THE GULF STATES: CHANGING ECONOMIC OPPORTUNITIES

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88T00096R000800950002-9
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 35
• Document Creation Date: December 22, 2016
• Document Release Date: June 1, 2011
• Sequence Number: 2
• Publication Date: November 1, 1987
• Content Type: REPORT

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Directorate of
Intelligence
Opportunities
The Gulf States:
Changing Economic
NESA 87-10050
November 1987
Copy 3 8 3
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Directorate of
Intelligence
Opportunities
The Gulf States:
Changing Economic
This paper was prepared by
25X1
Office of Near Eastern and South Asian Analysis,
It was
25X1
coordinated with the Directorate of Operations.F]
25X1
Comments and queries are welcome and may be
directed to the Chief, Persian Gulf Division, NESA,
Reverse Blank Secret
NESA 87-10050
November 1987
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The Gulf States:
Changing Economic
Opportunities
Key Judgments Economic opportunities in Bahrain, Kuwait, Qatar, Saudi Arabia, and the
Information available United Arab Emirates are promising for the United States into the next
as of 2 November 1987 decade. A number of nonoil sectors in the Gulf states' economies, in
was used in this report.
particular, are poised for substantial growth as oil revenues stabilize and
rebound and as governments refocus their development priorities. The
complementary nature of Gulf state service needs and US service industry
strengths should give the United States a significant edge over Japanese
and European competitors.
Regional trade in services will probably outpace merchandise sales in the
years ahead as governments strive to keep abreast of mounting demands
for social services and attempt to consolidate gains achieved under previous
development schemes. Waste and water management, data processing,
financial services and technology, and administrative skills almost certainly
will be areas of high demand as economic planners attempt to improve the
rate of return on national investments.
The US position as a leading merchandise supplier to the region probably
will continue to deteriorate, but the dominant US position as a provider of
services to the Gulf states is likely to offset most, if not all, of this decline.
The United States now trails Japan as the single largest merchandise
supplier to the Gulf states, and Washington's second-place position is
under challenge from several European countries. Last year the United
States ran its first merchandise trade deficit with the region since 1981.
Investing in the Gulf is several times as risky as investing in the United
States, according to our estimates, but diversification can achieve impres-
sive rates of return. Nonoil sectors, in particular, have weathered the Gulf
recession well, and performance in these sectors is largely uninfluenced by
events in the US economy. Moreover, when oil demand and prices rebound,
Gulf oil sectors will again produce handsome opportunities for US
participation.
Gulf state economies still retain significant barriers to foreign investors.
Foreign ownership is often restricted, and financial kickbacks to key
officials are frequently required to obtain contracts. Divergence from Gulf
state views on the Palestinian issue and other sensitive political matters can
lead to a boycott or other forms of discrimination. Conflicting business
practices and a poorly trained work force often frustrate productivity and
raise business costs.
Secret
NESA 87-10050
November 1987
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For the most part, regimes in the region are politically stable and resilient.
They share a high regard for US technology and are favorably disposed to
further US economic participation. Each regime appears to have the
support of loyal and effective security forces. Nevertheless, all are vulnera-
ble to worsening economic conditions, vagaries of the oil market, and the
spread of the Iran-Iraq conflict. In addition, deepening social and economic
problems in the Gulf states-underemployment, overcrowded cities, grow-
ing disenchantment with Western-style development, and mounting strains
on scarce resources-can, in the long run, weaken the foundations of
domestic political stability and substantially increase the risk of financial
or property loss.
When oil revenues rebound in the next decade, Gulf state petrodollars are
likely to be increasingly recycled as long-term investments in the West
instead of as trade or short-term financial holdings as in the past. The
growing realization that Gulf economic development is not advanced
enough to provide a viable means of support once oil production begins to
decline-a near-term reality for several states-will force domestic eco-
nomic planners to emphasize investment income. Investment receipts
already equal oil revenues in Kuwait. This trend almost certainly will have
major consequences for the international financial system, for the financ-
ing of growing trade deficits with the region, and for political relations as
Gulf states obtain significant ownership of US and other Western assets.
As these developments gather momentum, competition for Gulf state trade
among the United States, Western Europe, Japan, and possibly the Soviet
Union almost certainly will intensify. Japan and the European Economic
Community already have large trade deficits with the Gulf states and are
more dependent on the region's oil resources. West European governments
often support domestic firms operating in the Gulf region, a practice that
enhances their competitive edge over US firms. US dominance of regional
arms sales-a $10 billion market over the next seven years-is particularly
vulnerable to such European initiatives
Although mutually acceptable opportunities for expanded economic rela-
tions between the Gulf states and the Soviet Union are limited, Moscow's
energy problems almost certainly will increase its economic interest in the
region. Near-term Soviet gains, however, will depend largely on changes in
the political or economic interests of the Gulf states rather than on Soviet
initiatives.
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Key Judgments
Development During the Boom Years, 1970-80 1
Economic Consolidation Under Austerity 2
Emerging Opportunities for the United States 3
Population Growth 12
The Israel Question 13
Cultural Idiosyncrasies 13
Changing Rules of Economic Engagement 16
The European Challenge 19
An Opening for Moscow 20
Risk Methodology 23
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Figure 1
Selected Middle East Oil Facilities
BAGHDAD
Caspian
Sea
Turkey l\ /) ~ . tA~ Soviet Union
NIC
Cypr
Mediterranean
Sea Leben
E RUY
Isra~
Tel Aviv-Yafo%
Gl'of
Egypt' Aq
aba
~/
1
Administrative
Boundary
Sudan
Syria
Yanbu'
al Betr
ddah
Mecca
Iraq-Saudi Arabia
Neutral Zone
Iran
ir~it 0
KUWAI~inB?
_ Afjmadi
Persian
Gulf
Pump
RIYADH Station 3
Saudi east-west pipeline
Petroline est. 3.0
Saudi Arabia
Al Ju'aym; h
Ras Tenure
Bahrain ' NNQrth
t f "jast? egd
Ghawar
Strait of 1b
Hormuz
i
Kha`wr
FakkBn
Boundary representation is
not necessarily authoritative
Unlted Ar*b
no define 05?f arY
d
Administrative
Line
Ethiopia
*SANAA
Y.A.R:
(N. Yemen)
?uti
DJIBOUTI
Phase I-Iraq-Saudi
Spurline 0.5-1.6
P.D.R.Y.
(S. Yemen)
F
Oman
2.6
Existing oil pipeline
Oilfield
Oil terminal
Pipeline capacity (million b/d)
Note: Pipeline alignments are approximate.
0 300 Kilometers
0 300 Miles
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The Gulf States:
Changing Economic
Opportunities
The Arab states of the Persian Gulf continue to offer
substantial opportunities for investment and economic
participation by the United States.' Overall, we esti-
mate that development spending for the rest of the
decade will top $40 billion annually, which implies a
$30 billion market for merchandise imports and an
equally large market for services. We expect that
demand for services will be especially brisk as govern-
ments focus on consolidating economic gains achieved
over the past decade, maintaining existing infrastruc-
ture, meeting the needs of rapidly growing popula-
tions, and establishing the foundation for the next
round of development early in the next decade. The
fact that the Gulf states have over 40 percent of the
world's petroleum reserves suggests that they will
continue to pay hard currency for large-scale develop-
ment and import programs.
