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China’s continued economic IV drip should keep Russia alive and everyone in line.
Last week we wrote about collateral analysis and how it could facilitate a hand-off from Dollar to Yuan as reserve currency in a Crisis of Commodities. Today we write about how the Russian-Ukraine war factors into that calculus from China’s perspective and their possible decision analysis.
China can and will keep the Russian economy on life support via goods trade. So begins a truthful report by Christopher Granville for TS Lombard describing the increasing influence of China on the outcome of the Russo-Ukraine war raging right now.
The upside of that truth? Russia is less likely to commit (more) desperate acts to survive Western sanctions. The less obvious downside of it? China becomes the king-maker in a conflict between Europe and Russia as preventer of those desperate acts. In being king-maker, and war-preventer, they could become one step closer to reserve currency.
China Decides Who Wins the War
At first glance, China’s stated neutral stance may not seem a very powerful position. Politically this is largely correct. Not lending overt weapon-support or mediating on Russia’s behalf hardly seem like power plays on China’s part, right? But economically the picture is much smarter for them to remain neutral. As the report states:
China’s do-nothing approach could prove important in keeping the Russian economy on life support.
And this is the brilliance of China’s strategic neutrality. Their keeping the Russian economy barely alive serves as a backstop preventing escalation into global conflict. The West knows this and must deal with it. Without China’s oil demand, the West’s sanctions are a declaration of World War on Russia.
Conversely, Russia knows that without Chinese demand; Their economy is screwed. Putin would risk civil war. He would then either escalate hostilities or capitulate to Western sanctions.
Three Possible Outcomes for Russia
Who benefits? China does, of course. The longer this goes on, the more they bleed Russia and gouge the west1. For China, slow play is rewarding play.
Paths for Russia…
Taken together, China’s thumb-on-the-scale global “neutrality” increases the likelihood of a chronic economically depressive process (stagflation); even as chances of an acute, escalating war subside. Russia and Europe wear each other out while China gets stronger.
Russia and US Both Lose, China Wins
From Russia, China gets to buy oil at a severe discount to global prices, as low as $30 under global indexes. They can buy up Russian debt for pennies on the Yuan. They can, for all intents and purposes, bail-in Russia as a (very ornery) vassal state.
In the West, China gets to sell its goods at inflated prices. That is, if they decide to do so at all. In combination, China is the Marc Rich of this generation, arbitraging sanctions and embargoes. Lombard adds:
This should help keep the crisis on the relatively less dangerous Scenario 1 (negotiations-alongside-fighting) track
China’s continued economic IV drip should keep Russia alive just enough to keep everyone in line. Russia can go from a developed nation to submerged market in a generation at this rate. Simultaneously, Europe can be “grateful” to China because Russia doesn’t go nuclear.
China: All Urals Belong to Us
The key mechanism in support of this concept is bilateral Russo-China trade. According to the report: In 2021 trade between the two countries stood at about $150 billion. This year’s target is about $200 billion. This may be the only trade budget globally close to target! 2
The report then goes on to distinguish between the types of trade that would be flagged by western regulators and that which will not be flagged:
It is vital to distinguish between financial activity that US regulators could easily identify and penalize with secondary sanctions; and, on the other hand, bilateral trade conducted across a long land border by pipeline and rail freight and settled in RMB.
Simply stated: China will avoid businesses that have Western sanctioned Russian counterparties. This is not a new practice and is how China has dealt with Western sanctions on Russia in the past, just now on steroids. Alternative networks are already in place on items like aircraft parts the report notes.
China will not flaunt sanction law even while chafing at it. They have much longer term interests than defying western sanctioned trade with Russia. They can hoard the world’s much needed resources in traditional bilateral trade with their weakened neighbor.
When it comes to importing oil and gas, coal, grain, and metals from Russia, China will have a clear interest in maintaining this trade. This is another area they also already have much experience in going back to the GFC:
In the wake of the 2008 financial crisis, Rosneft accepted a deeply price-discounted long-term offtake contract from Chinese counterparties.
This trade will give China both operating margin relief (profit) and relative competitive advantage (marketshare) amid the global commodity price bifurcation from the war.
China has already started on this path: As Zerohedge stated Friday:
Russian oil giant Surgutneftegaz (Surgut) has allowed Chinese buyers to receive oil without providing guarantees known as letters of credit (LC) in order to bypass Western sanctions.
If this isn’t all reason enough for China to be violently neutral, keeping Russia alive while slowly eviscerating it; there is one more factor. China has no interest in a destabilized nuclear Russian neighbor. Look at Scenario 3 in the graphic above. TS Lombard adds here that: [Russian] destabilization could even delay or derail progress on the preferable – for all concerned – negotiating track.
China Has Options, Russia Doesn’t
While all three scenarios are possible- the one that benefits China most, while keeping their options alive for the other two scenarios, is Scenario 1. They can, if things get ugly for their relationship with Russia, pull the plug on that IV any time and go Scenario 3.
China is getting paid to be long vol…
This, we think also is why the West will make a lot of noise about China enabling Russia’s economy, but will do nothing about it. Nobody benefits from complete Russian collapse. If, however, Russia seems ahead in the war, (Scenario 2) they can alternatively overtly support Russia in its endeavors and expedite that scenario.
Playing Both Sides Against the Middle
Here is the kicker. In this slow-play game, we believe Russia folds before the West does. Then you have a battle-weakened west standing against a much stronger China which just LBO’d Russia with its own resources. What happens next is either military aggression on Taiwan, or more slow play in the form of getting the world currency changed from soft Dollars to hard Yuan. In last week’s premium report we said:
We would not be surprised if China rescues things. Then upon that event, demand a bigger slice of the IMF SDRs, add commodities to the basket, and advances its agenda of moving the pricing mechanisms of global trade to the East in GoldenYuan terms.
And quoting Zoltan Pozsar from that report:
From the Bretton Woods era backed by gold bullion, to Bretton Woods II backed by inside money (Treasuries with un-hedgeable confiscation risks), to Bretton Woods III backed by outside money (gold bullion and other commodities). After this war is over, “money” will never be the same again…
That is how China wins.
Remaining neutral where the "person in the middle" actively manipulates both sides can also be used when the third party, in this case China, doesn't necessarily do anything. They wait to take their own action against the weakened victor. They are maliciously neutral in the eyes of the West.
Thumb on scale?
And so, scenario one above is the path most countries can stomach best, even if it means destruction of Ukraine. This will most likely prove long and drawn-out with sanctions and the associated market disruption persisting. Inflation for the west, and depression for Russia.
For Americans, it means structural stag/inflation, reverse hedonics, and lower standards of living on deck.
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