The economic opportunity cost for countries located in crisis zones: Evidence from the Middle East

Accepted Manuscript Title: The Economic Opportunity Cost for Countries Located in Crisis Zones: Evidence from the Middle East Author: Diana Abu Ghunmi PII: DOI: Reference:

S0275-5319(15)30051-9 http://dx.doi.org/doi:10.1016/j.ribaf.2015.10.010 RIBAF 427

To appear in:

Research in International Business and Finance

Received date: Revised date: Accepted date:

19-5-2015 15-10-2015 16-10-2015

Please cite this article as: Ghunmi, D.A.,The Economic Opportunity Cost for Countries Located in Crisis Zones: Evidence from the Middle East, Research in International Business and Finance (2015), http://dx.doi.org/10.1016/j.ribaf.2015.10.010 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

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GDP & FDI

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Military Expenditure s

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*Graphical Abstract

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*Manuscript, excluding Author Details Click here to view linked References

The Economic Opportunity Cost for Countries Located in Crisis Zones: Evidence from the Middle East

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Abstract

Whether the Middle East is a blessed or damned region is a matter of perspective and

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evidence. This paper investigates the effect of regional instability on countries caught in such conflict solely because of their location. By use of an interrupted time series model, an unrestricted error correction model, and the incremental capital output ratio (ICOR), the indirect economic costs of regional unrest are estimated for Jordan, as an exemplar of Middle Eastern countries. Jordan has lost during 24 years of regional turmoil the equivalent of 40% to 72% of its 2012 gross domestic product (GDP), or US$12.6 billion to US$22.7 billion. Furthermore, it has lost US$2.3 billion of foreign direct investment (FDI) and its return, which are higher than the annual FDI inflows in most of the years covered by this study. This substantial loss is a warning sign that should be seriously considered by politicians and economists in the Middle East, especially for countries whose resources are already constrained.

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Keywords: Opportunity cost, GDP, FDI, Middle East, regional instability Classifications: F3, F4, E2, E6

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1. Introduction The misfortune of living in a politically unstable zone is usually borne by the majority of the population through endurance of the economic consequences. In theory, regional instability1 disturbs not only the countries involved in the turbulence but also neighboring countries by

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discouraging saving and investment via a negative incentive effect, increasing military spending, and disrupting trade with other countries (Ades and Chua, 1997). The economic

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costs of regional conflict include not only direct cost but also indirect cost, or opportunity

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cost,2 such as income lost due to reduced domestic and foreign investment, uncertainty, and inefficient resource allocation (Arunatilake et al., 2001). Foregone investment may be

and Abu-Qarn, 2003)

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attributed to rising military expenditure (Deger, 1986; Arunatilake et al., 2001; Abu-Bader and hence military spending3 may obstruct economic growth by

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crowding out investment (Deger, 1986; Arunatilake et al., 2001; Abu-Bader and Abu-Qarn, 2003) or by deterring savings and resource creation (Deger, 1986).

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The relationship flow from military spending to investment to economic growth is well documented. On one hand, the crowding-out effect of military spending has been supported

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by Chen et al. (2014) and Arunatilake et al. (2001). On the other hand, evidence that investment—whether domestic investment or foreign direct investment (FDI)4—has a positive effect on an economy has been confirmed by a number of authors, including Omri

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and Kahouli (in press), Gupta et al. (2014), Li and Liu (2005), Alfaro et al. (2004), Borensztein et al. (1998), and Levine and Renelt (1992). Furthermore, many studies (e.g., Abu-Bader and Abu-Qarn (2003), Aizenman and Glick (2006), and Deger (1986)) have provided proof of the negative effect of military expenditure on economic growth.

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Regional instability refers to “political instability in neighboring countries” (Ades and Chua, 1997, p. 279). This opportunity cost is also referred to by Anderton and Carter (2001). 3 Military expenditure may also enhance economic growth, by boosting aggregate demand via a Keynesian effect (Deger, 1986; Arunatilake et al., 2001; Abu-Bader and Abu-Qarn, 2003). 4 FDI enhances growth through a number of vehicles, including technology, infrastructure, human capital, and production inputs (Li and Liu, 2005). See Li and Liu (2005) for a review of the related literature. 2

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The current economic and political situation in the Middle East is far from stable. The Arab countries have been jolted by the Arab Spring, a significant regional turmoil that started in Tunisia in December 2010 and toppled ruling regimes in a number of countries and left other ruling regimes, such as those of Jordan and Morocco, facing growing pressure to take

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counteractive actions (Campante and Chor, 2012). Indeed, the economic conditions in Jordan have been considerably affected by the political events in the neighboring countries,5 as

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evidenced, at the very least, by the acknowledged disruption in FDI inflows to Jordan (the

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Organisation for Economic Co-operation and Development (OECD), 2013). However, like many others Middle East countries, Jordan is no stranger to regional instability: It has

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suffered economic consequences previously, including during the Gulf War (1990–1991), in the form of decreased gross domestic product (GDP), lost tourism, and decreased exports and

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remittances as many Jordanians returned from Gulf countries (Ades and Chua, 1997). During the past decade, Jordan has experienced a substantial surge in its military expenditure, with

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the 2012 expenditure reaching about 2.7 times its 2000 level, according to data from the World Bank’s World Development Indicators. Furthermore, in 2013 Jordan was among the

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world’s top 10 militarized countries, based on the Global Militarization Index (GMI), and the Middle East was the world’s top militarized region (Bonn International Center for Conversion, 20136)7.

