The Demonetization of the East

Summary: In December 2002, Poland decided to purchase 48 F-16 Falcons from Lockheed Martin Corporation - an American defense contractor. Pegged at $3.5 billion, this is the biggest defense order ever issued by an east or central European country.

In December 2002, Poland decided to purchase 48 F-16 Falcons from Lockheed Martin Corporation - an American defense contractor. Pegged at $3.5 billion, this is the biggest defense order ever issued by an east or central European country. The financial package includes soft loans and a massive offset program - purchases from Polish manufacturers that more than erase the costs of the deal in foreign exchange. Offset in all its forms - including co-production, licensing, subcontracting, and joint ventures - is not uncommon in the defense industry. It is being offered even to far richer clients such as Israel. But in central and east Europe it is more prevalent than the West realizes. According to numerous studies, barter-like arrangements (known throughout the region as "compensation") constitute between 20 and 40 percent of all transactions in the economies of the former Soviet bloc. Corporate debts to suppliers, payments for goods and services, even taxes - all have a non-cash component or are entirely demonetized. The implosion of communism led to a rapid shrinking of the manufacturing base and the evaporation of the agricultural and mining sectors in many countries in transition. Export-derived earnings in hard currency collapsed even as millions lost their jobs and their purchasing power. Unemployment affects one fifth of the population in Poland, one third in Macedonia and three fifths in Kosovo, for instance. Rather than remonetize these cash-bleeding economies, the IMF imposed strict austerity programs on the entire area, further eroding disposable incomes and intra-regional trade. Countertrade, barter, buyback, offset, clearing, technology transfer and other non-cash dealings flourished. Moreover, the clearing system of the now defunct eastern trade bloc, COMECON - the Council of Mutual Economic Assistance (CMEA), was based on effective barter and the use of a fictitious "wooden" ruble. From Hungary to Cuba, communist countries were coerced into outlandish terms of trade, often beneficial to the Soviet Union or to a member in need. Mounting debts led to the disintegration of the entire edifice and Russia was reduced to giving east European countries aircraft and other weapons systems in lieu of cash disbursements. Russia reimburses Kazakhstan with (shoddy) goods for leasing the Baikonur Cosmodrome. Until 2000, it was common practice in the Russian Federation to pay wage arrears, inter-enterprise debt and back taxes in kind. Russia and Turkmenistan accept food and other commodities, semi-finished products and construction services from Ukraine, Armenia and Belarus in exchange for their gas debts and, in Russia's case, for disposing of Ukraine's nuclear waste. The recipients often complain of the quality of the products or services they receive - and of recurrent breaches of delivery schedules and quantities. But they have little choice. Ukraine is one of Turkmenistan's major export clients, for instance. Nor are these exchanges post-communist phenomena. Canadian firms, led by AECL - Atomic Energy of Canada Limited - were forced to accept Romanian goods for their nuclear reactors throughout the late 1980s. There is a general misconception that barter is a thing of the past. Far from it. In the last six months of 2002, payments-in-kind to Gazprom, the Russian energy behemoth, have tripled due to an increase in its tariffs. The use of "veksels" (mostly corporate promissory notes) surged 60 percent. Hence the rise to prominence of barter experts, such as Igor Makarov, who, as general manager of Itera, oversaw Gazprom's sales of gas throughout the Commonwealth of Independent States. As prices are adjusted to reflect waning state subsidies, consumers' purchasing power diminishes and countertrade transactions burgeon. A global recession coupled with the woes specific to transition from communism to capitalism herald an era of unmanageable inter-corporate debt. In tiny Macedonia, it is thought to have surpassed $600 million in 2001 - close to one fifth of GDP. The bulk of such debt is ultimately settled by barter. Proponents of barter trade - mainly a proliferation of Western consultancies, financial boutiques and trading companies - count their advantages thus (from the Export911.com Web site): "Countertrade provides a means of trade with countries using a blocked currency - currency that is not readily convertible into other currencies - or lacking the foreign exchange, thus removing the difficulties and risks in a trade financing and paving the way for a successful deal that otherwise would fail. Countertrade also provides a means to preserve foreign exchange reserves by eliminating the use of hard currency." The US Embassy in Moscow counters by describing the nefarious effects of barter on the Russian economy: "In Russia, the barter system is used for various reasons: monetary risk, lack of money, illicit enrichment, tax evasion and to continue business operations beyond viable economic life. The system creates numerous negative effects, namely: low tax receipts, price distortions, oversupply of products, ineffective monetary policy instruments, imprecise economic measurements, and, as a consequence, poor public policy decisions. Barter is tolerated and sustained because of short-term management perspectives, its value as a social safety valve and poor application of bankruptcy laws." The demonetization of the economy and the distortion of the price signal (which ensures the proper allocation of economic resources) are not the only pernicious effects of non-cash business. Barter transactions tend to enhance the militarization of the region. No one wants Russian TV sets or Ukrainian stockings. But MiG fighter planes and Kalkan and Grif patrol boats are in great demand. Turkmenistan, for instance, has built an entire Caspian Sea coast guard out of its gas-for-goods agreement with Ukraine signed last year. Non-cash transactions are an integral part of the informal sector of the economy, estimated to constitute at least one third of the region's total gross domestic product. They are impossible to track, let alone tax. They are conducive to capital flight and offshore stashing of export proceeds. Technically, barter deals are a kind of non-tariff barrier as they interfere with the free market by binding specific buyers to given sellers. Hence the recent Russian-Chinese agreement to ban non-cash transactions in their border areas. Countertrade deals are complex and multi-phased. If improperly structured, they leave a lot of space for corruption and worse. Radio Free Europe/Radio Liberty reported that the military court of the Moscow garrison sentenced in April 2002 the former head of the Defense Ministry's Main Directorate of Military Budget and Finances, Colonel-General Georgi Oleinik, to three years in prison. In a typical scam - oft-repeated in Chechnya - Oleinik absconded in 1996-1997 with some $450 million. The money belonged to Ukrainian firms and was paid out in the framework of a multistage barter deal. It was earmarked for the purchase of materiel for the Russian army. Interestingly, in his defense, Oleinik insisted that the deal was authorized by former Finance Minister Andrei Vavilov and other senior officials. Still, in the long-run, barter is doomed. As more former Soviet satellites either divert their trade towards the European Union or join it as members, countertrade will be restricted to the financially backward economies of the former Soviet Bloc. In time, even these laggards will have to face market realities - especially the use of cash as the foundation of the price mechanism and the optimal allocation of scarce economic resources. Put vernacularly, the citizens of barter-addicted countries will inevitably grow disenchanted with shoddy and shabby goods delivered late. Imports from and exports to cash paying destinations will surge. "Ghost" factories will close down, releasing capacity to more productive entrants. Cash-starved governments will deepen and widen tax collection. A foreign-owned banking system will do a better job of matching savings to investments. Barter will be reduced to a marginal, last resort, activity.