INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP97-00771R000807760001-4
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 38
• Document Creation Date: December 22, 2016
• Document Release Date: October 18, 2010
• Sequence Number: 1
• Publication Date: November 1, 1985
• Content Type: REPORT

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Directorate of
Intelligence
Seeret
Weekly
International
Economic & Energy
1 November 1985
t
DI IEEW 83-044
1 November 1983
Cnnv L 0 L
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International
Economic & Energy Weekly
iii . Synopsis
Perspective-Rajiv Gandhi's Economic Scorecard
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India: Deteriorating Foreign Payments Prospects) 25X1
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South Korea: Loosening the Reins To Spur Growth
Italy: Improved Prospects for Wage Restraint
21 / Moroccan-Libyan Union: Costs and Benefits
Energy
International Finance
Global and Regional Developments
National Developments
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Comments and queries regarding this publication are welcome. They may be
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i Secret
DI IEEW 85-044
1 November 1985
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International
Economic & Energy Weekly 25X1
Synopsis
1 Perspective-Rajiv Gandhi's Economic Scorecard
In the year since Indira Gandhi was assassinated, Rajiv Gandhi has moved to
transform the Indian economy into a more dynamic and competitive force.
Gandhi's economic modernization program is not without its limitations, and
he also must contend with potential domestic opposition to his economic
measures
3 India: Deteriorating Foreign Payments Prospects
A deterioration in India's comfortable foreign payments position is highly
likely before 1990. We believe Indian efforts to ease constraints on production
of exportable goods will have some success, but not enough to compensate for
the increasing payments burden.
7 South Korea: Loosening the Reins To Spur Growth
Seoul is cautiously loosening four years of austerity to reverse a broadly based
economic slowdown. If Seoul's remedies fail and sluggish growth persists,
pressures from business and the bureaucracy to slow the government's market
opening program will intensify, and this in turn could produce heightened
trade frictions with the United States.
13 East Asian NICs: Slower Increases in Labor Costs
The East Asian NICs as a group have maintained their huge labor cost
advantage over the United States during the past five years despite a decline in
labor compensation costs for US workers after 1979. Over the longer term, we
expect the East Asian NIC labor edge to narrow as these countries move into
technology-intensive industries, which usually command higher wages.
17 Italy: Improved Prospects for Wage Restraint
Current national wage negotiations in Italy are likely to result in a moderate
settlement that will help industry contain labor costs and improve its
international competitiveness. Rising unemployment and internal wrangling
have weakened labor's bargaining position in the negotiations-which again
will center on reform of the automatic wage indexation system.
Secret
DI /EEW 85-044
1 November 1985
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21 Moroccan-Libyan Union: Costs and Benefits
Both Morocco and Libya have received tangible benefits from the year-old
Moroccan-Libyan union, even though they continue to have divergent long-
term interests in North Africa. Despite some recent bilateral strains, we see
nothing to suggest that Hassan will end the union.
Secret iv
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Perspective
International
Economic & Energy Weekly
Rajiv Gandhi's Economic Scorecard
budget.
In the year since Indira Gandhi was assassinated, Rajiv Gandhi has moved to
transform the Indian economy into a more dynamic and competitive force. His
strong interest in upgrading technology and productivity has prompted him to
accelerate liberalization moves begun several years ago. Gandhi still intends
for the government to retain overall control of the economy, but he believes
that less bureaucratic meddling and more competition in the private sector will
spur modernization, limit corruption, and ease strains on the government
pushed the bureaucracy to expedite decisions that affect business.
Gandhi's policy reforms have fueled an atmosphere of optimism in the business
community. Manufacturers in several industries may now set up new opera-
tions or expand capacity and vary their product mix without seeking govern-
ment permission. He has also relaxed antimonopoly legislation, lowered
personal and corporate tax rates, encouraged imports of high technology, and
systems.
Rajiv's efforts already are showing some signs of success. The incentive
programs and a crackdown on tax evasion apparently have struck a responsive
note with the middle class and business leaders-government officials estimate
that more than $4 billion in taxable income will surface from the underground
economy this year. Indian monetary officials believe revenue from taxes will be
20 percent higher this year. Private businessmen have moved to increase
investment in response to the Gandhi administration's decision to ease
licensing requirements in several industries, and investor confidence remains
high, as demonstrated by a booming stock market. Improved Indo-US ties,
following Gandhi's successful visit to Washington in June, have contributed to
the approval of US export licenses for over 60 advanced high-technology
deficit is almost 70 percent greater than for the same period last year.
Gandhi's economic modernization program is not without its limitations. Rajiv
is probably very much aware of government revenue shortages-a major factor
in his push to free the private sector-and the limits they set on additional tax
concessions. He will also have to weigh looming foreign payments strains
against his desire to promote productivity through increased technology
imports. Trade data for the first quarter of the current fiscal year indicate the
1 Secret
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1 November 1985
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Rajiv also must contend with potential domestic opposition to his economic
measures:
? Many businessmen have benefited from economic controls.
? Cutting food subsidies or closing unprofitable factories to reduce public-
sector losses run the risk of increased social unrest.
? Bureaucrats have traditionally resisted efforts to reduce their authority.
? Farmers, last month, held their first major public protest against his
economic policies.
? Perhaps most importantly, Gandhi hopes to deflect charges, particularly
coming from within the Congress Party, that he is widening the gap between
the rich and poor. 0
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India: Deteriorating Foreign
Payments Prospects '
A deterioration in India's comfortable foreign pay-
ments position is highly likely before 1990. New
Delhi expects to cope with these strains mainly by
increasing exports of manufactured goods much
faster than in the past. We believe Indian efforts to
ease constraints on production of exportable goods
will have some success, but not enough to compen-
sate for the increasing payments burden. Prime
Minister Gandhi will likely move to limit growth in
imports, even at the cost of a slowdown in the
domestic economy. Such a policy reversal would
curb opportunities for US suppliers not yet estab-
lished in the Indian market.
Payments Improvement Since 1980
India's current foreign payments position is man-
ageable. Its reserves are equivalent to four to five
months' merchandise imports; the trade deficit is
substantially lower than in the early 1980s; and
debt service payments are probably less than 20
percent of current foreign receipts:
? India's net oil import bill last year was only half
that in fiscal year 1981 2 because of increased
domestic crude oil production and a decline in
world oil prices.
? Foreign aid has continued at more than $3 billion
annually.
? The IMF has provided $4.2 billion in credits over
the past four years.
? Private remittances and bank deposits from Indi-
ans who live and work abroad continue to add
more than $3 billion in hard currency each year.
Increasing Strains Likely
The outlook is gloomy, however. Indian Finance
Minister V. P. Singh has publicly warned of an
"impending foreign exchange crunch." Several fac-
tors indicate that this probably will take place:
? Gandhi's push to improve industrial efficiency
will increase demand for imported capital goods
and technology.
? The volume of petroleum imports is likely to go
up by as much as 7 percent a year, as New Delhi
pushes for faster growth. The net oil import bill,
at current world prices, could easily exceed $6
billion per year by FY 1989, compared to $2.8
billion last year.
? Past purchases of military equipment, as well as
arms currently under negotiation, could bring
cash payments and debt service for military goods
to as much as $2.4 billion a year in the early
1990s.
? India's debt service burden will escalate over the
next five years as obligations to the IMF and
commercial banks are added to the substantial
repayments due on aid received over the past 30
years. We believe the official Indian projection of
principal and interest payments in FY 1989 of
$3.2 billion is conservative because it excludes
military payments and loans now being
negotiated.
credits to more expensive loans.
? The terms of financial support available to India
from bilateral donors and multilateral lending 25X1
institutions have already begun to harden. World
Bank support is shifting from highly concessional
Indian officials look primarily to a sharp increase in
exports, particularly manufactured goods, to keep
anticipated foreign payments strains manageable.
