INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP97-00771R000707420001-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 39
• Document Creation Date: December 22, 2016
• Document Release Date: July 15, 2010
• Sequence Number: 1
• Publication Date: March 1, 1985
• Content Type: REPORT

Directo"rate of
Intelligence
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Weekly
International
Economic & Energy
DI IEEW 85-009
1 March 1985
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International
Economic & Energy
Weekly
iii ` Synopsis
1 /Perspective-West European Restructuring Outlook
3 Briefs Energy
International Finance
Global and Regional Developments
National Developments
15 /West Germany: Cutting Back the Budget Deficit
19 /Italian Machine Tool Industry: A European Success Story
23 /The European Fighter Aircraft Progra
27 ~ ~~1Vew Steel Technologies for the 1990s: Impact on Competitiveness
31 Oman: Facing aGuns-or-Butter Dilemma
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Comments and queries regarding this publication are welcome. They may be
directed to Directorate o.J'Intelligence, 25X1
Secret
I March 1985
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Secret
International
Economic & Energy
Weekly
Synopsis
1 Perspective-West European Restructuring Outlook
There has been growing talk in Western Europe-and even some action-
concerning ways to reinvigorate their economies through private entrepreneur- 25X1
~~,:...,,,a to~~ ,.,,..e..,,..,o...:..?e-..e..?:,,..
15 West Germany: Cutting Back the Budget Deficit
Many developed countries have been preaching austerity, but West Germany
has been uniquely successful in reducing budgetary red ink.
19 Italian Machine Tool Industry: A European Success Story
Unlike the bulk of West European industry, the Italian machine tool industry
has adapted quickly to changes in technology and markets and thus has
weathered the worldwide economic downturn better than its European coun-
terparts.) I 25X1
23 The European Fighter Aircraft Program
Senior defense officials from France, the United Kingdom, West Germany,
Italy, and .Spain will meet in Rome this month to decide the fate of the
multibillion-dollar European Fighter Aircraft (EFA) codevelopment program.
We believe that some accommodation will be reached as political commit-
ments are too deep to allow the joint venture to fail at this juncture.
27 New Steel Technologies for the 1990s: Impact on Competitiveness
The steel industries in the major industrialized countries are turning to
innovative new technologies to reduce costs and increase profitability following
a decade of weak demand and low prices that have kept the industry in
turmoil.
31 Oman: Facing aGuns-or-Butter Dilemma
Increasingly large defense expenditures are beginning to cause concern within
the Omani Government that the country's economic development will suffer,
threatening the stability of Sultan Qaboo's regime. Oman will press the United
States for additional military aid to purchase F-16s and for more "rent" for
the use of facilities by US forces during bilateral talks scheduled for 18-19
May.
iii Secret
DI IEEW 85-009
1 Marcti 1985
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International
Economic & Energy
Weekly
An important theme at the Bonn Economic Summit in May will be overcom-
ing "economic rigidities," particularly in Western Europe. There has been
growing talk in Western Europe-and even some action-concerning ways to
reinvigorate their economies through private entrepreneurship and less govern-
ment intervention. Europessimism-looking at how bad things are in Europe,
in terms both of analysis and public.opinion-may have peaked and may be in
the process of being replaced by growing interest in solutions and positive
examples
The West Europeans seem to recognize that labor immobility, administrative
bottlenecks, and conservative or inadequate financial systems are hindering
economic progress. Nonetheless, they will likely claim that the appreciating
dollar is making the economic adjustment process more difficult. They will
argue that the US budget deficit causes high interest rates, thereby encourag-
ing foreign financing of the US deficit and reducing West European invest-
ment.
We think the West European economies do have some serious and fundamen-
tal economic problems:
? West European employment today is about the same as it was 10 years ago.
The US economy over the past 10 years has added some 20 million people to
the job rolls.
? Largely because of inadequate job creation, Western Europe's unemploy-
ment rate-now over 11 percent-has increased in each of the past 13 years
and may continue increasing through this decade.
? Over the past four years, the combination of the strong dollar and the rapid
US recovery has produced a swing in the US-West European trade balance
of $40-50 billion in Europe's favor. This shift is equivalent to about 2
percentage points of West European GNP growth, implying that, absent the
trade gains, West European growth could well have remained near zero over
the past two years
The West Europeans may be starting to realize that there are at least two sep-
arate steps involved in successful restructuring and technological development:
(1) knowing how to make a product and (2) knowing how-or being allowed-
to make it profitably. Seemingly adequate levels of R&D spending have
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produced meager results, and the frustrating technology gap vis-a-vis the
United States and Japan widens. West European companies are buying into
high-tech firms to ensure access to new technological developments. Buying in,
however, is only the first, and easiest, step-a classic example, the VCR was
invented in Western Europe, but the Japanese now dominate the market.
We believe Western Europe's chances of successfully commercializing new
technologies would be improved to the extent governments encourage greater
market flexibility. West European governments, however, generally have tried
to play it safe by guaranteeing success on the upside and preventing job losses
on the downside. European governments clearly are not comfortable with
rough-and-tumble capitalism; nor are their voters likely to allow the full range
of wage and employment adjustments necessary to become fully competitive.
This defensiveness will, in our judgment, continue to put severe limits on West
European economic progress and, in addition, will prevent agreement on
significant policy initiatives at the Bonn summit.
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/OPEC January
Oil Production
Energy
OPEC produced slightly under 16 million b/d of crude oil in January-the
lowest monthly average in almost two years-as output fell 800,000 b/d below
December levels. Although the organization has finally achieved the
16-million-b/d ceiling on total output agreed upon last October, the produc- .
tion drop was absorbed primarily by Saudi Arabia and Nigeria. To support
prices, Riyadh continues to appear willing to accept low levels of output as long
as production remains above 3 million b/d. We believe Lagos lowered output
before OPEC's January ministerial meeting in part to blunt criticism of its
refusal to abide by the group's production and pricing guidelines. Of the other
members, however, at least seven are currently producing above their quotas.
1984
1985
January
October
Quota
Year
Fourth
Quarter
November
December
Total
16.00
17.7
16.6
16.4
16.6
15.8
Algeria
0.66
0.7
0.7
0.7
0.7
0.7
Ecuador
0.18
0.3
0.3.
0.3
0.3
0.2
Gabon
0:14
0.2
0.2
0.2
0.2
0.2
Indonesia
1.19
1.4
1.3
1.3
1.3
1.4
Iran
2.30
2.4
2.1
2.1
2.3
2.1
Iraq
1.20
1.2
1.3
1.3
1.3
1.3
Kuwait
0.90
0.9
0.9
0.8
0.9
0.8
Libya
0.99
1.1
1.0
1.0
1.0
1.0
Neutral.Zone .
a
0.5
0.4
0.4
0.4
0.4
Nigeria
1.30
1..4
1.6
1.5
1.7
1.4
Qatar
0.28
0.4
.0.3
0.3
0.3
0.3
Saudi Arabia
4.35
4.4
3.8
3.8
3.5
3.3
United Arab Emirates
0.95
1.2
1.2
1.1
1.2
1.1
Venezuela
1.56
1.7
1.6
1.6
1.6
1.6
a Neutral Zone has no production quota; output is divided evenly
and added to Saudi and Kuwaiti totals.
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Nuclear Power Boosts
EC Electricity
Production in 1984
S apish-Algerian
as Dispute Ended
EC electricity production in 1985.
Led by a 28-percent increase in nuclear power generation, net electricity
production rose by 4.8 percent in the European Community (EC) in 1984,
approximately double the growth rate for the previous year. Average growth in
consumption increased by more than 4 percent, boosted by the recovery in
some major industries, continued growth in the electricity-intensive service
industries, and sustained household demand. The increase in nuclear power
continued the European trend away from fossil fuels, displacing the equivalent
of about 60,000 b/d of crude oil. For the year, nuclear energy accounted for a
record 27 percent of total electricity production, up from the previous record of
21 percent in 1983. We expect nuclear power to continue to lead the growth in
years.
