Russia's Near Term Is Far from Rosy; Long Term Is Another Story

We've been watching Market Vectors Russia (RSX) since last August, and had a buy price target of $10 on it. Since we began watching, it fell from $40 in August to $10.34 in January when it barely missed our price target, rose to $26 at the beginning of this month, and closed last Friday at $21.31.

Having witnessed that wide range, I asked myself if there was still a chance that Russia would hit newer, harder times to send the ETF down to the $10 level again. In pursuit of the answer, I dove back into our Russia folder for the latest reports. What I found was interesting, as it revealed how Russia will manage its politics and business together to control its energy economy. Remember, it's the "R" in the BRICs, the future of the world economy as defined by Goldman Sachs: Brazil, Russia, India, and China. Its economic strategy is an important one to understand.

Russian President Dmitri Medvedev warned CNBC viewers of "alarming figures" when talking about his economy on June 2. His alarming figures were rising unemployment and falling industrial production -- and those two figures are fairly alarming everywhere we look, not just in Russia.

In Russia, however, they've taken an especially large toll and put GDP on track for somewhere around 7.5% this year, a level not experienced since the fall of the Soviet Union twenty years ago. It fell almost 10% year-over-year in the first quarter alone. Foreign investment plunged 30% and that referenced unemployment figure is on its way to double-digits, as it is in the U.S. as well.

The near term, then, is far from rosy in Russia.

One group that doesn't mind, though, is the Kremlin. Credit has always been hoarded by the Russian government, so private businesses headed by the famous oligarchs turned to foreign sources of capital for funding. When the credit crisis spun out of control last year, private corporations in Russia were more starved than their counterparts in other countries, most notably the U.S. where the credit crunch became a bonanza for the financial industry that found itself swimming in taxpayer capital.

In Russia, the relative balance of power shifted from the private entities, which were already under attack by the government, to the Kremlin. Foreign investors pulled out of Russia en masse, sending the ruble down in value, and bringing the Kremlin into currency markets to buy rubles in an effort to stave off another currency crisis like the one the ruble caused in 1998. The plan worked, the ruble stabilized, but private banks found themselves holding foreign-denominated loans that they couldn't repay.

No problem, said the Kremlin, and it has been merrily consolidating the banking system to its liking and under its influence. The elite business leaders who survive this weeding out process will be pawns of the Kremlin, dependent on credit extended by state-controlled banks and subject to centrally-planned economic directives.

You can be sure that those directives will focus on managing political relationships around the world to maximize Russia's economic benefit. Energy exports as a share of overall exports rose from 50% in 2000 to 66% last year, and the two components are crude oil and natural gas. Europe is trying to diversify its natural gas dependency away from Russia, and Russia is already working hard to limit that diversification through political wrangling.

For example, the Kremlin forced aluminum magnate Oleg Deripaska to give some $33 billion of his personal $36 billion fortune to boosting his aluminum company RUSAL and supporting the Kremlin directly. In return, Deripaska was given management of a state-controlled metals corporation where he can carry out other ideas from the Kremlin. The first was participating in a partnership between state-controlled Sberbank and Deripaska's GAZ auto maker to buy German auto maker Opel. It also involved Canadian auto parts company Magna, and will result in Opel cars being made in Russia.

That kind of business web involving the Russian government, a Russian oligarch with business connections to the West, and Western businesses themselves is precisely how the Kremlin sees itself maneuvering through the coming decades of commodity scarcity and political sensitivity. The Opel buy -- which was a kind of bailout, really -- gave a big boost to German Chancellor Angela Merkel just ahead of her bid for re-election. The timing was no coincidence, of course, and brings both Merkel and Germany closer to Russia and farther from the United States. That will come in mighty handy when Europe discusses where to get its natural gas in the future, Russia or the U.S. At least one powerful voice, Merkel's, will be suggesting Russia.

That type of government is not the type that runs through my blood as a U.S. citizen, but it's one that looks appealing to me as a potential investor. I think the Russia that emerges from this credit crisis will be in a far better position than the one that went in. The Kremlin has taken control of its currency, acquired the country's most savvy international business people, and has already used those new assets to begin managing the political connections it will need to get the most out of its natural resources in the coming energy crunch.

Therefore, I doubt we'll again see the $10 level on RSX. There's too much relief in the air, too much anticipation of recovery, and too many smart investors on to the new teamwork happening between private companies and the Kremlin. On the latter, most seem to think the partnerships will be good for business, even if they result in government skimming as much profit off as it wants. That profit will assure that the state-connected businesses will have access to endless credit and a pretty tough partner on the world stage. In any event, there's no longer doubt about government's involvement in enterprise in Russia, and that alone helps investors quantify risks. At least it's not an unknown anymore.

What I think could happen, however, is that the coming dip in oil prices that we expect could lessen the enthusiasm for the Russian economy, giving us a chance to get RSX at around $15. Therefore, I've changed our target price from $10 to $15.

Comments

[ECONOMICS 101:]

Russia is the land of missing witnesses, missing people, missing financials, missing oil, missing gas and let's not forget the missing nukes!!

