This is bne's Russia chairman’s newsletter, a selection of forward looking stories on development in eastern Europe and the region. Feel free to request topics or ask questions: editor@bne.eu

Contents: Top Story

Ukraine crisis rending the globe Putin decree bans food imports from EU and US EU and US extend sanctions, target state-owned banks US imposes sanctions on Russia as US exports to Russia hit historic high

Politics – the good

Russian suicide rate falling Politics – the bad

Putin Changes Constitution to Strengthen Grip on Senators Anti-Kremlin Protesters Turn to European Court State Duma toughens penalties for repeat violations of protest rallies rules

Politics – the ugly

Russian lawmaker's aide sentenced to prison for extortion Anti-Corruption Agents Plead Guilty in Organized Crime Case Ex-YUKOS lawyer Lechbinskaya gets 8 years in absentia in Russia Former Bank of Moscow president charged with embezzling $30m

Polls, mood, sociology

One in Ten Russians Want to Leave Their Country Putin’s ratings up thanks to new Putin majority forming in Russian society Business Mood Brightens, But Won't Save Russian Economy Sberbank CIB Ivanov Consumer Confidence Tracker ticks upwards Half Russians want country to regain superpower status Survey Ranks Russia as World's 2nd Most Traditional Country Russians doubt Association Agreement with EU will help Ukraine Majority of Russians View Inflation as Country's Biggest Problem Russia's Global Image Takes Negative Turn Amid Ukraine Crisis Wave of patriotism boosts consumer confidence Only 11% of Russians Want to Move Abroad Less than half of Russians inclined to boycott Ukrainian goods

Banks and Finance

Russia trumps West with BRICS bank Russian banking sector reflects growth of uncertainty Maintaining profitability is the key task set before banks in the next 18-24 months

State artificially boosting corporate borrowing from state-owned banks Central Bank ready to assist VEB, Gazprombank over US sanctions Russia’s 66 banks exceed owners’ loan limit Russian banks payments to the CBR for credits to reach $600bn a year Russia sets RUB10bn minim bank capital for state co ops Russia's banking sector assets growth slows to 0.3% in June Russia's upper house approves raising deposit insurance to RUB1m Russian retail deposit growth slows to 8% y/y in June Third of Russians make payments over the internet Russia's Sberbank, VTB units to be under ECB oversight Foreign banks cut loans to Russian corporates to lowest level since crisis

Economics

Food inflation CBR hikes the reference rate as international tensions rise EU directs sanctions at core branches of the Russian economy Production and demand in Russia shrank in June Two thirds of Russia's exports are hydrocarbons Bill Proposes 30% Income Tax on Russia's Rich to Fund Crimea Russian consumer demand weakens while investment improves Russia Sanctions Negative, But Ratings Unaffected For Now Russian consumer not a happy

Incomes in Russia fall 2.9% in June after growing 5.8% in May - Rosstat Russian M&A tumbles to 2009 level amid regional turmoil Proprietary Intelligence Russia's federal budget surplus of 1.9% of GDP in 1H14 Ruble finds support from Russian foreign trade and calming capital flows Ruble finds support from Russian foreign trade and calming capital flows Unemployment drops to a historic low Russia's households' foreign cash demand falls to $9bn Russian CBR registers $74.6bn net capital outflow in Jan-Jun Russian foreign trade surplus up 15% to $105bn Jan-Jun Russian government may raise personal income tax and VAT starting 2019 Sales Tax May Counter Soaring Deficit in Regions

Infrastructure

Russian cheap airline forced to suspend operations due to EU Sanctions Air transport solid statistics in June driven by domestic routes Government considers partial removal of gas pipeline monopoly from Gazprom RDIF launches an initiative to set up a joint fund to implement BRICS infrastructure projects Russian cargo turnover grows in June Gazprom's Gas Pipeline to China to Cost Up to $70Bn, Kremlin Says Korea's DSME will build 9 Yamal LNG tankers for $2.8bn

Firms from Japan, Canada may build $3bn Yamal LNG tankers Investors spend RUB10.5bn on Russian Highways' projects in 2013 RusHydro, Chinese firm to invest $4-5bn in hydro plants Rail Freight volumes declined 2.8% year-on-year in June

ECM

IPOs offer hope Foreigners slash Russia stock, bond investments Six Russian firms in world's top return on equity BCG ranking Aeroflot State may sell part of its stake to 50%+1 Clearstream includes Russian stocks in its international settlement system early Schwab Capital cuts stakes in Russian power, metals, telecom assets Blackrock funds cuts Russian investments 65% in Feb-Apr Russia's Runa Capital to form second $200m fund Russia's Pension Fund budget may reach RUB8.5 trillion in 2017 Russian shares make strong recovery in second quarter

DCM

Sanctions Push Foreign Lending to Russian Companies to 5-Year Low Russia's state debt to reach 15% of GDP by 2017 Russia's external debt up $5.1bn in 2Q14 Russian corporate foreign debt down $1bn in 1H14 First Russian domestic bond defaults as pressure mounts Russian banks may have fewer market collateral

Russia's state debt to reach 15% of GDP by 2017 RusAl Freezes Loan Payments

Sectors

Russia's gas exports soar 80% to 3.149 bcm in June Russia's high-end food retailer Azbuka Vkusa may raise sales 50% in 2014 LCV, MCV sales of Russia's GAZ Group fall 28% to 32,991 units H1 Russia's car imports fall 6% to $56.3bn in Jan-May Renault H1 Sales Rise Despite Weaker Russian Market Investments in Russia's real estate slump 59% in Jan-Jun Housing Market Cools as Russians Stop Panic Buying Russia's potash fertilizer exports soar 56% in Jan-May Anticipating a Strong 2Q14 for Russia's leading retailers Fight breaks out between Rosneft and Gazprom over access to pipelines Beer Ads Return to Russian Stadiums, Television for World Cup Russia to build a record-breaking skyscraper Arms Exports Thrive Amid Military Revamp Russia's AvtoVAZ to raise car parts localization to 90% Russian mobile customer overdue payments growing Russia to become third largest wheat exporter by 2023 Russian luxury good market shrink for first time since 2009

Top Story Ukraine crisis rending the globe The crisis in Ukraine is tearing at global relations on several levels. The tension in the West was highlighted yet again by the lopsided sanctions imposed on Russia on July 16. While Washington targeted Russian banks and oil companies, Europe was unwilling to follow suit. The US is happy to cut into the business of some of Russia's most important companies, as it has little exposure to the Russian economy. However, a slowdown in Russia hurts Europe in the pocket: and an EU summit on July 16, while stiffening sanctions a tad, ducked out of naming specific targets. On the ground in Ukraine, the country is being split asunder in what has rapidly developed into a de facto civil war. Separatists have become militias and militias have become guerrilla fighters; self-defence forces from the Maidan have become brigades and the Ukrainian army. Only a few months ago the violence was limited to hurling stones and Molotov cocktails, but that has given way to heavy calibre machine guns, mortar shells, bombardment from the air, Grad missile systems, and the indiscriminate shelling of towns and villages. The population of east Ukraine is literally being blown to pieces.

Understandably they have been fleeing. The numbers reported to be camped out in camped out in Russia or Crimea vary from 24,000 to over 100,000. There is also confusion over the death toll, but at least 250 servicemen, and about three-times as many civilians, have been killed in the fighting according to various reports. The rising body count has unsettled Ukraine's European allies, and they are now calling for a pause in hostilities. However, President Petro Poroshenko appears determined to see the military operation through to the end to crush the separatists. The fighting is being fuelled by the major powers standing behind the two sides: the US is visibly supplying at least flak jackets and army rations to Kyiv; Russia is rather less innocuously supplying ammunition, sophisticated weapons, handheld missiles, mercenaries, and possibly even tanks and regular troops. (Dis)United Europe But the conflict has spread beyond Ukraine's borders and is straining European affairs due to the widely varying relations European states enjoy with Russia. Many find themselves caught between their alliance to the US, which is implacably opposed to allowing Moscow any say in Ukraine, and business and trade ties with the increasingly lucrative Russian

market. Dependence on Russian energy is another major issue. In the 1990s Russia was a basket case, but over the last 14 years the economy has made a dramatic recovery. It is not only a major energy supplier for much of Europe, but it is now the second largest consumer market in Europe (and soon to be number one). That sees a growing number of European countries increasingly dependent on Russia as an export market. This dependence risks growing more acute as the European recovery has visibly slowed in the last month. The debt/GDP ratio in many European countries is now at, or over, an unsustainable 100%. Europe desperately needs to grow, but Germany and France both reported slowing industrial production growth in the last month, and the international financial institutions have started to warn that the European recovery could falter. At the same time, loyalties have been split by the Russian proposal to build a third massive gas export pipeline to Europe. South Stream would ship up to 63bn cubic metres a year to southern Europe, and for the countries along its route (including Bulgaria, Serbia and Hungary) its offer of cheaper gas and lucrative transit fees is hugely tempting. Even the bastions of the EU - Germany, France and Italy - are torn over what to do with Russia. They were amongst nine countries that were ready on June 15 to

block the phase III sanctions that have been threatened in Brussels and Washington, according to Russian media. "France, Germany, Luxembourg, Austria, Bulgaria, Greece, Cyprus, Slovenia and ... Italy see no reason in current conditions to impose sectorial trade and economic sanctions on Russia and will stand against the measure during the summit," an unnamed EU source said, according to Prime. "There is a big battle going on at present in the West over the scope/extent of new sanctions to be imposed on Russia," says Tim Ash of Standard Bank, summing up the situation. "The US is likely mindful that Ukrainian forces currently have momentum on their side, and might be in a position to re-establish control and order over Donetsk and Luhansk... by pushing further sanctions the US is trying to encourage Moscow not to further escalate on the ground. I think that is unlikely, as Moscow cannot now afford to let Poroshenko win on the ground in Donetsk and Luhansk, hence further sanctions seem inevitable." Europe has to stand by its US ally at the political level, but at the economic level business lobbies across Europe are complaining. They have too much money invested in Russia to want to see the economy wounded in any meaningful way. Pragmatism The upshot is an unseemly fudge. On the one hand, German Chancellor Angela Merkel makes unequivocal threats to increase

sanctions; on the other hand, the European sanctions lists have drawn scorn for their weakness. As our chart shows, the US has been unable to create a united front in Western Europe, let alone garner support from the rest of the international community. That puts relations at a global level under stress. The rhetoric coming out of the US White House talks of "isolating" Russia, but in reality its coalition is weak. Only a small proportion of the world's countries have signed up to the sanctions programme, with Canada, Japan and Australia the only states to join the US and EU in taking concrete action. Our chart shows (click on the map to see interactive version) that the condemnation of Russia's military adventures in Ukraine is not universal; it is actually limited to a few of world's developed markets. Far from looking isolated, Russian President Vladimir Putin was surrounded by increasingly good friends this week during a trip to Brazil to attend the annual BRICS summit. The leaders of Brazil, Russia, India, China South Africa, as well as countries from outside the club - most notably Cuba - signed off on a multitude of deals, including the establishment of a BRICS development bank with $100bn in capital. The emerging markets have long criticised the current global multilateral lenders like the World Bank and the International Monetary Fund (IMF) for being dominated by the G-7 rich club. They want a development bank of their own and

these five nations have the money to finance it. There is then another outcome to the current confrontation; one in which Russia is not isolated. Instead the leading emerging markets, worried by the US lead in a unipolar order, increasingly co-invest, trade and cooperate politically to create a multipolar world - that will nevertheless include the US. Together these countries already account for at least 40% of global GDP according to Goldman Sachs, which also said in a report last year that global trade is growing exponentially, with most of that expansion coming from the emerging markets. This week's BRICS summit was a stark reminder that most of the attention has been narrowly focused on the row between the Kremlin and the White House. However in the meantime Russia continues to build its relationships with the other countries of the world, include many in the heart of Western Europe. The economic slowdown in both Europe and Russia will play an important role in how this crisis plays out. It is easy to stick to principle when things are going well, but when they are going badly pragmatism and compromise takes over policy making. The 2008 crisis has already shown the extent to which the globe's economies are intertwined. The crisis in Ukraine is taking on multinational dimensions and talks

on that scale are needed. The continuation of the unilateral policies encapsulated by both Moscow's and Washington's refusal to compromise threatens a disaster of global proportions.

Putin decree bans food imports from EU and US Russian President Vladimir Putin August 6 signed a decree that bans imports of certain agriculture and food products for one year from countries that have imposed economic sanctions on Russia, i.e. the EU and US first and foremost, but also Australia, Canada and Japan. According to the decree, the government still has to devise a list of products that will be banned and take measures to prevent acceleration of food inflation and increase domestic food supply.

Russia imported $43bn in food products in 2013, or 12% of total food retail sales and 15% in procurement prices. The US, EU and Ukraine jointly accounted for $19bn in food imports, according to the Federal Customs Service. The decree lacks details, but according to Kommersant the final list of products will be presented today.

Allegedly, the restrictions will be applied to crop products (grains and produce) while restrictions will also be applied to categories like meat, fish and dairy. Jointly, these products accounted for around $10bn last year. Meanwhile, processed products (such as beverages) are unlikely to be banned. The idea behind this selection is to boost local production and import substitution in Russia. The initiative will drive negative sentiment toward retail chains, particularly those with a higher share of imports. Stripping out non-food products, we estimate that imports account for 17% of turnover at X5 Retail Group, 13%

at O’Key, 10% at Magnit and 9% at Dixy Group. However, the actual share of food imports from the EU and US is actually much lower, as the main product categories are fruit and vegetables sourced from South America and Turkey. For instance, we estimate that Magnit’s food imports from the US and EU account for just around 1% of its revenues, and this can easily be sourced from other countries. Note that the import of several fruit categories from Poland has been banned since August 1. Putting aside negative sentiment, the decree should not have material implications for the retail chains we cover, and Magnit is the least exposed.

EU and US extend sanctions, target state-owned banks The EU imposed new sanctions on July 29 that target Russian state-owned banks’ access to EU capital markets, restricting transactions with new equity or new debt with maturity exceeding 90 days. The restrictions are supposed to be in force for one year starting after their official publication on July 31, but they can be revised in three months, according to Reuters. Separately, the US added VTB, Bank of Moscow (VTB subsidiary) and Russian Agricultural Bank to its sector sanctions list (which already included VEB and Gazprombank), where restrictions are similar to those announced yesterday by the EU. While it remains to be seen exactly which banks fall under the new EU sanctions, this is clearly a negative development, albeit one that has been increasingly expected. VTB in particular will suffer, both in terms of external funding opportunities and sentiment toward the stock, as it looks as if it is now under sanctions from both the EU and US. That said, we would expect the Central Bank to provide full-fledged support to the affected banks if it is needed by utilizing existing refinancing options and perhaps implementing some new liquidity provision tools (e.g. providing unsecured credit or even FX liquidity in some form). Moreover, as the EU sanctions will be reviewed in three months, much will depend on further developments in Ukraine.

