Geopolitical Outlook 2018

January 16, 2018 08:00 AM
The Issue With Forecasting

Even if neither side wants a war — and it is not clear that that is the case — there is roughly a 25% chance of military engagement, and, in the absence of a significant change in strategy on the part of the United States, the probability will rise over the coming months. Assuming a conflict were limited to conventional warfare, there is still every reason to expect that both South Korea and Japan would suffer a significant loss of life and, in the case of South Korea, extensive damage to the country’s productive capacity.   

As tensions have risen, South Korea’s won has weakened, while the yen has made gains against the dollar, reflecting the perception of Japan as a safe haven (see “Won on notice,” right). Those trends will likely persist into 2018, but the Japanese government risks undermining confidence if its bellicose rhetoric prompts Pyongyang to make direct and pointed threats to target Japan in the event of an outbreak of war.

Extensive damage to South Korea’s manufacturing capacity would have significant negative implications for the global supply chain, particularly in the case of semiconductors, electronics products, and automobiles and vehicle parts. As such, a rising threat of violent conflict will affect the value of firms elsewhere that either compete directly with South Korean manufacturers or rely on imports from Korea for inputs.

A Hot War in the Gulf

Another risk to consider in 2018 is the possibility that the longstanding cold war between the Gulf Cooperation Council (GCC) and Iran could turn hot, with one side or the other deciding that the proxy battles being waged in Yemen and Syria (and, to a lesser extent, in Saudi Arabia’s Eastern Province and Lebanon) are failing to adequately protect its interests.

Since its formation in the early 1980s, the GCC’s emphasis on consensus has acted as a brake on Saudi aggression in the region. However, the teaming of Saudi Arabia, the United Arab Emirates, and Bahrain with Egypt to impose a blockade on GCC member Qatar since June 2017 has highlighted the breakdown of consensus within the Gulf bloc. It suggests that Saudi Arabia’s youthful Crown Prince Muhammad bin Salman, who is the architect of the kingdom’s increasingly hawkish foreign policy and is widely seen as the de facto ruler of the kingdom, sees the GCC as an obstacle to his ambition to establish Saudi Arabia as the dominant military power in the region.

Historically, Iran has been the more aggressive of the rivals, as indicated by its meddling in the Eastern Province. Although Riyadh has regularly directed threats of violence toward Iran over the years, the recent assertion that Iran-backed Houthi rebels in Yemen attempted an unsuccessful rocket attack on the Saudi capital, which the Saudi government blamed on Iran, and characterized as a declaration of war, represents a higher order of saber-rattling.

If a war between Saudi Arabia and Iran were to break out, it would most likely be triggered by moves by Riyadh to stoke unrest among the Sunni population in Iran — in a tit-for-tat response to Iran’s similar actions in the Eastern Province — rather than by an organized military offensive.  Consequently, it is unlikely that a war scenario would catch the world by surprise, implying that there would be an opportunity for international mediation aimed at averting generalized hostilities.

Moreover, the damage that direct military conflict would inflict on both sides is potentially massive, which is the main reason that war between the Sunni and Shia powers has remained cold for so long. For those reasons, the risk of such a scenario is still low.  That said, it is also higher than it has been in the past, and will likely increase in the near term, especially should the United States withdraw from the nuclear deal with Iran. Consequently, the possibility cannot be ignored.

A protracted military conflict between two of the world’s major crude oil producers (including one capable of choking off oil shipments through the Strait of Hormuz) would obviously have significant negative implications for the global oil supply, and any signs pointing to a growing risk of such a scenario can be expected to contribute to upward pressure on oil prices, and an actual outbreak of hostilities could send the price of oil soaring to $175 to $200 per barrel.

The economic damage would be widespread and severe, with the biggest hit inflicted on energy-poor countries in Europe, as well as Japan, South Korea, and China. Under the circumstances, foreign powers would face pressure to enter the fray, setting up the potential for intervention, whether direct or indirect, by the United States and China, as well as Russia, from its newly acquired foothold in Syria. Such a scenario would be accompanied by disruptions to trade and investment relationships across the globe, wreaking havoc in markets throughout the developed world.

Page 2 of 3
About the Author

Chris McKee is president and CEO of PRS Group, which provides quant-driven political and country-specific risk forecasts. He is also CEO and portfolio manager for PRS’ parent Gavea Emerging Markets. @prs_group