INTERNATIONAL ECONOMIC & ENERGY WEEKLY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP97-00770R000100700001-5
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 42
• Document Creation Date: December 22, 2016
• Document Release Date: July 7, 2011
• Sequence Number: 1
• Publication Date: December 12, 1986
• Content Type: REPORT

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Directorate of
Intelligence
Weekly
International
Economic & Energy
.hV 5?,Ot
DI IEEW 86-049
12 December 1986
Cony 6 7 7
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Secret
International
Economic & Energy WeeklyF__1 25X1
iii Synopsis
1 Perspective-East European Energy: Long-Term Dilemmas
3 Poland: The Gloomy Energy Outlook
7 Yugoslavia: Falling Oil Prices-A Mixed Blessing
11 Saudi Near-Term Oil Strategy
17 China: A Market Approach to Technology Diffusion
21 Mexico: Renewing Its Nonoil Export Drive
Comments and queries regarding this publication are welcome. They may be
directed to Directorate of Intelligence
Secret
DI IEEW 86-049
12 December 1986
Energy
International Finance
Global and Regional Developments
National Developments
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International
Economic & Energy Weekly 25X1
Synopsis
1 Perspective-East European Energy: Long-Term Dilemmas
East European energy officials undoubtedly are closely monitoring energy supplies
as peak seasonal demand approaches. Occasional brownouts and sporadic fuel
shortages can be expected during a normal winter, but harsher weather would
produce severe disruptions in energy supplies to homes and industry.
3 Poland: The Gloomy Energy Outlook
Poland, one of the world's leading coal producers, faces an energy shortage
brought on by stagnant, increasingly costly coal production, inefficient energy
consumption, and unwillingness to cut hard currency coal exports to meet steadily
rising demand. We believe that energy constraints will limit economic growth and
contribute to declining trade performance during the next five years and threaten
the regime's efforts to rebuild social accord through improved living conditions.
7 Yugoslavia: Falling Oil Prices-A Mixed Blessing
Yugoslavia has taken advantage of the oil price windfall mainly to boost oil
imports and stimulate domestic performance rather than improve its hard
currency balance of payments as Western creditors would probably have pre-
ferred. The short-term benefits of the fall in energy prices could give Yugoslav
policymakers a false picture of the country's economic and financial position and
ease pressures to address fundamental weaknesses.
11 Saudi Near-Term Oil Strategy
In our view, while Saudi Arabia's long-term oil market objectives remain intact,
Riyadh's short-term strategy now emphasizes its revenue objective of maximizing
earnings at higher and stable prices. Nonetheless, the loss of Oil Minister
Yamani's experience and expertise will make Riyadh's petroleum policies more
unpredictable at least over the near term.
17 China: A Market Approach to Technology Diffusion
China is attempting to increase the development and use of technology through a
market in which technologies-both hardware and processes-are treated as
tradable commodities. We believe that more progress in joint research and
cooperation agreements between research and production enterprises will be
needed before sustained economic growth through technological innovation is
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DI IEEW 86-049
12 December 1986
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21 Mexico: Renewing Its Nonoil Export Drive
We believe that Mexico's traditional bias toward import substitution and protec-
tion of domestic industry will continue to constrain the President's ability to
replace petroleum income with other exports.
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Secret
International
Economic & Energy Weekly
Perspective East European Energy: Long-Term Dilemmas
East European energy officials undoubtedly are closely monitoring energy supplies
as peak seasonal demand approaches. After experiencing a critical energy crisis
two years ago, the countries of the region have devoted more attention to
stockpiling fuels and repairing power plants. Moreover, the startup of two nuclear
reactors in Czechoslovakia and Hungary this fall and an end to drought-induced
limits on hydroelectric generation in Yugoslavia and Bulgaria should augment
energy supplies.
Even a successful stockpiling campaign cannot totally buffer the region against
energy disruptions. Occasional brownouts and sporadic fuel shortages can be
expected during a normal winter, but harsher weather would produce severe
disruptions in energy supplies to homes and industry. Limitations on energy
storage facilities leave little margin to cover surges in demand, and chronic
bottlenecks in distribution systems often prevent energy from moving to areas of
greatest need. Moreover, the region cannot depend on the USSR as much as
previously, except possibly for natural gas
To avoid the annual concerns over winter energy supplies, the East European
regimes must select some combination of strategies to reduce energy demand or
boost supply. Each approach, however, poses intractable problems.
Efforts to promote conservation in the energy-guzzling, outmoded industrial sector
face major difficulties:
? The regimes have always been reluctant to accept the difficult structural
adjustment that using market-determined energy prices would entail.
? Adjustment to the debt problems of the early 1980s required sharp declines in in-
vestment-including expenditures on energy conservation-and the needs of
such a program still far exceed available funds.
An alternative strategy is to boost the supply of energy. In this way, limited
investment funds need only be focused on a few key sectors rather than diffused
throughout the economy. Here there are several options. The nuclear route, despite
Chernobyl', remains attractive because it diminishes dependence on either the
USSR or other foreign oil suppliers, and reduces air pollution. Heightened
concerns about safety, however, will raise the cost of the nuclear option as more
safety mechanisms are installed and the plants are sited in more remote areas.
Another option is to cooperate on energy projects in the USSR. This approach also
requires expensive investment in both oil and gas extraction as well as extensive
pipeline networks. The regimes might be loath to subsidize the development of the
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DI IEEW 86-049
12 December 1986
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Secret
Soviet oil and gas industry, especially now that world energy prices are so low. In
addition, although the USSR has abundant natural gas, but Eastern Europe may
be unable to bear the costs of restructuring their economies to substitute gas for oil
and coal.
Frictions among the Soviet Bloc countries will complicate the implementation of
long-term energy strategies. The regimes will tend to their own national interests
first, frustrating efforts to develop regionwide solutions. Poor management of the
CEMA power grid has already resulted in sharp disputes. One Hungarian official
recently complained that Romania drew too much power from the grid last winter,
making it hard for other CEMA countries to keep factories open and meet delivery
commitments to non-Bloc customers. Exploitation of the Danube and other rivers
will become a sore point as several countries vie for water for the competing uses of
irrigation and power. Finally, because of Chernobyl', some regimes may not take
kindly to CEMA partners building a nuclear plant near their border.
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Poland: The Gloomy
Energy Outlook
Poland, one of the world's leading coal producers,
faces an energy shortage brought on by stagnant,
increasingly costly coal production, inefficient energy
consumption, and an unwillingness to cut hard cur-
rency coal exports to meet steadily rising demand.
Warsaw's policies focus on the development of costly
new energy sources and assign secondary importance
to improved efficiency and conservation. As a result,
Poland probably will seek to increase its energy
imports from the USSR, but Soviet supplies are not
likely to keep pace with Polish demand. We believe
that energy constraints will limit economic growth
and contribute to declining trade performance during
the next five years. The possibility of worsening
energy shortages also threatens to undermine the
regime's efforts to rebuild social accord through
improved living conditions.
The Polish economy runs on coal. In 1985 hard coal
and lignite (a low-quality soft coal) accounted for 81
percent of total Polish energy consumption and 97
percent of electricity generation. Coal is also Poland's
most important export, accounting for nearly 20
percent of hard currency export revenues in 1985.
Hard coal production, however, has leveled off at 192
million metric tons since 1983. Plans call for produc-
tion to stay at the same level for the next five years
and to reach only 195 million tons by 1995. Polish
mining officials cite the depletion of easily mined coal
and more difficult geological conditions such as thin-
ner seams and greater depths as the main factors in
stagnating coal output and rising costs.
Because prospects for increased hard coal production
are poor, Warsaw has begun to rely more heavily on
lignite, especially for electric power generation. Lig-
nite production has increased 53 percent since 1982,
reaching nearly 58 million tons in 1985, and plans call
for extraction of 74 million tons annually by 1990.
Lignite production increased by 16 percent in the first
nine months of 1986 and accounted for 30 percent of
electricity generation. Growing environmental con-
cerns, however, will limit lignite's role in filling the
energy gap. The high cost of pollution control technol-
ogy, for example, inhibits the broader use of lignite-
burning power stations.
Other Sources of Energy
With no domestic alternatives to hard coal and lig-
nite, Poland's demand for energy imports from the
USSR will increase and require costly investment in
equipment capable of transporting and using other
energy sources. The extent to which the USSR can
cover shortfalls in Poland, however, may be limited.
Poland currently receives 6 billion cubic meters (bcm)
of Soviet gas annually, about one-half its total con-
sumption, and plans call for Soviet deliveries to reach
7.4 bcm by 1990. Poland has begun receiving addi-
tional Soviet gas in exchange for coke exports and its
participation in construction of the new Kobryn-
Brest-Warsaw natural gas pipeline. Warsaw has also
agreed to participate in the construction of the Yam-
burg gas pipeline, and will receive an additional 2 bcm
annually in the 1990s as compensation. Despite the
growing Soviet deliveries in 1985, gas still accounted
for just over 7 percent of total energy use. Moreover,
the high cost of conversion of industrial facilities will
limit the use of gas as a substitute for coal.
