INTERAGENCY GROUP ON INTERNATIONAL ECONOMIC POLICY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85-01156R000200170023-3
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 15
• Document Creation Date: December 22, 2016
• Document Release Date: December 5, 2008
• Sequence Number: 23
• Publication Date: January 28, 1983
• Content Type: MEMO

EXECUTIVE SECRETAIIIAT
. Routing Slip
ACTION
INFO
DATE
INITIAL
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DCI
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DQQI
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EXDIR
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D/ICS
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DDI
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DDO
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DDS&T
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Chm/NIC
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GC
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IG
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Compt
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D/EE0
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D/Pers
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D/OEA
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C/PAD/OEA
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SA/IA
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 OFFICE OF THE SECRETARY OF THE TREASURY
WASHINGTON, D.C. 20220
January 28, 1983
UNCLASSIFIED
(With Secret Attachments)
MEMORANDUM FOR OVP
STATE
OPD
NSC
AGRICULTURE
CIA
COMMERCE
DEFENSE
USTR
CEA
OMB
ENERGY
INTERIOR
L 'c /T~l1l
-
MR.
PHILIP HUGHES
-
MR.
L. PAUL BREMER, III
-
MR.
LES DENEND
-
MR.
MICHAEL 0. WHEELER
-
MR.
RAYMOND LETT
-
MRS.
HELEN ROBBINS
-
COL.
JOHN STANFORD
-
MR.
DENNIS WHITFIELD
-
MR.
WILLIAM A. NISKANEN
-
MR.
ALTON G. KEEL
-
MR.
WILLIAM VITALE
-
MR.
J. ROBINSON WEST
Subject Interagency Group on International Economic
Policy (IG-IEP)
On Tuesday, February 1, 1983, at 11:00 a.m., Assistant
Secretary Marc Leland will chair an IG-IEP meeting in Room 4121
in the Main Treasury building. The meeting is to discuss
international oil prices. Attached, please find background
papers for the discussion.
Please telephone the name of your representatives to the
Executive Secretariat (566-2404) by noon, Monday, January 31.
Attendance is limited to principal, plus one.
UNCLASSIFIED
(With Secret Attachments)
 3. Effect of a Total Loss on Loans to Indonesia, Mexico,
and Venezuela
4. Economic Impact on U.S.
5. Impact on World Macroeconomic Situation
6. Impact on Energy Industry and Energy Policy
7. Effects on the U.S. Energy Situation
8. Country Data and Immediate Impact of Oil Price Drop
Treasury/ICE
January 28, 1983
 eV%nrr nrarrTsL 1/26/83
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A Sharp Decline in Oil Prices
During the past several months, continual softening of oil
prices has raised questions about the gains or losses that would
result from a fall in world oil prices. Last weekend's OPEC
disarray added to the timeliness of these questions. It has been
argued that a decline in real oil prices should be avoided. It
was argued that a decline in the real price would disrupt conser-
vation efforts; reduce exploration; and diminish incentives for
substituting energy sources -- with the view that this would
diminish energy security. These arguments rested on the belief
that earlier real oil price levels were appropriate in a long-
term sense and that temporary declines from a rising trend should
be avoided because the temporary gains would be outweighed by
slower adjustment to the high real price. We would reject that
premise because the dramatic increase in alternative supplies of
both non-OPEC oil and substitute energy sources and evident mar-
ket pressures for lower prices have shown that there was nothing
magical about OPEC's ability to determine 'correctly' an equilib-
rium level for real oil prices.
From an economic perspective the answer to the question 'are
lower oil prices good or bad7' is perfectly straightforward and
clear. Unambiguously, the non-OPEC world economy would be better
off with lower oil prices: real growth and employment would be
higher; inflation would be lower; and LDC debt problems on average
would be less severe. The non-OPEC world would enjoy more of its
output and have to transfer less to OPEC. These are the macro-
economic effects.
 CONFIDENTIAL
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There will,'however, be problems. Any sudden sizeable change
in the world economic environment can cause disruptions, change
expectations, and require structural changes. Adjustment to sub-
stantially different economic conditions proceeds neither smoothly
nor costlessly. Adjustment also takes time to occur fully.
In the short-run: (1) oil exporting LDCs already facing dif-
ficult debt situations would face worse financing problems; (2)
for the banking system, there may be serious debt servicing prob-
lems for some loans -- both domestic and international. From a
bank's perspective this has to be weighed against improvement in
other loans in their portfolios. (3) Some industrial country oil
producers would lose government revenue; and (4) specific energy
sectors would suffer losses. Furthermore, the losers will be
aware of their losses and can be expected to complain loudly; but
consumers enjoying lower heating bills and cheaper gasoline may
be less likely to express their appreciation to public officials.