According to press reports, the Five-Year Plan for
FY 1985-89 will call for 6.8-percent annual growth
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India: Estimated Balance of Payments, 1980-85 a
Trade balance b
-7,546
-6,825
-5,970
-5,700
-4,490
-4,540
Petroleum
-6,661
-5,575
-4,570
-3,130
-2,790
-3,040
Nonpetroleum
-885
-1,250
-1,400
-2,570
-1,700
-1,500
Exports
8,316
8,660
9,455
9,600
9,530
8,800
Petroleum
11
237
1,245
1,540
1,530
400
Nonpetroleum
8,305
8,423
8,210
8,060
8,000
8,400
Imports c.i.f. b
15,862
15,485
15,425
15,300
14,020
13,340
Petroleum
6,672
5,812
5,815
4,670
4,320
3,440
Nonpetroleum
9,190
9,673
9,610
10,630
9,700
9,900
Private transfers, net
2,688
2,314
2,510
2,600
2,500
2,500
Interest payments b c
526
591
948
1,233
1,350
1,425
Current account balance b
- 2,950
-3,200
- 3,050
-2,850
- 2,100
- 2,200
Principal repayments b d
-851
-887
939
-938
-960
-1,150
Aid disbursements b
2,049
1,833
2,211
1,989
1,763
NA
Grants
707
595
560
514
463
Loans
1,342
1,238
1,651
1,475
1,300
652
786
1,109
974
800
515
858
887
1,378
1,450
NA
174
421
288
471
250
IMF receipts
1,187 f
710
1,958
1,365
210
NA
Nonresident deposits
145
179
592
838
700
NA
Change in reserves
-346
-2,397
504
882
263
NA
a Fiscal year beginning 1 April of the year stated. Major balances
may not add because of categories not shown.
b Excluding military. Annual cash and debt service payments for
military imports have risen gradually from approximately $600
million in 1980 to around $800-1,000 million in 1985.
Including payments to the IMF and on nonresident deposits.
Including IMF repurchases.
e Medium- and long-term only.
r Including Trust Fund loan and SDR allocation.
Secret 4
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in export volume. During the past five years, the
volume of nonpetroleum exports grew less than 2
percent annually.
The Indians hope to boost manufactured exports by
improving productivity and easing infrastructure
constraints. Gandhi's greatest interest is in over-
coming technological obsolescence, which has con-
tributed to the high cost and low quality of much of
India's production. He expects productivity gains
from cooperation with foreign firms, greater com-
petition within India, and reduced bureaucratic
interference. New Delhi is continuing financial
incentives-cash payments, tax refunds, income
tax concessions, and transferable import privi-
leges-to make production for export more profit-
able.
In our view, however, electricity supplies-about
11 percent short of estimated requirements in FY
1984-are the major obstacle to increasing the
output of exportable goods. New Delhi's efforts to
speed construction of new power capacity by con-
centrating financial resources on projects already
under way and to improve operational efficiency of
thermal power plants will probably not be sufficient
to eliminate this bottleneck.
Import substitution remains a major theme of
foreign trade policy. The current emphasis on
developing indigenous high-technology industries,
however, could risk encouraging a new generation
of uncompetitive manufacturing sectors with mini-
mal net foreign exchange savings. Increased pro-
duction of oilseeds and natural gas could lead to
significant foreign exchange savings, but a marked
impact in these sectors is not likely before the early
1990s.
While India is not seeking direct foreign invest-
ment, receipts from commercial borrowing are
likely to increase during the next five years. None-
theless, the total will remain below the $3.6 billion
annual average recommended in a World Bank
high-growth scenario. Indian bureaucrats remain
leery of falling into a debt trap. Some have recom-
mended a clampdown on imports if debt service
payments seem likely to exceed 20 percent of
India: Recent Economic Trendsa, 1980-85
Note scale change
Crude Oil Production
Thousand b/d
Trade Deficit
Billion US $
Exports Total Imports Total
Billion US $ -Petroleum Billion US $ -Petroleum
International Reservesc
Billion US S
1-Total
Jun Jun Jun Jun Jun
1980 81 82 83 84
a Fiscal year beginning I April of the year stated.
b Estimated.
c End of period.
current receipts.
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Policy Response
We foresee gains in export growth and in easing
domestic supply constraints over the next five
years, but too little improvement to overcome the
increasing burden of petroleum imports, military
purchases, and debt service payments. Business
complaints about import competition will likely
mount, and foreign commercial banks probably will
harden their lending terms.
Rather than risk unmanageable debt servicing
problems, New Delhi, under such circumstances,
probably would sacrifice some import liberalization
measures. We believe the government would initial-
ly try to meet demand for imported petroleum,
fertilizer, and grain and preserve access to foreign
technology. We speculate, however, that Gandhi
would postpone plans to spur domestic efficiency
through increased import competition and might
close off recently introduced opportunities for im-
port-intensive production of vehicles and consumer
durables.
Gandhi's support for simplifying bureaucratic pro-
cedures suggests that he would emphasize tariffs
rather than discretionary import licenses to slow
import growth. The administrative structure for
tighter licensing controls remains in place, however,
and New Delhi probably would take some steps in
this direction. Policy-induced cutbacks in the vol-
ume of imported capital goods and industrial inputs
would lower India's potential overall growth, but
not necessarily force it below the average annual
rate of 3.8 percent maintained since the mid-1960s.
Implications
Opportunities for US suppliers will be curtailed if,
as we expect, Indian exports do not grow fast
enough to ease the foreign payments burden. Im-
port restrictions and slower Indian growth would
reduce demand for foreign goods. Purchasing deci-
sions by Indian Government agencies would proba-
bly give greater weight to price and financial terms,
even in high-technology areas, which might provide
an advantage for Japanese or European suppliers.
US exporters who have established ties to Indian
firms would probably suffer less than newcomers,
since New Delhi usually considers import history
when allotting licenses to Indian businessmen.
The United States could also face some political
fallout from any marked slowdown in Indian
growth. Some Indian officials already see an anti-
India bias in US policies that limit Indian access to
loans from multilateral financial institutions.
The Soviet Union, however, could reap benefits
from a deterioration in India's payments situation.
New Delhi's dependence on the Soviet market for
its manufactured goods will increase if sales to hard
currency buyers falter, and Moscow would un-
doubtedly highlight the benefits of bilateral agree-
ments that obviate the need for payment in hard
currency.
Questions may be raised about Indo-Soviet rela-
tions, however, when targets for the next five-year
bilateral trade agreement are announced, probably
in December. We anticipate that a massive Indian
merchandise trade surplus with the Soviet Union
will be planned to balance payments for military
purchases.' This surplus will provide the Indian
business and intellectual communities with an indi-
cation of the payments burden for Soviet military
equipment, which so far has attracted only small
intermittent press attention.
' Economic ties to Moscow for imports, exports, and debt service
are made through a clearing account that avoids the use of hard
currency. To avoid large or persistent payment imbalances, the two
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aecrer
South Korea: Loosening the
Reins To Spur Growth
Seoul is cautiously loosening four years of austerity
to reverse a broadly based economic slowdown. The
sense in South Korea that the economy is faltering
is a serious political problem for President Chun,
potentially providing a common ground for his
critics in the National Assembly, the labor move-
ment, and on campus. Nevertheless, economic poli-
cymakers have avoided "quick-fix" inflationary
policies in favor of programs that will poise South
Korea for future growth. Moreover, stronger policy
actions are constrained by a large foreign debt and
provisions of the latest IMF standby agreement. If
Seoul's remedies fail and sluggish growth persists,
pressures from business and the bureaucracy to
slow the government's market opening program
will intensify, and this, in turn, could produce
heightened trade frictions with the United States.
Reacting to a Year of Slow Growth
Seoul has reacted slowly to the yearlong slide in
economic growth, waiting until April to stimulate
the domestic economy in order to take up some of
the slack from an export falloff. Government econ-
omists continued to forecast 7.5-percent real GNP
growth for 1985 until early this summer. Since
then, they have successively downgraded the out-
look to a still optimistic 5 to 6 percent. In the first
half of 1985, real GNP grew at 3.3 percent, a four-
year low. We believe the economic planners were
counting on continued strength in the foreign sector
to buoy the economy and may have deferred action
until they were confronted with slack export growth
in the first half of this year.
In our view, the mounting criticism of President
Chun also figured prominently in the decision to
prime the pump. In fact, the slowdown in growth
has already deprived Chun of one area in which he
has been able to claim success in the past. For some
of Chun's advisers-and perhaps the President
himself-an effort to improve the economy now
offers a means to deny more ammunition to his
opponents.
Seoul Steps Back From Austerity
Chun's economic technocrats are cautiously back-
ing away from their heretofore steadfast adherence
to monetary and fiscal austerity. The success of the
restrictive policies in helping to put the economy on
a firm footing after negative real GNP growth in
1980 and taming the inflation of the preceeding
decade has made them reluctant to alter this
strategy. Their willingness since spring to use these
levers to spur growth underscores their concern
over current economic and political problems.
Loosening Monetary Policy. The focus of Seoul's
newly relaxed monetary policy has been to ease the
current financial difficulties of domestic banks and
large conglomerates and to boost lagging invest-
ment. Since the easy credit days of the 1970s,
South Korean banks, particularly commercial
banks, have been saddled with an increasing num-
ber of loans made to debt-heavy conglomerates-
often at the behest of the Ministry of Finance-
that have gone bad. Government officials acknowl-
edge $4.6 billion in corporate bad debt-three
times commercial bank equity. Much of the debt is
held by overseas construction companies, which are
active in the Middle East. Their contracts have
dried up as dropping oil prices have forced cuts in
development projects.
