8 January 2014

Vladimir Miklashevsky Economist, Trading Desk Strategist Danske Bank Markets, Research + 358 10 546 7522 vladimir.miklashevsky@danskebank.com

Russia: from disappointing 2013 into better 2014

Important disclosures and certifications are contained from page 19 of this report.

2

2013 disappoints but better expectations for 2014

Russian economic growth slowed sharply in 2013, posting a 1.3% y/y expansion in January-November 2013, due largely to internal factors, e.g. fixed investments fell 0.8% y/y over the period.

We expect 2013 growth to end up at 1.5% y/y but see an optimistic acceleration to 2.6% y/y in 2014 due to improvements in the external environment (US, eurozone), an average oil price over USD100/bl, the ‘Sochi Olympics effect’, lower inflation, decent private consumption growth, fixed investment expansion and a low base effect.

Inflation targeting by Bank Rossii, a weakening rouble and a firm path towards a freely floating currency should be supportive for domestic industries.

Although the current situation is often defined as ‘comfortable stagnation’, we see it differently due to the low unemployment rate.

3

Decent private consumption but no room for miracles

Despite investment activity remaining sluggish in Russia, the consumer sector continues to grow, although much more slowly (3.9% y/y in January-November 2013) than before the crisis due to a high base, moderate real wage growth and lower growth in consumer loans (31% y/y as of 1 October 2013).

In 2013, real wages grew most in the public sector (>10%), with all sectors expanding by 5.5% y/y in January-November 2013, averaging RUB30,670 monthly. However, we expect real wage growth to stay under 4.5% in 2014.

Unemployment remains low (5.4% in November 2013) supporting private consumption. However, the scarcity of the labour force due to weak demographics continues to curb long-term economic growth.

4

Source: Rosstat, Danske Bank Markets

0

5

10

15

20

25

30

35

40

45

50

-40

-35

-30

-25

-20

-15

-10

-5

0

5

1Q/07 2Q/08 3Q/09 4Q/10 1Q/12 2Q/13

Consumer confidence

Consumer confidence index, left

Appetite for large purchases, right

5

Moderate consumer lending growth has come to stay

The Russian central bank is trying to limit excessive growth in consumer loans through stricter regulation to prevent growth in non-performing loans (NPLs).

However, we expect excessive curbing of the

overheating and high interest rates to lead to declining consumer demand as more of income is directed to serve old debt.

Thus, policy is about balancing between supporting the consumer sector and eliminating the symptoms of overheating.

6

Residential construction expands on a steady path

• In Q3 13, residential construction expanded 18.5% y/y to 16.1m m2 versus 8.5% y/y in Q2 13 and 6.5% y/y in Q1 13.

• Mortgage stock is traditionally low in Russia: only 14.3% of all consumer loans issued in 2012 (13.2% in 2011) were mortgages as high rates impose limits. The average rate for RUB mortgages was 12.4% as of 1 November 2013. In 2012, RUB mortgage loan issuance grew 54% y/y versus 97% in 2011. However, as we expected it slowed to only 29% y/y in January-November 2013. We expect mortgage loan issuance to slow further in 2014, as banks are tightening conditions and real income is set to grow moderately.

• FX loans are just a tiny part of the stock: 1.4% in 2012 (2.7% in 2011) of all mortgage loans issued.

• In 2012, the average payback of RUB mortgages was 180 months. As high rates prevail, Russian consumers seek to pay back their loans as quickly as possible. The share of mortgages paid in advance was 25%.

2010 2011 2012 20134.7

4.8

4.9

5.0

5.1

5.2

5.3

5.4

5.5

5.6

5.7

5.8

5.9

6.0

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

40% y/y

millions, m2, 12M MA

volume >>

<< % change

Dwellings commenced

Source: Bank Rossii, Reuters EcoWin, Danske Bank Markets

7

FX exposure in loans is decreasing

Source: Bank Rossii, Danske Bank Markets

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Corporate RUB and FX loans, % of total

corporate loans

RUB

FX -5 %

0 %

5 %

10 %

15 %

20 %

0 %

10 %

20 %

30 %

40 %

50 %

60 %

70 %

80 %

90 %

100 %

Mortgage loan and rate development in Russia

Source: Bank Rossii, Danske Bank Markets

8

Inflation continues on its downward trend

Inflation disappointingly stayed elevated in 2013, ending up at 6.5% y/y in December, which is outside Bank Rossii’s target range (5-6%). Inflation expectations remain high and, in our view, the structural imbalances of the Russian economy continue to push consumer prices up.

We expect the tight monetary policy, freeze in tariffs for industrial consumers and slow economic growth to push inflation down further over 2014. However, the weak rouble may add some upside pressure to import prices.

The central bank’s inflation targets are 5.0% for 2014, 4.5% for 2015 and 4.0% for 2016.

All in all, the Russian central bank has shown commitment to its inflation target, which just might turn out to be a strategy worth sacrificing growth for for some years.

