Fitch Changes Republic of Karelia's Outlook to Positive

Fitch Ratings-London/Moscow- 25 December 2006: Fitch Ratings has today changed the Republic of Karelia's ("Karelia") Outlook to Positive from Stable. Its Long-term and Short-term ratings are affirmed at 'B+' and 'B' respectively. The National Long-term rating is affirmed at 'A(rus)'.

The Positive Outlook reflects Fitch’s expectations of a recovery in budgetary performance in 2007 due to lower spending needs resulting from increased capital expenditure efficiency and high quality of management. The latter allowed the Republic to successfully overcome budgetary pressures stemming from both the social sector and administrative reforms in 2006. Karelia was also able to compensate for the temporary adverse effect of the decline in enterprise profit in the same year. The operating performance is expected to rebound in 2007, with operating margin seen remaining close to 10%.
The Republic has been able to achieve a high level of capital spending efficiency as the capital spending in utility companies has allowed the region to significantly reduce the accumulated depreciation of the main assets relative to the national average (estimated 47% versus 70%). Lower level of accumulated depreciation is expected to result in lower spending needs and cost savings in the utility sector.
At the same time, the regional budget is characterised by a high level of operating expenditure rigidity. Financial support for municipalities accounts for 40% of the budget, while social expenditure, education and healthcare take up almost 28.9%. Recent increases in public sector salaries initiated by the federal government resulted in a further growth of expenditure rigidity.
The regional budget was negatively affected by the temporary decline in enterprise profit in 2006, which resulted in a sharp reduction of corporate income tax revenues in H106. This in turn caused operating margin to fall to 2.4% at end-2006 from 10.9% in 2005 and current margin to decline to 1% from 9.9% in 2005. However, the Republic’s administration has been able to reach a mutual agreement with the management of “Severstal” company and secure additional tax payment of RUB400 million by end-2006.