comparative analysis of the issuance of government bonds in the uk and russia

8/14/2019 Comparative Analysis of the Issuance of Government Bonds in the UK and Russia

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Comparative analysis of the issuance of government bonds in the UKand Russia.

INTRODUCTION

Bonds and Government gilts: Determinants of bond movements and prices Economic factors Mature markets: the UK

UNITED KINGDOM

Summary on government bonds performance:

Market correction by unexpected move from MPC Performance of long dated bonds Best value fixed income instrument

Recent issuance into the market In the news

UK ECONOMIC FORECAST

Economic policy outlook Fiscal policy Monetary Forecast Economic Structure Inflation Investment rises strongly in the third quarter of 2006

Employment, wages and pricesFinancial indicators

RUSSIA

Emerging markets debt volatility Sectors that are looking to outperform High income Outlook Risk elements, concerns. Fitch Ratings analysis on Russia in 2007

Russia Economic policy outlook

Policy trendsFiscal policyMonetary PolicyInflationExchange ratesExternal sector

Economic policy and structural changes

Gas market liberalisation is subject to disagreements

Tax reform proposals for VAT and UST are in preparation Major state banks will be partly privatised

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New regulations give foreign investors in banks equal rightsDividends to be free from tax

Monetary policy framework remains driven by oil prices Rosneft set to complete the renationalisation of Yukos

The domestic economy

Output and demand Consumer spending boosts construction and retail sector Consumer price inflation eases somewhat

Sectoral Trends

Oil and gas output rise but Gazprom continues to falte. Bank profits rise as banks consolidate New IPO regulations are being considered

CONCLUSION

APPENDIX

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INTRODUCTION

The following report looks to investigate and compare the advantages anddisadvantage of either UK government bonds and Russian government bonds. Inorder to analyse this we first have to consider the factors that affect the bond markets

such as inflation and interest rates, as well as the structure of each individualeconomy. As well as their ability to honor payments on the bonds issued. Sinceinternational capital markets are freely mobile, the attractions for a specific security isaffected by the conditions around the rest of the emerging markets.

Bonds and Government gilts:

Conventional gilts are the simplest form of government bond and constitute thelargest share of liabilities in the Government's portfolio. A conventional gilt is aliability of the Government which guarantees to pay the holder of the gilt a fixed cash

payment (coupon/ interest) every period, (6-12 months) until the maturity date. Themain benefit of these investments is that you normally get a regular stable income.

They are not generally designed to provide capital growth. Bonds have a nominalvalue. This is the sum that will be returned to investors when the bond matures at theend of its term.

Determinants of bond movements and prices

Several factors affect the movements in price of bonds. The differences in yield ofcorporate and treasury bonds are not caused by economic forces, but rather bydifferent characteristics that cause differences in the risk premiums.

They are separated into 4 different components:1. The credit quality of the issue as determined by the risk of default relative to otherbonds. A quick glance at the financial papers reveals that UK gilts are classed with anAAA grade were as an emerging market such as Russia is classed under BBB+, Thisindicates in part the confidence that rating agencies, such as Fitch, have in the abilityof each government to honor their debt obligations. They use a number of factors tohelp determine this such as the structure of the economy, political stability, growthand monetary policy. Its important to note that risk premiums between bonds ofdifferent quality change over time depending on the prevailing economic conditions.During a recession or a period of economic uncertainty there is an increased demandfor quality bonds, thus investors bid up the price of high rated bonds which reducestheir yields.

2. The term to maturity of the issue, which can affect yield and price volatility. SinceBond prices move inversely to bond yields (interest rates) and for a given change inyields (interest rates), longer-maturity bonds post larger price changes; thus, bond

price volatility is directly related to term to maturity. Also price volatility (percentageof price change) increases at a diminishing rate as term to maturity increases. Forinstance, the UK interest rates rise in January, the prices of short term bonds fell,creating an opportunity to cash out on short term maturity bonds thus making themlook cheap. Now this has a knock on effect on long term maturity issues as capitalmoves away from these securities in search of higher profits due to the change in

price and yield.

Price movements resulting from equal absolute increases or decreases in yield are not

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symmetrical. A decrease in yield raises bond prices by more than an increase in yieldof the same amount lowers prices. Higher coupon issues show smaller percentage

price fluctuation for a given change in yield; thus bond price volatility is inverselyrelated to coupon (interest rates).

Foreign bond risk including exchange rate risk and country risk, these are importantcomponents of foreign bonds.

Note also that indenture provisions indicate the collateral pledge for a bond, its call-ability and the sinking fund provisions. Collateral gives insurance to the investor if theissuer defaults on the bond, because the investor has a specific claim on the assets incase of liquidation.

Economic factors

Government monetary policy have a significant impact on the supply of money. Thedemand for loan-able funds is determined by the capital and operating needs of thegovernment, corporations and institutions. Federal budget deficits increase the

treasurys demand for loan-able funds, like wise the level of consumer demand forfunds to purchase houses, autos, and appliances affect rates as does corporate demandfor funds to pursue investment opportunities.

Mature markets: the UK

The US, UK, Germany et al, seem to have the safest investments money can buy sincetheir governments are amongst the most credit worthy borrowers, as such the

premiums they offer are not as high or lucrative as those of emerging markets who aretrying to attract capital to fund their growth. These emerging markets pay a premiumas a result of the quality ratings given to a country, which not only depends on theirability to payback but also the opportunity cost of investing in a safer and more stableenvironment. For instance the issuance of a 30 year Russian government bonds wereexpected to meet 7% coupon where as UK bonds only average about 4.5-5%.

UNITED KINGDOM

Summary on government bonds performance:

Government bonds in the UK Last year you had two-year UK yields rise by about 1.3per cent which is a fairly substantial move. In fact it retraced all of the move thathappened in 2005. But if you look at the longer end you get a very different story. 30-year guild yields almost didn't move - they started the year at 4.05 and end of the year

just under 4.30. So in terms of net change it was mostly the yield curve that changed

in shape rather than big volatility across all maturities. By looking at forwardvolatility, that is at 15 year lows, the market is now that the MPC have adjusted ratesup and that there will be fairly little moves from here onwards and we think that might

be wrong. If you look at an extended time horizon of two or three years we feel thatwe might have to retrace quite a bit of the hikes we've had so far.

Have markets been correct in the pricing in of rate move expectations?

the UK market is the odd one out because it didn't get the hikes of 2006 and early '07right. In fact the market was wrong at the beginning of '06 expecting a rate cut by theMPC. It was mid year, when in August the MPC hiked and surprised the market then.

And it was wrong in January, in not expecting a further hike.The interesting thing is that now the market is discounting that the MPC will have to

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go probably twice again to control inflation. And that might also be wrong because ifyou look at current levels, if the MPC hikes again we will be at 5.5 per cent. The trendgrowth of the UK GDP on nominal basis has been just around 5 per cent. So we'regetting to the point where interest rates are above nominal growth and that's whenusually they start to bite in the real economy and cause some slowdown in housing

first and then in retail spending and in employment markets. So our sense is themarket has been wrong but could be surprised also going forward by extending whatthe MPC has done into the future.

Can long-dated bonds maintain the good performance from last year?

for long-dated bonds yields meant that they didn't rise. So we define a goodperformance here as having been stable where the rest of the yield curve moved up. Ithink they were stable because there is a pretty large appetite for long-dated interestrate risk from pension funds which, on the other side of the balance sheet have long-dated liabilities.What is interesting going forward is that the cost of doing that has increased

noticeably. So whereas you can buy 30-year gilt at just above of 4 per cent you canbuy a 5-year gilt close to 5.5 per cent. So the opportunity cost has increased a lot andtherefore to some extent you might still see 30 year yields be relatively stable but youmight do better in some other area of the curve, particularly five year and shorter.

Which fixed income instruments do you feel are offering the best value at the

moment?

In terms of maturity, instruments that are around five years. That gives you exposureto a period where interest rates could possibly peak and then start declining. I wouldavoid in general, corporates in so far as not enough risk is priced in, in terms of areversal of current liquidity conditions and possibly a slowdown in the economy. The

paper that we would favour would probably be bank debt. Today you can buy topbank, tier one, debt at 6 per cent and above which is a very sensible yield, if you thinkthat the target inflation rate of the MPC is about 2 per cent that gives you a net realyield of 4 per cent which is, in the current circumstances, probably a pretty optimalinvestment

Recent new issuance into the marketthe very odd shape of the yield curve, where long-dated yields are so low, is giving agreat opportunity for the government to borrow at cheap levels. Essentially the

pension fund market, by buying long-dated yields is subsidising the cost of funding

for the government. And so we're likely to see the issuance concentrated in very longmaturities; 30, 40 and 50 years. So that in fact the real yields that they lock in are verylow.

