INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88-00798R000300100005-5
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 48
• Document Creation Date: December 22, 2016
• Document Release Date: June 8, 2011
• Sequence Number: 5
• Publication Date: April 4, 1986
• Content Type: REPORT

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Directorate of CAL
Intelligence
Weeklyr
International
Economic & Energy
Secret
DI IEEW 86-014
4 April 1986
838
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International
Economic & Energy Weekly
4 April 1986
iii Synopsis
1 Perspective-South Korea's Economy: Vulnerable to Political Unrest
3 South Korea: Outlook for Trade and Economic Growth
7 South Korea: Penetrating Communist Markets
13 North Korea's Approach to the West
17 Summit Issues: Big Six Budget Deficit Trends
21 USSR: Facing the Dilemma of Hard Currency Shortages
25 Pakistan: On a Foreign Payments Tightrope
31 Briefs 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
Secret
DI IEEW 86-014
4 April 1986
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International
Economic & Energy Weekly 25X1
Synopsis
1 Perspective-South Korea's Economy: Vulnerable to Political Unrest
Opposition efforts to marshal broad popular backing for political reform face a
less receptive audience because of the economy's rebound from last year's
lackluster performance. Nonetheless, a hardline government response to
popular pressures and demonstrations could hurt the economy and growth
prospects.
South Korea's export-oriented economy is poised for a recovery spurred by
Seoul's exchange rate policy and export promotion programs and by an
After almost a decade of indirect trade with the Communist world-largely as
a political tool to undercut North Korea-South Korea has recently begun to
profit from its economic relationships with P'yongyang's longtime allies.
Growing trade relations between South Korea and Communist countries could
not only displace US sales to the South Korean market but may also provide a
expected upturn in foreign demand and export prices.
7 South Korea: Penetrating Communist Markets
new conduit for transfer of sensitive technologies.
13 North Korea's Approach to the West
Faced with chronic shortages in its economy and a failure to secure increased
support from its Communist trading partners, P'yongyang has begun to look to
the West for equipment and technology to modernize its industry. So far,
however, this flurry of activity has yielded few payoffs because of North
Korea's abysmal repayment record during a similar turn to the West in the
mid-1970s.
17 Summit Issues: Big Six Budget Deficit Trends
Bix Six efforts to trim budget deficits have had mixed success during the
1980s. For FY 1986, most Big Six governments plan budget tightening and, if
they succeed in implementing more austere budgets, we expect fiscal policy to
have a negative or, at most, neutral impact on growth.
iii Secret
DI IEEW 86-014
4 April 1986
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21 USSR: Facing the Dilemma of Hard Currency Shortages
Declining oil earnings took a heavy toll on the USSR's hard currency position
in 1985 and will do so again this year.
25 Pakistan: On a Foreign Payments Tightrope
We judge Pakistan will face serious foreign payments problems despite recent
agreement on a $4 billion, six-year US economic and military aid package. We
believe the financially strapped Junejo regime will probably face increased
political activism from groups such as students, labor, and small farmers, who
were neglected during the martial law years.
Secret iv
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Perspective
International
Economic & Energy Weekly
4 April 1986
South Korea's Economy: Vulnerable to Political Unrest
prospects.
Opposition efforts to marshal broad popular backing for political reform face a
less receptive audience because of the economy's rebound from last year's
lackluster performance. Nevertheless, a hardline government response to
popular pressures and demonstrations could hurt the economy and growth
The downfall of President Marcos has given new impetus to the political
struggle between President Chun and the South Korean opposition. Opposition
leaders now believe they have a window of opportunity to press Chun for a
commitment to genuine political liberalization by 1988. In the next few weeks,
the possibility of violent clashes remains high as the main opposition party
pushes its petition drive for direct presidential elections and as students
demonstrate to commemorate several symbolic events-particularly the 17-27
May anniversary of Chun's takeover in the wake of the bloody 1980 riots.
two years.
Harsh government tactics historically have provoked stronger opposition
defiance in Korea-and these days the chances for escalating confrontation
and repression are even greater because Chun's antagonists believe they have
him at a disadvantage. To assuage foreign reaction, Chun backed off from his
initial crackdown on the opposition's petition campaign. He visits Western
Europe next week, and the British and Canadian prime ministers will visit
South Korea in May. Because the Asian Games in Seoul are only six months
away and the 1988 Seoul Olympics are on the horizon, Chun is making
domestic stability his top priority. Nonetheless, the president is surrounded by
hardliners, and the potential for political turmoil remains high over the next
Three decades of remarkable economic development have instilled most South
Koreans with confidence in the future and a jaundiced view of political unrest
that could endanger continued economic growth. As a result, the unemployed
and underemployed workers spawned by last year's sluggish GNP growth did
not join the opposition in the street. In 1986, we expect the economy will
remain, on balance, a plus for the government:
? Chun will continue to benefit from the expert management of economic
policy by his largely apolitical technocrats. However, the failure of a large
business group, a major financial scandal, or further rapid increases in
foreign debt could lend credence to opposition charges of economic
mismanagement.
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4 April 1986
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? Sparkling export performance in the first two months of this year-up 35
percent-and favorable exchange rate and oil price trends will help stimulate
the economy.
? The gains from South Korea's "economic miracle" are remarkably well
distributed.
? Although some violence has occurred as workers press hard for wage gains,
labor is largely unorganized or under government control.
Our optimism about the economy does not allay our fears that an unstable po-
litical climate could sour growth prospects in the months ahead. Seoul
calculates it will need $6 billion in foreign loans annually through 1988. Some
bankers, however, are already skittish about adding to their South Korean
exposure. If South Korea's credit rating falls because of civil strife, Seoul at a
minimum will face higher interest rate spreads, which would add to the debt
burden. Moreover, South Korean economic planners are counting on foreign
investment and rising domestic savings to complement the increased lending as
a way to spur capital spending and maintain Korea's industrial competitive-
ness. Political unrest that undermined the confidence of foreign investors and
businessmen could cut short the recovery and erode one of the major sources of
Chun's strength.
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South Korea: Outlook for
Trade and, Economic Growth
South Korea's export-oriented economy is poised
for a recovery spurred by Seoul's exchange rate
policy and export promotion programs and by an
expected upturn in foreign demand and export
prices. After a poor export performance last year,
we forecast higher growth of real exports, imports,
and GNP over the 1986-90 period, although growth
rates probably will be below the average for 1970-
84. Although continued high unemployment could
unite domestic opponents to trade liberalization, we
do not believe that economic issues will provoke a
dramatic confrontation between the South Korean
Government and the opposition.
Low Export Growth in 1985
South Korea: Export and Import
Trends, 1975-85
South Korean export growth slowed dramatically
in 1985. We estimate that export earnings in-
creased less than 1 percent, down from the 13-
percent increase recorded in 1984 and the smallest
export gain in 30 years. Three factors contributed
to the export slowdown:
? Slowing growth of OECD real GNP-especially
in the United States and Japan-reduced the
growth of demand for South Korean exports.
OECD real income increased about 3 percent last
year, compared with nearly 5 percent in 1984.
? Lower export prices-due to weakening demand,
greater competition, and Seoul's aggressive deval-
uation of the won-sliced South Korean export
earnings last year. We estimate that US-dollar-
based export prices declined 7 percent, after a
4-percent drop in 1984.
? Increased trade protectionism reduced South Ko-
rean export revenue. As of February 1985, South
Korean goods faced trade restraints-including
antidumping measures, import quotas, and volun-
tary export restraints-in 20 industrialized coun-
tries. South Korean authorities estimate that
these restrictions cost $1 billion in lost export
80 85
Imports
Exports
Stronger Export Growth in the Medium Term
Likely ... I
Over the medium term the pace of export growth
should increase. Under our baseline scenario, we
forecast an average annual 13-percent increase in
export earnings during 1986-90, with real (infla-
tion-adjusted) export gains averaging just over 9
percent per year. This real export growth, however,
would be well below the pace recorded during
1970-84.
' Our assessment of export growth is based on econometric analysis,
with exports assumed to be dependent on OECD real GNP and the
South Korean real exchange rate. Under our baseline scenario, we
assume real OECD income growth of 3 percent annually during
earnings in 1985.
Secret
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Exports and Import Capacity,
1985-90 a
Change over previous
year (percent)
Import capacity
Change over previous
year (percent)
0.6
9.1
12.5
13.8
14.9
14.4
26.4
28.7
32.6
36.9
42.3
48.2
-3.5
8.7
13.6
13.2
14.6
13.9
a Figures for 1985 are based on preliminary data; all export and
import figures are reported f.o.b.
