'CRUDE' Assumptions about an 'ENERGY' Shock

20 Feb, 2003

Trudging through war psychosis, hysteria and hype, it becomes a well nigh impossible task, even for the learned newspersons, to sift fact from fiction i.e. the proverbial wheat from chaff. It is equally an arduous accomplishment for erudite economists, given that these days, they are inundated with information galore, thanks to the Internet and electronic mail and deluged with so much detail in terms of commentaries, news, views and rumour and innuendoes.

The more recent matter exercising every strategic economist's mind, is the state of the world economy. The tumultuous falls in the global securities / stock markets, the sharp rise in the prices of oil and gold, the volatility in the values of the Euro, Jap. Yen and the US Dollar i.e. a whole host of fundamental issues are causing concern, The deteriorating health of some leading emerging markets on the one hand and the worsening unemployment / stagnation in the mature markets (Germany, in particular but across the OECD) on the other, are further exasperating the economist. It would therefore, take a brave columnist, in the circumstances, to stick his neck out to make forecasts but some forecast is better than none and the 'energy' / oil price induced market sentiment lends itself readily to some 'crude' assumptions.

The speculation over energy prices is heating (!) upto a frenzy or tizzy as it were. Some estimate, in an exaggerated manner, that the oil price will start shooting upto US$ 40 plus; if and when the shooting war starts in the Northern Gulf.

Hyperbole and humour apart, such levels of oil prices if sustained, will savage world economic growth well into the negative territory. This is estimated @ 0.5% GDP drop for every US$ 10 rise. There are others who talk about the war-induced flight to quality / safety of capital flows. The Swiss banks and the U.S. Dollar are regarded as the traditional and last refuge of the proverbial wealthy and war-weary.

Mercifully, the global markets have already factored the fear of disruption and spurt in prices. There is a hope that the strategic petroleum reserve in the U.S. may be released by way of upto 4 mbd (million barrels a day) for 110 days. Besides, the harsh, gas-guzzling winter weeks could be behind us by mid-March; the start date for a conflict. OPEC countries may also disregard quotas (as reported) and pump more oil to keep oil prices stable. The 'soft' state of the global economy at present, may not pick up momentum. Switch to abundant coal and natural gas supplies could cap 'crude' consumption. Thus, there are multiple factors / scenarios that could diminish the doomsday syndrome.

The other circulating myth is that the economies reel only from the Iraqi war threat. The deeper malaise may well include North Korea, which, quite apart from being a self-confessed nuclear state, has always been lurking, behind the scenes, in clandestine arms and transfers of missile technology.

Fortunately, right now, both Britain and Blair appear to be backing off from the brink; towards needing a second U.N. resolution to authorise war. After a huge public demonstration, there is palpable dissension among the Labour ranks.

The U.S. is therefore, almost isolated, even as it tries to portray the measures in a new light; i.e. as protective of America's vital national interests. The previous slogan of destroying weapons of mass destruction (WMD) is still there but sounds less credible when WMD is ubiquitous and heavily entrenched in the hands of the Security Council members themselves . The pots cannot call the kettle back.

A more acceptable approach suggested first by some Arab states is to attempt a regime change in Iraq. While this may be anathema to the die-hard (!) democrats, it could be justified if a war crimes tribunal investigated the 1991 invasion and destruction of properties and people in Kuwait during and before the Desert Storm.

Ultimately, any new military action will cause untold suffering to be inflicted on the Iraqis directly. The people of the rest of the world, will end up paying the price for this in one form or another.

The costs are estimated at US$ 40 billion although the U.S. is playing this down; just as it is arm twisting African, Asian & Latin American Security Council members with carrot & stick! Already Turkey has been promised a largesse (a sum of US$ 20 billion in grants and US$ 4 billion in cash) for providing access to U.S. military / air bases. The consequential costs of a conflict will indeed be staggering. With a massive U.S. budget deficit, such an expenditure will end up being recharged by the U.S. to pliant and pliable states around the world. The war costs will also, through the oil price / tax mechanisms, get transferred to other countries eventually. This will put a further burden on the fragile global economy. If there were to be a smooth regime change in Iraq and its territorial integrity is preserved to prevent balkanisation, then a huge collective sigh of relief will propel market sentiment and restore economic stability. A Marshall-type reconstruction effort in Iraq that follows in, will help global manufacturing and trading interests.

However, a reconstruction in Iraq will cost a huge amount of money. The U.S. plans to 'back private banks' to lend this pile but such guarantees are non-funded obligations that need to be considered in fiscal assessments about the U.S. Greenspan has already sounded a note of caution on the escalating U.S. budget deficit last week and will not be enthused if there are further unfunded commitments on top of this yawing fiscal gap. All these may steepen the yield curve into higher borrowing costs.

The U.S. will, no doubt, try to shift the costs of the war and the reconstruction to other countries. Japan and Germany may not oblige this time. Germany is already in a dire state and along with France, has spoken against rushing into a war. Japan's economy is also in a bad shape but it is notoriously susceptible to U.S. pressures. This leaves out only a few prosperous countries that can afford to foot the estimated staggering bill of US$ 250 billion (including the collateral and consequential costs of a conflict). It would be a travesty if these costs were to be passed on to the wealthy regional states who may have been consulted but only briefly, in the run up to the conflict. Unilateralism in the U.S. position prior to a conflict is already splintering the global alliance. Subsequently, multilateralism for footing the bill, will prove to be difficult to cobble together.

When all is said and done, the economic consequence of military actions will take a heavy toll on the global economy's slowing down GDP growth for years to come. Hopefully, the current charade in the public eye is only brinkmanship and not a war in the making; and the pressures will lead to a regime change. There is much scepticism on this score, given that gold diggers and grave-diggers are at work in different parts of the world. Even if one wishes to end on a positive note, this is a sad tale and a grim foreboding, for the world economy. The energy shock, given that oil demand is price inelastic, may be the least of the problem in such a context, as the destruction of tangible natural and financial resources will be the real cruncher.

(The author (sureshk@emiratesbank.ae) is a General Manager in Emirates Bank Group. The views expressed in this article are not necessarily shared by the Bank.)

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