How will the Second Karabakh War affect the economy of Armenia and Azerbaijan?

3rd article

The Second Karabakh War will undoubtedly have different effects on the economies of Azerbaijan and Armenia. Even in the post-war period, rising military, social, and health spending in both countries will limit the ability of the state budget to allocate sufficient funds to other important areas. Governments will feel this difficulty significantly during the formation of the 2021 budget. On the other hand, investments in the restoration of dilapidated infrastructure for Azerbaijan, as well as housing for IDPs returning home, will increase government spending and investment in the economy. This will stimulate economic growth with the approach of Keynesian economists. Such that Keynesian economists claim that military spending stimulates economic growth. They explain this with the increase in government spending during the war.

However, some researchers claim that military spending, on the other hand, prevents economic growth. Such that a number of empirical studies show that military spending is not a productive activity that can make a positive contribution to GDP. In fact, the findings of empirical studies of the impact of war on GDP are contradictory. Barro and Lee[1] think the war has had little effect on economic growth. Jong‐A‐Pin’s[2] research shows that political instability has affected economic growth, but not war. However, Murdoch and Sandler[3] found in their research that civil wars have had a negative impact on per capita GDP growth.

During the study of the impact on economic growth and per capita income in 85 countries from 1998 to 2017, a special model was established to determine the relationship between defense spending and economic growth.[4] This model shows that defense spending has a negative impact on economic growth. Because as military spending increases, there is less money left in the budget to invest in infrastructure, health, education, and other areas of the economy. As for the interaction between military spending and arms exports, one of the highlights of the model described was that if military spending had a negative impact on economic growth, arms exports had a positive impact on economic growth. Thus, the level of GDP of arms exports and the positive effects of arms exports on GDP growth are typical only for countries with modern and developed military-industrial complexes.

Using an expanded neoclassical production function, McMillan[5] concluded from a collection of data on military spending in a number of South African countries between 1950 and 1985 that military spending had a positive effect on economic growth, while external effects of military spending had a negative effect on growth. Applying a dynamic panel, Chang, Huang, and Yang[6] concluded that the experience of India, Pakistan, Nepal, Sri Lanka, and Bangladesh has shown that military spending in low-income countries has a negative impact on economic growth.

Using a joint integration method in a panel study of five developing countries in South Asia between 1988 and 2007, Wijeweera and Webb[7] found that a 1 percent increase in military spending has reduced real GDP by 0.04 percent.

According to the calculation of the United Nations[8], the total economic damage from the First Karabakh War was $ 53.5 billion.

Summarizing the researches, it can be concluded that meeting the costs of military spending in the medium and long term creates additional challenges for the economy. These difficulties can already be seen in the course of budget discussions in Armenia. Such that speaking at the parliamentary debate on the budget, the Minister of Finance of Armenia, Atom Janjughazyan, said that the country's economic recession forecast for 2020 has deteriorated from the previously expected 2.6% to 6%. This was stated by the Minister of Finance during a speech in parliament today. The minister also noted that the worsening of the forecast for the economic downturn is due to the war in Karabakh and the growing rate of coronavirus in the country. According to him, in 2021, Armenia's GDP growth is projected at 4.6%. Speaking at the parliamentary debate on the budget, Deputy Prime Minister of Armenia, Mher Grigoryan, told MPs that 2021 will be a hard year. He suggested that in order to ensure socio-economic development in the coming year, it is necessary to form a budget that will take into account all the risks and problems.[9]

At the same time, the forecast of the economic recession of the Central Bank of Armenia for 2020 is more pessimistic. The Central Bank now expects GDP to shrink by 7% by the end of this year. The bank's previous forecast was 4%.

The International Monetary Fund, which announced its forecasts before the start of the war, forecast a 4.5% economic decline in Armenia in 2020 and a 3.5% GDP growth in 2021.