Three factors will have a positive influence on
exports:
? Real exchange rate depreciation. South Korean
exchange rate policy is geared toward improving
the foreign payments position, and we believe
Seoul will allow the real (price-adjusted and
trade-weighted) exchange rate to depreciate at a
moderate pace (about 3.5 percent per year) to
improve export competitiveness vis-a-vis other
Asian countries.
? Higher export prices. South Korean export
prices, when measured in US dollars, have fallen
every year since 1981, and we forecast an addi-
tional 1-percent drop in 1986. However, export
prices should begin to rise after this year as
steady economic growth in the major industrial-
ized countries, combined with the expected real
exchange rate depreciation, boosts demand for
manufactured goods.
? Export promotion programs. These include sim-
plified export procedures, favorable export fi-
nancing, increased loans to small- and medium-
sized firms for export facilities, and the providing
of funds to the textile industry for modernization.
In addition, South Korea's rapid climb up the
technology ladder should continue, a trend that
should raise the importance of higher value tech-
nology-intensive products in the export mix and
boost Seoul's export earnings over the next five
years.
There are two powerful factors, however, that could
limit future export gains: industrial country protec-
tionism and competition from other Asian nations.
Protectionist pressures are particularly strong in
the United States-South Korea's largest market
and one where its textiles, steel, and footwear have
made substantial inroads. Moreover, bilateral trade
frictions have increased particularly over intellectu-
al property rights and US access to South Korean
insurance markets. Although some progress is be-
ing made to resolve these issues, other problems-
such as import liberalization-remain, and addi-
tional restraints on US imports of South Korean
goods are possible if negotiations stall or exports to
the United States continue to rise sharply.
Foreign competition is also likely to dampen South
Korean export growth. Seoul is reducing its depen-
dence on light manufacturing as it loses competi-
tiveness with countries such as India and Bangla-
desh. Even in technology-intensive industries such
as electronics and transport equipment, where
South Korea has a labor cost advantage, competi-
tion with established exporters such as Japan and
Taiwan is likely to be fierce.
Impact on Imports and Economic Growth
Our baseline export scenario indicates that South
Korea will be able to increase real imports at a rate
that should allow for domestically acceptable rates
of real income growth.' Real GNP gains would
' To reach our assessment we used a methodology that linked our
expectations of export growth, our figures for debt service pay-
ments, and our estimate of the services balance (excluding interest
payments). We also assume that the level of new credit extended to
South Korea remains unchanged at last year's level, and that
foreign exchange holdings remain unchanged over the next five
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South Korea: Exports by Commodity
1978
Machinery 2
Chemicals 3
Ships 7
Machinery 3
Nonmanufactures 4
Chemicals 7
Light
manufactures
53
Light
manufactures
40
average about 6 percent per year during 1986-90
under our baseline scenario-lower than the aver-
age annual growth rate of 8.3 percent between
1970 and 1984, but an improvement over last year's
estimated 4- to 4.5-percent real growth rate. We
forecast that import capacity will rise nearly 13
percent per year on average, with real import gains
averaging ayound 7.7 percent per year, compared
with growth rates of 20.5 percent and 12.5 percent
per year, respectively, during 1970-84. Lower ex-
port growth will be the main factor contributing to
the import slowdown. With foreign exchange re-
serves at about $8 billion (less than four months'
Falling Oil Prices: Substantial
Benefit to South Korea
Lower petroleum prices will have a substantial
impact on South Korea's import bill. In addition,
South Korea will save on debt servicing costs
because of declining interest rates. Our analysis
indicates that a drop in oil prices to $15 per barrel
saves South Korea $2.4 billion per year in energy
costs and an additional $432 million per year in
interest costs. A decline to $10 per barrel would
reduce Seoul's yearly oil import bill by $3.5 billion
and annual interest payments by $620 million.
Savings of these magnitudes would have a favor-
able impact on South Korea's ability to boost
imports of other essential inputs. In turn, this
could increase real GDP growth at a time when
South Korea is facing a period of below-average
income gains. Our calculations indicate that, if oil
prices remained at $15 per barrel through the end
of the decade, annual real GDP growth could
average about I percentage point above the base-
line case. Should oil prices fall to $10 per barrel
and remain at that level, annual real income gains
over the medium term could be increased by about
1.5 percentage points over the baseline scenario.
over the size of South Korean debt.
import coverage), South Korea would need to
sharply increase foreign borrowing to boost import
growth-an unlikely policy given Seoul's concern
Broader Implications
President Chun has deflected much of the criticism
aimed at his economic policies by pointing to
cyclical factors, an upsurge in protectionism, and
slack world demand for South Korea's exports.
With real GNP growth forecast to pick up over the
rest of the decade, we feel that the economy is
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unlikely to become a source of confrontation be-
tween the South Korean Government and the
opposition. Economic growth, however, will proba-
bly merely keep pace with new entrants into the
labor market. As a result, unemployment-particu-
larly among college graduates-will remain an
exploitable issue for the political opposition.
We believe trade will probably remain the most
contentious issue between the United States and
South Korea over the next few years. Chun's
reorganization of the cabinet in January apparently
signals his continued backing for the proponents of
liberalization even in the face of the economic
slowdown and rising domestic tensions over
US-South Korean trade. If opponents of liberaliza-
tion can be held off until the economy revives,
additional progress in this area would help defuse
bilateral strains.
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South Korea: Penetrating
Communist Markets
After almost a decade of indirect trade with the
Communist world-largely as a political tool to
undercut North Korea-South Korea has recently
begun to profit from its economic relationships with
P'yongyang's longtime allies. Total trade between
South Korea and Communist countries in 1985 was
about $1.3 billion-four times the 1983 level-with
China accounting for a 90-percent share. Last year,
South Korea made its first investment-albeit indi-
rect-in a Communist country, and commercial
travel by South Korean businessmen to Communist
countries tripled. Although the long-term outlook
for commercial relations between South Korea and
Communist trading partners is good, political fac-
tors-primarily Soviet and Chinese ties to North
Korea-will continue to hamper development of
open trading relations and investment. Growing
trade relations between South Korea and Commu-
nist countries could not only displace US sales to
the South Korean market but may also provide a
new conduit for transfer of sensitive technologies.
South Korea's payoff from trade with Communist
countries over the last two years has resulted from
an open-door economic policy launched in the mid-
1970s. Initially, Seoul wanted to use unofficial
trade as a first step toward improved relations-at
the expense of its North Korean rival. That motiva-
tion is still strong in South Korean efforts to isolate
and weaken the North diplomatically, and we
expect it to become more pronounced as Seoul tries
to cement Communist country participation in the
1988 Olympics. South Korea undoubtedly sees the
Soviet Union's role, in particular, as a key to the
success of the 24th Olympiad-not only in political
terms but also from a business perspective, to
generate world interest and hence revenue.
Notwithstanding South Korea's important political
motives, we believe Seoul increasingly views Com-
munist countries as potentially lucrative export
markets as well as sources of energy, raw materials,
and semifinished manufactured goods. Although
this trade is only about 2 percent of the total,
Communist countries are now South Korea's elev-
enth-largest trading partner. In the face of growing
protectionism in South Korea's traditional markets,
expanded trade with Communist nations may help
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sustain export growth. For instance, last year-a
year in which exports of goods and services grew a
sluggish 3.3 percent-about one-fourth of Seoul's
export gain came from greater sales to Communist
countries, according to our estimates.
Growing Ties to China
Commercial ties between South Korea and China
have been the most successful:
? Trade. We estimate total trade in 1985 reached
almost $1.2 billion-the second consecutive year
that this trade doubled. South Korean imports of
corn, cotton, and coal accounted for much of the
increase. South Korean sales focused on textile
fibers, fabric, consumer electronics, and steel.
? Investment. A Hong Kong subsidiary of Daewoo
has invested $250,000 in a refrigerator and televi-
sion assembly plant in Fujian Province-the first
investment in China by a South Korean corpora-
tion. South Korean firms are considering invest-
ment in Chinese manufacturing operations and
coal mines,
? Construction. A South Korean firm will build a
bridge between China and Hong Kong. South
Korean workers, who will be involved in a project
on Chinese soil for the first time, will be required
to keep a low profile to avoid publicity.
? Commercial Travel. The number of South Kore-
an businessmen traveling to China increased from
10 to 30 between 1984 and 1985, according to the
US Embassy in Seoul. One in three reportedly
entered China using South Korean passports. The
US Embassy also reports a similar flow of Chi-
nese technicians and economic officials who visit-
ed industrial facilities in South Korea.
