Snafus mar Russia and China's marriage of convenience

China’s burgeoning investment in Russia’s infrastructure is bolstering cross-border trade, but such state-led largesse comes with strings attached and China has the upper hand in talks

When a $27 billion liquefied natural gas plant in the Russian Arctic came online in December, the first symbolic shipment from the Yamal peninsula was supposed to sail to China, instead it went to the UK.

The public relations snafu is one of the more high-profile illustrations of how growing trade between Russia and China has been hindered by blunders and misunderstandings.

Russia can’t afford to nettle China. Moscow needs to find ways to continue to attract Chinese investment in order to avoid projects floundering and the economy growing as Western sanctions bite harder. Much is at stake as Chinese investment in Russia has been rising fast, diverting resources, trade and infrastructure across Russia towards China.

The value of major projects underway in Russia with Chinese involvement has jumped to $73.1 billion as of September, up from $10.1 billion in September 2015, according to BMI Research, a risk analysis unit of Fitch Group for investors. These projects represent 42% of the total infrastructure project pipeline in Russia, up from 10% just two years ago.

“Chinese capital is coming, it is already increasing substantially,” Alexey Tyupanov, chief executive of EXIAR, a Russian agency for export credit and investment insurance, told FinanceAsia.

Top-down political pressure has so far been powering the spending by Chinese state-run institutions in Russia. Chinese President Xi Jinping’s signature policy, the Belt and Road Initiative, aims to spread Chinese influence along ancient trade routes, including across Russia to Europe.

Chinese banks in particular have been savagely undercutting other lenders on pricing, to the point where the Russian and Chinese banks now dominate debt finance for projects across the country.

“They are trying to interfere in the existing relationships by introducing very aggressive pricing, with half price of the contract and zero interest rates for example,” said Anna Ponomareva, head of export finance at Russia’s second-largest lender by assets, VTB Bank.

“I don’t think anyone will be able to compete on financial terms with the Chinese, but from the point of view of certain areas of knowledge of certain experience [we can],” said Alessandro Decio, CEO of Italian ECA Servizi Assicurativi del Commercio Estero (SACE), speaking to FinanceAsia on the sidelines of a conference in Moscow.

For Russia, this flood of investment is expedient. The US slapped sanctions on Russia in 2014 following Moscow's annexation of Crimea from Ukraine. US President Donald Trump approved fresh sanctions on Russia in August for its interference in the 2016 US elections.

Longer-term a stronger relationship with China could lessen Russia’s reliance on western markets and bolster the commodities-dependent economy against the threat of a glut of North American shale gas.

The volume of Sino-Russian trade from January to September hit $61.6 billion, up 22% from a year earlier, according to the Kremlin. Russian President Vladimir Putin said in November he is confident that trade in 2017 would reach $66 billion. He noted in September that over the previous two years, investment from China into the Russian Far Eastern Federal District alone amounted to more than $3 billion.

Partly as a result of this largessse from China, Russia is fighting its way out of recession – just in time for elections in March.

While Chinese investment in Russia seems mutually beneficial, the relationship is not entirely smooth. Geopolitical tensions combined with cultural differences have been the cause of tension between the two neighbours.

The negotiating power in trade deals is heavily weighted towards the Chinese. China has been Russia’s biggest trading partner for years, while Russia languishes in 15th place, based on Chinese trading relationships by export sales in 2016.

As a result, Chinese state-run investors may be able to negotiate favourable terms for Chinese sub-contractors for the projects or divert exports to China, for example.

In Gazprom’s gas pipeline to China, dubbed “Power of Siberia”, its Chinese partner is China National Petroleum Corporation. The Russian energy giant awarded CNPC’s pipe-building unit, China Petroleum Pipeline, a contract to construct part of the pipeline in 2016.

If contracts are not entirely awarded on economic grounds this could impact the profitability of projects. So other parties looking to invest in these infrastructure projects will need to carefully study project finance contracts before committing capital, to see what clauses and concessions have been made that prioritise Chinese policy above more financially beneficial options.

Another potential pitfall is the lack of experience and contacts Chinese companies have in Russia.

One prominent private Chinese investor told FinanceAsia he was wary of picking up so-called bargains in Russia’s beaten-up economy given the currency volatility and widespread corruption. Russia is ranked 131 out of 176 countries in Transparency International’s 2016 corruption index, tied with Iran.

The key sector to watch as this relationship develops will be the energy, given Russia’s global importance as a commodities supplier and China's position as the world’s largest importer of a wide array of commodities.

Already the field of players in Russia is morphing.

