The Costs of Terrorism

Paper presented by Dr Geoff Raby, Deputy Secretary, Department
of Foreign Affairs and Trade to APEC Senior Officials Meeting, Chiang Rai,
21 February 2003 and submitted by Australia to the Secure Trade
in the APEC Region (STAR) Conference, 24 Feb 2003. Economic Analytical
Unit.

Main Points

• The increased risk and prevalence of global terrorism looms as a
  major threat to regional development.� Terrorist acts have already
  imposed significant increased costs on all economies.
• The immediate costs of terrorist acts including loss of life, destruction
  of property and depression of short term economic activity are compounded
  by the costs associated with the continuing threat of terrorism.
• Terrorism unchecked creates uncertainty, reduces confidence and increases
  risk perceptions and risk premiums leading to lower rates of investment
  and lower economic growth.� Terrorist acts can severely disrupt international
  trade and the continuing threat of terrorism imposes costs on international
  trade.
• Given their greater reliance on trade and capital inflows, developing
  APEC economies may incur higher costs relative to GDP from unchecked
  terrorism.
• The costs of implementing counter-terrorism measures should be viewed
  as an investment that, by reducing the threat of terrorism, will reduce
  risk premiums and the bias against longer term, productivity raising
  activities that uncertainty and risk create.
• New technologies introduced to strengthen security can increase efficiencies
  in trade and reduce trade costs.
• Due to regional and international economic linkages, terrorist events
  in one economy can impose significant costs on other regional economies.� All
  economies have an economic interest in cooperating to reduce the threat
  of terrorism.� Economies which fail to combat terrorism and ensure
  the safety of trade and people movement could expect to incur significant
  costs in terms of lost investment and trade opportunities.
• The positive spill-overs from anti-terrorism activities, with all
  countries benefiting from a more secure trading and investment environment,
  as well as the negative spill-overs from inaction, make collective
  international action the most efficient response.

Unchecked Terrorism Undermines Trade

The threat of terrorism reduces trade flows.

• A
  study of over 200 countries from 1968 to 1979 found a doubling of the
  number of terrorist incidents decreased bilateral trade between targeted
  economies
  by about 6 per cent (Nitsch and Schumacher, 2002).

A shutdown of major ports or airports due to terrorist attacks could result
in high costs, particularly for those economies more reliant on trade.

• The
  two week lockout at 29 US West Coast ports in late 2002 delayed the unloading
  at port of more than 200 ships, carrying 300,000 containers. Railcars
  and inter-modal shipments were parked all over the country as US and
  Asian
  exports filled warehouses, freezers and grain elevators. Costly diversions
  were made to other ports and many businesses laid-off workers or cut
  back production (Gooley and Cooke, 2002).
  • Analysts
    estimate the month long disruption at US West Coast ports cost Asian
    economies 0.4 per cent of nominal GDP. The negative impact in Hong
    Kong, Singapore
    and Malaysia was estimated to be as high as 1.1 per cent of nominal
    GDP (Saywell, 2002).

The continuing threat of terrorism raises the cost of undertaking trade
through a range of mechanisms:

• It
  increases insurance costs for cargoes and passengers.
• It
  creates the need to carry higher levels of inventory (due to the potential
  for terrorism to cause bottlenecks in delivery systems) thus reducing the
  benefits of just-in-time manufacturing processes and undermining supply
  chain management. International information technology and automobile production
  chains, which have a major presence in APEC economies, are particularly
  vulnerable to supply chain disruption from security threats.
  • Recent
    estimates indicate that if the United States has to carry 10 per cent
    more in inventories and pay 20 per cent more for commercial insurance
    premiums
    as a result of the increased terrorism threat, it would cost 0.1 per
    cent and 0.3 per cent of GDP or US$7.5 billion and US$30 billion
    per year, respectively
    (UBS Warburg, 2001).
  • Developing
    APEC economies, particularly those with internationally integrated production
    chains, would face relatively higher costs as a result of the fact that
    trade is a more important component of GDP.

Piracy and Terrorism

The costs piracy imposed on international shipping and trade are analogous
to those of terrorism. Between 1814 to 1860, mainly due to the European
powers eliminating piracy, international shipping costs fell by over
80 per cent and the industry's total factor productivity rose by about
500 per cent. Improvement in management also contributed. By allowing
ships to dispnse with cannon and reduce their manpower, shippers could
introduce faster, cargo-specific ships dramatically reducing costs and
boosting productivity. This fall in shipping costs significantly expanded
international trade flows in the nineteenth and twentieth centuries.

Source:� North, 1968.

The Threat of Terrorism Reduces Investment and Economic Growth

Terrorism and the spectre of future terrorist acts creates uncertainty
which increases perceived risk.� This increases costs through several channels
and dampens economic activity.