Despite these positive developments, China did not
let trade grow unbridled in 1985. Beijing restricted
access to foreign exchange last summer after surg-
ing imports during the first half of the year drained
reserves. In addition, logistic problems and fraud
contributed to the slowdown in trade growth.
Seoul's interests were particularly hard hit when
the Chinese again centralized their control over
trade. The South Koreans had traditionally by-
passed nettlesome and politically sensitive contacts
with officials in Beijing in favor of dealing with
local Chinese in the special economic zones and the
provinces. China's stricter policies were applied
across the board, and we do not believe they were
directed at South Korean firms.
The Bloc: Trade Up, Travel Booms
Unofficial contacts between South Korea, the Sovi-
et Union, and Eastern Europe have rebounded
since the 1983 downing of a Korean Airlines 747 by
a Soviet fighter. In addition to several sports and
South Korea: Trade With China,
1979-858
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South Korea: Estimated Composition
of Trade With China, 1985
Exports
Textile fibers 2
Resins 3
Consumer
electronics 30
Textile yarns
and fabrics 29
308731 4-86
academic exchanges, the US Embassy in Seoul
reports that 159 South Korean businessmen visited
the Soviet Bloc, primarily East European countries,
in the first 11 months of 1985-trebling the 1984
tally. Two-way trade increased nearly 50 percent in
1984 over the previous year-but showed a smaller
gain of 20 percent last year, according to closely
held South Korean trade statistics.
Although Hungary is far from being South Korea's
largest Communist trading partner, commercial
relations between the two are the most open. We
believe that negotiations to establish a correspon-
dent relationship between South Korea's Export-
Import Bank and the Hungarian National Bank
are progressing well, and that an agreement may be
signed this year. In addition, the semiofficial Korea
Trade Promotion Organization (KOTRA) is negoti-
ating a trade pact with Hungarian and East Ger-
man trading organizations, according to Embassy
reporting. These agreements reportedly will autho-
rize Hungarian and East German firms to contract
directly with the overseas branches of South Kore-
an trading companies located primarily in Western
Europe. We believe these arrangements will have
little immediate impact on trade, but they will
enable the South Koreans to make their business
dealings with at least two Communist countries
routine. Still, we see no evidence-or likelihood-
that the arrangements will have a bandwagon
effect on other East European countries.
Trade growth with the Communist countries is
likely to slow primarily because of China's contin-
ued foreign exchange constraint. Over the long run,
however, Communist countries will probably be-
come more important economic partners for South
Korea. In our judgment, future trends in economic
relations will be molded by several factors,
including:
? Erosion of Japan's Market Share. South Korea is
emerging as a competitor to Japan in a number of
export sectors. If Korean firms displace even 10
percent of Japan's exports to China and the
Soviet Union, Communist-South Korean trade
would double. Beijing, in particular, has been
vocal about its large trade deficits with Japan and
is looking to South Korean sources for capital and
consumer goods.
? Communist Energy Development. Seoul's long-
standing policy of energy diversification increases
the attractiveness of coal and oil imports from
Communist countries, particularly as China ag-
gressively develops its energy resources.
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South Korea: Trade With the Soviet Union
and Eastern Europe, 1979-85
? Scarce Foreign Exchange. Falling energy prices
are depressing Soviet and Chinese hard currency
earnings. South Korean businesses-with Seoul's
encouragement-stepped up purchases from Chi-
na last year to keep trade relatively balanced and
to appear to respond to Beijing's foreign exchange
concerns. In addition, South Korea's general
trading companies are willing to strike barter
deals.
Notwithstanding the factors that favor increased
bilateral trade and investment, the politics on the
Korean issue will continue to affect trade growth.
We have seen some evidence that Beijing, at least,
is becoming less sensitive to P'yongyang's objec-
tions to economic contact with the South. Burgeon-
ing trade through Hong Kong last spring, for
example, drew protests from North Korea, but
Beijing made no moves to clamp down as it had in
1982. Nonetheless, with North Korean-Soviet ties
improving and China seeking to maintain what
leverage it has in North Korea, we believe both
Moscow and Beijing will manage the relationship
with Seoul carefully.
Trade through third countries will allow maneuver-
ing room, but it also discourages trade growth by
adding a costly cut to middlemen in each transac-
tion. We would expect progress on the dialogue
between North and South Korea to further open
the channel for direct contacts. The North-South
talks are addressing an agreement for economic
cooperation, and an accord would help Communist
countries justify direct commercial deals with the
South.
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South Korean Communist Trade Ties:
A Thin Facade
South Korea's trade with Communist countries is
still cloaked behind third-country middlemen, but
the cover is wearing thin. No Communist country
recognizes Seoul, and China officially bans trade
with South Korea. Sino-South Korean trade
through Hong Kong is one of the world's worst
kept secrets, and Western and Asian press exposes
of "clandestine" trade and investment are com-
monplace. The majority of manufactured goods
traded between South Korea and China passes
through Hong Kong and, to a lesser extent, Japan.
Bulk commodities, such as coal, cotton, and corn
are often shipped directly from Chinese to South
Korean ports
Implications for the United States
US firms and farmers have already been hurt by
growing South Korean trade with the Communist
world. We estimate China sold $200 million worth
of corn, soybean meal, and cotton last year to South
Korea-a traditional US market. While the Com-
munist countries pose a limited threat to US agri-
cultural sales, coal from China and the Soviet
Union-along with Soviet timber-also could dis-
place US exports to South Korea.
South Korea's rapid climb up the technology ladder
in manufacturing, machine tools, and microelec-
tronics also raises technology transfer concerns. We
expect South Korea to be increasingly viewed by
the Soviet Bloc and China as a potential source of
proscribed technology. Rapidly growing commer-
cial contacts are increasing the possibility of illegal
trade deals. Of particular concern are advanced
microelectronics, such as 256K and 1-megabit
memory chips, semiconductor manufacturing
plants, and personal computers.
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North Korea's Approach
to the West
Faced with chronic shortages in its economy and a
failure to secure increased support from its Com-
munist trading partners, P'yongyang has begun to
look to the West for equipment and technology to
modernize its industry.
For nearly two
years P'yongyang has been engaged in a round of
contract negotiations with Western firms and a
campaign to acquire Western financing for im-
ports. North Korea also has adopted a joint venture
law in the hope of attracting Western investment.
So far, however, this flurry of activity has yielded
few payoffs because of North Korea's abysmal
repayment record during a similar turn to the West
in the mid-1970s.
Just as South Korea has been expanding trade with
Communist countries over the past two years,
North Korea has attempted to increase imports and
financing from the West. While Seoul's motives
have been largely political, North Korea's approach
to the West has been driven primarily by economic
and technological concerns. In economic terms, the
North continues to fall further behind its southern
rival. Recurrent shortages, ranging from energy to
rail cars, have long created serious production and
transportation bottlenecks. Moreover, Kim Chong-
il, Kim 11-song's son and designated heir, who is
credited by P'yongyang with running the domestic
economy, almost certainly hopes that Western
technology will provide some economic successes to
add legitimacy to his father's succession plan. F_
North Korean Shopping List
Included among the items in which the North
reportedly has expressed interest is equipment for:
? Exploration and exploitation of offshore and
onshore oil.
? Two coal-fired power plants that will use low-
grade coal and have a generating capacity of
500,000 megawatts (about $275 million).
? Coal liquefaction gas plant ($30 million).
? Coal mining.
? Aluminum refinery ($280 million).
? A 3-million-metric-ton-a-year steel plant.
? Plant to produce magnesite, magnesia clinker,
and .firebricks.
? Integrated-circuit production plant ($5 million).
? Plant to produce fiber optics.
? Plants to produce telephone equipment.
? Paper plant ($25 million).
? Production of clothing, toiletries, shoes, food-
stuffs, furniture, and kitchen appliances.
? The manufacture of agricultural machinery,
such as combines and rice planting machines.
? An international airport in Pyongyang (total
package to cost about $80-120 million).
West. The North has also put out feelers for
equipment to produce consumer goods, including
clothing and textiles, and is planning to seek West-
ern help in developing tourist facilities. The North
Koreans are approaching firms in Western Europe
and Japan as potential sources.
The Shopping List
North Korea has put together an extensive list of
industrial equipment it hopes to acquire from the
Secret
DI IEEW 86-014
4 April 1986
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Given North Korea's limited financial resources,
the shopping list is far too ambitious. We estimate
that the value of the Western equipment and
technology P'yongyang hopes to line up for its next
seven-year plan period (1987-93) exceeds $1 billion.