Spain and Algeria have settled their liquefied natural gas contract disagree-
ment,~ according to Embassy reporting. The 1975 contract, in dispute since
1981; called for deliveries of 4.5 billion cubic meters (bcm) of gas per year, al-
though Spain has actually purchased only 1.5 bcm annually. The Spanish
national gas company has reportedly agreed to compensate the Algerian state
energy company by providing $500 million in goods and services for gas not
purchased under the take-or-pay contract terms. In return, Algeria has agreed
to lengthen the original contract to 2004 to permit reduced annual purchases
of 3.2 bcm per year until 1992 and 3.8 bcm per year thereafter. Algeria has re-
portedly dropped the take-or-pay previsions and has agreed to a $1 price rise to
just under $3.90 per million Btu. Although natural gas now provides less than
3 percent of total Spanish energy consumption, this share is expected to double
by 1992. Currently, Spain imports nearly all its gas from Algeria and Libya,
but new domestic production is expected to amount to nearly 3 bcm in 10
J
Tehran Seeks Canadian Iran has selected a Canadian company as the prime supplier of new oilfield
~ilf~eld Equipment turbine and compressor equipment as well as spare parts for older-probably
Iran is determined not to import any
oil~ipment irectly from the United States or France. Much of the
equipment purchased from Canada, however, is actually made in the United
States and only shipped to Canada for final assembly.
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1 March 1985
European and Japanese suppliers.
Iran has ashort-term need for a substantial amount of oilfield equipment to re-
place US-made equipment that is no longer operational. The new equipment
purchased from Canada will probably be used for gas injection, and we expect
additional purchases of Western equipment to~reverse Iran's seriously deterio-
rating oilfield productive capacity. Besides Canada, Tehran can turn to West
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Pakistani Oil Pakistan's oil production will nearly double-to 47,000 to 50,000 b/d-within
Output To Double the next year, according to US Embassy sources in Islamabad. The govern-
ment's hopes for petroleum self-sufficiency by the end of the decade have been
greatly improved by progress at the US-developed Dhurnal field near Rawal-
pindi, which is expected to produce 20,000 to 25,000 b/d by the fall. Pipeline
capacity is currently limiting production, but the government and a US oil
company are cooperating to rush construction of a new pipeline to a nearby re-
finery. At a time of deteriorating nonoil trade balance and declining worker re-
mittances, areduced oil import bill would be most welcome. An additional
20,000 b/d from the Dhurnal field, for example, would save Pakistan about
$200 million a year at today's prices. Pakistan will still need to import an aver-
age of about 90,000 b/d of petroleum and petroleum products, however, to
meet domestic demand.
exican Water
Injection Problems
Poor results with water injection projects at several major Mexican oilfields in
the Reforma area have prompted Pemex to scale back to a pilot project for
water injection at Abkatun field in the Bay of Campeche to begin later this
year. By the end of 1984, Pemex had suspended nearly all water injection at 25X1
Reforma because of growing evidence of damage to some of the fields. The
Campeche reservoirs are geologically similar to those in Reforma, and
preliminary reservoir testing for the effects of water injection at Abkatun has
shown disappointing results. We believe that Mexico should instead concen-
trate its investments in oil exploration to meet future needs. As things now
stand, however, austerity and declining world oil prices make it unlikely that
the investments needed to sustain any major exploration program will be
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Chad's Oil Exploration Preliminary estimates from exploratory drilling in southern Chad are promis-
hows Promise ing, and the US company carrying out the project expects to bring in a test 25X1
well in a few weeks. A company spokesman told the US Embassy that the kid-
naping of two US employees by Chadian dissidents will not disrupt operations
at the drilling site. The hostages were rescued unharmed by Chadian forces on
13 February, after being held for five days. The company says it will consider
laying a pipeline to the Cameroonian port of Douala-several hundred miles 25X1
distant-if sufficient quantities of light oil are found, an increasing possibility.
sues Increase
Issues of foreign and international bonds by LDCs rose by more than $1 billion
in 1984, the first increase since 1981. The largest issuers last year were
Malaysia and South Korea, which floated about $2.2 billion of the $3.5 billion 25X1
LDC total. Since the onset of the Latin American debt problems in 1982, the
market for LDC bonds generally has been limited to countries with prime
credit ratings. Asian countries--considered the most creditworthy LDCs-
have taken advantage of their access to bond markets, obtaining better terms
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Thailand
253
283
Trinidad and Tobago
50
107
Tunisia
60
0
increase syndicated lending.
than on syndicated loans. We believe that the bond markets will remain a
minor source of funds for LDCs as a whole but will be used more widely by the
better credit risks particularly if commercial banks remain reluctant to
Philippine Financial Signing of the commercial banks' financial rescue package, scheduled for this
Rescue Package week, has been postponed indefinitely because a major Saudi bank is refusing
Hits Snag to participate. Bankers coordinating the package apparently are concerned
that other banks will withdraw if the Saudi bank-still miffed over a 1980
transaction with Philippine banks-does not pledge the $13 million in new
financing that its exposure in the Philippines requires. Commercial bank
financing-including $925 million in loans-is the third element in a $10
billion rescue package comprising new money, an IMF balance-of-payments
loan, and rescheduled official debt payments. Other commercial banks, the
IMF, and Manila's large aid donors are pressuring the reluctant bank, and a
breakthrough is likely soon. The delayed signing and the feared withdrawal of
other banks, however, underscore the fragile nature of the financial rescue
package and suggest it could still unravel because of unfavorable political or
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1 March 1985
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Moroccan-US
Financial Problems
The Turkish Central Bank announced last week that prolonged negotiations
fora $500 million medium-term commercial loan were concluded. The seven-
year loan will have an interest rate of 1.375 percentage points above LIBOR,
according to the US Embassy, slightly better than the 1.75-percentage-point
spread Turkey received in its March 1984 syndication. Nineteen banks will 25X1
participate in the credit, with each taking shares of $20-30 million. Arranging
the loan proved difficult because of the new type of credit facility being used-
lead banks will underwrite successive issues of short-term Euromarket notes-
and the increase in the amount of the loan. Last year's credit facility with com-
mercial banks amounted to $300 million. ~ 25X1
imports and outstanding bills to Washington and other foreign creditors.
Rabat's inability to service its external debt already has caused the suspension
of $250 million in CCC credits and could cost Morocco access to US military
assistance by this spring. The government put repayment of official debt on 25X1
hold in January to conserve dwindling foreign exchange reserves-less than
$35 million-until a new debt rescheduling agreement is negotiated. As a
result of the loss of CCC credits, Rabat has made overtures to the French to
cover the estimated 150,000-ton wheat shortfall expected this month. If Paris
does not come through, Morocco may be forced to use remaining reserves to
meet grain import needs and forgo resolving arrears on US military purchases.
The US Embassy in Rabat estimates that about $17 million in overdue
payments is subject to Brooke amendment sanctions this year of which $8
million is due on 30 April. Without a new debt rescheduling agreement or ad- 25X1
ditional food aid, the government will be hard pressed to pay for both essential
Islamic Development The Islamic Development Bank (IDB) at its annual meeting last month in
Bank Annual Meeting Dhaka restored Egypt to full membership and released to Cairo $25.5 million
in deposits frozen since 1979. Syria and Libya found little support for their op-
position to Egypt's readmission. The IDB actions reflect the continued 25X1
reintegration of Egypt into mainstream Islamic and Arab affairs. Afghanistan
is now the only IDB member still under suspension. Turkey received a
permanent seat on the Board of Governors alongside Saudi Arabia, Kuwait,
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t
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West European
Software Agreement
UK Miners'
Strike Eroding
French Investment
Prospects. Brighten
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1 March 1985
Libya, and the UAE. The Board approved $123 million in new aid requests,
with Pakistan, Bangladesh, North Yemen, and Syria receiving most of the
funds. The IDB has been criticized by its poorer members for concentrating on
short-term foreign trade financing, but development loans are more difficult to
arrange given the Islamic prohibition on interest.
Global and Regional Developments
status quo.
The recently announced West European software agreement on operating
systems standards will not achieve its desired effect. The major West
European manufacturers have chosen a software standard based on the
popular Unix operating system developed by AT&T. The often stated purpose
of this choice was that it would help reduce IBM's domination of the West Eu-
ropean market. Because IBM has supported a common standard for Western
Europe and has recently started offering fully supported implementations of
Unix System V, European manufacturers are liable to see little~change in the
National Developments
Developed Countries
returned, probably by the anniversary of the strike on 12 March.
