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Outlook 2018: The economic impact of geopolitical risks and events on the Dutch economy

Economic Quarterly Report

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  • The Dutch economy is doing well despite higher geopolitical risks
  • The Netherlands is highly integrated with the global economy and thus also significantly exposed to regions with geopolitical tensions
  • A conflict in the Middle East involving Saudi Arabia could lead to a substantial oil price shock, which would see Dutch GDP 3 percent lower by 2020 vs. our current forecasts
  • There are also geopolitical tensions in East Asia. For example, around the South China Sea, where the Netherlands has FDI and portfolio holdings worth around $140bn
  • These calculations illustrate the potential impact of geopolitical events if they happen, but economic theory suggests that even the risk of such events should weigh on growth
  • Our analysis suggests increases in geopolitical risk have slowed Dutch GDP growth in the past
  • We estimate that the recent spike in geopolitical risk has shaved 0.5 percentage point off of GDP-growth

Overview

Together with most other countries, the Netherlands is experiencing a broad-based economic recovery, even though there have been widespread worries about geopolitical risk. In a 2017 Gallup survey among 1,000 investors, 75 percent of respondents expressed concerns about the economic impact of military and diplomatic conflicts happening around the world. As the Dutch Ministry of Foreign Affairs puts it in its annual policy agenda, "a quarter of a century after the fall of the Wall, the hopes of that time have turned into the uncertainty of today". Most notably, the election of Donald Trump has unsettled US international relations. There is a risk that the ‘America First’ principle, worries about terrorism and pressures from migration will aggravate already rising tensions in Eastern Europe, the Middle East and East Asia.

There are other reasons why geopolitical risk has increased. In this publication we do not attempt an exhaustive analysis of the causes or scale of current geopolitical risks. We rely instead on work by others to show that these risks have indeed risen. We focus on the economic impact of such risks and why we have not seen much of an adverse effect on the Dutch economy. To illustrate the potential impact that geopolitical events could have on the Netherlands, we examine two scenarios: conflict in the Middle-East and tensions in East Asia. They show that an open economy like the Netherlands, with strong trade and financial ties with the rest of the world, is particularly exposed to geopolitical risk and would be negatively affected in each of these scenarios.

Given that a geopolitical event could cause real economic damage and that the risk of such an event has increased, standard economic theory suggests that consumers and businesses should respond by reducing spending, particularly on durable goods and investments. Nevertheless, the recent increase in geopolitical risk been accompanied by strong growth in the Netherlands and across the globe. Are these risks being ignored? Are consumers and businesses behaving unusually and will they come to their senses and put the brakes on the global recovery?

Historical statistical analysis indicates that such risks have not been ignored by them in the past. Indeed, geopolitical risk has impacted advanced economies in a measurable way. The reason we may not observe its effect now is because the typical impact of geopolitical risk, while measurable, is not overwhelmingly strong. Based on past relationships we would expect that geopolitical risk has taken about 0.5 percent off of GDP growth in the Netherlands in 2017, so that growth would have been 3.7 percent over the last year. That would actually have been more consistent with past economic recoveries. So geopolitical risk may be weighing on growth, but the effect is just not strong enough to actually derail an ongoing recovery. However, if geopolitical risks actually materialize, then our scenarios suggest that the resulting disruptions would be real and cause more noticeable economic damage.

Defining and measuring geopolitical risk

We are interested in how the risk and occurrence of geopolitical events impact the economy. Because people may vary in their perception of what entails such events, it is important be clear about the definition we use here. We consider geopolitical events as instances of conflict between countries or international organizations that have a disruptive economic impact on at least a continental scale. Such a conflict typically involves a military confrontation, but doesn’t necessarily have to. An oil embargo would fall under the definition of a geopolitical event. Terrorism would also fall under this definition.

Figure 1: Caldara and Iacoviello Geopolitical Risk (GPR) Index
Figure 1: Caldara and Iacoviello Geopolitical Risk (GPR) IndexSource: https://www2.bc.edu/matteo-iacoviello/gpr.htm
Note : Geopolitical risk index (12-month average)

Measuring geopolitical risk in an objective and quantitative way is particularly challenging. Fortunately, Dario Caldara and Matteo Iacoviello, economists at the Federal Reserve, the US central bank, have created a measure of geopolitical risk (GPR) using the incidence of terms like ‘geopolitical tensions’, ‘war risk’ and ‘terrorist threat’ in major US, UK and Canadian newspapers. The ‘benchmark’ version of their index goes back to 1985, while their ‘historical’ index, which uses a narrower set of newspapers with longer publications histories, dates back to 1899. The spikes in the index clearly correspond with periods of major geopolitical tensions and events (figure 1). The index also clearly indicates that there has been a notable rise in geopolitical risk over the last few years.

