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The Soviet Bloc Hard Currency Problem and the Impact of Western Credit Restrictions (u)
National Intelligence Council Memorandum
Information available at2 has been uttd in lhe preparation of this report.
Thu Memorandum was coordinated within Ihc National Intelligence Council and the Directorate oMntclligcncc Comments are welcome and may be addreaaed lo iu author. Maarice Ernst. National Intelligence Officer for Economicslttl (o)
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lhc Sonet Bloc Hard Currency Problem and thc Impact of Western Credit Restrictions (u>
This paper assesses lhc potcntul impact of Western financial measures against Soviet Bloc countries on the capacity of lhe USSR to imporr from thc West. It examines the hard currency problem of Ihc USSR, lhat of thc Easi European countries, and thc manner in which their problems affcel thc USSR. Ii analyzes ihe role of governmeni-financed and guaranteed credits in lhc overall flow of Western capilnl lo Ihe Soviet Bloc and thcaffecting lhe direct and indirect impact of official restrictions on this flow. Attitudes of US allies concerning financial sanctions are treated briefly. Thc last section deals with some policy implications of ihe foregoing analysis.
Thc paper does noi evaluate in detail ihc impact of reductions in hard currency imports on lhe Sovicl economy This important topic is treated in other studies. Nor does it address possible Soviet Bloc reactions to Western sanctions.
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The Soviel Bloc Hard Currency Problem and lhc Impact of Western Credit Restrictions (u)
Key"med very negai.ve about lending to
he BJoc have largely
Western government restrictions on credits to Soviel Bloc countries if maintainederiod of yean, could:
Moderately reduce thc USSR, capacity for hard currency .mports in the next few years.
all in such imports in lhe long term, thereby further lightening the resource constraints on thc USSR and tbe difficully of coping with its defense burden.
The US allies arc alreadyood to restrict government-guaranteed credits to lhe Sov.ei Bloc for economic reasons; they may be willing toeiling on such credits but noiut them off or severely curtail them.
The most powerful government iiuirumcnt for restricting credit lo the Soviet Bloc would be placing quanlilaiive limits on governmeni-financed and guaranteed credits. Establishing such limits, even if they involved no absolute decl.ne in thc rate of new credits, wouldwedegative signal in captlal markets, intensifying their disinclination to lend to Ihe Sovicl Bloc.
Eastern Europe is in far worse shape than thc USSR* ihis means that Moscow would probably have to share atmall pari of the coston Eastern Europe by Western restriciions. but could expect no
lSUia if ,be ntf'Wtwwimposed only on the USSR. The USSR could obtain new long-term credil from non-NATO non-Japanese sources only on stringent terms. Most East European countries could receive no such credits.
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Tlic Soviet Bloc Hard Currency Problem and ihe Impact of Western Credit Restrictions (u)
A fundamental reassessment of the risk of tending lo Soviet Bloc countries has cu nailed those countries' access to Western private credil and made some of tbc remaining credit flows vulnerable to new negative developments The Soviet hard currency position bis svcifsencxl rreatly in recent months. Thc USSR is in the midst ofa short-term liquidity problem, due partly lo bad crops and the Western recession. With large assets (told reservesoos worthillionrice0 an ounce) and small fiied obligations (long- and medium-term debt service re-qulicmentsear, or less thanercent of merchandise and armsoscow has the flexibility lo cope with this problem.undamental long-term problem willUSSR's hard currency exports arc likely to stagnate or fall, with the result lhat hard currency imports will also stagnate or decline unless thc West is prepared to provide substantially more credit than in the past. Eastern Europe's hard currency position is far worse than lhe USSR's. Most East European countries cither cannot meet their hard currency oblitauons or must make severe economic adjustments to do so
The severe deterioration of tlte Soviet and European hard currency positions has been due to Ihe following factors:
Increasingly evident syslomic deficiencies, resulting in declining growth of productivity
Thc logical implications of Ihe raped accumulation of hard currency debt in nasi year- rocess which obviously could not coniinue unless hard currency earnings were also growing rapidly,ey are nca
In the Soviet case, anduch lesser extent the Easi European counlries. events cat tide llseir con-trol (Western recession, bad crops, lower oil and cold prices).
