Sunday, 10 January 2016

Can Iran and Saudi Arabia afford their cold war?

The fall in oil prices is raising the share of military spending in the two economies above historical norms.


There is a theory which states that the fall of oil prices ended the Iran-Iraq war in 1988. Given their reliance on oil revenue, the collapse in prices meant that neither country could afford to continue financing the war (which was reaching a stalemate anyway).


Last week saw a heating up of the cold war between Iran and Saudi Arabia. The events were triggered by the execution of a Saudi cleric, Nimr al-Nimr. Things then escalated quickly: the Saudi embassy in Tehran was ransacked; Saudi Arabia cut diplomatic ties with Iran; and Iran accused the Saudi-led coalition of bombing its embassy in Sanaa.

Last week also saw a further collapse in oil prices. They are now trading at around $33 per barrel. Only 18 months ago, oil prices were above $100, but the days of triple-digit oil prices seem well behind us.

Can Iran and Saudi Arabia financially afford the escalation of their cold war in this environment?


Iran and Saudi Arabia have different appetite for military spending. Saudi Arabia spent an average of 9.6% of GDP (a measure of the size of the economy) on defence and security each year between 1992 and 2012. This was one of the highest shares in the world. Iran, meanwhile, spent an average of 2.7% of GDP on its military over the same period.

In both countries, the share of military spending in the economy has been rising in recent years. The World Bank estimates that military spending accounted for 10.8% of GDP in Saudi Arabia in 2014. US sources estimate Iran’s military spending at around $15bn in 2014, or 3.6% of GDP.

This was before the great collapse in oil prices.


The ongoing fall in oil prices mean that the Iranian and Saudi economies are shrinking in nominal terms. Saudi Arabia is more affected by this given the greater importance of the oil sector in its economy (40% share to Iran’s 20%). If oil prices stay at $33 per barrel, my own estimates suggest that the Saudi economy will be smaller by 21% in 2016 compared to 2014, while the Iranian economy will be smaller by 6%.

 [These calculations take into account the impact of the new Saudi budget and assume that Iran will increase its oil exports following the expected lifting of the sanctions early this year].


Even if military spending (in US dollars) was maintained at 2014 levels (before the war in Yemen), its share in the shrinking Iranian and Saudi economies would rise. In the case of Iran, the share would increase to 3.8% of GDP. In Saudi Arabia, it would reach 13.7%. For both countries, the numbers are higher than their respective average and are near the high points of the historical range (which included outright wars with Iraq in the 1980s and early 1990s. See chart).

Will the decline in oil prices force Iran and Saudi Arabia to reconcile in order to reduce their military spending back to historical norms? Or will the two countries discover a new appetite for allocating a higher share of their resources to the conflict? We can only wait and observe. 

Sunday, 3 January 2016

Why are markets negative about the Saudi budget?

Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.

The announcement of the Saudi budget on 28 December created a contradiction. On the one hand, the announced budget deficits, while large, were much smaller than expected. The Saudis’ preliminary estimates suggest a deficit of 367bn riyal in 2015, lower than the International Monetary Fund’s (IMF) forecast of 511bn riyal. Similarly, the Saudi budget points to a deficit of “only” 326bn riyal in 2016, compared with the IMF’s expectation of 468bn. On the other hand, the market reaction to the smaller deficit numbers was negative. The Saudi stock market fell sharply after the announcement. Why is there such a contrast between the positive deficit data and the negative market reaction? I believe two reasons are behind this.

First, markets fear that the large spending cuts will lead to slower growth in 2016. The budget slashes spending by 13.8% between 2015 and 2016. This is much larger than the IMF’s expectations of cuts around 5.7%. We can adjust the IMF’s forecast for Saudi growth in 2016 by taking into account the new, smaller spending figures. The result is growth of 1.4% in 2016 instead of 2.2% previously forecast—a significant deceleration from the 3.4% growth recorded in 2015.

Second, markets interpreted the news about subsidy cuts, which accompanied the budget, rather negatively. Saudi Arabia removed some of the subsidies on water, fuel and electricity, leading to significant price increases almost overnight. There is no question that the subsidy system is inefficient and wasteful. But markets might have interpreted the measures as an act of desperation in response to low oil prices. In addition, these measures are likely to lead to even lower growth, as the resulting price inflation will leave the population with less income to spend on other items.

Are markets concerns overstated? Concerns about the ability of Saudi Arabia to run large deficits or maintain the value of the currency are exaggerated: Saudi Arabia still possesses very large reserves at its disposal. But markets concerns about the impact of spending cuts on growth are legitimate. Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.