INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88-00798R000400090005-6
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 40
• Document Creation Date: December 27, 2016
• Document Release Date: June 20, 2011
• Sequence Number: 5
• Publication Date: July 25, 1986
• Content Type: REPORT

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Intelligence 25X1
Weekly
International
Economic & Energy
Seeret
DI IEEW 86-030
25 July 1986
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International
Economic & Energy Weekly
iii Synopsis
1 Perspective-South America's War on Inflation
3 Argentina: Austral Plan Running Out of Steam
7 Brazil: Uneven Progress Under the Cruzado Plan
11 Near-Term Oil Price Outlook
15 Kuwait-USSR: Expanding Economic Ties
Energy
International Finance
International Trade
Global and Regional Developments
National Developments
Comments and queries regarding this publication are welcome. They may be
directed to Directorate of Intelligence
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DI IEEW 86-030
25 July 1986
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International
Economic & Energy Weekly 25X1
Synopsis
1 Perspective-South America's War on Inflation
The civilian governments of Argentina, Peru, Brazil, and Bolivia-perceiving that
unabated price spirals in the three-to-five-digit range could be their downfall-
have moved boldly to slash inflation in the past year. In our judgment, however,
these gains will prove temporary unless greater attention is directed to eliminating
the root causes of inflation and labor demands for wage increases are held in check
in 1987.
3 Argentina: Austral Plan Running Out of Steam
Argentina's year-old economic austerity program, the Austral Plan, has reined in
chronic inflation and budget deficits, but President Alfonsin has largely failed to
exploit this success to reduce the size and role of government in the economy and
create a more favorable climate for private invesrtment. We expect the economic
gains from the program to dissipate over time and that Argentina's persistent
payments problems and strained relations with international creditors will re-
emerge.
7 Brazil: Uneven Progress Under the Cruzado Plan
Brazil's five-month-old Cruzado Plan so far has checked the growth of inflation.
While economic growth does not appear to have been hurt, the plan-because of
growing skepticism about the government's willingness to curb its spending-has
not dampened consumer spending, encouraged savings, or spurred investment, a
sign that Brasilia has not yet succeeded in breaking inflationary expectations.
The oil market during the next six months will be characterized by substantial
price volatility. We believe that oil prices will average between $10 and $15 per
barrel, but we do not expect a smooth pattern.
15 Kuwait-USSR: Expanding Economic Ties
Kuwait and the USSR have concluded an agreement that will strengthen bilateral
ties and provide Moscow loans and access to state-of-the-art Western oil technol-
ogy. If these projects are successful, Moscow probably will increase its use of
commercial arrangements for political as well as economic gains with other
Persian Gulf countries.
Secret
DI IEEW 86-030
25 July 1986
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19 LDC Banking Systems: Impact of Liberalization
The banking systems of some key LDCs are undergoing major changes as a result
of debt-related reform programs and past bad management policies. LDC
governments' efforts to liberalize their banking systems could complicate relations
with international creditors if further bank failures are the result.
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Perspective
International
Economic & Energy Weekly
creases are held in check in 1987.
The civilian governments of Argentina, Peru, Brazil, and Bolivia-perceiving that
unabated price spirals in the three-to-five digit range could be their downfall-
have moved boldly to slash inflation in the past year. In the face of growing
nationalistic sentiment and impatience with externally prescribed austerity, each
developed "stabilization formulas" independent of the IMF, although Argentina
and Bolivia subsequently concluded loan agreements with the Fund. These self-
designed programs are slowing South American inflation dramatically from a
1985 average of 280 percent to a projected 50 to 60 percent this year. In our judg-
ment, however, these gains will prove temporary unless greater attention is
directed to eliminating the root causes of inflation and labor demands for wage in-
money creation.
The centerpieces of the stabilization strategies adopted by Argentina, Peru, and
Brazil have been comprehensive and, ostensibly, temporary price and wage freezes.
Argentina and Brazil supplemented these controls with some significant reforms,
including issuance of new currencies and an end to indexation practices that
perpetuated past inflation. Deindexation and the price and wage freezes were
expected to break the psychological back of spiralling inflation, restore savings and
investment incentives, and give governments time to address structural imbalances
in their economies. For these three countries, stronger fiscal and monetary
discipline has played a secondary role in their strategies. Only in the case of
Bolivia did the government's anti-inflation package closely resemble conventional
IMF prescriptions. La Paz has made large reductions in government spending,
substantially reduced the public-sector deficit as a percent of GNP, and stopped
administrations of Presidents Alfonsin, Garcia, and Sarney.
All four programs have throttled inflation effectively, but the consequences have
differed. In Bolivia, real wages and social programs have borne the brunt of the
stabilization efforts although the Paz Estenssoro administration has not come
under any immediate threat so far. In contrast, the price freezes in Argentina,
Peru, and Brazil have come to represent a form of "tax" on the countries' private-
sector producers but led immediately to sharp cuts in monthly inflation rates,
widespread popular support for the programs, and immense political gains for the
1 Secret
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We believe the prospect for long-term success is clouded for all four stabilization
programs, despite their differences. Bolivia-already impoverished-cannot sus-
tain continued draconian measures without substantially increased foreign finan-
cial assistance. Moreover, the government will be hard pressed to withstand
intense pressure from labor for large wage increases, traditionally a major
determinant of inflation in Bolivia. In the other countries, the selective gains of the
price freezes in the early months-not the least of which have been political-may
obstruct the longer term economic prospects for success. In our judgment,
Argentina and Peru are backing away from earlier plans to slash bloated public-
sector spending and are maintaining the major parts of their freezes longer than
initially indicated. The Brazilian Government, bent on getting its favored candi-
dates elected to Congress in November, may be headed down the same path.
Excessive reliance on price freezes, we believe, will have self-defeating effects.
Instead of providing incentives to save and invest, the controls-if maintained-
will fuel ongoing consumer spending booms while prompting private investors to
delay plant expansion until further government intentions become clearer. As a
result, product shortages are likely to grow, black markets may develop, and
inflationary pressures will mount. Already, in Argentina, Peru, and Brazil
inflation rates are inching up as businesses ways to circumvent government ef-
forts to enforce price controls.
Before prices can be fully decontrolled, the governments of Argentina, Peru, and
Brazil need to begin important structural adjustments such as slashing government
subsidies, privatizing more state-owned corporations, and cutting government
payrolls. The danger is that the government leaders in these three countries will
continue to shirk tougher reforms and squander their opportunities to create the
conditions for low inflation and high growth in the future. President Sarney's
announcement this week of new measures to reinforce Brazil's fight against
inflation falls short of redressing structural imbalances but does hold out some
hope that Brasilia may be willing to take increasingly tough steps to ensure the
program's longer term success. As for Bolivia, its government probably will be
unable to withstand political opposition and pressure from labor for large wage
hikes unless additional foreign financial assistance becomes available to lessen the
social sacrifices required to make needed adjustments.
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Argentina: Austral Plan
Running Out of Steam
Argentina's year-old economic austerity program, the
Austral Plan, has reined in chronic inflation and
budget deficits, but President Alfonsin has largely
failed to exploit this success to reduce the size and
role of government in the economy and create a more
favorable climate for private investment. Although
Alfonsin may tinker further with economic policy, we
doubt he will carry out the radical restructuring
needed to generate long-term growth. We therefore
expect the economic gains from the program to
dissipate over time, and that Argentina's persistent
payments problems and strained relations with inter-
national creditors will reemerge.
The Austral Plan worked quickly to stabilize the
economy. Its freeze of wages and prices, introduction
of a new currency, and end to printing-press financing
slashed monthly increases in the consumer price index
from more than 25 percent during the first half of
1985 to 3 percent during the second half of the year.
The government deficit as a share of GDP shrank,
and real wages leveled off from their free-fall. Alfon-
sin's popularity as measured by public opinion polls
soared.
The economic program, which stole the public spot-
light from labor unions and opposition parties de-
manding a moratorium on foreign debt payments, was
also popular with the international financial commu-
nity. The plan paved the way for a revised $1.4 billion
standby agreement with the IMF and $4.2 billion in
new lending from commercial banks. Buenos Aires
liquidated its interest arrearages-many of which had
been pending since 1982-and increased reserves by
$1.9 billion, according to US Embassy reporting.
