Russia — Europe’s Bright Light of Growth

Kingsmill Bond
Chief Strategist
Troika Dialog

As the rest of Europe staggers under its accumulated burden of debt, it is Russia that is emerging as the most dynamic place on the continent. According to data from McKinsey, gross levels of debt in Europe were about 300 percent of gross domestic product at the end of 2008, with debt levels higher in the worst offenders, such as Spain at 350 percent and the United Kingdom at 380 percent of GDP. The deleveraging process has only just started, and its resolution is likely to define a miserable decade for many countries. On comparable data, Russia is a model of restraint, with total debt of 71 percent of GDP, 5 percent from the government, 10 percent from households, 16 percent from the financial sector and 40 percent from corporates. There is thus little restraint on the ability of Russian consumers to spend, significant room to maneuver for the government and no need to endure a long and painful process of systemic deleveraging.

Moreover, the financial crisis had a clear silver lining for Russia — for the first time since the end of the Soviet Union, the country has broken the back of inflation, with rates now in single digits for nearly a year and likely to be under 6 percent in 2010. There are a series of significant consequences arising from the ending of high inflation levels: Consumers can start to borrow at reasonable rates (mortgage rates are 13 percent and falling), businesses can borrow to invest in rubles and at low maturity (we expect the average duration of the domestic bond market to double by the end of the year), and money is encouraged to stay at home.

Meanwhile, Russia still has tremendous potential, with penetration levels for most goods and services at well under half of those in Western Europe: For example, mortgage penetration is 3 percent of GDP, and only 20 percent of people have cars; Service sectors are still in their infancy, with retail, restaurants or broadband companies looking forward to many years of high growth. The transformation that we have seen take effect so dramatically across Eastern Europe over the last twenty years still has a long way to run. We forecast 5 percent real GDP growth in Russia for the next few years, with earnings-per-share growth of more than 40 percent this year and 20 percent in 2011.

The foundation for this story is of course oil, and an oil price of more than $60 is now necessary to keep the current macroeconomic parameters of the country on track. However, high oil prices are in large part a play on the continued rise of China, which is perhaps a rather better bet than most other risks in our uncertain world. Russia is seizing this opportunity, building pipelines, roads and ports in the east; it is notable for example that in Russia it was the Far East Federal District alone that was able to grow during the crisis.

And yet investors remain nervous: The RTS index remains the cheapest among major markets, with a 2010 price-to-earnings ratio of 8 and a price-to-book ratio of 1.1, the market continues to track the oil price, and we are thus far spared the enthusiasm that has driven the other BRIC markets. In this contrast we see opportunity: As growth in Russia is compared with stagnation in Europe, we expect to see more capital flow to the East, into Europe’s bright light of growth.