Anthony Seghers

September 2008

The economic and financial aftermaths of the war between Russia and Georgia

I. General overview
The war in Georgia, meaning the conflict between Russia and Georgia in South Ossetia and Abkhazia
began with the Georgia move in South Ossetia.
The capital Tskhinvali is reported to have been shelled, as well as Russia peace maintaining troops
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killed on August, 7 .
Russian troops, reaching 20,000 men, supported by about 2,000 armoured vehicles entered South
Ossetia, crossing the Roki tunnel the following day.

The discrepancy in terms of forces between Georgia (army of 30,000 soldiers) and Russia (one million
soldiers) explain the quick victory of Russia over its Caucasian neighbour.

Indeed, South Ossetia and Abkhazia have very important Russian populations and these territories
have not been historically Georgian.
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The sovereignty of these two territories has been recognized on August, 26 by Russia, which
maintains troops on their land.

Aside the evolution of Caucasus, the main aftermaths to analyze are the economic consequences of
this war and of the tensions between US and the EU on one side and Russia on the other side.

In order to understand to what extend this war is a real turning point in terms of economic
perspectives; I will focus on several elements which can be regarded as central ones.

The political risk and the business climate remain the key points in a long term perspectives regarding
Russia.

Français

Cette note vise à mettre en lumière les points déterminants du conflit entre la Fédération de Russie et
la Georgie, afin d’en analyser les conséquences économiques, financières et politiques, dans un
cadre de crise économique au niveau mondiale.

Les enjeux en termes de ressources naturelles, de stabilité politique ou de ré-émergence d’un fort
antagonisme entre certains pays de l’OTAN d’une part, et la Fédération de Russie d’autre part, sur
fond de montée en puissance de la Chine et de contestation du modèle économico-financier
occidental semblent par conséquent fondamentaux.

Les points développés dans cette note visent à illustrer l’impact de la guerre russo-géorgienne sur les
principaux agrégats économiques de la Fédération de Russie. Compte tenu du poids de cette
dernière, c’est en effet son évolution économique et financière qui nous intéresse ici.

Les effets de la faillite de la cinquième banque d’affaires américaine, Lehman Brothers ne seront que
marginalement abordés, dans la mesure où ils ne sont pas propres à la Russie et ne sont pas causés
par elle non-plus. En revanche, les forces et faiblesses économiques de la Russie seront
nécessairement confrontées aux conséquences du renforcement de la crise financière à la suite de
cette faillite historique.

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 II. Economic analysis
1. Oil and Gas

In terms of economic power, the huge stocks of gas and oil Russia benefits from give it a clear
advantage in the international scene.

Part of the conflict with Georgia relies on oil and gas issues. The speech given by Saakachvilii when
he opened the Bakou-Tbilissi-Ceyhan oil pipeline was quite clear, highlighting than it was about much
more than oil and gas.
The will expressed to gain independence from its major neighbour by bringing oil directly to Turkey,
one of the strategic partners of the US.

As oil price is unlikely to go back to the levels we knew 5 years ago, it is indeed a strategic issue,
Russia being a major oil producer.

With a 10 million barrel / day production in 2007, Russia is the second largest producer worldwide (81
mb/d for all producers), which means that 12,5% of global consumption comes from this country. The
close links between the Russian oil companies and the Russian power explain that it can be used as a
strategic weapon.
Yet this production should decrease in the future, the 12.5 mb/d reached in 1992 being in today’s
conditions almost impossible to achieve.

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 Crude Oil-Brent Cur. Month FOB U$/BBL

160
11 Jul
140

120 8 Aug 08

100

80

60

40

20

0
04/07/2003 04/01/2004 04/07/2004 04/01/2005 04/07/2005 04/01/2006 04/07/2006 04/01/2007 04/07/2007 04/01/2008 04/07/2008

Crude Oil-Brent Cur. Month FOB U$/BBL

Source : Thomson / Datastream

In terms of gas, Russia benefits from the largest stocks in Europe and provides EU members with
more than 50% of their consumption.

New EU members in the East buy more than 90% of the gas they need from Russia.

If, in terms of oil, the Russian stocks represent between 7.5% and 15% of the world ones, regarding
gas, the figure is much more impressive, 25% to 40% of global stocks being located in Russia. The
Russian minister for Energy believes that they will supply more than 70% of the gas consumed in the
EU within 2020.

