EY in partnership with Russia-China Investment Fund China and Russia in 2017: an intricate path of growth April 2017
China and Russia in 2017: an intricate path of growth China and Russia in 2017: growth at all levels 2016 marked the 15 th anniversary of the Treaty on Good-Neighborliness, Friendship and Cooperation between China and Russia. It also meant that 20 years had passed since the establishment of strategic cooperation and partnership relations between the two states 1. During 2016, President Putin and President Xi met four times 2 to discuss the development of China-Russia cooperation. Further, in the course of 2015 and 2016 3, a range of politicians announced that Russian-Chinese ties had reached a new historical peak, providing a springboard for further development in 2017. 1 Signed in July 16, 2001. Original text (in Russian) http://www.mid.ru/ru/maps/cn/-/asset_publisher/whkwb5dvbqka/content/id/576870 2 June 25, 2016, from the press-release on a meeting in Beijing between President Xi and President Putin: http://www.kremlin.ru/events/president/news/52273 3 http://tass.com/russia/817796
2012 2013 2014 2015 04 /2017 Russian trade turnover 2016 Export from Russia Import to Russia China World Trade turnover with China as % of total Russian trade turnover Source: Federal Customs Service of Russia 10.5% 10.5% 11.3% 12.1% 14.1% 2012 2013 2014 2015 2016
China and Russia in 2017: an intricate path of growth 2012 2013 2014 2015 2016 Export to China as % of total Russian export 6.8% 6.8% 7.5% 8.3% 9.8% Import from China as % of total Russian import 16.6% 16.6% 17.8% 19.1% 20.9% China Russia trade flow YOY growth Export growth in January 2017 YOY 39.3% 34% 29.5% January 2016 January 2017 China Russia
04 /2017 Apart from the surging cooperation in sectors such as e-commerce, mining, agriculture, entertainment and construction (see Moscow metro stations and aboveground infrastructure development), the two countries continued to strengthen their ties through increasing trade flows. The scale of cooperation grew in strategic sectors such as oil and gas, where China both owns shares in strategic projects (Yamal SPG) and directly buys oil and gas from Russia (i.e. In January [2016], China imported nearly 60% of all [ESPO brand crude oil] leaving Kozmino while teapot refiners in the north of the country have recently begun importing crude via train from Russia 4,5 ). Considerable projects are also being carried out in infrastructure (i.e. the high-speed rail connecting Moscow and Beijing), defense, aviation, and even nuclear energy (floating nuclear power plants), generally a highly secretive sector for each country. In January 2017, Russia became the biggest crude oil exporter to China, exceeding Saudi Arabia. According to Chinese customs data, fuel supplies from Russia rose by a quarter last year compared with 2015, up to 1.05m barrel per day. Early statistics from 2017 identify even greater progress in partnership between the two states: in January 2017 alone, trade flows between China and Russia increased by 34% YoY. Interestingly, China-Russia exports increased by 29.5% YoY, up to USD 3.41B in January 2017, while Russia-China exports increased by 39.3%, up to USD 3.14B in the same period. This shows that not only the volumes, but also the structure and format of economic cooperation are evolving, in line with the political courses of both countries. China intends to take further steps to diversify its export-oriented economy (in March 2017: The official non-manufacturing Purchasing Managers Index (PMI) stood at 55.1. Throughout 2016 the services sector accounted for over half of China s economy 6 ), reducing the share of exports. At the same time, Russia is taking further steps in its turn to the East state policy, aiming to expand cooperation with the Asian region, and with China in particular. However, despite noticeable country-level progress that each of the two states has made in respect of economic cooperation with each other, business-level challenges still remain considerable for both stateowned and private enterprises. 4 https://sputniknews.com/politics/ 201603041035761674-russia-china-relations/ 5 As per the statement of the IEA in its Oil Market Report for March 2016: https://sputniknews.com/business/201603111036148349-chinagermany-russian-oil/ 6 http://www.reuters.com/article/ china-economy-pmi-servicesofficial-idusennh3s0sm 03
China and Russia in 2017: an intricate path of growth EY Survey of perspectives from China According to the EY survey Perspectives from China: how concerns about the Russian market influence Chinese investment strategies (hereinafter the Survey ), the Russian market remains highly attractive for 28% and attractive for 45% among 142 surveyed investors. Notably, this parameter is even higher (48%) with resident investors those Chinese enterprises who have already established a presence in Russia and possess practical experience on the local market. Also, according to the Survey, the key challenge is entering the market without prior knowledge and an in-depth understanding of how it works 66% of residents confirmed that their knowledge of Russian legislation is below average. SWOT analysis for Chinese business in Russia Strengths Size of domestic market Abundance of natural resources Weaknesses Insufficient knowledge of Russian legislation Lack of awareness of competitors Access to technology 04 Infrastructure
04 /2017 Russian market attractiveness for Chinese entrepreneurs that do business in Russia 48% highly attractive 44% attractive 8% not attractive Within the course of 2015 and 2016, the Survey was presented at events hosted by a number of local, regional and national level Chinese authorities, including the Regional Tax Authority of the Heilongjiang province, the Regional and Local Tax Authority of the Xinjiang province, as well as an investment summit held by the Hunan Ministry of Finance. The Survey was also presented to over 40 Chinese businesses with projects in Russia. It served as the basis for a communication on proper structuring of investment strategy and market entry strategy. Opportunities High return of investments Human capital Threats Regulatory and tax environment Macroeconomic turbulence Geopolitical tensions