Soviet oil deliveries, which account for more than 90
percent of Polish oil consumption, will at best main- 25X1
tain present levels during the current Five-Year Plan
(1986-90). Poland imported 259,000 b/d of crude oil
and about 46,000 b/d of petroleum products from the
Soviet Union in 1985, slightly less than it received in
1980. Polish-Soviet trade plans call for Soviet exports
to remain at about 260,000 b/d until 1990.
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DI /EEW 86-049
12 December 1986
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Poland: Coal Production and Exports, 1979-86
Poland purchases only a small amount of oil from
Arab producers, and hard currency limitations will
prevent Warsaw from taking advantage of currently
low world prices. Ironically, lower world oil prices
hurt Poland because they tend to depress competing
demand and prices for coal. Although Warsaw's coal
export volume increased by about 3 percent in the
first six months of 1986, revenues have declined by
about 16 percent, according to the US Embassy. A
Polish Ministry of Finance official told the Embassy
that lower prices for Polish raw material exports are a
major factor in Poland's disappointing trade perfor-
mance this year.
Poland expects to increase electricity imports from the
Soviet Union in exchange for its participation in the
construction of the Khmielnicki nuclear power com-
plex in the Ukraine. Moscow may have difficulty
honoring its electricity commitments in the wake of
the Chernobyl' accident, however.
Warsaw is looking to nuclear power to meet the bulk
of its future electricity needs, but construction delays
and safety concerns in the wake of the Chernobyl'
disaster have added to uncertainty over the contribu-
tion of nuclear power to the overall energy balance.
According to a regional party newspaper, work on
Poland's first nuclear plant was halted for several
months this summer because of a shortage of high-
quality building materials. Polish nuclear power ex-
perts are also reviewing monitoring and safety sys-
tems for the plant. The Poles are likely to seek
additional outside assistance-probably from other
CEMA countries-to address safety concerns and
alleviate materials shortages, leading to higher import
content and costs. Officials concede, however, that
nuclear power will not make a significant contribution
to Polish energy supplies before the late 1990s.
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Poland: Primary Energy
Sources, 1985
In addition to domestic demand, Warsaw needs to
maintain a high level of coal exports for hard currency
to fulfill its burdensome debt service obligations, to
finance imports of modern capital equipment, and to
meet heavy demand for Western consumer goods.
Polish officials claim that domestic consumption takes
priority over exports, but Warsaw cannot afford to
reduce coal exports at a time when world coal prices,
and thus export revenues, are falling.
Warsaw's energy policy emphasizes large investments
in new energy sources and production facilities and
gives a backseat to energy conservation. Energy in-
vestment in 1986-90 is to increase by nearly 100
percent over 1981-85 with the opening of six new coal
mines, construction of several conventional power and
heating plants, participation in the construction of the
Yamburg gas pipeline in the USSR, and the begin-
ning of construction of a second nuclear power plant.
While new investments are badly needed after the
sharp drop in investment in the early 1980s, the
program has drawn criticism from members of the
Polish parliament for failing to promote restructuring
of the economy and for providing inadequate incen-
tives for conservation.
Projected increases in domestic energy production and
imports appear insufficient to meet the growing de-
mand for energy in industry and the household sector.
The 1986-90 plan calls for industrial output to grow
at an average annual rate of slightly more than 3
percent. Energy requirements will probably grow at
least as rapidly because Polish industry is among
Europe's least energy efficient. According to the
official party newspaper, heavy industry uses 70
percent of total energy supplies while producing only
17 percent of national output.
The five-year plan calls for 10-percent growth by
1990 in the housing stock and a significant increase in
electrical appliances.
new housing units will require an additional 7-million-
tons coal equivalent annually for heat and electricity,
and electricity demand will grow more rapidly than
supply, leading to a 2,500- to 3,000-megawatt deficit
at peak demand times.
Warsaw has taken only limited measures to reduce
wasteful energy use and gain tighter control over
energy supplies. In April the regime increased retail
prices for coal, gas, electricity, and central heating by
15 to 45 percent, and, according to the US Embassy,
it plans to continue raising domestic coal prices over
the next three years until they cover production costs.
In August the government reduced coal allocations
for farmers, who often sell their excess coal on the
black market. In the most significant move to date,
Warsaw last month raised producer prices for coal 25X1
and coke in an effort to increase conservation and
improve profitability in these heavily subsidized in-
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In late September, Mining and Energy Minister
Piotrowski, an army general who had been Minister
since 1981, was replaced by Jan Szlachta, a coal
mining specialist who brings needed expertise to this
key ministry. Piotrowski's replacement may signal a
shift toward increased emphasis on improved conser-
vation and efficiency. Piotrowski was an advocate of
rapidly increasing investment in energy production,
and may have been removed for obstructing reforms
in the mining and energy sectors. Nonetheless,
Szlachta is unlikely to abandon Piotrowski's costly
push for expansion of the coal mining sector.
The conservation measures enacted by Warsaw to
date will not lead to a significant reduction in energy
demand or improvement in efficiency over the rest of
the decade. Despite the consumer and producer price
increases this year, according to one Polish economist,
retail coal prices currently are only about 30 percent
of production cost. The leading economic newspaper
estimates that coal prices would have to rise by 20
percent annually to eliminate subsidies by 1990-
given a gradual reduction in extraction costs. Ministry
of Finance officials told the US Embassy that the
regime plans to raise retail coal prices by 50 percent
and producer prices by 25 percent next year, but
Warsaw probably will proceed cautiously given public
sensitivity to inflation. Moreover, Warsaw appears to
be hesitant to cut energy subsidies and allow ineffi-
cient enterprises to go bankrupt.
Energy shortages are likely to be a major constraint
on economic growth over the next few years. Poland
will also be increasingly vulnerable to energy shocks
triggered by bad weather. Consequently, Warsaw will
have little choice but to continue to give priority to
domestic coal consumption-limiting its ability to
increase hard currency export revenues in the near
term. Moreover, worsening energy shortages would
add to consumer frustrations, depress work incentives,
and undermine the regime's efforts to rebuild a social
consensus through improved living conditions
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Yugoslavia: Falling Oil Prices-
A Mixed Blessing
Yugoslavia has taken advantage of the oil price
windfall mainly to boost crude oil imports and stimu-
late domestic performance rather than improve its
hard currency balance of payments as Western credi-
tors would probably have preferred. The drop in
prices, however, has meant little relief for hard-
pressed consumers, has probably resulted in reduced
export earnings in key Middle East markets, and
threatens to disrupt trade with the Soviet Union.
Moreover, the short-term benefits of the fall in energy
prices could give Yugoslav policymakers a false pic-
ture of the country's economic and financial position
and ease pressures to address fundamental weakness-
Through most of the 1970s the Yugoslav economy
appeared immune to fluctuations in world oil markets.
With the economy growing at a rate of 6 percent
annually, consumption of crude oil rose from 147,000
b/d in 1970 to almost 321,000 b/d by 1979, replacing
domestically produced coal as Yugoslavia's primary
energy source. Domestic energy prices were kept
stable, and few conservation measures were adopted.
With the second oil shock in 1979, sharply higher oil
import prices fueled inflation and exacerbated the
country's worsening foreign payments problems. Sub-
sequent restraints on oil imports led to gasoline
rationing and contributed to periodic blackouts. In
1985 crude oil consumption remained more than
64,000 b/d below the peak 1979 level.
Despite efforts to become more energy self-sufficient,
Yugoslavia has remained heavily dependent on im-
ported oil. In 1985 oil imports of 175,000 b/d ac-
counted for more than two-thirds of total crude oil
consumption, or more than 20 percent of the country's
total energy needs.
Prices and Terms Renegotiated
Since the first quarter of this year, Belgrade has
negotiated lower oil import prices from its major
suppliers, including the Soviet Union. Prices have
fallen from an average of $28 per barrel in January to
an estimated average of $12 to $14 by midyear. To tie
prices more closely to world market trends, contract
periods reportedly have been shortened, and Belgrade
has purchased some oil on a net-back basis.
The reduction in oil prices, however, has not provided
Yugoslavia with much more cash. Yugoslavia imports
almost all of its oil under long-term compensation and
barter agreements. Prices are fixed in dollars and
linked to official OPEC prices. Iran, Iraq, Libya, and
Algeria, for example, barter oil largely in return for
Yugoslav goods and services-consumer items, ma-
chinery, and construction services. Libya and Iraq
also barter oil for military arms and services. More
than one-half of Yugoslavia's oil trade-either direct-
ly or indirectly-is with the Soviet Union and is
conducted on a dollar clearing account in the context
of total Yugoslav-Soviet trade.