Oil and gas should represent sustainable revenues for Russia in the next decades. As the economic
links with EU members should tighten, it is highly probable that the Georgian conflict will be put aside
from long term debates.

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As Simon Blakey of Cambridge Energy Research Associates (Cera) says: “The scale of the inter-
dependence is so huge it is really not possible to make a major difference to it even over the space of
two decades.”

2. Economic outlooks

GDP growth since 2000 has reached an average 6% in Russia. After permanent decreases from
1991, GDP growth, household’s consumption, investment and corporate growth have been very
substantial since 1999-2000.

Indeed, in spite of the current turmoil, 2007 GDP growth was 8.1% and 2008 one should reach
7.8/8%.
During the H1 2008, investment in Russia has increased 17% and GDP 8.2%. Households’ real
income has increased 8.1% during the same period.

Unemployment has reached lower levels than in Europe or the US, in the past few months. Russia
seems to be able to face the current turmoil in better conditions than the countries it faced politically
during the war.
UNEMPLOYMENT RATE (%OF ECONOMICALLY ACTIVE POPUL)

16

14

12

10

4
juin-98 juin-99 juin-00 juin-01 juin-02 juin-03 juin-04 juin-05 juin-06 juin-07 juin-08

Source : Thomson / Datastream

Inflation reaches now 15%, which is a strong increase in comparison with its level a few years ago, yet
it is far from the levels faced in 1999-2000.

CHANGE IN CPI (%YOY)

133
126
119
112
105
98
91
84
77
70
63
56
49
42
35
28
21
14
7
0
sept-98 sept-99 sept-00 sept-01 sept-02 sept-03 sept-04 sept-05 sept-06 sept-07

CHANGE IN CPI (%YOY)

Source : Thomson / Datastream

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Russia benefits in this context from the very low level of debt beard by households, in comparison with
the levels faced in the US or in some European countries. It is indeed an advantage in the current
context. Russian households are not used to borrowing to finance investments or consumption.

The USD 247 bn investments realized in Russia in 2008 do not depend on credit levels, as debt does
not exceed 10% of the total.

3. Banking / financial strength

Russia had to face a USD 16.4 bn decrease of its currency reserves over the 8-15 August week,
th
following the war with Georgia, including USD 6 bn on August, 8 and 1 bn the following Monday. The
Russian central bank had to sell 2.7% of the currencies it held in order to support the rouble. These
reserves, which were USD 597 bn in July, fell to USD 581 bn at August’s end.

In spit of a substantial drop, the overall reserves remain high, and very impressive in comparison with
what they were a few years before. As far as oil will continue to be paid in dollar, they will benefit from
strong inflows of foreign currencies.

The charts below highlight the limited impact of a USD 16 bn decrease on the medium term for
Russia.
Banking sector Reserves
Bn Rble

6000

5000

4000

3000

2000

1000

0
déc- déc- déc- déc- déc- déc- déc- déc- déc- déc- déc- déc- déc- déc- déc-
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

RS BANKING INSTS.: RESERVES CURN RS CENTRAL BANK: RESERVE MONEY CURN

Source : Thomson / Datastream

Reserves in USD
Bn USD
700

600

500

400

300

200

100

0
nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai- nov- mai-
96 97 97 98 98 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08

RS FOREIGN EXCHANGE RESERVES CURN RS GROSS INTERNATIONAL RESERVES - OFFICIAL RESERVE ASSETS CURN

Source : Thomson / Datastream

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 4. CDS

Russian CDS premium have faced a strong increase on August, 8th, reaching 14% for the 1 year, 3
years, 5 years and 10 years ones. In comparison, following Lehman bankruptcy, the evolution was
30% in two days. Indeed, the chart below shows that the huge premium rise for all kind of CDS
occurred in September, due to the financial crisis deepening.
CDS Russian Federation

350

300

250

200

150

100

50

0
07/08/07 07/10/07 07/12/07 07/02/08 07/04/08 07/06/08 07/08/08

RUSSIAN FEDERATION SEN 10Y CDS - CDS PREM. MID RUSSIAN FEDERATION SEN 1YR CDS - CDS PREM. MID

RUSSIAN FEDERATION SEN 3YR CDS - CDS PREM. MID RUSSIAN FEDERATION SEN 5YR CDS - CDS PREM. MID

Source : Thomson / Datastream

5. Government bonds

Russian government bonds did not face heavy changes when the war with Georgia burst out. Indeed,
the following charts show the discrepancy, in terms of international confidence between Russia and
Georgia.
Russian government bond yields remain relatively steady when the war began. The 30 year bond yield
increased 5 bp, the 10 years 21 bp and the 5 years 27 bp over the week following the entrance of
Georgia troops in South Ossetia and the Russian counter-attack.
On the contrary, over the week, the Georgian 5 year government bonds (maturity in 2012 and 2013)
increased 183 bp.