To provide some background, the banking sector’s total foreign debt is around $207bn, or 12.7% of total liabilities, with remaining 2014 redemptions of $20.6bn and 2015 redemptions of $30.0bn. Sberbank as of 1Q14 had R1.4 trln ($39bn) in wholesale funding denominated in dollars or euros, which constitutes 8% of liabilities. As for VTB, as of 2013 (more recent data has not been disclosed) it had R0.9 trln ($27bn) in wholesale funding from OECD countries, which equals 11% of total liabilities. Speaking about shorter- term maturities, for 2014 Sberbank has to repay around $1.7bn in Eurobonds and syndicated loans, while VTB is lighter on 2014 maturities, with only around $0.1bn left for this year after its $3.1bn syndicated loan matured in July.

US imposes sanctions on Russia as US exports to Russia hit historic high The efforts to penalize Russia have all be symbolic so far. sanctions have had almost no direct impact on the Russian economy, but they have had a massive indirect impact in the from of driving capital flight and killing off investment plans.

The announced targeted sanctions against several Russian companies and individuals in March, but trade data published in July shows exports to the country were the highest on record at $1.2bn in May. The sanctions, organized with Europe and other major industrialized nations over Moscow’s alleged actions to destabilize its former client state,

sparked investor flight out of Russia, led the ruble to tumble and pushed the economy into a recession. Russian markets have since recovered somewhat, but investors have been wary of an escalation in the sanctions battle. Demand for products apparently hasn’t been hit, however, and in fact jumped 21% from the previous month. The data also showed signs that demand is picking up in two of America’s largest export markets, Europe and China, where weak growth has hobbled the and global recoveries. Exports to the EU were up nearly 4%, driven by a surge in buying from the U.K., the Netherlands, Spain and Ireland.

Politics – the good Russian suicide rate falling Western journalists often paint the Russian population living under the repressivel boot of dictatorship, but as we reported last month Russian are actually amongst the happiest people in Europe. The chart below is the flip side of the same story showing how the suicide rate in Russia has been falling over the last decades.

Still, Russia’s level of suicide is still very high in comparison to Western countries, and on an absolute level Russians are still quite likely to take the extraordinarily tragic step of ending their own lives. But Russians on average are much less likely to kill themselves than they were a mere decade ago.

SuicideRussia1992-2014

Politics – the bad Putin Changes Constitution to Strengthen Grip on Senators President Vladimir Putin signed a law adding seats to Russia's Federation Council, the upper house of parliament in July. According to the new law, the Constitution will be amended to allow the president to appoint 17 senators, thus boosting the composition of the Federation Council by 10%. Also, senators appointed by one president will be exempt from dismissal by the succeeding president for the duration of his first term in office. An explanatory note for the original bill said the move was intended to "provide additional conditions to attain a balance of powers." The law also stipulates that senators appointed by judicial or executive organs will have a mandate corresponding to the mandate of the appointing state body. Anti-Kremlin Protesters Turn to European Court Two men who were convicted in and then amnestied from an ongoing case involving anti-Kremlin protests that took a violent turn in 2012 filed a complaint

against Russia with the European Court of Human Rights in July. Vladimir Akimenkov and Leonid Kovyazin alleged in their complaint that their rights to free speech and free assembly had been violated in connection with the case, their lawyer Dmitry Arganovsky told RAPSI. Currently, the court is deciding whether or not to examine the complaints on a priority basis, he said. Akimenkov and Kovyazin were among 10 individuals amnestied late last year after initially being convicted and sentenced to prison for their participation in what prosecutors referred to as mass riots on Moscow's Bolotnaya Ploshchad on May 6, 2012. Many of the dozens of suspects in the so-called Bolotnoye case have rejected the term "mass riots." State Duma toughens penalties for repeat violations of protest rallies rules The Duma adopted a bill in the third and final reading in July to tighten the criminal and administrative penalties for repeat violations of public event and demonstration regulations, as part of Russian President Vladimir Putin moves to increase the levers of power he holds over popular protest.

The legislation introduces fines ranging between RUB600,000 and RUB1m ($17,547-$29,244) or up to five years’ imprisonment for repeat violations of demonstration regulations. Repeat violators in this case are those who were sentenced to administrative penalty within the previous 180 days. The Administrative Offences Code is to be amended to increase the length of administrative arrest from 15 to 30 days.

Demonstration participants and organizers can be held for 30 days for resisting the police, the Federal Security Service or the Federal Guard Service. Fines will range from RUB5,000 ($146) for individuals, to RUB10,000-RUB20,000 ($292-$585) for officials and to RUB50,000-RUB100,000 ($1,462-$2,924) for legal entities.

Politics – the ugly Russian lawmaker's aide sentenced to prison for extortion The Khoroshevsky District Court in Moscow has sentenced Alexei Shirikhin, an aide to a State Duma lawmaker, to 5.5 years in prison in a 100,000 rubles ($2,915) extortion case, the court’s press secretary, Olga Litsareva, told RAPSI on Tuesday. Other persons convicted under this case are lawmaker aides Pyotr Khromov, deputy head of the Public Initiative Foundation (to five years), and foundation member Oleg Trushkov (six years). Trushkov is the assistant of Andrei Babushkin, member of the Public Council at the Interior Ministry’s Main Department for Moscow. Shirikhin is State Duma Deputy

Yury Afonin’s assistant. The court’s press secretary said the reading of the verdict lasted several hours and ended late in the evening. According to investigators, the extortion complaint was filed by a retail trader, who said that unidentified persons who said they were MP assistants and representatives of public institutions extorted 100,000 rubles ($2,915) from him under threat of initiating administrative proceedings against him. Anti-Corruption Agents Plead Guilty in Organized Crime Case Three men pleaded guilty to having used their positions in the Interior Ministry's anti-corruption department to ensnare unsuspecting officials

and businesspeople into elaborate bribery schemes. The defendants include Alexei Klyushkin and Alexander Leonov, both of whom reportedly worked as undercover agents for Moscow's anti-corruption department starting in 2013, and businessman Sergei Laskin. All three pleaded guilty to charges of collusion to abuse office, and petitioned for exemption from a formal trial. The Investigative Committee and the General Prosecutor's Office have already agreed to these conditions, according to the report. Each suspect faces up to 10 years in prison. The Investigative Committee was the subject of a purge instigated by Russian President Vladimir Putin in the first days of August following a string of scandals where high officials were linked to corruption cases. Ex-YUKOS lawyer Lechbinskaya gets 8 years in absentia in Russia Natalia Lechbinskaya, an ex-lawyer for defunct oil giant YUKOS, has been convicted of fraud, sentenced in absentia to eight years in prison and fined RUB400,000 (over $11,600). Lechbinskaya was charged with a large scale fraud allegedly committed by a criminal group, money laundering and embezzlement. The investigation into the alleged fraud was initiated in 2008 when Russia’s Investigative Committee filed a

request to bring the lawyer to justice. The case was heard just before a European arbitration court awarded $51bn to Yukos shareholders after ruling the Russian government illegally dispossessed the owners fo the company of their assets for political reasons. Former Bank of Moscow president charged with embezzling $30m The former president of the Bank of Moscow, Andrei Borodin, has been charged in an embezzlement case totalling RUB1bn ($30m), the Interior Ministry announced on its website. According to a previous fraud case initiated against Borodin and Akulinin, they used their positions at the Bank of Moscow to transfer at least RUB50bn ($1.5bn) to the accounts of affiliated commercial companies in Cyprus in 2008-2011, the Interior Ministry said. Investigators claimed that the former bankers conducted illegal financial transactions in excess of RUB623m ($18m). In late 2010, Russia launched a criminal case against Borodin and Akulinin on charges of large-scale fraud involving state funds. They were accused of lending $443m to

shell companies, which then transferred the funds to Yelena Baturina, the wife of former Moscow mayor Yury Luzhkov and the owner of the construction empire Inteco. Borodin, whose Bank of Moscow was the main investment vehicle

under Luzhkov, fled to the UK in 2011. In November 2011, the Russian Interpol bureau put Borodin and Akulinin on the international wanted list. In March 2013, Borodin was granted political asylum in the UK.

Polls, mood, sociology One in Ten Russians Want to Leave Their Country About one in every 10 Russians wants to emigrate from the country, a recent poll has shown, and while few seem to be actively pursuing their wish, the number is significant because it represents mostly young and educated professionals. Among those who said they wanted to leave Russia, 47% were motivated by the chance of a higher living standard and better wages abroad; 14% were attracted by greater opportunities for career advancement; and 12% said they wanted better social protection, the state-run VTsIOM pollster said in a report released Monday. The question on why Russians would want to leave the country allowed for multiple answers, and political disagreements with the government were not listed among the responses.

The total number of those wishing to emigrate, 11%, has remained largely unchanged in recent years after spiking at 16% in 1996, according to previous polls published on the VTsIOM website. Putin’s ratings up thanks to new Putin majority forming in Russian society Russian President Vladimir Putin’s ratings have risen unprecedentedly high thanks to a new Putin majority that has formed in the Russian society over the recent years, according to the Political Analysis Centre. “The Putin majority is evolving as a social coalition for sustainable development, where each social group develops its ways of joining the majority,” the authors of the report "New Putin Majority: Critical, Pragmatic, Non-indifferent and Patriotic" said. According to a public opinion poll conducted for the Political Analysis Center, 18% of respondents said

their attitude towards Putin had become more positive over the past two years, while only 4% stated otherwise. The recent tendencies demonstrate that Putin is winning more and more support among managers and people with higher education (support growth of 48% and 25%, respectively). Apart from that, the president’s popularity is growing among residents of the capital city and other big cities and students (35% growth), among pensioners (31% growth), public servants (36% growth). Allegations about aging of the presidential electorate turned out to be ungrounded. Along with that, the president traditionally enjoys the support from the military, women and elderly people. Business Mood Brightens, But Won't Save Russian Economy Economic sentiment among Russian businesses improved in the second quarter, but the effect was largely seasonal and shot through with troubling long-term trends, a study published by the Higher School of Economics found. As the mood in retail and the services industry brightened — largely thanks to traditionally strong demand for food products and seasonal services in the spring and summer — the spirits of entrepreneurs in construction and manufacturing continued to slide.

"It is clear that in the second quarter the consumer sector, including retail and the services sphere, remained the driver for sluggish growth in the Russian economy," the study found. Businessmen in manufacturing most often attributed their negative ratings to "insufficient demand for products," while businessmen in construction and retail complained of high taxes. Economic sentiment as a whole rose to 99.3 — still in the negative zone of the indicator, with 100 indicating neutral. This was a clear improvement from the first quarter of the year, when the indicator fell to 97.1 amid a drastic decrease in investment in the Russian economy and resulting slowdown in economic growth. Sberbank CIB Ivanov Consumer Confidence Tracker ticks upwards The eight tracker indicates a recovery in the consumer confidence index, with the overall score rising to –11% from –13% in November thanks to improving employment trends and readiness to spend on durables amid prevailing macroeconomic uncertainty. The main findings of our survey are shown survey below: The index of country wealth expectations for the next 12 months jumped from –13% in March to –8% in June. We think that this is due to easing concerns over the ruble exchange rate (cited by just 17% of

respondents versus 29% in 1Q14). As a result, we saw a sharp drop in the number of respondents describing the economic conditions as unstable (from 78% in 1Q14 to 70% now). Improving conditions for big ticket purchases suggest that 2Q14 and June non-food sales could be less dismal than we had initially thought. That said, we would not be overly excited, as the uptick may indicate that households were previously extremely pessimistic with regard to the macro and geopolitical backdrop and we are now seeing some mean reversion. That said, the real economy is deteriorating and we expect wage growth to slow in 2H14, so sentiment could worsen again. Unemployment remained broadly flat Q-o-Q at 9.3%, while the net hiring index dipped from –32% to –33%, as the share of companies suspending hiring rose from 18% to 20%. The Ivanovs were more upbeat on the prospects for their employers. The share of businesses expected to grow over the next 12 months rose from 28% to 31%. We also saw an increase in average wages from R28,600 in March to R29,500 in June. Savings data were mixed. The propensity to save increased: 23% of Ivanovs now believe that this is a favorable time to save money, up

from with 18% in our previous survey. The share of Ivanovs with no savings fell from 38.0% in March to 37% in June, yet the average share of monthly incomes saved dropped from 11.5% in 1Q14 to 8.8% in 2Q14. Overall, we do not expect any further trading down relative to 1Q14. The number of price-sensitive customers remained flat at 68% in June. The proportion of respondents trying to save by switching to cheaper groceries and those cutting non-discretionary consumption were also mostly flat Q-o-Q (at 56% and 28%, respectively). Price investments undertaken by the largest food retailers helped to smooth inflation for households: respondents did not notice shelf prices rising in 2Q14 and even commented that prices had become more attractive at Lenta, Magnit (convenience), Pyaterochka and Auchan. As a result, inflationary concerns actually eased compared with 1Q14. Modern retail is gaining at an accelerated pace: we calculate its market share has increased 3 pp since September 2013. This explains how all the largest retail chains have been able to report traffic gains. Hypermarkets are the fastest growing format.

Leading food retailers are investing in prices amid high food inflation, which should see LFL bounce in 2Q14. They are taking market share from non-organized retail, and this should be reflected in strong 2Q14 operating results. Half Russians want country to regain superpower status Just under half of Russians want the country to regain its super power status, according to a poll held by VTsIOM in July. One-third of Russians believe that army and weaponry help their country build up a strong image abroad, a state-run pollster said in July. Additionally, 15% of respondents said President Vladimir Putin and his foreign policy promoted the country's image, while 13% named culture and traditions the main source of Russia's power. Assessing the attitude of foreign nationals for Russia, 33% of respondents described it as interest, 22% as envy and 21% as respect. According to 14%, foreigners do not trust Russia. Survey Ranks Russia as World's 2nd Most Traditional Country Russia is the second-most traditional country in the world, according to a survey from IPSOS MORI Global Trends Survey, which found that 79% of men and 67% of women believe the woman's role in society lies in her domestic responsibilities toward her husband and children.

Notably, the Russian results were based on answers supplied by only 500 respondents. In contrast to Russia, only 9% of Swedes and 11% of Spaniards agree that a woman's social role is tied to domestic responsibilities, according to the poll. Among the 20 countries surveyed, China was considered the most traditional, followed by Russia in second place, and Britain in third. Russians doubt Association Agreement with EU will help Ukraine Most Russian citizens are aware of the fact that Ukraine has recently signed the association agreement with the EU but doubt this decision of the Kyiv authorities is beneficial for the development of Ukrainian economy, Public Opinion Foundation (FOM) said following a survey. 70% are aware that the EU-Ukraine Association Agreement was signed on June 27, sociologists said. As to why Ukraine needs this agreement, 9% Russians think Kyiv did it "under the EU and pressure," 6% respondents believe Ukrainian leadership and oligarchs pursuing "personal interests" were interested in signing the document, other 6% suppose Ukraine expects "the country's life to improve", and 5% referred to Ukraine counting on Western help, the survey showed.