This would almost double the current annual level
of plant and equipment imports-reminiscent of
P'yongyang's disastrous buying spree that ran up
massive debts in the mid-1970s. Even some of the
individual projects may be too costly for the North.
Nonetheless, if P'yongyang judiciously trims its
import program to a realistic level, the economy
would benefit from an infusion of Western technol-
ogy. For example, a focus on power projects and a
paring back of other items on the shopping list-
such as the large steel plant-could be affordable
and would help alleviate energy and transportation
shortages that seriously hamper industrial produc-
tion.
Reportedly, only a few of the many contracts North
Korea is negotiating with Western firms have been
concluded,
In the first half of 1985, North Korea signed
contracts with Japanese firms for mining equip-
ment valued at $19 million and a rolling machinery
plant costing $2 million. In April 1985 the North
signed a $7 million contract with a Danish firm for
equipment for a prefabricated construction materi-
als plant.
Limited Export Potential
P'yongyang's policy of self-reliance has severely
hampered the development of North Korean export
industries. Exports are encouraged only as a means
of covering essential imports, not as a means of
providing employment as in the South. Exports to
the developed West-which consist largely of non-
ferrous metals, iron and steel sheet, foodstuffs, and
gold-have on average risen little in value terms
over the 1976-80 level. The North's nonmilitary
finished goods are in general of such poor quality
that even its Communist trading partners are reluc-
tant to accept them. Given the production shortfalls
we expect will plague the economy for some time to
come, the North Koreans will remain hard pressed
to supply their domestic needs while trying to raise
exports to both its Communist and non-Communist
partners.
The Search for Financing
P'yongyang continues to search for credits to fi-
nance the machinery and equipment it hopes to
import. Its bad repayment record, however, has
made it a poor credit risk:
? North Korea has approximately $1 billion in
debts to the West, nearly all of which were
originally incurred during the mid-1970s.
? North Korea has also failed to repay short-term
borrowing.
and interest payments.
? The leadership remains unwilling to cut back on
hard currency imports to pay off its obligations;
we estimate a cut in imports of more than 50
percent would be needed to meet annual principal
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P'yongyang's passage of a joint venture z law in
September 1984 was probably designed to get
around its hard currency shortages and Western
reluctance to extend credits. The law-patterned
after a similar program in China-obstensibly
opens the way for direct Western participation in
funding and operating companies in North Korea.
It is not clear, however, how much control P'yon-
gyang will be willing to share with Western firms.
Despite the North's high hopes for the joint venture
law, only seven deals-all
involved with services rather than production-
have been concluded since late 1984.
2 The North Koreans have used the term joint venture rather
loosely. For example, P'yongyang has cited an agreement with
West German firms for the construction of a cement plant as a joint
venture, but the arrangement may in fact be an outright equipment
purchase from the Germans. Even if the West Germans agreed to
take some of the product as partial payment, this would be a
The Nagwon Department Store. This joint venture
between Asahi Sansa (formerly Asahi Shoji Com-
pany, Ltd.) of Tokyo and the Mangyong Trade
Corporation of North Korea was formed in Janu-
ary 1985. The main branch of the store is in
Pyongyang, and 31 branches are planned for
major North Korean cities.
the contract.
The Hotel in P yongyang. Shortly after passing its
joint venture law in September 1984, North Korea
concluded an agreement with a French firm,
Camenon Barnaul, to build a 45-story hotel in
P'yongyang. In early 1985 the government an-
nounced that the foundation work was complete
and construction was progressing as scheduled. By
December 1985, however, although ground had
been broken, apparently no work was under way. It
is possible that North Korea's failure to make
good on debt repayments to France cast a pall on
the French firm's willingness to continue with the
hotel. Representatives of Camenon Barnaul were in
P'yongyang in early March, presumably to discuss
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progress of the few joint ventures
under way suggests Western firms are encounter-
ing a variety of difficulties, which will continue to
dissuade other foreign investors.
We believe that North Korea-with its lack of
creditworthiness and poor export potential-will be
unable to obtain most of the items on its shopping
list. Moreover, Western partners clearly are dissat-
isfied with the joint ventures they have entered so
far. Given the Kims' history of tight central author-
ity and "on-the-spot guidance," P'yongyang will be
unlikely to change their views. North Korea's
Communist economic partners will probably offer
little relief. Neither Moscow nor Beijing, to which
P'yongyang also owes large sums, appears willing
to extend the large volume of credits that would be
required for North Korea to substantially increase
its imports. Without large infusions of foreign
capital-together with dramatic changes in P'yon-
gyang's approach to economic management-the
North Korean economy probably will continue to
plod along, falling farther behind that of the South.
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Summit Issues: Big Six
Budget Deficit Trends
Big Six efforts to trim budget deficits have had
mixed success during the 1980s. The governments
that have doggedly pursued deficit reduction as
their chief economic priority have succeeded; Japan
and West Germany are close to budget balance.
The United Kingdom, despite recent slippage, has
also made considerable progress, but primarily as a
result of privatization, not expenditure restraint. In
contrast, budget deficits are on the rise in the other
three countries. Because of the size of the Japanese
and West German economies, however, the net
budget position of the Six had a slight deflationary
impact on Big Six economic growth in 1985. For
FY 1986, most Big Six governments plan budget
tightening and, if they succeed in implementing
more austere budgets, we expect fiscal policy to
have a negative or, at most, neutral impact on
growth.
Despite recent efforts to contain budget deficits
that grew markedly during the 1970s, the Big Six
countries as a group have shown only little progress
toward deficit reduction in the 1980s. The average
central government deficit as a share of GNP for
the Big Six has remained in the 3.3- to 4.7-percent
range since 1978. This aggregate figure masks
widely disparate country performances, as fiscal
austerity in West Germany and Japan has been
offset by higher deficits elsewhere:
? The Socialist government in France enacted high-
ly expansionary budgets after its election in 1981,
and, although the government switched to fiscal
austerity two years later, Paris has failed to make
significant inroads on the deficit.
? Italy's chronic budget deficits have grown to 15
percent of GNP despite attempts by successive
governments to bring the budget under control.
? Canada has experienced a major deterioration in
its budget position due to the 1981/82 recession,
reductions in some taxes, and a continued failure
to reduce expenditures.
Expenditures, Revenue, and Debt
West Germany and Japan have closed their deficits
chiefly through spending restraint, without resort-
ing to major tax increases. As a share of GNP,
central government expenditures have been declin-
ing lately in both countries. London's sales of
public assets-which are counted as negative
spending-have helped hold the line on expenditure
growth during the 1980s, but revenues have not
risen fast enough to close the government deficit.
Spending jumps in France and Italy during the
early 1980s exceeded revenue growth. In Canada
central government expenditures have risen as a
percentage of GNP, while revenues have remained
fairly flat.
? West Germany and Japan have pursued fiscal
austerity with a vengeance and are on the way to
achieving budget balance.
? The United Kingdom has reduced its deficit as a
share of GNP by 2 percentage points during the
1980s, although its deficit last year was only
slightly below the six-nation average.
Central government debt as a share of GNP has
continued to climb in all Big Six countries, al-
though recent trends suggest it is leveling off in
West Germany and Japan. The growth in govern-
ment debt poses a major problem for deficit reduc-
tion programs, because debt service is a nondiscre-
tionary expenditure.
Secret
DI IEEW 86-014
4 April 1986
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Big Six: Central Government Budget Balances,
as a Share of GNP a
Impact of Fiscal Policy
During 1979-85, Big Six government budget bal-
ances-when calculated on a high-employment,
inflation-adjusted basis (HEIA)-had a slight de-
flationary effect on growth. The average HEIA
balance has shifted from a small deficit to a small
surplus, but the balance has fluctuated around zero
in intervening years. The shift has been dramatic in
Japan and West Germany, however. Japan ran an
HEIA surplus equivalent to 2.2 percent of GNP
last year, while that of West Germany grew to 1.7
percent. Canadian fiscal policy, which was relative-
ly tight in the early 1980s, has turned markedly
expansionist in recent years, and Italian fiscal
policy is more lax. Fiscal policy has been slightly
expansionist in France, and slightly restrictive in
the United Kingdom.
Budget programs announced for 1986-if success-
fully implemented-suggest some narrowing in in-
tercountry disparities. West Germany and Japan
will continue tightening, while other Big Six gov-
ernments plan to trim or at least stabilize their
deficits:
? Japan is adhering to fiscal restraint, although
recent yen appreciation has lowered growth pros-
pects. The FY 1986 budget cuts administrative
and investment spending to keep total discretion-
ary expenditure within last year's level. The
modest spending increases planned for the sepa-
rate public works budget will have little impact
on this year's deficit.
