MACRO ADVISER: The EEU will keep Russia in the Chinese OBOR game

MACRO ADVISER: The EEU will keep Russia in the Chinese OBOR game
China's six economic corridors are at the core of OBOR.
By Tom Adshead of Macro-Advisory July 10, 2017

From the point of view of the Russian government, the map of the Chinese Belt and Road strategy (OBOR) looks like a deliberate snub. If one of the goals of OBOR is to reduce Chinese dependence on the South China Sea as the main conduit for its exports, then not including the cheapest and fastest land route to Europe can only be explained by a political desire not to include the Russians. At its most ambitious, OBOR is a plan to re-design the world’s economic geography for the next century, linking China with Africa and Europe. Russia is reduced to a role that would likely be limited to the supply of raw materials as and when needed.

The Russian response has been pragmatic. They accept that if they were China, they would do things the same way. The Russians have learned from their experience with gas pipelines to Europe that dependence on single export routes creates both economic and political risks. Once a pipeline is in place, it is as much a hostage as a lifeline. They understood that the only way to persuade the Chinese to give Russia a more fruitful role in OBOR would be to bring something to the table, and that something was the Eurasia Economic Union (EEU).

When President Putin referred to the break-up of the Soviet Union as the greatest geopolitical catastrophe of the 20th century, he may have been harking back to the Ancient Greek origins of the word “catastrophe”. In Greek tragedy, the catastrophe is the denouement at the end of the play when the circumstances overcome the central motive, creating a sudden change in circumstances. Only later has the word come to mean a disaster.

One aspect of this catastrophe was that the economic development that had been permitted by the integration of the countries of the former Soviet Union was rapidly reversed by the political desire of each member country to go their own way. Since the break-up of the Soviet Union, the non-Russian countries have been looking for ways to re-integrate, starting with a speech by Kazakh President Nursultan Nazarbayev in 1994 calling for the creation of a Eurasian Economic Union. The Russians did nothing more than pay this lip-service for decades, because they had plenty of internal problems of their own, without having to take on those of their neighbours.

The start of the OBOR strategy seems to have caused a re-think in the Kremlin. Someone (we think it was First Deputy Prime Minister Igor Shuvalov) took a look at the map and understood its implications for Russia’s role in China’s economic future. This probably happened in 2011 or 2012. The next step in the argument was also elegant. The Kremlin realised that they had a ready-made solution at hand, as Nazarbayev had been pushing for some years to revive the economic integration of the former Soviet Union, and Russia now had a reason to give him what he wanted.

Just as the core axis of the European Union is the economic integration of Germany and France, so the backbone of the EEU is Russia and Kazakhstan. By locking in Kazakhstan, Russia gets a direct seat at the table of talks about OBOR. Kazakhstan gets an allaying of its fear of being too dependent on China and sharing the fate of Mongolia. It now has access to Russian markets as well, and can talk to the Chinese on less unequal terms. Russia can bring in Belarus as well, which creates a land corridor all the way to the border of the EU.

Once you understand the economic and political geography of the EEU, it becomes much harder to dismiss it as “an attempt to re-create the Soviet Union” as I heard one European diplomat describe it. One reason why Russia does not want to re-create the Soviet Union is that it required large transfers of resources from Russia to the rest of the Union, and Russia wants those resource for itself. Put more bluntly, Putin is reported to have told a Western businessman, who asked him about whether he wanted to annex Eastern Ukraine: “Do you really think I want seven million more pensioners?”

Given this motivation, it becomes easier to understand why Russia is putting resources into the EEU, and sacrificing so much sovereignty to it. You only have to visit the EEU’s headquarters, and talk to its staff to get a sense of the ambition of the organisation. Its previous incarnations have been almost insulting to Russia’s partners in terms of their lack of resources and attention. The EEU is getting too many resources for it to be a sop.

The other implication of this motivation for the creation of the EEU is that its success needs to be judged on a longer-term basis. The key performance indicator for the EEU is not trade flows in the short term, but the degree to which it gets Russia a seat at the table of the OBOR.

Even so, the EEU is achieving its short-term goals on the trade front. Some American commentators have pointed to the fall in trade between EEU members in the year following its creation. This would have got them thrown out of my first-year economics class at Cambridge. The fact is that all trade flows in the region fell in that year, because of the recession in Russia that was induced by sanctions and the fall in the oil price. The share of EEU trade in the overall trade of the EEU members actually rose slightly that year, which is about all that can be expected.

At the same time, a little reflection on the economic reality would recall that the trade flows between these countries are dominated by energy, and it takes more than a year or so to change these flows. Pipelines create rigidities in many ways, which brings us back to Russia’s role in OBOR. It should not be forgotten that the EEU members are developing countries, and as they develop, they may well trade less with their neighbours as they integrate themselves better into the global division of labour.

The other point that critics of the China-Russia land route make is that it costs about $500 to send a ton of goods from China to Europe by sea, and it costs about $1,500 to send it by rail through Russia. This is actually out-dated, as the fall in the price of fuel and the weakness of the ruble mean that it costs about the same to send a container by land as it does by sea. But the maximum possible container throughput is at best a tenth that of what can be done by sea, so the land route via Russia will never replace container traffic.

The land route will likely be limited to goods with shorter lives, like clothes, where modern retailers now order for as many as thirteen different seasons, and expect a much quicker turnaround. These goods cannot spend a month at sea, and clients need to get them faster. This brings China into the European fashion supply chain and allows them to compete with Southern European manufacturers. No one is expecting all Chinese goods to reach Europe by train, but large sub-categories will.

This means that companies need to include the EEU in their long-term calculations. It is explicitly modelled on the EU, but its second mover advantage enables it to avoid the pitfalls. There will be no single currency, because the member countries look even less like an ideal currency area than those in the Eurozone. The focus will be on harmonising laws to allow the free movement of goods. This is likely to cause friction with contradicting laws at the EEU and local levels, which will not be made easier by the fact that the courts in these countries are not as independent as one would like. That said, the civil courts are much more willing to rule against the government than criminal courts are.

Immigration is unlikely to be a political issue in Russia, because it desperately needs the extra workers, until 2030 at least. Oddly enough, the main issue about freedom of movement may be that some member countries will object to too many of their workers leaving for Russia. However the macroeconomic benefits of remittances will outweigh this uncomfortable fact.

The EEU has the potential to do tremendous good because it can force countries to accept legislation that would otherwise be squashed by entrenched bureaucracies. The problem in all of them, and in Russia in particular, is whether these bureaucracies can learn to obey their laws, which will in many cases be written outside local government. But that has been the central question of reform in the entire post-Soviet space, and the EEU alone cannot solve it.

Oil and gas pipelines in Central Asia