China-Russia Friendship: How “Eternal” Is It?

15 March 2022

Recent history is full of seminal events. The two World Wars and America’s emergence as a global power, the Russian Revolution, the OPEC oil embargos, Mikhail Gorbachev’s reforms (perestroika, glasnot, and detente), the collapse of the Soviet Union (and the end of the Cold War), and Deng Xiaoping’s “Opening Up” modernisation all shaped global geo-politics and economic relationships for decades to come.

Russia’s invasion of Ukraine feels like one of these moments. President Putin’s agression violates the postwar international values of national sovereignty and territorial integrity, which have contributed greatly to peace, security, and prosperity (despite numerous hiccups). Nevertheless, following the imposition of sanctions after the annexation of Crimea in 2014, the bond between Russia and China has developed. Most recently, Presidents Xi Jinping and Vladimir Putin met during the Beijing Olympics proclaiming their “eternal friendship has no limits”, and highlighted by the signing of an enormous natural gas deal. Moreover, despite President Xi’s oft-stated commitment to the non-interference in domestic affairs of other countries and other global norms (in part to deflect criticism of China’s human rights record and ambitions in Taiwan), China has failed to condemn Russia’s invasion of Ukraine.

The longer Russia’s invasion of Ukraine continues, China is likely to find the contradiction between its burgeoning friendship with Russia and its support of these valued international norms increasingly untenable. Not to put too fine a point on it, but how China balances these interests could define the nation’s role in world for years to come. On the one hand, if President Xi intervenes to convince Russia to change course, China’s international stature would be enhanced greatly. Alternatively, continued support of President Putin runs the risks of ushering in an extended period of confrontation between western, liberal democracies and nations adhering to autocratic political values (where India sits will be a topic for future consideration).

At this moment, it’s hard to anticipate how China will respond. However, China has benefited immensely from its participation in the existing international order in recent decades. Likewise, in contrast to the chaos President Putin is creating, China prioritises political stability, an especially important consideration prior to this October’s National Party Congress (where Xi seeks a rubber-stamped third term). No doubt, President Xi will be impressed by NATO’s unified, strong reaction to Russian aggression. And, western leaders will continue to communicate to President Xi that there will be heavy costs involved with providing support to Russia.

On balance, however, my investigation of the prevailing bilateral Sino-Russsia relationship leaves me guardedly hopeful China may attempt to pursuade Putin to change course — without undermining China’s desired access to much-needed Russian natural resources. In either case, I fear globalisation will be amongst the casualties of the Ukraine war. Given the effectiveness of NATO sanctions, I anticipate China may adopt a more inward-looking economic model in the future in an effort to “sanction-proof” its economy, especially if President Xi aspires to reclaim Taiwan during his tenure. Western economies may need to reconsider their supply chains. Over the medium term, a retreat from globalisation would lead to slower growth and higher inflation than the global economy has enjoyed in recent decades.

The Xi-Putin Bromance: What Price Will China Pay?

Geo-political considerations are the cornerstone of the renewed Sino-Russia link. Both view the existing US-dominated (their words) international order works against their interests. President Putin believes the US-led NATO expansion aims to threaten and humiliate Russia. President Xi believes America aims to block China’s aspirations to become the top Asian power, and its pursuit of territorial claims in the South China Sea and Taiwan. In addition, there’s a strong personal link between the two leaders, who have met on dozens of occasions. Both are roughly the same age, and each was deeply impacted by roughly simultaneous events: the collapse of the Soviet Union and the Tiananmen Square Massacre. Both appear to have concluded that dissent is dangerous, and must not be tolerated.

In addition, the Chart above illustrates bilateral trade has more than doubled since Russia’s annexation of Crimea. From Russia’s perspective, the value of deepening economic ties is obvious. China is now Russia’s top trading partner by a wide margin (Chart below). Likewise, as the European Union now plans to eliminate its reliance on Russian oil and gas by 2027, China’s enormous energy needs will cushion the blow. Already, China is the largest importer of Russian oil (31% of Russia’s oil exports), but collectively Europe still accounts for 48%. Natural gas exports are a huge, relatively untapped opportunity, as China only represents 5% of Russia’s NG sales abroad (compared to 72% destined to Europe).

From China’s standpoint, however, the relationship is quite different. To be sure, imports of Russian oil and gas are key ingredients in China’s energy security. Indeed, Russia has overtaken Saudia Arabia as China’s top petroleum supplier. Nevertheless, as Russia’s market share is only 16%, China has numerous importing options. Meanwhile, Russia is only the fourth largest supplier of natural gas (8%), while Australia accounts for 30% of China’s imports (Turkmenistan and Qatar collectively represent 27%). Of course, Russia aims for a larger NG market share, and is expanding its pipeline infrastructure accordingly. Australia and Indonesia account for nearly 70% of China’s coal imports (Russia 15%). Overall, despite the recent growth, Russia accounts for a mere 2% of China’s total imports compared to nearly 30% collectively for the USA (top single partner) and the European Union (next Chart).

Therefore, despite the advantages of the strengthening bilateral economic/political ties, there may be limits to the cost President Xi is willing to pay for his bromance. Inevitably, eventually China will encounter reprisals from its key western trading partners for its support of Russia. And, despite China’s understandable concern about its energy security, Xi does have a wide range of other import possibilities. In addition, China puts a premium on political stability, and will not welcome the chaos President Putin is creating. Further, to be sure, China views its transition from coal to natural gas as part of its climate strategy. However, most countries view natural gas as a “bridge” on the road to renewable energy sources. China may discover it needs to accelerate its transition away from all fossil fuels in order to cap C02 emissions by 2030, and to achieve carbon neutrality by 2060, as pledged.