Seoul has moved to ease the financial sector's
liquidity squeeze by:
? Abandoning the targeted 9.5-percent annual
growth of the money supply.
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South Korea: Selected Economic
Indicators, 1981-85
Comparative Real GNP Growth
Percent, at an annual rate
South Korea
0 1 11 111 IV I 11 111 IV I II
1983 1984 1985
Dollar/Won Exchange Rate
Index: 1980=100
RM
60 1 11 III IV I 11 III IV I II III IV 1 111111V I II
1981 1982 1983 1984 1985
Money Supply Growth
Percent, at an annual rate
I I J I
0 A M J J A S O N D J F M A M
1984 1985
? Covering payment of bad corporate debts by
extending $575 million in cutrate loans to domes-
tic banks this year.
? Earmarking $530 million for investment in the
manufacturing sectors that have the best growth
potential-such as autos and electronics-areas
dominated by South Korea's large conglomerates.
? Easing the cap on bank lending that prevented
banks from extending more than 65 percent of
their loans to the largest firms. Until lifted, these
firms were unable to secure financing for many of
their expansion plans, in part, because of this
credit ceiling.
Officials in Seoul realize relaxation of money sup-
ply restraints and the infusion of liquidity into the
banking system will do little in the near term to
foster growth. But Seoul's policy reversal will im-
prove the financial condition of commercial banks.
In our view, it is also important for many large
firms that are facing the consequences of both the
economic slowdown and a squeeze on their liquid-
ity. The collapse last spring of Kukje, once the
country's sixth-largest conglomerate, illustrates the
fragile financial condition of many South Korean
companies. Seoul managed the reorganization of
Kukje well, and we do not believe any other major
firm or commercial bank is near collapse. But the
demise of another large conglomerate could seri-
ously undercut the confidence of the international
financial community and scare off potential
investors.
Boosting Government Spending. Seoul has acceler-
ated several construction projects and some minor
welfare programs in its $290 million supplemental
budget passed in August. The steps clearly signal
the government's commitment to a more expan-
sionary fiscal policy after three years of tight
budgets.' The new spending authorization boosts
overall government outlays by 9 percent in real
terms. The proposed 1986 budget, now before the
J National Assembly, also continues the expansion-
ary trend by increasing government spending over
' Seoul passed a supplemental budget in 1984, but it was designed
to aid victims of severe flooding and was not part of a deliberate
expansionary policy.
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10 percent. Seoul has some surplus funds already
programed into the original 1985 budget to cover
the new expenditures, but several special accounts
often run in the red and the government's largess
could quickly put it in the hole.
Bolstering Export Competitiveness
Seoul remains committed to promoting exports and
has underscored this sector's importance by imple-
menting a two-pronged program in August.
The devaluation strategy has substantial costs.
Producers of VCRs and other advanced electronics
goods, which have critical imported components
that represent a high proportion of the product's
cost, will be hard hit. Manufacturers of these items
now enjoy substantial cost advantages over their
rivals but may be forced to cut margins to remain
competitive. Devaluation, moreover, will partially
offset the benefits of recent declines in interest
rates and oil prices.
rowth Prospects
Improving Exporters' E iciency. Seoul has an-
nounced a comprehensive export promotion pack-
age crafted to enhance the competitiveness of
South Korean goods by:
? Offering favorable export financing and simpli-
fied export procedures, including faster refunds
on duty paid for imported items used to produce
export goods.
? Allowing accelerated depreciation of industrial
facilities producing exports and increased loans to
small- and medium-sized firms for export
facilities.
? Providing $57 million to the textile industry for
factory modernization.
These steps will improve the financial health of
some exporting firms in the short run by reducing
their costs. But we believe the measures will have
virtually no impact on trade performance during
the second half of this year because of the long-
term nature of investment and the lag between a
cost reduction and increased shipments.
Devaluing the Won. In a dramatic departure from
last year, the Ministry of Finance this year has
aggressively devalued the won vis-a-vis the dollar
but was deaf to industry cries for a one-shot drop in
the exchange rate. Devaluation will enhance South
Korea's export competitiveness, particularly in the
European market where the high dollar-to which
the won is closely tied-battered sales last year. In
addition, devaluation will aid Seoul's perennial
efforts to discourage nonessential imports-in gen-
eral, those not used to produce exports-as con-
sumers face higher prices.
Seoul's stimulative tack should offer some help in
boosting growth. Benefits will begin to accrue in
the last quarter of 1985 as Seoul's resuscitation
measures take hold in conjunction with an expected
improvement in foreign demand in South Korea's
major trading partners.
We forecast real GNP growth of 4 to 5 percent
during the last half of 1985, yielding 3.5-to-4-
percent growth for 1985 as a whole. The cost of this
growth, in our estimation, is likely to be rekindled
inflation. As the stimulative policies combine with
devaluation to force domestic prices up, inflation in
South Korea could run as high as 7 percent over the
next 12 months. This would be the highest level for
South Korea in three years and is likely to be cited
by government critics as indicative of Chun's in-
competence in economic management. Indeed,
South Korean officials have made curbing inflation
the cornerstone of economic policy since 1980 and
almost certainly will worry that the fears of infla-
tion they have calmed will resurge once more.
We believe that real GNP growth for 1986 should
be about 6 percent-1 percentage point below the
government's forecast. The economy could improve
more vigorously, but will be heavily dependent on
forces outside Seoul's control. On balance, al-
though we are cautiously optimistic about South
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South Korea: Growth of Selected
GNP Components, 1983-85a
Percent, at an annual rate
25
Merchandise
exports
Private
consumption
cross
product
Capital
formation
Chun, thus far, has deflected much of the criticism
aimed at his economic policies by pointing to
cyclical factors, an upsurge in protectionism, and
slack demand for Korea's exports. He has been
especially adept at relieving political pressure by
bowing to industry demands for easing austerity. A
failure to stem the downturn, however, obviously
could become a serious pocketbook issue and great-
er focus of popular discontent with Chun. The
perception of increasing pressure on the President,
in turn, could threaten foreign investor and busi-
ness confidence that is critical to economic recov-
ery-particularly if workers initiate strikes to dem-
onstrate solidarity with the political opposition.
:.. i --_-l. I. 1 t
1 1 1 1 1 1 I V 1 11 111 IV 1 11
1983 1984 1985
Korea's near-term performance, the prospects for
1986 could be clouded by slow economic recovery
in developed countries, protectionist and other legal
barriers to key exports, and reluctance of interna-
tional bankers to increase their exposure in South
Korea.
In our view, Seoul's willingness to use monetary
and fiscal policy flexibility to spur growth does not
presage a return to the "growth at any cost"
approach of the 1970s. Such a choice already is
circumscribed by a large foreign debt, slumping
demand for Korea's exports, and a recently negoti-
ated IMF standby agreement that calls for contin-
ued monetary and fiscal restraint, as well as a
reduction of short-term debt. We believe South
Korea remains committed to the notion of auster-
ity, and will carefully gauge the inflationary impact
of loosening the reins. When exports once again
lead South Korea's growth, Seoul is likely again to
tighten the money supply and government spend-
ing, although, in our view, without reverting to the
overly restrictive policies that helped precipitate the
current economic sluggishness.
Implications
However the growth rate fares in the next year, we
believe US economic and political interests in
South Korea will be increasingly linked to the
performance of the Korean economy. In our view,
there are several areas of concern that will become
even more pronounced if the economic slide contin-
ues. These include:
? Diminishing ability to service a growing foreign
debt. US interests hold about one-third of South
Korean debt and have direct foreign investment
of nearly $1 billion. Although a debt reschedul-
ing, even under a worst case scenario, is remote,
bankers may be reluctant to extend further credit
in a loan market now considered safe.
? Intensifying resistance to market opening mea-
sures and possible backsliding on progress already
made. Seoul's postponement last month of a
major economic liberalization package-especial-
ly after encouraging highly visible press pre-
views-and harsh reaction to US legal action to
improve protection of intellectual property under-
score the serious reservations about opening Kor-
ea's markets harbored outside the small circle of
President Chun's advisers and liberalizers. For
example, the ruling and main opposition parties,
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in a rare show of cooperation, have banded
together to protect South Korea's markets. Force-
ful international insistence on additional liberal-
ization during South Korea's economic doldrums
could precipitate the replacement of one or more
key proponents of market opening with more
conservative advisers.
? Reductions in future outlays for national defense
because of sluggish real GNP growth that could
add up to $1 billion by 1991. Defense expendi-
tures are tied to real GNP growth, and Seoul
would have to increase the percentage of GNP
devoted to defense to make up the shortfall. We
believe such a move would act as a brake on
future growth.
