<PAGE>
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MORGAN STANLEY
RUSSIA & NEW EUROPE
FUND, INC.
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THIRD QUARTER REPORT
SEPTEMBER 30, 1998
MORGAN STANLEY ASSET MANAGEMENT INC.
INVESTMENT ADVISER
MORGAN STANLEY
RUSSIA & NEW EUROPE FUND, INC.
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DIRECTORS AND OFFICERS
Barton M. Biggs
CHAIRMAN OF THE BOARD
OF DIRECTORS
Michael F. Klein
PRESIDENT AND DIRECTOR
Peter J. Chase
DIRECTOR
John W. Croghan
DIRECTOR
David B. Gill
DIRECTOR
Graham E. Jones
DIRECTOR
John A. Levin
DIRECTOR
William G. Morton, Jr.
DIRECTOR
Stefanie V. Chang
VICE PRESIDENT
Harold J. Schaaff, Jr.
VICE PRESIDENT
Joseph P. Stadler
VICE PRESIDENT
Valerie Y. Lewis
SECRETARY
Joanna M. Haigney
TREASURER
Belinda A. Brady
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
<PAGE>
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
PricewaterhouseCoopers LLP
1177 Avenue of the Americas
New York, New York 10036
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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.
<PAGE>
LETTER TO SHAREHOLDERS
- ---------
For the nine months ended September 30, 1998 the Morgan Stanley Russia & New
Europe Fund, Inc. (the "Fund") had a total return, based on net asset value per
share, of -60.19% compared to -67.99% for the Fund's benchmark (described
below). For the one year ended September 30, 1998 and for the period since the
Fund's commencement of operations on September 30, 1996 through September 30,
1998, the Fund's total return, based on net asset value per share was -65.52%
and -38.54%, respectively, compared to -72.57% and -48.16%, respectively for the
benchmark. For the period from the commencement of operations to December 31,
1997, the Fund's performance had been compared with the Russia (Moscow Times 50)
and New Europe Blended Composite. This composite was comprised of 50% of the
market capitalization weighted Morgan Stanley Capital International (MSCI) local
indices for the Czech Republic, Hungary and Poland, and 50% of the Moscow Times
50 Index, including dividends. Beginning December 31, 1997, the Fund's
performance has been compared with the Russia and New Europe Composite. This
composite is comprised of the market capitalization weighted MSCI local indices
for Russia, Poland, the Czech Republic and Hungary. The historical performance
of the Fund's benchmark has been calculated using the Russia (Moscow Times 50)
and New Europe Blended Composite for the period from commencement of operations
to December 31, 1997 and the Russia and New Europe Composite for periods
subsequent to December 31, 1997. On September 30, 1998, the closing price of
the Fund's shares on the New York Stock Exchange was $7 7/8, representing a
22.7% discount to the Fund's net asset value per share.
Russia's year-old financial crisis, caused by a combination of external shocks
and internal weaknesses, reached a climax during the third quarter of 1998. By
July, the lack of investor confidence, marked by enormous triple-digit
re-financing rates, made it impossible for the government to meet the burden of
domestic debt redemptions. Hard currency reserves, used to defend the Russian
Central Bank's strong-ruble policy, dwindled to around $10 billion as investors
exited ruble-denominated assets. On August 17, Russia gave up the struggle of
defending the currency and meeting its short-term debt obligations. The
government announced three key measures: a significant increase in the ruble
corridor rate; a 90-day moratorium on all of the country's external debt and
rescheduling of domestic debt due before the end of 1999. The government's
actions amounted to a devaluation and sovereign debt default and represented a
step backward for Russia's gradually-progressing reform program. Although
foreign investors have recognized Russia's difficult financial situation, the
new measures took investors by surprise and accelerated the fall in asset prices
that had begun at the end of 1997. The debt markets were hit particularly hard
as ruble-denominated debt stopped trading. The government tentatively announced
a plan to restructure the debt into longer-term maturities, but the plan proved
very unpopular and has been delayed.
