The cost of war and the peace dividend

Middle East governments have pulled no punches in condemning US plans to attack Iraq. Across the region, heads of state have taken every opportunity to publicly attack President George Bush for even considering a move on Baghdad.

On the surface, their pleas seem well founded. No country wants a war on its doorstep - military conflicts have a nasty habit of spilling over. However, closer scrutiny suggests that some Middle East countries, particularly in the Gulf, have plenty to gain if it goes ahead.

In the short term, oil prices will shoot up, leading to windfall revenues for the likes of Saudi Arabia, Kuwait and the UAE. In the medium term, the economic rebuilding of Iraq will throw up lucrative commercial opportunities for its neighbors. And in the long term, a stable regime in Iraq will bring greater stability to the entire Gulf region, invigorating foreign investment.

"I don't think war in Iraq would do much damage to the regional economy," says Gill James, Standard Chartered bank's Middle East economist. "We have looked at this and while there would be some short-term shocks, I don't foresee major problems."

Of course, debates on the post-war prospects for the regional economy assume that conflict is a foregone conclusion. By and large, they also assume that it will be short and decisive - an assumption that is wide open to question. However, the international consensus points towards a US assault in the first half of this year, with the fighting over by summer.

"We are saying that it is highly likely," says Neil Partrick, Middle East economist and defense specialist with the Economist Intelligence Unit (EIU) based in London. "We put the probability of war at 70 percent." The EIU forecasts an attack within the first four months of 2003, and for it to be a short-lived campaign. "It is likely that it will be more a matter of weeks and months - three months at a maximum - although putting hard times on it is difficult."

Given this baseline scenario, what will be the economic implications for the Middle East when war breaks out and, perhaps more importantly, in years to follow? On the whole, largely favorable. Clearly, a war in Iraq will carry some costs for its neighbors. But these are likely to be outweighed by significant benefits in the short, medium and long term.
The short-term implications are dominated by oil markets.

"Clearly, there will be some oil price volatility," says Standard Chartered's James. The most likely outcome is that Iraqi exports will dry up for at least two months in the event of an attack. When this happens, Saudi Arabia, Kuwait and the UAE will step in to make up the shortfall. (Their combined spare capacity is estimated at around 5 million barrels per day (b/pd) at present, so they will easily cover Iraq's current production, which fluctuates around 2.3 million b/pd).At the same time, prices will spike, at least in the short term, leading to revenue windfalls for the region's major oil producers.

On the flip side, tourism will be the main short-term casualty. Vacationers are notoriously fickle creatures, and the Middle East's beaches are likely to empty as soon as the first shots are fired. Egypt and Dubai will be hit hardest. Tourism forms the backbone of their economies, and the wider business communities will feel the pinch as tourism revenues dry up.

Egypt will suffer the most from the drop in revenues as its economy is already in a fragile state. Tourism is one of the main sources of US dollars in Egypt, and a sharp downturn in the hospitality sector will have serious implications for the strength of the Egyptian pound, public spending and economic reform.

The Gulf's shipping industry will also take a hit. The slightest hint of trouble in the Gulf sends insurance rates soaring for vessels entering the Strait of Hormuz, so Dubai's twin ports of Jebel Ali and Mina Rashid in particular will be affected. But their loss will be others' gain. Rival container ports on the region's eastern seaboard will look to mop up the business lost by their rivals in the Gulf. Salalah in Oman will be the main beneficiary, with Fujairah and Khor Fakkan in the UAE also likely to enjoy an upturn in traffic.

Crucially, though, these effects are likely to brief. "There will be short-term shocks [when war breaks out]," says James. "The tourism industry will be affected, and you will see some tailing off of foreign direct investment. But I don't think these will last too long." The experience of September 11th provides valuable, and encouraging, pointers. Regional tourism dried up in the immediate aftermath of the attacks, but within six months hotels were once again hanging out the "no vacancy" signs.

Even in neighboring Kuwait, the victim of Saddam's last act of international military aggression, analysts expect the impact to be limited. "The idea of Iraq invading Kuwait seems to me entirely irrational," says the EIU's Partrick. "I cannot see how Saddam would think that invading Kuwait would help." Indeed, it is questionable whether Iraq troops would obey orders to march across the border. More likely is an Iraqi missile attack on US bases in Kuwait.

But unless Saddam Husseins's Scuds are armed with biological warheads, the impact will be minimal. As such, the EIU - in common with the International Monetary Fund and other agencies - forecasts a strong economic recovery in Kuwait for 2003 and 2004, albeit with a slight dip in consumer spending and investment while the conflict rages.