British coal miners returned to work in record numbers this week, following
the collapse last week of another attempt to end the 50-week-old strike. The
National Coal Board claims that 49 percent of the 187,000 miners now have
abandoned the strike. The government has ruled out further negotiations and
is offering strikers a cash bonus of up to $107 if they return by 11 March. In
the first break among union officials, the president of the Yorkshire local
where the strike began admits that members may have to return to work
without a settlement. This return-to-work trend is likely to continue. Prime
Minister Thatcher will declare victory when 50 percent of the miners have
rather than to expand capacity.
French investment is likely to increase in 1985, judging from recent govern-
ment surveys. Although many businessmen complain that profits are still
unsatisfactory and overall financial conditions remain difficult, a growing
proportion of firms are reporting improved profits. Industrialists, including
those in state-owned manufacturing enterprises, say they intend to increase
real investment by 5 percent in 1985; as late as last summer, they planned to
reduce investment this year. Although this will stimulate demand, the effect on
employment in the investing industries may be disappointing because most
investment is designed to replace old equipment and to increase productivity
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Japan Debates
Capital Controls
Concerned about the recent yen depreciation against the dollar, Japanese
parlimentarians are privately pressing the Ministry of Finance to restrict
capital outflows. Embassy reporting indicates Ministry officials are trying to
defuse the pressure, which runs counter to Japan's commitment to capital
market liberalization, by soliciting ideas from financial circles on how to spur
capital inflows. On the basis of a similar episode in the summer of 1983-when
Prime Minister Nakasone called for capital controls-we believe the Finance
Ministry will succeed in heading off formal measures. Finance officials are
likely, however, once again to request life insurance companies to limit
purchases of foreign securities voluntarily. It is not yet clear whether Tokyo
will act on recommendations from local bankers that more government-
guaranteed bonds be issued overseas.
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/Austerity Measures
Less Developed Countries
Mexico City announced further austerity measures last week, probably in an
effort to gain IMF approval for its economic program and to allay public
concern over the exceptionally high January inflation figure.
the government will now cut $1.2 billion from
the $85 billion budget for this year, largely through cuts in public-sector
investment, with the remainder coming from the sale of state-owned compa-
nies and decreases in current expenditures and subsidies. We expect political
pressures will continue to prevent the de la Madrid administration from fully
implementing significant deficit reduction measures. Lack of private-sector
interest in purchasing inefficient or loss-plagued state-owned companies will
also frustrate government efforts to cut spending. Meanwhile, the Bank of
Mexico indicated it plans to reduce the money supply to 11 percent below
December's level, suggesting a high level of concern over the 7.4-percent
inflation in January. Continuing depreciation of the peso, wage hikes, and
further reductions in subsidies, however, will fuel increases in the cost of living.
,. Moreover, failure to cut the budget as planned will also weaken the fight
against higher prices.
Mexican Trade
/ Policy Initiatives
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1 March 1985
Mexico is reviewing its
suits against Mexican exporters.
trade policy and stance on.joining GATT probably are designed to impress US
officials. President de la Madrid and Commerce Secretary Hernandez indicat-
ed in speeches over the past several weeks that Mexico is willing to review the
multilateral trade framework, and emphasized the importance of improving
trade relations with the United States. With the drop in oil prices and limited
access to international financial markets, Mexico is counting heavily on
increased access to US markets to boost foreign exchange earnings this year.
The government probably is seeking to ease growing tensions over Mexican
protectionist policies that are threatening several crucial bilateral trade
agreements. Mexican officials are pressing for a bilateral subsidies pact that
would make it more difficult for US producers to initiate countervailing duty
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Sudan Adopts
Economic Reforms
Libyan Water
P1,oject Expanded
United States and other bilateral donors.
The Nimeiri regime has announced a combination of budgetary, price, and
foreign exchange reforms designed to stabilize the economy and induce foreign
donors, particularly the United States, to resume suspended financial assist-
ance. Increased customs receipts-nearly half from added oil import duties-
selected tax increases, and modest budget cuts are expected to reduce the
projected $240 million budget deficit. New petroleum pricing measures will
increase gasoline prices by more than 60 percent. The government has also
instituted foreign exchange reforms, including a 48-percent official devalua-
tion of the Sudanese pound, a new commercial bank rate, and abolition of the
licensed private foreign exchange dealer system. The new commercial bank
rate may have been set too low to attract private remittances, however, and a
parallel black market is likely to develop. Nimeiri probably believes he has
now pushed economic reform about as far as he can without provoking political
unrest and expects at least a partial resumption of economic support from the
Tripoli probably will seek bids totaling $3.3 billion in June on the next stage of
the Great Manmade River Project
particularly if such spending causes import shortages.
South Korea's Dong Ah Company, the main contractor for the first stage, has
had difficulty meeting construction schedules and probably will not participate
in the second phase. Other South Korean firms and Japanese companies are
competing, however, and. may offer price discounts and oil barter arrange-
ments as sweeteners. US companies are at a serious
disadvantage because of Libyan concern over US sanctions and the less
favorable terms offered. Qadhafi has placed considerable personal prestige on
the Great Manmade River Project and has met his financial obligations on the
project. His refusal to cut back the scheme in the face of persistent low oil rev-
enues probably will intensify domestic opposition to his economic policies,
Mauritania Faces Nouakchott plans to raise cereal prices by up to 30 percent to reduce the
raise expectations of additional Arab funds.
budget deficit and promote domestic grain production. Wage hikes of 10 and 5
percent, respectively, for low- and high-income Mauritanians are scheduled to
soften the impact on living standards. The regime also may devalue the
ouguiya and trim spending-issues that have hindered negotiations with the
IMF and stalled debt rescheduling efforts. Implementing these measures,
however, will be hampered by another year of bleak economic prospects.
Receipts from iron ore and fishing-the primary sources of foreign ex-
change-probably will languish at the 1984 level. As a result, real GDP
growth probably will stagnate around the 1-percent yearly average achieved
since 1980, frustrating efforts to trim the budget deficit and reduce the current
account deficit. The Taya regime will have to rely even more heavily on
foreign benefactors. Saudi Arabia recently supplied $30 million in aid, and the
recent rapprochement with Morocco and contacts with several Gulf states
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1 March 1985
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Aluminum Company
ispute With
Ghana Settled
'ran Cuts Budget
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After atwo-year shutdown, Ghana's US-owned Volta Aluminum Company
(Nalco) resumed production in January at its smelting plant-the largest in
Africa. The closure resulted when the populist-oriented Rawlings regime
demanded renegotiation of the original 30-year operating agreement in order
to increase government revenues. Although Accra settled for less than it
originally asked, the new agreement boosts the government's share of Nalco's
earnings and increases its revenues from hydroelectric power. The settlement
probably reflects Nalco's considerable economic contribution and Rawlings's
commitment to maintaining his economic opening to the West and attracting
foreign investment. If production reaches preclosure levels, Ghana should
return to the ranks of the top 10 US trading partners in Sub-Saharan Africa.
spur greater domestic unrest.
Last Sunday.Iran's Majles (Parliament) approved a $38.7 billion budget for
the fiscal year beginning 22 March that cuts spending by 10 percent and raises
taxes by 30 percent compared with last year's budget. The Majles wants to
boost fiscal responsibility and reduce reliance on oil revenues. The Majles also
lowered Prime Minister Musavi's projection of oil revenues from $19.8 billion
to $17.5 billion because oil revenues for the current fiscal year~.are $6.4 billion
below the budget target of $19.1 billion. Moreover, there was concern that
Musavi's oil income target would require Iran to exceed its OPEC quota,
risking a price war. In addition to higher taxes, doubling the price of heating
fuel or gasoline is also being considered, although both measures are likely to
Taiwan's Financial Ten senior officials of a major Taiwan corporation and its banking subsid-
candal
foreign investment and to become more active in international banking.
iary-possibly including some senior government officials-have been arrested
for financial irregularities. The Ministry of Finance suspended the bank's
lending activities on 11 February, and depositors have since withdrawn about
$425 million. An audit had revealed illegal private loans and inaccurate
bookkeeping practices. The case has sent shock waves through Taiwan's
business circles, where private loans at high interest rates absorb as much as
40 percent of savings. Other domestic and some foreign banks have pledged as-
sistance to keep the corporation afloat, and the authorities are moving quickly
to contain damage to Taiwan's reputation as a profitable investment market.
