'Proceed But With Caution' Says Economist as India Mulls Rupee-Ruble Trade Pact

© REUTERS / Danish SiddiquiA customer deposits 1000 and 500 Indian rupee banknotes in a cash deposit machine at bank in Mumbai, India, November 8, 2016
A customer deposits 1000 and 500 Indian rupee banknotes in a cash deposit machine at bank in Mumbai, India, November 8, 2016 - Sputnik International
An Indo-Russian joint working group is currently studying the latter’s proposal of returning to the rupee-ruble trade settlement by bypassing the dollar. Pronab Sen, an Indian economist, explains why this time around, Russia seems to be keener, but India is dragging its feet for such an arrangement.

New Delhi (Sputnik) — After a gap of over two decades, India and Russia are again mulling over the revival of the rupee-ruble trade arrangement. This time around, Russia seems to be keener, but India has some reservations.

Speaking to Sputnik, Pronab Sen, the country director for the International Growth Centre's India Central Program and former chief statistician of India, says that while there is justification for India's hesitancy in reviving this trade, the prevailing conditions are such that it makes eminent sense for both sides — provided appropriate precautions are taken. 

Sputnik: Many stakeholders in India, especially the exporters, have been urging the commerce ministry to put in place a rupee payment mechanism for trade with Russia. Is their enthusiasm valid and substantial?

Pronab Sen: Exporters always love this sort of bilateral arrangement since it provides them with a captive market. This enthusiasm by itself does not justify a rupee payment agreement since it can lead to at least two undesirable outcomes: diversion of Indian exports from third countries to Russia without any increase in the overall export volumes; and a reduced incentive to be effective among exporters.

Sputnik: What are your suggestions to minimize losses for India in such a trade mechanism? Some experts hold a view that the balance of trade will be in favor of Russia — is this view completely justified?

Pronab Sen: It is certainly true that in the past the USSR ran a substantial trade surplus in the rupee payment arrangement and, as a result, built up a large rupee balance in its account. It took more than 10 years to finally spend these funds.  However, a trade imbalance is not a matter of grave concern if the use of the rupee funds is restricted to trade and not to the acquisition of assets.

Sputnik: Who stands to gain from a direct Indo-Russia currency trade? Is it a win-win situation or it could be an imbalanced one? What would the advantages and disadvantages be for India?

Pronab Sen: There are two conditions which make rupee trade beneficial for Russia. The first condition is that the ruble has to be less overvalued relative to a common "hard" currency, say the dollar, than the rupee. Unfortunately, this condition cuts two ways in that if the arrangement is beneficial for Russia, it will not be so for India, and vice versa. During the time that the arrangement was in place, both the ruble and the rupee were grossly overvalued. However, the ruble was clearly vastly more overvalued than the rupee. Thus, the belief that India unambiguously gained from rupee trade was unquestionably true. On the other hand, the USSR appears to have been a loser, at least on this count, and thus the "trade as aid" view appears to have been justified to some extent.

Russian President Vladimir Putin and Indian Prime Minister Narendra Modi, left, during their meeting at St. Petersburg International Economic Forum 2017 in Konstantinovsky Palace in Strelna - Sputnik International
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The situation has changed dramatically since then. Today, the rupee and the ruble are roughly at par vis-à-vis the dollar at around 67 each. In other words, during the intervening 25 years, the ruble has depreciated by more than 2,200 percent against the dollar as compared to a 180 percent depreciation of the rupee. It is quite clear that the ruble is now undervalued, probably quite significantly. The rupee, on the other hand, continues to be overvalued despite persistent current account deficits, mainly on account of strong capital inflows.  Consequently, the balance on this count has tilted decisively in favor of Russia, which would at least partly explain Russia's eagerness and India's reluctance to revive rupee trade.

The second condition under which the rupee arrangement was beneficial for the USSR is more complex and depended upon the nature of the products exported by the USSR to India under the arrangement. If the goods exported by the USSR to India were such that both international demand and supply were not very sensitive to price changes in the short run, and if the USSR retained control over the quantities supplied to India, then the USSR unambiguously benefited if it calibrated its supply carefully.  

During the period under consideration, the main export from the USSR to India was crude petroleum (or oil), and there is no doubt that this condition was met. For most of this period, it may be recalled, the Organisation of Petroleum Exporting Countries (OPEC) was at its most effective and pretty much determined the world price of oil through restrictions on the output of its member countries. As a result, the USSR had to restrict its oil output below its potential. The rupee trade with India allowed it to increase its oil output without violating its commitment to OPEC. Indeed, the USSR could actually reduce its supply to the world market, thereby raising the spot price even further.  The benefit from both these effects to the USSR is obvious.