The Polish political crisis ond economic collapse and its fallout.
The general worsening of East-West relations,in thc pan year.
Western covtramcnt policiesole in encour-agtni ihc accumulation of Soviet and Easi European debt by providing credit on easy terms during. Wiihout Western governmeni cricouragcmcnt, private bank exposure svould not have increased io Ibe extern that it did. In the past few months, the possibility that Western governments might restrict or discourage credit to Eastern Europe has createduncertainly in financial markets and has further discouraged bank lending.
The Crisis
Following two years of soaring foreign exchange earningsesult oft] price rise and continued increases in arms sales, Moscow suddenlyevere hard currency bind in the latter parihe Soviets probably expected sorne worsening in Iheir hard currency position during the tc'. but thc speed of rhe turnaround appears to have caught them by surprise The following appears lolausible reconstruction of events:
In lhe first quarter. Moscow gave Polandillion in emergency hard currency aid.
Oil prices unexpectedly began to fall so thathad to revise downward its expected earnings from oil exports.
A ihtrd successive bad grain crop forced Moscow to buy even more grain, meal, and soybeans than hud been planned
The weakening of tbc Western economics after the first pari of the year reduced the demand for Sovicl e* ports.
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unexpected expenditures and shortfalls wore probably responsible for the precipitous decline in Moscow's hard currency assets in foreign banksillion at the beginning1 to only5 billion six tnonibs later Thcevel appears to be lhc lowest Tor at leastears relative to Soviet hard currency imports, being equivalent io only about one month's imports. Moscow must have concludedevere liquidity problem hadand had to take some drastic action
Tbc Soviet Policy ReacUon
During the final quarter of last year. Moscow took the following stepsuickly improve its hard currency posilion:
Selling large amounts of fold,eakening market. After largely slaying out of thc market for iho first ihree quartersoscow sold anons between August and tbc end1 (ivrice the amount sold in allnd at leanons through
Increasing ils use of short-term credit.
Severely rationing expenditures for hard currency imports other lhan food, by requiring additional authorization and controls throughout tne Soviet economic decision structure.
Moscow has noi entered Ihe Eurodollar nurkei for mid- or long-term nonguaranieed bank credits as it did5 when facedimilar foreigncrunch. One can only speculate as lo tlie reasons Many Western bankers have been reluctantake new large Eurodollar ssndiotions to lhe USSR Even so, Moscow probably could obtain Euto dollar credits, bui on less favorabkhai it did not do so may be dueesire to avoid thc widespread publicity thattep would have stimulated in view of the situation in Poland and ihc lensc slate of East-West relations generally. There would have been speculation in lbc Western press that the Soviets were borrowing money to pay off Polish debts: others would have pointed to the borrowing as a
sign of Soviet economic weakness and vulnerability io Western government pressures. In recent months, tbe Soicts have been investigating borrowing possibilities in Arab banks. apparenUy wiih liltic success as yet.
Short-Term Prospects
The emergency measures adopted laic lasl yearcertainly enabled the Soviets io return their liquid hard currency assets to more normal levels, but did not eliminate lhc need for various other forms of exlraordinary financing lo meet expendituresorces beyond Moscow's control are even lessio Moscow's hard currency situation this year than ihey were last year:
Oil prices are continuing lo fall.
Demand and prices for Soviet capons are probably also falling
Moscow's food import bill will probablyillion dollars or so higher lhan last year.
Since other major balanc^Kif-payme'iiisales, service receipts and payments, nnd so forthare unlikely to change much, this means thai unless nonfood imports arc cut very sharply indeed. Moscow will have io sell substantially more gold or borrow more short-term capital than last year
ll is impo-t'ibie to know what corn bt nation of import cuts, short-term borrowing, and gold sales Moscow will select. For example, if lhe Sovieis cut iheir nonfood imports byercent in volume (which, given higher prices, would mean little change inith exports down and food imports up. their trade and current accounl deficits would be someillion larger than last year. By selling Ihcir net annual gold producUonons,tile more than S3 billion0 an ounce, ihey would still have to borrow about J) billion in short term credits to cover thc deficit. This is by no means in feasible, although Ihe ml crest com would be high.
