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Wartime Economics 101

A quick victory over Iraq, without any complications, could snap the local and national economies out of the doldrums by midyear


February 13, 2003
Copyright © 2003 CARIBBEAN BUSINESS. All Rights Reserved.

What price WAR?

In a worst-case war scenario, global recession will be unavoidable, while a best-case scenario has the U.S. and Puerto Rico economies growing faster

The world is holding its breath.

By press time Monday, it was all but certain President George W. Bush would give the go-ahead to the planned invasion of Iraq this week and the war would start before the end of February.

With 150,000 U.S. troops already deployed to this volatile region and more arriving every day--plus another 50,000 British and Turkish troops ready to cross the border into Iraq upon command--it appears the only thing that could stop the invasion would be the abdication of Saddam Hussein and his administration.

The war time bomb reverberates around the globe. And with it, the fates of the world economies lie in the balance, with Puerto Rico’s no exception.

Will our economy slip back into recession, or will it snap out of the doldrums and recover vigorously during the second half of this year?

According to a cross section of local industry leaders, the answer will depend on whether the war develops into a protracted conflict with complications or whether there’s a quick victory over Iraq.

The estimate by the Bush administration is that barring Iraq’s use of chemical weapons, the major part of the war would actually be over within 10 days. Of course, there remains the possibility of terrorist attacks on U.S. soil--a state of high alert was declared last week--which could complicate the picture and prolong the uncertainty.

Can we can draw some lessons from history? Perhaps. The parallels to the first Gulf War are significant. When war broke out in January 1991, the U.S. was still in the middle of a recession. In Puerto Rico, the brunt of it had been made milder by the influx of billions of dollars in post-Hurricane Hugo disaster relief throughout 1990, but the economy on the mainland was hurting.

Operation Desert Storm was a short campaign. The decisive victory by the U.S.-led coalition did boost consumer and business confidence and brought the price of oil down below $20. Immediately after the war, the U.S. economy started to recover. (See graph.) However, the recovery was too mild to help President Bush’s chances of re-election. The president--hailed in victory at war--was defeated at the polls the following year.

This time around things are different. The national and local economies aren’t in recession. They’re in the middle of a very slow recovery, unable to take off, in part precisely because of the uncertainty of war. The quicker the war, the sooner the uncertainty would be over.

Furthermore, according to experts, most markets have already priced in the downside of a short military engagement. In other words, contrary to the situation in 1990-91, war has been anticipated for so long now that most businesses have already taken measures--cutting costs and downgrading revenue projections--in anticipation of the conflict. Thus, experts say if victory is quick, the national economy is well-poised for the more vigorous recovery that has eluded it in the past 12 months.

Against that backdrop, what will be the war’s impact on Puerto Rico’s economy?

Island’s banking and financial leaders, economists mull war’s impact

Some of Puerto Rico’s top financial leaders still harbor hope war can be avoided. "If Saddam Hussein has any instinct of self-preservation, he’s going to have to act quickly," said First BanCorp Chairman, President & CEO Angel Alvarez.

"If…Saddam went into exile and war was avoided, it would be phenomenal," said Santander Securities President Carlos Garcia. "However, the reality is that war looks to be just about inevitable."

"This is the chronicle of an announced war," said economist Juan Castañer. "The problem in trying to gauge the impact of war is that you have many imponderables, many uncertainties."

Among the unknowns are the duration of the conflict and whether it will provoke civil unrest, including the possibility of terrorist acts on the U.S. "We no longer have that sense of internal security we had before 9/11," said R&G Financial President Ramon Prats.

"You can’t rule out suicide bombers in New York, Washington and, for that matter, in San Juan," said Myrna Rivera, president of San Juan-based investment management firm Consultiva Internacional. "A protracted conflict with civil unrest of that nature would just compound uncertainty and volatility."

Rivera noted the prevailing doubt of the past several months has caused unprecedented volatility on the stock market, with daily swings of 2% in either direction. "The market has been moving sideways, and a sustained flat market like the one we had for a period during the 1960s and ’70s would certainly be the worst-case scenario as far as the impact on the equity market is concerned," she said.

However, Rivera isn’t a pessimist. Despite the unknowns, she believes a swift end to the war is the most likely scenario. "If the war is resolved quickly, my bet is we will see markets rally, because we believe this market is trading at a slight discount," said Rivera.