Impact of Declining Prices
Yugoslav officials, while noting the benefits of lower
oil prices, acknowledged earlier this year that a steep
plunge in prices-below $25 a barrel-would harm
foreign trade. They feared that Yugoslavia's oil-
exporting trade partners would reduce their purchases 25X1
of Yugoslav goods and services. To forestall such a
drop in exports, Belgrade had two options: increase
imports of oil and other goods from these countries, or
reroute exports to new markets.
Belgrade's success in exercising its options has been
mixed, varying by trading partners. Initial fears that 25X1
Moscow would cut back on the level of Yugoslav
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The USSR normally provides more than one-half of
Yugoslavia's imports of crude petroleum, or about 40
percent of the country's total consumption. The Sovi-
et share has remained relatively steady since 1981,
when Yugoslavia's financial difficulties and the Iran-
Iraq war left Moscow the dominant supplier. Pur-
chases of Soviet crude oil in 1981-85 were valued at
$6.2 billion, or about 40 percent of Yugoslavia's total
imports from the USSR. The Soviet Union also
supplies substantial quantities-28,000 b/d in
1985-of petroleum products to Yugoslavia.
The level of Soviet crude oil deliveries is fixed under
annual and five-year bilateral trade agreements. The
1986-90 agreement calls for annual base deliveries of
111,000 b/d, compared with 90,000 b/d in 1981-85.
The actual increase, however, is expected to be
somewhat less. In recent years, Moscow has regularly
granted Belgrade's requests for advanced deliveries of
oil-most of which were not charged to the next
year's quota-amounting to 20,000 b/d annually, a
practice the Soviets say will end under the new
agreement.
Yugoslav-Soviet trade is conducted on a dollar-
denominated clearing account basis, with Soviet oil
valued at official OPEC prices. Belgrade in return
supplies Moscow with a variety of consumer goods,
machinery and equipment, ships, and agricultural
products. The arrangement has proved very favorable
for Yugoslavia. It receives a guaranteed minimum
level of crude oil at world prices in exchange for
goods with a high domestic content that generally are
not readily salable in Western markets.
Nearly all of the oil delivered under the bilateral
agreement in recent years has been non-Soviet in
origin, coming largely from Middle East producers.
In 1985, for example, Middle Eastern suppliers ac-
counted for virtually all of the 86,000 b/d of oil
delivered to Yugoslavia on Soviet account. The Mid-
dle East oil is delivered largely in exchange for
Soviet arms deliveries.
imports in 1986 to offset a growing trade imbalance
appear unfounded. Both Moscow and Belgrade have
asserted that the fall in prices is a mutual problem
and will not lead to a reduction in the planned $5.5
billion trade level for 1986. To offset a growing
Yugoslav trade surplus-initially projected at nearly
$1 billion-Yugoslavia earlier this year agreed to
increase its purchases from the Soviet Union by $500
million, and Moscow reportedly agreed to increase oil
deliveries.
Efforts to maintain Middle East markets have been
less successful. Exports of Yugoslav goods and ser-
vices-including the signing of new long-term con-
struction contracts-are believed to have fallen sharp-
ly this year. While we expect these countries to
increase oil deliveries to Yugoslavia this year, we do
not believe the increased volume will be sufficient to
offset the drop in prices and support traditional levels
of imports from Yugoslavia. These countries are
trying to conserve oil reserves or find more attractive
markets. In addition, some Yugoslav firms, disgrun-
tled over redtape and tardy payments, have been
reluctant to accept additional compensation in oil,
opting instead to cut back on trade and new construc-
tion contracts.
The reduction in Middle East demand has not been
offset by increased exports to developing countries
and key West European markets, both of which have
benefited from the fall in energy prices. Exports to
hard currency markets were down 3 percent through
October. Increasing protectionism and the mediocre
quality of many Yugoslav goods are partially respon-
sible, as are Belgrade's faulty trade policies. Yugoslav
exporters and some officials blame the new foreign
exchange law and an overvalued dinar for reducing
incentives to export.
Little Help for the Balance of Payments
On paper the drop in oil prices is worth almost $1
billion to Yugoslavia. Belgrade is expected to receive
an additional 60,000 b/d of oil (worth $350 million) in
1986, while reducing its total expenditures for oil by
an estimated $650 million
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Yugoslavia: Imports of Crude Oil, 1981-86
We estimate, however, that the net gain to Yugosla-
via's hard currency balance of payments in 1986 will
be much less, perhaps $200-300 million. More than
one-half of the projected savings in oil expenditures
will occur in clearing trade with the USSR, with little
effect on hard currency payments. Moreover, the
expected reduction in export revenues to the Middle
East will offset a portion of the hard currency savings
resulting from the reduced outlays for petroleum.
Belgrade could have further improved its hard curren-
cy payments position by reselling imported oil, but has
apparently not done so. Lower oil expenditures are
expected, however, to offset much of the deterioration
in the trade account, producing a hard currency
current account surplus in 1986 close to last year's
$344 million.
Domestic Impact Mixed
Lower oil prices and increased supplies have clearly
contributed to improved domestic economic perfor-
mance. Growth rates are running ahead of both last
year's rates and planned 1986 levels. Prices of petro-
leum products for industrial and agricultural use have
been reduced significantly, restraining producer costs.
Firms are reportedly well supplied with oil and gaso-
line stocks.
The consumer, however, has seen few direct benefits
of lower petroleum prices. Record inflation at the
retail level is running at a near-triple-digit pace.
Retail prices of most petroleum goods, gasoline in
particular, have not been lowered. Some officials fear
that passing along lower costs would stimulate an
upsurge in consumption. The difference between re-
finery and retail prices is slated to go to a special fund
to support exports and agriculture. Price declines have
been further moderated by long-term contracts and 25X1
by the dinar's sharp depreciation against the dollar.
The impact of lower oil prices has varied widely by
industry and region, threatening to further exacerbate
large disparities in wealth. Those industries (electric
power, food and chemical processing, and metal man-
ufacturing) and those republics (Serbia, for example) 25X1
that are large users/importers of petroleum have
realized the greatest gains. In contrast, those indus-
tries that are less energy intensive and those republics
that are large oil producers (such as Croatia) or
heavily dependent on Middle East export markets
(Montenegro, for example) haved fared less well.
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Yugoslavia: Economic Indicators,
1985-86
Gross social product (percent) 0.5 3.7-
Industrial production (percent) 2.7 4.2-
Producer prices (percent) 82.0 78.0 b
Retail prices (percent) 76.0 98.0 b
Personal consumption (percent) 0.0 4.0 c
Hard currency trade balance -1,771 -2,000 d
(million US $)
Hard currency current account 344 340 d
(million US $)
Data for January-October.
b Data for January-August.
Estimated for January-October.
Estimated.
Lower oil prices on balance will continue to benefit
the Yugoslav economy in 1987 but probably to a
much lesser degree than in 1986. Increased oil stocks
could permit Belgrade to reduce oil purchases next
year, and lower prices should continue to help prop up
domestic performance. The sharp, one-time stimulus
from the steep price decline, however, is past, and
several longer run factors could moderate any
advantages:
? Declining Middle East Sales. Belgrade may lose
further sales to Middle East markets. Alternative
markets for specialized construction services are
lacking, and Belgrade's ablility to penetrate new
markets is limited. Depressed oil prices will proba-
bly further exacerbate payment and debt settlement
difficulties with Libya and Iraq. Attempts to show
more flexibility in trade and payment arrangements,
such as seeking countertrade deals with third coun-
tries, are likely to be only partially successful.
? Lack of Domestic Reform. The gain from lower oil
prices together with other favorable external fac-
tors-such as a weaker dollar and falling interest
rates-could mask Belgrade's failure to address the
economy's fundamental weaknesses and could ease
pressure on the regime to pursue economic reforms.
? Continuing Soviet-Yugoslav Trade Imbalance.
Moscow may cut back on its purchases of Yugoslav
goods despite assurances to the contrary if Yugosla-
via's trade surplus continues unchecked. Despite a
series of high-level talks, trade difficulties apparent-
ly have not been resolved.
deficit of perhaps $500 million in 1986 and
could be reduced by $1 billion. Should this occur,
Yugoslavia would be hard pressed to find alternate
markets for industries highly dependent on the
as a result, bilateral trade next year
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Saudi Near-Term Oil Strategy
Despite King Fahd's decision to fire Oil Minister
Yamani and seek an increase in oil prices to $18 per
barrel, we believe the Saudis still base their oil policy
decisions on a combination of economic, political, and
security considerations:
? Increase near-term oil revenues to avert deep spend-
ing cuts and foreign reserve drawdowns.
? Capture a greater share of the oil market, prefera-
bly through producer cooperation.
? Ensure a growing long-term market for oil by
making consuming countries more dependent on oil.
? Secure Saudi Arabia's dominant position within
OPEC vis-a-vis Iran.
