<PAGE>
----------------------------------------------------------------------
MORGAN STANLEY
RUSSIA & NEW EUROPE
FUND, INC.
----------------------------------------------------------------------
ANNUAL REPORT
DECEMBER 31, 1998
MORGAN STANLEY DEAN WITTER INVESTMENT
MANAGEMENT INC.
INVESTMENT ADVISER
MORGAN STANLEY
RUSSIA & NEW EUROPE FUND, INC.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
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 Dean Witter Investment Management Inc.
1221 Avenue of the Americas
New York, New York 10020
- -------------------------------------------------------------------------------
ADMINISTRATOR
The Chase Manhattan Bank
73 Tremont Street
Boston, Massachusetts 02108
- -------------------------------------------------------------------------------
CUSTODIAN
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
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 year ended December 31, 1998, the Morgan Stanley Russia & New Europe
Fund, Inc. (The "Fund") had a total return, based on net asset value per
share, of -50.62% compared to -57.84% for the Fund's benchmark (described
below). For the period since the Fund's commencement of operations on
September 30, 1996 through December 31, 1998, the Fund had a total return,
based on net asset value per share, of -23.77% compared with -27.42% for its
benchmark. For the period from September 30, 1996 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
Moscow Times 50 Index and 50% of the market capitalization weighted Morgan
Stanley Capital International (MSCI) local indices for the Czech Republic,
Hungary and Poland, 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. On
December 31, 1998, the closing price of the Fund's shares on the New York
Stock Exchange was $9 13/16, representing a 22.4% discount to the Fund's net
asset value per share.
Investor attention during 1998 focused on the turmoil surrounding the
devaluation of the Russian ruble and declaration of a debt moratorium during
the third quarter. Although the Russian economic crisis did not directly
impact most countries, the default on its domestic debt sent shock waves
throughout the emerging markets. Due to its proximity, Central Europe was
hit particularly hard. Financial institutions that were directly hit by
Russian losses sold the more liquid Central European securities. Asset
prices fell across the region, particularly companies with exposure to Russia
through exports or loans.
Although the crisis was a shock to the region's financial markets, it proved
to be relatively short-lived as stock prices bottomed within 2 months. While
the impact of the crisis will be severe for Russia, the economies of Central
Europe proved to be both resilient and strongly integrated with Western
Europe. All of the region's markets rebounded sharply during the fourth
quarter. After reaching significantly depressed levels, the Russian market,
which had been rapidly falling for almost a year, staged a rebound, rising
68%. Despite the strong year-end performance, the market finished the year
down 82%. Poland, Hungary and the Czech Republic rallied 10%, 39%, and 15%
respectively during the fourth quarter. The rally was not enough to bring
Poland and Hungary into positive territory as those markets finished the year
down 7% and 9%, respectively.
A combination of internal weaknesses and external shocks caused the Russian
crisis. At the root of Russia's problems lay a basic fiscal
imbalance--government expenditures significantly outpaced tax collection.
Due to capital flight and a high level of tax evasion, there was a lack of
domestic investors. The government was forced to turn to short-term foreign
capital to fill the gap--a problem that has plagued several emerging markets.
Once sentiment turned negative and it became apparent that an anticipated
increase in tax revenue collection was not forthcoming, foreigners pulled
out. The crisis was exacerbated by the collapse in commodity prices, an
important source of revenue for government coffers. Politics were also a
factor as Yeltsin proved to be an ineffective leader during a time of crisis.
After the devaluation, he dismissed Prime Minister Kiriyenko and put forth
Viktor Chernomyrdin for the position, whom he had dismissed from that
position five months earlier. Chernomyrdin, however, was unacceptable to the
Russian communist-dominated parliament (the Duma). Yeltsin turned to Sergei
Primakov, a 'moderate' communist and former member of the Soviet Politburo.
The situation faced by the new government in September was daunting. Due to
poor tax collection and the severe economic contraction, taxes that were
collected could not cover government expenditures and domestic investors were
not able (and foreign investors unwilling) to finance government debt.
