RUSSIA'S "SAFE HAVEN" STATUS SLIPPING?

C O N F I D E N T I A L MOSCOW 002125

SIPDIS

STATE FOR EUR/RUS, EEB/IFD
TREASURY FOR TORGERSON
DOC FOR 4231/MAC/EUR/JBROUGHER
NSC FOR WARLICK

E.O. 12958: DECL: 07/24/2018
TAGS: EFIN ECON RS
SUBJECT: RUSSIA'S "SAFE HAVEN" STATUS SLIPPING?

REF: MOSCOW 1616

Classified By: Acting DCM Eric T. Schultz, Reasons 1.4 (b/d).

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Summary
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1. (C) In contrast to Russia's record-setting financial
performance for 2007 and high hopes for 2008, the results
from the first half of 2008 have revealed signs of strain.
Net capital inflows are down substantially, as are Initial
Public Offerings (IPOs),which through June have totaled only
USD 500 million, compared to USD 15 billion during the first
half of 2007. General uncertainty about the economic
resilience of emerging markets explained part of the drop-off
according to Merrill Lynch-Russia Chief Economist Yulia
Tsepliaeva. Goldman Sachs Executive Director for Economic
Research Rory MacFaquhar suggested that inflation concerns
were the primary cause of the decreases. These results may
tip the scales in Finance Minister Kudrin's
inflation-fighting favor when budget amendment season begins
in September. End Summary.

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High Hopes for 2008; Disappointing Results
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2. (U) Amidst global financial uncertainty, particularly
among developed market economies, the steady climb of oil
prices, increasing corporate profitability, and a
strengthening ruble prompted officials and observers alike in
January to begin referring to Russia as a potential financial
safe haven while developed markets resolved the various
issues stemming from the sub-prime induced liquidity squeeze.
Russian officials forecast year-end inflation at 10.5
percent, and investment analysts predicted the benchmark RTS
index would grow by 50 percent during 2008.


3. (U) The results posted in the intervening months,
however, have not vindicated expectations, according to
Merrill Lynch-Russia Chief Economist Yulia Tsepliaeva.
Through June 2008, industrial production rose 5 percent,
compared to 7.1 percent from January-June 2007. Retail
sales, the most concrete measure of Russia's consumption
boom, had grown an estimated 15 percent, compared to 35
percent the previous year. Inflation, moreover, was on its
way to exceeding 15 percent for the year by official
estimates (with the rate on the middle and lower classes
exceeding 30 percent),and the RTS Index had grown less than
10 percent by mid-year.


4. (U) Tsepliaeva observed that the reason behind slowing
growth rates in various sectors of the economy was partially
explained by investors' concerns about emerging markets in
general. According to Tsepliaeva, investors had determined
that Russia was not immune to capital tightening affecting
firms in developed markets and as a result where less
inclined to invest in Russia. As evidence, she noted that
IPOs in the first half of 2008 totaled USD 500 million
compared to approximately USD 15 billion a year earlier. In
addition, private net capital inflows reached USD 12.5
billion through June 2008, compared to USD 60 billion a year
earlier.

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Inflation as Explanation
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5. (U) Goldman Sachs Executive Director for Economic
Research Rory MacFaquhar agreed that the slowdown in the flow
of capital to Russia was part of a general trend affecting
emerging market economies, particularly the BRIC (Brazil,
Russia, India, China). He argued, however, that Russia's
situation was worse than the other BRIC countries because of
concerns about Russia's ability to fight inflation (reftel).
McFaquhar said inflation accounted for the magnitude of the
decline Russia was experiencing in these financial indicators.


6. (U) In particular, MacFaquhar said Russia has exhausted
the spare production and infrastructure capacity that was
available following the collapse of the Soviet Union, which
is driving inflation. Consequently, the economy's dominant
characteristic was now competition between long-term,
capacity-expanding capital needs and current production
demands. The result has been higher prices for inputs, from
construction material and energy to salaries. Industrial
input prices have risen more than 4 percent per month this
year; average salaries have risen more than 28 percent from
January to June 2008.


7. (U) MacFaquhar added that GOR fiscal laxity threatened to
exacerbate inflation even further. He noted that Kudrin's
three-year budget plan has not survived its first year of
implementation without political tampering. Out-year
expenditures on the Sochi 2014 Olympic Games and much-needed
transportation projects have been moved to this year's
budget, according to MacFaquhar. He also contended that the
policy shift away from exchange rate targeting toward
inflation targeting, which Kudrin announced at the
Renaissance Capital annual conference in June, could take as
long as five years to become effective.

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Comment
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8. (C) Russia is between the inflation rock and a growth
hard place. In the short term, it appears the GOR cannot
address one without adversely affecting the other. Although
the GOR has already indicated its preference for a pro-growth
approach of state funding for infrastructure and innovation
projects alike, Kudrin may cite the drop in these indicators
of financial health in an effort to revisit curbing
expenditure growth during budget amendment meetings in
September.
RUBIN