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Taking the analysis from previous authors as an indication that outsized military expenditure can result in second-order effect resource misallocation. In addition to this perverse outcomes, it can also act as a deterrent to external foreign investment since this militarisation 5

Furthermore, the consequences of the financial crisis in the Gulf Cooperation Council (GCC) countries have added insult to injury for Jordan’s economy (OECD, 2013). 6 According to this report, the Bonn International Center for Conversion (BICC) is conducting a study in cooperation with a number of researchers, in Jordan as well as other countries, to investigate how military behavior has been affected by the economic conditions and other conditions resulting from the Arab Spring. For a ranking of GMI during 1990–2012, see Bonn International Center for Conversion, Global Militarization Index, http://gmi.bicc.de/index.php?page=ranking-table&year=2012&sort=rank_asc, last accessed on August 16, 2014. 7 In part, the high militarization of the Middle East can be attributed to the Israeli–Arab conflict (Abu-Bader and Abu-Qarn, 2003).

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implies a present or future potential for domestic or geopolitical instability, disrupting the free flow of capital and supply chains. This paper attempts to investigate the effect of the regional political unrest on Jordan’s economy as an exemplar of countries in the Middle East. We quantify in monetary terms, the FDI inflows and economic growth that are lost as a result

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of regional instability and increased military spending. What makes Jordan an interesting case to study is that it has been among the top-ranked developing Middle East and North

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Africa (MENA) countries in terms of military spending as a percentage of GDP (Table 1). To

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the best of the authors’ knowledge, this study is the first to attempt to estimate the investment opportunity cost, in monetary value, of the regional instability in the Middle East. The

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remainder of this paper is organized as follows: Section 2 reviews the relevant literature, Section 3 presents the data and describes the methodology, Section 4 reports the results and

2. Literature Review

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discusses them, and Section 5 summarizes the conclusions.

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Economists and politicians may have as much curiosity as do academics with regard to measuring the extent to which their respective countries suffer the Neighbor’s Curse, a term coined by Ades and Chua (1997). By studying a large number of countries, including Jordan,

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Ades and Chua (1997) found a significant negative effect of neighboring countries’ political turmoil on a country’s economic growth, transmitted through increased military spending and disrupted international trade. Consistent with that finding, Chen et al. (2014) showed that military expenditure crowds out private investment and hence reduces economic growth in low-income and middle-income countries, including Jordan, while the Keynesian effect of military spending boosting economic growth prevails in high-income countries. For three Middle Eastern countries (Syria, Israel, and Egypt), Abu-Bader and Abu-Qarn (2003) found that military expenditure is driven by domestic and regional threats and, in contrast to other 4 Page 5 of 27

government expenditures, has an adverse effect on economic growth.8 In another study (Aizenman and Glick, 2006), the theoretical relationship between economic growth and military expenditure was shown to be nonlinear. Aizenman and Glick (2006)9 reported a direct negative effect of military expenditure on economic growth in Middle Eastern

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countries; however, they showed a positive effect of military expenditure on economic growth as along as external threat is above a threshold level but a negative effect if the threat

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is below the threshold level.

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Interestingly, Aizenman and Glick (2006) also confirmed the presence of an adverse effect of military spending on economic growth when corruption is high but a positive relationship

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between military spending for countries with low corruption. Dakurah et al. (2001) concluded that there is no strong support for military expenditure having an effect on economic growth.

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However, they warned that their finding could be attributed to data and procedural issues. Alptekin and Levine (2012) attempted to reconcile the mixed findings with regard to the

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relationship between military spending and economic growth. They provided evidence of (1) a nonlinear relationship and (2) a positive relationship in developed countries. They argued

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that the nonlinearity indicates a positive relationship up to a point, which confirms the positive findings for developed countries, and then, as military expense increases, the associated higher opportunity costs dominate the relationship, turning it negative. Deger

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(1986)10 argued that the theoretical negative effect of military spending on economic growth could result from opportunity cost of foregone investment through reduced savings. He concluded that military expenditure has an adverse effect on economic growth when its unfavorable effect on savings exceeds its favorable effect of modernization. 8

Abu-Bader and Abu-Qarn (2003) justified, in part, their selection of these countries by the countries being among the highest ranked in terms of military spending. 9 Aizenman and Glick (2006) calculated how many percentage points growth decreases as a result of increasing military expenditure. 10 In his cross-country analysis (including Jordan), Deger (1986) showed that a dummy variable for war has a significantly positive coefficient in explaining military spending, which he characterizes as strategic expenditure.