China and Russia in 2017: an intricate path of growth Key trends with Chinese investors in Russia, by sector Concerns that Chinese investors have in respect of their Russian projects often differ from sector to sector. Energy It is getting increasingly better in the energy sector due to active support that the sector receives from both states as well as the resilient structure of the oil and gas industry. We are seeing growth in trade flows, numbers, scale, geography and revenues of these projects. A challenge we have knowledge of, from a major subsidiary of a key Chinese oil and gas company running a project in Russia, is related to purely technical matters. These concern the international structuring of the project, financing options, and profit repatriation (where the revised China-Russia and Russia-Hong Kong Double Tax Treaties have been taken very well by investors). That said, the investor s actual view of the investment environment and law enforcement practices in Russia was quite positive supported by the advice it received from another branch of the same group that has already been running several projects in Russia for over two years. Real Estate For Chinese real estate developers, who are expanding their global footprint with investments steadily growing each year, the challenges have a slightly different nature. Compared with other sectors, RE suffers from the deeper and longer-term consequences of economic instability, thus the stimulation of a stable economic environment is critical to attracting foreign investments to the sector. 2015 saw a significant drop in activities from both international and domestic investors. However, new projects are surging in 2017, including those run by major Chinese RE developers.
04 /2017 Infrastructure A large number of significant infrastructure projects have been launched recently. One of them is the construction of the first ever railway bridge over the Amur River at the border between Russia and China. The new bridge will have a capacity of 21 million tonnes per year and will connect the Jewish Autonomous Region of Russia with the Chinese province of Heilongjiang. Construction of the bridge will create a new export corridor between Russia and China to overcome infrastructural barriers for cargo transportation from new deposits developed in Eastern Siberia and the Russian Far East. The bridge will considerably increase cargo turnover and the competitiveness of Russian producers and exporters in the region, as the transportation distance to the end user will be reduced by approximately 700 kilometers compared with operating export railway routes. The Russia-China Investment Fund is one of the key investors in this project. However, sometimes issues still persist. A major Chinese infrastructure group with strong positions in Global Fortune 500 has been struggling to enter the infrastructure market in Russia for over two years: although open from a legislation perspective, projects are quite hard to access in practice due to the dominance of major local players, who are granted better contracts compared with foreign investors. The investor considered several major projects starting 2014, but after spending over six months in just preliminary discussions with the project owner, it realized that there were no guarantees for the planned investment (the type of tendered contract was less safe than the one offered to local producers, and it also covered territories of Russia that are almost unpopulated, hence the investor was left with no ability to calculate ROI for a toll-road project and gain approvals with headquarters for this investment, or with potential lenders). An alternative decision for the investor was taking on smaller projects that, while still not being entirely transparent from the perspective of ROI, were associated with less financial risk. Upon communication with the same project owner, whose position is fairly monopolistic on the market, and leaving no market leverage for entities without established domestic connections (i.e. for foreign investors), the investor still failed to establish a dialogue, as most of the projects proposed were offered as-is and the flexibility of the Russian party was limited. Thus, over two years on, the investor is still reviewing the market and is very interested in injecting money in new projects, but to our current knowledge has taken a safer decision to provide EPC (engineering procurement construction) services, requiring no investment in Russia. To a certain extent, the investor has achieved its goal of market entry. 07
China and Russia in 2017: an intricate path of growth It is worth mentioning that the option the investor did not consider to the moment of late 2016 was creating a JV with a Russian partner. Judging from recent projects, this is a reliable instrument for both parties and Chinese investors tend to use it more often today compared with just one or two years ago. Situations similar to the above have been evident in the construction sector in particular. E-commerce We have learned that TMT investors, in the e-commerce sector in particular, have a highly positive outlook on working in the Russian market, and they believe that it has great potential that can be unlocked at a fast pace. There is a certain concern, however, related to tightening industry regulations in both Russia and China, as the speed with which certain legislation may come into effect may sometimes be higher than the speed of operational restructuring to adjust to the new rules, which may render negative effect to ongoing business operations. Indeed, grace periods may not always be granted based on recent Russian lawmaking practice. One