<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
- --------------------------------------------------------------------------------
INVESTMENT ADVISER
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
- --------------------------------------------------------------------------------
ADMINISTRATOR
The Chase Manhattan Bank
73 Tremont Street
Boston, Massachusetts 02108
- --------------------------------------------------------------------------------
CUSTODIANS
The Chase Manhattan Bank
Chaseside
Bournemouth BH7 7DB
United Kingdom
The Chase Manhattan Bank
3 Chase MetroTech Center
Brooklyn, New York 11245
- --------------------------------------------------------------------------------
SHAREHOLDER SERVICING AGENT
American Stock Transfer & Trust Company
40 Wall Street
New York, New York 10005
(800) 278-4353
- --------------------------------------------------------------------------------
LEGAL COUNSEL
Rogers & Wells LLP
200 Park Avenue
New York, New York 10166
- --------------------------------------------------------------------------------
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.
- --------------------------------------------------------------------------------
ANNUAL REPORT
DECEMBER 31, 1997
MORGAN STANLEY ASSET MANAGEMENT INC.
INVESTMENT ADVISER
<PAGE>
LETTER TO SHAREHOLDERS
- --------------------------------------------------------------------------------
For the year ended December 31, 1997 the Morgan Stanley Russia & New Europe
Fund, Inc. (the "Fund") had a total return, based on net asset value per share,
of 48.19% compared to 48.23% for the Fund's benchmark. The Fund is 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 through December 31, 1997, the Fund had a total return, based
on net asset value, per share, of 54.38% compared with 61.94% for its benchmark.
Beginning January 1, 1998, the Fund's performance will be compared with a market
weighted benchmark composite comprised of the MSCI local index for each of
Russia, Poland, the Czech Republic and Hungary. On December 31, 1997, the
closing price of the Fund's shares on the New York Stock Exchange was $23 7/8
representing a 10.2% discount to the Fund's net asset value per share.
At the beginning of the fourth quarter of 1997, the Fund reduced its position in
the Russian market to a modest underweight versus the benchmark due to a
combination of stretched valuations and high investor expectations. The market's
meteoric 157.6% performance during the first 9 months of 1997 pushed standard
earnings and asset-based valuations of Russian stocks to historically high
levels in a short period of time. By the end of the fourth quarter, the market
fell 17.9% but still finished the year up an impressive 111.6%. The performance
of the Fund was helped by country diversification into the markets of Central
and Eastern Europe as its net asset value declined 13.21% for the three months
ended December 31, 1997, versus a 14.31% fall for the Index.
Continued progress towards economic liberalization and an increased
institutionalization of reform justified an upward re-rating of Russian equities
during 1997. Under the leadership of President Boris Yeltsin and Finance
Minister Anatoly Chubais, Russia successfully tackled critical problems such as
inflation, currency instability and the slow pace of privatization, setting the
stage for the first year of economic growth after nearly a decade of decline.
The Russian economy, however, continues to face several major hurdles such as
poor tax collection and inter-company payment difficulties.
The Asian currency crisis focused investor attention on risk throughout the
emerging markets universe and led to a wave of profit taking. In the case of
Russia, the sudden focus on currency stability and external balances, was not
fundamentally justified. Russia has a current account surplus due to significant
natural resource exports and an underdeveloped, under-geared banking sector. In
addition, economic growth is accelerating, aided by increased flows of foreign
direct investment (FDI). Nevertheless, global negative sentiment and the general
increase in perceptions of risk led to a decline in confidence in the Russian
equity and fixed-income markets. In an effort to defend the currency from the
possible outflow of foreign capital, the Russian Central Bank hiked interest
rates during the second week of November and yields on government treasury bills
(known as GKOs) reached 40%. The rating agency S&P, which had been slow to react
to economic deterioration in Asia, wasted no time in downgrading Russia's
outlook to "negative" based on continued budget problems and the lack of tax
collection.
Another factor exacerbating the decline in investor confidence was a political
shake-up during November that led to the dismissal of Chubais as Finance
Minister due to an ethics scandal. Chubais was replaced by Mikhail Zadornov, a
free-market reformer and member of Parliament from the pro-reform Yabloko
faction. The Cabinet shakeup was an effort to placate Parliament ahead of a vote
on the 1998 budget. Another casualty of the shake-up was Russia's other key
reformer, Boris Nemtsov, who was removed from the head of the Energy Ministry.
Both men will remain in government and close to Yeltsin. Only a few years ago
such change might have led to a derailment of the reform process, but the
continuation of economic policy in the aftermath is a clear indication of the
full extent of the institutionalization of reform.
While the current investment milieu has turned negative, the long-term
fundamental case for investing in Russia is improving. The Russian Central Bank
(RCB) successfully slashed inflation to around 12% by year-end as the economy
grew by 1%. And the RCB successfully defended the ruble against the global
currency turmoil that has wreaked havoc in Asia. As a signal of growing
confidence to the country's improved monetary stability, beginning in 1998, the
Russian government debt markets will be fully convertible into dollars and the
ruble will be re-denominated. New-style corporate thinking is sweeping Russian
business as indicated by a wave of foreign investments such as the strategic
alliances between Royal Dutch/Shell and Gazprom (the natural gas monopoly) and
British Petroleum with Sidanco (the country's fourth largest oil producer). We
maintain a neutral Russian weighting as these positive signs and attractive
valuations (post-correction) are offset by the remaining areas of concern.
Although global financial unrest suppressed all the markets of Central and
Eastern Europe, Hungary's solid fundamentals allowed it to ride out the turmoil
unscathed, as the market managed a positive 12.6% return for the quarter and
93.4% for the year. The benefits of the March 1995 austerity plan surfaced
during 1997, producing a fundamentally stronger economic picture. Economic
growth, which had been stagnant for several years, accelerated to over 4% by
year-end, as the balance of
2
<PAGE>
payments and external debt problems improved. Tight fiscal and monetary policies
subdued inflationary pressures which fell to about 18% by year end.
Macroeconomic performance was equally matched by corporate restructuring.
Hungary has gone further than many developed OECD economies in privatizing key
sectors such as telecommunications, energy and banking. Not surprisingly,
Hungarian companies are strong exporters, aided by a faster-than-inflation
devaluation rate and low unit labor costs.