As Santander’s Garcia sees it, people need to understand a short war is now defined not as one that lasts three weeks but as one that goes on for about three months. "The downside is that it could paralyze investment and movement on future plans for an entire quarter."

Garcia said Santander has initiated contingency plans that take into account such a slowdown. "For banks, the main concern in a contingency plan is making sure the necessary liquidity is there," he said.

"Beyond three months, we have to go back to the drawing board," said Castañer.

Although FirstBank’s Alvarez acknowledges increases in the price of crude oil are a concern, he said he doesn’t think the impact will be as great as during the Gulf War. "The price of oil has already risen substantially in anticipation of war," Alvarez noted. "It’s not in the best interest of oil-producing nations to let them rise substantially higher for a prolonged time."

Economist Vincente Feliciano of Advantage Business Consulting agrees with Alvarez. "There’s strong interest by Saudi Arabia and other major producers to have stable oil prices, so as not to rock the boat and kick up conservation efforts and initiatives to turn to alternative energy sources," he said.

Rivera also sees the price of oil being better controlled this time. R&G’s Prats, however, believes it’s still a source of anxiety. "The prospect of rising oil prices still really concerns me," said R&G’s Prats. "From transportation to construction, higher energy costs make everything more expensive."

According to economic forecasts by local consulting firm Estudios Tecnicos, in a worst-case scenario--where the price of crude oil spikes to $38 per barrel and doesn’t fall back until late in the third quarter--U.S. economic growth would be below 2%. Puerto Rico’s economy in fiscal year 2003 would either remain stagnant for a second consecutive year (with flat growth) or would go into a recession (negative growth).

Estudio Tecnicos President Jose Joaquin Villamil believes it is more likely oil prices will spike only moderately higher, to no more than $32 per barrel, for most of the first half of the year, before falling back to the prewar buildup levels of 2002. In such a scenario, the U.S. gross product would grow by more than 2% and Puerto Rico’s fiscal year 2003 growth would exceed 1%. In the best-case scenario, there would be no spike in the price of oil, a price decline would soon set in, and the economies of both the U.S. and Puerto Rico would exceed 2%.

"Most people are focusing on the oil issue, but I think what should be of greater concern is the likelihood of the cost of war and budget deficits driving up interest rates again," said Feliciano. "If interest rates do go up that will have an immediate impact by making construction and housing more expensive, and it could put the brakes on consumer spending."

Feliciano thinks the most likely scenario is a short war but a long occupation, which would fuel deficit spending and lead to pressure for higher interest rates. "This war could be more like Korea, with a long-term commitment following initial occupation," said Feliciano.

The good news, though, is that once the war is over, the uncertainty that has been hindering economic recovery will be lifted. "It’s the uncertainty that has really been holding back this recovery," said Rivera. "With the onset of the Gulf War, everything the market lost in the previous three months came back in a week."

"We have to plan for the worst but hope for the best," was the consensus among the banking and financial leaders interviewed.

Tourism: a sure casualty in the short term

A war with Iraq would definitely strike a critical blow to Puerto Rico’s beleaguered tourism industry, according to local industry sources. However, some say a war with Iraq wouldn’t hurt the island’s tourism industry as much as the Gulf War did. That war came suddenly and caused a significant drop in tourist traffic during the peak (winter) tourism season.

Whatever their prediction, all agree this crisis calls for efforts like those made over a decade ago. Back then, the Puerto Rico Tourism Co. launched a series of public relations campaigns in key U.S. cities; hotels and airlines slashed prices, and tourism writers were invited to inspect Puerto Rico and verify it was a safe destination.

The Tourism Co. has been working on a new contingency plan for some time now. "We have a crisis management plan that has effective promotions, advertising, and public relations to be implemented in our key markets, when needed," said Ramon Sanchez, deputy executive director of marketing & promotions at the Tourism Co.

Although Sanchez said he couldn’t go into details for competitive reasons, he did say the contingency plan would probably include a measure similar to the "Fly Free to Puerto Rico" program initiated after 9/11. "Fly Free" offered two free airline tickets to tourists who booked a five-night minimum stay on the island.

Another strategy implemented in response to 9/11 was to design hotel packages for island residents. Immediately after 9/11, hotel occupancy rates hovered between 10% and 40% and hotel rates were cut by 25%. "The government has been designing programs with attractive hotel and airline packages like those used after 9/11," said Rick Newman, who is on Gov. Sila Calderon’s tourism subcommittee. "There will be a lot of creativity…to avoid layoffs of hotel employees."