The incident, however, may impede the government's attempts to attract
New CEMA Initiatives Two recent CEMA initiatives highlight a renewed effort, probably spearhead-
Secret
1 March 1985
ed by the USSR, to reduce dependence on the West. Two officials of the
International Investment Bank (IIB) told the US Embassy that the IIB plans to
increase the share of loans for CEMA projects in "transferable rubles" relative
to hard currency loans. The proposed Yamburg gas pipeline, for example,
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Secret
ugoslavia's Foreign
Exchange Control
Dispute ,
would receive a greater share of ruble financing than the Orenburg pipeline,
because CEMA members now have the capability to produce most of the
equipment needed. Although the USSR and its East European partners can
produce most of the pumping equipment, we believe they will have to rely on
the West for most of the 2.8 million metric tons of large-diameter pipe
required.) 25X1
further behind.
In early February, ahigh-level CEMA committee on machine building met for
the first time to discuss plans for producing world-class equipment through
greater cooperation and specialization. Unless its high-level nature gives it
greater authority than the existing CEMA commission on machine building,
the new committee's efforts probably will be no more successful than those in
the past. According to a Soviet economist, of 18 CEMA machine-building
sectors studied, only one had achieved world standards between 1970 and
1982, five were approaching world levels, and the remaining 12 had fallen even
Disputes among republics about central controls over foreign exchange have
become a major issue. Prime Minister Planinc, in a recent interview, said that
the debate over the foreign exchange system is now the most divisive question
in the Yugoslav leadership. A recent ruling by the Constitutional Court Voided 25X1
legislation that gave exporting firms the right to retain foreign exchange
receipts and requires the government to draft substitute legislation by the end
of March. According to US diplomatic reports, officials in Croatia and
Slovenia-which earn surpluses of hard currency-are concerned that new
legislation will use political criteria to distribute foreign exchange and thereby
undermine the export-led economic recovery program. In contrast,0 25X1
the poorer republics of Serbia, Montenegro, and Macedonia are
will aggravate the usual divisions among the regions.
the leading proponents of recentralizing authority over foreign exchange. New 25X1
legislation probably will reflect a compromise, but it is not likely to be worked
out in time to meet the deadline. The dispute is likely to fester for months and 25X1
Secret
l March 1985
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West Germany: Cutting Back
the Budget Deficit
Many developed countries have been preaching
austerity, but West Germany's has been uniquely
successful in reducing budgetary red ink. Under
Chancellor Kohl, the federal budget deficit is de-
clining both in absolute terms and as a percentage
of GNP. Kohl's policies, however, have taken their
toll, falling largely on social programs for the
disadvantaged. Moreover, economic growth in 1983
and 1984 was depressed by reduced government
spending and higher consumption taxes. Although
the government's fiscal plans should begin to pro-
vide some stimulus to the economy starting in 1986,
we believe a major tax overhaul is necessary to
reduce the tax systems's high progressivity that
discourages savings and capital investments.
increase, Kohl hopes to bring the figure back under
45 percent by 1988. Recent tax policy has favored
investment over consumption. Although indirect
and social security taxes have increased slightly,
the ratio of government tax revenue to GNP has
remained relatively constant at about 25 percent.
Kohl has had little alternative to concentrating
spending cuts in the social area. The West German
budget, like those of many developed countries, is
dominated by nondiscretionary spending. Entitle-
ment programs, public employee salaries, and debt
service together constitute about 70 percent of total
expenditure. Interest payments have grown most
rapidly in recent years, although the escalation in
debt servicing costs is now beginning to taper off.
Kohl's Approach
Since coming to power in October 1982, the Kohl
government has sought to reduce the role of the
government in the economy, while stimulating in-
vestment and medium-term growth. Rather than
instituting sweeping reforms or blanket spending
freezes, Kohl adopted an eclectic, gradualist ap-
proach and has made exceptions to suit industrial
policy and other objectives. The depressed housing,
shipbuilding, and steel industries, for example, have
benefited from increased subsidies. Bonn was more
than eager to increase research and development
expenditures, and defense has also been favored. By
altering a wide range of taxes slightly and spread-
ing budget reductions over a number of,special
interest groups, Kohl has attempted to defuse
political resistance to austerity. ~~
Kohl, however, is sensitive to charges that the brunt
of austerity has fallen on the less afliuent. In an
attempt at equity, the 1983 budget called for a
5-percent income tax surcharge-in the form of a
compulsory, non-interest-bearing loan-to be im-
posed on those in higher tax brackets. This measure
was declared unconstitutional late last year, how-
ever, and the proceeds have been refunded. Al-
though the Cabinet decided against a replacement
levy, Kohl still hopes to achieve somewhat more
balance in his fiscal programs. In the future, for
example, the government intends to aid large fam-
ilies through increased tax deductions.
The Budget Specifics
In pursuing a more balanced budget, Kohl has
focused on spending control rather than tax in-
creases. Total spending by all levels of government
rose from 39 percent of GNP in 1969 to almost 50
percent in the early 1980s. Concerned by this
The new Christian Democratic/Free Democratic
coalition's revised 1983 budget was similar to an
earlier draft submitted by Helmut Schmidt, but
Secret
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Billion deutsche marks
2i7.5
234.9
246.6
248.3
251.7
Percent growth
6.1
8.0
5.0
0.7
1.4
Revenue
Billion deutsche marks
189.9
196.9
208.9
216.4
223.3
Percent growth
6.0
3.7
6.1
3.6
3.2
Taxes (billion deutsche marks)
177.5
181.9
184.6
191.9
NA
Other b (billion deutsche marks)
12.4
15.0
24.3
24.5
xn
Net borrowing
Billion deutsche marks
27.6
38.0
37.7
31.9
28.4
Percent of GNP
1.8
2.5
2.4
1.9
1.6
e Figures for 1984 are estimated. All figures are on a finance basis.
n Includes Bundesbank profit.
entitlements were cut further and public salaries
were curbed. The budget reduced child-care pay-
ments, delayed cost-of-living adjustments on pen-
sions, and increased health care user charges. On
the revenue side, the value-added tax was increased
by a percentage point, and employee social security
contributions were raised. At the same time, tax
breaks and interest subsidies were increased for
residential and industrial investment.
The 1984 federal budget again hit social spending
and postponed salary increases for public employ-
ees, with -the aim of holding total expenditure
growth to 1.5 percent. Unemployment compensa-
tion was cut, as were maternity payments. Social
security obligations were raised to strengthen the
national pension system. Tax credits and deprecia-
tion allowances for corporations and small busi-
nesses were hiked to stimulate capital spending.
In both 1983 and 1984, the federal budget deficit
was smaller than expected. The 1983 budget had
projected a slight rise in the deficit to DM 42
Secret
1 March 1985
billion, but the actual shortfall dropped to DM 32
billion. Likewise, in 1984 the deficit totaled about
DM 5 billion less than the gap projected in the
budget. The improvements were partly the result of
a stronger-than-expected recovery, but government
finances also benefited from external developments.
The weak deutsche mark inflated import prices
and, hence, tariff revenues. In addition, high US
interest rates and Bundesbank exchange market
intervention resulted in record central bank earn-
ings on its $40 billion in foreign reserves, and these
profits are remitted to the Federal Government.
Future Prospects
The 1985 federal budget and the Finance Minis-
try's most recent revision of the Medium-Term
Financial Plan indicate that government spending
constraints will continue. Bonn's 1985 draft budget,
passed by the Bundestag in December, projects
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Taxes (billion deutsche marks)
200.1
211.7
218.5
231.3
241.8
Other b (billion deutsche marks)
23.2
24.2
23.1
21.1
19.4
Net borrowing (billion deutsche marks)
33.6
24.0
26.0
23.2
22.4
e As of mid-1984.
b Includes Bundesbank profit.
nominal expenditures up only 1.2 percent from the
1984 draft, although actual spending may rise
somewhat more. After 1986, federal expenditure
growth is to be held at 3 percent per year, less than
the expected rise in nominal GNP. In presenting an
otherwise tightfisted document, the Finance Minis-
try emphasized the good news: the budget crisis is
past, and reducing the deficit can proceed without
major new cuts in the social riet or the threat of
increased taxes. The Finance Ministry projects a
gradual reduction in government borrowing
through 1988 despite the added drain of increased
EC contributions beginning next January and high-
er subsidies for agriculture.