In our view, while Saudi Arabia's long-term oil
market objectives remain intact, Riyadh's short-term
strategy now emphasizes its revenue objective of
maximizing earnings at higher and stable prices. The
shift in emphasis stems mainly from Fahd's increasing
concern about chronic budget deficits and growing
criticism by senior princes and technocrats about
fiscal mismanagement. Now that average world crude
oil prices have fallen substantially from $28 per
barrel, conditions that will improve the longer term
outlook have largely been set in motion-world oil
demand is higher and non-OPEC output has slowed.
King Fahd probably believes that oil prices at $18 per
barrel will ease Saudi revenue problems without
endangering this year's favorable oil market trends.
We believe, given current market conditions, Saudi
Arabia will have a difficult time raising prices to $18
per barrel at least in the next six months. Moreover,
the dismissal of Oil Minister Yamani-and the loss of
his knowledge of the oil market and negotiating skills
within OPEC-probably will make Riyadh's petro-
leum policies more unpredictable, at least over the
near term
Fahd is concerned that current oil prices will not
generate enough revenues for the upcoming fiscal
year 1986/87 Saudi budget and does not want to
Saudi Arabia: Crude Oil Production
Necessary To Reach Selected
Revenue Targets
At SIU At S15 At 518
per barrel per barrel per barrel
draw down financial reserves much further. We esti-
mate that liquid reserves are about $55 billion. Ri-
yadh reportedly will announce projected government
expenditures of about $40 billion, although actual
spending will probably be less. Nonoil income is
expected to provide some $10 billion, leaving about
$30 billion in oil revenues needed to balance the
budget. Over the next year, we believe Saudi oil
strategy will be dominated by efforts to achieve this
oil revenue target. The King's production and price
goals of 5 million b/d and $18 per barrel would yield
roughly this amount.
Secret
DI /EEW 86-049
12 December 1986
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Secret
Other combinations of oil prices and output that
would earn Riyadh close to $30 billion are probably
less desirable from Fahd's viewpoint. At current
prices or lower, for example, the Saudis would have to
produce more than 6 million b/d to generate the
revenue target. This would almost certainly trigger
another price war, making it more difficult to achieve
the revenue goal. If prices were to fall below $10 per
barrel, the output necessary to earn $30 billion in
1987 might exceed current productive capacity.
Riyadh at the OPEC Meeting
King Fahd's apparent strategy for the OPEC session
in Geneva that began 11 December is to encourage
the group to adopt his price objective of $18 per
barrel. He may have already succeeded; OPEC's price
committee recently announced it would recommend
that target to the full ministerial session in Geneva.
Now that the target appears to be a common objective
rather than merely a Saudi one, Riyadh is in a better
position to ask the group to make the necessary
production cuts to support this price. We expect
acting Saudi Oil Minister Nazir will try to pressure
other members to accept most of the burden through a
10-percent cut in overall OPEC output, according to
US Embassy reporting.
Despite some positive signs going into the meeting, we
believe the Saudis will have difficulty garnering
strong OPEC cooperation in supporting prices. Some
OPEC officials are billing the December meeting as
perhaps the cartel's most difficult session ever, and
any Saudi inflexibility would make agreement even
more elusive. The Saudis probably will not be willing
to make unilateral production cuts or resume the role
of swing producer. If the group comes close to a
realistic scheme to raise prices, however, Riyadh may
be willing to lower output slightly if its share of
OPEC production remains near the current 25 per-
cent. Even this would be difficult for Fahd, because
such an effort could result in a reduction in oil
revenues.
In our judgment, based on our forecast of market
conditions in 1987, OPEC will have a difficult time
raising oil prices to $18 per barrel at least over the
next six months. At current prices, we expect demand
for OPEC oil next year as a whole to average near
current OPEC production-including natural gas liq-
uids-of about 19 million b/d. Low seasonal demand
in the spring, however, will probably hold demand
below 18 million b/d during the first half of 1987.
Thus, if OPEC does not decrease output during this
period, prices could fall considerably. Prospects of
lower prices would probably lead to higher-than-
anticipated stock draws, which would increase down-
ward pressure on oil prices. We estimate primary oil
stocks on land at the end of September stood at 4.3
billion barrels, about 200 million barrels above year-
earlier levels. Under these conditions, a replay of
circumstances in 1986 could evolve, with prices tem-
porarily falling rapidly to as low as $10 per barrel.
In our judgment, to raise oil prices to $18 per barrel in
the near term would require a decision by OPEC to
hold down oil output. We believe the cartel needs to:
? Cut output by 1-2 million b/d from current levels
early next year. This should boost prices during
peak winter demand and create the expectation of
higher prices for the rest of the year, thus discourag-
ing a large stock draw. The group would also need
to ensure strict compliance with the new guidelines
to prevent price erosion.
? Seasonally adjust output. Further cuts in the spring
would be needed to maintain the higher price.
? Abandon netback pricing arrangements if a fixed-
pricing scheme is to be initiated.
In any event, these output decisions must be made
early to avoid excessive speculation and market vola-
tility.
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Secret
Key Indicators of Saudi Oil Strategy
If King Fahd is serious about pursuing a price support strategy in coming months
we would expect the Saudis to begin taking more concrete actions that could be
detected both in OPEC forums and in the marketplace. So far, we have seen no
firm indications that Riyadh is ready to make such a commitment. We have
identified, below, actions that would provide advanced notice whether the Saudis
are indeed willing to support prices, or whether they see higher prices as an
eventual goal, and will seek to sustain market share as the best way to maximize
revenues.
Price Support Approach
Phase out netback contracts and encourage the same
from other members.
Reduce Saudi oil production toward its quota of 4.35
million b/d.
Increase bilateral contacts with Persian Gulf produc-
ers, including Iran.
Maintain pragmatic, flexible position at OPEC
meetings.
Make legitimate attempt to agree on fluctuating
OPEC ceiling, individual quotas, and on crude oil
price differentials.
Support Iranian insistence that Iraq be included in
OPEC quota system.
Little Help From Other OPEC Countries. Despite
endorsement of higher prices, other OPEC countries
do not appear prepared to take the steps necessary to
raise and hold prices near $18 per barrel. On 10
December several OPEC delegates indicated publicly
that they believe OPEC had little chance of reaching
agreement on a new production allocation scheme
during the current meeting. Some OPEC country
officials have reported that they believe it is too
early-because of market conditions-to try to reach
the price objective, while others reportedly believe
that a reduction in the group's output is unnecessary
Market Share Approach
Continuation of netback contracts, or renewal of
discounts to maintain export volume.
Sustain Saudi output at or near current levels of 5
million b/d.
Remain inflexible, using a take-it-or-leave-it attitude
at December's OPEC session.
Leave Geneva with a weak or unsound agreement,
postponing discussions on difficult issues.
Increase security measures at key oil installations.
Maintain technical ability to raise output within a
wide range.
to achieve the $18 per barrel price. Many OPEC
officials have indicated that members will try to avoid
discussions on production quotas for another six
months and will merely extend the current system.
Moreover, Arab producers continue to produce above
their quotas. This will begin to increase oversupply
pressures now that Iran has made repairs to damaged
export facilities, enabling it to increase production by
over 1 million b/d above the August-October levels of
1.2-1.4 million b/d.
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Secret
Saudi Arabia: Crude Oil Production and World
Average Oil Prices. August 1985-November 1986
Production
OPFC Quota
I 1 ___! L L__ I I I LEI
Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
198h 1986
Aug Sep Oct Nov Dec Jan Fch Mar Apr May Jun Jul Aug Sep Oct Nov
1985 1986
Includes Neutral Zone production.
- World average
oil price
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Despite the King's desire for price stability, we believe
the market over the next six months or so will return
to the volatility experienced in the first half of this
year, with prices averaging $10 to $14 per barrel.
How far prices fall will depend on what the Saudis do
after the OPEC meeting. Because OPEC is unlikely
to take the steps necessary to hold down output,
probably the best revenue option available to Riyadh
is to continue producing at least 5 million b/d and
allow prices to erode somewhat during the next
several months. Although this would temporarily
yield oil export revenues at an annual rate of less than
$25 billion, the alternative-substantially boosting
output--would push prices well below $10 per barrel,
and make matching even this level of earnings very
difficult. Nevertheless, the King may decide to pursue
the latter route to teach other OPEC members that
lowering output to support higher prices is less painful
financially than a price war.
In the less likely case where the Saudis decide to
compromise at the OPEC meeting and OPEC coun-
tries agree to lower output by about 1 million b/d,
prices could rise to the $15 to $18 range in the near
term. After midyear, if OPEC kept output near 18
million b/d, prices would probably remain above $15
per barrel.
We believe the King's objectives are more easily
attainable after next year. Market forces will continue
to work in OPEC's favor. Increased demand and flat
or declining non-OPEC output will boost demand for
OPEC oil. If the cartel keeps output near current
levels, we believe prices could rise to near $18 per
barrel by early 1988.