At the same time, 41% respondents think Ukraine's signing the association agreement with the EU will have "rather negative consequences" for Russia and only 9% expect positive outcome, sociologists said. 27% Russian citizens said the association agreement will have no impact on Russia, and 23% failed to respond. Majority of Russians View Inflation as Country's Biggest Problem 59% of Russians see inflation as the country's biggest problem. Housing issues and general living standards are a little bit behind in the list of issues with 54% and 45% of respondents, respectively, having singled them out, state-run pollster VTsIOM revealed in July. Concern with the level of drug abuse in the country has surged by 13% since past year, reaching 42%, according to the poll. Concern about the state of democracy and human rights in the country remained at the bottom of the list, receiving a nod from only 9% of respondents. Russia's Global Image Takes Negative Turn Amid Ukraine Crisis Russia's global image has soured significantly over the past year amid the ongoing crisis in Ukraine,

a new study by the Pew Research Center has shown. On average, 43% of respondents across 44 countries have an unfavorable view of Russia, compared to 34% who are sympathetic toward the country, according to the study released Wednesday. Meanwhile, attitudes toward Russia have deteriorated in 20 of the 36 countries surveyed both this and last year, improving in just six countries and remaining relatively similar in 10. The worst dynamics were observed in the U.S., where the number of people with an unfavorable view of Russia grew from 43% in 2013 to 72% in 2014. In the EU, the number of people with the same attitude rose 20%age points to 74%. The general attitude toward Russia was also negative in the Middle East, Latin America and Japan, though in India and China, the majority of the population approved of Russia — with more people doing so than last year. In Ukraine, which lost the Crimean peninsula to Russia in March, 60% view Russia negatively, compared to just 11% in 2011. However, among Russians polled in the survey, 92% displayed a positive attitude toward their own country — up from 83% in 2013.

Majorities or

Wave of patriotism boosts consumer confidence Consumer confidence significantly improved in 2Q14. Rosstat published consumer confidence data for 2Q14. The headline figure substantially improved during the quarter, adding 5 bps to reach minus 6% after a year of decline. The index of expected changes in the economic situation in the near future grew 11 ppt to 0% compared to minus 11% in 1Q14, with the share of respondents expecting their economic situation to improve in the next 12 months rising to 23% in 2Q14 from 15% in the previous quarter. The index of changes that have occurred in the economic situation grew 7 ppt to minus 6% in 2Q14. The share of respondents that positively assessed the changes that occurred in the economy rose to 20% in 2Q14 from 14% in 1Q14. The index of expected changes in personal material situation grew 4 ppt QoQ to minus 2%, with the share of respondents expecting their material situation to worsen in the next 12 months decreasing to 16% in 2Q14 from 20% in 1Q14. The index of changes that have occurred in

personal material situation grew 1 ppt QoQ to minus 6% in 2Q14. The index of favorable conditions for large purchases increased 4 ppt QoQ to minus 16% and the index for savings grew 4 ppt to minus 33%. The headline consumer confidence index showed growth among all age groups, with the highest growth seen among the youngest age groups. … as economic growth surprised. We see several reasons behind the improvement in consumer confidence in 2Q14. One is that the economy performed much better than was expected during the period. GDP was up 1.2% year-on-year in 2Q14, due largely to the 2.5% year-on-year expansion in industrial output. The manufacturing sector received a boost from import substitution and ruble depreciation. Real wage growth accelerated to 5% year-on-year, while unemployment reached a record low of 4.9% in May. Another reason behind the improvement in consumer sentiment was the rise in patriotism following the annexation of Crimea, a move supported by the majority of Russians, according to Alexei Devyatov

Only 11% of Russians Want to Move Abroad One in nine Russians want to emigrate from the country, a recent poll has shown, and while few seem to be actively pursuing their wish, the number is significant because it represents mostly young and educated professionals. Among those who said they wanted to leave Russia, 47% were motivated by the chance of a higher living standard and better wages abroad; 14% were attracted by greater opportunities for career advancement; and 12% said they wanted better social protection, the state-run VTsIOM pollster said in a

report released at the start of August. The question on why Russians would want to leave the country allowed for multiple answers, and political disagreements with the government were not listed among the responses. The total number of those wishing to emigrate, 11%, has remained largely unchanged in recent years after spiking at 16%in 1996, according to previous polls published on the VTsIOM website.

Less than half of Russians inclined to boycott Ukrainian goods Russians are divided practically 50/50 over the expediency of boycott of Ukrainian commodities and business relations with the neighbor, sociologists told Interfax. Some 42% of Russians said they would support a boycott of Ukrainian commodities up till the end of the conflict in eastern Ukraine, and 49% rejected that option, said the Russian Public Opinion Study Center (VTsIOM), which polled 1,600 persons in 130 populated localities in 42 regions on June 28-29. The readiness not to buy Ukrainian products was mostly expressed by Muscovites and St. Petersburg residents (54%), respondents with

low incomes (53%) and A Just Russia supporters (53%). The negative attitude was mostly characteristic of followers of non-parliamentary parties (69%) and prosperous respondents (54-56%). Respondents were also divided over the idea that Russian companies should severe relations with Ukrainian partners. Some 45% of Russians opined domestic entrepreneurs should stop doing business with Ukraine and 40% supported further partnership.

Banks and Finance Russia trumps West with BRICS bank At the sixth summit of the BRICS developing nations in July is the founding of two multilateral financial institutions designed to erode the dominance of the World Bank and International Monetary Fund as arbiters of the global economic system. For Russia, the creation of a $100bn BRICS development bank and a reserve currency fund worth another $100bn is a political coup. Just as the West freezes Russia out of its own economic system as punishment for its politics in Ukraine, Russia is tying itself into the financial superstructure of the next generation of economic heavyweights: India, Brazil, China and South Africa. The World Bank and the IMF have come under criticism from the rapidly developing BRICS, who together account for 20% of global GDP and 40% of the world's population. In their view, the two financial institutions are dominated

by the rich nations of the G7 and attach stringent conditions to their lending that impinge on the economic sovereignty of its members. The World Bank estimates the annual need for infrastructure investment in low- and middle-income nations at $1 trillion dollars and rising — far beyond its own capacity. The World Bank reports that it gave out $52.6bn in 2013, not all of which went

to infrastructure projects. The BRICS bank will have starting capital of $50bn, made up of $10bnin cash and $40bn in guarantees. Each BRICS country will

contribute $2bn to the starting capital pot. In the longer term, capital will rise to $100bn. The bank is to be named the New Development Bank, Siluanov said, signifying that other developing countries are welcome to join, although the BRICS countries' share will not be allowed to fall below 55%. Likely headquartered in Shanghai, the bank is expected to make its

first loans in 2016 and will focus on bi- or multilateral development projects involving companies from participant countries. According to a report for the UN released in March by Columbia University economist Stephany Griffith-Jones, the bank could could ramp up lending to $34bn per year within 20 years. Russian banking sector reflects growth of uncertainty The Central Bank published headline banking sector data for July. • Assets. Sector assets climbed 1.2% m-o-m, implying growth of 16% year-on-year and 8% YTD. • Loans. Corporate loans increased 2.2% m-o-m, largely due to the revaluation of FX loans following the 6% ruble depreciation in July (growth adjusted for that would have been around 0.6%), and are still showing respectable growth of 16.0% year-on-year and 10.6% YTD. Retail loans added 1.7% m-o-m, bringing the YTD figure to 8.7%, while year-on-year growth cooled to 20%. Sberbank underperformed the rest of the sector in corporate lending (0.8% versus 3.1%) but outperformed in retail lending (2.4% versus 1.3%). • Deposits. In July, retail deposits added 1.4%, though this number was also boosted by the ruble depreciation (actual inflows seem to have been mild). Hence, retail deposit growth YTD went into positive territory (1%), although year-on-year growth is running at only 8%. Corporate funds

increased 1.0% m-o-m. Sberbank underperformed the rest of the sector in retail deposit growth in July (0.6% versus 2.1%). • Earnings. Total sector EBT was R513bn in 7m14, down 10% year-on-year. • Overdue loans. The overdue loan ratio (which incorporates only the overdue portion of a loan) edged up from 4.4% to 4.5% in corporate and from 5.3% to 5.4% in retail. Growth in household deposits came to a standstill in early this year on uncertainty caused by ruble weakness and tensions from the conflict in Ukraine. The deposit stock shrank by 0.4 % in nominal terms from January to June. During 1H2013, the deposit stock still grew about 10 %. In March and April in particular, households changed bank deposits into foreign currency cash and moved up planned purchases. Foreign currency deposits at end-June amounted to over 18 % of all household deposits, about one%age point higher than a year earlier. The ratio of household deposits to total assets of the banking sector fell by two%age points during the first half to 28 %. The shares of central bank financing and state deposits (including the finance ministry) as well as interbank lending have all grown. The share of central bank financing has nearly doubled over the past year; it now accounts for about 9 % of banking sector total assets, while it reached 12 % in early 2009, the crisis year.

Growth of corporate credit stock was 16 % year-on-year at end-June, slightly faster than a year earlier. The acceleration in growth of the credit stock may reflect increased difficulties in foreign borrowing. On-year growth of the

stock of household credit slowed from 34 % at end-June 2013 to 21 % at end-June 2014. A driving factor was the central bank’s earlier measures (see BOFIT Weekly 6/2014). The bulk of new household borrowing is however going to servicing existing loans.

Maintaining profitability is the key task set before banks in the next 18-24 months Having focused on growing assets for most of the last decade and half the game for Russian banks has changed and they will now focus on cost optimization, increasing the share of fees and development of remote services going forward, in a move that analysts say is healthy for the system, which will last until mid-2015 at least. Banks will have to adapt their business models to the new rules of game: extensive growth degradation, the deterioration of assets, a system-wide shortage of liquidity and toughening of regulatory supervision. The

transformation will be accompanied by a reduction of the number of banks and growing concentration of assets with large banks. Banks will have to put a cap on high-risk (including captive) business, optimize costs, increase the share of fee and commission income, step up relations with small and medium-size business, and develop remote services. Expert RA forecasts that assets of the banking sector will add 13% in 2014 (versus 16% a year earlier and 50% a year in the boom times) and not more than 10% in 2015. This is comparable with the growth rate of prices in the economy. Retail lending will slow down most

drastically: its growth will go down to 23% in 2014 compared with 29% in 2013. A decline in unsecured consumer lending will account for much of the slowdown in the segment. The segment will shrink both under the pressure of regulatory innovations (due to restrictions on maximum interest rates in the first place) and in response to contraction of the demand from quality borrowers. Finding new customers will be harder as punters switch from borrowing to saving more due to the economic uncertainties. As a result, consumer lending will increase not more than 23% in 2014 versus 32% in 2013. The largest retail banks will lose positions in the segment. In 2014, the overall growth in the retail segment is supported only by federal banks with state participation while retail loan portfolios of other lenders are shrinking. Mortgage lending will be a "point of support" to the retail segment. As of the end of Q1 2014, the mortgage portfolio added 6.1% versus 4.9% in Q1 2013. It allows to expect that growth of the mortgage portfolio will be at least 28% as of the year-end. A minor slowdown of annual growth is due to an increase in interest rates on mortgage loans (by about 0.5-1%) expected in Q2-3 (some large banks increased interest rates on mortgage loans at the end of Q1 2014), which might make part of borrowers put off purchases of housing.

Expert RA expects short-term acceleration in lending to big business in 2014 following refinancing of the external debt of large companies. As a result, the loan portfolio will increase 12% as of the end of 2014 versus 10% in 2013. However, the effect of refinancing will be exhausted this year, and the market will start to slow down again in 2015 (the portfolio is expected to add 9-10%). Geopolitical difficulties may give a boost to the market of domestic letters of credit which is related with lending. It will pave the way for additional growth of the largest banks. Lending to small and medium-size business will be affected adversely by a diminishing effect of the former drivers such as credit factories and all-inclusive services. Almost all segments of lending will be affected by deterioration of assets in 2014 and 2015, but it will not always be evident from official financial statements. Stagnation in the economy and restricted access to external funding will hit first on large companies, but most banks will choose to restructure large loans or refinance debts of such companies. As a result, arrears of large loans will increase slightly formally, but restructuring will actually mean deterioration of assets of large banks. At the same time, possible funding from the Bank of Russia (including against security of investment loans) and expected toughening of requirements to financial institutions with which free funds of

state companies and corporations may be placed will help cover risks of liquidity related with forced extension of large debts. Arrears of unsecured retail loans will grow most rapidly, a new increase to be seen late 2014 when stagnation in the economy affects small and medium-size companies. However, it will hardly turn into a crisis, including due to a shift in banks' focus onto higher-quality borrowers (for example, payroll customers). The share of loan arrears in mortgage lending is expected to stay at the current level which is 1.5-1.7% (versus 8-9% in unsecured loans). Deterioration of assets will go hand in hand with liquidity tension. In June, the Bank of Russia changed the estimate of providing liquidity to the sector from RUB5 trillion to RUB7 trillion as of beginning of 2015. Therefore the regulator's funding in liabilities may come to 10-11% (8.4% as of May 1, 2014). Small and medium-size banks are most sensitive to such situation since their business is in a limited number of regions: the overflow of customers to large banks seen late 2013 continued in Q1 2014. Refinancing is distributed in the system unevenly: over 70% goes to the largest banks with state participation. They use the liquidity surplus to carry out own projects, for example, in retail lending, rather than transfer it to the interbank market while smaller banks often have to keep a surplus stock of liquidity to the detriment of profitability.

