THE SOVIET BLOC FINANCIAL PROBLEM AS A SOURCE OF WESTERN INFLUENCE

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP83T00966R000100030026-0
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 34
• Document Creation Date: December 21, 2016
• Document Release Date: June 17, 2008
• Sequence Number: 26
• Publication Date: April 8, 1982
• Content Type: MEMO

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THE DIRECTOR OF CENTRAL INTELLIGENCE
National Intelligence Council
DDI #2893-82
8 April 1982
MEMORANDUM FOR: Acting Director of Central Intelligence
FROM: Henry S. Rowen
Chairman, National Intelligence Council
SUBJECT: The Soviet Bloc Financial Problem As a Source
of Western Influence
1. Attached is a paper on The Soviet Bloc Financial Problem As a
Source of Western Influence prepared by Maurice Ernst in response to a
request from Hugh Montgomery, Director of Intelligence and Research,
Department of State. As you will note in the Montgomery memo
(Attachment 2), the paper was asked for by Secretary of State Haig so that
he might have a better overview of the main themes of East-West economic
issues.
2. We have already forwarded the typescript of the paper to the
Department of State and are in the process of releasing the paper as a NIC
Memorandum.
3. This is a very good overview of this topic in my view. It is well
worth reading.
Henry S. Rowen
Attachments,
As stated
State Dept. review completed.
Deriv Cl By Signer
All portions SECRET SECRET Revw on 8 Apr 88
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DDI #2893-82
8 April 1982
SUBJECT: The Sovit Bloc Financial Problem As a Source
of Western Influence
DCI/NIC/NI0/Econ:
Dist: (w/atts)
Orig - Addressee
1 - DDCI
1 - ER
1 - ExDir
1 - C/NIC
1 - DDI
1 - D/EURA
1 - D/SOVA
1 - DD/SOVA
1 - DD/OGI
1-
1-
1-
1 - DDI
1 - NIC/AG
1 - NI0/USSR
1 - NI0/AL (Hans Heyman)
1 - NI0/WE
2 - NI0/Econ
1 - SRP
25X1
25X1
25X1
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THE SOVIET BLOC FINANCIAL PROBLEM AS A SOURCE OF WESTERN INFLUENCE
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Key Judgments
The USSR and Eastern Europe are encountering serious hard currency
problems caused by systemic deficiencies, accumulated hard currency debt,
weak Western markets, and the Polish crisis. Private sources of long-term
credit to the Bloc have largely dried up. Poland and Romania are unable to
meet their hard currency obligations and most of the East European
countries will be forced to curtail imports. The USSR still has
substantial short term flexibility but its long-term hard currency earnings
prospects are poor.
These problems give the West an unusual opportunity to influence
Soviet Bloc developments, although there exists little direct leverage on
these countries' policies. The main instruments of influence are:
the volume and terms of new government-guaranteed credits and the
rescheduling of existing obligations. These actions can affect the Soviet
Bloc's ability to finance hard currency imports both directly and through
their impact on the willingness of private bankers to lend at their own
risk.
Western financial restrictions would further curtail the USSR's
ability to pay for hard currency imports in the 1980s and would thereby
increase Moscow's difficulty in coping with worsening economic problems,
including an already massive and rising defense burden. Hard currency
shortages might force Moscow to weigh financial costs more carefully before
embarking on foreign assistance programs or adventures. Such restrictions,
however, would not force Soviet concessions in important areas of foreign
or defense policies, such as Afghanistan. They could influence indirectly
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the evolution of Soviet policies, although the Soviet reaction might be
either aggressive or accommodating.
With respect to Eastern Europe, Western financial instruments--notably
the handling of Polish and Romanian rescheduling--can be used as sticks or
carrots. A strongly restrictive policy could trigger widespread debt
default, which would hurt the East European economies, force the Soviet
Bloc economies closer together, increase the burden on Moscow of supporting
its empire, and also create risks for the stability of the international
banking system. On the other hand, a liberal Western financial policy
would allow Hungary, and to a lesser extent Poland, some flexibility in the
choice of economic and social policies, and Romania, some limited
independence in foreign policy. By the same token, Moscow's economic
burden would be somewhat relieved.
The West's ability to use what potential influence its financial
instruments provide is substantially restricted, however, by differences
between the US and our West European allies as to the role and importance
of trade with the East. The Europeans view this trade as providing jobs at
a time of severe unemployment and as creating mutual interdependencies
which will tend to limit Soviet adventurism and provide bargaining chips
with Eastern Europe. The European governments, like the private bankers,
are concerned about excessive financial exposure to Soviet Bloc countries
but are not willing to severely restrict trade with these countries. The
common ground which does exist, however, may be sufficient to support an
informal agreement which has the effect of limiting the volume of new
government-guaranteed credit and of tightening their terms.
