<PAGE>
MORGAN STANLEY
RUSSIA & NEW EUROPE FUND, INC.
- --------------------------------------------------------------------------------
DIRECTORS AND OFFICERS
Barton M. Biggs William G. Morton, Jr.
CHAIRMAN OF THE BOARD DIRECTOR
OF DIRECTORS
James W. Grisham
Michael F. Klein VICE PRESIDENT
PRESIDENT AND DIRECTOR
Harold J. Schaaff, Jr.
Peter J. Chase VICE PRESIDENT
DIRECTOR
Joseph P. Stadler
John W. Croghan VICE PRESIDENT
DIRECTOR
Valerie Y. Lewis
David B. Gill SECRETARY
DIRECTOR
Joanna M. Haigney
Graham E. Jones TREASURER
DIRECTOR
Belinda A. Brady
John A. Levin ASSISTANT TREASURER
DIRECTOR
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INVESTMENT ADVISER
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
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ADMINISTRATOR
The Chase Manhattan Bank
73 Tremont Street
Boston, Massachusetts 02108
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CUSTODIANS
The Chase Manhattan Bank
Chaseside
Bournemouth BH7 7DB
United Kingdom
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SHAREHOLDER SERVICING AGENT
American Stock Transfer & Trust Company
40 Wall Street
New York, New York 10005
(800) 278-4353
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LEGAL COUNSEL
Rogers & Wells
200 Park Avenue
New York, New York 10166
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INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
1177 Avenue of the Americas
New York, New York 10036
- --------------------------------------------------------------------------------
For additional Fund information, including the Fund's net asset value per share
and information regarding the investments comprising the Fund's portfolio,
please call 1-800-221-6726.
- --------------------------------------------------------------------------------
MORGAN STANLEY
RUSSIA & NEW EUROPE
FUND, INC.
- --------------------------------------------------------------------------------
THIRD QUARTER REPORT
SEPTEMBER 30, 1997
MORGAN STANLEY ASSET MANAGEMENT INC.
INVESTMENT ADVISER
<PAGE>
LETTER TO SHAREHOLDERS
- ----------
For the nine months ended September 30, 1997 the Morgan Stanley Russia & New
Europe Fund, Inc. (the "Fund") had a total return, based on net asset value per
share, of 71.13% compared to 73.00% for the Fund's benchmark. Until a more
appropriate benchmark is created, the Fund will be compared to a market
capitalization weighted composite consisting of 50% of the Moscow Times 50 Index
(dollar adjusted) and 50% of the MSCI Czech Republic, Hungary and Poland
indices. For the period since the Fund's commencement of operations on September
30, 1996 trough September 30, 1997, the Fund had a total return, based on net
asset value per share, of 78.28% compared with 88.99% for its benchmark. On
September 30, 1997, the closing price of the Fund's shares on the New York Stock
Exchange was $34 1/8 representing a 3.8% discount to the Fund's net asset value
per share.
The Russian equity market was unsettled over the third quarter but finished the
quarter having gained 12% as measured by the dollar based Moscow Times index.
International concerns, such as jitters on Wall Street and the Asian currency
worries affecting all emerging markets, were the primary causes of the markets
erratic nature for the quarter.
The quarter did provide some encouraging economic news with July to September's
monthly year-on-year real GDP change being positive each month and September's
figures displaying growth of 2.3%. This trend is extremely encouraging and
represents the first time since reforms that economic growth has continued for a
whole quarter. Such performance bodes well for the predicted 3.0% real growth in
1998. Inflation has remained under control and should be under 14% for 1997.
Less encouraging news surrounds the fiscal side of the Russian economy. Although
the budget deficit remains below the IMF ceiling, tax collection continues to be
extremely problematic. Political wranglings have delayed the likely imposition
of a new tax code from January 1st, 1998 to a piecemeal implementation starting
possibly on July 1, 1998. The government's tough 1998 budget is also facing a
difficult time in the Duma. As has been said before, these measures are
important in dealing with the continually worsening inter-company payment
problems within Russia. Overdue receivables and payables continue to grow in the
absence of progress on these fiscal issues, and this will hold back strong
economic growth.
