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Working Papers

HARD GOODS AND SOFT CURRENCIES : A Note on Bilateral Payment Arrangements

I. INTRODUCTION

One of the most striking characteristics of the export behaviour of the erstwhile USSR was the fact that it exported a fairly large volume of goods which had a ready demand in the world markets (henceforth called 'hard' goods) in exchange for non-convertible currencies, such as the "convertible" rouble or the rupee (henceforth called 'soft' currencies). This trade behaviour existed not only with the CMEA-member countries, but with a number of developing countries, such as India, as well.2 It is sometimes held that this practice was the Soviet version of bilateral aid, and reflected political imperatives rather than economic rationality.

This view is apparently shared by the present economic leadership in Russia. The haste with which bilateral payment arrangements have been scrapped in favour of payments in convertible currencies appears to indicate that Russia considers such bilateral arrangements to be an unaffordable luxury in its present economic condition. In fact, this is a major component of its transition strategy to a market-oriented economy.

One of the purposes of this paper is to argue that a political argument is not necessary to justify trading hard goods for soft currencies, there is indeed sound economic logic to it. A natural corollary of this argument is that the hasty scrapping of all the bilateral arrangements may have done more harm than good to the Russian economy at a time when it could afford it the least.

It would be well to mention at the outset that sound economics on the part of the USSR does not mean that the partner countries did not benefit from the arrangement. To the contrary. All it means is that too much should not be laid at the philanthropic door; and it should be remembered that trade is not necessarily a zero-sum game.

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2. CMEA stands for Council for Mutual Economic Assistance.

Although such bilateral payment arrangements have all but ceased to exist with the collapse of the USSR and the revocation of the arrangements by Russia and the other CIS states, an analysis of the economic logic of these arrangements is not merely a curiosum. Another purpose of this paper is to argue that for a number of countries, both among the erstwhile CMEA states and developing countries, establishment of bilateral payment arrangements in specific products with specific partner countries makes eminent economic sense even in this age of ‘globalisation’. Unfortunately, the mainstream economics establishment views such arrangements as an unacceptable form of trade intervention. Thus Article VIII of the IMF specifically bars member countries from entering into bilateral payment arrangements without seeking the express approval of the IMF. However, if it can be shown that such arrangements are Pareto superior to other, more acceptable, forms of trade intervention, an argument can be developed for some of the existing restrictions being relaxed. This is particularly important in the context of the regional groupings which are being sought to be formed by developing and transitional economies as a prelude to globalisation, and the clearing arrangements that may need to be set up as part of this process.

Before going into the formal statement of the model, it may be desirable to briefly describe the nature of the hard good/soft currency transactions.3 In the description that follows, we have used the Indo-USSR arrangement, which was fairly typical of those that existed with most non-CMEA bilateral trading partners of the USSR. The arrangements within the CMEA were somewhat different, but the results of the model carry through with equal force to those arrangements as well.4

For purposes of discourse we shall refer to 'hard' goods as petroleum (or oil) and the trading partner country as India. The 'soft' currency will be referred to as the rupee. The basic arrangement that existed was as follows :

The USSR contracted to sell to India a fixed volume of oil during the year under a bilateral trade protocol. The price payable by India for this supply was the dollar spot market rate prevailing in the international market at the time the supplies were effected. These dollar values were converted to rupees at the prevailing dollar/rupee exchange rate and were credited to the Soviet account maintained by the Reserve Bank of India. The USSR would then allocate these rupee funds to Soviet trading organisations for purchase of goods from India. Since the rupee was not convertible, these funds could not be used for making purchases from third countries. 5
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3. This description draws upon the more detailes version given in Vyas and Sen (1989).
4. See Van Brabant (1987) for details of such arrangements.
5. There is some evidence, however, that at least a part of the rupee resources generated by this trade was used by the USSR to import from hard currency areas with the cooperation of Indian traders.   There was of course a price for this.  Typically, the Indian trader received a margin of about 33 per cent over world market prices, which was necessitated by the Indian trade policy.  See Sen (1990) and Chandra (1977) for details.

It should be noted that since the price payable was determined by the international spot price for oil, India paid no more than it would have had it bought the oil from the world market.6 On the contrary, since the payment was in rupees, no foreign exchange outgo was necessitated. Thus, if the shadow exchange rate of the dollar to India exceeded the official exchange rate,7 India gained to the extent of the shadow premium saved. In addition, since the currency of transaction was the rupee, India did not have to hold precautionary foreign exchange reserves for this quantum of imports; thereby saving on seignorage. This much is obvious and clear. But what did the USSR get out of it?

