USSR: ECONOMIC PROJECTIONS THROUGH 1990--A NEW LOOK

Created: 2/7/1984

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Please Note:

Ihis paper isjSprovidet BACKGROUND JISE ONLY.^lt may not be regained, coajred, or cited ipTany othenraubllcation, It is^to be retutgned to the Offeree of SoviaT Analysis at close of^wie meeting on Februarys

USSR:

ECONOMIC PROJECTIONSEW LOOK (U)

A Research Paper

OA HISTORICAL REVIEW PROGRAM RELEASE IN9

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Preface

Projections of Soviet economic Oevelopnent provide an essential backdrop for discussions of Soviet policy options and their implications for the United States. The annual research papers in this series are designed for analysts of Soviet economic, political, and military trends and are Intended to giveuantitative outlook for the Soviet economy that incorporates as much as we can say about specific factors influencing growth prospects-highlighting areas of uncertainty. tudy of alternative projections enables us to distinguish between those uncertainties that significantly cloud our view of future growth (that 1s, those in areas where change willajor Impact) and those whose Impact on growth is likely to be small.

In this annual paper we link recentanalyses of particular Soviet economic Issues, published during the year, and events affecting the economy--to overall Soviet growth prospects. For example:

Lastajor study of the outlook for Soviet energy production throughas completed; its growth Implications arc examinedhis projections paper.

A new estimate of Soviet defense spending was also published. The Implications of future defense spendingat rates of the recent past or after possible shifts in defense spendinggrowth in general and for the Soviet consumerarticular are examined in this paper.

Leadership changes during the past year and the increasing focus on the need to improve economic

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performance could affect productivity; and we have used the quantitative framework of this paper to bound the impact that productivity gains could have on economic performance during this decade. Given its focus on an attempt to quantify the major influences on Soviet growth prospects, this paper omits much of the informationualitative nature that is dealt with in other publications. Such Informationarticularly important to analysts who are considering the likelihood of future events in order toingle best estimate of the Soviet economic future. The objective of the annual projections paper Iseference picture of the future and to bound some of the major uncertainties that affect it.

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USSR:

Economic Project ionsew Look

Key Judgments

Information available as of3 was used in this report.

1 andfirst two years ofh Five-Yeargrowth in Soviet gross national product (GNP) averagedercent per year. 3 itopercent, according to our estimates. This improvement probably owes much to the effect of favorable weather on sectors such as agriculture and transportation and something to the effect of gains from the regime's efforts to enforce labor discipline. Despite that Improvement, however, ourthe assumptions set forththat Soviet economic growth will averageercent per year for the decade.

This paperet of conditional projections of the growth prospects for the Soviet economy arge-scale econometric model, wotructural description of the economy with assumptions about likely trends inoaseline projection or reference outlook. We then adopted other assumptions--possible, though perhaps less likely, developmentsmportanttors--and used these in the model to project the bounds within which future econonic growth Is likely to fall. Taken together, the baseline and alternative projectionsreliminary, quantitative picture of the prospects for the economy through the rest of the decade,oint of departure for discussion and further analysis.

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On the basis of these projections, we expect that:

The average annual GNP growth rate will be roughly 2

percent in. (Itercent inercent in

0 Industrial output, which accountsittle over one-third of the national product, will grow at slightly moreercent per year over the decade.

0 Agriculture will be the most volatile sector of the economy, as always. We make projections based on known trends in agricultural production and an assumption of average weather conditions, but the changeability of specific weather from year to year will cause actual agricultural output to vary rather widely around any projected trend.

0 Per capita consumption will remainow level during the decade, allowing at best only modest improvements In average living standards.

0 Energy supplies will constrain economic growth little through the middle of the decade. In the later years, they couldodest drag on growth if energy exports are held close to present levels and energy demand continues on the trend we expect.

0 Foreign trade will not help the Soviet economy in the

s it did in, when fast-rising prices for energy and gold and the rapid growth of arms sales enabled the Soviets to increase real hard currency

Importsapid rate. During the rest of this decade, real hard currency exports are projected to growear.

This general growth outlook could change with changes In various economic factors. The model's response to our alternative assumptions indicates that:

" hift in defense spending policy would have only a

small impact on overall growth during the decade, because the industrial plant in the Soviet Union is very large relative to the amount of resources involved in shifts of this kind. hiftefense spending policy, however, has considerable impact on both consumption and investment In the near term, and changes in Investment could have important Implications for growth tn the.

Only one of our alternative assumptions would open the possibility of significant improvement in growtti prospectseturn to more favorable productivity levels of thend. Ihe comprehensive organizational reforms needed to achieveramatic turnaroundhe USSR are not likely to be in place soon. Our results suggest that,undamental reform of the economic systemombination of very favorable circumstances bringing backroductivity relationships, the Soviets probably can do little to alter the economic growth trend0 as it Is Indicated in our baseline. They will, however, have some opportunity to change the distribution of output to

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competingvestment, defense, and the constimer--in pursuit of policy goals.