While we believe considerations about Iran have
played a relatively minor role in Saudi oil policy in the
past, the role of the Iranians in the future is less
with Tehran so far, and, for the near term, he
probably will do little to dispel Iran's perception that
Fahd's support of higher prices and Yamani's dismiss-
al were conciliatory gestures to Iran. Any alliance
between the two at the meeting, however, probably
will hinge, in large part, on Riyadh's position on Iraqi
production. Nevertheless, Riyadh probably will op-
pose an expected Iranian move to include Iraq in any
new allocation scheme. Any OPEC production accord
will be complicated by the substantial increase in
Baghdad's export capacity expected in mid-1987. Any
Saudi unwillingness to address this issue could indi-
cate that Riyadh is not seriously committed to sus-
taining higher prices.
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China: A Market Approach to
Technology Diffusion '
China is attempting to increase the development and
use of technology through a market in which technol-
ogies-both hardware and processes-are treated as
tradable commodities. Initial market activities sug-
gest mixed results. Beijing is disappointed, for exam-
ple, that most transactions involve low-level technol-
ogy sold to smaller enterprises. But China also claims
that transactions through the new technology market
have improved production and increased economic
productivity. We believe that more progress in joint
research and cooperation agreements between re-
search and production enterprises will be needed
before sustained economic growth through technologi-
cal innovation is realized. In addition, overreliance on
market-oriented research is shortchanging the basic
research needed for innovation in the long run.
Learning To Manage the Technology Market
China is counting on technology to transform its aging
industries and boost production, but lack of incentives
and procedures for diffusing technology have kept
research achievements from being used effectively-
or at all-in the past. To improve the contribution of
science and technology to economic growth, Beijing
has encouraged greater commercial exchange of tech-
nology within China. According to statements by
Chinese officials, this technology market is intended
to introduce new technologies, both domestic and
foreign, and facilitate their transfer to industry-
particularly to medium- and large-scale enterprises.
Beijing further expects the technology market to
promote the rational flow of knowledge and personnel
and to improve the quality of Chinese products for
both domestic and international consumption
implementation of
measures to spur technology trade has encountered
several problems. Beijing is having difficulty resolving
the issue of how to place a value on technology that
satisfies ideological concerns and, at the same time,
provides incentives for technology development. One
S&T official suggested that price should depend on
the economic results from applying the technology to
production, while the party's theoretical journal called
for laws preventing "technology monopolies, waiting
for a good price to sell, and other indecent tenden-
cies."
Sales of unreliable technologies, selling technologies
for excessive profit, plagiarizing technologies, fraud,
and broken contracts have alarmed Beijing and dis-
couraged potential technology buyers. Chinese offi-
cials report that these problems caused a sharp de-
crease in the number of technology transactions 25X1
during the first half of 1986 compared with the same
period in 1985. Moreover, some universities and re-
search institutes have resisted the directive that per-
sonnel be permitted to earn additional income through
work on outside projects in their spare time by
refusing to allow them to keep the money. Also,
managers whose products already are in great de-
mand fail to see the need for improving either their
product or production processes.
To alleviate these problems, Beijing is creating new
oversight groups and drafting legislation covering
pricing, contracts, and other aspects of technology
development and sales. Beijing may find it difficult,
however, to balance the need to curb market abuses
with the need to provide adequate incentives for
technology transfer. The proliferation of groups in-
volved in managing technology trade also raises the
potential for greater managerial confusion. Nonethe- 25X1
less, we believe that many of these initial problems
will lessen as organizations gain experience in the 25X1
applying technology to industrial problems.
market. Because Beijing's continuing economic re-
forms provide additional incentives for technology
innovation, more enterprises should be interested in
Secret
DI IEEW 86-049
12 December 1986
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Beijing has adopted policies that allow market
forces-supply and demand-to influence technology
development and sales. The goal is to use technology
to spur economic growth and development by chan-
neling research results into production. Until recent-
ly, state authorities dictated what research was to be
done and who would receive the results. Results were
turned over to the factory for which they were
intended at no cost, but generally not made available
for use or sale to others. No one was responsible for
determining how useful the research had been; ac-
cording to Chinese officials, most research was never
used.
Who is involved? Research institutes, civilian and
military factories, individuals, foreign firms, indus-
trial ministries, and state commissions. Beijing is
now requiring most research institutes to become self-
supporting, forcing them to look to industry for
contracts. Factories are also encouraged to seek new
technology to improve production. Small and medi-
um-sized Chinese enterprises have been most active in
technology transactions, but large factories, individ-
uals, and foreign firms also develop and sell technol-
ogy. Most of the technology transactions reported in
the Chinese press refer to indigenous technology, but
foreign firms are also involved in the technology
market through technology sales and participation in
joint research projects. Central government organiza-
tions oversee market activity.
Initial activities suggest the market is not meeting
several of Beijing's major goals, although some bene-
fits are occurring.
Low-Level Technology. Despite the dramatic increase
in the number of technology transactions, most have
involved relatively low-level technology related to
daily life rather than more advanced innovations
needed to promote industrial development. Chinese
How does it work? Technology development and
exchange activities are conducted through: technol-
ogy fairs or exhibits; joint research projects involving
research and production units; sales of the rights to
use a technology; joint ventures for the production of
a new product; contracts for technical services; tech-
nology shareholding, in which a research institute
helps manage a new technical process in a factory in
return for a share of the output value; personnel
exchanges; and training.
What kind of technology? Technologies traded range
from food processing equipment to production tech-
nology for pulp board to microprocessor-controlled
instruments. The market stimulates sales of equip-
ment, such as precision temperature gauges for the
metallurgy industry, or a production line for making
components for video recorders; processes, such as
the use of cementing techniques for artificial marble;
and methodologies, ranging from how to conduct
feasibility studies for technologies to ways of improv-
ing quality control.
Where are market activities conducted? Throughout
China; over 3,000 technology fairs were held in 1985
alone. Some organizations have established perma-
nent sites for fairs or exchanges; other forums are
temporary.
journals and foreign observers suggest that both buyer
and seller often look for a technology that can be
applied quickly and with little effort, and tend to
avoid advanced equipment and processes that require
more effort to integrate into an existing facility. Some
of the items displayed at technology fairs-such as
herbal cigarettes-would not qualify as technological
achievements outside China.
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Reliable totals for the value and volume of technol-
ogy transactions through all of China's trade forums
are unavailable; estimates are contradictory and mis-
leading. State Science and Technology Commission
Chairman Song Jian, for example, said the value of
technology transfers in 1985 exceeded 2.3 billion
yuan ($720 million), a threefold increase over 1984.
For one national technology trade fair in 1985,
however, the Chinese press reported transactions
totaling 8 billion yuan ($2.5 billion). These numbers
are often inflated by including tentative arrangements
such as letters of intent and agreements in principle.
Provincial reporting frequently overstates much of
the activity that swells national totals. One article,
for example, reported on a so-called technology fair
held during the annual mule and horse fair; technol-
ogy sales figures apparently included purchases of
wheat, sugar, and logs.
Few Large Enterprises. Most contracts for research
have come from smaller enterprises, which have limit-
ed resources to pay for outside assistance; the large
enterprises Beijing sees as priority areas for techno-
logical transformation tend to rely on in-house re-
search staffs rather than establishing cooperative
links to new sources of technology. Managers also are
concerned that implementing a new technology will
adversely affect production; they are judged on short-
term output and profits, while improvements based on
technology may be demonstrated only over the long
term. Beijing plans to give 1,000 large and medium-
sized enterprises special tax benefits to encourage
their participation in technology transformation.
mobility of S&T personnel-an important
means of transferring technology-remains a sensitive
issue. Job centers and exchanges are able to match
talented people with prospective employers, but home
organizations are reluctant to let skilled workers go.
Additional prodding from Beijing apparently is neces-
sary to complete job transfers.
On the positive side, we believe the market overcomes
some of the defects of relying heavily on the govern-
ment for the management of S&T, and offers certain
benefits:
? Increasing the diffusion and application of research
results, particulary in rural and border areas that
desperately need technology.
? Stimulating the development and use of technology
needed by industry.
? Promoting awareness of the need to choose technol-
ogies carefully, with improvements in planning for
technology development and use, at least at the
national level.
The market has led to some import substitutions, with
savings of foreign exchange, and Beijing expects
exports of technology to result as well.
Beijing publishes glowing reports on the effect of
commercial technology transfers on production. Some 25X1
gains undoubtedly have occurred, although we do not
know how China counts technology items, determines
a causal link between a technology and an increase in
output, or measures the economic impact. Many of
the successes reported in the Chinese press may refer
to quick fixes that produce immediate results because
of the poor technology base in many factories; but
transfers of the low-level, often inefficient, older
technologies involved in most market transactions
probably contribute only very modest economic gains.
Progress in joint research and cooperative agreements
between Chinese organizations, and implementation
of the many technology transfer agreements signed
with foreign firms in recent years, will be needed
before sustained economic growth through technologi-
cal innovation is realized, in our view.
