MIDDLE EASTERN OIL EXPORTERS: LIVING WITH LESS REVENUE

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88T00096R000600780001-1
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 37
• Document Creation Date: December 27, 2016
• Document Release Date: April 7, 2011
• Sequence Number: 1
• Publication Date: July 1, 1987
• Content Type: REPORT

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Directorate of
Intelligence
Middle Eastern Oil Exporters:
Living With Less Revenue
Secret
NESA 87-10033
July 1987
Copy 3 91
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Intelligence
Directorate of Secret
Middle Eastern Oil Exporters:
Living With Less Revenue
An Intelligence Assessment
This paper was prepared by
of Near Eastern and South'Asian Analysis'
with the Directorate of Operations.
Division, NESA
Comments and queries are welcome and may be
addressed to the Chief, Issues and Applications
Secret
NESA 87-10033
July 1987
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Key Judgments
Information available
as of 1 June 1987 was
used in this report.
Middle Eastern Oil Exporters:
Living With Less Revenue 25X1
groups, especially the military.
The oil-exporting states of the Middle East will find it increasingly difficult
to cope with the pressures resulting from low oil revenues over the next two
years. We project a 7-percent decline in their combined GDP this year and
another 1 percent next year, even if oil prices stay at about $18 per barrel.
The most serious challenge will come as governments try to distribute
cutbacks equitably while accommodating the demands of key interest
Soviet intentions.
The recession and its effects will encourage leaders of the Middle Eastern
oil-exporting states to put distance between themselves and the United
States. Indeed, some leaders will attempt to shore up their political
positions by blaming their problems on the United States. The economical-
ly hardest pressed states will increase demands for US economic and
financial aid. Although Moscow will try to exploit tensions between the
United States and the Middle Eastern oil exporters, its gains over the next
two years are likely to be limited because most of these states are wary of
poorer elements of society.
The size of the population, accumulated savings, and the strength of the
political system and security services will determine the impact of the
recession on the individual countries. The countries facing the biggest
challenge are Algeria, Egypt, and Tunisia, all of which have large
populations, high current expenditures, and limited financial reserves. The
Gulf states, and Saudi Arabia in particular, have small populations relative
to their savings and thus are better equipped to maintain spending, but
they still must work to defuse growing tensions between the richer and
successfully co-opted or repressed religious groups.
The oil price decline is only one of many threats to stability in the area, but
the strains of trying to live with less revenue will encourage regime-
destabilizing activities in many of the countries. The lingering recession
provides a breeding ground for Islamic fundamentalism. Many disadvan-
taged Middle Easterners find the fundamentalist message persuasive and
are inclined to blame Western influence for social injustice and disparities
between rich and poor. The threat is most acute in Egypt, where
fundamentalist groups are relatively well organized and social and econom-
ic conditions are bleak. Islamic fundamentalism is also gaining adherents
in the Persian Gulf states, but the leaders of these states have either
iii Secret
NESA 87-10033
July 1987
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Regimes will rely primarily on nonviolent repressive measures to prevent
dissatisfaction with the recession from developing into open unrest. If
unrest does break out-as is likely in some states-the governments will
quickly use their large security and military services to contain it. Most
governments-especially Egypt in the wake of last year's police riots-will
try to shield the military and security forces from serious financial
cutbacks to insure their loyalty. Area rulers will draw on their financial re-
serves as long as necessary to continue this policy, and the poorer states will
cut the security forces proportionately less than other sectors.
In all states in the region, government officials and disgruntled citizens will
scrutinize bloated bureaucracies and wasteful spending practices more
closely than before. Governments will send home some expatriate workers
and encourage their own populations to develop skills appropriate to
domestic needs. But economic reforms such as diversification and stimula-
tion of private enterprise will founder in most countries because business-
men and governments do not have sufficient capital or are unwilling to risk
promoting new projects.
The preoccupation of most oil-exporting states with their economic and
other domestic problems will tend to make their foreign policies less
assertive. Foreign aid disbursements by the richer Gulf states will be
reduced, even to other Arab states such as Syria, Jordan, and perhaps Iraq.
Competition for declining funds will strain relations between donors and
recipients. Assistance to states outside the Arab or Islamic worlds will be
cut even more.
In the unlikely case that oil prices drop to about $10 per barrel and remain
there for a.prolonged period, the problems of the Middle Eastern oil
exporters would intensify significantly. At $10 per barrel, GDP would fall
by 25 percent this year and by another 15 percent in 1988. The Gulf states
could cope better than the North African states with such a drop because
they have smaller populations and greater financial and oil resources. Still,
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all of the countries would be required to make wrenching cuts, in some
cases reaching regime-threatening proportions.
The economic difficulties that these countries face would diminish only
moderately under a more optimistic, but also unlikely, scenario in which oil
prices stabilize at about $25 per barrel during the next two years. Real
GDP would increase by 5 percent this year and by 3 percent in 1988. Ex-
treme spending cuts would be avoided, but concern about another price
decline probably would discourage new initiatives in economic develop-
ment.
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Scope Note This assessment examines the methods the Middle Eastern net oil export-
ers-Algeria, Bahrain, Egypt, Iran, Iraq, Kuwait, Libya, Oman, Qatar,
Saudi Arabia, Tunisia, and the United Arab Emirates-are using to cope
with reduced revenues and the threat of social and political instability. It
also looks at related economic, political, and social developments over the
next two years and how these states will deal with them. The assessment
assumes that oil prices and production will remain near OPEC's targets
established in December 1986 but explores alternative scenarios.
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Key Judgments
Scope Note
The Foreign Payments Problem
6
Sending Expatriates Home
8
Borrowing Supplements Savings
9
Social and Political Impact of Austerity Measures
11
Employment Tensions
11
Maintaining Stability
12
Protecting the Military and Security Services
13
Emphasizing Pragmatic Foreign Relations
15
Impact on Checkbook Diplomacy
15
Coping With Reality
High Absorbers
Implications for the United States
Econometric Methodology
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Figure 1
Middle Eastern Oil-Exporting Countries
Bound ary representation is
not necessarily authoritative.
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Middle Eastern Oil Exporters:
Living With Less Revenue
The Middle Eastern oil-exporting countries reaped an
unprecedented revenue bonanza from the dramatic oil
price hikes of 1973 and 1979 and quickly began
developing their economies.' They undertook major
industrial projects; expanded roads, ports, and com-
munications; implemented social welfare programs to
provide education, health care, and basic necessities
for their citizens at subsidized prices; and embarked
on ambitious military modernization programs. All of
these efforts were overwhelmingly dependent on oil
income.
The golden days of the oil boom have faded-at least
temporarily-and these states are being forced to
adjust to significantly lower oil revenues and a poten-
tially troubling recession. After peaking at $34 a
barrel in 1981, oil prices declined to an average of
about $15 per barrel in 1986. With inflation and the
fall of the dollar, in which oil prices are denominated,
the purchasing power of a barrel of oil sold by these
states is only about 40 percent of what it was in 1981.
