Russia, China, Australia, and the Fate of the Pacific Rim

In our ‘rim of fire’ tour, Russia is perhaps the most difficult to categorise. It’s partly an energy company masquerading as a nation state (as my friend John Robb has said) and partly a seller of sophisticated weapons systems that generate cash flow and challenge US global military superiority.

Let’s deal with energy first. But let me first say we should have admiration for the Russians. I once met an executive from Boeing who said the Russians have done more with less than any people on the planet. And they’re nearly imperturbable.

I once ate dinner with a Russian who had a chili pepper lodged in his sinus cavity. It must have been quite painful. But I wouldn’t have known unless he’d told me. The only visible sign of his distress was a red face and watery eyes.

But let’s talk energy. I’ll be short with it since everyone now knows about the $400 billion energy deal announced between Russia and China in late May. Gas from Eastern Siberia will eventually make its way to China via pipeline. The map below from Gazprom shows the two main fields to enter production over the next ten years, the 1.2 trillion cubic metre Chayandinskoye field and the 1.5 trillion cubic metre Kovyktinskoye field.

Gazprom pipeline, gas field production

Source: Gazprom

Is it a geopolitical game changer? For China, it’s diversification of gas supply. China still gets gas from Central Asia (Turkmenistan). But if you’re trying to build a portfolio of energy sources so you’re not completely dependent on one of them (oil from the chaotic Middle East), this is the kind of deal you make, provided the price is right.

For Russia, its diversification of gas sales. Russian sales to Europe are still far greater than the mooted sales to China. But the slow expansion of NATO to the East and the troubles in Ukraine and Crimea have apparently encouraged the Russians to expand their gas business to the East. Realistically, the gas reserves in Eastern Siberia won’t be developed without Chinese demand. The deal makes sense from that perspective.

For Australia, the risk is that Eastern Siberia becomes a hub for North Asian gas supply in the way the Northwest Shelf LNG supplies power utilities in Japan and Korea. This won’t happen overnight. But on the supply side, if you figure in US exports of LNG from the shale boom, and you bring on Russian supply from Siberia, plus you add in Qatar, then Australia starts to lose some of its competitive advantage as a gas supplier to the world’s fastest growing region.

The energy story will be a regular feature here in the Markets and Money and The Denning Report. But in the aim of completing our tour of the ‘rim of fire’ in a reasonable time (this week), let’s look at the geopolitical aspect of Russian and Chinese cooperation. It’s the one area that could most directly affect Australia’s interests, its economy, and its financial markets. Take a look at the chart below.

Teritorial claims in the south china sea

The ‘nine dash’ line is China’s territorial claim on the East and South China seas. I’ve highlighted how much is at stake economically. And I’ve highlighted how Australia and Japan plan to collaborate on submarine technology to enforce the UN Law of the Sea and neutralise Chinese claims. But the ‘facts on the ground’, will tell the story. And with Russian technology, the Chinese may be able to change the facts on the ground before the US, Japan, or Australia can do anything about it.

The Chinese call it the ‘Scarborough model’. It’s a strategy that establishes de-facto Chinese control of disputed territorial waters without provoking an actual military conflict. It achieves this through the use of civilian vessels (fishing boats) and by building structures like the concrete fort built on the Chigua Reef in the Spratly islands. If you reclaim some sea with an artificial island and plant a flag on it, then any attack on that island becomes an act of war initiated by another country.

The Russians come into with their impending decision to sell their 4th generation Sukhoi SU-35 fighter to China. The SU-35 isn’t a stealth fighter. But it would give the Chinese the ability to patrol and linger over disputed waters in the South and East China seas. That mere presence may be enough to create new ‘facts on the ground’ for Vietnam, Malaysia, and the Philippines. Those countries would be either unwilling or unable to challenge China’s new air capability.

But I should back up a second and put the SU-35 in context. The context is that the US arguably has a superior plane, the F-22 raptor. The raptor is a ‘5th generation’ fighter. And the premise behind ‘5th generation’ fighters is they give you the ‘first look’, the ‘first shot’, and the ‘first kill’.

Because the planes are hard to see (stealth) and have superior information (access to the WGS system), they can detect and destroy enemy aircraft before they’re even visible. At least that’s the premise. The Pentagon believes that capability, along with formidable naval resources, would be enough to keep the Chinese in their box.

