U.S.-Soviet and East European Economic Relations: A Risk Assessment

Written
Testimony of

ROGER W.
ROBINSON, JR.

President, RWR Inc.

former Senior Director
for International Economic Affairs

at the National
Security Council (1982-1985)

before the

COMMITTEE ON
FOREIGN RELATIONS

UNITED STATES
SENATE

March 1, 1990

Mr. Chairman and Members of the
Committee, I am pleased to have this
opportunity to appear before the
Committee on the subject of U.S.-Soviet
and East European economic relations. I
am currently President of RWR, Inc., a
Washington-based consulting firm, and was
former Senior Director for International
Economic Affairs at the National Security
Council (1982-1985). Prior to my
government service, I was a Vice
President in the international department
of the Chase Manhattan Bank where I had
responsibilities for Chase’s loan
portfolio in the USSR, Eastern Europe,
and Yugoslavia for a five year period.

The still incomplete “revolution
of 1989″ has produced an avalanche
of Western government and business
interest in supporting Eastern Europe’s
wrenching transition from command to
market economies — from one-party rule
to political pluralism. Naturally,
prospects for successful economic and
political reform vary widely in the
region, hence Western assistance efforts
are being appropriately tailored to
individual country circumstances. In
short, there is no longer such a thing as
the “East Bloc.”

To gain perhaps a better understanding
of the current drama playing out in the
East, I will offer some thoughts
concerning the relative prospects for
structural transformation in Eastern
Europe, including how past financial
policies of these countries have shaped
their current situations. In addition, I
wish to examine briefly the levels of
East European dependency on Soviet energy
supplies and how the attendant risk for
Eastern Europe could be translated into
both an earnings and political windfall
for Moscow. The Soviet Union’s
creditworthiness will also be discussed,
as will Mr. Gorbachev’s efforts to
diversify and strengthen the USSR’s
critical access to Western credit
markets. Finally, some recommendations
will be offered concerning U.S. and
Alliance policies which could bolster
prospects for economic revitalization in
Eastern Europe, help the Soviet Union
transform itself, and improve the overall
investment climate of the region.

At this time, the East European
countries showing the best prognosis for
systemic transformation and profitable
Western investment — or what could be
termed “fast adjusters” — are
Czechoslovakia, Hungary, the fast-fading
German Democratic Republic and, to a
lesser extent, Poland. Those countries
with considerably more uncertain futures,
or “slow adjusters,” include
Romania and Bulgaria. Although I plan to
discuss Soviet economic prospects in some
detail later, I would place the USSR in
this second category.

Czechoslovakia has emerged as the
pacesetter for regional economic and
political reform movements, with its
public commitment to: a market economy;
the quick removal of all Soviet forces;
ceasing cooperation with Moscow in the
areas of foreign espionage and technology
theft; banning the export of Semtex
plastic explosives used by terrorists;
and, challenging COMECON’s debilitating
nonmarket trading arrangements. Hungary
is in close competition with
Czechoslovakia in several of these areas.
The GDR has been placed on a unique
“fast track” by almost certain
large-scale infusions of capital and
investment resources by the Federal
Republic of Germany and Deutsche mark
monetary union. Poland has shown great
courage in its “cold turkey”
shift to more market conditions, but the
country’s massive debt overhang and other
infrastructure bottlenecks are likely to
bobble any near-term turnaround.

Czechoslovakia was also the first East
European country whose leadership has
expressed a willingness to help reduce
Western security costs by discontinuing
damaging intelligence-related
collaboration with Moscow — an action
which adds to the justification for
Western assistance and will hopefully
serve as a precedent for other East
European recipients of bilateral and
multilateral aid flows. To their credit,
Hungary and Poland have begun negotiating
with the United States concerning means
to protect against the diversion of
militarily-relevant Western technology
either to the Soviet Union or
unauthorized users within those countries
in exchange for relaxed export controls.