9

Corporate giants are not investing enough

The slowdown in fixed investments in 2013 was due mostly to a decrease in public investments and investments by state-owned companies. Giant construction works have been completed.

High taxation of the sector deterred

investments in mineral extraction. Private investments have been falling due to

shrinking corporate profits. Access to finance is an obstacle as well for

private companies as rates for corporate loans in RUB remain around 15% p.a.

We expect the low base, frozen tariffs for industries and monetary easing to increase fixed investment growth in 2014 to above 3%.

Source: Rosstat, Danske Bank Markets

0

10

20

30

40

50

60

70

80

90

2012

% o

f t

ota

l in

ve

st

me

nt

s

Fixed investments in Russia in most important

sectors of total fixed investments

Real estate

Transport and communication

Electricity, gas and water

Manufacturing

Mineral extraction

10

High oil price to keep budget balanced

• The Russian budget saw a 0.02% of GDP deficit in 2012 versus a 0.8% surplus a year earlier. The budget stayed almost balanced from one month to another due to high energy prices and increased tax collection. Oil and gas revenues continue to exceed income from non-energy sources.

• We expect a deficit of 0.4% in 2013 and less than 1% of GDP in 2014, as the weakened rouble helps to cover increased expenditure. The budget deficit will be financed mostly through borrowing.

• The budget suggests that in 2014 and 2015, GDP is set to amount to RUB74trn and RUB83trn and inflation will not exceed 5%. We expect the oil price to be USD97/bl, USD101/bl and USD104/bl in 2013, 2014 and 2015, respectively.

Russian budget balance and oil price

2010 2011 2012 201370

80

90

100

110

120

130

-25

-20

-15

-10

-5

0

5

10Brent-oil price >>

USD/bl

<< Budget surplus/deficit

% of GDP

Source: Reuters EcoWin, Danske Bank Markets

11

More room for weaker rouble

Source: Macrobond, Danske Bank Markets (both charts)

Despite the nominal weakening of the rouble (-8.5% against the USD and -12% against the EUR over the past 12 months), high inflation ensures real appreciation of the rouble as inflation in trade partner countries is lower on average.

In practice, the real appreciation means that

Russian companies lose their international competitiveness but Russian consumers are able to consume more and more foreign goods.

An increasing monetary base is adding up to inflation, although not significantly, and weighing on the RUB. At the same time, growing money supply is helping the Russian economy through better liquidity and expectations of lower rates.

Russia's central bank's reserves and money supply

Source: Danske Bank Markets, Reuters Ecowin

2008 2009 2010 2011 2012 2013375

400

425

450

475

500

525

550

575

600

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5USD, bn

<< Money supply, narrow

RUB, trn

Gold and FX reserves >>

12

Steadily towards free float

Although the Russian central bank continues to mitigate rouble volatility, the rouble is almost free floating already. Thus, the current level of the rouble reflects its market valuation.

Moreover, the rouble will not be defended as strongly as it was in 2008-09 and, consequently, Russia will not drift to such a severe liquidity crisis in the case of a weakening rouble.

A weaker rouble is favourable for the government budget, as a big share of government income is USD denominated from energy exports.

30

32

34

36

38

40

42

30

32

34

36

38

40

42

RUB's trading band vs. RUBBASK

lower border

upper border

RUBBASK (45%EUR+55%USD)

31.7

32.2

32.7

33.2

33.7

34.2

34.7

35.2

35.7

36.2

36.7

37.2

37.7

38.2

38.7

39.2

39.7

40.2

31.70

32.20

32.70

33.20

33.70

34.20

34.70

35.20

35.70

36.20

36.70

37.20

37.70

38.20

38.70

39.20

39.70

40.20RUB's trading band vs. RUBBASK

lower border

upper border

RUBBASK (45%EUR+55%USD)

new no intervention zone

old no intervention zone (informal)

Bank Rossii sells

USD350m/day

Bank Rossii sells

USD200m/day

Bank Rossii buys

USD200m/day

Bank Rossii buys

USD350m/day

38.10

35.00

34.00

39.10

Source: Danske Bank Markets, Bank Rossii (both charts)

13

Putin’s 100 steps programme shows positive progress

Russia has climbed 19 spots to 92nd out of 189 countries in the World Bank's 2014 ‘Ease of doing business’ rankings. The results suggest that it is now easier for companies to operate in Russia than in China, the previous leader in the ranking among the BRIC nations.

Russia was just ahead of China, which fell five places to 96th. It was also ahead of Brazil, which moved up 14 places to 116th and well in advance of India, which moved down two spots to remain in 137th place.

Putin’s 100 steps programme aims at improving Russia’s rank in the ‘Ease of doing business survey’ by 100 steps, ranking 20th as soon as 2018.

Progress has been apparent since the launch of the programme in 2012 and some red tape can still be removed relatively quickly (construction permits, trading across borders).

