MACRO ADVISER: Russia's Asian pivot starts to pay off

MACRO ADVISER: Russia's Asian pivot starts to pay off
Russian President Vladimir Putin has held regular summits with Chinese President Xi Jinping. / Photo: CC
By Chris Weafer of Macro-Advisory June 19, 2017

Hopes that China would quickly fill the vacuum created by US and EU sanctions were initially disappointed. But over the past year the situation has changed and China investment into Russia is steadily rising and, more importantly, broadening away from the previous exclusive interest in hydrocarbon and extractive industries. More importantly, having recovered from the economic crisis, Russia is now in a better position to get improved commercial terms for China investment than it was in 2014 or 2015, and to broaden its investor relationships.

The main danger to that improving position is that tougher US sanctions, which could also restrict some major EU companies from investing in Russian projects, would again shift the advantage to China and force Moscow to sell more of its prized assets on Beijing’s terms. The actions of US Congress will undoubtedly damage Russia’s longer-term recovery prospects as well as some major US and EU corporations. The only winner here will be China.

In 2014, as the EU, Europe and several other developed nations imposed sectoral sanctions and financial restrictions on Russia, the chant from nationalist politicians in the Duma was “Asia-pivot”. The idea being to replace what they saw as a failed experiment to develop a mutually beneficial and respectful relationship with the West by making a sharp turn to Asia, to China in particular. It was assumed that China would be eager to fill the role vacated by the US and EU as, after all, Russia is the world’s biggest energy exporter and a significant exporter of industrial materials while China is the world’s biggest importer of most of these products.

It wasn’t just the politicians calling for the switch to a China focus. Ministers and state officials, looking for a financial lifeline against the uncertainty of sanctions and collapsing oil revenues, also tried to tap China. But, with the exception of interest in modern weaponry and access to energy projects, it seemed that China simply was not interested in bailing out its neighbour or in any sort of strategic relationship. Sberbank CEO, German Gref, famously said after returning from a China trip “we were in a long line of people looking for money and nobody called us to the front of the queue”.

So, has the hope for a stronger trade and investment relationship with China failed? Despite government optimism, is the country facing an uncertain future as US senators pass a bill aimed at making it more difficult for US companies to work in Russia, and the EU is expected to keep existing sanctions at least until 2H18 or later?

It is very difficult to get exact figures for China investment into Russia but the fact that the volume has picked up strongly is clear enough. Russia’s Central Bank reports that direct investment from China in 2015 and 2016 was only $645mn and $350mn respectively. But reports from China say the total was $3bn in 2015 and rose to $14bn in 2016.

The reason for the difference is that the Central Bank only accounts for direct transfers from a China-located bank while the China-sourced figures take into account the reports of China investors from all sources. Anecdotally, given the announcements of individual deals, the higher figures also make more sense. What is not unclear is that the value of cross-border trade between the two countries has risen from $16bn in 2013 to almost $70bn last year and, with the completion of new projects under construction, is realistically set to reach $200bn early in the next decade.

Value-added processing

The focus of investment is still overwhelmingly in hydrocarbon and extractive industries but we are seeing a shift away from direct investment into production and pipelines and into processing plants. The key hydrocarbon projects are still the Power of Siberia gas pipeline, which will pump 38bn cm of natural gas to China starting sometime in 2019, the Yamal LNG plant, in which Chinese investors own a 29.9% stake, will start to send LNG to China later this year, and the 2nd leg of the Eastern Siberia Pacific Ocean (ESPO) pipeline which will double direct crude oil exports into China’s heartland to 600,000 barrels per day when completed in 2018.

In addition, Chinese investors have proposed investing 6bn yuan ($880mn) into building a petrochemical complex on the Russian side of the border and sending the products to China. This is the latest phase of investment from China and reflects Moscow’s stronger negotiating position as the economy returned to growth, and investment from other countries is picking up; it no longer has to sell raw materials cheaply for processing in China but is able to insist on value-added processing in Russian territory before exporting the products.

Recently the Minister for Regional Development reported that Chinese investors have proposed plans for 13 separate projects in the Far East with a value of $11bn. These cover extraction and processing of minerals, agriculture and transport projects. 

Moscow is certainly keen to attract Chinese investors into the Far East and is offering tax breaks and “administrative preference” for China-backed projects in the region, especially outside of extractive industries. The $3bn invested by Chinese investors into the Primorye 1 & 2 Transport Corridors, which helps Chinese exports use Russian port facilities on the Pacific Coast, is a tangible example.

The opening up of the Belt and Road network, which in February saw a 100-container train transit Russia from China to London in 18 days, is also a potential game-changer in terms of China investment. Officials in Beijing have stated that they expect, and will encourage, a lot more investment along the network routes to take advantage of more efficient transport links and local resources.

In 2016 China investors created tens of thousands of jobs in such sectors as auto-manufacturing, food and tobacco and other consumer focused sectors. The number of individual projects was more than 30, up from 21 in 2015 and 12 in 2014.

But, as mentioned, Moscow’s perceived need for Chinese investment has changed since 2014. Partly this is because the economy is in relatively better shape and the widely predicted doomsday scenarios failed to materialise. A major reason for that is that Russia, faced with no easy way out, had to make the tough choices, such as letting the ruble freely float, and saved itself. That is a lesson that the Kremlin has learned and it has shaped trade and investment and political relations since. Russia is no longer interested in the sort of close and vulnerable relationship it once had with the US and EU, and which it nearly fell into with China in 2014. Been there, done that, didn’t work out.

Today the policy is one of diversification. India’s Prime Minister was prominent at the recent St Petersburg Forum and Japan’s Prime Minister has become a frequent visitor to Russia. According to FDi Monitor, Russia was the third most attractive investment location for EU investors in 2016, attracting $12.0 billion in deals, most from German companies. The November deal with Opec has greatly improved relations with Saudi Arabia and other Arab states and investment from that region is also picking up.

One example is the project to develop the former Tushino military airbase, in north-west Moscow, into one of the largest technology parks in Europe. The investors in the project are the Russia-China Investment Fund (a 50-50 $2bn venture between the Russia Direct Investment Fund and the China Investment Corporation) and some Arab sovereign fund investors. 

This project does also show how, on the one hand, Moscow has diversified its investor base and has a more confident position when it comes to deal structures, but of course it also shows how China has adapted its approach. The Tushino Park will be home to Rostec, the state company at the core of the military industrial complex and owner of many of the advanced weaponry that Beijing would still like to buy from Russia. Now they will be neighbours in a Moscow suburb. Somebody should tell US Congress that they should be careful what they wish for. 

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer.