With the focus on the Winter Olympics in Sochi and the showcasing of President Vladimir   Putin’s reinvented Russia, perhaps it is time to ask the question: should you buy Russian debt?  Emerging markets have been hammered over the last year with rumors of the Fed’s taper, and Russia has been no exception.  The prospect of rates being set naturally by markets instead of overactive central banks has created fear of capital repatriation back to developed countries as developed market rates will certainly have to rise.    Russian government bonds have lost more than 20% of their value and the RUB has depreciated at comparable levels. 

In addition, Russia has experienced a slowdown in GDP growth to the surprise of emerging-market economists.  This slowdown stems from a dampening of energy prices due to the American shale gas revolution and the persistent societal problem of systemic corruption from the local to national government level.  Russia was recently listed by the World Bank as 92nd in terms of ease of doing business and 178th in dealing with construction permits.  This corruption acts as a damper on entrepreneurial activity and small business creation. 

The perception of a corrupt business environment could continue to keep foreign capital from entering Russia on the scale needed to spur growth.  Without this strong economic growth, interest rates will rise and further hurt bond prices.

Low natural gas prices are here to stay, as other countries with large hydrocarbon reserves also develop hydraulic fracturing technology and capability.  In the last year, oil and gas accounted for 50% of Russian national revenue.  Russian budgets had relied on higher energy prices to cover a growing pension burden as the Russian population ages.  Memories of previous economic crises have dampened the Russian birthrate which is a further drag on the economy.  With the highly probable prospect of falling energy prices in the foreseeable future, how can Russia jumpstart its economy? 

The key metric to watch is corruption.  Former President Medvedev instituted a serious reform effort to root out systemic graft, improve law enforcement, and modernize the Russian economy away from the oil and gas sector.  These efforts saw minimal progress.  Upon returning to the presidency, Putin reversed much of this effort as the Kremlin saw the resulting political chaos and growth of the opposition as a threat to stability.

However, Putin understands that corruption is a problem.  He has installed a new anti-corruption department recently in the Kremlin to at least give lip service to the issue and create the appearance of a serious reform effort.  The Winter Olympics have hurt that desired outcome.  If one is to believe the opposition, upwards of 20% of the funds allocated for Sochi construction were siphoned off to corrupt coffers.  The Kremlin vehemently disputes this.  For evidence of this ingrained culture of graft, one only has to look to the traffic police in Moscow, where bribery to line the pockets of individual officers is rampant and normal.

There are many economic positives in Russia.  Overall Russian debt at the end of 2012 was $308 billion, which is approximately 10% of gross domestic product.  An argument can made that this percentage should be higher when including the corporate debt of state owned corporations.  When this debt is included, the debt-to-GDP ratio is still small compared to most of the developed world.  Russia also has over $500 billion of foreign exchange reserves, a highly educated work force, and fairly cheap labor.  All of these favorable attributes helped Russia weather the 2008 economic crisis without serious pain.  However, due to the high exposure to oil and gas revenue, Russia is still significantly exposed to financial market turbulence abroad.

So, this is the decision a bond investor must make.  If you think Russia will deal with its systemic corruption problem and move its economy to a broader footing, unleashing small business and entrepreneurial activity and therefore attracting foreign capital, then you back the truck up on Russian bonds.  The relative fiscal health of the Russian government will act as a buffer as the economy transforms to a more opportunistic society. 

If you think that corruption is there to stay in the Russian Federation and that the economy will continue to slow with weak energy prices and a difficult business climate, then look to other emerging markets for yield and total return opportunities.

L. Todd Wood is a former emerging-market bond trader and contributes to The Moscow Times.  His first thriller novel, Currency, deals with the consequences of overwhelming sovereign debt.  LToddWood.com