But the conclusion about (permanently) lower oil prices is that
the U.S. is better off, as are most industrial countries; most
LDCs and Eastern Europe; a few industrial countries (Canada,
Norway, and the UK) will be worse off; OPEC will suffer income
losses; and the USSR will face reduced hard currency earnings.
The gains are fairly clear cut: after an oil price decline
to, say, $20 a barrel (a 40 percent drop) the results would be as
follows (the effects are roughly linear, thus a drop of half as
much, to $26 a barrel, would result in about half the effects
described below):
1. Real growth: The U.S. growth rate would rise somewhat
less than 1 percent by the end of the first year and
about 1.5 percent after the second year following the
price decline.
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 -3-
other industrial countries would see growth rise by
1 to 1.5 percents
-- non-oil producing LDCs could increase real growth 2
to 2 1/2 percent.
2. Inflation: U.S. down 1.5 to 2.0 percent in the short-run
and perhaps 2.5 percent after two years; others similar
gains depending on the relative share of oil in their
cost-of-living indices.
3. oil import bills: The 1983 oil import bill for industrial
countries will be reduced by $90-100 billion; (the U.S.
import bill alone by roughly $22 billion or about 1.5
billion net of increased demand for oil imports due to
lower prices).
-- LDC oil import savings could reach $9 billion.
4. Current accounts:
OECD total current account balance would swing into
surplus (from -$18 billion to +517 billion).
-- LDC exports could rise about 3 percent in real terms.
Their current account deficit could decline by $18
billion.
For the U.S. economy some industrial sectors would gain more
than others; those using oil and other energy sources the most
heavily as a direct input would gain the most. The gainers would
include chemicals and fertilizers, steel, transportation (airlines,
trucks), food processing, agriculture, automobile manufacturing,
etc. Of course, all users of energy for heat and light would be
gainers as well (hospitals, schools, retail sales, etc.).
Debt problems.
CONFIDENTIAL
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 Debt problems.
LDC problems. The only less developed countries
adversely affected from a drop in oil prices would be net
oil exporters, particularly those already facing serious
financial problems. Oil importing LDCs would have their
debt servicing capacity strengthened. Of the 10 largest
LDC debtors to commercial banks, only Mexico and
Venezuela are oil exporters; the other eight large debtors
would benefit from lower oil prices.
1. Mexico. If oil drops to $20 a barrel Mexico's
loses roughly $9 billion in oil revenues which must
be added to required net new bank borrowings (a drop
to $25 would mean a loss of $5 billion). Mexico
may be able to increase production and exports to
offset part of this loss. To date authorities have
not wanted to disrupt market conditins by pushing
exports, but if the market becomes disorganized
there is some scope for higher sales. In any event,
the banks would have little choice but to grin and
bear the new loan demands. Mexico would not likely
go belly-up and declare default. A seperate paper
is being prepared analyzing the possibilities of default
for Mexico and others.
2. Venezuela. At current production and export levels,
oil revenues would be roughly 7 billion at $20 a
barrel and about $5 billion less at $25. Again,
there is some scope for increased exports.
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CONFIDENTIAL
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OPEC. All members would face a sharp drop in oil earnings --
a decline on the order of $100 billion (at $20). Such a drop could
not realistically be covered by drawing down foreign exchange
revenues or by undertaking new private market borrowings (banks
would be very hesitant to make new energy related loans). Some-
thing like half of the revenue loss would have to be met by reduced
imports.
Banking System. Considerable concern has been expressed about
bank exposure in energy sector loans. The Comptroller's office
believes too much has been generalized from the Penn Square example,
where outright fraud affected the loan portfolio distribution.
Since early September, when we began focusing on the potential
effects of a sharp drop in oil prices, the OCC has been reevaluating
the potential exposure problems of energy sector loans. This
ongoing reevaluation has led to sufficient concern that the OCC is
now undertaking a "test case" study of an individual "typical"
energy bank to determine the likely loan problems. Results should
be available the week of January 24. As noted above, however, banks
would be "forced" to increase their exposure in Mexico and Venezuela,
and could not expect a corresponding rise in interest receipts. In
the absence of service payments, there will more likely be more net
lending with explicit rescheduling to these countries.
Commercial banks would see some outstanding loans reduced in
quality (e.g. to LDCs -- (Mexico, Nigeria, Egypt, etc and to
specific sectors -- oil developers, coal mining, etc) but would
simultaneously see some outstanding loans increased in quality
(to LDCS -- Brazil, Korea, Hong Kong etc and to sectors -- air
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CONFIDENTIAL
lines, shipping, steel, etc). So long as they have run relatively
balanced loan portfolios, the winners and losers will tend to
offset each other.