US sanctions restrict access for a list of Russian energy companies to US capital markets and make tapping European markets difficult. The White House also banned exports to Russia of high-tech oil exploration and production equipment.

Both American and European companies have been pulling out of Russian deals in the wake of these US moves.

ExxonMobil suspended drilling by its joint venture with state-controlled oil major Rosneft in the Arctic and Black Sea, while Royal Dutch Shell and Gazprom Neft have put plans to develop an offshore shale project on ice.

To be sure, Russian gas exports to Europe and Turkey quietly climbed 8.1% year-on-year in 2017 to a record high of 193.9 billion cubic metres despite Western sanctions, according to Alexi Miller, head of Gazprom.

However that looks likely to change. The US has also voiced objections to projects such as Nord Stream 2, the gas pipeline between Russia and the European Union via the Baltic Sea.

In sharp contrast to the West, China’s Xi has been notably warmer towards his Russian counterpart.

“President Putin and I are united in the fact that at present the Chinese-Russian relations are experiencing the best period in their history,” Xi said in July during a trip to Moscow. Xi has visited Moscow more than any other capital since becoming China’s leader.

On January 1, 2018, the Second Russia-China Crude Pipeline invested and constructed by CNPC officially became operational.

The interplay of all these heavyweight national interests played out dramatically in the case of the Yamal LNG project, the first Russian LNG project commissioned for eight years.

In July 2014 the US Office of Foreign Asset Control included Timchenko, co-owner of Russia’s fastest-growing natural gas producer Novatek, on its Sectoral Sanctions List, which prohibits US companies and banks from providing new finance of longer than 90 days to the company.

Novatek still needed funding for its mega LNG project on the northeast corner of the Yamal Peninsula, in northwest Siberia. It went cap in hand to China, which stepped up with equity investment, private equity, and loans.

China is the world's second-biggest importer of LNG after Japan, and growing fast as the country switches from coal to gas usage. China imported 384,000 tons of natural gas from Russia from January to November, a year-on-year growth of 49.6%, according to Chinese custom statistics.

The shareholders in the $27 billion Yamal LNG project are Novatek with 50.1%, French oil major Total owns a 20% stake, state-run China National Petroleum Corporation (CNPC) with 20%, and finally the China state-run Silk Road Fund with 9.9%.

The biggest lenders to the project to the tune of $12 billion are two Chinese policy banks, China Development Bank (CDB) and the Export and Import Bank of China (CEXIM).

Despite sanctions, Europeans did find ways to participate in Yamal LNG with export credit agencies (ECAs), which provide state support for exporters, taking the lead.

“Of course there are some private credit insurers in the market as well, but for those mega projects with long tenor repayment periods and very high volumes, there is actually no alternative than to have state support for such schemes,” Edna Schöne, head of Germany’s Euler Hermes, one of the ECAs that provided insurance coverage for lenders in Yamal LNG, told the audience at a Russian investment conference in Moscow.

Germany is Russia’s largest LNG customer.

But when the project is fully operational, Novatek expects the plant’s annual capacity will reach 16.5 million tons, of which one third will be transported to China.

Chinese sub-contractors are working on Gazprom's Power of Siberia pipeline

Ultimately, China’s ambitious Belt and Road plans stretch much further than Russia; the routes go south through Central Asia and across Western Europe to the UK, as well as across the sea to Africa. French President Emmanuel Macron urged Europe to take part in China's Belt and Road plan as he began a state visit on Monday.

China is already streamlining overland trade links with Central and Eastern Europe by helping governments to implement critical infrastructure projects as they grapple with fiscal weakness.

All the while it is establishing a European bridgehead in pursuit of more lucrative contract opportunities in Western Europe for its domestic infrastructure companies. China announced a series of investments and cooperation deals with Hungary at a trade forum held in the capital city Budapest in late November.

For Russia, that could appear threatening geopolitically and damaging commercially. “They are trying to win the European contracts where Russian companies were always contracted,” VTB Bank’s Ponomareva said.

China’s investment is not boundless. Gazprom’s plan for an LNG plant in Vladivostok to sell to Asian markets was put on ice in 2015 and has recently been revived on a much smaller scale.

China is already mulling over several natural gas projects, including a fourth pipeline from Central Asia. CNPC, CDB and Novatek have an understanding for investment in the Arctic LNG 2 project in northwestern Siberia while Gazprom is lining up Chinese money for its Power of Siberia 2 project. Further afield Sinopec, Bank of China and the Chinese Investment Corp have inked agreement on an Alaska LNG project.

Such a large supply of potential projects in 2018 means Russia needs to up its game as China holds the upper hand in talks.

¬ Haymarket Media Limited. All rights reserved.