II. THE MODEL

Suppose the USSR produced some fixed quantity 'Q' of oil in excess of its own internal requirements. It had a choice of selling this either in the world market for dollars or to India for rupees under the bilateral arrangement. Suppose it decided to sell some fraction 'l ' to the world market and the remainder (1 - l ) to India at a common dollar spot price of oil in the world market of 'p*'. Suppose further that the USSR had a preference for dollars over rupees, such that :

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6.   Except of course to the extent that the international spot price for oil was above the long-term contract price that may have been available.  In
the long-run, however, such variations would have probably evened out.

7. The shadow exchange rate of the rupee, for instance, has always exceeded the official rate, except perhaps since 1993-94. Even today there is a view that holds that the rupee is over-valued by anywhere between 10 and 20 per cent.
8. The standard neo-classical specification would have made Q a function of p*.  However, the stylized facts of Soviet behaviour seem to indicate that this sort of a rigid specification is a better representation of reality.


$1 = (1 + µ ).e                                                                                                                      (1)   

where : µ  = shadow premium of the dollar to the USSR vis-a-vis the rupee;
           e = official rupee/dollar exchange rate.

Then the 'value' of its total sales of oil to the USSR in terms of rupees would be :

         (1 + µ ).e.p*. l .Q + e.p*.(1 -l ).Q 

or :                   

         e.p*.Q.(1 + l . µ)                                                                                                           (2) 

Notice that in an unconstrained maximisation of (2), there would almost always be a corner solution depending upon the value of ' µ '. If  µ > 0, then the USSR would not sell any oil to India under the rupee trade arrangement. Conversely, if  µ < 0, the USSR would try to sell all its excess oil to India. The limiting factor in this latter case would be the Indian demand for oil at the given price. In the case where  µ = 0, the USSR would be indifferent between the two markets, and the choice could indeed be purely political. The interesting issue really relates to the case where  µ ³ 0 and yet the USSR voluntarily and in its own enlightened self-interest chose to sell at least some oil to India. 

In so far as India is concerned, it is assumed that it faced a binding 'hard' currency foreign exchange constraint, such that the shadow exchange rate for dollars was higher than the official. Thus its demand for oil is assumed to be not only a function of the price that it paid for it, but also of the currency in which the payment was to be made. To simplify the analytics, we shall assume, without loss of generality, that for any given rupee price of oil, if payment was to be made in rupees then India would import a fixed higher fraction 'j ' of the amount it would have imported had payment been in dollars, where ‘j ’ is the shadow premium of the dollar vis-a-vis the rupee for India.9 Thus the Indian demand curve for oil is specified as : 

          | X(p*) if paid in dollars
X =     |                                                                                                                           (3)
          | (1 + j ).X(p*) if paid in rupees

         where : X’ < 0

Since the maximum supply of oil under the rupee payment arrangement was specified ex-ante by the USSR in the annual trade protocol, and since it was always in India's interest to draw its oil requirements first from the Soviet source, the entire burden of adjustment to changes in prices and quantities would fall on the Indian demand for oil from the international market. This residual demand from India in the international oil market can be specified as : 

                    (1 - l )
XR = X(p*) -     --------.Q                                                                                                                 (4)
                    (1 + j )                                                                                                               

The total demand in the international oil market can then be specified as the sum of the total non-Indian demand for oil (W) and the residual demand from India : 

DW = W(p*) + X

                       (1 - l )
      = D(p*) -     ---------.Q                                                                                                             (5)
                      (1 + j )                                                                                                                                            

where : D(p*) = W(p*) + X(p*) = Total international demand 
                                               for oil in the absence of a
                                                rupee payment arrangement 

On the other hand, the total supply of oil in the international market is assumed to comprise of the supply function of all other oil-exporting countries (S) plus the volume that the USSR put on the market. Thus the aggregate supply function can be specified as : 

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9. This assumption implies that India is a rational consumer which uses shadow prices for such decisions, and that the shadow exchange rate remains constant over the relevant range.  It also assumes that the foreign exchange constraint is expressed uniformly across all imports.   In view of the assumed binding foreign exchange constraint, a more natural assumption would be to make ‘f’ an increasing function of ‘p*’.  This, however, needlessly complicates the analytics, although it reinforces the argument sought to be made.