Economic prospects for the Middle Eastern oil export-
ers hinge largely on the OPEC agreement reached in
December 1986 that set production quotas and fixed
prices at an average of $18 per barrel. Even if prices
are maintained at OPEC-mandated levels, the pro-
ducing countries in aggregate are unlikely to experi-
ence any economic growth over the next two years.
According to our econometric model, overall GDP
will decline by about 7 percent this year, decline by
another 1 percent next year, and will slightly recover
in 1989. We believe these countries will do little more
regarding economic development than try to limit the
impact of the continuing recession. Even those
' The Middle Eastern oil-exporting countries include Algeria,
Bahrain, Egypt, Iran, Iraq, Kuwait, Libya, Oman, Qatar,
Saudi Arabia, Tunisia, and the United Arab Emirates (UAE).
countries with substantial financial reserves will con-
tinue to fear renewed instability in the oil market and
will be reluctant to initiate costly development pro-
grams, perhaps even postponing projects already un-
der way.
Efforts To Boost Revenues
We believe that many of the governments will attempt
to increase revenues by raising tax rates and compli-
ance, but these policies are unlikely to affect the
revenue picture substantially. Many of their 1987
budgets include fees for social services and utilities,
taxes on luxury items, excise taxes on tobacco and
alcohol products, tolls, and increased tariffs. Accord-
ing to US Embassy sources, Tunis is considering a tax
hike for higher income brackets and tighter adminis-
trative policies to make tax avoidance more difficult.
Even countries that do not have income taxes, such as
Saudi Arabia, are considering levying them, accord-
ing to US Embassy reporting. We believe, however,
that fears of domestic unrest will deter these states
from implementing effective measures to increase
substantially domestic tax revenues. We expect, con-
sequently, that oil will continue to provide an average
of roughly two-thirds-as low as 20 percent for
Tunisia and as high as 90 percent for the UAE-of
aggregate government revenues.
Cuts in Spending
Despite slashes in government spending by about 20
percent during the last three years, the governments
are likely to make additional spending cuts even if oil
prices remain at $18 per barrel. Our model projects
that government spending this year will fall 5 percent
from the 1986 level and at best remain constant next
year. Many of these states probably will try to trim
the sizable budget and current account deficits they
have experienced over the last few years. Although
the biggest cuts have already been made, they have
also been the easiest. Future cuts, even small ones, are
likely to be more painful.
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Figure 2
Middle Eastern Oil Exporters: Improvements in Health,
Education, and Welfare,-- 1970 and 1986
Life Expectancy
Years
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
1970
1986
Literacy Rate Per Capita Incomeb
Percent Thousand US $
8 Estimates based on available data.
b Figures for Persian Gulf countries include large expatriate
populations which skews actual figure for native per capita income
downward.
Spending on defense and security personnel and pro-
grams that promote a specific government objective or
protect critical interest groups will probably follow
past trends and be spared or cut proportionately less
than the overall budget. In Saudi Arabia, for exam-
ple, the 1987 budget increases spending for manpower
and education programs to support Riyadh's Saudiza=
tion efforts and includes new funding for Islamic
universities and more services in Mecca and Medina
to appeal to religious groups.
Most states will probably avoid significant cuts or
move cautiously in changing existing subsidies or
services. In Tunisia, for example, concern that the
bloody 1984 food riots would be repeated delayed the
Bourguiba government's cut in subsidies until mid-
1986 when rapidly deteriorating economic conditions
forced the implementation of reforms. Similar qualms
have prompted Egyptian President Mubarak to pur-
sue a highly cautious and gradualist approach to
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Figure 3
Middle Eastern Oil Exporters: Declining Oil Revenues
Aggregate Oil Revenues, 1980-87 Purchasing Power of One Barrel of Oil,e
Billion US $ 1970-87
Index: 1970=100
Oil Revenues,c d 1980 and 1985
Billion US $
Algeria
Bahrain
Egypt
I ran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
1980
1985
W
a See appendix I for methodology. C Oil revenues accruing to the government.
b Estimated, based on $18 per barrel and the d Source: International Financial Statistics.
OPEC assigned production quota.
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Figure 4
Middle Eastern Oil Exporters:
Aggregate Real GDP Growth,
1980-88
-30 1980 81 82 83 84 85 86 87a 87b 87c 88a 88b 88?
a Assumes oil at $18 per barrel.
b Assumes oil at $10 barrel.
c Assumes oil at $25 per barrel.
raising prices. The price of bread was raised by first
doubling both its size and price and then slowly
trimming the size of the loaf. We believe he will
retract any increases at the first sign of trouble. An
attempt by President Sadat to raise food prices in
1977 resulted in widespread rioting and an immediate
retraction of the cost increases.
Operating, maintenance, and administrative expendi-
tures are likely to suffer the biggest cuts. We expect
most states will try to make reductions evenly from
nearly all civilian categories in their 1987 budgets and
to follow a similar pattern in 1988. With most major
development projects already scaled back or dropped,
the governments are now attempting to spread the
cuts broadly to avoid creating additional economic
disparities. The governments will try to spare wages,
but we believe the middle class-especially techno-
crats, civil servants, and small businessmen-will be
Figure 5
Middle Eastern Oil Exporters:
Oil Exports as a Share of
Government Revenue, 1985
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
hurt disproportionately. Those governments that elect
or are forced to cut benefits will try to mask the
impact of the measures. In Libya, for example, the
government trimmed the salaries of government work-
ers by reducing the number of pay periods in a year,
delaying checks, and forcing employees to deposit
funds in government accounts with limited
withdrawals.
The business community is likely to continue to bear
most directly the negative impact of the economic
recession because governments have canceled develop-
ment projects, cut contractors' profit margins, de-
manded that companies finance projects without gov-
ernment assistance, and delayed payments. US
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Figure 6
Middle Eastern Oil Exporters: Cuts in Government Spendingab
Current 1982
Capital 1982
Current 1985
Capital 1985
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.?
Current and Capital Government
Spending, 1982 and 1985
Billion US $
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
1982
1985
Military Spending as a Share of
Total Spending, 1982 and 1985
Percent
ii
4
Aggregate Government Spending,
1980-88
Billion US $
a Actual spending during fiscal year.
b Source:
CIA estimates.
c Federal spending. Individual emirates fund
capital projects outside the context of the federal
budget, but defense expenditures are generally
covered by federal spending.
dEstimate based on CIA model and $18 per
barrel of oil.
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Embassies in the Gulf states report that a sharp
increase in bankruptcies of private firms, including
some of the largest in the UAE, has led to consider-
able grumbling among businessmen. Although we
believe that resentment of government economic poli-
cies by this group will increase significantly, the
business communities' close identification with, and
sometimes membership in, the countries' ruling estab-
lishments will limit exploitation by opponents of the
regimes.
Economic Reform
As the economic recession has settled into the region,
the Middle Eastern oil exporters have been forced to
reevaluate their economic policies. Many of the coun-
tries have started to streamline their institutions and
look more pragmatically at their economic pro-
grams-actions that please traditionalists who are
concerned with the rapid pace and direction of devel-
opment. In Saudi Arabia the government is consider-
ing eliminating several agencies charged with specific
oil market functions, according to Embassy reporting.