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TRENDS IN EAST-WEST ECONOMIC RELATIONS
Political detente in the 1970s helped to stimulate a massive increase
in the volume of East-West trade--more than a three-fold increase for the
USSR and about a doubling for Eastern Europe. Trade with the West also
grew as a share of most Eastern countries' total trade, with the most
dramatic increase occurring for the USSR. The importance of trade with the
West to the Eastern Bloc economies is greater than its share in their GNP
would suggest (3 to 7 percent in Eastern Europe and less than 2 percent in
the USSR). These countries all rely on the West for critical imports of
food, steel, and high quality equipment.
The expansion of East-West trade was aided by formal and informal
encouragement by Western governments, including a loosening of export
controls, and a massive expansion of credit. In the early 1970s, most of
the Western credit was in the form of government-guaranteed loans for
machinery and equipment sales. As trade surged, however, and contacts
multiplied, the USSR and the East European countries entered private
Western financial markets on a much larger scale than before. For example,
the USSR and several East European countries adjusted to the unexpected
drop in foreign exchange earnings during the 1975 recession by borrowing on
a large scale in the Eurodollar market. Encouraged by the detente
atmosphere, the Communist countries' excellent payments record, the belief
that Communist governments had the power to undertake any economic
adjustment that financial circumstances might require, and the assumption
that the USSR would play the role of lender of last resort for Eastern
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Europe, Western banks competed with each other for loans to the Eastern
Bloc. By the end of 1980 Eastern Bloc hard currency debt exceeded $80
billion (compared with only $8 billion in 1971), or nearly $100 billion if
the debt of the CEMA banks is included.
Poland has incurred the largest debt, about $25 billion. The other
East European countries have been more cautious, but Romanian, East German
and Hungarian debt ranges between $8 and $15 billion. The Soviet hard
currency debt surged from less than $2 billion in 1971 to over $10 billion
in the mid-1970s, leveled off in the late 1970s at about $18 billion as
Moscow restricted its hard currency imports, and then began to rise again
to over $19 billion (see Tablet ).
The Soviet Bloc Hard Currency Problem
A fundamental reassessment of the risk of lending to Soviet Bloc
countries has curtailed those countries' access to Western private credit
and made some of the remaining credit flows vulnerable to new negative
developments. The Soviet hard currency position has worsened greatly in
recent months and long term prospects are poor. Most East European
countries either cannot meet their hard currency obligations or must make
severe economic adjustments to do so.
The severe deterioration of the Soviet and European hard currency
positions has been due to the following factors:
o Increasingly evident systemic deficiencies, resulting in declining
growth of productivity and poor export performance.
o The logical implications of the rapid accumulation of hard currency
debt in past years--a process which obviously could not continue
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Table 1
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Soviet Bloc Hard Currency Debt
and Debt Service Ratio
Gross Hard
Currency Debt
($US Millions)
Debt lervice
Ratio
1970
1980
1970
1980
USSR
1,800
18,300
6
9
Poland
1,103
26,000
19
101
East Germany
1,416
14,500
14
55
Romania
1,639
10,700
36
25
Czechoslovakia
564
4,620
9
18
Hungary
601
8,700
16
30
Bulgaria
681
2,975
30
32
1) Repayments of and interest on medium- and long-term debt as a
share of hard currency exports.
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unless hard currency earnings were also growing rapidly, which they
are not.
o In the Soviet case, and to a lesser extent the East European
countries, events outside their control (Western recession, bad
crops, lower oil and gold prices, high interest rates).
o The Polish political crisis and economic collapse and its fallout.
o The general worsening of East-West relations, especially in the past
year.
These factors led to a fundamental reassessment of the risk of lending
to Soviet Bloc countries, which in turn has curtailed those countries'
access to Western private credit and made some of the remaining credit
flows vulnerable to new negative developments. In the past few months, the
possibility that Western governments might restrict or discourage credit to
Eastern Europe has created added uncertainty in financial markets and has
further discouraged bank lending.
The Soviet Problem
The Soviet hard currency position has worsened greatly in the last
12 months because of falling oil prices, bad crops, weak markets for other
exports and aid to Poland, and probably will remain difficult in the
foreseeable future. Last year, Moscow drew its hard currency assets to
dangerously low levels and has since had to sell large amounts of gold,
expand its short-term borrowing, and cut nonfood imports. With large gold
reserves (worth some $17 billion at a gold price of $300 an ounce) and
small fixed debt obligations (equal to less than 10% of export earnings),
Moscow has substantial flexibility to deal with its foreign exchange
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problems in the short run. Longer term prospects for increasing hard
currency earnings, however, are poor.