The elimination of OPEC's current account surplus will not
reduce the banking system's lending capabilities. Money previously
transferrred to OPEC to buy oil which OPEC then deposited with
banks will be kept in the industrial world. It will still end up
in the banking system. For example, suppose a U.S. public utility
spends $10 on Saudi oil which the Saudis saved and deposited with
Citibank, which then lent the $10 to Chile -- the classic recycling
process. Now the utility cuts electric rates, and consumers
deposit the $10 at First Chicago, which lends it in the Federal
Funds market to Citibank. Citibank is still able to lend to Chile.
There may be distributional effects among banks and countries, but
the money will still be available for lending to creditworthy
borrowers.
Industrial Country losers
Three industrial countries use earnings from domestic oil
production as a major revenue source: Canada, Norway and the
UK. The direct revenue losses to the British government -- before
any offsetting policy change -- would be sizeable for the UK
about 1.5 percent of GNP at a $20 oil price; and even greater for
Norway -- about 5 percent of GNP. But these revenues are dollar
denominated and part of the domestic currency loss could be offset
by exchange rate depreciation. Neither country would face external
debt problems as a result of the oil price decline. Canada is
essentially in net balance on energy. Most federal revenue from
CONFIDENTIAL
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CONFIDENTIAL
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energy would be lost at a $20 oil price, but the federal deficit
would rise (before adjustments and assuming the domestic price of
oil were allowed to fall) only from about $30 billion to $32.5
billion, a revenue loss of less than 1 percent of GNP. Perhaps
the principal effect would be to apply the coup de grace to an
already faltering Canadian energy policy.
Sectoral Problems
Fuel producing sectors -- oil, gas, coal, -- could expect
profit declines following a sharp decline in oil prices.
General
Perhaps the most difficult question is whether the oil price
decline would be temporary or permanent. If the current glut is
based solely on worldwide recession, economic recovery would quickly
firm prices and we would move back to the earlier trend line growth
of oil prices. If this were to be the case, the disruption and dis-
locations caused by the decline might outweigh the short-term
benefits and should be avoided by imposing a tax on oil -- the
revenues being used to reduce the budget deficit.
But if the decline reflects a combination of too high a real
price, increased use of alternative energy sources and non-OPEC
supplies, and general conservation regarding energy consumption --
which we generally regard to be the case -- then the decline will
not be temporary and the gains it offers should not be resisted.
CONFIDENTIAL
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 Implications for Banks of a Maior fall in Oil Prices
It'is difficult to predict the exact form in which a fall
in oil prices might affect the international financial system.
In analyzing the potential impact on the international financial
system, it is useful to construct a worst case scenario, in
which a severe crisis affected the major banks operating in
international markets. The attached table examines the impact
of such a serious financial shock to the banking system; namely,
that a heavily indebted oil producer is unwilling or unable to
pay interest and that banks, in response to pressures from
their auditors or regulators, set up reserves equal to 20
percent of their outstanding exposure to that country. Because
the costs of funding non-performing assets and provisions to
reserves are charged against the banks' pre-tax earnings, the
after-tax impact on profits and capital depends on the marginal
tax rate of the banks, which is roughly 50 percent.
The attached table presents the estimated impact on esti-
mated aggregate earnings of the nihe largest U.S. banks of:
(1) a loss in interest income or, and/or (2) creation of loan
loss reserves against exposure to the three major borrowers
amongst the oil producing countries (Indonesia, Mexico and
Venezuela). The calculations show the effects of a severe
crisis on the nine largest U.S. banks in the aggregate; the
impact on some will be greater while less on others.
The calculations in the attached table indicate that the
impact of Mexico's ceasing to service its debt would be to
reduce the aggregate earnings of the nine largest U.S. banks
by about two-thirds, while the impact of a similar scenario for
 Approved For Release 2008/12/05: CIA-RDP85-01156R000200170023-3
Venezuela would reduce the earnings of this set of banks by
about one-third; the effect of Indonesia imposing a moratorium
would be barely noticeable. Were all three countries to simul-
taneously cease servicing their debt, earnings for this group
would be wiped out. While in the aggregate the nine largest
U.S. banks could absorb even such cataclysmic shock, it is
likely that those with poor earnings and relatively large
exposure could experience losses. Aggregate (pre-tax) loan
loss reserves of about $3 1/2 billion as of September 1982 would
provide a second line of defense. Finally, the capital of
these nine banks was about $25 billion, so that even a total
loss on all loans to all three countries would, after taxes,
consume little more than a third of their equity.
