A Troublesome Partnership

By Alexandr Gabuev

Fettered by Western sanctions, major Russian companies are looking for new opportunities in East Asia, pinning most of their hopes on China, the world’s second largest economy and Moscow’s closest political partner. And yet, private businesses and top managers of state-run companies are talking about numerous problems and risks stemming from the increased dependence on China. Minimizing them is a task that business and the government should tackle together.

 

 

SANCTIONS FOR FRIENDHSIP

 

“There is a clear trend towards reconciling positions with Asian partners, necessitated by both economic and political reasons. China is interested in the Russian market. Chinese companies are ready to invest in integrated development of Russian deposits, energy sector, infrastructure, automotive industry and aircraft making. Reciprocally, there is a great deal of interest among Russian companies as well, and not only in the resource sector… I think the Western sanctions can significantly speed up our cooperation,” billionaire Gennady Timchenko said in an interview published by the Kommersant business daily on September 15, 2014.

 

This statement by an entrepreneur, who Forbes says is the sixth wealthiest person in Russia (with personal holdings estimated at$15.3 billion), reflects the overall attitude the Russian political and business elites have been communicating both inside the country and beyond after the West imposed its sanctions. Since April 2014, government officials and business people have been continually claiming that the development of partnership with Asia and primarily with powerful China would be a reply to the EU and U.S. policy. From time to time top Russian leaders correct this message, saying that the turn to the East began long before the Ukrainian crisis, but the demonstrative nature of Russian-Chinese friendship strikes the eye.   

 

Gennady Timchenko is the most notable figure in this process. On March 20, 2014, he was included in the second “black list” announced by U.S. President Barack Obama in reply to Russia’s actions in Ukraine. On April 29, Timchenko became co-chair of the Russian-Chinese Business Council, replacing Boris Titov who had held this position for ten years. During his visit to Shanghai in May, President Vladimir Putin said at a meeting with Russian tycoons that, in his opinion, Timchenko was now “the main person responsible for China.” In an interview with TASS on August 4, the entrepreneur, who also has Finnish citizenship and who spent most of his time in Switzerland before the sanctions, stated that he had given up the Visa and MasterCard credit cards and had switched over to the Chinese payment system UnionPay. “I did it immediately after the sanctions were imposed. It’s accepted in many places and working just fine. It’s even more reliable in some ways than Visa. Certainly, it’s out of reach of the Americans,” he said. 

 

Being officially the chief expert on China among leading entrepreneurs, Gennady Timchenko can afford to make public comments on the risks of partnership.  “There is always the risk of losing to a stronger competitor. But I think it should not override our relations. We must take into account the prospects being opened up by our cooperation with Asian partners in terms of attracting capital and technology. It is common knowledge that the notions of ‘risk’ and ‘possibility’ can be conveyed by one and the same hieroglyph in Chinese. If we pool our possibilities, business will have much more to gain than to lose,” he told Kommersant. But not all Russian entrepreneurs and top government officials share this point of view.

 

THE CHINESE TURN

 

In recent years, the issue of risks has always been part of top-level discussions on broader trade and economic cooperation with China. This to a large extent is the echo of the 1990s when trade with China was not a priority for the Russian state and the bourgeoning wealthy class. While in 1992 China remained Russia’s third largest trade partner by inertia after the rise of Soviet-Chinese relations in the late 1980s, it rolled back to tenth place in 1993. During the decade that followed the disintegration of the Soviet Union, our economic relations were dominated mainly by defense contracts (it was Chinese orders that supported the crippling Russian defense industry), chaotic cross-border trade and Chinese entrepreneurs’ attempts to buy resource assets in Siberia and the Far East. By the beginning of the 2000s, China was Russia’s sixth largest trade partner, with the trade turnover slightly exceeding $40 billion a year. 

 

When Vladimir Putin came to power, relations with China were streamlined. Significant progress was made at the political level: in 2001, the two countries signed the Treaty of Friendship, followed in 2004 by an addendum to the border agreement which officially closed the territorial issue (Russia ceded 337 square kilometers of disputable territory to China); the two countries began forming “a soft alliance” in foreign policy, primarily by working together in the Shanghai Cooperation Organization and voting concertedly in the U.N. Security Council.  

