Are We Too Pessimistic?

At the risk of making comparisons of news stories and opinions a theme of this blog, two articles caught my eye today: Tom Friedman's op-ed in today's New York Times, "Win, Win, Win, Win, Win..." and an op-ed by Patrick Seale in Gulf News last Friday entitled, "Arab world faces uneasy new year." Friedman's piece basically bemoans a bit of news he caught on CNNMoney about truck and SUV sales picking up in December and America's failure to honestly face its gasoline addiction absent price signaling in the markets. In it he argues that the only ones who benefit from this are the large oil producers. He uses the phrase "It's a new morning in Riyadh." Seale, a British citizen and long time observer of the Gulf, has a much different outlook on things. Seale argues that the day of the oil producers is drawing to a close as the incoming Obama administration appears to be serious about developing renewable energy alternatives to hydrocarbons. These policies coupled with the global recession and precipitous drop in oil prices stand to cause some havoc for the Persian Gulf. So which view is right or are they both? One could argue that Friedman's frustration is understandable but represents a more long term view. Industry consensus is that oil prices (and therefore demand) are not likely to recover until 2010. IEA is now forecasting a return to $100/barrel by '10 but not before a further price erosion in 2009. Friedman's pessimism also ignores the the likely albeit gradual decline in SUV production and sales being forced on US automakers in the wake of the US government bailout of the big 3. Add on to this US automakers' wrestling with scrapping popular lines because of declining sales (Salon ran a somewhat humorous article on Hummers recently, linked here), and the probability of a return to "normal" grows somewhat slim.

Still, Seale's equal but different pessimism also seems somewhat misplaced. There is little doubt that 2009 is shaping up to be a difficult year almost universally with the decline in developed world having a significant impact on the export capabilities of the developing world (and here, both goods and commodities producers are likely to suffer equally.) But any conversion to alternative energies will be a slow, many decade process. Even if the new administration is able to keep its promise on patronizing and developing green technologies, fossil fuels are not going to disappear overnight. And, as the IEA forecast suggests, prices are likely to favor the oil producers in the medium to long term, not work against them.

More than Friedman's qualms (which mirror many of those in the fledgling but growing green community in the US that low oil prices are actually bad for us as a nation overall), the pessimism in Seale's article as well as the press accounts going into the GCC ministerial beginning today in Muscat surprise me by the level of defeatism. This was a region of the world who a scant few months ago was really beginning to feel its oats internationally. Riyadh was at the forefront of pushing for diplomatic efforts in the Middle East, hosting religious dialogues, invited to attend the G-20 meeting in Washington in recognition of its status as a growing international financial player, and being heralded by the British Prime Minister as being a strong candidate for a wider role in global financial institutions. The tide has turned since then with the decline in oil prices, but it isn't as if the region is suffering in isolation. No one, not even the formidable China, is optimistic about its economic future at this point. But reading the list of things that the GCC can't control in the run up from today's meeting (the global recession, the fall in the price of oil, inflation, piracy in the Gulf of Aden, the recent Israeli aggression in Gaza), according to an Omani analyst with a local paper, one wonders why the group bothers meeting. I am not suggesting that the GCC can work miracles, but going into a meeting with no hope of adequately addressing any of the problems on your agenda seems a doomed way to begin. Or in this case end 2008.

All of this makes me wonder how far the region has really come in the past seven years. I admit to being frustrated that the region would rather continue to view itself as a passive recipient of events rather than as an actor. I have no doubt that GCC intervention might be of limited utility in global events, but they are still players and should see themselves as such.

More Signs of Trouble Ahead- this time North Africa

I wish I had some good news to blog about, especially so close to the holidays, but the more I read these days the harder it is to find any ray of sunshine, at least over the next year or so.  Two reports struck me today as being particularly ominous, even though both only tangentially deal with the Middle East.  The World Bank this month released its 2009 update of Global Economic Prospects, this one subtitled, "Commodities at a Crossroad."  Although the report is not entirely pessimistic about the outlook for established commodity producers in the short and medium term, largely because of the large surpluses they were able to build up during the past five years, the Bank notes that one of the most significant effects of the current downturn will be a decline in investment in emerging markets which is forecast to fall by almost 10 percent from 2007 to 2009.  The Bank attributes this steep drop to tighter credit conditions and a shrunken appetite for risk.  The second report was a front page article in the Washington Post which reported that many countries have already begun to enact protectionist measures despite pledging an ongoing commitment to free trade at the G-20 Summit in Washington in November.  (The article also contains an excellent map detailing measures being taken globally.) 