The average ROE in the banking sector fell to 15.2% as of the end of 2013 (18.2% in 2012), the fall seen both in small banks and in large federal ones. Many small and medium-size lenders had to sacrifice their ROE to maintain liquidity at an adequate level in case of new panic among depositors. Profitability of the banking sector will continue decreasing in 2014 and 2015. Apart from the slowdown of the key segments of lending and difficulties with liquidity, banks' profitability will be affected adversely by toughening of banking regulation and supervision in respect of transactions with related parties and making doubtful transactions: the criteria for a bank's high involvement in doubtful transactions were increased in May 2014; the rate of related party exposure and stricter criteria for treating borrowers as related parties will be put in place in 2015. State artificially boosting corporate borrowing from state-owned banks Demand for corporate loans has increased in recent months: After growing 13% y/y in 2013, corporate loans accelerated to 18% y/y in April-May, which took place despite an increase in interest rates, and did not coincide with stronger economic activity. Our take is that the extra demand for local debt was due to the declining availability of the external market to Russian borrowers. Company foreign debt growth in 1Q14 was

only $4bn, and local banks were a substitute. Lending growth rose sharply to 25% y/y in state banks, while decelerating to 5% y/y in private banks: The surprising fact is that the sole beneficiaries of increased demand for local loans were state banks, which boosted corporate lending growth from a market average of 13% y/y in mid-2013 to the current 25% y/y growth, while local private bank lending decelerated to a mere 5% y/y. One explanation could be that the demand for loans comes primarily from state monopolies and their contractors, which need additional leverage after the tariff freeze enforced this year. However, these are attractive borrowers that have no strong requirement to borrow only from state banks; and the lack of private banks in the lending rally is still surprising. CBR support is additional funding for state banks: The answer to the divergence between state and non-state lending growth lies on the funding side. Reflecting client concerns on the multiple license revocations, the growth of the retail deposit base of private banks decelerated from 30% y/y to 5% y/y in the last 12 months. State banks, on the contrary, have not lost attractiveness for retail depositors, and have benefited from inflows from corporate accounts, possibly from abroad. The paradox is that state banks also increased CBR borrowing faster than private banks, indicating that they use it as an extra source of funding versus private banks that see it as a

refinancing tool, compensating for the weakness of their funding base. Without CBR injections, interest rates would be 300-400bp higher: While being positive for loan growth, the expanding presence of the CBR and Finance Ministry support to banks, which has from RUB0.6tr to RUB6.0tr over the last four years, has led to interest rates staying 300-400bp below the equilibrium level, thus discouraging savings. The household savings rate dropped from 15% in 2010 to 10% in 2013 and 4% in 4M14, and Russia’s gross national savings rate is low by global standards. Role of state banks is controversial: The CBR policy also favors an increase of the state banks’ presence in banking markets that rose from 40% in 2004 to around 60% currently. Apparently, the government sees this as a tool to stimulate growth in strategic sectors. However, we note that the large state presence is leading to a misallocation of capital and underperformance in productivity growth. Cross-country studies suggest that the growing share of state banks increases banking sector margins through low interest on deposits. Acceleration in loan growth coincides with faster drop in investments, and is negative for GDP growth outlook: With state banks channeling a higher share of loans to state-focused sectors, the acceleration in loan growth is not able to boost economic activity. Investment growth, which is supposed to be the result of state-

banks’ faster lending, fails to materialize. This keeps Russia’s investments at a low 22% of GDP,

and the persisting lack of capital stock upgrade keeps potential GDP growth at a low 1.5-2.0%.

Central Bank ready to assist VEB, Gazprombank over US sanctions The Central Bank of Russia is ready to provide support to the two Russian banks targeted by sanctions: Gazprombank and Vnesheconombank (VEB). Gazprombank and VEB were included on the expanded list of Russian banks subject to Treasury Department sanctions, restricting their access to capital markets in July. The sanctions prohibit investors from dealing in new debt of longer than 90 days maturity or new equity for the two banks from July 16. This step will close the medium- and long-term dollar lending window to these banks, and will impose additional significant costs on the Russian Government for its continued activities in Ukraine, the US Treasury Department statement said. Gazprombank has already announced that the sanctions would have no effect on bank operations, and that all commitments to clients, investors, depositors and creditors were being met on time and in full. The bank has anticipated the sanctions and has little exposure to foreign borrowing and has built up a large forex cash buffer. VEB has not commented on the impact of sanctions yet. VEB, which does not possess a banking license, is governed by the law on development banks.

Russia’s 66 banks exceed owners’ loan limit Russia’s 66 banks are exceeding the 20% limit of crediting their beneficiaries, which will be introduced next year, Central Bank (CBR) Deputy Chairman Mikhail Sukhov said on the sidelines of the Saint-Petersburg International Banking Conference. Sukhov said that 16 banks out of 66 have capital of over RUB5bn ($142.8m). Sukhov also said that 30 largest banks’ capital adequacy will not suffer if they incur losses of up to RUB1 trillion ($28.5bn). Russian banks payments to the CBR for credits to reach $600bn a year Russian banks debt to the Bank of Russia amounts to more than 8% of all banks' liabilities, while 3 years ago it was only 1.7% If by the end of the year total refinance volume will reach RUB7 trillion (the Bank of Russia forecasts) and remains unchanged in 2015 while average interest rate will be more than 8% (7.5% on short-term credits in security of market assets and 8.5% on credits on security of non-market assets) than banks will have to repay to the Bank of Russia a bit less than RUB600bn of interest, analysts of Sberbank CIB write. Sberbank CIB also mentions rapid growth of banks' dependence on the Bank of Russia's money. At present moment share of the Bank

of Russia's money in banks' liabilities is more than 8% -- less than during crisis of 2008, but the situation is far from the global crisis. In the preceding year it doubled, analysts of Sberbank CIB write. During crisis the Bank of Russia's money reached 14% of all liabilities of banks. In Q3 2011 it was all-time low - 1.7% and since then it has been growing. Russia sets RUB10bn minim bank capital for state co ops Russia's central bank has set the minimum capital for banks to be allowed opening accounts for state companies at least at RUB10bn says Deputy Finance Minister Alexei Moiseyev. Banks, in which state companies could open accounts and deposit funds, must meet at least one of three criteria, Moiseyev said. A bank must have a capital of at least RUB10bn, or be controlled by the government directly or indirectly, he said. The third criterion implies that the government may include a bank into the list of credit organizations authorized to cooperate with state companies on petition by a strategic company if a specific situation arises, Moiseyev said. Around 100 banks may be included in the list, according to Moiseyev's estimate. Russia's banking sector assets growth slows to 0.3% in June

The growth Russia's banking assets slowed down to 0.3% in June from 1.6% in May, the central bank said in a statement in July. The regulator explains the slowdown by a 0.2% decrease in corporate loan portfolios on the back of a 2.7% decrease in the currency loans. The share of soured loans in corporate portfolios decreased by 2.6%. In the retail loan portfolio, the share of soured loans increased by 1.7%. Clients' deposits decreased by 0.8% with corporate deposits falling 3.7% and retail deposits rising 0.8%. Russia's upper house approves raising deposit insurance to RUB1m The Federation Council, the Russian parliament's upper house, on Wednesday, approved a bill seeking to raise the insurance payment to depositors of banks which go bankrupt to RUB1m on July 9th from RUB700,000 currently. The bill envisages that the Deposit Insurance Agency will repay RUB700,000 to each depositor of a bankrupt bank, while the remainder of no more than RUB300,000 may be paid before "other" claims of first-priority creditors are satisfied.

Russian retail deposit growth slows to 8% y/y in June The CBR yesterday reported on July 9th preliminary banking statistics that indicate a material deterioration in the funding base of Russian banks in June. The key concern is very weak retail deposit growth that slowed to just 8% y/y from 10% y/y in May and 19% y/y in 2013, suggesting no recovery in retail deposit inflows following the March panic run. One explanation could be that the ongoing revocation of bank licenses in the small-bank segment combined with the persisting fear of foreign sanctions against large institutions are driving households mostly to prefer capital outflow rather than keep savings in local banks. Also, with persistently high inflationary expectations taken into account, the negative retail deposit trend may reflect an increased preference for consumption. However, in the worst but less likely case, it could mean some deterioration in the income trend. An additional concern is the material slowdown in corporate funding growth, which, according to Alfa Bank's estimates, dropped to 12% y/y from the 16-20% y/y seen in the last six months, and remains an enigma for now. As a result, banks increased their exposure to CBR support by RUB350bn in June and RUB900 YTD in order to offset the

weakness in the funding base. Combined with Finance Ministry deposits, the state is currently funding almost RUB7 trillion, or 11% of banking assets, which is close to the 13% level seen at the peak of the 2008-09 crisis. Third of Russians make payments over the internet Only a third of the Russian people make payments and cash transfers via the Internet. Over two thirds do not pay and are not going to pay using mobile devices. 40% of the Russian people do not know about automatic payment orders, and only 2% of the population uses them. These are findings of the second part of the survey conducted by the Bank of Russia together with the National Agency for Financial Studies (NAFI) 11.7% of residents from those who pay via the Internet make payments and cash transfers using a bank account in the personal area of the Internet bank. 8.4% indicates bank card details on various website, and 6% of respondents use both options. The latter is chosen by residents of two capital cities of Russia most frequently. Moscow and St. Petersburg residents use both ways of payment by 2-3 times more frequently than residents of other localities. Young people aged from 25 to 44 years make payments and transfer money via the Internet most frequently. Internet banks are used most frequently by residents of the Far-Eastern federal district (32.9% of

respondents make payments and cash transfers via the personal area in the Internet bank) and the North-Western federal district (16.5%). However, the same regions take the lead by the number of people who never made payments and cash transfers via the Internet. Russia's Sberbank, VTB units to be under ECB oversight The Austrian financial market control agency has put Sberbank Europe and VTB Bank Austria, affiliates of Russia's Sberbank and VTB, on the list of systemically important financial institutions and they will be under the European Central Bank's oversight from November, the agency said in July. According to EU legislation, banks with assets of over €30bn or which hold a significant share of an EU country market are to fall under EU control. Sberbank Europe and VTB Bank Austria are listed as important institutions although their assets are below the €30bn mark, the agency said.

Foreign banks cut loans to Russian corporates to lowest level since crisis Russian companies are feeling the squeeze from international sanctions as foreign banks cut lending to the lowest level since 2009. Syndicated loans for Russian raw-material companies fell 82% in the first six months of 2014 from a year earlier to a five-year low of $3.5bn, data compiled by Bloomberg show. The slump outpaced the 2% decline in global commodity borrowing to $344.2bn. Even as record-low interest rates allow European and US companies to borrow more cheaply, HSBC Holdings Plc and other foreign banks have pulled back from certain deals in Russia since the European Union and imposed sanctions. Russian corporate borrowers have $191bn in international debt payments coming due this year, or about 9.6% of the nation’s economic output.

Economics Food inflation At the start of August Russia banned all US, Canadian and European food imports to Russia in a move that is likely to send prices and inflation soaring. However, rising food prices were already a problem for the Central bank that

as hoping to drive inflation down to 4%-5% this year but will probably end the year with inflation running closer to 8%. Even as food prices rise dramatically around the world, the rate of increase in Russia has been roughly three times greater than

that in the European Union. In April, the cost of basic foodstuffs rose in Russia by 6.4%, compared to 1.8% in Europe, according to official Russian figures. Depending on the region, prices of basic products such as bread, milk, and meat have risen between 7% and 22% so far this year, moving inflation to the top of the list of Russia's national concerns. An opinion survey in March found that 39% of Russians view rising food prices as the biggest national problem, while 38% named inflation generally, and 27% named low wages. Just 8% of respondents mentioned corruption. The Kremlin has moved to use 1990s tactics by imposing prices freezes on some basic products as well as freezing tariff hikes on things like power. As the last price freeze expired on April 30, the government was preparing a special "food-security" law that would indefinitely fix the prices of seven "socially important" commodities. Medvedev, who for the last three years has overseen an ambitious national project to revive the agricultural sector, has tried to contain the political damage that seems inevitable if prices surge following the expiry of the latest price freeze. The problem is made worse by the fact that Russia is one of the

world's leading importers of food. As such, it stands to suffer disproportionately from the food crisis. Among G8 countries, only Russia and Japan are net food importers. Russia imports about 46% of the food and agricultural raw materials it consumes each year. At a February 14 press conference, Putin revealed that some of Russia's largest cities import up to 85% of the food they consume. All in all, Russia imports 75% of the meat it consumes and half of the vegetable oil. Still worse, Russian dependence on imported food is on the rise. Food imports increased by a factor of three between 2000 and 2006, and the primary reason for this is the ongoing decline of the country's agricultural sector. To take just one example, meat and milk production has fallen by half since 1990, and Russia's total cattle herd has declined to the level of 1918. Russia, for instance, imports 35% of its beef and 40% of its pork from the European Union. The good news for Russia is that the country has available land and water resources to boost agricultural production. The bad news, however, is that this cannot be done quickly enough to forestall the social, economic, and political impact of its food deficit. The country simply lacks the workforce, the infrastructure, and the financial mechanisms for rapid development in this sector.

CBR hikes the reference rate as international tensions rise On July 25 the Central Bank of Russia raised its key rate by a half%age point to 8%. It was the third such hike since March, when the central bank has desperately wanted to cut rates to shore up poor economic growth performance and boost borrowing. The CBR noted its decision to raise the rate reflects increased risks of ruble’s weakening and higher inflation caused by the international political tensions. The

CBR also referred to domestic fiscal policies, i.e. hikes in tax rates and tariffs that are under preparation in the government for next year. The central bank noted that the reasons for slow economic growth are structural in nature. Growth is restrained by the high rate of capacity utilisation particularly in sectors producing competitive products, near-full employment conditions and slow productivity growth. The CBR further noted that economic growth is depress by the tense international political climate, which increases uncertainty over

entrepreneurial ventures, limits access to long-term financing and depresses investment demand. Under such conditions, the possibilities of monetary policy to promote growth are limited. The CBR’s end-year inflation target range is 6.0–6.5 %. As of mid-July, the central bank estimated 12-month inflation was still running at 7.5 % and economists expect it to rise further on the back of the food import bans.

The rate hike came as surprise to most analysts. They now believe that the main motivation for the CBR’s action was the concern about rising capital exports if the international political situation continues to deteriorate. Analysts also see the CBR’s rate hike as an effort to convey its concern about the possible relaxation of fiscal policy.

EU directs sanctions at core branches of the Russian economy On July 29 the EU decided to implement further sanctions against Russia. The new measures took effect on August 1. The most significant sanctions relate to key parts of the economy, particularly the financial sector and oil

production. EU exports of certain oil exploration technology and drilling equipment to Russia are now banned. The defence sector, which Russia has developed intensively in recent years, is also subject to sanctions. Russia will not be permitted to import weapons systems or dual-use items for military purposes.

