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Hermitage Capital Management Limited

Hermitage Capital Management LimitedRegistered Office: St. Martin’s House, Le Bordage, St. Peter Port, Guernsey GY1 4AU, Channel IslandsTel: +44 207 440 1777 / Fax: +44 207 440 1778info@hermitagefund.com

January 12, 2009Dear Hermitage Global Investor,In December 2008, Hermitage Global was down 3.32% (net of fees, on bid-to-bid basis).It was a mixed month for emerging markets as we approached year-end. Unfortunately, themarkets of the Middle East were among those that went down in December, with the declinedriven by two main factors. First was the largest regional corporate default in recent memory. TheKuwaiti investment bank, Global Investment House, defaulted on its $3 billion debt and enteredrestructuring negotiations with local and foreign creditors, which cast a pall on the whole regionas investors wondered who would be next. Second, the price of oil fell 18% over the course of themonth. Even though historically there has not been a high long-term correlation between the oilprice and Middle Eastern equities, the markets are currently so driven by sentiment that the sharpmove down in oil pushed the Kuwaiti market lower by 13.2%, Abu Dhabi down 13.9% andDubai down 16.7%.After waves of bad news in 2008, there have been some recent signs of muted optimism. Despitethe continued deterioration in the global economy, there are a few indications that the marketpanic of late last year has started to subside. The VIX Index (a measure of volatility and “fear”levels in the markets) has declined by 52% from mid-November through the first week of January. The TED spread, the difference between the interest rate at which banks lend to eachother and the interest rate on 3-month US treasuries, has fallen from 4.64% to 1.26% (a 73%decline) in the past two months, and the yields on a broad composite of US corporate debt havefallen from a peak of 8.01% at the end of October to 6.29% by the end of December. Does thismean that the market problems of 2008 are over? While it would be nice if that were the case, wethink there is still more trouble ahead. Persistent structural flaws in the banking system and theextreme condition of government finances around the world both convince us that we will seemore value destruction in the markets before the world is on a path to real recovery.

Growth of $100 Investment

Hermitage Global Performance

(bid-to-bid, net of fees, unaudited)

December 2008

-3.32%

November -5.86%October -22.99%September -14.77%August -8.30%July -1.73%2008 Year to Date -42.00%2007 (from April 2) 31.13%Inception to Date

-23.95%Compounded -14.48%Volatility 25.82%

As at 31 December 2008; on a weighted-average bid basis

$70$80$90$100$110$120$130$140$150Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08

$76.05

January 12, 2009

Page 2

Our practice at this time of year is to share our thoughts on the big market trends that we seematerializing in the coming year. Last year we predicted four big events for 2008. First, wethought a major US investment bank would fail. In fact, two failed outright (Bear Stearns andLehman Brothers), to say nothing of the sudden “disappearance” of the old investment bankingmodel as the surviving institutions of Goldman Sachs and Morgan Stanley were converted intobank holding companies. Second, we believed that the Chinese stock market was overvalued andwould crash, taking the other BRIC markets along with it. Indeed, China fell 63.0% in 2008 andwas joined by Brazil, India and Russia which were down 55.3%, 61.0% and 72.4%, respectivelyin US dollar terms (although the Chinese crash wasn’t the direct cause of the other countries’declines). Our third prediction that equity returns in the oil-producing countries would be boostedby the biggest wealth transfer in history as oil traded above $100 was only half right. This ideaworked well until August, when oil prices turned around and crashed to $33 per barrel. Finally,we thought that a number of undervalued currencies, including the pegged currencies of theMiddle East, would revalue relative to the dollar. This looked like it was going to happen in theGulf region in particular in the spring of last year, but then the movement lost momentum andfailed to materialize when the oil price fell dramatically.So what are our predictions for this year?