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borrowingeasonable means ofinancial gapear or so. bul obviously noi over much longer periods Import cuts, (oo. would be viewed differentlyeans of copingrief foreign exchange shortfall than as partonger term problem The USSR, like most bureaucracies, tends to spread shori-term cuts fairly evenly among users, exceptew priority areas like food.onger period, priorities among different types of imports and their uses svould have to be much more carefully worked oui.
Moscow probably believes that the foreign exchange bind isemporary rAeriomenon. Thereeasonable basis for Moscow lo hope lhat Soviei gram crops will return lo normal or better, which would make some reduction in food imports possible. In addition, (he likely cyclical upswing of (he Western economieshould increase both thc price of and thc demand for Soviet exports These factors alone could add several billion dollars to meet Moscow's other hard currency needs
The Long-Term Uind
Even wiih some likely improvement in thc hard currency position during the nexl ycai or Iwo. the USSRcarcity of hard currency through. Thc chances are lhat the volume of Soviet hard currency exports will stagnate or decline during the coming decade. Specifically:
Tbe volume of Soviet crude oil exports has been declining for three years and. with domestic oil production likely lobeat best constani. and ai worst in steady decline, it will be extremely difficult tourther drop, and eventuallyomplete cessation, of oil exports for hard currency.
Gas exports wiU continue to increase but noiarge scale unlil tbc Yama! Pipeline can bewill probably noi be before the latter pari of lhe decade. Even then the increase in gas exports will probably less Ihan offset the decline in oil exports.
Arms exports for hard currency appear to have leveled off for lack of large new clients. Even curreni large cusiomers. such as Libya, may have to pare purchases if oil export revenues continue to decline.
Other Soviel exports (wood, metals, manufactures) are likely to stagnate because of supply limitations and Sovicl inability to adapt to Western market needs.
Without theizable decline in exportsbe inevitable, even if Moscowsome of thc gasls own and Eastern Europe's use in order to free some oil for export to the West With the pipeline and some good luck in oillhc volume of hard currency exports may be held aboul constant.
Moscow's main hope fo* sizable increases in hard currency earnings would be another large jump in tbc prices of oil, gas, andn thc case of oil, an event thai appears unlikely in the nexl iwo or three years, but increasingly likely during the second half of.
If Soviet hard currency earnings are stable orm the long term. Moscow wilt need lo increase iu new borrowing from thc West toecline in its hard currency import capacity. Soviet debt service payments will slowly increase, reflecting the past growth of new credits; consequently, if drawings on Western long- and medium-term credits remained constant, lhe nci inflow of long-term Western capital would slowly decline, and import capacity would fall.
A constant or declining hard currency import capacity would pose serious problems for Moscow. Inlower economic growth will present the Soviel leader-ship with increasingly lough und politically painful choices in resource allocation and economic matiagc-rnenl. Annual itscrcrrsents io national output svill be too small to simuluneously meet mounting inveu menl requirements, maintain giowih In defense spending at the rales of die past, and raise lhc standard of living. Simply staled, something will have to give. The Soviet need for Western goods and
technology will iheicforc increase greatly. Imports can relieve some economic problems byhe irxhrtotoftcal level of key Soviet indasirics and by reducing shortages of grain and such importantmaterials as sieel. Western cquipmenl and know-how will be particularly imporlant to raitingin the Critical machine building and energy industries. The Sovieis must continue importing large amounts of agricultural products and will probably expand their purchases of steel and some othermaterials.