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Big Six: Central Government Revenues
and Expenditures, 1979-85
30 30
I I I I I I I I I I I I I I I I I I I I I I I I I I I
40 40
Revenue
Expenditures
1
II 1 1 1 1 1 1
85 10 1979 85
? West Germany continues its fiscal consolidation
program into 1986, with budget expenditures
expected to rise only 2 percent over last year's
level. Deficit reduction is proceeding faster than
foreseen in Bonn's medium-term financial plan,
due in part to extraordinary profits from central
bank operations. This year's tax cuts will barely
compensate for past fiscal drag, and Bonn is
resisting suggestions to move up tax cuts sched-
uled for 1988.
? Italy's 1986 budget reduces the deficit as a share
of GNP by about 1 percentage point below last
year's level. The package, however, leaves unde-
termined $4 billion in spending cuts, making
achievement of the deficit goal almost impossible.
Reduced central government transfers to the
regional and local governments will be offset by
new local taxes.
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Big Six: Central Government Debt, 1979-85
Canada
United Kingdom
Big Six
West Germany
France
Japan
I I I
0 1979 80 81 82 83 84 85
? Canada has announced a FY 1986 budget aimed
at trimming the government deficit by $3.3 bil-
lion next year. The reduction will be implemented
by a combination of tax increases and spending
cuts.
? France aims to hold this year's central govern-
ment deficit constant as a share of GNP. The
1986 budget plans an increase in noninterest
expenditures of only 2.8 percent, but cuts in
personal taxes and increased debt service charges
should preclude any reduction in government
indebtedness.
? The United Kingdom intends to lower public-
sector borrowing as a share of GNP this year
through higher direct tax receipts and increased
public asset sales. General government spending
will be frozen in real terms. London cites reduced
oil tax revenue as a rationale for lower-than-
promised income tax cuts.
Calculating HEIA Budget Balances
To derive high-employment budget balances, we esti-
mated an aggregate production function for each
country. Combining this equation with the actual
levels of capital stock and the labor force yields
measures of potential GNP. The highest percentage of
potential GNP obtained over the time period is
defined as the high-employment level for purposes of
determining high-employment balances. Using simu-
lations of a reduced form of our Linked Policy
Impact Model (LPIM), actual budget deficits were
adjusted to the levels that would have been obtained
under high-employment conditions. This methodolo-
gy does not rely on arbitrarily set levels of full
employment that vary between business cycles.
We then adjusted these calculated budget balances
for inflation by reducing the deficit-or increasing
the surplus-by an amount that leaves the real level
of government debt-including bonds and central
bank money-unchanged. Budgets that increase the
level of government debt by exactly the current
inflation rate are considered to be balanced on an
inflation-adjusted basis. An inflation-adjusted bud-
get shows a surplus if it decreases the real level of
government debt; it shows a deficit if it increases the
real debt level.
If budget plans are implemented, the average Big
Six deficit would decline by 0.5 to 1 percentage
point as a share of GNP. We estimate that fiscal
policy will have a negative, or at best neutral,
impact on growth in 1986.
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USSR: Facing the Dilemma of
Hard Currency Shortages
Declining oil earnings took a heavy toll on the
USSR's hard currency position in 1985 and will do
so again this year. Moscow's current financial
standing remains strong, however, offering the
Soviets some leeway in the short term. Moscow is
unlikely to resort to massive borrowing, however,
and instead will cut imports to make up for most of
the earnings decline. Over the longer term, General
Secretary Gorbachev will need to formulate a more
coherent import plan than is now apparent-and
probably even ease up on the Soviets' conservative
approach to borrowing-if he hopes to both main-
tain needed imports of agricultural products and
intermediate goods and keep his modernization
program on track.
Temporizing in 1985
Moscow's hard currency trade surplus dropped
from $4.8 billion in 1984 to about $1 billion in
1985, largely as a result of declining export earn-
ings. Preliminary Soviet trade data indicate that
hard currency exports declined by 15 percent to
$27 billion, the lowest level since 1979. Falling oil
prices and sluggish domestic oil production led to a
20-percent reduction in oil export revenues. Avail-
able data further suggest a similar percentage
decline in Soviet arms exports while exports of most
other commodities remained near the 1984 level.
USSR: Hard Currency Imports
and Exports, 1970-85
Exports
Imports
1970 75 80 85
credits or deferred payments for Soviet purchases.
In addition, gold sales reached approximately 180
metric tons, compared with less than 100 tons in
each of the previous two years, earning Moscow
about $1.8 billion.
Moscow countered the export decline by stepping
up borrowing. The fall in imports was limited to an
estimated 5 percent, with most of the reduction
coming in the second half of last year. According to
Western financial statistics, Soviet debt to Western
banks increased by $5 billion by the end of Septem-
ber. In addition to taking advantage of short-term
borrowing, the Soviets also used their strong credit
rating to raise about $2.5 billion in medium- and
long-term syndicated loans at favorable interest
rates and repayment periods. Moscow also request-
ed some Western firms to arrange for supplier
The sharp reversal of Moscow's hard currency
position appears to have taken Soviet planners by
surprise. Soviet officials, in fact, may have initially
viewed the export shortfalls last year as a tempo-
rary event resulting from lagging oil production
and severe winter weather. Trade officials contin-
ued to negotiate and sign major contracts with
Western firms throughout the summer and early
fall for projects to be constructed during the 1986-
90 plan. The failure to come to grips with the
Secret
DI IEEW 86-014
4 April 1986
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problem sooner may also have been due to some
confusion in the Soviet bureaucracy, resulting from
the appointment of a new Gosplan chairman and
foreign trade minister.
Deteriorating Export Earnings in 1986
Reduced world oil prices and continued problems in
oil production are likely to push Soviet hard curren-
cy exports in 1986 down even further than in
1985-earnings could fall by as much as $7 billion.
The bulk of this drop would result from sustained
low oil prices of about $17 per barrel or less,
affecting Soviet earnings from gas as well. Oil
production problems will probably limit Moscow's
ability to boost oil export volume: at best, oil
production will remain at the current rate of 12
million b/d and could drop to 11.6 million b/d by
the end of the year.
Moscow must also contend with a sharp erosion in
its buying power caused by the continuing fall of
the US dollar. Roughly two-thirds of Soviet exports
are priced in US dollars, while about 70 percent of
Soviet purchases are made in other hard currencies.
Assuming a 20-percent drop this year in the value
of the US dollar against the market basket of
currencies used to finance Soviet imports, Soviet
export earnings would buy about 15 percent less
this year than in 1985.
Coping With Revenue Declines
Because of Moscow's currently comfortable finan-
cial position, Soviet planners have several options
available to help offset falling oil earnings in 1986:
? Soviet assets in Western banks currently amount
to $10 billion, and Moscow could probably draw
down these assets by as much as $2 billion
without seriously jeopardizing its liquidity
position.
USSR: Impact of Oil Price, Oil
Volume, and Dollar Decline on
Hard Currency Exports
Oil price drop a
1986 volume of
oil exports
reduced b
a Assumes price drops to $15 a barrel.
b In addition to price drop, this assumes oil export volume
declines by 300,000 b/d.
c Additional impact of a 20-percent depreciation of the
dollar, assuming 70 percent of imports are in nondollar
currencies.
? The USSR's excellent credit rating among West-
ern creditors offers the possibility of increased
borrowing at favorable rates. For example, Mos-
cow could easily raise another $1-2 billion in
syndicated borrowings this year. The Soviets may
also push for lower interest rates and longer
repayment terms.
? The USSR-with an estimated 2,800 tons of gold
in reserve and annual production of 340 tons-
could increase annual sales to 300 tons without
disrupting the market. Perhaps up to an addition-
al 150 tons could be sold discreetly through
futures markets and nontraditional buyers. Sales
of 300 to 450 tons in 1986 would raise roughly
$3-5 billion.
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? Moscow also could try to boost other nonenergy
exports such as diamonds, chemicals, nonferrous
metals, and wood products, by offering below-
market prices or countertrade arrangements.
Because of uncertainties over the duration of this
earnings decline beyond 1986, the Soviet leadership
will probably approach these options with caution.
In particular, Moscow is unlikely to repeat last
year's strategy of heavy borrowing to limit the fall
in import capacity
Other than expanded
gold sales, the USSR's options offer little potential
to counter declining oil revenues, given the general-
ly weak market for Soviet goods, including arms.
Mounting evidence indicates that Soviet planners
are in the process of adjusting the 1986 import
program to reflect reduced Soviet earnings.