Two illustrations of the economic impact of actual geopolitical events

So, the risk of a geopolitical event appears to have risen. What would the economic impact of a geopolitical event be? That is a very difficult question to answer because there are so many different possible geopolitical flashpoints (some which we may not yet even be aware of) and there is a wide range of ways in which these could play out. The economic impact obviously varies enormously between a trade embargo and a nuclear war. To make this problem tractable we quantify the potential economic impact on the Dutch economy of events in two widely recognized geopolitical hotspots, namely the Middle East and East Asia. We explore specific scenarios based on the political situation in Saudi Arabia and the struggle over control of the South China Sea, however, the economic impact could apply more generally to geopolitical events that could lead to disruptions in these economically important regions. We also do not try to quantify the probability of geopolitical risks, although we do provide some qualitative assessment of the risk of the specific scenarios we consider here.[1]

The Middle East – How stable is Saudi Arabia?

The Middle East has long been the centre of attention for geopolitical risk not only because it has experienced recurrent political instability and military conflict but also because it is economically important through its oil resources and position along important shipping lines. The largest oil producer in the region, Saud Arabia, has historically been politically stable and able sell oil to the world when oil supplies from other part of the region were under embargo or impaired (examples include the Iran embargo or disruptions in Iraq and Libya). However, if Saudi Arabian production were to come under threat this would have a much bigger impact on oil prices and affect the world economy. This is particularly relevant now that Saudi Arabia is in a phase of political transition that has seen it take a more aggressive stance in the region.

Mohammad Bin Salman recently emerged as the de facto leader of Saudi Arabia, after being appointed Crown Prince by his father, King Salman. What was previously a stable and a conservative country has now emerged as the nexus of a swirl of actions that are acting to destabilize the broader Middle East region.

Internally, Bin Salman has ripped up the consensus-based system by which a coalition of members of the ruling House of Saud have collectively taken major decisions. Power has now been centred on him alone. At the same time, rival princes have been arrested, including some of the wealthiest men in the world, on ostensible charges of corruption. Meanwhile, Bin Salman is pressing ahead with two other elements of a strategy to entirely revolutionize Saudi Arabia. One is an economic revolution, which by 2030 is aimed at reducing the Kingdom’s almost total reliance on oil. The other is a social revolution to promote moderate Islam, to encourage the role of women in society, and to give greater leisure and employment opportunities to the majority of Saudis aged under 30. Puritanical Wahabi Muslims, with whom the House of Saud had long made a pact to rule the country, strongly disfavour the first two measures.

Furthermore, Bin Salman is simultaneously forging ahead with ambitious regional actions that could potentially further destabilize the region. At root, Bin Salman is openly pushing back against the emerging Iranian Shi’ite regional hegemony. This Saudi push-back has already seen it fund Islamic extremists to attack pro-Iranian Syrian government forces, declare war against the Shi’ite Houthis of neighbouring Yemen and recently come close to declaring war on Lebanon, home to Shi’ite militia Hezbollah.

The actions of Bin Salman carry both internal and external risks. At home, the combination of wealthy princes frozen out of power and discontented social conservatives points to significant risks that Saudi Arabia could see political instability ahead – perhaps a counter-coup against Bin Salman. Similarly, while the push against Iran has had no effect so far, at some point the actions of Bin Salman in such a volatile region could trigger a serious conflict.

How might such a conflict impact the Dutch economy? The price of oil is the most obvious transmission channel but the Netherlands also has other significant economic relations with the region. Saudi Arabia is the largest oil exporter in the world and any event involving Saudi Arabia, regardless if it involves other large oil exports in the region, will definitely affect oil prices. Oil wells may be taken offline and, even if they are not, oil traders will price in higher risks.