The East European Hard Currency Problem
East European countries' hard currency problem it fnr more severe than the USSR's. Their gold and foreign exchange assets are minimal and Ihcir debt service obligations arc enormous Leaving asidewhich islass by itself. East Germanyebt service ratio aboveerceni. and (hc rest, except Czechoslovakia, arc all aboveercent. These ratios put ihc Last European countries in lhe same class as Brazil, Mexico, and Chile, countries wiih far more flexible economics and generallyincreasing export earnings
Poland aside, Ihe facl is thai Rumania cannoi meet its obligations, and thai East Germany could not achieve any substantial reduction in its indebtedncst without wrenching economic adjustments. Hungary, too. would have great difficulty reducing its debt. Even if cutting dcbi were just rolled over, lhc bast European economics would at besi limp along with little or no economic growth for Ihe nexl several years. It is important to keep in mind thai Western credits played an important role inarge increase in invcslment in nearly all Easi European countries during, and thai (his investment was an important factor in sustaining tolerable, if generally slow, growth rales. This important prop for inefficient economies has disappeared
The Soviet-East European Connection
Soviet-East European economic relations rarelytransfers of hard currency. UsI year's Soviel hard currency aid io Poland was clearly viewed as an cxccpimnal sicp. ouiside thc normal framework ol
economic cooperation and aid. Some trade is paid in hard currency, but (he net flows arc probably small.
More basically. Soviet (rade with Eastern Europe helps lo knit lhe Soviet empire (ogether. bui at substantial cost to Moscow. By denying Eastcountries (he possibility of developing economies and economic systems lhat could be reoriented mainly toward the West. Moscow has little choice but to provide some direct and indirect forms of aid. Thc direct aid is in. thc form of credits on bilateral account. The indirect aid lakes lhc form of delivery of undervalued Soviel taw materials and foods in rciurn for overvalued East European manufactured goods. Many of the Soviet exports are sold on the world market and some of (hem. nolably oil, are sold lo Easiern Europe far below world market price Mosl of the East European exports can be sold onmarkets only al severe discoums. if al oil, bui ihc Soviets pay world market prices for ihem
A worsening ofthe East European hard currency and economic situation is bound lo impose additional burdens on the USSR Moscow simply cannot affordet thc East European countries go begging to the West by themselves, or alternalively to lei iheir economics deteriorate lo tbe point thai seriousconsequences could follow. Additional Sovietio Eastern Europe may or may not lake the form of hard currency, but even if it did not. there would be indirectly an unfavorable impact on the Soviel hard currency position.
The Role of Western Goiernntenls Western governments have encouraged anof Soviet Bloc hard currency debtillion by providing credits and credit guarantees, oftea ai subsidized interest rates, and. jrtdircctly. by helping io create an atmosphere of East-Westwhich fosiered the confidence of private lenders Credits financed or guaranteed by Western govcrn-mcnls make up aboul one-third of lite Sovici Bloc's total hard currencyPoland, lhc USSR, and Fast Germany having relied lhe moti on such credits (Icing generally long term, these ctedits ac-
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uch smaller pari of lhe current gross inflow of Western capital than ofoercent, except in Poland and the USSR (seexcept in Poland, they are financingoercent of hard currency imports.
As things now stand, no Soviet Bloc country has received any mid- or long-term unguaranteed bank credit forear. Shorter term credit is available, except to Poland and Romania, but on less favorable Icrms Ihan in lhc past.
Impact of Western Financial Measures
Western countries can influence Ihc (low of capital to Soviet Bloc countries both directly, by regulating thc volume and terms of government-guaranteed crcdiis. and indirectly, by affecting the willingness of the private sector la lend at their own risk. To date, credit restrictions have come entirely from thc privateand noi from any specific Western government
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Some Of Ihe specific actions Western governments might lake to curtail the Bow of capital to ihe Soviet Bloc are:
Tightening the terms on long-lcrm government-guaranteed credits.
Limiting or reducing government-guaranteedbyeiling on new loans.
Stopping completely the issuance of any newuaran iced credits.
Also hatting drawings on existingcredit packages for orders in train and existing lines for future orders.
Refusing to reschedule existing credits (for example,oland and Romania).
The ilrtct impact of smite such mcasutes would not be severely disruptive. For example:
A Vpercent increase in interest rates charted on lhc new government-guaranteedthe recent increase in OECD Consensus rates for Ihcat1 annual level would gradually increase inieresi payments for the USSR byear,ive-year repayment schedule and no grace period inThc cumulative effect ofolicyycar period, for example, would resultotal increase of interest pa.-nems uf someillion For ihc Blochore (excluding Poland) the total cumulative impact overears might5 billion The aggregate numbers still pale, however, in face of an East Bloc financing requirement of hundreds of billions of dollars for all of.