1. Commercial banks will “gate” deposits.

Just like the wave of hedge funds that are now“gating” redemptions (i.e., not letting clients withdraw their money in full and on time), weexpect commercial banks will begin limiting depositor withdrawals sometime this year. As wehave written before, the health of western banks is dire. The ten largest banks in Western Europeand North America had tangible equity of just 2.8% of total tangible assets at the end of September 2008. That means that if their assets go down by more than 2.8%, they are effectivelyinsolvent. It is hard to imagine that this is not the case today. In the fourth quarter of last year, theMSCI World Equity Index fell by 22.2%, the Credit Suisse Leveraged Loan Index was down24.9%, the RJ/CRB Commodity Price Index declined 33.6%, and commercial real estate valuesplummeted. At the same time, banks’ primary assets – loans to consumers and corporations – arevery likely about to face the highest loan default rates since the Great Depression. In thisenvironment, it seems like a safe assumption that many banks’ assets have fallen by far more thanthe 2.8% that would wipe out their equity and render them insolvent.If our analysis is correct and a large number of banks are effectively insolvent, it is just a matterof time before depositors understand this and want to withdraw their money. Serious depositorconcern about banks first surfaced last September, and the only thing that prevented a full-scalebank run was swift and overwhelming government intervention via capital injections and depositguarantees. Some may argue that government intervention has done the trick and the bankingproblem is solved. We don’t think so. First of all, because of the decline in the value of all bank assets since the recapitalizations were done, most banks are even more insolvent today than theywere in early October.Second and more importantly, if one looks at the numbers, the deposit guarantees provided by anumber of governments just aren’t credible. Take Ireland for example. The total amount of guaranteed bank deposits in Ireland is approximately €400 billion. At the same time, Ireland’sannual tax receipts are €41 billion and the total government debt (domestic and international) is €59 billion. If next week a journalist in Dublin were to write a convincing column questioningwhether Irish government bank guarantees were sufficient to protect all depositors, some readersmight feel worried enough to withdraw their money. If enough of them do so, it could turn into arun, and if just 20% of the insured depositors (or accounts worth €80 billion) requested theirmoney back, the Irish government’s financial resources would be overwhelmed. In this particularexample, Ireland cannot unilaterally print money to meet their obligations because that ability

January 12, 2009

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rests exclusively with the European Central Bank in Frankfurt. For Ireland, it would have toincrease its debt burden by 136% to solve this particular problem, which is obviously unfeasible.Moreover, the ECB couldn’t help because doing so would require increasing the Eurozone’soverall debt burden by 19% in a single stroke – a step it would be unlikely to take for onemember of the currency union, particularly as Ireland is only one country among many with asimilar problem. Ultimately, Irish banks and the Irish government would have no choice but totell panicked depositors, “Your money is safe, but you just cannot have it all back right now.”While this may sound extreme, this is exactly what happened in Latvia in December (shortly afterthe Latvian government nationalized the second largest bank in the country) and Iceland inOctober (again, following nationalization). Ukraine has also recently taken similar steps to limitdepositors’ access to the full funds in their accounts. It is also what happened in Russia (1998),Ecuador (1999), Argentina (2001) and Uruguay (2002). This is what governments do if theirbanking system doesn’t have the necessary liquidity to satisfy withdrawal requests. Central bankshave the capacity to bail out individual banks in trouble, but not an entire national bankingsystem.The truly disturbing effect of “deposit gating” is that once it happens in one major country, it willalmost certainly jump borders and spread to other countries. If the scenario above plays out inIreland as we describe, it is entirely plausible to imagine a depositor in France saying to himself,“That situation in Ireland is very unpleasant. I want to get all of my money back before the samething happens here.” Once one major country permits its banks to gate deposits, the credibility of government deposit guarantees disappears nearly everywhere else – with the result that manyother countries will be forced to gate deposits as well.

2. Crash of US government bonds.

One of the only asset classes that performed well lastyear were G-8 government bonds, particularly US government debt. The price of the US 30-yearbond (futures) rose 20.6% in 2008 and now yields 3.06%, not far from the lowest-ever yield of 2.52% reached on December 18, 2008. The US 10-year bond yields 2.39% (close to its all timelow of 2.05% reached in December). Three-month US treasuries now yield just 0.056%. Asinvestors everywhere seek a safe haven amid the market turmoil, yields on creditworthysovereign debt have fallen across the board. The conventional wisdom is that governments (andparticularly the US government) will always meet their debt obligations. Given the marketturmoil, this seems sensible until one considers the economics of owning these bonds. In ourview, the current buyers of government bonds are completely ignoring the very real hazards of receiving only 2.39% (in the case of 10-year paper) as compensation for assuming both the creditrisk and inflation risk of owning a 10-year government bond.Starting with credit risk, whenever a company dramatically increases its borrowing, the marketdemands a higher rate of return to hold its debt in order to compensate for heightened default risk.In the case of US government bonds, exactly the opposite has happened. The US government hasadded $1.15 trillion to its debt burden over the last six months, but at the same time, the interestrate it has to pay to borrow money (on 30-year bonds) has declined from 4.52% to 3.06% –meaning it has become 32% cheaper for the US government to borrow. Meanwhile, the growinglist of announced and potential policy actions the US will take to try to avoid a full-scaledepression has become very long and very expensive: a $1.2 trillion expanded federal budget for2009, a future $1 trillion stimulus plan, automaker bailouts, municipality bailouts, bank nationalizations, pension fund bailouts and so on. This ultimately must raise the credit risk of owning US government bonds. Already, the market for credit default swaps (CDS) (which reflectthe cost of insuring against issuer default) is reflecting the increased credit risk of the USTreasury. Since December 2007, the 1-year CDS on US treasuries has risen 478%, from 9 to 52basis points. It is still a low number, but the trend is worrying. The perception of sovereign risk is