 -5.4

11

Real income per capita (% change) 11.1 15.0 9.9 11.1 13.5 12.1 2.3 2.3 4.2 3.7 5.5

Nominal GDP (US$ bn) 345.1 431.6 589 763 990 1300 1665 1233 1477 1912 2154Nominal GDP (RUB bn) 10,831 13,243 16,966 21,598 26,917 33,248 41,429 39,101 44,856 52,759 60,085Inflation (% change, Dec/Dec) 15.1 12 11.7 10.9 9.1 11.9 13.3 8.8 8.8 8.8 7.5Inflation (annual average %) 16 13.6 11 12.5 9.8 9.1 14.1 11.7 6.9 9.7 7.5RUB/USD (level, eop) 32.0 29.2 27.7 28.7 26.3 24.5 29.4 30.3 30.5 26.8 28.0

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RUB/USD (level, eop) 32.0 29.2 27.7 28.7 26.3 24.5 29.4 30.3 30.5 26.8 28.0REER (% change) 1.6 0.8 6.1 8.1 9.4 4.2 5.1 -5.6 7.3 10.4 4.2

Federal cash fiscal balance (% GDP) 2.3 1.7 4.4 7.5 7.4 5.4 4.1 -5.9 -4 -0.5 0.2Stabilization fund (US$ bn) - - 18.7 43 89.1 156.8 - - - - -Reserve Fund (FX holdings, US$ bln) - 137 60 25 43 73National Well-being Fund (FX holdings, US$ bln) - 74 77 74 81 81Total public sector debt (US$ bn) 151 145 142 107 92 98 92 107 132 162 -191

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Total public sector debt (US$ bn) 151 145 142 107 92 98 92 107 132 162 191Total public sector debt (% GDP) 43.7 33.7 24.0 14.0 9.3 7.5 5.5 8.7 9.0 9.0 -8.8

Current account balance (US$ bn) 29 35 59 84 94 76 102 49 73 86 62Current account balance (% GDP) 8.4 8.2 9.9 10.9 9.5 5.9 6.1 4.0 4.9 4.5 2.9Capital / financial account balance (US$ bn) -18 -9 -14 -23 13 73 -148 -46 -36 -20 -15Capital / financial account balance (% GDP) -5.1 -2.1 -2.4 -3.0 1.3 5.6 -8.9 -3.7 -2.4 -1.0 -0.7Trade balance (US$ bn) 46 60 86 118 139 131 180 112 149 176 163

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nf Trade balance (US$ bn) 46 60 86 118 139 131 180 112 149 176 163Merchandise exports (US$ bn) 107 136 183 244 304 354 472 303 398 491 534Foreign exchange reserves* (US$ bn) 48 77 125 182 304 479 426 439 479 573 617Total external debt (US$ bn) 152 186 214 257 311 464 481 467 483 511 530External debt/GDP (%) 44.1 43.1 36.2 33.7 31.4 35.7 28.9 37.9 32.7 26.7 24.6Urals crude oil price 23.7 27.0 34.6 50.0 61.4 69.7 95.1 61.3 78.2 102.0 108.0

Net FDI (US$ bn) 0 1 1 8 1 7 0 1 9 2 8 5 17 9 7 3 7 6 4 7 1 1

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Source: Central Bank of Russia, Rosstat, Ministry of Finance and J.P. Morgan estimates

Net FDI (US$ bn) -0.1 -1.8 1.7 0.1 9.2 8.5 17.9 -7.3 -7.6 -4.7 -1.1Inward FDI (US$ bn) 3.5 8.0 15.4 12.9 32.4 54.3 70.3 38.7 35.4 44.7 53.9Net capital flow to private sector (US$ bn) -8 -2 -9 0 42 81 -134 -57 -39 -20 -15

* Including FX assets of the Reserve Fund and the National Well-being Fund

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DisclaimerDisclaimer

Analyst Certification:

The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) h (1) ll f h i d i hi l fl hi h l i b d ll f h bj i i i d (2) f f h

11

that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

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201 outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant

index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating.

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y analyzing, among other things, the issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer’s balance sheet relative to the operational leverage in its business. J.P. Morgan Credit Research Ratings Distribution, as of December 31, 2010

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Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage.*Percentage of investment banking clients in each rating category.

Other DisclosuresJ.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K.

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g ( ) g g ( ) g ginvestment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries. QIB ONLY

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Disclaimer11

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201 Kalina, Santacruz East, Mumbai - 400098, is a member of the National Stock Exchange of India Limited (SEBI Registration Number - INB 230675231/INF

230675231/INE 230675231) and Bombay Stock Exchange Limited (SEBI Registration Number - INB010675237/INB010675237) and is regulated by Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Indonesia Stock Exchange and is regulated by the BAPEPAM LK. Philippines: J.P. Morgan Securities Philippines Inc. is a member of the Philippine Stock Exchange and is regulated by the Securities and Exchange Commission. Brazil: Banco J.P. Morgan S.A. is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. Mexico: J.P. Morgan Casa de Bolsa, S.A. de C.V., J.P. Morgan Grupo Financiero is a member of the Mexican Stock Exchange and authorized to act as a broker dealer by the

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Country and Region Specific DisclosuresU.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment

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General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account

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“Other Disclosures” last revised January 8, 2011.

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Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.#$J&098$#*P

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