The situation is very different today. Although the demand for oil probably continues to be relatively price-insensitive, the same is not true for its supply. The shale oil revolution has made the supply of oil far more flexible than ever before,  and hence Russia may not reap the benefit that it got earlier from rupee trade. However, if a more strategic view is taken, it appears that the shale oil threat becomes credible only when the price of oil goes above about $65 per barrel. There is thus a fair range of oil prices over which an OPEC arrangement will be effective. Coordinated production cuts by the main oil producers are inevitable in the near future; in which case the argument in favor of the rupee arrangement again becomes valid for Russia.

Sputnik: On both counts, therefore, Russia stands to gain from a revival of the rupee trade arrangement. What about India?

Pronab Sen: There are two small pluses and one large minus. The first plus is that since the shadow price of the dollar continues to be higher than the official rate, any essential import that is switched from dollar payment to rupees is a gain. The second is that if the rupee is the medium of exchange with Russia, there is some seigniorage to be made for India. The minus arises from the overvaluation of the rupee vis-à-vis the ruble, which encourages higher inessential imports from Russia by India as well as the diversion of Indian exports from the world market to Russia. This negative, however, can be addressed through a suitably designed Indo-Russian agreement.

Sputnik: The rupee payment mechanism with Russia needs a role model. Is the past model with Russia sufficient?

Pronab Sen: Indeed, the agreement that was in force earlier provides a good template with some changes. It may, therefore, be useful to briefly describe the rupee trade arrangement as it existed. The USSR contracted to sell to India a fixed volume of specified commodities (mainly oil) during any given year under a bilateral annual trade protocol. The price payable by India for this supply was the dollar rate prevailing in the international markets at the time the supplies were affected. These dollar values were converted to rupees at the prevailing rupee/dollar exchange rate and were credited to the Soviet account maintained by the Reserve Bank of India (RBI). The USSR would then allocate these rupee funds to Soviet trading organizations for the purchase of goods from India. Since the rupee was not convertible, these funds could not be used for making purchases from third countries, but there were no restrictions on what could be imported from India.

A Russian ruble coin is pictured in front of the Kremlin in in central Moscow, on November 6, 2014 - Sputnik International
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This time around, there are two important differences that need to be taken into account. The first is that in the earlier period, all exports to India under the rupee arrangement were state controlled.  This is not so now — most products today are privately owned in Russia. The Russian industrialists are likely to demand a more open regime, but India should resist this and continue with a restricted list of goods that can be imported from Russia under this arrangement. The import list will almost certainly contain all Russian products for which the international markets have inelastic demand and supply, but can also include other products. which feature prominently in India's import basket. The only question here is the rising of such products which do not have readily available international benchmarks.  Given that the degree of misalignment of the rupee and ruble exchange rates at present is not particularly large, it may be left to the trading partners without much risk of damage.

The second difference is that the potential importers in Russia will also be private entities, and a mechanism will have to be put in place in order to ensure that the rupee funds are optimally utilized. A possible way to do this would be for Russia to buy all the rupee funds of exporters at the prevailing rupee-ruble exchange rate and then auction these funds to importers.

On the Indian export side, there are two dangers that need to be protected against: the first is the diversion of Indian exports from the international market to Russia; and the second is re-exports from third countries through the rupee payment route. Under other circumstances, it may have been desirable to draw up a positive list of permissible exports, which could include all products that are not major exports from India and such export products for which excess capacities exist in the country. However, in view of the state of the global economy and the fact that Indian exports have registered negative growth for the past eighteen months, such precautions are unnecessary and may even reduce the benefits from the arrangement. It should be sufficient to simply deny export benefits to all supplies made against rupee payment. This provision existed in the earlier arrangement as well and served the purpose quite effectively.  

Sputnik: Will the rupee-ruble arrangement help break American hegemony in trade negotiations. How will this upset the global trade equations if it happens? 

Pronab Sen — The rupee-ruble arrangement by itself will not materially affect the international trading order, but it will certainly help insulate our two countries from the volatility in the dollar. However, if such arrangements proliferate around the world, it will certainly eat into U.S. dominance. China has been using a similar instrument — the "currency swap" — to good effect since the global crisis started, which has played a significant part in making the renminbi a serious contender for "reserve currency" status.

The views and opinions expressed by Pronab Sen in this article are those of the speaker and do not necessarily reflect the position of Sputnik.

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