Relations with the IMF were strained and lending from international agencies
was not forthcoming. The Russian Central Bank (RCB) gradually increased the
monetary base and looser monetary policy put downward pressure on the ruble.
This, combined with the impact of the devaluation, led to a pick up in
inflation with CPI rising 11% in December. At the end of the year, the Duma
began to debate the 1999 budget. The IMF has stipulated that the passage of
a realistic, austere budget is a pre-requisite for a continuation in loan
disbursement. Although the Duma did pass the first of several readings of the
budget before year-end, the budget's assumptions do not appear to be
realistic and will not appease the IMF in its current form. Overall, the
situation in Russia proved not to be as severe as some predicted earlier,
thus allowing the market to stage a recovery from its bottom. Yet, the basic
problems that confront the country remain unresolved. The Fund remains
cautious on the country's prospects in the medium-term.
Turmoil in financial markets masked continued strong macroeconomic performance
in Central Europe, particularly Poland and Hungary, which remained overweight
positions in the Fund versus the benchmark at
2
<PAGE>
year-end. Poland's structural reform, namely the price liberalization of the
early 1990s, coupled with the fall in food and commodity prices, continues to
produce significant progress in reducing inflation. By the end of the year,
inflation had fallen to 8.6%, which is below the government's original
year-end target of 9.5%. The fall in inflation allowed the central bank to
drastically cut interest rates throughout the year and led to a massive rally
in Poland's bond market. The National Bank of Poland manages the zloty
within a depreciating currency band. Aside from some short-term weakness
during the third quarter, the currency has remained on the strong end of the
band. The government has made progress in privatizing the remaining
state-owned companies, successfully selling a 15% stake in TPSA, the monopoly
telephone operator, during a generally difficult year end for raising capital
in the emerging markets. Continued privatization demonstrates that the
current ruling coalition is committed to structural reform. Foreign direct
investment into Poland has accelerated and is set to reach $8 billion for the
entire year, a clear indication of long- term investor confidence.
The Hungarian economy demonstrated similar characteristics to Poland. CPI
fell dramatically during the year, reaching 11% by year-end and allowing for
a significant fall in interest rates. Gross domestic product (GDP) growth
during the year was robust, growing above 5% for most of the year, led by the
manufacturing and export sectors. The third quarter of 1998 turmoil led to
some capital flight from the country and the currency, the forint, moved to
the weak end of the narrow currency band forcing the central bank to briefly
intervene. But by the end of the year, the currency returned to the strong
side of the band. Because both the Hungarian forint and the Polish zloty
gradually depreciate over time, they do not appear overvalued or
significantly exposed to a large correction. With the slowdown in Western
Europe, Hungary and Poland are likely to witness weakening growth in 1999.
In addition, as both countries trade significantly with Europe, soft demand
from countries such as Germany will reduce export growth markedly and have
negative impact on the trade balance. Both countries will therefore likely
suffer from a growing current account deficit, particularly during the first
half of the year. A slowdown in domestic growth would depress domestic
demand and help offset the situation. Progress towards eventual EU
integration continues at a stable pace as the formal negotiations began
earlier in the year. At year-end, Polish and Hungarian stocks continued to
represent significant weights in the Fund - over 60% of total assets on a
combined basis. The Fund has taken large positions in telecommunication
stocks, such as an 11% position in the Hungarian telecommunications company
MATAV, which are domestically driven and generally insulated from
international developments. The Fund also participated in the TPSA
privatization, taking a 7% position in the stock. Since the offering, the
stock has risen 11%.