Although the Armenian government reconsidered the budget in April due to the coronavirus crisis, on October 7, it amended the budget for the second time this year. According to the report, tax collection will be reduced by 35 billion drams compared to the April forecast. As a result, tax revenues in 2020 will reach 1 trillion 320.5 billion drams ($ 2.72 billion), or 112.7 billion drams ($ 230 million) less than expected in April. Budget expenditures will be 1 trillion 637.4 billion drams (about $ 3.38 billion), or 9.5 billion drams ($ 19.5 million) more than in April.[10] Thus, the budget deficit will be about $ 660 million, or 7.4% of GDP, which means that the budget deficit will be about 135 billion drams more at the end of the year than in April.

As can be seen, expenditures related to pandemic and war in Armenia have significantly increased the current year's budget deficit. Even if we take into account that the social expenses of Armenians, who returned to Armenia during the war and were relocated from Karabakh, create an additional financial burden on the budget. In this case, by the end of 2020, the budget deficit in Armenia is expected to increase to 10 percent of GDP.

As for Azerbaijan, the Ministry of Economy[11] predicts that in 2020, GDP will decrease by 3.7 percent in real terms. According to the International Monetary Fund's new forecast for Azerbaijan in the October issue of the World Economic Outlook[12], Azerbaijan's economy will shrink by 4% this year due to the coronavirus pandemic and the country's GDP will grow by 2% in 2021.

According to the report[13] on the implementation of the state budget (operative) for the first nine months of 2020, the state budget deficit in the first nine months of 2020 amounted to 677.6 million manats, which was 479.0 million manats or 41.4 percent less than the forecast deficit of 1,156.6 million manats for the current year. Most likely, the budget deficit in Azerbaijan will increase sharply in the last quarter of this year due to expenditures related to war and pandemic. The Azerbaijani government intends to cover the deficit this year through non-privatized revenues, foreign loans, domestic borrowing, and the balance of the unified treasury account.

In conclusion, I would like to note that the growing military spending in both Azerbaijan and Armenia deepens the decline in GDP and increases the budget deficit in both countries.

[1] Barro, R. J., and Lee, J.-W. (1993) “Losers and Winners in Economic Growth.” NBER Working Paper No. 4341

[2] Jong‐​A‐​Pin, R. (2009) “On the Measurement of Political Instability and Its Impact on Economic Growth.” European Journal of Political Economy 25 (1): 15–29.

[3] Murdoch, J. C., and Sandler, T. (2004) “Civil Wars and Economic Growth: Spatial Dispersion.” American Journal of Political Science 48 (1): 138–51.

[4] Taimur Rahman, Danish Ahmed Siddiqui, The Effect of Military Spending on Economic Growth in the Presence of Arms Trade: A Global Analysis, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3401331

[5] John Paul Dunne, David S. Saal Military Spending and Economic Growth in South Africa, https://www.researchgate.net/publication/227347797_Military_Spending_and_Economic_Growth_in_South_Africa

[6] Hsin-ChenChang, Bwo-NungHuang, Chin WeiYang, Military expenditure and economic growth across different groups: A dynamic panel Granger-causality approach, https://www.sciencedirect.com/science/article/pii/S0264999311001337

[7] Matthew J. Webb, Albert Wijeweera Military Spending and Economic Growth in South Asia: A Panel Data Analysis, https://www.researchgate.net/publication/234007041_Military_Spending_and_Economic_Growth_in_South_Asia_A_Panel_Data_Analysis

[8] Azerbaijan Human Development Report 2000, http://hdr.undp.org/sites/default/files/azerbaijan_2000_en.pdf

[9] http://www.finmarket.ru/database/news/5345969

[10] https://ru.armeniasputnik.am/economy/20201006/24794475/Pravitelstvo-Armenii-perelozhilo-byudzhet-na-voennye-relsy.html

[11] https://qazet.az/business/iqtisadi/167846/

[12] https://www.imf.org/en/Publications/WEO/Issues/2020/09/30/world-economic-outlook-october-2020

[13] http://maliyye.gov.az/news/5491/2020-ci-ilin-doqquz-ayinda-dovlet-budcesinin-icrasina-operativ-dair-melumat