Although corruption and wasteful spending persist,
the actions of officials are being more carefully
scrutinized by the public. Last fall Oman fired the
influential Minister of Housing because of growing
public criticism of his corruption and mismanage-
Figure 7
Middle Eastern Oil Exporters:
Oil and Gas Exports as a Share of
Total Exports, 1986
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
ment, according to US Embassy sources.
Many of the Middle Eastern oil exporters are looking
to privatization and diversification to make their
economies more efficient and less vulnerable to oil
market fluctuations. But liquidity problems facing
private companies even in relatively wealthy states
such as Saudi Arabia, Kuwait, and the UAE will
probably make it difficult for the private sector to
become a major force in stimulating growth. Press
reports indicate that economic sectors considered for
diversification include agriculture, minerals, fishing,
light industry, and finance. The governments have
taken little action on these proposals because of
reduced revenues. Many of the states, however, are
beginning to consider changing or implementing legal
and commercial codes to attract and maintain com-
mercial ties to the West to promote diversification,
The Foreign Payments Problem
We expect the Middle Eastern oil exporters to contin-
ue to face substantial, but diminishing, current ac-
count deficits. Oil revenues probably will increase
once again if, as we expect, OPEC members limit
production and world demand grows. Our model
shows an increase of nearly 18 percent in aggregate
export revenues for this year over the 1986 level of
about $86 billion, with another 4 percent increase in
according to Embassy reporting.
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Figure 8
Middle Eastern Oil Exporters:
Foreign Payments Problems
Current Account Balance, 1980-88
Billion US $
Imports and Export Trends, 1980-88
Billion US $
-40 1980 81 82 83 84 85 86 87b 88b 0 1980
Current Account Balance by
Country, 1980 and 1985
Billion US $
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
1980
1985
a Excludes most imports of military equipment.
b Estimate based on CIA model and $18 per
barrel of oil.
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
85 87b 88b
Imports Trends by Country,s
1982 and 1986
Billion US $
1982
1986
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1988. Increased revenue combined with spending cuts
should reduce this year's aggregate current account
deficit by about $9 billion from the 1986 level of $26
billion, assuming an average price of $18 per barrel.
All of the oil states will almost certainly try to reduce
the outflow of foreign exchange. They already have
made deep cuts in imports, including capital goods,
consumer goods, and luxury items, and some have
adopted rationing to control the distribution of basic
commodities. To further discourage imports, several
countries, including Tunisia, Libya, and Oman, deval-
ued their currencies by more than 10 percent last
year. Other states probably will reluctantly consider
similar action this year. With an increase in oil
revenues this year, some states might increase imports
slightly, but we would expect most to loosen import
restrictions only cautiously. Moreover, we expect the
impact of past import restrictions to have a lagged
effect and impair economic growth during the next
few years, even if oil prices remain near $18 per
Figure 9
Arabian Peninsula: Composition of
Labor Force, 1986
Saudi Arabia
Kuwait
U.A.E.
Oman
Bahrain
Qatar
Additional measures to cut imports to offset persisting
current account deficits could easily cause or worsen
shortages, inflationary pressures, and an increase in
illegal commercial activity. Increased tariffs and
other restrictive measures on imports have already
raised the prices of consumer and durable goods such
as chocolate, coffee, appliances, electronic equipment,
and apparel in the last few years.
Several countries, including Libya, Iran, and Iraq, are
witnessing substantial growth of black markets and
smuggling Active
black markets in these countries make some commod-
ities virtually unavailable on the legitimate market,
In Libyan cities, for
example, many foods cost four to five times the price
they did a year ago. Food and most other basic
commodities are rationed. With the exception of Iraq,
most countries tolerate this illegal activity because it
relieves pressure on the government to supply goods,
the governments can do little to control it, and many
officials benefit from it through bribes and kickbacks.
Sending Expatriates Home
The lack of new development projects and an interest
in saving foreign exchange will almost certainly
prompt the Gulf states to pare the most expensive
segments of their large expatriate labor forces. On the
basis of Embassy and press reporting, we estimate
that foreign workers make up about 80 percent of the
labor force in several of the smaller Gulf states.
Although only a small percentage of the region's total
foreign work force is likely to return home any time
soon, many of those who leave either will not be
replaced or will be replaced by cheaper labor from
South or East Asia. Their departure will offer few
new employment opportunities for indigenous work-
ers. Although the labor-importing states would like to
indigenize their work forces, the departure of large
numbers of expatriates would hurt their economies
because most nationals do not have the training,
experience, or management skills equal to that of the
expatriates they replace.
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Even a limited repatriation of additional workers
would have a negative effect on the economies and
societies of the labor-supplying states. Cairo has
depended heavily on remittances from Egyptians
working in other oil-exporting countries. Remittances
from all workers abroad are Egypt's largest source of
foreign exchange. According to Embassy reporting,
Egypt may have lost as much as $2 billion during the
past year as a result of lost jobs and of curbs on the re-
patriation of earnings in countries such as Iraq.
According to our analysis, Egyptians working abroad
comprised approximately 20 percent of the country's
working-age population. In one Egyptian village, as
many as 80 percent of the men had been working in
the Gulf states, and most are returning home, accord-
ing to press reports. Embassy reporting
indicate the expulsion from Libya last
year of about 32,000 Tunisian workers and their
families cost Tunisia about $140 million in remit-
tances, trade, and additional outlays for social ser-
vices.
Despite some cuts in civilian expatriate labor, we
believe the Gulf states will continue to rely on foreign
military personnel to compensate for endemic short-
ages of skilled technicians and tactical advisers in
military-related jobs. We believe, however, that the
efficiency of the armed forces in these countries will
decline as some expatriates leave and others are
replaced with less expensive and less qualified person-
nel from poorer countries. Our analysis shows that
about 60,000 foreign military personnel currently
serve in the oil-exporting states, mostly in the Gulf.
expatriates play
critical roles in managing Saudi Arabia's military
logistic system and in maintaining US, French, and
British military equipment.
most of the smaller Gulf states could not
operate and maintain their air forces and navies
without foreign personnel. Expatriates also support
local security services in the Gulf states.
Borrowing Supplements Savings
The broad range of monetary and fiscal policies
undertaken by the oil-exporting countries has been
insufficient to cover their growing deficits, and most
of the countries will almost certainly continue to draw
on foreign assets or to borrow on the international
Figure 10
Middle Eastern Oil Exporters:
Foreign Military Personnel, 1986
Algeria
Egypta
Libya
Tunisia
Iran a
Iraq
Bahrain
Kuwait
Oman
Qatar
Saudi Arabia
U.A.E.b
t
a Probably less than 200.
b Does not include 13,600 Omani troops.
313119687 25X1
capital markets. Since the early 1980s Iraq has drawn
down its reserves by nearly $20 billion and Saudi
Arabia by about $40 billion to $2 billion and $105
billion, respectively.