The chief obstacles to substantial inuproveroent in Soviet economic performance are problems built into the economic system itself. Nevertheless, the period of continued low-level of growth that we project0 should not be takenarbinger of economic collapse. Growth will be sufficient toide range of policy initiatives, especiallyhe areas of defense and investment, and still keep the living standard of the traditionally hardpressed Soviet consumer from declining. It would be more accurate to Interpret our projections asifficult and stressful periodarge and viable, if inefficient, economy.

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Contents

1

Key

Baseline

Aspects of Soviet Economic Growth Under Baseline

Sources of

Uses of

Key Resources

Labor

Energy Balance

Hard Currency

Variations on the Baseline Growth

Energy

Other Factors Influencing Economic

Distribution of

Comparison23

Scenarios Favoring the Consumer or the

Appendix: Selected Tables from the Baseline

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USSR:

Economic Projections ThroughA Hex Look

Introduction

He continue toifficult time for the Soviet economy through. Energy problems may pose lesshreat to growth this decade than we thought earlier, but demographic factors are certain to hold down labor force growth, and partial depletion of the raw material base in the developed European regions will increasingly force expensive new investments in remote areas of Siberia. Furthermore, improvements in labor productivity will be hindered by the continued slow growth of capital Investment, and hard currency trade is not likely toolution to the Industrial materials and Investment problems that are already emerging. Superimposed on these trends is the sharpening competition for resources between the civilian and military sectors of the economy.

Andropov's accession to power has Increased the uncertainty in our economic forecastseneral and in our forecasts of the distribution of national output among major claimants In particular. The new leadership is consolidating Its position and its policy focustill unclear. Decisions lo be made45 will have Important implications for the pursuit of policy goals related to defense, investment, and consumption duringh Five-Year Plantime span thatarge part of the period of our forecasts. While overall growth inay not itself be shifted much by choices here, the impacts on military spending or on tho consumer could be substantial.

The projections shown io this paper were developedarge-scale econometric model.1 The model enables us to integrate individual assumptions and analytical judgments soonsistent set of general quantitative trends can be deduced. The assumptions and judgments that underlie the baseline projections are of two general types: where we have developed supporting analyses, the Input represents our current view of likely developments in the Soviet economy during the rest of; and where the futurearticularly ambiguous, we use an extrapolation of the recent pastoint of departure, and then consider alternative assumptions (see inset).

The baseline projections, therefore,oviet growth scenario that differs from other scenarios only in the values that are given to the model. He have developed some alternative scenarios by deliberately changing the inputs from their baseline values to reflect alternative Soviet policies or external events and have also analyzed the projected trends that result from these changes. The purpose of these projectionsoense of the range within which future Soviet growthikely to fall and to assess some major factors influencing that range. In this sense, the baseline should be viewedoint of departure and should not be construedormal "best estimate" of the outlook for the Soviet economy.

'An earlier version of this model is documented in CIA Research Paper1OVSIM: odel of the Sovietumber of improvements in the model have been madeut its essential structure has not changed. This model was constructed primarily to make medium- to long-term projections. Its estimates for the short term, while very near the trend, are not generally as accurate as those available from alternative methods.

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Inset

Uncertain, ties tn the Projections

The growth rate of Soviet 6NP durings the "bottom line" of the economic projections presentedhis paper. The projections of this growth rate are developedrocess in which our model calculates GNP values on the bastsumber of input variables, which represent many kinds of dataariety of sources. The process requiresalue for each variable be put Into the model for each year of the period over which the GNP projections are to be made. Whenever previous analysis has provided estimates of likely trends in some of these input variables, we have adopted those estimates; in other cases, we have developed Independent estimates; and in economic areas where the future is particularly ambiguous, we have simply examined alternative assumptions.

There are differing degrees in the certainty that can be attached to these input data values. Our estimates of labor force growth are relatively firm, for example, because all the people who will start working during this decade can already be identified in existing population data and we have good Information on mortality rates. At the other end of the certainty spectrum is the distribution of GNP among primary uses--consumption, investment, and defense. This distributionubject to the policy choices of Soviet leaders, and the values for the allocations to defense spending and investment that we must develop and put into the model are analytical assumptions on our part, which may be subject to substantial revision as events unfold. For example, we assume certain growth rates for

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FOR-OMICIAt'llSf ONLY

Inset,

defense expenditures and for military hardware procurement throughn the basis of our analysis of observable current and historical trends. The actual growth rates of these variables in the future, however, can be influenced by decisions of the leadership in ways that the size of the labor force inarge extent already determined by demographic factors) is not.

Most input data fall between those extremes, and the degree of certainly frequently depends on the amount of research that can successfully be applied to the subject. Confidence In our energy production forecast is buttressedajor research effort in that area, for example, and continuing research Indicates substantial evidenceong-run decline in productivity growth In the Soviet economy. On the other hand, no one would claim that the future price offactor in our calculation of the Soviet trade balance--can be forecast with confidence.

In general, we have more certainty about input values that are subject to little,ny, manipulation through policy or are clearly reflections of long-term trends that are not likely to be reversed quickly. Certainty is less about the assumed values of input variables that can be strongly Influenced by such factors as policy decisions and marker, prices. One reason for looking at alternative GNP projections is to gauge how sensitive the values generated by the modeling process are to some of the more important uncertainties in the Input variables.