Island hotels were forced to cut about 11% of their 14,000-member work force after 9/11, less than the 25% they had expected. The additional layoffs were avoided because the government quickly stepped in and provided a stimulus package.

Economists believe a war with Iraq would have the largest impact on chain-affiliated full-service hotels. Revenue per available room (RevPAR) growth in that segment would be significantly reduced in the case of a short war (one quarter) and would be negative in a lengthy war (four quarters).

However, most say the war will have only a moderate effect on the local economy because of the advanced warning and because they don’t expect it to last long. "I believe it’s. . .not going to be a protracted battle," said Newman, who is also president of the Puerto Rico Hotel & Tourism Association. "It is expected to be short and sweet, which means it won’t have much of a negative impact."

As for the airlines, a war with Iraq could aggravate their already precarious situation inasmuch as it would both curtail travel and cause fuel prices to climb. The federal government could also call on the airlines to provide their aircraft as military charters.

"Iraq has to be dealt with, but not in a way that will kill the aviation industry," said airline analyst Michael Boyd of Colorado’s The Boyd Group. "Air traffic dropped during the Gulf War, causing severe financial losses, but that war didn’t come on the heels of an event like 9/11, which caused a material reduction in the air transportation industry. If 9/11 hadn’t happened, the airline industry would still be taking in another $15 billion in revenue."

Spiking oil prices to hit maritime cargo transportation

Should a war with Iraq break out, shipping industry experts will be closely watching what is already hitting them below the belt--the price of oil. Otherwise, though, cargo transportation to the island is unlikely to be disrupted, given that none of the merchant marine vessels serving the U.S. mainland-Puerto Rico trade are likely to be called into duty.

"The most immediate effect is the rising cost of petroleum," said Gabriel Serra, vice president & general manager for Puerto Rico of U.S.-flagged CSX Lines. "The price has gone up approximately 50% in the past six months. Our industry consumes a lot of petroleum and price hikes affect us.

"We will try to recover through what is called a bunker surcharge for oil," continued Serra. "However, we have to be careful about how the company implements this since we [don’t want to] harm our relations with customers."

Foreign-flagged carriers serving Puerto Rico, such as Maersk Sealand, have already been losing an estimated $1 billion on transpacific routes each year because of the low ocean-freight rates.

"The global average bunker price ranged from $97 per ton to $194 per ton in 2002. That’s a 100% fluctuation in the same year," said Maersk Sealand Owners Representative Charles Hall. "These fluctuations in the price of oil have had their cost impact, such as when the service disruption in Venezuela’s port prevented us from taking out our vessels.

"Even during the West Coast cargo stoppage, it took the company a few weeks to start running smoothly again," continued Hall. "Maersk Sealand spends a lot of time changing or modifying operational and security practices and will continue being pre-emptive to assure properly managed facilities."

Sea Star Lines has seen the price of oil increase as much as 35% in the past six months. General Manager John Emery said, "With oil prices continuing to rise, we are paying more than $30 per barrel. The cost of fuel per slot, or container, was $201 on June 4, 2002. When things started to heat up with Iraq and after Venezuela’s hike, the cost rose to $208 in November 2002. In mid-January, the cost of fuel per slot was $272. I don’t expect that trend will change any time soon."

Trailer Bridge President John McCown, who for years has spoken out about the supply-and-demand imbalances in Puerto Rico-U.S. trade, is also carefully evaluating what might occur if a war erupts. "Fuel is a significant cost for all carriers," he said. "All we seek is not to bear the burden of price increases alone. Bunker surcharges rarely cover the full impact of fuel cost increases and never generate a profit for a carrier."

All the carriers interviewed by CARIBBEAN BUSINESS said their vessels are fit and registered for use by the U.S. Armed Forces or by other military organizations in case of war, though they believe it unlikely they will be called upon to serve in this capacity.

"The U.S. Department of Transportation’s Maritime Administration has already activated 36 of the 72 vessels in its ready-reserve force in support of Operation Enduring Freedom. In addition, the Military Sealift Command has a 125-ship cargo fleet," said Crowley Liner Services spokesman Mark Miller.