The drawdowns have permitted some of the oil-
exporting countries, particularly those in the Arabian
Peninsula, to continue funding their generous social
welfare programs and to avoid deep cuts that would
negatively affect their citizens. Although drawing on
them to cover current financial shortfalls has pro-
voked concern among some government officials be-
cause of the commitment of several of these govern-
ments to save a portion of their oil revenues for future
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Figure 11
Middle Eastern Oil Exporters:
International Financial Assets, 8
Yearend 1981 and 1986
Billion as $ Figure 12
Middle Eastern Oil Exporters:
Debt Service Ratios, 1980 and 1985
Algeria
Bahrain b
Egyptb
Iran
Iraq
Kuwait
Libya c
Oman
Qatar
Saudi Arabia
Tunisia b
U.A.E.
1981
1986
a CIA estimate.
b Foreign exchange and gold holdings.
e Includes holdings in Arab Banking Corporation.
generations, those states with generous reserves prob-
ably will draw them down further to avoid politically
difficult decisions. Many of these states will probably
try to balance drawdowns with domestic and interna-
tional borrowing, but in some cases-Saudi Arabia in
particular-this alternative is limited because influen-
tial religious groups believe that the government
should abide by the Islamic prohibition against paying
Algeria
Bahrain
Egypt
Iran
Iraq
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Tunisia
U.A.E.
1980
1985
a Debt service ratio is the percentage of export
earnings used to make principal and interest
payments on the foreign debt. International
financial institutions consider a ratio of 25
percent or more to be high.
The North African countries, except for Libya, have
borrowed heavily to cover their deficits and almost
certainly will continue to do so. Borrowing by Egypt
and Algeria has increased their already high debt-
service ratios to over 50 percent each-more than
twice the rate that international financial institutions
consider dangerous. The IMF and other international
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organizations helped Tunisia obtain additional aid
and have rescheduled Egypt's debt. Iraq also has
increased its borrowing substantially since 1983 and is
continually trying to reschedule its debts. Baghdad
faces less immediate pressure than the North African
oil exporters, however, because nearly two-thirds of its
debt-$30 billion-is owed to Saudi Arabia and
Kuwait, which have supported the Iraqi war effort
and almost certainly will not demand prompt repay-
ment.
The oil price decline is only one of many threats to
stability in the Middle Eastern oil-exporting coun-
tries, and thus it is difficult to analyze precisely its
political and social impact. Reduced revenues compli-
cate the ability of these governments to cope with a
host of problems, including ethnic tensions, political
corruption, demands for greater political participa-
tion, border disputes, and interstate disputes. Some of
the economic policies implemented to adjust to re-
duced oil revenues will increase the risk of unrest,
particularly as social spending dries up, standards of
living decline, unemployment grows, and popular
expectations of a better life go unmet. Indeed, we
believe the greatest danger of this particular economic
crisis is its tendency to aggravate a broad range of
social and political problems simultaneously in states
that no longer have large surplus funds to ease these
tensions.
Employment Tensions
The rapidly growing populations of these states and
the lack of matched skills to the needs of their
economies make employment prospects relatively poor
for the unemployed and for new entrants to the labor
force. The diminished demand for labor in both the
public and private sectors caused by the oil price
decline, moreover, is closing an important safety valve
for social tensions.
increasing number of disgrun-
tled unemployed workers are contributing to growing
delinquency, crime, and drug abuse.
Employment prospects for growing numbers of Arab
youth are dimmer than for the previous generation.
The Growing Demographic Burden
Demographic factors will severely complicate the
region's ability to cope with lower income-particu-
larly in the North African states, where populations
are larger than those of the Gulf states and per capita
oil income is substantially less:
? Annual rates of population growth are high
throughout the region. Kuwait's population, for
example, is growing at 3.5 percent. Egypt's popula-
tion of 51 million-the largest in the Middle
East-is growing at 2.7 percent annually, a rate
that adds another million mouths to feed approxi-
mately every seven months.
? Well over half the people in the region are under 25,
and, although population growth rates may decline
slightly before the end of this century, we do not
expect a significant slowdown in growth for at least
several decades.
? The growing concentration of people in urban
areas-more than 60 percent of the population in
1985 compared to 45 percent in 1970-increases
the potential for large groups to assemble in protest
against reduced subsidies for food or other services.
? Feeding the growing population will become more
burdensome. Egypt, Libya, and Algeria, for exam-
ple, must import at least 60 percent of their total
food requirements.a Dwindling oil income will
make it increasingly difficult to maintain adequate
supplies of low-cost food.
? Housing shortages are acute, particularly in the
large cities of North Africa. The US Embassy in
Algiers lists the lack of adequate housing as Alger-
ia's most pressing social problem.
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Reductions in public-sector expenditures will contrib-
ute to the increased inability of these countries to
provide jobs for the large number of people who will
be entering the job market. Unemployment and un-
deremployment are already a problem-topping 30
percent in Tunisia and Algeria and reaching nearly 60
percent in some urban areas. Reduced revenues led
the UAE to declare last year that it would hire no new
employees and prompted the Egyptian Government to
implement new hiring restrictions for college gradu-
Youth in the wealthier Gulf states could improve their
employment prospects, but only by accepting less
prestigious positions or pursuing more practical
courses of study. These governments are encouraging
local students to select technical and scientific train-
ing to compete for jobs now largely filled by expatri-
ates. Despite this encouragement, we doubt that many
of these students will shift their educational focus,
believing that the boom days will return after a
temporary lull in the economy and that they will find
high-paying jobs regardless of their area of study.
Popular dissatisfaction with a proposal to establish a
trade school in Kuwait contributed to the ouster of the
Minister of Education last year, according to US
We believe the fundamentalist threat will be most
acute in Egypt and Tunisia, where Islamic groups
have shown themselves to be relatively disciplined,
organized, and, in some cases, well financed. Radical,
violence-prone sects are difficult to uproot. Although
Egyptian security authorities claim to have them
under control, we believe that extremists of the sort
who murdered President Sadat in 1981 have not been
completely neutralized by government security forces.
The confrontation between the government and Is-
lamic fundamentalists in Tunisia has become more
violent this year in response to the government's
campaign to eliminate all independent political
activity.
We believe that the threat from Islamic fundamental-
ists is not so serious in most Gulf states because their
societies are conservative and their more prosperous
governments appear to have blended appeasement
with repression of religious groups. States with large
or regionally concentrated Shia populations-Iraq,
Bahrain, Kuwait, the UAE, and Saudi Arabia-are
particularly concerned about potential unrest and
have begun to burnish their Islamic credentials
through stricter enforcement of Islamic laws.
Embassy sources.
Pressure From Islamic Fundamentalists
We believe that deteriorating economic and social
conditions will provide an increasingly fertile breeding
ground for discontent that could be exploited by
religious groups. Islamic fundamentalism will contin-
ue to be especially attractive because it focuses on the
conditions that disadvantaged Middle Easterners hold
responsible for their economic plight-social injustice
brought about by misguided policies; profligate spend-
ing and extravagant lifestyles by ruling families;
growing disparities between rich and poor resulting
from corruption; and increasing Western influences
that are undermining traditional Islamic values. Pop-
ular discontent with these perceived injustices will
almost certainly grow during a prolonged recession.'
