Most of the developed world reacted to Russian government’s military operations in Ukraine with a prompt economic counteroffensive.

Foreign producers who have heavily invested in Russia over the past two decades – betting on Russia’s political stability, size, and access to the post-Soviet market - now face a hard choice: how to do business without losing face. Many are considering to go-in-between jurisdictions (Armenia, Kazakhstan, Serbia, etc.) to continue trading with Russia to circumvent sanctions.

In 2020, the value of total FDI inward stock in the Russian Federation amounted to 31% of the overall national GDP. Most of this investment came from high value-added industries (from oil&gas extraction, machinery production, food processing and paper production), important for technologically lagging behind Russian economy. This explains high effectiveness of technological sanctions.

Sanctions, capital flights, partial exclusion from the SWIFT system, and subsequent Russian countermeasures are already hitting global supplies and raising inflation as well as shortages, which will all cause major redistributive effects globally. In the current economic war, the potential winners may win without a fight as the Sun Tzu’s “Art of War” book teaches us. In this scenario, the main winner is expected to be China.

The Oil&Gas Crisis

Russia is the world's top exporter of natural gas (238.1 bcm in 2020) and the second largest crude oil exporter behind Saudi Arabia ($US 72.6 billion). Russia’s GDP is 15-20% dependent on Russian oil&gas according to the evaluation given by the Russian statistical agency. Nevertheless,

Russia’s reliance on the EU for oil&gas exports may be higher than the EU’s own dependence on Russia (though specific countries face more risks).

Russian President Vladimir Putin’s attempt to introduce payments for gas export in rubles from so-called “unfriendly countries” from April 1st, the EU’s subsequent refusal to pay in rubles, and continuing supplies are a good demonstration that the Russian government may not afford to weaponise its oil&gas in the coming future.

The current exclusion of several Russian banks from the SWIFT system did not include Gazprombank — a key bank for oil&gas trade transfers with Russia — and Sberbank, Russia’s biggest bank. This further allows oil&gas trade to occur. Higher prices combined with continued imports of Russian energy is a valuable source to finance of Putin’s decisions in the face of new sanctions. Nevertheless, the direct effects of many European countries’ self-imposed embargo on Russian oil, combined with the indirect effects of major logistics companies refraining from cooperation with Russia, sanctions on shipment, and some insurance companies following suit collectively result in significant pressure on Russia’s ability to hold its previous supply levels.

In the first semester of 2021, the Russian Federation was the EU’s main importer of natural gas (46.8% of trade in value) and petroleum oil (24.7%). It is more likely that these countries will try to find other key partners rather than resort to costly green sources to satisfy their energy demand and re-establish oil prices, though alternative energy has become relatively cheaper due to gas and oil price hikes. In its analysis on Strategic dependencies and capacities, the EU had already noted the need to be less dependent on imports for raw materials and "develop strategic international partnerships to secure a diversified and sustainable supply". At present, some EU members are looking at OPEC countries such as Saudi Arabia and Qatar. The EU energy consumption’s gradual shift towards Saudi Arabia and OPEC countries may happen as naturally as it did from Saudi Arabia towards the USSR in the aftermath of the 1973 crisis.

In the meantime, Saudi Aramco has recently announced it will consider accepting renminbi-denominated payments for oil exports to China, which acquires around 25% of its exports – an unprecedented action that may strengthen the yuan’s global position —an ultimately psychological decision that may start the de-dollarisation of oil exports. This trend may be amplified by the USD’s changing image from a reliable reserve of value, as sanctions have showed that reserves can be frozen and payments blocked based on unexpected political decisions. This adds momentum to China’s growing global influence: it is one of Russia’s neighbours but with a population and GDP that are 10 times bigger, and which refrained from visibly active participation in the ongoing war, opting for its traditional strategy of waiting things out.