On the political side, the Government is facing a challenging time in dealing
with the Duma as well as prominent private individuals. The privatization of 25%
of the telephone holding company Svyazinvest, in which the Fund participated,
was a tremendous success in that it was the first competitive privatization that
raised substantial sums for the country (over $1.8 billion). However, it became
surrounded in controversy as unsuccessful parties started making accusations of
unfair practices. President Yeltsin eventually called a meeting of Russia's most
influential businessmen in order to calm this damaging practice of pursuing
private disputes in such a public fashion. Yeltsin has also been forced to quiet
the Duma which has come close to calling a no confidence vote in his Government.
These political disruptions are damaging not because they represent very real
threats to the government but because they significantly delay the
implementation of crucial policies as those described above.
The combination of these political and economic factors, combined with an
uncertain international feeling towards emerging markets leads us to continue
our policy of being neutrally weighted in Russia compared to the Fund's
benchmark. International flows are still the driving force of Russia, and, in
recent months, the market has shown a high level of correlation with the U.S.
market and its uncertainties. However, within the Russian section of the
portfolio there has been some repositioning. In particular, the Fund has been
reducing its holdings in oil subsidiaries such as Megionneftegaz and
Noyabrskneftegaz due to the increase in uncertainty surrounding merger terms
between such entities and their holding companies. On the other hand, exposure
to oil companies with no or low merger risk such as Lukoil, Tatneft and
Surgutneftegaz has increased. The inclusion of Svyazinvest in the portfolio,
which gives unique exposure to practically all telephone entities in Russia, has
meant it appropriate to reduce some of the Fund's regional telecom exposure such
as Nizhny Novgorod Telephone and St. Petersburg Telephone.
The Polish market rebounded during the third quarter, rising 8.6% according to
the MSCI Polish Index in U.S. dollar terms. Two factors lent support to the
market: the end of large-scale equity offerings and the resolution of political
concerns. During the first half of the year, several relatively large companies
came to market, absorbing liquidity and causing an imbalance between supply and
demand. While there are several more IPOs and secondary offerings coming to
market in the next 12 months, the volume of new stock will be significantly
lower. On the political front, general elections were held in September which
resulted in the defeat of the ruling Socialist-led coalition by a group of
Solidarity parties. A new government was in the process of being formed during
the end of the quarter, but it appears that basic economic policy will remain
intact. Leaders of the new dominant parties have cited their support for the
most critical
2
<PAGE>
challenge facing the government, namely a balanced budget. The Polish economy,
which continues to grow at around 6% per year, is experiencing a boom in
consumer credit. As a result, the current account balance has swung from
positive to negative during the year, led by a growth in imports. The new
government recognizes the need to slow the economy and Solidarity has announced
its support for a budget deficit of less than 2%. Meanwhile, significant
progress has been made in the fight against inflation, which fell from 18.5% in
December 1996 to 14.6% in May. With the supply of new issues limited, the
Polish market should recover during the second half of the year and the Fund is
positioned to capture strong corporate performance from select Polish
companies.
After a dismal first half, the Czech market staged a short-lived rally during
the quarter, rising 13.4%. The recovery was not based on fundamental changes in
the outlook for the Czech economy. In response to the unexpected devaluation of
the Czech crown in May, authorities have tightened both fiscal and monetary
policy. The national bank has continued to keep basic interest rates relatively
high and the government has just begun to deliver on promises of substantial
fiscal cuts with an aim to balance the budget by the end of the year. On the
positive side, the government has announced new measures that could improve the
poor market transparency and weak minority shareholders rights that plague the
Prague Stock Exchange. For example, the government has announced its willingness
to create an independent SEC-type watchdog with enforcement capabilities. While
the proposals show potential progress, many market-watchers will adopt a
wait-and-see attitude. Based on the poor economic outlook, the Fund remains
underweight in the Czech republic, but will take advantage of opportunities as
they arise.
Hungary's economic fundamentals continue to improve and the market responded by
moving up 9.8% during the quarter. In particular, anticipated economic growth
has surfaced after several years of austerity. Industrial growth, led by a
resurgence in construction, is now growing at around 8% annually. After falling
for several years, real wages have begun to pick up but productivity growth
continues to offset wage pressure. Hungary's drive to join the European Union
will result in continued reforms, such as the elimination of import duties. The
market is currently anticipating large offerings during the second half of the
year, particularly the national telephone monopoly Matav which should add size
and liquidity to the Hungarian market which after rising significantly during
the last two years is still only a total $9 billion in market capitalization.