The threat of antiregime violence by fundamentalists
takes a different form in Iran-the only country
governed by fundamentalists. Discontent is growing
because of chronic shortages of consumer goods and
high unemployment and inflation. In addition, clerical
rivalries kept under control by Khomeini could pose a
serious threat to the stability of the regime after his
Maintaining Stability
We believe the oil states will be able to maintain
public order despite the hardships austerity is likely to
produce. We see little prospect of violent regime
changes stemming from economic problems during
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the next two years. Nonetheless, some domestic unrest
is likely, especially in the poorer North African states,
as various interest groups compete to enhance their
positions and their share of the national income while
governments are vulnerable.
Regimes will rely primarily on nonviolent repressive
measures to prevent dissatisfaction from developing
into open unrest. We anticipate continued tight con-
trol over the news media, close monitoring of the
population by security services, and restrictions on
most political groups, particularly those the regimes
believe constitute a threat to their rule. Surveillance,
censorship, and heavyhanded security measures are
all likely to increase as the recession deepens:
Protecting the Military and Security Services 25X1
The need to protect social services and welfare pro-
grams almost certainly will require cuts in military
budgets for most countries in the region. The Middle
Eastern oil-exporting states will focus cuts on the least
sensitive items-spare parts, new equipment, facili-
ties, training, and maintenance-to protect the sala-
ries and benefits of military personnel. Iran and Iraq,
however, will continue to give military budgets a high
priority, at least until their war ends. We believe
Libya is also an exception.
press accounts indicate Qadhafi has attempted to
continue buying advanced equipment while reducing
personnel costs. He has frozen most promotions and
ended generous commissary, housing, and travel privi-
? Last year Kuwait abolished its parliament because
it was too critical of government policies. It has also
begun censoring its freewheeling press and is con-
templating nationalizing three newspapers, accord-
ing to US officials.
? In Tunisia a growing crackdown on Islamic funda-
mentalist groups is being extended to other opposi-
tion elements, according to the US Embassy in
Tunis. The campaign is contributing to a sense of
political alienation outside ruling party circles that
could provoke further unrest as power slips from the
hands of the aging Bourguiba.
? Oman already has ordered all natives and foreign
residents to carry identification cards to aid the
internal security service, according to press reports.
If unrest does break out-as is likely in some of the
Middle Eastern oil-exporting states-we believe the
governments will quickly use their large security and
military services to contain it. Although these services
vary considerably in their ability both to detect
embryonic dissident groups and to contain outbreaks
of unrest, we believe they are capable of maintaining
order, at least in the short term. None except Egypt,
however, has had recent experience in putting down
large-scale riots, and we believe the loyalty of these
services would be severely tested if they became
engaged in sustained street campaigns, such as those
that occurred in Iran in 1979.
leges.
Except for Libya, we expect such policies to help
ensure the military's loyalty to the regime, but they
are almost certain to undermine the military's opera-
tional readiness and capabilities, particularly as train-
ing and maintenance are further reduced. Regional
self-defense and military cooperation are likely to
suffer as funds for joint military exercises are diverted
elsewhere. The annual military exercises planned by
the Gulf Cooperation Council have been postponed or
scaled down since October 1984, in part because
many of the participants are looking for ways to save
money These countries
will probably try to meet military threats through
cooperation agreements with more experienced mili-
tary establishments such as those of Morocco anc25X1
Pakistan, or they will rely on the US security um-
brella. i
In the Gulf states, policies to protect military person-
nel from major cuts have muted much of the dissatis-
faction that might have developed from lower spend-
ing for defense. In some cases, restrictions on the
hiring of expatriates have opened more opportunities
for native military personnel. In addition, cutbacks in
purchases of equipment are not likely to be a severe
problem, because most of these countries cannot
operate all of the equipment already in their inven-
tories or about to be delivered.
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Declining Arms Purchases
Cuts in military spending are most obvious in the
stated production policies. Embassy reporting indi-
cates that the oil used in barter arrangements is
generally produced in excess of OPEC quotas, thus
adding to world supplies and putting downward pres-
sure on prices. In Saudi Arabia the Ministry of
Defense, not the Ministry of Petroleum, has the
authority to decide on barter arrangements for arms
sales, according to US Embassy reporting. Falling oil
prices have complicated these agreements, since the
terms usually have to be renegotiated to reflect the
price change
reduction in foreign arms purchases.
the value of Middle East-
ern oil-exporting countries' arms purchase agree-
ments peaked in 1980 at more than $32 billion, just
before the price of oil reached its highest levels.
Actual deliveries of weapons peaked four years later
at about $23 billion, reflecting the timelags inherent
in arms deliveries. Both agreements and deliveries
subsequently have declined. Although orders re-
bounded in 1984 and 1985, this was largely on the
strength of two large deals involving Saudi Arabia.
Deliveries have not reflected the upswing in contracts
and are not likely to do so. We believe most custom-
ers will stretch out deliveries or cancel some con-
tracts because of decreasing revenues and the need to
conserve cash.
Faced with lower revenues, some oil exporters have
bartered oil for arms
In late 1984 the United Arab Emirates ordered 18
Mirage 2000 fighters from France and agreed to pay
with a combination of cash and oil. Saudi Arabia's
1985 purchase of Tornado fighter-bombers from the
United Kingdom called for oil as payment for part of
Oil barter, while conserving cash, probably is adding
to the woes of oil exporters and often conflicts with
Shielding military personnel from additional austerity
may prove to be difficult for the poorer states of
North Africa, given the risk of coup plotting by
discontented military officers. Egyptian leaders-who
depended heavily on the Army to restore order after
the 1986 police mutiny-probably will require that
disproportionate cuts be made in the civilian sector to
continue providing military officers with relatively
generous benefits and comfortable living standards.
Even so, it will be difficult to avoid some lowering of
these standards and, thus, of military morale.1
Reduced oil income is straining relations with arms
suppliers because of the oil exporters' inability to pay
for arms deliveries:
? Iraq's largest Western suppliers, Italy and France,
are becoming reluctant to grant more arms credits
to Baghdad, which has already fallen behind in its
payments.
? Oman has postponed until at least 1992 the pur-
chase of eight Tornados from the United Kingdom,
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effectively canceling
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Grumbling in the ranks may be even more ominous in
Algeria, where President Bendjedid has been criti-
cized by Army leaders for cuts in the military pro-
curement budget and elimination of some pay incen-
tives and medical benefits. As part of an effort to
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Figure 13
Middle Eastern Oil Exporters: Arms
Agreements and Deliveries, 1975-85
I ~ I ~ I
0 1975
reporting
quash dissent and protect his position, Bendjedid
moved last year to reestablish his control over the
military by firing his chief of staff and reorganizing
his Presidential Guard, according to defense attache
Emphasizing Pragmatic Foreign Relations
We do not believe that economic problems have
greatly changed regional alliances of oil exporters,
although they have encouraged more nationalistic
policies. We believe that pressing internal problems
will reinforce the proclivity to focus on internal issues
rather than regional and international issues. Pan-
Arabism is no longer seen as a practical solution to
the region's problems because of inter-Arab bickering
and the failure to defeat Israel, although Arab leaders
still give lipservice to the idea of Arab unity. We
believe that interest in the Palestinian issue among
other Arabs has waned, even though they still strongly
believe that an injustice has been perpetrated on the
Palestinians.F___1 25X1
Efforts to increase oil prices have led to renewed
cooperation among the Middle Eastern oil-exporting
states. OPEC-to which all the Middle Eastern ex-
porters except Bahrain, Oman, Egypt, and Tunisia
belong-has held frequent conferences to discuss
prices, and these gatherings have provided a setting
where ranking officials of member countries could
meet informally and discuss political issues. We be-
lieve that the relative success of the December 1986
OPEC accord has been one of the factors leading to
Riyadh's reevaluation of its relations with Tehran and
Baghdad. Despite their generally strained relations,
Iran's and Saudi Arabia's interests converge on the
need to bring oil pricing and production discipline to
OPEC. Iraq's refusal to agree to the terms of the
OPEC accord has put the Saudis in the awkward
position of defending what other members consider to
be Iraqi cheating.) 25X1
Impact on Checkbook Diplomacy
Lower oil revenues have reduced the scope of econom-
ic aid as a foreign policy tool. For more than a decade
Saudi Arabia, Kuwait, the UAE, and Qatar have
used foreign aid to foster regional consensus, support
the Arabs against Israel, promote their influence over
both moderate and radical regimes, and secure pro-
tection from terrorism and more powerful neighbors.