In the News

UK gilts were affected by strong house price data. In the latest reports UK giltssuffered in spite of the UKs PMI also dropping, with a reading for December of 51.9against 52.6 a month earlier. The pressure on gilts came late on from Land Registrydata that showed UK house prices had risen at the fastest annual pace since mid-2005in November, growing 6.8 per cent. The news helped strengthen the belief that UKinterest rates will rise, which they did. Two-year gilt yields were higher at 5.189 per

cent, meaning they have risen by 106bp since the opening day of 2006, the largestannual rise since 1999. The yield on 10-year gilts was also higher, up 1.8bp at 4.756

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per ON Friday Jan 12, 2007 the Financial times reported that bond fund managers weresnapping up UK government bonds after the Bank of England's surprise interest raterise on Thursday burnished gilts' appeal relative to U.S. Treasury bonds. Assetallocaters see an opportunity to buy short maturity UK gilts, whose yields spiked

sharply after the BOE increased its base rate to 5.25 percent. This means that it is nowcheaper to buy these gilts due to the hike in interest rates. Many strategists expectthat, although the UK central bank may raise rates once more, the BoE(Bank ofEngland) is close to the end of its monetary policy tightening cycle. Once bondinvestors become convinced of that prospect, they may start to buy short-dated giltson the prospect that yields will fall, anticipating later BoE interest rate cuts. Fundmanager Scottish Widows Investment Partnership, expects the Bank of England willsee inflation pressures ebb sharply starting in April and that global and UK economicgrowth will be less robust than expected. These factors will cause the BoE to reverseThursday's rate rise, cutting rates once or twice before the end of this year, wroteRichard Dingwall-Smith, chief economist, in a research note. Scottish Widows had

some 99 billion pounds sterling of funds under management at the end of September.If the gilts market were to anticipate that shift in the months ahead, that would boostUK government bond prices. "Because policy has moved into a restrictive mode andin my judgement there is not an underlying inflation threat in the UK, we are at the

point now where ironically, a hike by the BoE, once it has been absorbed, could pushbond yields lower," said Richard Clarida, global strategic advisor at behemoth bondfund management company PIMCO. Fund management companies have already

jumped in to buy gilts against Treasuries, betting that chances of more UK monetarytightening are already limited and that gilt yields will not rise much more. PutnamInvestments reckons UK government bonds' sell-off after the Bank of England's rateincrease was an overreaction.

UK ECONOMIC FORECAST

Economic policy outlookThe Labour governments efforts to improve the UK!s public services will dominatethe rest of its third term in office. Public expenditure on the education and healthsectors will rise further to pay for such improvements, but the state of the publicfinances will ensure that this happens at a slower rate than during Labour!s secondterm in office. Improvements in the health sector will be slow to materialise,moreover, because of low productivity growth in the public sector. The governmentwill try to raise the productivity of the economy as a whole by reducing the regulatory

burden, improving rates of innovation and relaxing planning restrictions, but theUKs productivity performance will remain mediocre, notably because of deficienciesin intermediate skills and a congested transport network. The forging of somethingapproaching a national consensus should allow the government to implement the

broad thrust of the Turner Commissions proposals on pensions, but government plansto approve a new generation of nuclear power stations may prove to be morecontentiouswith the electorate.

Fiscal policy

The UK!s fiscal position, which deteriorated sharply between 2000 and 2004, will

improve modestly over the outlook period. However, the government will struggle tomeet its "golden rule which prohibits it, over the course of an economic cycle, from

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borrowing to fund current spending without further rises in taxes. By altering the dateon which the current economic cycle is deemed to have started, the government

provided itself with enough fiscal headroom to avoid having to increase tax rates inthe 2006 budget. However, increases in tax rates still look more likely than not atsome point over the next two years if the government is not to empty its golden rule

of what little residual credibility it has left.

Monetary Forecast

In November 2006 the Bank of England (the central bank) raised its key repo rate by25 basis points to 5% [as at January 2007 5.25%], against a backdrop of robust GDPgrowth, limited spare capacity and rapid growth in broad money (M4). With bothinflation and consumers! Inflation expectations running well above the officialcentral target of 2%, the central bank was also keen to take pre-emptive action toreduce the risk of "second-round" effects on wages. One final interest rate increaseearly in 2007 now looks likely before the current cycle of monetary tightening comesto an end. With headline inflation well above the official target, the Bank of England

will proceed with one final interest rate increase to prevent consumers!inflation expectations from rising further. With historically high levels of debtincreasing households! sensitivity to rises in the cost of borrowing, further increasesin official interest rates should be unnecessary. The Economist Intelligence Unitexpects official interest rates to peak at 5.25% and to fall slightly towards the end of2007, as price pressures abate. A further modest easing of monetary policy is likely in2008 as the economy slows.

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Despite an uncertain geopolitical backdrop, the world economy has remained

buoyant. World GDP measured at purchasing power parity (PPP) exchange rates isestimated to have grown by 5.4% in 2006, while at market exchange rates (whichreflect the rates at which firms trade and repatriate profits), world GDP growth isestimated to have expanded by 3.9%. However, with monetary policy being tightenedaround the world, the period of easy money that hasunderpinned the recent global economic boom is coming to an end. A modestslowdown is likely in 2007, when world GDP is forecast to grow by 4.7% on a PPP

basis and by 3.1% at market exchange rates. World GDP growth should gather paceagain in 2008, reaching 4.8% on a PPP basis and 3.3% at market exchange rates. Thisrelatively benign outlook is nevertheless threatened by a number of downside risks.Geopolitical risks currently loom particularly large "the nuclear programmes in North

Korea and Iran, for example, or worsening conflict in the Middle East could upsetmarket sentiment and push up international oil prices again. There are majoreconomic risks too. Many asset prices, particularly property, look overpriced in somecountries and could fall sharply as interest rates rise. Large global macroeconomicimbalances also subsist, and disruptive adjustments in financial markets may benecessary to correct them. Many of these risks are US-related. One is the possibilitythat the US dollar could fall sharply, as the cycle of US monetary tightening comes toan end and foreign investors! concerns about the US!s huge current-account deficitreassert themselves. A sharp depreciation of the US dollar would help to correct someof the imbalances in the US, but it would depress GDP growth in regions such aswestern Europe

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The UK economy is estimated to have expanded by 2.6% in 2006, up from 1.9% in2005. With macroeconomic policy becoming more restrictive, however, domesticdemand growth is forecast to moderate in 2007. As a result, real GDP growth willslow to 2.4% in 2007 and to 2% in 2008. This relatively downbeat forecast reflectsour assessment that the UK will have to experience a few years of below-trend growthto correct the economic imbalances that have built up over the past decade. Thegreatest imbalance is the level of household indebtedness, which, at 150% ofdisposable income, has reached a historical high. Although consumer spending has

been sustained over the past two years by massive net immigration from central andeastern Europe, financial strains among British households continue to increase.

Personal insolvencies have been rising sharply since the middle of 2004, as have courtorders for homes to be repossessed.With debt-servicing costs set to continue rising in 2007 and the tax burden likely toincrease further, strains on financially overextended households are unlikely to ease.The need for British households to repair their weakened balance sheets will weigh onconsumer spending throughout the outlook period. The outlook for businessinvestment, in the short term at least, is more positive. Balance sheets are strong,

profitability is high, companies are awash with cash, the cost of borrowing is not tooonerous, and business confidence remains high. however, after growing by a buoyant5.6% in 2006, we expect gross fixed investment growth to ease to 4.5% in 2007 and2.9% in 2008. Several factors will weigh on capital spending. Profit growth willmoderate, slower demand growth at home and in key export markets such as the USand Germany will ease pressures on capacity, and the large holes that subsist in manyfirms! Pension funds will continue to divert cash away from capital spending. A moodof caution will therefore start to weigh on firms! investment plans at a time whengovernment consumption and investment will be constrained by the state of the publicfinances. UK trade was distorted in 2006 by an explosion of "carrousel fraud" relatedto value-added tax (VAT). Our forecast assumes that a government crackdown onsuch fraud will result in a normalisation of trade in 2007. Since carrousel fraudartificially boosted trade in 2006, a normalisation of trade in goods will show up as asharp slowdown in growth of imports and exports in 2007. However, with domestic

demand growing at around the same rate as in the UK!s main export markets, theforeign balance will make a broadly neutral contribution to

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GDP growth in 2007-08.