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Arunatilake et al. (2001) emphasized the long-term effect of lost investment on economic growth and argued that military spending affects economic growth negatively, by crowding out public investment, private investment, and FDI and by changing the efficiency of investment via unfavorable investment conditions. In their attempt to estimate the economic

military spending crowds out government capital investment.11

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costs, direct and indirect, of the Sir Lankan civil war, Arunatilake et al. (2001) found that

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The significance of investment to economic growth is supported in literature; it is well

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documented that investment is positively related to economic growth (Aizenman and Glick, 2006; Levine and Renelt, 1992). Another study (Borensztein et al., 1998) found that

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investment, domestic and foreign, is a key determinant of economic growth and that FDI is a more significant determinant than domestic investment. In fact, according to neoclassical

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economics, economic growth is a positive function of FDI, which increases the level of investment, the efficiency of investment, or both (Li and Liu, 2005). The significance of the

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FDI effect on economic growth also has been supported by Alfaro et al. (2004) and Borensztein et al. (1998). Further work has shown that, although both FDI and domestic

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investment enhance economic growth, FDI has a superior effect when augmented by human capital capable of absorbing technologies brought in by foreign investors (Borensztein et al., 1998). Li and Liu (2005) found that economic growth is a positive direct function of FDI and

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domestic investment. Moreover, they found that economic growth is a positive indirect function of FDI through the interaction term of FDI and human capital in all countries, but a negative indirect function of FDI through the interaction term of FDI and the technology gap in developing countries. Li and Liu (2005) attributed the negative relationship of economic growth to the interaction term of FDI and technology gap to low technology absorptive ability in developing countries. In addition, Durham (2004) showed, using a large number of 11

Abu-Bader and Abu-Qarn (2003) stated that [neo]classical economics argues that government expenditure has a crowding-out effect on private investment through substitution of goods and services and high interest rates.

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countries, including Jordan, that the effect of foreign investment, both direct and equity, is positive but conditional on financial development. Absorptive capacity, in the form of ex ante technological capacity and the breadth and depth of capital markets, is a crucial indicator of the receptiveness of an economy to growth-inducing investment outside of political economy

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and security considerations. More support for the vital role of investment in the economy was provided by Omri and

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Kahouli (in press) who found that economic growth in MENA countries is positively affected

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by FDI and domestic capital, that domestic capital is positively enhanced by economic growth and FDI, and that FDI is only positively influenced by economic growth. They also

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reported that in MENA countries both economic growth and domestic investment are deterred by government expenditure. Inefficiency in the relationship between investment and

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economic growth can act as a restraint on growth. Gupta et al. (2014) showed, for a number of countries, including Jordan, that economic growth is considerably enhanced by efficiency-

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adjusted public capital and that investment quality affects economic growth differentials. Gupta et al. (2014) reported that failing to account for inefficiencies in public investment

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underestimates the marginal productivity of public and private investment.

3. Data and Methodology 3.1 Data

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Annual data for 1980-201212 for the required variables for this study were obtained from various sources: World Development Indicators in the World Bank database, the Central Bank of Jordan, and the United Nations Conference on Trade and Development (UNCTAD). All data were downloaded mainly for Jordan, unless otherwise stated. The variables obtained

From World Development Indicators in the World Bank’s database:

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from each source are as follows:

FDI net inflows (for all countries)



FDI net inflows as a percentage of GDP



Military expenditure



Military expenditure as percentage of GDP (for all countries)



Household final consumption expenditure per capita



Gross Domestic Product (GDP) (for all countries)

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

From the website of the Central Bank of Jordan: Government capital expenditure



Number of residential permits

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

Jordan’s ‘bordering or neighbouring’ countries, in which major political unrest and crisis night have taken place during the period studied, have been identified by Ades and Chua

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(1997) as Syria, Saudi Arabia, Iraq, and Israel. Also following the definition of Ades and Chua (1997), political instability in the neighbouring countries refers to occurrence of revolution or coup. Therefore, the major unrest events in the MENA region are the Gulf war (1991) and the Iraq War (2003) (https://en.wikipedia.org/wiki/2003_invasion_of_Iraq), and the Syrian Civil War (2011- present) (https://en.wikipedia.org/wiki/Syrian_Civil_War). 3.2 Methodology 3.2.1

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Interrupted Time Series Model

Data for a few of the variables have later start years based on availability.

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In order to examine the trade effect of war, Anderton and Carter (2001) used the multiple interrupted time series approach of Lewis-Beck and Alford (1980).13 Therefore, to investigate the disruption to Jordan’s economy that was caused by major political crises and instability in the neighboring countries, this paper follows the Anderton and Carter (2001) methodology of

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the multiple interrupted time series approach of Lewis-Beck and Alford (1980) estimated by ordinary least squares (OLS) or maximum likelihood (ML) regression in the presence of

(1)

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autocorrelation, as follows:

in which Economic Activity represents one of the following variables: FDI net inflows,

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Military expenditure, Number of residential permits, Household final consumption expenditure per capita, GDP, or Jordan’s UNCTAD FDI performance index ranking.14 Also represents number of variables: Trend, which takes an increasing discrete

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in the model,

number for each year in the time series, starting with 1 for the first year; War level, which is

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set equal to 1 for the year in which the unrest or crisis begins and for all subsequent years in the time series, and zero for all preceding years; War trend, which takes an increasing

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discrete number for each year during and after the unrest, starting with 1 for the year in which the unrest or crisis begins, and zero for all preceding years; Peace level, which is set equal to 1 for each year after the year in which the unrest begins and zero for the year in which the

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unrest begins and all preceding years; and Peace trend, which takes an increasing discrete number for each year after the unrest, starting with 1 for the year following the year in which the unrest begins and zero for the year in which the unrest begins and all preceding years. In addition, for short wars that began and ended with a single calendar year, this paper again follows the approach of Anderton and Carter (2001), who used the formulae of Barbieri and 13

Anderton and Carter (2001) showed that trade is badly disrupted during wartime. The UNCTAD FDI Performance index is calculated, for all countries, based on UNCATD’s own methodology. According to UNCTAD (2002, p. 23) “The Inward FDI Performance Index is the ratio of a country’s share in global FDI flows to its share in global GDP.” 14

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Levy (1999), which exclude two variables; War trend and Peace level and redefine the variable Peace trend such that it takes an increasing discrete number for each year during and after the crisis, starting with 1 for the year in which the crisis begins but zero for all preceding years. Table 2 reports the results. As Anderton and Carter (2001) stated, the coefficient of

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interest is the coefficient on the variable War level.