Soviet officials have
stated that imports would be cut to match declines
in earnings. Since late last year, Soviet purchasing
activity has slowed noticeably
The decision to cut hard currency expenditures
appears to be affecting all types of purchases:
? According to the US Em-
bassy, the Soviets have scaled back plans for two
petrochemical complexes and an agrochemical
plant.
Japanese offi-
cials reported to the US Embassy in Moscow that
cutbacks in purchases of consumer goods such as
clothing and textiles appeared to be in the offing.
Beyond 1986
We believe Moscow faces a high probability that
real imports will remain severely depressed for the -
rest of the decade. Prospects for hard currency
earnings are extremely poor as long as oil prices
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remain low. Reductions that are likely to occur in 25X1
export potential in the West.
Soviet oil production could depress export earnings
further. In addition, growth in nonenergy exports-
especially arms-shows little promise because low
oil prices will hurt the economies of Moscow's
major Middle Eastern arms clients. Moreover, the
poor quality of Soviet manufactures will limit their
The recent import cuts, especially those involving
large projects scheduled for the 1986-90 plan, may
reflect a recognition by the leadership of the long-
term nature of the hard currency problem. The
cutbacks, in addition to dealing with the immediate
scarcity of hard currency, will also allow time for a
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Secret
more coherent import strategy to be put into place.
Such a strategy must weigh the costs of large
import cuts on Gorbachev's modernization program
and consumer welfare.
Allocating the available hard currency among com-
peting domestic users will present the Soviet leader-
ship with difficult choices. Machinery and equip-
ment imports will probably bear the brunt of
import cutbacks. While some cuts in imports of
spare parts and intermediate goods such as chemi-
cals and specialty steels are probable, large, sus-
tained cuts could slow or even temporarily halt
production in some enterprises. In addition, drastic
cuts in agricultural imports could jeopardize efforts
to improve consumer welfare.
The import pattern that will emerge over the next
12 to 18 months may bear little resemblance to the
established priorities of recent years. Rather than
apportioning the blow among existing claimants for
hard currency allocations, the leadership will have
to formulate new priorities for the various sectors of
the economy. Coping with reduced imports, more-
over, may force Gorbachev and his lieutenants to
attempt even bolder domestic initiatives to further
improve the management of Soviet resources and
trading practices.
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Pakistan: On a Foreign
Payments Tightrope'
We judge Pakistan will face serious foreign pay-
ments problems despite recent agreement on a
$4 billion, six-year US economic and military aid
package. Pakistan's external financial position will
probably stabilize this year, but Pakistani exports
are likely to face increased competition and lower
world commodity prices over the next few years. In
addition, declining remittances also are likely to
widen the current account deficit. When foreign
payments problems occur-possibly as early as
next year-Pakistan will try to lay the blame on
the United States, push Washington to write off the
military debt and provide more commodity aid, and
seek IMF assistance. We believe the financially
strapped Junejo regime will probably face in-
creased political activism from groups such as
students, labor, and small farmers, who were ne-
glected during the martial law years.
Dodging a Financial Bullet
Expansionary economic policies, a steady decline in
worker remittances, and a disastrous cotton crop
two years ago, however, precipitated a serious
foreign exchange crisis last summer.' Rather than
curb imports or slash government spending, Islam-
abad financed the rapidly growing current account
deficits by drawing down reserves. From a high of
$2 billion in December 1983, liquid reserves plum-
meted to roughly $325 million in mid-August
1985-equivalent to about 3 weeks' imports.
I Pakistan has been able to sustain a more than 6-percent real
average annual growth since FY 1977. Our analysis shows, howev-
er, that for every 1-percent increase in GDP, import growth
increased by more than 1 percent. As a result, the trade balance
deteriorated even though the domestic economy performed well.
Since then, President Zia's luck and creative finan-
cial maneuvering have enabled Pakistan to more
than double foreign exchange reserves, avoid going
to the IMF, and finance much of the public deficit:
? Export earnings, primarily raw cotton and cotton-
based manufactures, increased more than 18
percent in value terms while imports dropped
about 1 percent compared with the first half of
FY 1985,' according to US Embassy reporting.
? An improved US dollar exchange rate, better
banking procedures, and savings carried back by
returning workers stimulated a near 6-percent
rise in remittance earnings.
? Since August 1985, sales of Special National
Fund Bonds (SNFB) tapped the nation's vast
reserves of "black money," netting more than $1
billion and the introduction of Foreign Exchange
Certificates (FEBC) has probably added more
than $500 million to Pakistan's foreign exchange
reserves.'
To help cover its current account deficits, Islam-
abad has required large infusions of foreign aid.
Since FY 1980, Pakistan has received on average
more than $1 billion a year in project and commod-
ity assistance from the United States and multilat-
eral donors. Islamabad recently agreed to a US
assistance program of $4 billion-less than its
SNFBs are special one-time bearer bonds that allow Pakistanis to
launder their "hidden assets" and avoid tax investigations. FEBCs
are foreign currency certificates of deposit that pay high interest,
are cashable in foreign currencies, and guarantee purchaser confi-
Secret
DI IEEW 86-014
4 April /986
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Pakistan: Economic Indicators,
1980-86a
a Data are for fiscal years ending on 30 June of the
stated year.
b Liquid foreign exchange reserves at end of fiscal years.
c Including interest, amortization, and FMS.
d Estimated.
original $6.5 billion request. The new package is
weighted more toward economic aid and offers
concessional military assistance in contrast to the
current $3.2 billion program for FY 1982-FY
1987. The Pakistanis argued that even greater
concessionality and an increase over the current aid
package was essential to bolster their fledgling
democracy, assuage domestic critics, and ease the
country's growing debt burden, according to US
Embassy reporting.
Pakistan let its economic foundation weaken while
it was "buying" political stability with imports
(including military purchases) and subsidies. With
government investment stagnating, irrigation
works, roads, and energy facilities fell into disre-
pair. Over the next few years, Pakistan's dilapidat-
ed economic infrastructure is likely to impede
efforts to narrow chronic current account and
budget deficits by hampering agricultural and in-
dustrial growth:
? Agriculture is the most promising sector of the
economy, but over the years underfunding of
Pakistan's irrigation, agricultural research, and
extension service has led to low yields and erratic
production.
? Although industrial production has grown rapidly
over the past few years, this has not translated
into increased exports. High import duties have
sheltered producers from international competi-
tion and hampered export competitiveness.
? Over the past few years, chronic energy short-
ages, particularly electrical power, have required
increasing energy imports, disrupted production,
and raised costs.
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Secret
Pakistan: Balance of Payments, 1981-86 a
a Data are for fiscal years ending 30 June of the stated year.
b Estimated.
c Includes principal and interest payments.
Balance-of-Payments Scenarios
We envision growing foreign payments problems
over the next five years. Pakistan is likely to face
growing competition and lower prices for its com-
modity-based exports. Although lower world oil
prices will help stabilize Pakistan's energy import
bill, it will also reduce remittance earnings from
workers in the Gulf states. Moreover, repayments
to the IMF, to Washington on the Foreign Military
Sales (FMS) debt, and to other lenders will raise
A Worse Case. Prospects for matching the export
growth of the last five years are dim because
Pakistan's major exports-rice, cotton, and tex-
tiles-face glutted markets, domestic production
uncertainties, and stiff international competition.
Prime Minister Junejo's new civilian government
might be inclined to allow imports to grow in order
to appease consumers and develop a domestic con-
stituency. A drop in export growth on the order of 2
percentage points, an increase in import growth of
Pakistan's debt service burden.
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Falling world oil prices and a slowdown in Gulf
economic activity threaten to undermine Pakis-
tan's major foreign exchange earner-worker re-
mittances. Even though remittances have dropped
nearly 15 percent since FY 1983, they still account
for nearly 50 percent of Pakistan's foreign ex-
change earnings. Because the majority of remit-
tances come from manual workers in the Middle
East, they are particularly vulnerable to economic
downturns. near-
ly two-thirds of the remittance income goes toward
living expenses-mostly in rural areas-with the
remainder flowing into land and housing.
1 percentage point, and a sharp falloff in remit-
tance earnings would result in a financial gap of
about $5 billion in FY 1991, compared with rough-
ly $2 billion in FY 1986.
A Better Case. Because it will be difficult for
Pakistan to increase its exports, we believe Islam-
abad will have few options other than to cut back
on imports to hold down trade deficits. Consumer
goods and some raw materials-an estimated 30
percent of total imports in FY 1985-would be
targeted for cuts. By cutting its import growth rate
by 2 percentage points and maintaining an export
growth rate of roughly 4 percent with remittance
earnings declining at a 2-percent annual rate,
Pakistan could contain its current account deficit to
slightly over $2 billion in FY 1991. Even then, the
financial gap would reach $3.5 billion.
