Rio Tinto Ltd said on Wednesday it would team up with its biggest customer China Baowu Steel Group to develop an iron ore project in Western Australia for $2 billion as it looks to prop up its production from the Pilbara region.

The deal comes amid fraught ties between Australia and China - the world's top exporter and buyer of iron ore, respectively - with a recent push by Beijing to centralise purchases of iron ore stoking worries of a hit to mining giants such as Rio, BHP Group and Fortescue Metals.

China's outbound direct investment in Australia has seen a steady drop since 2016, with a meagre $585 million investment in 2021 versus $11.54 billion in 2016, according to a report by accounting firm KPMG and the University of Sydney.

Rio, however, said last week it had established a strategic partnership with the new Chinese state-owned agency created to centralise iron ore purchases.

About the Western Range project in Pilbara, Rio said it would invest $1.3 billion to develop it and will hold a 54% stake in the project, while state-owned China Baowu will hold the remaining stake and will invest $700 million.

"Western Range's annual production capacity of 25 million tonnes of iron ore will help sustain production of the Pilbara Blend from Rio Tinto's existing Paraburdoo mining hub," the world's largest iron ore producer said .

Pilbara Blend products are known for their high-grade quality and consistency, and make up about 70% of Rio Tinto's iron ore product portfolio, according to the miner's website.

Baowu said on its official WeChat account that the deal with Rio would help "strengthen the partnership of mutual benefit and win-win results".

The deal is subject to approval from the governments in Australia and China, as well as Rio shareholders.

China's State Administration for Market Regulation, which oversees acquisitions, did not immediately respond to a fax seeking comment on the deal.

A Chinese source familiar with the deal said it was not expected to face regulatory hurdles, given that Beijing has long encouraged its firms to expand investment in overseas resources.

Rio and China Baowu also entered a sales agreement that will see China Baowu, the world's top steelmaker, buy up to 126.5 million tonnes of iron ore over about 13 years from the Western Range project in Pilbara.

"Rio and Baowu already have a JV arrangement in eastern range in Pilbara. Today's deal is essentially an extension of that in the Western Range of Pilbara," said John Mills, an equity analyst covering mining at Morningstar in Sydney.

Construction at the project is expected to begin in early 2023, with first production anticipated in 2025, Rio Tinto said.

(Reporting by Sameer Manekar in Bengaluru and Praveen Menon in Sydney; additional reporting by Siyi Liu in Beijing; Editing by Himani Sarkar and Lincoln Feast)