East-West Finance

From my earlier days as an East-West
banker, I have found that an assessment
of a country’s creditworthiness can be
instructive in highlighting commercial
and political risks for both US business
interests and taxpayers. Accordingly,
when asked to provide a one or two
sentence summary of East European
prospects — clearly an impossible task,
but not uncommon to the
“sound-bite” world of
Washington — I sometimes describe Poland
as “40-40” — $40 billion of
debt for 40 million people; Hungary with
$20 billion of debt for 10 million
people; and Czechoslovakia with $7
billion of debt for 16 million people.
The large shares of total hard currency
income absorbed by debt service
requirements for Poland and Hungary may
leave a good deal less for Western profit
repatriation than in the case of
Czechoslovakia. There are, of course,
many other considerations involved in
such an assessment that can change the
“bottom-line” conclusions
regarding the chances for economic
revitalization in these countries such as
the levels of debt relief, systemic
reform, market access, Western credits
and investment, and integration into
international trade and financial
institutions. Money and energy, however,
are not bad places to begin.

The borrowing patterns of East
European countries during the 1970s have
substantially influenced the country by
country balance sheets we see today. As
Dr. Lawrence Brainard, chief
international economist for Bankers Trust
Company, recently stated “After all,
the $190 billion in existing [East bloc]
debts failed to bring adequate
improvements in economic performance and
living standards, despite the borrowers’
past good intentions. Why should we
expect that an additional $10-20 billion
in new money will bring radically
different results?” href=”#N_1_”>⁽¹⁾

To illustrate this point, Poland,
Hungary, Romania, and Bulgaria routinely
went to Western credit markets in the
1970s for large general-purpose —
so-called “balance of payments”
— syndicated loans. This same pattern of
undisciplined sovereign borrowing was
going on in Latin America and elsewhere
during the heady years of merchant
banking and petro-dollar recycling. The
central banking authorities of these
countries were, for the most part,
looking for “quick fixes” to
balance the books, satisfy consumers, or
initiate large government-sponsored
projects. The concept of selfliquidating
credits — taking loans for projects or
trade transactions that would either
directly or indirectly generate a new
hard currency cash flow to eventually
repay the loans — was rarely employed.
Eastern Europe’s problems were
exacerbated by inefficient
centrally-controlled economies that left
huge white elephants — politely known as
“national projects” —
littering the countryside.

The collapse of commodity prices,
disinflation, and capital flight combined
with imprudent untied Western lending to
financially electrocute Poland and
Romania in 1981-82. Hungary was left
lurching from one refinancing to another
trying to stave off a formal debt
rescheduling — a situation which
Budapest still faces today.
Czechoslovakia, on the other hand,
maintained a sparse presence in the
credit markets. Although it also borrowed
in the form of “balance of
payments” syndicates, it did not
abandon its traditional financial
conservatism. In addition to securing
some of the finest loan pricing in the
Eastern market, it kept Prague out of
harm’s way when the recycling boom
disintegrated.

East Germany was regarded by many
Western commercial banks as occupying the
middle-ground between the large-scale
borrowing of Poland, Hungary, Romania and
Bulgaria and the more disciplined Czech
approach. The GDR did a great deal of
grain import financing and typically two
medium-term syndicates of $300-$400
million annually. The FRG was always
looked to by Western banks for hidden
credit support as between $2-5 billion
annually was moving through the still
secret inter-German financial corridor.
Among the revelations of the post-Berlin
Wall period has been the troubling news
that the GDR is, in reality, worse off
from a financial perspective than most
Western banks realized.

Energy Politics and Risk

Today, one of the most strategically
significant — yet least understood —
risks to East European economic recovery
emanates from the inordinate reliance of
these countries on Soviet energy
supplies. In short, with the exception of
Romania, the region is almost completely
dependent on oil deliveries from the
Soviet Union. For example, Soviet oil
deliveries represent the following
estimated percentages of total oil
consumption in these countries: Bulgaria
88%, Czechoslovakia 99%; East Germany
123%⁽²⁾;
Hungary 99%, Poland 93%; and Romania 28%.

Overall, Eastern Europe consumes about
1.9-2.0 million barrels of oil per day
(b/d), produces about 315 thousand b/d
and exports roughly 400 thousand b/d. It
also imports small amounts of oil from
countries other than the Soviet Union.
The total daily volume of Soviet oil
deliveries to Eastern Europe for 1988 —
the last year for which complete data are
available — was in excess of 1.5 million
b/d.

