<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
Michael F. Klein Stefanie V. Chang
PRESIDENT AND DIRECTOR VICE PRESIDENT
Peter J. Chase Harold J. Schaaff, Jr.
DIRECTOR VICE PRESIDENT
John W. Croghan Joseph P. Stadler
DIRECTOR VICE PRESIDENT
David B. Gill Valerie Y. Lewis
DIRECTOR SECRETARY
Graham E. Jones Joanna M. Haigney
DIRECTOR TREASURER
John A. Levin Belinda A. Brady
DIRECTOR ASSISTANT TREASURER
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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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CUSTODIAN
The Chase Manhattan Bank
Chaseside
Bournemouth BH7 7DB
United Kingdom
The Chase Manhattan Bank
3 Chase MetroTech Center
Brooklyn, New York 11245
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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 LLP
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.
- --------------------------------------------------------------------------------
FIRST QUARTER REPORT
March 31, 1998
MORGAN STANLEY ASSET MANAGEMENT INC.
INVESTMENT ADVISER
<PAGE>
LETTER TO SHAREHOLDERS
- ----------------------
For the three months ended March 31, 1998, the Morgan Stanley Russia & New
Europe Fund, Inc. (the "Fund") had a total return, based on net asset value per
share, of -1.43% compared to -5.20% for the Fund's performance benchmark. The
Fund is compared, for performance purposes, with a market weighted benchmark
composite comprised of the Morgan Stanley Capital International (MSCI) local
index for each of Russia, Poland, the Czech Republic and Hungary. For the one
year ended March 31, 1998, and for the period since the Fund's commencement of
operations on September 30, 1996 through March 31, 1998, the Fund had a total
return, based on net asset value per share, of 11.75% and 52.17%, respectively,
compared with 16.10% and 63.19%, respectively, for the benchmark. On March 31,
1998, the closing price of the Fund's shares on the New York Stock Exchange was
$24 3/16 , representing a 7.7% discount to the Fund's net asset value per share.
Thus far in 1998, political maneuvers in the Russian Kremlin have dominated
investor attention throughout the region. After an illness in December,
President Boris Yeltsin returned to office and demonstrated renewed emphasis on
reform by dissolving the Cabinet, which he claimed had not made sufficient
progress in addressing the country's key problems, such as tax reform and the
large budget deficit. Prime Minister Victor Chernomyrdin, who had publicly
stated his ambitions to become Russia's next President, lost his job. Political
uncertainty significantly increased; the reform program was put on hold and
political power became highly centralized in one person, President Yeltsin. In
the long term, however, the country is likely to receive a much needed boost to
its restructuring program. The political turmoil served to exacerbate the
downward trend in the market that began in October 1997. During the first
quarter, the Fund maintained the underweight position in Russian equities that
began in the fourth quarter of 1997. MSCI Russia, which is the largest country
in the Fund's benchmark with an 49.3% weight, fell 13.2% for the quarter.
In addition to political turmoil, several other factors weighed down the
performance of Russian stocks this year. The steep fall in global commodity
prices was detrimental to Russia's many natural resource companies. Oil stocks,
which represent 44.3% of the Russia index, fell around 25% in the wake of a 30%+
drop in Brent Crude prices. Oil exports are the primary source of cash sales
for Russian oil companies leading not only to a drop in income, but to financing
problems. Crude oil and oil products constitute nearly one quarter of Russia's
exports and weak prices have led to a rapid reduction in the country's once
large trade surplus. The current account is falling from a surplus of 2.6% GDP
in 1996 to a slight deficit in 1998. Current account deterioration, coupled
with concerns over Russia's ability to finance the Federal budget through tax
collection, led to pressure on the ruble which, at one point in February, forced
the Russian Central Bank (RCB) to raise interest rates. Interest rates on
short-term government debt peaked at 42%. Yet, once again, the RCB proved it
was capable of defending the currency under difficult conditions. A strong
ruble remains a key part of the Central Bank's economic strategy and the RCB is
clearly willing to let interest rates climb to achieve this goal. Higher levels
of short-term debt have added pressure to the budget as the RCB endeavors to
lower yields. Moody's downgraded it's credit rating for Russian foreign
currency bonds this past February. The credit agency cited the government's
poor tax collection, worsening budget situation, and decreasing foreign reserves
as reasons for the rating change.