Hungary has become the second largest holding in the Fund, reaching almost 20%
by the end of 1997. The Hungarian companies in the Fund are among the region's
most competitive. For example, Richter Gideon, a pharmaceutical company,
continues to deliver consistent double digit earnings growth, due to its ability
to increase exports by 40% per year to the Russian market, where it enjoys
significant market share. Another holding, Graboplast, the biggest Hungarian
home improvement producer group, has become a major regional company through
acquisitions. In general, the Hungarian market offers a stable economic
environment and attractive growth stocks. The Fund will remain overweight in
Hungary.
Under the harsh investor scrutiny caused by global financial turmoil, the Polish
market suffered a steep decline, falling 22.4% in U.S. dollars during the fourth
quarter, leaving the market down 23.6% for 1997. Through the year, Poland
displayed impressive macroeconomic performance. After expanding 6.1% in 1996,
the Polish economy managed close to 7% growth in 1997. Simultaneously, consumer
price inflation fell to almost 13% by year end, reaching the government's
ambitious target set last year. Strong economic performance, however, could
not detract investor attention from the country's growing external imbalance.
During the first half of 1997, the current account sharply deteriorated from a
deficit of 1.4% of GDP in 1996 to a forecasted 5%. Growing real wages coupled
with explosive household credit growth has fueled an import boom. National Bank
of Poland hiked interest rates in an effort to slow growth and stabilize the
currency. Towards the end of the year the external picture began to show signs
of improvement. Tight monetary policy slowed credit expansion, slowing imports
as exports to economically-strong Western Europe have picked up. The Fund
continues to maintain an overweight position due to attractive valuations, such
as the market's 1998 earnings multiple of 9 times, continued strong growth and
the improvement in the current account.
The Fund continued to reduce its large underweight position in the Czech market.
At the end of May, speculative pressure forced the Central Bank to abandon the
fixed currency regime and float the Crown. The currency's unexpected drop
prompted authorities to implement restrictive monetary and fiscal policies.
During the second half of 1997, the Czech economy underwent a necessary but
painful adjustment, characterized by an economic slowdown and higher-than-
expected inflation. The economic situation created a difficult environment for
equities and political instability exacerbated investors' negative sentiment. On
November 30, the coalition government of Vaclav Klaus collapsed. A temporary
government has been formed, but until new elections in mid-1998, the new
administration will be a 'lame duck' and reforms such as the continued
privatization of the banking sector will be on hold. The Social Democrats are
expected to become Czech's largest party in the next elections, and it is not
clear if the restructuring process will continue when they are in power.
The Fund continues to be selectively invested in the smaller markets of Croatia,
Slovakia and Romania and we are closely following the developments in the new
'frontier' markets of the region such as Romania, Bulgaria and Ukraine, so as to
be in a position to act when attractive opportunities arise.
Finally, this is to inform you that effective January 1, 1998, Paul Psaila, a
Vice President of Morgan Stanley Asset Management Inc. ("MSAM"), will share
primary responsibility for the day-to-day management of the Fund's assets with
Michael Hewitt. Mr. Psaila joined MSAM in 1994 after two years as a Research
Associate at the International Monetary Fund. He is a political science graduate
from Brandeis University and holds a Masters degree in Economics and Latin
American Studies from Johns Hopkins School of Advanced International Studies.
Sincerely,
/s/ Michael F. Klein
Michael F. Klein
PRESIDENT AND DIRECTOR
/s/ Michael Hewett
Michael Hewett
PORTFOLIO MANAGER
/s/ Paul C. Psaila
Paul C. Psaila
PORTFOLIO MANAGER
January 1998
3
<PAGE>
MORGAN STANLEY RUSSIA & NEW EUROPE FUND, INC.
INVESTMENT SUMMARY AS OF DECEMBER 31, 1997 (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>
One Year 53.53% 53.53% 48.19% 48.19% 48.23% 48.23%
Since Inception* 38.61 29.79 54.38 41.45 61.94 46.96
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
RETURNS AND PER SHARE INFORMATION
[CHART]
<TABLE>
<CAPTION>
PERIOD FROM
SEPTEMBER 30, 1996* YEAR ENDED
TO DECEMBER 31, 1996 DECEMBER 31, 1997
-------------------- -----------------
<S> <C> <C>
Net Asset Value Per Share. . . . . $ 20.77 $ 26.59
Market Value Per Share . . . . . . $ 18.00 $ 23.88
Premium/(Discount) . . . . . . . . -13.3% -10.2%
Income Dividends . . . . . . . . . $ 0.07 --
Capital Gains Distributions. . . . -- $ 3.68
Fund Total Return (2). . . . . . . 4.18% 48.19%
Index Total Return (3) . . . . . . 9.43% 48.23%
</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) For the period up to December 31, 1997, the Fund's performance has been
compared with the Russia and New Europe Blended Composite. This composite
is a capitalization weighted index comprised 50% of the Morgan Stanley
Capital International regional indices for the Czech Republic, Hungary and
Poland and 50% of the Moscow Times 50 Index, including dividends.
Beginning January 1, 1998, the Fund's performance will be compared with a
market weighted benchmark composite comprised of the MSCI 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 DECEMBER 31, 1997
- --------------------------------------------------------------------------------
DIVERSIFICATION OF TOTAL INVESTMENTS
[CHART]
<TABLE>
<S> <C>
Equity Securities 88.7%
Debt Securities 1.8%
Short-Term Investments 9.5%
</TABLE>
- --------------------------------------------------------------------------------
SECTORS (UNAUDITED)
[CHART]
<TABLE>
<S> <C>
Banking 6.9%
Broadcasting & Publishing 2.0%
Building Materials & Components 3.1%
Energy Sources 25.4%
Health & Personal Care 5.7%
Metals 4.2%
Miscellaneous Materials & Commodities 2.6%
Multi-Industry 2.2%
Telecommunications 17.9%
Utilities -- Electrical & Gas 18.8%
Other 11.2%
</TABLE>
- --------------------------------------------------------------------------------
COUNTRY WEIGHTINGS
[CHART]
<TABLE>
<S> <C>
Russia 53.3%
Hungary 19.4%
Poland 16.5%
Czech Republic 7.3%
Croatia 2.3%
Slovakia 1.2%
Turkey 0.4%
Romania 0.3%
Other -0.7%
</TABLE>
- --------------------------------------------------------------------------------
TEN LARGEST HOLDINGS*
<TABLE>
<CAPTION>
PERCENT OF
NET ASSETS
----------
<C> <S> <C>
1. Unified Energy System (Russia) 10.6%
2. Lukoil Holdings (Russia) 9.1
3. MOL Magyar Olaj-es Gazipari Rt. (Hungary) 5.9
4. Sugutneftegaz (Russia) 5.2
5. Mosenergo (Russia) 4.6
6. AO Tatneft (Russia) 4.4%
7. Richter Gedeon (Hungary) 4.4
8. SPT Telekom (Czech Republic) 4.0
9. Rostelecom (Russia) 3.9
10. MATAV Rt. (Hungary) 3.6
----
55.7%
----
----
</TABLE>
*Excludes Short-Term Investments.