The impact of a fall in oil prices on smaller U.S. banks
and non-banks is a bit more difficult to estimate. The exposure
of smaller U.S. banks to these countries tends on average to be
less in relation to capital and to earnings than at the largest
U.S. banks. However, there are cases where individual second-tier
U.S. banks have very large exposures to particular countries,
so a specific crisis could affect some individual smaller U.S.
banks more severely. In general, the problems for smaller
U.S. banks would be less severe.
Since the estimated exposure of non-U.S. banks to Latin
America relative to their size tends to be less than the exposure
of U.S. banks, they would be relatively less affected by any
problems, although again individual non-U.S. banks have large
exposures to particular developing countries.
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3
The conclusion from this exercise is that a serious prob-
lem on the part of Mexico -- far sore serious than anything
we hive seen so far -- could hurt but not destroy the profitability
of the largest U.S. banks. By themselves, crises in Indonesia
and Venezuela would have a perceptible but not critical impact
on bank profits; in conjunction with Mexico, they would eliminate
bank profits but not undermine the financial integrity of the
banking system.
Perhaps most important, our anlaysis suggests that continued
difficulties in debt servicing by these countries, similar to
those they have experienced in the past would have a substantial
impact neither on bank profitability not on the international
financial system.
 Impact of Default Scenario on Nine Larjest U.S. Hanks
(millions of dollars)
Oountry
Actual
Exposures
1/
June 1982
Indonesia
1,900
Mexico
13,600
Venezuela
7,150
Total
22,650
Estimated After-tax
Impact of Loss of
2/
Estimated After-tax
Impact of Requirement
to Reserve
Estimated Impact on Both
Loss of interest ad
ve
R
Interest 20 Percent of Exposure
'
eser
Requitement to
s
one Year
Percent of
i
lrnount
Percent of
Earnings
?rnount
Percent of
Earnings
Anoumt
ngs
Earn
105
3.2
190
5.8
295
9.0
750
23.1
1,360
41.8
2,110
64.9
12
2
715
22.0
1,110
34.2
395
.
1,250
38.5
2,265
69.6
3,515
108.1
urea year-end 1982 s ptestm d not to be significantly greater, given dcvelapments in
international bank lending.
Estimate based an 11 percent interest rates charged to borrowers and 0y perSalumm cent marginal as tmt oe".
Earnings for nine U.S. banks based on estimates of earnings per share f
Deohshber, 1982. Total estimated 1983 earnings for nine banks is $3,250 million.
 A possible concern that may arise if the world market
price of oil drops sharply to $20 or $25 a barrel is the effect
that such a price drop could have on the petrodollar holdings
in the United States of the major oil producing countries.
This concern, however, is unwarranted.
Assume that a major oil producer, such as Saudi Arabia,
has an account at a U.S. bank. Many of the payments by U.S.
producers for oil purchased from the Saudis have been deposited
in this U.S. bank account. These funds, therefore, have never
left the United States.
if the price of oil drops sharply, U.S. payments for oil
purchases will also drop. The Saudis will receive fewer dollars
to be deposited in their accounts. At the same time, U.S. oil
consumers will retain more dollars which will remain in the
consumers' U.S. bank accounts. Furthermore, instead of paying
the Saudis for oil, U.S. consumers might buy autos and food or
invest their funds. Their payments for such consumer and invest-
ment items would be deposited in the U.S. bank accounts of the
sellers. Although the banks in which the various accounts are
kept may not be the same, the funds continue to be a part of the
U.S. money supply which, in the aggregate, the Federal Reserve
can control. Thus, a sharp drop in the price of oil would not
precipitate a financial crisis within the United States. Even
if some dollars are transferred from one bank to another, this
can easily be accommodated by the transfer of banks reserves via
the Federal funds market within the banking system, or the sale
of assets by one bank to another.
If the Saudis draw down existing accounts in U.S. banks
in order to pay their debts as oil prices drop, the adjustment
process also can easily be accommodated within the United States
banking system. The Saudis would use their balances in their
U.S. account to pay for U.S. goods and services. The payment
process would simply involve the transfer of funds from one U.S.
bank to another, leaving the money supply unchanged. Only the
actions of the Federal Reserve can increase or decrease the
money supply.
If the Saudis use some of their funds in U.S. banks to
pay their debts abroad, this too should not have major rami-
fications. The foreign recipients of these funds presumably
could use some of the funds to purchase U.S. goods and services.
The funds, therefore, would find their way back into U.S. banks
either directly or through the Eurodollar market.
The effect on the world banking system is similar. Funds
paid by U.S. oil consumers over the years to oil producers have
been deposited in U.S. bank or offshore Eurodollar accounts. The
U.S. banks or Eurodollar market has then lent the funds around
the world. If spending on oil declines, the funds will still
exist in the U.S. or Eurodollar accounts of oil consumers, and
are still available for lending around the world by U.S. and
Eurodollar banks.