TFGG01: DOOM, GLOOM, AND WISHFUL THINKING: THE

C O N F I D E N T I A L MOSCOW 002386

SIPDIS

STATE FOR EUR/RUS; NSC FOR MWARLICK

E.O. 12958: DECL: 08/13/2018
TAGS: PREL ECON EINV ETRD PGOV RS
SUBJECT: TFGG01: DOOM, GLOOM, AND WISHFUL THINKING: THE
BUSINESS COMMUNITY REACTS TO GEORGIA

Classified By: CDA Eric S. Rubin, for Reasons 1.5 (b) and (d).

--------------
Summary
--------------


1. (C) The Russian markets ticked up slightly August 12, with
news that President Medevev had ordered military operations
in Georgia to cease and with French President Sarkozy's
mediation efforts appearing to gather steam. However, the
markets are down over 30 percent from their mid-May peak, a
loss of some $400 billion in share-holder value, much of it
in the past few weeks. The conflict in Georgia was just the
latest blow to investor confidence, following hard on the
heels of the TNK-BP investor dispute and the GOR attacks on
steelmaker Mechel. Our contacts differed on where the
markets are headed, with the key variables the length and
intensity of the conflict and international and Western
reaction. End Summary.

--------------
Markets React
--------------


2. (SBU) As the conflict began on Friday, August 8, Russia's
"blue chip" RTS stock market index fell 6.5 percent to the
lowest level since November 2006, and the broader MICEX fell
5.3 percent. When the markets reopened on August 11, both
indices initially fell precipitously before recovering in the
afternoon on hopes that the conflict might be easing. On
Tuesday, both markets again rallied following Medvedev's
announcement on the cessation of the military operation and
on hopes that the French mediation would bring the conflict
to an end. However, markets were lower again on Wednesday,
reflecting continued anxieties.


3. (SBU) The conflict also precipitated a mini-liquidity
crisis in the banking system and foreign exchange markets.
Since August 8, the ruble has depreciated more than four
percent against the dollar/Euro basket. Analysts noted that
the Central Bank had allowed the ruble to depreciate by more
than two percent on August 11, primarily to ease further
liquidity pressures. The Finance Ministry also announced
August 11 that it would supply up to RUB 300 billion, by
auctioning temporarily available budget funds to banks on
August 12, to further ease liquidity problems.

--------------
Doom and Gloom
--------------


4. (C) Merrill Lynch's Moscow Head of Global Trading, Bernie
Sucher, an Amcit active in Russia since 1991, told us August
11 that the appetite for Russian equities was gone for now.
Turmoil in the global markets had begun the downward trend in
mid-May but a series of unfortunate events within Russia, of
which the Georgian conflict was merely the latest, had
accelerated the decline. Medvedev's signing of the decree in
May transferring billions of dollars in state assets, to
Rosteknologia had been the first blow. This decision had
been completely at odds with Medvedev's rhetoric concerning
state corporations and the need to reduce their role in the
economy. Investors had come away concerned that the
"property redistribution phase" of Russian governance had not
in fact ended.


5. (C) Sucher said the dispute over TNK-BP and the Mechel
incidents had been the next blows. He discounted TNK-BP
somewhat, noting everyone knew foreign investment into the
oil and gas sector was dicey and so the markets had already
priced in such a dispute. Mechel, however, had been a deeply
unpleasant surprise to Russian and foreign investors, with
its confirmation that no investment was safe from government
insiders and that the government was prepared to use
administrative means to intervene in the markets to control
prices as well as to seize assets. Sucher said he had been
surprised by the degree to which the Mechel incident had
unnerved his Russian friends and clients. In particular,
they had pointed to the extreme language Putin had used in
his public attacks, which had been similar to the language he
had used toward Chechen separatists.


6. (C) Sucher said taken together the incidents had been a
nasty reminder of the fundamental reality in Russia: that
government insiders controlled the commanding heights of the
economy and were not about to allow that to change. Sucher
added that longer-term, without clear contract and property
rights, it would be impossible for the Russian economy to

modernize, become more competitive, and sustain growth. What
Mechel had driven home was the growing loss of confidence
among investors in the Medvedev government's promises of
reform and increased economic freedom and transparency.
Absent those reforms, Sucher said he could foresee a moment
in the not too distant future when the Russian elite would
have to make a choice between their ability to deliver rising
living standards for the people and their own personal greed.