These two reports taken together should sound a note of extreme alarm for North Africa watchers.  Morocco, Tunisia, and Egypt all have been enjoying economic growth largely through their trade links to Europe and, more recently, through a boom in investment from the Persian Gulf.  (Europeans have been important investors in each of these countries as well although in the past two years, Gulf investment flows have surpassed those from the EU, and in the case of Egypt, from the US.)  In fact, these countries have tied their economic liberalization and future development strategies to the joint pillars of exports and investment.  North African policymakers have few tools to counter this twin blow since domestic consumption in each of these countries is minimal, although before this year, consumption in Egypt was on the rise.  But in Morocco and Tunisia, domestic consumption remains stubbornly tied to the agrarian culture that formally marked the underpinnings of those economies.  In times of abundant harvests, consumers spend more, whether or not those consumers are inherently tied to the agriculture industry.  Likewise, in times of drought, consumption tends to retract.  It's been the recovery in Europe and petrodollar flows in the form of foreign direct investment and portfolio capital that have smoothed out some of the jarring movements in GDP that has been typical in North Africa.  

With so much being tied to new investment and further development in export-oriented industries, we should expect to see these economies enduring significant slowdowns in the short to medium term.  Of course with this comes rising unemployment, burgeoning current account deficits, and potential balance of payment troubles.  Although the economic downturn is being felt globally and should be worried about in many countries, North Africa holds a special place for me since it is really the birthplace of economic reform in the Middle East.  Tunisia, in particular, has been working for decades to break the resource curse and get itself on more stable footing.  I don't believe that the current slowdown will become a deal breaker for any of these countries in terms of their ultimate reform agenda, but it is a shame that after finally undertaking some serious changes (especially in the case of Egypt) this downturn will prevent these countries from reaping the fruits of their labors.

The Shifting Fortunes of Sovereign Wealth Funds

Found this article in Business Middle East this morning. Think it's so well written that I don't have much to add but for a few additional issues to ponder.

http://www.bi-me.com/main.php?id=28882&t=1&c=34&cg=4&mset=1011


If SWFs have been a significant player in M&A activity, along with private equity, what happens now? A even greater slowing of investment capital globally?

If SWF investment is turned more inwardly, what is the outlook for US bond issuances? Who buys? (As readers of this blog know, this has been one of my biggest dilemmas when it comes to financing US fiscal imbalances.)

Will the global response to SWFs change? Will developed countries be more welcoming in the hopes of attracting what capital is left available for investment?

The one caution I have is that we have not seen the last of these entities. Surely as the sun shines, oil prices will go back up as the world comes out of recession. Structural issues in the oil industry and oil trading (everything from under-investment by the NOCs and IOCs to the continued opaque nature of over the counter trading) continue to hinder market "efficiencies" and I would expect the next time prices rise, it will be even faster and less rational than the last time. So when the fiscal surpluses start piling up, expect to see Mudabala and QIA on another shopping spree.

New Investment Strategies for the GCC?

Celent, an international strategy consulting firm, last Monday released a report that made the most detailed projections for the future of Gulf investment to date.  The report, in its entirety, is available only to subscribers but a summary of its findings may be found on zawya.com (linked here: Gulf Investors Alter Portfolios to Focus on Asia Investments).  The report may not be particularly profound in suggesting that more Gulf money will flow to Asia-- it's something that many of us who cover these issues have been watching since the beginning of the oil surge 5 years ago.  Investment flows between Asia and the Middle East grew rapidly in 2007, in particular, and, until the unraveling of global credit markets and oil prices, such trends would have likely continued this year.  Particularly interesting, though, is the rate of change in asset allocation Celent predicts will guide Gulf investment between 2010-2015.  Celent estimates that by 2015 Gulf investments in the US will constitute only 30 percent of Gulf countries' portfolios (down by 10 percent from today.)  Europe will also see a decline, falling by 5 percent to total 10 percent of Gulf asset portfolios by 2015.  In Celent's estimation, the biggest gainers in these shifts will be Asia and Africa.  One wonders if Qatar was looking to confirm these predictions with its announcement of new projects in the Philippines, which could total up to $1 billion.  