Inflation

Inflation (EU harmonised measure) rose sharply during 2006, reaching 2.7% in November "well above the official central target of 2%. Although increases in

university tuition fees and the continued pass-through of high energy prices intohousehold bills will keep inflation above the Bank of England!s central target in thenear term, we expect inflationary pressures to ease during the course of 2007, withannual average inflation falling back to 2.2% in 2007 and to 1.7% in 2008. Severalfactors support this benign outlook. First, recent falls in international oil prices shouldease pressure on producer input prices, transport costs and heating bills. Second, evenif international oil prices were to rise from their level of US$60/barrel in early 2007,

base effects will be favourable for most of the first half of the year so long as pricesaverage less than US$70/b. Favourable base effects, moreover, will be amplified if, aswe expect, sterling strengthens further against the US dollar (the currency in whichinternational energy prices are denominated). Finally, although there is little spare

capacity in the economy, pressures on capacity are unlikely to increase against abackdrop of moderatedomestic demand growth and rising unemployment. Perhaps the main risk to this

benign outlook is that the persistence of inflation above its central target will have"second-round" effects on pay claims, particularly in the public sector (where tradeunions have been asking for pay awards well in excess of the rate of inflation).

Investment rises strongly in the third quarter of 2006

Gross fixed investment rose strongly in the July-September period, growing by 1.8%quarter on quarter and by 4.9% year on year. Public investment grew by 3% comparedwith the previous quarter, but it was still 0.2% lower than a year earlier a reflection ofweakness in the first half of the year. The main factor behind the buoyancy of capitalspending in the third quarter was the pick up in investment by the private businesssector (which accounts for 60% of capital spending across the economy as a whole).Business investment expanded by an impressive 3.1% quarter on quarter and by 8.2%year on year. Investment in machinery and equipment rose by 3.6% quarter on quarterin July-September and by 8.9% year on year, suggesting that British companies arefinally expanding capacity after a period in which capital spending by the corporatesector has been surprisingly low given the high levels of corporate profitability andfavourable borrowing costs. In 2005 business investment accounted for its lowestshare of GDP for 40 years. Despite the recovery in investment in 2006, UK

companies continue to invest less than their counterparts in many other OECDcountries. Low levels of investment ensure that the UK!s capital stock per worker is

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lower than in countries such as the US and France, which, in turn, explains part of theUK!s productivity gap with such countries. There are several possible explanationsfor the apparent unwillingness of UK companies to invest. One is that the datacurrently under-records spending on intangibles such as software. A second is that therelative price of capital goods has been declining, allowing firms to keep up the

volume of investment while paying less for it. This certainly explains why businessinvestment has been falling consistently in nominal terms since the mid-1980s, whilerising in real terms (in real terms, business investment!sshare of GDP has been well above its historical average since the late 1990s).However, what it does not explain is why business investment!s share of GDP should

be consistently lower in the UK than in other EU countries.

Employment, wages and prices

Inflation as measured by the consumer price index (CPI), which is based on the EU!sharmonised index of consumer prices, rose to 2.7% year on year in November, theseventh consecutive month that it was above the Bank of England.s central target of

2%. Despite the pronounced fall in international energy prices since August, thefastest-rising components of the CPI were once again those most exposed tointernational energy prices. The price of electricity, gas and other fuels, for example,rose by 30% year on year. The discrepancy between movements in international

prices and domestic retail prices partly reflects the time lag between changes inwholesale and retail prices. Having been slow to pass on increases in wholesale

prices, utilities companies will be slow to pass on falls. Other components that sawabove-average rises in prices were water distribution (up by 5.7% year on year) andseasonal food (up by 13.3% year on year). In both cases, the rises were linked toexceptionally dry weather during the year. The fourth quarter of 2006 saw a reneweddivergence between the tradeable and non-tradeable sectors of the economy. Inflationin the services sector rose to 3.7% year on year in November, up from just 2.9% inAugust, while goods sector inflation fell back to 1.8% year on year, down from 2.2%in August. The strongest downward pressure on goods price inflation in October-

November continued to come from the audio-visual equipment and related goodssector. Although the pace of decline eased, the price of photographic and opticalequipment still fell by 17% year on year. The prices of household appliances andclothing also continued to fall, suggesting that the disinflationary impact of theUK.s rising trade with China has not yet ended. The prices of many nontradableservices, by contrast, rose by markedly more than the overall CPI. Particularly sharpincreases were recorded by hospital services (up by 6.9% year on year in November),

dental services (up by 5.9%) and recreational and cultural services (up by 4.5%).

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Financial indicators

Sterling strengthened in the final quarter of 2006 as robust GDP growth and risinginflation pushed up UK interest rate expectations. Sterling!s effective exchange rateended the quarter on 104.2, a rise of 1.8% on the end of the previous quarter. Sterlingappreciated sharply against the US dollar and the Japanese yen, but was broadlyunchanged over the quarter against the euro. The inversion of the yield curve becamemore marked during the final quarter of 2006 as rises in short-term interest ratesoutpaced increases in long-termgovernment bond yields. Despite the Bank of England!s decision in November toraise is key repo rate by 25 basis points, three-month rates continued to rise asfinancial markets priced in the likelihood of one final increase before the current cycleof monetary tightening comes to an end. Accordingly, the yield on three-month

Treasury bills finished the year on 5.28% (up from 4.89% at the end of September),while the three-month interbank rate ended the year on 5.32% (up from 5.07% at theend of September). Long-term interest rates also rose over the final quarter, althoughthe scale of the rise was less pronounced than at the short end of the yield curve. Theyield on ten-year government bonds ended December on 4.74%, up from 4.52% at theend of September. The rise in ten-year government bond yields reduced the gap withGerman long-term interest rates from 81 to 78 basis points.

Despite increases in short- and long-term interest rates, equity prices continued to risein the final quarter of 2006. The FTSE-100 index of leading blue-chip companiesended December on 6,220.8, an increase of 4.4% on the end of the previous quarterand of 10.7% on a year earlier. Once again, however, the main index was eclipsed bythe performance of the FTSE-250 index of mid-sized companies, which ended theyear on 11,177.8. This represented an increase of 11.8% on the end of September andof 27.1% on a year earlier. The main indices

were boosted by strong profits and strong takeover activity, with utilities andinfrastructure companies (which were at the centre of much of the takeover activity)

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performing particularly strongly. Two sectors that exerted a drag on the FTSE-100index were oil and pharmaceuticals. The oil sector was hit by falling prices in thelatter part of 2006, as well as by firm-specific issues such as British Petroleum!s

problems in the US. The UK!s two largest pharmaceutical firms (GlaxoSmithKlineand AstraZeneca) suffered from concerns about the quality of their drugs pipelines, as

well as from fears about pricing pressures following theresults of mid-term elections in the US in November. The yield on the FTSE-100index at the end of December was 2.9%, while the historic price earnings ratio stoodat 14.1.

The interest rates currently stand at 5.25%, market reports indicate that the effectshave started to kick in, the effect being firstly on house prices, therefore the MPC isunlikely to increase them further as the economy is trading on a nominal GDP growthrate of 5%

RUSSIA

Emerging markets debt volatilityVolatility in emerging market debt has been primarily an externally driven issue inthat if you look at global risk appetite particularly, and if you look at say the

performance of some of the major equity markets, I think you can see that this hasn't

been like previous episodes. It hasn't been an internal emerging market event. It'sreally been a global stepping back from risk appetite. There's a period of uncertaintyhere because of not only the US but also the European and the Japanese interest ratemoves. And I think that uncertainty, the desire effectively to book profit where profithas been had (and we've had some run-ups in a variety of securities' markets over thelast couple of years)... also the fact that in some emerging market countries thefundamentals, I would say, have been deteriorating. They aren't as good as they mayhave been in the past. Those have been a bit of the victims in this event.Emerging markets have seen a lot of popularity in the last couple of years which hasled to some of the markets in emerging markets, particularly the local bond markets,

becoming relatively crowded with foreign investors and as those foreigners decided to

basically book profit and to exit the market, I think what we found is that the way inwas much easier than the way out. And that these markets which really hadn't seen alot of foreign participation in the past struggled somewhat to cope with outflows orwith hedging activity.

