IX. ECONOMIC IMPLICATIONS OF THE GULF WAR

In January 1990, the Saudi government announced its Five Year Development Plan for 1990-95. According to this plan, public expenditures were expected to amount to $201 billion, one-third of which would be military spending (plus an unspecified amount for foreign aid). The plan envisioned high average annual growth rates of value-added in production: agriculture, 7 percent; petrochemicals, 8 percent; oil refining, 5.4 percent; and other manufacturing, 5 percent. The targeted growth rate for GDP as a whole was 3.2 percent, including growth in non-oil GDP of 3.6 percent and in oil GDP of 2.7 percent. Industrial exports, including petrochemicals, were to rise by 50 percent over the five-year period. The planned expansion of the economy and a stronger drive toward "Saudization" would provide jobs for 575,000 Saudis over the plan period, of which 294,00 would be created by the expansion of the non-oil economy, and the remainder (281,000) by replacing foreigners with Saudi nationals' According to the deputy minister of planning, the overall goal of the development plan was "stable growth rates so that we don't have ups and downs that will greatly affect the private sector. The emphasis was on greatly increased investment by the private sector, especially in industry, in order to relieve some of the burden previously borne by the treasury. In fact, the plan implied continued heavy subsidization of key sectors, especially agriculture and manufacturing. Indeed, the planned growth rate of 3.6 percent for non-oil GDP as a whole was double what had been achieved in the previous five years, and could only be achieved through large-scale government spending.

The plan's growth rate of 2.7 percent for the oil sector implies that the Saudis had an expectation of a major expansion of oil output during the first half of the 1990s from its relatively low level of 5.5 mbd in 1989. In 1989, the oil minister had announced plans to restore production capacity to 10 mbd, where it had been two decades earlier.1 Unofficial estimates published in the spring of 1990 envisioned Saudi production capacity rising from the current 7.75 mbd to 10 mbd by 1995. The Saudi expansion plans were based on forecasts that both prices and demand for OPEC oil would rise significantly in the 1990s and beyond. The secretary-general of OPEC, quoting some of these forecasts, predicted that demand for OPEC oil would rise from 23 mbd in 1989 to 29 mbd by 1995, and oil prices would climb from $17 in 1989 to $30 a barrel. Saudi Arabia wanted to be in a position to capture a large share of the incremental demand for OPEC oil. These forecasts also prompted other oil producers, in the Middle East and elsewhere, to expand their productive capacity.

The significant rise in oil prices from $14.15 per barrel in 1988 to $17.19 in 1989 also had an impact on Saudi expectations of future prices and plans to raise productive capacity. At the time, many oil analysts predicted that these increases were only the beginning of an upward trend. What they failed to note, however, was that the price increases in 1989 were mainly a consequence of a confluence of exogenous factors that were not likely to be repeated. As the Financial Times noted:

1989 was a charmed year for OPEC. A dry winter shut down hydroelectric generators in Europe [increasing reliance on oil-powered generators]; nuclear plant problems in France and Japan boosted demand for fuel oil. Accidents in the North Sea reduced UK production by more than one-quarter. The Valdez accident shut off Alaskan production for a while. Soviet output declined; and then [there was] the coldest winter on record in North America.

Aside from the decline in Soviet output, these were all temporary factors not indicative of a new trend in oil prices. As should have been expected, after oil prices peaked in January 1990, they fell precipitously by about one-third by June, back to the low levels prevailing in 1987, about $14 a barrel.

Overall, the Saudi budget for 1990, presented in January, projected a deficit of $7 billion, approximating the actual deficit in 1989. However, the estimates of revenues were based on the expectation of continued high oil prices approximating their 1989 levels. The sharp fall in oil prices during the first half of 1990 implied that the actual 1990 deficit would have been far greater than had been projected even in the absence of armed hostilities in the Gulf. In any event, the Gulf War and its aftermath brought about far reaching changes in the Saudi economy that could not have been envisioned by those who formulated the 1990-95 Development Plan and the 1990 budget.

THE GULF WAR AND OIL MARKETS

In July 1990, Iraqi officials issued threats to Kuwait and the United Arab Emirates (UAE), two members of OPEC that Baghdad accused of "over-producing." Iraq called these actions "a premeditated and deliberate plan to weaken Iraq and undermine its economy and security. Kuwait and the UAE were not the only countries over-producing, but they were more vulnerable than others to Iraqi threats. The impact of Iraqi threats in July 1990 was to reverse the down-trend in oil prices. Then, Iraq's invasion of Kuwait on August 2 led to a sharp increase in world oil prices. According to one estimate, panic buying added 2 mbd to demand virtually overnight. The subsequent UN embargo on oil shipments from Iraq and occupied-Kuwait had the immediate effect of removing 4.4 mbd from world oil markets.

The Saudis and others with spare capacity were more than happy to fill the void. As a result, Saudi output rose rapidly from 5.6 mbd in the first half of 1990 to 8.2 mbd in the third quarter of 1990, compensating for 60 percent of the gap left by the embargo. The balance was made up by Venezuela, Abu Dhabi (UAE), Libya, Nigeria, Indonesia, Mexico, Norway, and others. Like Saudi Arabia, these countries were suffering from budget and/or balance of payments deficits and readily took advantage of the opportunity to expand the volume of sales and obtain higher prices. Though prices soon descended from the panic levels of $30-40 a barrel, they remained far above their pre-invasion levels, prompted mainly by fear that Iraq might attack and damage oil installations in Saudi Arabia and throughout the Gulf. When allied air attacks on Iraq commenced in January 1991, prices again rose sharply, out of fear that Iraq would retaliate by air strikes on Saudi and Gulf oil installations. Following the cease-fire at the end of February 1991, oil prices declined.