 

However, economic cooperation with China was constrained by informal restrictions: the presence of Chinese businesses in the Far East and Siberia was reduced; joint infrastructure projects in the Primorye Territory were suspended; military-technical cooperation was slowly declining; Chinese companies were kept away from mineral deposits and major construction projects such as the APEC Summit in Vladivostok. At that time Moscow was seriously concerned about Beijing’s plans with regard to the territory east of the Urals (the main factor testifying to Beijing’s purported expansion plans was the demographic imbalance between China’s northeast and Russia’s Far East). Furthermore, Russia did not want to become a mere supplier of raw materials to the rapidly growing neighbor and sought instead to provide technology to most of the Asian partners, including China. Finally, Moscow was worried by the unauthorized reproduction of Russian equipment, especially weapons, by China. All this explains why trade turnover between the two countries did not rise above $60 billion despite the 4,200 km common border and the mutually complementary structure of their economies. Contracts like the one made by Rosneft and China National Petroleum Corporation (CNPC) in 2004 to supply 48 million tons of oil (Russia used the $6 billion prepayment made by China to buy YUKOS assets) were rather an exception. 

 

Changes began in 2009 at the height of the global crisis. Faced with a shortage of cash in the West, Russian companies turned to China. The biggest oil deal was made by Rosneft and Transneft which borrowed $25 billion over 20 years from the China Development Bank to build an oil pipeline to the neighboring country, with the promised supply of 15 million tons of oil a year as collateral. In 2009, China became Russia’s leading trade partner, having outdone Germany, and has been holding this position ever since ($89.2 billion in 2013). However, many informal investment restrictions remained in place. Until recently, Chinese companies were kept away from large gas field development projects, and red tape frustrated the creation of joint ventures in machine-building and the automotive industry (Moscow feared that Chinese enterprises would quickly seize the domestic market using dumping practices). The presence of Chinese financial institutions in Russia was also restricted. Unlike Western banks, Chinese ones were not let into the retail market. Even the bodies that were formally intended to step up Chinese investments in the Russian economy (like a joint fund of China Investment Corporation and the Russian Direct Investment Fund) were limited in investing in the sectors that Moscow considered “sensitive.”

 

In 2013, however, this began to change. CNPC acquired 20 percent in the Yamal LNG project (controlling interest held by NOVATEK co-owned by Leonid Mikhelson and Gennady Timchenko), and Rosneft signed an agreement on multi-billion advance payments from CNPC and Sinopec in exchange for future oil supplies. The new approach was dictated by the economic slowdown in Russia (1.3 percent in 2013) and the Kremlin’s concerns about long-term expenses incurred among others by the president’s May decrees that were essential for keeping the electorate’s loyalty. 

 

The crucial moment came with Western sanctions in the spring of 2014. As the sanctions broadened and deepened (the U.S. and the EU moved from “black lists” to borrowing restrictions for key Russian banks and state-owned companies and discontinued technological cooperation in strategic industries, such as the fuel and energy sector), the need for an external counterbalance became ever more obvious. Since Japan had also declared sanctions (as a G7 member and a U.S. ally) and South Korea had assumed a wait-and-see position, China naturally poised itself as the main rescuer for Russia. Putin’s trip to Shanghai in May resulted in some 40 agreements, followed by another 38 signed during Chinese Prime Minister Li Keqiang’s visit to Moscow in October. High-ranking government officials say that there have been virtually no informal investment restraints for China since April 2014. Now Russia is trying to counterbalance the effects of Western sanctions by entering China’s market and getting access to its investments, direct bank loans, financial institutions and critical technologies. Both government officials and entrepreneurs admit that the deepening of partnership with China in all these areas is already creating problems and will bring more risks in the future. What are these problems and risks like?

 

COVERT THREATS

 

The main problem in cooperation with China, which has been pinpointed by many government officials and entrepreneurs, is that in the short and medium term contracts with that country cannot make up for losses from the breakup with the West even if Beijing wholeheartedly wished to do so. It is generally believed that China is not prepared to lend capital in amounts sufficient to replace Western loans and listings in London and New York. Nor can China quickly become a source of critical technologies for Russia. If the European Union slashes the consumption of Russian hydrocarbons, China won’t be able to fill the gap in corporate or national budget revenues. It is very unlikely though that Europe will give up Russian oil and gas in the medium term.    