As regards natural gas, thesituation is slightly different. In 2020, Russia was the world’s second top producer of natural gas (693,4 bcm) and the world’s 1st exporter (197,7 bcm pipeline; and only 40,4 bcm LNG). A re-orientation of the EU’s national gas policies to different countries is more difficult, especially of that coming through tubes, which is a fixed physical infrastructure. Potential new partners such as Qatar, Norway, or Algeria cannot unilaterally replace the EU’s energy needs without affecting supplies to other regions (with Norway already operating at maximum capacity). Moreover, the recently approved additional exports of liquefied natural gas from the US may not be a sustainable alternative to Russian gas due to insufficient volumes, higher costs, and the uneven distribution of gas storage across Europe. However, given Russia’s minor role in LNG exports, if the US decides to fully utilize its reserves it would be an efficient, short-term strategy to improve the cumulative effects of sanctions, though it would be putting at risk US energy supplies and the government’s control over domestic inflation. At the same time, growing LNG imports from Australia may strengthen the Suez Canal, boosting the geo-strategic and economic security role played by Egypt, which operates the Canal and has refused to introduce sanctions against Russia.

On the other hand, Russia cannot completely replace EU imports by turning to other countries (e.g. China), at least in the short term, considering the present distribution and flow capacity of gas pipelines. Power of Siberia, the only pipeline through which Russia can export gas to China, exported 16.5 bcm of gas in 2021 and is expected to reach 38 billion cubic meters of natural gas per year by 2025. The pipeline works at less than a half of its capacity, meaning that the Chinese demand for Russian gas was not high enough even before sanctions. New lockdowns in China further decrease Chinese demand on Russian energy.

The planned Power of Siberia 2 pipeline may add additional 10 billion cubic meters to Russia’s annual natural gas exports to China by mid-decade, if the demand is there. More importantly, the new pipeline may enable Russia to divert production from gas fields on the Yamal peninsula (supplying gas to the EU) to the Chinese market, thus reducing dependence on EU customers. On March 8, the EU proposed the REPowerEU, a plan to make Europe independent from Russian fossil fuels by gradually removing at least 155 bcm of fossil gas use by 2027.

Any potential re-orientation of Russian oil exports towards different countries is a hard process that implies the disruption of contracts and sanctions as well as technological complications. 70% of Russian oil is exported, and the technological process does not allow for the overnight re-orientation of oil exports or the halt of oil extraction for some time without any prejudice to resume the process later on. Negative oil prices in 2020 were a good illustration of that phenomenon, when Russia was looking for ways to discharge its oil amidst low demand during the pandemic. As such, if Europe were to cut its consumption levels of Russian oil in 2022, it would amplify the results of sanctions and hit the Russian economy more than its own. 1/3 of the Russian federal budget is oil and gas based.

China is unlikely to make quick moves towards Russia in 2022 because of solid economic reasons. A newly discovered form of Covid-19 and the Saudis’ potential use of the yuan for oil exports already benefit China’s role on the world stage in the mid-term and make Beijing Russia’s most desirable economic partner.

A scenario whereby China may decide to circumvent other sanctions — either directly or through third states — to honour its ‘no limits’ cooperation with Russia does not seem likely as Russia only represents a small fraction of Chinese foreign trade. Chinese exports to the US and EU are nearly 9 and 8 times bigger in value than its exports to Russia, respectively. Furthermore, China is preparing for the 20^th Party Congress this upcoming autumn, where Xi is supposed to be re-elected as President, as such, China will be trying to demonstrate good economic results. Because the country has been experiencing an economic deceleration since 2020, it is unlikely it will risk sanctions from the EU and the US — its main trading partners — to support a far less important economic partner such as Russia.

Thus, the Russian economy is set to degrade in a fast pace in 2022, yet absence of energy sanctions helps to stay afloat and to continue filling the federal budget. If the EU manages to quickly reach agreement to strengthen its energy sanctions benefiting from unprecedented public support and disapproval of Putin’s decisions, the degradation may be accelerated in a more productive manner, despite higher inflation in Europe. If the EU loses momentum to introduce energy sanctions, the socio-economic results of the biggest since the WWII refugee crisis in Europe (over 5 mln refugees according to the UN) would become more apparent, and Europe will risk populism and nationalism appealing to the purchasing power of the Europeans, but also a diminished compared to now tolerance to inflation and diminished readiness to cut Russian energy and to become greener.