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3.2.2 Unrestricted Error Correction Modeling

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In order to measure a country’s economic costs associated with its increasing military expense, this paper follows the approach of Arunatilake et al. (2001), who modeled

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government capital expenditure as a percentage of GDP as a function of military expenditure

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and foreign investment as follows:

(2)

in which Gov. Capital Exp. is government capital expenditure as a percentage of GDP; ∆

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represents the change in a variable from the preceding period, Military Exp. is military expenditure; For. Inv. is FDI as a percentage of GDP, WarDummy is a dummy variable equal to 1 for each year in which a major regional instability occurs in a neighboring country and 0

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for all other years and t is time period. Arunatilake et al. (2001) pointed out that unrestricted error correction modeling (UECM) can be used to avoid identifying a spurious relationship when the augmented Dicky-Fuller (ADF) test shows that variables are nonstationary. Therefore, following their recommendation, in this study the ADF test is used to examine the stationarity of the variables and the UECM is used to estimate Equation 2. Table 3 reports the results. 3.2.3 Measuring Economic Costs: Opportunity Costs

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The next step is to calculate the following: (i) the GDP lost as a result of increased government spending on the military, which crowds out government capital expenditure and (i) the FDI lost as a result of unrest in the region. For this purpose, the current paper follows the procedure of Arunatilake et al. (2001)15, as follows: The reduction in government capital expenditure, as a result of increased military

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

spending, is calculated from Equation 2.

The incremental capital output ratio (ICOR),16 which equals the investment as a

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



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percentage of GDP divided by the GDP growth rate, is calculated for each year. The hypothetical GDP growth rate, lost GDP growth rate and the hypothetical GDP,

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which would have occurred absent the increased military spending, are estimated based on the ICOR.

The difference between the hypothetical GDP and the actual GDP is calculated for each

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

year. This amount represents the lost GDP for each year. The lost income is then calculated based on an assumed 2% rate of return, similar to the

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



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rate of return on FDI inflows as reported by OECD (2013). In order to calculate the lost FDI, this study relies on the annual UNCTAD FDI performance index rankings and values for Jordan, calculated for each year based on UNCATD methodology. The average during what are considered normal years (without

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unrest in the region) is used to estimate the hypothetical FDI, the FDI had the region not experienced turmoil. This approach is similar to Arunatilake et al.’s (2001) approach. They calculated the lost FDI and its return by using the average FDI as a percentage of GDP in the normal years and apply this average to the subsequent conflict years to

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Arunatilake et al. (2001) argued that using the ICOR method to calculate the lost GDP may underestimate the real loss to the economy as a result of the favorable short-run economic growth effect of military expenditure. 16 Arunatilake et al. (2001) indicated that this approach is called the Comparative Static Harrod-Domar model of Grobar and Gnanaselvam (1993).

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calculate the hypothetical FDI and its associated lost income. Lost income was then calculated based on an assumed 2% rate of return (OECD, 2013).

4. Discussion of Results

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4.1 Economic Activities and the Crisis Zone With the purpose of gaining insight into the potential effect on a country’s economy of the

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country being located in a crisis zone, Table 1 shows Jordan’s military spending as a

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percentage of GDP was in the top ten MENA countries during 1990 to 2010. Furthermore, Table 2 shows the results of estimating a multiple interrupted time series model for each of

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several measures of economic activity.

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Table 1. Country Ranks of Military Expenditure (based on military expenditure as a percentage of GDP), 1990–2010 2005 Oman Saudi Arabia Djibouti Syria Yemen Jordan

2010 Saudi Arabia Oman United Arab Emirates Jordan

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Rank 1990 1995 2000 1 Kuwait Oman Saudi Arabia 2 Oman Kuwait Oman 3 Saudi Arabia Saudi Arabia Jordan 4 Jordan Syria 5 Morocco 6 Lebanon 7 Yemen 8 Djibouti 9 Bahrain 10 Jordan Source: World Development Indicators in the World Bank database

Table 2. Effect of Regional Unrest on Jordan’s Economy FDI

JorRankFDIper

Military*

Residential*

HouseCon*

GDP*

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Intercept

18.03 (0.00) -0.09 (0.37)

Trend Dummy1997

Peace trendGW

-1.88 (0.06) 0.42 (0.00)

19.46 (0. 00) -0.03 (0.77)

8.58 (0. 00) 0.05 (0.01)

7.75 (0. 00) -0.02 (0.04)

20.88 (0. 00) 0.08 (0.00)

0.15 (0.32) 0.04 (0.01)

0.45 (0.00) 0.01 (0.49)

-0.32 (0. 00) 0.02 (0.02)