Development During the Boom Years, 1970-80
Economic development in the Gulf states has been a
relatively recent and dramatic phenomenon. The
rapid escalation of oil prices in the early 1970s
provided the five Gulf economies-especially that of
Saudi Arabia-with the financial wherewithal to
embark on massive and pervasive development ro-
grams.
the gross domestic product of
these states in current dollars increased almost five
times between 1970 and 1980 to $226 billion-a
17-percent average annual growth rate. Saudi Arabia
accounted for more than two-thirds of the total GDP,
the United Arab Emirates (UAE) and Kuwait con-
tributed 25 percent, and Qatar and Bahrain made up
the difference.
' Bahrain, Kuwait, Qatar, Saudi Arabia, and the United Arab
Emirates are defined as the economically important Gulf states in
this Intelligence Assessment because of their large oil reserves and
substantial opportunities for further economic participation by the
United States. We exclude Oman from the list. Its relatively small
economy, restricted trade relationship with the United States,
limited long-term oil supply potential, and different demand pros-
pects for US goods and services in the years ahead make it atypical
Development spending during the 1970s focused on
the establishment of heavy industry and transporta-
tion networks. About two-thirds of available funds
were earmarked for economic infrastructure, with less
than 15 percent flowing into social development.
During the decade the five Gulf states spent an
estimated $230 billion on domestic development that
generated over $150 billion in related merchandise
imports.
US firms have been instrumental in the development
of the modern Gulf economies. Five major US oil
companies-Exxon, Mobil, Gulf, Texaco, and Chev-
ron-pioneered the discovery and exploitation of oil in
all five states. Beyond oil-related activities, US firms
established a secure foothold in virtually all aspects of
the Gulf economies.
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US manufacturers and service industries were the
largest suppliers to the Gulf economies during the
1970s. Trade statistics show that the United States
accounted for up to 20 percent of regional imports.
Japan followed with about 17 percent, and the West
European countries collectively obtained an additional
40 percent of the Gulf import trade. Together, the
Gulf states were the sixth most important customer of
the United States behind Canada, Japan, West
Germany, the United Kingdom, and France. We 25X1
estimate, on the basis of US Embassy reporting, that 25X1
60,000 US citizens were directly employed in the Gulf
states by 1980. US military sales to the region
benefited from growing regional security concerns
and topped $20 billion-a 68-percent market share
during the 1970s. Strong US commercial relations
also led government planners to rely heavily on US
educational institutions as the chief source of training 25X1
for thousands of Gulf Arab students, a measure that
has served to cement business ties over the years.
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Table 1
Country Statistics
Bahrain Kuwait Qatar Saudi Arabia United Arab
Emirates
Amir Isa bin Amir Jabir Amir Khalifa bin King Fahd bin President Zayid
Sulman Al al-Ahmad Al Hamad Al Thani Abd al-Aziz Al bin Sultan Al
Khalifa Sabah Saud Nuhayyan
Type of government Nominal consti- Nominal consti- Traditional mon- Traditional mon- Federation of
tutional monar- tutional monar- archy with ap- archy seven emirates;
chy; National As- chy; National As- pointed Advisory appointed Feder-
sembly dissolved sembly dissolved Council al National
1975
1986
Population (1,000 persons) a
464
1,865
316
14,905
Population growth a (percent)
3.6
4.3
4.1
4.9
Population below age 15
(percent)
48
46
50
47
Gross domestic product (billion
Us $)
2.88
13
5.75
86.92
Average GDP growth (1981-86)
(percent)
-3.6
-11.3
-6.6
-8.9
Proved oil reserves (million
barrels)
144
91,916
3,154
166,573
(1,000 barrels per day)
3,979 b
OPEC quota, third quarter
1987 b (1,000 barrels per day)
NA
996 b
4,343 b
Foreign exchange reserves less
gold, June 1987, (billion US $)
1.4
4.2
20.5
Foreign official assets (billion
US $)
2.0
85.0
100.0
Council
1,846
7.8
44
31,700
1,338
948
3.9
40.0
a Reflects immigration.
b Excludes Neutral Zone production of 374,000 barrels per day,
which is equally shared by Kuwait and Saudi Arabia.
Except for Kuwait, all currencies are pegged to the US dollar.
Valuations are as of 30 June 1987.
Although development efforts in recent years have
been hampered by sharply lower oil revenues-they
have dropped 73 percent since 1980-the major as-
pects of previously planned development programs
have been completed. Saudi Arabia, Bahrain, and
Qatar, in particular, have drawn down their foreign
assets to keep development schemes on track. The
region remains financially healthy as indicated by still
low debt burdens, high levels of gross fixed investment
as a percent of GDP, and a substantial cushion of
foreign exchange reserves. In addition, total imports
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Table 2
Gulf States: Current Account Balance, 1982-87
Projected.
b Assumes combined oil exports of 6.4 million b/d at $16.50 per
barrel.
Table 3
Gulf States: Indicators of Financial Health, 1986
Percent
(except where noted)
Gross Fixed
Foreign Exchange
Debt Service
Merchandise
Debt to GDP
Investment to
Reserves to Mer-
Imports to GDP a
GDP
chandise Imports a
(months)
as a percent of GDP-a measure of development regional consensus on development stresses the need
priority and domestic demand-has remained almost to reconcile the pace and direction of development
constant over the past five years at about 40 percent with the needs of society. Specifically, each of the
of GDP, Gulf state development plans:
? Deemphasizes further industrial expansion.
The sharp decline in oil prices and a growing aware- ? Calls for the maintenance of the existing social and
ness of the shortcomings of previous development economic structures.
efforts have brought about significant changes in the
development priorities of the Gulf states. The current
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Table 4
Gulf States: Total Real Growth by Sector, 1981-86
Qatar Saudi Arabia United Arab Weighted
Emirates Growth
? Mandates the integration and consolidation of past
development gains and improved rates of return on
public-sector investments.
? Encourages further diversification of the national
economy.
? Stresses increased efficiency and productivity.
? Calls for reductions in the foreign labor force and
increases in the levels of domestic skills and partici-
pation of local workers in the economy.
? Underlines the importance of greater private-sector
participation in the economy.
? Promotes the need to restructure the public sector
and improve management in the civil service.
Growth since 1980 in the nonoil sectors emphasizes
the change in development priorities. Official country
data show that activity in the construction sector fell
off sharply in the last several years as major projects
were completed and oil revenues dwindled. Agricul-
ture and manufacturing, however, experienced consis-
tent and rapid growth as governments attempted to
close the growing gap between domestic demand for
basic goods and local supply
At the same time, the demand for services
blossomed as public and private sectors attempted to
meet the needs of the region's increasingly affluent
and urbanized societies.