Raw Materials and Global Supply Chains

In 2020, Russia was the major exporter of palladium ($US6.4 b) and the 2nd major producer in 2021. Among world’s major palladium importers in 2020, there were the EU (40% of palladium imports from Russia) and Japan (43% of palladium imports from Russia). Both have introduced sanctions. This suggests that a potential total disruption of supply and difficulties in processing international payments with Russia will hugely increase prices. Palladium is essential to produce vital goods such as catalytic converters, medical supplies, electrical components – whose demand is going to increase. In the short-term Russia has no equivalent in terms of production and export capacity, meaning that there will still be many countries willing to buy Russian palladium.

However, China may win in this unseen game as well. Palladium is used to produce chips, whereas China accounts for 60% of world semi-conductor demand and it also plans to expand its emerging technologies sectors by 2025 in compliance with its “Made in China 2025” strategy launched in 2015.

Palladium is an illustration of how vital materials found in Russia— that the world depends upon — may further affect the re-distribution of wealth; potentially benefitting China in this case. Another example of such resources includes titanium and neon gas, among others, where Russia plays a key role, sometimes alongside Ukraine (such as in the case of neon gas).

The Withdrawal of Foreign Companies from Russia: What's Next?

Amid sanctions, a great number of foreign multinationals started withdrawing their capitals from Russia, leaving behind unsold resources behind.

That has been the case with major Japanese automakers, including Toyota, which have indefinitely halted their production and sales in Russia due to Western sanctions. In 2020, cars and vehicle parts were the most commonly imported goods in Russia— $7.75B and $7.28B, respectively — while car exports accounted for 30.4% of total Japanese exports to Russia in 2020. Russia also represents a strategic market for the supply of steel bars, pig-iron, and raw aluminum used for car production. This strong interdependence in the supply chain may push some companies to consider countries such as Kazakhstan as a viable option to relocate their production facilities and/or export their products to Russia.

It is worth noting that the withdrawal of capital by big foreign companies does not necessarily mean their place will be taken by the Chinese. China may indeed be more proactive in the oil&gas sector, as Shell and Exxon exited their Russian energy projects. The role of Shell, Exxon, and BP in Russia was to share their technologies as Russians do not produce modern, high-tech equipment for their oil&gas industry. Thus, China could see this as an opportunity to fill the gap and gain more control over strategic resources, which is consistent with its current political and economic strategy. This could be done by offering Russia credits to buy Chinese technologies, creating a double dependence on Beijing in the future.

China may also take advantage of the current situation to accelerate the process of a cautious internationalization of the RMB, which is part of Xi Jinping’s broader ideology for a “New Era of Socialism with Chinese Characteristics”. The 2021 RMB Internationalization Report of The People’s Bank of China expresses China's will to advance the RMB’s international use by expanding cross-border use of the RMB, improving international infrastructure, and facilitating channels for RMB cross-border investment and financing.

Additionally, the current sanctions lay the groundwork for the RMB’s strengthened trade role globally as Russia would need secured systems for payments in non-energy sectors. Moreover, the strengthening of the yuan and of China’s role will happen naturally as people will opt for the Chinese Union Pay system, accepted in over 180 countries, unlike the Russian MIR system, which is accepted in less than 20, mainly post-Soviet states and Turkey.

Conclusion

The “economic war” between the West and Russia will lead to changes in the geography of global supply chains and cross-border payments: as new actors are bound to emerge, Beijing is likely to benefit the most from this new economic order. Swift cuts in demands for Russian oil&gas would reap the most productive results now, given future potential socio-economic risks related to the refugee crisis and lockdowns in China. Beijing is willing to take advantage of these new, favourable conditions, though this does not mean its actions must be interpreted as an attempt to help its neighbour. While Russia appears to be on free fall, China may take considerable advantage in following Sun Tzu’s wisdom of winning without directly engaging. On the contrary, Moscow’s dependence on Beijing is likely to increase, leaving no hope for an equal partnership. Will the ‘West’ have appropriate economic tools to strike a balanced relationship with its stronger economic opponent in the future?