"Rising oil prices increase our cost of doing business. We purchase fuel for our vessels and we purchase transportation services from rail and motor carriers, which are also affected by rising oil prices," said Miller. "Each transportation provider passes along the added costs to their customers in the form of fuel surcharges. When fuel prices return to more moderate levels, the surcharges will be reduced or eliminated."

Real estate to remain soft; construction to face higher costs

Jorge Fournier, executive vice president of Commercial Centers Management, said a bad economy and a jittery stock market have already affected Puerto Rico’s commercial real-estate industry, and a war with Iraq could worsen the situation.

"Nevertheless, interest rates are low and that has kept us sitting pretty," said Fournier. "We don’t foresee demand for large commercial spaces, because tenants aren’t expanding operations because of the soft economy, the poor performance of the stock market, and the prospect of war."

War could have positive and negative consequences for the commercial real-estate industry worldwide, said the Center for Strategic & International Studies (CSIS), a four-decade-old Washington think tank.

According to ResearchWorldwide, a national commercial real-estate information firm, the best-case and worst-case scenarios predicted by CSIS create dramatically differing outlooks for the commercial real-estate markets worldwide. "Consumer, business, and investor confidence levels determine demand for commercial real estate, locally and globally," said ResearchWorldwide. "In the worst-case scenario, investing in real estate during early 2003 could be tantamount to investing in a market headed for a recession. In the best-case scenario, investing in real estate at this time could be heralded as clever buying at the bottom of the market."

Jose Vizcarrondo, vice president of construction firm Desarrollos Metropolitanos, said the price of construction materials, mostly wood, in the U.S. has already increased 15% to 20%. "As stateside construction slowed down, so did production of materials. There are fewer materials in inventory and therefore they cost more," said Vizcarrondo, a former president of the local chapter of the Associated General Contractors of America.

Vizcarrondo noted that when there’s an economic boom, the demand for and the price of construction materials rise. "If there’s a war, however, cargo ships will be used to supply the military, which will make construction materials harder to get and therefore much more expensive," said Vizcarrondo. "This has a lot of people in the industry concerned."

Low interest rates are benefiting the construction industry, but a prolonged war probably would cause interest rates to go up, hurting an industry that has been afflicted by the soft economy of the past two years and by delays in the permitting process.

War might destabilize island retailers, but only temporarily

According to most retail industry insiders interviewed by CARIBBEAN BUSINESS, the industry won’t suffer tremendously if the U.S. goes to war with Iraq, though it could slow its recovery.

"War won’t help the economy in the short term," said Josh Podell, vice president of real estate for G+G Retail Inc., which operates 60 Rave and Rave Girl stores in Puerto Rico. In the long term, the war could actually help the economy grow, as happened in the 1990s, he said.

"The initial reaction by consumers will be to stay home and not go shopping, but this will be temporary," said Mike Nolla, president & COO of Manley Berenson Puerto Rico, which operates several malls on the island. "That is what happened when the first Gulf War broke out. The few days after that war started saw traffic at shopping malls drop significantly, but everyone started shopping again not much later."

Valerie Castro, PMI Inc. marketing director for the southeast region, said the war could disrupt the upswing in sales. "We expect sales to stabilize in 2003, but a war could change that," she said.

Supermarkets will probably be least affected by the war, according to Atilano Cordero Badillo, president of Supermercados Grande. "The supermarket industry will remain strong, even if there is war. I don’t think war will bring about major changes in consumer behavior, at least with regard to supermarkets," he said.

Advertising, or how to make things look pretty in the face of disaster

Advertising executives expect the possibility of war in the Middle East to have roughly the same effect the lagging economy has had on the industry for the past couple of years.

According to agency heads interviewed by CARIBBEAN BUSINESS, budgets may be reined in if war is declared, but not for long. "At first people get scared and cut back; we’re already seeing it happen," said Joey Jimenez, president of JMD Communications. "However, that reaction eventually forces advertisers to get back into the game, because they want those who are spending money to spend it on their product."

"I don’t think a war would have any major effect because consumers will continue to consume," said Erasto Freytes, president of Badillo Nazca Saatchi & Saatchi. "In fact, I don’t remember the Gulf War having an adverse effect on the industry. When times are tough some people cry and others sell handkerchiefs. We must turn adversity into opportunity."