Such predictions come at a particularly unfortunate time for the US.  The US in the past eight years has relied on global imbalances, particularly the huge trade surpluses being generated in China and the Persian Gulf, to fund its chronic deficits.  Even today with global imbalances unwinding, the US has no good option to finance its continuously growing deficits (which could reach as high as $1 trillion this year if the bailout and fiscal stimulus packages being discussed are all adopted) beyond debt issuances.  This report suggests one big misunderstanding in that strategy: that Gulf appetite for US debt will remain strong.  Beyond the geographic shift, Celent suggests that while Gulf investment appetite for fixed income is likely to remain steady (albeit not incredibly high), its desire for equities will decline sharply.  The second misnomer with debt issuances is that buyers still have the financial wherewith all to buy and to buy at levels previously seen.  With the sharp fall in oil prices, this is no longer the case.  The IIF is forecasting that Gulf surpluses will be whittled down to $48 billion in 2009 from a high of $321 billion in 2008.  Samba, in a recent report, is not so sure things will look smooth for Saudi Arabia if oil prices hover around $40/barrel for an extended period of time.  (Oil at $40 Will Impact the Saudi Economy)   

One last interesting thing to note about this report is its forecast for asset class allocation.  As I mentioned above, Gulf interest in equities is forecast to go down, along with allocations towards real estate ventures.  Celent forecasts some growth in deposits, but the largest growth area for Gulf investment is alternate investments.  What those alternate investments might be is unclear (at least in the synopsis of the report posted in Zawya) but I'll be curious to see how the money gets allocated.  With so much talk in the US about a possible green revolution, it would be ironic yet somehow fitting if the world's biggest purveyors of the fossil fuel economy were providing the funds for its unraveling.  

Iran's Uncertain Times

The Singapore-based Facts Global Energy yesterday released a report that had many dire predictions regarding Iran's ability to produce and export oil.  The report argues that despite Iran's own projections of bringing oil production up to 5 million barrels a day after 2015, the country is likely to see production decline to 3 million a day by 2015.  The report cites Iran's abysmal record attracting foreign investment, its growing inability to technically handle recovery in its own fields, and the combined impact of sanctions--driving away interest from legitimate businesses--and the global credit crunch has had on Iran's ability to find financial partners to begin the work of upgrading its oil facilities.  The numbers seem pretty incredible given that FGEnergy's estimates mean that Iran will be looking at a one million barrel per day decline in the next 7 years if it does nothing but maintain the current status quo.  That rate of decline seems even greater than widely recognized disappearing producers such as Syria, Yemen, and Oman.  The icing on the cake here is that the report suggests that if domestic refining capacity does come on line during this time frame, OPEC's second largest producer may cease exporting oil entirely.  

Even if FGEnergy's analysis is alarmist in its time horizon, no one argues that Iran has put itself on a path of self-destruction that can only eventually end up where FGEnergy predicts.  And the reckoning may happen even more quickly than Iran could have imagined or hoped.  During the heyday of high oil prices, a few short months ago, Iran could afford fiscal mismanagement and increasing isolation from international creditors.  A back of the envelope estimate by a respected group of economic modelers estimated last year that Iran's "break even" point budget wise was about $60/barrel.  That made it one of the most expensive countries within OPEC, but with oil spending most of its trading days of 2008 above $100/barrel, the Iranian government could breath somewhat easily.  With oil today at $45/barrel (representing a $3 increase I might add over recent trading), the situation becomes remarkably different.  Iran will need to pay attention to how and when it spends and on whom it relies for trade and investment.  Relying on Sinopec and the Chinese willingness to flaunt the US and to a lesser extent Europe's interest in isolating Iran may not be quite as easy to do in current global circumstances.  And as the Chinese look at contraction at home, defending Iran may become more of a nuisance than it's worth.

All of this, ironically, places the incoming Obama administration in a unique position.  Some analysts posit that Ahmedinejad's letter to the president-elect after Election Day this November could signal an opening salvo of interest in talking with the United States.  Certainly, the Iranians are in an economically sensitive, if not vulnerable, position right now.  Using a well crafted carrot might produce some interesting results.

