IMPACT OF INFLATION AND RECESSION ON THE USSR AND EASTERN EUROPE (S-6806)

Created: 3/1/1975

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CiA HiSiOSCAL REVIEW PROGRAM

id FULL

Impact of Inflation and Recession on the USSR and Eastern _Euroj>c

The USSR has been helped and Eastern Europe hurt by the rise in.oil and raw material prices,

terms of tradeis the West improved, and the Soviet hard currency balance of trade was in surplus for the first time in seven years.

- Eastern Europe's terms of trade with the West deteriorated, and its trade deficit increased sharply -

Western inflation and recession are affecting both the USSR and Eastern Europe,

raw material prices are falling, prices of manufactured goods are rising, and the terms of trade are beginning to go against the USSR.

the other hand, tlie Soviets are able to extract more trade concessions from Western countries because of their desire to expand exports.

Europe will be hurt by higher Soviet prices this year and has been hurt by deteriorating market conditions in Western Europe. Economic growth and the growth of consumer welfare is likely to be cut back-Soviet economic control over Eastern Europe is being strengthened because of Eastern Europe's increasing dependence on relatively low-priced Soviet fuels and raw materials-Moscow, reluctant to extract political gains from econoniic problems in Europe, is urging Western communist parties to pursue graoualist policies rather than take radical action

that could jeopardize Soviet detente policy -

Impact ot Inflation and RecessionSSR and Eastern Europe

Communist-type economies by their nature are protected from the vagaries of the world capitalist market. Prices are

administered, and there is no systematic relationship between domestic prices and foreign trade prices. If higher prices are paid for imported Western goods, for example, the difference between the domestic price and the foreign trade price is covered by state subsidies, leaving domestic price levels unaffected. The Soviets have been more successful than the Eastern Europeans in insulating their economy from world market conditions largely because Soviet foreign trade accountsmall share of GNP. In the USSR, total imports are only aboutf GNP and imports from the West, For Eastern Europe itespectively. USSR

As the USSR has increased its trade with the West, Western economic conditions have become more important to the Soviet economy. Western equipment and technology is an ever growing element in the Soviet scheme to upgrade its industry.

Imports from the West are limited by earnings from exports of goods and gold and by credit availability. The rapid increase in oil, raw material, and gold prices has greatly strengthened Moscow's ability to inport trom the West. The dollar value of Soviet exports to the West rose by more3 and

apparently increased substantiallylthough demand for Soviet raw materials may have weakened in the latter part The Sovietsrade surplus4 for th* first time in seven yearsesult of high oil and raw material prices. eficit ofillionhe Soviet hard currency surplus reached perhaps SI billion.

Tho slackening of demand and lower prices for some Sovietlatinum, diamonds, copper, and woodprobably resultedecline in earnings for these commoditiesj the lower prices should remain in effect for tho balanceut4 agreements Soviet gas prices will be higher and coal and oil prices also should stay uplthough the volume of oil deliveries may decline. Another surplus5 is probable.

Western inflation has also ledapid increase in the prices the USSR has paid for its purchases in the West. In some instances the Soviets have been forcod to accept price escalation clauses in purchase contracts; in other cases they found that the cost of equipment has greatly increased. Prices charged by International Harvester for crawler tractors ordered by thu USSR last fall, for example, were increasedver previous levels.

The deepening recession has resultedarked slowdown in the rise of Western export prices as well. In contrasthen increases in annual export price indices of major

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Soviet suppliers ranged (West Germany) to overin export prices5 is

expected to average The leveling off in prices will directly benefit Soviet buyers, who aro in the process of

placing several billion dollars of orders in support oflan. Sincehe USSR has ordered over S3 billion in machinery and equipment and an additional S2 billion in large diamotar pipe.

ajor potential buyerepressed market the Soviets have been able to exact economic concussions from Western governments. Since4 the USSR has received over S6 billion in low-interest credit lines from the UK and France and could receive an additional SI billion or more from Japan and Italy As indicated by the recently signed USSR-UK cooperation agreement. Western governments may also prove more willing to support the long-term corunodity pay-back deals increasingly favored by Moscow. The Soviets haveedium-term and long-term debt to the West of more thanillion already. Judging by its recent capital goods purchases and current negotiations, they are willing to run it up considerably moreparticularly if they believe the inflation rate will exceed the interest rates they aro getting on these credits.