The magnitude of the crisis led to a collapse in the equity market which fell
75% during the third quarter and is down almost 90% for the year, as measured by
the MSCI Russia Index. The Fund maintained its defensive underweight position
versus the Russian market which was implemented at the end of last year. In
particular, the Fund significantly reduced its exposure to Russian utility and
local telecommunication stocks whose earnings are particularly vulnerable to
rising inflation, an inevitable by-product of a devaluation. The remaining
Russian exposure is in the oil stocks, namely Lukoil Holdings and
Surgutneftegaz, which should benefit from a devaluation and a recovery in the
international price of oil, but fell nonetheless with the overall market.
At the root of Russia's problems lay a basic fiscal imbalance -- government
expenditures significantly outpaced tax collection. Due to capital flight and
tax evasion, there is a lack of domestic capital and the government has been
forced to turn to short-term foreign capital to fill the gap. The situation was
tenable as long as foreign investors were willing to finance the deficit. Once
sentiment turned negative and it became apparent that an anticipated increase in
tax revenue collection was not forthcoming the government faced insolvency. The
crisis was exacerbated by the collapse in global commodity prices, an important
source of tax revenue for the government. Politics were also a factor as
Yeltsin's leadership has been erratic. After the devaluation, he dismissed
Prime Minister Kiriyenko and put forth Viktor Chernomyrdin, who had been
dismissed from that position five months earlier. Chernomyrdin, however, was
unacceptable to the Russian communist-dominated parliament (the Duma). The
president was clearly weakened by the devaluation and the Duma pressed for a
more acceptable Prime Minister. Yeltsin turned to Sergei Primakov, a 'moderate'
communist and former member of the Soviet Politburo. The new government faces
difficult challenges ahead and has thus far been slow to form a strategic plan
to deal with the situation. The most significant risk to Russia's economy at
this point is a return of inflation as at least 50% of a consumer's basket of
goods is imported, particularly foodstuffs. Therefore the devaluation will be
inflationary. The Fund remains cautious on the country's prospects in the
medium-term.
Russia's default on its domestic debt sent shock waves throughout the emerging
markets universe and, due to effects of proximity, Central Europe was hit
particularly hard. The direct impact of the Russian economy on the region is
actually small. Trade between Russia and Central Europe has dwindled to no more
than 8% for either Poland, Hungary or the Czech Republic. Yet financial
contagion has spread, transmitted through the actions of financial institutions
that have been hit by the turmoil in
2
<PAGE>
Russia and have sold the more liquid Central European securities. Stocks fell
across the region, particularly companies with direct exposure to Russia
through exports or loans. By the end of the quarter, Poland, Hungary and the
Czech Republic fell 27%, 34% and 18%, respectively. Central European
currencies, which had been very stable this year, suffered from some
short-lived pressure, but recovered quickly from their lows.
The fall in stock prices masked continued strong macro-economic performance in
Central Europe, particularly Poland and Hungary, which are overweight positions
in the Fund versus the benchmark. After three consecutive years of growth above
6%, Poland's gross domestic product slowed slightly to 5.9% during the first
half of 1998. Investments and exports remain the engine of growth for the
economy. Due to downward lower growth prospects in Western Europe, gross
domestic product growth is expected to slow to around 5% in the next twelve
months. Poland's structural reform of the early 1990s continues to produce
significant progress in reducing inflation. August inflation fell to 11.3%
year-on-year, down from more than 30% three years ago.
In a clear signal that Poland's economic outlook remains healthy despite the
Russian turmoil, the central bank cut interest rates in early September by 1%
and cut the monthly devaluation rate. Although the cuts were expected in order
to keep real interest rates stable in the face of falling inflation, the timing
of the cut (during a period of global turmoil) came as a surprise. By the end
of the quarter, the Polish currency, the zloty, moved toward the strong side of
its band. In addition, Poland's political situation remains stable; the current
ruling coalition is committed to structural reform and has accelerated the new
pension scheme.