7. (C) Sucher said this shift in investor sentiment and the
reasons for it were critical to understanding the economic
reaction to the conflict in Georgia. Georgia itself was
unimportant to the Russian economy but the conflict had
reinforced the sense that economic considerations were
secondary for the GOR and that made investors very nervous.
If the conflict ended quickly and proved to be a limited
event, he predicted the markets would recover somewhat.
However, if the conflict persisted or if it led to a
protracted cold spell in relations with the West, then all
bets were off.


8. (C) Deutsche Bank Securities Chief Economist Yaroslav
Lissovolik also told us the conflict had strengthened the
hand of hard-liners in the GOR at the expense of the economic
liberals. He noted that Deutsche Bank had been warning
investors for the past two years that the main geopolitical
risk in Russia was regional conflicts with Georgia and
Ukraine that could shift the balance of power toward Kremlin
hard-liners. With the hand of the "siloviki" now
strengthened, needed reforms in the tax, pension, and health
care systems, and the need for WTO entry, would no longer be
GOR priorities this year.


9. (C) Lissovolik added that at least $8 billion initially
flowed out of Russia on August 8 on the foreign exchange
markets and the capital outflow then spread to the stock
markets. He expected the capital outflows to continue this
week, with long-term institutional investors likely to pull
out of the Russian stock market if the conflict was
prolonged. Lissovolik predicted that even if the conflict
ended quickly, it was likely to cause a loss in annual GDP,
albeit a small drop from the current robust levels of better
than seven percent.


10. (C) Igor Nikolayev, Strategic Analysis Director for the
business consulting firm FBK, told us that he also believed
the conflict would cause a decline in annual GDP. The
conflict was yet another negative factor in the context of
high inflation, a lack of meaningful competition in many
economic sectors, and the gloomy investment climate stemming
from the recent administrative pressures on TNK-BP and
Mechel. In particular, the military conflict, coupled with
the TNK-BP and Mechel incidents, would contribute to a
decline in international investment in Russia. Given all of
the negative factors, he said that FBK had revised its
forecast for real GDP growth downward to six percent for the
year.

--------------
Wishful Thinking
--------------


11. (C) Renaissance Capital's Deputy Chairman, Bob Foresman
told us the company's official position, dictated by CEO
Steven Jennings, was that the Georgian conflict would have no
long-term adverse effect on the Russian economy. Russia's
economic fundamentals were still strong and Russian equities
were priced too low. In addition, he said they expected the
TNK-BP and Mechel situations to be resolved in the near
future, setting the stage for a fall rally in the markets.
Foresman cautioned that his own view was less bullish.
Russia was not the "safe haven" that it had seemed a few
months ago. Political and economic stability had weakened
and the perception of risk, and therefore its price, had
risen. It appeared that the markets might be reassessing the
value of Russian equities.


12. (C) Foresman's colleague, Roland Nash, the head of
Rencap's Research Department, said the result of that
downward assessment had been a roughly 30 percent drop in the
value of Russian equities since their high point in mid-May.
Market capitalization had dropped from $1.6 trillion to $1.2
trillion, a loss of $400 billion in share holder values.
Much of that loss had come in the past few weeks. Nash said
Rencap still felt that Russia was the best of the emerging
markets and the one most likely to weather any global
downturn. The lower the markets went now, the higher they

would bounce back later in the year when stocks rallied.
Nash acknowledged that the conflict in Georgia could affect
that calculus if it continued or if the West responded in
ways that would raise the cost of capital in Russia, but he
hoped that would not be the case.


13. (C) Goldman Sachs Executive Research Director Rory
MacFarquhar also told us that he thought the conflict with
Georgia would be a "blip" for Russia's economy. He expected
military operations to be wrapped up quickly, especially
following Medvedev's August 11 statement. Moreover,
MacFarquhar doubted that concerns about South Ossetia would
derail any planned foreign direct investments and posited
that weeks of stock market selloffs had probably priced
Russian markets into an acceptable range for investors who
might have previously thought Russian stocks were overvalued.

--------------
Comment
--------------


14. (C) Russia's economic rough patch got a lot rougher this
week. Even the most optimistic investors appear to be
hedging their bets, with the real concern not so much the
conflict in Georgia itself but what it might mean for
Russia's relations with the West, its place in the global
economy, and the prospects for badly needed domestic reforms.

RUBIN