The rapid increase in Soviet export pricesas far outweighed the higher prices of Soviet imports of manufacturon from the west, and Moscow's terms-ot-tradc remain significantly Moscow has also benefited from higher prices for gold. Whereas Moscow used to solL qold only to

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help cover trade deficitsons were sold, earning aboutillionit was also selling gold4 to take advantage of high prices. Continued uncertainty in the West should keep gold prices high, enabling Moscow to earn SI billion or more per year from sales out of current production. Meanwhile the Soviets are successfully increasing their output of gold every year.

The USSR hasontinuing, but fluctuating need for many food products produced in tho West and currently has the financial ability to purchase large amounts at any given time. esult, Soviet purchases, or even the threat of purchases, canignificant impact on world food prices, especially grain. Even good Soviet harvests will not preclude the import of specific types of grain, such as corn and high-quality milling wheat. One large grain exporter who has close Soviet contacts believes that the USSR will "normally"illion tons of corn and "periodically"illion tons of wheat, barring serious crop shortfalls. Eastern Europe alsoontinuing need for Western feed grains, in particular to support their growing livestock programs.

In most international markets the Sovietsassive role, accepting market conditions as given. Thus, Moscow has profited greatly from high raw material prices in recent years, while usually not causing these increases. The Soviets followed OPEC in raising oil prices, but they have not profited much from non-oil cartels,

mainly because the latter have enjoyed only limited success.. The copper cartelC1EPEChas had some success in supporting prices, and Soviet copper earnings have probably boon aided somewhat, but

other attempts to form producer cartelsfor iron ore and mercury, for example have failed. Moscow, however, has profited from the anticipated US embargo on Rhodesian chrome by raising the price of Russian chrome ore byinn tho rapid run-up of sugar prices late last year, the Soviets,ajor factor. At the time there were rumors that the Soviet purchases were speculative, but no concrete evidence of this has emerged.

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Eastern Europe

astern Europe was confronted by higher prices lor imports of Western machinery and equipment as well as for semimanufactures and raw materials. The prices for East European exports to the West also rose, but much less than import prices. The resulting decline in terns of trade varied from one country to another, depending largely on its raw material resources. Thus, Romania and Poland, whose exportsubstantial volume of fuels and raw materials, fared much better than the rest.

In addition to its deteriorating terms of trade, Eastern Europe suffered another reversal: lump in demand for some of its exports owing to the recession in the West. Overall, Poland and Romania managed to increase the volume of their exports, largely because of greater deliveries of energy products. For the others, little volume increase, if any at all, was registered. Higher prices explained most of the growth in the value of exports.

The unfavorable development in prices and markets combined tootal East European deficit5 billion, nearly twice the deficit Poland's deficit increased by0 million1 billion, and accounted for nearly half the total East European doflcit. The deficits were covered larqely by increased drawings on Western government guaranteed credits and through other borrowing. Eastern Europe's

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debt to the West, which had already reachedthe ondas subtantially higher at the end of.

The East Europeans depend more on foreign trade than the USSR and ordinarily would have suffered severe hardships because of the reversal in their terms of trade and export markets. But they were able to mitigate the impact of these developments on their economies because more than half of their trade4 was conducted with other CEMA countries at stable prices. Also, the availability of Western credits allowed the East Europeans to continue to secure other materials vital to maintaining production in major industries. Thus, the East European economies managed to grow at an above average pacefronn Czechoslovakia to moren Romania in spite of the deepening recession in the West.

Still conscious of the Polish riots0 over higher prices, the East Europeans made extensive use of budget subsidies4 to insulate their domestic economies from the impact of Western inflation. Most retail prices were stablelthough the desire to conserve oil prompted the East Europeans to raise domestic fuel prices. mall extent, consumers were charged higher prices through changes in the assortment of merchandise available to the public. For example, like the USSR, Eastern Europe was affected by deterioration in the quality of goods and the disappearance of cheaper varieties from the shelves.