Most of the foreign aid has gone to Arab states
opposing Israel-Syria, Jordan, and, until 1979,
Egypt. Gulf state donors, which have large Palestin-
ian communities, also pledged to give $300 million
annually to the Palestine Liberation Organization
(PLO) as part of the 1978 Baghdad Agreement-
signed following the Camp David agreement to help
Syria, Jordan, and the PLO finance their struggle
against Israel. Last year, however, only Saudi Arabia,
Kuwait, and the UAE made payment
o the PLO. Since the Iran-Iraq war began,
the Gulf states have also provided Iraq with
cash, aid in kind, and loans. 25X1
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Foreign assistance to non-Arab recipients-never a
priority of the donor states' overall aid package-is,
nonetheless, significant to mostly Islamic African and
South and East Asian recipients. In return, the Gulf
states seek support for Arab positions in international
forums and reductions in ties to Israel. This funding
has been reduced as the Gulf states marshal their
funds for pressing needs closer to home. According to
US Embassy reporting, Kuwait, for example, plans to
avoid additional financial commitments to African
Islamic republic in Iraq.
We expect the donors to take a harder look at their
aid disbursements, particularly as the 10-year Bagh-
dad Agreement approaches expiration in the fall of
1988. Gulf lenders almost certainly will use declining
foreign reserves and austerity measures at home to
justify reductions in foreign aid to Syria, Jordan, and
possibly Iraq, despite their concern over the reaction
of these recipients. We believe that both Iraq and
Syria will retain considerable leverage in seeking
financial aid. Cash aid to Iraq will probably depend
on the level of fighting in the Iran-Iraq war, Iraqi oil
production, and the Gulf states' assessment of Bagh-
dad's ability to prevent Iran from establishing an
Egypt is likely to receive increased aid from the Gulf
states in recognition of its mounting economic trou-
bles and its strategic significance. Iranian advances in
the war against Iraq convinced the donor states of
their need for a strong, moderate, and supportive
Egypt. They are likely to continue courting Cairo with
a view toward securing Egyptian assurances of mili-
tary support in the event of a major Iranian threat to
the Gulf states. The Gulf states pledged as much as
$2 billion to Cairo in the last year to help relieve
Egypt's economic problems
As they increase aid levels to Egypt, however, the
Gulf states risk complicating their relations with other
recipients by obliging them to make do with less.
Resentment of Egypt by these recipients is likely to
increase as Cairo regains a share of Gulf aid money.
Iraq almost certainly fears that Egypt will soak up
Saudi aid money that Baghdad hopes to use for
postwar reconstruction.
states because of its own economic problems.
Coping With Reality
Most of the leaders of the oil-exporting states will
probably try to muddle through the period of low
economic growth we expect during the next two years
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Figure 15
Middle Eastern Oil Exporters: Relative Indicators of
High and Low Absorbers, 1986
High absorbers
War-torn economics
Low absorbers
Algeria
Egypt
Tunisia
Iran
Iraq
Bahrain
Kuwait
Libya
Oman
Qatar
Saudi Arabia
U.A.E.
Population
Million
^
a Excludes nonrecoverable loans.
b Includes Reserve Fund for Future Generations.
313124687 25X1
Proved Oil Reserves,a
Yearend 1986
Billion barrels
Recoverable Financial
Assets,a Yearend 1986
Billion US $
150 200 0 30 60 90
and avoid having to grapple with fundamental dilem-
mas plaguing their countries. As the low oil prices
persist, however, resorting to quick fixes will become
increasingly difficult. Countries with large popula-
tions and high current expenditures-the high absorb-
ers-probably are the most vunerable. Most of the
countries with the highest dependence on oil revenues,
ironically, are not those seriously threatened. Many of
the countries highly dependent on oil revenues are low
absorbers-they have small populations relative to
their revenue-and can supplement current income
with accumulated savings.
High Absorbers
With few financial reserves to fall back on and large
populations to care for, high absorbers-especially
Algeria, Egypt, and Tunisia-will face particularly
tough choices over future cuts. Restoring financial
stability will probably require additional belt-tighten-
ing, which many political leaders will find unpalat-
able. Political inaction is likely to result as govern-
ment infighting about policy and the allocation of
scarce resources increases. These states are likely to
require more foreign aid and loans and may resort to
debt rescheduling to meet financial requirements even
if they come to grips with the need for additional
economic reforms.
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The situation in Tunisia is complicated by a political
vacuum at the top, according to US Embassy report-
ing, where President Bour-
guiba is increasingly resorting to heavyhanded tactics
to shore up his authority. This trend-aggravated by
economic austerity-could foster links among the
opposition groups, secular and religious, who have not
been able to forge a common political front.
Leaders in the high-absorbing countries are likely to
proceed slowly and carefully with further economic
reforms for fear that harsh austerity measures would
provoke unrest long before they produced economic
benefits. Algeria and Tunisia have implemented some
impressive reforms, but more must be done before
they can cover their requirements for foreign ex-
change. Only Algerian President Bendjedid appears
willing to try to mobilize public support for austerity.
Through media blitzes and regional meetings and
conferences, Algiers has, with considerable success,
urged the people to reduce imports and eliminate
resource waste. Even so, economically inspired rioting
by students took place in Constantine last November,
and minor disturbances occurred in several other
wealthy ruling elites is likely to increase during the
next few years. Reporting from US Embassies in the
region indicates a growing resistance to both, especial-
ly among small businessmen and recent university
graduates, who have had to reduce their spending and
lower their expectations.
Libya does not fit the low-absorber pattern because its
population already is suffering from a precipitous
drop in living standards. In our view, Libya has
sustained far greater damage and incurred a greater
risk of instability from Qadhafi's policies than it has
from the decline in world oil prices. Qadhafi has been
unwilling to draw on foreign reserves to ameliorate
consumer dissatisfaction and, instead, is forcing the
population to make sacrifices to continue his foreign
adventurism, such as the incursion into Chad. Unlike
the leaders of most of the other Middle Eastern oil-
exporting countries, he appears oblivious to public
opinion, even within the military. Qadhafi's commit-
ment to his revolutionary goals will probably lead him
to demand even greater sacrifices from the Libyan
people, adding further strains to the society and
economy.
cities, including the capital.