0.03 (0.65) 0.07 (0.00)

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War levelGW

3.15 (0. 00) 0.14 (0.02) -0.80 (0.22) 0.55 (0.29) -0.11 (0.03)

0.39 -0.99 -0.13 0.15 -0.04 (0.66) (0.10) (0.36) (0.35) (0.63) Peace trendIW -0.26 0.17 0.11 0.01 0.02 (0.14) (0.13) (0.00) (0.86) (0.21) War levelSCW -0.76 2.08 -0.14 0.12 -0.03 (0.72) (0.05) (0.63) (0.58) (0.79) Peace trendSCW -0.14 -0.88 -0.08 0.05 -0.02 (0.91) (0.05) (0.66) (0.61) (0.79) Notes: This table reports the results of the multiple interrupted time-series model estimated for a number of economic variables, based on OLS regression for FDI; foreign direct investment and JorRankFDIper; UNCTAD FDI performance index ranking for Jordan and based on ML for the rest of the economic variables which exhibited autocorrelation (Military; military expenditure, Residential; number of residential permits, HouseCon; household final consumption expenditure per capita, and GDP; gross domestic product. GW; Gulf war (1991), IW; Iraq war (2003) and SCW; Syrian civil war (2011-present). P-values are shown in parentheses. Dummy 1997 is included for JorRankFDIper model to account for the year in which FDI inflows to Jordan started picking up (OECD, 2013). Also see Figure 2 below in Section 4.2.2.

-0.10 (0.13) 0.07 (0.00) 0.02 (0.86) -0.07 (0.29)

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War levelIW

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In each model, the intercept measures the level of the dependent economic variable before the beginning of the unrest, the coefficient on Trend captures the growth rate in economic

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activity before the unrest, and the coefficients on War level and Peace trend indicate whether the unrest changed the level of economic activity and its growth rate during and after the unrest, respectively (Anderton and Carter, 2001). From these results, it is evident that the

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turbulence in neighboring countries influenced economic activity in Jordan. Jordan’s FDI fell during the Gulf War and then grew positively afterward. FDI absolute value ignores the size of the economy, because the larger the economy generally the greater the FDI inflows (UNCTAD, 2002); in order to better measure the attractiveness of the economy, the economy size should be accounted for (UNCTAD, 2002). Therefore, column 3 in Table 2 reports the results for the regression in which Jordan’s UNCTAD FDI performance index ranking is the dependent variable. Jordan’s economic performance deteriorated during the Gulf War and during Syrian Civil War, the most recent turmoil in the region, for which the 13 Page 14 of 27

reduction was statistically significant. Interestingly, the FDI performance, in terms of growth rate, improved significantly after both unrest events (see Figure 2, Panel C). In contrast to the Gulf War, during the Iraq War, in 2003, FDI performance improved but only marginally. This finding is expected, given that the Jordan Investment Board underwent restructuring in

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2003 to improve investment in the country, and there was then more FDI into Jordan from other Arab countries because Jordan was seen as comparatively more stable (OECD, 2013).

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Additional capital inflow originated from Iraqis who took refuge in Jordan (OECD, 2013).

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The strong FDI inflows after the Gulf War and during the Iraq War were accompanied by Jordan’s economy regaining its prewar economic growth rate (GDP) after each of the two

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wars (Table 2, Column 7)

Household consumption per capita in Jordan deteriorated during the Gulf War but improved

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afterward. Interestingly, this measure also decreased during the other regional turbulences, though not significantly in statistical terms. The number of residential permits increased

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during the Gulf War that could be due to the return of many Jordanian expatriates (Ades and Chua, 1997). Ades and Chua (1997) used Jordan as an example of a country with a high

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percentage of military spending to GDP caused by the need to face the consequences of regional instability such as war spillover and incoming refugees 17. As can be seen in Table 2, column 4, Jordanian military spending grew after the major regional unrests of 1991 and

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2003. Although no such growth in military spending took place during the most recent regional turmoil, Jordan remains one of the world’s most militarized countries, as mentioned earlier and shown in Figure 1.

Figure 1. Jordan’s Military Expenditure: 1998–2012 Panel A. Ranking of Military Expenditure as Percentage of GDP: Jordan Vs Other Countries

17

See Satloff and Schenker (2013) for a political analysis of the situation in Jordan

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15 10 5 0

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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Time

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300,000,000 250,000,000

2012

2011

2010

2009

2008

2004

2003

2002

2001

2000

Time

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1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

0

1999

50,000,000

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100,000,000

2006

150,000,000

2005

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200,000,000

1988

Arms Imports (SIPRI Trend Indicator Values)

Panel B. Arms Imports (SIPRI Trend Indicator Values)

2007

Ranking of Military Expenditure as Percentage of GDP

20

Sources: World Development Indicators in the World Bank database

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This observation was also noted by AbuAl-Foul (2014); however, he reported that military spending boosts Jordan’s economy. He explained that as evidence of a Keynesian effect. His

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interpretation can be challenged in light of Deger’s (1986) findings, in addition, AbuAl-Foul (2014) admitted that “omitted variables” could be a problem in his paper. Deger (1986) emphasized

that the actual relationship between economic growth and military spending cannot be

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determined unless the interrelationships between each of these two variables and savings are addressed. Furthermore, Arunatilake et al. (2001) argued that the Keynesian effect, if any, is of short-term nature, and they concluded that military spending has a negative effect on economic growth by crowding out public investment. More evidence of this will be reported later in this paper in Section 4.2. Furthermore, Figure 1, Panel B shows what seems to be an upward trend in arms imports Stockholm International Peace Research Institute (SIPRI) trend indictor values.