End of Inset

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The baseline assumptions and projections follow, in two parts: one presents textraphical summary, and the other displays selected estimates tn tabular form.^ Given the nature of the assumptions -postulated in this paper, we have much more confidence in the general trends of the projections than in estimates for particular years. The annual figures, however, can be used to Illustrate where the economy might beiven year in the absence of major changes in political and economic conditions.

Later In the text, appropriate sections discuss hypothetical shifts in our baseline assumptions about the future Soviet economic environment and policy decisions and the Impact of these shifts on the baseline solution. Three of these scenarios deal with the prospects for agriculture, trade, and productivity. Two reflect alternative degrees of Soviet success in meeting energy requirements. And two involve alternative sets of assumptions reflecting fundamentally different policy decisions as to the priorities to be accorded defense and consumer welfare. The illustrations that accompany the discussion summarize some major aspects of the data in the appendix. Baseline Assumptions

The projections presented in this report are basedumber of key assumptions about future trendshe Soviet economic environment. We have chosen these tohat we think will be likely developments Inontinuation of present or historical trends, where data are too ambiguous toudgment about the most likely outcome. Our baseline assumptions include the following:

^Throughout this report, components may not add to the totals shown because of rounding.

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The average productivity of the Soviet capital stock, which has fallen substantiallyill continue to fall,iven amount of Investment willmaller growth Increment than in the past. The labor force will grow more slowlyhan It didhean average annual rateercent, downercent.

The allocation of Investment and labor among producing sectors will reflect the trends evident in the Soviet Five-Year Plan. The shares going to the energy sectors will increase (at the expense of some consumer sectors). The shares accorded to heavy industry will remain relatively constantil production4 million barrels per day) will nearly reach the plan target6henlow decline. On the other hand, gas production will continue to Increase rapidly, more than offsetting the drop in oil output. The energy efficiency of newly installed plant and equipment will continue to improve. By coupling these gains with our projections of capital stock, we can estimate total Soviet energy requirements. With continued growth of domestic energy requirements, the Soviets willonflict between maintaining oil exports and meeting domestic needs. We assume that (whileignificant reduction In oil exports)

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they will absorb most of the energy shortfall domestically, thus slowing the rate of growth of the economy.

c The Soviets cannot count on foreign trade toay out of their difficulties. The oil and gas markets are likely to be soft for most of the decade, arms sales will face increased competition from other suppliers, production problems and growing domestic demand will hold back Increases In exports of most nonfuel minerals, and low quality and poor marketing techniques will continue to retard Increases in exports of machinery and other manufactured goods. 0 Fundamental economic reform will not be part of the

Politburo agenda. We assume that there will be no shift in political or economic policyignificant impact on economic performance. The issue of future Soviet defense spending deserves special attention. Our latest estimate of recent defense spending concluded that real growth in total outlays for theveragedercent annually, rather thanercent It had averaged earlier. Ourlng the same period, there was little real growth In procurement of military hardware.

Because the causes of the slowdown In military procurement growth are not fully understood, we cannot statehether the growth trend will rebound quicklyhether the procurement slowdown will retard the increase in overall defense expenditures for some time. Toaseline projection of Soviet growthe have assumed that the slower growth In

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total defense expenditures will continue unchangedut that, within the total, military procurement growth will rise slightly androwth will fall slightly Since the Issue of future defense growth Involves considerable uncertainty at this point, we examineater section the Impact on Soviet growth prospects of alternative defense spending assumptions.

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Aspects of Soviet Economic Growth Under Baseline Assumptions

Sources of GUP

Our baseline projection ofercent average annual GNP growth inndicates that Soviet economic growth will remain at recent low levels for the balance of the decade. Soviet GNP grew at an average rate ofercent per year1 The stronger economic showing3 (which returned GNP growth to anercent for that year) was due primarily to favorable weather and does notigher rate of growth through the rest of. Low average growth will persist through, in spite of the improved outlook for oil production and the reduced growth in expenditures for military procurement that we assume in this year's forecast. These changes in our assumptions improve growth only marginally, because the additional resources released for productive use representmall percentage gain for the economyhole. The average GNP growth rate ofercent that we project forontrastsercent inercent in.

Industrial output, which constitutes aboutercent of the national product. Is likely to grow during the rest of this decadeittle above 2

rate about one third that of thend less than half that

of. Industry faces the economywide problems of slower growth of

plant and equipment, labor, and other inputs. The industrial heartland of

European Russia alsoapid depletion of raw materials production

capacity. More and more Investment resources that might otherwise contribute

additional industrial output are being used simply to maintain existing

production levels, as new raw material and energy deposits are developed 1n

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the remote and high-cost areas of Siberia. Even if the share of annual investment in the oil sector were to double between nowecline in oil production over the last half of the decade cannot be prevented.

Farm production is highly dependent on weather conditions. He estimate future crop yields on the basis of the historical trends, incorporating changing weather trends. The return to trend-line agricultural growth after the bad harvest years01 resultsstimates of short-term agricultural growth that are deceptively high, the return to normal having the appearance of "growth." Nevertheless, ignoring year-to-year fluctuations, it is likely that Soviet agrlcultral output will grow at the trend rate over the rest of.