A moratorium on new government-guaranteedlo Soviet Bloc countries would reduce the ncl flow of Western capital by amounts equal to no moreercent of1 level of hard currency imports Moreover, tbe effects svould uke some three io five years to be fully felt as Ihc governmcnt-gua ran iced credits in the pipeline were drawn down.
Refusal to reschedule Polish or Romanian hard currency delinquencies could force Ihose countriesefault. They would presumably stop all interest payments but their hard currency Irade would be temporarily disrupted. Thc net impact on Ihc current account balance would be small Private lenders would viewtepegative signal
The greatesi poteniial impaci of Western government credil restrictions arc of an indirect nature. It would come from ihe political signal such restrictions would convey io private lenders. It is highly unlikely lhal Western banks would be willing to resumelong- and medium-term lending if Westernwere imposing politically motivated limns on krovcrnment guaranteed credits Shon-termmight also contract, depending partly on lhe credit worthiness of (he individual countries.
Western aiiempu io dilfcrenliatc between ihe USSR and Fast emope or among East Europeanin the application of credil restrictions would tavc to consider lhc following:
Thc Fast European counlries are in such bad shape lhal if credit restrictions were aimed al ibe USSR alone, Moscow could noi recoup its losses ai the expense of ils satellites. By the same token,aimed also al Easiern Europe would probably force an exlra burden on Ihc USSR
Thc imposition of official credil controls against any Soviet Bloc counlries would have some negative effects on private willingnessendhc olher counlries as well Hungary is particularly vulnerable to cuts in private lending. Outside lhe Soviel Bloc, Yugoslavia svould be hurt by tbe fallout.
A general worsening in the atmosphere for private lending might be offset for selected counlries by specific new Westernexample, IMF membership for Hungary.
The impact of restrictions by NATO countries and Japan on credits io ibe Soviet Bloc could be weakened by increased lending from various capital suppliers-European neutrals, OPEC countries, and so forth. Nearly all alternative sources of credit, however, would be available only on stringent terms, if al all. Most Easi European countries probably could not get any medium- or long-term credits from private sources Moscow probably could get some loans, but would be forgoing ihe interest rate subsidies now being provided by many NATO countries, and, in addilion. would be paying laige interest premiums to cover political and economic risk. Wuh the worsening of East-West relations and Ihe devcloprnent of lhe Palish crisis. Western government ctcdn guarantees have become important for political risk insurance. Few countries are willing to provide such insurance
Allied Views on financial Sanctions
West European governmeni* will be receptive to US initiatives for moderate restrictions on credits to the Eastern Bloc counlries if such proposals are justified primarily in economic terms. The Europeans arc mosi
likely lo be receptive to sound economic argumewt pointiriE to lhe alarmingly large Soviel Bloc hard currency debts, tlie weakened economic position of rnosi East Bloc countries, the likelihood of abaUnoc-of-payrrrenu situation for lhc USSR, and (hc high cost of Western governmcni subsidies. Thc current payments problems in Poland and Romaniaand the high potential cost of honoring export creditreinforce such arguments and serve toense of urgency to thc situation. Thereeasonable chance of agreement on holding governmcni-guaranteed credits lo or below somebase level.
Thc degreehich Ihe Allies would be willing to curb leading to the East, cut subsidies, raise interest rales, or shorten maturities is lempcrcd by domestic economic, political, and strategic considerations. The Allies' East-West trade is small relative to total trade bui is important for specific industries in eachIn thc long lerm. the Allies slill hope to increase their exports to the Soviet Bloc and almost certainty would not be willing lo commit themselvesong-term restrictive credit policy that prevented such an expansion
Policy Implications
Tke foreign financial bind facing ike Sovieu and their Eon European allies ihis decade provides an unusual opportunity to use economic menus toMoscow's bekavior. As with most other such leverage possibilities, (he impact will be subtle and undramatic. and it could lake years before these modest results become apparent.
