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Putin Is on a Mission to Develop Ties With China

Looking to escape Western economic sanctions over his actions in Ukraine, Russia’s president is working to develop an economic and trade relationship with China.

  • By Craig Mellow

On September 1, with Russian troops advancing alongside separatist rebels in eastern Ukraine and the European Union promising one more round of economic sanctions against the Kremlin, Vladimir Putin took a day trip from Moscow to the wastes of Yakutia, in northeastern Siberia. The Russian president went there to celebrate the formal start of construction on the Power of Siberia natural-gas pipeline. This was no standard ribbon-cutting ceremony, though. For Putin the pipeline is an economic masterstroke that will render his country immune to what he calls blackmail by the West.

The Power of Siberia will deliver some $400 billion worth of Russian gas to China over three decades, starting in 2020, under an agreement that Putin struck with President Xi Jinping at a Sino-Russian summit in Shanghai in May. Putin has lauded the gas deal as the bulwark of a Russia that can say no to the U.S. and Europe. It marks a decisive turn toward Asia and in particular China, whose economy continues to expand rapidly and where resistance to Western geopolitical views is strong. “You could say that a durable Russo-Chinese diplomatic attachment has developed,” Putin told a meeting of Russian ambassadors in Moscow in late June. “It is based on shared views about global processes and key regional problems” (see also “Russia Touts Gas Deal at St. Petersburg, but Who’s Listening?”).

But financiers for Gazprom, the state-controlled Russian company that is building the pipeline and developing the gas fields to feed it, soon identified a flaw in Putin’s vision: Much of the enormous sums the company needs to forge its link to Asia will under current circumstances have to be raised on European financial markets. Gazprom estimates the up-front cost of drilling wells and constructing the pipeline network at $55 billion. It hopes to receive $25 billion in prepayment from its partner, China National Petroleum Corp. For the remaining $30 billion, Gazprom planned to borrow about $3 billion a year on the Eurobond markets. But EU sanctions, imposed to protest the Kremlin’s support for separatists in Ukraine, have effectively closed that market to Russian borrowers. Sources say the company’s bankers explored Asia as an alternative but determined that they could raise no more than $300 million at a time on markets in Hong Kong or Singapore, an amount not worth the company’s trouble — at least, not at the moment.

The big Russian banks that might speed to Gazprom’s aid, Sberbank of Russia and VTB Bank, have funding constraints of their own. The EU and the U.S. slapped sanctions on both after the destruction of Malaysia Airlines Flight MH17 over eastern Ukraine in July: They are forbidden from raising funds for more than a 90-day duration from Western financial institutions (see “EU Tightens the Economic Screws on Putin’s Russia”). VTB had to turn to the Kremlin for a capital boost in August, splitting a 239 billion-ruble ($6.5 billion) infusion with state agricultural lender Rosselkhozbank. That leaves Gazprom’s financiers hoping for a thaw over Ukraine next year or a surge of syndicated credits from so-far-unspecified Asian banks.

Gazprom’s dilemma is emblematic of the broader challenge Putin faces in defying the West and shifting Russia’s economy to take advantage of the position nature granted it, between Europe and Asia. It also offers some insight into the conflicting pressures on the Russian leader as he tries to achieve something he can call victory in Ukraine while mending the biggest rift in relations with Brussels and Washington since the cold war. Even if the tenuous cease-fire agreed to in Ukraine in early September holds, the path to a political settlement in the country’s eastern region — and a return to business as usual between Russia and the West — promises to be thorny and long (see also “Battling for Ukraine with Capital Instead of Combat”).

Russia wields a powerful hand in the current standoff. Aside from clear military superiority over Ukraine, Moscow could continue a gas boycott on Kiev that it instituted in June, inflicting untold hardship on Ukraine as winter moves in and undermining support for the so-called Maidan Revolution and newly elected President Petro Poroshenko. Such a stance could also cause fuel shortages across much of the EU, which depends on Russia for one quarter of its natural-gas supply. Half of those supplies travel through pipelines that run across Ukraine.