Although the situation appears difficult, Russia's structural differences with
Asia reduce the likelihood of a devaluation. Russia has enjoyed a current
account surplus that is moving into a small deficit in 1998. In addition,
banking is underdeveloped and the majority of enterprises have low debt levels.
In the long-term, the fall in commodity prices will lead to accelerated
restructuring. Companies in the oil sector are pushing forward cost reduction
programs while the entire sector is undergoing a consolidation phase. In
general, the short-term fears that plague the Russian market obscure the
progress being made. In the area of tax reform, collection has improved
dramatically as new rules are introduced, increasing revenues by 30%. The Duma
and the Federation Council approved a tight 1998 budget with unexpected speed
this past March. If Russia forms a new reform-oriented Cabinet, free from the
political connections of the previous administration, the prospects for
continued tax reform and adherence to the tight budget plan will improve.
Hungary, the second largest country in the Fund after Russia, is overweight
versus the index. Economic conditions in the country continue to create a
positive environment for companies. Industrial growth accelerated by the end of
1997 and continued into 1998. Growth has been led by the manufacturing sector
which should push up GDP by 4.8% this year. The significant amount of foreign
direct investment the country has received in the last five years has been a
critical part of the Hungarian formula. The crawling peg currency regime has
been successful in keeping Hungarian products competitive. Export growth last
year was above 30% in U.S. dollar terms.
There are some negative developments, however, on the horizon. After years of
decline, wages have begun to rise faster than inflation. While productivity
growth continues to be strong in Hungary, real wage growth may become a problem
for authorities if it leads to the import boom that has plagued many economies.
In the short-term, high unemployment should limit the potential for real wage
increases. 1998 is an election year for Hungary. Major parties are endorsing a
continuation of basic economic policies, while the markets are focusing on
possible change.
2
<PAGE>
Overall, the first quarter of 1998 was positive for Hungary. The country, along
with Poland and the Czech Republic were welcomed into NATO, which is a
preliminary step before the next major move, entry into the European Union. The
MSCI index for Hungary was up 12.2% for the quarter.
After a troubled 1997, the Czech economy entered a stage of relatively healthy
growth during the beginning of 1998. Last year's trade balance deterioration
reversed as steadily rising exports have increased industrial production.
Initially, the positive export performance was due to a weakened currency, but
there have been signs of industrial restructuring. The government is currently
running a budget surplus and will likely end the year with a balanced budget.
The political uncertainty caused by the fall of the Klaus government stabilized
during the quarter. President Havel was re-elected and a new temporary cabinet
was approved. Historically, the Czech equity market had been plagued by poor
oversight and a general lack of minority shareholder rights. This created a
significant disincentive for foreign portfolio investment. As part of an
overall effort to attract increased foreign capital flows, the government
approved a law that created a U.S.-style Securities Exchange Commission, thus
establishing the base for effective market regulation.
While economic fears have ameliorated and market regulation is set to improve,
another potentially distracting issue has emerged - general elections in June.
Current public opinion polls indicate the Social Democrats will win the most
Parliamentary seats, but they might not win by a majority and be forced into
coalition. In addition, the Social Democrats are not the most market-friendly
party. If they win the elections, the Party has stated that the privatization
process will slow and they will pursue an expansionary fiscal policy. While the
direction of economic reform will most likely remain the same, the pace of
essential bank privatization and price deregulation is uncertain. The Fund
remains underweight in the market which was up 6.3% during the first quarter of
1998.
After a difficult 1997, the Polish market rebounded strongly during the first
quarter of 1998. Last year's crisis in Asia focused investor attention on
Poland's import boom and its growing current account deficit. At one point in
the third quarter of 1997, Poland's currency, the zloty, traded near the bottom
of the currency band, forcing the central bank to intervene and sell dollars.