There are several problems with this strategy, though. First, it appears that the Chinese strategy is to avoid armed conflict and accomplish new ‘facts on the ground’. This is classic Sun Tzu. The best kind of victory is one achieved without any fighting.

Another problem with the F-22 is that it’s too expensive to risk because there are so few of them. In war games against 3rd and 4th generation fighters, it has an astronomical kill ratio. But US President Barack Obama suspended production of the F-22 in 2009. That means there is a limited supply of combat-ready planes, around 123 according to Air Force estimates, with 27 for training, 16 for testing, and 20 as ‘attrition reserves’ or spare parts.

Let’s say, then, that the US could put 180 F-22s into combat. The People’s Liberation Army Air Force has 2,800 total aircraft, according to the US Department of Defence’s most recent report to Congress. Of that, only 1,800 are combat aircraft. And of those, only 600 are modern. Using war-games kill ratios, you’d need about four F-22s to win that fight (assuming you had enough missiles).

How is that possible? You can compare it to a boxing match in which you’re up against a fighter with superior reach who also happens to be invisible. He can pummel you with impunity because you can’t see him. And even if you could see him, you’d have to get inside his reach in order to hurt him. You’d have to close and grapple.

The Pentagon concedes that other fighters are faster, with greater range, and more manoeuvrable than the F-22. But they claim it won’t matter. If you can be killed without knowing someone’s shooting at you, the fight is over before you know it’s even begun.

The idea behind Russia’s SU-35 is to neutralise the F-22s superior killing range with agility. The SU-35 is not a stealth aircraft. But by all accounts, it’s much more nimble and manoeuvrable than either the F-22 or the F-35 (the JSF).

Again, this is by design. A more manoeuvrable aircraft can make it harder for a missile to hit its target. That means the plane launching the missile has to get closer to ensure a kill. And the closer it gets, the more the advantage swings to a fighter with greater speed and manoeuvrability.

Do yourself a favour and watch the SU-35 at the Paris air show last year. You can find the clips on YouTube. It stole the show. Its Russian-designed engines allow it to stay in control and unpredictably change direction at low speeds. It sometimes looks like a giant grabbed the plane in his hands, and threw it up in the air topsy-turvy. Yet the pilot remains fully in control of the plane the whole time.

The Chinese would dearly love to purchase the plane. And in fact, a deal to sell them has been in the works for several years. It’s always been just about to happen. But it still hasn’t happened. A report on Russian radio in June quoted former Russian air force commander Vladimir Mikhailov as saying the deal was, at long last, near.

The only hitch is that the Russians appear reluctant to sell the planes to the Chinese. They fear the Chinese will ‘reverse engineer’ the engines, which make the SU-35 so slick, and then export the technology at a profit. It’s a stand-off. The Chinese need the planes now to achieve their territorial ambitions in the South China Sea. The Russians could use the cash. But both are suspicious of the other.

It’s a testament to the ineptness of US foreign policy that its driven reluctant adversaries into each other’s arms as untrusting allies. But that’s precisely what’s happened. Russia is selling energy to China. And more importantly, it may sell the one weapons platform that can change the ‘facts on the ground’ in the South China Sea and give the Chinese what they want.

Australia has firmly aligned itself with the US in this conflict. That may be the best choice, given that the Chinese aren’t exactly going to be looking out for Australia’s best interests. But if the Chinese have leverage over Vietnam, Malaysia, and the Philippines because they can physically intimidate them or threaten them with punitive economic measures, how much leverage does China have over Australia?

Or is the other way around? Does Australia have leverage over China because China’s growth model will collapse without Australian resources? Further, is the demographic clock ticking on China, Russia, AND Japan? Does Australia just have to bide its time and wait until Father Time catches up with everyone else?

These are questions worth pondering. In the final instalment of the ‘rim of fire’ series tomorrow, I’ll bring it back to America, Australia, and investments. Sometimes you raise more questions than you have answers. But at the end of the day, we all have to do something with our money. Tomorrow, I’ll show you my top three investment ideas derived from the ‘rim of fire’ analysis. Until then!


Dan Denning
for Markets and Money

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Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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