Emerging Opportunities for the United States
Oil prices and demand to a large extent will determine
the pace of future development as they have in the
past. We believe that OPEC's ability to support prices
at $18 per barrel, its apparent commitment to restrain
output, rising demand for Gulf oil, and dwindling
supplies outside the Gulf are strong indicators that oil
revenues in the Gulf states will begin to rise, though
probably only gradually for the next several years.
This trend almost certainly will buoy local economies.
As long as the oil market is perceived to be tightening
and revenues rising, we believe most Gulf states will
proceed with modest development programs. We esti-
mate that financial reserves will be sufficient to
bridge revenue gaps in these states through 1990 at
current rates of drawdown.
Although governments will continue to direct develop-
ment efforts in all five states, we expect private
enterprise will play a growing role. We believe that
changes in development priorities and other economic
factors will lead to enhanced commercial opportuni-
ties for the United States in both the public and
private sectors.
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Table 5
Gulf States: Development Spending by Sector, 1982-86
Total 2.55 17.10
Share of total (percent) 0.9 6.2
a Includes development expenditures of the UAE federal govern-
ment, Abu Dhabi, and Dubayy.
Qatar Saudi United Arab Total Percent
Arabia Emirates a
4.93 240.00 10.00 274.58 100.0
1.8 87.5 3.6 100.0
We believe that petroleum exploitation and develop-
ment will remain the foundation of the Gulf econo-
mies and the primary source of economic growth,
despite the contraction in this sector in recent years.
Conversion industries such as plastics manufacturing
offer significant growth prospects. Maintenance ser-
vices are in constant demand and will probably
grow-especially in Bahrain, Qatar, and the UAE-
as aging fields require enhanced recovery technology
to maintain production. Several Gulf states hope to
use the leverage of trading as a bloc to increase their
market share of petrochemical exports. Saudi Arabia
offers the best prospects for petrochemical production
because of its greater economic diversification and
large petroleum reserves.
Agricultural development and production have in-
creased steadily since 1980 and, we believe, offer
significant opportunities for further US participation.
The Gulf states, particularly Saudi Arabia, achieved
a high degree of self-sufficiency in some grains and
dairy products over the past five years 2.5X1
Processing, storage, and transporta- 25X1
tion, however, are the weak links in the otherwise
impressive agricultural program. Saudi development
plans, in particular, place high priority on overcoming
these gaps. Moreover, Riyadh, which pays several
times world prices for domestic production, is eager to
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Figure 2
Gulf States: Direction of
Merchandise Trade, 1986
UK 11.5
Other 40.1
in many areas of agricultural production should give
the United States a distinct advantage in capturing a
large share of this high-growth sector. US investment
can have a significant impact on agriculture by
helping the Gulf states work toward capital-labor
ratios more consistent with their long-term plans for
self-sufficiency in food production.
Regional governments continue to emphasize expan-
sion of domestic manufacturing to offset increased
imports. Labor and skill constraints mandate the use
of capital-intensive technology. Most governments,
particularly that of Saudi Arabia, are eager to consid-
er joint ventures, according to US Embassy reporting.
Joint production and maintenance of military goods
are much sought areas of cooperation. The skills
shortage, in particular, could create opportunities for
foreign maintenance contracts in everything from
janitorial work to skilled repair services in the manu-
facturing sector.
Financial services have experienced rapid and consis-
tent growth since 1980 and will be a leading area for
development by several Gulf states. Bahrain has taken
the lead in establishing itself as the financial services
center of the region to supplement its small and
declining oil resources. Kuwait, Saudi Arabia, and the
UAE also are developing domestic financial services.
Despite this development, the budding money centers
of the region lag major US financial institutions in
technical and money management skills
Communications, data, and finan-
cial management and technology almost certainly will
be in high demand as both regional and international
banks in the Gulf attempt to expand and improve the
efficiency of their operations.
Service sectors probably offer the most promising
areas for additional US participation. Partly because
trim domestic farm subsidies by obtaining more cost-
efficient production technology, according to US Em-
bassy reporting. The other Gulf states also give
priority to agriculture, but their smaller resource
bases offer fewer opportunities for large-scale agri-
business. We believe that US technological strength
of lower oil revenues, the contribution of services to
regional GDP matched that of the oil sector last year.
Expansion in the service sector-a reflection of local
demand and government priority-shows little corre-
lation with events in the oil sector and has experienced
growth in most states since 1980, according to US
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Prospects for Military Sales
Demand for military goods and services remains
strong in the Gulf states despite reduced oil revenues.
We estimate that over the next seven years these
regimes will purchase $10 billion in new arms. Re-
gimes are particularly interested in improving their
air defense capabilities in response to heightened
concerns over the spread of the Iran-Iraq war, accord-
ing to US Embassies in the region:
? Bahrain is seeking about $260 million in combat
helicopters, antiaircraft defenses, and air transport.
? Kuwait is considering the purchase of over
$2 billion in new fighter aircraft and armored
vehicles.
? Qatar would like to buy 18 new combat aircraft and
additional armor.
? Saudi Arabia represents the largest potential mar-
ket in the region. Planned upgrading of Saudi
defenses could top $6 billion before 1995, including
tanks, antiaircraft systems, and possibly
submarines.
? The UAE is moving ahead with plans to purchase
24 combat aircraft and additional armor in a
modernization program likely to exceed $1.8
billion.
Most states would prefer US military goods, but
Washington's reluctance to sell sophisticated arms in
the past and a desire to diversify sources of supply
are causing Gulf states to consider West European
and Third World equipment. As a result, the United
States is likely to lose its dominant military supply
position in the region to West European arms sup-
pliers.
Embassy I Selected service areas
where we anticipate significant growth in the coming
years include: 25X1
? Because of the large construction effort of the past
and the increasing urbanization of Gulf societies,
maintenance probably will be the boom industry of
the next five years. High temperatures and frequent
duststorms increase maintenance problems in virtu-
ally all areas of the economy. A trend toward
growing capital intensity of industry and greater
technological sophistication suggests an escalating
demand for all types of services.
? A growing demand for data management and train-
ing is following the rapid development of the Gulf
economies. Meeting government goals of better
resource management and improved services will
require the rapid development of data management
skills and capacity.
? Waste management in the Gulf is following global
trends. We believe that rapid urbanization, the
shortage of water, and the Arab disdain for dealing
with sanitary control combine to create a lucrative
market for waste management in the Gulf states.
Sewage and solid waste control and disposal and
control of water supplies are top priorities
? Health care, already satisfactory, is a top priority
under regional plans to enhance living conditions.
Here again, social customs-such as the prohibiting
of women working as nurses-prevent the effective
use of local human resources, creating opportunities
for US health care specialists.
? Management and training skills in the civil service
are inadequate to the task of efficient government
operation and have been targeted for substantial
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improvement. A broad cross section of personnel,
logistic support, and technical training will be
required to improve government efficiency.
? Developing a cadre of skilled workers is a high
priority for most governments in order to avoid
complete dependence on foreign maintenance ser-
vices. US Embassy reporting says that, as a result of
long-term neglect, vocational training programs are
inadequate to meet rapidly growing needs for me-
chanics, plumbers, electricians, and other skilled
workers. This trend suggests opportunities for US
training expertise.