 

For a substantial part of the Russian elites the fact that China will become Russia’s main economic partner is associated with a number of specific risks. Some of them stem from China’s domestic system as the Russian ruling class understands (or does not understand) it. The other part is connected with internal Russian problems in organizing cooperation with Beijing. 

 

First, the Russian elites do not understand China’s strategic goals with regard to Russia. The first and foremost question asked by government officials and entrepreneurs in private conversations is “Who are we for the Chinese? What do they want from us?” Many believe that China’s long-term goal is colonization of Russia and that Beijing’s current closeness with Moscow is underlain by its desire to control resources in Russia’s Siberia and Far East in the future. This perception is rooted in the infamous conflict of 1969, vague information about the rise of nationalism in China and the logic of tight control over a weaker partner which is typical of many members of Russia’s ruling class and which they project upon the Chinese elites.   

 

Perhaps, one of the main factors that make many in Moscow look for a hidden threat in China’s drive for closer relations is the difference in demographic potentials in Russian and Chinese border-lying regions. While the Far Eastern Federal District, which accounts for 36 percent of Russia’s territory (about 6.2 million square kilometers), is home to 6.2 million people (about 4.2 percent of the country’s population), three northeastern provinces of China (Heilongjiang, Jilin and Liaoning) occupying 804,000 square kilometers accommodate almost 110 million people. These figures bring up the memory of the “yellow threat” that was popular in the late 19th century. Besides, the views of many members of the Chinese elites were shaped up, strange as it may seem, by Western authors like Zbigniew Brzezinski who openly speaks about the risk of Chinese colonization of Russian regions east of the Urals.     

 

Fears are also fueled by the poor knowledge of statistics about Chinese migrants in Russia. Although the official census of 2010 counted less than 30,000 Chinese, and experts (specifically, demographer Zhanna Zaionchkovskaya of the Higher School of Economics) put their number at 400,000, many entrepreneurs and government officials talk about “a transparent border” and “millions of clandestine migrants” beyond the Urals. It’s noteworthy that in private conversations some members of the Russian elites extrapolate the situation in Crimea and eastern Ukraine to the Far East to suggest that if cooperation with China is broadened, the region will be flooded by Chinese who will then declare a “people’s republic” and try to separate from Russia. This explains why Russian entrepreneurs and government officials react so nervously to any Chinese offer of workforce for joint projects. 

 

The second risk lies in the absence of alternatives in the search for Asian partners because of the sanctions. The current political situation around Russia, including in East Asia, gives Beijing a trump card in discussing joint economic projects with Moscow and leaves Russia no choice but choose the options that tie it down to China without any chance of arbitration in the way of cooperation with other partners. While before the crisis in Ukraine Moscow was discussing many projects in the Far East not only with Chinese but also with Japanese and South Korean companies, after the sanctions many of them backtracked or took a break. As a result, Russian partners who need certain projects to support their business weakened by sanctions and nearly zero GDP growth in Russia have to gear their interests solely to Chinese demand.

 

The same is true of the state. While previously the Ministry for the Development of the Far East and the region’s authorities tried to broaden contacts with investors in the Asia Pacific Region, the Chinese are now the main partners.

 

This is particularly manifest in infrastructure projects. Previously Russia, which had largely missed out on the rapid development of the APR energy market, was trying to catch up by building export infrastructure on its Pacific coast (predominantly LNG plants Gazprom and Ronseft planned to construct in the Primorye Territory) with possible access to a wide circle of customers.  Now plans boil down mainly to pipelines to China, for even if Japan and South Korea decide to buy Russian LNG, they won’t be able to provide loans and technology for fear of a possible U.S. reaction. And Russian companies have no money or technology of their own. The contract signed by Gazprom and CNPC in May 2014 for the supply of 38 billion cubic meters of gas to China a year via the Force of Siberia pipeline (the gas will come from the Kovykta and Chayanda fields) has most probably derailed the Vladivostok LNG project, the abandonment of which is being discussed by the Gazprom management almost as a decided matter. The channeling of resources from Eastern Siberia and the Far East to China alone via aboveground pipelines puts Russia in a market that is controlled completely by a single buyer which is free to dictate its own conditions.   