In addition, the program set the stage for short-term
industrial improvement. Euphoria over price stability,
combined with uncertainty over how long it would
last, increased demand for consumer durables. Manu-
facturing, steel production, and electricity consump-
tion all rose significantly during the first quarter of
1986 over year-earlier levels, according to press re-
ports. Help wanted ads indicate that demand for labor
has risen sharply over the past year.
Disappointing Followthrough
Despite its initial promise, the Austral Plan has
turned out to be largely an emergency measure to
overcome hyperinflation and maintain political stabil-
ity, rather than a well-conceived project to reform
Argentina's economy. We believe that Alfonsin frit-
tered away his political honeymoon following the
plan's implementation, missing what the US Embassy
has dubbed "an historic opportunity" to introduce
structural reforms that could have spurred private
investment and reduced Argentina's bloated public
sector. The policy supplements that Buenos Aires has
added to the Austral Plan in the last six months
confirm our view that Alfonsin is resigned to making
only incremental changes that will not reduce signifi-
cantly the government's role in the economy.
Alfonsin's recent initiative to privatize six large state-
owned enterprises-a badly needed move in a country
where the government controls over 350 companies
and state activity accounts for one-half the GDP-is
only a drop in the bucket. Moreover, few Argentine
firms have sufficient capital to acquire these compa-
nies, and stiff nationalistic resistance is likely to
hamper foreign purchasers. At the same time, Alfon-
sin announced a list of companies he would not
privatize that includes the largest money losers. He
has also created a ministry to oversee state enterprise
activities and announced a hiring freeze in a bid to
stem their losses. We doubt, however, that the Presi-
dent will be much more successful than his predeces-
sors at increasing efficiency of the public concerns.
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Argentina: Economic Indicators, 1985-86
GDP Growlha
Percent
I
1985
Treasury Surplus Deficit
Million Australes
I
1986
Monthly Inflation
Percent
I I I I I I I I I I I I I I I I I I
0 J F M A M J J A S O N D J F M A M J
1985 1986
Demand for Labor
Index: 1974= 100
20
Percent change from year-earlier levels. ?Due to a strike at the Central Bank, some public employees salaries were not paid on
b Including collections from forced savings plan. time. Had they been paid, a deficit of 200 million Australes would have resulted.
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He has already pledged to avoid the massive layoffs
needed before profitability could be restored.
In the area of banking reform, Argentina lowered
100-percent reserve requirements and allowed banks
to introduce a free-market interest rate. It then
partially negated the effect by requiring banks to
deposit the money freed by this measure in blocked
accounts and to purchase Central Bank bonds yield-
ing government-regulated rates of return with money
deposited in "free" accounts. There was little attempt
to improve the efficiency of the overstaffed and costly
financial system, and credit remains expensive and
scarce.
This spring Alfonsin replaced the wage and price
freeze in force since June 1985 with an administered
price system. The new scheme, however, is scarcely
more market oriented than the freeze: it clamps
maximum prices on 50 essential products and requires
case-by-case approval of price hikes on other goods
produced by medium- and large-sized firms. This
system is already bogging down-a strike in the
Commerce Ministry forced the government to set the
most recent changes unilaterally.
Buenos Aires has, for the time being, closed the gap
between official and parallel market exchange rates,
which will help make exports more competitive.
Moreover, it obtained World Bank financing for a
scheme to replace export taxes with a production-
enhancing tax on land. We believe, however, that a
new plan to promote industrial exports could backfire
as it widens the bureaucracy's discretion in awarding
incentives and complicates the regulatory maze al-
ready confronting exporters.
refunded after five years-funnels surplus capital to
the government and discourages foreign investors
from making new commitments. Tight money policies
have helped stem the flow of capital abroad, but the
government has had little success inspiring Argentines
to repatriate their capital.
In addition, Alfonsin is losing room to maneuver
politically. Recent public opinion polls show that his
popular support, while still high, is beginning to erode.
Nationwide strikes-a 24-hour work stoppage last
month was honored by 70 to 80 percent of the
population in Buenos Aires, according to US Embassy
reporting-underscore labor's impatience to regain
real wages lost before the program was implemented.
Farmers, too, are becoming increasingly vocal; they
recently struck for 48 hours to demand relief from low
commodity prices and high export taxes.
Meanwhile, Argentina's international position re-
mains precarious. Flooding in agricultural areas last
fall contributed to a 20-percent drop in exports during
the first three months of this year, the Embassy
reports. Despite last year's sizable debt rescheduling
and the $875 million the IMF and commercial banks
disbursed last month, Buenos Aires is not meeting all
of its current commitments. Argentina continues to
unilaterally withhold payments on Paris Club debt
due this year, and makes only sporadic payment on
the rescheduled bilateral debt, according to a US
government official.
Alfonsin may further refine the Austral Plan over the
next year, but we judge that he is unlikely to an-
nounce an "Austral Plan II" centered around far-
reaching fiscal and structural reforms. The President
and his economic team believe their gradualist ap-
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The bloom of Alfonsin's initial success is already
starting to fade. GDP growth during the first quarter
was an unimpressive 0.4 percent. Inflation has begun
to inch up over the past four months, and this year's
fiscal deficit will probably equal 6 percent of GDP-
double the government's initial projection. Investment
continues to stagnate as a forced savings plan-
essentially an additional tax that is supposed to be
proach toward recovery is working,
Moreover, Buenos Aires's
economic decisions are molded primarily by politics,
and it is likely that Alfonsin believes that radical
adjustments are not politically feasible at this time
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Over the long run, however, the outlook is somewhat
more hopeful. Alfonsin's turn toward free-market
solutions such as privatization, wage increases based
on productivity gains, and the promotion of foreign
investment-all previously associated with the dis-
credited military regime-is, in our view, helping to
change the rhetoric of Argentine economic policy
making for the better. Alfonsin has laid some of the
groundwork that may enable a more secure civilian
government to take bolder actions at a later date. The
President's proposal to move the capital to Viedma-
in the underdeveloped southern portion of the coun-
try-could be a politically acceptable way to cut the
size of the government, as thousands of employees are
expected to quit rather than move from Buenos Aires.
Declining interest rates and a favorable reserve posi-
tion have diminished short-term pressure on the debt
front, although problems are likely to resurface next
year.
We believe Buenos Aires
will eventually conclude a new IMF standby agree-
ment, but will continue its pattern of falling in and out
of compliance during the coming year.
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Brazil: Uneven Progress Under
the Cruzado Plan
Brazil's five-month-old Cruzado Plan so far has
checked the growth of inflation. While economic
growth does not appear to have been hurt, the plan-
because of growing skepticism about the government's
willingness to curb its spending-has not dampened
consumer spending, encouraged savings, or spurred
investment, a sign that Brasilia has not yet succeeded
in breaking inflationary expectations. Because the
plan is still very popular with the general public,
Brasilia appears reluctant to make major adjustments
to the program before the important November do-
mestic elections. Although President Sarney an-
nounced new measures this week, they were little
more than fine-tuning adjustments. Even so, if rosy
economic forecasts for the remainder of this year hold
up, Sarney will enter the November elections in
strong shape. In order to prevent the unraveling of his
Cruzado Plan next year, however, we believe the
President will need to ease the controls soon after the
elections and, at the same time, exercise tighter
budget and monetary restraint.
The Cruzado Plan has brought the Sarney adminis-
tration good economic news. Deindexation-the elim-
ination of automatic price adjustments to compensate
for past inflation-and the comprehensive price freeze
have for the time being broken the inflationary spiral.
Since February, monthly consumer price increases
have averaged less than 1 percent, a drastic reduction
from the nearly 15-percent average in the months
leading up to the plan. With lower prices and higher
wages, consumer spending remains strong, at least
temporarily removing the fear that the stabilization
package will lead to a recession. The deceleration of
inflation, according to an Embassy report, has also
caused a sharp decline in interest rates, although
nominal rates are still significantly above measured
inflation, especially for consumer credit.
Indexation offindncial assets was eliminated, except
for passbook savings accounts that will be corrected
for inflation on a quarterly basis.
All prices were frozen for an indefinite period.
A new currency, the cruzado, replaced the cruzeiro.
One cruzado equals 1,000 cruzeiros.
The dollar/cruzado exchange rate was fixed at
13.84 cruzados per dollar for an indefinite period.