With continued improvement in both macroeconomic conditions and corporate
restructure, the Fund will maintain a significant position in the Hungarian
market.
The Fund has also made its first investment in Kazhakstan over the last quarter
with a purchase of Kazkommertsbank Co. A highly successful, privately run bank
formed in 1990. As always, the Fund is closely following the developments of
other, less developed, potential markets, such as the Bulgarian and Ukrainian
equity markets, so as to be in a position to act when opportunities arise.
Sincerely,
/s/ Michael F. Klein
Michael F. Klein
PRESIDENT AND DIRECTOR
/s/ Michael Hewett
Michael Hewett
PORTFOLIO MANAGER
/s/ Madhav Dhar
Madhav Dhar
PORTFOLIO MANAGER
/s/ Robert L. Meyer
Robert L. Meyer
PORTFOLIO MANAGER
October 1997
3
<PAGE>
MORGAN STANLEY RUSSIA & NEW EUROPE FUND, INC.
INVESTMENT SUMMARY AS OF SEPTEMBER 30, 1997 (UNAUDITED)
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- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
HISTORICAL TOTAL RETURN (%)
INFORMATION --------------------------------------------------------
MARKET VALUE (1) NET ASSET VALUE (2) INDEX (3)
---------------- ------------------- ---------
CUMULATIVE CUMULATIVE CUMULATIVE
---------- ---------- ----------
<S> <C> <C> <C>
FISCAL YEAR TO DATE 90.03% 71.13% 73.00%
ONE YEAR 71.56 78.28 88.99
SINCE INCEPTION* 71.56 78.28 88.99
</TABLE>
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- --------------------------------------------------------------------------------
RETURNS AND PER SHARE INFORMATION
[CHART]
PERIOD FROM NINE MONTHS
SEPTEMBER 30, 1996* ENDED
TO DECEMBER 31, 1996 SEPTEMBER 30, 1997
-------------------- ------------------
Net Asset Value Per Share..... $ 20.77 $35.46
Market Value Per Share........ $ 18.00 $34.13
Premium/(Discount)............ -13.3 % -3.8 %
Income Dividends.............. $ 0.07 --
Capital Gains Distributions... -- $ 0.08
Fund Total Return (2)......... 4.18 % 71.13 %
Index Total Return (3)........ 9.43 % 73.00 %
(1) Assumes dividends and distributions, if any, were reinvested.
(2) Total investment return based on net asset value per share reflects the
effects of changes in net asset value on the performance of the Fund during
each period, and assumes dividends and distributions, if any, were
reinvested. These percentages are not an indication of the performance of a
shareholder's investment in the Fund based on market value due to
differences between the market price of the stock and the net asset value
per share of the Fund.
(3) The Russia and New Europe Blended Composite is a capitalization weighted
index comprised of the Morgan Stanley Capital International regional
indices for the Czech Republic, Hungary, Poland and the Moscow Times 50
Index, including dividends.
* The Fund commenced operations on September 30, 1996.
4
<PAGE>
MORGAN STANLEY RUSSIA & NEW EUROPE FUND, INC.
INVESTMENT SUMMARY AS OF SEPTEMBER 30, 1997 (UNAUDITED)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
PORTFOLIO INVESTMENTS DIVERSIFICATION
[CHART]
Equity Securities (93.1%)
Debt Instruments (2.0%)
Short-Term Investments (4.9%)
- --------------------------------------------------------------------------------
SECTORS
[CHART]
Automobiles (2.2%)
Banking (6.2%)
Building Materials & Components (3.2%)
Chemicals (2.3%)
Data Processing & Reproduction (2.6%)
Energy Sources (23.8%)
Health & Personal Care (3.5%)
Metals-Non-Ferrous (2.5%)
Utilities-Electrical & Gas (21.9%)
Telecommunications (11.5%)
Other (20.3%)
- --------------------------------------------------------------------------------
COUNTRY WEIGHTINGS
[CHART]
Russia (52.8%)
Other (7.8%)
Slovakia (0.9%)
Kazakhstan (1.7%)
Croatia (3.2%)
Czech Republic (6.1%)
Hungary (11.7%)
Poland (15.8%)
- --------------------------------------------------------------------------------
TEN LARGEST HOLDINGS*
PERCENT OF
NET ASSETS
----------
1. Unified Energy System (UES) 15.0%
2. Lukoil Holdings 7.6
3. Surgutneftegaz 5.8
4. MOL Magyar Olaj-es Gazipari Rt. 4.7
5. SPT Telekom 4.6
6. Mosenergo 4.4
7. Tatneft 3.6
8. Rostelecom 3.4
9. Richter Gedeon Rt. 2.3
10. Zagrebacka Banka 2.0
-----
53.4%
-----
-----
*Excludes Short-Term Investments.