Forecast for the Technology Market
For the technology market to develop into an impor-
tant tool for stimulating significant technology devel-
opment, transfers, and use, more encouragement and
guidance from Beijing are needed. Additional mea-
sures-such as the establishment of pilot facilities to
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test technologies and tax reductions for technological
transformation-probably will be needed to encour-
age the participation of larger enterprises and to
stimulate projects involving the more advanced tech-
nology needed to boost industrial development.
In the long run, we believe reliance on the market
poses several risks for Beijing. Overemphasizing mar-
ket-oriented research on consumer goods is seriously
shortchanging basic research needed to support inno-
vation in the future. The opportunity to earn extra
income by engaging in market activities is also divert-
ing some of China's most talented people-including
students trained abroad-from teaching responsibil-
ities, raising the possibility that China's already weak
educational system will increasingly be unable to
provide an adequate supply of well-trained scientists
and technicians.
What US and Western Suppliers Can Expect
The market offers foreign firms new forums for
exhibiting their wares. In addition, as Chinese firms
increase their familiarity with technology transferred
through the market, they might become more realistic
about the transfer process and more knowledgeable
partners in joint ventures. On the other hand, as
Chinese firms gain experience with problems involved
in technology transfer-including large initial capital
outlays or temporary disruptions of production-they
probably will exert additional pressure on potential
foreign partners to bear more of the burden. China
also intends to reduce duplication of imports by
promoting awareness of technology already available
within China, which may shrink opportunities for
selling China some technologies over the long run.
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Mexico: Renewing Its Nonoil
Export Drive
We believe that Mexico's traditional bias toward
import substitution and protection of domestic indus-
try will continue to constrain the President's ability to
replace petroleum income with other exports. Despite
President de la Madrid's commitment dating back to
1982 to open the economy to increased trade, every-
one, including Mexico's foreign creditors, have con-
centrated almost exclusively on Mexico's ability to
increase petroleum exports and reduce imports. Initial
attempts at maintaining a competitive exchange rate,
eliminating regulatory barriers, and providing finan-
cial credits quickly dissipated in early 1984 as the
domestic economy recovered and election politics
derailed pressures on businessmen to become interna-
tionally competitive. Now, however, with Mexico's
recent entry into GATT and a pledge of up to $500
million in World Bank loans to promote nonoil ex-
ports, the focus has shifted back. Even though Mexico
City again appears to be making significant progress
in encouraging exports by undervaluing the peso,
giving exporters preferential access to credit, and
allowing exporters to retain foreign currency earnings,
we believe that many of the same roadblocks are
likely to obstruct the President's efforts to build on
this momentum.
In 1982 de la Madrid began to implement his plan to
boost nonoil exports. His commitment was reinforced
by the need to implement an IMF-supported program
and to improve Mexico's trade balance:
? The peso was sharply devalued in 1982 and some of
the more onerous foreign exchange restrictions were
eliminated.
? Regulations covering export licenses were gradually
liberalized and export tariffs were reduced or
eliminated.
? The budgets of Bancomex, the foreign trade bank,
and FOMEX, the government's export promotion
fund, were sharply increased to provide additional
Mexico: Real Effective Exchange Rate, 1982-86
I I I I I I I I I I I I
1 11 111 IV I 11 111 IV I II III IV 1 11 111 IV 1 II
1982 83 84 85 86
De la Madrid's program together with a strong
rebound in US economic growth achieved positive
results during the early years of his term. In 1983
nonoil merchandise exports grew 32 percent from $4.8
billion in 1982 to $6.3 billion. Manufactured exports
exhibited the most impressive gains, indicating that
the President's program to revive private industry and
provide incentives for export was working. Nonoil
exports rose a further 21 percent in 1984.
loans to private businesses.
Secret
DI /EEW 86-049
12 December 1986
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2
4 ^ 125
z ivv
Billion US$
is
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Secret
Mexico's Current Account Balance, 1984-88
a Projected.
b Income earned from the border assembly operations.
Despite the initial success of the program, pressure
began mounting from business and labor groups to
pursue a path of domestic economic growth, cap
inflation, and slow the government's move to reduce
protection of domestic industries. As Mexico began
gearing up for important local and gubernatorial
elections in 1985, the President increasingly placed
added emphasis on these domestic considerations:
? As the economy began to grow in late 1984 and
early 1985, domestic producers once again turned
back to producing for the more lucrative domestic
market.
? Quotas continued to protect most industries against
competition from imports, allowing prices of most of
Mexico's tradable goods to rise even faster than the
general price level, making them less competitive
overseas.
? Mexico's exchange rate became increasingly over-
valued during this period as government officials
sought to stem the inflationary impact of previous
devaluations, further reducing the attractiveness of
the country's exports.
Meanwhile, economic growth among Mexico's major
trading partners had turned sluggish. Despite a new
program in April 1985 to give import preference to
exporters and provide direct financing for export
goods, nonpetroleum exports dropped almost 7 per-
cent by yearend to slightly more than $7 billion.
The dramatic drop in Mexican petroleum revenues
during the past year and a half has refocused de la
Madrid's attention on the need to boost nonoil ex-
ports. In a show of support for Mexican exporters, the
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Secret
? Mexican Central Bank officials have kept the peso
undervalued, thus making Mexico's exports more
Mexico has traditionally exported a wide variety of
goods, although oil began to dominate earnings after
the mid-1970s. We believe that future expansion in
nonoil exports will depend largely on manufactured
goods. Based on past trends and current policy
directions, auto parts and engines, electronic and
mechanical equipment, processed foods, chemicals,
telecommunications equipment, synthetic fibers, and
possibly small computers will grow fastest. Border
assembly plants, which export finished products un-
der special tariff concessions, have particularly
strong export potential, as long as favorable US
tariffs are not rescinded. Domestic agricultural policy
and external constraints will hinder the growth of
food exports, although sales of coffee, cocoa, beef,
and shrimp should rise. Most of the increase will be
directed toward the United States, which purchases
about 80 percent of Mexico's nonpetroleum exports.
competitive internationally.
The results have been impressive. Nonpetroleum ex-
ports have risen 20 percent since last year. Although
the bulk of the increase has been in agricultural
goods, up 50 percent, exports of manufactured goods
also rose by a healthy 25 percent. While much of the
rise can be attributed to shrinking domestic demand
and a good harvest that has made more goods avail-
able for export, government financial inducements
and devaluation of the peso also have played a major
role,
De la Madrid's ability to sustain the momentum of
these initiatives will depend largely on his capacity to
gain the confidence of the private business sector.
while some Mexican
President has moved decisively on a number of fronts.
Late last year, Mexico City successfully negotiated a
bilateral agreement with the United States-which
purchases 60 percent of Mexico's exports-sharply
increasing Mexican access to US markets in return
for Mexican promises to eliminate unfair export
subsidies. In August of this year, Mexico formally
became a member of GATT in spite of objections by
smaller, less efficient domestic producers. In addition,
Mexican economic officials earlier this year again
introduced comprehensive inducements to urge do-
mestic producers to divert resources toward the export
market:
? More than $4 billion in public funds was earmarked
for the Mexican Foreign Trade Bank to help finance
companies moving into the export market.
? Measures were announced allowing exporters to
retain foreign currency earnings, rather than turn-
ing them over to the government.
? Exporters have been given preferential access to
domestic credit lines and foreign exchange alloca-
tions, as well as being granted exemptions from
domestic taxation and bureaucratic procedures.
businessmen are responding to the President's pro-
grams, many are reluctant to make a long-term
commitment because they consider government incen-
tives to be only temporary. Many businessmen still
complain that lack of domestic credit and high inter-
est rates are preventing them from making the kinds
of investments needed to become internationally com-
petitive. Moreover, US Embassy reporting indicates
that businessmen are not convinced that Mexico City
is dedicated to providing the financial support and
stable economic environment needed to induce large
investments in export-oriented production.
So far, de la Madrid has not made great strides in
attracting foreign investment needed to bring in new
technology and capital to help make Mexico's indus-
tries more competitive. Government officials have
been reluctant to make changes in the country's
restrictive foreign investment laws to encourage new
international ventures. In addition, recent regulations
boosting the domestic content of products manufac-
tured by foreign companies-in many cases this re-
quires these companies to establish supplier firms in
Mexico-has substantially hiked the costs of invest-
ment.
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Secret
Public- and private-sector commitment to boosting
nonoil exports probably will slip again as Mexican
officials move to stimulate the domestic economy in
1987 and 1988. As the economy grows, Mexican
businessmen-who have been using excess industrial
capacity to raise exports-are likely to trim overseas
sales to supply domestic demand. Faced with the
specter of triple-digit inflation during the period,
economic policymakers may be tempted to slow the
depreciation of the peso and maintain relatively tight
controls on domestic credit. As the 1988 presidential
election draws near, we predict that credit allocations
to domestic industries are likely to be used more as a
political tool-rather than going to companies with
the highest export potential.