The war could also influence the tone of advertising efforts, allowing emotional and values-oriented messages to flourish. "The tone of most advertising has already changed since 9/11 and will probably continue to change," said Jaime Fortuño, vice president & general manager of Lopito, Ileana & Howie. "Reinforcing messages of quality and value will be the prevailing strategy."

A concern for most was the possible effect of a war on oil prices. If oil prices go up, provoking an inflationary economy, consumer spending will go down and advertising budgets will follow. Cesar Cienfuegos, president of Lowe Circulo, pointed out that the price of oil is much more vulnerable now than it was during the Gulf War because the political and economic crisis in Venezuela has effectively eliminated an alternative source.

A trend that probably will continue in the event of a war is the shift from brand-building efforts to more tactical, hard-sell efforts, said Jose Luis Alvarez, president of Axiom International. "The scenario would present an opportunity to develop short-term strategies, which keeps revenue flowing into agencies," said Alvarez. He added that clients would likely break budgets down into smaller pieces, instead of assigning large amounts to long-term campaigns.

Cienfuegos said if the war is short, like the Gulf War, its effects on the advertising industry will be mild, but a protracted engagement could have devastating consequences for the economy in general. John Raevis, president of De La Cruz & Associates, added that if the U.S. emerges victorious from a short war, the economy will see an immediate boost, as happened in 1991.

Associate Editors Evelyn Guadalupe-Fajardo, Jose L. Carmona, Marialba Martinez, and Ken Oliver-Mendez, and Staff Reporters Taina Rosa and Laura Rentas-Giusti contributed to this story.

The CSIS matrix: four war scenarios


Research scenario planning by the Center for Strategic & International Studies (CSIS), a Washington think tank, indicates the critical uncertainties, should a war with Iraq materialize, are the duration and intensity of the war, disruptions to the oil supply, and the likelihood of related terrorist attacks on the U.S. and its allies.

CSIS developed four scenarios: no war, a benign war (probability of 40% to 60%), an intermediate war (probability of 30% to 40%), and worst case (probability of 5% to 10%).

According to experts, each scenario has different economic consequences for the global economy. The best-case (benign) scenario could create a short-term boost for the U.S. economy, which should filter through to the global economy. However, a global recession is unavoidable in the worst-case scenario.

The benign scenario envisions a quick, decisive U.S. victory within four to six weeks, no damage to oil-supply capabilities, and no serious terrorist attacks. The effect on the U.S. economy would be limited. In fact, experts say the U.S. economy would grow faster in the short term in such a scenario.

The U.S. government would increase spending. The prevailing uncertainty about the war and the extent of its effects would be eliminated. Equity markets would be expected to rally. Although U.S. inflation would rise briefly because of the spiking oil price, inflation would decline quickly thereafter, according to CSIS.

CSIS said the worst-case scenario is far more catastrophic for the global economy. It envisions intense urban warfare and an armed conflict that could last three to six months. Iraq would be expected to attack oil facilities in the region with weapons of mass destruction and cause significant damage. The region would experience massive political unrest and terrorist attacks would intensify. The U.S. economy’s growth rate would slow by 4.5% relative to the no-war scenario, U.S. unemployment could reach 7.5%, and an economic recession would ensue.

Puerto Rico consumes some 160,000 barrels of oil a day


"Puerto Rico’s current consumption of oil averages about 160,000 barrels a day," said Popular Inc. Senior Executive Vice President David Chafey. "Based on current consumption, every dollar the price per barrel of oil climbs represents an outflow of $58 million on an annual basis."

During 2002, the average price of crude oil was $25.10 per barrel. So far in 2003, the average price has been $7.40 higher, at $32.50 per barrel. Were such an increase to hold for the entire year, Chafey said it would represent $432 million more in outlays for oil in Puerto Rico than in 2002.

"This type of increase puts pressure on the disposable income of consumers," said Chafey.

"It tends to result in consumers becoming more conservative in their spending."

Map of Iraq

Size of Iraq: 172,476 square miles

Bigger than: California, plus three Puerto Ricos combined

Same size as: Vermont, New York, Massachusetts, Connecticut, Pennsylvania, New Jersey, Maryland, and Virginia combined

Some people think 102 United Nations weapons inspectors, if given more time, might find Iraq’s weapons of mass destruction or be able to certify there are no such weapons in such a vast country.

Isn’t that being naive?

This Caribbean Business article appears courtesy of Casiano Communications.
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