The Czech economy remains in recession. GDP fell almost 3% during the third
quarter and will likely finish the year down at least 1-2%. Economic
austerity measures implemented in the aftermath of last year's forced crown
devaluation have taken their toll on the economy. There are signals that
economic weakness will continue: inflation near year end turned negative;
industrial production fell by as much as 10% year-on-year; and unemployment
jumped to 7.5%. Rapidly falling domestic consumption is driving the
recessionary pressures. The weaker economy, coupled with a fall in commodity
imports, has led to lower inflation levels and, as in other countries in the
region, has led to significant interest rate cuts. The depressed economic
conditions has attracted fixed-income investors to the market in anticipation
of interest rate cuts that strengthened the Czech crown. The political
situation remains tenuous. The Social Democrat-led minority coalition is
strained and at risk of falling apart. On the equity market, the Czech banks
are likely to report major losses in 1998 due to a deterioration in loan
quality across the region. Bad debts continue to grow and have led to the
government bailout of the former state bank Ceska Sporitelna. The Fund
remains underweight the Czech market, but will review the situation as the
economic situation improves.
Finally, at a meeting held on February 18, 1999 the Fund's Board of Directors
approved a change in the Fund's policies to require that the Fund invest no
more than 25% of its assets in the energy sources industry. The Fund's prior
policy had been to invest not less than 25% nor more than 40% of the Fund's
assets in the energy sources industry.
Sincerely,
/s/ Michael F. Klein
Michael F. Klein
PRESIDENT AND DIRECTOR
January 1999
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.
3
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Investment Summary as of December 31, 1998 (Unaudited)
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
HISTORICAL
INFORMATION
TOTAL RETURN (%)
---------------------------------------------------------------------------------
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 -57.34% -57.34% -50.62% -50.62% -57.84% -57.84%
Since Inception* -40.87 -20.81 -23.77 -11.36 -27.42 -13.27
</TABLE>
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
- -------------------------------------------------------------------------------
RETURNS AND PER SHARE INFORMATION
[GRAPH]
<TABLE>
<CAPTION>
PERIOD FROM YEAR ENDED DECEMBER 31,
SEPTEMBER 30, 1996*
TO DECEMBER 31, 1996 1997 1998
-------------------- ---------- ----------
<S> <C> <C> <C>
Net Asset Value Per Share. . . . . $ 20.77 $ 26.59 $ 12.65
Market Value Per Share . . . . . . $ 18.00 $ 23.88 $ 9.81
Premium/(Discount) . . . . . . . . -13.3% -10.2% -22.4%
Income Dividends . . . . . . . . . $ 0.07 -- --
Capital Gains Distributions. . . . -- $ 3.68 $ 0.67
Fund Total Return (2). . . . . . . 4.18% 48.19% -50.62%
Index Total Return (3) . . . . . . 9.25% 48.23% -57.84%
</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.
* The Fund commenced operations on September 30, 1996.
4
<PAGE>
Morgan Stanley Russia & New Europe Fund, Inc.
Portfolio Summary as of December 31, 1998
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
DIVERSIFICATION OF TOTAL INVESTMENTS
[CHART]
<TABLE>
<S> <C>
Equity Securities (97.7%)
Short-Term Investments (2.3%)
</TABLE>
- -------------------------------------------------------------------------------
SECTORS
[CHART]
<TABLE>
<S> <C>
Other (5.9%)
Telecommunications (25.0%)
Multi-Industry (5.7%)
Health & Personal Care (2.8%)
Banking (18.8%)
Broadcasting & Publishing (2.0%)
Consumer Goods (1.0%)
Construction & Housing (1.0%)
Data Processing & Reproduction (7.3%)
Electronic Components, Instruments (3.0%)
Energy Sources (27.5%)
</TABLE>
- -------------------------------------------------------------------------------
COUNTRY WEIGHTINGS
[CHART]
<TABLE>
<S> <C>
Other (3.9%)
Croatia (2.8%)
Czech Republic (8.3%)
Russia (18.4%)
Hungary (34.4%)
Poland (32.2%)
</TABLE>
- -------------------------------------------------------------------------------
TEN LARGEST HOLDINGS*
<TABLE>
<CAPTION>
PERCENT OF
NET ASSETS
----------
<S> <C>
1. MOL Magyar Olaj-es Gazipari Rt. (Hungary) 14.7%
2. Matav Rt. (Hungary) 10.8
3. OTP Bank Rt. (Hungary) 8.3
4. Telekomunikacja Polska (Poland) 7.0
5. LUKoil Holdings (Russia) 6.8
6. Elektrim (Poland) 5.7
7. SPT Telekom (Czech Republic) 5.4
8. Surgutneftegaz (Russia) 4.7
9. Prokom (Poland) 4.4
10. Wielkopolski Bank Kredytowy (Poland) 3.0
----
70.8%
----
----
</TABLE>
* Excludes short-term investments.