The chances are that the volume of Soviet hard currency exports will
stagnate or decline during the coming decade. Specifically:
o The volume of Soviet crude oil exports has been declining for three
years and, with domestic oil production likely to be at best
constant, and at worst in steady decline, it will be extremely
difficult to prevent a further drop, and eventually perhaps a
complete cessation, of oil exports for hard currency.
o Gas exports will continue to increase, but not on a large scale
until the Yamal Pipeline can be completed--which will probably not
be before the latter part of the decade. Even then the increase in
gas exports will probably less than offset the decline in oil
exports.
o Arms exports for hard currency appear to have leveled off for lack
of large new clients. Even current large customers, such as Libya,
may have to pare purchases if oil export revenues continue to
decline.
o Other Soviet exports (wood, metals, manufactures) are likely to
stagnate because of supply limitations and Soviet inability to adapt
to Western market needs.
Without the Yamal pipeline a sizable decline in exports would be
inevitable, even if Moscow redirected some of the gas to its own and
Eastern Europe's use in order to free some oil for export to the West.
With the pipeline and some good luck in oil development, the volume of hard
currency exports may be held about constant.
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Moscow's main hope for sizable increases in hard currency earnings
would be another large jump in the prices of oil, gas and gold--in the case
of oil, an event that appears unlikely in the next two or three years, but
increasingly likely during the second half of the 1980s.
If Soviet hard currency earnings are stable or declining in the long
term, Moscow will need to greatly increase its new borrowing from the West
to avoid a decline--even more to achieve an increase in its hard currency
import capacity. But, unless the new credits were on very easy terms, with
long maturities, the Soviet debt service ratio would reach dangerous
proportions within only a few years. For example, with average maturity of
new credits (other than for Yamal) of 5 years, and continuation of recent
interest rates, hard currency borrowings sufficient to raise import
capacity by 3 percent a year would push up debt service ratios to between
25 and 50 percent by 1985 and over 70 percent or more by 1990.
The East European Problem
East European countries' hard currency problem is far more severe than
the USSR's. Their gold and foreign exchange assets are minimal and their
debt service obligations are enormous. Leaving aside Poland, which is in a
class by itself, East Germany has a debt service ratio above 60 percent,
and the rest, except Czechoslovakia, are all above 25 percent. These
ratios put the East European countries in the same class as Brazil, Mexico,
and Chile, countries with far more flexible economies and generally rapidly
increasing export earnings.
Although Poland's 1981 private debt rescheduling agreement finally has
been signed, Warsaw has next to no chance of generating a large trade
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surplus or obtaining enough debt relief and credits to cover a 1982 debt
service burden of $10 billion. None of the possible outcomes to Poland's
financial mess is likely to improve the prospects for borrowing by other
East European countries.
Romania also is in de facto default--a problem which, like Poland's,
has hurt other East European countries' ability to borrow. Bucharest's
effort to reschedule its debt with banks is off to a smoother start, but
several obstacles must be overcome to conclude an agreement. Even with
debt relief, Bucharest would face a large financial gap. After sharp
import cuts in 1981, there is less scope for adjustment without damage to
the already strained domestic economy. Reserves are low and Romania is
reluctant to draw from its gold stock perhaps because some of it has been
used as collateral for loans. Large, additional cuts in imports would set
in motion an economic decline, such as has occurred in Poland.
East Germany and Hungary have multi-billion dollar borrowing needs
this year, and they are virtually shut out of Western capital markets.
Banks have been reducing their medium- and long-term exposure for the past
year, and in recent weeks, some West European banks have reduced their
short-term lines of credit. Even if the cutbacks are modest, East Germany,
Hungary, and Yugoslavia will face serious problems in 1982, but they might
be able to get through by recourse to government-guaranteed loans, supplier
financing, reserve drawdowns, and sharp import cuts.
Even if existing debt were rolled over, the East European economies
would at best limp along with little or no economic growth for the next
several years. It is important to keep in mind that Western credits played
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an important role in financing a large increase in investment in nearly all
East European countries during the 1970s, and that this investment was an
important factor in sustaining tolerable, if generally slow, growth
rates. This important prop for inefficient economies has disappeared.
THE POTENTIAL FOR LEVERAGE AND INFLUENCE ON THE SOVIET BLOC
The Soviet Bloc's hard currency problems coupled with deteriorating
economic performance throughout the Bloc presents the West with an
opportunity to exert a degree of influence over the USSR and its Warsaw
pact allies. Soviet Bloc dependence on Western credits for food, equipment
and technology gives the West the opportunity to use credits as an
instrument of influence.