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Spot Oil Market
Developments
New Kuwaiti
Export Pipeline
Soviet Chernobyl'
Units Operating
Intermittently
the Saudi $18-per-barrel target.
Spot oil prices fluctuated within a narrow range in the two weeks preceding the
December OPEC meeting. North Sea Brent and West Texas Intermediate crudes
are now selling at about $14.60 and $15.00 per barrel, respectively. The average
world oil price is now about $14.25 per barrel. Stable prices have benefited a
number of non-OPEC producers by keeping their export prices competitive with
spot quotes. Egypt, for example, has seen its production rebound to over 900,000
b/d from a summer low of 600,000 b/d. UK production, however, has temporarily
declined by about 300,000 b/d because of a pipeline leak in the North Sea. OPEC
production will be the key in determining prices over the next several months. The
group's output, which continues to exceed the November quota level by over 1
million b/d, would have to be cut within the next few months to push prices up to
Yanbu' al Bahr.
Kuwait has signed a turnkey agreement with a US firm to construct a 500-
kilometer, 42-inch pipeline that will join the Saudi East-West crude oil export
pipeline. The pipeline, expected to be completed by late 1987, will have a capacity
of 1 million b/d and will cost approximately $1.4 billion. The connection to the
Saudi East-West pipeline will enable Kuwait to divert nearly all of its crude
exports to the Red Sea, reducing the opportunity for Iranian air attacks on its
crude carriers in the Persian Gulf. Kuwaiti exports of petroleum products, which
account for at least half of current sales, will still have to transit the Persian Gulf.
The new line will give Kuwait greater flexibility in its export options, but it will not
increase the total amount of oil exports available through the Red Sea terminal at
TASS reported this week that units at the Chernobyl' nuclear power facility had
returned to normal operation: unit 1 is re rted to be workin at full c city, unit
2 at 50-percent capacit units 25X1
1 and 2 were shut down, suggesting the major problems that have plagued these
two units since October have not been resolved. The units have operated only 25X1
intermittently since then A number of possible LOA I
conditions might be preventing the Soviets from restoring units 1 and 2 to full
service. Corrosion problems may have occurred during the six-month shutdown.
The outages may also be related to modifications-needed at all 14 Chernobyl'-
type reactors-being made at the plant to prevent a recurrence of the accident.
The Soviets may also have experienced unacceptably high levels of radioactivity in
contaminated water from the cooling pond. For each month those units are down,
the total supply of electricity is reduced by about 1 percent-a loss that other
Soviet power plants cannot make up during peak winter demand. 25X1
27 Secret
DI IEEW 86-049
12 December 1986
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Latin America Increases Latin American governments gradually are expanding the programs for converting
Debt-Equity Swaps some of their large outstanding foreign debt into equity. Under such programs,
foreign creditors either trade their US dollar debt to Latin central banks for local
terested foreign or domestic investors who similarly intend to acquire equity in
local enterprises. Chile and Mexico so far have implemented the most successful
swap programs in the region by offering investors especially attractive terms. Each
probably will convert nearly $1 billion of its foreign debt by the end of 1986,
The Brazilian Government has been studying ways to
Financial
Communications
Systems Delayed
Secret
12 December 1986
stable economic policy climates for investment.
liberalize its rules for debt-equity swaps since early this year, and its recent
approval of foreign investment in the Brazilian stock market may be a significant
step in that direction. Argentina has drafted a tentative swap scheme and,
according to the financial press, may relax some of its constraints on investors
before enacting the program. Ecuador, too, is considering regulatory changes
needed to permit debt to equity conversions. Despite the growing appeal of these
arrangements, swaps are not likely to lead to a major reduction of Latin foreign
debt until debtor governments ease foreign investment restrictions and create more
network shutdown.
An upgrading and expansion of the world's largest international financial commu-
nications network-SWIFT (Society for Worldwide Interbank Financial Telecom-
munications)-has been delayed for the third time at least until fall 1987.
SWIFT-which carries more than 800,000 messages a day between some 2,100
banks in 47 countries and is growing at 20 percent per year-was to be replaced by
SWIFT II beginning in March 1987. SWIFT II will expand the capacity of the
system, upgrade encryption, and introduce a distributed communications and
computer network that will allow most bank-to-bank communications to continue
even with the loss of key facilities. As network traffic levels approach SWIFT's
message-handling capacity, the network is becoming more vulnerable to disrup-
tions. Lacking a distributed network structure, SWIFT I routes all bank communi-
cations through one of three operating centers-the loss of any one could cause a
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Impasse Solved on
Soviet Alumina
Plant in Greece
Japanese Growth
Slows in
Third Quarter
Major obstacles appear to have been worked out for the construction of a 600,000-
metric-ton-per-year alumina plant in Greece. The viability of the $500 million
project depends on a guaranteed market for the plant's output. The Athens News
Agency reported in November that the two countries will sign a contract by the
end of the year that will call for the USSR to purchase the entire output of the 25X1
plant for 10 years. Previously, the Soviets had agreed to purchase only 380,000
tons annually. Bulgaria had agreed to purchase the remaining amount but backed
out of the deal in June because of the payment terms. Moscow will apparently re-
coup its construction costs by buying part of the alumina at below-market prices.
In addition, Athens has agreed to offset the additional alumina purchases by
increasing imports of Soviet products-reportedly 70-percent oil (and possible gas),
20-percent machinery, and 10-percent aluminum. Moscow's primary motive for
building this plant probably is to provide a long-term, low-cost source of alumina
for expansion of its aluminum production. 25X1
National Developments
The Economic Planning Agency reported last week that real GNP growth slowed
to 0.6 percent in the third quarter-a drop from the 0.9 percent recorded in the
previous three months. The slowdown stems largely from a reduction in govern-
ment inventory accumulation-following a runup in the second quarter when 25X1
Tokyo was purchasing gold to mint coins commemorating the 60th anniversary of
29 Secret
12 December 1986
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Secret
Japan Refines
Recommendations
for Boosting
Domestic Demand
Impact of Japanese
Tax Reform
Secret
12 December 1986
which begins on 1 April, will be finalized within the next few weeks.
the emperor's reign, a fall in export volume, and a slowdown in government capital
spending. The deteriorating economic picture, while disappointing to Tokyo, is
probably not severe enough to generate a shift in the government's commitment to
fiscal austerity over the next few months. Moreover, the budget for FY 1987,
from yen appreciation.
The preliminary report of the committee charged with implementing last spring's
Maekawa recommendations argues strongly for policies to stimulate housing
investment and consumer demand-even if such measures require an easing of
fiscal austerity. The draft report, which came out in late November, also
recommended accelerating industrial restructuring, largely by facilitating the
shrinkage of basic industries such as steel and shipbuilding. The committee noted
such measures were necessary because Japan could not rely on yen appreciation
alone to reduce the trade surplus to acceptable levels. Despite these recommenda-
tions, we see little sign that Tokyo will follow through on anything other than mod-
est economic stimulus unless the economy fails to strengthen by late next year. The
key indicator may well be unemployment. Although the Maekawa Committee
noted that in the next few years new jobs in services would probably be sufficient
to replace those lost through industrial restructuring and overseas investment,
language in the draft urging the maintenance of employment suggests that Tokyo
is becoming more concerned about the domestic political and economic fallout
rates should boost consumer spending.
Tokyo's planned tax cut for early next year will give a modest boost to the lagging
economy, but only if the Finance Ministry agrees to delay a revenue-enhancing in-
direct tax and to refrain from slashing government expenditures to make up for
lost income. The reform package calls for $28 billion in personal and corporate
income tax cuts, matched by revenues from a new indirect tax and the elimination
of a previously sacrosanct tax exemption for interest on small savings accounts.
Despite Tokyo's claim that the tax cuts will help fulfill its commitment to increase
domestic demand, the real impact on the sluggish economy and on Japan's trade
surplus will depend on several as yet undecided issues. Our econometric model of
Japan suggests that, if tax hikes are delayed until 1 January 1988 and there are no
expenditure cuts, the package would add 0.3 percentage point to economic growth
in 1987 and 0.4 percentage point in 1988. The Finance Ministry's estimate for
1987 is 0.5 percentage point. Even under the Finance Ministry's more optimistic
scenario, the impact of the tax changes on Japan's trade surplus would be minimal
in the next few years. Over the longer term, however, the sharp cuts in personal tax
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Japan Exploring
Innovative Reactor
Technology
Mitsubishi Heavy Industries is developing a demonstration molten-salt reactor--a
long-term project that they believe has commercial potential in Third World
nuclear markets . Unlike standard reactor
technology, the uranium fuel is an integral part of the reactor's primary coolant-
fuel preparation is simpler and spent fuel can be continuously reprocessed while
the reactor is operating. The engineering concept is based on US research in the
1950s, but corrosion and contamination control problems led to commercial
development of water-cooled reactors. Despite these large technical obstacles, the
molten-salt reactor generates a higher power density and fuel burnup, has a much
lower operating pressure, and in some aspects is safer to operate. Once its technical
problems are overcome, these advantages combined with the potential of being less
expensive than water-cooled reactors could make the molten-salt reactor an
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Liberalization of
Italian Capital
Movements
Spain Eases
Foreign Investment
Controls
attractive alternative.