Although federal spending will remain tight, some
fiscal stimulus will come from federal tax cuts and
from local government spending. Bonn has decided
on a two-stage tax reform for 1986 and 1988 to
compensate in part for the bracket creep-personal
income tax scales were last adjusted in 1981. The
first stage will result in tax breaks of about DM 11
billion-roughly 1 percent of disposable income-
of which about half is to accrue to families with
children. The 1988 tax cuts of about DM 9 billion
are designed to reduce the overall progressivity of
the income tax system. Fiscal stimulus should also
be provided by the regional governments, which are
reviving public works projects postponed during
austerity. Surveys indicate increased public-sector
contracting activity in recent months, which should
translate into higher capital expenditures late this
year and next.
Economic Impact
When warning against government indebtedness,
the West German Finance Ministry focuses on the
national phobia-inflation. The connection be-
tween deficit financing and inflation in West Ger-
many, however, is tenuous. Past deficits have been
financed primarily by domestic borrowing, not by
money creation. The Bundesbank has had no diffi-
culty in achieving its monetary targets in recent
years; and monetary expansion in West Germany
has not been inflationary. The reduced monetary
growth target of 3 to 5 percent for 1985-consid-
ered restrictive by some West German econo-
mists-will complement tight fiscal policy. The
Secret
1 March 1985
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West Germany: Public-Sector Finances a, 1975-84
Expenditures and Receipts
Billion deutsche marks
Public-Sector Deficit.
Billion deutsche marks
0 1975 80 84 0 1975
~ Federal and regional governments and social security on a national
income accounts basis.
Bundesbank implicitly assumes that all significant
price pressures have been squeezed out of the
economy and that an economic growth path of 2.5
to 3.0 percent is optimal.
On the negative side, Kohl's fiscal policies in 1983
and 1984 have reduced economic growth because
government consumption and investment have been
depressed. The local authorities, who are responsi-
ble for most of the public investment in West
Germany; have reacted to federal austerity by
cutting capital expenditures. Moreover, higher
VAT taxes and reduced transfers have curbed
personal consumption. Because of tight budgets the
overall performance of domestic demand has been
generally disappointing. and the West German.
economy has been forced to rely on exports-
buoyecl by the strong dollar-for growth. More-
over, the Social Democrats argue that the govern-
ment's budget policies have worsened unemploy-
ment, which stands at about 9 percent.
Secret
1 March 1985
i ~ i i i i
80 84
Although Kohl's tax reforms should provide some
fiscal stimulus starting in 1986, a major tax over-
haul is necessary to reduce the systein's_ high
progressivity to increase incentives for savings and
capital investments. The German Council of Eco-
nomic Advisers in its January 1985 report applaud-
ed Kohl's past budget policies, but argued that
more aggressive tax action was needed to returm the
economy to a full employment growth path. Fi-
nance Ministry officials have recently advocated
revisions to reduce corporate tax burdens and end
distorting investment subsidies. Such measures, ,
however, will not be deliberated until the new
legislative session begins in spring 1987.~~
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Italian Machine Tool Industry:
A European Success Story
Unlike the bulk of West European industry, the
Italian machine tool industry has adapted quickly
to changes in technologies and markets and thus
has weathered the worldwide economic downturn
better than its European counterparts. A stronger
performer than many industries in Italy, the ma-
chine tool industry has managed to hold market
share at home and abroad. Government susidized
loans for machine tool users helped turn domestic
sales around in 1984, and a recent industry export
drive is beginning to pay off; particularly in the US
market. The USSR also figures prominently in
Italian efforts to boost exports, offering the poten-
tial for increased Soviet acquisition of advanced
machine tool technology with military applications.
A Tough Competitor
The Italian machine tool industry is a world class
competitor, ranking as the world's fifth-largest
producer and exporter. Exports have been particu-
larly important to the Italian industry because the
domestic market is relatively small. Italy has the
second-highest ratio of exports to production
among non-Communist producers-57 percent, as
compared with Japan's 33 percent.
As in most countries, the Italian machine tool
industry is fragmented; it consists of approximately
450 companies averaging 25 employees each. Ac-
cording to an OECD survey, only three firms
employ more than 200 workers, and the top 40
companies account for about half of the industry's
output. Located in the industrial north, most firms
are highly specialized, .family-owned operations.
Several factors are responsible for the success of
Italian machine tool manufacturers:
? Most of the industry has concentrated on carving
out niches in the world machine tool market
rather than producing general-purpose machines.
? The small size of most Italian producers has
helped these firms maintain relatively low labor
and production costs compared with West Euro-
pean and US competitors. A large segment of the
industry is not subject to cumbersome govern-
ment regulations-such as those on employee
dismissal-which generally apply only to firms
with more than 20 employees. Moreover, small-
ness has discouraged unionization.
? The ability of Italian producers to adapt more
quickly to new technology than many of their
West European counterparts is another plus. Ita-
ly was one of the first West European countries to
begin using and building numerically controlled
(NC) machine tools.
The Italian Machine Tool Builders Association
(UCIMU) has promoted the international competi-
tiveness of the Italian industry. The association
offers domestic and overseas marketing services,
loans for member firms, and funding fora govern-
ment-sponsored research lab. More than 150 com-
panies are members of the UCIMU, and together
they account for about three-fourths of Italy's
machine tool production.
Although in the past little government aid was
aimed specifically at the machine tool industry,
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legislation passed in 1982-pushed forcefully by
UCIMU-provides subsidized loans for small- and
medium-sized firms to finance up to one-third of
the cost of new, advanced capital equipment. The
program's initial allocation of $53 million was
approved at the end of 1983. The Italian manufac-
turing sector has been quick to request loans to
cover retooling of traditional and high technology
industries. During the first nine months of 1984,
the government approved 1,900 applications valued
at $41 million. Largely in response to lobbying by
UCIMU, an additional $113 million was allocated
to the program in the last half of 1984.
Like other major producers, the Italian industry
was affected by the 1981 /82 worldwide economic
downturn-production dropped 24 percent during
1981-83 period. Domestic sales fell the most be-
cause of a steeper recession than in many of its
major trading partners. Moreover, debt problems
and economic sanctions have. hurt sales to Eastern
Europe and the USSR.
The industry, however, fared better than most of its
West European counterparts. Italy was able to
maintain its share of the world market at about 7
percent while most other West European exporters
saw their share of world sales decline. Italy also
was able to maintain its large trade surplus in
machine tools during the period.
Although other major producers faced growing
import penetration in the early 1980s, particularly
from Japan, Italian producers held their own.
Italy's strong competitive position coupled with the
weak.lira kept import penetration relatively con-
stant at about 30 percent, the lowest ratio among
major producers except Japan. The Japanese share
of the Italian market, for example, remained con-
stant at less than 1 percent.
With the pickup in the world economy in 1984, the
Italian industry is rebounding. Export orders
picked up in the fourth quarter of 1983 and
domestic orders-helped by government incen-
Secret
1 March 1985
Machine Tool Production, 1980-84
Y
United Kingdom
~ i United States
i
I I I I I
0 1980 81 82 83 84
a Index based on local currency in real terms.
tives-increased by 60 percent during the first nine
months of 1984 compared with the same. period in
1983. The industry estimates that 1984 total ship-
ments reached a record high in lira terms, and the
decline in export and domestic shipments reversed
itself. In real terms output jumped 10 percent in
1984.
Looking Ahead
We believe that Italian machine tool producers are
in a good position to take advantage of the global
economic recovery. Moderate wage demands are
. Italy
France
-~ West German
25X1
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World Market Shares for Major
Machine Tool Manufacturers
West Germany 2
5
23
24
23
22
Japan 1
3
16
14
15
19
Switzerland
8
7
8
8
7
Italy
8
7
7
7
7
United States
7
9
6
5
4
United Kingdom
6
5
5
4
4
France
5
4
3
4
3
helping to keep the industry competitive. Aided by
the weak lira, the Italian machine tool industry is
placing increased emphasis on exports particularly
to the United States, the USSR, and the LDCs.