Given the recent decline in Soviet oil
production and Moscow’s willingness to
exercise political leverage through
energy deliveries, Eastern Europe could
face debilitating supply shortfalls in
the period ahead either for reasons of
production and transportation bottlenecks
within the USSR or the deliberate
withholding of committed deliveries. The
Baltic states have already had a strong
hint concerning the latter possibility
when Soviet Foreign Ministry spokesman
Gennadi Gerasimov responded to a question
on NBC’s “Meet the Press” on
December 31, 1989 regarding how the
Soviet Union could make the Baltics
remain part of the USSR. He replied,
“By persuasion and by proving that
it’s better to stay in the Soviet Union
— the union, the new federation — than
to go it alone …. [The Baltics] cannot
really be on their own in economic terms.
If you take figures, you can see that
these Baltic republics are getting our
oil at very cheap prices, which they
cannot get from the West, if they go it
independently.”

On the nonpolitical front,
Czechoslovakia has already been informed
that Moscow would be able to deliver only
18 percent of this year’s total
contracted amount of crude oil in the
first three months of 1990 due to
“the political situation in the
Soviet Union.” href=”#N_3_”>⁽³⁾
Another illustration is a one-third
reduction in the operations of the large
Polish refinery in Plock due to
interrupted Soviet oil deliveries.

Moscow’s Hard Currency Windfall

What is likely to be a major emerging
risk for East European economic recovery
could serve as a hard currency windfall
for the Soviet Union. Consistent with the
discussions at the recent COMECON
meetings in Sophia, payment for Soviet
energy deliveries to Eastern Europe are
being shifted away from barter or
clearing arrangements — such as oil in
exchange for manufactured goods — to
straight hard currency compensation. This
“energy payments” conversion
will significantly increase Soviet hard
currency income without the need for any
expansion of Moscow’s energy exports or,
for that matter, the sale of any other
Soviet commodities in the West.

Applying the world average oil price
for 1989 of $17.38 per barrel to the
USSR’s total oil export volume to Eastern
Europe of about 565 million barrels
(estimated volume in 1988) would yield
Moscow about $9.8 billion annually. Total
Soviet gas exports to Eastern Europe of
about 37 billion cubic meters (the
estimated volume in 1987) would have a
market value of roughly $4.8 billion
annually when applying the average 1990
price of about $3.50 per million BTU.
Clearly, these potential Soviet earnings
(outlined in the chart below), which
total an estimated $14.6 billion
annually, would not be fully achievable
for perhaps a few years as most East
European countries simply do not possess
adequate hard currency resources to make
such payments. In the event that these
energy hard currency revenues are
obtained by Moscow, they would represent
roughly 40 percent of current Soviet hard
currency income.

Estimated
Market Value of
Soviet Oil and Gas Supplies to Eastern
Europe
($US Billions)

* Based on 1989 oil export data
valued at $17.38 per barrel.

** Based on 1987 gas export data
valued at $3.50 per mm BTU.

Source: Center for Security Policy,
Washington, D.C., 1990.

The GDR, however, may well be
requested to compensate the Kremlin in
Deutsche marks for all Soviet oil and gas
deliveries, valued at about $3.4 billion
annually, effective immediately after the
monetary union with the Federal Republic.
Bonn would probably view such a Soviet
demand as a modest price to pay for
greater Kremlin flexibility toward the
ultimate terms of German reunification.
If the West is going to look the other
way concerning subtle payment schemes
associated with German reunification,
then the process should at least be made
fully transparent to all interested
parties, including the Poles.

The most likely scenario is,
therefore, the “phasing in” of
most East European hard currency energy
payments to Moscow which would rise as
Western capital flows into these
economies. Through this mechanism, the
USSR could become a major — if
unintended — beneficiary of Western
efforts to assist economic revitalization
in Eastern Europe. Put another way,
billions of dollars annually in Western
assistance resources to Eastern Europe
could well exit “out the back
door” into Moscow’s coffers in the
form of energy and other trade and
service payments.

