Gulf War II spectre stalks hopes of global recovery

The prospect of US action against Saddam Hussein is haunting financial markets, which dare not bet on an economic recovery until Washington makes its move.

Intense US efforts to persuade allies that a regime change in Baghdad is necessary have convinced investors an attack is inevitable and is an outstanding risk to resumed growth until its duration and impact on oil prices become clear.

But on the first anniversary of the attacks against US cities, comparisons with the Gulf War have encouraged hopes that a quick win would kick-start the faltering world economy.

Optimists say oil prices could even fall if a new Baghdad government sells its pent-up reserves to rebuild the nation.

Oil is the main channel through which turbulence in the Middle East makes itself felt in the industrial world and some say that the market has already priced in an attack.

Following the August 2, 1990 invasion by Iraq of Kuwait, it rose to a $40/barrel peak but then collapsed once the ground offensive was launched and traders saw Baghdad could not interrupt oil supplies from its neighbours.

Talk of war has pushed oil back near $30/barrel with as much as $5 of this move blamed on the threat of US-led action.

Hoping for a swift, surgical defeat of Baghdad, optimists predict a speedy rally in stock markets and point to the rebound after the fall of Kabul last January, as well as recoveries after other global threats like the 1962 Cuban missile crisis.

"Rousing victory could paint a tremendously more optimistic world picture, with reformation in the Middle East, oil tamed and Iran isolated," said Gary Hufbauer, a strategic expert at the Institute for International Economics in Washington.

Oil subsided under $20/barrel after Iraq was evicted from Kuwait, and US growth, which was tipped into a recession by the conflict, exited the trough in March 1991 to stage a moderate recovery.

So what happens to oil this time around is crucial in weighing the fallout for growth and financial markets.

Unfortunately, it is also extremely hard to predict how other Arab oil producers will react to an attack on Iraq, although the United States might employ strategic oil reserves to keep the price per barrel from soaring, said Hufbauer.

But although the eviction of Iraq from Kuwait by US-led forces in January 1991 was an exception to the rule, conflicts usually hurt growth and are bad news for stocks.

Sceptics say it is not so simple as quick war good, long war bad. They argue that the world economy is far more vulnerable to the shock of a prolonged conflict or higher oil price than during the first Gulf War.

For example, the fallout from an attack on Iraq could tip the balance elsewhere, at a time when policymakers have little ammunition left with which to cushion external shocks.

Such arguments are also surfacing among European politicians as a reason for caution and have been employed by the government of German Chancellor Gerhard Schroeder, who has turned the issue into an important part of his re-election campaign.

"There is a danger from correlated risks... For example, a shock from an attack on Iraq could hit confidence generally and tip an emerging market economy over the edge," said Vincent Koen, a senior economist at the OECD in Paris.

"Right now it still looks like we are slowly crawling out of the downturn and avoiding a double dip. But a double dip would be a possible outcome if one or more shocks hit," said Koen.

The Organisation for Economic Cooperation and Development estimates that a 10 dollar rise in the price of a barrel of oil would shave 0.2-0.3 percentage points from growth in the US and euro zone. The world needs this growth.

Thumping stock market losses, provoked by accounting scandals in the US as well as concern at another attack on the US, are already curbing this year's tentative upswing.

Growth in Japan is at a standstill, whereas in 1990/1991 it was still pulling ahead. Germany is also much weaker than during the first Gulf War, when it was still enjoying a unification boom after the fall of the Berlin Wall.

"The fragility factor is clearly now much greater," said Hufbauer, who also saw an increased risk of a double dip recession if the conflict proved prolonged.

Inflation, sparked by higher oil prices, would create a real dilemma for central bankers who may want to cut interest rates again to kick-start growth and at the moment have the comfort of very low consumer price levels.

An inflation-imposed rate hike would be particularly bad news for the United States and Britain, where the cheapest borrowing costs in a generation have supported a housing boom that has sheltered consumers from the stock market bloodbath.

"Policy has less room for manoeuvre in the United States than a year ago and there is also little room in Europe. So it is not obvious how easily policymakers could put the global economy back on a growth path," said Koen.

There is also the weakened condition of financial institutions after steep stock losses to consider.

Japanese banks were already in a much worse state than a decade ago and the damage done to the share prices of European lenders shows that investors see them as being badly wounded.

US banks generally have more capital than in 1991. But the Bank for International Settlements, while saying bad loan levels are well under the scale of the early 1990s, sees signs of tightening credit conditions, or a credit crunch.

This could prevent borrowers from taking advantage of low interest rates and means investment remaining tepid.

Then there is the question of who pays for military action, which has a direct bearing on the US budget and its already swelling public deficit?

During the Gulf War, whose ground offensive lasted only 10 days, the costs to the US was estimated around $50 billion.

Kuwait and Saudi Arabia shouldered most of the bill, with Japan and the European Union also chipping and together these contributions covered about 80 per cent of Washington's tab.

But the lack of a similar alliance is likely to mean an altogether heavier burden for the US budget, especially if a campaign, aimed at toppling Hussein rather than simply pushing him back to Baghdad, turns out to be much more prolonged.

Based on estimated costs of military spending of one billion dollars per day, and supposing a 90 day campaign, this could push towards $100 billion or nearly one per cent of US GDP.

"There is a high certainty that the allies won't pay very much... So either the money comes straight off of the US budget or you get Iraq to bear part of the cost," said Hufbauer.