"DENGI FEVER": RUSSIA'S IPO AND CAPITAL MARKET BOOM

C O N F I D E N T I A L SECTION 01 OF 03 MOSCOW 013006

SIPDIS

SIPDIS

STATE FOR EUR/RUS
TREASURY BAKER/GAERTNER
NSC FOR GRAHAM AND MCKIBBEN

E.O. 12958: DECL: 12/19/2016
TAGS: ECON EINV EFIN RS
SUBJECT: "DENGI FEVER": RUSSIA'S IPO AND CAPITAL MARKET BOOM

REF: MOSCOW 1898

Classified By: ECON M/C Quanrud, Reasons 1.4 (b/d).

SUMMARY
--------------


1. (SBU) Russia's initial public offering (IPO) bonanza
continued to gain momentum in 2006. Fifteen Russian
companies launched IPOs this year, raising over $17.5
billion. At the same time, Russia's domestic exchanges have
enjoyed explosive growth. Russian companies are increasingly
able to tap the domestic markets for cash, as relaxed listing
standards and increased liquidity have made Russian exchanges
attractive IPO venues. Though motivations vary, many in the
evolving IPO arena seem focused simply on raising investment
capital. To get to the money, Russian companies have had to
increase transparency and improve corporate governance to
meet foreign and domestic listing requirements. Indeed,
public offerings appear to be playing a significant role in
transforming Russian business practices and creating a robust
domestic equities market.

RUSSIA'S IPO BOOM KEEPS BOOMING
--------------


2. (SBU) The Russian IPO market has reached new heights this
year, easily eclipsing the $5 billion raised in 2005
(reftel). By the end of 2006, Russia will have the largest
single stock in the emerging-market universe (Gazprom),will
have placed the fifth-largest IPO in history (Rosneft),and
will have raised through equity issuance more money in 2006
than every country in the world except the U.S., China, and
France. And some predict 30-40 more Russian IPOs in the
coming year, bringing another $30 billion worth of equity to
the market.


3. (SBU) As was the case in 2005, the London Stock Exchange
(LSE) was the foreign exchange of choice for Russian
companies looking to list abroad, as most see U.S. standards
as too high and too costly. More than half of this year's
Russian IPO activity included listings on the LSE. However,
unlike last year, Russian companies also came to the Moscow
Interbank Currency Exchange (MICEX) and the Russian Trading
System (RTS) to raise capital, with six Russian IPOs occurred
exclusively on the domestic exchanges. Indeed, one of the
biggest shifts over the year has been the increase in the
number of Russian companies looking to raise capital at home.



4. (C) The head of Russia's Federal Service for Financial
Markets (FFMS),Oleg Vyugin, can take much of the credit for
encouraging growth in the domestic exchanges. Vyugin has
simplified the procedure by which companies launch IPOs on
the Russian markets. In fact, he claimed recently to us that
it is now easier to launch an IPO in Russia than it is to do
so in London. Vyugin also spearheaded a 30% domestic-listing
requirement earlier this year, but he is slow to celebrate
the success of this initiative. He suspects that brokerages
operating in Russia have been taking ordinary shares on their
books, and then sending these same shares abroad. A deeper
analysis, which is currently underway, should reveal whether
Russian capital is staying close to home. Whatever the
result, the impressive growth of Russia's domestic exchanges
is hard to ignore. The MICEX and the RTS now have a combined
market capitalization of almost $800 billion, or 80% of GDP.
Trading on the MICEX grew by 191% over 2005, while the RTS
grew by 122%. Around 70% of Russian stock trading now occurs
on the domestic exchanges, up from 55% one year ago. Without
a doubt, the stereotype of a cash-poor Russian equity market
is crumbling.

NEED FOR CAPITAL IS THE MAIN,
BUT NOT SOLE, DRIVER
--------------


5. (SBU) Russia's economy continues to chug along. Real GDP
looks to be coming in just below 7% in 2006. Russia's money
supply has increased by 40% this year, yet its inflation rate
(though still high) will be below 10%. Both public and
private consumption have grown over the year, as Russians
continue to make more money and take out more consumer loans.
Capitalizing on new market opportunities has been a
challenge for Russian firms, as many still suffer from
underinvestment. It comes as no surprise that demand for
investment capital is high. Russian companies have turned to

MOSCOW 00013006 002 OF 003


IPOs to raise the money they need for growth in an
increasingly competitive market.


6. (C) Of course, the need for investment capital is not the
only force driving IPOs. As in 2005, some strategic
shareholders have looked to IPOs as a way of "cashing out" of
their holdings. Doing so has helped them capture immediate,
and often tremendous, wealth. However, our contacts have
been quick to downplay the significance of the "cash-out"
incentive in 2006. They argue that strategic shareholders
stand to gain much more from staying with their lucrative
businesses than they do from cashing out of them.


7. (C) Oleg Vyugin echoed this sentiment in our recent
conversations with him. He believes raising capital for
company growth is the main target of recent IPOs. Vyugin
also described an additional role IPOs have assumed in
corporate strategy: enhancing management capacity. "As a
company grows, it becomes more difficult for management to
handle the size of the company." By increasing the
shareholder base, new people are attracted to help manage the
firm. In some cases, these people are industry elites with
superlative reputations. Company boards have been increased
to include managers championing Western-style business
practices. With new management, Russian companies are coming
to realize that efficiency, increased accountability, and
improved corporate governance are essential to success in
today's global market. And, he adds, strategic investors
(many of whom are founding oligarchs) have their hands freed
to pursue other interests.