SW = S(p*) + l .Q                                                                                                                     (6)

Ignoring forward trading and other such complications, the spot price of oil in the international market would be determined by the market clearing condition : 10

SW = D

which, using equations (5) and (6), can be written as : 

(1 + j )[S(p*) - D(p*)] + (1 + l .f ).Q = 0                                                                                           (7) 

As the principal decision-making entity, the USSR would wish to maximise (2), subject to the equilibrium condition for the international market (7) and the boundary condition imposed by the Indian demand : 

(1 - l ).Q < (1 + j ).X(p*)                                                                                                                 (8) 

Notice first that if the USSR had no specific preference for dollars over rupees (i.e. µ = 0), then the maximand (2) collapses to :

p*.Q
and further, since from (7) we have : 

dp*         - j .Q
--- =   ------------------- < 0                                                                                                                   (9)
dl      (1 + j )[S' - D']  

therefore the USSR would sell as much oil as possible to the soft currency area, i.e. India, subject to the boundary condition (8). The intuition behind this result is obvious : Since the spot price of oil is determined by the aggregate demand and supply in the international market, every unit transferred by the USSR from the international market to India reduces the supply by 1 unit but the demand by only a fraction [1/(1 + j )]. Thus the equilibrium spot price would rise, which always benefited the USSR. 

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10. The assumption of a price-, rather than a quantity-, clearing adjustment mechanism is being made on the grounds that it is more appropriate for almost all 'hard' goods except oil, and even in the latter case it is a better characterisation of the post-OPEC scenario.

Conversely, if the Indian demand for oil was not sensitive to the currency of payment (i.e. j = 0), the market equilibrium condition (7) collapses to : 

D(p*) = S(p*) + Q 

which implies that the equilibrium spot price (p*) would be independent of l . In such a situation, the USSR would sell its entire output in the international market, provided of course that there was no specific preference for rupees over dollars (i.e. µ  ³ 0). The intuition in this case too is clear : Since the total Indian demand is constant irrespective of the currency denomination, the spot price will be exactly the same whether any quantity is supplied under the rupee payment arrangement or not. Therefore the USSR would maximise its benefits by earning as much dollars as possible.

III. OPTIMALITY OF THE HARD GOOD/SOFT CURRENCY ARRANGEMENT 

It should be clear therefore that it is only when both the conditions that µ >> 0 and  j >> 0 were met that the USSR was faced with a problem of optimal choice in allocating its oil surplus between the hard and the soft currency areas. As the model has been set up, the only control variable available to the USSR was the share (l ). In such a situation, the first-order condition for an interior maxima can be derived by differentiating (2) with respect to l and equating to zero, which yields : 

                                    dp*
µ .p* + (1 + µ .l ).      ---  =    0                                                                               (10)
                                   dl

Notice that the boundary constraint (8) is not being used, since its operation has been ruled out by assumption. 

Substituting the price determination condition (9) into (10) yields the constrained optimum as : 

                (1 + j ).p*.[S' - D']            1
        l =    -------------------------   -    ---
                   j. Q                                µ 

                 (1 + j )[S.e S - D.e D]              1
         =    ----------------------------------   -   ---                                                                      (11)
                     j .Q                                     µ 

where : e S = p*.S'/S = price elasticity of supply of other oil-exporting countries 

            e D = p*.D'/D = price elasticity of demand for oil 

In equation (11), the right hand side continues to be a functional of l . Using equations (7) and (11), and rearranging terms, we obtain the optimal value of l as : 

                     [µ .(1 + j )(1 - q )(e S - e D) - q .j - q .µ .e D]
              l * = -----------------------------------------------------------------                                           (12)
                                    q .µ .j .(1 + e D

where : q = Q/(S + Q) = share of USSR in total supply of oil  

The first point to note is that if the international demand for oil is elastic (i.e. - e D> 1), then the second-order condition for a maxima is violated. Therefore, a necessary condition for an economically rational hard good/soft currency arrangement to exist is that :

                   |e D| << 1.

The second requirement of course is that the USSR must supply some oil voluntarily under the rupee payment arrangement. This implies :

                    l * << 1

which holds iff

                     µ .(1 + j )[e S - e D - q .(1 + e S)] + q .(µ - j ) << 0                                                          (13) 

The sufficient conditions for the inequality (13) to obtain are : 

                                    (e S - e D)
                       (a)    q >----------------                                                                                                   (14)
                                    (1 + e S)

and
                      (b)    j > µ                                                                                                                   (15)  

Condition (14) is really nothing but the Marshall-Lerner condition for cases where the international demand curve is specified in gross rather than net terms.11  Therefore, at one level, the argument in favour of the hard good/soft currency arrangement is substantively no different from the 'optimal export tax' argument, which has been widely accepted as a valid rationale for trade intervention. In order to see this, consider the optimisation problem for the USSR if the hard good/soft currency arrangement had not been available. The optimisation problem for the USSR in this case would have been : 