The Woes of OPEC

With the news of oil prices at just about $40/barrel today and analysts like David Moore from the Commonwealth Bank of Australia predicting that it was "way, way premature" to think that the commodities markets have hit bottom in the AFP (Merrill Lynch predicts that oil could go to $25/barrel in 2009 if the recession spreads to China, according to their new report), one wonders what has happened to OPEC. The papers were filled earlier this week with ridicule for the group after they had failed to reach consensus on a production cut during their impromptu meeting in Cairo over the weekend. Business Middle East staff writers suggested that OPEC indecision heralded a return to the 1990s when the group badly misread the Asian financial crisis and let oil fall to $10/barrel. Even Saudi King Abdallah's attempt to set a marker of $75/barrel as a "fair price" for oil right before the Cairo meeting (the first attempt by any OPEC member to set a price marker since oil began its climb in 2004) was ignored outright by the market in the wake of depressing economic news out of the US. So was Qatari Oil Minister Al-Attiyah's announcement that the group would surely cut at its scheduled meeting in December.

All of this hoopla surrounding OPEC's ineffectiveness in the face of the oil price downturn confirms my long held belief that OPEC doesn't really matter at all when it comes to determining the price of oil. I recognize that this is not a particularly profound statement in the wake of falling prices, but I would argue the same to be true when prices were rising. I don't deny that OPEC makes all the difference in the world when it comes to supplying the markets but the idea that the group can effectively target a price (or control a price rise or fall) is laughable. Witness Saudi's make-or-break moment in June when they announced an out of cycle production increase (a move which they knew to be completely unnecessary to a well supplied market) in the hopes of dampening down a furiously rising price of oil. The market barely blinked an eye and continued going up. The fact that the market moved more this summer on the "wisdom" of Jeff Currie at Goldman Sachs than Ali Naimi proved to me, at least, that something very quirky way going on in commodity markets. In fact, much of this "quirkiness" was elucidated in a fascinating article in the Washington Post in August which explained that much of the price volatility in the oil markets in July, at least, was being caused by a single firm: Vitol. It's too bad not more attention was paid to the story. Stories like that raise my conspiracy hackles a bit and I wonder how much people in the business of trading really knew what was going on despite the bunk analysis they kept churning out.

So where does all of this leave OPEC, our favorite bogeyman when times are bad? In not a very good place, I am afraid. As long as market forces keep driving the price of oil down (and I am on record in this blog with the belief that markets are currently overshooting), there isn't much OPEC can do to intervene. Production cuts are not going to solve much if the market remains bearish just as increases did little to stave off the bull market. But no one, including OPEC, should get used to low oil prices. What comes down will go back up. And in this current environment, if oil company executives in both the IOCs and NOCs convince themselves that they cannot afford to investment in exploration and drilling, we're all in trouble in the long run. I have a feeling that market volatility is here to stay.

Think the OPEC topic is interesting? Check out these stories-

http://www.bi-me.com/main.php?id=28429&t=1&c=6&cg=2&mset=

http://www.bi-me.com/main.php?id=28177&t=1&c=6&cg=2&mset=

http://www.zawya.com/story.cfm/sidZAWYA20081205080721/?query=OPEC

The Problem with Pirates

Oxford Business Group published an interesting article a few days ago in response to Egypt’s announcement of its intentions to fight pirates as part of any UN-sponsored mission. (Cairo said it opposes unilateral action to combat piracy off Somalia’s coast.) Oxford Business Group, among others, suggests that piracy could become a real problem for Egypt if it deters business away from the Suez Canal. Although Egyptian officials say that piracy has not yet affected business through the canal, OBG reports that Denmark’s AP Moller-Maersk has ordered its slower ships to sail around the Cape of Good Hope to avoid the canal altogether, even though this means an additional two to three weeks. Any loss in revenue from the Suez Canal poses a special problem for Egypt as it sees its other GDP drivers—particularly foreign investment from Europe and the neighboring Gulf states and tourism—begin to slow down in the wake of a possible global recession. Again, according to the OBG report, Egypt earned $2.6 billion in revenue from the canal in the first half of 2008. In 2007, canal revenues accounted for roughly 13 percent of government revenue.