 

The absence of alternatives is also dangerous because of the specific way Chinese companies handle the contracts they sign. The Russian elites consider the peculiarities of Chinese legal practice another risk associated with the lack of alternatives. 

 

A classic example of this risk in Russian-Chinese relations was vividly illustrated by the following events. In 2011, Rosneft, Transneft and CNPC were locked in a dispute over the price of Russian oil supplies by the Skovorodino-Mohe stretch of the Eastern Siberia – Pacific Ocean (ESPO) pipeline. China cut its payments by about $10 per barrel without prior arrangement, saying that the distance from Skovorodino to the Chinese border was shorter than to the final stretch of the pipeline in Kozmino, and the reduced payment was compensation for this difference. Rosneft and Transneft referred to the contract which set the same tariff for the entire length of the pipeline, insisting that the Chinese corporation had no right to withhold the difference for the transportation of oil from Skovorodino to Kozmino. The Russian companies threatened CNPC with a lawsuit, but even if they had won it, they would have faced gloomy prospects: the termination of the contract would have left Rosneft and Transeft with a pipeline built using a Chinese loan and leading nowhere and a debt of $25 billion they would have had to repay with cash which they didn’t have. CNPC would have been affected much less as oil supplies from Russia are important but not critical for it.

 

But the Russian companies had good luck: when the Arab Spring had swept and destabilized the Middle East, Beijing decided against spoiling relations with one of the two countries (Kazakhstan being the other) that were supplying oil to China by land rather than by vulnerable sea routes. And yet, the Russian partners took $1.5 off the price of barrel, sustaining about $3.5 billion in losses throughout the contract term.   

 

Yet another risk is that the terms of borrowing in China are not as good as those in London or New York. All entrepreneurs seeking funding in China complain about a very tough position of Chinese bankers at the talks, especially when it comes to complex and costly projects with a long recoupment period. It’s somewhat easier for strategic state-owned companies like Rosneft and Gazprom which can count on government guarantees. The situation in the financial sector is quite reminiscent of the risks associated with China’s position as a single buyer of Russian resources supplied by land. Theoretically, it will be easier for potential Russian borrowers to give up a stringent Chinese loan (by borrowing elsewhere or getting the support of the government) than for a company to abandon a project that involves the construction of physical infrastructure. In practical terms, the sanctions and the cautiousness of bankers and investors from other Asian countries have put Chinese financial institutions in a very advantageous position as there are not enough sources of loans in Russia to meet all needs (cash-strapped banks are increasingly unwilling to lend; the Central Bank is refusing to print more money; and the National Welfare Fund has limited resources).

 

This situation has been exacerbated by a combination of factors which make it much more difficult for Russian companies to borrow in China. Russia’s turn to China amid the Ukrainian crisis has coincided in time with a large-scale anti-corruption campaign which has also affected the Chinese banking sector. Communist Party General Secretary Xi Jinping, who came to power in 2012, started out by fighting his opponent, Zhou Yongkang, a former permanent member of the Politburo Standing Committee, who was overseeing security and law enforcement agencies and the energy sector (in the 1990s he was the head of CNPC). In order to collect compromising evidence against Zhou, sweeping checks were carried out in all energy companies where the state had a stake and in their creditor banks. Many top managers in state-run banks were arrested for issuing loans detrimental to the state, and their replacements are now lending on the strictest terms possible to avoid being accused of ineffective management of state property. Russian potential borrowers have already experienced the consequences of these purges as many negotiations have slowed down because of the stringent requirements put forth by their Chinese partners.  

 

The second negative factor for Russia is the conservatism of Chinese private funds and their reluctance to invest in Russia due to the lack of interest in the Russian market (most investments go to industrialized countries, Southeast Asia and Africa) and reputational risks. The Chinese take note of both Russia’s low Doing Business ratings and negative developments like the demolition of the Cherkizovo marketplace in Moscow in 2009, which caused Chinese companies to sustain multi-billion losses. Finally, Russian companies have limited access to China’s stock market. Its exchanges in Shanghai and Shenzhen are off limits to foreign issuers and their liberalization, promised by the Chinese fiscal authorities as far back as 2007, has been constantly postponed. In Hong Kong Russian companies have poor reputation because of Rusal’s IPO in 2010 when the company’s securities plunged after placement (following aluminum price fall in London). Since the offering had been lobbied by Hong Kong’s then Chief Executive Donald Tsang and a large part of the securities had been purchased by Russian state-owned banks (VEB and Sberbank), local investors now regard any IPO or bond placement by Russian companies as a political campaign and take them with great caution.   