Uses of GNP

The projections of aggregate and sectoral economic growth are Influenced by many interrelated factors. The projected distribution of GNP among end-uses (figures particularly sensitive to the assumptions we have made about amiu<il investment allocation shares and the trend In defense expenditures over the decade. After calculating GNP as the output of the producing sectors in the economy, we estimate consumption as the residual claimart on GNP after investment and defense requtrenents have been met. This

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method is useful because it reflects the historical order of priorities In the Soviet command economy; buteans that our projection of consumption will be directly affected by errors in our defense and investment assumptions.

Thp declining growth inoted above in the section on sources of GNP means slower expansion in the availability of goods and services lo be divided among the competingfor future qrowthhe consumer, anc defense. Our projections In

Uses of GNP

Annual Growth

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sndicate that for the rest of the decade Soviet economic planners will continue to face the dilemma of how best to distribute very small Increments to national output. At the endowever, some of our GNP distribution assumptions differed significantly from those In brief, we now assume that the Soviets will giveontinuing ratherising priority; this Is reflectedhe proportion of GNP we project as being allocated to defense. The difference between our findings23 is discussedhe section on GNP distribution. Key Resources

The Soviet economy hasath of "extensive" rather than "intensive" growth. Growth has been largely drivenapid expansion of the labor force and the stock of plant and equipment rather than, as in the Industrial West, by productivity Increases.

The increase in the labor force inill be less than half of what it was in The labor force--up byillion duringexpected to Increase byillion. (U)

Our projections Indicate that new fixed investmentill increase at less than half the rate of, primarily because of slower growth in machinery production and new constuction starts. However, our current estimate of the growth rate of new fixed investment for,ercent annually. Is greater than last year's projection. Thisainly because we assume that the total value of durable goods going to the defense sector will not Increase during the period up

The Impact of the generally reduced expansion of Investment inn GNP growth will be compoundedarticular by the increasing demand for investment goods per unit of output in the energy sectors. Just to sustain a

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Key Resources

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Shares (pram)

low rate of growthnergy output, the Soviets will have to givereatly increasing share of investment. This will depress the expansion of Investment In the nonenergy sectors.

Over the decade, according to ourignificant energy deficit could develophe domestic economy. We assume that adjustmentshis situation would Include retirement of the most inefficient energy-using equipment and somewhat lower rates of capital use.

Labor Productivity

The key to Soviet labor productivity improvement in the past has been increases in capital per worker. Now, however, unless Soviet planners achieve more success In realizing technological innovations, improvements In organization, and other sources of productivity increases, any additional increases In capital per worker will have less and less effect on productlvlty.

Since thehe returns on additional capital have been diminishing more rapidly than in earlier years. The reasons for thisaw materialreater costs associated with the shift In the locations of raw material supplies from the depleted areas west of the Urals to Siberia,ransportation bottlenecks, andorsening worker morale.

In spite of the publicity given domestically and abroad to Andropov's labor discipline ca-ipaign, we have as yet insufficient data to measure an Intermediate to long-term positive effect on productivity. It is even possible that the influence of those factors that ledeclinehe effect of extra capital on output in theay intensify in the

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future. If that is the case, our low labor productivity growth estimates shown here are conservative, and the actual growth will be even smaller.

The pattern of productivity growth in3 projectionsnly marginally different from those The differences are not significant in terms of trend. They are due to some shifts3 in our assumptions about Soviet Investment allocations and to Improved prospects for production In some energy sectors, particularly oil.

Energy Balance Trends

Estimated Soviet production and export of energy are key Inputs to our model, and the difference between them can be taken as the estimated amount available for domestic consumption. In addition, the model allows us to develop an independent estimate of Soviet domestic energy requirements basedrojection of Soviet plant and equipment. Ithe relationship between this need for energy and the amount actually available for consumption that affects projected GNP growth: the closer the amount of energy available for consumption comes to meeting requirements, the closer is GNP growth to the potential defined by labor force and capital stock trends. In our modeling, if energy available for domestic consumption is not sufficient to meet requirements, growth will not reach this potential because some capital stock, lacking energy, will be Idle.

we estimate that primary energy production will grow byercent per year on average for the rest of the decade, downercent in. Expected gainsas production will be somewhat offset by declining oil production and continued stagnation of coal output. In order for the USSR toositive energy balance, the planners must hold domestic energy

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Energy Balance "rends a

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consumption growthttleear if critical exports to Eastern Europe and exports to the West for hard currency are to be met,t the same time, our projections indicate that domestic requirements for primaryare largely determined by the size, age, and composition of the capitalcontinue to rise at an average ofercent annually.

The Implication of these trends is that the economy may be operating under an energydomestic energy requirements greater than the energy available forly as the end of the decade approaches. At the macroeconomic level of our analysis, the impact of an energy constraint is to prevent full use of available capital. This leads to reduced output and has the effect of making our baseline projection of annual GNP growth almostercentage point lower in the last half of the decade than it would be otherwise. Our modeling, however, can only roughly account for the effectsossible energy imbalance.