5
<PAGE>
INVESTMENTS (UNAUDITED)
- ---------------
SEPTEMBER 30, 1997
SHARES VALUE
(000)
- --------------------------------------------------------------------------------
COMMON STOCKS (90.3%)
(Unless otherwise noted)
- --------------------------------------------------------------------------------
CROATIA (3.2%)
BANKING
Zagrebacka Banka GDR 90,500 U.S.$ 3,609
---------------
HEALTH & PERSONAL CARE
Pliva d.d. GDR 104,500 2,043
---------------
5,652
---------------
- --------------------------------------------------------------------------------
CZECH REPUBLIC (6.1%)
FINANCIAL SERVICES
Resolution Investment Fund 26,100 767
---------------
MACHINERY & ENGINEERING
CKD Praha Holding 23,656 766
Skoda Plzen 36,500 1,046
---------------
1,812
---------------
TELECOMMUNICATIONS
SPT Telekom 65,000 8,222
---------------
10,801
---------------
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HUNGARY (11.7%)
AUTOMOBILES
Mezogep 45,000 1,376
North American Bus Industries Rt. 28,500 731
---------------
2,107
---------------
BUILDING MATERIALS & COMPONENTS
Zalakeramia Rt. 21,000 925
---------------
CHEMICALS
BorsodChem Rt. GDR 63,000 2,512
---------------
ENERGY SOURCES
MOL Magyar Olaj-es Gazipari Rt. GDR 386,000 8,405
---------------
HEALTH & PERSONAL CARE
Richter Gedeon Rt. GDS 39,300 4,127
---------------
MISCELLANEOUS MATERIALS & COMMODITIES
Graboplast Rt. 16,000 946
Pannonplast Rt. 16,825 912
---------------
1,858
---------------
PHARMACEUTICALS
EGIS Rt. 16,000 825
---------------
20,759
---------------
- --------------------------------------------------------------------------------
KAZAKHSTAN (1.7%)
BANKING
Kazkommertsbank Co. GDR 106,380 3,085
---------------
- --------------------------------------------------------------------------------
POLAND (15.8%)
AUTOMOBILES
Sanockie Zaklady Przemyslu Gumowego Stomil 71,986 1,364
Stomil Olsztyn 35,000 335
---------------
1,699
---------------
BANKING
Bank Slaski 34,600 U.S.$2,603
BIG 1,323,770 1,698
---------------
4,301
---------------
BEVERAGES & TOBACCO
Okocimskie Zaklady Piwowarskie S.A. 178,074 1,091
---------------
BUILDING MATERIALS & COMPONENTS
Gorazdze 44,000 1,854
Polifarb Cieszyn - Wroclaw 'C' 215,000 1,079
Zaklady Lentex 135,614 1,882
---------------
4,815
---------------
CONSTRUCTION & HOUSING
Budimex 146,628 667
---------------
DATA PROCESSING & REPRODUCTION
Computerland Poland 100,900 2,236
OPTIMUS 'D' 72,666 2,394
---------------
4,630
---------------
ENERGY EQUIPMENT & SERVICES
Elektrobudowa 60,000 901
---------------
FINANCIAL SERVICES
National Investment Fund GDR 50,000 2,125
---------------
FOOD & HOUSEHOLD PRODUCTS
Farm Food 137,204 1,760
Sokolowskie Zaklady Miesne 683,750 947
Sokolowskie Zaklady Miesne (Rights) 683,750 --@
---------------
2,707
---------------
MERCHANDISING
Best 77,000 543
---------------
METALS - NON-FERROUS
KGHM Polska Miedz GDR 106,000 1,341
---------------
MULTI-INDUSTRY
Elektrim 296,000 3,306
---------------
28,126
---------------
- --------------------------------------------------------------------------------
RUSSIA (50.9%)
ENERGY SOURCES
Lukoil Holdings 370,000 9,084
Lukoil Holdings (Preferred) 230,000 4,393
Megionneftegaz 25,000 207
Orenburgneft 60,000 495
Purneftegaz 265,000 2,703
Surgutneftegaz ADR 875,000 10,281
Tatneft ADR 41,200 6,448
Urdmurtneft 3,500 201
---------------
33,812
---------------
MACHINERY & ENGINEERING