Which sectors or regions are looking seeking outperformance

For external debt in emerging markets we're most positive on what's going on inRussia and also some of the CIS countries and also in Indonesian corporates, as wellas selected Latin American corporates.On the Russian side I think that's where we're most positive. We think there are somevery interesting opportunities in the banking sector as well as upon just the generalcorporate names. Banking in Russia is undergoing quite a lot of consolidation and inthe corporate sector it's a good way to play upon just the rise in the general Russian

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GDP, as well as play upon the improving wealth of the Russian consumer. And thereare also some specific sectors where the government is effectively looking tostrengthen that part of the economy.

Now on the internal or on the local currency debt side we're also positive on Russia.

We think that their liberalisation in the rouble, was very positive. The Russiandomestic rouble bond market maturing effectively. It's both attracting domesticinvestors, but also a number of foreign investors. And also the rouble is a relativelystable currency. We also like the domestic bond market in local currency terms.

High income

The interesting ways to go about getting high income right now is to combine actuallyemerging markets with high yield. the attractive thing about combining the two assetclasses together is first they're not very correlated. So even though many peoplewould lump them together, actually high yield and emerging markets are driven bydifferent factors. Emerging markets are typically quite macro. High yield is very

micro. So you wouldn't expect them to go up or down in parallel, or in tandem.The difficulties in being in emerging markets invester, if you want to becomedefensive, is that historically you've retreated to cash or to US or Europeangovernment bonds which has, generally speaking, entailed a substantial yield give-up.Whereas if you effectively retreat to high yield securities, you can retain a highrunning yield, which is a positive, and also you can lessen the volatility in the

portfolio. You can effectively step away from emerging markets and wait for a re-entry point and we think that's quite an attractive way to approach emerging marketsand also the high yield product area.

Outlook

On emerging markets, I think we're obviously in a period of fairly strong turbulence. Iwouldn't say that we're at the cusp of a secular bear market. I think that what we'reseeing now is the fact that you've got not only the US moving interest rates higher, butalso moves higher in European and also particularly Japanese cash rates, which iscreating this period of uncertainty and it's really a period of risk aversion. Investorshave had relatively good runs in a number of asset markets. I think there is a naturaltendency to book profit and to basically stand on the sidelines.

Having said that, I think we're probably nearing the end of the US rate-hiking cycle.We don't think there will be a sharp recession or a sharp slowdown in 2007. We think

there will be a relatively modest slowdown in 2007. So again I would be concernedabout emerging markets if we thought there was going to be a substantial recession inthe US. We don't think that's the case. We think that we're basically in a period ofmost volatility which is at the end of the hiking cycle when there is the highestamount of uncertainty. At the beginning of a hiking cycle it's relatively clear. Youhave several hundred basis points ahead of you. Now the market is very fixated uponwhether it's another one or two or three hikes and I think once we move through that

period we'll probably see some stability return to emerging markets. And particularlysince the economic fundamentals for many of the countries remain quite positive Ithink we'll see investors come back to the markets because there has been some value,or actually quite a bit of value, created.

High yield: we're looking for high yield securities to trade relatively sideways for the

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next 12 months or so. Default rates, particularly in Europe, have been extremely lowin the last year or two. That will probably rise slightly, but very slightly, and we thinkthat basically high yield spreads remain pretty range bound. The economicenvironment both in the US and in Europe is such that it is supportive for corporates.The US will probably slow, but not dramatically so, because Europe is on somewhat

of an upswing right now. So we think that it will probably encourage sideways tradingin high yield spreads for the next year or so.

Risk elements, concerns.

Russia has not been tested by a major downturn in oil prices since its default in 1998.Uncertainty over the oil price is exacerbated by the fact that Russia has adopted anUrals oil price assumption of USD61pb for the 2007 budget. As a rule of thumb,around 40% of federal government revenues come from oil and gas sector taxes, and aUSD1pb fall in the oil price would result in a loss of around RUB55bn (0.2% GDP) inrevenue. If the outturn for the Urals oil price was USD50pb, rather than USD61pb inthe budget, Fitch estimates the federal budget surplus would drop from the target of

4.8% of GDP to around 3% of GDP.

New and emerging markets for asset-backed securities are popular among investorsnot only for the diversification they can add to portfolios but also because of the extrayield they offer over deals from more established markets in western Europe and theUS. But lack of certainty about strength of local legal frameworks in many countriesmakes such investments far more risky than those in established markets, hence thehigher yields on local deals and continued dominance of so-called future flowtransactions.These deals nearly 62 per cent of all securitisations from emerging markets inEurope, the Middle East and Africa are backed by payments owed to domestic

banks from abroad and so transactions can be based in more established jurisdictions.Total issuance from these markets was up by 38 per cent to $10.9bn equivalent,according to Moodys most of it driven by an increase in deal volumes from Russia,where issuance rose from $198m to $3.46bn. With a rapidly growing mortgagemarket, Russia is expected to see a substantial increase in the number and volume ofmortgage-backed transactions, and this asset class has the potential to become themost active,

Fitch Ratings analysis on Russia in 2007

Abstracting from recent lurid headlines, this note flags up four key issues to watch.

Fitch Ratings BBB+ Sovereign Rating is currently on a Stable Outlook. But trendsin oil prices, fiscal policy, the political transition of power and investment could havea significant bearing on Russias economic development and creditworthiness in2007.

High oil prices have precipitated a massive improvement in Russias financialposition and been a key factor behind recent sovereign upgrades. However, they havedropped 10% since 1 January and 32% since their peak in August 2006, raising thespectre of a less supportive credit environment. Fitchs assumption for Urals isUSD50 per barrel for 2007, compared with USD61pb in the 2007 budget.

Nevertheless, that is still well within Russias comfort zone and should be

compatible with a continued accumulation of Stabilisation Fund (SF) assets andforeign exchange (FX) reserves, which Fitch expects to reach around USD135bn and

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USD370bn, respectively, at end-2007.

A significant loosening of fiscal policy is underway that will add to inflationary andreal exchange rate pressures. The IMF forecasts that the general government non-oildeficit could widen to 8.3% of GDP in 2007 from 4.3% in 2004, and Fitch forecasts

that the federal government surplus will narrow to 3% in 2007 from 7.5% in 2006.Nevertheless, this would still be an enviable performance and Russias public financesremain a rating strength. Fitch estimates that the federal budget would still balance ataround Urals USD38pb.

The looming transition of power, with parliamentary elections due in Decemberand presidential elections in March 2008, means that Russia is entering an uncertain

political period. President Vladimir Putins designated successor is highly likely towin the election and broad policy continuity is the most likely scenario. However,weak and opaque democratic institutions and the winner takes all nature of thecontest raise event risk. And a post-election change in economic policies or

heightened uncertainty over property rights cannot be ruled out. A smooth transitionof power would improve Russias risk profile, but major political instability could putthe rating under negative pressure. A take-off in investment is underway, with growth of around 12% in 2006, recordinward foreign direct investment (FDI) of USD31bn and net private sector capitalinflows of USD42bn. Higher investment could help to sustain GDP growth and

promote economic diversification, providing a stronger foundation for the economy.However, some adverse developments in the business climate pose a downside risk tothe amount and efficiency of investment.

Russia Economic policy outlook

Policy trends

Although relatively prudent macroeconomic policies will be maintained, fewadvances in structural reform are likely in the run-up to the 2007-08 elections.Economic policy will focus on implementing the "national priority projects", designedto raise standards of living through increased public spending on health, educationand housing, and on increasing the birth rate. The government will seek to takeadditional measures to bolster the popularity of the new president; for instance, taxcuts for 2007 are already in preparation. The government will also continue with its

policy of establishing state control over the so-called commanding heights of theeconomy which is being extended from Russias energy and metals resources toinclude other sectors. Economic policy is unlikely to change direction after the March2008 presidential election. The popularity of Mr Putin!s policies, focused onimproving the living standards of the poorest sections of the population while alsokeeping big business under control largely by strengthening the state!s presence inkey sectors"will ensure their continuity, especially as high oil prices will make themeasy to implement.

Fiscal policy

High oil prices ensure that the federal budget will record another large surplus in

2006, even as spending has increased. The oil Stabilisation Fund has continued togrow, reaching US$70.7bn by the end of September. The governments medium-term

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budget plans essentially envisage a fiscal loosening. Oil price assumptions are lessconservative than previously. Federal budget expenditure for 2007 is set at 17.5% ofGDP, compared with less than 17% previously. Theincrease comes fully from non-interest expenditure, which is to rise by 23% year onyear. The planned increases are directed towards policies to improve Russia!s

demographics, boosting wages of public-sector employees, implementation ofnational priority programmes, defence and national security, transfers to the pensionfund, regional support, and road construction and maintenance.