               Max. l .p*.Q 

               s.t. D(p*) = S(p*) + l .Q 

Solving as before, yields the optimum value of l as : 

                 (1 - q )(e S - e D)
         l ’ =    ------------------------                                                                                                         (16)
                  q (1 + e D)  

which gives the necessary and sufficient condition for l ’ << 1 : 

                   (e S - e D)
          q >> ---------------                                                                                                                 (17)
                  (1 + e S)  

which is identical to condition (14) above. Thus, the sufficient condition for a less than full supply of oil by the USSR to the international market, or in other words for an ‘optimal export tax’, is also one of the conditions under which the bilateral arrangement is optimal for the partner countries. 

Therefore, the counterfactual against which the wider welfare effects of the bilateral arrangement should be evaluated is not the pure laissez-faire solution, but the solution which would have emerged if the USSR was assumed to be economically rational in its external trade policies and had adopted an ‘optimal export tax’ approach.

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11.  The usual Marshall-Lerner condition (eS - eD < 1) is derived by defining the international demand curve in net terms, i.e.
as international demand less international supply.

There is, however, an additional condition (15), which in essence states that if the shadow premium on ‘hard’ currencies is higher for India than for the USSR, the hard good/soft currency trade is optimal for the partners even if the Marshall-Lerner condition for an optimal export tax is not met. Conversely, if the shadow premium on hard currencies is higher in the USSR, the probability of the bilateral arrangement being optimal for the USSR is much lower than that of the optimal export tax argument. 

The issue therefore hinges on the relative magnitudes of the shadow premia on hard currencies relative to the common soft currency that is used for transactions between the two bilateral trading partners. Consider first the case where the shadow premium is higher for the USSR than for India (i.e. µ > j ). In such cases, the existence of the bilateral arrangement is of no real consequence to the USSR, since it is always preferable for it not to include the concerned ‘hard’ good in any bilateral trade protocol. If condition (17) were satisfied, the USSR would simply supply less than the total amount available; if not, it would place its entire output in the international market. It would of course allow India to buy whatever it wanted against payment in hard currencies. Thus, the situation would be no different from one in which the bilateral payments arrangement did not exist. 

However, if the shadow premium on hard currencies is lower for the USSR than for India (i.e. j > µ), the matter becomes somewhat more complex. If condition (14), or equivalently (17), is met, it is always in the interest of the USSR to supply oil to India under the bilateral arrangement. However, the over-all welfare effects would depend upon the relative size of l * vis-a-vis l ’. If, on one hand, l * > l ’, the existence of the bilateral arrangement is unambiguously Pareto-superior to the alternative. The reason for this is that under this condition, the optimal supply of oil to India under the bilateral arrangement would be lower than the withholding dictated by the optimal export tax argument. Thus the USSR would withhold exactly the same amount from the world market as it would have done otherwise and supplied a part of this to India. Thereby the total availability of oil in the world would rise without any reduction in the supply to the international market. 

On the other hand, if l * < l ’, the USSR would prefer to withhold more oil from the international market for supplying under the bilateral arrangement than would be the case otherwise. Thus, although both the USSR and India would unambiguously experience welfare improvements, the welfare effects on the rest of the world could possibly be negative. The effect on the rest of the world would depend largely upon the level of Indian demand for oil relative to the desired supply from the USSR as given by the boundary condition (8). If Indian demand was less than (1 - l ’)Q, the USSR would again withhold exactly the same amount of oil from the world market that it would have under the optimal export tax arrangement and supplied India’s demand to the full, with the difference being held as stocks. In this situation again there would not only be no reduction in welfare of the rest of the world, but on the contrary the international supply net of Indian demand would actually rise, and the bilateral arrangement would therefore be unambiguously Pareto-superior to the alternative. 

If, however, Indian demand were to be higher than (1 - l ’)Q, then, and only then, the possibility exists that the rest of the world might suffer some welfare loss through a lower availability of oil supplies since the USSR would be supplying more oil to India than would have been withheld from the international market under the optimal export tax argument. It must be remembered, however, that reduction in supplies to the international market is at least partly counterbalanced by the reduction in Indian demand, and the net position needs to be examined for a welfare judgement to be made. Since the reduction in supply of oil in the international market will be :

                       (l ’ - l *)Q

while the reduction in demand, through withdrawal of Indian demand, will be :

                        l *.Q/(1 + j )

it can be shown by using equations (12) and (16) that the necessary condition for the net supply to the international market to decrease is :12

                         -e D < j /µ

Although the above condition will always be met when the bilateral arrangement is optimal, since the second order condition requires (-e D << 1) and (j > µ ) by assumption, this is only a necessary condition and the sufficient condition is considerably more stringent (see footnote 12), and unlikely to be met in most circumstances. 