Hungary also continues to demonstrate solid macroeconomic performance. Gross
domestic product continues to grow at the 5% level and inflation fell to 14% by
mid-year. With a relatively large export sector as a percentage of the economy,
Hungary is more exposed to a global economic slowdown. The turmoil caused some
capital flight from the country and the forint moved to the weak end of the
narrow currency band. This forced the Central Bank to raise interest rates by
1% which stabilized the currency. Hungarian corporates continue to perform
well. For the overall market, Hungarian companies registered a 30% increase in
earning for the first half of 1997. Overall, the long-term prospects for
Central Europe remain favorable and progress towards eventual EU integration
continues at a stable pace. Solid fiscal policy coupled with excellent monetary
policy should create a benign backdrop for equities once turmoil in global
markets subsides.
The Czech market remains an underweight in the Fund due to the country's poor
economic outlook. Economic austerity measures implemented in the aftermath of
last year's forced crown devaluation are taking their toll on the economy.
Gross domestic product fell 2.4% during the second quarter and will likely
finish the year down at least 1%. Rapidly falling private consumption is a
driving force behind the recessionary pressures. The weaker economy, coupled
with a fall in commodity imports, has led to lower inflation levels. Falling
inflation, which has led to rising real interest rates, has allowed the Central
Bank to cut interest rates three times during the quarter. The Czech crown has
been remarkably strong thus far this year, appreciating more than 15% versus the
U.S. dollar, due mainly to capital inflation attracted by high real interest
rates. But the currency's strength may begin to undermine the country's export
position. In stark contrast to the previous regime, the new Socialist-led
government is planning a significant fiscal easing to deal with the economic
slowdown. The latest 1999 budget calls for a 1.4% budget deficit to gross
domestic product, but the plan faces serious opposition from center-right
parties in the Parliament. The Fund remains underweight the Czech market, but
will increase its exposure in that market as the economic situation improves.
On September 15, 1998, the Fund commenced a share repurchase program for
purposes of enhancing shareholder value and reducing the discount at which the
Fund's shares traded from their net asset value. From that date through
September 30, 1998, the Fund repurchased 72,600 shares of its Common Stock at an
average price per share of $7.79 and an average discount of 23.03% from the net
asset value per share. The Fund will continue to repurchase its outstanding
shares at such time and in such amounts as it believes will further the
accomplishment of the foregoing objectives, subject to review by the Board of
Directors. We will update you on the progress of the repurchase program in
future shareholder reports.
The information contained in this overview regarding specific securities is for
informational purposes only and should not be construed as a recommendation to
purchase or sell the securities mentioned.
Sincerely,
/s/ Michael F. Klein
Michael F. Klein
PRESIDENT AND DIRECTOR
October 1998
3
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Investment Summary as of September 30, 1998 (Unaudited)
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<TABLE>
<CAPTION>
HISTORICAL
INFORMATION TOTAL RETURN (%)
------------------------------------------------------------------------------------
MARKET VALUE (1) NET ASSET VALUE (2) INDEX (4)
---------------------- ----------------------- ------------------------
AVERAGE AVERAGE AVERAGE
CUMULATIVE ANNUAL CUMULATIVE ANNUAL CUMULATIVE ANNUAL
---------- ------ ---------- ------ ---------- ------
<S> <C> <C> <C> <C> <C> <C>
Fiscal Year to Date -65.77% -- -60.19% -- -67.99% --
One Year -72.34 -72.34% -65.52 -65.52% -72.57 -72.57%
Since Inception* -52.55 -31.12 -38.54 -21.60 -48.16 -28.00
</TABLE>
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- --------------------------------------------------------------------------------
RETURNS AND PER SHARE INFORMATION
[GRAPH]
<TABLE>
<CAPTION>
PERIOD FROM NINE MONTHS
SEPTEMBER 30, 1996* YEAR ENDED ENDED
TO DECEMBER 31, 1996 DECEMBER 31, 1997 SEPTEMBER 30, 1998
----------------- -------------------- ------------------
<C> <C> <C>
Net Asset Value Per Share. . . . . . . . . . . . . $ 20.77 $ 26.59 $ 10.20
Market Value Per Share . . . . . . . . . . . . . . $ 18.00 $ 23.88 $ 7.88
Premium/(Discount) . . . . . . . . . . . . . . . . -13.3% -10.2% -22.7%
Income Dividends . . . . . . . . . . . . . . . . . $ 0.07 -- --
Capital Gains Distributions. . . . . . . . . . . . -- $ 3.68 $ 0.67
Fund Total Return (2). . . . . . . . . . . . . . . 4.18% 48.19% -60.19%
Index Total Return (3) . . . . . . . . . . . . . . 9.25% 48.23% -67.99%
</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 from the commencement of operations to December 31, 1997,
the Fund's performance had been compared with the Russia (Moscow Times 50)
and New Europe Blended Composite. This composite was comprised of 50% of
the market capitalization weighted Morgan Stanley Capital International
(MSCI) local indices for the Czech Republic, Hungary and Poland, and 50% of
the Moscow Times 50 Index, including dividends. Beginning December 31,
1997, the Fund's performance has been compared with the Russia and New
Europe Composite. This composite is comprised of the market capitalization
weighted MSCI local indices for Russia, Poland, the Czech Republic and
Hungary.