The current response to the yearlong economic
slide suggests that Seoul's economic technocrats
may not be as strong an influence in decisionmak-
ing as was Kim Jae-ik, who was killed in the 1983
Rangoon bombing. If a reshuffling of key economic
advisers takes place in December as rumored-a
usual response during economic doldrums-our
uncertainty about the direction of economic policy
will increase even if Chun continues to declare his
proliberalization faith. In short, the current eco-
nomic policy making team appears to us less cer-
tain of its course and less able to tip the balance in
favor of liberalization and reform than was the old
team around Chun.
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OcUtut
East Asian NICs:
Slower Increases in Labor Costs
The East Asian NICs' as a group have maintained
their huge labor cost advantage over the United
States during the past five years despite a real
decline in labor compensation costs for US workers
after 1979. South Korea and Hong Kong, in partic-
ular, have become even more competitive in terms
of labor costs, which have fallen as a percentage of
US costs. We expect the NICs to maintain this
advantage in the near term because the economic
slowdowns that these countries are currently facing
should reduce labor demand, resulting in down-
ward pressure on wages. Over the longer term, we
expect the East Asian NIC labor edge to narrow as
these countries move into technology-intensive in-
dustries, which usually command higher wages.
Labor Compensation Costs
Labor compensation costs are used rather than
earnings comparisons because they better reflect
the true cost of employing labor, and, therefore,
the competitiveness of labor inputs in manufac-
tured goods production. In contrast to earnings,
this broader definition includes items such as:
unemployment insurance costs, contributions to
pension plans, all bonuses and special payments,
pay for time not worked (that is, holiday, vacation,
and sick pay), payment in kind (for example,
housing allowances) and payroll taxes that are
paid by the employer but that do not necessarily
benefit the worker directly.
Real Wage Growth Slows
Low labor costs have been a key element in the
East Asian NICs' ability to attract foreign invest-
ment and to manufacture competitive exports. Rap-
id growth in labor costs, especially before 1980,
eroded NIC competitiveness in simple assembly
and labor-intense production. Even though their
labor cost growth has generally slowed in recent
years, the NICs are now faced with sluggish de-
mand and rising protectionism in global markets.
Countries with even lower wages such as Thailand,
Indonesia, Malaysia, and China are becoming in-
creasingly competitive in producing goods with
high labor content. As a result, the East Asian NIC
governments are reevaluating their economic pro-
grams, including wage policies, targeted growth
industries, and trade liberalization measures
Singapore was the only NIC to have faster growth
in its manufacturing labor costs during the last five
years than in the five years before 1979. The
government of Singapore adopted a high wage
' The East Asian newly industrializing countries (NICs) are Hong
Kong, Singapore, South Korea, and Taiwan.
policy in 1979 to accelerate the transition from
labor-intensive, low-skill production toward more
capital-intensive, higher value-added production.
While the strategy has resulted in a more industri-
alized economic base, the current economic slow-
down has induced the government to ask for a two-
year wage freeze to improve labor cost
competitiveness.
Taiwan has had real increases in domestic labor
costs in each year of the last decade. Rapid produc-
tivity gains in Taiwan allowed real wage increases
without hurting competitiveness. According to the
US Embassy, Taiwan's growth in productivity far
exceeded that of most other countries between 1974
and 1983. Because of rising wages, a shortage of
unskilled labor, and lagging productivity growth in
labor-intensive activities such as textiles and appar-
el, the US Embassy reports that Taiwan is also
emphasizing capital- and technology-intensive
growth.
Secret
DI /EEW 85-044
1 November 1985
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East Asian NICs:
Changes in Real Domestic
Labor Costs, 1975-84
Hong Kong
6.6
2.0
Singapore
7.0
8.7
South Korea
12.9
2.4
Taiwan
12.0
7.2
Asian average
9.8
5.2
United States
1.0
-0.5
South Korea's real domestic labor costs fell 9
percent from 1979 to 1981, but rose subsequently.
The downturn in wages coincided with the global
increases in oil prices, an overheated domestic
economy, a failed grain harvest, and political un-
rest. The decline extended into 1981 because of
government efforts to restrain wages as part of a
broad stabilization program. Seoul also urges em-
ployers to maintain maximum employment, and, as
a result, some firms have been saddled with ineffi-
cient or redundant labor. The success of the stabili-
zation program has allowed Seoul to ease wage
restraints in recent years.
Following British Prime Minister Thatcher's 1982
discussions in Beijing, real domestic labor costs fell
slightly in Hong Kong as uncertainty about the
colony reverting to Chinese control began to rise.
But with Beijing providing increasing access to its
markets, Hong Kong has had a large increase in
domestic exports and in reexports to China in the
first half of 1985, putting real domestic wages back
on an uptrend.
Exchange Rates Enhance NIC Competitiveness
Because movements in the real exchange rate have
increased the value of the US dollar against all
NIC currencies during the past five years, the East
Asian NICs have been able to maintain their labor
cost advantage over the United States by more than
could be expected from real wage changes denomi-
nated in their local currencies. In fact, we estimate
that NIC cost competitiveness benefited from real
devaluations that averaged 16 percent against the
US dollar by 1984 compared to 1979 exchange
rates.
The South Korean and Hong Kong currencies fell
sharply against the dollar after 1979, contributing
to actual declines in their dollar-denominated labor
costs over the past half decade. South Korea posted
a 26-percent real devaluation relative to the US
dollar between 1979 and 1984, according to our
calculations. This allowed real dollar labor costs to
fall 18 percent even though real domestic costs rose
12 percent in the same period. Hong Kong's US
dollar labor costs declined 14 percent on an esti-
mated real devaluation against the dollar of 23
percent during 1980-84 caused, in part, by uncer-
tainty over the colony's repatriation to China.2
In contrast, US dollar labor costs in Singapore and
Taiwan are higher than they were in 1979. Al-
though both countries have experienced mild ero-
sion in the value of their currencies relative to the
dollar, authorities in Singapore and Taiwan prefer
to maintain a strong exchange rate. As a result,
their domestic labor cost increases are more fully
reflected in their dollar costs, which grew 35
percent between 1979 and 1984.
Outlook and Implications
for the United States
All of the East Asian NICs have a large labor
compensation cost advantage over the United
States. Average labor costs were $1.77 in the NICs,
while comparative US costs were $12.59 in 1984. It
2 The nominal value of Hong Kong's currency has been more stable
since late 1983 when the central bank pegged the Hong Kong dollar
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NICs: Real Compensation in the Manufacturing Sector, 1974-84
100 V 100
I I I I I I I I I I I I 1 1
80 1974 75 80 84 90 1974 75
100
I I I I I I I I I I I I I I I I I
260
240
220
200
160
140
120
100
II ~~I
is difficult to predict trends in either labor costs or
exchange rates, but we expect the differentials in
NIC labor costs relative to the United States to
remain fairly constant in the near term. We expect,
however, the NICs labor cost advantage to erode in
the long run, although these countries would still
employ labor at only a fraction of current US costs
through the 1990s. If the value of the US dollar
falls against the NIC currencies, press reporting
indicates that the NICs would adjust their curren-
cies downward with the US dollar, minimizing the
loss of NIC competitiveness in the US market
while stimulating greater demand for NIC prod-
ucts in non-US markets.
While weakening against the US dollar during the
last five years, the currencies of the East Asian
NICs actually strengthened against most others.
This has resulted in a progressive loss of competi-
tiveness for these countries in non-US markets
since 1980. This reduced competitiveness, in turn,
has increased dependence on the US market to fuel
their growth. Sales to the United States accounted
for 34 percent of East Asian NIC exports in 1984
as compared to 25 percent in 1981. The share of
their sales going to the EC and Japan declined.
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Average Average
Annual Annual
Growth Growth
1975-79 1980-84
(percent) (percent)
Hong Kong
1.50
1.59
1.88
1.90
1.80
1.60
4.5
-3.1
Asian average
1.13
1.24
1.52
1.65
1.69
1.77
7.9 _
1.5
United States
12.28
12.66
13.18
12.38
12.40
12.59
1.0
-0.5
a Hourly labor compensation costs expressed in domestic currencies
were translated into nominal US dollars by using the average
foreign exchange rates in each year; the resulting values were
converted to constant dollars using a US price index. Primary data
sources were BLS for cost data and the IMF for the price index.
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Italy: Improved Prospects
for Wage Restraint
Current national wage negotiations in Italy are
likely to result in a moderate settlement that will
help industry contain labor costs and improve its
international competitiveness. Rising unemploy-
ment and internal wrangling have weakened labor's
bargaining position in the negotiations-which
again will center on reform of the automatic wage
indexation system. The final accord will probably
include a reduction in the degree of automatic wage
indexation as well as limits on overall wage in-
creases, which will contain the advance in real
wages to 0.5 to 1 percent annually over the next few
years. The talks are likely to drag on into January
because both sides want to appear firm and because
of uncertainty over the outcome of parliamentary
debate on the 1986 budget, which was postponed by
the recent collapse of the government. If an agree-
ment does not seem likely as the 31 January
expiration for the present accord approaches, the
government may intervene to force a conclusion.