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Wages were increased 8 percent above their average
value during October 1985-February 1986. The mini- 25X1
mum wage was boosted one-third to 804 cruzados
($58) per month.
Wages will remain frozen for a year or until cumula-
tive inflation reaches 20 percent. Future cost-of-living
adjustments will guarantee only 60 percent of past
price increases, with the other 40 percent negotiable.
Rents and mortgage payments were frozen for a year.
A limited form of unemployment insurance was set
up. Eligible workers will draw up to 1,206 cruzados
per month ($87) for up to four months.
President Sarney has reaped
substantial political benefit from his bold economic
move. USIA polls indicate that his public approval
rating-which stood at 35 percent before announce-
ment of the plan-has reached an unprecedented 90
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Brazil: Monthly Consumer Price
Inflation, 1985-86
percent. According to the polls, most Brazilians be-
lieve they have benefited from the plan; the price
freeze has been hailed by middle-class consumers, and
wage earners have benefited from the 8-percent boost
in real wages. Moreover, press reports indicate that
the wage freeze is supported by most businessmen,
although the hurried imposition of price controls has
drawn their ire.
The program has also set in motion some market-
oriented reforms necessary to strengthen Brazil's
economy. The US Embassy reports the domestic
banking system was quick to recognize that deindexa-
tion would mean the end of huge profits from invest-
ing in indexed securities. Banks are streamlining their
operations through layoffs and branch closures, and
the government has enacted legislation to allow them
to charge fees for various services. Moreover, stock
prices surged as Sao Paulo's market index rose nearly
85 percent during March and April. Government
officials are publicly expressing confidence that the
stock market will become a source of equity capital
for Brazil's heavily indebted private sector.
investment in additional capacity.
We believe that the decision to proceed with the
Cruzado Plan was predicated on Brasilia's conviction
that inflationary expectations had become so in-
grained as to constitute a major impediment to contin-
ued high levels of growth and that shock treatment
was necessary. Stable prices were expected to stop
consumers from hedge buying and increase incentives
to save. The architects of the plan also hoped that the
drastic reduction in inflation would spur badly needed
sharply declined from March through May.
To date, however, neither consumers nor businessmen
have reacted to the plan as expected. The US Embas-
sy reports that consumers went on a spending spree,
with retail sales increasing more than 40 percent
during the first three months of the plan. Much of the
spending, however, was fueled by drawdowns of sav-
ing accounts. Consequently, passbook savings-a key
financial instrument for capital formation in Brazil-
Meanwhile, new business investment continues to be
sluggish while overall capacity utilization is about
80 percent, according to the US Consulate in Sao
Paulo. Various investor surveys report most business-
men are still inhibited from sinking money into plant
expansion because profits have been cut by the price
freeze and because of uncertainty about future remov-
al of price controls. Instead of investing in additional
capacity, businessmen are di-
verting production into more lucrative export markets.
In addition, a, recent wave of wildcat strikes in Sao
Paulo's important industrial park indicates that labor
support for the Cruzado Plan is faltering. Nearly
50,000 workers in more than 40 businesses are now on
the picket lines demanding higher wages, according to
the US Consulate in Sao Paulo.
This behavior on the part of consumers, businessmen,
and labor indicates to us that the Cruzado Plan has
done little to dampen the psychology of inflation.
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black markets and hoarding.
Indeed, reporting in Brazil's financial press indicates
that investment in real estate and demand for dollars
on the unofficial market-both traditional barometers
of inflationary expectations-have increased rather
than declined since 1 March. Moreover, the combina-
tion of rising demand and capacity constraints is
causing the economy to begin to overheat, as evi-
denced by recent spot shortages of a wide range of
goods. Although the government is encouraging im-
ports to fill supply gaps, we believe the persistence of
shortages could introduce serious distortions, such as
A significant part of the problem, in our view, is that
Brasilia has not followed through on its pledges to
curb its own spending habits. Soon after implement-
ing the package, government officials contended that
the real public-sector deficit would drop to only 0.5
percent of GDP this year, from last year's 3.2 percent,
on the strength of increased taxes legislated last
December. In contrast, large deficits registered dur-
ing the first two months of the plan have led officials
to admit that this year's deficit is likely to match last
year's. According to the press, the government has
introduced a subsidy to ensure ample supplies of milk
and has granted tax breaks to some industries hit hard
by the freeze-measures that enlarge the deficit.
The government's monetary management is more
difficult to gauge. Despite reforms earlier in the year
designed to break the rapid rise in the money supply,
official statistics indicate that the monetary base has
increased by more than 90 percent since March. The
government argues that this has not been inflationary
because velocity has dropped dramatically; this is
probably true, as consumers are now more willing to
hold currency, but no data are available to confirm
this. The US Embassy suggests that rapid expansion
of the monetary base is slowing, as the economy
adjusts to lower prices.
These signs of trouble have not been lost on Brazilian
economists such as former Planning Minister Delfim
Netto and former Finance Minister Henrique Simon-
sen, who are expressing doubts in the press about the
viability of the program. Although they agree that
deindexation is an important first step, they argue
that the price freeze is not sustainable over a long
period. Moreover, these economists contend that the
public deficit will need to be controlled in order to
prevent inflationary pressures from resurging. In Ad-
dition, many experts are questioning the wisdom of
the fixed exchange rate and are urging the govern-
ment to return to a policy of minidevaluations. Others
advise more import liberalization and reform of the
domestic capital market.
Brasilia has been making economic adjustments in an
effort to keep the program from faltering. In an
attempt to prevent overheating, the administration
recently tightened consumer credit terms. The Na-
tional Monetary Council enacted measures to make
savings accounts more attractive, and, in June, depos-
its exceeded withdrawals for the first time since
February. Measures to cool stock market speculation
were implemented in late April, but new issues and
prices in May and June were still higher than before
deindexation. The government is considering legisla-
tion that would limit use of the parallel market in
foreign exchange, according to the US Embassy. To
enhance monetary control, Brasilia also has limited
lending by state-owned banks.
While such measures are important, the government
recognized they would not be enough, and, according-
ly, unveiled new measures this week to shore up the
Cruzado Plan. According to press reports, Brasilia
took actions designed to dampen demand, encourage
savings, and stimulate investment. These include:
? Excise taxes ranging from 25 to 30 percent on
automobiles, fuel, foreign travel, and on the pur-
chase of dollars.
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? Creation of a fund to stimulate investment to be 25X1
capitalized by the tax revenues.
? Easing of restrictions on foreign investment.
The new measures probably will cool off the overheat-
ing economy and may help to promote some invest-
ment. However, President Sarney continues to avoid
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making major adjustments to the plan-a course he is
likely to continue through the gubernatorial and
congressional elections set for November. He will
probably be particularly loath to ease the price freeze
because of its immense popularity, according to the
US Embassy. Likewise, deep spending reductions
would be politically difficult in an election year.
Consequently, we believe the government probably
will continue to respond with fine-tuning adjustments.
These relatively minor adjustments should be suffi-
cient, in our view, to drop inflation from the 235-
percent level recorded in 1985 to about 70 percent this
year. We further anticipate that strong consumer
demand will lead to an economic growth rate of 5
percent this year and will forestall major discontent
with the program through the end of this year.
Against this backdrop, we believe that moderates will
make gains in the congressional elections and leftists
will be kept in check.
At the same time, however, we believe Sarney will
have to move fairly soon after the elections to address
fundamental problems that, if not dealt with, could
lead to the ultimate unravelling of the Cruzado Plan.
To prevent shortages and to stimulate investment, we
believe Sarney will need to ease price controls quickly.
In addition, he will have to implement tighter fiscal
and monetary policies to prevent a resurgence of
inflation as the controls are loosened. The key indica-
tors of Sarney's resolve to tackle these problems will
be his willingness to implement measures to reduce
government subsidies, privatize state-owned enter-
prises, cut government payrolls, and avoid financing
the public deficit by increasing the money supply.
Secret 10
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Near-Term Oil Price Outlook
The oil market during the next six months will be
characterized by substantial price volatility. The in-
teraction of several variables-seasonal swings in oil
demand, inventory behavior, producer intentions, and
market psychology-will determine the extent of
price fluctuations. We believe that oil prices will
average between $10 and $15 per barrel, but we do
not expect a smooth pattern. Indeed, prices could
plunge well below $10 per barrel followed by quick
turnarounds. Under no circumstances do we antici-
pate that prices will rise above $15 per barrel unless
the Saudis decide to drastically change course. At this
time there are no signs that Saudi Arabia is prepared
to pare production.