A reduction in the availability of Western credits to the Soviet Bloc
would at least temporarily affect the Bloc's capacity to import Western
goods. For Moscow, declining hard currency imports would pose serious
problems. In the 1980s slower economic growth will present the Soviet
leadership with increasingly tough and politically painful choices in
resource allocation and economic management. Annual increments to national
output will be too small to simultaneously meet mounting investment
requirements, maintain growth in defense spending at the rates of the past,
and raise the standard of living. Simply stated, something will have to
give. The Soviet need for Western goods and technology will therefore
increase greatly. Imports can relieve some economic problems by raising
the technological level of key Soviet industries and by reducing shortages
of grain and such important industrial materials as steel. Western
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equipment and knowhow will be particularly important to raising
productivity in the critical machine-building and energy industries. The
Soviets must continue importing large amounts of agricultural products and
will probably expand their purchases of steel and some other industrial
materials.
The main Western government policy instruments affecting the flow of
capital to Soviet Bloc countries are: the volume and terms of government-
guaranteed credits; interest rate subsidies; rescheduling of past
government-guaranteed credits; and pressure on private banks. Moreover,
any official financial actions would surely have an indirect effect on the
willingness of the private sector to lend at their own risk to the Soviet
Bloc. Credits financed or guaranteed by Western governments make up about
one-third of the Soviet Bloc's total hard currency debt--with Poland, the
USSR, and East Germany having relied the most on such credits (see
Table 2).
The Direct Levers
Western governments have at their option a number of direct measures
to influence the flow of capital to the USSR and/or its Warsaw Pact allies.
To illustrate the direct impact of some such measures:
o A 3-percent increase in interest rates charged on the new
government-guaranteed credits--roughly the recent increase in OECD
Consensus rates for the USSR--provided at the 1981 annual level
would gradually increase interest payments for the USSR by roughly
$60 million a year, assuming a five-year repayment schedule and no
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Table 2
Soviet Bloc Dependency on Western Government-Backed Credits in 1981 Million US $
Soviet East Czech
Bloc USSR Poland Romania Germany Hungary Slovakia Bulgaria
Total hard currency debt
87 7 7 5 24.500
*000
10.700
14,730
8,250
4.620
3,975
Of which:
Government-backed debt
29,225 8.500
13,500
1,700
3,800
350
900
475
As a percent of total debt
33 41
52
16
26
4
19
16
Flows
Grass hard currency borrowing
40,
324
5 , 600
10,000
4.274
6,600
4,310
1,930
910
Grass borrowing from
government-backed credits
9 ,
715
2 , 300
5.750
360
700
100
265
140
As a percent of gross
borrowing
24
41
58
8
11
2
14
15
Asa percent of imports
88
5
10
2
6
6
Net change in stock of
government-backed debt
+ 300
+3,100
+300
+50
+50
+35
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grace period in repayments. The cumulative effect of such a policy
over a 10-year period, for example, would result in a total increase
of interest payments of some $1.5 billion for the USSR and $2-
2.5 billion for the Soviet Bloc, excluding Poland. It should be
noted, however, the aggregate numbers still pale in face of an East
Bloc financing requirement of hundreds of billions of dollars for
all of the 1980s.
o At the extreme, a moratorium on new government-guaranteed credits to
Soviet Bloc countries (excluding credits for the Yamal pipeline)
would reduce the net flow of Western capital by amounts equal by 5
to 6 percent of the 1981 level of hard currency imports. The
effects would take some three to five years to be fully felt as the
government-guaranteed credits under existing commitments were drawn
down.
o Western creditors could also declare Poland in default of its
obligations as a result of the initiatives of either private banks
or Western governments, but formal default would not of itself have
much impact on Poland's capacity to import from the West. It would
cause substantial but short-lived disruptions of Polish exports,
thereby reducing earnings. Polish default could have severe
repercussions for other East European countries, and for Western
banks. Private bankers' willingness to lend to other East European
countries would be even further weakened. Not only Romania, but
also Hungary and East Germany could be forced into debt rescheduling
or, failing this, into de facto default.
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The Indirect Impact
The greatest potential effects of Western government credit'
restrictions are of an indirect nature. They would come from the political
signal restrictions on government guaranteed credits would convey to
private lenders. It is highly unlikely that Western banks would be willing
to resume unguaranteed long- and medium-term lending if Western governments
were imposing politically motivated limits on government-guaranteed
credits. Short-term lending might also contract, depending partly on the
credit worthiness of the individual countries. To some extent, this effect
has already been felt by the Bloc.
As things now stand, no Soviet Bloc country has received any mid- or
long-term unguaranteed bank credit for almost a year. Shorter term credit
is available (except to Poland and Romania) but on less favorable terms
than in the past. To date, credit restrictions have come entirely from the
private sector, and not from any specific Western government action. The
current discussion over credit restrictions has contributed to an
atmosphere of uncertainty for the private banking community, however.