We calculate the economic impact of a sharp oil price shock after an adverse event in the Middle East that involves Saudi Arabia and estimate the subsequent impact on the Dutch economy. We assume a price increase to 180 dollars per barrel in the second quarter of 2018. The increase is consistent with the rise in prices during the early 1970s around the first oil boycott, when the oil prices roughly tripled. The level is also about the same as the oil price peak in 2008 in terms of current prices[2]. Unlike in the early 1970s, we assume that oil prices decline after the disruption in the Middle East as production in other parts of the world increases. In particular, production in the US from (more expensive) shale oil can be ramped up relatively quickly because there is mothballed capacity standing by and smaller rigs are used that can be brought online more quickly. We estimate quantitatively that it will take about two years for this effect to push down oil prices to a new equilibrium. The oil price shock drives cuts approximately three percent off of Dutch GDP at the end of 2020 compared to our baseline forecast (see the appendix for details on our calculations).

This is a possible macro effect of turmoil in and around Saudi Arabia on the Dutch economy through the oil price shock. It does not include, however, the impact on direct exposures to the Middle East. To quantify these vulnerabilities, we show outstanding Dutch foreign direct investment (FDI) and portfolio investment in different countries in the Middle East (figure 2)[3]. Together these amount to at least $61 billion, which is equivalent to 8 percent of Dutch GDP. Dutch companies have the highest exposures in Turkey, Egypt and Israel, but are less directly exposed to the centre of any conflict involving Saudi Arabia or Iran.

Figure 2: Dutch exposures in the Middle East
Figure 2: Dutch exposures in the Middle EastSource: IMF

East Asia – Tensions in the South China Sea

Figure 3: Overlapping territorial claims in the South China Sea
Figure 3: Overlapping territorial claims in the South China SeaSource: Asia Maritime Transparancy Institute

East Asia has been relatively stable in recent history and seen itself grow into a central part of the global economy as the ‘factory to the world’. But this masks the fact that there are important so-called unresolved or ‘frozen’ conflicts in the region, most notably between North and South Korea, and between Taiwan and the People’s Republic of China. The latter also factors into a more complicated patchwork of competing claims around the South China Sea (SCS). China, Taiwan, Malaysia, Indonesia, the Philippines and Vietnam all claim overlapping parts of the area (figure 3). Several non-claimant countries, such as the United States, are also involved in the dispute over the South China Sea, as they want to ensure freedom of navigation. As it involves a large part of the region and China has been strengthening its hold on the region, we explore the potential for this geopolitical hotspot to create economic damage.

The motivation for territorial claims to the South China Sea are clear. There are abundant natural resources, such as oil, gas and fisheries. Furthermore, the area has great strategic value, in part because an estimated one-third of global shipping passes through it.

Recently, China has ramped up its activities in the South China Sea, from establishing military bases on artificial islands, to taking its naval claims right the way to the shores of Vietnam, the Philippines and Malaysia. It is has also warned off countries looking to explore for energy in the South China Sea. In a 2016 case brought by the Philippines, the International Tribunal for the Law of the Sea (ITLOS) rejected part of China’s claims over the area. China has rejected the ruling, citing historical rights to legitimize their claims over the South China Sea.

This means that the risk of conflict has increased. Other countries may act to try to ensure the sea does not fall under Chinese control, which could trigger a response. For example, the US continues to undertake freedom of navigation exercises in the South China Sea. An accident between a US ship and a Chinese vessel, or plane, is not outside the realm of possibilities and could trigger a wider conflict.

As a trading nation, the Netherlands is vulnerable to developments in vital trade arteries such as the South China Sea. About $87 billion worth of Dutch imports and $27 billion worth of Dutch exports flow through the South China Sea (Center for Strategic and International Studies, 2016), that’s equivalent to more than respectively 10 percent and 3 percent of GDP. FDI exposures to the region are much larger than to the Middle East. Dutch companies have FDI exposures to countries with claims to the South China Sea that amount to more than $90 billion or about 12 percent of Dutch GDP. There are also substantial portfolio holdings, i.e. securities owned by pension funds and other Dutch investors. These are worth more than $40 billion, equivalent to 6 percent of Dutch GDP. This suggests that financial markets and asset values more generally would be a more important transmission channel than in the first scenario.