5
<PAGE>
FINANCIAL STATEMENTS
- ---------
STATEMENT OF NET ASSETS
- ---------
DECEMBER 31, 1998
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- ---------------------------------------------------------------------------
<S> <C> <C>
COMMON STOCKS (95.3%)
(Unless otherwise noted)
- ---------------------------------------------------------------------------
CROATIA (2.8%)
HEALTH & PERSONAL CARE
Pliva d.d. GDR 102,600 U.S.$ 1,703
-------------
- ---------------------------------------------------------------------------
CZECH REPUBLIC (8.3%)
BANKING
(a) Komercni Banka 12,100 149
(a)Komercni Banka GDR 54,000 216
-------------
365
-------------
BROADCASTING & PUBLISHING
(a) Ceske Radiokomunikace GDR 25,688 828
-------------
TELECOMMUNICATIONS
(a) SPT Telecom 213,100 3,256
-------------
UTILITIES -- ELECTRICAL & GAS
(a) Czech Power Co. 24,800 558
-------------
5,007
-------------
- ---------------------------------------------------------------------------
HUNGARY (34.4%)
BANKING
OTP Bank Rt. 100,366 5,011
-------------
ENERGY SOURCES
MOL Magyar Olaj-es Gazipari Rt. GDR 320,270 8,848
-------------
LEISURE & TOURISM
(a) Danubius Hotel and Spa Rt. 16,551 345
-------------
TELECOMMUNICATIONS
(a) Matav Rt. ADR 219,040 6,530
-------------
20,734
-------------
- ---------------------------------------------------------------------------
POLAND (32.2%)
BANKING
Bank Slaski 975 51
BIG Bank Gdanski 488,694 439
BIG Bank Gdanski GDR 24,523 332
BPH 10,586 627
BRE 58,283 1,345
Powszechny Bank Kredytowy 62,780 1,342
Wielkopolski Bank Kredytowy 291,343 1,834
-------------
5,970
-------------
BEVERAGES & TOBACCO
(a) Okocimskie Zaklady Piwowarskie 26,386 154
-------------
CONSTRUCTION & HOUSING
(a) Exbud 53,571 463
(a) Exbud GDR 18,335 158
-------------
621
-------------
CONSUMER GOODS
Zwyiec 5,198 622
-------------
DATA PROCESSING & REPRODUCTION
Prokom GDR 141,660 2,670
Softbank 21,300 552
Softbank GDR 44,550 1,181
-------------
4,403
-------------
- ---------------------------------------------------------------------------
MULTI-INDUSTRY
Elektrim 315,086 U.S.$ 3,411
-------------
TELECOMMUNICATIONS
(a) Telekomunikacja Polska GDR 825,000 4,207
-------------
19,388
-------------
- ---------------------------------------------------------------------------
RUSSIA (17.6%)
BEVERAGES & TOBACCO
(a) SUN Brewing Ltd. GDR 50,000 123
-------------
BROADCASTING & PUBLISHING
(a,b)Storyfirst Communications 'A'
(Preferred) 1,920 340
-------------
ELECTRONIC COMPONENTS, INSTRUMENTS
Unified Energy Systems ADR 28,700 93
(a) Unified Energy Systems GDR 533,940 1,735
-------------
1,828
-------------
ENERGY SOURCES
Gazprom ADR 98,800 837
(a) LUKoil Holdings 197,000 798
LUKoil Holdings ADR 204,920 3,279
Surgutneftegaz ADR 802,300 2,808
-------------
7,722
-------------
TELECOMMUNICATIONS
(a,b) Mustcom 5,356,352 605
-------------
10,618
-------------
- ---------------------------------------------------------------------------
TOTAL COMMON STOCKS
(Cost U.S.$65,819) 57,450
-------------
- ---------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
FACE
AMOUNT
(000)
- ---------------------------------------------------------------------------
<S> <C> <C>
DEBT INSTRUMENTS (0.8%)
- ---------------------------------------------------------------------------
RUSSIA (0.8%)
TELECOMMUICATIONS (0.8%)
(b) Svyazinvest (Cost U.S.$3,146) U.S. $ 3,146 491
-------------
- ---------------------------------------------------------------------------
SHORT-TERM INVESTMENTS (2.3%)
- ---------------------------------------------------------------------------
UNITED STATES (2.3%)
REPURCHASE AGREEMENT
Chase Securities, Inc. 4.45%,
dated 12/31/98, due 1/4/99,
to be repurchased at
U.S.$1,383, collateralized by
U.S.$1,015 United States
Treasury Bonds, 10.375%, due
11/15/12, valued at U.S.$1,420
(Cost U.S.$1,382) U.S. $ 1,382 1,382
-------------
- ---------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of the financial statements.