Russia has impressive financial reserves to ride out the Western sanctions. Gazprom held R689 billion in cash at the end of 2013, and Russia’s fiscally prudent government has socked away $177 billion in two national savings funds. However, with the price of North Sea Brent, the benchmark global crude, falling below $100 a barrel recently, undercutting the government’s oil revenue, the Kremlin may need to draw on those reserves to maintain public spending (see “Drop in Crude Oil Prices Could Pressure Russia’s Budget”).

There’s no question that Russia is paying a steep price for its confrontation with the West over Ukraine. Formal sanctions are inflicting some economic damage, and financial markets are exacting an even bigger toll. The ruble has slumped by 16.4 percent against the dollar this year, a stark contrast to the gains posted by many other emerging-markets currencies, as many investors have decided that Russia has become too risky. Stocks have been volatile, with the Moscow Exchange’s Micex Index plunging by 16 percent after mass protests forced Ukrainian president Viktor Yanukovych to flee in February, recovering all of that ground by early July, then tumbling anew after the downing of MH17. The index was off 6.4 percent for the year as of September 29 (see also “Russian Equities Are Hit Hard by Slowing Economy”).

The economy has taken some self-inflicted blows as well. Countersanctions that the Kremlin slapped on food imports from the West and Ukraine are aggravating Russia’s inflation problem. Consumer prices will rise by 9 percent this year, up from 6.8 percent in 2013 and far above the official target of 5 percent, predicts Yulia Tseplyaeva, Sberbank’s chief economist for Russia and the Commonwealth of Independent States. In a bid to contain the pressures, the Bank of Russia has hiked its key short-term repurchase rate by 2.5 percentage points, to 8 percent, since March. Not surprisingly, economic growth, which limped along at a rate of just 1.3 percent last year, has effectively stalled. The International Monetary Fund forecasts that the economy will expand by only 0.2 percent this year. As Tseplyaeva puts it, “Price increases at that pace combined with zero growth make a classic case of stagflation.”

The years ahead will bring little relief if Russia and the West remain at loggerheads, the economist predicts. Russian oligarchs, though resolutely silent on political matters, quietly share foreigners’ bearish outlook. Their pessimism drove a 3.8 percent year-on-year contraction in fixed investment from January through May, according to HSBC Holdings data, leaving the state as the primary economic engine. “Our most optimistic scenario would see growth returning to 2.5 percent a year by 2017, which would still lag world growth levels,” Tseplyaeva says. “Our negative scenario involves a recession.” In the medium term the economy stands to suffer from restrictions on the export of Western oil and gas technology, which the EU and the U.S. imposed as part of the post-MH17 sanctions packages.

GIVEN THOSE PRESSURES, it’s not hard to see why Putin wants to shift Russia’s economic and political orientation to the east. Moscow’s current economic ties are lopsidedly concentrated in Europe. Two-way trade with the EU totaled $427 billion last year, compared with $88 billion with China. EU countries account for three quarters of Russia’s foreign direct investment, according to Brussels’ statistics, although that figure includes a substantial chunk of money that Russian corporations have brought home from offshore havens such as Cyprus and the Netherlands, where the companies — including Gazprom and state-owned oil flagship Rosneft — have established subsidiaries to shelter their wealth.

China and its Asian neighbors have good reason to warm up to Russia. Despite the huge infrastructure costs, Gazprom can likely guarantee a steady supply of energy at a fixed price, reducing the Asian countries’ dependence on liquefied natural gas, whose price is volatile. The Russian giant’s gas tariffs for Europe are about equal to current Asian LNG prices of some $11 per million BTUs. But LNG, which was trading as high as $20 just last winter, is currently near a three-year low.