Figure 4: Dutch exposures around the South China Sea
Figure 4: Dutch exposures around the South China SeaSource: IMF

It is very difficult to assess the probability of either a conflict in the Middle East or the South China Sea. However, it seems to us that the probability of the former is somewhat higher than the latter given the recent history of instability in the Middle East, the transition in Saudi Arabia and underlying religious tensions that run deeper than economic interests. Regarding the South China Sea, the economic benefits of control over the region are probably less than the damage the conflict could cause, so all parties have an interest in keeping the conflict contained. However, the size of the economies involved and their integration with global supply chains means that the economic and financial market effects of a conflict would go well beyond that of an oil shock. The Netherlands, with its substantial exposure in both the region and the rest of the world, would be severely affected.

The economic impact of the risk of geopolitical events

The two scenarios presented above illustrate how geopolitical events can have a significant impact on the Dutch economy. And, as we show in this text, the risk of such events has risen. Standard economic theory suggests that an increased threat of any future disruptive event should weigh on consumer and business spending and thus slow economic growth now. This should be most true of spending on durable goods. Businesses should invest less in machines and other capital goods if they fear that they will be not be able to recoup the cost of the investment if a geopolitical event leads to higher input prices or reduce sales. While business investment is likely most sensitive to risk, consumers may also refrain from buying durable goods like cars or investing in housing if they are afraid that a geopolitical event will hurt their income or wealth.

Despite the theory, the state of the economy seems to be disconnected from the elevated level of geopolitical risk. Private investment growth, which covers both business and housing, appears robust; our latest estimates for 2017 are 4.4 percent for the euro area and 8 percent in the Netherlands. Overall GDP growth is also likely to have been healthy over the past year, at 2.4 percent and 3.2 percent respectively. Given that the Netherlands economy is highly open (the most globalized in the world, according to logistics firm DHL) it is particularly notable that it is doing so well in the face of geopolitical risk.

Is this apparent disconnect between growth and geopolitical risk normal historically? If not, should we worry that businesses and consumers will wake up to these risks and curtail their spending? To answer these questions we look at the statistical analysis by Caldara and Iacoviello and supplement it with our own research aimed at the Netherlands.

Caldara and Iacoviello use a couple of econometric techniques with varying specifications to do a robust analysis of the impact of their geopolitical risk index on economic growth and financial markets in the US and other countries. They conclude that there is indeed a measurable impact of geopolitical risk. Using their coefficients we estimate that the most recent spike in geopolitical risk knocked about 0.6 percent off of US industrial production and 0.3 percent off of industrial production in advanced economies.

Figure 5: Dutch GDP growth and effect of geopolitical risk in historical context
Figure 5: Dutch GDP growth and effect of geopolitical risk in historical contextSource: Macrobond, data from Statistics Netherlands since 1997, OECD prior, calculations Rabobank

We are particularly interested in the Dutch economy, where we would expect the impact to be bigger due its significant international exposures. We do our own analysis using similar techniques to Caldara and Iacoviello. However, we focus on GDP instead of industrial production. We find that a rise in the index similar to what we saw recently would decrease GDP growth in the Netherlands by about half a percent within a year (see the appendix for a more detailed description of these estimates).

The effect we find for the Netherlands is certainly not negligible. However, it is also not so large that we must conclude that recent economic growth would only be possible if consumers and businesses were showing a reduced sensitivity to geopolitical risks. Both our current estimate for GDP growth in 2017 and what it might have been without geopolitical risk, respectively 3.2 percent and 3.7 percent, fit comfortably within the range of past economic recoveries in the Netherlands.

Conclusion

The economic recovery in a globalized economy, like the Netherlands, might appear at odds with the increase in geopolitical risk. Indeed, if these risks were to materialize, the Netherlands would be badly affected. We’ve explored two examples and find that a sharp rise in the oil price could significantly slow growth while conflict in East Asia would leave Dutch investments equivalent to nearly 20 percent of GDP exposed. Why then have we not seen more of an impact on economic growth from the rising risk of such disruptive events? Statistical analysis of the relationship between geopolitical risk and economic growth suggests that there is a measurable link, but that the effect is not so strong that we should expect it to derail the current economic recovery. An actual geopolitical event is another matter. Depending on the nature and severity of the event, the Netherlands could be significantly impacted.

Footnotes

[1] We thank Michael Every, Rabobank Senior Asia Strategist, for his political analysis of the situation in the Middle East and East Asia

[2] We use US consumer prices to translate historical oil prices into current prices

[3] The Netherlands also has portfolio exposure to these countries, but they are much smaller at only about a tenth of the FDI exposures.

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