Monetary Policy

The monetary policy of the Russian Central Bank (RCB) continues to oscillate between prioritising the reduction of inflation and trying to stem real roubleappreciation to protect Russian producers. On the whole the RCB will target theexchange rate, but it will also have to respond to inflation"as it has tended to dotowards the end of a year in an effort to meet official inflation targets by periodicallyallowing the rouble to appreciate. Overall, the RCB will not abandon its dual policy of

targeting both inflation and the exchange rate, despite the recent full liberalisation ofthe capital account. The adoption of a monetary targeting regime, and the

prioritisation of inflation-reduction, is unlikely to happen any time soon.

Economic forecast

After a buoyant 2006, a slowdown in most parts of the developed world will reduceworld GDP growth in 2007-08 to an average of 4.8% at purchasing power parity(PPP) weights. In the EU, Russia!s largest trading partner, growth will slow from anestimated 3% in 2006 to 2.3% in 2007, remaining at that pace in 2008. China andIndia are playing a key role in sustaining global economic growth, as they continue toexpand rapidly. China, in particular, is an increasingly important trade partner forRussia, with trade turnover between the two countries rising by 42% year on year inJanuary-August 2006. This trend will be more to China!s advantage than Russia!s:China!s role as a global supplier of cheap consumer goods is amply reflected inRussian customs statistics, which show imports from China nearly doubling from thefirst eight months of 2005 to the same period of 2006.

Global demand growth for oil is set to rise again, led by China, and this is likely toabsorb most of the expected increases in world crude supply. Consequently, the much-

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anticipated rise in global spare capacity will be smaller than previously expected. Wehave also lowered our oil supply projections for non- OPEC countries, and our priceforecasts remain high to reflect these factors. There is also a continued risk of supplydisruptions. In 2008 prices will come down slightly as new crude capacity comes onstream in Africa and several OPEC countries; our forecast for oil prices in 2008 has

been revised downwards slightly, to US$63/barrel. Despite this, spare capacity willstill remain low, and with the Iran nuclear issue unlikely to disappear, prices willcontinue to be supported by a geopolitical risk premium.

Strong domestic demand is driving Russias current economic expansion, and willcontinue to do so in 2007-08, ensuring annual real GDP growth rates of well over 5%.Although this can be considered a reasonable performance relative to mosteconomies, it is well below the pace of growth expected in China and India theemerging markets with which Russia is most often compared and below growth ratesin much of the CIS. Several important constraints will continue to act as a brake onfaster growth of the Russian economy.Export-oriented production is dominated by the oil and gas sector, where outputgrowth has been sluggish in 2005-06. Several oil companies are struggling to increase

production, most notably Lukoil-Russias largest producer as existing fields aredepleted and recovery becomes more difficult. Consequently, there will be a time-lag

until current investments translate into higher oil production growth. Yet Russiaslarge-scale investment needs in the oil sector and elsewhere are not being met, despitecurrent annual fixed investment growth ofover 10%. A large share of investment spending goes on maintenance, replacementsand repairs, and with obsolescent fixed capital at close to capacity in many sectors,new investment will be crucial to generating growth in the future. However, strongerinvestment spending will be held back by a difficult business environment and

political uncertainty related to the 2008 presidential election.An appreciating rouble will, moreover, erode competitiveness in the manufacturingsector, limiting export growth and boosting import growth. Insufficiently tight fiscaland monetary policies will also contribute to booming consumer spending, adding to

import demand for consumer goods. This means that the foreign balance will continue

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to exert a considerable drag on overall GDP growth.

Inflation

Annual inflation continued to fall in October, to 9.2%, driven in large part by falls inpetrol and sugar prices on the back of easing international oil prices. The October

consumer price data put the governments year-end target of 9% conceivably withinreach. However, the last two months of the year tend to be subject to acceleratinginflationary pressures stemming from a surge in fiscal expenditure, as local authoritiesrush to use up unspent funds otherwise theyhave to be returned to the federal government. The RCB is likely to pursue a flexibleexchange-rate policy in order to meet the governments year-end target, but withmoney supply growth running at over 40% we expect the target to be overshot by asmall margin. In 2007-08 foreign-exchange inflows and domestic demand growth willremain strong, and inflation is likely to decline only modestly. The RCB will continueto keep an eye on the maintenance of competitiveness and will not consistently

prioritise inflation-reduction.

Exchange rates

The policy emphasis in 2006 has continued to swing back and forth, even more thanusual, between trying to prevent excessive real appreciation and fighting inflation.The extent of real appreciation in recent years has eroded the competitiveness gainsfrom the 1998 devaluation. Although the RCB will seek to prevent significant roublestrengthening in 2007-08, continued large-scale foreign-exchange inflows and thedearth of sterilisation instruments at the RCBs disposal mean that continued realappreciation, even if at a slower rate, is inevitable.

External sector

Preliminary balance-of-payments figures from the RCB show that the current accountsurplus rose to US$80bn in the first nine months of 2006, from around US$62bn inthe same period of 2005. Despite some recent easing, international oil prices remainedhigh and this meant that the US dollar value of exports of oil and gas rose by 37%year on year; oil and gas sales now make up two-thirds of total export receipts. Goodsexports as a whole grew in January-September by 28% year on year in US dollarterms, and import growth accelerated to almost 29%. The current-account surplus isforecast to peak in 2006, before slipping back slightly in 2007 and 2008. Large oil-driven trade surpluses will more than offset substantial deficits on the income andservices accounts.

Interest payments on corporate debt will rise, offsetting a fall in the sovereign debt-servicing burden after the August payment of Russias Soviet-era debt to the ParisClub of sovereign creditors. According to provisional data, foreign direct investment(FDI) into Russia surged to US$20.8bn in the first nine months of 2006, significantlyhigher than the full year total for 2005. The latest data are in line with our bullishassessment of Russias FDI prospects and underline the fact that many investorscontinue to be attracted by strong market opportunities and at least outside the energysector remain unaffected by Russias increased statism and the imposition ofrestrictions on foreign involvement. The years 2007-08 will nonetheless see a drop innet FDI flows relative to 2006, as Russian companies seek to invest more aggressivelyabroad.

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Economic policy

The final version of the 2007 budget, approved by the State Duma (the lower house ofparliament) in November, has clearly been shaped by electoral concerns. The budgetstill envisages a surplus of Rb1.5trn (US$43bn), amounting to 3.8% of GDP, but thismasks a large increase in budget spending from oil and gas revenue. With revenueexpected to rise 12.8% above the revised 2006 budget target, to Rb6.96trn, in 2007expenditure is scheduled to rise in nominal terms by 23.3% compared with 2006, toRb5.46trn. The spending increase includes electorally popular measures such as a50% real rise in public-sector salaries, a 33% nominal rise in education spending anda 31% rise in the healthcare budget. The critical assumption in the budget for 2007 isan average Urals Blend price of US$61/barrel, which could prove optimistic. UralsBlend prices in January-September 2006 averaged around US$63/b, and the

Economist Intelligence Unit assumes a decline from current levels in 2007.Nevertheless, a lower oil price will affect mainly the automatic transfers to theStabilisation Fund (the oil windfall account), and even then the Stabilisation Fundshould continue to grow as long as Urals Blend prices do not decline below US$27/b.The federal budget surplus in the first ten months of 2006 rose to Rb1.9trn(US$70bn), according to preliminary estimates, compared with Rb1.4trn in the year-earlier period and a surplus of Rb1.6trn for 2005 as a whole. More detailed figuresavailable for January-September show a strong increase in customs duties, reflectingrising import demand (see The domestic economy and Foreign trade and payments).The strong fiscal performance so far in 2006 has led the Duma to revise the full-year

budget, in order to take into account higher than planned revenue this year. InNovember deputies approved an additional Rb1.1bn to expected revenue in 2006, andexpenditure has been raised by Rb161bn. The budget surplus has been set at Rb1.7trn,

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or around 6.2% of GDP. The Stabilisation Fund will receive nearly Rb1.7trn, which isaround Rb817bn more than originally planned.