Over the next few years, the new civilian govern-
ment is unlikely to experience the kinds of fortu-
itous economic developments that Zia experienced
during the period of martial law. Even under the
better case scenario, foreign exchange shortages
will be a serious problem. Total capital inflows
from US aid, the IMF, and the World Bank are
unlikely to increase much from the current $1.6
billion annual level. Therefore, we believe that an
austerity program considerably more stringent than
the better case scenario would have to be imple-
mented sometime before the 1990 elections.
Stringent austerity measures, however, are likely to
provide populist politicians the opportunity to de-
velop a powerful constituency among disenfran-
chised groups such as students, farmers, and labor.
Effective protests from these elements are likely to
develop slowly, because political party organization
atrophied during martial law. If repatriation of
Pakistani migrant workers occurs rapidly, the al-
ready glutted domestic labor market will be unable
to absorb the influx, increasing the possibility of
widespread political unrest.
Pakistan: Average Foreign Exchange
Earnings, 1978-858
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As Pakistan's foreign payments situation deterio-
rates, we expect Islamabad to blame the United
States for providing inadequate aid while, at the
same time, increasing pressure on Washington to
provide more help. At a minimum, Islamabad will
press the United States to intervene with the IMF
for less restrictive targets on currency devaluation,
tax reform, and subsidy reductions, in return for a
standby agreement. They are also likely to request
rescheduling on outstanding FMS obligations and
the conversion of new disbursements to grants.
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Iran May Increase The need for revenue probably will prompt Iran to increase oil production by
Oil Production early summer. Oil Minister Aqazadeh announced during the recent OPEC
conference that, if the group failed to reach agreement to reduce output, Iran
would increase its production.
probably will restrict exports for several more weeks as it continues to press
OPEC-particularly Saudi Arabia and Kuwait-for production cuts. Iran has
the capacity to increase exports by about 800,000 b/d within a few months, if
it can find buyers and if Iraqi attacks do not damage export facilities further.
Malaysia Maintaining Kuala Lumpur announced last week that it would continue to produce 510,000
Oil Output b/d of oil at its current price of about $16.45 per barrel despite the recent
OPEC request to cut output. At the March meeting in Geneva, OPEC asked
the five non-OPEC observers-Malaysia, Egypt, Mexico, Oman, and Angola,
whose production equals roughly one-fourth of OPEC's 18 million b/d-to cut
output by up to 20 percent although Britain and Norway-the other major
non-OPEC producers-continued to ignore such requests. In a show of support
for market stabilization, Malaysia temporarily cut production by 40,000 b/d
to about 410,000 b/d last summer but restored output to about 440,000 b/d
within a few months. We believe that the loss of as much as $1 billion in annu-
al revenues from recent oil price declines will adversely affect the country's de-
velopment plans, making Kuala Lumpur unwilling to incur further production
cuts. Malaysia, however, probably could not increase oil production much
further now without damaging the ultimate recovery potential of its fields.
31 Secret
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Fffect of Sanctions As of mid-March, there were no impediments to oil company operations
on Libyan Oil resulting from the US sanctions
Industry US-origin oilfield and pipeline equipment can be purchased
easily in Western Europe from third parties because there is no control over
end user certification. Western oil industry workers-mostly Canadians,
Britons, West Germans, and Austrians-have taken the place of those US oil
workers who have left permanently. Moreover, many US nationals have
reportedly returned to Libya after leaving for Malta at the end of January
1986. the main problems in the Libyan oil industry
are a result of falling oil prices, which could reduce Libyan oil revenues to only
$6 billion this year-down from $11 billion in 1985. Reduced revenues are
causing cutbacks to maintenance and development plans. Libya should be able
to maintain its current production of about 1 million b/d over the next few
years without major expenditures for exploration and production because of its
significant excess production capacity.
Spain Requests Spain is pressing Algeria to reduce the price of liquid natural gas (LNG).
Algerian Gas Madrid wants to bring the price of imported LNG in line with the state-
Price Reduction administered domestic gas price, which is tied to the price of oil. The price dif-
ferential has led to huge losses for ENAGAS, the state-owned natural gas
firm, requiring large government subsidies. Moreover, ENAGAS's shaky
financial situation has slowed its efforts to expand pipelines and develop other
infrastructure projects that could generate sufficient demand for the growing
supply of LNG. Current demand is well below supply, and under a 1985
agreement Spain is committed to double its LNG imports from Algeria by
1992. Madrid probably will not risk a termination of the contract, because
Algeria supplies about two-thirds of Spain's natural gas consumption. More-
over, in light of the dispute with Morocco over two Spanish enclaves and the
government's desire to maintain balanced relations with North Africa, Madrid
is unlikely to risk a major confrontation with Algiers.
Nigeria's Unresolved Nigeria's reported agreement last week with commercial creditors in London
Debt Problems on a 90-day debt moratorium will not offset the decline in oil export earnings,
and the press reports that Lagos will request a similar standstill from official
creditors this month. Lagos obtained preliminary approval to roll over
principal payments through June in the talks with bankers-who hold about
40 percent of Nigeria's $19 billion external debt. The request followed
President Babangida's announcement last January that debt service would be
limited to 30 percent of export earnings. According to US Embassy estimates,
Nigeria's 1986 debt obligations total $5.4 billion, roughly three-fourths of
projected export revenues of $7 billion.
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4 April 1986
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Bolivia's The Paz Estenssoro government hopes to conclude a $57 million IMF standby
Negotiations agreement by mid-May to lay the groundwork for commercial bank debt
With the IMF rescheduling, release aid from other sources, and assist domestic recovery. In
return, according to the US Embassy, La Paz pledges to reduce its fiscal
deficit from 13 to 5.8 percent of GDP, hold inflation to 85 percent in 1986, and
limit foreign exchange reserve losses to $20 million. Once the agreement is in
place, Bolivia plans to approach foreign commercial banks to begin negotia-
tions on rescheduling $850 million in commercial debt.
Thai Financial The probable collapse of a Thai conglomerate is intensifying concern among
Jitters the financial community in Bangkok and may cause some foreign bankers to
reassess their exposure in Thailand, according to the US Embassy. About $70
million in loans from large Thai and foreign banks-including at least two US
banks-reportedly would be at risk should Paul Sitthi-Amnuay Enterprises
(PSA) go bust. Although the group's collapse probably would not seriously
destabilize Thailand's financial system, the PSA debacle has renewed concerns
over the quality of assets held by the Thai banking sector, which was shaken
by the failure of several finance companies two years ago. As a result, Bangkok
is likely to further tighten its regulation of financial markets and may give the
Central Bank more powers to intervene.
US Textiles Talks According to US Consulate General reporting, Hong Kong remains skeptical
With Hong Kong and uncompromising on the US request for a "standstill" on textile exports.
During recent bilateral discussions, Hong Kong criticized the United States
for reopening negotiations and changing rules of origin. It was also critical of
US attempts to allow poorer LDCs to increase textile exports, at the expense of
"middle income" exporters, such as itself, and not at the expense of OECD
textile exporters such as the EC. Hong Kong implied that there are "connec-
tions" between US-Hong Kong bilateral discussions, the Multifiber Arrange-
ment negotiations, and the new GATT round. According to Consulate reports,
Hong Kong's uncompromising attitude may be dictated by a desire to
maximize its concessions from the United States, and to see how bilateral
negotiations with other major Asian suppliers progress. Hong Kong's negotia-
tors know Washington is under pressure to curb imports from the "Big
Three"-Hong Kong, South Korea, and Taiwan. Nonetheless, Hong Kong
was careful not to close the door to further discussions, which could take place
in April.
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Secret
Global and Regional Developments
Per Capita GDP Continuing the trend of the last five years, per capita real GDP in the key
Slump of Key LDC LDC debtors is projected to fall again this year. During 1981-85, Nigeria,
Debtors Continues Venezuela, and Argentina registered declines of 17 to 22 percent. Brazil and
Mexico experienced downturns of only about 3 to 4 percent. During 1986,
Brazil will be the major bright spot with a 1.7-percent gain-considerably less
than last year's remarkable performance, however. Mexico, Venezuela, and
Nigeria, hard hit by sagging oil prices, are expected to post the steepest
Key LDC Debtors:
Real Per Capita GDP Growth, 1981-86 a
Total
1981 1982 1983 1984 1985 1981-85 19866
Argentina -7.8 -6.3 1.4 0.4 -5.3 -16.8 -1.5
Brazil -3.7 -1.3 -5.3 2.2 5.9 -2.6 1.7
Chile 3.8 -15.6 -2.3 4.1 0.3 -10.6 0.2
Mexico 5.1 -3.1 -7.6 1.0 1.2 -3.8 -5.2
Nigeria -6.1 -5.1 -5.4 -3.9 -3.8 -22.0 -5.5
, Data based on 1984 US dollars.
b Projected.