5
<PAGE>
FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
STATEMENT OF NET ASSETS
- --------------------------------------------------------------------------------
DECEMBER 31, 1997
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- ---------------------------------------------------------------------------
<S> <C> <C>
COMMON STOCKS (98.6%)
(Unless otherwise noted)
- ---------------------------------------------------------------------------
CROATIA (2.3%)
BANKING
Zagrebacka Banka GDR 39,500 U.S.$ 1,318
-------------
HEALTH & PERSONAL CARE
Pliva d.d. GDR 104,500 1,732
-------------
3,050
-------------
- ---------------------------------------------------------------------------
CZECH REPUBLIC (7.3%)
FINANCIAL SERVICES
Resolution Investment Fund 26,100 682
-------------
MACHINERY & ENGINEERING
(a) CKD Praha Holding 23,656 786
-------------
TELECOMMUNICATIONS
(a) SPT Telekom 50,000 5,346
-------------
UTILITIES - ELECTRICAL & GAS
(a) Czech Power Co. 88,500 2,903
-------------
9,717
-------------
- ---------------------------------------------------------------------------
HUNGARY (19.4%)
AUTOMOBILES
(a) North American Bus Industries Rt. 28,500 699
-------------
BANKING
OTP Bank Rt. 60,700 2,304
-------------
BUILDING MATERIALS & COMPONENTS
Zalakeramia Rt. 21,000 976
-------------
ENERGY SOURCES
MOL Magyar Olaj-es Gazipari Rt. GDR 323,500 7,893
-------------
HEALTH & PERSONAL CARE
Richter Gedeon Rt. GDS 55,300 5,806
-------------
MISCELLANEOUS MATERIALS & COMMODITIES
Graboplast Rt. 16,000 847
(a) Graboplast Rt. GDR 184,000 1,684
Pannonplast Rt. 16,825 887
-------------
3,418
-------------
TELECOMMUNICATIONS
(a) MATAV Rt. ADR 182,000 4,732
-------------
25,828
-------------
- ---------------------------------------------------------------------------
POLAND (16.5%)
AUTOMOBILES
(a) Sanockie Zaklady Przemyslu Gumowego
Stomil 71,986 1,174
-------------
BANKING
Bank Slaski 34,600 1,914
BIG 1,535,000 1,502
Wielkopolski Bank Kredytowy 315,000 1,582
-------------
4,998
-------------
BEVERAGES & TOBACCO
(a) Okocimskie Zaklady Piwowarskie 320,000 2,179
-------------
BUILDING MATERIALS & COMPONENTS
(a) Gorazdze 44,000 1,086
(a) Zaklady Lentex 135,614 2,077
-------------
3,163
-------------
CHEMICALS
(a) Polifarb Cieszyn - Wroclaw 215,000 1,019
-------------
DATA PROCESSING & REPRODUCTION
(a) Computerland Poland 100,900 1,603
-------------
FINANCIAL SERVICES
(a) National Investment Fund GDR 50,000 1,725
-------------
FOOD & HOUSEHOLD PRODUCTS
(a) Farm Food 137,204 1,168
Sokolowskie Zaklady Miesne 683,750 834
-------------
2,002
-------------
METALS - NON-FERROUS
(a) KGHM Polska Miedz GDR 167,000 1,233
-------------
MULTI-INDUSTRY
Elektrim 296,000 2,863
-------------
21,959
-------------
- ---------------------------------------------------------------------------
ROMANIA (0.3%)
PHARMACEUTICALS
(a) Terapia 229,813 345
-------------
- ---------------------------------------------------------------------------
RUSSIA (51.2%)
BROADCASTING & PUBLISHING
(b) Storyfirst Communications Tranche III
(Preferred) 1,862 2,663
-------------
ENERGY SOURCES
AO Tatneft ADR 41,200 5,855
Lukoil Holdings 370,000 8,547
Lukoil Holdings (Preferred) 230,000 3,600
(a) Orenburgneft 60,000 303
(a) Purneftegaz 70,000 554
Surgutneftegaz ADR 675,000 6,899
(a) Urdmurtneft 3,500 158
-------------
25,916
-------------
MACHINERY & ENGINEERING
(a,c) Uralmash Zavody 111,190 568
-------------
MERCHANDISING
(a) TSUM 2,982,000 969
-------------
METALS - NON-FERROUS
(a) Norilsk Nickel 299,000 1,899
(a) Norilsk Nickel (Preferred) 100,000 580
-------------
2,479
-------------
METALS - STEEL
(a) Izhorskie Zavody 13,774 1,089
(a) Seversky Tube Works 200,000 400
(a) Seversky Tube Works ADR 10,000 323
-------------
1,812
-------------
PHARMACEUTICALS
(a) Slovakofarma GDR 80,000 660
- ---------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE>
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- ---------------------------------------------------------------------------
<S> <C> <C>
TELECOMMUNICATIONS
(a,b) Mustcom 5,356,352 U.S.$ 4,553
(a) Nizhnovsvyazinform 90,000 292
(a) Rostelecom 1,455,000 5,165
St. Petersburg Telephone Network 705,000 1,005
-------------
11,015
-------------
UTILITIES - ELECTRICAL & GAS
(a) Gazprom ADS 7,900 185
Irkutskenergo 4,000,000 788
(a) Lenenergo 1,000,000 860
Mosenergo 4,800,000 6,091
(a) Permenergo 30,000 138
Unified Energy System (UES) 46,800,000 14,040
-------------
22,102
-------------
68,184
-------------
- ---------------------------------------------------------------------------
SLOVAKIA (1.2%)
CHEMICALS
Slovnaft 60,000 1,602
-------------
- ---------------------------------------------------------------------------
TURKEY (0.4%)
BANKING
(a) Kazkommertsbank Co. GDR 26,380 554
-------------
- ---------------------------------------------------------------------------