• Increased
  risk perceptions undermine investor confidence, reducing their willingness
  to commit to new projects. Over time, higher risk premiums increase required
  rates of returns on investments, reducing equity prices and biasing investment
  decisions against riskier, potentially higher return and long term investments
  towards lower risk, lower return and shorter term investments. The cumulative
  effect is to reduce overall investment and retard economic growth. Higher
  risk premiums impact mostly on economies with substantial external financing
  requirements, which must pay more for their capital, lowering investment
  and output growth.
  • Modelling
    the impact of security on private investment and growth in 53 developing
    countries from 1984 to 1995 shows economies can achieve significant
    benefits from reducing their security risks. In the short to medium
    term, this study
    found measures that increased economic security in relatively insecure
    developing countries to levels in best practice regions raised private
    investment by 0.5 to 1 percentage point of GDP. In the long term, these
    measures boosted economic growth by 0.5 to 1.25 percentage points per
    year. Political terrorism was found to be one of the most important
    security
    factors undermining economic growth in the short to medium term (Poirson,
    1998).
  • One
    analysis estimates the fall in US investment due to ongoing terrorism
    threats is about 0.2 per cent of GDP (Becker and Murphy, 2001, cited
    in Joint Economic
    Committee, 2002). This drop in investment and hence income is transmitted
    to other economies through lower US demand for imports.
  • Investments
    in major long term energy and infrastructure projects that require large
    scale networks and coordination across several countries are highly sensitive
    to increased perceptions of security risk.� Terrorists attacks on pipelines
    in Pakistan have disrupted natural gas supplies to business, compounding
    fiscal problems and deterring investors in future pipelines (stratfor.biz,
    2003).
• Airline,
  travel, tourism, accommodation, restaurant, postal services and insurance
  industries are particularly susceptible to increased terrorism risks. Regions
  and economies where these industries are concentrated are likely to suffer
  most from output and employment falls. Resulting discounting to attract
  travellers reduces the return on capital and undermines future investment.
  • In
    2001, international tourist arrivals fell by 0.6 per cent, the
    first year of negative growth since 1982.
  • Partly
    reflecting the Bali tragedy, Indonesia's 2002 tourist arrivals fell by
    2.2 per cent. As tourism accounts for 3.4 per cent of Indonesia's
    GDP, financial market analysts place the expected cost of lost tourist
    receipts at around 1 per cent of Indonesia's GDP (Euroweek, 2002).
  • Modelling
    of tourism activity in Greece, Israel and Turkey also shows sensitivity
    to terrorist incidents (Drakos and Kutan, 2001).
• Increased
  terrorism risks and associated uncertainty also reduce consumers' willingness
  to spend, particularly on discretionary items and major consumer durables,
  thereby reducing investment in consumer goods industries and depressing
  growth.
• Another
  major concern, particularly for developing economies, is that those economies
  which markets perceive as failing to deal effectively with terrorism will
  face higher risk premiums and the cost of protecting assets will rise,
  reducing foreign direct investment (FDI) inflows.
  • One
    study showed that from 1975 to 1991, heightened terrorism reduced average
    annual net FDI inflows to Spain by 13.5 per cent and to Greece
    by 11.9 per cent (Enders and Sandler, 1996).
• Currencies
  of economies seen as carrying higher risk premiums may experience exchange
  rate volatility and sudden depreciation in response to terrorist events,
  as investors switch to reserve currencies like the US dollar; this could
  impose significant costs on such economies.
  • After
    11 September, the US dollar strengthened at the expense of many emerging
    market currencies. Exchange rate depreciation may make exports more
    competitive but it also increases domestic inflation and raises foreign
    currency debt
    obligations, while exchange rate volatility can discourage foreign
    investment and encourage capital flight.
  • The
    fear of depreciation and inflation also can adversely affect the process
    of financial deepening by undermining confidence in the domestic currency
    (Addison, et. al., 2002).
• Insurers
  are responding to the increased risk of terrorism by increasing premiums
  and reducing terrorism risk coverage; in the medium term this could significantly
  lower investment and output in affected sectors and economies. While insurance
  markets may learn to price for large terrorist risk events, the unpredictability
  and potential size of terrorism events will make this difficult and premiums
  for risky activities are likely to be high.

The Overall Economic Costs of Terrorism Are High

• The
  IMF estimates that the loss of US output resulting from terrorism related
  costs could be as high as 0.75 per cent of GDP or US$75 billion per year
  (International Monetary Fund, 2001).� The cost to the regional and world
  economy would be significantly higher.
  • By
    comparison, US benefits from the Uruguay Round are estimated to be
    between 0.4 and 0.6 per cent of GDP per annum.
• A
  2002 US Congressional Budget Office study estimated terrorism directly
  cost the United States about 0.3 per cent of non-farm GDP and also reduced
  total factor productivity by around 0.3 per cent (Congressional Budget
  Office, 2002).
• A
  study of the Spanish Basque country shows terrorism reduced the Basque
  region's per capita GDP by 10 per cent, with the gap between expected
  and actual per capita GDP appearing to increase in response to spikes
  in terrorist
  activity (Abadie and Gardeazabal, 2001).

The threat of terrorism may hurt developing economies more

While the costs of unchecked terrorism are significant for all economies,
terrorism could impose a disproportionately high cost on developing APEC
economies' trade and income growth because:

• Most
  developing APEC economies depend more heavily on trade flows, particularly
  with the United States and OPEC economies.
• Many
  regional developing economies rely on receiving strong FDI inflows.� The
  recent increase in world and regional terrorism activity could raise risk
  premiums, reducing FDI inflows to economies considered at risk.
• Insurance
  premiums may be higher on cargoes and vessels travelling to and from
  developing economies because of insurers' uncertainty about the adequacy
  of local
  security procedures.