Eroding Union Power
The current round of Italian labor negotiations is
taking place against a backdrop of declining union
strength. Although still very powerful, the unions
have lost some control over the hiring and firing of
workers over the past five years and have been
unable to prevent a weakening of the previously
unassailable automatic wage indexation system. In
the last round of wage negotiations in 1982-83,
they were forced to accept caps on wage increases
for all three years of the contracts.
both 1983 and 1984. In addition, declining indus-
trial employment and the decentralization of pro-
duction activity have cut into union membership,
allowing business leaders to exert a greater control
over the workplace. A slight political shift to the
right has also contributed to the decline of the
unions whose policies are heavily shaped by the
political parties. For example, recent setbacks to
the Communist Party in local elections and in a
referendum on wage policies have weakened the
ability of CGIL-the Communist-dominated labor
union-to influence government policy.
Disagreement among the unions over past wage
reform has also hurt labor's bargaining position.
Management's successful attempt to weaken wage
indexation in 1983 was a major shock, and cracks
emerged in labor's solidarity as the unions blamed
each other for losing ground. In 1984 the CGIL's
refusal to go along with the other two major
unions-the Catholic-dominated CISL and the un-
affiliated UIL-on changes in wage indexation
openly divided labor along Communist/non-Com-
munist lines. Leaders of the UIL have told Embas-
sy officials that, although they have reached agree-
ments with the other unions on specific issues, they
doubt the three organizations can regain the degree
of unity enjoyed before the split.
Focus on the Wage Indexation System
The first issue which must be addressed in the
negotiations is further reform of the automatic
wage indexation system-the scala mobile.
Part of the unions' problem is that slow economic
growth and rising unemployment have put them on
the defensive as rank-and-file members have be-
come more concerned with job security than with
large wage gains. This has resulted in a significant
decline in the number of hours lost due to strikes in
Business Goals. Confindustria, the main business
organization, has demanded a one-third reduction
in wage indexation, although its officials have
Secret
DI IEEW 85-044
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How Italy's Labor Negotiations Work
Italian labor contracts are negotiated on two over-
lapping levels, with the more visible national talks
taking place between the national union federation
and various business groups. The three major
unions are the Communist-dominated CGIL, the
Catholic-associated CISL, and the unaffiliated
UIL. The most important business confederation is
Confindustria, representing most of the large, pri-
vately owned manufacturing companies. Other
business organizations represent employers in agri-
culture, commerce, the small business sector, and
the public sector. The national negotiations ad-
dress general issues such as working conditions,
hours of work, and-most important-wage levels,
including increases in the scala mobile.
Supplementing the national contracts are plant
level negotiations, which have become increasingly
important over the past two decades. The provin-
cial arms of the unions take the lead in these talks,
which focus on piece rates, productivity premiums,
job evaluation procedures, union rights, overtime
pay, and vacations. The negotiation of additional
wage benefits also can take place at the plant level,
confided to the US Embassy their willingness to
accept a 20-percent reduction. The proposed
change would mean that a 1-percentage-point rise
in prices would cause only a 0.4-percentage-point
rise in the wage index instead of the current 0.6.
Confindustria also wants the automatic wage ad-
justments to be made semiannually rather than
quarterly. Business blames the high automatic
wage increases for perpetuating Italian inflation,
because more than half of total wage gains over the
last decade can be attributed to scala mobile
increases. Moreover, the scala mobile has contrib-
uted to real wage growth in Italy that has greatly
surpassed the EC average.
Confindustria also argues that more flexibility is
needed in the wage calculations to encourage pro-
ductivity improvements. By giving each worker the
same absolute increase in salary, the present scala
although the unions generally agree not to demand
wage increases significantly different than set in
the national accord.
In one way or another the government usually
becomes involved in the labor negotiations. The
unions are concerned with social reform and eco-
nomic policy in general, and often present a list of
demands to the government as well as business
during the national contract talks. What the
unions ultimately will settle for depends in part on
what Rome does in matters such as taxes and
social security. The government may also intervene
more directly: to settle talks hung up on the issue
of the Scala mobile in 1983, it virtually locked
labor and industry leaders in a closed room until a
settlement was reached. When all parties could not
agree on further modifications to the system the
following February, the government implemented
emergency measures that limited increases in the
scala mobile index to 8 points for the year, al-
though actual price increases would have triggered
a 12 point increase.
mobile system causes a gradual narrowing of wage
differentials, which Confindustria views as a disin-
centive for employees to improve their skills. Con-
findustria would like to implement a system similar
to that used prior to 1975 where the degree of wage
indexation varied-within a set range-by job cat-
egory.
Finally, Confindustria wants an explicit agreement
that fractional-point increases in the scala mobile
index will be permanently dropped from the calcu-
lation. Labor-as well as the government-argues
that the fractions should be accumulated until
equaling a whole point and then added to the wage
calculations. Since the last agreement in 1983, the
accumulation of fractions totals 3 percentage
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Italian Wages:
Significance of the Scala
Mobile, 1975-85 a
Percent Italy: Real Wage Growths, 1970-85
Change in
Compensation
Change in Degree of
Cost-of- Inflation
per Worker
Living Index Protection
Total
Due to
Scala Mobile
Provided by
the Scala
Mobile
10.4
17.0 0.6
1979
16.8
11.0
14.7 0.8
1980
21.1
13.0
21.2 0.6
1981
25.3
13.6
17.8 0.8
1982
17.0
10.9
16.5 0.7
1983
15.3
9.2
14.7 0.6
1984
13.0
4.9
10.8 0.4
1985 b
10.5
5.2
8.7 0.6
a Scala mobile currently provides for quarterly cost-of-living ad-
justments to the monthly wages of all public- and private-sector
workers (except the self-employed) and pensioners.
b Estimated.
points. Because the existing wording is vague, the
government and some of the smaller employers'
associations have paid the disputed points, but
Confindustria has refused.
Labor Demands. Labor insists that all businesses
pay the disputed fractional scala mobile points, but
is more willing to meet other business concerns.
The unions agree on a shift to semiannual wage
adjustments and are willing to reduce the degree of
indexation-although not as far as Confindustria
demands. The unions proposed a two-tiered scheme
in July that would reduce the overall degree of
indexation by fully protecting the first $312 of
monthly wages, but indexing the remaining portion
by only 30 percent. Ironically, the unions are now
concerned that the scala mobile may have eroded
their power. Labor leaders reason that large auto-
matic wage increases make unions appear less
necessary to the wage negotiation process. In addi-
tion, the Catholic-associated CISL wants more
flexibility in contract negotiations because it be-
lieves that tailoring demands to a specific industry
or company would result in bigger concessions from
management.
Once the indexing issue is settled, agreement will
be needed on contractual wage increases beyond
those determined by the scala mobile. We believe
the union will demand more than the 6- to 7-
percent annual wage increases offered by Confin-
dustria to make up for the small gains in real wages
since 1981; the unions will almost certainly demand
more. Agreement should be easier in the public
sector where the unions have indicated a willing-
ness to accept a 6.5- to 7-percent annual increase in
wages, only slightly above the government's offer of
6 percent.
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Next to the scala mobile, the most contentious
issue appears to be labor's plan to reduce the
workweek by two hours over the next three years.
Although the reductions would be implemented on
an industry-by-industry basis and only in conjunc-
tion with productivity improvements, Confindustria
is strongly opposed. Job creation is another con-
cern. With the unemployment rate at 10.5 percent
and rising, the unions have demanded that compa-
nies hire new workers rather than invest their rising
profits in labor-saving improvements as has been
the case. Business, however, is reluctant to hire new
workers unless the union's nearly complete control
over hiring and layoffs is reduced.
Although the atmosphere of the preliminary negoti-
ations has been surprisingly good, a final agree-
ment probably will not be concluded until January,
at the earliest. Disagreement on several issues and
the postponement of parliamentary discussions on
the 1986 budget-because of the collapse of the
government-seem certain to make the negotia-
tions protracted. The unions will hesitate to settle
on wage increases until the government's fiscal and
social welfare policies are worked out, which is
Business probably will be able to convince the
unions that benefits should be more closely tied to
improvements in productivity. As a result, the
unions will be the most successful in pushing
through reductions to the workweek in industries
having shown improvements in productivity, but it
is unlikely that widespread cuts will be accepted.
An agreement on job creation is unlikely. Confin-
dustria has made it clear that efforts to add new
jobs will depend on the relinquishment of union
control over hirings and firings-which the unions
will be reluctant to grant.