The sanctions on the financial sector affect all Russia’s large state-majority banks. While equity and debt issues of these banks are now banned on European markets, the EU still allows Russian banks to take loans with maturities less than three months. The US extended on Tuesday its sanctions agreed upon a few weeks ago and now a total of five state banks are off limits for loans longer than three months. Unlike the EU sanctions, the US sanctions do not target the biggest Russian state bank, Sberbank. Some of Russia’s largest state banks have traditionally played important roles in brokering loans from international capital markets to meet domestic market needs. In the short-term, the constraints on access to financing are unlikely to have serious impacts as banks can still raise funds elsewhere (e.g. Asian markets). However, financing costs for Russia will likely go up in all markets due to Russia’s heightened country risk and poorer prospects for economic growth caused by the sanctions. According to observer estimates, the relatively strong fiscal position of the Russian state and ample sovereign oil funds make it possible for banks to be financed from domestic sources for about a year. As reciprocal sanctions, Russia has so far considered import restrictions on certain foodstuffs from the EU and the US. These goods can be rather quickly replaced with similar imports from elsewhere. The constraints on imports are hoped to provide domestic firms with an opportunity

to increase production. However, higher prices are an obvious consequence of the measure. Production and demand in Russia shrank in June Economy ministry estimates GDP growth in the second quarter was 1.2 % year-on-year, a slight improvement from 0.9 % in the first quarter and a surprise on the upside. Most of the improvement in GDP growth came from industry. However, in June seasonally adjusted industrial production contracted notably, to just slightly above the level of December 2013. In particular, manufacturing growth slowed steeply after a spring recovery (observers have noted that transitory factors boosted growth in spring, such as the advantage conferred on certain industrial branches from the drop of the ruble and sharp growth in defence spending.) Manufacturing was up 2.6 % year-on-year in the first half and 0.3 % year-on-year in June. Growth of seasonally adjusted resource extraction industries remained at zero for three months in a row. In year-on-year terms, output growth in June and for the entire first half came in at slightly below 1 %. Crude oil output increased 1.5 % year-on-year in the first half, while natural gas production declined 2 % year-on-year. Seasonally adjusted retail sales contracted in the last three

months, after a revival in late winter. Back then, people accelerated their purchases as the ruble slid and inflation rose. Although retail sales grew 2.7 % year-on-year in the first half, they were up just 0.7 % year-on-year in June. Households’ real disposable income declined slightly in 1H2014 from 1H2013, e.g. due to their increasing debt servicing. Investments fell almost 3 % year-on-year in the first half on

weakness in the first quarter of the year. June investment, however, was up slightly from a year earlier. Some of this gain can be attributed to the low base of June 2013. Completed housing projects in June, on the other hand, continued at the record pace set in the first half. In terms of floor space, the volume of finished housing was up one third from a year earlier both in the entire first half and June.

Two thirds of Russia's exports are hydrocarbons Russia is a major exporter of crude oil, petroleum products, and natural gas. Sales of these fuels accounted for 68% of Russia's total export revenues in 2013, based on

data from Russia's Federal Customs Service. Russia received almost four times as much revenue from exports of crude oil and petroleum products as from natural gas. Crude oil exports alone were greater in value than the value of all non-oil and natural gas exports.

Bill Proposes 30% Income Tax on Russia's Rich to Fund Crimea Russia could ask its richest citizens to help foot the bill for the annexation of Crimea by paying a "solidarity tax" proposed by a group of lawmakers. Deputies from the State Duma lower house of parliament, which is dominated by backers of President Vladimir Putin, have drawn up a draft law that would increase income tax for people earning more than more than RUB1m ($28,700) a month. It would affect less than 2% of the working population, but taxes for this group would rise considerably: The draft bill proposes that they pay up to 30% of their earnings compared to the current flat rate of 13%.

Russian consumer demand weakens while investment improves The State Statistics Service reported in July that retail sales rose just 0.7% year-on-year in June, bringing the 1H14 tally to 2.7% year-on-year (down from 3.1% year-on-year in 5m14). Household consumption was suppressed by rising spending on consumer debt servicing, accelerating year-on-year inflation and slowing nominal wage growth (up 9.6% year-on-year in June versus 13.0% growth in May). However, the better news was investment rose 0.5% in June, bringing the 1H14 figure to around –1.8% -- still an extremely poor result. But this is an improvement

on the 3.8% year-on-year contraction seen in 5m14. Although these numbers were skewed by strong base effects (rather uneven monthly investment growth last year), investment showed clear signs of improvement and could turn positive by year end.

It looks like the sanctions imposed on some Russian companies and wealthy individuals have encouraged residents of Russia to invest more domestically. Meanwhile, retail sales (and consumption in general) are slowing more quickly than we had expected.

0714_Russia_macro_CA_components

Russia Sanctions Negative, But Ratings Unaffected For Now Fitch Ratings said on July 17 that US sanctions against specific Russian companies are negative, but not an immediate threat to bank and corporate ratings. "The additional sanctions are an indication of the willingness to tighten sanctions and may increase downside risk to growth. We lowered our growth forecast in June for Russia to 0.5% in 2014 and 1.5% in 2015, mainly due to the impact of US and EU sanctions and ruble depreciation. We also revised the Outlook on Russia's 'BBB' sovereign rating to Negative from Stable in March in anticipation of the impact of the sanctions announced that month," the ratings agency said. Russian consumer not a happy The economy entered the summer with the long-awaited convergence between demand and supply, as the abnormal strength in manufacturing output faded, while domestic demand remained lacklustre as consumer spending slowed sharply. On the brighter side, a pick-up in the homebuilding industry underpinned investment and employment indicators in June. This, coupled with a positive contribution from import substitution, is likely to have brought about a milder slowdown in 2Q14 than we initially expected. The outlook for the rest of the year, however, remains challenging.

Retail sales slow to below 1% year-on-year. For the fourth month in a row, real retail sales registered a gradually lower pace of annual growth, and in June it edged down to one of its weakest rates in 50 months, possibly in response to almost stalled consumer loans (excluding mortgages) and lacklustre income data (by the way, May’s strong 5.0% year-on-year gain in real wages growth was substantially revised downward this time). Component-wise, the year-on-year growth in the food component dipped further into the negative area (-1.2%), while a double-digit drop in car sales weighed heavily on the non-food part. For the rest of the year, we see further weakness in consumption and so do not rely on consumer spending as a major driver of economic recovery near future. Robust homebuilding is likely behind the pickup in FAI and employment. Most encouragingly, the June report showed investment struggling out of its five-month contraction, with a 0.5% year-on-year increase that can partly be attributed to the base effect and a pick-up in housing construction. 1Q14 saw a spike in demand for housing and now homebuilders have accelerated the construction of pre-sold apartments. There is little evidence, however, that private companies in the broader economy (i.e. beyond the homebuilding industry) have started to scale up their capex programmes and as demand for housing has started to moderate, its impact on investments is likely to as well. Employment growth has

reaccelerated to 0.7% year-on-year, bringing the SA unemployment rate down a little to 5.1%, which also likely reflects construction-related works as surveys continued to signal labour shedding. Manufacturing strength eventually passed away. In June, IP surprised on the downside, posting a mere 0.4% year-on-year increase after several months of solid gains (2.2% on average in February-May). The main drag was manufacturing, which came to a standstill as the impact from one-off factors ended (particularly, in oil processing) and the fundamentals of softening local

demand and lacklustre export orders took hold. 2Q14 GDP might have remained not far below 0.9% year-on-year. The aggregated April-June monthly statistics imply that the economy continued to slow last quarter but not as sharply as we initially expected due to a positive contribution from import substitution and housing construction. The outlook remains challenging, though. Import substitution and housing construction will probably continue to prop up growth in the near term, but this is unlikely to offset the impact of the persistent slowdown in domestic demand

Incomes in Russia fall 2.9% in June after growing 5.8% in May - Rosstat Real disposable incomes in Russia grew fell 2.9% in June compared with the same month last year after rising 5.8% in May and 1.9% in April, the Federal State Statistics Service (Rosstat) said. Real incomes fell 0.2% in January-June 2014. The nominal wage due to employees averaged up 9.6% to 33,600 rubles in June. The real wage grew 1.5%. Average per capita income was up 5% at 27,500 rubles in nominal terms Russian M&A tumbles to 2009 level amid regional turmoil Proprietary Intelligence Russian M&A during the first half of the year fell to levels last seen in the 2009 financial crisis due to Russia-Ukraine standoff. Overall deal value amounted to EUR 12bn, a 57% drop compared to the same period last year, according to Mergermarket data. The foreign investment stalled as investors sought clarity on sanctions imposed by Western governments. Despite the deal slowdown, M&A could well begin to recover next year should the geopolitical situation stabilise, Steven Hellman, Chief Executive Officer of Russia and the CIS for Credit Suisse said.

Notable deals A distinctive feature of Russian M&A has long been the prevailing dominance of energy, mining and utilities sector. This year it has been responsible for some 62.5% of value - 21 deals worth EUR 7.5bn, according to Mergermarket data. Alliance Group and Independent Petroleum Company’s oil and gas joint venture ranked as Russia’s largest deal in the opening half of the year valued at EUR 1.7bn. Other notable energy transactions include the EUR 728m acquisition of 49% in Yugragazpererabotka by SIBUR Holding and the EUR 727m purchase of Burneftegaz by oil giant Bashneft [MCX: BANE]. Utilities saw three major deals conducted by electric and thermal energy company, Volzhskaya [MCX:VTGK], which totalled EUR 2.47bn. Consolidation in the utilities space is expected to continue amid the prospect of tariff reforms being kicked off in the Duma next year. This should stimulate investors to reposition themselves in the sector. Among the possible deals expected to be announced is Quadra’s sale to a consortium involving Inter RAO [MCX:IRAO] and EdF, as reported. But subdued commodities markets are likely to hinder activity within the mining sector. Large international players and investors remain keen on Russia’s most attractive consumer-focused sectors. These include technology,

e-commerce, food and specialty retail and logistics, according to Hellman. Pharma secured two deals in the top ten. Abbott Laboratories of the US acquired Veropharm [VRPH:RM] for EUR 463m while Pharmstandard and Millhouse bought up Biocad for EUR 513m. The trend is expected to continue into the second half of the year and beyond as foreign pharma groups actively look to acquire in order to conform to the government’s Pharma 2020 programme that urges local manufacturing. Whereas deal value slumped in 1H14, the number of deals did not fall as sharply. Russia saw 110 deals recorded in the first half compared to 135 transactions during the previous six months and 80 versus one year ago. Challenging economic conditions and escalating political tension has caused some Russian firms to accelerate concluding deals and

assets sales, Alexandra Tarannikova, deputy director of corporate ratings at Moscow rating agency, RAEX, said. Modest expectations This year is on course to be the weakest for Russian M&A since 2009. The second half of the year is likely to remain on the same level, a Moscow-based analyst said. “[We] cannot see clear signs, factors or circumstances that could lead to a sharp increase in the scope of M&A activities.” German oil and gas company, RWE Dea’s sale to group of investors led by Russian tycoon Mikhail Fridman, is subject to government approval. Russia's international reserves amounted to $474.3bn, the Bank of Russia informed As of June 27, international reserves amounted to $475.8bn, for a week they shrank by $1.5bn.

Russia's federal budget surplus of 1.9% of GDP in 1H14 Russia's Ministry of Finance reported on July 10 that the federal budget was in surplus by 1.9% of GDP in first half of this year. The seemingly good standing of public finances amid the economic slowdown is due to steadily high oil prices, the depreciation of the ruble and the growth of hydrocarbon exports The figures disclosed by the Ministry of Finance show that revenue of the federal budget for

the period January-June 2014 reached RUB7.120 trillion and expenditures were RUB6.471 trillion. The surplus is RUB649bn, which makes 1.9% of GDP. The surplus as of the end of Q1 2014 was nearly half as high (1.1%). During the first six months of 2014, the budget revenue is executed by 52.5%, expenditures by 46.4%. A year ago, as of the end of the first six months of 2013, the cash execution%age was lower: 48.6% in respect of revenue and 44.4% in respect of expenditures.

Ruble finds support from Russian foreign trade and calming capital flows After losing 5.7 % of its value in the first quarter, the ruble gained 1.6 % in the second quarter. On July 4 one euro bought 46.7 rubles and one dollar 34.2 rubles. As of end-June, the ruble had recovered to its January level relative to the CBR’s dual dollar-euro currency basket, a key indicator used in setting exchange-rate policy.

Ruble strengthening was due to a settling of market reactions to the Ukraine crisis and the tight monetary stance pursued by the CBR. The central bank raised its key rate 2% points during the spring. The ruble should get some support in coming months from stable oil prices and high domestic interest rates. Conditions could shift quickly, however, if e.g. the Ukraine situation flares. Preliminary balance-of-payments figures from the Central Bank of

Russia show revenues from exports of goods and services in the second quarter rose slightly from a year earlier, largely on higher earnings from energy exports. At the same time, however, earnings on other goods exports continued to shrink and earnings on services exports, particularly tourism, went into decline. Russian spending on imports in 2Q2014 was still down from a year earlier. In value terms, goods imports were off 7‒8 % year-on-year. There was no longer growth in spending of Russian travellers abroad. Overall, slightly higher export earnings and lower spending on imports lifted the current account surplus, which for the past four quarters equalled 2.5 % of GDP. With most critical tensions subsiding in the second quarter, capital outflows from Russia and the ruble partly cooled off. While

the flight to foreign-currency cash diminished sharply and the CBR estimated grey capital exports contracted substantially, capital outflows from banks remained large as their foreign debt declined to an exceptional degree. Russian corporate borrowing internationally was minimal. Foreign direct investment flows into Russia and DI outflows from Russia were largely unchanged with outflows continuing to slightly outpace inflows. The current account surplus and calming of capital flows have supported the ruble. The ruble’s nominal exchange rate against its trade-weighted currency basket rose 7 % in the second quarter. Since the ruble’s slide ended, the cost advantage for Russia has narrowed significantly with the ruble’s real effective exchange rate in June just 4 % below early 2013, when it hit its all-time peak.