(4) The historical performance information presented for the Fund's benchmark
has been calculated using the Russia (Moscow Times 50) and New Europe
Blended Composite for the period from commencement of operations to
December 31, 1997 and the Russia and New Europe Composite for periods
subsequent to December 31, 1997.
* The Fund commenced operations on September 30, 1996.
4
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Investment Summary as of September 30, 1998 (Unaudited)
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DIVERSIFICATION OF TOTAL INVESTMENTS
[CHART]
<TABLE>
<S> <C>
Short-Term Investments (0.1%)
Equity Securities (99.1%)
Debt Securities (0.8%)
</TABLE>
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SECTORS
[CHART]
<TABLE>
<S> <C>
Telecommunications (31.6%)
Utilities--Electrical & Gas (2.7%)
Other (19.4%)
Banking (10.2%)
Beverages & Tobacco (4.4%)
Contruction & Housing (2.3%)
Data Processing & Reproduction (6.4%)
Energy Sources (13.6%)
Health & Personal Care (2.5%)
Multi-Industry (4.0%)
Recreation-Other Consumer Goods (2.9%)
</TABLE>
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COUNTRY WEIGHTINGS
[CHART]
<TABLE>
<S> <C>
Czech Republic (18.4%)
Russia (9.1%)
Other (16.4%)
Hungary (31.7%)
Poland (24.0%)
</TABLE>
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TEN LARGEST HOLDINGS*
<TABLE>
<CAPTION>
Percent of
Net Assets
----------
<S> <C>
1. Matav Rt. (Hungary) 14.6%
2. SPT Telekom (Czech Republic) 10.4
3. MOL Magyar Olaj-es Gazipari Rt. (Hungary) 10.3
4. Ceske Radiokomunikace (Czech Republic) 4.9
5. Okocimskie Zaklady Piwowarskie (Poland) 4.2
6. Prokom (Poland) 3.5
7. OTP Bank Rt. (Hungary) 2.9
8. Orbis (Poland) 2.9
9. Richter Gedeon Rt. (Hungary) 2.5
10. Lukoil Holdings (Russia) 2.5
----
58.7%
----
----
</TABLE>
* Excludes short-term investments.