It is unclear what role the government will play in
the present talks. In general, the government's
interests tend to coincide with those of business, but
it is extremely susceptible to pressure from the
unions. Labor Minister De Michelis's position on
reform of the scala mobile is not far from that of
the unions. For this reason, Confindustria is resist-
ing the government's involvement in the negotia-
tions. Preoccupation with re-forming the five-party
coalition government and the expected difficult
debate over the budget will probably preclude the
government from taking an active part in the talks.
If agreement does not seem likely before the 31
January expiration date for the present accord,
however, the government probably will step in.
unlikely before yearend.
We believe the final agreement will call for only
moderate wage increases. The degree of indexation
in the scala mobile will probably be reduced to
around 50 percent, with business perhaps agreeing
to some kind of a two-tiered protection system. The
issue of the fractional points is likely to remain
unsolved, as Confindustria appears firm in its
position and the unions probably would rather let
the issue slide than take a direct defeat. Confindus-
tria should also be able to hold contractual wage
increases close to 7 percent annually since forecasts
of slow economic growth, rising unemployment,
and a growing trade deficit lend force to its de-
mands for moderation in wages. Moreover, accord-
ing to Embassy reporting, the union rank and file
are not as concerned with wage increases as the
Labor's inability to re-exert itself in the contract
negotiations will allow Italy to continue the recent
trend toward smaller real wage gains. While real
wages are likely to advance by 2 percent this year,
we believe the figure will drop to only 0.5 to 1.0
percent in each of the next two years because the
inflation rate probably will rise. This represents a
slowing of wage growth compared to the average
annual increase of 3.8 percent in real wages during
1975-82. Moreover, less strike activity and a more
incentive-oriented scala mobile should increase in-
dustrial productivity and reduce unit labor costs.
This will give some relief to Italian businesses,
which are seeking to improve their competitveness
abroad.
leadership.
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Moroccan-Libyan Union:
Costs and Benefits
Both Morocco and Libya have received tangible
benefits from the year-old Moroccan-Libyan union,
even though they continue to have divergent long-
term interests in North Africa. King Hassan has
received substantial economic benefits, has effec-
tively offset growing Algerian influence in the
Maghreb, and has curtailed Libyan support of the
Polisario. Libyan leader Qadhafi has used the
union to promote his plans for Arab unity and to
thwart US and Algerian efforts to isolate him.
Despite some recent bilateral strains, we see noth-
ing to suggest that Hassan will end the union. F_
Foreshadowing the Union
The rapprochement between Morocco and Libya
began in June 1983 when, with Saudi encourage-
ment, Hassan agreed to see Qadhafi. Frustrated by
his failure to obtain the chairmanship of the Orga-
nization of African Unity and Libya's isolation in
the Arab world, Qadhafi had asked Riyadh to open
the way for discussions with Hassan.
JHas-
san and Qadhafi signed the Arab-African Federa-
tion, as the union is formally known, on 13 August
1984 at Oujda, Morocco.
In addition to the strategic considerations involving
the struggle with Algeria over the Western Sahara,
the timing of the accord suggests that the King
viewed the union as a quick way to relieve growing
domestic pressure over Morocco's deteriorating
economic and social conditions. Widespread riots in
January 1984 brought home to Hassan the severity
of the domestic situation. He faced potentially
divisive parliamentary elections in September 1984,
a shortfall in Western aid-especially US-and
considerable disgruntlement over planned cuts in
education subsidies. Hassan also was aware of
Libyan contacts with Moroccan opposition leaders.
Is the Well Half Full or Half Empty?
cent of Morocco's annual needs
At the outset, King Hassan encouraged the popular
belief that under the union Libya would provide
about $1 billion to Morocco during the first year.
We believe that this figure greatly exaggerated the
level of support Qadhafi was willing to supply.
Nevertheless, since the union, Libyan financial
assistance has totaled about $150 million:
? Tripoli advanced $50 million to Rabat in Septem-
ber 1984 to finance some of Morocco's interna-
tional bank loans that had come due and to pay
for Hassan's daughter's wedding.
? Tripoli extended a $100 million concessional loan
to Rabat in May 1985 to support the purchase of
3.6 million barrels of Libyan crude oil-10 per-
In addition, Saudi Arabia-in what we believe is a
sign of Riyadh's approval of the rapprochement-is
providing 15 million barrels of crude oil this year,
which covers Morocco's total oil needs for five
months and saves Rabat nearly $400 million in
foreign exchange. The grant is nearly double what
the Saudi's gave Hassan in 1984.
Libya is providing a market for Morocco's agricul-
tural and manufactured exports at a time when
Rabat's traditional markets in Western Europe are
threatened-partly because of the entry of Spain
and Portugal into the European Community. Mo-
roccan exports to Libya totaled $34 million in
1984, equal to Rabat's exports to the United States.
Since the union accord, bilateral trade is up 200
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percent, but still only represents 5 percent of
Morocco's total trade. Morocco hopes to raise the
total annual exports to Libya to $100 million by
1986, but this may be optimistic in view of reports
of Libya's failure to pay its bills.
A particularly attractive part of the union agree-
ment for Hassan was Qadhafi's offer to permit a
substantially larger number of Moroccan workers
in Libya. Morocco has a severe unemployment
problem-30 percent of the urban labor force-and
faces even greater difficulties as Moroccan workers
return because of declining job availability in
Western Europe. Worker remittances are Moroc-
co's most important single source of foreign ex-
change-$870 million in 1984.
As part of his campaign to sell the union, King
Hassan promoted the belief that Tripoli initially
would take up to 80,000 Moroccan workers. We
believe the increase to date has been about 8,000.
Moroccan officials state that an average of approx-
imately 1,000 workers enter Libya each month, but
Embassy sources claim that the number actually
has averaged 500 per month. Moreover, most of
these are skilled or professional workers, which
does little to ease Morocco's oversupply of unskilled
labor. Morocco may benefit marginally from the
recent expulsion of large numbers of other foreign
workers from Libya. Tripoli agreed to raise the
number of authorized Moroccan worker entries to
450 workers per week beginning 1 September 1985
and to employ 1,000 Moroccan teachers.
What's In It For Qadhafi?
The union furthers several of Qadhafi's goals. For
example, Morocco is no longer being used as a
training ground for Libyan dissidents and Hassan
personally decided to turn over some dissidents to
Qadhafi. Qadhafi also hopes the union will be
viewed in the region as an example of Libyan
cooperation with moderate Arabs and will preempt
US and Algerian efforts to isolate him in the
Middle East. For Qadhafi, the union symbolizes his
ideological commitment to Arab unity as an exam-
ple of Arab states with different political systems
working together. In addition, Qadhafi has cited
his reduced support to the Polisario and the eco-
nomic benefits to Morocco as examples to persuade
other states facing Libyan-supported local insur-
gencies and financial pressures-such as Sudan
and Somalia-to strike a deal with him. Such
exhortations are accompanied by frequent remind-
ers from Qadhafi of US unwillingness to back up
its verbal condemnation of the union with concrete
actions against Hassan.
Qadhafi has derived substantial political benefits
from the union. Hassan has remained quiet on
Libya's continued subversion in Sudan and has
refused requests from Chadian President Habre to
provide him with troops and other logistic support.
Indeed, Hassan is playing a key role in attempting
to arrange a summit meeting between Qadhafi and
Habre. The King has also taken a more restrained
position on other Middle East issues, including a
noticeable lack of support for both the Hussein-
PLO peace initiative and Jordan's resumption of
diplomatic relations with Egypt. Closer to home,
Hassan's behavior during the current tension be-
tween Libya and Tunisia is in marked contrast to
his response following a Libyan commando raid in
Tunisia in 1980. At that time, Hassan sent helicop-
ters as a gesture of support for Tunisia; during the
present crisis, he has only sent two envoys in a
halfhearted mediation effort.
The union also has been advantageous for Qadhafi
domesticially. Libyans burdened with austerity at
home can now travel to Morocco and purchase
goods in short supply or unavailable in Tripoli.
Moreover, Morocco's willingness to barter agricul-
tural goods for oil has helped Libya alleviate
shortages of fruits and vegetables. Finally, Moroc-
can technicians allegedly have provided occasional,
but much-needed, maintenance on Qadhafi's US-
manufactured civilian aircraft.
As with any marriage of convenience, Qadhafi and
Hassan have not hesitated to do things that irritate
the other partner. Tripoli's recent "strategic allian-
ce" with Tehran, for example, prompted a strong
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response from King Hassan, who viewed that devel-
opment as a threat against his and other moderate
Arab monarchies. Moreover, the early departure of
the Libyan delegation from the recent Arab
League summit hosted by Morocco-as well as
Tripoli's condemnation of the Bright Star-85 mili-
tary exercises involving the United States, Moroc-
co, and other moderate Arab states-embarrassed
the King and highlighted the gulf between Hassan
and Qadhafi on key security and diplomatic issues
in the Middle East.