Gas market liberalisation is subject to disagreementsThe Ministry of Industry and Energy has submitted a proposal in effect to deregulategas prices for industrial enterprises. Supplies of 100bn cu metres a year would bederegulated, which would mean that around 90% of industrial enterprises would haveto buy gas at market prices. Administrative controls would remain on prices forhouseholds and for housing and public utilities, as well as for energy producers, butelectricity producers would pay aroundUS$70 per 1,000 cu metres rather than the US$40-50 charged now. The expectedlevel of deregulated prices to most industrial producers would be around US$180 per1,000 cu metre equivalent to the average price to the EU minus transportcosts"compared with the current price of US$50. The amount of gas sold at market

prices is to be divided equitably between Gazprom and independent gas producers,but how this will be implemented in practice has not been made clear. The plans are tolaunch the reform in 2007, but this seems unlikely in an election year; furthermore,the scheme has already encountered oppositionwithin the government, worried about the inflationary impact of the deregulation.Prices of gas account for anything from 40% to 80% of the costs of chemicals output,and for up to 15% in the metallurgy sector, for example.However, a pilot scheme, which has already been approved, will test the broaderreform plan. The "5+5" scheme, which started on November 22nd and is to runthroughout 2007, involves the sale of 10bn cu metres through electronic exchanges:

5bn cu metres will be sold by Gazprom, and another 5bn cu metres by independentproducers. Gas price deregulation thus appears to be firmly on the policy agenda,even if the timing has not yet been agreed.

Tax reform proposals for VAT and UST are in preparation

The government has announced that it intends to introduce further reforms to the taxsystem in early 2007, mainly to improve compliance and lower the cost of collection.The proposals involve replacing value-added tax (VAT) with a sales tax and changingthe unified social tax (UST). There is an alternative proposal to unify the existing18% and 10% VAT rates and charge a lower rate overall, but at this stage thegovernment appears to lean towards introducing a flat 10% sales tax"the rationale

being that sales tax is simpler and less costly to

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collect. A fall in VAT collection in 2006 is likely to have been an additionalcontributing factor for revising the tax framework, and the government may also hopethat a sales tax would provide fewer opportunities for corruption and evasion. In anycase, estimates by Moscow brokerage Aton Capital show that replacing VAT with aflat sales tax of 15% would be revenue-neutral, even before the resource savings in

terms of paperwork and administration.Apart from VAT reform, the presidential administration!s expert group on taxes is alsorecommending cutting the UST to 13-14% from the current rate of 26% (after a cutfrom 36% in 2005). The UST covers contributions to state pensions, healthcare andsocial security. The proposal is for part of the UST be replaced by separatecompulsory insurance and health insurance payments, with the eventual introductionof voluntary contributions as well. The whole process could take three to five yearsand appears to have considerable support albeit not including from the Ministry ofFinance, which is worried about the fiscal gap that such proposals could create. A side

benefit of the reform could, however, be increased compliance: the UST currently hasan effective rate of around 22%, owing to a large number of grey avoidance schemes

in existence.

Major state banks will be partly privatised

According to proposals put forward by the finance ministry, the state will reduce itspresence in the banking system, and eventually exit the sector completely. Theministry proposes to start with the partial privatisation of Vneshtorgbank (VTB), byreducing the state!s share in the bank from 99% to 51%, with the possibility of a full

privatisation later. The proposal also includes a reduction of the states stake inSberbank from the current 66.6% to 51% over the next five to seven years. Thefinance ministrys proposals appear to have the blessing of the National BankingCouncil, which has agreed to them in principle. However, in order to be put into

practice they will need to be signed by the president, Vladimir Putin. The proposedsales would require VTBs removal from the governments list of strategic enterprisesin which private ownership is subject to restrictions before any initial public offerings(IPOs) could be launched. The plans also include the possibility of a partial

privatisation of Rosselkhozbank, which is fully owned by the state, but the timehorizon is longer. The third group of state-owned banks Vneshekonombank (VNB),Rossiisky Bank Razvitiya and Rosekonombank may be merged before any decisionsare made on a privatisation timetable.

New regulations give foreign investors in banks equal rights

In the context of its negotiations for Russia to join the World Trade Organisation(WTO), the government has approved a series of amendments to Russias bankingsector regulations. These give domestic and foreign investors equal rights to buyRussian banking assets. The regulations have nonetheless been tightened at the sametime, and Russian banks have to obtain a permit from the Russian Central Bank(RCB) when selling more than 10% of the shares in a bank, compared with 20% now.At the same time investors, domestic or foreign, will have to notify the RCB when

buying 1% or more of a banks stock currently banks only need to ask for permissionwhen buying over 5% of stock.Tighter supervision over the acquisition process is designed to improve control overthe banking system, making ownership more transparent and hopefully reducing

opportunities for corruption and money-laundering. Removing restrictions on foreigninvestors should help medium-sized banks, in particular, to attract foreign capital"with

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potential investors facing a streamlined notification and approval process rather thanmonths of bureaucratic delays.Easier access for foreigners to the domestic banking system has been a keyrequirement of Russia!s WTO membership, particularly from the US. The proposalsto improve supervision of the acquisition process in the banking system would bring

Russian regulations in line with international practice as enshrined in the Baselagreement. The proposals have to be ratified by the Duma but should not face anyproblems there.

Dividends to be free from tax

The Duma has approved the first reading of new regulations exempting Russiancompanies from paying tax on dividends from their shares in foreign or domesticcompanies. The finance ministry estimates that the exemption will cost the budgetaround Rb30bn a year, and has already watered down earlier proposals wherebyRussian companies would have been exempt from tax on dividends from companiesin which they held a stake of at least 20%: this has now been changed to 50% on the

finance ministry!s insistence. The tax exemption is designed to encourage strategicinvestors and cross-holdings in domestic companies. However, the raising of theexemption threshold may make the tax proposals unattractive to many strategicinvestors, especially if they want to diversify into new areas carrying higher risk.Currently Russian companies have to pay a 9% profit tax on dividends received fromholding shares in other companies, or 15% if the holdings are in foreign companies.

Monetary policy framework remains driven by oil prices

Monetary policy was focused on sterilising foreign-exchange inflows for most of2006, but a slight easing in oil prices in the second half of the year allowed the RCBto switch to active liquidity management from the essentially defensive policy ofsterilising ever-increasing inflows. The RCB bought an average of US$12bn-13bn amonth in the first half of the year, but needed to buy substantially less in September-October. According to its first deputy chairman, Aleksei Ulyukayev, the RCB evenhad to inject liquidity into the market through reverse repo operations. The RCB is

planning to widen the range of instruments that can be used in repo operations inorder to make them more effective.However, liquidity management is still not a pressing need: the spread betweeninterbank lending rates"which can be as low as 3%"and the RCB!s refinancing rate of11% shows the abundant liquidity in the market, and illustrates the limited use ofinterest rates as a policy instrument. The refinancing rate itself was cut to a record

low 11% from 11.5% in October"after a 500-basis-point cut in June in order to narrowthis spread gradually and thus eventually make the refinancing rate more effective asa policy instrument. More cuts were promised by the RCB if inflation falls to the 9%year-end target, but the usefulness of interest rates as a monetary policy tool is likelyto remain limited in the near future. The outline monetary policy for 2007 presentedto the Duma in November appears driven entirely by oil price developments, with

policy scenarios ranging from US$85/b to US$45/b. The policy priority remains thesame: a not always mutually compatible mixture of containing inflation (with theyear-end target set at 6.5-8%) and preventing the excessive appreciation of the rouble,mainly by sterilising foreign-exchange inflows.

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6.6% year-on-year expansion in the third quarter of 2005. The expenditure sideestimates published by the economy ministry showed that strong domestic demand isthe main driver of growth, offsetting an export performance that continues todisappoint"albeit with a measure ofimprovement relative to 2005. The pace of growth in household spending accelerated

steadily over the first three quarters of 2006, and although the economy ministry didnot publish an estimate for third-quarter growth in government spending, first-halfdata from RosStat suggest that it too is on a trend of acceleration. Gross fixed capitalinvestment growth softened in yearon- year terms from the second to the third quarterof 2006, but the double-digitrate of growth in both quarters was a marked improvement on a first-quarterexpansion of less than 6% year on year.

Consumer spending boosts construction and retail sector

Production-side real GDP data reflected the strong growth in household spending andfixed investment seen on the expenditure side of the national accounts. Construction

grew by 14.9% year on year in the third quarter of 2006, followed by retail andwholesale trade, which rose by 11.8%. Industrial output in value-added terms was upby a much weaker 4% year on year in the third quarter of 2006, and a poor harvestaffected by the harsh 2005/06 winter resulted in a contraction of 1.1% year on year inagricultural output in January- September 2006.