6
<PAGE>
<TABLE>
<CAPTION>
AMOUNT AMOUNT
(000) (000)
- ---------------------------------------------------------------------------
<S> <C> <C>
FOREIGN CURRENCY ON DEPOSIT WITH
CUSTODIAN (0.0%)
British Pound
(Cost U.S.$4) GBP 2 U.S. $ 4
-------------
- ---------------------------------------------------------------------------
TOTAL INVESTMENTS (98.4%)
(Cost U.S.$70,351) 59,327
-------------
- ---------------------------------------------------------------------------
OTHER ASSETS (3.5%)
Cash U.S.$ 871
Receivable for Investments Sold 672
Interest Receivable 420
Dividends Receivable 88
Deferred Organization Costs 44
Other Assets 3 2,098
-------------- -------------
- ---------------------------------------------------------------------------
LIABILITIES (-1.9%)
Payable For:
Investments Purchased (888)
Investment Advisory Fees (78)
Professional Fees (58)
Shareholder Reporting Expenses (32)
Administrative Fees (11)
Directors' Fees and Expenses (10)
Custodian Fees (2)
Other Liabilities (37) (1,116)
-------------- -------------
- ---------------------------------------------------------------------------
NET ASSETS (100%)
Applicable to 4,767,248, issued and
outstanding U.S.$0.01 par value shares
(500,000,000 shares authorized) U.S.$ 60,309
-------------
- ---------------------------------------------------------------------------
- ---------------------------------------------------------------------------
NET ASSET VALUE PER SHARE U.S.$ 12.65
-------------
- ---------------------------------------------------------------------------
AT DECEMBER 31, 1998, NET ASSETS CONSISTED OF:
- ---------------------------------------------------------------------------
Common Stock U.S.$ 48
Capital Surplus 97,026
Undistributed Net Investment Income 1
Accumulated Net Realized Loss (25,720)
Unrealized Depreciation on Investments
and Foreign Currency Translations (11,046)
- ---------------------------------------------------------------------------
TOTAL NET ASSETS U.S.$ 60,309
-------------
-------------
- ---------------------------------------------------------------------------
</TABLE>
(a) -- Non-income producing
(b) -- Security valued at fair value -- see note A-1 to financial
statements.