For the Middle East region as a whole, the outlook is even more bullish over the medium term. Broadly speaking, this can be defined as covering the second half of 2003 (assuming that the current Iraq regime has been defeated by then) through to 2005.

Crucially, this phase will see the start of the rebuilding of post-Saddam Iraq - a process that should present some very rich opportunities for Iraq's Gulf Arab neighbors. "This is something I definitely expect to see," says Standard Chartered's James. "Particularly in somewhere like Dubai, which can emerge as a gateway to Iraq."

EIU economist Partrick agrees that the rebuilding of Iraq represents a golden commercial opportunity for the Gulf states. However, he warns that the process will not begin as soon as the guns fall silent. "We expect the conflicts to be over in a matter of weeks, but it could take some time to put in place a new regime. It will probably be towards the end of 2003, or early part of 2004, before we see a new regime emerge."

Even with a new regime in place, crucial issues must be resolved before rebuilding work begins in earnest. Specifically, the issues of UN weapons inspections, UN sanctions and Iraq's 1991 Gulf War reparation obligations: "It is certainly going to take time before the economic regeneration of Iraq gets going," says Partrick. "I don't think sanctions will come off as soon as Saddam is dead or out of his palaces. In a meaningful sense, the rebuilding of Iraq will begin to happen in 2004."

Once this happens, Gulf businesses can look forward to a mini-boom. On the macroeconomic level, Iraq's rebuilding will be financed from three areas: international aid, soft loans from Arab neighbors and oil revenues. On the ground in Iraq, this is certain to stimulate a construction boom - great news for Gulf-based contractors, suppliers and consultants.

Gulf banks will inevitably come out winners, as they will be asked to finance much of the development work. Further opportunities will emerge as Iraq's regeneration reaches maturity - for a start, the country's entire information technology and telecommunications infrastructure will need to be rebuilt.

Indeed, some of the Gulf states have been preparing for a post-Saddam Iraq for years. Dubai has a provisional agreement to manage Baghdad Airport once it reopens to international traffic, and the UAE has stepped up its diplomatic and trade relations with Iraq in recent years. Similarly, Bahraini merchants have established ties with their counterparts in Iraq through a regular, UN-approved ferry service between Manama and Umm Qasr.

And Kuwaiti traders have been awaiting the removal of Saddam Hussein for decades, hoping that a thriving, new Iraq will allow them to rebuild their status as a robust regional entrepôt.
Clearly, this is all good news for the Gulf. "The early stages of the rebuilding process are likely to be a win-win situation for the Gulf states," says one Bahrain-based banker. "On the one hand, demand for products and services from Iraq will surge. At the same time, regional stability should encourage the inflow of tourists and foreign investment."

In the long term, however, a serious downside begins to emerge: from 2005 onwards, Iraq should be able to ramp up its oil production. Iraq is home to the world's second largest oil reserves - second only to Saudi Arabia - but today it just scrapes into the top 10 of world producers, behind the likes of Russia, the United States, Britain and Iran. This situation will not survive into the post-sanctions era.

"Once sanctions come off, we will see spare parts for the oil industry coming through much more quickly," says Partrick. The EIU does not expect this to have a great deal of impact in the immediate post-war period. But by 2005 Iraqi production should have reached 4 million b/pd, and rising. Sharp increases in Iraqi output will play havoc with OPEC's already strained efforts to prop up prices by limiting supply.

Iraq is a member of OPEC, but since 1991 it has fallen outside the cartel's quota system, thanks to United Nations sanctions. Once those sanctions end and Iraq becomes OPEC's 11th active member it is likely to insist on an unlimited quota - a move that could shatter the group's recent cohesion. The upshot will be a sharp fall in oil prices, with all the associated negative consequences that brings to the Middle East.

Inevitably, there will be winners and losers from war in Iraq, with conflicting forces pulling the regional economy in opposite directions. But it is already clear that war is far from a nightmare scenario if, as forecast, the US-led operation is swift and decisive.

For two decades, Iraq has been a constant thorn in the side of the Gulf states - from the Iran-Iraq War that began in 1982, to the fear and uncertainty it is spreading today. With that "fear factor" missing, the region could look forward to a period of unprecedented prosperity.

It is unlikely that Middle East governments will ever thank George W. Bush for replacing Saddam Hussein. Indeed, the purely economic argument in favor of regime change ignores crucial political questions about the United States emerging as an armed, dangerous and arbitrary regional policeman. But the irony is that while local leaders will never admit it in public, they are likely to have much to be grateful for if the United States does usher in a new era in Baghdad.