example of lawmaking from another industry is the following. Automotive A major state-owned Chinese automobile company, which had run operations in Russia for quite some years and had accumulated tax losses for six tax periods, intended to recognize these losses in 2017 to the maximum extent for corporate income tax purposes. However, amendments to 401-FZ in force from January 1, 2017 amended the tax deduction principles with wording stating that deductions for corporate income tax purposes within a current tax period may not exceed 50% of the tax base for the given tax period. There is no grace period granted by this amendment and it may lead to a situation where not all of the tax loss is utilized, with no grandfathering provisions covering the actual tax loss generated by the fully legal operations of the company in Russia. The absence of an ability to predict such changes in Russian legislation is among the major challenges that the Chinese investor
04 /2017 sees in doing business with Russia while legislative updates themselves are a regular international practice, the structure of their implementation should be well thought out to avoid unwanted damage to business. In addition to that case, interesting statistics about Chinese investors in the Russian automotive sector are available. Similarly to real estate, the automotive sector is significantly dependent on economic stability. According to Autostat, against a background of an overall decline in the automotive market and sales in Russia in the past two years, sales of Chinese automobiles grew 10% YoY in 2016. This figure in an example of the overall steady growth of Chinese automotive players on the Russia market in the last two years. We are seeing not only car imports, but also the construction of new assembly plants and the creation of China-Russia JVs supporting the sector and attracting actual FDI from China. According to Autostat, one of the leading Chinese producers is a key player on this market, while the share of Chinese cars on the Russian automotive market grew overall from 1.9% in 2015 to 2.6% last year, leaving much space for further expansion. The producer made relatively fast success on the Russian market and the first news announcing the producer s intentions to build a plant in central Russia spread in late 2014, however no real actions have been taken so far. According to our information, key reasons for that are economic instability and concerns about currency devaluation, which are shared by all production companies whose business model includes imports from China to Russia of already pre-assembled parts. The cost of production of these parts is calculated in US dollars and Chinese yuan, whereas sales in Russia bring ruble revenues, meaning that any currency fluctuations render damage to the whole international-level value chain of automotive producers hence they are inclined to wait until the situation stabilizes. At the same time, complete car assembly in Russia is not a feasible option in current market conditions due to the absence of local providers capable of producing the required high-quality parts under long-term contracts. 09
China and Russia in 2017: an intricate path of growth Russian entrepreneurs are positive to their perspectives in China SWOT analysis for Russian business in China Strengths OPPORTUNITIES Speed High of decision return making of investments / Engagement Prices Human Capital Banking conditions / Funds availability Working efficiency Scale of decisions Weaknesses THREATS Need for a local partner Language barrier Logistics / Delivery time Long certification procedures
04 /2017 In April 2017, EY held a series of in-depth interviews with Russian entrepreneurs who had business experience in China. The respondents proved to be very positive and noted considerable potential in the Chinese market. Opportunities Size of internal market Demand for Russian products and their image Focus on innovation Absence of locally produced substitutes Possibility of long-term planning Threats Cultural differences Regulatory issues Authoritarian style of management Copyright protection problems Uncommon distribution model 11
China and Russia in 2017: an intricate path of growth China-Russia ties: in the short and long term China is the No 1 purchaser of Russian oil and the No 4 FDI investor in Russia. At the same time, China is a tremendously diversified market, the second largest economy in the world, increasingly dominating the GF500 list and focusing last year on outbound investment more than it ever did, in particular, within the state s one belt one road initiative. Statistics and the current level of cooperation prove the rapidly increasing interest of Chinese business in Russia. And, importantly, this interest is already tied up with long-term projects such as Yamal SPG, the Free Port of Vladivostok, and the high-speed railroad connecting Moscow and Beijing. Thus, there is indeed great mutual China-Russia investment interest, and it continues to grow. And to maintain that interest at the level of an individual Chinese project in Russia, it is important not only to have input from local partners and the government, but also from the investors themselves. This means that a good understanding of local regulations, best practices and required measures is becoming increasingly critical in estimates that the Chinese investor may make when trying to forecast the success of their investment in Russia. 12
04 /2017 Contact information Alexander Ivlev EY, Country Managing Partner, Russia alexander.ivlev@ru.ey.com Vladimir Abramov Partner, China Overseas Investment Network, CIS, Moscow vladimir.abramov@ru.ey.com Pavel Medvedev Manager, Head of CIS Desk in China, Beijing medvedev.pavel@cn.ey.com Ka Yan Pau Manager, China Overseas Investment Network, CIS, Moscow kayan.pau@ru.ey.com Aleksey Rybnikov EY, CIS Knowledge Leader aleksey.rybnikov@ru.ey.com 13
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