The newly elected government that came into power in October cut fiscal spending
significantly and, with the help of very tight monetary policy, engineered a
"soft landing" for the economy. Renewed macro-economic confidence, coupled with
a reduction of the monthly crawling peg attracted significant foreign capital to
the local market. The zloty appreciated against the dollar during the first
quarter of 1998, and the currency now trades near the top of its band. The Fund
remains significantly overweight in the Polish market which is up 18.7% for the
year-to-date.
During the quarter, the Fund selectively increased its weighting in core Russian
positions in stocks that have sold off sharply. In particular the Fund added to
its holding in Unified Energy Systems (UES), the national energy company, which
should benefit if a new government makes progress against the huge non-payment
problem. The Fund also added Vimplecom, the cellular telephone provider in
Moscow, that should benefit from the tremendous demand for wireless telephone
services. In Central Europe, the holding in MOL, the Hungarian oil and gas
monopoly was increased. Hungary, and MOL, should benefit from falling oil and
gas prices. After a strong first quarter, the Fund reduced several of the large
Polish holdings. The Fund continues to examine the entire region for attractive
investment opportunities.
Sincerely,
/s/ Michael F. Klein
Michael F. Klein
PRESIDENT AND DIRECTOR
/s/ Paul C. Psaila
Paul C. Psaila
PORTFOLIO MANAGER
April 1998
3
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Investment Summary as of March 31, 1998 (Unaudited)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------------
HISTORICAL TOTAL RETURN (%)
INFORMATION ------------------------------------------------------------------------
MARKET VALUE (1) NET ASSET VALUE (2) INDEX (3)
---------------------- ---------------------- ----------------------
AVERAGE AVERAGE AVERAGE
CUMULATIVE ANNUAL CUMULATIVE ANNUAL CUMULATIVE ANNUAL
---------- ------- ---------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
FISCAL YEAR TO DATE 1.31% - -1.43% - -5.20% -
ONE YEAR 17.27 17.27% 11.75 11.75% 16.10 16.10%
SINCE INCEPTION* 40.43 25.43 52.17 32.33 63.19 38.65
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
RETURNS AND PER SHARE INFORMATION
[GRAPH]
PERIOD FROM THREE MONTHS
SEPTEMBER 30, 1996* YEAR ENDED ENDED
TO DECEMBER 31, 1996 DECEMBER 31, 1997 MARCH 31, 1998
-------------------- ----------------- --------------
<S> <C> <C> <C>
Net Asset Value Per Share. . . . . . . . $ 20.77 $ 26.59 $ 26.21
Market Value Per Share . . . . . . . . . $ 18.00 $ 23.88 $ 24.19
Premium/(Discount) . . . . . . . . . . . -13.3% -10.2% -7.7%
Income Dividends . . . . . . . . . . . . $ 0.07 - -
Capital Gains Distributions. . . . . . . - $ 3.68 -
Fund Total Return (2). . . . . . . . . . 4.18% 48.19% -1.43%
Index Total Return (3) . . . . . . . . . 9.55% 57.12% -5.20%
</TABLE>
(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 market weighted benchmark
composite comprised of the Morgan Stanley Capital International local index
for each of Russia, Poland, the Czech Republic and Hungary.
* The Fund commenced operations on September 30, 1996.