18

15

12

3
09/04/08 24/04/08 09/05/08 24/05/08 08/06/08 23/06/08 08/07/08 23/07/08 07/08/08 22/08/08 06/09/08 21/09/08

RUSSIA1998 12 3/4% 24/06/28 S - RED. YIELD RUSSIA2007 6.1% 11/07/12 - RED. YIELD
RUSSIA2000 8 1/4% 31/03/10 REG.S - RED. YIELD BANK OF GEORGIA2007 9% 08/02/12 - RED. YIELD
GEORGIA 2008 7 1/2%15/04/13 S - RED. YIELD

Source : Thomson / Datastream

6. Ratings

Russia ratings have remained stable since the war, benefiting from a BBB+ given by Fitch. Even if risk
premium have increased, so far Russia has not faced downgrades, whereas some of its neighbours
faced some, such as the Baltic States.

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Fitch cut Georgia's long-term local and foreign currency ratings to "B+" from "BB-" on August 8, as it
has already announced it in May, in case of a war with Russia.

7. Stock exchange evolution

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On August, 8 , the main Russian index the RTS, has dropped 6.5%, to reach in lowest level since
2006. Since May 2008, it has decreased more than 30%.

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What is more, since the beginning of the war, until September, 12 (the day before Lehman triggered
a clear deepening of the turmoil), the Moscow stock exchange index in roubles (MICEX) dropped by
20%, the one in USD (RTS) more than 27%. In comparison, the two main Ukrainian indexes,
challenged as well by the conflict, as Ukraine appeared in a difficult position between Russia and
Georgia, fell more than 31%.

Yet, the drop registered in August is limited in comparison with the one that occurred mid-September,
forcing the stock exchange authorities to stop trading operations, as the two indexes have lost more
than 21% (RTS) and 24% (MICEX) in three days. Since the beginning of the year, they have
decreased 41% and 42%, the Georgian war being of relatively limited impact.

3000

2500

2000

1500

1000

500

0
07/08/06 07/11/06 07/02/07 07/05/07 07/08/07 07/11/07 07/02/08 07/05/08 07/08/08

RUSSIARTS INDEX - PRICE INDEX RUSSIAN MICEXINDEX- PRICE INDEX

Source : Thomson / Datastream

The Price Earning Ratio of the companies listed in Moscow (RTS and the MIDEX) is now 5.5x. It was
at 12.5x at 2007 year end and still 8x before the war with Georgia. If we compare it with the PER of the
European indexes, it is far below their levels. This means that huge financial opportunities exist there,
and then, that foreign investors will continue to benefit from substantial returns there. Indeed, when
European PER are between 10x and 13x now, a 5.5X PER offers potentially high returns.

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 Price Earning Ratios

17,00x

16,00x

15,00x

14,00x

13,00x

12,00x

11,00x

10,00x

9,00x

8,00x
03/01/2005 03/05/2005 03/09/2005 03/01/2006 03/05/2006 03/09/2006 03/01/2007 03/05/2007 03/09/2007 03/01/2008 03/05/2008 03/09/2008

CAC 40 DAX FTSE 100

Source : Thomson / Datastream

As far as Eastern Europe will continue to offer strong opportunities, in comparison with the EU or the
US, investments should not decrease substantially.

8. Investments

Russia invested USD 46 bn abroad in 2007, reaching it highest level ever, whereas foreign
investments in Russia were USD 52 bn. In spite of the war with Georgia, these links should continue to
tighten.

9. Business climate

The recent report « Doing Business » published by the World Bank in September 2008 points out that
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Russia is now the 120 best country to do business out of 181 (between Bosnia and Herzegovina
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above it at 119th and Nepal below at 121s. In 2007, Russia was 112 ). Georgia, on the contrary is
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regarded as the 15 most attractive country in terms of business. The sixth annual report bases its
rating on the costs of opening, operating and closing a business, construction permits, hiring labor,
and other factors, ten in all. The indicators are maximally formal, to avoid expert opinion and
macroeconomic indicators. It is the most authoritative rating of business climate available.