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4 April 1986
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Secret
Japanese Businessmen According to the US Embassy, last month a Japanese delegation visited
Consider Investment several Caribbean countries and made a positive assessment of the investment
in the Caribbean potential in the region. This is due in part to tax incentives available under the
Caribbean Basin Initiative and the region's proximity to the US market. We
believe Japanese companies will increase investment in Jamaica because of
past private-sector economic cooperation. Access to the US market will remain
an important stimulus, especially if trade tensions worsen between Japan and
the United States. Elsewhere in the region, however, we believe investment will
be delayed for at least the next year or two because of concerns about labor re-
lations and the quality of labor and materials. In Trinidad and Tobago, for ex-
ample, companies operating there stressed labor problems-including absentee
rates of up to 30 percent-in talks with Japanese businessmen.
EC-GCC Representatives from the EC and the Gulf Cooperation Council (GCC) will
Petrochemical Talks meet in Riyadh next week to discuss their dispute over GCC petrochemical ex-
ports. The GCC countries are seeking a much more open market for their
petrochemicals in the Community, but EC members-especially France and
Netherlands-are opposed. The EC reportedly is hinting it will propose a
solution that will involve the United States and Japan, but it has failed to pre-
sent specifics. Although the two sides are still far apart on the issue, the EC
may again make small concessions to facilitate slightly higher Saudi petro-
chemical sales.
Saudi Arabia According to the US Embassy in Khartoum, Saudi Arabia has agreed to
Supplies Oil provide, gratis, 2.9 million barrels of crude oil to Sudan. Sudanese petroleum
to Sudan officials have confirmed that the first consignment of 365,000 barrels has
already reached Port Sudan. The Saudi deliveries will cover most of Sudan's
petroleum requirements through June and will help eliminate the threat of
crippling fuel shortages during the critical period following the April elections
as well as free Khartoum from short-term dependence on Libyan crude. Libya
has provided, over the past six months, 2.2 million barrels of crude to Sudan,
but promises of future deliveries have remained vague and contingent upon
future political cooperation with Tripoli.
35 Secret
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National Developments
Developed Countries
Substantial Japanese Although Tokyo's economic stimulus package due for release in early April
Wage Hike Unlikely may recommend higher wages and fewer hours, this year's national wage
negotiations (shunto)-traditionally concluded for the major unions during the
second week of April-will probably yield meager increases. The business
sector is determined to keep the wage hikes modest, insisting they be linked to
productivity, while the rank and file appear unwilling to support the kind of ac-
tion-such as strikes-that might jolt employers into concessions.
we estimate an average increase roughly equal to
last year's 4 to 55.5 percent, which would do little to boost domestic demand.
Wage hikes in some depressed industries may even be less. For example the
US Embassy reports the steelworkers union has agreed to a 3-percent raise,
while two unions in the troubled shipbuilding industry are not even seeking in-
creases this year.
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Secret
Japan Promoting Its MITI recently introduced into the Diet a revision of the 1958 Aircraft
Aircraft Industry Industrial Promotion Act to establish a fund for the development phase of
international joint ventures. Funding would come from low-interest Japan
Development Bank loans, private capital subscriptions, loan guarantees, and
government subsidies. Japan's aircraft industry has been hampered by balloon-
ing development costs, fierce international competition, and a small domestic
market.
the Japanese industry is far too small to gain
more than 10 percent of the world market. Moreover, the policy change
probably reflects Tokyo's recognition that the Japanese aircraft industry would
not be able to manufacture large jet aircraft independently.
West Germany Bonn will sell portions of three nationalized companies this year in its next
Resuming Modest cautious step toward reducing the government role in the economy. In June,
Denationalization Bonn will sell 40 percent of VIAG, the large energy, chemicals, and aluminum
firm. In June and September, respectively, Bonn will substantially increase the
capital of Prakla-Seismos, a major gas and oil exploration firm, and IVG, an
industrial holding company, and offer about 45 percent of the new stock to the
public. In addition, the federal railway will reduce its 100-percent holdings in
a bank and a transport firm to 25 percent.
Bonn's only previous denationalization involved reduc-
ing its stake in the Veba energy conglomerate from 44 percent to 25 percent in
1983. Finance Minister Stoltenberg's much more ambitious 1982 privatization
program encountered unexpected strong political opposition, most notably
from Minister President Strauss of Bavaria, where a number of the privatiza-
tion candidates are headquartered.
Another Danish Denmark has announced the second austerity package in four months in an ef-
Austerity Package fort to curb the current account deficit, but the measures are unlikely to be
successful. The measures, which raise taxes on energy, a variety of consumer
and durable goods, and share transfers, narrowly passed parliament on 21
April. The current account deficit reached $2.7 billion in 1985, 30 percent
higher than the government had expected. The government felt compelled to
implement the package because of a more-than-doubling of the seasonally
adjusted trade deficit for the three months ending in January compared with
the same period a year ago, and probably because of a significant decline in
foreign exchange reserves in February. Furthermore, a published study showed
that Denmark's export competitiveness deteriorated in the second half of 1985.
Nonetheless, the higher taxes will only partially offset the stimulus to import
demand from rising real incomes, falling interest rates, rising employment, and
lower oil prices.
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4 April 1986
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Secret
Nicaraguan Port
Construction
Less Developed Countries
Bluff.
Expanded port facilities at El Bluff could be operational next year. Work is
progressing for a berthing area capable of accommodating 20,000-ton ships.
The roughly $100 million project, undertaken primarily with Bulgarian-and
to a lesser extent Soviet and Dutch-assistance will give Nicaragua its first
Caribbean deepwater port and direct access to the Atlantic. It will save the re-
gime some $10 million annually in transportation costs. Currently, large
merchant ships from Europe must go through the Panama Canal and use the
Pacific coast harbor of Corinto, the country's only deepwater port. The project
also will improve Nicaragua's ability to unload arms shipments arriving at El
Ethiopia Agrees to Ethiopia has told the EC it would initiate agricultural reforms in exchange for
Agriculture Reforms additional development assistance, according to the US Embassy. The reforms
reportedly include lower state quotas for sales by peasant associations and
collectivized farms, the removal of restrictions on interregional grain trade,
and an adjustment of official prices. Addis Ababa probably consented to the
changes because of continued declines in agricultural productivity and living
standards and the refusal of major donors to commit funds to agricultural
projects without policy reform. In addition, Moscow reportedly has encouraged
Chairman Mengistu to improve agricultural performance before proceeding
fully with collectivization. The new measures, if effectively implemented,
could help reverse the decline in Ethiopian agricultural production but would
take several years to close the food gap. We believe the Ethiopian leadership
probably views these reforms as a temporary measure and will pursue
collectivization as soon as the current crisis eases.
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Secret
Lack of Progress Recent reporting from the US Embassy indicates that negotiations for a Sino-
on Sino-US US Bilateral Investment Treaty (BIT) continue to be stymied by Chinese
Investment Treaty reluctance to concede on three points: protecting foreign investors from future
changes in Chinese domestic law, guaranteeing full value compensation for
expropriation, and delineating what disputes may be settled through interna-
tional arbitration. We believe the Chinese are in no hurry to sign the BIT be-
cause the lack of a treaty apparently has not slowed investment-US firms are
major investors in China. Furthermore, about 20 nations have either signed or
are negotiating with China investment treaties that lack these guarantees.
China Adopts China's National People's Congress adopted a controversial law in March that,
Controversial as of 1 October, requires individuals and collectives that mine coal, gold, iron
Mining Law ore, and other minerals to obtain a license and pay an unspecified resource ex-
ploitation tax. It also requires reclamation work and prohibits unsafe mines.
The law will mainly affect China's 61,000 small-scale coal mines, which
produced 243 million metric tons of coal last year, over 28 percent of China's
total output. Small-scale mining has grown rapidly in China since 1983 when
Beijing began allowing peasants to set up local mining operations. Complaints
have surfaced in the coal industry, however, that these mines have caused
environmental damage and overlapped larger state mines. Although signifi-
cant mine closures are unlikely because many rural areas have become
dependent on these small-scale mines for much of their coal supply, the law
provides several mechanisms to shut down more mines if Beijing chooses.
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Secret
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