 

Possible technological dependence on China is also viewed in Russia as a risk. These concerns are generated mainly by infrastructure projects such as the high-speed railroad from Moscow to Kazan, the memorandum on which was signed during Li Keqiang’s visit to Moscow in October 2014. The document provides for the use of Chinese technologies in exchange for funding. This may mean a narrow gauge railway like that in China (1,435 mm vs 1,520 mm in Russia). An associated risk may affect Russian equipment manufacturers if the Chinese firmly insist on using their own technologies in joint projects in Russia (for example, the construction of power plants) and building their plants in central regions of the country (the risks are particularly big for the automotive industry). Specific security risks may also be created by the change of the existing telecommunication infrastructure currently dominated by American Cisco for Chinese equipment made by Huawei or ZTE. Government and security service officials say that in this case American bugs will simply be replaced with Chinese ones which cannot be detected by current Russian technologies. A separate risk related to technological cooperation is the copying of Russian technologies by Chinese companies which then take them to third countries where they have advantages over Russian manufacturers because of dumping prices and government support (agreements like the one on the protection of intellectual property rights signed in 1996 have so far failed to solve this problem).

 

THE ENEMY WITHIN

 

Apart from the risks of cooperation with China associated with the political situation around Russia or China’s own peculiarities, the Russian business community has also identified problems that are rooted inside the country. The main of them is that there is no sufficient expert assessment of projects with China both at the national and business levels or in the non-government sector. There are several aspects to this problem. 

 

First, companies themselves conduct no expert assessment. With a small volume of contracts signed, both state and private companies until recently preferred to hire Chinese to Russian interpreters and many entrepreneurs practiced outsourcing for this purpose. By so doing the companies could not build a critical mass of experts knowing all the subtleties of work in China, having broad connections and understanding intimately the Chinese decision-making and legal systems. The companies that are training their own personnel for work with China started doing this only recently and still have no top managers speaking Chinese or knowing China’s specifics. Being unable to correctly assess prospects for a certain sector, company chief executives miss opportunities (as was the case with Gazprom which failed to use the chance in the 2000s to enter the Chinese gas market on advantageous terms).  This gap is not easy to fill as China studies in Russia have certain peculiarities and usually pay more attention to the language and traditions, while basically neglecting applied disciplines. So companies are facing the risk of hiring economists with a very poor knowledge of Chinese or sinologists with virtually no economic skills (let alone in narrow sectors). Both have to be trained by companies themselves. As China’s importance for Russia is growing, this may create problems at negotiations since Chinese companies have lots of specialists on Russia.    

 

Second, there is no well-developed market of independent assessment services for projects with China. While international corporations can hire a large number of top consulting firms and use the expertise of Western universities and analytical centers to assess political or macroeconomic risks, Russian companies for the most part cannot do this. The competencies of academic and university specialists understanding modern China, especially in business terms, were largely lost due to the lack of funding after the disintegration of the Soviet Union. With China being a low priority in the previous years, neither the state nor business invested in the development of third-party assessment programs. Organizations which were supposed to provide services to companies, such as the Russian-Chinese Business Council (overseen by the Chamber of Commerce and Industry) or the Russian-Chinese Center for Trade and Economic Cooperation (operating under the Russian Union of Entrepreneurs and Industrialists), are not functioning properly. Entrepreneurs say that none of them is prepared to provide effective and full support to major projects in China.

 

Third, the government has no sufficient knowledge of China or experience of working with it. The only agency that has a large staff of sinologists is the Foreign Ministry, but its employees are not adept at interacting with entrepreneurs and advancing their interests. Sinologists in the Ministry of Economic Development (which also controls the trade mission in China) are few and busy dealing with bureaucratic formalities. The upsurge of interest in China among Russian corporations has practically paralyzed the work of these agencies and entrepreneurs are complaining about the lack of help from diplomats who, in turn, point to a flood of unrelated requests from businesses. And there is no expert assessment whatsoever at the level of economy ministers and deputy prime minister overseeing relations with China.    