Egypt’s Investment Minister, Mahmoud Mohieldin, predicts at least a full percentage point slowdown in GDP growth this fiscal year for the country, from 7.2 percent last year to 5-6 percent is year. Much of the slowdown in the Egyptian economy is out of Egypt’s hands-just as it rode the boom in the Persian Gulf and a strong Europe (much of Europe’s trade with Asia passes through the Suez Canal and the majority of its tourists come from Europe and the Arab world) so Egypt must ride out the slowdown in its economic partners. Piracy out of Somalia, nonetheless, would seem to be adding insult to injury for a government and economy that was just beginning to factor in sustained growth. Egypt is unlikely to actually take matters into its own hands if the situation deteriorates further, but it might be time for Egypt to rediscover its African identity and exert a little pressure on its neighbor to the south.

The End of Dubai Inc?

Press accounts in recent weeks are raising concern that Dubai might be in serious financial straits. Zawya Dow Jones reported on Tuesday that the government has hired financial advisers to help restructure its economy as it struggles to meet payments on its large debt. Wednesday, the Financial Times reported that Dubai was in talks with Abu Dhabi to arrange for a loan facility that would make state funds available to Dubai firms as international credit markets continue to dry up. Dubai officials later denied the allegations in a report on Al-Arabiya. Still, speculation about Dubai's financial health is rampant. According to local rumors, Dubai might offer Abu Dhabi strategic stakes in some of its largest firms, including Emirates Airlines, Nakheel, and Dubai Proprieties. Rumors have become so persistent that Dubai World CEO Sultan Ahmad bin Sulayem on Tuesday angrily denied that the company was in any kind of financial trouble. He said that the company was studying options for offering stakes in Dubai World for public subscriptions but that the company had not entered into negotiations for selling stakes or received any offers.

It's hard to appreciate how serious the issue of Dubai's indebtedness may become for the emirate. Estimates vary on how much debt they actually hold. Fitch estimates that Dubai's debt level is close to $70 billion, which as the FT notes, puts their debt to GDP level at more than 100 percent. But, in a separate report quoted by Zawya Dow Jones, Standard and Poors estimates that its debt to GDP level is closer to 42 percent. What is not at issue, however, is the seriousness of Dubai's failing economic health. Dubai's once thriving real estate market, which accounts for 30 percent of local GDP, is slowing rapidly. HSBC Global Research found that real estate prices in the secondary market fell in October by four percent in Dubai, with much more substantial price erosions in certain developments. For example, prices at the Pal on Palm Jumeriah fell by 32 percent; and at DIFC (last week rebranded as NASDAQ Dubai in order to attract more business to the fledgling exchange), prices fell by 30 percent. These are the first price declines the emirate has seen in six years. The decline in the real estate sector, along with Dubai's ability to finance its ever growing debt on equitable terms, has caused Citibank to name Dubai as the most vulnerable to an economic downturn in the Persian Gulf in a report released early last week.

Many of the problems confronting Dubai have been long standing. Analysts for years have been concerned about over-building in the emirate itself and a far too aggressive mergers and acquisitions strategy overseas. Rulers of Dubai have always shrugged off these concerns building a modern metropolis out of the dessert to great success. Analysts questioned the viability of Jebel Ali and Port Rashid when MBR's father, Rashid bin Saeed, began building the twin ports in the late 1970s. They continued to question the construction boom from the mid 1990s on. And while many of these doubts appear to have been unjustified as Dubai proved time and time again that it could best the capacity argument, what it could not outrun was the issue of growing too large too fast. What many of the state-owned firms are wrestling with now (even more than the downturn in their home market) is the souring of their investments overseas because of the global downturn and the tight credit market internationally. Like any corporation that undertakes a massive expansion over a short period of time, Dubai entities had to borrow to make it work. And when the market goes down and demand dries up, so goes the rationale behind making those investments. Over expansion has cost many an industry.

What makes Dubai different is that (to borrow a phrase from the US crisis), it is too big to fail. Duabi is not just the crown jewel of the UAE but also for the rest of the Persian Gulf. The belief that business transactions could happen smoothly and profitably was realized in Dubai first. Foreign ownership of property was brought to Dubai first. World class transportation hubs and a hint of western ethos making businessmen comfortable all began in Dubai. If Dubai fails, so does the rest of the region. That is not to say that other Gulf countries will move to bail the emirate out (Abu Dhabi has enough surplus capital for that) but they all have a stake in continuing the dream, even if it is more tarnished than it once was.

