The outbreak of war against Iraq has raised fears of recession in the European Union. Immersed in their own internal confrontations, the Fifteen [EU members] are fighting to recover their unity of action, now that the military campaign against Saddam Hussein has begun. Spain and the United Kingdom, unconditional allies of the United States, have been unable to dent the fierce opposition of France and Germany. Nevertheless, with war declared, the Old Continent is trying to set aside its differences in order to combat a common enemy – the menace of recession.


“The economic cost of the war will depend on the length or brevity of the conflict,” notes Felix López Iturralde, professor of economics at the University of Valladolid. “In principle, a rapid action will not have grave repercussions. The problem will come if it lengthens, so that this negatively affects the price of crude oil and the confidence of markets. Moreover, Europe is not at this moment prepared for the shock that a war of this sort would imply, since it doesn’t have the economic capability to absorb that cost.”


On March 20, amidst the first bombardments of Iraq, the Governing Council of the European Central Bank (ECB) signaled that it is preparing a plan to inject liquidity into the system if that becomes necessary. With this message, the organization wanted to send a reassuring sign to markets, as well as make sure that the countries of the EU don’t use the conflict to relax their budgetary discipline. Under discussion are the problems that some countries currently have complying with the limit on public sector deficits – 3% of their GDP. Among such countries, Germany stands out, with its economy on the verge of recession.


In line with its opposition to the armed conflict, Chancellor Gerhard Schroeder has indicated that “Germany will not participate in the war, but will comply with its obligations within the framework of NATO, and will contribute with humanitarian aide which the United Nations coordinates to relieve the victims of war.” French president Jacques Chirac warned of “serious consequences” from the war, however long it lasts, and expressed his hope that “intervention is as fast as possible, has the fewest fatalities, and that what has been done [by the U.S., U.K. and Spain] doesn’t lead us to a humanitarian catastrophe.”


Despite these differences, the Fifteen have managed to produce an emergency plan for avoiding recession that can be summed up this way: greater liberalization, cutting aid to public enterprises, controlling the public-sector deficit, and searching for a single voice in order to avoid cracks in the European position.


Even with this emergency plan, however, José Maria Peredo, professor of international relations at the Universidad Europea de Madrid is skeptical about reaching a consensus. “It has never been possible to create a total meeting of the minds, and it is very difficult to do that now,” he says. Yet he considers that “these differences of opinion are not a step backward. Europe is what we have just seen now – some countries with great international relevance and other countries that accept the common order but want to continue having their own decision-making power regarding international topics. The European Union has lived through advances, not backward steps, in economic and political integration.”


An Absence of Clarity

“You can’t speak about a division at the core of the EU, but only about a small fissure that, with the passage of time, will wind up closing itself,” says López Iturriaga. “Now that war has erupted, Europe knows that it must find points of common understanding in order to prepare for the reconstruction of Iraq.”


But whatever decision the Fifteen makes will depend on the duration of the conflict. “You have to take a cautious view about waiting for any spectacular, discernible impact from the war,” emphasizes Peredo. “To see some beneficial results, you have to focus on the length of the war.”


Stock exchanges were the first places to exhibit anxiety about the conflict. The main European indexes greeted the first day of bombing with declining prices. During the week before the war, the major European indexes had registered a rise, convinced that nothing could stop the attack, and confident that the intervention would be rapid. Nevertheless, the spirit of investors collapsed with the recognition by U.S. president George W. Bush that the conflict could be longer than expected.


Federico Trillo, Spain’s minister of defense, also noted that the war could be  … longer,” noted López Iturralde. “With these words, he underlined the marketplace’s need for a [clear] answer. For markets, there is nothing worse than uncertainty. That’s why the future progress of investments is very much tied to the duration of the conflict.”


The first signs of confidence arrived during the second day of the bombing, March 21. The rapid advance of American troops toward Baghdad acted like an oxygen canister on the floor of the Exchange. The German index, Dax Xetra, gained 4.2%, after having lost 0.4% during the previous day. In France, the CAC 440 rose 3.4%, compared to a previous decline of 1.5%. Spain’s IBEX 35 gained 2.5%, after a fall of 1.1% on the first day of the war. Meanwhile, the British Footsie 100 improved by 2.56%, which added to the small 0.1% increase on the previous day.