Moreover, we do not yet have clear indications of Soviet policy concerning energy investment, production, consumption, and trade. The Soviets' success in avoiding energy Imbalances willarge extent be determined by their ability to implement an intricate combination of energy production policies, which are likely to be costly in terms of other economic objectives, and energy conservation policies, which will face serious obstacles in the rigidity of Soviet economic management.

Adding to the complexity of this issue, the mix of energy outpu: will also shift during the decade, as shown in figure 5. If the economy Is to adapt to the new mix of energy produced, energy-consuming sectors will have to make significant adjustments. For example:

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" The chief are* of gas-for-oil substitution Is electric power generation. Yet the Soviet refining Industry, which currently produces vast quantities of fuel oil,ot equipped to process Into lighter products the large amounts of excess fuel oil that would be made available through gas substitution. Gas-for-oil substitution also requires substantial construction of feeder pipelines and, in some cases, adaptation of capital equipment. The Soviets have made some progress in these areas, but the outlook is unclear. Of the two problems, the inadequate refining mix is the more serious. Although the Soviets have long been aware of the need to shift the refinery output mix to emphasize lighter products, they have yet to introduce sufficient cracking units. For example, they planned to build nine cracking units Ineriod, but by3 they had reported only two under construction. Any rapid development of this sector would probably require Western assistance.

Energy exports are expected to decline slightly,0 energy exportsercent below2 level. The relative importance of oil and gas exports will shift, with the expected decline In oil exports. Increased gas exports will take up some, but not all, of the slack. Despite these changes, energy will still remain the dominant Soviet hard currency earner.

Oil Production Trends. The Soviets' current oil output of4ccounts for roughlyercent of their total primary energy production. Three-fourths of this oil is used domestically and one-fourth exported. Roughly half of the exported oil goes to the Council for Mutual

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Economic Assistance (CEKA) countries, and about one-third goes to the West for hard currency.

We estimate that Soviet oil production will begin to decline after the. This is based on the Increasing requirements for drilling and fluid-lift and on the lagging infrastructure developmentest Siberia. The severity of the decline will depend on Soviet willingness to Increase Investment rapidly.

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barrels per day oil equivalent accounts for nearlyercent of total primary energy production. Aboutercent of tne gasxported. We estimate that gas output will rise substantiallyhis decade. The annual growth rate will averageercentnd nearlyercent of the Increase will be used to meet rising domestic energy requirements. Lagging gas-for-oil substitution could slow tho Increase In gas demand, and hence production could be lower than these projections. We estimate thatas will account for aboutercent of total primary energy production.

Coal Production Trends. Coal production, currentlyrepresents aboutercent of total Soviet primary energy output. exports account for lessercent of the coaJ mined. Wecoal proCuction and exports will remain near current levelsdecade, but rising output will be accompaniedegradation incontent of the

Hard Currency Trade

Foreign trade is not expected to boost the Soviet economys It did in. At that time, fast-rising energy and gold prices ann the rapid growth of arm sales enabled the Soviets to increase real hard currency imports at an average rate of more thanear. Through.s likely that prices will be far more stable and the volume of exports will rise more slowly.

The real value of both fuel and nonfuel exports is assumed to grow atear over the rest of the decade. Fuels, therefore, will continue to account for about two-thirds of export earnings, with the real price of energy assumed to remain roughly constant. The earnings mix, however, is expected to change:

Earnings from oil sales declining aboutercent In constant dollars.

Earnings from gas sales risingercenteal

terms, making gas tie most important Soviet hard currency export.

We estimate that real exports of other commodities will grow very little and that earnings from gold and arms sales will remain stagnant In real terms.

Real import growth will depend on the need to buy grain and other farm products and on policies and opportunities regarding the purchase of foreign machinery, high-technology equipment, steel, and other Investment goods. Assuming rising domestic grain production, unchanged meat production policies,ontinuation of low real grain prices in the world market, we project that the real value of annual grain imports will remain well below

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Hard Currency Trade

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level for the rest of the decade, although grain imports may reachillionear The Soviets will probably need to import more investment goods, however, because of their growing desire to raise industrial productivity, even though machinery imports from the West can have, at best,odest impact on overall growth.

Because real hard currency earnings are likely to grow slowly,t all, during the rest of the decade, real growth of imports would require Increased use of foreign creditsrowing hard currency debt. It may well be difficult fur Soviet leaders to accept these conditions. Hence import growth In real terms over the next seven years will probably be well below the average rate of. odest yoalear real growth for all hard currencyfigure we used in our baseline projections-would cause the trade deficit to growerr.ent In constant dollars Reai credit drawings could remain fairly constant over the next several years but would escalate quickly toward the end of the decade to nearly twice their current level. Over the same time period, tie real hard currency debt would increasehird. The debt service ratio, however, would remain roughly tho sane for most of the decade and would still be only aboutercent

This situation could be stronglyoviet grain output and by

thercy situation. tring of poor harvests, necessitating larger grain imports than we here envisage, could add billions ofear to Soviet hard currency needs or force the redirection of imports from other commodities to grain. Any increase in imports wo-jld have to be met through additional sorrowing (causing foreign debt to rise even more) or at the expense of critical investment good imports (retarding even more the sluggish

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growth of the Soviet economy). On the other hand, an upturn in energy prices and demand--say, because of an expansion of the Middle Eastdrastically Increase revenues from fuel exports. This could eliminate the need for most of the projected hard currency credit drawings, thus causing foreign debt to decline sharply Or the Soviets could use the increased revenues to raise imports of needed investment goods, thus fostering industrial and energy growth. i

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Variations on the Baseline Growth Case Energy Availability

Overall Soviet economic growth may have suffered from the slower growth in energy production that beganhe. esult, output of cement, chemicals, food, and other commodities was impeded. Moreover, Soviet sources Indicate that power shortages in theost an averageillion rubles annually in damaged equipment and disrupted processes. We expect this problem to worsennd beyond.