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4.2 Opportunity Cost: Indirect Economic Costs 4.2.1 Lost GDP The attention turns now to the economic costs of Jordan’s location in a conflict zone. In fact,

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Moreno and Trehan (1997) showed that a country’s location matters. In order to measure such

economic opportunity costs resulting from lost investment caused by increased military

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expenditure,18 the first step is to estimate Equation 2. The estimated results are reported in

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Table 3.

Table 3. Unrestricted Error Correction Estimation of the Government Capital Expenditure Model Estimate

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Variable

6.27 (0.01)

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Intercept

Adjusted R-Squared

-0.18 (0.77) -0.36 (0.06) -0.03 (0.74) 0.03 (0.76) -0.65 (0.00) 0.48 (0.60) 26%

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Notes: This table reports the results of estimating Equation 2 using UECM. Gov. Capital Exp. is government capital expenditure as a percentage of GDP; ∆ represents the change in a variable from the preceding period, Military Exp. is military expenditure; For. Inv. is foreign direct investment as a percentage of GDP, and WarDummy is a dummy variable equal to 1 for each year in which a major political crisis occurs in a neighboring country but 0 for all other years. The augmented Dicky-Fuller (ADF) test is used to test for stationarity. P-values are shown in parentheses.

Table 3 shows that the government’s military expenditure adversely affect its capital investment, which supports Arunatilake et al.’s (2001) finding that government capital investment is crowded out by military expenditure. As mentioned in Section 2, investment is one of the major determinants of economic growth (Li and Liu, 2005) and in support of the link between military spending and economic growth, Abu-Bader and Abu-Qarn (2003) 18

Arunatilake et al. (2001) classified these opportunity costs as indirect investment costs.

16 Page 17 of 27

pointed out that evidence of the negative relationship between military spending and investment is indirect evidence of the negative effect of military expenditure on economic growth. Therefore, the next analysis in this study uses Arunatilake et al.’s (2001) technique based on ICOR in order to investigate how this affects the GDP of the country. The results

ip t

for Jordan are reported in Table 4. Table 4. Estimating Jordan’s GDP Lost due to Increased Military Spending, 1988–2012

4,181,595 26,300,627 16,391,433 66,322,870 34,557,182 55,666,561 39,374,576 21,853,033 30,012,171 72,724,617 31,899,986 52,879,070 78,687,122 80,007,627 71,279,852 134,373,724 181,295,899 397,847,296 464,238,591 1,711,384,350 541,841,356 1,268,496,959 1,151,985,699 1,747,324,574

Ac

an

GDP Value as of 2012 (JOD)

cr

0.18 1.08 0.59 2.24 0.96 1.43 0.90 0.46 0.61 1.42 0.57 0.92 1.31 1.26 1.05 1.86 2.24 4.46 4.35 14.11 3.47 7.50 6.14 8.53

us

4.51 0.73 1.56 0.44 0.99 0.71 1.00 1.99 1.82 0.86 2.29 1.47 1.04 1.08 1.40 0.83 0.69 0.38 0.51 0.22 1.01 0.47 0.56 0.42

M

-0.80 -0.79 -0.93 -0.99 -0.95 -1.01 -0.90 -0.92 -1.11 -1.22 -1.30 -1.35 -1.37 -1.36 -1.47 -1.55 -1.54 -1.69 -2.21 -3.04 -3.51 -3.51 -3.47 -3.61

Lost GDP (JOD)

ed

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

ICOR

Lost GDP growth rate (%)

ce pt

Year

Effect of Military Exp. on Gov. Capital Exp. as a percentage of GDP

6,593,955 40,660,235 24,843,943 98,552,296 50,343,289 79,505,556 55,133,912 29,999,532 40,392,431 95,958,588 41,266,034 67,063,447 97,837,546 97,528,851 85,186,022 157,440,234 208,252,001 448,040,674 512,556,916 1,852,457,458 575,006,381 1,319,744,236 1,175,025,413 1,747,324,574

8,906,713,523 Total (Jordan Dinar) 12,562,360,399 Total (U.S. dollars) Notes: The Effect of Military Exp. on Gov. Capital Inv. as a percentage of GDP is the reduction in government expenditure as a percentage of GDP as a result of increased military spending, which is calculated from Equation 2. ICOR is equivalent to Investment as a percentage of GDP divided by GDP growth rate. Lost GDP Growth rate % is estimated based on ICOR. GDP Value as of 2012 is calculated using an assumed 2% rate of return (OECD, 2013).JOD is Jordanian Dinar.