Successful Western efforts to sustain or tighten the financial hind will make even more difficult lhe decisions Moscow must muke among heyenhancing the military, feeding the population, improving ihe civilian economy, sustaining its torrapi in Eastern Europe, and expanding (or maintaining) its overseas empire. Such an effort thus could make Moscow consider even more carefully undertaking cosily new foreign involvements and increase iisfor arms control negotuliorn Bui it could not force lhe Soviel regime to lake actions which ii
believes run counter to ils vital national intcrests--for example, withdrawal from Afghanistan or allowing Poland lo slip oul of its power orbit, or conceding signifieani miliiary advantages to lhe West. Al lhc same time, lhc Soviel Union couldore aggressive stance in foreign areas to show its defiance of Western actions Over the king (crm. such policies could also lead ihc USSR toore autarkic stance.
^mi'KK the ration: means of crimping the foreign exchange arailable to Ike Soviets, tke most plausible method seems to be the limitation of new loans to Ike
Soviet Bloc. In addition io Ihc Soviel financial bind, iwo key factors lead to this conclusion:
Credit limitations would lake advantage of already strong and prevailing political-economicThc Soviet Bloc has become highlyon foreign loans to sustain economic progress and in some cases even io maintain ibe current level of economic activity. Weslern governments and especially commercial financial institutions have become less inclined to lend large sums to the Soviel Bloc as they sec little hope ihai ihe East's economic and financial situalion will improve much, as long as Current economic policies are pursued. The likely continuationolish crackdown makes selling thc idea of credit limitations easier
Weslernnecessary for effectivea much better chance in lhe case of credit limitations than of other proposals, such as hailing Die development of lhe Yamal gas pipeline. greaUy reducing Western purchases of Soviel Bloc exports, pushing down lhc wot Id market ptiors for key Soviel exports (gold, diamonds, and oili. or embargoing trade wiih ihe Soviet Union. Wcsicrn Europe and Japan would cenainly believe ihey have much lessose from imposing credii restrictions than from employing these other types ol economic levernge.
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Western nations are ai present disinclined to provide the Sorters and their allies with new credits, it is important to pat the credit restraints in place now. After the memories of thc East European credit problems and of the Polish polilical repression subside, it will be much harder to achieve credit constraints. Action now also wouldtrong signal to Moscow as to the West's cohesion and strengthactor that would also help overcome thc current belief that thc Atlantic Alliance is incapable of collectiveinally, it would preserve an imporiant bargaining chip for Ihc future, in thc sense that Ihe possibility of expanded credits could be dangledressed Soviet leadership, especially in thc post-Brezhnev era.
The kind of restraint on credit most feasible under current conditionseiling on the flow of new credit that would not exceed recent levels ratherutoff of all loansharp curtailment of new credits.
would be nearly impossible tonified Western policy stance on the tougher approaches.
It is not necessary to achieve tlic more stringent steps to make the financial situation worse for the Soviet Bloc. Even the expected leakage of new credits through third countries or by "cheating" by the Western nations would do little to reduce thc impact of credit limitations.
It would leave open thc possibility of imposing more stringent financial credit restrictions in thc fiiiure.
Thc best way of achieving Credit limitations teems to be through restrictions on government-guaranteed credit.
Control over government lending is centralized: it would be difficult tn regulate thc flow of private lending.
Limits on government-guaranteed credits would curiail private lending lo the Soviet Bloc, as tliey would be viewedegative signal in capital markets, intensifying disinclination to lend to thc Soviet Bloc.
A companion clement of the credit limitations could be the elimination or reduction of the concessional element on government loans to rhe USSR and its allies. In the past, competitive pressuie for export business has induced Western counlries to provide loans to thc Soviet Bloc at much less than market rates, forcing the taxpayer to pay the difference, (liven their budgetary problems, the governments of Europe and Japan might findarticularly good lime to forgo these subsidies.
Finally, establishment ofa Western system forcredits to the Soviet Bloc would provide abasis for linking East-West economicto Soviet political behavior. To makeystem workustained basis, however, would require broad agreement among thc major Western powers on bask goals concerning relations with the USSR.
In sum, the key points here are:
Thc limiting of new credits to the Eastern Bloc at near recent levels would significantly consirainpolicy choices.
Such credit restraint is all that is politically feasible in terms of the US allies' view of their long-term interestsis thc Soviet Bloc.
More stringent credit restraints would be harder to achieve but would have proportionately greater and more immediate consequences for lhe USSR.
Secret'
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