Counter-terrorism measures: an investment against future attacks

Implementation of new counter-terrorism measures will require one-time
investments in new infrastructure and may, in some cases, lead to short-to-medium
term increases in the costs of doing business internationally.

• Extra
  trade security measures taken in response to the 11 September attack
  cost from 1 to 3 per cent of North American trade flows, equivalent to
  increasing traders' annual costs from between US$5.6 and US$15.8 billion
  (Organisation for Economic Co-operation and Development, 2002). If such
  measures were applied to total 2001 world merchandise trade, they would
  cost between US$60 billion and US$180 billion.
• Another
  study estimates world welfare would decline by about US$75 billion
  annually for a 1 per cent increase in the costs of trade. North America,
  Western Europe and North Asia face the highest losses, while agriculture
  and food products, textiles and leather, non-metallic minerals and machinery
  are the most affected sectors (Walkenhorst and Dihel, 2002).

These costs should, however, be viewed as an investment that will, by
reducing the threat of terrorism, pay future dividends through reduced
risk premiums and increased trade efficiency.

Security measures can facilitate trade

APEC's trade facilitation and improved security objectives are mutually
reinforcing.� Regardless of the benefits of reducing exposure to terrorism,
technological advances to increase security are likely to increase the
efficiency of cargo handling and people movement, lowering trade costs
and making trade flows more efficient.� For example:

• Advance
  passenger information systems and other electronic identification techniques
  at airports should speed up passenger movements and, over time, lower
  business costs, as well as providing increased security at the border.
• Standardising
  the electronic manifests system at all ports would save time and reduce
  costs through quicker processing of cargo, faster vessel turnaround,
  a more consistent approach to cargo and vessel data reporting, increased
  confidence in the reporting system and more timely responses for importers
  and exporters. All these benefits should lower freight and handling
  costs
  reducing final prices of traded goods; hence increasing demand.
  • Introducing
    compatible electronic systems to handle trade also will reduce businesses
    costs.� For example, after introducing an electronic supply chain and logistics
    system, a US manufacturer with a turnover of US$1.2 billion per year
    who buys US$100 million in imports now takes only 20 minutes with
    half as many people to produce a manifest that formerly took two to
    three days to prepare (Chabrow, 2003).
• A
  presentation by the US delegation at the APEC Committee on Trade and Investment
  meeting in Chiang Rai, Thailand, on 17 February, showed how the US Customs' Automated
  Commercial Environment (ACE) project will increase security by enabling
  US Customs to more readily identify and intercept high risk cargo,
  while at the same time reducing costs to business and facilitating
  the faster
  processing of goods.
  • A
    related study estimates that the ACE system will save US importers
    US$22.2 billion in costs over 20 years
  • And
    will also save the US government US$4.4 billion in administrative costs
    over 20 years.

With international trade expanding rapidly, global logistics systems already
are becoming a necessity. Thus, expenditure on these new systems represents
an investment which will deliver considerable efficiency returns in the
future, regardless of their added benefits in countering terrorism.

APEC economies need to be creative in working together to find innovative
ways, using new technologies, to both strengthen security and facilitate
trade.

Cooperating to achieve trade security

The public good nature of anti-terrorist activities means all economies
can benefit from a more secure international environment and have an interest
in achieving it. Reducing terrorism creates increased international security
benefits from which no economy can be excluded; also individual economies
can benefit from this increase in security without diminishing other economies' ability
to enjoy these benefits.� On the other hand, any individual country's failure
to take action will impact negatively on global, regional and domestic
welfare. Economies which fail to cooperate in multilateral counter terrorist
measures run the risk of marginalising themselves from many international
transactions.

By taking coordinated joint action to counter terrorism, APEC economies
will increase the effectiveness and reduce the costs of their efforts to
ensure the security of their citizens, trade and investment. Without regional
and multilateral cooperation, individual economies are likely to face higher
public and private spending on security and trade requirements and regulations
and measures to combat terrorism in individual economies may need to be
more stringent.

Due to complex cross border linkages between financial institutions and
new banking technologies, for instance, actions to counter money laundering
and combat terrorism financing require all economies to work together.
Those economies that do not take counter measures could face a loss of
investor confidence and boycotts by other banks. Financial institutions
involved in terrorist financing also will face criminal charges and reputation
damage.

Summing Up

Effective action to combat terrorism will generate significant benefits
for the global economy, preventing losses from reduced trade flows and
investment undermining economic growth. Since international goods and financial
markets transmit terrorism's costs well beyond the country where acts occur
and terrorist groups operate across borders, any economy's actions to curb
terrorist activities should produce global and regional benefits. Similarly,
failure to counter terrorism will produce costs for all economies and populations.
Given their active participation in international trade and high investment
requirements to promote growth, developing APEC economies have at least
as much to gain from countering terrorism as industrial economies.

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