Russia pivots East – or just plays the field?

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This is an extended version of an article originally published by Business New Europe on 24 November 2014. For more information please view the original article.

After the love has gone

Anyone reading the Western business press relating to Russia recently will be left with the distinct impression that global trading relations with this part of the world are undergoing a momentous and irreversible shift East. Russian business ties with the West are severed, sanctioned and broken. Asian players, most prominently the Chinese corporations, are set to step in and fill the gaps left by retreating Western investment.

Certainly the recent fanfare of political handshaking ceremonies and deal signings would support such a proposition. The APEC Summit in Beijing in November saw Moscow and Beijing conclude an agreement between state-backed companies Gazprom and CNPC (China National Petroleum Corporation) to supply gas from Western Siberia to China, from gas fields currently piped to Europe. This follows hot on the heels of the “Power of Siberia” project agreement between these companies signed in May and now under early-stage construction, with a purported $400bln deal value. If both projects are completed, overall volumes of gas supplies to China could exceed those supplied to Europe over the medium term.

The roster of other announced or planned transactions is impressive. In May some 40 other Sino-Russian transactions were purportedly concluded in finance, investment, aircraft and automobiles, including a joint venture between the Russian United Aircraft Corporation and China’s Commercial Aircraft Corporation (COMAC). Sibur signed a contract with Sinopec, the China Petroleum and Chemical Corporation, to establish a joint venture for the construction of a rubber plant. Russia’s Eurocement signed a number of contracts with the Sinoma, CNBM and Sinomach Groups and the Russia-China Investment Fund (RCIF) and Vcanland agreed to invest $800m in the development of tourism and social projects between the two countries. RCIF is itself a joint venture between RDIF (the $10bln Russian Direct Investment Fund established by the Russian government) and China Investment Corporation. Novatek signed a deal with CNPC to supply liquefied natural gas from their joint Yamal LNG project in the Russian Arctic. Investment required for the project is estimated at $27bln and in the absence of Western financing, Chinese banks are now said to be ready to commit $10bln.

CNPC is apparently planning to acquire a 10% stake in Vankorneft, a subsidiary of Russian state energy giant Rosneft. A currency swap worth $25bln between China and Russia has also been announced and is thought to be an attempted step towards ending the hegemony of the US dollar in global transactions. Both countries have publicly spoken of their desire to use national currencies for mutual transactions. Sanctioned Russian banks Vnesheconombank (VEB), VTB and Russian Agricultural Bank have signed credit line framework agreements with China Exim bank. China Development Bank has signed a memorandum of understanding with VEB with a view to investing “billions of dollars” in Russian real estate construction, starting with a Russian government-backed affordable housing programme. Telecoms giant MegaFon has agreed a $500m financing with China Development Bank. Chinese power company Amur Sirius has also announced plans to invest up to $1bln in Russian solar energy. Meanwhile senior officials at VTB have hinted that they may consider delisting from the London Stock Exchange and look for a listing in China instead.

China is now Russia’s single largest trading partner and trade between the two countries has more than doubled in the past 5 years, reportedly reaching $89.2bln in 2013.

Can we still be friends?

Nonetheless, there remains a high level of scepticism in many business circles, including many Russian ones, as to how real or achievable this pivot East really is, at least in the short-to-medium term. The reality is that Europe will remain by far Russia’s largest export market for gas and as a bloc its largest overall trading partner for years to come. US trade with Russia is much lower, but for now the US remains Russia’s single largest foreign direct investor for infrastructure and power projects.

The Gazprom-CNPC deals are we understand still just broad framework agreements, the latest milestones in years of protracted negotiations, with much planning and negotiation of the underlying contracts still to come. The pipelines and associated infrastructure will take years to build at high cost. The Power of Siberia’s investment cost alone is (depending on who you speak to) estimated at $55-100bln and a mooted $17bln prepayment by CNPC has already been taken off the table. The final prices for supply are not disclosed, but are thought to be at the low end of the scale, lower than European prices and more in line with the cheap prices currently enjoyed by China for its gas supplies from Central Asia. If the pipelines are built, the huge upfront capital investment will need to be recouped by gas sales and Russia could be vulnerable to price renegotiations from the Chinese side, who will no doubt also be speaking to their American counterparts about the expected availability of LNG exports from the shale gas revolution currently underway in the US.

When speaking to bankers and professional advisers in Moscow, Beijing and Shanghai, there is an large element of wait-and-see about the realistic levels of deal flow that might emanate from Russian-Asian business cooperation over the next few years, as compared to those relating to Russian-Western trade and investment.