Source: World Bank, Danske Bank Markets

0 50 100 150 200

Total rank

Starting a business

Dealing with construction permits

Getting electricity

Registering property

Getting credit

Protecting investors

Paying taxes

Trading across borders

Enforcing contracts

Resolving insolvency

Russia’s rank in Ease of doing business survey

2012 and 2014

2014 2012

14

Russian stocks under the Fed’s tapering pressure

• During 2013, Russian stocks together with other emerging markets were very sensitive to tapering news. The Micex stock exchange index lost 0.7% last year, while Brazil fell almost 17.0% and Mexico 4.3%. However, India gained 5.3%.

• Downside risks for Russian stock indices in 2014 include Fed tapering and declining prices for Russia’s main exports (energy and metals) as Chinese economic growth could slow further and an oil production increase in the US moves the oil price down.

Russian Micex stock and P/E indices

1 3 5 7 9 11 1 3 5 7 9 112012 2013

4.5

4.6

4.7

4.8

4.9

5.0

5.1

5.2

5.3

5.4

5.5

5.6

5.7

5.8

1300

1350

1400

1450

1500

1550

1600

P/E >>

<< Micex

Source: Reuters EcoWin, Danske Bank Markets

15

Scandinavian stocks with Russian exposure

Source: Bloomberg, Danske Bank Markets

Company Sector Performance, %, y/y,

as 19 Mar '13

Oriola-KD Pharma 32.3

Carlsberg Consumer 25.8

Rockwool Construction 23.1

STOXX Nordic Index 11.9

Tikkurila Construction 6.3

Scania Auto 1.2

YIT Construction -0.4

TeliaSonera Telecoms -2.0

Nokian Renkaat Auto -4.6

Oriflame Consumer -11.3

Fortum Utility -18.6

Aspo Industrial -19.0

Modern Times Media -21.2

Stockmann Retail -26.0

Company Sector Performance, %, y/y,

as 7 Jan '14

Rockwool Construction 54.6

Modern Times Media 43.6

Tikkurila Construction 36.4

TeliaSonera Telecoms 17.0

Fortum Utility 14.7

STOXX Nordic Index 14.4

Nokian Renkaat Auto 10.2

Oriola-KD Pharma 8.2

Carlsberg Consumer 3.7

Aspo Industrial -6.6

Oriflame Consumer -6.9

Scania Auto -7.8

YIT Construction -15.7

Stockmann Retail -16.5

16

Foreign direct investments to Russia

Source: Bank Rossii, Danske Bank Markets

0

100,000

200,000

300,000

400,000

500,000

600,000

Dec-09 Dec-10 Dec-11 Dec-12

Total inward FDI accrued (USDm)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

Dec-09 Dec-10 Dec-11 Dec-12

FDI accrued by country of origin (USDm)

Denmark Norway

Finland Sweden

Source: Bank Rossii, Danske Bank Markets

17

Capital outflows slow down

• The private sector’s net capital exports continue to weigh on the RUB in the long run. As the oil price stays high, outflows continue to be elevated.

• The private sector’s net capital exports official forecast for 2013 has been shifted from USD10bn to USD50bn and then to USD70bn. Our forecast has been unchanged since early 2013, at USD50.0bn (USD56.8bn in 2012). Although we believe that neither a high oil price nor capital outflows currently affect the RUB dramatically, an unexpected acceleration in outflows would be RUB negative.

Source: Bank Rossii, Danske Bank Markets

-40

-30

-20

-10

0

10

20 Russian private sector's capital net

flows (USDbn)

Other sectors

Banks

18

Macroeconomic and FX forecasts for Russia

Source: Macrobond, Rosstat, Danske Bank Markets

Russian macro forecasts -Danske Bank

5.5 6.8

3.4 5.7 2.3

5.1

2013 1.5 4.4 -0.6 -1.8 3.8 7.2 3.1 0.3

3.5 6.0 9.5

2015 2.3 3.4 3.8 -1.5 3.0 5.8 5.2

Infla-

tion1

Russia

2012 3.4 6.6 6.7

Year Gdp1

Private.

Cons1

Fixed Inv1

Export1, 4

Import1, 4

3.5 2.6 5.3

Trade

Balance2, 4

Current

acc.2, 4

Industrial

prod.1

Unem-

ploym3

2014 2.6 3.9 3.6 -2.0 3.7 6.3 2.7 2.8 5.6 5.8

1) Average % y/y 2) % of GDP 3) % of total work force 4) export and import prices

EUR USD Basket

RUB*

13-Dec ‘13 45.12 32.87 38.36

+3M 43.80 33.18 37.96

+6M 45.85 35.27 40.03

+12M 46.10 36.59 40.87

Note: A new RUB forecast is due to be published in FX Forecast Update on 15 January 2014

19

Disclosures

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of this research report Is Vladimir Miklashevsky, Analyst.

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20

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