To minimize these shortages, the USSR will give priority to energy investment. It has grown faster than overall Soviet investmentnd this trend will continue through the decade. Ineriod, the Soviets plan to increase energy investment byercent, boosting Its share of all new Industrial investment to over one-third. (Overall investment Is slated to grow by roughlyercent.)

The Soviets are facing Increasingly difficult investment choices. The rising cost of this investment will strain the economy by "crowding out" investment in other key sectors. The energy industry already consumesercent of Soviet pipe production, overercent of machinery output, and substantial shares of other sector production. As energy production costs increase, the investment burden of rising energy production will grow over time. One Soviet energy expert estimates-ercentage-point increase in energy's share of investment could lower overall economic growth5 percentage points and the consuming sector's shareercentage points. On the other hand,ill be difficult to slow the pace of energy investment, given the growth of energy demand by other

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productive sectors.

Given the impact of rising energy costs innd the potential impact of energy shortfalls, the Soviets may emphasize conservation and energy efficiency, especially later in the decade. If effectively implemented,olicy could minimize shortfalls. Results could be achieved more quickly if the governmentigh priority to energy conservation and consequently were willing to sacrifice other economic objectives. We estimate that progress in energy conservation will be slow. The Soviets know the potential benefits of using more energy-efficient equipment and structures, but they have trouble realizing this potential. Energy efficiency is only one (and by no means the most important) of the many goals set for Soviet machinery producers and builders. Managers incorporate design improvements slowly, so as not to risk failure to meet production targets.

Moreover, equipment continues to be used as long as it can be repaired. The avnrace annual retirement rate of Soviet capital stock has beenercent, less than half that of normal Western practice; and, in contrast to Western experience, no major Soviet industry has modernized its entire establishment with new, more energy-efficient cctuipnent. If the government were willing to pushore rapid retirement of outmoded equipment would reducf; energy requirementsost of slower economic growth in the short-to-intermediate term.

We have examined two additional scenarioshich differ from the baseline case in our forecasts for oil, gas, and coal production and our estimates of the investment necessary to achieve those output levels. For this study, we set production and investment for the oil, gas, and coal sectors at other "reasonable" levels. For example, we assumed that oil

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production0 would ben the low-energy scenario andn the high-energy scenario. Based on our assessment of Soviet energy demand in, both scenarios assume that most of the adjustment in energy availability is madehe export sector. Therefore, the impact on the domestic economy is rather small in either case.

otal GNP isillion rubles (orercent) higher in the high-energy case than In the low-energy case. Industrial Investment4 percent higher, and the Industrial growth rate is four-tenthsercentage point higher. As noted above, most of the impact will be felt in the export sector, where the additional energy exports (principally oil) associated with the higher-energy scenario would boost export earnings0 by more thanillion over the earnings in the lower-energy scenario (that is,3 billionillion).

If the Soviets could Improve energy efficiency sufficiently to remove the energy constraint, then growth prospects would improve. The GNP growth rate, for example, would beercent ineriod, upercenthe baseline case.

We assume that Soviet economic planners will squeeze the consumption sector hard in order to allocate sufficient investment to energy. , even in the low-energy scenario, the annual growth rate of per capita consumption is reduced to less than one percent, down from an averageercent in. Given the slowdown in economic growth, the Soviets will be hard pressed to maintain consumption's share of GNP.

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Other Factors Influencing Economic Growth

Agriculture. Conditions and actions takenhe agricultural sector strongly affect year-to-year growth figures for the Soviet economy. In recent years, bad weather in the main grain-growing areas has caused output to run well below trend levels.3 Our baseline projection of Soviet agricultureeturn to more normal weather conditions for the rest of the decade. Continuing unfavorable conditions could keep grain output below these trend expectations, while favorable weather during the rest ofould cause it to outrun thea.

The implications of these possibilities were explored In two8). One assumes grain output to beercent below trend levelsrest of the decade (as could be the case in the event of lessand the otherercent above (which could result fromweather). Ue believe these scenarios are plausible becauseaveragedercent below trend levels9ercent above6 Historically, each percentagedeviation of grain output from trend levels is associatedhangeSoviet agriculture outputercentage points in the Our analysis shows that almost all of this Impact Is passedSoviet

In the short run, rates of growth of agricultural output and consumption, as well as labor and capital productivities in the agricultural and consumer goods sectors, can be greatly affected by shifts in weather conditions. In

^The trends we assume are based on Soviet grain output2ee Soviel zccno.ny in: Problems and Prospects (Washington:,.