TOTAL COMMON STOCKS
(Cost U.S.$100,961) 131,239
-------------
- ---------------------------------------------------------------------------
<CAPTION>
FACE
AMOUNT
(000)
- ---------------------------------------------------------------------------
<S> <C> <C>
DEBT INSTRUMENTS (2.1%)
- ---------------------------------------------------------------------------
RUSSIA (2.1%)
TELECOMMUNICATIONS
(b) Svyazinvest (Cost U.S.$3,146) U.S.$ 3,146 2,737
-------------
- ---------------------------------------------------------------------------
SHORT-TERM INVESTMENTS (10.5%)
- ---------------------------------------------------------------------------
UNITED STATES (10.5%)
REPURCHASE AGREEMENT
Chase Securities, Inc., 5.95%,
dated 12/31/97, due 1/2/98, to
be repurchased at U.S.$13,987,
collateralized by U.S.$14,090
United States Treasury Notes,
5.875%, due 11/15/05, valued at
U.S.$14,272
(Cost U.S.$13,985) 13,985 13,985
-------------
- ---------------------------------------------------------------------------
TOTAL INVESTMENTS (111.2%)
(Cost U.S.$118,092) 147,961
-------------
- ---------------------------------------------------------------------------
<CAPTION>
AMOUNT AMOUNT
(000) (000)
- ---------------------------------------------------------------------------
<S> <C> <C>
OTHER ASSETS (3.0%)
Cash U.S.$ 1,754
Receivable for Investments Sold 1,784
Interest Receivable 347
Dividends Receivable 85
Deferred Organization Costs 60
Other Assets 3 U.S.$ 4,033
------------- -------------
- ---------------------------------------------------------------------------
LIABILITIES (-14.2%)
Payable For:
Distributions Declared (18,030)
Investments Purchased (315)
Custodian Fees (264)
Investment Advisory Fees (186)
Professional Fees (60)
Shareholder Reporting Expenses (29)
Administrative Fees (17)
Director's Fees and Expenses (15)
Other Liabilities (7) (18,923)
------------- -------------
- ---------------------------------------------------------------------------
NET ASSETS (100%)
Applicable to 5,005,000, issued
and outstanding U.S.$0.01
par value shares (500,000,000
shares authorized) U.S.$ 133,071
-------------
-------------
- ---------------------------------------------------------------------------
NET ASSET VALUE PER SHARE U.S.$ 26.59
-------------
-------------
- ---------------------------------------------------------------------------
AT DECEMBER 31, 1997, NET ASSETS CONSISTED OF:
- ---------------------------------------------------------------------------
Common Stock U.S.$ 50
Capital Surplus 100,051
Accumulated Net Investment Loss (62)
Accumulated Net Realized Gain 3,246
Unrealized Appreciation on Investments
and Foreign Currency Translations 29,786
- ---------------------------------------------------------------------------
TOTAL NET ASSETS U.S.$ 133,071
-------------
-------------
- ---------------------------------------------------------------------------
</TABLE>
(a) -- Non-income producing
(b) -- Security valued at fair value - see note A-1 to financial statements.
(c) -- Security fair valued at cost.
ADR -- American Depositary Receipt
ADS -- American Depositary Shares
GDR -- Global Depositary Receipt
GDS -- Global Depositary Shares
The accompanying notes are an integral part of these financial statements.
7
<PAGE>
SUMMARY OF TOTAL INVESTMENTS BY INDUSTRY
CLASSIFICATION -- DECEMBER 31, 1997 (UNAUDITED)
<TABLE>
<CAPTION>
PERCENT
VALUE OF NET
INDUSTRY (000) ASSETS
- ---------------------------------------------------------------------------
<S> <C> <C>
Automobiles U.S.$ 1,873 1.4%
Banking 9,174 6.9
Beverages & Tobacco 2,179 1.6
Broadcasting & Publishing 2,663 2.0
Building Materials & Components 4,139 3.1
Chemicals 2,621 2.0
Data Processing & Reproduction 1,603 1.2
Energy Sources 33,809 25.4
Financial Services 2,409 1.8
Food & Household Products 2,002 1.5
Health & Personal Care 7,538 5.7
Machinery & Engineering 1,354 1.0
Merchandising 969 0.7
Metals -- Non-Ferrous 3,711 2.8
Metals -- Steel 1,812 1.4
Miscellaneous Materials & Commodities 3,418 2.6
Multi-Industry 2,863 2.1
Pharmaceuticals 1,004 0.8
Telecommunications 23,830 17.9
Utilities -- Electrical & Gas 25,005 18.8
Other 13,985 10.5
------------- -----
U.S.$ 147,961 111.2%
------------- -----
------------- -----
</TABLE>
SUMMARY OF TOTAL INVESTMENTS BY COUNTRY --
DECEMBER 31, 1997 (Unaudited)
<TABLE>
<CAPTION>
PERCENT
VALUE OF NET
COUNTRY (000) ASSETS
- ---------------------------------------------------------------------------
<S> <C> <C>
Croatia U.S.$ 3,050 2.3%
Czech Republic 9,717 7.3
Hungary 25,828 19.4
Poland 21,959 16.5
Romania 345 0.3
Russia 70,921 53.3
Slovakia 1,602 1.2
Turkey 554 0.4
United States (short-term investments) 13,985 10.5
------------- -----
U.S.$ 147,961 111.2%
------------- -----
------------- -----
</TABLE>
The accompanying notes are an integral part of these financial statements.