How Low Can you Go?

Yesterday, oil dropped below $50/barrel, its lowest level since May 2005.  In four short months, oil has shed close to a $100 off the per barrel price.  It's a fall that is almost inconceivable.  Even those hawks (few and far between over the summer) who were arguing that $140 was unsustainable and would not last have been dumbfounded by the drop.  In fact, this sudden and severe deflation has gotten folks of every stripe a bit unnerved and few consumers are celebrating as the weight of the economic downturn is playing a larger role in household decision-making than are the fall of gas prices.  Suddenly, talk has turned to the evils of deflation rather than the evils of inflation that was all the rage in the spring and early summer.  Citibank warned in a report released Monday of the fiscal consequences for Persian Gulf oil producers of oil prices averaging in the $50/barrel range.  Citi forecasts that at that level only Kuwait would be able to maintain a surplus.  Speculation has it that Iran is looking for some measure of reconciliation with the US as it begins to feel the vise of lower oil prices and sanctions.  High cost oil producers are being squeezed with supply at risk for being shut in as many of these producers have fairly high break even points.  Several years ago, Wall Street analysts estimated that the break even point for Canadian tar sands was about $50/barrel. Surely that has risen as costs throughout the industry continue to increase.

Are we witnessing a trend that will take us back to 1998 when oil prices fell to $10/barrel?  Speculating on oil prices movements is always a dangerous game but to many people (myself included) it's just too tempting to resist.  So here's my bet: just as markets were overshooting at the beginning of the year and had so far separated themselves from the physical market fundamentals that $140/barrel not only seemed plausible, it was reasonable; so too are markets overshooting the downside risk now.  Again, the market mentality seems stuck.  Until the end of this summer, the market saw no downside risk to prices and prices just kept rising, even in the face of declining demand from the OECD.  Market analysts (many of whom worked for firms that had ties to the trading side) prophesied that even though demand was being met now by adequate supply, soon the world would be short on oil because of growth from non-OECD countries.  $140/barrel was completely justified.  In November, the call is just the opposite: the world is in a deep recession and oil demand is not going to come back.  This even though we still don't have a good handle on where Chinese demand (the big villain during the summer months) is currently.  Chinese consumption has slowed but is still growing.  And the effects of a Chinese stimulus package announced last week are still to be determined.

So where is the "fair" price for oil?  Of course, it's anyone's guess but future contracts point to a range of $80-$85/barrel, suggesting that traders remain bullish on the long term outlook for the oil market.  And, although I reject the notion of a "virtuous" price for oil, $80 seems a bit more reasonable for multiple agendas: low prices contributed to excessive consumption in the US.  A long term sustainable price of $80 would help conservation, the development of energy alternatives, and the long term fiscal health of the oil producers.  Convincing Wall Street of this is another story. 

Dragon, Meet Camel

The news of China's $586 billion "bailout" package for its domestic economy raises some interesting prospects for growing ties along the new Silk Road. According to press accounts of Beijing's plans, the money would be spent on infrastructure development--specifically, building railways, subways, and airports--and rebuilding the earthquake-devastated Sichuan province. Unlike fiscal stimulus packages in the US, the money for these projects will not come from the central or local governments but will be financed by state banks and state-owned companies. The Chinese government designed the plan to stimulate economic growth and consumer spending as the country faces a rapidly slowing economy. The latest projections put Chinese growth at 5.8 percent in the fourth quarter, or close to half of what it was towards the beginning of the year.

You might wonder what this has to do with the Middle East. During the period of the most recent global economic boom, trade and investment ties between China and the Middle East, particularly the Persian Gulf, grew rapidly. As Chinese consumption of Middle East oil grew, Middle East investment capital also began to swell and head east. Much of this investment was destined for infrastructure projects, albeit largely in real estate. With Middle East companies, such as DP World of the UAE and Agility of Kuwait, having a competitive advantage in logistics, could we see an expansion of such ties? With one market drying up in the West, will China turn to its nearer neighbors for capital and know-how for its development?