Consumer price inflation eases somewhat

Consumer prices rose by just 0.3% month on month in October, bringing cumulativeJanuary-October inflation to 7.5%, compared with 9.2% in the same period of 2005.Preliminary data on inflation in November showed a slight acceleration, to 7.8% bymid-November. With less than two months left in the year, the end-December

inflation target of 8.5-9% has come within reach. Prices continued to grow rapidly inthe services sector, with October 2006 services prices 12.5% higher than in January,but this was significantly lower than the 19.3% cumulative price increase over thesame period of 2005; this deceleration has been the main factor behind the slowdownin inflation in 2006. However, the fact that much of the moderation in services sectorinflation has in turn been owing to low administrative rises in tariffs shows thatinflation is in part being kept artificially low in order to meet the year-end target.Prices for food and non-food consumer goods rose even more moderately thanadministrative prices an effect of competition from imports. According to economyministry estimates, imports accounted for one-third of food sales in the second quarterof 2006 and over 41% of sales of non-food manufactured goods, making it more

difficult for domestic producers to pass on their cost increases in higher prices. Pricesof electrical appliances, which are likely to be mostly imported, rose by just 1.2%

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year on year in January-September; prices of cars, a substantial share of which alsoconsist of imports, were up by 4.3% in the same period. At the other end, prices of

building materials the import content of which is likely to be far lower rose by 8.2%year on year in the first nine months of 2006.

Sectoral Trends

Oil and gas output rise but Gazprom continues to falterOutput in the extractive industries rose by 2.2% year on year in January-October. Oiloutput alone also increased by 2.2% year on year, with gas output rising by 2.6%thanks to an 18% year-on-year increase in output from independent producersalthough their share of total gas output is still relatively small, at 16%. Gazpromsoutput increased only marginally, by 0.7% year on year, a poor performance that wasalso reflected in a nine-month year-on-year decline of 3.6% in gas exports. Gasexports for September alone rose by 12.4% year on year, so gas exports may yetrecover in the last quarter of 2006; although independent producers are not allowed toexport gas directly, their expansion in the domestic market allows Gazprom to exportmore of its supplies.

Bank profits rise as banks consolidate

The banking sector continued to consolidate in 2006. By November 1st Russia had1,203 active credit organisations licensed to carry out banking operations (of which1,156 were banks), down from 1,253 (1,205) at the start of the year. Overall profits ofthe banking system reached Rb252bn (US$9bn) in January- September 2006, anincrease of 45% over the same period of the previous year. The 30 largest institutionsaccounted for 80% of total profits in the sector. Given that a year ago the 30 largest

banks accounted for 95% of total profits in the banking sector, this also suggests thatthe profitability of smaller banks must have improved markedly in 2006. One factor

behind rising profits has been a marked increase in banking sector activity. Accordingto data from the Russian Central Bank (RCB), total bank lending (in both roubles andforeign currency) rose by 44% year on year by end- August, with a rapid expansion in

both corporate and personal (mainly consumer) lending. Personal loans accounted fornearly one-quarter of total bank lending, having expanded by 87% over the twelvemonths to end-September. The rapid increase in consumer lending has raised the riskof non-payment: according to the RCB, 2.7% of loans were overdue in August,compared with 1.9% in the same period of 2005. Although not yet alarming, the rapidgrowth in both

personal lending which is mainly consumer credit and the equally rapid rise inoverdue repayments is not sustainable. However, outstanding personal loans in 2005

accounted for just 5.6% of GDP; this is significantly less than in the OECD area,where consumer lending accounts for over 40% of GDP.

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New IPO regulations are being considered

The popularity of IPOs continued in 2006, putting Russia in fourth place in the worldbehind the US, China and France in raising finance through share issuance. Only sixRussian companies launched IPOs in 1996-2003, but this was followed by sevencompanies in 2004, eight companies in 2005 and 19 so far in 2006. The number ofIPOs could reach 35 in 2007, according to some estimates. The success of the IPOshas in part been attributable to the fact that Russian companies have been allowed to

place up to 70% of their IPOs on international markets. The regulations, introduced in

2005, recognised that the Russian domestic capital market was too small and tooilliquid for such issues. However, the regulations could change yet again, reducing the

portion that Russian companies could place abroad to 50%; the remaining 50% wouldhave to be placed on the domestic market.The proposal, which could be implemented over the next few months, is intended toincrease liquidity on the domestic market, on the basis that there have been no

problems with placing the 30% under current stipulations, and that the market canabsorb more. Large domestic IPOs would attract more capital from domestic sourcesand help to reduce capital flight. The new regulations could, however, provecounterproductive if implemented too quickly; despite the abundant oil-drivenliquidity in Russian capital markets, they remain relatively small and almost certainlywould not be able to absorb 50% of large issues. There is also a risk that, faced withsuch restrictions, someIPOs could be cancelled altogether.

CONCLUSION

Russia has climbed considerably in terms of ratings and more importantly ineconomic growth. Russias debut 30 year sovereign bond drew strong demand onissue, but only after investors pushed for a higher yield. The bonds were priced toyield on average 6.99%. Much of the growth [in Russia] has been driven by severalsuccessive years of strong economic growth which has led to the rapid expansion ofconsumer and mortgage lending, Moodys (rating agency) said. Russian mortgagelending had trebled to nearly $14.5bn by the end of the third-quarter last year

compared with all of 2005. however oil has a significant impact on the markets,The two key oil plays in emerging Europe, Russia and Kazakhstan, continue to put in

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very strong performances. Both are rated at 77 (B+), but Russias ability to pay scoreis much higher at 48/55 than Kazakhstans 39/55. The corollary of this is thedifferential in the willingness to pay scores in Kazakhstans favour. This is because ofthe absence of succession-related issues in Kazakhstan, and the increasing worries wehave over the effects of the election of a successor to President Vladimir Putin in

2008. This has led to a two point decline in the countrys willingness to pay rating in2007. We expect to see higher social spending as well as increased policy uncertaintyas various factions jockey for position. However, the big caveat to this somewhatworrying picture developing in Moscow is that oil prices are going to remain high forsome time yet, and will provide a huge liquidity cushion which will offset any

As it can be seen from the text above Russia is clearly a favourite amongst fixed

income investors or fund managers. It has a higher GDP growth rate than that of

the UK, and due in part to the 1998 default, and other structural issues, investors

are demanding a higher yield than normal. The UK presents unexciting income

with rates averaging 4%, but the emerging markets, of which Russia is a key

market player, seem to have much better options, and bigger payouts.

APPENDIX

1. Definitions and terms

A bond is a loan to a company, government or a local authority. Generally, interestis paid to you as the lender and the amount of the loan repaid at the end of theterm (usually ten years or less). There are many other names for this type ofinvestment, for example, loan stock, fixed interest, debt securities, gilts (loans tothe government), and corporate bonds (loans to companies).

The main benefit of these investments is that you normally get a regular stableincome. They are not generally designed to provide capital growth. Bonds have anominal value. This is the sum that will be returned to investors when the bondmatures at the end of its term. Most bonds have a nominal value of 100.

However, because bonds are traded on the bond market, the price you pay for abond may be more or less than 100. There are several reasons why the pricemight vary from the nominal value, for example:If a bond is issued with a fixed interest rate of, say, 8% and general interest rates

then fall well below 8%, then 8% will look like a good yield and the market priceof the bond will tend to rise perhaps from 100 to 110 or 120. The reverse isalso true. If interest rates rise, the fixed rate of a particular bond might becomeless attractive and its price could fall below 100.

Ratings agencies might take the view that a particular company's bond no longerqualifies for a high rating perhaps the company is not doing as well as it waswhen the bond was issued. If this happens then the market price of the bond mightfall. On the other hand, the company's rating may be improved leading to a pricerise. Also the inflation rate might start to creep up and the interest rate on some

bonds might start to look less attractive compared with other investments.

A gilt is a UK Government liability in sterling, issued by HM Treasury and listed

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on the London Stock Exchange. The term gilt or gilt-edged security is areference to the primary characteristic of gilts as an investment: their security.This is a reflection of the fact that the British Government has never failed tomake interest or principal payments on gilts as they fall due.The gilt market is essentially comprised of two different types of securities -

conventional gilts and index-linked gilts which between them account foraround 99% of gilts in issue.