? Marketing skills and technology, including distribu-
tion technology, will find broad application through-
out all Gulf economies. Planning, producing, pric-
ing, and promoting the output of the Gulf states'
industrial base will be a priority in the years ahead.
This area not only offers opportunities for new
entrants to the Middle East but also a new outlet for
firms with long-term regional experience.
Although the Gulf region offers a broad range of
attractive opportunities to US firms, the individual
states differ sharply in the areas available for poten-
tial investment.
Bahrain is the smallest Gulf state economy in size, but
it has the most fully developed nonoil sector. Manama
is rapidly becoming the financial services center of the
Gulf with a growing demand for communications
technology, data management, and investment skills.
The age of the domestic oil industry's oilfields sug-
gests a growing need for enhanced recovery technol-
ogy. Potable water supplies and waste management
are growing concerns on the island and the focus of
increased government spending.
Kuwait depends more heavily on oil. With almost 200
years of proved oil reserves at recent production levels,
the government has considerable wealth at its disposal
to finance development. Kuwait's emphasis on invest-
ing its wealth has opened opportunities for foreign
financial managers. The government's movement into
petroleum processing and distribution is also creating
a demand for foreign management expertise. The
pervasive social welfare system fostered by Kuwait's
oil wealth provides growing opportunities for US
health care and waste management services. The
government also may require greater assistance in
marketing technology to improve the prospects for
domestic petrochemical and petroleum processing
capabilities.
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Figure 3. Saudi garbage gener-
ates business for US firms. A
US company has a $155 mil-
lion contract with the city of
Qatar is the second-smallest economy in the Gulf with
a growing appetite for a wide variety of services,
including petroleum development expertise. The small
population ranks as one of the richest in the world,
and Doha's oil wealth has provided a cradle-to-grave
welfare state, according to the US Embassy. This
affluence and the lack of a strong work ethic foster a
great dependence on foreign expertise and manage-
ment. Although the government has trimmed develop-
ment spending plans to curb its growing budget
deficit, Doha recently went forward with the first
phase of its multibillion dollar North Dome gas
project. We believe that this effort to tap one of the
largest gas deposits in the world will generate sub-
stantial demand, not only for petroleum-related goods
and services, but also for consumer goods and services
by the large number of foreign workers employed by
the project. Qatar probably will seek heavy US
participation in this project, according to the US
Embassy in Doha. The government is disappointed
with past British management of petroleum opera-
tions and failure to include more Qataris in domestic
oil operations.
Saudi Arabia's economy is the largest in the Gulf,
and, as a result, the largest market for US goods and
services in the region. Riyadh's large oil resources-
about one-quarter of proved world oil reserves-
underscore the potential of the Saudi market. The
hundreds of billions of dollars spent on development
over the past 17 years have produced a broad market
for maintenance services of all descriptions. Rapid
population growth and rising urbanization have creat-
ed a growing demand for water and waste control.
The US Embassy in Riyadh says that the government
so far has expended an estimated $15 billion in
financial assets this year to keep social and economic
programs on track. We believe that a combination of
improving oil revenues and additional drawdowns of
reserves will allow Riyadh to maintain development
spending and import programs over the next several
years.
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Figure 4
Gulf States: Composition of
GDP, 1980, 1986
Agriculture 1.0
Financial
Services 5.6 -
Figure 5
Share of Gulf State Trade, 1986
? Exports
Agriculture 2.5
Manufacturing 7.0
Financial Services 9.5
The United Arab Emirates represents seven markets,
each with its own potential demand for US goods and
services. Abu Dhabi and Dubayy are the two principal
markets for US goods and services. Dubayy, in partic-
ular, is moving to develop its nonoil sector in advance
of declining oil production, according to the US
Embassy in Abu Dhabi. Dubayy's relatively advanced
economy has a growing demand for financial services
management, water and waste management, and ad-
vanced oil recovery technology. Abu Dhabi's oil re-
serves by comparison are projected to last almost 90
years. US Embassy reporting says that Abu Dhabi's
relatively small population with a limited education
demands a growing variety of services to keep the
economy operating.
We believe development priorities, and therefore in-
vestment opportunities, will be increasingly deter-
mined by changing social conditions. Deepening de-
mographic problems-rapid population growth,
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Figure 6
Gulf States: Composition of
Merchandise Trade 1986
Fuels $.2
Raw
Materials $.2
Foodstuffs $3.1
Foodstuffs $.02
Manufactured
Figure 7
Gulf States: Contribution to
GDP 1980, 1986
E 13.2
Kuwait 12.2
S
Fuels $39.2 Kuwait 9.9
UAE 17.4
overcrowded cities, underemployment, basic resource
constraints, and conflicting social customs-are un-
dermining the foundations of economic and political
stability in the region. As these problems gather
momentum, we expect alienation among traditional
societies to increase the appeal of political radicalism
and protest. Dealing with political challenges will tax
domestic resources, test political wills, and leave
foreign investments more vulnerable to financial and
physical loss.
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Population 'Growth
Rapid population growth is a primary factor affecting
social change in the region that almost certainly will
direct future development priorities and investment
opportunities. Explosive growth of the native popula-
tion in the Gulf states of 3.3 percent annually will
decline only slightly over the next decade, according
to estimates by the US Bureau of the Census. Fertility
control programs will not significantly alter this pro-
jection, because it would take two decades under the
best of circumstances to stabilize lower birthrates. We
believe that family planning will be slowed by govern-
ment restrictions on the distribution of pertinent
information as well as by the spread of Islamic
fundamentalism in the region. Even though Islamic
scholars acknowledge that no Islamic tenets directly
prohibit the use of contraception, Islamic fundamen-
talists condemn family planning practices as a "West-
ern evil." Even with native population growth held to
2.5 percent annually beginning in 1990 and no signifi-
cant increase in the foreign work force (optimistic
assumptions), projected population in the region
would reach 25 million by the end of the century
compared to 19.5 million today. Urbanization will
exceed 85 percent of the population by the late 1990s,
according to UN estimates, which will further strain
social services budgets.
Resource Constraints
We believe that demand for water, waste manage-
ment, and other services commensurate with popula-
tion pressures will become major political issues for
the Gulf states and lucrative areas for US participa-
tion. Demand for water, already in short supply, will
probably double by the end of the century based on
population growth, complicating social and industrial
development, according to US Embassy reporting.
Overuse of ground water resources has already left
most population centers and many industrial facilities
dependent on desalination plants that are vulnerable
to sabotage or terrorist attack. Sewage and solid
waste disposal problems already tax local sanitary
control systems. We estimate that construction of new
sanitary treatment facilities will require heavy expen-
ditures of public funds over the next five years. We
project that the demand for health care, housing,
transportation, and other social services will rise
rapidly in the next several years as governments strive
to keep urban populations satisfied and minimize
public criticism of national economic management.