Unemployment drops to a historic low Unemployment among economically active individuals fell to 4.9% from 5.3% in April. Seasonally adjusted unemployment grew to 5.2% from 5.1% in April. Conditions in the labor market improved in May. The number of vacancies rose by 199,500, to 2.2m by the end of May. In May, there were 48.8 applicants per 100 job vacancies, down from 55.5 applicants in April. We expect unemployment to remain between 5% and 5.5% in the next few months

Russia's households' foreign cash demand falls to $9bn Russian households' demand for foreign currency cash fell 6% on the month and rose 33% on the year to $9bn in May, the central bank said in a statement Thursday. The households' dollar demand fell by 6%, while the euro demand fell 4%. The net demand for foreign cash stood at $3bn, an increase of more than 50% on the month. In Q1 2014, resident individuals continued stepping up withdrawal of funds to foreign countries other than the CIS and transferred $11.2bn, the Bank of Russia reports. This is 7% more than in Q4 2013 and 69% more than a year earlier. The total amount transferred abroad (including the CIS countries and transfers by nonresidents) decreased slightly to $16.72bn from $18.11bn in Q4 2013 ($11.7bn a year earlier). Russian CBR registers $74.6bn net capital outflow in Jan-Jun The Russian central bank preliminary estimated the net capital outflow to amount to $74.6bn in January-June. In April-June, the outflow amounted to $25.8bn. Russia recorded a current account surplus of $17.1bn in 2Q14 (up from $1.8bn in 2Q13) and $44.2bn in 1H14 (up 65% year-on-year on

1H13). The CBR also slightly downgraded its estimate for the 1Q14 current account surplus from $27.6bn to $27.1bn. The trade balance surplus came in at $54.5bn for 2Q14 and $105.2bn for 1H14 (up 15.1% year-on-year). Capital outflows weakened, dropping to $12.3bn in 2Q14 from $62bn in 1Q14 (revised downward from the initial $50.6bn estimate). Thus, $74.4bn left Russia in 1H14 compared to $33.5bn in 1H13. The central bank foresees the net capital outflow to amount to $85-90bn in 2014. Russian foreign trade surplus up 15% to $105bn Jan-Jun Russia's foreign trade surplus grew 15.1% to $105.2bn in January-June, as seen by PRIME in to the central bank's documents on Wednesday. In April-June, the surplus amounted to $54.5bn. Russia's exports in monetary terms amounted to $257.8bn in January-June, while imports stood at $152.6bn. In April-June, exports grew 9.3% on the quarter to $134.6bn and imports rose 10.8% to $80.2bn. Economic Development Minister Alexei Ulyukayev said that Russia's foreign trade surplus will significantly exceed $170bn in 2014.

Russian government may raise personal income tax and VAT starting 2019 Russian government may raise personal income tax and VAT starting 2019 by 2pp each to 15% and 20%, respectively. The tax burden on Russia’s households is a very low 4% of GDP vs. the average 14% of GDP in the OECD. However, low household taxation is part of the social contract established by Putin in 2000 and breaking it could be politically dangerous. Raising personal income tax would require institutional reforms, rendering this move a rather emergency-case scenario for the government. An increase in indirect tax on consumption, such as VAT and the recently proposed sales tax, appears to be a slightly less-painful option. Still, we continue to believe that raising taxes in an environment of very low economic growth remains a rather worst-case scenario for the government in the near term, and tapping the defined contribution pension system as a source of extra financing for the government still

appears to be a more likely scenario. Sales Tax May Counter Soaring Deficit in Regions Facing a rapidly increasing budget deficit in the Russian regions, the Finance Ministry is considering reintroducing a sales tax for the first time in more than a decade. The ministry estimates that the regions' total budget deficit will reach 857bn rubles ($25bn) in 2014 — 33.5% higher than in 2013, Prime reported Sunday, citing data from ITAR-Tass. Nonetheless, the ministry intends to cut that deficit nearly in half by 2017, bringing it down by 26% in 2015, 8% in 2016 and another 21% in 2017 to end at just 455bn rubles ($13bn). In order to accomplish this rapid reversal, the ministry has proposed an unexpected maneuver: allowing the Russian regions to introduce a sales tax.

Infrastructure Russian cheap airline forced to suspend operations due to EU Sanctions Aeroflot announces that its subsidiary airline Dobrolet will

temporarily suspend flights as of 00:00 Moscow time on 4 August 2014 due to economic sanctions imposed by the EU. The airline was launched earlier

this year to provide cheap flights to the holiday-happy Russian population. While cheap operators like EasyJet are already working in Russia, Dobrolet was also supposed to offer cheap flights into the interior of the country where ticket prices are multiple times higher than flying from Moscow to western Europe. Several European counterparties have notified Dobrolet of their refusal to fulfil their Leasing, repair and maintenance services and airplane insurance agreements were annulled, as well as the provision of aeronautical information. Due to the unprecedented pressure that has been applied to Dobrolet by its European counterparties, the carrier has no option but to suspend flights and ticket sales. Air transport solid statistics in June driven by domestic routes RosAvia, Russia’s aviation regulator, published 1H14 passenger traffic data for Russian airlines: passenger turnover (RPK) increased 7.4% YoY to 109.6 bln pkm in 1H14 and 11.1% YoY to 24.3 bln pkm in June. Passenger flow grew 10.8% YoY to 41.5 mln passengers in 1H13 and 13.8% YoY to 9.7 mln passengers in June. The passenger load factor for the industry remained flat at 77.9% in 1H14 compared to the same period last year. Growth driven by domestic routes. In contrast to previous years, the overall growth of passenger turnover is mainly driven by domestic routes (which contributed

65% to the overall RPK of Russian airlines), where passenger turnover grew 13% YoY to 38.2 bln pkm in 1H14 and 17.5% YoY to 8.7 bln pkm in June. The growth on domestic routes was driven by the traffic related to the Crimea. Weakening macro and consumer demand hamper further growth. Nevertheless, despite the strong traffic data for June, we expect growth to decelerate on international routes in 2H14 given the weakening macro and consumer demand. We have a Hold recommendation on Aeroflot ( Government considers partial removal of gas pipeline monopoly from Gazprom The Russian government has until September 1 to consider allowing independent gas producers to sell gas for export, but only from fields in East Siberia and the Far East, according to Vedomosti reporting on the minutes of the meeting on the subject signed by President Vladimir Putin. The netback of gas sold for export (ex-transport costs from the field and export duties) is about $110/mcm higher than the domestic wellhead tariff, we estimate (or over a $1bn gain for every 10 bcm). However, the geographic restriction would mean that the only major company to benefit from this would be Rosneft, which intends to be producing almost 6 bcm of associated gas from the Vankor field within the next one or two years, in addition to 9 bcm

from its jointly controlled Sakhalin-1 project. It may also have associated gas from its East Siberian crude oil properties, including Yurubcheno-Tokhomskoye, Taas- Yuryakh and Kuyumba. That said, for a company of Rosneft’s size (over $30bn EBITDA), the relative gains from higher netbacks from gas would be moderate. Novatek (with $4.4bn expected EBITDA this year) could of course stand to gain much more on a relative basis if export rights are extended just a tad further west to Yamalo- Nenetsk. Then again, we would expect significant resistance from Gazprom, and we note that this is not the first time that proposals to ease the pipeline export monopoly have been floated only to be later squashed. RDIF launches an initiative to set up a joint fund to implement BRICS infrastructure projects Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF), has announced an initiative to form a joint fund to invest in the equity capital of BRICS infrastructure projects while he attends the BRICS summit in Fortaleza. Representatives of leading financial institutions, BRICS sovereign wealth funds and RDIF’s international partners have given their complete support to the initiative. Should the negotiations be successful, the joint fund will become operational by the next BRICS summit which is scheduled

to take place in Ufa (Russia) in 2015. Since its inception in 2011, the RDIF has raised in excess of $12bn in foreign capital by building long-term strategic partnerships with leading sovereign funds and state financial institutions of China, Japan, Korea, Qatar, Kuwait, the UAE, Bahrain, Italy and France. RDIF CEO Kirill Dmitriev led the B20 Taskforce on Investments and Infrastructure as part of Russia’s G20 Presidency. The Taskforce worked closely with a range of partners, including major investment banks, sovereign funds, pension funds, leading global companies, international financial institutions and corporate consultants, to develop a package of proposals to encourage investment and create new jobs. The recommendations formed part of the White Book presented to the Group of Twenty heads of state during the 2013 G20 St Petersburg summit. Kirill Dmitriev, CEO, Russian Direct Investment Fund, commented: “Every BRICS nation has huge potential to develop infrastructure projects, as well as a great need to attract large volumes of equity financing from foreign investors. The establishment of such a fund would do much to address the challenge of insufficient financing for infrastructure projects in BRICS countries, which each present a huge opportunity and experience similar issues in the delivery of infrastructure projects. The exchange of best practice and expertise will enable us to

structure infrastructure projects on both a national and international scale in a way that makes them equally appealing to leading sovereign wealth funds, institutional investors and private investors. Indeed, many such investors have already voiced their support for the idea of establishing a new BRICS infrastructure fund." Russian cargo turnover grows in June Turnover at Russian seaports grew 6.5% year-on-year in 1H14. According to the Association of Trade Sea Ports (ASOP), throughput at Russian ports grew 6.5% year-on-year to 303m tons in 1H14: coal throughput rose 15.3% year-on-year to 57m tons, oil products’ turnover grew 16.5% year-on-year to 63m tons, fertilizers added 18.8% year-on-year to 7m tons, containers increased 7.8% year-on-year to 23m tons, ferrous metals grew 5.1% year-on-year to 12m tons and grain turnover more than tripled. However, oil turnover (the largest type of cargo by tonnage) dropped 7.6% year-on-year to 96m tons. Positive trend continues in June. Turnover kept growing in June (up 6% year-on-year), driven mainly by the solid growth of coal and oil products. The transloading of containers, grain (up from last year’s low base) and fertilizers (as many producers are operating close to full capacity) also supported growth. Neutral for stocks. The results, including those for Novorossiysk

port, where NCSP Group’s (NCSP LI – Buy) main terminals are located, reflected year-on-year growth. We have a Buy recommendation on NCSP and a Hold recommendation on Global Ports (GLPR LI – Hold). Gazprom's Gas Pipeline to China to Cost Up to $70Bn, Kremlin Says The price tag for state-run energy giant Gazprom's forthcoming gas pipeline to China is estimated at between $60bn and $70bn, Kremlin chief of staff Sergei Ivanov said. Once built, the pipeline will transport 39bn cubic meters of gas annually to China for a period of 30 years, raking in a total of $400bn in revenues for Russia and diversifying Russia's gas delivery infrastructure away from Europe, currently Gazprom's key market, under a deal signed by Gazprom head Alexei Miller and his counterpart at the China National Petroleum Corporation in May. Ivanov's estimate exceeds a price quoted previously by Energy Minister Alexander Novak, who said that the pipeline and associated infrastructure would swallow up $55bn in investment, ITAR-Tass reported. China has agreed to pay a $25bn advance to help finance the pipeline, with the remainder to come from state-owned Gazprom.

Korea's DSME will build 9 Yamal LNG tankers for $2.8bn South Korean Daewoo Shipbuilding and Marine Engineering (DSME) has won a $2.8bn tender to build nine liquefied natural gas (LNG) tankers for Yamal LNG project, 60%-owned by Russian independent gas producer Novatek, Bloomberg reported citing its sources on Tuesday. According to the agreement with DSME, Canadian company Teekay in partnership with China Shipping LNG is to supply six Arc7 tankers with deadweight of 170,000 cubic meters for the Yamal LNG project, while each tanker costs $316m, and Japan's Mitsui OSK Lines will buy and operate three of the vessels. Under the project, an LNG plant with an annual capacity of 16.5m tonnes will be built to process resources of the Yuzhno-Tambeiskoye field on the Yamal Peninsula in Russia's north. Firms from Japan, Canada may build $3bn Yamal LNG tankers Japan's Mitsui OSK Lines and Canada's Teekay will sign a $2.8bn agreement to build nine tankers for the Yamal LNG project, 60%-owned by Russian independent gas producer Novatek, on July 8 in South Korea, newspaper TradeWinds reported on Friday. Teekay jointly with China Shipping LNG will build six Arc7 tankers for Yamal LNG, while Mitsui OSK Lines will supply three tankers. South Korea's DSME will also participate

in the deal. Each tanker will cost $316m. Novatek declined to comment. Under the project, an LNG plant with an annual capacity of 16.5m tonnes will be built to process resources of the Yuzhno-Tambeiskoye field on the Yamal Peninsula in Russia's north. Investors spend RUB10.5bn on Russian Highways' projects in 2013 Investors' spending on the projects of Russian Highways, also known as Avtodor, stood at RUB10.5bn in 2013, overshooting the company's investment plan by 42%, as the company launched several road segments ahead of plan, Russian Highways said in a statement. The company also received RUB94.2bn of subsidies from the federal budget. RusHydro, Chinese firm to invest $4-5bn in hydro plants Top Russian hydropower company RusHydro and Chinese corporation PowerChina plan to invest $3.5-5bn in the construction of small hydropower plants in Russia, business daily Vedomosti reported Thursday, quoting an agreement signed by the firms in May. The companies are now in talks to set up a joint fund, a source close to one of the firms. RusHydro may contribute money and design decisions in the joint venture, while PowerChina will probably invest money. The companies plan to finance 70-80% of joint projects

with money from Chinese banks, the source said. Rail Freight volumes declined 2.8% year-on-year in June Mixed dynamics in June. Russian Railways reported 1H14 operating results yesterday. Rail freight turnover grew 6.1% year-on-year to 188bn ton-km in June and 5.6% year-on-year to 1.13 tln ton-km in 1H14. Rail freight volumes declined 2.8% year-on-year to 101m tons in June and 1% year-on-year to 600m tons in 1H14. Fertilizer, grain and liquid cargo volumes keep growing. The operating trend in freight volumes in 1H14 was driven by declining

volumes of thermal coal (down 0.9% year-on-year) and construction materials (down 15.2% year-on-year). Iron ore volumes (down 0.9% year-on-year) dropped as well. The only categories of cargo where freight volumes grew were mineral fertilizers (up 8.4% year-on-year), grains (up 55.4% year-on-year) and liquid cargoes (up 2.6% year-on-year). Volumes decline for five consecutive months. After growing in December and January, rail freight volumes have now declined for five months in a row. We see the update as being neutral for Globaltrans (GLTR LI – Buy), as its freight volumes are guaranteed by longterm contracts, while M&A remains the key value driver.

ECM IPOs offer hope Retail chain Lenta’s London listing hopes in February – the only Russian IPO so far this year – scraped through just before the crisis erupted. Other planned placements, however, were put on hold, including and Russian METRO Cash & Carry, oil company Bashneft, Moscow Credit Bank, and Detskiy Mir - a children's goods retailer. Notwithstanding the poor macroeconomic conditions, some Russian blue chip listings could take place in September, including Bashneft and Russian METRO Cash & Carry, as reported. Recent successful secondary share sale of Russian payment provider QIWI could open the door to further ECM activity. This is, however, subject to a further reduction in geopolitical tensions in the region, he added. The remaining IPO candidates are not expected to float until next year at the earliest. Foreigners slash Russia stock, bond investments Foreign equity and bond investors who had tentatively ventured back into Russia after a huge early-2014 selloff are again slashing their

holdings for fear of being caught in the crossfire of Western sanctions. Russia has fared worst among the big emerging equity markets this year, with dollar-based losses of 13%. The ruble is down 5% against the dollar, second only to the Argentine peso, and investors are demanding a 2.8%age point premium to Treasuries to hold Russian dollar bonds, 80 bps higher than January. However, some funds are buying as relative to expected earnings over the next 12 months they trade at about half the emerging markets average. Many investors see the West as reluctant to hurt their economic interests by cutting off trade and investment ties with Russia. President Vladimir Putin too will seek to avoid conflict that may wreck Russia's economy. And Russian firms need to go back to the international capital markets eventually: Russian corporates must repay $160bn in debt in the next year, while state-owned banks, that the EU is proposing to ban from capital markets, have around $33bn coming due in the next year.