Hassan also realizes that the union has damaged
his relationship with Washington and has jeopar-
dized acquisition of much-needed credits and weap-
ons. Moreover, Moroccan Government officials are
concerned that the union has accelerated the warm-
ing of ties between Algeria and the United States.
Rabat probably believes that the Algerians will try
to persuade the United States to support their
position on the Western Sahara problem and to
pressure Hassan into a settlement.
The union also poses some domestic problems for
Hassan. In particular, it has resulted in a sizable
influx of Libyans, which increases the potential for
subversion, especially if the union fails. Moroccan
security officials are particularly worried about the
lack of immigration controls over Libyans entering
Morocco and about Libyan real estate purchases.
Although the costs of union to Qadhafi have been
minimal so far, he does have his own frustrations
with it.
/Libyan officials are also frustrated by
Morocco's reluctance to cooperate on defense, as
called for in the treaty, and by its refusal so far to
provide embargoed US parts for Libya's US-manu-
factured aircraft.
In the longer term, the implications of the Moroc-
can-Libyan union may be ominous for Qadhafi.
The union has served to polarize North Africa and
to move Algeria toward a collision course with
Libya. During the past year, Algeria and Egypt
have moved into a closer relationship, based mainly
on their opposition to Qadhafi. Tunisia-increas-
ingly fearful of Qadhafi and doubtful of Hassan's
continued support-has expanded its defense rela-
tionship with Algeria and improved its ties to
Egypt. While this polarization of North Africa is
not due solely to the Moroccan-Libyan union, we
regard the union as a catalyst for heightened
regional tension and more active efforts by Qadha-
fi's neighbors to stymie him.
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J
Energy
7 Iraqi Air Attacks on The Iraqis claim their Air Force struck four pumping stations inside Iran on
Additional Iranian Monday, although the attacks have not been confirmed so far. The strikes
/Oil Facilities follow extensive attacks last week against Iranian oil platforms in the Persian
Gulf. The Iranian ability to keep Khark Island functioning despite continuing
Z
J
Iraq Boosting Oil
Exports
achieve these results. The raids against the oil platforms are designed to knock
Iraqi attacks may have caused Baghdad to extend its operations into Iran's
interior. Damage to critical pumping stations and other facilities could
decrease refinery output, cut natural gas to Iranian cities, and reduce oil
exports. The Iraqis, however, would need to make a determined effort to
out Iranian early warning stations there, possibly as a prelude to a larger
attack on Khark.
Iraq is aggressively lining up customers to load its oil at Saudi Arabia's Yanbu
al Bahr terminal on the Red Sea. Baghdad has arranged to export more than
500,000 b/d this month from its new pipeline through Saudi Arabia. Despite
Saudi claims to the contrary, Riyadh also continues to sell Saudi oil on Iraq's
behalf. Iraq probably has urged Riyadh both to continue aid and to ease
restrictions on the flow of Iraqi oil to Yanbu. Baghdad has been seeking
greater economic relief to offset growing war weariness and political unrest.
The spur line's capacity will rise from about 500,000 b/d to an estimated
800,000 b/d when additional pumping capacity is added early next year. Iraq's
exports through Yanbu will nevertheless be limited by the amount of oil Saudi
Arabia allows through the main pipeline, which has a capacity of 2 million
b/d; Riyadh is now shipping about 500,000 b/d of its own oil through the line.
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Egyptian Oil
Production
Set To Increase
rdy
year.
Insurgents Destroy
/Afghan Natural
Gas Well
Egypt, which is now producing about 900,000 b/d, is expected to increase its
production to I million b/d by late 1986, according to the US Embassy.
Output is expected to stay at that level for two or three years as a result of new
production near existing fields in the Gulf of Suez and new discoveries by a US
company in the desert 200 kilometers west of Alexandria. The new western
fields may come on stream in early 1987-producing between 20,000 and
50,000 b/d-and tenders have been let for a pipeline to the Mediterranean
coast. This additional production will help offset rising domestic demand-
now about 400,000 b/d and growing 10 to 15 percent per year. The Egyptian
Government has publicly stated that its oil exports would cease in seven to 10
years if consumption is not curbed. Oil exports are expected to earn approxi-
mately $2.2 billion in badly needed foreign exchange during the current fiscal
Afghan insurgents last month destroyed a natural gas well at Jar Qoduq-one
of the most productive gasfields in Afghanistan-and ruptured the gas pipeline
Afghanistan,
which exports more than 90 percent of its natural gas production to the Soviet
Union, earns approximately $300 million for the roughly 2.4 billion cubic
meters of gas exported annually. If such attacks continue, they would prove
costly because of Afghanistan's heavy reliance on earnings from natural as
exports to help pay for its massive purchases of Soviet arms.
Program in Jeopa
aq Secures
Additional Loans
State Department and press reports indicate that Jamaica widely missed
September targets under its $118 million IMF program and that the Fund
may not grant a waiver. Seaga, fearing a violent public reaction, told the IMF
that he would not institute price hikes for food and petroleum or other belt-
tightening required under the program. Instead, he wants to try to limit
consumer imports to strengthen Jamaica's finances. Jamaica's grim economic
outlook and insistence by donors and creditors on a valid IMF program as a
prerequisite to new funds, give Seaga little choice but to begin negotiations for
a new program should the current accord collapse. The talks are likely to be
protracted, but, even if he secures another accord quickly, low world de-
mand-particularly for bauxite/alumina, Jamaica's primary export-will
limit economic recovery. Regardless of the outcome of IMF talks, the
weakening economy is likely to continue to diminish Seaga's popularity,
significantly aid Manley's efforts to force early elections, and further alienate
the influential business community.
Iraq has obtained a five-year $500 million syndicated loan from Arab, West
European, and US banks, according to press reports.
The new credits will help ease Iraq's financial burden over
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once the war with Iran ends.
the next two years when already large rescheduled debt payments come due.
Baghdad's ability to secure medium-term commercial financing-despite
recent debt reschedulings-reflects creditor faith in Iraq's creditworthiness
Global and Regional Developments
Thai Foreign Minister Sitthi this week offered to send a high-level delegation
to Washington to resume negotiations on the US embargo on imports of Thai
apparel. Bangkok's request for further discussions reverses its earlier decision
to accept the three-month halt in garment exports to the United States rather
than face reduced quotas under a new trade agreement. According to the US
Embassy, a continued cutoff of shipments would likely idle at least 50,000
textile workers and slash 1985 apparel exports to the United States-its major
buyer-by 30 percent. Moreover, if Bangkok cannot obtain some relief from
the embargo, Prime Minister Prem probably would be forced to bow to
mounting domestic political pressure to endorse retaliatory action against US
interests. Following September's coup attempt, Prem is seeking to rebuild his
political standing at home, and a soft response to Washington's actions against
Thai exports will likely make that difficult if tensions continue.
C-Middle Eastern EC members have tentatively agreed to propose reducing the tariffs on citrus
Progress on Trade fruit and other agricultural imports from 11 non-EC Mediterranean coun-
Agreement tries-including Morocco, Tunisia, and Israel-to preserve these nations'
competitive position in the EC market after Spain and Portugal join the
Community in January. The agreement, expected to be confirmed as formal
policy by the EC Foreign Ministers late this month, will be the basis for
renegotiating all the EC's preferential trade agreements with the Mediterra-
nean countries. Despite a US deadline of 31 October for action, the EC
probably will wait until the Mediterranean negotiations are nearly concluded
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B ngkok Requests
eopening of Textile
egotiations With
United States
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before addressing the US complaint that the new preferential agreements will
hurt US citrus exports to the EC. The negotiations with the Mediterranean
states, which could begin late this year, are unlikely to be concluded before
next spring.
CEMA Increasing Aid Soviet Bloc countries promised to boost economic and technical aid to
to Nicaragua Nicaragua during the second annual meeting of the CEMA-Nicaragua Mixed
Commission, which ended last Friday in Managua. According to the US
Embassy and press releases, Sandinista policymakers claim the new accord
will substantially increase aid, but they refuse to provide specifics. Projects
that CEMA countries have been financing include cattle and vegetable farms
a deepwater port on the Atlantic coast, and scholarships for Nicaraguan
students in the USSR and Eastern Europe. Diplomatic sources in Managua
report that the Soviets and East Europeans rejected Managua's continuing
attempts to become a full CEMA member, reflecting Moscow's concerns
about its increased outlays if Nicaragua were to become a full member and
possibly about adverse reactions in the West.