Uralmash Rursoo 22,238 568
---------------
MERCHANDISING
TSUM 2,982,000 1,998
---------------
- --------------------------------------------------------------------------------
6
<PAGE>
SHARES VALUE
(000)
- --------------------------------------------------------------------------------
METALS - NON-FERROUS
Norilsk Nickel 166,000 U.S.$ 2,075
Norilsk Nickel (Preferred) 100,000 1,050
---------------
3,125
---------------
METALS - STEEL
Seversky Tube Works 200,000 720
Seversky Tube Works ADR 10,000 360
---------------
1,080
---------------
TELECOMMUNICATIONS
Mustcom 2,436,259 2,436
Nizhny Novgorod Telephone 90,000 540
Rostelecom 1,455,000 6,111
St. Petersburg Telephone Network 745,000 1,684
---------------
10,771
---------------
UTILITIES - ELECTRICAL & GAS
Gazprom ADR 63,800 1,579
Irkutskenergo 4,000,000 1,304
Lenenergo 1,100,000 1,144
Mosenergo 4,800,000 7,776
Permenergo 9,000 468
Unified Energy System (UES) 66,800,000 26,653
---------------
38,924
---------------
90,278
---------------
- --------------------------------------------------------------------------------
SLOVAKIA (0.9%)
CHEMICALS
Slovnaft 60,000 1,604
---------------
- --------------------------------------------------------------------------------
TOTAL COMMON STOCKS
(Cost U.S.$97,958) 160,305
---------------
- --------------------------------------------------------------------------------
FACE
AMOUNT
(000)
- --------------------------------------------------------------------------------
DEBT INSTUMENTS (1.9%)
- --------------------------------------------------------------------------------
RUSSIA (1.9%)
BROADCASTING & PUBLISHING (1.1%)
Storyfirst Communications
Tranche III (Convertible) U.S.$ 2 1,938
---------------
TELECOMMUNICATIONS (0.8%)
Svyazinvest 1,431 1,431
---------------
3,369
---------------
- --------------------------------------------------------------------------------
TOTAL DEBT INSTRUMENTS
(Cost U.S.$3,369) 3,369
---------------
- --------------------------------------------------------------------------------
SHORT-TERM INVESTMENTS (4.8%)
- --------------------------------------------------------------------------------
UNITED STATES (4.8%)
REPURCHASE AGREEMENT
Chase Securities, Inc. 5.75%, dated
9/30/97, due 10/1/97 to be repurchased
at U.S.$8,421, collateralized by United
States Treasury Notes, 5.875%, due
1/31/99, valued at U.S. $8,594
(Cost U.S.$8,420) U.S.$ 8,420 U.S.$ 8,420
---------------
- --------------------------------------------------------------------------------
TOTAL INVESTMENTS (97.0%)
(Cost U.S.$109,747) 172,094
---------------
- --------------------------------------------------------------------------------
OTHER ASSETS AND LIABILITIES (3.0%)
Other Assets 16,383
Liabilities (11,004) 5,379
--------------- ---------------
- --------------------------------------------------------------------------------
NET ASSETS (100%)
Applicable to 5,005,000 issued and
outstanding U.S.$0.01 par value
shares (500,000,000 shares authorized) U.S.$177,473
---------------
---------------
- --------------------------------------------------------------------------------
NET ASSET VALUE PER SHARE U.S.$ 35.46
---------------
---------------
- --------------------------------------------------------------------------------
@ - Value is less than U.S.$500.
ADR - American Depositary Receipt.
GDR - Global Depositary Receipt.
GDS - Global Depositary Shares.
7