Pressure on the USSR could also be exerted via Eastern Europe. Soviet
trade with Eastern Europe helps to knit the Soviet empire together. All
the Eastern European countries, except Romania, depend on the USSR for one
third or more of their trade (see Table 3), including the bulk of supplies
of oil, gas and other critical commodities. But Moscow pays a high price
for this close relationship. By denying East European countries the
possibility of developing economies and economic systems that could be
reoriented mainly toward the West, Moscow has little choice but to provide
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Soviet Bloc
Trade Patterns
1980
(Percent of
Total Exports)
Exports To
USSR
East
Europe
Developed
Countries
Other
USSR
---
42.3
31.9
25.8
Poland
33.1
22.4
34.2
10.3
East Germany
35.5
24.5
24.3
15.7
Romania
20.7
19.1
34.5
25.7
Czechoslovakia
34.4
26.9
22.2
16.5
Hungary
36.6
26.6
23.7
13.1
Bulgaria
50'.0
16.5
16.9
16.6
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some direct and indirect forms of aid. The direct aid is in the form of
credits on bilateral account. The indirect aid takes the form of delivery
of undervalued Soviet raw materials and foods in return for overvalued East
European manufactured goods. Many of the commodities the USSR exports to
Eastern Europe are also sold on the world market, generally at higher
prices. The most important Soviet export--oil--is sold to Eastern Europe
far below world market prices. Most of the East European exports can be
sold on world markets only at severe discounts, if at all, but the Soviets
pay world market prices for them.
Before the Polish crisis and its negative impact on Soviet Bloc
creditworthiness, Moscow had planned to reduce its price subsidies on oil
exports to Eastern Europe, thereby forcing painful economic adjustments in
those countries. The Bloc hard currency crisis reopens the issue of Soviet
support.
A worsening of the East European hard currency and economic situation
is bound to impose additional burdens on the USSR. Moscow simply cannot
afford to let the East European countries go begging to the West by
themselves, or alternatively to let their economies deteriorate to the
point that serious political consequences could follow. Additional Soviet
assistance to Eastern Europe may or may not take the form of hard currency,
but even if it did not, there would be indirectly an unfavorable impact on
the Soviet hard currency position. By the same token, an improvement in
the East European economic situation would make it easier for Moscow to
reduce some of its economic burden of empire.
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The Limitations of Leverage and Influence on the USSR
This is not to say the West could force the Soviet Union to reverse
basic policies through the use of credit levers. Although Moscow could
make good use of increased imports from the West to help relieve its
serious and growing economic problems and Western aid to Eastern Europe
would serve to reduce the Soviets' burden, Western credit policy used
either in a negative or positive fashion would provide little direct
leverage on the USSR. It would be difficult to find any specific linkages
between Western credit policies and Soviet military and foreign policies.
The East-West interface is simply not broad enough to permit policy quid
pro quos which might be feasible given the nature and limited scope of the
economic restrictions and at the same time do not engage central issues of
national power and prestige. On these central issues there is little
chance that Western economic pressure on the USSR would induce Moscow to
become more accommodating. For example, the threat of Western credit
restrictions, or a promise to lift them once they have been imposed, could
not induce Moscow to withdraw from Afghanistan, or allow Poland to slip out
of the Soviet power orbit, or concede significant military advantages to
the West. Moreover, the Soviet economic problems are predominantly home-
grown, and cannot be greatly worsened by Western actions.
On the other side, Western economic pressure could provide hard line
Soviet leaders with an excuse for economic problems, a justification for
continuing dynamic military growth at the expense of the Soviet consumer,
and a political rationale for assuming a more aggressive stance in foreign
areas to show defiance of Western actions. There also exists a slight
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possibility that a sharp curtailment of Western credits could provoke
Moscow to declare a moratorium on the repayment of the Bloc's $80 billion
worth of debt to the West.
Within these limits, there remains the possibility that sustained
Western economic pressure could influence Soviet policy choices.
Restrictions on government-guaranteed credits, coupled with the likely
negative reaction of private lenders, would increase the cost to the USSR
of both civilian and military programs and thereby exacerbate the worsening
economic trends. It is reasonable to expect that the negative impact would
fall particularly hard on Soviet programs requiring large foreign exchange
expenditures, such as foreign aid to or other involvements in Third World
countries. Moscow might then give greater weight to costs considerations
in their policy decisions concerning such programs. Eventually, growing
economic stringencies could lead to major changes in Soviet policies and
priorities, although we see no sign that such changes are in the offing.