4
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Portfolio Summary as of March 31, 1998 (Unaudited)
- --------------------------------------------------------------------------------
DIVERSIFICATION OF TOTAL INVESTMENTS
[CHART]
<TABLE>
<S> <C>
Short-Term Investments (1.2%)
Equity Securities (96.6%)
Debt Securities (2.2%)
</TABLE>
- --------------------------------------------------------------------------------
SECTORS
[CHART]
<TABLE>
<S> <C>
Other (14.6%)
Utilities - Electrical & Gas (20.2%)
Telecommunications (17.0%)
Banking (7.2%)
Beverages & Tobacco (3.0%)
Building Materials & Components (3.7%)
Electronic Components & Instruments (2.1%)
Energy Sources (22.6%)
Health & Personal Care (4.8%)
Metals - Non-Ferrous (2.2%)
Multi-Industry (2.6%)
</TABLE>
- --------------------------------------------------------------------------------
COUNTRY WEIGHTINGS
[CHART]
<TABLE>
<S> <C>
Other (3.1%)
Romania (0.3%)
TUrkey (0.5%)
Slovakia (0.8%)
Czech Republic (4.3%)
Poland (18.6%)
Hungary (22.8%)
Russia (49.6%)
</TABLE>
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TEN LARGEST HOLDINGS
<TABLE>
<CAPTION>
PERCENT OF
NET ASSETS
----------
<S> <C>
1. Unified Energy Systems (Russia) 11.3%
2. MOL Magyar Olaj-es Gazipari Rt. (Hungary) 7.6
3. Lukoil Holdings (Russia) 6.7
4. MATAV Rt. (Hungary) 4.6
5. Mosenergo (Russia) 4.5
6. Richter Gedeon Rt. (Hungary) 4.4
7. Surgutneftegaz (Russia) 4.1
8. AO Tatneft (Russia) 3.6
9. Rostelecom (Russia) 3.6
10. Mustcom (Russia) 3.3
----
53.7%
----
----
</TABLE>
5
<PAGE>
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- --------------------------------------------------------------------------------
<S> <C> <C>
COMMON STOCKS (94.7%)
(Unless otherwise noted)
- --------------------------------------------------------------------------------
CZECH REPUBLIC (4.3%)
TELECOMMUNICATIONS
SPT Telekom 25,000 U.S.$ 3,236
---------------
UTILITIES - ELECTRICAL & GAS
Czech Power Co. 79,300 2,384
---------------
5,620
---------------
- --------------------------------------------------------------------------------
HUNGARY (22.8%)
AUTOMOBILES
North American Bus Industries Rt. 55,500 1,298
---------------
BANKING
OTP Bank Rt. 60,700 3,087
---------------
BUILDING MATERIALS & COMPONENTS
Zalakeramia Rt. 27,500 1,354
---------------
ENERGY SOURCES
MOL Magyar Olaj-es
Gazipari Rt. GDR 323,500 9,915
---------------
HEALTH & PERSONAL CARE
EGIS Rt. 9,000 485
Richter Gedeon Rt. GDS 55,300 5,779
---------------
6,264
---------------
MISCELLANEOUS MATERIALS & COMMODITIES
Graboplast Rt. GDR 154,000 1,044
Pannonplast Rt. 23,825 970
---------------
2,014
---------------
TELECOMMUNICATIONS
MATAV Rt. ADR 193,200 6,014
---------------
29,946
---------------
- --------------------------------------------------------------------------------
POLAND (18.6%)
AUTOMOBILES
Sanockie Zaklady Przemyslu
Gumowego Stomil 71,986 876
---------------
BANKING
Bank Slaski 28,900 2,094
BIG 1,535,000 2,157
Wielkopolski Bank Kredytowy 279,000 2,061
---------------
6,312
---------------
BEVERAGES & TOBACCO
Okocimskie Zaklady
Piwowarskie 390,000 3,210
---------------
BUILDING MATERIALS & COMPONENTS
Gorazdze 44,000 1,237
Zaklady Lentex 135,614 1,807
Zaklady Metali Lekkich Kety 26,500 499
---------------
3,543
---------------
CHEMICALS
Polifarb Cieszyn - Wroclaw 215,000 897
---------------
DATA PROCESSING & REPRODUCTION
Computerland Poland 98,400 1,868
---------------
FINANCIAL SERVICES
National Investment Fund GDR 50,000 1,825
---------------
- --------------------------------------------------------------------------------
FOOD & HOUSEHOLD PRODUCTS
Farm Food 137,204 1,252
Sokolowskie Zaklady Miesne 433,750 541
---------------
1,793
---------------
METALS - NON-FERROUS
KGHM Polska Miedz GDR 77,000 568
---------------
MULTI-INDUSTRY
Elektrim 276,600 3,447
---------------
24,339
---------------
- --------------------------------------------------------------------------------
ROMANIA (0.3%)