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Eastern Europe is likely to incur another sizable deficit in its trade with the West Attempts to save foreign exchange by cutting back cr> non-essential Western imports are likely to be thwarted by wore prices rises in the West. Meanwhile, attempts at increasing exports will continue to be frustrated by Western recession. In anticipation of these developments, the East Europeans have already obtained some ccmmitiTiHnts for "Western credits to cover the anticipated deficits and are seeking other loans, particularly from OPEC countries. If the necessary financing does not materialize. Eastern Europe will have to cut back sharply on imports from the West.

Economic growthS is likely to fall short of4 pace. Increases in prices with Other CEMA Countries, particularly for Soviet raw materials, will place further strains on the East European economies. Domestic endowment of raw materials will allow Poland and Romania to continue to boost industrial production, but others will have to cut back on growth plans. Moreover, as prices continue to rise each year, long-terra planning becomes more problematic.

The sectors hardest hit by higher costs or any cutbacks in fuel supplies would be chemicals, metallurgy, agriculture, and food processing. These are the industries relying most on imports of Western equipment and basic materials, which also may be trimmed. Consumer industries, such as textiles.

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leather, wood, and paper, may require more investment and output to satisfy Moscow's desire for additional consumer goods from Eastern Europe.

The requirement to boost exports to both the West and the USSR will leave fewer goods for domestic consultation. Planners will have to slow down the growth of real income and increase some retail prices. The Hungarians in5 and the Poles inS have already raised retail prices for some goods that incorporate high-priced Western materials, and the other East European countries are likely to follow.

Soviet-East European Economic Relations

Eastern Europe conducts almost one-third of its trade with the Soviet Union." The USSR traditionally has been Eastern Europe's main supplier of oil and many raw materials essential to the viability Of these economies. The USSR supplies more than three-fourths of Eastern Europe's imports of crude oil, and the bulk of its imports of iron ore, pig iron, lumber, and the like. These countries have obtained "goods from the USSR without the expenditure of scarce hard currency and at bargain prices. umber of years the USSR has not been happy with its terms of tradeis Eastern Europe, selling high-cost raw materials at low prices for what it considered overpriced machinery and equipment.

* The share of Eastern Europe in Soviet trade

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To offset its disadvantage, the USSR has insisted in recent years that the East Europeans purchase more Soviet machinery* buy more oil in the West, and invest in Soviet raw material projectsuarantee of future deliveries. Despite adjustments stemming from these demands, the USSR still considered itselfisadvantage in trade with Eastern

steeply in world markets, the Soviets refused to increase this.

The Easternocted the USSR to maintain prices until the and of the current five-year plan The Soviets, however, have already boosted the price for most oil deliveries fromarrel totill well below world prices. This will increase Eastern Europe's bill for Soviet oil byillior. equivalent t<f its exports to the USSR In addition, Lhe Soviets are raising priceside spectrum of other raw materials, but most of these prices will also be below world market levels. The resulting worsening of Eastern Europe's terms of trade withS3 will vary with each country, according to its dependence on imports of raw materials-Moscow probably will grant concessions to those hardest hitCzechoslovakia, East Germany, Bulgaria, and Hungaryin order to prevent severe strains on their economies. The

Soviets will probably be more generousb than subsequently

since the East Europeans hav> already drawn up their plans at the old prices. The Hungarians have already been promised ten-year credits^ .Moscowt be as forthcoming to countries such as Poland and Rcr>ania, which rely less on Soviet raw materials.

Despite these concessions. East. European terns of trade with the USSR will continue to worsen during the next few years. Intra-CEMA prices reportedly are to be recalculated annually on the basis of the previous five-yenr average world price. World prices for many raw materials have begun to level off or even decline, but CE.VA prices will continue to rise for several years as low-priced years are dropped from tho fornula. oderate rise in world prices, the East Europeans could bexel for Soviet crude

Concessions by the USSR are meant to prevent major economic disruptions in Eastern Europe, but they will also serve Moscow's political ends. Concessions in return for closer Eastern European ties to the USSR clearly promote Soviet policy toward CEMA integration and measurably strengthen Moscow's economic control over Eastern Europe.