The public debt market is typically divided into three segments depending on theissues original maturity.1. Short term issues with maturities of one year or less. The market for theseinstruments is commonly known as the money market.2. Intermediate term issues with maturities in excess of one year, but less than 10years. These issues are known as notes.3. Long term maturities in excess of ten years are called bonds.

The lives of debt obligations change constantly as the issues progress towardsmaturity. Thus, issues that have been outstanding in the secondary market for any

period of time move from long term to intermediate to short term. This change inmaturity over time is important, because a major determinant of the pricevolatility of bonds is the remaining life ( maturity) of the issue.

2. BOND CHARACTERISTICSTerms of ownership

Bonds differ in terms of their ownership, with bearer bonds the issuer keeps no

record of the issue, thus the bearer is the owner. Interest from the bond is obtainedby clipping coupons attached to the bonds and sending them to the issuer forpayment. The issuers of registered bonds maintain records of owners and pay theinterest directly to them.

Types of issues

Bonds can have different types of collateral, they may be senior, unsecured orsubordinate securities. Secured (senior) are backed by a legal claim on somespecific property. Unsecured bonds (debentures) are backed only by the promiseof the issuer to pay interest and the principle when its due. They are thus secured

by the general credit of the issuer. Subordinate (junior) debentures make a claimon income that precedes other debentures, for example income bonds. They arethe most junior types as interest is only paid of its earned. These are popularmunicipal issues and called revenue bonds. there are also Refunding issues, which

provide funds to prematurely retire subsequent issues.the type of issue has only a marginal effect on comparative yields because its thecredibility of the issuer that determines bond quality. A study of corporate bond

behaviour found that whether the issuer pledged collateral did not becomeimportant until the bond issue approached default. The collateral and securitycharacteristics of a bond influence yield only when these factors affect the bondsquality ratings.

Bond ratings

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Bond ratings provide fundamental analysis of bonds. The ratings analyse theissuing organisation and the specific issue to determine the probability of default(Credit quality), and inform the market of their analysis through their ratings.Therefore the fundamental issue is whether the company can service their debt ina timely manner over the issue life of the debt along with historical and current

financial information about the issuer.

The Ratings assigning the risk of default of an obligation with AAA (Aaa) beingthe highest rating, indicates an extremely strong capacity to pay interest and

principle, bonds in this category are often referred to as Gilt-edge securities. C andD. Were CC are highly speculative issues that are often are often in default or

posses other marked shortcomings or C where there is no interest being paid andthere are D issue bonds which are the lowest, with issues in default with principleor interest in arrears. Such bonds are extremely speculative and should be valuedonly on the basis of their value in liquidation or reorganisation. Currently RussianBonds have a BBB+ rating thus bonds are regarded to have adequate capacity to

pay principle and interest, but certain protective elements may be lacking in theevent of adverse economic conditions that could lead to a weakened capacity for

payment.

Sources:Duff and Phelps, Fitch investors service, Moodys, Standard and Poor s,

Capital intelligence limited, Dominion bond Rating.

GOVERNMENT BONDS

UK Government Bonds Conventional gilts

Conventional gilts are the simplest form of government bond and constitute thelargest share of liabilities in the Government's portfolio. A conventional gilt is aliability of the Government which guarantees to pay the holder of the gilt a fixed cash

payment (coupon) every six months until the maturity date, at which point the holderreceives the final coupon payment and the return of the principal. The prices ofconventional gilts are quoted in terms of 100 nominal. However, they can be tradedin units as small as a penny.

A conventional gilt is denoted by its coupon rate and maturity (e.g. 4% Treasury Gilt2016). The coupon rate usually reflects the market interest rate at the time of the firstissue of the gilt. Consequently there is a wide range of coupon rates available in themarket at any one time, reflecting how rates of borrowing have fluctuated in the past.The coupon indicates the cash payment per 100 nominal that the holder will receive

per year. This payment is made in two equal semi-annual payments on fixed dates sixmonths apart (these payments are rolled forward to the next business day if they fallon a non-business day). For example, an investor who holds 1,000 nominal of 4%Treasury Gilt 2016 will receive two coupon payments of 20 each on 7 March and 7September.

Conventional gilts also have a specific maturity date. In the case of 4% Treasury Gilt2016 the principal will be repaid to investors on 7 September 2016. In recent years the

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Government has concentrated issuance of conventional gilts around the 5-, 10- and30-year maturity areas, but in May 2005 the DMO issued a new 50-year maturityconventional gilt.

Index-linked gilts

index-linked gilts (IGs) form the largest part of the gilt portfolio after conventionalgilts. The UK was one of the earliest developed economies to issue index-linked bonds for institutional investors, with the first issue being in 1981. As withconventional gilts the coupon on an index-linked gilt reflects borrowing ratesavailable at the time of first issue. However, as index-linked coupons reflect the real

borrowing rate for the Government rather than the nominal borrowing rate there is amuch smaller variation in real yields over time.

Index-linked gilts differ from conventional gilts in that the semi-annual couponpayments and the principal are adjusted in line with the UK Retail Prices Index (RPI).This means that both the coupons and the principal paid on redemption of these gilts

are adjusted to take account of accrued inflation since the gilt was first issued. Forindex-linked gilts whose first issue date is before July 2002, the Bank of England

performs the function of calculating and publishing the uplifted coupons on eachindex-linked gilt following the release of the RPI figure which is relevant to it, whilefor index-linked gilts first issued from July 2002 onwards the DMO performs thisfunction. The DMO has produced a detailed paper with examples which sets out themethod for calculating cash flows on index-linked gilts.Each coupon payable on index-linked gilts consists of two elements:half the annual real coupon. The real coupon is quoted in the gilt's title and is fixed(e.g. 2_% Index-linked Treasury Stock 2016 pays a real coupon of 2_%, 1% twice ayear); an adjustment factor applied to the real coupon payment to take account of theincrease in the RPI since the gilt's issue.

Three-month lag index-linked gilts

New index-linked gilts issued from September 2005 employ the three-monthindexation lag structure first used in the Canadian Real Return Bond market and notthe eight-month lag methodology used for index-linked gilts issued before that date.In addition to the lag being shorter, with this design the indexation is applied in asignificantly different way. The new design of index-linked gilts also trade on a realclean price basis. As a result, the effect of inflation is stripped out of the price of thenew gilts for trading purposes, although it is included when such trades are settled.

Indexation methodology

An index ratio is applied to calculate the coupon payments, the redemption paymentand accrued interest. The index ratio for a gilt measures the growth in the RPI since itwas first issued. For a given date it is defined as the ratio of the reference RPIapplicable to that date divided by the reference RPI applicable to the original issuedate of the gilt and is rounded to the nearest 5th decimal place.

The reference RPI for the first calendar day of any month is the RPI for the monththree months earlier (e.g. the reference RPI for 1 June is the RPI for March). Thereference RPI for any other day in a month is calculated by linear interpolation

between the reference RPI applicable to the first calendar day of the month in whichthe day falls and the reference RPI applicable to the first calendar day of the month

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immediately following. Interpolated values should be rounded to the nearest 5thdecimal place.

Trading convention

Index-linked gilts with a three-month lag trade and are issued on the basis of the real

clean price per 100 nominal. Settlement proceeds are calculated by multiplying thereal clean price by the relevant index ratio to get the inflation-adjusted clean price andthen adding the (inflation-adjusted) accrued interest to this.

Eight-month lag index-linked gilts

To calculate the inflation adjustment two RPI figures are required - that applicable tothe gilt when it was originally issued and that relating to the current interest payment.In each case the RPI figures used are those applicable eight months before therelevant dates (e.g. for a November dividend date the RPI from the previous March isused). This indexation lag is required so that the size of each forthcoming interest

payment is known at the start of the coupon period, thereby allowing the accrued

interest to be calculated.

Double-dated conventional gilts

In the past, the Government has issued double-dated gilts with a band of maturitydates. There are now only three of these bonds remaining in issue, with first and finalmaturity dates fairly close together (3-4 years apart). The Government can choose toredeem these gilts in whole, or in part, on any day between the first and final maturitydates, subject to giving not less than three months' notice in the London Gazette.Where the coupon on a double-dated gilt is higher than the prevailing market rate, theGovernment will usually have an incentive to redeem the gilt on the first maturity dateand refinance it at the lower prevailing rate.

All three remaining double-dated gilts are rumps. Rump gilts are small, generallyolder, illiquid gilts in which the Gilt-edged Market Makers are not required to makemarkets. Rump gilts are not available for purchase from the D

comparative analysis of the issuance of government bonds in the uk and russia

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