23

il ii i

Agricultureffect of Low and High Assumptions About Grain ftoduction

the long run, these rates are more affected by other factors underlying agriculturalas capital formation, technical change, and institutional developments.

If the weather were favorable, the grain output0 would beillion tons greater than the trend level for that year. This would be enough to meet almost all Soviet needs (unless Soviet planners chose to expand the nation's grain reserves). Under these circumstances, grain Import requirements would be well below the levels indicated by our baseline conditions. Actual Imports, however, could still be high, because of long-term grain agreements. Existing agreements obligate the USSR to purchase at leastillion metricear until the second half of the decade.

If the weather were unfavorable, Soviet grain output would be more thanillion tons below the trend level This would require substantial imports, but the Increase would be constrained by the grain-handling capabilities of Soviet ports and by policy considerations. Additional grain Imports could increase hard currency credit drawings, accelerating the growth of debt to Western countries. The Soviets could decide, however, to offset some of the cost of grain imports by reducing imports of other commodities; under similar conditionshey chose to reduce* imports of machinery from hard currency countries.

Trade^ If unfavorable grain-growing conditionsong-lasting reduction of hard currency imports, could that reduction harm Soviet industrial investment and accelerate the decline in Soviet productivity and economic growth? Two scenarios explore this question In the first, the real value of hard currency machinery imports is assumed to return

1JiTil I

TRADE SCENARIOS

Effect of Low and High Machinery Imports on Selected Economic Aggregates

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lam ml* Th* rodof hord currencyImport! Ii hold conatont otnd that ot total hor0Importa Ii radwcod

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to the1 level and remain there for the rest of the decade. In the second, the real value of total hard currency Imports is assumed to growateercent faster than in the baselinehe additional imports being accounted for by purchases of machinery. We assume in both scenarios that the shiftachinery importsot offset by changes in the levels of other types of imports and thus comes to affect hard currency credit drawings and debt.

Our model suggests that these shifts would havemall impact on total investment, consumption, and economic growth. This Is because, in aggregate terms, hard currency machinery Imports are relatively small. In thehey werehird of the level of machinery Imports from Coonunist countries,ercent of the total output of the Soviet machine building and metal working sector, and onlyercent of the level of total Investment. One should keep In mind, however, that hard currency machinery imports dopecial value for the Soviets; they are willing to use their scarce hard currency and increase their hard currency debt to obtain them. These imports may be criticalumber of key areas, such as energy production, where their effect on the Soviet economy may well be greater than our model results Indicate.4

Our analysis suggests that changesard currency machinery imports

0

couldignificant impact on the Soviet hard currency payments

dTne valuation of hard currency Importsontroversial Issue. The results from ourdoes not distinguish (in quality or productivity terms) between hard currency machinery Imports, Communist country machinery imports, and machinery produced in theunderstate the value of hard currency machinery imports to the Soviets. Nevertheless, we judge that the model's valuation ofimports relative to the larger economic aggregates is near the mark.

25

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position. In the scenario with lower import growth,0 trade deficit Isercent below the deficitur baseline projection, debt service payments and the debt service ratio are overercent lower, and net borrowing Is two-thirds lower. The gross debthird lower. In the scenario with greater imports of hard currency machinery, the trade deficitore thanercent higher, debt servicehird greater, and net borrowing two-thirds more than in the baseline case. 0 the gross debt is overillion dollars and the debt service ratio isercent. Soviet leaders probably would avoid this second scenario unless they were driven to itritical need for specific key import items.

Productivity. Past Soviet efforts to boost output focused on increasing inputs of capital and labor. umber of reasons, the difficulty of continuing this approach has grown substantially. Emphasis now appears to be focused on:

0 Improving the productivity of labor, initially through greater

discipline of the work force and eventually through better training. Increasing the efficiency of capital Investments, with special

attention to the completion of projects already under way and better maintenance of the existing capital stock. This emphasis creates its own problems. Event can be made to work, wouldave an appreciable Impact on the growth of the Soviet economy?

Putting aside the question ofcost Involved, the Implications for other sectors, or the speed with which It could be effected--we have examined the Implications of improved productivity by assuming the Soviet economy to operates it did (Econometric analysis of the various sectors of the industrial economy reveals that the

26

PH Mill HI IHIi IHU I

Productionffect of Increosed Productivity on Selected Economic Aggregates

Impact of additional investment on labor productivity dropped) eturn toroductivity growth trends would help the Soviet economy to grow faster by increasing the gain in labor productivity derived from increases in the stock of machinery and equipaent.

If the Soviet industrial economy were operating as It didndustrial output would be growing at almost twice Its actual rate. This growth would slow down considerablyhe last half of the decade but would still remain well above the growth wc now project for that period. 0 machinery output would beoercent higher, total Investment almostercent greater, and consumptionercent more thanow projected. The economy's total stock of capital would grow faster under these conditions thanhe baseline case, although our results suggest that an energy shortfall could retard the growth rate of capital stock actually used in production.

To approach the growth rates of our Improved productivity scenario within the next five to seven years, the Soviets would almost certainly have to make very ambitious and incisive reformside spectrum of policy areas-Including investment, labor, trade, and economica scale that we consider unlikely for the Soviet bureaucracy.