Economic benefits accruing to Moscow include the greater availability of investment fur.ds for Soviet projects and increased supplies of Eastern European goods. f Soviet imports from Eastern Europe is made up of consumer

goodf and substantially increased imports of such goods will make the Soviet consumer happier. Fewer goods will be left for consumption in Eastern Europe, but leaders in these countries cannot afford to ignore the lessons of the Polish riots0 when prices were raised to dampen demand.

Impact of World Energy Situation on the USSR and Eastern Europe

The USSR is the only industrial country in the world that is self-sufficient in energy. Oil is the USSR's major energy export, and, indeed, its major export, and the sharp increase in prices4 helped the Soviet Union toard currency trade surplus. Oil earnings doubled to at5 billion. As muchay be sold to hard currency countries5 andarrel, earnings would be4 billion Western industrial countries have curtailed oil demand and restricted imports, including those from the USSR, andstimate may be high, but oil revenues should reach at leastillion and thus help assure the Soviets another hard currency trade surplus.

While Soviet oil exports to the West may level off, exports of natural gas are to rise sharply during the next few years. Because of the USSR's critical need for large-diameter pipe and ancillary equipment for pipelineit has signed contracts to receive such equipment in exchange for long-term deliveries of natural gas. Soviet exports of natural gas to Western Europe5 willillionnd expand toillion0 The USSR was able to renegotiate natural gas'prices upward4 talks with Austria and West Germany.

Table I

USSR: Estimated Oil Supply and De=and (MillionofOil Equivalent)

e

2/

2/

2/

Ccrestic Production Imports

TOTAL

DEMAND

Domestic Consumptio Available for Expor Eastern Europe Other CorrrmnistWest for soft c1 West for hard o

The range of possible Soviet supplies"'to Eastern Europe affscti thn amount available for hard currency countries.

Includes swap oil for Cubad currency suppliers on Soviet account.

Actual Soviet exports to hard currency countries inay bo reducedf Soviet hard currency

hi!

5

E c:

IE

Henceforth, prices will bo tied to fuel oil costs in each of lhe two countries. esult of these negotiations and increased deliveries, Soviet hard currency earnings from natural caa sold in Italy, Austria, and West Gerr-any should0 millionS. rd currency earnings from theso gas sales will amount toillion.

Soviet exports of coal to the West probably willslightly5 because of the recession-related necessity to restrict energy consumption and reduce ir.ports Soviet earnings of hard currency fcora coalowever arc likely to rise toillion as the USSR gets higher prices for the coal it exports.

The Soviet economy has been helped by the improvement in the USSR's terms of tradeis the West resulting from high fuel prices. Increased export earnings has allowed the Soviets to step up imports of highly-priced equipment and technology. Equipment imported to increase gas and oil production would help to boost future exports, but the world-wide shortage oi such cquiprxjnt may retard Soviet, exploration and development in tho next few years.

Eastern Europe is becoming increasingly dependent on the USSR for oil and natural gas. Excluding Romania, which does not import Soviet oil, the remaining five countries of Eastern Europe rely on the USSR forf their

supplies The remainder io obtained from the West, chiefly as crude oil from the Middle East and North Africa and mainly through barter. The higher price Moscow is charging for oil, although still well belower barrel for Saudi crude, will cost the five countries an additionalillionS.

The need for oil in Eastern Europe will continue to rise, and its import bill will also rise, at least for several years unless oil prices decline sharply in the near future. ew Soviet-East European price formula has been agreed to which calls for an annual revision in oil prices based on tho average world price for theears. In addition, Soviet deliveries to Eastern Europe will probably level offew years, and Eastern Europe will have to buy more oil from the West. These purchases will bc mostly hard currency since barter deals for oil with Arab countries are likely to be limited by Arab reluctance to take large quantities of East European goods.

As tho USSK becomes unable or unwilling to increase deliveries of oil, larger supplies of Soviet natural gas will be available for export. Soviet gas reserves are much larger than those for oil, but the equipment and technology required to produce the gas from fields located in remote areas and to transport it by pipeline is costly.