Historically, on the other hand, Russia and China have often sought to improve bilateral relations, but with mixed success. In past episodes, however, Russia has always been the senior partner. President Putin may not relish Russia’s diminished stature in the current arrangement. To be sure, China will vigorously pursue its interests. In negotiating the recent natural gas deal, for example, Xi took advantage of Russia’s weakness to extract an attract price discount.

Economic Sanction-Proofing: A Risk to Globalisation?

In addition to expanding bilateral trade links with China, Russia has attempted to limit its vulnerability to sanctions following Crimea’s annexation in other ways. The Chart above, for example, illustrates the Russian central bank (CBR) has reduced dramatically the US dollar’s share of its vast FX reserves. Meanwhile, holdings of gold have risen. And, reflecting the decision to conduct trade with China in yuan, the RMB’s share of CBR reserves has increased sharply. The shift away from US dollars has been reflected in the virtual elimination of the CBR’s holdings of US Treasury securities (next Chart).

To be sure, China will have observed the impact of the current NATO sanctions on Russia. Further, President Xi does not hide his view that the United States is more of a foe or rival than a simple competitor. He believes America aims to block China’s ambitions to become Asia’s top geo-political power and its intention to resolve territorial issues in the South China Sea, Taiwan, and Hong Kong. Indeed, he has already begun these efforts: when was the last time anyone has heard about “One country, Two systems” in Hong Kong? And, Hong Kong was supposed to provide a model of a smooth, peaceful territorial reclamation to be replicated in Taiwan!

What would be the consequences if China “sanction-proofed” it’s economy in anticipation of a conflict with the USA, especially as America is building a coalition with Japan, Korea, and Australia regarding Taiwan? First of all, while the composition of China’s FX reserves is a well-guarded state secret, the Chart above illustrates China’s central bank (RBOC) holds over $1 trillion of US Treasury securities (the second largest foreign investor), seven times Russia’s peak amount. Therefore, while financial markets barely took note of Russia’s liquidation, large-scale diversification by China would be a different matter.

Russia’s vulnerability to its recent exclusion from the SWIFT messaging system has created speculation that China’s development of its alternative payment system may undermine the US dollar’s supremacy. I am not convinced. Over the years, I have heard that SDRs, ECUs, yen, and Euros would all supplant the US dollar. However, the greenback’s share in central banks’ reserves has not declined much in recent decades (Chart above). To be sure, the RMB may gain market share, as trade with Russia and some Asian countries may become increasingly denominated in yuan. But, the RMB’s role will remain limited (now 2% of global reserves) until China’s financial markets are deepened and capital controls are eliminated.

However, more concerning would be if China sought to reduce its external vulnerability by adopting a more inward-looking economic model. China’s bilateral trade imbalances highlight its previously successful economic strategy (Chart above). On the one hand, China runs large trade deficits with OPEC, Brazil, Australia, South Africa, etc. in order to meet its food, natural resource, and energy requirements. Likewise, large-scale imports of capital equipment from Germany, Switzerland, Japan, and Sweden also produce negative bilateral imbalances. Meanwhile, Taiwan and Korea provide vast amounts of electronic components to China’s manufacturing sector. Chinese factories use these imputs to satisfy the seemingly insatiable demand for consumer goods in the USA and Europe (where China enjoys large surpluses).

To be sure, as part of its ongoing economic rebalancing strategy, China is already trying to expand its domestic consumer/service sectors, and to reduce the nation’s reliance on exports, investment, and manufacturing. But, the adoption of an autarkic growth model in anticipation of future sanctions would greatly disrupt global supply chains (already upset by the Covid pandemic) to the detriment of Taiwan/Korean manufacturers, Australian miners, Brazilian farmers, American soy bean farmers and aerospace manufacturers, as well as capex producers in Europe and Japan. ASEAN trade may expand, as China exploits the region’s low wages, and seeks to broaden its regional influence. Greater economic uncertainty and the prospect of heightened protectionism could encourage US manufacturers in China to return home, and Americans and Europeans would pay higher prices for their consumer goods. Overall, global growth would be slower and inflation higher than experienced in recent decades.

Strategic Considerations:

  • China’s continued support of Russia risks contributing to a chasm between the world’s liberal democracies and those adhering to autocratic values, which could define global geo-politics for many years.
  • If the war in Ukraine becomes protracted, China’s friendship with Russia will become increasingly costly. China’s strong economic ties with NATO countries suggest it would be in its interest to pursuade President Putin to change course, which would enhance greatly China’s international prestige. Alternatively, supporting Russia risks alienating its key western trading partners, who will continue to communicate the consequences of this decision. For example, the implementation of the EU-China Comprehensive Agreement on Investment, already delayed by China’s treatment of its Uyghur minority, may be shelved. Likewise, the USA may expand its China sanctions, especially as China has failed to meet its US import commitments in Phase 1 of the recent trade deal.
  • In any case, China may to pursue a more inward-looking economic strategy in an attempt to reduce its vulnerability to Western sanctions if future conflicts emerge over Taiwan and other territorial disputes in the South China Sea. Both global growth and inflation would suffer over the medium term.
  • In the near term, China will implement additional monetary and fiscal stimulus in response to slowing domestic and global growth in coming months. This may lead to a modest depreciation of the RMB in the period ahead.