ADR -- American Depositary Receipt
GDR -- Global Depositary Receipt
SUMMARY OF TOTAL INVESTMENTS BY INDUSTRY
CLASSIFICATION -- DECEMBER 31, 1998
<TABLE>
<CAPTION>
PERCENT
VALUE OF NET
INDUSTRY (000) ASSETS
- ---------------------------------------------------------------------------
<S> <C> <C>
Banking U.S.$ 11,346 18.8%
Beverages & Tobacco 277 0.5
Broadcasting & Publishing 1,168 2.0
Construction & Housing 621 1.0
Consumer Goods 622 1.0
Data Processing & Reproduction 4,403 7.3
Electronic Components, Instruments 1,828 3.0
Energy Sources 16,570 27.5
Health & Personal Care 1,703 2.8
Leisure & Tourism 345 0.6
Multi-Industry 3,411 5.7
Telecommunications 15,089 25.0
Utilities -- Electrical & Gas 558 0.9
Other 1,386 2.3
-------------- ----
U.S.$ 59,327 98.4%
-------------- ----
-------------- ----
- ---------------------------------------------------------------------------
</TABLE>
SUMMARY OF TOTAL INVESTMENTS BY COUNTRY --
DECEMBER 31, 1998
<TABLE>
<CAPTION>
PERCENT
VALUE OF NET
COUNTRY (000) ASSETS
- ---------------------------------------------------------------------------
<S> <C> <C>
Croatia U.S.$ 1,703 2.8%
Czech Republic 5,007 8.3
Hungary 20,734 34.4
Poland 19,388 32.2
Russia 11,109 18.4
United States (short-term investments) 1,382 2.3
Other 4 0.0
-------------- ----
U.S.$ 59,327 98.4%
-------------- ----
-------------- ----
- ---------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of the financial statements.
7
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1998
STATEMENT OF OPERATIONS (000)
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C>
INVESTMENT INCOME
Dividends ........................................................................................ U.S. $ 648
Interest ......................................................................................... 898
Less: Foreign Taxes Withheld ..................................................................... (34)
- ---------------------------------------------------------------------------------------------------------------------------
Total Income ................................................................................... 1,512
- ---------------------------------------------------------------------------------------------------------------------------
EXPENSES
Investment Advisory Fees ........................................................................ 1,488
Custodian Fees .................................................................................. 360
Administrative Fees ............................................................................. 158
Shareholder Reporting Expenses .................................................................. 146
Professional Fees ............................................................................... 109
Directors' Fees and Expenses .................................................................... 20
Amortization of Organization Costs .............................................................. 16
Other Expenses .................................................................................. 38
- ---------------------------------------------------------------------------------------------------------------------------
Total Expenses ................................................................................ 2,335
- ---------------------------------------------------------------------------------------------------------------------------
Net Investment Loss ......................................................................... (823)
- ---------------------------------------------------------------------------------------------------------------------------
NET REALIZED GAIN (LOSS)
Investment Securities Sold ...................................................................... (25,614)
Foreign Currency Transactions ................................................................... (258)
- ---------------------------------------------------------------------------------------------------------------------------
Net Realized Loss ............................................................................. (25,872)
- ---------------------------------------------------------------------------------------------------------------------------
CHANGE IN UNREALIZED APPRECIATION/DEPRECIATION
Depreciation on Investments ..................................................................... (40,893)
Appreciation on Foreign Currency Translations.................................................... 61
- ---------------------------------------------------------------------------------------------------------------------------
Change in Unrealized Appreciation/Depreciation ................................................ (40,832)
- ---------------------------------------------------------------------------------------------------------------------------
Total Net Realized Loss and Change in Unrealized Appreciation/Depreciation .......................... (66,704)
- ---------------------------------------------------------------------------------------------------------------------------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS ............................................ U.S.$ (67,527)
- ---------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED
DECEMBER 31, 1998 DECEMBER 31, 1997
STATEMENT OF CHANGES IN NET ASSETS (000) (000)
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
INCREASE (DECREASE) IN NET ASSETS
Operations:
