The geopolitical game in the Middle East is at a boiling point. The proxy war between Saudi Arabia and Iran and the conflict between Shiite and Sunni Muslims had been regarded as a security matter. That is, up until now.
When Iranians set ablaze the Saudi Embassy, tensions reached a new level that could have severe economic implications.
Investors had been earmarking China as the likely cause of the next financial meltdown. However, that crisis could actually come from the Middle East. A ratcheting of Middle East problems could destabilize Saudi Arabia and dramatically impact oil supplies. Both scenarios could have a profound affect on the global economy.
How the Chaos Started
The conflict between Sunni and Shiite Muslim factions goes back centuries and has had highs and lows. When petro dollars were flowing and Arab nations were generally stable, the conflict was muted. But lately, as some Arab states, including Syria, Libya and Yemen, are facing varying degrees of crisis, tribal politics have re-emerged. The Sunni/Shiite Muslim conflict is in full throttle.
On one side is the Sunni faction, led by Saudi Arabia and its allies. Saudi Arabia is the world's largest oil producer. On the other side is the Shiite faction led by Iran. Its allies include Hezbollah and other proxy groups. Iran has the support of Russia, which has been trying to expand its influence in the Middle East.
A wildcard in the mix is the Sunni-run, Islamic State group known as ISIS. The strategies of ISIS are not always clear. Would they cooperate with the Saudis against Shiite rivals or are they looking to push the Saudi crown off the throne as they pursue an Islamic caliphate. Regardless, ISIS and other extremists are potential threats to Iran and Saudi Arabia.
Both Sunnis and Shiites have opposing rebels on their door steps. Saudi Arabia is fighting pro-Iranian rebels across its border in Yemen. Iran is fighting Sunni rebels in Iraq and Syria, which has a large Sunni minority. If these conflicts escalate, extreme scenarios could materialize. Here are two that could ignite a meltdown.
The Saudi Kingdom Could Fall: For years, the Saudi crown has given its citizens subsidies that defy a Westerner's imagination. They have included an aggressive subsidy of fuel to a handout of $32 billion from the crown to average citizens. These are designed to draw attention away from the regime's failings, which include a woeful record on human rights, especially in its treatment of women.
But now, with the Saudi state running a deficit of 15% of GDP, the government has had to aggressively curb spending. The petro dollars that were used to cushion the Saudi regime are quickly disappearing. If that continues, Saudi citizens could become discontented. The Saudi state, already more fragile than it looks, could even crumble. It bears noting that ISIS enjoys support from some Saudi citizens.
A War between Saudi Arabia and Iran: So far, both sides are waging a proxy war against the other. As each side is pushed into the corner it could escalate into a direct war. That would engulf many of the region's powers, including the Emirate states. If that happens, the situation could deteriorate quickly. How badly? The Iranians could block the Hormuz Straits, which is key for the world's oil supplies. There is even the possibility that Qatar and Dubai, the region's financial centres, could be bombed.
Why the Financial System is at Risk
The global economy is experiencing a somewhat fragile recovery. That recovery is held together by low interest rates and aggressive liquidity injections from central banks. Among the main reasons that central banks are able to follow their stimulus strategies and keep money cheap is low to non-existent inflation.
But what happens if inflation increases as oil supplies unexpectedly come under serious threat? Central banks will have to tighten policy just as they did during the 1979-1980 oil crisis. What happens when tightening occurs faster than the economy can digest, especially under extremes? The answer: Recoveries end and stock markets experience meltdowns.
To be sure, those two scenarios are extreme and might not materialize. In that case, the global recovery might continue to plod along. But there have been a number of terrible, unexpected scenarios that have occurred in the region since Arab Spring. It's clear that Middle East turmoil could worsen. When that happens, it may take the global recovery with it.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.