8
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1997
STATEMENT OF OPERATIONS (000)
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C>
INVESTMENT INCOME
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ 582
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,360
Less: Foreign Taxes Withheld . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (79)
- -----------------------------------------------------------------------------------------------------------------------------
Total Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,863
EXPENSES
Investment Advisory Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,422
Custodian Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 916
Administrative Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Professional Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Shareholder Reporting Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Directors' Fees and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
- -----------------------------------------------------------------------------------------------------------------------------
Total Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,784
- -----------------------------------------------------------------------------------------------------------------------------
Net Investment Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,921)
- -----------------------------------------------------------------------------------------------------------------------------
NET REALIZED GAIN (LOSS)
Investment Securities Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,292
Foreign Currency Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (141)
- -----------------------------------------------------------------------------------------------------------------------------
Net Realized Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,151
- -----------------------------------------------------------------------------------------------------------------------------
CHANGE IN UNREALIZED APPRECIATION/DEPRECIATION
Appreciation on Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,389
Depreciation on Foreign Currency Translations . . . . . . . . . . . . . . . . . . . . . . . . . . . . (83)
- -----------------------------------------------------------------------------------------------------------------------------
Change in Unrealized Appreciation/Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . 26,306
- -----------------------------------------------------------------------------------------------------------------------------
Total Net Realized Gain and Change in Unrealized Appreciation/Depreciation . . . . . . . . . . . . . . . 49,457
- -----------------------------------------------------------------------------------------------------------------------------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ 47,536
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
PERIOD FROM
YEAR ENDED SEPTEMBER 30, 1996*
DECEMBER 31, 1997 TO DECEMBER 31, 1996
STATEMENT OF CHANGES IN NET ASSETS (000) (000)
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
INCREASE (DECREASE) IN NET ASSETS
Operations:
Net Investment Income (Loss). . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ (1,921) U.S.$ 293
Net Realized Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,151 397
Change in Unrealized Appreciation/Depreciation. . . . . . . . . . . . . . . . 26,306 3,480
- -----------------------------------------------------------------------------------------------------------------------------
Net Increase in Net Assets Resulting from Operations. . . . . . . . . . . . . 47,536 4,170
- -----------------------------------------------------------------------------------------------------------------------------
Distributions:
Net Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (325)
Net Realized Gains. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (18,410) --
- -----------------------------------------------------------------------------------------------------------------------------
Total Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (18,410) (325)
- -----------------------------------------------------------------------------------------------------------------------------
Capital Share Transactions:
Common Stock Issued through Initial Public Offering (5,005,000) . . . . . . . -- 100,100
- -----------------------------------------------------------------------------------------------------------------------------
Total Increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,126 103,945
Net Assets:
Beginning of Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,945 --
- -----------------------------------------------------------------------------------------------------------------------------
End of Period (including accumulated net investment loss of U.S.$62 and
distributions in excess of net investment income of U.S.$10, respectively.). U.S.$ 133,071 U.S.$ 103,945
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
*Commencement of operations
The accompanying notes are an integral part of these financial statements.
9
<PAGE>
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
PERIOD FROM
YEAR ENDED SEPTEMBER 30, 1996* TO
SELECTED PER SHARE DATA AND RATIOS: DECEMBER 31, 1997 DECEMBER 31, 1996
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
NET ASSET VALUE, BEGINNING OF PERIOD . . . . . . . . . . . . . . . . . . . . . . U.S.$ 20.77 U.S.$ 20.00
- -----------------------------------------------------------------------------------------------------------------------------
Net Investment Income (Loss) . . . . . . . . . . . . . . . . . . . . . . . . . . (0.38) 0.06
Net Realized and Unrealized Gain (Loss) on Investments . . . . . . . . . . . . . 9.88 0.78
- -----------------------------------------------------------------------------------------------------------------------------
Total from Investment Operations. . . . . . . . . . . . . . . . . . . . . . . 9.50 0.84
- -----------------------------------------------------------------------------------------------------------------------------
Distributions:
Net Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (0.07)
Net Realized Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3.68) --
- -----------------------------------------------------------------------------------------------------------------------------
Total Distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . (3.68) (0.07)
- -----------------------------------------------------------------------------------------------------------------------------
NET ASSET VALUE, END OF PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ 26.59 U.S.$ 20.77
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
PER SHARE MARKET VALUE, END OF PERIOD . . . . . . . . . . . . . . . . . . . . . U.S.$ 23.88 U.S.$ 18.00
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:
Market Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53.53% (9.72)%
Net Asset Value (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48.19% 4.18%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
RATIOS, SUPPLEMENTAL DATA:
- -----------------------------------------------------------------------------------------------------------------------------
Net Assets, End of Period (Thousands). . . . . . . . . . . . . . . . . . . . . . U.S.$ 133,071 U.S.$ 103,945
- -----------------------------------------------------------------------------------------------------------------------------
Ratio of Expenses to Average Net Assets. . . . . . . . . . . . . . . . . . . . . 2.50% 3.30%**
Ratio of Net Investment Income (Loss) to Average Net Assets. . . . . . . . . . . (1.27)% 1.15%**
Portfolio Turnover Rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71% 2%
Average Commission Rate:
Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S.$ 0.0113 U.S.$ 0.0456
As a Percentage of Trade Amount . . . . . . . . . . . . . . . . . . . . . . . 0.61% 0.59%
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
* Commencement of operations.
** Annualized.
(1) 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. This percentage is 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.
The accompanying notes are an integral part of these financial statements.
10
<PAGE>
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997
- --------------------------------------------------------------------------------
Morgan Stanley Russia & New Europe Fund, Inc. (the "Fund") was incorporated
in Maryland on February 3, 1994 and is registered as a non-diversified, closed-
end management investment company under the Investment Company Act of 1940, as
amended. The Fund's investment objective is long-term capital appreciation
through investments primarily in equity securities.
A. The following significant accounting policies, which are in conformity with
generally accepted accounting principles for investment companies, are
consistently followed by the Fund in the preparation of its financial
statements. Generally accepted accounting principles may require management to
make estimates and assumptions that affect the reported amounts and disclosures
in the financial statements. Actual results may differ from those estimates.
1. SECURITY VALUATION: In valuing the Fund's assets, all listed securities for
which market quotations are readily available are valued at the last sales
price on the valuation date, or if there was no sale on such date, at the
mean between the current bid and asked prices. Securities which are traded
over-the-counter are valued at the average of the mean of current bid and
asked prices obtained from reputable brokers. All non-equity securities as
to which market quotations are readily available are valued at their market
values. Short-term securities which mature in 60 days or less are valued at
amortized cost. All other securities and assets for which market values are
not readily available (including investments which are subject to
limitations as to their sale) are valued at fair value as determined in
good faith by the Board of Directors (the "Board"), although the actual
calculations may be done by others.