Traditional Values
Traditional values and education priorities prevalent
in the Gulf states hurt economic development, con-
tribute to growing unemployment, and raise the cost
of doing business. Education systems in the Gulf do
not stress innovation or creativity. The educational
programs are not geared to provide the skills neces-
sary for technical and industrial jobs let alone mana-
gerial positions
Nevertheless, graduates expect better than
entry-level positions, something that most govern-
ments will be increasingly unable to provide. We
expect the economic cost of placing poorly trained
graduates in senior positions will grow dramatically in
the years ahead. As decisions become more complex
and resources more limited, we believe that demand
for foreign expertise will increase.
Foreign Workers
The Gulf states' heavy reliance on foreign labor puts a
heavy burden on national finances which could slow
the pace of development. Nearly 6 million foreign-
ers-37 percent of the population-are required to fill
highly skilled jobs that Gulf workers cannot perform
or unskilled jobs they refuse to accept, according to
US Embassies in the region. At the same time, the
role of women in the work force is circumscribed by
conservative social customs. Reliance on expatriates
inflates the expectations of local populations, in-
creases unemployment, and raises potential security
and political problems for Gulf regimes. Foreigners do
not contribute to domestic consumption in proportion
to their numbers, because they remit a high percent-
age of their earnings to families outside the region,
hindering the growth of domestic markets. But the
foreign populations increase demands on already
strained social services. Although all governments
publicly acknowledge the need to reduce the size of
the foreign work force, we believe that most will limit
their efforts to reducing costs by substituting lower
wage Asians for Western workers over the next
several years.
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Table 7
Gulf States: Native and Foreign
Populations, 1986
thority and Western-oriented development.
Native Foreign
Population Population
11,005
1,281
3,900
565
Islamic Fundamentalism
Religious extremism has not been a serious threat to
Gulf regimes so far, but the close relationship between
religious and political authority leaves ruling
families-and the hospitable business environment-
vulnerable to the spread of radical fundamentalism.
Austerity and the growing social dislocation accompa-
nying development have caused many to question the
direction of society and the influence of Western
development and to reassess their cultural identity,
according to US Embassies in the region. This process
contributes to the appeal of Islam and to militant
fundamentalism in particular. Fundamentalism has
spread throughout the region and extends beyond the
unemployed youth and disfranchised to include the
well-to-do and intellectuals. Tensions between Sunnis
and local Shias are always simmering, complicated by
the successful Islamic revolution in Iran. The bloody
riot during the Hajj in Mecca in August, allegedly
fomented by Iranian Shia pilgrims, underscores how
quickly religious tensions can flare into violence. US
Embassies in the region report Sunni-Shia tensions
are of particular concern in Kuwait, Bahrain, and
Saudi Arabia's Eastern Province-areas that have
large and disadvantaged Shia populations. The great-
est threat posed by the Islamic resurgence, however,
stems from its manipulation by opposition groups or
subversives as a tool for challenging established au-
The Israel Question
The Arab boycott against firms assisting Israel re-
mains a potential threat to US firms as well as an
obstacle prohibiting some US companies from partici-
pating in Gulf development. The cost of the boycott to
US firms in terms of lost business with the Gulf states
is difficult to measure, but it probably totals in the
millions of dollars annually. The boycott almost cer-
tainly will remain an impediment to US commercial
participation in the Gulf economies, given the growing
local concern over strong US-Israeli ties.
Cultural Idiosyncrasies
Arab culture poses significant obstacles to further
development and foreign investment. Organizational
and managerial skills are not traditional strengths of
Gulf Arabs. Most Gulf managers exhibit an extreme
reluctance to delegate authority and a misunderstand-
ing of Western business methods,
The tendency to remain centralized,
inflexible, and small, works against successful privati-
zation and industrialization on a large scale. Preoccu-
pation with maintaining control and Islamic tenets
against usury have frustrated the development of
efficient capital markets and hindered the spontane-
ous growth of new business ventures. A preference for
consultation and consensus contrasts sharply with
Arab perceptions that the US business culture is
impersonal and exclusionary. Maintaining a public
facade of prosperity supersedes the need for objective
problem solving. In addition, a strong predilection
toward fatalism, associated with Islamic values,
dampens innovation and entrepreneurial spirit.
Our analysis shows that much of the business risk in
the Gulf can be substantially reduced or eliminated
by appropriate diversification. Although the Gulf
business environment is several times more risky than
the environment in the United States, much of the
risk inherent in investing in the Gulf is specific to
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Arab boycotts against the Jewish community in Pal-
estine and firms dealing with this community predate
the establishment of the State of Israel in 1948.
Today, only companies considered to be significantly
contributing to the economic development or military
strength of Israel are subject to the boycott. The
Arab League does not distinguish among the various
types of boycotts it administers, but the world busi-
ness community generally does. The primary boycott
bans all direct trade between Arab states and Israel.
Until the United States enacted strict antiboycott
legislation in 1977, the primary ban was most com-
monly enforced by a negative certificate of origin
stating that the goods in question had no association
with Israel. Currently, the Gulf states accept a
positive certificate of origin indicating where the
product is produced and the name of the manufactur-
A secondary form of the boycott, instituted in the
early 1950s, expands on the type of activity consid-
ered to significantly benefit Israel's economy or mili-
tary. A firm is blacklisted under the secondary
boycott if it:
? Has a plant, branch, licensee, or regional agent for
the Middle East in Israel.
? Is a partner in any Israeli company.
? Advises Israeli manufacturers.
? Acts as agent or principal importer for any Israeli
firm.
? Prospects for natural resources in Israel.
Third-country firms suspected of proscribed activity
in Israel are usually presented with a questionnaire
asking if they are engaged in forbidden practices. A
positive response results in blacklisting. US firms are
prohibited from responding to boycott questionnaires
under the 1977 antiboycott legislation. The law also
requires US companies to report the receipt of ques-
tionnaires to the US Department of Commerce.
An extended form of the secondary boycott requires
the third-country firm to refuse to use products or
services of blacklisted companies in fulfilling a con-
tract or sale to enforcing countries. A clause requir-
ing such a refusal sometimes appears as a contract
condition. This requirement has been labeled a tertia-
ry boycott in the United States. It is especially
prevalent in international banking. As Arab financial
institutions have increased their role as lenders to
corporate and government borrowers, some borrowers
have been pressed to refrain from dealing with black-
listed banks or other institutions with Israeli connec-
tions. This problem is likely to assume greater
proportions as the international prowess of Gulf
financial institutions grows.
The boycott is administered by a Central Boycott
Office (CBO) with headquarters in Syria and national
boycott offices in each Arab country. A central
committee composed of a representative from each
Arab League state meets semiannually to revise the
list of blacklisted firms. Implementation of the CBO
recommendations is not compulsory, and compliance
varies widely among the Gulf states, essentially
creating five individual blacklists. In the region,
Kuwait probably adheres most closely to the CBO
recommendations, while Saudi Arabia exhibits the
greatest flexibility in interpreting the committee's
recommendations. A primary determinant of govern-
ment support for the boycott is the relative availabil-
ity of goods or services. Tenets of the boycott have
frequently been overlooked by all of the Gulf states to
secure badly needed goods or services available only
from a blacklisted firm.