In effect, the far higher oil prices in the second half of 1990 more than offset declining prices in the first half of the year. On average, oil prices in 1990 were $22.05 per barrel, almost $5 above 1989 prices. However, despite the hostilities in the first months of 1991 and concomitant increases in prices, average 1991 prices were far lower-$18.30.

In addition to the higher prices, Saudi Arabia gained from a major expansion of its volume of exports. Oil production rose from 5.5 mbd in 1989 to 6.8 mbd in 1990, and then to 8.6 mbd in 1991 and 8.9 mbd in 1992. This increase was due to three main factors: the continuing embargo on Iraq, the two years needed by Kuwait to reach pre-war production levels, and (unrelated to the Gulf crisis) the sharp drop in oil production in the former Soviet Union.

SAUDI OIL REVENUE AND ESCALATING MILITARY EXPENDITURES

The much greater volume of Saudi oil exports, combined with high prices, raised the kingdom's oil export revenues very sharply from $24 billion in 1989 to $40 billion in 1990 and $43.5 billion in 1991. In 1992, they declined to $39 billion.3 The 1992 decline in oil revenues is difficult to explain, since production rose from 8.6 mbd to 8.9 mbd, and the drop in prices from an average of $18.30 a barrel in 1991 to $18.22 a barrel in 1992 was hardly significant. One possible explanation might be the increase of oil shipments under barter arrangements (i.e., used as payment for weapons purchases that are off-budget and may also be excluded, at least in part, from the official balance of payments). Payments to some of the allies in the Gulf War were also in oil shipments, which may be unrecorded in the official balance of payments. In short, the Gulf War, aided by the wholly unrelated oil debacle in the former Soviet Union, allowed Saudi Arabia to raise its oil production and revenues far beyond expectations.

Government expenditures, however, rose even more rapidly than revenues. The budget report for the two-year period of 1990-91 (combined) includes an item called "emergency expenditures" of almost $30 billion. These apparently refer to Saudi payments to the United States and other wartime allies. Among these were payments to the United States of almost $17 billion; to Egypt, $1.7 billion (in addition to cancellation of $4.5 billion in debts); and to Britain, France, Syria, and Turkey of about $1 billion each.

In addition, the budget report also states that military expenditures in FY1990 were $31.5 billion, about $5.5 billion above defense outlays in the previous two years. This presumably refers to higher outlays by Saudi forces as a result of the Gulf War. The report lists foreign aid in FY1990 as $4.5 billion, nearly $1 billion above the previous two-year period.2 However, the balance of payments shows higher figures for foreign aid, almost $10 billion for 1990-91 as compared with $4.7 billion in 1988-89.3 The sum total according to the official accounts, including the higher estimate for foreign aid, is about $40 billion. But other sources quote official estimates of Saudi war costs at no less than $65 billion.4 Most of the discrepancy is probably attributable to the massive orders for military equipment that are included as costs of the war, even though the arms shipments and payments are spread out over a number of years. This would include, for example, $25 billion in orders from the United States between August 1990 and the end of 1992 as well as a long-term agreement with British arms suppliers initiated in the mid-1980s and paid for by oil shipments of 500,000 barrels per day; orders for additional British military supplies were made during and after the war as well. A 1992 estimate stated that the orders were worth C3O billion (about $53 billion), with annual payments of £3 billion ($5.3 billion) for the rest of this decade. In January 1993, Saudi Arabia announced orders for 48 Tornado fighter aircraft at a cost believed to be between $6 billion and $7.5 billion. In 1992, when the value of the oil shipments of 500,000 barrels per day was not sufficient to cover their debt to Britain, the Saudis had to pay an additional $2.6 billion in cash; to do so, the Saudis borrowed Y-1 billion (about $1.8 billion) from British banks. None of these payments are included in the budget.

In addition to boosting military purchases, the war also persuaded the Saudis to double the size of armed forces and provide them with the latest in weaponry. The New York Times quoted an unnamed Saudi adviser to the royal family: "Iraq invaded and we all asked, 'where is the army?' We realized then that we don't really have one. The Financial Times reported in December 1990 that, "when British and U.S. military men arrived in Saudi Arabia [following Iraq's invasion of Kuwait] they were surprised to find warehouses full of unused 155 mm artillery and M60 tanks purchased from Britain and the United States. They were brand new, never touched. The Saudi armed forces' greatest weakness: lack of manpower." The reference was to quality as well as to quantity. Before the war, the Saudi monarchy apparently feared that a large army might become a base for a military takeover. The war experience prompted the leadership to take a different view, recognizing that an expensive "paper army" provides virtually no security. Shortly after the end of hostilities in 1991, the king announced "his firm decision ... to expand and re-equip all sectors of our armed forces ... with the world's most powerful and modern equipment and technology.... The government [also decided to] redouble recruitment efforts to meet the requirements of protecting and defending" the kingdom. One observer suggested that additional motives were that "the expanded armed forces represent a desirable means to discipline the country's youth [and] at the same time provide income and employment. Since open dependence on the United States for the kingdom's defense is not politically viable, the Saudis have stressed that they intend to bolster their own military deterrent with greater determination than in the past." According to the International Institute for Strategic Studies (IISS), by 1992 the armed forces had been expanded to 158,000, including 57,000 in the National Guard (but not the 20,000 in "tribal levies" attached to it). This created a military twice its 1990 size. The IISS estimates of Saudi military expenditures, including payments to allies, for the three-year period 1990-92 are $94 billion; Saudi budgets give military and "emergency" expenditures for the three years as $76 billion.