That country scares me and we must be very, very cautious of them.

by Johnathan Vrozos JV

johnathanvrozos.ca
johnathanvrozos.com

Jun 22 09:42 AM

[Mad Hedge F...:]

You got it! Last January I was extremely positive about building long equity exposure in Russia, one of the two BRICKS that is a big energy exporter (See madhedgefundtrader.com...). I predicted that the RSX would deliver double the upside of the S&P 500. Well I lied. It actually came in at 2.4 times the US market performance. It even would have worked as a pairs trade, long Russia, short the US. This turned out to be an oil play on steroids, and a recovery in the ruble gave you a nice hockey stick effect in the dollar traded ETF. The bounce in the Russian currency stopped the country’s reserve outflow dead in its tracks, and enabled the Russian Central Bank to start shaving interest rates from the nosebleed territory of 13%. There is plenty of room for further cuts. Russia is not out of the woods yet. Some 30% of the $780 billion in corporate debt is due for rollover this year, the unemployment rate is at 9.5% and climbing, and ruble short term rates are at a sky high 15-20%. It also doesn’t help that they lock up oligarchs on bogus tax charges, and will expropriate foreign assets, as they did with Shell, at the drop of a hat. But none of my investors told me I could only do business with nice people who gave me a warm and fuzzy feeling. I had to bribe my late wife out of Moscow’s notorious Lubyanka prison once. But a rising oil price atones for all sins. Use this dip in crude to add to your positions, but watch out for the volatility.

Jun 22 10:01 AM

[User 357705:]

Long term it sounds as though Russia will be much better off than US.

Jun 22 10:04 AM

[Nyetnichevo:]

No mans' land, exercise extreme caution. It's their country, businesses, oil, graft and corruption at every juncture, yet they have some excellent companies like MBT. Russia has huge potential but does not give a damn about transparency or democratic rule of law.

Jun 22 11:28 AM

[Valley Boy:]

It is hoped that in some future year wave energy technology will evolve to the point where it will be economically practical. This might have certain geopolitical ramifications. This development could enable the European countries to better manage their energy capacities without the over-reliance on imported Russian carbon-based energy.

Jun 22 02:41 PM

[Alex Filonov:]

Investing in Russia is Russian Roulette. If you have money you don't mind to lose, go ahead. By the way, Russian government kills business, government meddling is exactly why you don't want to invest in the country. Just remember Yukos.

Jun 22 05:18 PM

[robert.b.fe...:]

Alex, Filonov: Greetings. I am in complete agreement with you. They can grab what ever assets atract thier fancy. Those of Yukos, yours, mine or any others under thier control. I'm avoiding Russia like the plague.

Jun 22 05:47 PM

[Phiota:]

One long term problem for Russia especially is declining population and with that declining domestic growth.

Jun 22 09:51 PM

[Old Trader:]

I'd have to agree with Alex and robert.b. While Russia has great potential, that lack of transparency, and disregard for rules of law continue to keep me away. I'd look at investing funds there in the same way I'd look at placing a $2 bet on a 100-1 long shot at the local race track. A small bet...if it pays off, great, although it won't change my lifestyle....if it doesn't, its cheap "fun".

Jun 22 11:29 PM

[User 357705:]

Gee, sounds allot like that other country to stay away from for the same reasons! USA!


On Jun 22 11:29 PM Old Trader wrote:

>lack of transparency, and disregard for rules of
> law continue to keep me away.

Jun 23 07:03 AM

[manuel:]

You are a funnY guY, in a good sense i mean ...... it is interesting and funnY reading your articles and comments

Ciao


On Jun 22 10:01 AM Mad Hedge Fund Trader wrote:

> You got it! Last January I was extremely positive about building
> long equity exposure in Russia, one of the two BRICKS that is a big
> energy exporter (See madhedgefundtrader.com...).
> I predicted that the RSX would deliver double the upside of the S&P
> 500. Well I lied. It actually came in at 2.4 times the US market
> performance. It even would have worked as a pairs trade, long Russia,
> short the US. This turned out to be an oil play on steroids, and
> a recovery in the ruble gave you a nice hockey stick effect in the
> dollar traded ETF. The bounce in the Russian currency stopped the
> country’s reserve outflow dead in its tracks, and enabled the Russian
> Central Bank to start shaving interest rates from the nosebleed territory
> of 13%. There is plenty of room for further cuts. Russia is not out
> of the woods yet. Some 30% of the $780 billion in corporate debt
> is due for rollover this year, the unemployment rate is at 9.5% and
> climbing, and ruble short term rates are at a sky high 15-20%. It
> also doesn’t help that they lock up oligarchs on bogus tax charges,
> and will expropriate foreign assets, as they did with Shell, at the
> drop of a hat. But none of my investors told me I could only do business
> with nice people who gave me a warm and fuzzy feeling. I had to bribe
> my late wife out of Moscow’s notorious Lubyanka prison once. But
> a rising oil price atones for all sins. Use this dip in crude to
> add to your positions, but watch out for the volatility.

Jun 23 10:38 AM

[Tony Petroski:]

The author: "... the Kremlin, and it has been merrily consolidating the banking system to its liking and under its influence. The elite business leaders who survive this weeding out process will be pawns of the Kremlin, dependent on credit extended by state-controlled banks and subject to centrally-planned economic directives." "That type of government is not the type that runs through my blood as a U.S. citizen, but it's one that looks appealing to me as a potential investor."

Investor? Are you insane? People placing bets at the roulette table can make fabulous gains but none of them think they are investors. Read "The Gambler" by Dostoyevsky. Russia is a fabulous incubator of fiction and poetry but good investments?

Jun 26 12:51 AM

[TradingHelp...:]

Russia's latest efforts to invite Shell back to the next Sakhalin development phase tells you everything you need to know.

The political interference ebbs and flows depending on their desire for control and their current, short-term need for dollars.

My advice to Shell would be: Be careful what you wish for. It may come true.

Jun 29 10:53 AM