To strengthen Italy's position in the US market,
UCIMU opened an office in the United States in
1981 and restructured the dealer network and
service centers. An increasing number of Italian
machine tool manufacturers are establishing sales
subsidiaries, and others are linking with US firms
to gain marketing and service capabilities. Italy has
supplied only about 4 percent of US machine tool
imports in the past.
Italy is also hopeful of boosting exports elsewhere.
UCIMU, for example, is bullish on sales to the
USSR-Italy's second-largest market. In addition,
UCIMU, in conjunction with the Foreign Trade
Ministry and Italy's foreign trade institute is draw-
ing up a three-year program aimed at improving
exports to Third World markets, especially India,
Egypt, Mexico, and South America.
Implications for the United States
We believe the push by Italian machine tool build-
ers to expand exports will adversely affect US
domestic and foreign markets and may undermine
Secret
1 March 1985
1975
432
213
219
1976
359
160
199
1977
442
193
249
1978
596
195
401
1979
689
256
433
1980
848
356
492
1981
795
300
495
1982
640
209
431
1983
593
182
411
19848
580
194
386
US efforts to contain the flow of advanced technol-
ogy to the Soviet Union. Italian efforts to increase
US market share comes at a time when US firms
are already losing ground to overseas suppliers,
primarily the Japanese. Italian exports to the Unit-
ed States are further enhanced by Italian ties with
US firms, which can thereby expand their product
line while avoiding head to head competition in
areas where Italy's machine builders are particu-
larly strong. Such connections sometimes benefit
the US industry when they move beyond marketing
to include production; several leading Italian ex-
porters have transferred final assembly to their US
partners. Outside the US market, the Italian export
push is in direct competition with US machine tool
manufacturers. Many of the markets most sought
by Italian manufacturers-such as Mexico, the
largest US export market-have long been US
preserves.
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Italy: Machine Tool Exports Million US $
by Destination, 1983
Value
Percent
of Total
Total
593
100
Developed
363
61
United States
38
6
Western Europe
276
47
France
91
15
West Germany
53
9
United Kingdom
18
3
Switzerland
14
2
Belgium and
Luxembourg
11
2
Spain
11
2
Sweden
9
2
Other
69
12
Eastern Europe
21
4
Romania
9
2
Italy's targeting of the USSR for machine tool
sales increases opportunities for Soviet acquisition
of advanced machine tool technology. Sales pros-
pects to the USSR appear good based on the
Italian-Soviet gas accord, which promises to offset
gas sales with purchases of Italian goods. The
Soviets are anxious.to acquire the type of complete
automated systems the Italians can provide.
Mandelli, for example, which recently supplied a
flexible manufacturing system to Aerospatiale's
Toulouse plant, is setting up a subsidiary specifical-
ly to sell such systems to the Bloc. According to
Embassy and press reporting, the Soviets indicate
that they may buy up to $1.8 billion worth of plant
and equipment from Fiat by 1990.
Secret
1 March 1985
Although such sales do not necessarily include
embargoed technology, they will, nevertheless, pro-
vide Moscow with highly sophisticated technology
with military applications. Flexible manufacturing
systems, for example, enable Soviet plants to pro-
duce avariety of more reliable parts for military
equipment and make possible quick changeover
from civil to military production.
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The European Fighter
Aircraft Program
Senior defense officials from France, United King-
dom, West Germany, Italy, and Spain will meet in
Rome this month to decide the fate of the multi-
billion-dollar European Fighter Aircraft (EFA) co-
development program. Earlier sessions have set the
stage for a showdown between French and British
factions over program leadership and engine selec-
tion. We believe that some accommodation will be
reached as political commitments are too deep to
allow the joint venture to fail at this juncture. EFA
is important to the continued viability of Western
Europe's military aircraft industry and aerospace
employment rolls in the 1990s. Despite insistence
on an "all European" product, close relationships
between European and US defense firms will likely
provide opportunities for US involvement.
Motives for the Program
The European Fighter Aircraft is intended to re-
place aging inventories of US-, French-, and
British-made fighters. The five national partners .
anticipate procurement of 800 aircraft for their
own forces and significant exports to the Third
On economic grounds, EFA participants see the 25X1
program as a way to spread costs and risks. They
also believe EFA will protect domestic employment
and increase the technical proficiency of European
aerospace firms. With production runs ending for
all current European fighters, the absence of new
fighter programs could mean a disbanding of de-
sign teams and layoffs of assembly line workers.
The impact of lower production levels is already 25X1
being felt:
? In early 1984, France's Aerospatiale announced
that it was reducing production of sub-assemblies
for F-1 and Jaguar fighters.
? West Germany's Messerschmitt-Boelkow-Blohm
recently indicated that its 40,000-man work force
will be cut 10 percent over the next four years as
the Tornado program winds down.
? Dornier also is reducing its work force as West
German participation in the Alpha Jet-light 25X1
trainer, attack-program comes to a close.
World.
The Europeans cite a number of political and
economic reasons for embracing EFA. On the
political front, the project would allow member
governments to claim an important contribution to
NATO solidarity and defense cooperation. It also
would dispel the European industry's image as a
mere assembler of US weapons systems and pro-
vide afreer hand for export sales. Moreover,
concern over US dominance in advariced weapons
development is helping to unify government and
industry support for increased intra-European de-
fense cooperation. Britain's chief military science
adviser recently stated, for example, that the Unit-
ed States is too large to be a viable partner.
US attache reports and the press indicate that a
preliminary consensus has been reached on the
mission and design of the EFA. In addition,
operational capability has been targeted for 1995,
and initial production orders have been set-200
to 250 each for the United Kingdom, France,
West Germany; 100 to 200 for Italy, and 100 to
150. for Spain. Despite agreement on the basic
Secret
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design features and the strong political motiva-
tion for EFA, a number of critical hurdles re-
main.
Program Leadership. Selection of a program
leader is central to settling related problems of
final design, work distribution, and funding. Both
the United Kingdom and France are vying for
this role, and their positions reportedly remain far
apart. British Aerospace and Dassault-Breguet
both claim superior expertise in airframe manu-
facturing technology. The French are demanding
a dominant role in the program (40 percent) based
on Dassault's acknowledged leadership within
Europe as a builder and exporter of fighters.
British Aerospace
believes its experience in managing the three-
nation Panavia consortium (United Kingdom,
West Germany, and Italy) qualifies them to
spearhead EFA. APanavia-type arrangement,
however, is strongly opposed by the other partici-
pants, especially the West Germans.
On the basis of the positive outcome of the last
ministerial meeting and recent country official
comments, we are convinced that a balanced
work distribution can be worked out at this
month's meeting. US Embassy reports indicate
Secret
1 March 1985
that the production share arrangement agreed to
last July, giving equal shares to the United
Kingdom, France, and West Germany will help
settle the problem. Observers suggest that French
direction of the airframe group and British lead
on the engine and some components could be one
way out of the leadership dilemma.
Engine Selection. Four main engine candidates
are being considered by the consortium. All could
deliver adequate thrust; they differ only in levels
of technology. According to open sources, the
UK-West German RB199 engine-currently
used in the Tornado- incorporates technology of
the late 1960s. The General Electric F404 power-
plant, used in the F18, and France's SNECMA-
developed M88 engine are based on mid-1970's
technology. SNECMA claims that improvements
to its M88 engine will make it competitive with
engines to be offered in the 1990s. Officials of
Rolls-Royce state that their experimental XG40
engine incorporates current technical achieve-
ments, including advanced materials, and is
scheduled for demonstrator testing next year.
We believe that the British and French could
reach a compromise on engine selection, possibly
by electing to form a separate EFA propulsion
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European Supersonic
Aircraft Production
e Projected. European Fighter Aircraft production scheduled to
begin in 1993-95.
consortium that would marry the technical ad-
vances from both the M88 and XG40 engines.
The EFA requires some 15-percent weight reduc-
tion by any of the proposed engines to meet
performance re uirements-a hi hl ambitious
goal.