OPEC production in June-including natural gas
liquids-averaged nearly 20 million b/d, some 3
million b/d above average 1985 levels. Nearly all the
gain reflects increased Saudi output, which is now
hovering around 6 million b/d. The only offset to
Saudi gains has been a 500,000 b/d to 1 million b/d
decline in non-OPEC output due in large part to
marketing problems. On the consumption side, we
estimate non-Communist oil usage during first half
1986 was about 500,000 b/d above last year's levels,
less than some oil companies had expected. Delays in
passing on lower crude costs combined with sluggish
economic growth is for the most part responsible for
the modest rebound in oil use.
OPEC has met four times so far this year to try to
resolve its differences over the production-sharing
issue. In the wake of OPEC's latest stalemate last
month, spot prices have fallen sharply and are hover-
ing near $10 per barrel-the lowest level in 13 years.
We estimate the world average oil price was $12 per
barrel last week, compared with $27 per barrel last
year. Spot prices have become extremely volatile-
often fluctuating by as much as $5 within a few
weeks.
Key determinants of price behavior over the next six
months will be consumption patterns, inventory be-
havior, non-Saudi supplies, and Saudi oil production
policy.
Consumption. The consensus view among forecasters
looks for non-Communist oil consumption to increase
at an annual rate of about 2 to 3 percent during the
last half of the year. Almost all of the increase in
demand will come from OECD countries, principally
the United States. This assumes OECD real GNP
growth of about 2 to 3 percent above year-earlier
levels, roughly what the major forecasting organiza-
tions now expect. Oil consumption under these cir-
cumstances will approximate 45 million b/d during
the third quarter and somewhat over 47 million b/d in
the winter heating season. In general this forecast is
consistent with prices in the $10 to $12 range. It could
prove optimistic, however, if economic activity in the
industrialized countries falters.
Inventory Overhang. Under normal circumstances we
would expect a seasonal inventory drawdown in the
fourth quarter of less than 1 million b/d. It could
prove much larger this time, however, because of the
large inventory overhang accumulated in recent
months. This unusually high stock accumulation was
driven largely by buyers' expectations that prices
would rise later this year to the $1,8-per-barrel level.
This is unlikely to happen-the market is rapidly
coming to recognize that prices will not rise to that
level-and buyers may now decide that inventories
are in fact far too high and accelerate the destocking
that normally occurs. If this process happens too
rapidly it would contribute to price volatility. Indeed,
the high inventory accumulation that occurred in
recent months probably prevented' prices from falling
even further than they have.
Secret
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Saudi Oil Production, 1985-86
Volume Increases ... ... Dominating OPEC Output ...
(Saudi Share of OPEC Total)
0 ASONDJFMAMJJa 0 ASONDJFMAMJJa
Non-Saudi Supply. Although non-OPEC producers
lost market share early this year, most have become
more competitive in an attempt to recapture market
share. Consequently, we expect their output to re-
bound by several hundred thousand b/d during the
rest of the year, although some high-cost production
in the United States and Canada is unlikley to come
back on stream:
? Mexican liftings, down substantially in the first
half, have rebounded to about 2.8 million b/d and
could remain at these levels through yearend.
... And Crowding Out Non-OPEC
Output
(Change in Volume: August 1985 - June1986)
-2 Saudi Other Non-
Arabia OPEC OPEC
? Production increases-expected prior to the price
plunge-in Colombia, Brazil, Syria, and Angola are
still likely.
? Net Communist exports have been increasing
steadily since March and are expected to continue
at least at current levels for the next several months.
OPEC countries other than Saudi Arabia will want to
produce about 14 million b/d, in our view. Financial
pressures will prevent OPEC's poorer members-
Nigeria, Indonesia, and Venezuela-from reducing
output substantially. Indeed, Venezuela's state oil
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Oil Prices Plummet .. .
(Average World Price)
West Texas Intermediate
North Sea Brent
... And Are More Volatile
(Spot Prices)
I 1 I 1 1 I 1 1 I I I
0 March April May June
Non-Communist Oil Supply and Demand Balance
Total consumption b
46.6
43.3
43.6
45.9
44.9
46.7
44.2
45.3
47.4
45.9
Inventory change
-2.6
0.2
-0.2
0.7
-0.6
-1.0
1.7
0.7
-1.0
0.1
Total supply
44.0
43.5
43.4
46.6
44.3
45.7
45.9
46.1
46.4
46.0
Non-OPEC
26.3
26.8
27.3
27.6
27.0
26.7
26.2
26.4
26.5
26.5
OPEC
17.7
16.7
16.1
19.0
17.3
19.0
19.7
19.7
19.9
19.5
a These figures are projections based on assumed trends in OPEC
and non-OPEC production and an average price of about $10 per
barrel.
b Excludes refinery gains and includes natural gas liquids.
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OPEC and Non-OPEC:
An Unlikely Partnership
In the wake of the recent price collapse, we cannot
rule out that nonmembers might join OPEC in an
international production-sharing pact to stabilize the
market. Norway's new government, for example, re-
cently met with an OPEC minister and indicated it
might be willing to support higher prices by limiting
future increases in output.
Recent trends suggest, however, that any such coali-
tion will be shrouded in distrust and guided by a
you first " principle. The non-OPEC oil producers
that have expressed a possible willingness to cooper-
ate this year-Oman, Egypt, Mexico, Malaysia, Bru-
nei, Angola, and China-have said that any cutbacks
are contingent upon a new OPEC output ceiling
substantially below current production levels. More-
over, the cutbacks they have suggested are less than
the amount already reduced because of lost market
share in earlier rounds of the price war.
In our view, attempts to maintain a long standing
agreement between OPEC and nonmembers probably
would be thwarted. The wide divergence in interests
among all oil producers probably would lead to the
same kind of violations that currently plague OPEC
and would work to undermine an international pro-
duction-sharing pact. For example, the major non-
OPEC exporters-the United Kingdom, Norway, and
Canada-are industrialized nations with larger,
more diversified economies and are less dependent
than OPEC on oil for revenue. In addition, non-
OPEC LDCs striving for energy self-sufficiency are
unlikely to join in an effort that would dampen their
production prospects.
company recently announced intentions to boost oil
exports over the course of the year by about 200,000
b/d. Even wealthier OPEC states have suffered from.
the lower oil prices, and countries like the UAE,
Kuwait, and Qatar appear adamant to keep oil ex-
ports at a high level.
Saudi Oil Production Policy. Saudi Arabia will play
the key role in determining market conditions over the
balance of 1986. The Saudis now hold about 15
percent of the world oil market-about 6 million b/d.
If Riyadh is determined to maintain this share of the
market and demand fails to grow as market analysts
are forecasting-either because of excessive destock-
ing or slow economic growth-prices could drop well
below the $10 per barrel level and stay there until
other producers back out. The Saudi dilemma is that
at $10 per barrel Riyadh's oil revenues approximate
$18 billion annually, below the level Saudi Arabia
earned last year. Even if Riyadh adjusted its present
stance and decided to shave output to bolster prices it
may not work. Specifically, Riyadh has no guarantee
that other producers would not replace Saudi supplies.
Saudi Arabia.
We continue to believe that Riyadh would like to see
prices stabilize, at least for a while, at around the $15-
per-barrel level. At this price we believe that the
Saudis would be comfortable with a production level
of about 4.5 million b/d-enough to generate a
revenue flow of roughly $20 billion. The 4.5-million-
b/d level would also assure Riyadh's position as the
world's largest oil exporter, a goal we believe was
important to Riyadh when it initiated the market
share fight last August. We doubt, however, that the
Saudis will substantially reduce production to achieve
the $15-per-barrel price level unless they are reason-
ably certain that others will not simply increase their
market share at Saudi expense. The major risk Saudi
Arabia runs may be the danger of retaliation from
Iran if Riyadh is unyielding on the production front.
Tehran is pushing for higher prices and, if diplomatic'
pressures fail to convince Riyadh to stabilize prices,
we are concerned that Iran may increase pressure on
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Kuwait-USSR:
Expanding Economic Ties
Kuwait and the USSR have concluded an agreement
that will strengthen bilateral ties and provide Moscow
loans and access to state-of-the-art Western oil tech-
nology. The agreement, signed during the visit last
week of a high-level Soviet delegation to Kuwait, is
aimed at expanding economic cooperation, particular-
ly in oil-sector development, investment, and finance.