Deteriorating Soviet
Creditworthiness

Despite the prospect of windfall hard
currency gains siphoned off from the new
Eastern Europe, there are a number of
observations which emerge from an
assessment of Soviet creditworthiness
that are far from encouraging. Among
these are the following:

• Economic perestroika, at least as
  currently configured, is dead in
  the water with little prospect
  for revival. This view is shared
  by observers as diverse as
  leading Soviet economists and
  NATO.
• The new Soviet Five Year economic
  plan is symptomatic of the causes
  of perestroika’s decline as it
  represents a continuation of
  bankrupt central planning and
  further postpones genuine
  systemic reform such as
  decontrolling prices, privatizing
  industry, permitting widespread
  private ownership, and
  implementing full data
  disclosure.
• Other major contributors to the
  demise of what may be termed
  “perestroika I” were
  the estimated 3 percent real
  increases in Soviet defense
  spending in each of the first
  four years of Gorbachev’s
  government and the precipitous
  drop in tax revenues caused by
  his anti-alcohol campaign.
• The fledgling Soviet private
  sector — exemplified by the
  cooperatives — is being
  increasingly vilified in the
  media and Congress of Peoples’
  Deputies as engaged in
  “price gouging and
  profiteering.” Inordinately
  high taxes, price controls, and
  other newly imposed restrictions
  are undermining entrepreneurial
  incentives for this otherwise
  productive sector.
• Soviet oil production, the most
  strategic sector of the civilian
  economy, is declining which bodes
  ill for meeting the rigid
  requirements of the domestic
  economy, Eastern Europe, and the
  crucial hard currency export
  market. Production dropped in
  1989 from 12.6 million barrels
  per day at the beginning of the
  year to 12.1 million barrels by
  year-end. It will be very
  difficult for the domestic
  economy alone to absorb even a
  six percent supply shortfall.
• Moscow’s total annual hard
  currency income remains only
  about $37 billion or roughly
  one-third of the yearly sales of
  General Motors Corporation.
  Between 80-90% of Soviet annual
  hard currency earnings stem from
  just four export items — oil,
  gas, arms, and gold —
  commodities which face
  substantial price and market
  volatility.
• Virtually all of Moscow’s hard
  currency income is used just to
  purchase imports from the West
  and to service debt. This means
  that the majority of the hard
  currency requirements to meet
  Soviet global commitments (e.g.,
  client-state support, financing
  of arms sales, espionage,
  technology theft, disinformation,
  etc.) have had to be financed
  through Western borrowing and
  possibly the sale of portions of
  Soviet strategic gold reserves.
• According to a recent defector
  from Moscow’s economic hierarchy,
  Soviet leadership has been
  spending a portion of its
  strategic gold reserves annually
  since 1986 in the expectation of
  a turnaround in perestroika’s
  fortunes which has yet to
  materialize. If true, this could
  mean that rather than possessing
  strategic gold reserves
  traditionally estimated to be in
  the range of $25-32 billion,
  remaining Soviet reserves could
  be as low as $17-24 billion
  (assuming about $2 billion in
  annual depletions).
• The Soviet hard currency loan
  portfolio to Third World
  countries, often viewed as an
  important “asset” by
  Western creditors, is estimated
  to be somewhere in the range of
  $50-$60 billion. As the majority
  of these loans were in support of
  arms sales to impoverished
  client-states like Nicaragua,
  Vietnam, Ethiopia, and Syria, the
  real value of this portfolio may
  be only in the range of 10-30
  cents on the dollar or less
  depending on the country.
• Moscow has been borrowing rather
  heavily since the fourth quarter
  of 1988. In 1989, the Soviet
  Union engaged in gross borrowing
  in the West totaling about $9
  billion and continues to borrow
  at a similar pace this year.
  Total Soviet gross indebtedness
  is now about $50 billion, more
  than double the amount in 1984.
  The USSR’s debt service ratio has
  similarly doubled in this period
  to about 28 percent.
• The roughly $14 billion which the
  USSR maintains on deposit in
  Western banks is primarily
  overnight, short-term money which
  could disappear quickly in times
  of acute need. Gaps in Western
  statistical reporting also
  prevent the ability to determine
  how much of these Soviet deposits
  are, in fact, Western bank
  deposits which have been cycled
  unseen through Moscow.
• The promises made by Soviet
  leadership to striking coal
  miners last summer have not been
  kept. This has caused serious
  resentment in the labor force
  which could easily result in new
  strikes by miners and possibly
  transport workers. Any
  large-scale labor unrest in these
  crucial sectors could create a
  dire economic emergency.
• Finally, the political landscape
  within the USSR is highly
  volatile, fueled by increasing
  labor unrest, ethnic strife,
  consumer shortages, huge pent-up
  inflation, and division within
  the leadership. The political
  tensions currently afflicting
  Azerbaijan, Tadjikistan, Georgia,
  Moldavia, Mongolia, the Baltics,
  and other republics need not be
  explained here.