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Social Customs and Economic Development
Economic development in the Gulf states relies on a
balance between the area's need to modernize and the
conservative, traditional values of society. These two
opposing and in some cases incompatible elements
frequently frustrate development and influence oppor-
tunities for participation. Regional customs stemming
from tribal origins, religious beliefs, geographical
constraints, and tradition often have a direct impact
on the commercial environment through higher costs
or barriers to entry. Such customs include:
? The exclusion of women from gainful employment
outside the home. Segregated working areas must
be provided for most women who work. Excluding
women from the workforce restricts the supply of
labor and hinders productivity.
? Unemployment is not a disgrace, and prolonged
effort to achieve a task is often the exception among
the native work force.
? Islamic tenets against the payment of interest have
frustrated the development of efficient capital mar-
kets in several Gulf states and hinder business
transactions.
? The preference for consultation and consensus
slows the decisionmaking process.
? Tribal allegiance and financial kickbacks continue
to influence business decisions.
each state and sector and is largely unrelated to
external events in the world economy or the United
States. This is especially true of most nonoil sectors.'
The cumulative effect of appropriate diversification of
foreign investments into selected Gulf nonoil sectors is
to reduce the level of risk of investment. This would
be especially true of joint US investments in the
nonoil sectors of Bahrain, Qatar, Saudi Arabia, and
the UAE. The risk associated with the oil industry is
much higher and less subject to reduction through
diversification. This sector, however, will remain the
backbone of all Gulf economies, and improving pros-
pects for oil sales and prices imply growing opportuni-
ties for profitable participation in this area.
Overall, we assess the level of political risk, either of
radical regime change or threat to US operations, to
be moderate for the rest of this decade. Most regimes
appear to be in firm control and supported by loyal,
effective security forces, according to US Embassy
reporting. Regimes in general are favorably disposed
to the US business community and investment. Nev-
ertheless, the proximity of the Iran-Iraq conflict, the
growth of Iranian-inspired subversion, and incipient
opposition movements raise the prospect of increasing
social tension and political instability over the next
several years.
If the US military presence in the Gulf increases, the
threat of hostile action against US operations almost
certainly will rise-especially in Bahrain, Kuwait,
and Saudi Arabia.
Kuwaiti oil
facilities were bombed-apparently by Iranian sym-
pathizers-three times last spring, and eight Iranian
Silkworm missiles have been launched at Kuwaiti
industrial targets this year, damaging two tankers and
a primary crude oil export facility. US operations that
are most vulnerable to political violence include:
? Obvious US firms. Companies that include "Ameri-
can" or "US" as part of their corporate name fall
under this rubric as would firms marketing distinct-
ly US products such a Coca Cola, IBM, Ford, and
General Motors.
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? Companies regarded as "multinational." Major oil
companies, international construction firms, and
financial institutions with global operations are ex-
amples of organizations facing a higher risk of
political violence.
? Manufacturers of symbolic products. Companies
that produce cars, cigarettes, soft drinks, or other
products that have widespread distribution, high
visibility, and evoke an image of superiority or
dominance that is at odds with beliefs of the local
population-especially the religious community-
may be targets of political retaliation.
? Firms that lack local management.
? Businesses with poor labor or industrial relations.
? Companies with poor corporate-community
relations.
We expect that Gulf governments and private firms
will subject international firms to greater scrutiny and
operating restrictions as they deal with reduced oil
revenues and the regional recession:
? Economic planners are placing greater emphasis on
managing the cost of capital and improving the
return on investment-virtually unconsidered con-
cepts in previous planning periods.
? Governments are giving preference to national or
regional companies more often than in the past.
? International firms have come under increased scru-
tiny for financial and technical strength.
? Price competition is an increasingly important de-
terminant in contract negotiations.
? Quality control and time schedules are more strictly
enforced and larger penalties assessed for deviations
from contract specifications.
? Contract bids increasingly require project financing
to be considered.
? Payment for contracts is often delayed to conserve
foreign exchange.
The changing business environment poses significant
obstacles to US participation in Gulf economies. We
believe that US firms will be more acceptable if they:
? Consider establishing a local company, if regula-
tions permit, or a joint venture with local or regional
companies.
? Bid for projects that include a high content of
technology, engineering, maintenance, and sophisti-
cated management.
? Bid on projects for which acceptable financial pack-
ages can be arranged. Financing may become one of
the most important factors deciding project awards.
? Allow for a long waiting period for contract accep-
tance and processing of payments.
We believe that the rise of the service sector as an
increasingly important source of GDP and target of
government spending and the leveling off of merchan-
dise imports will lead to fundamental changes in the
nature of Gulf markets. Emphasis will shift from
selling a product to selling the solution to a customer's
problem in the years ahead. The shift to a service
economy implies a longer term relationship between
customers and suppliers that, once started, may be
difficult and costly to change.
We believe rising oil prices in the early 1990s will help
initiate another round of Gulf state development. We
project that demand for Gulf oil will increase more
rapidly early in the next decade as output outside the
Gulf stagnates or begins to decline. Higher oil prices
and exports will translate into accelerating growth in
revenues and GDP in most Gulf states. Trade and
budget deficits will be reversed, allowing depleted
foreign exchange and investment positions to be
replenished.
We believe that rising oil revenues, increasingly ap-
parent flaws in past development schemes, and a
growing sense of the depletion of domestic oil reserves
will combine in the early 1990s to give the third wave
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Figure 8
Gulf States: Composition of
Merchandise Trade with the U.S.
Millions of U.S.$
Manufactured Goods 0 Raw Materials
0 Foodstuffs IN Otner.
0 Fuels
18,000
16,000
14,000
12,000
10,000
8,000
Imports
6,000
F'~
4,000
2,000
0
1980 81 82 83 84
85 86
of Gulf state development a much different look from
the last two phases. In our judgment, this phenome-
non will be confined to Kuwait, Saudi Arabia, and
Abu Dhabi in the UAE because oil production in the
other emirates, Bahrain, and Qatar will probably be
declining. The third wave will most likely be charac-
terized by further improvement in infrastructure and
an escalating demand for services-especially social
Figure 9
Gulf States: Origin of GDP
Non-oil
Oil
services. More important, however, an increasing
share of Gulf state revenues is likely to be invested
abroad-similar to Kuwait's current development
strategy-as regional planners come to realize that
past growth has not produced an economic base
capable of sustaining national populations. Western
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The Kuwaiti Development Model
Kuwait's approach to development and long-term
planning differs sharply from programs followed by
the other Gulf states. Kuwait did not embark on
massive development schemes during the boom years
or attempt to diversify its economy into areas that
ultimately could not survive or support the nation
after oil reserves are depleted. Instead, the Kuwaiti
regime placed a large share of its oil revenues in long-
term foreign investments, deliberately tying their fate
to the performance of Western economies. As a result,
the Kuwaitis have established a world-class distribu-
tion network for their oil and purchased substantial
stakes in a variety offoreign productive assets.
Despite facing the same obstacles to development as
the neighboring Gulf states, the Kuwaitis have ridden
out the Gulf recession with less disruption to their
economy. Investment income in recent years has
surpassed oil revenues as a source offoreign earnings.
financial scholars have frequently noted the incongru-
ity between the low levels of national savings and
rates of return on development and the depletion of
domestic oil reserves. In a sense, the Gulf states will
buy the means of production that they have been
unable to build locally.