2. TAXES: It is the Fund's intention to continue to qualify as a regulated
investment company and distribute all of its taxable income. Accordingly,
no provision for U.S. Federal income taxes is required in the financial
statements.
The Fund may be subject to taxes imposed by countries in which it invests.
Such taxes are generally based on income and/or capital gains earned or
repatriated. Taxes are accrued and applied to net investment income, net
realized gains and net unrealized appreciation as such income and/or gains
are earned.
3. REPURCHASE AGREEMENTS: In connection with transactions in repurchase
agreements, a bank as custodian for the Fund takes possession of the
underlying securities, with a market value at least equal to the amount of
the repurchase transaction, including principal and accrued interest. To
the extent that any repurchase transaction exceeds one business day, the
value of the collateral is marked-to-market on a daily basis to determine
the adequacy of the collateral. In the event of default on the obligation
to repurchase, the Fund has the right to liquidate the collateral and apply
the proceeds in satisfaction of the obligation. In the event of default or
bankruptcy by the counterparty to the agreement, realization and/or
retention of the collateral or proceeds may be subject to legal
proceedings.
4. FOREIGN CURRENCY TRANSLATION: The books and records of the Fund are
maintained in U.S. dollars. Foreign currency amounts are translated into
U.S. dollars at the mean of the bid and asked prices of such currencies
against U.S. dollars last quoted by a major bank as follows:
- investments, other assets and liabilities at the prevailing rates of
exchange on the valuation date;
- investment transactions and investment income at the prevailing rates
of exchange on the dates of such transactions.
Although the net assets of the Fund are presented at the foreign exchange
rates and market values at the close of the period, the Fund does not
isolate that portion of the results of operations arising as a result of
changes in the foreign exchange rates from the fluctuations arising from
changes in the market prices of the securities held at period end.
Similarly, the Fund does not isolate the effect of changes in foreign
exchange rates from the fluctuations arising from changes in the market
prices of securities sold during the period. Accordingly, realized and
unrealized foreign currency gains (losses) are included in the reported net
realized and unrealized gains (losses) on investment transactions and
balances.
Net realized gains (losses) on foreign currency transactions represent net
foreign exchange gains (losses) from sales and maturities of foreign
currency exchange contracts, disposition of foreign currencies, currency
gains or losses realized between the trade and settlement dates on
securities transactions, and the difference between the amount of
investment income and foreign withholding taxes recorded on the Fund's
books and the U.S. dollar equivalent amounts actually received or paid. Net
unrealized currency gains (losses) from valuing foreign currency
denominated assets and liabilities at period end exchange rates are
reflected as a component of unrealized appreciation (depreciation) on
investments and foreign currency translations in the Statement of Net
Assets. The change in net unrealized currency gains (losses) for the period
is reflected in the Statement of Operations.
11
<PAGE>
The Fund intends to use derivatives more actively than it has in the past. The
Fund intends to engage in transactions in futures contracts on foreign
currencies, stock indices, as well as in options, swaps and structured notes.
Consistent with the Fund's investment objectives and policies, the Fund intends
to use derivatives for non-hedging as well as hedging purposes.
Following is a description of derivative instruments and their associated risks
that the Fund intends to utilize:
5. FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS: The Fund may enter into
forward foreign currency exchange contracts generally to attempt to protect
securities and related receivables and payables against changes in future
foreign exchange rates and, in certain situations, to gain exposure to a
foreign currency. A foreign currency exchange contract is an agreement
between two parties to buy or sell currency at a set price on a future
date. The market value of the contract will fluctuate with changes in
currency exchange rates. The contract is marked-to-market daily and the
change in market value is recorded by the Fund as unrealized gain or loss.
The Fund records realized gains or losses when the contract is closed equal
to the difference between the value of the contract at the time it was
opened and the value at the time it was closed. Risk may arise upon
entering into these contracts from the potential inability of
counterparties to meet the terms of their contracts and is generally
limited to the amount of unrealized gain on the contracts, if any, at the
date of default. Risks may also arise from unanticipated movements in the
value of a foreign currency relative to the U.S. dollar.
6. LOAN AGREEMENTS: The Fund may invest in fixed and floating rate loans
("Loans") arranged through private negotiations between an issuer of
sovereign debt obligations and one or more financial institutions
("Lenders") deemed to be creditworthy by the investment adviser. The Fund's
investments in Loans may be in the form of participations in Loans
("Participations") or assignments of all or a portion of Loans
("Assignments") from third parties. The Fund's investment in Participations
typically results in the Fund having a contractual relationship with only
the Lender and not with the borrower. The Fund has the right to receive
payments of principal, interest and any fees to which it is entitled only
from the Lender selling the Participation and only upon receipt by the
Lender of the payments from the borrower. The Fund generally has no right
to enforce compliance by the borrower with the terms of the loan agreement.
As a result, the Fund may be subject to the credit risk of both the
borrower and the Lender that is selling the Participation. When the Fund
purchases Assignments from Lenders it acquires direct rights against the
borrower on the Loan. Because Assignments are arranged through private
negotiations between potential assignees and potential assignors, the
rights and obligations acquired by the Fund as the purchaser of an
Assignment may differ from, and be more limited than, those held by the
assigning Lender.
7. FORWARD COMMITMENTS AND WHEN-ISSUED/DELAYED DELIVERY SECURITIES: The Fund
may make forward commitments to purchase or sell securities. Payment and
delivery for securities which have been purchased or sold on a forward
commitment basis can take place a month or more (not to exceed 120 days)
after the date of the transaction. Additionally, the Fund may purchase
securities on a when-issued or delayed delivery basis. Securities purchased
on a when-issued or delayed delivery basis are purchased for delivery
beyond the normal settlement date at a stated price and yield, and no
income accrues to the Fund on such securities prior to delivery. When the
Fund enters into a purchase transaction on a when-issued or delayed
delivery basis, it either establishes a segregated account in which it
maintains liquid assets in an amount at least equal in value to the Fund's
commitments to purchase such securities or denotes such securities on the
custody statement for its regular custody account. Purchasing securities on
a forward commitment or when-issued or delayed-delivery basis may involve a
risk that the market price at the time of delivery may be lower than the
agreed upon purchase price, in which case there could be an unrealized loss
at the time of delivery.