On the contrary, in 2007, Reuters analysed that the highest business climate values were registered in
Russia and Slovakia, followed by Poland and Serbia. In Russia and Serbia Montenegro, the positive
results were mainly driven by optimistic business forecasts, as investors are seeing a lot of business
potential. The situation has clearly changed since the summer.

The main Russian weaknesses, in terms of business climate, have not improved. Since Medvedev’s
elections, numerous investors have believed that Russia would implement a more transparent law
framework for business, as well as less arbitrary in terms of political intrusion into private companies.
It does seem to be the case so far, as post-imperial behaviours still appear, like with the steel-giant
Metchel.

10. Political risk

The specific political risks of doing business and investing in Russia will need to be tested against the
allure of a resource-rich economy with a fast growing middle class hungry for consumer goods.

"There is clearly a reassessment of Russia risk and that will make funding conditions for Russian
banks and Russian corporates corporate difficult even after the current crisis," said Shahin Vallee, a
currency strategist at BNP-Paribas.

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Political tension and fear of arbitrary state action against foreign companies will make it hard for
Moscow to entice investors back, he argued, even if the government takes business friendly measures
and sticks to prudent fiscal management.

Indeed, since the financial crisis has deepened mid-September, Russian economy and financial
market are accumulating troubles which could eventually be burden heavy to carry. Indeed, as
markets need to bring back confidence, the messages sent since the summer by the Federal State
authorities may not be able to achieve this very aim.

However, Russia may prove a too big and dynamic market for Western business to shun.

III. Geopolitical analysis

Three territories host substantial Russian minorities, which may trigger the same problems as in
Georgia with these countries:

1. Kaliningrad

The former city Königsberg which became the Oblast de Kaliningrad at the end of the second World
War, remain an issue between the European Union and Russia. Indeed, the 900,000 inhabitants
region is part of Russia, yet it is located inside the European Union (at the North of Poland and the
South of Lithuania).
These two countries are quite reluctant regarding the development of this Russian region, which
threatens directly their boarders.
As Kaliningrad remains Russian, there is limited risk of international tension, except with Lithuania, as
goods are allowed to travel from the enclave to mainland Russia without paying taxes. If changes
should intervene regarding this issue, it might raise high tensions between Russia and Lithuania, as
Kaliningrad is already facing substantial economic troubles.

2. Transnistria

Transnistria, also known as Trans-Dniester, Transdniestria, and Pridnestrovie is a breakaway republic

within the internationally recognized borders of Moldova, with the official status of an autonomous
territory. It is de jure part of Moldova and it is de facto independent and functions like a state.
After a war with Moldavia in 1992, following the dismantling of the Soviet Union, the Russian troops
that intervened to protect the Russian minorities had remained in this region. In spite of several
summits, Russia has not withdrawn from Transnistria so far. If the situation there worsened, it would
probably have an impact of the relations between Ukraine and Russia, as Transnistria does not have
any sea frontier, thus crossing Ukraine would be necessary to enter the territory.
What is more, Moldavia and Romania have historically been close countries, Romania being today the
Eastern frontier of European Union, a crisis there would necessarily have an even more important
impact than the Georgian one.
A crisis in Moldavia would mean for the EU a war on its frontier (Romania being the Eastern border of
the Union).

3. Crimea

The region, given to Ukraine by Khroutchev in 1954, is much more important than South Ossetia and
Abkhazia.
Indeed, this region has three main issues:
a. It much more important, in terms of population (2.5 million inhabitants, of which 60% are
Russians).
b. It is part of Ukraine, which faces Russia and wants to tighten its links with NATO and the EU.
If Kiev joined the EU, it would mean that Russia would have a direct border with the Union.
c. Sebastopol hosts the main Russian naval basis historically. 12,000 seamen as well as 388
war ships are still based there. The lease for the basis should terminate in 2017 and the
Ukrainian government has already said that it would not renew it.
We also have to note that the population of Sebastopol had expressed a very clear support to Russia
during the war with Georgia. Indeed, the black sea fleet departure may become a geopolitical issue, if

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Ukraine joined NATO, especially if this organization was more orientated against Russia in the coming
years.