On the one hand, both the Middle East and China could be served by drawing on each other's strengths as the rest of the world falters. Persian Gulf oil producers and China offer more complimentary production capabilities than competitive. The Gulf supplies the oil, the capital, and, in some cases, the ability to manage multi-billion dollar projects. China grows, buys more oil and more contracts. Everyone is happy. But, on the other hand, China's decision to focus on infrastructure does directly clash with Middle East development goals since many of those countries are focusing intensely on infrastructure development as well. In a world of limited investment capital, human capital (a shortage of engineers, architects, and skilled foreman has plagued the Middle East in recent years), and material (such as steel), China's development plans make the country a direct competitor of the Gulf. It may be possible to reconcile the two region's goals. China's plan is very short term--according to the New York Times on Monday, Beijing's idea is to spend the money over a two-year period. With such a tight schedule to identify projects, put out bids, and then contract, it may be possible for both regions to have their cake and eat it too if the Gulf is willing to delay some of its projects with an eye to the longer term.

Things might be looking up for the Gulf producers.

A New Day for the US and a New Chance for Middle East Relations

I generally refrain from commenting on US-Middle East relations since the topic honestly bores me a bit. It seems to me to be a never-ending chain of recriminations, dashed hopes, unmet expectations, and a constant misread of the others' intentions. That's not to say that the US and Middle East governments always fail to get it right (and in some important instances they do make bilateral relationships work.)

It is hard, however, to let the election of Barack Obama pass without some comment on the possibility of altering the dynamic between the US and the Middle East even just a little. The New York Times on Wednesday morning was filled with uplifting stories of international reaction to the US election. And it would seem, to Times reporters, that there is an optimism in the Arab world that an underclass black man born to a Muslim father might be more willing to make things right in the Arab world than his predecessor was. At the same time, there is a certain amount of cynicism that, at the end of the day, politics is politics and even if Obama wanted to do the right thing by the Palestinians, for example, there are huge obstacles that stand in the way domestically in the US.

I wouldn't argue them on that point, but I do think that a new Obama administration has the opportunity to change the dynamic fundamentally and make the relationship more productive from both perspectives. A very simple way to begin this is to shift the focus a bit to concentrate on economics. Prime Minister Gordon Brown was in the Gulf this week promising the Gulf states for a larger say in international institutions like the IMF if they would lend a hand in recapitalizing failing banking systems and adding to financial stability globally. I think this is an excellent idea and one that Obama's future administration should take seriously. By giving the Gulf states a bigger say, it elevates their status both domestically and globally and shows that that we can treat Arab governments with respect. Also, I think the new administration should dust off one of the Bush administration's best policies that they let wither on the vine: MEFTA. I know there are many naysayers out there over this idea, but I doubt that even Bob Zoellick appreciated how brilliant the idea was when he conceived it. Incremental change with the promise of free trade has led to institution building, more transparency, and some measure of government accountability in those countries that have FTA with the US. Increasing trade is almost beyond the point from a US foreign policy perspective. Bringing partners like Egypt, the UAE, and Kuwait closer and encouraging them to further reform can only be a good thing and contributes to more good will in the region. Finally, our export promotion programs should be spruced up and made to include foreign investment promotion. The US has been losing out to European, Asian, and other Middle Eastern companies in breaking ground in the Arab world. It's hard to imagine any room for expansion in the face of global contraction, but the Arab world may be one of the regions that does not suffer as harsh a setback as other emerging markets.

The Middle East writ large is in a period of transition and while we are bound to disappoint politically it is within our means to succeed economically. And in the long run, there is no better good will than helping to economically equip young populations for their future.

How Bad Will the Middle East Hurt?

The New York Times ran a front page story on its website Wednesday reporting on the spread of the global crisis to the Gulf. The Wall Street Journal ran a similar story on Tuesday. Both stories focused on the impact of lower oil prices on the Gulf economies and suggested that while the Gulf could withstand the lower prices, the real losers in this scenario were the Gulf's new dependent states- i.e., the Egypts and Jordans of the world. This is a theme I briefly touched on in my previous posts and one to which I will surely return in future posts. The theory here is that although Egypt, Jordan, and other non-oil producing states will benefit from a decline in inflation with a reduction in oil prices (and also, I might note, an easing of their fiscal accounts since both countries still heavily subsidize commodity prices despite modest reforms in recent years,) the potential for a slowdown in remittance payments and investment flows will have an overwhelmingly worse effect on their macro positions than high oil prices had.