However, to provide a robustness check of this potential effect of military expenditure on government investment, Table 5 reports the results of estimating Equation 2 for a number of

17 Page 18 of 27

other countries that rank among the ten most peaceful countries in the world according to the Institute for Economics and Peace (2014). Table 5. Unrestricted Error Correction Model Estimation for Peaceful Countries, 1988–2012 Switzerland 7.23 (0.06) 0.33 (0.10) -0.01 (0.93) -0.01 (0.94) -0.06 (0.66) -0.29 (0.10) 14%

ip t

Canada 5.63 (0.10) 0.02 (0.63) 0.02 (0.07) 0.17 (0.19) 0.00 (1.00) -0.40 (0.06) 8%

cr

Denmark 6.59 (0.09) 0.08 (0.09) -0.01 (0.64) 0.13 (0.10) 0.04 (0.64) -0.31 (0.09) 13%

an

Adjusted R-Squared

New Zealand 7.01 (0.21) -0.18 (0.65) -0.05 (0.76) -0.01 (0.96) 0.05 (0.89) -0.30 (0.13) -2%

us

Intercept

Finland 4.23 (0.27) 0.10 (0.77) 0.00 (1.00) 0.19 (0.16) 0.16 (0.38) -0.24 (0.08) 8%

M

Notes: This table reports the results of estimating Equation 2, using UECM, for a number of countries. Gov. Capital Exp. is Gross capital formation as a percentage of GDP; ∆ represents the change in a variable from the preceding period; Military Exp. is military expenditure; and For. Inv. is foreign direct investment as a percentage of GDP. P-values are shown in parentheses. Source of data used in the estimation is World Development Indicators in the World Bank database

ed

The results of these regressions show that military spending has no effect whatsoever on capital formation19 in these five peaceful countries, except for Canada where military

ce pt

spending has a positive effect rather than negative effect on capital investment. During 1988– 2012, the average military expenditure as a percentage of GDP for these countries ranges from 1.16% to 1.62% with a maximum value of 2.39% while Jordan’s average military

Ac

expenditure is 6.24% with a maximum value of approximately 10%. The total GDP lost to regional instability, as of 2012, is Jordanian Dinar (JOD) 8,906,713,523, which is equivalent to $12,562,360,399. The lost GDP is greater than Jordan’s output in any year prior to 2004 and close to that of 2005. Furthermore, the lost GDP is equivalent to 40% of Jordan’s 2012 GDP, which is approximately 2.5 times its 2005 GDP.

19

Gross capital formation was used as a proxy for government capital expenditure because of the inaccessibility of government capital expenditure data.

18 Page 19 of 27

This finding shows that Jordan experienced a surge in its GDP during 2005–2012,20 which resulted in Jordan joining the group of upper-middle-class countries by 2011 (OECD, 2013). Given that Jordan itself has not engaged in any direct conflict during this period and this GDP loss is estimated based on a negative effect from only expanded military spending, the loss is

ip t

considerable. Furthermore, it could be argued that this estimate of lost GDP is a conservative estimate, given the findings of Omri and Kahouli (in press) about the interrelatedness of

cr

domestic investment, FDI, and economic growth, as well as Arunatilake et al.’s (2001)

us

argument. Arunatilake et al. (2001) argued that military spending adversely affects economic growth by crowding out government investment, private investment, and foreign investment

an

when the increased military expenditure is associated with a conflict situation that, in turn, creates an unhealthy investment climate that discourages investment.

M

This paper takes the analysis a step further, motivated by Gupta et al. (2014)21 who use the normalized Public Investment Management Index (PIMI) to capture the efficiency of public

ed

investment. This approach results in22 an estimated lost GDP equal to 181% of the lost GDP shown in Table 4; i.e., the new estimate of lost GDP is JOD 16,120,748,457

(US$

ce pt

22,737,303,889), which is even more significant amount. In fact, Gupta et al. (2014, p. 170) stated that “the MPG (Marginal Product of Government Investment) is high given downward corrections in the public capital series to capture inefficiencies,” because they showed that,

Ac

when accounting for efficiencies, public capital marginal productivity is between 170% and almost 200% for middle-income countries.

4.2.2 Lost FDI

20

Al Khatib et al. (2012) made similar remarks about Jordan’s 2006–2009 GDP growth. Gupta et al. (2014) referred to Dabla-Norris et al. (2012) for the PIMI construction from which the PIMI for Jordan was obtained for this study. 22 Results are unreported due to space considerations 21

19 Page 20 of 27

Jordan has attracted FDI inflows as a results of its policies toward privatization, free trade zones, and domestic-foreign partnerships, as well as its political stability, its tax system and its easy access to international markets (The American Chamber of Commerce in Jordan, 2009). FDI to countries in the United Nations Economic and Social Commission for Western

ip t

Asia (ESCWA) has decreased since 2008 due to the financial crisis and its consequences (ESCWA, 2009). However, FDI inflows to Jordan have been affected substantially by both

cr

the recent unrest in the region and the consequences of the financial crisis including, the latter

us

impact on Gulf states (OECD, 2013). Indeed, FDI inflows to Jordan have been vulnerable to the uncertainty in the region, as acknowledged by the following OECD statement:

M

an

“Cross-border acquisitions seem to have played a significant role in FDI inflows into Jordan during the early 2000s. . . . Data on cross-border acquisitions illustrates that they have corresponded to roughly 30% of FDI inflows on average from 2000 to 2008 but have since declined considerably with the regional unrest and the global economic slowdown.” (OECD, 2013, p. 44)

ed

Figure 2, Panel A confirms this OECD observation: It shows that Jordan’s FDI had a general increasing trend which picked up in 1997 and peaked in 2006. FDI as a percentage of GDP

ce pt

also showed a similar pattern (see Figure 2, Panel B). Furthermore, the UNCTAD FDI performance index in Figure 2, Panel C also shows that the performance of Jordan’s share of FDI relative to its share of GDP had a similar generally upward trend from 1997 to 2009