This could have direct impact on the Ukrainian political risk and on the economy. Foreign investors
may be worried by this issue.

Key points

Russia has declared that it would defend the interest and security of Russians, in Russia, which is
absolutely traditional, as well as abroad, launching an equivalent of the US Monroe doctrine.
This may trigger new involvements of Russia in its sphere of influence, as far as since the collapse of
the Soviet Union, there are still very many Russian minorities in most of the states located in Centre
Europe, Eastern Europe, Caucasus…

As long as oil remains over USD 80 / barrel, which is highly probable, analysts believe that the
Russian State will continue to benefit from high energy incomes. It means basically that it could
finance its current foreign policy without begging the support of investors or the confidence of markets.

If the relations between Russia and the US had to continue worsening, I see a few potential issues
that could trigger new strong tensions:

1. Iran

If the US decided to increase its pressure on Iran, and if it had to turn into a conflict, Russia would
support Iran, at least diplomatically. It could also give it a military support by selling it specific
weapons.
The rumours of Sizzler missile sale to Iran could represent a potential danger for the stability of the
region, as the US Navy is said to have no protection against it for its ships. If an incident occurred
there, it may trigger a new conflict, directly involving Russia, through its weapons’ sales to Iran.

2. Ukraine

The current crisis in Ukraine between the two former elements of the pro-occidental coalition may
increase the instability of the region. Benefiting from the most important Russian investments abroad,
being totally dependent on the Russian gas, a tightening of its relations with Europe (by negotiating its
entrance in the EU) or with the US (by joining Nato) would necessarily create very strong tensions with
Russia. In the last case, the Crimean issue will necessarily come on the stage, as it would mean
having Russian troops behind Otan missiles pointed towards Russia.

3. Oil payment in Euros

As Vladimir Putin suggested it once in 2004, switching its trade in oil from US dollars to euros would
obviously trigger very high tensions with the US. Indeed, Iraq attempted to do so and Iran had decided
to implement this last year, though Chinese yen.
The measures taken by the US Federal state to prevent a deepening of the crisis and a systemic risk
will have a huge budgetary cost. Thus the dollar will face new challenges as the US economy will slow
down and the US debt will go up in a terrific way. If oil trade was not based on dollar, the demand for
this currency may collapse. I believe this threat, if implemented by the second producer worldwide
(Saudi Arabia would never do so), would put the US economy at risk.

Conclusions

To sum up all the aspects of the conflict with Russia and Georgia, and to grasp the main
consequences, I would focus on 4 points:

1. Russia is back as a strong State defending its own views and willing to keep control of
its neighbouring region:
a. The new concept of Russians’ interest defence abroad might be the instrument of this
policy
b. The Russian people clearly supports this political will

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 c. Any attempt from any countries from these region to join either the EU or Nato would
trigger high scale tensions with Russia

2. Its Oil (second worldwide) and Gas (first worldwide) stocks will enable it to benefit from
substantial income as well as from main economic weapons in the coming decades.

3. Russia benefits from relatively sane economic fundamentals (GDP growth,

unemployment, banks assets), which would help it to resist to the current turmoil perhaps
more effectively other economies.
If its economy is resilient and has strong sectors of competitiveness, the business climate
remains problematic and the political risk has risen further with the Georgian war.

4. The current financial crisis has clearly put the Georgian war on the background.
Neither the US, nor the EU would be likely to give top priority to this issue when they have to
face the most important financial crisis since 1929.

I believe that for all the stake holders in the Georgian war, except Georgia itself, are much more
challenged and concerned by the deepening of the financial crisis since Lehman bankrupted than by
the aftermath of the conflict in South Ossetia and Abkhazia.

The stock exchange drops, the worsening of the economic outlooks and the costs for the States will
have nothing in common between the August events and the September ones.

The main impact of the conflict will be on Russian neighbouring states which will be put under much
more pressure as:
a. Russia has proved to have kept some of its imperial behaviours;
b. The EU and the US will focus on national economic problems rather than on surrounding
Russia politically.

The through analysis the Georgian war impact could not be done since the financial markets
worldwide have calmed down. Then, we will see if investors decide Russia is just too big to ignore
regardless of how far its war in Georgia has damaged its economic and diplomatic relationships.

Anthony Seghers
18/09/2008
Paris

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