A likely joint production scenario
would include Rolls-Royce, SNECMA, West
Germany's MTU, and Fiat.
Other Problems. The sheer size of the program
will complicate the design and production pro-
cess. EFA currently involves six airframe manu-
facturers, four engine producers, and a host of
electronics and components firms. Overseeing
industry are the five defense and finance minis-
tries, in addition to the national air forces of each
country. Conflicts are likely to grow as the
Within the United Kingdom, the British Ministry
of Defense is pushing for an upgraded RB 199
engine to power the EFA, in part because it
would use this powerplant to reengine the Torna-
do.
Another source of friction is the disparate arms
export policies of the member nations. Attache
reports show that Dassault oflicials are insisting
that France receive a large proportion of any
export revenues arising from the EFA program
because of their experience in managing export
sales. In contrast to the French, West Germany's
arms export policy is quite restrictive. Within the
Panavia consortium, for example, Bonn has main-
tained the right to veto Tornado aircraft sales to
"areas of tension."
European leaders fear that job and technology
gains would be limited by US participation in
EFA. Consequently, the option of buying or
coproducing an advanced US fighter was killed at
the last ministerial meeting, even though there
was near unanimous agreement that the EFA
would be more costly and not as technologically
sophisticated. the
Europeans believe that such benefits are out-
weighed by stringent US technology transfer and
export restrictions, as well as the perceived stig-
ma attached to buying a US aircraft.
Even with the goal of an all European-produced
fighter, there should be at least limited opportuni-
ties for US manufacturers. Given the close rela-
tionships of many US defense firms with their
European counterparts, there is likely to be some
US role in the EFA project, especially at the
subcontractor and vendor levels. For example, an
Italian electronics company expected to be a
Secret
1 March 1985
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major subcontractor on EFA is majority owned
by a large US defense.contractor. Access by US
firms should increase once the EFA program gets
under way but is unlikely to include any major
US components that could control export sales.
Secret 26
1 March 1985
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New Steel Technologies
for the 1990s: Impact
on Competitiveness
The steel industries in the major industrialized
countries are turning to innovative new technol-
ogies to reduce costs and increase profitability
following a decade of weak demand and low prices
that have kept the industry in turmoil. These
technologies, which will gradually transform the
way steel is made in the 1990s, will be both risky
and initially costly to bring on line. We believe that
Japan will be in the best position to lead in the
application of the new technologies, but Japanese
leadership is not certain. Both West European and
US industries have an opportunity to improve their
competitive position if they aggressively move to
implement the new processes.
Steel Technologies for the 1990s
Two of the most promising new technologies-
near-net-shape casting and direct iron smelting-
will lead to smaller steel mills that cost about one-
third less to build and up to one-fifth less to operate
than today's mills. Near-net-shape casting-the
direct casting of liquid steel into a shape close to
that of the finished item-drastically reduces ener-
gy and rolling requirements. In addition to the
lower costs, some experts also believe direct casting
will lead to quality improvement.
Direct iron smelting will eliminate blast furnaces
and coking and sintering plants currently used in
smelting iron ore. These new systems gasify ordi-
nary coal to create the chemical agent needed to
reduce iron ore to iron and generate the heat
necessary to smelt reduced iron to hot metal.
Savings stem from: the use of ordinary rather than
metallurgical coal; the elimination of coke making;
Key Players and Programs
In near-net-shape casting, research is being vigor-
ously pursued in Western Europe, Japan, and the
United States.
we believe that the Japanese are
devoting more manpower and money to this tech-
nology than any of their major rivals. All of the
major Japanese steel companies and several large
equipment manufacturers are involved
Despite all this activity, the Japanese are taking a
fairly conservative approach and are putting most
of their effort into the development of a thin slab
casting system, the least radical attempt at near-
net-shape casting. Nevertheless, slabs cast in 1- to
2-inch thickness, compared with today's 6- to 12-
inch slabs, would save substantial amounts of ener-
gy and rolling. Sumitomo Metal appears to have
the largest pilot plant and is casting thin slabs in
batches up to 40 metric tons. Nippon Steel and
Kawasaki Steel are also casting thin slabs experi-
mentally, but on a much smaller scale. Quality is
reported to be good enough for the basic steel
Secret
DI IEEW 85-009
1 March 1985
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Alternate Iron Smelting, Steel Casting, and Hot Rolling in
Flat Rolled Integrated Mills
Metallurgical
coal
Iron ore and
concentrates
Direct Iron Smelting With Thin Direct Iron Smelting With Thin
Slab Casting Strip Casting
Iron ore and
concentrates
Iron ore and'
concentrates
Basic oxygen
furnace
Thin slab
caster
Basic oxygen
furnace
Continuous
caster
Hot strip mill
10 stands
Ho[ strip mill
Five stands
Secret 28
1 March 1985
Basic oxygen
furnace
Liquid steel
Ho[ strip mill
Three stands
_~
Hot rolled coil
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grades used in construction and some container
applications such as drums. Many industry experts
believe that one or more of these companies will
have acommercial-scale thin slab caster ready
within three to five years.
In Europe, the Swiss firm Concast, the oldest
builder of continuous steel casting equipment, told
US Embassy officials that it has developed a thin
slab process and is ready to build a pilot plant. In
addition, industry observers report that
Mannesmann-Demag in West Germany is doing
work generally comparable with Concast. Work is
under way at other European firms, such as Danieli
in Italy and British Steel, but reportedly is not as
far advanced.
Research in the United States has taken a bolder
approach to near-net-shape casting; most efforts
are aimed at the direct casting of a product roughly
equivalent to hot rolled strip, the primary flat rolled
product. Allegheny Ludlum recently demonstrated
an ability to cast a thin stainless steel strip, an
achievement that appears to give the United States
a clear lead in the development of this technology.
Despite Allegheny Ludlum's success, however,
many engineering problems remain in extending
this process to high-volume carbon steel production,
and most industry experts feel that the commercial
application is at least 10 years away.
We believe that West European firms currently
lead in direct iron smelting technology, but two
Japanese steel companies, Kawasaki and Sumitomo
Metal, are also working on the process. Industry
observers agree that the leading direct smelting
process appears to be the KR system developed in
West Germany by Korf Engineering. Korf operates
a pilot KR plant in Kehl, West Germany, and
current negotiations indicate that it is on the verge
of its first commercial sale. Several companies are
working on modifications of the KR process. The
chief effort is Dutch steelmaker Hoogovens's at-
tempt to adapt the KR system to fit into the shell of
an old blast furnace, thus achieving significant cost
savings. In addition, three less promising direct
smelting processes are under development in
Sweden.
Application: Who Will Lead?
Although no clear technological leader has
emerged, we believe that the Japanese will be in the
best position to commercialize these technologies.
For more than two decades, Japanese steelmakers
have been the most willing to take risks in bringing
commercially untried processes into production,
and the Japanese are also in the best financial
position to afford the new technologies.
At the other extreme, the US steel industry is in
very poor financial shape and has been among the
most cautious in introducing new technology. This
pattern, however, may be changing as excess capac-
ity is scrapped and a better supply-demand balance
gradually develops. In addition, US steel producers
have developed a keener interest in new processes
that cut costs and improve profitability. A major
US minimill operator, for example, recently an-
nounced negotiations looking toward cooperation
with one or more foreign companies to develop a
thin slab casting system for its mills.
We believe the new processes provide steel-
makers-particularly those with the oldest facili-
ties-with relatively low-cost ways of improving
productivity and financial performance. Industry
experts indicate that near-net-shape casting tech-
nologies, for example, offer higher returns on in-
vestment than the steel industry has realized for
many years. Direct iron smelting will also provide
large savings in operating costs and will cut re-
placement costs for aging, inefficient blast furnaces
and coking plants, particularly in the United States
and Europe.
A major steel industry restructuring is likely to be
spawned by the new technologies. Near-net-shape
casting, in particular, will spur development of the
minimill sector. Direct casting will make it possible
for minimills to enter the production of flat rolled
Secret
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~ecre~
steel on a major scale, something not currently
possible because of the large rolling mills required
by today's steel technology: In -addition, the new
technologies will help financially strapped Third
World steel producers to cut steel mill construction
costs and carry on expansion programs.