Leverage and Influence on Eastern Europe
Western economic leverage directed toward Eastern European countries
is potentially larger than that on the USSR because of their far greater
dependence than the USSR on economic relations with the West (Table 4), and
their lesser concern with national power and prestige. But Western
leverage on Eastern Europe is also severely limited by the present threat
of Soviet military control and the self-interest of Communist leadership
and elites in protection of the existing political system. Leverage,
moreover, is a two-way street. For example, West Germany for decades has
traded economic concessions to East Germany in return for limited rights of
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Table 4
Soviet Bloc Imports
from the Developed West
As a Share
of Total Imports
(percent)
As a Share
of GNP
1970
1980
1970
1980
USSR
24.0
35.3
0.7
1.7
Poland
26.0
33.7
2.4
3.9
East Germany
28.0
30.8
4.2
4.2
Romania
40.0
33.3
3.6
3.4
Czechoslovakia
24.8
24.0
3.1
3.3
Hungary
27.1
30.3
5.0
7.4
Bulgaria
19.3
17.7
3.7
4.2
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travel and access, and to Poland in return for the repatriation of ethnic
Germans.
Potential Western leverage or influence in Eastern Europe varies from
country to country. It is small in Czechoslovakia and Bulgaria, both
countries with a relatively small hard currency debt, close economic ties
with the USSR and hard line political leaderships. Although West German
economic leverage has been employed on East Germany, that country's central
role in sustaining the USSR's East European empire and military position in
central Europe leaves room for little political flexibility in relations
with the West. The possibilities for Western leverage and influence are
greatest in Poland, Romania and Hungary. It should be noted, however, that
realizing this influence requires use of both carrot and stick, for under
present circumstances positive Western government actions will be necessary
to avoid a further curtailment of Western trade with these countries.
The potential for Western political influence in Poland has been
greatly reduced by the imposition of martial law and the political dynamics
that this critical step set in motion. The present Polish leadership is
unwilling to share power in any meaningful way with the workers movement,
and the Soviets probably would not allow them to do so. This means that
Western actions can affect only those aspects of the Polish scene that are
considered politically safe by both Warsaw and Moscow. There remains
considerable uncertainty, however, as to how Poland can rebuild a workable,
if not efficient economy, and a tolerable form of political control.
Although the exigencies of martial law give the hard line elements in the
Polish Party a clear advantage for the present, competing political
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factions will push for diverse solutions, and there will be considerable
uncertainty as to what will work, what is politically safe internally, and
what will be acceptable to Moscow.
These uncertainties provide the West not so much with direct leverage
on the Polish government, as with a potential for indirectly influencing in
a small way Polish internal policies. So long as formal default, and the
consequent legal scramble for Polish assets can be avoided, reformist
elements in Poland can hold out the hope of some new Western assistance in
the future. Even more, a rescheduling by Western governments of Poland's
1982 official debt obligations, and/or acceptance of Poland as an IMF
member, would provide clear signals of support for Polish policies if these
were seen by the West as moving in the right direction. By the same token,
formal default would probably foreclose these options and would leave
Poland no alternative but to seek even greater Soviet support and economic
integration into the Soviet Bloc. Although Moscow might welcome these
added restraints on the restive Poles which would come with a formal Polish
default, it would be very unhappy at the prospect of adding to what it
regards as an already excessive level of economic assistance.
The degree of Western influence on Poland should not be exaggerated.
Western actions cannot affect Poland's foreign policies in any significant
way, its military position in the Warsaw Pact, or its fundamental political
system. Even the politically acceptable scope of economic reform would be
far less in Poland at this stage than in Hungary. Hungary was able to
undertake a substantial economic decentralization, but only years after
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Kadar had established a stable political base. By contrast, Poland could
expect any substantial decentralization of economic authority to quickly
become highly politicized, and to present a major threat to the Party's
monopoly of political power.
In Romania, as in Poland, the main Western policy issue is whether or
not to reschedule debt service obligations, and on what terms. A
successful rescheduling will not eliminate Romania's hard currency
problems, which are deep-seated, nor prevent a drastic slowdown in economic
growth. But it could give Romania some options other than a substantial
redirection of its trade from the West toward the Soviet Bloc. In recent
years, some 60 percent of Romania's foreign trade has been with non-
Communist countries and less than 20 percent with the USSR. Should Romania
be forced to make such a shift, the limited freedom of action Bucharest has
been able to exercise in its foreign policy will almost certainly be
greatly curtailed. These expressions of Romanian independence from Moscow,
although on largely peripheral issues, have been useful to the West. On
the other hand, accommodating Romania's economic needs would involve
substantial economic costs to the USSR.
Hungary has developed broad economic linkages with the West as well as
the CEMA countries and created a unique amalgam of central planning with
elements of market economy without in any way threatening the Communist
Party's monopoly of political power or the country's attachment to Moscow
in foreign policy. There are few indications that Moscow has opposed
Budapest's relatively liberal economic policies or would welcome an
opportunity to reverse them. Nevertheless, lack of access to Western
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credits could force a sharp curtailment of Hungarian trade with the West
and consequently greater economic dependence on Moscow. Hungary depends
little on government-guaranteed credits, but a great deal on medium-term
private credits, and these are highly vulnerable to changes in market
psychology. Membership in the IMF would provide both an important new
source of hard currency and a boost to market confidence in Hungary.