The Italian Treasury has decided to accelerate capital market liberalization and to
relinquish Italy's special rights within the European Monetary System (EMS).
15-percent deposit requirement on foreign investment by Italians and, by the end
of next year, will maintain the lira within the same fluctuation band observed by
other EMS members. Although senior Treasury officials reportedly are motivated
by recent success in selling bonds overseas and by their desire to unify the EMS,
the decision, in our view, is as much a concession to Bonn. The West Germans
have tied Rome's demand for a more unified EMS to Italian action on capital lib-
eralization and fluctuation of the lira. We also believe the Bank of Italy may argue
for a delay in capital liberalization, particularly if the lira weakens this winter.
the government in March will drop its
In another step to bring its capital regulations in line with those of the EC, Madrid
is relaxing controls on Spanish foreign investment-especially portfolio invest-
ment. Under a new decree, Spanish investors may invest up to 30 percent of total
assets in foreign stocks and bonds traded on domestic exchanges. The decree also
authorizes foreign companies with operations in Spain to list their stock on the
Spanish exchanges, and it is likely that bond trading will soon follow. While
generally pleased, the financial community is disappointed with the investment
limits and a provision allowing rejection of investment applications based on their
consequences for the domestic economy. Nevertheless, we expect Madrid to move
forward with investment reform. The new decree has the potential to improve the
domestic capital market. It should also reduce the upward pressure on the
peseta-caused by Spain's current account surplus and record foreign exchange
reserves-which has aggravated inflation, hurt export competitiveness, and con-
tributed to Spain's deteriorating trade balance with its EC partners.
31 Secret
12 December 1986
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Secret
Dim Prospects for
Norwegian Budget
Economic Slump in
New Zealand
Venezuelan
Footdragging
on Economic
Adjustment
Secret
12 December 1986
government, even if they unite and reject the budget.
With a vote expected on 16 December, the minority Labor government's revised
budget proposal seems unlikely to attract the nonsocialist support needed for
passage. This would heighten uncertainty about the economy and may even
threaten the government itself. The budget is almost unchanged from the original
October proposal that alienated Conservatives because it included significant
spending hikes and some tax increases. Labor has focused particularly on gaining
Center Party support, but Center chairman Johan Jakobsen recently said the
revised proposal only increased uncertainty about whether to accept the budget.
His recent criticism of Labor plans for a cut in the average workweek-which
Labor is unlikely to heed-reflect an effort to pressure the government for budget
concessions. The current uncertainty over the budget and economic policy comes
at a time when Norway's economic outlook is increasingly cloudy. The sharp
decline in oil export earnings in 1986 resulted in a $3.4 billion deficit in the first
nine months of the year, compared with a $2.6 billion surplus for the same period
in 1985. Despite a devaluation in May, failure to adopt a budget probably would
bring renewed downward pressure on the krone. The likelihood of continued
economic problems, however, reduces the nonsocialists' willingness to form a new
two years ago.
Prime Minister Lange is increasingly concerned that New Zealand's economic
slump-the economy contracted in each of the first three quarters this year-is
eroding confidence in his Labor Party government. He warned the public last week
that soon-to-be-released government data would show that the contracting econo-
my and widening trade imbalance and fiscal deficit have resulted in inflation and
interest rates above levels in most other industrialized countries. Lange maintains
that the economic downturn will be brief, but public opinion surveys show that
confidence in the Labor government is already dropping. Approval ratings of the
government's overall performance-as well as its handling of economic policy,
interest rates, unemployment, and taxes-fell several percentage points in Novem-
ber from the nine-month peaks recorded in October. With national elections to be
held no later than next September, Lange's government is under pressure to show
voters some tangible results from the economic restructuring program it initiated
President Lusinchi's reliance on obtaining a consensus on difficult policy decisions
helped delay by one month his promised "turn of the rudder." Last Saturday when
he announced his economic adjustments he tacitly admitted his government had
not yet arrived at a comprehensive set of measures. The adjustments announced in-
clude a major devaluation, but pave the way for tighter foreign exchange controls.
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Secret
engineer an economic recovery.
Lusinchi also announced minor financial incentives for certain sectors of basic
industry. To make the economic package palatable, Lusinchi retained price
controls on basic consumer goods and granted 25-percent wage increases to
organized labor and the military. These half measures may, in the short term, help
stabilize the nation's fiscal and external accounts, but over time will delay a more
rational allocation of resources and discourage the private investment that would
A $100 million drop in reserves during the last week of October and a trade deficit
for that month probably prompted Lima last week to announce a de facto
devaluation and a timetable for an official devaluation schedule to begin in
January. On 3 December, President Garcia announced that the dollar exchange
rate-both the official and financial rates-will be devalued 2.2 percent per month
next year. On the previous day, Lima had announced that all but essential imports
will be exchanged at the higher financial rate and that a greater number of exports
will receive this premium rate-tantamount to a 25-percent devaluation for many
products. A steady process of de facto devaluations this year has allowed Garcia to
nominally maintain his promise to not devalue the currency. Garcia froze the
official exchange rate with the dollar in July 1985 when he took office to buoy con-
fidence in the domestic currency, but local exporters have complained about the
steadily worsening overvaluation. With inflation running about 4 percent monthly
and likely to accelerate, the currency will become increasingly overvalued despite
Libya Developing a Tripoli is moving ahead with a program announced this fall to do away with the
use of money in local consumer transactions. Domestic bank accounts have been
mishandling of the prolonged decline in Libyan oil revenue.
bank account is debited and the sellers' account credited; no cash is exchanged.
The regulations are already being widely flouted, but the regime plans to mount a
major effort to ensure compliance. These restrictions are the latest indication that
Tripoli is not interested in easing unprecedented dissatisfaction with the regime's
workers' salaries are directly credited to their bank accounts. Consumers make
purchases using vouchers for the exact amount of the transaction-the buyers'
frozen and cash withdrawals prohibited.
Philippine Government According to press reports, President Aquino has established a cabinet-level
committee to oversee the sale of approximately 285 companies and various
properties acquired by government banks when loans made during the Marcos
administration went into default. Manila will be seeking local and foreign buyers
for such businesses as hotels, food processing, textiles, and shipping that the
government estimates are worth up to $7 billion. The sales meet a precondition the
World Bank placed on a $300 million economic recovery loan for government
financial institutions to remove nonperforming assets from their balance sheets.
33 Secret
12 December 1986
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Secret
Indonesian Military
Budget Cuts
investment in the Philippines has improved.
Although Aquino reportedly hopes that recent cabinet changes demonstrate that
her government is stable, foreign investors are likely to delay making sizable
purchases of these assets until they see further evidence that the outlook for
According to the I to cut its
defense budget further, including living allowances for junior officers and enlisted
personnel. Defense expenditures had been slated to be rolled back 7 percent in
1987, but the reductions were targeted initially at hardware appropriations. In the
case of the Navy, the proposed pay cuts come on top of cutbacks in the quantity
and quality of shipboard food, and elieves naval personnel will
increasingly resort to smuggling to supplement their income. Although we see no
indication that the military believes it is bearing a disproportionate share of the fis-
cal burden, trimming pay and benefits could undermine the military's loyalty at a
time when the risk of antiregime rioting is growing because of the deteriorating
25X1
Jobs Scarce for
Indonesia's Youth
economy.
senior Indonesian officials are worried about the
increasingly restive youth.
economy's inability to absorb the 2 million young people entering the labor force
each year. Employment prospects in the private sector are dim, and, because of
budget austerity, the government plans to hire only about 200,000 new employees
in 1987-approximately the same as this year and far less than the 500,000 in
1985. Moreover, according to US Embassy reporting, economic growth is likely to
be flat this year and next, while the World Bank estimates that 5- to 6-percent real
growth is necessary to generate jobs for all the entrants into the labor force.
Although Jakarta plans another public campaign calling on Indonesians to
"sacrifice for the national good," officials are worried that
unfulfilled career expectations could lead to antiregime violence by Indonesia's
Concern About the Public distress over the government's handling of Burma's deepening economic
Economy in Burma crisis is growing, according to the US Embassy, but as yet there is no indication
that dissatisfaction will translate into open protest against the Ne Win govern-
ment. Higher prices and shortages are hurting most consumers, and lack of foreign
exchange has cut production of import-dependent goods, providing a boost to the
already pervasive black market. Popular resentment is rising over privileged access
to scarce products by high-ranking government and military officials. In addition,
the middle and upper classes feel threatened by Rangoon's clumsy interference in
the economy-including periodic raids on black-market shops, new restrictions on
the operation of foreign companies, and vague new legislation against "illegally"
acquired property.
Secret
12 December 1986
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Secret
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