" nl

in 11

i: :

"

Much of the equipment and capital must come from the West,ew cooperative venture is now under way in which the five East European countries will assist the USSR ininch gas pipeline from Orenburg to Eastern Europe. Estimated Soviet deliveries of natural gas to Eastern Europe50 will beillion cf/d, respectively, and account for about one-fourth of total gas supply5 and one-halfuture Energy Needs

The growing depletion of resources available near existing population centers in the European USSR has forced the Soviet leadership to look to Siberia to meet future needs and to ponder ways to supply the area with the necessary capital, labor; and technology. The USSR will have to develop Siberian energy reserves, in particular, if it is simultaneously to meet its own rising requirements, satisfy the needs of Eastern Europe, and maintain sizable exports to hard currency areas.

Thushe USSR has been developing Siberian resources almost entirely with its own resources. It does not have the capital and, in some cases, the technology to exploit Siberian resources as quickly as it would like. The magnitude of gas and oil reserves and the difficult cold climate

engineering problems involved in their development are reflected in the urgency of Soviet efforts to obtain the assistance of Western capital, equipment, and technology. Without outside assistance, the pnce of development of onshore oil and gas resources would be delayed by three to five years or longer; and extensive development of offshore resources would be improbable

he USSR is to remain self-sufficient in energy, the development of Siberian resources is imperative. Total Soviet demand for energy is expected to double during thef the increase in Soviet production of energy0 will be obtained from Siberia. 0 Siberian fields probably will account for about half of total Soviet production of oil and gas.

Impact of the Energy Crisis on Soviet Oil Policy

The energy crisis has had no impact on Soviet oil production policy. Thus far, it has been Soviet policy to produce as much oil as possibleto meet its own and Eastern European needs and to maximize sales to hard currency countries.

Trade policy has changed only in the sense that the Soviets raised their prices of oil to non-Communist customersboth hard currency customers and their bilateral trading partnersfollowing OPEC's lead. 5 they are increasing oil prices to Eastern Europe. Apparently some hard currency customers, such as France, were unwilling to pay Soviet prices4 and reduced oil imports from the USSR. In addition, the Soviets were

unable to Import as much as they wanted to on barter from Iraq, the latter demanding world market prices and hard currency. Most of the Iraqi oil obtained on Soviet account is shipped to Eastern Europe. Thus, the USSR had to export additional oil to. those countries

5 the Soviets plan to increase oil production, sell more to Eastern Europe and hard currency customers, and obtain more from Iraq on barter, without barter imports from the Middle East, exports to hard currency countries probably would decline.

If the Soviets are unable to extract as much oil as needed for consumption and exports in the future, they may find it desirable to import more from the Middle East. Although the Iraqis resisted Soviet requests for barter oil4 and cut exports to the USSR sharply this year, they may relent if they can't sell as much as they would.like for hard currency. If excess producing capacity continues to be available in OPEC countries in the future as importing countries reduce consumption and/or produce more oil themselves, the Soviets are likely to attempt to procure substantially more oil from Iraq and other Middle East and North African countries by barter. Such procurement if large enough, would ease the pressure on Soviet oil resources.

Soviet View of World Economic Problems

Moscow undoubtedly perceives the current economic maladies in the West with mixed emotions. Moscow propaganda contrastshis latest crisis in capitalism with so-called stable economic conditions in the world socialist system. Moscow's claims of the Communist countries' immunity to world economic ills are being tested, however. Although the Soviet and East European economies will be able to escape the full impact of Western inflation and recession, they are being affected.

Inflation and Recession

Accordingecent Izvestiya editorial, the Western world has5 with anxiety: business activity islump, production is declining, the unemployment level is climbing to new highs, and inflation is setting new growth records. In contrast, the USSR and East Europeans are looking to the future with confidence. Accordingly, the West Europeans are looking more favorably on establishing closer economic relations with the socialist states and are now following the example of France, "one of the first" to establish close ties with the USSR.