 

Another problem is the extremely complex bureaucratic mechanism of cooperation with China created by the Russian government. While there is just one respective inter-governmental commission to deal with any other foreign country, there are four formats for China, all overseen by deputy prime ministers. Entrepreneurs are least concerned about the dialogue on social and humanitarian issues, which is co-chaired by Olga Golodets of Russia and Liu Yandong of China. The other three formats overlap. There is an inter-governmental commission headed by Deputy Prime Minister Dmitry Rogozin and Vice Premier Wang Yang. Strategic dialogue in the fuel and energy sector was begun in 2009 by Deputy Prime Minister Igor Sechin (now Rosneft President) to concentrate power in energy negotiations with China. In 2012, this format was passed over to Deputy Prime Minister Arkady Dvorkovich who is now overseeing the fuel and energy sector in Russia. His Chinese counterpart is Vice Premier Zhang Gaoli. Finally, at President Putin’s request, an inter-governmental commission was created in September 2014 to handle priority investment projects. It is co-chaired by Zhang Gaoli of China and Igor Shuvalov of Russia. The powers of the commissions and deputy prime ministers overlap and their work with China is not coordinated. This creates problems for companies which have to negotiate their activities with the secretariats of two or three deputy prime ministers at the same time. Besides, Deputy Prime Minister Yuri Trutnev, who is overseeing the Far East, also has a say in some of the projects.

 

TO VICTORY OF HARMONISM

 

Hedging against many of the risks described above is something neither Russian business nor the part of the government supervising ties with China can do. The main reason for this is that the Russian leadership is not going to give up its Ukraine policy. This means that there will be no quick reconciliation with the West, which could give more room for maneuver in cooperation with China. And yet, there is enough room as it is to make the work with China more effective and thus resolve at least some of the problems that worry the Russian elites. 

 

Moscow should work out a long-term strategy for China and other East Asian countries, which would be based on facts and realistic forecasts for the region rather than on prejudices and short-lived interests of certain domestic actors.  It should also identify its objectives in the region and decide whether it can seek a bigger role than a supplier of resources to the growing Asian economies. Since the structure of Russia’s trade with China is similar to that with the European Union (roughly it can be described as “Russian resources for foreign machines”), trade turnover can be changed only by modernizing the economy. Presently, by limiting Chinese investments in the development of its natural wealth, Russia is losing potential sources of economic growth and budget revenue which could be invested in human resources (education and healthcare).

 

Russia should also assess all geopolitical risks since it is a nuclear power and the Chinese People’s Liberation Army has already reached parity with the Russian army in the Far East in terms of conventional warfare. The Russian government should probably focus on migration policy and hire Chinese workers only on a temporary basis subject to their return home (this approach was used during the construction of facilities for the APEC Summit in Vladivostok) and effective border control.  

 

Moscow should also study the potential of the Chinese market and select the niches that will diversify Russian exports and bring big revenues. The obvious solution is to take the advantage of the growing middle class and urban population who are changing their eating routines and consuming more calories, make full use of fertile land in the Primorye Territory and start exporting food.  

 

Finally, Russia should use every opportunity to diversify contacts in the region by working with Japan and South Korea, playing with fears of Russian-Chinese integration (including those in the U.S.) and always keeping an eye on rising Southeast Asia with its 500 million-strong population and growing consumption of resources. 

 

In order to solve these three tasks, Russia should enhance its East Asia expert assessment capabilities for the needs of the state and business community within the shortest time possible. The state and business will need to put relatively small amounts of money in the training of government officials to work with China and other Asian countries, develop the market of independent expert assessment services and improve the quality of Oriental studies (including through broader international university cooperation and greater involvement of business in the training of personnel). The development of competencies will take time and won’t strengthen Russia’s positions in negotiations with China overnight (especially amid sanctions). But in the future Moscow will be able to pursue a smarter and more far-sighted policy in the region that will remain strategically important for the future of the country even after the rift with the West is mended.

 

Alexander Gabuyev is a sinologist and a member of the Council on Foreign and Defense Policy.

 

 

Russia In Global Affairs

 

 

23.02.2015

 

 

 

 

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