J int Chinese-US A Chinese machine tool plant has signed a 20-year contract with a US firm to
Helicopter r Production produce obsolete Sikorsky S-55, S-58, and S-62 helicopters in China. The joint
company, which plans to produce more than 100 helicopters annually, will
assemble the helicopters from the US company's large stock of parts and
components for five years before switching to Chinese-manufactured parts.
Production will be geared toward sales abroad-primarily in Third World
markets.
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1 November 1985
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Tokyo Considers
Eliminating Tax-Free
Savings
Portuguese Budget
Deficit Out of Control
National Developments
Developed Countries
A consensus seems to be developing among ruling party officials and key
government ministries to impose a small withholding tax-5 to 10 percent-on
current tax-exempt savings accounts. Tokyo hopes such a tax would reduce
Japan's high personal savings rate-about 17 percent of disposable income-
while adding needed revenues to the government's coffers. Every Japanese is
now entitled to hold the equivalent of about $50,000 in tax-free accounts.
proposal to prohibit anonymous savings accounts.
Numerous efforts since the late
1970s to tighten restrictions on or tax these accounts have failed because of
strong political opposition. The US Embassy now believes that increasing
support from top ruling party officials-eager to demonstrate to Washington
their commitment to encourage increased consumer spending-makes passage
of a small withholding tax possible in fiscal 1986. In our view, Tokyo is
unlikely to accompany such action by implementing a politically controversial
Lisbon's budget deficit-with government spending running 50 percent above
last year's level-probably will equal almost 20 percent of GDP compared
with 13 percent last year. Lisbon so far has failed to come to grips with the ris-
ing costs of social security, public wages, and health and education programs,
while neglecting to reform spending on public enterprises and municipalities.
In addition, revenues this year will likely be about a third less than expected-
partly a result of an overly optimistic GDP growth projection. We do not
expect an improvement in the deficit until Lisbon introduces fundamental
reforms in its system of public finances, an unlikely prospect in view of the po-
litical uncertainties resulting from the elections earlier this month. With no
party able to win a majority, the government will probably hold off on any
major changes at least until after the presidential election early next year.
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weden Eases The Swedish Central Bank last week announced that its penalty interest rate,
Monetary Policy the major instrument for influencing short-term rates, will be reduced by 1
percentage point to 14 percent in an effort to ease monetary policy and
promote domestic growth. Last May the government pushed short-term rates
up sharply in order to stem short-term capital leaving the country because of
higher interest rates abroad. The recent announcement-which follows by one
week a speech by Finance Minister Feldt advocating a looser monetary
policy-indicates that the Central Bank is now worried less about capital
outflows than about reviving sagging domestic production.
uwaiti Financial
Troubles
Mexico's Decline
in Tourism
Indonesian
Belt-Tightening
Secret
/ November 1985
Less Developed Countries
selected recipients.
The US Embassy reports that the Central Bank of Kuwait is being sued by
three US banks trying to recover $13.5 million in loans made to the
Abulhassan Foreign Exchange Company. The latter is one of Kuwait's largest
moneychangers and one of many financial institutions still feeling the effects
of the Kuwaiti stock market crash in 1982. Kuwait's handling of the
company's debts-reportedly guaranteed by the government-has frustrated
the US banks, and they are encouraging the government to bail the company
out. Whether or not the banks collect their loans-and the prospect is dim-
they want to register their annoyance with the central bank over what could
become precedent-setting policy. Kuwait has not yet defined its commitment
to financial institutions other than banks, and appears to be helping only
unaffected by the earthquake, hotel occupacy rates are also down 15 percent,
hope to attract some 2,700 US winter charter flights to Mexico, but the US
Embassy questions if all of these could be accommodated. In addition, price
hikes for rooms and air fares made prior to the earthquake are discouraging
visits to Puerto Vallarta and Guadalajara. In southeastern Mexico, an area
Income from tourism, a promising nonoil foreign exchange earner, may drop
because of the recent earthquake and price changes. Last year, tourism
increased 10 percent earning about $2 billion-roughly 8 percent of total
foreign exchange earnings. This year, however, half a dozen hotels collapsed
and another six suffered significant damage in Mexico City, the leading tourist
destination. On the Pacific coast, nearer to the earthquake's epicenter, several
luxury hotels were also destroyed. Despite this destruction, tourist officials still
Anticipating a continued slide in oil prices, Finance Minister Radius Parwiro
last week announced budget cuts designed to stem Indonesia's growing
external debt-which now stands at over $30 billion. Although budget cuts
and a cap on new foreign borrowing will help Indonesia keep its solid
international credit rating, we believe that fiscal austerity will depress
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economic growth, aggravate unemployment, and increase the risk of antigov-
ernment protests. Even if oil prices remain relatively stable, we estimate that
economic growth over the next several years will at best average no more than
4.5 percent annually-probably insufficient to fully employ the 2 million
workers entering the labor force each year.
Crowing Sri Lankan The Sri Lankan parliament recently approved another increase in defense
Defense Spending
spending, bringing total allocations for the year to about $250 million-80
percent greater than the original budget. The dramatic acceleration in military
spending to counter the Tamil insurgency has pushed defense to 12 percent of
government spending, compared to 3 percent in 1982. Meanwhile, overall
economic growth has slowed, and a 50-percent drop in world tea prices since
January has cut government revenues. Spending on rural development pro-
jects, public-sector industries, the Mahaweli irrigation project, and some social
welfare programs already has been reduced this year. Finance Minister de Mel
has implied that additional cuts are likely.
New Copper Smelter Mexico continues to seek private foreign financing for construction of pollution
in Northern Mexico abatement facilities for a new copper smelter near the US border, but low
metals prices and the overall weakness of the Mexican economy are likely to
make investors wary. The smelter-scheduled for completion by the end of the
year and part of the huge La Caridad copper complex near Nacozari,
Sonora-will have a capacity of 150,000 tons of copper per year, primarily
destined to replace imports of finished metal. It will also produce some 1,300
tons per day of sulfur dioxide, a pollutant that must be treated in accordance
with the 1983 US-Mexican Border Environmental Agreement.
Ethiopia Raises
Investment Ceiling
ic uncertainty will continue to discourage investors.
Ethiopia's Chairman Mengistu has announced that government ceilings on
private investment will be raised in an effort to stimulate the domestic
economy. The levels of savings and investment have declined steadily since
1979, and Addis Ababa forecasts an absolute decline in domestic savings this
year. Although some investment opportunities have been constrained by low
capital ceilings, the threat of nationalization and further political and econom-
/ Cuban Sugar J areas-probably will be down some 15 percent to about 7 million tons.
\ J Production
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The smaller crop also represents
another setback to Havana's goal of lifting annual sugar production to 12
million tons by 1990.
Bulgaria's Gloomy Bulgarian energy supplies remain insufficient to meet domestic needs because
Energy Outlook of a decline in the production of hydroelectric power caused by this year's
Soviet-Bulgarian
Production of Robots
z
tees a market for Bulgarian robots and flexible manufacturing systems.
Secret
1 November 1985
drought and a cut in Soviet oil deliveries, and government officials expect the
energy shortages to continue this winter and into next year. The US Embassy
in Sofia reports that power outages and curtailed shop hours and services are
becoming routine. The regime in September raised prices for electricity,
heating oil, and motor fuels in an effort to improve energy conservation, but
the current drive to recoup industrial losses suffered in the first half of the year
almost certainly will frustrate conservation efforts. Reflecting continuing 25X1
concern, Sofia in mid-October replaced the head of its State Planning
Committee and created a Party-Government Commission on energy problems
headed by Deputy Prime Minister Aleksandrov. Although the new Commis-
sion will encourage development of domestic resources and seek further
conservation, it probably will also place even tighter controls on energy
supplies. 0 25X1
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The USSR and Bulgaria signed an agreement in Sofia last week to establish
two joint "scientific-production associations" to produce robots and computer-
controlled manufacturing systems. During the next five years the associations
are to produce 13,800 numerically controlled lathes, 28,000 industrial robots,
and other kinds of manipulators. These machines will be produced for third-
country markets as well as for Bulgaria and the USSR. The Soviet-Bulgarian
associations are similar to a Soviet-Czechoslovak robotics organization estab-
lished last March, although it is not clear that the agreement with Bulgaria
will require construction of new facilities. The agreement improves Soviet
access to Western manufacturing technology licensed to Bulgaria and guaran-
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do so if China perceives that its trade balance with the United States is
worsening or if US trade legislation now under consideration is enacted.
China's Ministry of Foreign Economic Relations and Trade has established a
new unit to handle a growing number of countertrade deals. Beijing is seeking
to expand the use of countertrade to reduce trade deficits and buttress sagging
foreign exchange reserves. Although China now encourages firms from all
developed countries to engage in countertrade, US firms could be pressured to
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