Low Absorbers
With their far greater wealth and smaller populations,
we believe that the Gulf states have enough funds
remaining in their budgets to insulate most of their
populations from the impact of cutbacks, at least until
the end of the decade. They will probably be able to
stave off painful economic choices by drawing on their
sizable recoverable financial assets. As of the end of
1986 this accounted for $70 billion in Kuwait, $60
billion in Saudi Arabia, and $35 billion in the UAE.
Although their leaders almost certainly recognize the
longer term danger of such a policy, reporting from
Embassy sources indicates they believe their economic
problems will be eased by the early 1990s when,
according to energy experts, oil demand and prices
will increase.
Nonetheless, the Gulf states will have to defuse
growing tensions between society's rich and poor to
maintain domestic stability while accommodating key
religious, military, and business groups. Intolerance of
corruption and the extravagant lifestyles of the
War-torn Iran and Iraq face considerable hardships
from low oil prices, but the impact of the conflict
remains the overwhelming determinant of stability in
these two countries. In Iraq the government has
become concerned about popular resentment toward
corrupt members of President Saddam Husayn's ex-
tended family, according to the US Embassy in
Baghdad. In Iran, corruption is widespread, but gov-
ernment leaders live unostentatiously and the disad-
vantaged classes appear to believe they are getting
their fair share of national wealth.
What if Oil Prices Fall?
The problems facing the Middle Eastern oil-exporting
countries would intensify dramatically under the un-
likely scenario that oil prices were to fall to $10 per
barrel and remain at that level during the next few
years. Under this assumption, our model indicates
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Impact of the Iran-Iraq War
Decreased oil revenues are playing an increasingly
important role in the political stability and military
strategies of both Iran and Iraq. Low oil prices have
contributed to policy disputes within the ruling Bath
Party in Baghdad, and the low prices, compounded by
Iraqi air attacks on Iranian economic targets, have
contributed to increased strife among competingfac-
tions in Tehran. We do not believe that lower oil
revenues will, by themselves, threaten the stability of
either Iran or Iraq, but they will greatly contribute to
popular dissatisfaction over the war and the regimes'
management of it. We believe Iran and Iraq will
concentrate on economic recovery after the fighting
stops rather than renewing efforts to subvert the Gulf
monarchies.
Iran's economy is in shambles, and the urban poor, in
particular, suffered a precipitous decline in living
standards in 1986. We believe that Iran must show
progress in the war to justify the enormous human
and economic cost to its populace. At the same time,
reduced revenues hamper its ability to continue ma-
jor ground offensives, let alone finance an arms
buildup to threaten Iraq's superiority in advanced
weapon systems.
Iraq, wearied by the war, was forced in 1986 to
abandon the last traces of its "guns-and-butter"
policy and to slash nonmilitary spending. The Iraqi
people have endured reductions of consumer subsi-
dies, tax increases, expanded rationing, and short-
ages of consumer items, including foodstuffs. They,
like the Iranians, have held up reasonably well but
can anticipate little improvement, even after Iraq
opens a new oil pipeline through Turkey this summer.
that real GDP for all the Middle Eastern oil-exporting
countries would fall by 25 percent this year and by
another 15 percent in 1988. Export revenues would
decline substantially, contributing to an aggregate
reduction in spending of 23 percent this year and 11
percent next year, assuming past spending patterns.
The states would be forced to implement additional
severe cutbacks, and the economic problems of many
of them would reach regime-threatening proportions.
What if Oil Prices Increase? 25X1
Our model indicates that the economic difficulties
these countries face would lessen only moderately
under the most optimistic-but also unlikely
scenario-that oil prices stabilize at $25 per barrel
during the next two years. The lingering effects of
austerity measures taken over the past few years
would continue to hamper growth. Under this as-
sumption, aggregate real GDP growth for these coun-
tries would increase by 5 percent this year and by 3
percent in 1988. The overall current account balance
would improve from a deficit of $26 billion in 1986 to
a surplus of $26 billion this year. The countries could
avoid making extreme spending cuts, but, as in the
$18-per-barrel scenario, some of them would still not
have sufficient resources to ease significantly their
economic troubles. A continuation of the modest
economic reforms undertaken, however, would allow
some economic growth and forestall a major erosion
of benefits needed to placate their local populations.
Implications for the United States
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Although the United States is a major oil producer, it
is also the world's largest oil importer, and, on
balance, the decline in oil prices has helped the
domestic US economy. We believe, however, the
impact of continuing low oil prices on US relations
with the region will be largely negative. US economic
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The United States: Economic Implications
of Low Oil Prices
The United States has reaped significant economic
benefits from low oil prices. Lower oil prices in 1986
saved the United States more than $20 billion and
contributed to the lowest level of inflation in 25
years. The domestic oil industry, however, fell into a
severe depression. Exploration and development bud-
gets of domestic oil companies were slashed, and
high-cost oil wells were shut down. Oil production
fell by 300,000 barrels per day (b/d) from 1985 levels.
US energy experts predict that domestic production
will decline an additional 400,000 b/d in 1987 if oil
prices stay around $18 per barrel.
With depressed domestic production, the United
States once again faces a growing dependence on the
Middle East, with its large oil reserves and excess
oil producing capacity. US imports of crude oil from
these countries in 1986 were almost twice the average
of the previous two years and accounted for 20
percent of US crude oil imports. The continued
volatility of the region will in the foreseeable future
pose a potential threat to the flow of oil. The Iran-
Iraq war, a probable power struggle in post-Khomeini
Iran, the Arab-Israeli conflict, political instability,
and the US-Soviet competition for influence in the
region could all affect access to Middle Eastern oil.
and strategic interests would be seriously damaged if
political instability in the Middle East worsened
significantly-an unlikely prospect at present-and
led to curbed oil output and restricted Western access
to oil, or caused the collapse of friendly regimes and
installed a new crop of anti-Western leaders. Pro-
longed political turmoil in Egypt, for example, could
produce an anti-US regime interested in abrogating
the Camp David accords. A rise in fundamentalism
espoused by alienated youth would encourage some
states to move away from the United States and reject
Some of the oil states will probably attempt to focus
blame for their economic problems on the United
States to shore up their political positions. Arab
governments historically have paid a price in populari-
ty for close relations with Washington because the
United States is perceived to support Israel at the
expense of Arab interests. As political pressure
mounts, we believe these states will publicly dissociate
themselves from policies closely identified with the
United States to avoid criticism from neighbors and
constituents. Opponents of regimes with pro-US poli-
cies are likely to blame the United States for austerity
measures and some of the accompanying repression.
External threats, conversely, probably will encourage
the oil states, except Libya and Iran, to quietly
reinforce security ties to the United States, regardless
of their economic circumstances and threats of do-
mestic instability. The Gulf states, for example, al-
ready are looking to the United States for assurances
of protection against a spillover of the Iran-Iraq war,
even though they are likely to shun overt cooperation
with the US military or a US military presence on
their soil. Recent requests from Kuwait to the United
States to provide protection for Kuwaiti tankers in the
Gulf reinforces the US role as a guarantor of the
sovereignty of these states.
