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. 

1 comment:

  1. What is interesting is that despite near record tensions between the two, the oil price doesn't seem to include much if any political risk premium. If we'd had the same scenario we see today back in 2013, say, then I'd have expected oil to rise by $10-20. On military spending, it would be helpful if data was available (which it isn't) on the split between purchase of military hardware (mainly imports) and recurrent expenditure. Saudi has armed up substantially in recent years, and so may be able to cut its military expenditure without significantly reducing its war-making capacity. Iran, by contrasts, manufacturers more of its own military equipment, which may be a reason why its spending is lower relative to GDP. Also, undoubtably much military-related expenditure is off budget and may not be reflected well in the World Bank's data series.