Russia’s far east teems with untapped natural resources that might plausibly be developed for export to China and its other neighbors: oil, metals, coal, timber, arable land and water to generate hydropower. Russia’s Transneft, which has a monopoly on oil pipelines, and Rosneft are ahead of Gazprom in developing links to China. Transneft expects to spend $23 billion over the next four years to extend its pipeline network to China. Rosneft plans to double its deliveries there, to 600,000 barrels per day, starting in 2018; it expects to generate $270 billion in revenue from sales to China over the following 20 years. “China only needs two things to continue its economic rise — resources and food — and we have both of them,” says Viktor Kuvaldin, a former speechwriter for Mikhail Gorbachev who now teaches economics at Moscow State University.

The two countries are pursuing cooperation in advanced technology fields ranging from aircraft development to space exploration. A wide-body passenger plane is on the drawing board that could meld Russian design expertise and Chinese manufacturing prowess. At a June Russia-China industrial exposition in the northern Chinese city of Harbin, Russian Deputy Prime Minister Dmitry Rogozin suggested that the two countries work “hand in hand” on future cosmic exploration, including manned missions to the moon and Mars.

Putin’s hopes in playing the China card go well beyond the economic sphere. He envisions a Russo-Chinese-led bloc spearheading a global backlash against U.S. economic, political and strategic influence. “Putin is trying to put together a coalition of the unwilling,” says Tom Adshead, a Moscow-based portfolio manager at investment boutique Verno Capital.

This global strategy bore some tentative fruit in July, when the BRICS nations of Brazil, Russia, India, China and South Africa agreed to establish the $50 billion New Development Bank, headquartered in Shanghai, as an alternative to the World Bank.

Russia’s pivot toward China includes a military dimension as well. Putin and Xi took time out from their gas negotiations in Shanghai to launch joint naval exercises that the Chinese president said would “display the new level of strategic mutual trust and coordination between the two countries.” These were followed in August by land war drills in Chinese Mongolia under the aegis of the Shanghai Cooperation Organization, which unites Moscow and Beijing with four Central Asian states. “Ukraine is seen as a godsend in China,” says Gilbert Rozman, a sociology professor at Princeton University who focuses on Northeast Asia. “There is the potential for a Sino-Russian challenge to the world order that would entail a new cold war with periodic local hot wars.”

China’s enthusiasm for teaming up with Russia could prove limited, though. Beijing is happy to exploit Russia’s dilemma and obtain energy resources on better terms than Moscow had offered before its Ukrainian intervention. The two sides haven’t disclosed the price tag on Gazprom’s promised 30-year gas deliveries, but analysts believe it is closer to the European levels of about $11 per million BTUs, which China had held out for during years of negotiations, than the $14 that Russia had sought. Beijing made another long-awaited breakthrough during the Power of Siberia kickoff festivities, which Vice Premier Zhang Gaoli attended with Putin. The Russian president personally offered Zhang an unspecified stake in Rosneft’s Vankor oil field in eastern Siberia, whose output is expected to reach 500,000 barrels a day by the end of this decade. Previously, Russia had rebuffed China’s demands to invest in oil production in Russian territory.

Chinese officials are less exuberant about the prospects for investment outside of Russia’s oil and gas sector. At the Harbin expo Russia’s official media waxed optimistically about the prospects for commercial cooperation between the two countries, and the Kremlin nomenklatura turned out in force. “This event is the practical confirmation of our long-term cooperation in all areas,” proclaimed Deputy Prime Minister Rogozin, who headed the Russian delegation. The hosts’ assessment was more sober. “Factors inhibiting the development of investment cooperation include differences in law between China and Russia, and different conditions for investing,” said Wang Xiankui, governor of Heilongjiang province, where Harbin is located.

China can be expected to move cautiously toward any political support of Russia that riles the West. Beijing’s Foreign Ministry did speak out against the latest EU sanctions, in September, saying they “do not help to solve the underlying problems in Ukraine,” but it has also stressed its “friendly cooperation” with Ukraine and support for that country’s “sovereignty and territorial integrity.”