Kuwait also will participate in highly visible joint
development projects with the USSR in third coun-
tries, particularly Arab states. If these projects are
successful, Moscow probably will increase its use of
commercial arrangements for political as well as
economic gains with other Persian Gulf countries.
Konstantin Katushev, Chairman of the Soviet State
Committee for Foreign Economic Relations, who
plays a key role in Soviet economic policy formulation
as well as in arms transfers negotiations, according to
the US Embassy in Moscow. The parties agreed to
pursue economic development projects valued at
$1 billion in Kuwait and the USSR, and to begin
studies of joint ventures in Iraq, Greece, and
Morocco.
Kuwait and Moscow also agreed to cooperate on
financial matters. Press reporting indicates Kuwait
extended a $150 million loan to Moscow, and the
Soviets offered to allow Kuwaiti banks to purchase
Soviet treasury bonds. After discussing Kuwaiti de-
fense needs with Defense Minister Salim al-Ahmad,
Katushev declared Soviet willingness to accept oil in
payment for Soviet exports, according to press reports.
The recent Kuwaiti-Soviet meeting in Kuwait was a
followup to a meeting held last February in Moscow,
in which the two countries discussed a broad range of
issues and signed a memorandum of agreement that
listed proposed areas of cooperation.
these included:
? Construction of oil and other facilities in Kuwait.
? Construction of oil, natural gas, and petrochemical
facilities in the USSR, with Kuwait providing loans
and technology.
? Cooperation in construction of energy and economic
development projects in third countries, especially
Arab nations.
? Development of ties between Soviet and Kuwaiti
financial institutions.
In addition, Kuwaiti press reports speculated that the
parties discussed bartering oil for weapons, but Ku-
waiti officials denied these rumors
At last week's meeting in Kuwait, the parties agreed
to implement some of the proposals discussed at the
earlier meeting. The Soviet delegation was led by
Moscow's conclusion of the agreement with the Ku-
waitis appears partly motivated by its interest in
obtaining Western oil technology through Kuwait's
Santa Fe Corporation. According to press reports,
Santa Fe-the largest employer of Americans in
Kuwait-will play a major role in the proposed
projects in the USSR. Moscow has expressed interest
in Santa Fe's technology on oil refining, exploration-
particularly in coastal areas in the USSR-and in-
creasing the productivity of oil wells. Kuwait has also
agreed to allow Sante Fe to explore for oil in South
Yemen, according to the US Embassy in Kuwait.
The US Embassy in Kuwait reports that Kuwaiti
officials are aware of the possibility of US export
controls, and have equivocated about Santa Fe's
Secret
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Kuwait's efforts to build a world-class international
oil industry took a major step when it purchased the
US-based Santa Fe International Corporation for
$2.5 billion in 1981. At the time of purchase, the
company employed 14,000 people and had reserves of
$1.2 billion. The company is split into four divisions:
? Santa Fe Drilling Company. One of the world's
largest and foremost contract drilling operators. At
the time of purchase it had about 85 rigs engaged in
offshore and onshore operations in 16 countries,
including several in the Middle East.
? Santa Fe Minerals, Inc. An exploration and produc-
tion group set up in 1969. It is active in the United
States and in the UK North Sea with a share in
Thistle oilfield production. It also is involved in
exploration work in the South China Sea.
? C. F. Braun. An engineering, firm with an impressive
list of work worldwide. This division designs, engi-
neers, and constructs petroleum refineries, chemical
and petrochemical plants, and power plants. It also
has the available expertise to construct synthetic
fuel plants.
? Santa Fe Engineering and Construction. This divi-
sion is involved in marine construction, underwater
services, and specialized shaft drilling for construc-
tion and mining industries.
Something for Everyone
Both Kuwait and the USSR stand to benefit from the
agreement, which probably will be more extensive
than initial reports indicated. Access to Western
technology could enhance the Soviets' oil-processing
capabilities. Moreover, the equipment comes cheaply
to the Soviets, who may use the Kuwaiti loan to
finance the purchase. While the Soviets would like to
increase their oil exploration capabilities within the
USSR, acquisition of the advanced technology could
be used to improve their relatively poor oil exploration
record in other countries.
The composition of Moscow's delegation to last
week's meeting is an indication of the significance the
Soviets attach to their relationship with Kuwait and
of their awareness that this agreement could allow
them political rewards at little cost. Using Kuwaiti
financing and technology, Moscow will participate in
Kuwaiti development projects in third countries,
which may make the Soviet presence appear less
threatening. The Soviets probably hope that offering
development assistance and high-quality technology
will enhance their image in Arab and Third World
countries and provide them political entree.
The Kuwaitis, whose motivations appear primarily
political, also will gain from the partnership. Since the
US freeze of Libyan assets, the Kuwaiti Government
has been under domestic pressure to reduce its invest-
ments in the United States. The well-publicized
agreement with the Soviets will relieve some of this
pressure and burnish Kuwait's nonaligned credentials.
In addition, the superpower attention plays well in
Kuwait.
terms.
The Kuwaitis have become increasingly alarmed over
the last six months about the possibility of an Iranian
victory over Iraq. Although they believe that they can
ultimately rely on the United States, the Kuwaitis
probably hope to increase Moscow's investment in
Kuwaiti security. The Kuwaitis also may be able to
negotiate an arms deal with the Soviets on favorable
The economic benefits to the Kuwaitis are less signifi-
cant. The returns from the proposed joint ventures,
loans, and projects in the USSR, by themselves, are
an insufficient incentive to pursue the deals. Still, the
projects enable the Kuwaitis to keep their engineering
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Secret
company operating in a period of slack construction,
which will reduce earlier recriminations about the
purchase of Santa Fe and its financial well being.
Implications for the United States
If the proposed agreement proves fruitful, the Soviets
may be emboldened to seek similar arrangements with
other Persian Gulf countries. The Soviets established
diplomatic relations last year with Oman and the
UAE, although these ties are developing quite slowly.
It is not the policy of the other Gulf countries-as it is
Kuwait's-to seek balanced relations with the super-
powers, but they might be willing to respond favor-
ably to overtures from the Soviets. Even so, the
immediate political gains for Moscow would be mini-
mal, and probably would not be commensurate with
the commercial benefits. If Moscow proceeds slowly
and cautiously in cultivating a long-term relationship
with the Gulf states, including arms deals and securi-
ty guarantees, US security ties to some Gulf states
would be jeopardized. As Kuwait has done, the Gulf
states would try to play the superpowers against one
another to maximize their economic and political
investments.
I
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LDC Banking Systems:
Impact of Liberalization
The banking systems of some key LDCs are undergo-
ing major changes as a result of debt-related reform
programs and past bad management policies. Despite
domestic political pressure on governments to support
failing banks, a number of institutions may be allowed
to go under as a result of changes in LDC financial
systems. Disagreements, however, over how to handle
the debts that failed banks have outstanding to inter-
national creditors threaten to make debt restructuring
negotiations more difficult.
removed indexation and drastically reduced the re-
cord profits earned by Brazilian banks. The inefficien-
cies, previously hidden by high real interest rates and
indexation before 1986, are forcing the banking sys-
tem to cut back on personnel and to charge for
services that previously have been free. Embassy
reporting suggests that, despite these cost-cutting
measures, many banks continue to experience liquid-
ity problems and that further bankruptcies are being
avoided only by government-approved accounting
methods that allow banks to ignore overdue debts
Third World banking systems historically have lagged
behind the development of Third World economies.
Most systems are comprised of highly inefficient
state-owned institutions with officers who often lack
the training necessary, or the willingness, to assess
risks in a competitive loan market. These problems
have been exacerbated by: forced low-interest loans to
dying, yet still favored, industries; government-
directed takeovers of poorly run firms; and govern-
ment-approved accounting practices that overlook
nonperforming assets. As both government spending
and private-sector investment have fallen off, many
LDC domestic banks have been left with the burden
of managing large accumulations of bad debt.
Three countries-Brazil, South Korea, and the Philip-
pines-are illustrative of the problems and vulnerabil-
ities of LDC banking systems.