WESTERN EUROPEAN PERSPECTIVES AND INTERESTS
The differences of perspective and interests between the US and its
European allies concerning economic relations with the East make it
difficult to find common ground on which to base joint financial
restrictions aimed at the East and thus limits our ability to exercise that
leverage which exists.
The broadest agreement among the allies is in the private sector.
Bankers throughout the West are concerned about their financial exposure to
Soviet Bloc countries and would like to reduce it. They consider
themselves particularly overexposed in Eastern Europe but also have become
increasingly aware of the extent of the USSR's long-term hard currency
problem. Moreover, they see the severe worsening of East-West relations in
the past two years or so as substantially increasing the political risk
involved in any long-term lending to the Bloc.
To some degree the reduction in the Eastern Bloc's creditworthiness in
the private sector is reflected in the attitudes of Western governments.
As mentioned before, Western governments do not want to be saddled with the
heavy budgetary costs that would be entailed in a large scale bail-out of
19
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private bank exposure under government guarantees. Moreover, most Western
governments probably agree that they have excessively encouraged, credit to
the Bloc in the past and would prefer to reduce or eliminate the subsidy
element in this lending in the future.
This common ground becomes severely limited, however, by the following
considerations:
o Trade with the East is still viewed by the Europeans as promoting
their economic, political and strategic interests. West Europeans
view this trade as providing jobs at a time of severe unemployment
and as creating mutual interdependencies which will tend to limit
Soviet adventurism and provide bargaining chips with Eastern Europe.
o They give little weight to the argument that East-West trade
buttresses Soviet military power because of its small size in the
overall Soviet economy and the long established priority given to
the Soviet military.
o They are even more reluctant to reduce trade with Eastern Europe
than with the USSR because of their greater bargaining power with
the East European countries, the close bilateral economic,
historical and cultural ties with a number of them, and the belief
(or rationalization) that Western influence can spread through
Eastern Europe and eventually to the USSR.
More precisely, East-West trade plays a small role in the West
European economies but is important to certain industries. Even for West
Germany, which accounts for about one-fourth of OECD exports to the Soviet
Bloc, sales to the East amount to only about 6 percent of total exports and
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directly provide jobs for about 1 percent of the labor force. The relative
importance of trade with the Soviet Bloc increased sharply in the mid-
1970s, but has since been declining, and is now nearly back to what it was
in 1970 (see Table 5).
Nevertheless, the West European countries consider their trade with
the East to be important for both economic and political reasons:
o Although a small part of total trade, trade with the Soviet Bloc is
one of the most important sources of export earnings from outside
the European Community. In the case of West Germany and France,
exports to the Bloc about equal those to the United States and are
far larger than exports to Japan.
o About one-half of West European exports to the Soviet Bloc and the
USSR consist of machinery and steel. The Soviet Bloc, especially
the USSR, is an important market for West European steel and for
some types of machinery. For example, it accounts for about
15 percent of West German and 12 percent of Italian steel exports.
Some West European plants are almost exclusively dependent on the
Soviet Bloc market.
o During the current Western economic recession, there are few
alternative markets for exports to the Soviet Bloc. The US and
Western Europe are giving priority to fighting inflation. Many less
developed countries, faced with a massive debt burden and depressed
prices for their primary product exports, are forced to curtail
imports. Falling oil revenues are greatly slowing growth of the
OPEC market. Consequently, any source of increased or sustained
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Table 5
Soviet Bloc Share of Western Exports
1970 - 1980
(% of total exports)
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
West Germany
5.6
5.6
6.5
7.1
7.7
8.8
7.6
7.1
6.9
6.5
6.3
France
3.6
3.6
3.7
3.7
3.6
5.0
4.9
4.4
3.8
4.1
4.2
United Kingdom
3.1
2.6
2.7
2.5
2.6
2.9
2.6
2.5
2.6
2.3
2.3
Italy
5.3
4.9
4.2
4.4
5.4
6.2
5.3
5.0
4.3
3.7
3.5
Japan
2.3
2.2
2.6
2.2
3.0
3.9
4.2
3.3
3.3
3.2
2.8
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demand is important to the West Europeans. Moreover, the steel
industry is in secular decline, so that orders from the Soviet Bloc
are important in cushioning the needed adjustment in employment and
plant capacity.
o Perhaps most important, the Europeans see their political and
security interests best served by increasing economic contacts with
Eastern Europe and the Soviet Union to promote political and
economic stability there and to establish a web of interdependence
between East and West. For West Germany, moreover, ties with the
East are vitally important in keeping alive the ideal of German
reunification and maintaining a high level of personal contacts
between West and East Germans.