Those industries and companies that move most
aggressively are likely to enhance their competitive
position in world markets. In the case of the United
States, the shift toward efficient, low-cost minimill
steelmaking .probably will go further than in other
countries because the difference between scrap
prices and. hot metal costs-which accounts for
most of the minimill's competitive advantage-is
wider in the United States than it is abroad.
Because the new technologies probably will be
widely available, the gain in competitiveness
achieved by any one' company or country may be
small.
Secret 30
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Oman: Facing aGuns-
or-Butter Dilemma
Increasingly large defense expenditures are begin-
ning to cause concern within the Omani Govern-
ment that the country's economic development will
suffer, threatening the stability of Sultan Qaboos's
regime. Muscat has thus far managed to shield the
population from the effects of falling oil prices by
expanding production. Oman will press the United
States for additional military aid to purchase F-16s
and for more "rent" for the use of facilities by US
forces during bilateral talks scheduled for 18-19
May. Muscat wants the funds because of its tight
financial situation and because some Omani offi-
cials expect more tangible evidence of the United
States' appreciation for Omani military coopera-
tion.
Declining Current Account Surplus
The doubling of worker remittance outflows and
stagnant oil revenues have reduced Oman's current
account surplus from its 1981 peak of $1.3 billion
to an estimated $500 million last year. Foreign
exchange reserves have held fairly steady, largely
because of growing financial assistance from
abroad. This aid helps pay for the imports required
for the heavy defense buildup and economic devel-
opment program that bolster Sultan Qaboos's re-
gime.
A flood of foreign workers has provided the man-
power for Oman's military and economic projects.
The US Embassy estimates Oman's expatriate
labor force at 270,000-a 70-percent increase since
1981. In October 1983, Muscat implemented new
laws to restrict the inflow of foreign workers into
Oman, but continuing manpower requirements and
the lack of local skilled labor have resulted in lax
enforcement.
Oman, which is not an OPEC member, relies on oil
for virtually all of its export earnings and has
compensated for the decline in oil prices by boost-
ing production levels. These gains-from 282,000
b/d in 1980 to 410,000 b/d in 1984-were due in
large part to Oman's location outside the Persian
Gulf war zone. As a result, Oman's oil revenues last
year were only $100 million below the 1981 peak of
$4.4 billion. Muscat intends to continue expanding
production, despite OPEC objections, and has set a
production target of at least 500,000 b/d by the
end of the decade.
Despite fairly stable oil revenues, Oman has be-
come increasingly dependent on foreign assistance.
The Gulf Cooperation Council (GCC) granted
Oman $1.8 billion in 1983 to be allocated over 12
years to strengthen its military capability. Saudi
Arabia and Kuwait have paid their entire 1984
allotment, but Qatar and the UAE fell behind on
their 1984 payments. In addition, the United States
provided Oman with $40 million in credits under
the Foreign Military Sales (FMS) program in FY
1984 and has budgeted another $45 million for FY
1985. Muscat also received $15 million in loans
from the United States in FY 1984 under the
Economic Support Fund (ESF) program and $20
million is budgeted for this year. Oman also has
received concessionary loans from several Arab
development funds and from the United Kingdom
and West Germany for military construction pro-
jects.
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Oman: Balance of Payments
Million US S
19
80
1981
1982
1983
19848 19
85b
Current account
1,290
1,327
686
408
500
200
Trade balance
1,683
1,973
1,276
1,265
1,500
1,300
Exports (f.o.b.)
3,748
4,696
4,423
4,254
4,500
4,400
Oil
3,603
4,419
4,081
3,899
4,325
4,200
Imports (f.o.b.)
2,065
2,722
3,147
2,989
3,000 -
3,100
Services balance
-393
-647
-590
-857
-1,000 -
1,100
Worker remittances
(net)
-325
-448
-684
-793
-900 -
1,000
Government grants
101
148
42
151
150
150
Government loans (net)
14
146
121
387
400
450
Direct investment
117
96
133
194
150
150
Other
-959
-1,530
-1,146
-1,230
-1,037
-875
Errors and omissions
-398
-23
293
-20
-25
e Estimated.
b Projected.
The Defense Buildup
Omani officials view Iran as their country's most
immediate national security threat. Oman consid-
ers itself the guardian of the Strait of Hormuz and
worries about Iranian military and subversive
threats. Despite the establishment of diplomatic
relations between Muscat and Aden in October
1984, Sultan Qaboos also believes South Yemen
still poses a serious security threat. In addition,
Oman, which is avowedly anti-Communist, re-
mains wary of the Soviet presence around the
fallen below the levels assumed when the current
five-year plan (1981-85) was drawn up, military
spending has outstripped the plan's projections.
Concern is growing within the Omani Government
over the level of spending being siphoned from
economic development to defense. Although there
is little evidence of increased public disgruntle-
ment, several government officials have called for a
cut in defense expenditures-back to 35 percent of
the budget, according to US Embassy reports.
Arabian Peninsula.
Muscat's ambitious military procurement program
has produced defense outlays that, as a share of the
budget, are higher than those of any other Gulf
country. Defense and security expenditures ab-
sorbed 61 percent of oil revenues in 1984, up from
46 percent in 1981. Although oil revenues have
To date Qaboos has shown no interest in trimming
military outlays and, indeed, is moving forward
with plans to procure additional, highly advanced,
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Oman: Economic Indicators, 1980-85
Real GNP Growths
Percent
Foreign Exchange Reserves
Billion US $
Oil Production
Thousand b/d
equipment
~-at an estimated
total cost of $350 million and either eight or 12
British Tornado aircraft at a per-unit cost of about
$40 million. The financing of these purchases has
not yet been worked out. Although the F-16s are
less expensive and better suited to Oman's military
needs, the Sultan, a strong Anglophile, seems de-
termined to buy at least some new British aircraft.
Economic Development:
Taking a Backseat
Over the past decade, Qaboos's economic develop-
ment programs have modernized Oman, but many
Omanis have now become dependent on the govern-
ment for subsidized basic commodities, interest-
free business loans, land, and jobs. Although Oman
has achieved high rates of GNP growth, broader
social welfare indexes reveal that Oman is still
underdeveloped. Almost two-thirds of the labor
force, for example, still works in subsistence agri-
culture, life expectancy and literacy. rates are low,
and the infant mortality rate is among the highest
in the world. Moreover, health, education, housing,
and sanitation conditions are generally worse in the
villages than in the cities, prompting migration to
the cities and aggravating urban unemployment
and crowding
Qaboos has recognized the need for a more broad-
based economy. Muscat has earmarked funds for
the development of infrastructure and social ser-
vices in remote regions to stem the migration to
urban areas. Because present oil reserves are suffi-
cient for only about 25 years, Muscat has empha-
sized the development of light industry, minerals,
Secret
1 March 1985
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Oman: Government Budgets,a Million US S
1980-84
agriculture, fisheries, and services. Faced with a
budget deficit nearing $1 billion-roughly equiva-
lent to 15 percent of GDP-however, some of the
funds allocated for these projects have been shifted
to defense.
Oman's economic problems are manageable as long
as current revenue levels are maintained. Several
factors, however, could make it increasingly diffi-
cult to finance both development programs and
military procurement while shielding the popula-
tion from any hardships. These include:
? An escalation of the Iran-Iraq war into the Gulf
or a border clash with South Yemen that would
require even larger military outlays.
? A sharp drop in the price of oil.
Secret
1 March 1985
? A cut in grants from Saudi Arabia or other GCC
states that would force Muscat to reduce imports.
? A decline in the strength of the dollar to which
the Omani riyal is pegged, which would boost the
price of imports, especially those from the United
Kingdom-Oman's largest trading partner
Even in the absence of these factors, Muscat will
look to Washington for greater military aid to help
alleviate Oman's tight budget and to free up funds
for economic development.
including limit-
ed pre-positioning of military supplies. Qaboos will
probably push for increased rent-perhaps to be-
tween $50 million and $100 million
Muscat also hopes to
see US appreciation for Omani cooperation under
the Access Agreement reflected in administration
support for increased FMS credits
land, rather than do without,
will probably turn to the British or another supplier
willing to offer attractive terms.
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Secret
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