Moscow has played up the advantage to the British workers who will be gainfully employed filling the large orders for the USSR that will be financed by thebillion credit line

advanced to Moscow. Also addressing workers' interests, Politburo member Aleksandr Shclepin closed his address at the4 trade union meeting with the Finns by sharply criticizing the European Trade Union Confederation for its lack of aggressiveness in protecting the worker against the growing threat of inflation.

Moscow is worried, however, because as inflation mounts, the cost of imports from the West also increases. While the terms of trade are still in Moscow's favor, the inflationary process in tho Wast with its attenca.it higher prices for Western manufactured goods is eroding the price advantage recently won by Moscow. The Soviet leaders also must feel uneasy at having to sit on the sidelines while others make the decisions on oil prices.

Constantly rising prices for Western manufactures are maxing things difficult for Soviet planners. Not only will it be core difficult to plan long-term projects because of increased foreign exchange cost of equipment, but it may also become increasingly difficult to measure the viabilityarticular project on econooic grounds, because of uncertain capital costs.

The insulation of the world socialist system from Western economic instability also has beenerious blow by the adoption of the now CEMA pricing system which each year will adjust CEMA prices according to average world prices for the previous five years. Accordingly, Western inflation will be imported into CEMA trade and will add to the pricing and planning problems that now exist in East-West trade. The Raw Materials Problem

Moscow views the raw materials problemgraphic new manifestation of the general crisis ofhich in turn is aggravating the West's other economic difficulties. According to Soviet spokesran, it has increased the instability of the foreign exchange system because the rise in raw material prices has forced some Western countries to borrow funds for balance of payments purposes; the higher raw material prices are being borne by the population who are hit with increased retail prices;/raw material shortages and attendant higher prices are exacerbating the recession in several key industries, which in turn contribute ecline in business activity and an increase in unemployment. Moscow places the blame on Western monopol ies, which earlier had been exploiting tho less developed countries and ara now chafing at the bit for having to pay higher prices.

Moscow has benefited, however, from the sharp increases in raw materials prices, which in the last two years have

(jreatly improved the USSR's terms of trade with the West. Similarly, Moscow's terms of trade with Eastern Europe will improve dramatically this year according to the new CEMA trade pricing system. It appears tooregone conclusion that prices for raw materials (Moscow's major exports to Eastern Europe) will rise faster than prices for manufactured goods (Moscow's major imports from Easterneluctance to Exploit Political Openings

Moscow has been reluctant to extract political gains from economic problems in Europe. Detente comes first and the class struggle comes second, says Soviet Party Secretary Ponomarev. Whereas not so long ago, Moscow was telling the world's communists particularly those in Europe, that the crisis of capitalism presented themreater opportunity than they ever had, Ponomarev is now urging them to go slow. Apparently he is now more concerned with the possibility that the crisis of capitalism may bring fascists into power, particularly in Europe. The political turmoil thaL would be generated would complicate Soviet relations with the United States as well as adversely affect Soviet detente policies that also are yielding benefits to Moscow. Apparently Moscow is now hopeful that the West, because of its economic crisis, might now be more willing than in the past toeal measure of arms limitation ond reduction, and thus-pursue detente more earnestly.

Tnblo 4

Geographic Distribution of Soviet Trade-"

Area

rotal^

Communist countries

Eastern Europa

China

Othur

Frco World

Developed West

Less Developed Countries

Unspecified!/

US S

Exports iTporta Exports Inports Exports Imports Exports Imports

581

205

Because of rounding, components may not add to tho total shown.ncludes hong Kong. tf Estimated,

Table 5

opean Foreign Trade by Area

t;s

Eurose

I

Europe

Corrvjr.ist

05

Xtst

cr.s

.

Bulgaria

til

Europe

.

Otherr.isi

00*

Total ("

Europe

Ccr=iurtist

9

> 55

Naiio.-s

Cemazy

Total

5

Z-^xovs

-

Kcs,

326

Total

Europe

.

Ccn-.ir.ist

Saticas

Total

32

Europe

3

Corjsjnis;

Wesr

Nations

Romania

Total

Ejrope

st

*dJt

Nations

i-stir-atca.

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