It needs to be noted that if conditions (14) and (15) are both met, i.e. in situations where the bilateral arrangement is most beneficial to the partner countries, then l * will necessarily be strictly less than l ’.13 This implies that the expected welfare effects of the bilateral arrangement on the partner countries, on the one hand, and on the rest of the world, on the other, could possibly be negative and will depend partly upon the level of demand for the commodity of the importing partner country relative to the potential supply of the exporting country as described in the preceding paragraphs. In brief, the smaller the level of relative demand, the more likely is the arrangement to be Pareto-improving for the world taken as a whole, although the benefits to the partner countries is also likely to be smaller. On the other hand, the balance of probability is that the arrangement will, in almost all cases, be welfare improving for the world at large, provided of course that countries are assumed to act rationally in situations where they possess economic power and are permitted to do so by the international trading rules.  

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12.  The full condition for net supply to be reduced is :
               
2m(1 + f)(1 - q)(eS - eD) – (q f + q meD) < 0

13.  From equations (12) and (16) it can easily be shown that   l*  £ l‘ if :
                   
   m(eS - eD)
                q ³    --------
                       (meS + f)

Since conditions (14) and (17) are assumed to hold,it can easily be seen that the above condition is automatically fulfilled if :
                 
m(eS - eD)     (eS - eD)
                 --------     £      -------        Þ                 m £ f
                 (meS + f)      (1 + eS)

IV. CONCLUSION 

The purpose of this paper was to examine the bilateral payments arrangement that existed between the former USSR and a number of countries, including India, from the point of view of: (a) its rationality for the two trading partners; and (b) its wider welfare effects. The objective was to determine whether or not these arrangements had a sound economic basis, or were a method to by-pass, and possibly even subvert, the international trading order. The important point that emerges from the analysis is that the hard good/soft currency arrangement was indeed rational in purely economic terms for the USSR under not unreasonable conditions. However, its applicability was limited only to goods for which two conditions were satisfied :

  1. The USSR was a major producer/supplier of the product in the world market.
  2. Both the demand and supply for the product in the world market were inelastic. 

It is moot whether both these conditions were applicable to the wide range of goods that were traded between the USSR and her bilateral partners. There is, therefore, some justification for questioning a generalised bilateral trading regime on the grounds that it is distortionary and may result only in trade diversion. For specific goods which meet the above conditions, however, the bilateral arrangement turns out to be not only good for the trading partners, but also welfare improving for the world taken as a whole. This is of course contingent upon the counterfactual that is used to measure the welfare effects. It has been shown that in the case of commodities for which the "optimal export tariff" argument holds, a bilateral trading arrangement is almost always Pareto-improving, at least insofar as the partial (commodity-specific) equilibrium is concerned. 

This result has far-reaching implications for the trading behaviour of primary-producing countries, particularly those which have extensive trading links with developing countries. It is also of significance in the case of the emerging trading blocks among developing countries in Asia, Africa and Latin America. In these situations, an arrangement which permits the use of a non-convertible currency for payments against the supply of specific commodities can lead to substantial welfare gains for the world at large. This would, however, require a change in the way that such arrangements are presently viewed in various multilateral fora, such as the IMF and the WTO. The blanket prohibition that exists at present will have to be relaxed, and the modalities for doing so will need to be evolved. This may not be particularly easy despite the force of logic. The reason for anticipating resistance lies in the fact that such arrangements always lead to welfare loss of countries whose currencies are widely used as medium of international transactions (i.e. ‘hard’ currencies) through loss of seignorage, and such countries wield considerable clout in international bodies.

REFERENCES 

  1. Chandra, N.K. (1977), 'USSR and the Third World : Unequal Distribution of Gains', Economic and Political Weekly, Annual Number. 
  2. Nayyar, D. (1975), 'India's Trade with Socialist Countries' World Development, vol.3. 
  3. Sen, P. (1989), 'Growth and Instability of Indian Exports to the USSR', Economic and Political Weekly, April. 
  4. ------- (1990), 'Rupee-Rouble Exchange Rate', Economic and Political Weekly, March. 
  5. Van Brabant, J.M. (1987), Adjustment, Structural Change and Economic Efficiency, Cambridge University Press, Cambridge. 
  6. Vyas, A. and P. Sen (1989), 'Dimensions of Indo-Soviet Trade and Economic Relations', ICRIER Discussion Paper, No. 50.