As a consequence of evolving development strategies,
we believe that trade patterns will change substantial-
ly. Merchandise trade will probably grow slowly. New
investment policies for the Gulf states will probably
accelerate the shift of their foreign investment portfo-
lios away from short-term government securities to
equities, land, and foreign production facilities. Fewer
petrodollars are likely to be recycled to the West as
trade or financing for budget deficits, and a larger
share of Gulf state funds will return to the West as
long-term ownership of productive assets-especially
in the United States. The growing sophistication of
Gulf banks augurs for a greater role for them in the
recycling process. These changes in fund flows and
investments probably will raise prospects for conflict
over national ownership shares, investment laws, and
international taxation.
We believe that maintaining a large, if not dominant,
trade position with the Gulf states will be increasingly
important to the financial and energy security of the
United States in the years ahead as US oil production
begins to decline. Trade with the Gulf supports
approximately 240,000 jobs in the United States,
absorbs several billion dollars' worth of military sales
annually, and in recent years has provided a source of
financing for US trade and budget deficits, according
to estimates by the US Commerce Department.
About 40,000 US citizens are employed in the Gulf
states, according to US Embassy reporting. We be-
lieve that real annual demand for services of all
varieties will more than double to $60 billion by the
late 1990s. Annual Gulf state merchandise imports,
on the other hand, will probably remain in the $30-40
billion range unless Gulf governments undertake ad-
ditional large-scale infrastructure development, which
is unlikely. Moreover, the region will retain a high
degree of financial liquidity and ability to meet its
foreign payment obligations.
We believe that competition among the United States,
Japan, and Western Europe for lucrative Gulf
trade-both goods and services-will become more
intense and possibly contentious. Japan and the Euro-
pean Economic Community have taken the lead over
the United States in adapting their trade strategies to
the new commercial realities in the region by estab-
lishing greater government support networks for
domestic firms, offering enticing financial packages,
and expanding joint ventures and production roles
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The view that oil revenues will increase in the years
ahead and that economic prosperity will lead to
lucrative opportunities for US participation in the
Gulf economies is not the only interpretation possible.
There is a considerable risk that oil prices could once
again tumble. Wider fluctuations in oil prices and
demand would leave most regimes vulnerable to
destabilizing social turmoil or outside subversion.
Stability in world oil markets and Gulf economies
will depend heavily on continued OPEC discipline
that is only partly under the control of the Gulf
states primarily Saudi Arabia. A substantial weak-
ening of the Gulf economies would significantly raise
the risk offinancial or property loss.
The Iran-Iraq conflict could easily disrupt oil mar-
kets. Iran has threatened to expand the scope of the
war to the Gulf states if they continue to assist Iraq.
The conflict already has been internationalized and
the threat to oil tankers in the Gulf significantly
raised. Iran or Iraq could decide unilaterally to raise
their oil production, forcing the Gulf states-espe-
cially Saudi Arabia-to cut production to maintain
prices. Conversely, Riyadh could raise output and
trigger a price war in the hopes of restoring OPEC
with Gulf firms. Already large trade deficits the EC
and Japan run with regional states provide an addi-
tional strong motivation for enhanced trade ties
discipline. Another round of uncontrolled production
and price competition almost certainly would have a
ruinous impact on several Gulf economies.
Economic mismanagement or hardship have played a
role in regime changes in several Gulf states and
could easily become a rallying point for religious
fundamentalists or others seeking to change the
direction of Gulf societies. The coup attempt in the
emirate of Sharjah this year and the deposition of
Saudi King Saud in 1963 were the results of the
perceived ineptitude of these leaders in guiding their
economies. The dissolution of the national assemblies
in Bahrain and Kuwait and the autocratic style of
government in the other Gulf states leave these
leaders personally vulnerable to criticism for eco-
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created a more hospitable business environment for
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The European Challenge
West European countries, especially the United King-
dom, France, and Italy, have deep-rooted commercial
and historical ties to the Middle East that serve as a
foundation for expanded trade relations. Western
Europe's divergence from Washington on the Pales-
tinian issue and other sensitive political matters has
garnered considerable favor in Gulf capitals and
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Figure 10
Percent of US, EC, and
Japanese Petroleum Importsa
1980-1986
Japanese
EC
Us
Percent
82 83 84 85 86 b
Years
a Petroleum imports account for 33 percent of US demand, 70
percent of EC demand, and 100 percent of Japanese demand.
West European relations with the Gulf states will
continue to hinge on oil and military sales. European
dependence on Gulf oil will increase rapidly as North
Sea oil production begins to decline, perhaps in the
next few years, and bilateral trade deficits escalate.
This trade imbalance almost certainly will raise Euro-
pean government interest in securing a greater share
of Gulf trade. West European states are particularly
well positioned to benefit from large military proj-
ects-over $10 billion by 1995-planned by Saudi
Arabia, Kuwait, and the UAE. Lingering Arab per
ceptions of Washington's intransigence on past arms
requests and a regionwide desire to diversify sources
of military supplies underscore the European advan-
tage in arms agreements. The sophistication of the
large arms packages under consideration also implies
a long-term service relationship.
Japanese Competition
Japan's thirst for oil, dependence on export trade, and
tendency to play to all sides in the Middle East
combine to make Tokyo the favorite in the contest for
Gulf merchandise trade in the coming years.
Japan's virtual dependence
on imported oil-over 55 percent came from the Gulf
states recently-creates one of Tokyo's largest bilat-
eral trade deficits and a strong motivation to balance
commercial relations.
We do not believe, however, that Tokyo's competitive
edge is secure. A strong yen already is undercutting
Japanese merchandise sales. Limited expertise in oil-
related fields leaves Japanese firms at a disadvantage
An Opening for Moscow
Although traditionally unreceptive to Soviet and East
European economic overtures, most of the five Gulf
states probably view some increase in commercial
contact with Communist states as politically useful.
This view is strengthened by a desire to balance
relations with the superpowers. Improved relations
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Figure 11
Oil Reserves to
Production Ratio, 19868
North and South
America less US
I Based on average oil production and reserve levels for 1986.
Ratios can very greatly based on average oil production levels.
Ratios for the Gulf states would be higher for 1987 because of
lower oil production levels.
of Soviet goods, and Kuwait's desire to maintain
independence from either superpower. The other Gulf
states almost certainly will take their cue from Saudi
Arabia, which will move slowly in improving econom-
ic ties to the Soviets.
Oil remains the single area of long-term mutual
economic interest. Although the Gulf states have not
had a significant petroleum supply relationship with
the Communist countries, East European countries
probably will seek Gulf oil as Moscow husbands its
domestic oil resources. The weak foreign exchange
positions of the East European states suggest that
other means of payment will have to be found or
political relationships significantly altered.