The political prize Moscow has pressed for most energetically is Chinese participation in building an ambitious new rail and road bridge to connect mainland Russia with Crimea, the Black Sea peninsula that Moscow seized from Ukraine and annexed in March. In late June, Russian Railways sources told local media they had signed a memorandum of understanding with state-owned China Communications Construction Co. to cooperate on a 17-kilometer (10.5-mile) span, at a cost of R283 billion. The Chinese side has yet to comment, however.

China has been the most conspicuous winner in the post-cold-war global order, expanding to become the world’s second-largest economy and increasing its influence. It’s hard to see why Beijing would join with Russia to upend the existing order unless it decided to adopt a much more aggressive stance in its regional disputes with Japan, Taiwan, the Philippines and Vietnam.

Notwithstanding Moscow’s warm rhetoric about closer ties, Russia retains reservations about embracing China, analysts say. The Kremlin does not want ties with Beijing to grow so close that they preclude large gas deals with China’s chief Asia-Pacific rival, Japan. “For Japan after Fukushima, gas is a matter of survival,” notes Vasily Kashin, an Asia scholar at the Moscow-based Center for Analysis of Strategies and Technologies, referring to the nuclear power plant disaster of 2011. “Russia will not turn its back on that enormous demand.”

More broadly, Russians are wary of swapping the Euro-centrism of their international relations today for overdependence on a China that may not preach to it morally but could have territorial designs on its far east, a vast territory populated by just 5 million Russians. “If the current economic trends continue, it is very likely that Russia east of the Urals and later the whole country will turn into an appendage of China,” Sergei Karaganov, dean of the international politics faculty at the National Research University’s Higher School of Economics in Moscow, wrote this summer in the journal Russia in Global Affairs. Fears of this sort could return to the fore if Russia’s Ukraine-related tensions with Europe ease relatively quickly.

The shift of Russia’s economic and political focus toward the east is an event of global significance. Russia may well be fading and complacent, fitting U.S. President Barack Obama’s description of a “regional power acting out of weakness, not strength,” but it remains too big to ignore. It boasts the world’s sixth-largest economy, with a gross domestic product of $2.6 trillion in purchasing-power-parity terms, according to the IMF. Its per capita GDP stands at $17,884, nearly twice China’s level. And it will be a leading exporter of oil and gas for the foreseeable future. ?The huge China contracts already agreed to by Gazprom and Rosneft may not be the last. Russia is pushing for joint development of a pipeline that would start in the Altai region, farther west than the Power of Siberia. That would give Gazprom the flexibility to send fuel from its western Siberian fields to either Asia or Europe; currently, it can deliver that gas only to Europe. “If this project takes off, it would mark the critical turning point where Russia’s strategy starts to emerge at the West’s expense,” wrote Erica Downs and Emily Stromquist, analysts for New York–based Eurasia Group, in a recent note to clients.

Western Europe remains vulnerable to potential Russian use of the gas weapon. This explains why the EU moved slowly to adopt sanctions on Moscow and why Putin is likely to get away with the annexation of Crimea — the first foreign invasion in Europe since World War II.

Russia vies with Norway as the top gas exporter to the EU, supplying about one quarter of the 28-nation bloc’s total supply. The pre-Ukraine outlook was for increasing Russian shipments: EU domestic production has fallen by a fifth since 1995 as North Sea fields have declined, and consumption has grown as gas has replaced more environmentally destructive coal. The new South Stream pipeline, which was due to connect Russia to southeastern Europe via the Black Sea, with a scheduled opening date of 2018, and the Nord Stream network, which reaches Germany across the Baltic, could carry double last year’s volumes. The EU has suspended construction of South Stream in response to Russia’s support for separatists in Ukraine, and officials have vowed to seek alternative sources of gas.