5
<PAGE>
FINANCIAL STATEMENTS
- ---------
STATMENT OF NET ASSETS (UNAUDITED)
- ---------
SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
VALUE
SHARES (000)
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<S> <C> <C>
COMMON STOCKS (82.5%)
(Unless otherwise noted)
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CZECH REPUBLIC (18.4%)
BANKING
Komercni Banka 47,100 U.S.$ 847
----------
TELECOMMUNICATIONS
Ceske Radiokomunikace GDR 96,588 2,495
SPT Telekom 405,100 5,255
----------
7,750
----------
UTILITIES -- ELECTRICAL & GAS
Czech Power Co. 39,300 734
----------
9,331
----------
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HUNGARY (31.7%)
BANKING
OTP Bank Rt. 52,056 1,478
----------
ENERGY SOURCES
MOL MAGYAR OLAJ-ES GAZIPARI RT. GDR 270,270 5,196
----------
HEALTH & PERSONAL CARE
Richter Gedeon Rt. 7,210 223
Richter Gedeon Rt. GDR 35,270 1,058
----------
1,281
----------
MISCELLANEOUS MATERIALS & COMMODITIES
Pannonplast Rt. 30,335 694
----------
TELECOMMUNICATIONS
Matav Rt. ADR 341,740 7,411
----------
16,060
----------
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POLAND (24.0%)
BANKING
BIG Bank Gdanski 1,032,000 895
BIG Bank Gdanski GDR 24,523 307
BPH 6,590 452
Wielkopolski Bank Kredytowy 196,540 1,210
----------
2,864
----------
BEVERAGES & TOBACCO
Okocimskie Zaklady Piwowarskie 304,000 2,127
----------
CONSTRUCTION & HOUSING
Exbud 43,250 333
Exbud GDR 107,845 830
----------
1,163
----------
DATA PROCESSING & REPRODUCTION
Computerland Poland 44,300 434
Prokom GDR 99,660 1,774
Softbank 21,300 396
Softbank GDR 35,550 663
----------
3,267
----------
FOOD & HOUSEHOLD PRODUCTS
Farm Food 59,504 262
----------
MULTI-INDUSTRY
Elektrim 48,464 U.S.$ 491
Mostostal-Warszawa GDR 110,000 542
----------
1,033
----------
RECREATION -- OTHER CONSUMER GOODS
Orbis 214,865 1,443
----------
12,159
----------
- --------------------------------------------------------------------------------
RUSSIA (8.4%)
BEVERAGES & TOBACCO
SUN Brewing Ltd. GDR 50,000 107
----------
BROADCASTING & PUBLISHING
Storyfirst Communications 'A' 1,920 345
(Preferred) ----------
ENERGY SOURCES
Lukoil Holdings 197,000 552
Lukoil Holdings ADR 66,620 716
Surgutneftegaz ADR 362,300 407
----------
1,675
----------
METALS -- STEEL
Seversky Tube Works 200,000 4
Seversky Tube Works ADR 10,000 2
----------
6
----------
MULTI-INDUSTRY
(a)Pliva d.d. GDR 73,200 981
----------
TELECOMMUNICATIONS
Mustcom 5,356,352 424
Rostelecom 316,000 98
----------
522
----------
UTILITIES -- ELECTRICAL & GAS
Gazprom ADR 98,800 640
----------
4,276
----------
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TOTAL COMMON STOCKS
(Cost U.S.$66,063) 41,826
----------
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FACE
AMOUNT
(000)
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DEBT INSTUMENTS (0.7%)
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RUSSIA (0.7%)
TELECOMMUNICATIONS (0.7%)
Svyazinvest (Cost U.S.$3,146) U.S.$ 3,146 346
----------
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FOREIGN CURRENCY ON DEPOSIT WITH
CUSTODIAN (0.0%)
Polish Zloty (Cost U.S.$21) PLZ 75 21
----------
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TOTAL INVESTMENTS (83.2%)
(Cost U.S.$69,230) 42,193
----------
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</TABLE>
6
<PAGE>
<TABLE>
<CAPTION>
AMOUNT AMOUNT
(000) (000)
- -------------------------------------------------------------------------------
<S> <C> <C>
OTHER ASSETS & LIABILITIES (16.8%)
Other Assets U.S.$ 16,655
Liabilities (8,160) U.S.$ 8,495
-------------- --------------
--------------
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NET ASSETS (100%)
Applicable to 4,970,048 issued and
outstanding U.S.$0.01 par value
shares (500,000,000 shares
authorized) U.S.$ 50,688
--------------
--------------
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NET ASSET VALUE PER SHARE U.S.$ 10.20
--------------
--------------
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</TABLE>
(a) -- 144A Security - certain conditions for public sale may exist.
ADR -- American Depositary Receipt
GDR -- Global Depositary Receipt
- -------------------------------------------------------------------------------
7
