Annexing Crimea, sponsoring a violent separatist movement in eastern Ukraine, and provoking many countries to impose economic sanctions—Russia has been in the headlines for the past nine months. In December the ruble fell by 32% in two days and the stock market fell by 22%. Both have since bounced back, largely recovering the short-term losses. While prudence cautions against concentrating one’s investments in Russia, current market prices offer alluring risk premiums. The ruble is cheap, interest rates are high, and dividend yields of Russian companies are among the highest in the world.
Investing in Russia has never been easy. In the 20th century, Russia defaulted twice, massively. Early in the century, the Bolsheviks seized all private capital. The previous owners lost not only their property but also their lives, if the Bolsheviks could find them. The disintegration of the Soviet Union at the end of the century produced a series of defaults. Western investors recall the 1998 default on government obligations that resulted in the collapse of Long-Term Capital Management. Those inside Russia remember the hyperinflation of the 1990s, which had the economic substance of a default by reallocating wealth from citizens to the government, and “privatization,” the redistribution of public property to a small group of new owners.
Today, Russia presents extreme risks and plentiful opportunities. The economic risk of low oil prices is compounded by risks arising from the country’s foreign policies and internal politics. The actions of Russia’s nationalist government in its ongoing conflict with Ukraine and the resulting economic sanctions imposed by the West are raising the odds of default. And yet, while markets are rightly fearful, Russia needs western capital and is willing to pay dearly for it.
With its vast and thinly populated area, Russia always feels threatened. Its political elite employs a security apparatus that seems paranoid to outsiders. Reflecting the fear that other powers plan to dismember the country, Russian foreign policy is oriented toward promoting puppet regimes in bordering countries. The leader of Kazakhstan has been in power for 25 years and the leader of Belarus for 20 years. These pro-Russian regimes in former Soviet states are undemocratic dictatorships, some with strong criminal inclinations.
Russia’s “friendly bordering dictator” doctrine is unstable and tends to backfire. When the populations of these bordering countries become fed up with the Russian-supported dictator and try to install a more responsive government, Russian authorities interpret the political movements as anti-Russian plots instigated by foreign intelligence services to undermine Russian security.
Internally, Russia’s political and civil institutions are centralized and archaic. Russia does not have an effective multiparty democracy; it is a one-party state. United Russia is a political machine for Vladimir Putin to direct the bureaucracy and drive legislation through the parliament. The principal competition is the Communist party, whose agenda is to re-nationalize the economy. The third largest party represents ultranationalists who espouse even harsher militaristic policies than Putin’s. To be sure, these other parties are more political theater than serious opposition.
Putin and his “party” control the Russian media. The stories told on TV remind western observers of Orwell’s novels. Russia tolerates a small nongovernmental media sector that allows independent voices to let off steam—but in a controlled way. The Russian government has learned that countenancing the appearance of unhampered thought enables it to control information even more effectively. Orwell did not foresee this tactic.
The Russian legal system is subservient to its political leadership. As a result, Russian companies, both state-owned and private, suffer from official corruption. Investors need to take financial reports with a grain of salt. A telling fact, in 2002 Gazprom received an Ig Nobel prize in economics for “adapting the mathematical concept of imaginary numbers for use in the business world.” To be fair, Gazprom shared its prize with Enron and many other companies. Nevertheless, investors scrutinize Russian financial reports with skepticism. As in other emerging markets (and a few developed markets too), the regime often redirects cash flow to its political priorities and away from investors.
On a map of the world, Russia is hard to miss. It is the largest country by surface area. Nonetheless, Russia is sparsely populated and has an undiversified economy.1 Covering one-sixth of the dry surface of the earth, Russia holds huge reserves of mineral deposits. In international trade, Russia mainly focuses on exporting its natural resources. Close to 70% of Russian exports are energy related (see Figure 1). When energy prices fall, the country’s revenue stream tends to dry up.