Athough Soviet priorities in the Persian Gulf proba-
bly will continue to focus on Iran and Iraq, Moscow's
style of operating in the region has changed under
Gorbachev. He has pressed Soviet interests more
vigorously and imaginatively in the area, responded to
openings more quickly, and appears more attuned to
regional subtleties than his predecessors. Still, Soviet
initiatives over the next few years probably will not
produce significant gains unless the Gulf states con-
tinue efforts to diversify their relations with the
superpowers, enhance their nonaligned credentials,
and expand the market for their petrochemical
exports.
with the USSR and its allies can also be used as a
lever in relations with the West, as demonstrated by
Kuwait's efforts to obtain protection for its tankers.
On balance, however, there are few significant areas
of mutual economic interest between the Gulf states
and the Communist countries. Kuwait probably will
move ahead with several energy-related joint ventures
and further military trade agreements with the Sovi-
ets, but the extent of
the relationship will be limited by the poor rate of
return on such arrangements, the relative inferiority
25X1
25X1
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Appendix
Risk Methodology
Measuring the rate of real GDP growth-rate of
return on the economy-over time, its variability, and
its relationship to outside events is one means of
defining and understanding risk. Average growth of
gross domestic product (GDP) over time is a generally
available and quantifiable measure of performance
but gives no information about the dispersion of
growth around the average. The standard deviation is
a commonly accepted measure of dispersion-or total
risk-around the average that makes possible mean-
ingful statements about the probability of a given rate
of growth. Finally, the correlation coefficient-specif-
ically the Pearson Product Moment-measures the
relative performance of two events over time. This
measure ranges between 1 and -1 with estimates
closer to either extreme indicating a strong direct or
inverse relationship, respectively. The correlation co-
efficient, however, does not imply a cause-and-effect
relationship.
Combining these measures provides a useful concep-
tual framework for defining and managing risk. For
example, if two investments-in nations or firms-
have the same average growth but different standard
deviations of growth, the investment with the greater
dispersion of growth over time-larger standard devi-
ation-would be considered more risky. As a corol-
lary, combining two investments in equal proportions
that have the same average growth and standard
deviation of growth and a correlation coefficient of
+ 1 would yield a combined investment with the same
average growth and standard deviation as the two
separate investments individually. In sharp contrast,
assuming a correlation coefficient of - 1 between the
same two investments would produce a total invest-
ment with the same average growth but a zero
standard deviation-no risk. This last case demon-
strates the advantage of diversification commonly
referred to in modern investment theory.
Measuring risk, however, does not provide informa-
tion about its cause. Business risk includes uncertain-
ty about prices, the demand for output, cost of inputs,
and technological and managerial efficiency. In turn,
these factors are influenced by changes in the general
level of business activity, the political environment,
and international events. This framework suggests
two separate, but related, risk components-a unique
firm-specific risk component and an exogenous risk
factor that measures how a firm's level of activity
varies with general economic conditions. This separa-
tion of risk into specific and exogenous components is
consistent with the tenets of modern financial theory
and is the foundation of financial portfolio manage-
ment.
Using this framework and treating the economies of
each Gulf state and that of the United States as
discrete investment opportunities, one can obtain esti- 25X1
mates of respective total risk, and this can be divided
into its various components. For modeling purposes,
the real growth of the OECD was used as a proxy for
the international economy, and the real growth of
world oil sales was used as a proxy for the oil industry
sector. Using the ordinary least-squares regression
model, these two independent variables were re-
gressed against the five Gulf states' real GDP growth
rates and real nonoil GDP growth rates. The amount
of total risk-standard deviation-explained by the
real OECD growth variable was assumed to provide
an estimate of the exogenous risk component. The
amount of total risk explained by the real oil variable
was assumed to provide an estimate of one component
of the specific-risk factor. The residual unexplained
risk was assumed to explain remaining specific risk.
The result of this analysis shows that the international
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Table 8
Gulf States: Risk Indicators, 1981-86
Average Total Risk
Growth Standard
(percent) Deviation a
OECD GDP 2.4 1.6 0.98
United States GDP 2.6 2.7 1.00
Bahrain
Correlation Share of Risk Share of Risk Share of
With the US Explained by Explained by Unexplained
Economy b OECD Growth the Oil Market Risk (percent)
(percent) (percent)
a The standard deviation is a commonly used and generally accept-
ed measure of the variation in a population. The variation of GDP
is assumed to be a good proxy for the inherent risk of the business
environment of the Gulf states. The standard deviation is the square
root of the variance of the population.
b The correlation coefficient varies between 1.0 and - 1.0 and
measures the degree of association between two variables. An
estimate close to I implies a strong positive association, whereas a
value close to -1 implies a strong inverse relationship between the
variables. The correlation coefficient does not imply a cause-and-
effect relationship.
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Figure 12
Risk Schematic: Joint investment in the
United States and the UAE non-oil sector
Percent of total
risk explained by
OECD growth
Percent of total
risk explained by
oil market
Correlation coefficient
between the UAE
and the US
Percent of total
risk unexplained by
OECD or oil market
No reductions
Some reduction
Exogenous risk reduced
to risk of the OECD
No reduction
Some reduction
Total reduction of
this risk factor
No reduction
Some reduction
Total reduction of
this risk factor
Sum of adjusted
risk components
equals portfolio risk
economy factor explains only a small amount of the
variation in the economic performance of the five
Gulf states. More important, the analysis shows that
most of the total risk inherent in the economies of the
five Gulf states is country specific-especially in the
nonoil sector.
to portfolio analysis, it appears that the country-
specific risk component-the largest share of risk in
the Gulf states-is the one most subject to reduction
through appropriate diversification, especially when a
low or negative correlation exists between a specific
Gulf economy or economic sector and that of the
United States. Through diversification of investments
into selected Gulf economies, a significant reduction 25X1
in investment risk can be achieved. For example,
combining the information on average growth, total
risk, and correlation between the nonoil sector of the
UAE and the US economy demonstrates that an
25X1
25X1
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Figure 13
Example of Joint Investment
in the United States and the
UAE Non-oil Sector
- Portfolio Return Average Growth
? Portfolio Return Standard Deviation
0 0 10 20 30 40 50 60 70 80 90 100
Percent invested in the UAE Non-oil Sector a
a The percent invested in the United States equals one minus the
percent invested in the UAE Non-oil Sector.
Portfolio
Percent
in UAE
Percent
in US
Portfolio
Risk
Average
Growth
1
0
100
2.66
2.37
2
10
90
1.78
2.47
3
15
85
1.60
2.52
4
20
80
1.68
2.57
5
30
70
2.46
2.67
6
40
60
3.57
2.77
7
50
50
4.8
2.87
8
60
40
6.07
2.97
9
70
30
7.36
3.08
10
80
20
8.67
3.18
11
90
10
9.98
3.28
12
100
0
11.29
3.38
investment putting about 15 percent of assets in the
UAE nonoil sector and 85 percent in the US economy
would have maximized the rate of return and mini-
mized the portfolio risk. The average return would
have been slightly higher than that of the US share
alone, while the risk would have been 40 percent lower
than that of the US share. This level of performance
and risk surpasses the levels available from a single
investment in the United States or the UAE nonoil
sector over the period and demonstrates the advantage
of diversification and value of investments in selected
Gulf economies.
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Secret
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