8. (SBU) Naturally, companies have been improving business
practices to the extent there is incentive to do so.
Standard & Poor's Julia Kochetygova told us that she thought
listing requirements are shaping changes in transparency and
corporate governance -- for the better. For Russian
companies looking to list abroad, this normally means
adopting standards sufficient for listing with the LSE.
Similarly, in an effort to attract investors, Russia's
domestic exchanges have increased accountability standards
for companies looking to list in Russia. Firms trading on
the MICEX and the RTS now boast transparency and corporate
governance levels that meet international standards.
Kochetygova's work shows that most publicly-traded Russian
firms exceed the listing requirements of LSE's AIM market.

WHO'S BUYING?
--------------


9. (SBU) Improvements in macroeconomic conditions and
increased accountability have encouraged global investors to
boost exposure to the Russian markets. In the wake of the
elimination of the so-called "Gazprom ringfence," emerging
market indexes have been substantially rebalanced this year.
The Morgan Stanley Capital International (MSCI) emerging
markets index, widely considered the industry benchmark, has
been reconstituted in 2006 to increase its Russia composition
from 6% in 2005 to 11%. The upshot of this is that foreign
investment in Russian equities, once dominated by short-term
speculators, now comprises more long-term investors. Large
international investment houses, such as Morgan Stanley,
Merrill Lynch, and Citigroup, have come to Russia.


10. (SBU) Russia's domestic exchanges have also enjoyed
investment from local institutions. Mutual funds, pension
funds, and insurance companies constitute the bulk of
home-grown interest. In fact, Russia's mutual fund industry
has grown from virtually non-existent just a few years ago to
a $15 billion industry today. Even so, the domestic markets
have been slow to attract individual investors. Less than 3%
of the Russian population own stock or other investment
instruments. Nevertheless, there are signs that a domestic
investor base is forming. Our MICEX contacts are confident
that middle-class Russians will come to the markets as they
become better informed and more investment savvy.

MUSINGS OF A MARKET REGULATOR
--------------


11. (C) In an early December meeting with us, Vyugin said he
is considering abandoning the 30% domestic-listing
requirement. In its place, he would oblige Russian companies
to launch IPOs on a domestic exchange -- with at least 10% of
the capital of ordinary shares in Russia -- before listing
abroad. This policy change could gain momentum in the coming
year. Vyugin has also made some progress on a few of his

MOSCOW 00013006 003 OF 003


long-term do-list items. A draft law addressing price
manipulation and insider trading (first proposed two years
ago) is now with the Central Bank, the Ministry of Finance,
and the Ministry of Economic Development and Trade for final
comment, although Vyugin believes he has already secured
their basic agreement. The draft needs to go through a
formal signature process, after which it will go to the
Ministry of Justice for a final check before submission to
the Government, which he hoped would result in approval by
the end of this year. In addition, a draft law creating a
Central Depository was finalized in August. The Central
Depository would absorb the existing depository firms -- a
move which could receive resistance from those with an
economic interest in the status quo. A hardy perennial for
ten years, Vyugin hopes remaining disagreements over the
draft law will be resolved by the end of the year.

COMMANDING HEIGHTS STILL
COMMAND THE MOST MONEY
--------------


12. (SBU) As prices for oil, nickel, aluminum, platinum, and
copper reached new highs this year, Russia's state-controlled
companies benefited most on the bourses. Russia's energy and
steel sectors still constitute the largest portion of the
shares traded on the domestic exchanges, and foreigners
continue to invest mostly in these sectors. However,
Russia's diversifying economy is also producing attractive
investments in other sectors, particularly in banking,
communications, and retail, where sectors which were
well-represented in this year's IPOs. Russia's largest
domestic-only listing was retail giant Magnit, whose revenues
exceeded $1 billion in the first six months of 2006. Next
year looks equally promising, as some predict as many as 15
retail-related companies will launch IPOs.

COMMENT
--------------


13. (C) As Russian companies look to raise capital and gain
prestige, the requirements for them to do so are slowly
transforming Russian business practices. And there's a sense
that the new wave of business executives coming to Russian
industry will serve as iconoclasts to the current paradigm of
opacity and inefficiency. More and more, Russian companies
are recognizing that entry into the global business world
cannot happen without transparency. Even Russia's
state-controlled companies have taken notice. This is not to
say that companies under state control don't still have a lot
to learn. As Oleg Vyugin put it, "an imitation of good
corporate governance" won't make a company competitive.
Recent troubles at Gazprom illustrate this fact: either you
become efficient, or your stock price will freeze.


14. (C) Russia's domestic exchanges will continue to grow in

2007. Thus far, they have been able to produce surprisingly
impressive trading numbers with relatively few issuers. This
year we saw signs of a virtuous circle that we believe has
not quite run its course: with new listings come new
investors and added liquidity, which will likely lure yet
more to the IPO table. To the extent this also forces
transparency and compliance with international norms and
market expectations, it is one of the most visible signs of
grass-roots economic reform in Russia. The real test will
come when global and domestic liquidity tightens, and the
fight to keep shareholders happy sharpens.
RUSSELL