Net Investment Loss .............................................................. U.S.$ (823) U.S.$ (1,921)
Net Realized Gain (Loss).......................................................... (25,872) 23,151
Change in Unrealized Appreciation/Depreciation ................................... (40,832) 26,306
- ---------------------------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Net Assets Resulting from Operations .................. (67,527) 47,536
- ---------------------------------------------------------------------------------------------------------------------------
Distributions:
Net Realized Gains ............................................................... -- (18,410)
In Excess of Net Realized Gains .................................................. (3,351) --
- ---------------------------------------------------------------------------------------------------------------------------
Total Distributions .............................................................. (3,351) (18,410)
- ---------------------------------------------------------------------------------------------------------------------------
Capital Share Transactions:
Reinvestment of Distributions (32,748 and 0 shares, respectively) ................ 579 --
Repurchase of Shares (270,500 and 0 shares, respectively) ........................ (2,463) --
- ---------------------------------------------------------------------------------------------------------------------------
Net Decrease in Net Assets Resulting from Capital Share Transactions ............. (1,884) --
- ---------------------------------------------------------------------------------------------------------------------------
Total Increase (Decrease) ........................................................ (72,762) 29,126
Net Assets:
Beginning of Period .............................................................. 133,071 103,945
- ---------------------------------------------------------------------------------------------------------------------------
End of Period (including undistributed net investment income/(accumulated net
investment loss) of U.S.$1 and U.S.$(62), respectively)......................... U.S.$ 60,309 U.S.$ 133,071
- ---------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
8
<PAGE>
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, PERIOD FROM
--------------------------------- SEPTEMBER 30, 1996* TO
SELECTED PER SHARE DATA AND RATIOS: 1998 1997 DECEMBER 31, 1996
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF PERIOD. . . . . . . . . . . . . . . U.S.$ 26.59 U.S.$ 20.77 U.S.$ 20.00
- -----------------------------------------------------------------------------------------------------------------------------
Net Investment Income (Loss). . . . . . . . . . . . . . . . . . . (0.17) (0.38) 0.06
Net Realized and Unrealized Gain (Loss) on Investments. . . . . . (13.21) 9.88 0.78
- -----------------------------------------------------------------------------------------------------------------------------
Total from Investment Operations . . . . . . . . . . . . . . (13.38) 9.50 0.84
- -----------------------------------------------------------------------------------------------------------------------------
Distributions:
Net Investment Income. . . . . . . . . . . . . . . . . . . . -- -- (0.07)
Net Realized Gain. . . . . . . . . . . . . . . . . . . . . . -- (3.68) --
In Excess of Net Realized Gain . . . . . . . . . . . . . . . (0.67) -- --
- -----------------------------------------------------------------------------------------------------------------------------
Total Distributions . . . . . . . . . . . . . . . . . . (0.67) (3.68) (0.07)
- -----------------------------------------------------------------------------------------------------------------------------
Anti-Dilutive Effect of Shares Repurchased. . . . . . . . . . . . 0.11 -- --
- -----------------------------------------------------------------------------------------------------------------------------
NET ASSET VALUE, END OF PERIOD. . . . . . . . . . . . . . . . . . U.S.$ 12.65 U.S.$ 26.59 U.S.$ 20.77
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
PER SHARE MARKET VALUE, END OF PERIOD . . . . . . . . . . . . . . U.S.$ 9.81 U.S.$ 23.88 U.S.$ 18.00
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENT RETURN:
Market Value . . . . . . . . . . . . . . . . . . . . . . . . (57.34)% 53.53% (9.72)%
Net Asset Value (1). . . . . . . . . . . . . . . . . . . . . (50.62)% 48.19% 4.18%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
RATIOS, SUPPLEMENTAL DATA:
- -----------------------------------------------------------------------------------------------------------------------------
NET ASSETS, END OF PERIOD (THOUSANDS) . . . . . . . . . . . . . . U.S.$ 60,309 U.S.$ 133,071 U.S.$ 103,945
- -----------------------------------------------------------------------------------------------------------------------------
Ratio of Expenses to Average Net Assets . . . . . . . . . . . . . 2.51% 2.50% 3.30%**
Ratio of Net Investment Income (Loss) to Average Net Assets . . . (0.89)% (1.27)% 1.15%**
Portfolio Turnover Rate . . . . . . . . . . . . . . . . . . . . . 96% 71% 2%
- -----------------------------------------------------------------------------------------------------------------------------
</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 the financial statement
9
<PAGE>
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
- -----------
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.