A study by Goldman Sachs about military conflicts during the last 30 years affirms that market movements cannot be predicted. In those earlier periods, markets rose by between 1.5% and 21%. For its part, BNP Paribas believes that the behavior of investors should improve starting now, and that it could translate into improvements of as much as 20%.


That is what happened during the first Gulf War, a conflict that European analysts are using as the principal reference point in trying to explain the current situation. Over the six months that the first war lasted, markets advanced by between 16% and 20%. But there is this difference: In the current war, markets underwent a series of price rises based on confidence in a rapid war. However, in 1991 there were strong losses on the days just before the invasion took place.


In response to the lack of clarity that the economy is suffering, the European Central Bank (ECB) has committed itself to injecting necessary liquidity into markets, even under exceptional circumstances. The entity has already taken similar measures on other occasions, such as after the attacks on the Twin Towers.


Nevertheless, the ECB is adopting a cautious approach: “It is not possible at this point to evaluate in any conclusive way the implications [of the war] in the short and medium term,” noted the organization in a statement on the same day that action against Iraq began. Analysts, however, have interpreted these words as a sign that the ECB could lower interest rates if the war threatens to damage the economy of the Euro zone.


Looking Forward, to Reconstruction

For Peredo, the key that will open the door to an improvement in the economy isn’t going to be found in the war itself, but in the postwar reconstruction of Iraq. “The conflict is going to be brief, while the dismantling of the regime of Saddam Hussein and the reconstruction of Iraq are going to be long and complex,” he asserts.


In his opinion, “from the economic point of view, a reconstruction of this sort is not damaging. On the contrary, even if reconstruction is long and complex, it is going to be beneficial for the world economy.  That is, if the terms of the reconstruction are right; if there is an understanding between the various sides; if they create autonomy for the Kurds of the north, and if they establish a regime in Iraq that provides stability and credibility in the region. So, despite the fact that the reconstruction could last a long time, positive news will arrive – and that will stimulate confidence in the markets.”


“Depending on the regime that is set up, economic ties in the form of exports could be established,” adds López Iturralde. “European companies are going to have a major role in the reconstruction of Iraq, above all companies in the public works and oil sectors.” But the building up of Iraq, once the conflict is ended, can create new cracks at the heart of the EU.


“In the past, the countries that participated most actively in a conflict have also maintained the biggest role in the subsequent reconstruction of the area. This favors, for example, Spain and the United Kingdom,” notes López Iturralde. However, he adds, “France and Germany are not going to stay on the margins. They are the two major players in Europe, and you have to count on them to build up Iraq.”


At the moment, signs of confusion have already emerged regarding how to focus the participation of Europe once the war is over. The United Kingdom and Spain are putting pressure on EU members to open their national coffers to reconstruct Iraq. But Germany and France have already showed their opposition to that; they say financing must come from Iraq’s own oil.


The poor forecasts for EU growth this year, near 1%, advise against any sort of extra spending. Moreover, depending on the length of the conflict, the EU can arrive at the end of the war on the verge of a recession – with some of its key sectors seriously damaged.


Tourism and Oil

“Tourism and every industry related to crude oil, as well as oil companies, transportation firms and plastic companies, are going to be most damaged by the conflict,” says López Iturralde. Spain’s association of travel agencies, known as CAAVE, has already announced that in Spain alone, demand for travel during the Holy Week vacation will fall by between 10% and 20% [this year.] Already PricewaterhouseCoopers has calculated that a war of between four and six weeks long would lead to lower sales in the form of 50,000 unoccupied hotel rooms.


Starwood, the American hotel chain, is counting on its contingency plan and looking at personnel cuts that would amount to a total of more than 10,000 layoffs since the attacks of 9/11. Spain’s Sol Meliá, the tenth largest chain in the world, has indicated that trip cancellations have already become significant in the business travel sector but maintains that the ravages of war will not affect the company’s [financial] results.