8. SWAP AGREEMENTS: The Fund may enter into swap agreements to exchange the
return generated by one security, instrument or basket of instruments for
the return generated by another security, instrument or basket of
instruments. The following summarizes swaps which may be entered into by
the Fund:
INTEREST RATE SWAPS: Interest rate swaps involve the exchange of
commitments to pay and receive interest based on a notional principal
amount. Net periodic interest payments to be received or paid are accrued
daily and are recorded in the Statement of Operations as an adjustment to
interest income. Interest rate swaps are marked-to-market daily based upon
quotations from market makers and the change, if any, is recorded as
unrealized appreciation or depreciation in the Statement of Operations.
TOTAL RETURN SWAPS: Total return swaps involve commitments to pay interest
in exchange for a market-linked return based on a notional amount. To the
extent the total return of the security, instrument or basket of
instruments underlying the transaction exceeds or falls short of the
offsetting interest obligation, the Fund will receive a payment from or
make a payment to the counterparty, respectively. Total return swaps are
marked-to-market daily based upon quotations from market makers and the
change, if any, is re-
12
<PAGE>
corded as unrealized gains or losses in the Statement of Operations.
Periodic payments received or made at the end of each measurement period,
but prior to termination, are recorded as realized gains or losses in the
Statement of Operations.
Realized gains or losses on maturity or termination of interest rate and
total return swaps are presented in the Statement of Operations. Because
there is no organized market for these swap agreements, the value reported
in the Statement of Net Assets may differ from that which would be realized
in the event the Fund terminated its position in the agreement. Risks may
arise upon entering into these agreements from the potential inability of
the counterparties to meet the terms of the agreements and are generally
limited to the amount of net interest payments to be received and/or
favorable movements in the value of the underlying security, instrument or
basket of instruments, if any, at the date of default.
9. STRUCTURED SECURITIES: The Fund may invest in interests in entities
organized and operated solely for the purpose of restructuring the
investment characteristics of sovereign debt obligations. This type of
restructuring involves the deposit with or purchase by an entity of
specified instruments and the issuance by that entity of one or more
classes of securities ("Structured Securities") backed by, or representing
interests in, the underlying instruments. Structured Securities, invested
in by the Fund, generally will have credit risk equivalent to that of the
underlying instruments. Structured Securities are typically sold in private
placement transactions with no active trading market. Investments in
structured securities may be more volatile than their underlying
instruments, however, any loss is limited to the amount of the original
investment.
10. OVER-THE-COUNTER TRADING: Derivative instruments that may be purchased or
sold by the Fund are expected to regularly consist of instruments not
traded on an exchange. The risk of nonperformance by the obligor on such an
instrument may be greater, and the ease with which the Fund can dispose of
or enter into closing transactions with respect to such an instrument may
be less, than in the case of an exchange-traded instrument. In addition,
significant disparities may exist between bid and asked prices for
derivative instruments that are not traded on an exchange. Derivative
instruments not traded on exchanges are also not subject to the same type
of government regulation as exchange traded instruments, and many of the
protections afforded to participants in a regulated environment may not be
available in connection with such transactions.
11. OTHER: Security transactions are accounted for on the date the securities
are purchased or sold. Realized gains and losses on the sale of investment
securities are determined on the specific identified cost basis. Interest
income is recognized on the accrual basis. Dividend income is recorded on
the ex-date (except certain dividends which may be recorded as soon as the
Fund is informed of such dividends) net of applicable withholding taxes
where recovery of such taxes is not reasonably assured.
The amount and character of income and capital gain distributions to be
paid are determined in accordance with Federal income tax regulations which
may differ from generally accepted accounting principles. These differences
are primarily due to differing book and tax treatments for foreign currency
transactions, gains on certain securities of corporations designated as
"passive foreign investment companies" and the timing of the recognition of
gains or losses on securities.
Permanent book and tax basis differences relating to shareholder
distributions may result in reclassifications to undistributed net
investment income (loss), accumulated net realized gain (loss) and capital
surplus.
Adjustments for permanent book-tax differences, if any, are not reflected
in ending undistributed net investment income (loss) for the purpose of
calculating net investment income (loss) per share in the financial
highlights.
B. Morgan Stanley Asset Management Inc. (the "Adviser") provides investment
advisory services to the Fund under the terms of an Investment Advisory
Agreement (the "Agreement"). Under the Agreement, the Adviser is paid a fee
computed weekly and payable monthly at an annual rate of 1.60% of the Fund's
average weekly net assets.
C. The Chase Manhattan Bank, through its affiliate Chase Global Funds Services
Company (the "Administrator"), provides administrative services to the Fund
under an Administration Agreement. Under the Administration Agreement, the
Administrator is paid a fee computed weekly and payable monthly at an annual
rate of 0.09% of the Fund's average weekly net assets, plus $65,000 per annum.
In addition, the Fund is charged certain out-of-pocket expenses by the
Administrator. The Chase Manhattan Bank acts as global custodian for the Fund's
assets.
D. For the year ended December 31, 1997, the Fund made purchases and sales
totaling $101,377,000 and $97,361,000, respectively, of investment securities
other than long-term U.S. Government securities and short-term investments.
These were no purchases or sales of long-term U.S. Government securities. At
December 31, 1997, the U.S. Federal income tax cost basis of securities was
$118,201,000 and, accordingly, net unrealized appreciation for U.S. Federal
income tax purposes was $29,759,000, of which $38,369,000 related to appreciated
securities and $8,610,000 related to depreciated securities. For the year
13
<PAGE>
ended December 31, 1997, the Fund intends to elect to defer to January 1, 1998
for U.S. Federal income tax purposes, post-October currency losses of $57,000.
E. A significant portion of the Fund's assets consist of securities of issues
located in emerging markets, which are denominated in foreign currencies.