“We must avoid falling victim to political and commercial blackmail,” outgoing energy commissioner Günther Oettinger announced over the summer. “We need to accelerate the diversification of external energy suppliers.” But several meetings intended to formulate a new long-term EU energy strategy have come and gone without any results, and none of the non-Russian options looks especially attractive. After Russia and Norway, the biggest supplier is Algeria, which hardly looks like a more dependable partner than Moscow. Exploiting presumed shale gas reserves in Poland and the U.K. will raise environmental hackles, and liquefied natural gas will likely prove more costly than Gazprom. “Do we have alternatives to Russian energy sources? The consensus is, no, we really don’t,” says Thomas König, a scholar at the European Council on Foreign Relations in London.

In Russia, meanwhile, Gazprom and Transneft’s pending investments in pipelines and infrastructure are substantial enough to drive economic growth across the country’s neglected eastern regions. Putin exaggerated only slightly in May when he boasted at the St. Petersburg International Economic Forum that the two state-controlled energy giants would soon be overseeing “the world’s largest construction site,” stretching more than 3,000 kilometers, from Yakutia to the Pacific.

Russia’s bureaucracy is putting its best foot forward in a bid to maximize the multiplier effect on the wider economy. Yuri Trutnev, a former minister of Natural Resources and the Environment, will captain the effort as Putin’s presidential envoy for the far eastern district, a post he assumed in August 2013. (Trutnev shares his boss’s passion for martial arts, holding a prestigious fifth-dan black-belt ranking in Kyokushin karate.) Alexander Galushka, an ex-chairman of business lobby Delovaya Rossiya and a professor at the Higher School of Economics, came on a few weeks later as minister for far eastern development. The Duma plans to enact legislation this fall to create a dozen or so “territories of accelerated development” that would be showered with tax breaks and other incentives to lure investors to the new frontier. “Compared to previous decades, the Russian government is actively, aggressively trying to create improved conditions for foreign investors,” says Manabu Kato, who heads the Moscow office of the Japan Bank for International Cooperation, a public sector investment and export guarantee agency.

The Russian Direct Investment Fund, a $10 billion facility that the government created in 2011 to attract foreign investment, has also shifted its focus to the far east. During the Putin-Xi summit in May, the fund announced it would partner with China Investment Corp., Beijing’s big sovereign wealth fund, to invest $400 million in the construction of the first railway bridge across the Amur River, which separates China and Russia, cutting 700 kilometers off the existing freight rail line between the countries, says RDIF’s CEO, Kirill Dmitriev, who boasts a BA in economics from Stanford University and an MBA from Harvard Business School. Last year the two investment agencies spent $200 million for a 42 percent stake in Russian Forest Products Group, the largest wood-processing concern in Russia’s far east. They have committed a total of $4 billion to their joint Russia-China Investment Fund and are mulling investments in projects ranging from zinc mining to specialty glass manufacturing. “Many Chinese businesses do not make investment decisions until they see they are in line with state policy,” Dmitriev notes. “Putin’s trip to China and the gas deal gave them that reassurance.”

The development of Russia’s far east requires a strong hand by the state. Investors have to contend with the region’s forbidding landscape and climate: Daily high temperatures in the regional capital, Khabarovsk, average about –15 degrees Celsius (5 degrees Fahrenheit) in the winter, and the area’s road and rail network is antiquated. Transportation difficulties can add 40 percent to the cost of local goods, compared with European Russia.

How well positioned is Russia to finance the development of its vast eastern regions and withstand the de facto siege by Western banks and investors? The government has impressive resources at its disposal. The Bank of Russia holds $465 billion in currency reserves, up from $371 billion in January 2009. The Treasury, meanwhile, manages more than a third as much in two vehicles. The Russian National Wealth Fund is a sovereign wealth fund designed to ensure the long-term health of the country’s pension system. It contained $85.3 billion at the start of September. The Reserve Fund, with $91.7 billion, is a rainy-day fund created to help the budget ride out the ups and downs of oil prices, which generate the bulk of government revenues. It went from a peak of $142.6 billion in September 2009 to just $25.4 billion at the end of 2010 as the Treasury drained the fund to sustain public spending in the wake of the financial crisis.