Six Russian firms in world's top return on equity BCG ranking The Boston Consulting Group (BCG) released a new report showing the world leaders by total shareholders return (TSR) growth. The ranking includes six Russian companies, including three of them are leaders in their sectors: Bashneft, AFC Sistema and Magnit BCG assesses public companies based on a number of criteria in order to withdraw the result - the speed of increase in the value of their securities from the view of both current and future return to their shareholders. Until recently, not more than two Russian companies simultaneously have been found in the ranking published since 2009. In the ranking for the year 2009, NLMK ranked 3rd in the ore-mining and iron and steel sector. Not a single Russian company was included in the ranking for the following year. In 2011, X5 Retail Group ranked 5th in retail trade and Aeroflot 7th in the travel and tourism sector. A year later, Russia was represented by one company - NOVATEK which ranked 9th among large-cap companies and 2nd in Oil and Gas. In 2013, Bashneft became the first Russian company to join the top-10 global TSR growth leaders, at No.9, and ranked 2nd in this respect among oil companies. Magnit joined the ranking same year: the company ranked 6th among global retailers. This time, Magnit ranks 1st in its

sector. The same positions are held by Bashneft (in the oil sector) and AFC Sistema (telecommunications). The ranking also includes Sberbank (No.2 in Banking), NOVATEK (No.4 among oil companies), and Severstal (No.6 in Iron and Steel). Magnit is Russia's largest retailer by revenue and one of the most rapidly-growing retailers. In 2013, Magnit's GDRs on the London Exchange rose in price by 65.1%. Magnit top-managers promised to increase the share of net profit allocated for dividends. In 2014, this share will increase nearly by a third to 40%, Sergey Galitsky, the CEO of Magnit, said early this year. It means that dividends may increase three times from RUB5.2bn to RUB14bn. Capitalization of two other Russian companies in the ranking - AFC Sistema and its subsidiary Bashneft - increased 59.3% and 13.7% respectively on the Moscow Exchange in 2013. AFC Sistema increased in price by 70% on the London Exchange in 2013. Aeroflot State may sell part of its stake to 50%+1 State may reduce its stake to 50%+1 share. According to the state privatization plan, the Russian government (Rosimushchestvo) should reduce its stake in Aeroflot (AFLT RX – Hold) from 51.17% to 50% +1 share by 2016. Aeroflot may additionally sell a 4.8% stake that is currently held by its subsidiary Aeroflot-Finance. State-run Rostec, which owns a 3.55% stake, has not

announced that it intends to exit yet. First stage of privatization plan. The privatization plan announced earlier calls for the state to reduce its stake in Aeroflot to 50% +1 sometime in 2014-16. It has not decided yet whether the shares will be sold on the Moscow Exchange or abroad. The state could reduce its stake further going forward without giving up its blocking share, thus maintaining its influence over the company. Clearstream includes Russian stocks in its international settlement system early Clearstream decided not to wait until the Russian law is amended to allow equities to clear through its system and enabled customers to trade Russian shares with all restrictions on the exercise of shareholders' rights as provided in the current version of Russian laws ahead of schedule in July. "Our customers will have to provide notarized and apostilled documents to participate in corporate actions," Oliver Fischmeyer said. Euroclear is also expected to include equities into it system but not until 2015 as previously planned. Russian bond trading was included in the systems of both companies at the start of 2014.

Schwab Capital cuts stakes in Russian power, metals, telecom assets Investment fund Schwab Capital Trust has sold its stakes totaling several millions of dollars in various Russian assets, including power, metals and technological companies, in early 2014 on higher volatility and risks, and lower yields amid geopolitical tensions with Ukraine. The trust's funds sold a $3.7m stake in Internet company Yandex, $1.5m stake in e-payment system Qiwi, $1.3m stake in mobile operator MTS, and $870,000 stake in telecom company Rostelecom; as well as $442,000 and $384,000 stakes in power companies RusHydro and Russian Grids, and $470,000 and $230,000 stakes in metals companies Severstal and Mechel. The funds also sold a $1.3m stake in multi-industry holding AFK Sistema, $459,000 stake in TCS Bank, and $380,000 stake in chemical producer Uralkali; as well as cut its interest in Internet company Mail.Ru Group to $885,000 from $1.1m. As of April 30, Schwab Capital Trust only held shares in gas giant Gazprom, oil companies Lukoil, Surgutneftegas, and Tatneft, preferred shares in oil pipeline monopoly Transneft, as well as shares in top bank Sberbank and metals giant Norilsk Nickel, aside from a stake in Mail.Ru Group. The combined amount of the stakes was around $47m.

Blackrock funds cuts Russian investments 65% in Feb-Apr The combined investments in Russian stocks of three Blackrock Group's funds fell 65% in February-April due to a lower stocks value and sales of stakes in largest lender Sberbank, Internet company Yandex, and oil major Lukoil by some of the funds, according to the group's data seen by PRIME on Wednesday. Blackrock Global Allocation Fund cut its stake in Sberbank to 5.9m, or 2.9m papers, from $52.0m, or 18.7m papers, while Blackrock Emerging Markets Fund fully sold its $12.6m stake in the bank. Blackrock Master Fund kept its $13.4m stake (6.5m papers) in Sberbank unchanged, but sold an $18.0m stake in Yandex and $17.7m stake in Lukoil in the period. Russia's Runa Capital to form second $200m fund Russia's Runa Capital company, which controls the venture fund of the same name, is establishing a second, $200m fund Runa Capital II in July. The fund will be established within 18 months, its capital will be formed in the E.U., the and Russia. The fund will be controlled by Dmitry Chikhachyov, Sergei Belousov, Ilya Zubarev, Andrei Bliznyuk and a venture partner in the U.S.

Russia's Pension Fund budget may reach RUB8.5 trillion in 2017 The budget of Russia's Pension Fund may amount to 8.5 trillion rubles in 2017, Labor and Social Protection Minister Maxim Topilin told reporters on Thursday. "At the moment we suppose it (the Pension Fund's budget) at around 7.4 trillion rubles in 2015 and 8.5 trillion rubles in 2017," Topilin said, adding that these figures are yet to be specified and agreed. He also expects the fund's budget to hold around 130bn rubles by the end of 2014. Prime Minister Dmitry Medvedev said earlier on Thursday that the fund's spending will amount to 7.5 trillion rubles in 2015, while its revenue will amount to 7.4 trillion rubles, thus leading to a 100bn ruble deficit. By 2018, pensions in Russia will be indexed by around 36% on average compared to their level in 2013, Topilin said, citing the ministry's estimates. Russian shares make strong recovery in second quarter The drop in the Moscow stock exchange’s RTS index ended in May as the market uncertainty caused by the Ukraine crisis settled. By the end of June, the RTS index was up 30 % from its March low. The RTS is currently down just over 5 % for the year.

DCM Sanctions Push Foreign Lending to Russian Companies to 5-Year Low Foreign banks have cut lending to Russian commodities producers to their lowest level in five years as the effects of international sanctions imposed on Russia over the Ukraine crisis begin to bite. Global borrowing by raw materials producers fell 2% to $344.2bn in the first half of 2014, but in Russia the situation is considerably bleaker. The first six

months of the year saw syndicated loans for Russian commodities producers plummet 82% to $3.5bn compared to the same period in 2013, according to data compiled by Bloomberg. Last month's decision by HSBC and Lloyds to withdraw from a $1.5bn to $2bn trade finance deal between BP and Rosneft, Russia's largest oil producer, was just one example of Western banks' growing reluctance to fund Russian deals.

The deal for Rosneft to supply BP with up to 12m tons of refined oil products over five years still went ahead that month, as the company managed to raise the cash in a prepayment deal arranged by leading global financial institutions, but Rosneft was still forced to lower its sights from the $5bn it initially hoped to snap up. Rosneft's CEO, Igor Sechin, was blacklisted by the over the annexation of Crimea in March, though the company itself was not targeted. "It may not be that you are worried about the ability to repay the debt from cash flows, but if there are sanctions in place, in that environment, you just don't want to go there," David Basra, head of financing for Europe, Middle East and Africa at Citigroup in London, told Bloomberg last month. The threat of sector-wide economic sanctions from Washington and Brussels complicates matters further. Unidentified European Union officials said last week that the bloc has discussed freezing funding for new projects in Russia from the European Bank for Reconstruction and Development, from which Russia received $2.45bn last year, and the European Investment Bank. The return of yields on Russia's April 2020 bonds to pre-crisis levels, and the sale of euro-denominated bonds last month by state-owned Gazprombank and Sberbank offer some hope that

lending may get back on track, however. "A few months of no bad news out of Ukraine will allow people to go back to business as usual," Bloomberg quoted Daniel Seregin, ABN Amro's head of energy commodities for Commonwealth of the Independent States and West Africa, as saying. Russia's state debt to reach 15% of GDP by 2017 Russia's state debt will grow to 15% of the gross domestic product (GDP) by 2017 from 12% in 2013, Finance Minister Anton Siluanov said. At the same time the domestic debt is rising. Russia's domestic debt in ruble-denominated securities widened by RUB32.47bn in June to RUB4.496 trillion rubles as of July 1. The volume of OFZ-PD fixed-rate government bonds grew to RUB2.655 trillion. The volume of OFZ-AD bonds with sinking fund provisions remained flat at slightly over 1 trillion rubles. The volume of GSO-PPS savings bonds with a fixed coupon rate remained at 575.55bn rubles. The volume of GSO-FPS savings bonds with a fixed coupon rate was flat at 132bn rubles. Russia's external debt up $5.1bn in 2Q14 In Q2 2014 Russia's external debt grew by $5.1bn to $720.9bn following decline in Q1 by $13bn,

the Bank of Russia reported For six months debt burden decreased by $7.9bn from $728.9bn. Debt of the non-banking sectors for Q2 grew by $10.9bn to $443.7bn following some reduction in Q1 by $3.9bn. In Q2 banks reduced their debt by $7.5bn to $206.5bn after some reduction in Q1 by $0.4bn. Debt of the state run public authorities in Q2 raised by $1bn to $54.6bn. However, Russia's foreign debt falls 1% to $720.9 bln in Jan-Jun Russia's foreign debt decreased by 1% to U.S. $720.9 billion, as seen by PRIME in the central bank's materials on Thursday. State foreign debt decreased 11.5% to $54.6 billion as of July 1. Russian corporate foreign debt down $1bn in 1H14 The CBR yesterday provided data for 2Q14 foreign debt dynamics and revised its estimates for 1Q14. While corporate foreign debt was initially expected to grow by $4bn in 1Q14, the new estimate suggests that it actually dropped by $4bn, posting a very slight $3bn increase in 2Q14. The resulting decline in corporate foreign debt by $1bn in 1H14 (vs. $66bn growth in 1H13) represents the new reality of closed external markets for Russian borrowers. The inability to attract new debt explains half of the acceleration of net capital outflows from $34bn in 1H13 to $74bn in 1H14. Over the last five years, corporate foreign debt has grown on average around $40bn pa, which has been a factor limiting

net capital outflows. We anticipate that Russia will have to make do without the support of this factor for at least the next two quarters, which supports our expectations of strong $120bn net capital outflows this year. First Russian domestic bond defaults as pressure mounts A default season has started on the Russian public debt market: three issuers at a time are in a risk zone. Participants of the market are sure that the situation will affect financial institutions in the first place, although companies from the real sector will face problems with bond interest payments RTC-Leasing is the first company to fail to perform its put option obligations. On June 11, the issuer refused to buy back bonds worth RUB0.9bn and found itself in a technical default. Ten business days later, on June 27, the default was actually declared real. On June 17, Mordovcement Company failed to buy back bonds worth RUB1bn. However, the company managed to settle with holders of its bonds a day before a real default would occur. Bor, a mining and chemical company, is the third one on the list. On June 26, the company failed to pay the first coupon yield to the amount of RUB199.4m on a five-year issue of bonds worth RUB4bn. As of July 8, the company did not perform its obligations. Rising interest rates on the money market as well as rising rates on loans and bonds decrease profitability and credit quality of Russian companies even more.

Not the best representatives of the third tier are in a risk zone. However, almost all minor companies left the public debt market as far back as in 2008. Those who placed bonds usually came to an agreement with banks directly, and the latter placed bonds and purchased the issue for themselves. This was some form of lending, but it enabled a bank to resell such a high-yield debt in case of a change in the market environment instead of keeping it on the balance sheet. The situation became more complicated in response to the escalation of geopolitical risks worldwide. The demand for bonds of unreliable borrowers dropped for keeps. Investors offer all the bonds outstanding on the market for early redemption nearly in full. In fact, only those issuers who agreed with main holders of bonds manage with a put option. Russian banks may have fewer market collateral Russian banks' problems with the lack of market collaterals for central bank credits may worsen, the central bank said in July. According to the report, in January-March, banks issued fewer bonds but bought back more issues under offers. It becomes a pressing issue, taking into account that credit organizations raised the share of loans taken from the central bank in their liabilities structure to 8.4% on May 1, 2014 from 5.8% as of

October 1, as other sources growth has slowed down. Commercial banks may only lose up to 0.4%age points of capital adequacy and they will remain sustainable even if the stock market becomes as volatile and if it falls as much as it did in January-March. Russia's state debt to reach 15% of GDP by 2017 Russia's state debt will grow to 15% of the gross domestic product (GDP) by 2017 from 12% in 2013, Finance Minister Anton Siluanov told reporters in July. "This is a significant increase of the debt for our economy and finances. It is unacceptable when the debt growth is high, after all we depend on oil and gas. And any changes of the external markets sharply raise foreign part of (our) debt, and lead to trubles with its servicing," Siluanov said. The ministry has also proposed lifting the limits on payroll tax contributions to the obligatory healthcare system to be able to charge a 5.1% tax regardless of the size of wages. RusAl Freezes Loan Payments Struggling aluminum giant RusAl has agreed with its creditors to extend a period of forbearance on debts of more than $5bn until November, Interfax reported Wednesday, citing a company statement.

The company will freeze repayments on two loans — a $4.75bn pre-export financing loan and a another $400m loan. The previous freeze on loan repayments was to expire on July 7. Citing a source familiar with the situation, Reuters reported Tuesday that all the company's

creditors save one — the Royal Bank of Scotland — had agreed to a debt restructuring deal. The company has suffered heavy losses due to an extended drop in aluminum prices, which have only recently started to recover from 4 1/2 year lows.