We expect the harder pressed oil states to increase
requests for US economic and financial aid, including
softer loan terms and a rescheduling of official debts.
These states will view US largess as a measure of
Washington's commitment to their needs and as an
indicator of US reliability as an ally. The North
African countries, except Libya, will press Washing-
ton for generous economic and military assistance by
playing on their existing close relationship with the
United States (Egypt) or by emphasizing their impor-
tance for regional stability (Algeria and Tunisia).
Curbs on spending by the major oil exporters caused
by lower oil revenues are likely to cut deeply into US
exports of merchandise and, to a lesser extent, arms to
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the Middle East. US exports to the region in 1986 fell
almost 16 percent, to $8 billion. Much of this drop
was in sales to Saudi Arabia, which dropped from
$4.4 billion in 1985 to $3.4 billion last year. Nonethe-
less, we believe Washington will retain a large per-
centage of the Middle Eastern market. With oil prices
denominated in dollars, the oil-exporting countries in
the region will probably find the United States a more
attractive supplier of needed imports than countries
with stronger currencies.
Moscow almost certainly will seek ways to exploit any
weakening in ties between the United States and the
oil states and is likely to benefit marginally from US
setbacks in the Middle East. Still, Embassy reporting
indicates Moscow has few resources in most of the
region's oil-exporting countries to fully capitalize on
US problems. Local Communist parties are illegal
and, like other leftist groupings, weak. Moreover,
growing Islamic fundamentalism opposes Commu-
nism and is wary of secular leftists. The gains that the
Soviets make in the Middle East during the next two
years are likely to result more from external political
pressures faced by the states and their desire to
project a nonaligned image than from their economic
troubles.
Like the United States, the USSR's financial con-
cerns, in part related to lower prices for its oil exports,
will prompt it to be selective in the countries it targets
Reverse Blank 21
for assistance.' Moscow is likely to focus financial and
military assistance where it perceives its interests are
most threatened, such as in preventing an Iranian
victory over Iraq, or where it believes minimal assis-
tance would yield some influence. Nonetheless, Mos-
cow will make financial sacrifices only in highly
selective cases. We believe substantial Soviet conces-
sions on Egypt's military debt in March were granted 25X1
not only to strengthen ties to Cairo but also to
undercut US influence.
The Soviets probably will project an image of cooper-
ation with OPEC, but their oil export policy will
continue to be set to meet Moscow's economic needs
and hard currency requirements. Last August, Soviet
officials met with the Iranians and, after last Decem-
ber's OPEC meeting, with the Saudis. According to
press reports, Soviet spokesmen indicated to represen-
tatives of both countries that they would consider a
reduction in oil exports. Cuts in exports made earlier
this year, however, resulted from fluctuations in Sovi-
et oil production and domestic consumption rather
than from Soviet support for OPEC. Still, the Soviets
probably hope that contacts with the Middle Eastern
oil producers and the common interest in higher oil
prices will encourage Saudi Arabia, Bahrain, and
Qatar to establish diplomatic relations with them as
Oman and the UAE did in 1985.
`The value of Soviet oil exports, Moscow's most important hard
currency earner, declined by 50 percent from 1983 to roughly $7
billion in 1986, and the value of Soviet arms deliveries to the
Middle Eastern oil exporters declined from $7.3 billion in 1982 to
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Appendix A
Econometric Methodology
future developments.
Econometric models have become conventional tools
for analyzing and forecasting economic activity. In a
system of equations, a model combines a theoretical
representation of economic interactions, a statistical
analysis of the key relationships, and assumptions
about external events. The solution of the system of
equations produces conditional estimates of the future
and can be used to estimate an economic indicator's
sensitivity to alternative sets of assumptions about
ing power of each barrel of oil.
Three models were used in this project. The first is a
model of the world oil market, which examines the
linkages among oil demand, supply, and price. The
second model relates the world oil price to the.Middle
Eastern oil producers' export revenues, import de-
mand, government budget balances, and GDP. The
third model determines the effect of changes in the
values of key international currencies on the purchas-
country.
Data for some of the countries in the model are
difficult to obtain in a timely fashion and often
contain anomalies. To correct this problem, each data
series was compared among all of the modeled coun-
tries and was adjusted where obvious inaccuracies
were present. Only aggregate values for the total
group of countries were used, thus reducing the
distorting effect of data problems in any particular
The World Oil Market
Our model of the world oil market equates the
quantities demanded and supplied to determine the
equilibrium market price. The demand function con-
sists of an income effect and short-run and long-run
price effects. The supply function is based on current
projections of world energy supplies, adjusted for
expected withholdings of oil, and on short-run and
long-run price effects. The values for the elasticities in
these equations are the generally accepted estimates
that have been econometrically derived in energy
studies during the past decade. The quantities sup-
plied and demanded are then equalized in a market-
clearing equation. To complete the model, a feedback
equation is included that relates world income nega-
tively to increases in the price of oil in the short and
long runs.
This model was used in two different ways for the
purposes of this project. First, price paths were im-
posed on the model, forcing it to calculate the amount
of oil that would have to be withheld from the market
to achieve the given price. Second, expectations about
world income and oil supplies were imposed to deter- 25X1
mine the expected price path under various scenarios.
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Macroeconomic Effects
The macroeconomic model of the Middle Eastern oil-
exporting countries relates the world price of oil to
several key economic variables. Export revenue in
dollars is modeled as a logarithmic function of the
market price of oil. GDP in current dollars is assumed
to be a function of current and past values of the price
of oil, with a geometrically declining lag structure.
Two behavioral equations are included in the model:
the historic impact of changes in oil-export revenues
on the demand for imports, working through foreign
exchange constraints; and the impact of changes in oil
exports on the level of government spending, through
the government budget constraint as affected by the
price of oil. Regression analysis of data from 1970
through 1985 was used to obtain the values of the
elasticities. Identities are included in the model to
calculate effects on the current account balance and
the government budget balance.
produce a real purchasing power series.
The Purchasing Power of Oil
A simple spreadsheet model was constructed to esti-
mate the impact of exchange-rate changes on the
purchasing power of a barrel of oil priced in dollars.
The current pattern of sources of import flows is used
as a weighting system to determine the effect of a
change in any particular currency's value on the oil
exporters' purchasing power. The results are deflated
by the price levels in the exporting countries to
and multiplied by the current dollar price of oil.
To calculate the real purchasing power of a barrel of
Middle Eastern oil, the exchange rate for each trading
partner is first adjusted for inflation. Next, changes in
these real exchange rates are weighted by each coun-
try's share of sales to the Middle Eastern oil export-
ers. These values are then converted to a 1970 base
ed for dollar inflation.
The methodology can be summarized as follows:
? Obtain dollar exchange rates of trade partners.
? Deflate exchange rates by domestic inflation rates.
? Convert real exchange rates to a 1970-based index.
? Weight deflated exchange rates by market share.
? Multiply this series by the dollar price of oil adjust-
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