The Middle East’s economy is caught in the crossfire

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A month ago, on the eve of Hamas’s attack on Israel, there were reasons to be hopeful about the Middle East. Gulf states were ploughing billions of dollars of oil profits into flashy investments, building everything from sports teams and desert cities to entire manufacturing sectors. Perhaps, optimists thought, the wealth would even trickle down to the region’s poorer countries.

What prompted such hope was the longest period of calm since the Arab spring in 2011. Gnarly conflicts, such as civil wars in Libya and Yemen, as well as organised Palestinian resistance to Israel, appeared to have frozen. Violent clashes were rare, which some believed a precursor to them disappearing altogether. The region’s great rivals were inching towards warmer relations. International investors flocked to the Gulf to get in on the action.

Hamas’s attack and Israel’s response suggest that the region will now be laden with a bloody, destructive conflict for months to come, if not longer. Under pressure from their populations, Arab leaders have blamed Israel for the situation, even if they have been careful in their language. Overnight, their focus has shifted from economic growth to containing and shortening the war. Countries across the region, including Egypt and Qatar, are pulling out all the diplomatic stops to stop the spread of fighting.

Even if the conflict remains between just Hamas and Israel, there will be costs. Analysts had been upbeat about the prospects for economic integration. In 2020 the United Arab Emirates (uae) and Bahrain normalised relations with Israel, opening the door to deeper commercial ties. Although many other Arab countries refused to recognise Israel, many were increasingly willing to do business with it on the quiet. Even Saudi Arabian firms surreptitiously traded with and invested in their Israeli counterparts, whose workers are among the region’s most productive; the two countries were working on a deal to formalise relations.

How long the pause in such negotiations lasts remains to be seen, but the greater the destruction in Gaza, the harder it will be for Arab leaders to cosy up to Israel in future, given their pro-Palestinian populations and pressure from neighbours. Although Thani al-Zeyoudi, the uae’s trade minister, has promised to keep business and politics separate, others are unsure that will be possible. A Turkish investment banker, who draws up contracts for firms in the Gulf, reports that most of his clients considering Israel as an investment destination are waiting to see what happens next.

For the Middle East’s poorer countries, the consequences will be worse—and nowhere more so than in Egypt. The country was already struggling, with annual inflation at 38% and the government living between payments on its mountain of dollar debts by borrowing deposits from Gulf central banks. Now it has lost out on the gas that flowed from Israel. On November 1st officials in Cairo allowed across the border a handful of injured Gazans, as well as those with dual nationalities. Some diplomats hope that a larger influx might follow, perhaps even on the scale seen by Jordan when it welcomed Palestinians in the 1940s and Syrians in the 2010s, if Egypt were given the right financial incentives. In 2016 looking after 650,000 Syrian refugees cost Jordan’s state $2.6bn, much more than the $1.3bn it received in foreign aid. There are twice as many internally displaced people in Gaza.

What if the conflict escalates? In the worst case, the region descends into war—perhaps including direct confrontation between Iran and Israel—and economies are turned upside down. Any such war is likely to see a sharp rise in oil prices. Arab oil producers might even restrict supplies to the West, as they did during the Yom Kippur war in 1973, which the World Bank reckons could push up prices by 70%, to $157 per barrel. Even though the world economy is less energy-intensive today, the Gulf’s oil producers would benefit. All-out war, however, would hinder efforts to diversify their economies. Migrant workers would leave. Manufacturing industries would be hard to get off the ground without secure transport. Futuristic malls and hotels would lack the tourists to fill them. And for the region’s energy importers, which include Egypt and Jordan, a spike in oil prices would be a disaster.

There is another, more plausible escalation scenario. So far Iran has declined to turn threats and errant missiles into a direct attack. Israel’s ground invasion—smaller and slower than expected—is helping keep a lid on things. Nevertheless, conflict could still spill across Gaza’s borders. Imagine, say, fighting in the West Bank or greater involvement from Hizbullah. In this scenario, investing in the Middle East would look much riskier. If fighting flashed in neighbouring countries, leaders in the Gulf would find themselves working harder to convince investors that a return to calm and closer ties with Israel might happen soon.

In need of a parachute

In such a world, Egypt would not be the only country exposed. Lebanon’s economic free fall—now in its third year, as inflation rages above 100%—would accelerate with clashes between Israel and Hizbullah, which is based in the country. Fighting in the West Bank, where tensions are high, would spell trouble for Jordan, which sits next door. Like Egypt, the country is almost broke. It took out a $1.2bn loan from the imf last year, and was recently told by the fund that its annual growth of 2.6% was insufficient to fix its problems. Refugees could leave the state unable to repay debts. Unrest along its borders could deter creditors.

If either Egypt or Jordan were to run out of cash the results would be destabilising for the region. Both countries border a Palestinian territory, feeding it with supplies and providing allies with information. Both have the ear of the Palestinian Authority. And both have a young, unhappy population. The Arab spring showed how easily unrest in one Arab country can spread to another. Even Gulf officials, relatively insulated though they may be, would rather avoid such instability.

Read more from Free exchange, our column on economics:
Israel’s war economy is working—for the time being (Oct 26th)
Do Amazon and Google lock out competition? (Oct 19th)
To beat populists, sensible policymakers must up their game (Oct 12th)

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