Chinese companies China Railway Construction Corporation and China International Fund have already suspended work on the $2bln construction of a new Moscow metro line, reportedly over concerns of soaring costs for importing materials in light of the recent rouble devaluation. Other publicised deals often still need to be fully documented, funded and then implemented. To coin a phrase from the Tom Cruise film Jerry Maguire: “Show me the money!”.

What does Russia want?

Cutting through the political rhetoric, it is obvious what Russia wants and needs. Recent geopolitical events have brought into sharp focus the risks inherent in Russia’s current energy trading set-up. Europe (and particularly Germany) are fearful that Russia will turn off the gas, but likewise Russia is all too aware that Europe could turn off the money. Realistically, Russia is not looking to replace Europe as a trade partner and energy consumer, but to diversify and de-risk her customer and supply base somewhat. Asia, China in particular, is a perfectly logical next step and was on the agenda well before this recent political backdrop, which has just served as a catalyst to accelerate the inevitable economic policy shift.

It is well known that China’s economic boom has created an insatiable demand for raw materials and fuel and, despite a slow-down and fears of a credit bubble, this long term trend is clearly going only one way. For different reasons Japan is in a similar position, being a large consumer of natural resources but possessing few herself, with an acknowledged over-dependence on energy from the Middle East and a nuclear power strategy heavily overshadowed by the Fukushima disaster.

However, this doesn't stop with energy and natural resources. President Putin commented at APEC that Russia needs to increase her share of non-resource and high-technology products, with the goal to increase Russia’s trade turnover to 40% with the Asia-Pacific region. Also, sanctions are markedly squeezing the availability of financing and capital and the need to obtain this from alternative sources is real and pressing.

As might be expected, China has not adhered to the Western sanctions programmes, whilst Japan’s sanctions have been lighter than those of the EU or US and Russia has not retaliated with sanctions against Japan. South Korea, keen to build relations with Russia and perhaps hoping to benefit from a proposed Russian rail link to run through North Korea (in return for Russian forgiveness of North Korean debt obligations), has declined to impose sanctions at all.

Capital investment into infrastructure remains a priority for Russia and opportunities will continue to open for Asian investment. Japanese and South Korean companies have been active in Russia for many years, particularly in the automotive, manufacturing, natural resources and banking sectors. Chinese corporations in particular are known to be looking at a range of sectors including telecoms, logistics and transportation (including the construction of a $25bln high speed railway over 800km between Moscow and Kazan), agriculture, manufacturing, consumer and retail.

Where does this leave the West?

Political relations between Russia and the West look set to remain strained for years to come, but big business, rightly or wrongly, is far more dispassionate and financially-motivated and Russia remains an important market for many Western companies. In 2007-2008 during the (previously) lowest point of UK-Russia post-Cold War international relations (due to the Litvinenko poisoning incident and the Russia-Georgia conflict) bilateral trade between the two countries actually increased.

There is a sense of realism amongst Russian business people about the challenges facing economic diversification. There is also little desire to make Russia dependent only on Chinese/Asian trade and investment and a broad recognition of the importance of achieving a competitive balance which best serves the economic and strategic interests of Russia as a whole. The fact that China is a huge nuclear-armed power, with a population and economy many times the size of Russia’s and shared borders stretching over many thousands of kilometres, is an obvious strategic consideration which is certainly not lost on the Russians. Any Chinese investment into key strategic industries will be closely watched by Moscow and subjected to tight regulatory approvals.

The final important point is that Russia does not just need capital investment, but also technical support, equipment and expertise in order to diversify her economy, enable newly promoted “import substitutions” and boost development and at the moment this assistance will mostly be available from Western companies, subject as always to mutually acceptable terms and of course now the impact of sanctions. As in the past, this assistance is most likely to come via joint ventures and joint collaboration on projects. This extends well beyond just oil and gas, for example to healthcare and pharmaceuticals, IT, financial services, outsourcing, renewable energy and recycling, transport infrastructure, hi-tech manufacturing and so on.

The significance to Russia of this technical assistance has not gone unnoticed by Western politicians, who have also imposed sanctions on exports of state-of-the-art technology, including for off-shore extraction of hydrocarbons, civil aircraft production and dual-use (civil and military) technology. This cooperation and expertise remains vital for economic development and diversification and is not so easily replaced by a pivot East, for the time being at least. With sanctions seemingly set to stay in place for some time to come, it remains to be seen how this part of the economic equation will play out.

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