The Brazilian banking system, one of the more
sophisticated financial systems in Latin America, is
now suffering the results of attempts at liberalization
begun last year as well as recent monetary reform.
The Cruzado Plan, implemented in March 1986, has
from state-owned enterprises.
Until 1985, these types of problems were solved by
merging weak institutions with stronger firms and
then having the government step into stabilize the
newly formed company and resolve its outstanding
debts. President Sarney's government, however, has
discontinued these types of bailouts. When three
private Brazilian banks-Comind, Auxiliar, and Mai-
sonnave-failed last year, the government liquidated
the banks and denied responsibility for the obligations
of the three banks to foreign creditors. The govern-
ment's position became a major obstacle in negotia-
tions to reschedule $31 billion in Brazilian commer-
cial debt and trade credits, although a compromise
settlement appears to be imminent. The current up-
heaval caused by the Cruzado Plan probably will
cause a few more banks to close, but, if Brasilia's anti-
inflation package is successful, other financial institu-
tions should emerge in better shape.
In South Korea, the financial press has warned that
there are billions of dollars of bad loans-accumulat-
ed through government-directed policy loans to fa-
vored industries-that render the Korean banking
system technically insolvent. Most of these loans are
long-term, low-interest government credits to South
Secret
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Korea's huge shipbuilding and construction conglom-
erates. Such government support of these companies
helped backstop the economic prosperity of the 1970s.
These firms now are suffering the effects of a slump
in the construction and shipbuilding industries, and
the burden is being shouldered by Korean banks and
the government, according to US Embassy reporting.
For example, when the Kukje conglomerate, the
country's sixth largest, went bankrupt last year, the
government-faced with the prospect of letting
Kukje's creditor banks fail-stepped in to guarantee
all outstanding debts. Such support for domestic
banks, however, has put a sizable strain on the
national budget, and the economy would not easily
sustain the failure of either a major bank or another
major conglomerate. As a result, we believe Korean
officials, under renewed pressure to protect domestic
banks for local interests and nationalistic pride, may
have to scale back their reform schedule.
While the Philippines' financial system as a whole is
in a stronger position than in 1984, there are some
banks that remain vulnerable. A few of the largest
commercial banks were able to show hefty profits last
year, but a greater number of small commercial banks
are still suffering from a liquidity crisis that began in
1984, according to press reports. Those private banks
that have survived did so by maintaining a high
degree of liquidity and channeling money into high-
interest government securities. Many of these banks
continued to increase in size by attracting deposits
from weaker domestic banks and strengthening their
capital base.
Government-owned banks, holding 35 percent of the
assets in the commercial banking system, are a weak-
er link in the Philippine financial sector, however.
Recent press estimates state that up to 80 percent of
their assets are nonperforming. Many of the problems
of these institutions are the result of past policies that
fostered low-interest loans to Marcos's political cro-
nies. This has left the Aquino administration the
unpopular task of implementing banking reforms
needed to meet conditions for IMF and World Bank
support. Of the total government deficit for 1986,
about $1 billion (65 percent) will be needed to stave
off bankruptcies in state-run financial corporations,
an amount equal to 17 percent of total projected
government spending.
Minimum capital requirements instituted by the new
government will put pressure on undercapitalized
state-owned banks-specifically the Development
Bank of the Philippines (DBP) and the Philippine
National Bank (PNB)--to consolidate, potentially
causing 15,000 employees to be fired, according to
Embassy reports. In mid-July, the Central Bank
Governor outlined a reform program that is to trans-
fer nonperforming assets of the DBP and PNB to a
management trust, thereby cutting in half the involve-
ment of government banks in the system and accom-
plishing a primary goal of banking-sector reform.
Because of many problems in the Philippine banking
sector, the Aquino government will not attempt to
significantly liberalize the financial sector this year,
according to the US Embassy. International bankers
agree, stating that it will be many months before a
streamlining of the system is politically feasible. An
IMF team visiting Manila in June 1986, however,
observed steps under way to clean up government
financial institutions, specifically citing one major
government bank, the DBP, as moving ahead on
reforms. Nevertheless, in our judgment, Aquino will
accelerate banking reforms only if substantial im-
provement in the performance of the economy is
forthcoming.
We believe many LDCs, including the Philippines and
South Korea, will encounter some difficulties in re-
forming their banking systems, while a few such as
Brazil will probably proceed with liberalization mea-
sures. LDCs that do move to reform their banking
systems will do so in the face of significant domestic
opposition:
? Financial-sector liberalization is opposed by those
who are wary of increasing foreign influence in
domestic markets.
? Reforms that increase competition in the banking
sector probably will force more bank closures and
increase unemployment.
? Greater privatization in the banking systems will
decrease government power by transferring control
of financial resources to the private sector.
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LDC governments' efforts to liberalize their banking
systems could complicate relations with international
creditors if further bank failures are the result. In
particular, most LDC banks have fully utilized credit
lines with international banks and, as greater compe-
tition forces some banks to fail, loan obligations to
foreign creditors could then hold up international debt
negotiations. A large number of closures could easily
overwhelm the abilities of some debtor governments
to cover payments to foreign creditors.
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Turkish-Soviet Ankara and Moscow last week signed a construction agreement for a natural gas
Natural Gas Pipeline pipeline linking Turkey and the USSR. The Turkish portion of the pipeline will be
built beginning this September by a consortium of French, US, British, and
Turkish firms at a total cost of about $300 million. This agreement follows the nat-
ural gas contract signed in February that provides for delivery of 750 million cubic
meters of Soviet gas in 1987 rising to an annual level of 4 billion cubic meters by
1992. In exchange, the Soviets must purchase Turkish exports equal to about 70
percent of the value of the natural gas in the first three years of the agreement 25X1
(1987-89). In following years, Soviet purchases will gradually increase until all of
the Turkish gas purchases are offset by exports. The final contract revised an
earlier proposal calling for peak annual deliveries of 6 billion cubic meters.
China Trying To China is attempting to reduce Hong Kong's growing anxiety about a proposed
Calm Hong Kong nuclear plant 50 kilometers away at Daya Bay in Guangdong Province. According
Nuclear Fears to press reports, since the Chernobyl' disaster Hong Kong residents have displayed
surprisingly strong opposition to the planned joint venture with China; a petition
against the project has drawn over 1 million signatures. The Hong Kong
Government still supports the plant-70 percent of the electricity would go to
Hong Kong-but is sufficiently concerned to send delegations to Europe and the
United States to investigate nuclear safety issues. Beijing's recent press blitz
includes reporting on Deng Xiaoping's support for the nuclear program, on
extensive new domestic safety regulations, and on both new and continuing nuclear
safety cooperation with France and the United States. The French, who hope to
supply the plant's two reactors, agreed last week to provide full-scale nuclear
safety cooperation to China free of charge; the United States last week sold China
a simulator to train nuclear power plant operators. A pullout by Hong Kong would
probably force China to cancel the project, further reducing its commercial
nuclear program to plans for one to three domestically built reactors at Qinshan,
near Shanghai.
Secret
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Ecuador Seeking
$200 Million
Syndicated Loan
Secret
25 July 1986
assure minimum import levels.
Quito reportedly has asked the US Government and may ask the Japanese
Government to help persuade commercial banks in their countries to participate in
a $200 million syndicated loan secured by oil receipts currently being put together.
The loan is a key component of Quito's efforts to cover a widening external
financing gap, but bankers apparently are increasingly nervous over the unexpect-
ed depth of the oil price plunge and its impact on Ecuador's economy. Although
Febres-Cordero's management of the economy has earned him kudos from the
IMF and the World Bank, the continuing slide of oil export prices has thrown the
Ecuadorean economy into a tailspin-with negative economic growth and a
current account deficit of about $750 million expected this year. According to the
US Embassy, the continuation of Ecuadorean oil prices at $8.50 per barrel will ne-
cessitate the implementation of severe-and highly unpopular-austerity mea-
sures, and could force the government to secure relief from debt payments to
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Secret
Poland Requests Western government creditors last week rejected Poland's request to renegotiate
Debt Relief the 1986 rescheduling agreement initialed earlier this year and told Warsaw to
seek relief from its commercial bank and CEMA creditors. The Poles blame their
inability to meet obligations under previous rescheduling agreements on unexpect-
ed shortfalls of both new credits and hard currency. Warsaw agreed to approach
commercial bank creditors again but warned that hope was slim for any further
concessions. Earlier this year the commercial banks reluctantly agreed to resched-
ule $1.7 billion in payments due in 1986 and 1987. The Poles probably face a gap
of about $1 billion between payments and earnings this year and will continue to
appeal to all creditors for new loans and reschedulings. Ultimately, Warsaw will
have to seek IMF assistance to balance creditors' demands and to develop a
comprehensive package to deal with its debt problems. The IMF will require
Warsaw to accept austerity measures as a condition for new credits. The Poles,
however, as in the past, will resist measures that would reduce the population's
standard of living.