In sum, Soviet creditworthiness is in
the process of significant deterioration
as evidenced by gradually rising interest
rates on Western credits to the USSR.
This is not to imply that the Soviet
Union no longer enjoys substantial access
to foreign credit markets. Indeed, given
the current dearth of creditworthy
sovereign borrowers elsewhere in the
world due to the ravages of the
international debt crisis, Western banks
and securities firms continue to offer
Moscow more borrowing opportunities than
the USSR needs. Nevertheless, should
Soviet indebtedness continue to rise at
the present rate and hard currency
earnings remain depressed, the need for
either formal or informal debt
rescheduling arrangements could
materialize when the gross debt level
reaches $60-$70 billion, possibly within
two to three years. The highly uncertain
domestic political environment,
particularly the prospect of debilitating
strikes by the work force, could
accelerate the downside risk for Western
private and official creditors
significantly.

Securing a Financial Safety Net

As Moscow cannot count on adequate new
hard currency flows from Eastern Europe,
higher world oil prices, or other
potential sources, it is vigorously
constructing a financial safety net which
has two principal components: expanded
Western government guarantees and the
large-scale issuance of Soviet
securities, such as bonds and notes. With
regard to both of these financial
strategies toward the West, the policies
of the United States will send crucial
political signals to other Alliance
partners, notably the
“deep-pockets” of Japan.

By the end of June, it is likely that
the Administration win have decided to
restore Soviet access to U.S.
Export-Import Bank (Eximbank) credits and
loan guarantees through a waiver of the
Jackson-Vanik amendment. It is also
likely to permit Soviet bond offerings in
the United States by helping remove the
Soviet Union from the restrictive
provisions of the Johnson Debt Default
Act of 1934. This latter hurdle would be
cleared by means of Moscow settling, for
a few cents on the dollar, defaulted
czarist and other debt obligations (eg.,
Lend Lease) to the United States
estimated to be in excess of $1.5
billion.

In testimony before the House Ways and
Means Committee on January 30th, I
outlined five considerations which the
Administration and the Congress should
take into account prior to restoring
Soviet access to Eximbank programs. One
of the principal points raised before the
Committee was the fact that Eximbank
direct loans and credit guarantees
represent subsidies because the U.S.
government is either taking on all the
credit risk up-front (i.e., direct loans)
or on a contingency basis (i.e.,
guarantees) in the event of Soviet
inability at some future time to meet its
obligations to private U.S. lending
institutions. Commercial banks that are
covered by U.S. government credit
guarantees would price their loans to the
USSR on the basis of U.S. government
risk, not on an assessment of Soviet
risk. Not surprisingly, this practice
artificially lowers the interest rates on
loans to Moscow below normal market
terms, and expands the amounts banks are
willing to lend. Senator Bill Bradley and
others have opposed the prospect of
offering such guarantees, in the belief
that U.S. companies and banks should not
transfer private credit risk onto the
shoulders of American taxpayers.

Although the bilateral negotiations
underway at the State Department to
permit Soviet entry into the U.S.
securities market appear harmless, such a
development would have major strategic
implications for the 1990s and beyond.
Achieving Moscow’s goal of developing an
expansive presence in the international
securities markets would broaden the
sources of Soviet borrowing in the West
from only Western governments and banks
to include securities firms, pension
funds, insurance companies, leasing
firms, and even individuals. Over time,
hundreds and perhaps thousands of Western
nonbanking institutions (like securities
firms and pension funds), and millions of
Western citizens could be either
knowingly or unknowingly holding Soviet
paper in their bond portfolios and
pension funds.

Moscow is very mindful of the enormous
political advantage of recruiting
powerful new constituencies throughout
Western societies which would have a
financial vested interest in supporting
continued economic and, inevitably,
political concessions to the USSR. Such
support could easily take the form of
lobbying efforts to expand Western
government loans, guarantees, and
energy-related assistance to Moscow
should the Soviet Union have its access
to private credit markets curtailed by
its deepening economic and political
crises.