PHARMACEUTICALS
Terapia 229,813 414
---------------
- --------------------------------------------------------------------------------
RUSSIA (47.4%)
ELECTRONIC COMPONENTS & INSTRUMENTS
Story First 'A' (Preferred) 1,920 2,746
---------------
ENERGY SOURCES
AO Tatneft ADR 206,000 4,777
Lukoil Holdings 370,000 6,490
Lukoil Holdings (Preferred) 230,000 2,288
Orenburgneft 60,000 183
Purneftegaz 70,000 385
Surgutneftegaz ADR 675,000 5,400
Urdmurtneft 3,500 158
---------------
19,681
---------------
MACHINERY & ENGINEERING
Uralmash Zavody 111,190 945
---------------
MERCHANDISING
TSUM 2,982,000 820
---------------
METALS - NON-FERROUS
Norilsk Nickel 299,000 1,779
Norilsk Nickel (Preferred) 100,000 475
---------------
2,254
---------------
METALS - STEEL
Izhorskie Zavody 13,774 785
Seversky Tube Works 200,000 400
Seversky Tube Works ADR 10,000 225
---------------
1,410
---------------
TELECOMMUNICATIONS
Mustcom 5,356,352 4,371
Nizhnovsvyazinform 90,000 279
Rostelecom 1,455,000 4,748
St. Petersburg Telephone Network 705,000 881
---------------
10,279
---------------
UTILITIES - ELECTRICAL & GAS
Gazprom ADR 90,900 1,927
Gazprom ADS 7,900 164
Irkutskenergo 4,000,000 680
Lenenergo 1,000,000 445
Mosenergo 4,800,000 5,880
Permenergo 30,000 132
Unified Energy Systems (UES) 46,800,000 14,854
---------------
24,082
---------------
62,217
---------------
- --------------------------------------------------------------------------------
</TABLE>
6
<PAGE>
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- --------------------------------------------------------------------------------
<S> <C> <C>
SLOVAKIA (0.8%)
CHEMICALS
Slovnaft 20,000 U.S.$ 472
---------------
PHARMACEUTICALS
Slovakofarma GDR 80,000 616
---------------
1,088
---------------
- --------------------------------------------------------------------------------
TURKEY (0.5%)
BEVERAGES & TOBACCO
Efes Sinai Yatirim Holding A.S.
GDR 38,100 691
---------------
- --------------------------------------------------------------------------------
TOTAL COMMON STOCKS
(Cost U.S.$95,824) 124,315
---------------
- --------------------------------------------------------------------------------
FACE
AMOUNT
(000)
- --------------------------------------------------------------------------------
DEBT INSTRUMENTS (2.2%)
- --------------------------------------------------------------------------------
RUSSIA (2.2%)
TELECOMMUNICATIONS (2.2%)
Svyazinvest (Cost U.S.$3,146) U.S.$ 3,146 2,831
---------------
- --------------------------------------------------------------------------------
SHORT-TERM INVESTMENTS (1.1%)
- --------------------------------------------------------------------------------
UNITED STATES (1.1%)
REPURCHASE AGREEMENT
Chase Securities, Inc., 5.60%, dated
3/31/98, due 4/1/98, to be
repurchased at U.S.$1,480,
collateralized by U.S.$1,530
United States Treasury Bills, due
6/11/98, valued at U.S.$1,515
(Cost U.S.$1,480) 1,480 1,480
---------------
- --------------------------------------------------------------------------------
TOTAL INVESTMENTS (98.0%)
(Cost U.S.$100,450) 128,626
---------------
- --------------------------------------------------------------------------------
OTHER ASSETS AND LIABILITIES (2.0%)
Other Assets 5,746
Liabilities (3,174) 2,572
--------------- ---------------
- --------------------------------------------------------------------------------
NET ASSETS (100%)
Applicable to 5,005,000 issued and
outstanding U.S.$0.01 par value shares
(500,000,000 shares authorized) U.S.$ 131,198
---------------
---------------
- --------------------------------------------------------------------------------
NET ASSET VALUE PER SHARE U.S.$ 26.21
---------------
---------------
- --------------------------------------------------------------------------------
</TABLE>
ADR - American Depositary Receipt
ADS - American Depositary Shares
GDR - Global Depositary Receipt
GDS - Global Depositary Shares
7