The Two Germanys West Germany and East Germany last month revised their 1951 trade agreement
Expand Trade to include a payments mechanism for services. The pact further regularizes
Agreement commerce, clarifies some language to speed transactions, and could facilitate
further growth in bilateral economic links. Trade in services, including a number
of East German services for West Berlin, has risen to nearly $1 billion annually, or
13 percent of all commerce in 1985, and expanded into areas not covered by the
original agreement. The US Mission in West Berlin reports that negotiations for
the revision took two years. The pact reflects the interest of both Bonn and East
Berlin in gradually expanding basic economic ties despite continuing, major
political differences.
Airbus Industrie- Negotiations between Western Europe's Airbus Industrie consortium and
McDonnell Douglas McDonnell Douglas Corporation are continuing, but we believe formalization of
Discussions on any agreement will not come quickly. Proposals to jointly develop a commercial
Joint Program aircraft for long-range, thinly traveled routes are currently dominating the
Continuing discussions.
Industry experts believe this
market segment is too small to support two separate aircraft. While the talks
between Airbus and McDonnell Douglas are hampered by a lack of trust
stemming from the failure of previous US-European cooperative aircraft projects,
the limited market and growing development costs may force both parties to look
seriously at joint development.
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Secret
Japan Leaning Toward Recent Japanese press reports indicate that the Japanese Defense Agency (JDA) is
Joint Development of formally considering the codevelopment of its new multirole fighter, the FS-X,
FS-X Aircraft with US companies. This follows more than a year of planning for an indigenously
developed fighter design. We believe the jointly developed FS-X would be a new
design or an advanced version of a US F- 16 or F- 18 aircraft. Pressure over Japan's
trade imbalance with the United States, high development costs, and some
technological weaknesses are encouraging Japanese decisionmakers-primarily
the Ministries of Finance and Foreign Affairs-to favor codevelopment. We
believe some elements in the JDA and MITI as well as Japanese industrialists,
however, still may prefer an independent program. In any event, we expect the
JDA to request long lead funding for FS-X related programs in its FY 1987
budget; such funds could be applied to either independent or joint development.
Cocoa Producer and Faced with the lowest prices in three years and the threat of liquidation of a
Consumer Nations 100,000-metric-ton buffer stock owned by the International Cocoa Organization,
Negotiate New Accord cocoa producer and consumer nations have negotiated the essential elements of a
new five-year International Cocoa Agreement (ICCA) aimed at stabilizing world
cocoa prices. The accord, replacing the Third ICCA due to expire on 30 .
September, calls for defending a price range of 85 to 121 US cents per pound by
operating a buffer stock that will buy and sell cocoa. Moreover, prices under the
new agreement are to be expressed in Special Drawing Rights rather than in US
currency, a change designed to dampen exchange rate fluctuations. Agreement on
the new pact largely turned on acceptance of a lower price range by Ivory Coast-
the world's largest producer-and other key producers such as Ghana and Brazil.
The new range generally reflects current market prices, which have averaged 85
cents per pound over the last four months, as well as projections of weak prices
through the end of the decade due to continued oversupply.
Despite pushing for economic sanctions against Pretoria, India continues to import
India Continues large amounts of rough diamonds from South Africa. India's thriving diamond-
Purchases of processing industry-one of the world's largest-imported over $800 million worth
South African Diamonds of diamonds from the Central Selling Organization in London, which is controlled
by De Beers, the South African conglomerate. The Indian diamond industry earns
over $1 billion annually, more than 11 percent of India's export earnings. As
chairman of the Nonaligned Movement, India has supported South Africa's black
majority and has urged economic sanctions and a boycott of South African goods.
In the event New Delhi comes under public criticism for its double-handed policy,
it probably would seek alternative routes to secure South African diamonds or
alternatives suppliers, possibly the Soviet Union.
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Japanese Machine Tool Industry experts and trade journals report that several Japanese machine tool
Industry Increasing firms plan to build new facilities or expand existing production in the United
Investments in the States, a move that is seen as part of Japan's overall strategy to maintain an
United States approximate 23-percent share of the US market.
New Japanese
Finance Minister
Favors Economic
Stimulus
Developed Countries
Prime Minister Nakasone's appointment this week of Kiichi Miyazawa places a
longtime advocate of increased public works spending at the helm of the powerful
Finance Ministry. Miyazawa, who served in the Finance Ministry for several years
before entering politics in the 1950s, is best known for his proposal to double
spending on basic infrastructure over the next decade. He recently called for a $19
billion supplemental budget this fall-a record if implemented-to spur Japan's
lagging economy. We do not believe Miyazawa's appointment signals a major shift
in Japan's five-year-old policy of budget austerity. Instead, it appears Nakasone
gave Miyazawa, a longtime political rival, the post in part to quell his criticism of
the Prime Minister's conservative economic policy. Although Miyazawa may be
able-with the support of politicians and business groups concerned by the
economic slowdown-to push through a modest pump-priming package this fall,
his influence on the budget for the next fiscal year, which begins in April, is
questionable.
Ministry's budget guidelines.
The previous Cabinet on Monday approved stringent guidelines for ministries
drawing up budget requests for FY 1987. The guidelines, which call for a 1-
percent increase in general government expenditures, again require cuts in most
programs-except defense (allowed a 6.3-percent increase) and foreign aid (al-
lowed a 7.5-percent rise). Recent public statements by Nakasone, moreover,
suggest he remains committed to the goal of eliminating most types of deficit
financing by 1991. The budget negotiations will continue through December,
however, and another quarter of negative economic growth-following the first
quarter's 0.5-percent drop-may result in a substantial increase in the budget
Tokyo uses to finance public works; this spending is not included in the Finance
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Secret
Ottawa Considers Ottawa's continuing budget deficit, as well as expected tax reform in the United
New Tax as Remedy States, is sharpening Finance Minister Wilson's determination to introduce a
for Budget Deficit value-added tax-although under a different name. Wilson is worried by projec-
tions that Canada's 1986 budget deficit will be $1.5 billion larger than initially
forecast-reaching $23 billion-mainly because of the impact of low oil prices.
Two successive unpopular budgets-which emphasized personal and corporate tax
surcharges and sales tax increases-and the expected widening of the divergence
between marginal rates in the United States and Canada as a result of US tax re-
form, are curbing Ottawa's enthusiasm for hiking tax rates to control the deficit.
Instead, Wilson favors introducing a business transfer tax (BTT)-in effect a
value-added tax on consumer goods and services-to replace the narrowly based
federal sales tax and the recent surcharges. The BTT's primary advantage is its
broad base, which would permit Ottawa to raise substantial revenue with only
modest increases in the BTT rate. The Cabinet guardedly approved Wilson's
proposal two weeks ago, and it is expected to be the centerpiece of a tax reform
plan to be released in the fall.
Spain Pushing To reduce the strain on the troubled government-run pension system, Madrid has
Private Pension Funds introduced legislation that will not only allow the creation of private pension funds
but will also encourage them with a series of tax incentives. The bill is supported
by business and labor and should be signed into law before the end of the year.
Government officials look to the new funds-70 percent of whose assets must be
invested in government securities, stocks, bonds, and mortgages-to provide
venture capital for startup companies and to offer alternative long-term financing
to private firms. Businessmen believe that the reduction of their onerous social
security contributions will enable them to increase investment. Labor unions have
given their support with the stipulation that the government must continue to
guarantee state pensions. We do not see this as a problem, however, since Madrid
is not likely to abandon its constitutionally mandated responsibility. It aims,
rather, to move toward the model prevalent in most other industrial countries in
which state pensions are augmented by private pension plans.