Airlines have also put in operation their plans for minimizing the impact of the conflict. On the first day of the bombing, British Airways suspended its flights to Israel and Kuwait. Germany’s Lufthansa, the third largest airline in Europe, cancelled its flights to Jordan, Saudi Arabia and Israel – a measure seconded by Air France and KLM. Spain’s Iberia is looking into suspending the flight that ties Madrid with the Israeli capital.


IATA, the International Air Transport Association, estimates that global air traffic will decline about 10% around the world as long as the conflict continues. It calculates losses of more than $9 billion if the conflict is prolonged. Analysts consulted by Bloomberg emphasize that “most airlines are cutting their flight frequencies to the Near East, since there is a question about whether they can withstand excess capacity at this time.” As a cautionary measure, Qantas Airways has announced that it will increase its fares by 3%, while Japan Air is looking into similar measures.


Automobile companies are also putting into operation their plans for avoiding the possibility that war threatens their supply chains. During the weeks that preceded the conflict, major European manufacturers increased their inventories. But the great fear of these companies is that the conflict will widen and lead to falling car sales. During the past fiscal year, the European market was the market most affected by economic recession, falling by 2%. Manufacturers were forced to cut staff in order to adapt to [declining] demand. These measures could be repeated if the war against Iraq lasts longer than predicted.


European plants of Japanese manufacturers such as Toyota, Mazda or Mitsubishi will be most affected in the event of a prolonged war. As their principal sea route for importing automobiles, these companies use the Suez Canal, which is at the very center of the conflict. That fact could oblige the companies to change their route, making them go around the Cape of Good Hope at the southern end of the African continent. That route is longer and more costly, and it would negatively affect the companies’ results if they had to resort to it for long.


Transportation companies may also see their results damaged if the price of oil shoots up. “A quick action by the allies will favor a decline in the price of crude,” says López Iturralde. “But if the conflict lengthens and the price of oil shoots up, it would cause serious damage to all industries dependent on oil.” During the past two weeks, oil prices dropped by a total of 28%, to $25 [a barrel] because speculative funds were betting that the war would last only a couple of weeks. Nevertheless, analysts don’t discard the possibility that the outlook will change, if Saddam Hussein does in fact order the burning of his oil wells and if the war lasts longer than expected.


In such a case, the price of crude oil would shoot up above $30 a barrel. Executives in several European oil companies claim that they have no supply problems, and they doubt that the price of crude will rise up, unless something very serious takes place on the war front.


A Common Objective

“Until now, the ills of the economy have been attributed to the uncertainty of the war with Iraq,” says Peredo. “Nevertheless, I believe that there are other fundamental factors, such as accounting scandals and the instability of financial markets.” Peredo considers that the market shouldn’t be placing all its bets on how the Iraq conflict turns out. In his view, while the impact of the military confrontation on the European economy is important, it is also important to appreciate the new setting that will emerge once peace is signed.


“You have to take into account that geopolitical uncertainty has not disappeared, and that [even] after the conflict, there will be an almost permanent possibility of a terrorist attack on any location throughout the world,” adds Peredo. “If that should take place, it would lead to a slowdown of the economy as a result of the security measures taken in airports and by borders controls, in cargo traffic and so forth. Moreover, we have to see how Iraqi oil is managed during the reconstruction, since for some months the wells might be idle.”


The governments of the EU will play a fundamental role. On their shoulders will fall the greater part of the responsibility for building up Iraq and creating a new framework of international security. All their actions, however, are going to be determined by the economic impact that the war will have had on their financial performance.

“The war is going to affect every country equally, since we live in a globalized world. Nevertheless, there are going to be small variations as a result of the political decisions that are taken,” says López Iturralde. In his opinion, “those countries that are most active during the war are going to wind up with some advantages [after it]. But, in the end, all the members of the EU are going to take a common position, because they know that, above any sorts of internal friction, they have a common objective, which is Europe.”