Sectors Russia's gas exports soar 80% to 3.149 bcm in June Russia's gas exports to CIS countries soared 80% on the year to 3.149bn cubic meters in June, CDU-TEK, an agency that provides data and analysis to the Energy Ministry, said in July. Non-CIS exports remained flat on 10bn cubic meters in the period. In January-June, gas exports rose 9.2% on the year to 104.894bn cubic meters, while exports to CIS countries rose by 6.3% to 70.71bn cubic meters in the reporting period and non-CIS exports increased 20% to 26.707bn cubic meters. Liquefied natural gas exports grew 2.3% to 1.036bn cubic meters, while in January-June it rose by 1.8% on the year to 7.47bn cubic meters.

Russia's high-end food retailer Azbuka Vkusa may raise sales 50% in 2014 Russian premium food retailer Azbuka Vkusa plans to increase its sales by around 50% to 45bn-50bn rubles in the 2014 financial year, an official representative Andrei Golubkov said in July. Golubkov attributed the forecast mainly to launches of stores of new kinds, and acquisitions of Spar-branded stores in June. Azbuka Vkusa launched an AV Daily convenience store chain this year, by opening two outlets in Moscow, and plans to expand it to 150 stores within five years. The retailer will also launch a chain of AV Market gourmet supermarkets for families by opening 10 stores by the end of this year. In the 2013 financial year, ended on March 31, the company's sales amounted to RUB32.5bn.

LCV, MCV sales of Russia's GAZ Group fall 28% to 32,991 units H1 Sales of light commercial vehicles (LCVs) and medium commercial vehicles (MCV) produced by Russia's GAZ Group fell 28% to 32,991 units in January-June, according to the group's presentation released with an expert committee of Russian parliament's lower house. LCV sales fell 30% to 27,100 units in the period and MCV sales went down 20% to 5,900 units. GAZ Group expects the domestic LCV market to fall 31% to 111,900 units in 2014. This market decreased 16% to 47,300 LCVs in January-June, the group estimated. Russian car maker GAZ will lay off workers if sales continue falling, as its 5bn cost cutting program is exhausted, Vice President Yelena Matveyeva said in a presentation to the State Duma, the parliament's lower house. The company said that the Ukrainian crisis, the introduction of a utilization fee on Russian machines in Belarus, and stagnation in Russia hit its sales strongly. The company's January-June LCV sales dropped 30% to 27,100 cars while MCV sales fell 20% to 5,900 units in the period. GAZ forecasts that the Russian LCV market will decrease by 31% to 111,900 cars in 2014 after shrinking 16% to 47,300 cars in January-June.

Russia's car imports fall 6% to $56.3bn in Jan-May Russian car imports fell 6% on the year to $56.3bn in January-May, the Federal Customs Service said in a statement in July. Imports from countries outside the CIS amounted to $52.7bn, and imports from CIS countries were at $3.6m, which is a 3% and 36% decrease respectively. Russia car exports fell 10.5% on the year to $9.4bn in January-May, including $5.4bn of non-CIS exports and $4.0bn of CIS exports. Renault H1 Sales Rise Despite Weaker Russian Market Renault's first-half vehicle sales rose 4.7%, as a European rebound offset a slump in emerging-market demand, reversing the carmaker's recent market trends. Renault's global sales increased to 1.37m vehicles, the company said Monday, boosted by the success of its new Clio small car and compact crossovers in its wider home region even as France lagged. Russia, Renault's second-biggest market a year ago, dropped to third place in the first half of 2014. Argentina fell from fifth to eighth place, Algeria from sixth to eleventh and Turkey from seventh to ninth. Sales increased 18% in Europe and dropped 9% in the rest of the world, Renault said, with its no-

frills Dacia division becoming Europe's fastest-growing brand. Investments in Russia's real estate slump 59% in Jan-Jun Investment in the Russian real estate has dropped 59% on the year to $1.4bn in January-June, analysts from Jones Lang laSalle said in July. Economic slowdown, the exchange rate volatility, growing tensions with Ukraine together with international sanctions against Russia were the main reasons behind the market participants' worries, Tom Mundy, the company's head of research, said. In April-June, investment fell 36% to $842m, and plummeted 73% to $545m in January-March. The hotel and office segments were investors' priority in the period with 37% and 24% of the investment in January-June. Housing Market Cools as Russians Stop Panic Buying The buying frenzy that swept over the housing market in the first few months of the year has ended, with June by some accounts showing the least action yet in 2014. In terms of demand and the number of advance payments and deals, "June was the worst month of the year, falling about 10% compared to last June," said Sergei Shloma, head of the secondary housing department at real estate firm Inkom, in a

statement on the company's website. As the ruble exchange rate nosedived more than 10% against the dollar over the first three months of the year, many well-to-do Russians hastened to pour their capital into the most tangible asset they could find: real estate. The total number of property transactions rose 20% in Moscow in January and February as compared to the same period in 2013, realty firm Est-a-Tet estimated. With that early surge in demand now spent, the market is receding once again, further depressed by a typical summer buying lull. The early wave "washed those buyers who in other circumstances would be closing deals now out of the market," Shloma said. Russia's potash fertilizer exports soar 56% in Jan-May Russia's potash fertilizer exports went up 56.4% on the year to 4.127m tonnes in January-May, amounting to $1bn, an 11.5% increase, the Federal Customs Service said in a statement in July. Nitrogen fertilizer exports rose 8.2% to 5.08m tonnes and were worth $1.38bn, an 8.3% decrease. Exports of compound fertilizers fell 13.5 % to 3.5m tonnes and were worth $1.267bn, a 26% drop.

Anticipating a Strong 2Q14 for Russia's leading retailers Russia’s listed retailers will start to report 2Q14 operating results from July 9. With the exception of O’Key and M.Video, we expect a strong set of numbers that could trigger earnings revisions. The leading food retailers are investing in prices amid high food inflation, which should see LFL bounce in 2Q14. The companies’ forecasts are based on 5% inflation (versus the current rate of 9%), but they may wait until September before formally upgrading. We suggest buying X5 Retail Group and Magnit ahead of the numbers. In this report, we offer our views on the 2Q14 results (linked to the results of a consumer survey) and compare our forecasts with management guidance and the market consensus. • Magnit (June revenues July 9, unaudited 2Q14 IFRS results July 23-25). Revenues were up 30% year-on-year in April-May, and we expect 31% growth in June thanks to aggressive promos. We project 12% LFL growth (up from 7.5% in 1Q14) with a 3% traffic gain. This should bring 1H14 revenues to R348bn, up 28%, which would imply upside to the company’s full-year forecast of 22-24%, so earnings upgrades are likely to follow. However, LFL growth may start to ebb in 3Q14 as promotions come to an end. • X5 Retail Group (2Q14 revenues July 11). Sales expanded 14% in 1Q14 (and just 12% in 4Q13), but

we expect it to pick up to 15% in 2Q14, driven by better traffic and emerging ticket improvements due to ongoing assortment changes. We see discounters as the primary driver (20% sales growth in 2Q14 despite comparable promos Q-o-Q). Anticipated group sales growth of 14% for 1H14 would be above the full-year guidance of 10-12%. • Dixy Group (June revenues July 23-25). We expect revenue growth to ease to 24% in June (after a bumper 27% in May). For 2Q14, we see 25% growth (22% for 1H14), well ahead of the 15-20% guidance for 2014. • Lenta (2Q14 revenues July 15). In 4Q13, Lenta recorded its best ever quarter in terms of store openings, with 14 new hypermarkets and selling space up 22% Q-o- Q. Those new stores are maturing, which should boost the top line. Alongside traffic attracted from competitors, this should see 39% revenue growth in 2Q14 with 14% LFL growth. The market consensus of 34% revenue growth for the full year therefore looks rather conservative. • O’Key (2Q14 revenues July 10-11). We expect O’Key to lag, with top-line growth of 12.5% in 2Q14 on less competitive prices, focus on a more upscale offering and modest store openings. This should come as no surprise given the company recently downgraded its full-year revenue growth guidance to 12-16%. • M.Video (2Q14 revenues July 17). A worse macro backdrop and slowing consumer electronics

market should weigh on 2Q14 performance. We project 7.0% revenue growth on increased selling space, which is to be maintained throughout the year, unless the macroeconomic backdrop proves to be more benign than we currently assume. Fight breaks out between Rosneft and Gazprom over access to pipelines Rosneft has filed a lawsuit against Sakhalin Energy (with Gazprom being the majority shareholder) in which it demands access to the Sakhalin-2 gas pipeline, RIA Novosti reports in July. The first Russian liquefied natural gas (LNG) plant was commissioned as part of the Sakhalin-2 project in 2009, and began deliveries of Russian LNG to international customers. According to the court registry, Sakhalin Region Commercial Court registered the lawsuit on July 7. The claim was filed against Sakhalin Energy Investment Company Ltd, the main operator of Sakhalin-2 project. Gazprom holds a 50% plus one share stake in Sakhalin Energy, with Royal Dutch Shell 27,5% minus one share and Mitsui and Mitsubishi owning a 12,5% stake and 10% respectively. Currently , there is only one liquefied natural gas refinery operating in the Sakhalin Region, with Gazprom looking to expand it. Rosneft is developing its own refinery jointly with ExxonMobil,

and has requested access to the Sakhalin-2 pipelines for cost reduction. Beer Ads Return to Russian Stadiums, Television for World Cup Beer ads may soon reappear in Russian stadiums, print media and television — but only through the end of 2018, the year Russia hosts the FIFA World Cup, according to a bill recently approved by the State Duma. Proposed with an eye toward increasing regions' funding for sports events, the amendment, which passed its second and third readings on Friday, temporarily reverses a series of restrictions that were imposed in summer 2012 as part of a wide-ranging ban on alcohol advertising. Part of a campaign to reduce alcoholism in Russia, the ban prohibited alcohol advertising on television, radio, the Internet, public transport and billboards, as well as in stadiums and within 100 meters of sports facilities. An additional ban on advertising alcohol in print media went into force on Jan. 1, 2013, eliciting fierce opposition from media outlets who had previously counted on alcohol ads for up to 20% of their revenues. Russia to build a record-breaking skyscraper Moscow's Moscow-City business district just was not record-breaking enough for the city

authorities, apparently. But an extra two stories may just do the trick. The East Tower, one of two skyscrapers in the Federation complex, was already set to become the tallest building in Europe at 360 meters and 93 floors. But with a new design recently approved by the Moscow government, the tower will now be 13.2 meters taller, the city's committee for pricing policy in construction and state project inspections said last week in an online statement. The tower's floor space will also increase from 213,000 to 218,000 square meters, the statement said. Moscow-City already boasts the tallest skyscraper in Europe in the form of the 338.8-meter tall Mercury City Tower. The next tallest building in Europe is the Shard in London, which will be bumped down to third place once East Tower reaches its full height in the autumn of this year. East Tower is expected to open for use by the end of 2015. Arms Exports Thrive Amid Military Revamp President Vladimir Putin announced in July that Russian arms exports continue to flourish, with $5.6bn worth of weapons and military hardware having been sold in the first half of 2014, while its portfolio of export orders have expanded by $15bn. Moscow's plans to expand its presence on the global arms

market come at a time when the modernization of Russia's military and industrial production base is high on the agenda. The need for boosting domestic arms production has been highlighted by events in Ukraine, where Russian defense contractors are deeply integrated with large firms like Yuzhmash, which makes thousands of military components for the Russian defense sector. Though Russia's arms exports did not eclipse the total for the first six months of 2013, when more than $6bn worth of arms were sold, this year's sum of $5.6bn is still represents a success. Furthermore, orders worth $35bn for Russian-made weapons systems had been placed by the beginning of 2014, but six months later the figure sits at $50bn. Russia's AvtoVAZ to raise car parts localization to 90% Russian car manufacturer AvtoVAZ will raise the level of localization to 90% of all produced car components from 84%, CEO Bo Andersson told reporters in July. "The general localization is 84% for the whole Lada model range. Localization for Lada Largus amounts to 51%, for Chevrolet Niva stands at 95%, and for Kalina amounts to 85%," Andersson said. Largus provides the company with the most of opportunities, Andersson said, adding that localization of car components production for Largus reached 61% as the company started using batteries and wheels produced in

Russia. Andersson also said that "higher localization of production is the main trend for him." Russian mobile customer overdue payments growing Non-paymets to Big Three jumped 27% year-on-year ... The total volume of missed payments by customers to Russian telecom providers increased RUB4.2bn ($120m) year-on-year to RUB26.6bn ($782m) as of 1 July, 2014. The bulk of this (RUB22bn, $647m) was related to customers of the Big Three, which contributed RUB4.7bn ($140m) year-on-year to overdue payments. ... due to increased volumes of mobile services. The growing volume of overdue payments at the Big Three is likely due to the growing usage of modern services, i.e. mobile data especially under roaming. Taking into account that most of the Big Three’s customers are pre-paid it is likely that the bulk of missed payments are by users with contracts. Still acceptable level of missed payments. Despite noticeable growth, the total volume of overdue-payments by Big Three customers is still at only around 3% of the Big Three’s total annual revenues, which is not worrisome as at least part of the payments can be recovered. Nevertheless, all Russian mobile operators – MegaFon (MFON Li – Hold), MTS (MBT US – Hold) and Vimpel- Com (VIP US – Hold) – are trading close to fair valuations and we reiterate our neutral view on the sector.

Russia to become third largest wheat exporter by 2023 Russia will become the third largest wheat exporter after the and Canada by 2023, with its exports increasing by 6% since 2014 to 22m tonnes by 2023, according to a report of the U.N. Food and Agriculture Organization (FAO) said in July. The wheat exports will slightly fall to 28.0m tonnes by 2023 and the Canadian ones will amount to 22.3m tonnes, according the report. Russian luxury good market shrink for first time since 2009 The Russian market of luxury goods will shrink in 2014 for the first time since the crisis year 2009. The market will be affected by the weakness of the Russian economy for a few years, said Armando Branchini, the President of Altagamma, the Italian foundation representing the largest luxury companies and brands. An improvement may be seen in 2017 when the market feels an effect of Russia's accession to the WTO and of an expected decrease in duties on jewelry, fabrics, etc. Russia's luxury goods market is the world's tenth largest and Europe's fifth largest one, according to Altagamma. The turnover in 2013 reached EUR 5.8bn (up by 5% compared to 2012). Analysts forecast a decline in the turnover by 4-6% in 2014. The figures are comparable with the fall in the crisis year 2009

when the luxury goods market dropped 5%. According to Bain, the turnover was EUR 4.5bn. The consumption of luxury goods in Russia had been recovering since then. Moscow accounts for 59% of the market, St. Petersburg for 16%, according to Altagamma. The consumption on the Russian luxury goods market started to slow down late 2013 and gathered momentum early 2014 after a jump in the dollar and EUR exchange rates, sellers of luxury goods said. According to Esper Group, comparable sales of luxury goods increased 6.3% between January and March 2014 year on year. The growth rate typical for this season is twice as high.