Changes in currency exchange rates will affect the value of and investment
income from such securities. Securities in emerging markets involve certain
considerations and risks not typically associated with investments in the United
States. In addition to smaller size, lesser liquidity and greater volatility,
certain securities' markets in which the Fund may invest are less developed than
the U.S. securities market and there is often substantially less publicly
available information about these issuers. Further, emerging market issues may
be subject to substantial governmental involvement in the economy and greater
social, economic and political uncertainty. Accordingly, the price which the
Fund may realize upon sale of securities in such markets may not be equal to its
value as presented in the financial statements.
Settlement and registration of securities transactions may be subject to
significant risks not normally associated with investments in the United States.
In certain markets, including Russia, ownership of shares is defined according
to entries in the issuer's share register. In Russia, there currently exists no
central registration system and the share registrars may not be subject to
effective state supervision. It is possible the Fund could lose its share
registration through fraud, negligence or even mere oversight. In addition,
shares being delivered for sales and cash being paid for purchases may be
delivered before the exchange is complete. This may subject the Fund to further
risk of loss in the event of a failure to complete the transaction by the
counterparty.
F. In connection with its organization the Fund incurred $80,000 of
organization costs. The organization costs are being amortized on a straight-
line basis over a five year period beginning September 30, 1996, the date the
Fund commenced operations.
G. The Fund entered into an Agreement with a number of underwriters (the
"Underwriters") including Morgan Stanley & Co. Incorporated, an affiliate of the
Adviser, for the initial public offering of its shares and issued 5,005,000
shares on September 30, 1996. In connection with the initial offering of the
Fund's shares, the Adviser has agreed to pay the related offering costs totaling
approximately $420,000. In addition, the Adviser agreed to pay the underwriters
of the offering a commission equal to 4% of the initial public offering price
per share, other than for shares acquired for accounts managed by the Adviser.
H. Each Director of the Fund who is not an officer of the Fund or an
affiliated person as defined under the Investment Company Act of 1940, as
amended, may elect to participate in the Directors' Deferred Compensation Plan
(the "Plan"). Under the Plan, such Directors may elect to defer payment of a
percentage of their total fees earned as a Director of the Fund. These deferred
portions are treated, based on an election by the Director, as if they were
either invested in the Fund's shares or invested in U.S. Treasury Bills, as
defined under the Plan. The deferred fees payable, under the Plan, at December
31, 1997 totaled $9,000 and are included in Payable for Directors' Fees and
Expenses on the Statement of Net Assets.
I. During December 1997, the Board declared a distribution of $3.60 per share,
derived from net realized gains, payable on January 9, 1998, to shareholders of
record on December 31, 1997.
- --------------------------------------------------------------------------------
FEDERAL INCOME TAX INFORMATION (UNAUDITED):
For the year ended December 31, 1997, the Fund expects to pass through to
shareholders foreign tax credits of approximately $79,000. In addition, for the
year ended December 31, 1997, gross income derived from sources within foreign
countries amounted to $1,473,000.
14
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
- --------------------------------------------------------------------------------
To the Shareholders and Board of Directors of
Morgan Stanley Russia & New Europe Fund, Inc.
In our opinion, the accompanying statement of net assets and the related
statements of operations and of changes in net assets and the financial
highlights present fairly, in all material respects, the financial position of
Morgan Stanley Russia & New Europe Fund, Inc. (the "Fund") at December 31, 1997,
the results of its operations for the year then ended, and the changes in its
net assets and the financial highlights for the year then ended and for the
period September 30, 1996 (commencement of operations) through December 31,
1996, in conformity with generally accepted accounting principles. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits, which included confirmation of securities at
December 31, 1997 by correspondence with the custodian and brokers and the
application of alternative auditing procedures where confirmations from brokers
were not received, provide a reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP
1177 Avenue of the Americas
New York, New York 10036
February 18, 1998
15
<PAGE>
DIVIDEND REINVESTMENT AND CASH PURCHASE PLAN
Pursuant to the Dividend Reinvestment and Cash Purchase Plan (the "Plan"),
each shareholder will be deemed to have elected, unless American Stock Transfer
& Trust Company (the "Plan Agent") is otherwise instructed by the shareholder in
writing, to have all distributions automatically reinvested in Fund shares.
Participants in the Plan have the option of making additional voluntary cash
payments to the Plan Agent, annually, in any amount from $100 to $3,000, for
investment in Fund shares.
Dividend and capital gain distributions will be reinvested on the
reinvestment date in full and fractional shares. If the market price per share
equals or exceeds net asset value per share on the reinvestment date, the Fund
will issue shares to participants at net asset value. If net asset value is less
than 95% of the market price on the reinvestment date, shares will be issued at
95% of the market price. If net asset value exceeds the market price on the
reinvestment date, participants will receive shares valued at market price. The
Fund may purchase shares of its Common Stock in the open market in connection
with dividend reinvestment requirements at the discretion of the Board of
Directors. Should the Fund declare a dividend or capital gain distribution
payable only in cash, the Plan Agent will purchase Fund shares for participants
in the open market as agent for the participants.
The Plan Agent's fees for the reinvestment of dividends and distributions
will be paid by the Fund. However, each participant's account will be charged a
pro rata share of brokerage commissions incurred on any open market purchases
effected on such participant's behalf. A participant will also pay brokerage
commissions incurred on purchases made by voluntary cash payments. Although
shareholders in the Plan may receive no cash distributions, participation in the
Plan will not relieve participants of any income tax which may be payable on
such dividends or distributions.
In the case of shareholders, such as banks, brokers or nominees, which hold
shares for others who are the beneficial owners, the Plan Agent will administer
the Plan on the basis of the number of shares certified from time to time by the
shareholder as representing the total amount registered in the shareholder's
name and held for the account of beneficial owners who are participating in the
Plan.
Participants who wish to withdraw from the Plan should notify the Plan
Agent in writing. There is no penalty for non-participation or withdrawal from
the Plan, and shareholders who have previously withdrawn from the Plan may
rejoin at any time. Requests for additional information or any correspondence
concerning the Plan should be directed to the Plan Agent at:
Morgan Stanley Russia & New Europe Fund, Inc.
American Stock Transfer & Trust Company
Dividend Reinvestment and Cash Purchase Plan
40 Wall Street
New York, NY 10005
1-800-278-4353
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