10
<PAGE>
The Fund may use derivatives to achieve its investment objective. The Fund may
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 may use derivatives for
non-hedging as well as hedging purposes.
Following is a description of derivative instruments and their associated risks
that the Fund may utilize:
5. FOREIGN CURRENCY EXCHANGE CONTRACTS: The Fund may enter into 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 commit-
ments 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-
11
<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 generally
will expose the Fund to credit risks of the underlying instruments as well
as of the issuer of the Structured Security. 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-dividend 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", net operating losses 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 Dean Witter Investment 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 corporate 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, 1998, the Fund made purchases and sales
totaling $85,897,000 and $95,631,000, respectively, of investment securities
other than long-term U.S. Government securities and short-term investments.
There were no purchases or sales of long-term U.S. Government securities. At
December 31, 1998, the U.S. Federal income tax cost basis of securities was
$70,349,000 and, accordingly, net unrealized depreciation for U.S. Federal
income tax purposes was $11,026,000, of which $7,472,000 related to appreciated
securities and $18,498,000 related to
12
<PAGE>
depreciated securities. At December 31, 1998, the Fund had a capital loss
carryforward for U.S. Federal income tax purposes of approximately $23,890,000
available to offset future capital gains which will expire on December 31, 2006.
To the extent that capital gains are offset, such gains will not be distributed
to the shareholders. For the year ended December 31, 1998, the Fund elects to
defer to January 1, 1999 for U.S. Federal income tax purposes, post-October
capital losses of $1,827,000.
E. A significant portion of the Fund's assets consist of securities of issuers
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 have been amortized on a
straight-line basis over a five year period beginning September 30, 1996, the
date the Fund commenced operations. Due to a change in accounting guidance, the
balance of unamortized organization costs at December 31, 1998 will be charged
to expense in 1999.
G. 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, 1998 totaled $10,000 and are included in Payable for Directors' Fees and
Expenses on the Statement of Net Assets.
H. 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 December
31, 1998, the Fund repurchased 270,500 shares or 5.37% of its Common Stock at an
average price per share of $9.05 and an average discount of 18.02% from net
asset value per share. The Fund expects to 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.
- -------------------------------------------------------------------------------
FEDERAL INCOME TAX INFORMATION (UNAUDITED):
For the year ended December 31, 1998, the Fund designates $750,000 as
long-term capital gain distribution at the 20% tax bracket.
13
<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, 1998,
the results of its operations for the year then ended, the changes in its net
assets for each of the two years in the period then ended and the financial
highlights for each of the two years in the period 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, 1998 by
correspondence with the custodian and brokers, provide a reasonable basis for
the opinion expressed above.
PricewaterhouseCoopers LLP
1177 Avenue of the Americas
New York, New York 10036
February 8, 1999
14
<PAGE>
YEAR 2000 DISCLOSURE (UNAUDITED):
The investment advisory services provided to the Fund by the Adviser depend on
the smooth operation of its computer systems. Many computer and software systems
in use today cannot recognize the year 2000, but revert to 1900 or some other
date, due to the manner in which dates were encoded and calculated. That failure
could have a negative impact on the handling of securities trades, pricing and
account services. The Adviser has been actively working on necessary changes to
its own computer systems to deal with the year 2000 problem and expects that its
systems will be adapted before that date. There can be no assurance, however,
that the Adviser will be successful. In addition, other unaffiliated service
providers may be faced with similar problems. The Adviser is monitoring their
remedial efforts, but, there can be no assurance that they and the services they
provide will not be adversely affected.
In addition, it is possible that the markets for securities in which the Fund
invests may be detrimentally affected by computer failures throughout the
financial services industry beginning January 1, 2000. Improperly functioning
trading systems may result in settlement problems and liquidity issues. In
addition, corporate and governmental data processing errors may result in
production problems for individual companies and overall economic uncertainties.
Earnings of individual issuers will be affected by remediation costs, which may
be substantial and may be reported inconsistently in U.S. and foreign financial
statements. Accordingly, the Fund's investments may be adversely affected.
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
16