Ac

which peaked in 2006. Therefore, in order to estimate the lost FDI (as explained in Section 3.2 of this paper), the average of the Inward FDI performance index during 1997–2009 can be applied to the later years (2010-2012) during which FDI decreased. FDI performance index is used rather than average FDI as in Arunatilake et al. (2001), because this index takes into account the size of the economy and therefore the other factors that affect FDI inflows to

20 Page 21 of 27

the country (UNCTAD, 2002). The rate of return on FDI inflows is assumed to be 2% (OECD, 201323). Figure 2. Jordan’s Foreign Direct Investment

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500

35,000 25,000 20,000

cr

15,000 10,000 5,000

GDP (triangles)

ip t

30,000

0

2008

2010

2012

2008

2010

2012

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

us

FDI Inflows (squares)

Panel A. Foreign Direct Investment Inflows (million US$) and GDP (million US$), 1980– 2012

an

Panel B. Foreign Direct Investment Inflows (% of GDP), 1980–2012 25

M

20 15

5

0 -5

ce pt

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

ed

10

Panel C. UNCTAD FDI Performance Index Values, 1988–2012 8.00

7.00 6.00

Ac

5.00 4.00 3.00 2.00 1.00 0.00

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

-2.00

1980

-1.00

Sources: World Development Indicators in the World Bank’s database. Note: In Panel C, the data is from the World Development Indicators in the World Bank’s database and the calculations are performed by the authors based on UNCTAD’s methodology. 23

This OECD report stated that, compared with other selected MENA countries, Jordan had the lowest return on inward FDI, during 2008-2010.

21 Page 22 of 27

Table 6 reports the results of these calculations and shows that the total value of the lost FDI as of 2012 is US$ 2,326,958,31224, this amount represents both FDI and its return. To give more insight into this number, it is important to note that this lost FDI and its return, which occurred over only three years, is greater than the FDI inflows into Jordan in any single year

ip t

other than the record year 2006 and the following years 2007–2009, which had slightly

cr

higher inflows.

us

Table 6. Jordan’s Lost FDI during the Recent Years of Regional Crisis, 2010–2012 (US$) Value of lost FDI as of 2012 485,985,203

Lost FDI 467,113,806

2011

1,069,069,130

1,090,450,512

2012

750,522,596

750,522,596

M

an

Year 2010

Total

2,326,958,312

ed

Notes: UNCATD's Inward FDI Performance Index is calculated according to UNCTAD’s own methodology. The average of the index during the peacetime years 1997–2009 is applied to the years 2010–2012 in order to estimate the FDI lost as a result of the unrest in the region. The assumed rate of return is 2%.

ce pt

Furthermore, having presented in Section 2 the importance of FDI to economic growth, this estimate of lost FDI is conservative because it does not take into account the effect of this lost FDI. Borensztein et al. (1998) found that FDI may enhance economic growth not only

Ac

directly but also indirectly, through its potential effect on domestic investment. Furthermore, Al Khatib et al. (2012) found, using autoregressive distributed lag (ARDL) approaches and error correction model, that domestic investment in Jordan is positively driven by FDI and economic growth. They argued that this finding supports a crowding-in effect of FDI. The magnitude of the estimated FDI that Jordan has lost during these three years of regional turbulence is a warning signal to decision makers. It confirms the high vulnerability of Jordan’s FDI inflows. This vulnerability calls for the Jordanian government to take serious 24

US$ = JOD 0.709

22 Page 23 of 27

steps to counteract the effect of the country’s politically unstable surroundings by enhancing it investment climate, especially as foreign investors have little confidence in Jordan’s legislative framework and transparency and would like to see some of the current restrictions

ip t

on foreign ownership removed (OECD, 2013).25

5. Concluding Remarks

cr

Middle Eastern countries that are not themselves suffering political crisis seem to be paying a

us

heavy price for their neighbors’ problems. This study has examined the effect of regional instability on a number of measures of economic activity, using Jordan as an example

an

country. The analysis has shown Jordan’s military spending and its FDI inflows seem to respond to regional conflict. The negative effect of the high-militarization strategy on

M

government investment has been confirmed, and the GDP lost as a result of the foregone public investment has been estimated. The findings indicate that Jordan has lost to regional

ed

unrest GDP of between US$12.6 billion and US$22.7 billion, which is equivalent to 40% to 72% of its 2012 GDP or approximately 2.5 times its 2005 GDP. In addition, Jordan has lost

ce pt

FDI and its return estimated at $2.3 billion, an amount greater than the annual FDI inflows to Jordan in most of the years considered in this study. These findings have important implications for politicians and economists in Jordan, in particular, and in the Middle East in

Ac

general. They should design effective economic policies to counter the adverse effects of the regional unrest in order to revive their economies and boost economic growth.

References

25

This statement is based on the OECD’s findings for 13 MENA countries, including Jordan. Omri and Kahouli (in press) also suggested that MENA countries should improve political stability, the social and economic environment, and laws and regulations in order to enhance both FDI and domestic investment.

23 Page 24 of 27

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