27

Distribution of GNP

Comparison?3 Projections

ercent average annual growth of GNP overn3 projections is not significantly different from the growth rate that we projectedlthough it reflects new defense assumptions and our current judgments that oil production will not begin to decline until5 and will fall less far The difference in GNP distribution is more noticeable. Our assumptionercent average annual growth in defense expendituresercent last year) and slower growth in military hardware procurement has the effect of releasing resources for other uses. Investment and consumption both benefit, and per capita consumption Inh Five-Year Plan period no longer shows the absolute decline reflected in last year's projections.

The impact of the decreased drag on investment hasradual positive effect on output growth in. Nevertheless, production capacity is increased somewhat because crowth in the stock of plant and quipment will eventually follow growth inw of investment goods. Increases in investment and production capacity inould position the econoTry better for improved growth in. The implications of less stringency for the consumer,he form of continuing (though modest) improvements in average living standards, wouldoon for the Soviet leadership. Gains couldositive effect on labor productivity, as more goeds and services continue to bexchange for wages earned.

28

Comparison23 Baseline

The growth rate for defense expenditures that we currently assume Is approximately the same as our projected growth rate for the economyhole. Therefore, In our current baseline scenario the defense burden remains at aboutercent throughout the decade instead of Increasing (asid2 calculations) toercent5 andercent

Scenarios Favoring the Consumer or the Military

The estimate of Soviet economic prospects presented in our baseline depends in partumber of key judgments about the future Soviet economic environment and policy decisions. We have also examined two casesn which we assume Soviet leaders decide to distribute the economy's growth incrementanner different from that assumedur baseline case. In one weonsumer welfare, in theilitary, orientation. Neither policy option alters our baseline forecast of GNP growth by as muchuarterercentage point per year during the decade, but the outcomes for the claimants on national output are significantly different. The results are in accord with our observation that, leaving aside consideration of fundamental economic reform, Soviet policy choices are more likely to affect the distribution of national output than to affect Its growth during this decade.

Consumer Welfare Orientation. We assume that the aimelfare-oriented policy in the USSR would be to move the economyigher growth path by providing the material Incentives needed to spur productivity. Our assumptions for this case Include Increased shares of Investment for housing, light industries, andwhich produce goods for which thereuch unsatisfiedfor energy. For this scenario, we assume that

29

defense spending remains flat, to allow for Increased total Investment, and that the volume of food and other consumer goods Imported from the West is increased.

esult, GNP growth Is slightly lower thanhe baseline case during the last half of the decade, because of the shift of resources away from the sectors that produce Investment goods--machinery and construction. There are substantial gains for the consumer, however. Per capita consumption growth Is maintained atevel through the middle of the decade andwice as great0 as the growth In our baseline case.

Military Orientation. If the Soviet leaders felt that the challenge by the West to the nation's security Intereststronger response, they night accelerate the buildup of their military forces and choose economic policiesilitary orientation. In order to Increase military production in the long term, they would step up investment In energy. Industrial materials, and the investment goods sectors. For this scenario, we assume defense spending would growercent perate slightly higher than the historical rate oferiod. More repressive domestic measures would be likely, and weandatory returnonger work week, which Increases the labor Input to the economy. We also assumeefense spending growth rate ofercent per year above the historical level would not acutely alarm Western nations. Therefore, the Soviets could increase their machinery imports from the West to meet the greater need for Investment goods and their sales of oil to the West for the hard currency necessary to pay for the machinery. Oil sales to Eastern Europe would be reduced.

30

An accelerated arms buildup vrould be costly. GNP growth would increase slightly over that in the baseline case, primarilyesult of the extra investment (and subsequent production) in the energy and defense Industries. But the defense burden would escalate, forcing down the per capita consumption growth rate by nearlyercentageear on the average during the latter half of the decade. omewhat higher overall rate of Investment, important civilian sectors (especially consumption goods and services) would suffer, as an increasing share of new plant and equipment went to defense Industries. Furthermore, the combination of higher take home pay (which we postulate as resultingonger work week) and fewer consumer goods could Increase the repressed inflation in the USSR and lead to popular discontent. Under this scenario, the share of GNP going to defense would reachercentigure about one-third higher than the average defense burden during the Soviet military build-up.

31

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Uses or CNF (factor coat)

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administration

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research and development

SOVSIH estimates consumption as the residual end-use after subtracting Investment and defense and Otherexpenditures from CMP. investment Is estimated as the residual In an Investment goods balance that takes Into account production Of Invostmont goods end such claims on this production as consumer durable goods and mliltory procurement ofielecauso of data constraints, SOVSIH must work with two measures of new fixed Investment:actor cost measure that fit* in with Suva's reconstruction of Soviet CNPfficial Soviet moasure, which Is used In tracing Investment flows to producing sectors and housing. This table presents estimates of the factor cost moasure. Defense is an assumed variable, while the estimates for government administration and research end development are based on assumed shares oT GNP. Ihe uses of GNP shown do not sum to the totul sttuwn because theremall residual that Includes not exports anil Inventory change.

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