Although some groups within the West European countries--such as
certain conservative political parties and the military establishments-.-are
sympathetic to the view that Western exports to the East Bloc have at least
indirectly supported Soviet military efforts, these particular groups
generally have had little say in trade and credit matters. European
business interests and trade officials have consistently promoted increased
trade with the East as has most of the foreign policy establishment.
For all these reasons the West Europeans look favorably on trade with
the East and are reluctant to restrict this trade except where its specific
contribution to Soviet military strength can be demonstrated. Among our
major allies, West Germany and France have the strongest economic and
political stake in economic relations with the Soviet Bloc. Italy too has
substantial ties with the Bloc. UK interest is substantially less,
however, and Japan's is smaller than that of any West European country.
22
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The major West European countries have used government-guaranteed
credits as an important means of increasing exports to the Soviet Bloc.
These credits are particularly important in financing exports to the USSR
because a large proportion of those exports are for major projects, such as
gas pipelines and chemical plants, which require long-term credit
financing. About 30 percent of exports to the USSR, including the bulk of
exports of machinery and steel from the major West European countries have
been financed by government-guaranteed credits. At least for the next few
years, the Western governments will face a dilemma. They are loath to
increase an already large budgetary exposure to bank credits which are seen
as increasingly risky for both economic and political reasons. On the
other hand, they are under pressure to at least maintain exports to the
Bloc by providing increased credits under government guarantees to offset
the decline in Soviet Bloc access to the private credit market.
For all these reasons it is highly unlikely that our European allies
will accept any restrictions on government credits to the USSR or to
Eastern Europe, which would have the effect of forcing sizable reductions
of East-West trade. They may be willing to accept some sort of de facto
ceiling on credits or on debt exposure and some further reduction in
interest subsidies, but any such agreement is likely to be informal and
flexibly applied.
The European governments are extremely concerned with preventing a
spread of the Polish financial crisis to the rest of Eastern Europe. They
would very much like to see Poland's and Romania's 1982 debt service
obligations rescheduled and generally would like both Hungary and Poland to
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join the IMF. In addition, the West Germans want to avoid any public
discussion of East Germany's precarious financial position, for fear that
they will have to confront much more openly and dramatically the
inconsistencies between economic actions designed to maximize contacts with
East Germany and West Germany's key role in the Western alliance and the
European Community.
The strong West European views on protecting their economic ties with
Eastern Europe give the US some potential leverage with its allies, since
these may be willing to trade off some moderate restrictions on credits to
the USSR in return for some US cooperation on Polish and Romanian
rescheduling and Polish and Hungarian IMF membership.
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 ^NN~ uvcu i vi i ~cicaac wvuivui i I vi^ i wi u.' i vv~uvi wvv i vvv.'vv~u v
ON 25X1
DEPARTMENT OF STATE
THE DIRECTOR OF INTELLIGENCE AND RESEARCH
WASHINGTON
March 16, 1982
MEMOPANDUM FOR: Mr. Henry S. Rowen
Chairman
National Intelligence Council
SUBJECT Paper on East-West Economic Issues
I would be very grateful for your assistance on a project
of some urgency which the Secretary has requested; specifically,
he has asked for an overview of the main themes of East-West
economic issues, and the direction in wh&ch they are heading.
Essentially, he would like to examine the following topics:
A. The extent of Eastern European financial solvency, its
ability to meet both interest and debt repayment schedules, and
the implications of default by any one of the countries with
current problems (Poland, Hungary and Romania, for example);
B. The degree to which Western European businesses are
"dependent upon" their Eastern trading partners; put another
way, to what extent would a significant slackening of trade
between the East and West impact upon the economies of Western
Europe, Germany in particular?
C. An examination of the role of credit, and the
political leverage afforded by credit; how badly does Eastern
Europe need additional credits, and to what extent can their
being granted or withheld be translated into political pressures
on such subjects, say, as Afghanistan?
D. How effective would a joint economic policy with our
Western European allies be in the full panoply of relations
with Eastern Europe? Should we attempt to introduce the
shadings of differentiation into such discussions, and if so,
to what end?
These points represent a tall order, and I realize that
it will not be possible to do much more than an overall look-see
at the basic issues and related considerations, but I would
like to have something-in hand for the Secretary no later than
mid-April, if at all possible.
SECRET
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if his
The thought occurs that perhaps
other responsibilities permit, would be an ideal choice to
supervise the preparation of such a paper, knowing that any
product under his imprimatur would be a masterful effort.
Would you please let me know at your convenience add do an
assist with this problem, and if you require any
input from us? Many thanks for your help and contribution
on this important topic.
Hugh Montgomery
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