The Russian economy has plenty of liabilities, however. The country’s banks and corporations, both state-owned and private, owe $646 billion to foreign creditors, and $235 billion of that comes due by September 2015, estimates Sergei Guriev, former rector of the New Economic School in Moscow, who now teaches at Sciences Po in Paris. Typically, companies would look to roll over much of that debt, but Western sanctions will make that difficult, if not impossible, putting pressure on the authorities to step in.

Gazprom’s response to its own credit squeeze is instructive. The company managed to place a €750 million ($962 million) Eurobond before tensions erupted over Ukraine, leaving it some $2 billion short of its external financing target for the year. Gazprom management decided simply to cut investment by that amount for 2014. That’s not a big hit to the company or the economy in the short term, considering that Gazprom has an annual capital expenditure budget of more than $40 billion, but a prolonged cutback in investment could take a toll.

If European markets stay closed next year, the gas giant will likely turn to Asia’s capital markets despite their lack of depth, and to its majority shareholder, the Russian state. Gazprom’s financiers say the company could issue R40 billion of infrastructure bonds, which the Kremlin would purchase using either the Wealth Fund or Vnesheconombank, the government’s official development bank. Assuming the company could raise an additional $1 billion on Asian markets, that would leave it nearly $1 billion short of its needs for the year.

Less fortunate Russian companies are reaching out to the same pools of capital — Asia and the government — to survive the current drought, but they are less certain of finding liquidity there. Although there has been much talk since February of Russian borrowers tapping the offshore renminbi market by issuing so-called dim sum bonds in Hong Kong, none has actually come to market, and yields have jumped on the few outstanding Russian issues.

Back in Moscow the government has signaled an increasing willingness to tap the Wealth Fund as a source of corporate financing, and state giants are jostling to the front of the line. No sooner had the Kremlin announced that it would funnel R239 billion from the Wealth Fund into VTB and Rosselkhozbank than Rosneft CEO Igor Sechin — who has been personally sanctioned by the EU and the U.S. as a member of Putin’s inner circle — suggested that the government extend R1.5 trillion to his company.

Russia has deep enough pockets to avoid a string of humiliating corporate defaults, Sberbank’s Tseplyaeva concludes, but the West’s credit squeeze will sap the country’s growth potential and could wreak havoc in particular cases. “The large state-owned companies are not threatened, but some more highly leveraged sectors of the economy, like nonferrous metallurgy, may be,” she says. Unlike energy and banking, Russia’s metals sector remains almost entirely in private hands.

Putin has been insistently clear that Russia’s actions in Ukraine have implications that extend beyond its neighbor. They constitute a sort of declaration of independence from an international order that Moscow sees as rigged by the U.S and contemptuous of its interests. Putin set the tone in a March speech to the Duma announcing the annexation of Crimea. “They are constantly trying to sweep us into a corner because we have an independent position,” the president declared. “But there is a limit to everything. If you push the spring too hard, it will recoil.”

Yet the fallout from Russia’s show of defiance underlines how integrated it has become in the global economic system, and how much it has benefited. Russia couldn’t have prospered during the 14 years of Putin’s reign without Western capital and technology. The opening to China makes sense for Russia, but it cannot replace the special relationship with Europe any time soon — all the more so as Russia’s internal investment environment continues to deteriorate. Late September saw the house arrest of Vladimir Yevtushenkov, the billionaire majority owner of Sistema, which controls Russia’s leading cellular provider, Mobile TeleSystems, and the dynamic oil company Bashneft. Yevtushenkov’s apparent crime was resisting pressure to sell Bashneft on the cheap, probably to Rosneft.

Western leaders have faced strong criticism for a perceived weak response to Russia’s aggression in Ukraine, but they have shown Putin that the world community does not offer an à la carte menu; Russia cannot feast on its bounty while scoffing at the ground rules. Even if Putin has learned that lesson — and it is far from clear that he has — Russia will feel the damage for years to come. • •

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