Other factors which argue for NATO and
Japanese government discouragement of
Western bank and nonbank underwriting of
Soviet bond and note offerings are as
follows:

1. This form of Soviet borrowing is
   generally untied to any specific
   trade transactions or projects,
   hence loan proceeds can be used
   by Moscow to finance any purposes
   it deems appropriate, including
   activities inimical to Western
   security interests. href=”#N_4_”>⁽⁴⁾
2. The extension of credits by
   nonbanking institutions to the
   Soviet Union are not recorded in
   any Western statistics as adding
   to the total indebtedness of the
   USSR and thus constitute hidden
   Soviet borrowing.
3. Soviet entry into the securities
   markets represents a fundamental
   penetration of Western societies
   for the first time without an
   ability to determine those
   institutions and individuals
   holding Soviet paper and what
   amounts are involved.

At this writing, the Soviets have
successfully concluded at least seven
bond offerings in the West since market
entry in January 1988, valued at between
$1.3-1.6 billion (4-5 West German-led
deals, 1 Dutch, 1 Austrian and 1
Italian). U.S. banks and securities firms
are already involved in this new line of
commercially unsound sovereign lending.

Conclusion

In sum, I support the prudent
expansion of U.S. economic and financial
relations with USSR and particularly with
Eastern Europe. The over-arching task of
the Administration, the Congress, and
indeed the Western Alliance, is to
determine how best to use economic
resources to advance the movements toward
true democracy and free markets in these
countries. For example, large-scale
infusions of Western capital and
technology into the USSR have served to
retard, not catalyze, genuine systemic
reform. Accordingly, a more cautious and
disciplined approach to the channeling of
Western assistance resources to certain
countries of the region is essential to
maintaining the kind of
“constructive pressure” which
is working in favor of those seeking the
fundamental, structural transformation of
these societies. In short, greater
Western discipline, transparency, and
conditionality will ultimately do more to
“help” Mr. Gorbachev initiate a
far more radical and productive
“perestroika II,” than simply
rewarding continued economic
mismanagement.

On the energy front, the newly elected
governments of Eastern Europe should
immediately adopt a program to diversify
energy supply sources. The Soviet shares
of total oil and gas consumption
respectively should be limited to about
30%, mirroring the intent of the
International Energy Agency Agreement of
May 1983 pertaining to West European
dependency on Soviet gas supplies. Arab
states could be approached by East
European governments with the proposal
that they receive below-market oil and
perhaps gas deliveries for a period of
time in exchange for those
producer-countries gaining new energy
markets and the prospect of receiving
full market prim as soon as economic
revival permits such a step.

During the vulnerable period of supply
diversification, potential energy supply
short-falls could be covered through the
creation of an alliance-wide Contingency
Energy Fund for the countries of Eastern
Europe and the Baltic states. Middle East
producers could help lead this important
Western assistance effort and absorb some
of the costs which may be levied should
Soviet supply shortfalls occur for either
economic or political reasons. In
addition, the USSR should be obligated to
make purchases from Eastern Europe in
hard currency commensurate with its
demand for hard currency payments for
energy deliveries.

Finally, it is important that Western
governments be aware of Moscow’s strong
temptation, if not intention, to tap into
Western financial flows dedicated to
Eastern Europe, such as those of the
proposed European Reconstruction and
Development Bank. These limited funds are
desperately needed by the fledgling
governments of the region and should not
be supporting Moscow’s economic
half-steps. Hopefully, the Kremlin will
conclude that rapid East European
development is in its interest as well as
ours, and will implement the bolder
structural measures required to
jump-start the Soviet economy.

1. “Finance
and Debt in East-West Relations: Policy
Challenges in an Era of Change,”
prepared by Dr. Lawrence Brainard,
Bankers Trust Company for a joint
workshop on East-West Economic Relations
of the MIT-Japan Program and the
U.S.-Japan Economic Agenda.

2. The East German
statistical dependence on Soviet oil
exceeds 100% because East Germany imports
more Soviet oil than it consumes and
re-exports the surplus.

3. “Reduced
Soviet Oil Deliveries to
Czechoslovakia,” Radio Free
Europe/Radio Liberty Daily Report, 16
February 1990.

4. For more
information on this point and related
subjects, it is strongly recommended that
the video tape and/or transcript be
obtained of a one-hour special entitled
“Follow the Money” produced by
the Blackwell Corporation, Washington,
D.C. which was aired by the Public
Broadcasting System nationwide on July
12, 1989.