A Future Middle East of Failed States?

Via The Asia Times, a highly pessimistic look at the economies of the largest Muslim countries, namely Iran, Pakistan, and Turkey.  While I do not wholly agree with the thesis of the piece, I felt it useful to present The Times’ views.  As the article notes:

“…Iran’s President Mahmud Ahmadinejad controls Iran through a kleptocracy of Central African proportions, dissipating the country’s oil windfall into payoffs to an “entire class of hangers-on of the Islamic revolution”, as I wrote in June (see Worst of times for Iran, Asia Times Online, June 24, 2008), when oil still sold at US$135 a barrel. What will Ahmadinejad do now that the oil price has collapsed? According to my Iranian sources, the answer is: Exactly the same thing, but without the money. [1]

The point of the joke is that Iran’s regime cannot reduce subsidies or raise taxes without losing control of the constituencies that brought it to power. They are the peasants and the urban poor who barely afford shelter and food as matters stand. Despite the oil-price collapse, the government has not reduced energy subsidies that the International Monetary Fund (IMF) puts at more than a fifth of gross domestic product (GDP). A proposed value-added tax was withdrawn last October after strikes in the bazaars, starting in Isfahan and other provincial towns and spreading to the capital Tehran. Iran is eating through its $60 billion of foreign exchange reserves, unable to adjust to a collapse of its only significant revenue source.

Iran must break down, I argued last June, or break out, through a military adventure. The sand is slipping out of the hour glass, and the regime must decide what to do within a few months. If it does nothing, the default position, as it were, is Pakistan.

Iran’s Ahmadinejad rules through massive subsidies. Pakistan’s President Asif Ali Zardari does the same thing, but without the money. Pakistan ran out of foreign exchange reserves in November and obtained emergency financing from the IMF. Its current account deficit was running at an alarming 14% of GDP, or about $20 billion a year, a small sum, but an important one for a country two-thirds of whose 175 million people subsist on less than $2 a day.

Pakistan received just $7.6 billion from the IMF, covering a third of its current account deficit, which means that imports must be reduced drastically (although lower oil prices may help a bit). Inflation is running at 25% a year.

Pakistan has one of the world’s youngest populations and an enormous capital requirement. Young people borrow from old people, and countries with young populations should import capital from countries with aging populations. That is out of the question, for the world markets have turned Pakistan into a pariah. The cost of credit protection on Pakistani sovereign debt is now more than 3,000 points (or 30%) above the benchmark London Interbank Offered Rate (LIBOR), reflecting a complete shutout from capital markets.

Cost of credit protection for Pakistan government debt (5-year term, in basis points of spread to the London Interbank Rate).

Shown on the right-hand scale is the most populous Muslim country, Indonesia, where investors pay 1,000 basis points (10 percentage points) above LIBOR for five-year credit protection.

Pakistan was at least able to raise a modicum of official support. What will Iran do if its reserves run out? The same thing as Pakistan, but without the money, for Iran is a geopolitical pariah without access to official aid.

The Muslim risk premium has become so pervasive that investors are looking cross-eyed at Saudi Arabia. The cost of credit protection on the Kingdom of Saudi Arabia has jumped since August, and now is considerably higher than Israel’s.

Cost of 5-year credit protection on Saudi Arabia and Israel

Israel credit protection trades at 185 basis points above LIBOR, about the same as Italy, while Saudi Arabia is at 236 basis points. Considering the kingdom’s resources, that must be interpreted as a political risk premium.

Turkey has been able to keep afloat through the crisis, but barely so. The Turkish currency has fallen by a third, its stock market has fallen by nearly 80% in dollar terms, and the central bank must keep interest rates to finance its balance of trade deficit, and the crisis has pulled the carpet out from under its economy. In August, before the crisis erupted in force, Turkey had 10% unemployment. It will get much worse.

Turkish lira and Turkish 1-year interest rate

Turkey was the poster-child for the so-called carry trade, in which hedge funds and other investors borrowed in low-interest currencies, for example the Japanese yen, and lent the money in high-interest currencies, of which Turkey’s lira was the highest. The carry trade was the main source of money for Turkish business. What will Turkey do now that the credit crisis has made the “carry trade” a painful memory? The same thing, but without the money.

Pakistan is about to become a failed state, and Iran and Turkey will be close behind. As I commented to Chan Akya’s report of December 2 on this site (see The hottest place in the world), Pakistan’s military-age population is far greater than those of other Muslim military powers in the region. With about 20 million men of military age, Pakistan today has as much manpower as Turkey and Iran combined, and by 2035 it will have half again as many.

Half the country is illiterate and three-quarters of it subsists on less than $2 a day, according to the World Bank. That is to say that Pakistan’s young men are more abundant as well as cheaper than in any other country in the region. Very poor and ignorant young men, especially if their only education has been in Salafi at a punishing 20% to prevent money from fleeing the country. Turkey has a real economy with a few first-rate manufacturing companies, unlike Iran and Pakistan, so the comparison is not quite fair. Nonetheless, Turkey relied heavily on short-term interbank borrowings madrassas, are very easy to enlist in military adventures.

The West at present is unable to cope with a failed state like Somalia, with less than a tenth as many military age men as Pakistan, but which nonetheless constitutes a threat to world shipping and a likely source of funding for terrorism. How can the West cope with the humiliation of Pakistan’s pro-American president and the inability of its duly-constituted government to suppress Islamist elements in its army and intelligence services? For the moment, Washington will do its best to prop up its creature, Zardari, but to no avail. The alternatives will require the West to add several zeros to whatever the prevailing ceiling might be for acceptable collateral damage.

A final note: several readers have asked me to comment on the terror attack on Mumbai in November. I will do so with great caution, given the absence of accurate information. I have good reason to believe that the Indian authorities lied about the attack. India claimed that 10 shooters were involved, because nine were killed and one captured. The actual number is closer to 30, I am reliably informed, not counting support personnel in Mumbai who arranged safe houses with extra ammunition and explosives months in advance of the attack. It was not a suicide attack at all, but a new kind of urban terror assault, in which the participants had a reasonable expectation of survival, and the majority did in fact survive. That is an important wrinkle, for a better class of combatant can be recruited for missions in which survival is at least possible.

No analyst I know has answered with confidence the question, cui bono? To whose benefit was the attack? It has been suggested that al-Qaeda diverted a Pakistani military intelligence team from Kashmir to Mumbai, in a demonstration of power against India. But there may be another dimension. The Mumbai attack has been a test of a different kind of warfare, the kind that emanates from failed states: the tactics of the Somali pirates applied to random destruction of civilian lives.

The lights are going out across the Middle East; states are failing, and it is not in the power of the West to make them whole again. All the strategic calculations that busied policy analysts and diplomats are changing, and the West has a very short time to learn the rules of a new and terrible game.”

This entry was posted on Wednesday, December 17th, 2008 at 9:41 am and is filed under Iran, Pakistan, Turkey.  You can follow any responses to this entry through the RSS 2.0 feed.  Both comments and pings are currently closed. 

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