Less Developed Countries
Philippine Agricultural According to government data, Philippine agricultural output in the first quarter
Output Improves of this year rose 2.5 percent above the level recorded during the same period in
1985, a sharp contrast to the performance of the industry and services sectors,
which contracted by 3 percent, and total national output, which grew by less than
1 percent. Production of rice and corn-the two most common crops-increased
by 8 and 13 percent, respectively, aided by good weather, government credit
programs, and the elimination of price ceilings for major crops. The sector's only
production decline was registered by sugar, where output dropped 10 percent in re-
sponse to record-low world market prices. The growth of the rural economy has
probably helped many Filipinos adjust to widespread unemployment in urban
areas. Nevertheless, increasing the standard of living in the countryside-where
incomes have been depressed by rapid population growth and marketing monopo-
lies for agricultural products-is likely to require agricultural growth rates of over
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Secret
Taiwan
Coping With Its
Trade Surplus
marketing cartels.
4 percent annually. To this end, President Aquino's government is developing
market-oriented pricing policies and rural development programs that support crop
diversification, land reform, voluntary family planning, and the elimination of
Taiwan is taking steps to shift much of its $30 billion foreign exchange surplus into
overseas and domestic investment programs.
and probably will approach $12 billion in 1986.
~In addition, Taipei has announced it will increase domestic
spending on social development projects from 3 percent of GNP to 15 percent over
the next five years. Taipei may believe these measures will deflect foreign-
principally US-criticism of Taiwan's trade surplus and huge foreign exchange
holdings. However, these moves neither cut exports nor increase imports. More-
over, Taiwan has deferred several major industrial projects involving US firms
that would have reduced its bilateral surplus, which topped $10 billion last year
Coffee Downturn Kenya's hopes of improving its foreign payments position and reducing its budget
Shortens Kenya's Boom deficit have been hurt as world coffee prices have declined by about 25 percent
since first quarter 1986, according to the US Embassy. Coffee earnings for 1986
probably will exceed 1985 receipts by only 40 percent, well short of earlier
government projections of about 80 percent. The current account deficit could
widen by more than $100 million unless the government acts to reduce imports.
Moreover, lower tax revenues probably will undermine Nairobi's plan to cut its
budget deficit from the 1985/86 level of 4.5 percent of GDP to 3.5 percent of GDP
for 1986/87.
Rising Food In a 9 July speech, Afghan Prime Minister Keshtmand expressed concern over the
Prices in Kabul continuously rising price of some foods-particularly fruits and vegetables-in
Kabul. While the overall foodstuff price index in Kabul rose only 7 percent in
1985, the index for fruits and vegetables increased 17 and 23 percent, respectively,
according to official Afghan data. Keshtmand claimed rising transportation costs
are partly responsible. The increase in transportation costs is probably the result of
the poor security conditions in the countryside and the high demand for trucking
services from both the private sector and the black market. Keshtmand also cited
various production constraints including farmers' preference for growing wheat,
inadequate irrigation and storage facilities, and a weak marketing infrastructure
as contributors to rising produce costs. Fresh produce is frequently unaffordable
for many Kabul residents. Lack of a varied diet has caused malnutrition in 60 per-
cent of Kabul's children, according to recent reports from medical personnel in
Kabul.
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Secret
Turkish Turkey's current account deficit more than tripled to $690 million in first quarter
Current Account 1986, compared with the same period last year, largely because of a 17-percent
Deficit Rises rise in imports and a drop in worker remittances and tourism revenues. The jump
in imports follows liberalization by Ankara of restrictive import rules, although
government officials attribute the rise to a temporary surge in imports for
government investment. Net tourism revenues declined 22 percent, apparently
because of concerns over terrorism and because Turks are increasingly taking
advantage of their new opportunities to travel abroad legally. Worker remittances
fell 31 percent to $290 million, perhaps because of layoffs of Turkish workers in
oil-producing countries. Dislocations in these countries also hurt Turkish exports.
If it continues, the widening current account deficit will complicate Ankara's
efforts to meet the high level of debt repayments due over the next several years
and could shake confidence in the Ozal government's economic program
Baghdad Reshuffles The US Embassy reports that Iraqi President Saddam Husayn has returned some
Economic Decision key economic powers to First Deputy Prime Minister Ramadan by appointing him
Making Authority head of the "presidential committee" that controls foreign exchange. The decision
was announced during an extra session of the Bath Party Congress called by
Saddam earlier this month to counter growing criticism of his monopolizing
decisions on the war and the economy. The creation of the presidential committee
by Saddam earlier this year-after the collapse in oil prices-had centralized
decisionmaking and undermined Ramadan's role as the chief architect of econom-
ic policy. In retaliation, according to the Embassy, Ramadan-who orchestrated
tough austerity measures in 1982-83-stymied decisions on several economic
matters. By putting Ramadan back in charge, Baghdad probably will be better
able to eliminate bureaucratic delays that have hampered efforts to deal with
lower oil revenues.
Tanzania Presents Tanzania's 1986/87 budget presented last month calls for total spending increases
New Budget of about 70 percent, a 25-percent exchange rate devaluation, and price increases of
30 to 80 percent for agricultural products, according to the US Embassy. Other
measures-including reductions in income tax rates and increased allowances for
public workers-probably were taken to appease opponents to economic reform.
Although the government is avoiding a heavy reliance on domestic borrowing and
has introduced additional taxes on a wide range of goods to help fund the increased
expenditures, the boost in government expenditures may impair negotiations for an
IMF program. Moreover, deep ideological divisions within the Mwinyi government
remain a stumblingblock in implementing additional IMF-supported austerity
measures.
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Zimbabwean
Budget Problems
month, the budget will show a $520 million deficit, more than 10 percent of GDP.
The government is negotiating a $125 million loan from the World Bank but will
have to resort mainly to inflationary borrowing from the domestic banking system
to finance the deficit. Although the Cabinet has agreed on the need to cut
recurrent expenditures in order to devote more to investment, it has been unwilling
to make hard decisions on major line items such as education or defense spending
for the maintenance of Zimbabwean troops in Mozambique.
Soviet Grain Prospects Meteorological and other reporting indicate that dryness in the southern and
Less Favorable central Volga region-dating from April-continues and has spread to the North
Caucasus, Central Chernozem, and northwestern Kazakhstan. A week of hot,
drying winds further stressed crops in mid-June in the lower Volga and Rostov re-
gions and in eastern and central Ukraine. The affected areas produce about
20 percent of Soviet grain. The remaining grain regions, including the New Lands,
still look favorable. Given normal weather for the remainder of the season, Soviet
grain production probably will reach only 190 million tons, below last year's
estimated output of 195 million tons and far short of the goal of 220-230 million
tons Agriculture Minister Nikitin recently mentioned to US Department of
Agriculture officials. If weather conditions continue to deteriorate, the 1986 crop
may fall below the estimated 184-million-ton average for 1981-85.
China's China had a $4.8 billion trade deficit in the first six months of this year-
Large Trade according to State Statistical Bureau data-and China's 1986 trade deficit
Deficit Persists probably will be close to last year's level of roughly $10 billion, according to
estimates by the consulate in Hong Kong. As a result, China's foreign exchange
reserves will continue to decline, and Beijing is likely to step up pressure on foreign
countries to ease restrictions on imports of Chinese goods. Beijing has enjoyed
striking success with its efforts to make up for lost oil revenues by promoting sales
of grain, textiles, and coal; a surge in exports-up 13.3 percent over the same peri-
od in 1985-brought China's midyear deficit down from last year's level of $5.3
billion. Continued growth, however, in imports-up 6.2 percent-was evidence of
Beijing's inability to cut imports of capital equipment and raw materials needed
for its industrial modernization. Despite cutbacks in imports of 16 commodities
(including fertilizers, televisions, automobiles, and synthetic fibers), China's de-
mand for iron ore and rolled steel remains strong.
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Secret
New Chinese Bank China International Trust and Investment Corporation (CITIC)-Beijing's free-
Competing in wheeling international finance corporation-is setting up a new bank to compete
Domestic Market in China's domestic market. The move follows CITIC's purchase last month of the
Ka Wah Bank in Hong Kong, an international bank with branches in the United
States, Canada, and the PRC. CITIC's expansion is part of Beijing's continuing
push to reform China's banking sector. Beijing probably hopes the new institutions
will improve the sector's efficiency by competing with other state-owned banks-
including CITIC's rival, the Bank of China-that have been criticized by the
reform leaders as overly bureaucratic.
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