Although I think the impact on the non-oil producers is definitely interesting and worth considering, I think we need to challenge the notion that the oil producers' only real problem is the decline in oil prices. In fact, I think at this point, oil prices should be the least of their concerns. Much like Bear Sterns was a sort of prophetic symbol of what was to come down the pike for Wall Street, I wonder if Gulf Bank is not serving the same function for Gulf financial institutions. Here are the things that concern me: First, we just don't know how exposed not only Gulf commercial banks but also central banks are to the West. You would think by now some of their positions would have begun to unwind, and certainly, banks in the UAE and Bahrain, for example, have admitted to losing significant cash in the subprime mess. But if Gulf Bank can admit to losing $800 million seemingly overnight as recently as late October, who else might be similarly exposed? Remember that Gulf banks (both commercial and central) have traditionally invested heavily in US and European markets. In fact, SAMA has resisted forming a sovereign wealth fund believing that the slow and steady course of holding US sovereign and corporate bonds would serve them better than holding physical assets in the long run. But because the Gulf has traditionally resisted transparency when it comes to where it's putting its money, we just don't know how bad it might get for them. Second, Gulf banks and other financial institutions aren't just exposed to the West but they are also exposed to their local markets. In almost the entire Gulf, the non-oil economy has been growing at a faster rates than oil revenue. And that growth has been on the back of foreign investment or borrowing. A large chunk of Dubai is highly leveraged as are many Qatari institutions. With credit drying up around the world and businesses of all ilk facing some measure of retrenchment, who will be left to lend money to Gulf businesses? Or, on the other hand, who will want to open new offices in the Gulf? Sure, the governments have fairly deep pockets but not even they will be able to completely bail out their private sectors.

Finally, and in my mind most worrying over the long term, is something a bit more intangible. Gulf governments, led chiefly by Muhammad bin Rashid, have tried to upend the conventional development model by building economies chiefly centered on service industries. Shipping and logistics, tourism, business travel, retail, telecommunications- build it and they will come. And they have come- in droves in fact. It's a model being emulated throughout the Gulf and now by other Middle East countries as Gulf companies pour hundreds of billions of dollars into developing real estate ventures and tourism developments from Morocco to Syria. Here's the problem though- all of these new industries are predicated on attracting consumers of a certain economic status. To put it simply, Gulf companies have been banking on wealthy customers who demand what might be considered luxury goods and services. They are developing billions of dollars in delights for people can afford it. Superiority in logistics implies that people need and want to ship goods. Telecom implies that people can afford to purchase cell phones. Tourism implies that people can not only afford to travel but want to stay at your resort. It's easy to nay say this idea now, but given that these ideas were conceived of during a period of unprecedented global expansion, when each year groups like Global Insight were benignly calling for another year of "Goldilocks," you can't really blame them. Lots of people were getting rich, particularly in the developing world. And it was the developing world the Gulf was really trying to key into while maintaining some presence in the West. Unfortunately, if Roubini and others like him are right, it was a period that may be coming to an end.

Does this mean the end to the golden period in the Gulf? Insofar as the rest of the world is "girding their loins" (to quote Joe Biden) for a multi year recession, the Gulf should not and will likely not be immune. Still, I tend to think that all is not for naught. The global economy will eventually recover and people will once again want to ship goods, buy cell phones, travel, and consume more oil. And the Gulf should be pretty well prepared to serve those needs then.

That Sinking Feeling

The financial situation in the Gulf continues to worsen despite assurances from Gulf finance ministers over the weekend that local economies remain stable. Kuwait was hit strongest on Sunday when trading of shares in Gulf Bank, the emirate's second largest bank, were suspended after it was revealed that the bank had made significant losses in derivative trading. Although the bank offered no details, officials from the Central Bank of Kuwait told the Financial Times that the losses were estimated at around $800 million, triggered by the fall in the euro's value against the dollar. The announcement prompted CBK to appoint a supervisor to monitor Gulf Bank's treasury management and monetary market activity. The announcement also sent a wave of panic among Kuwaiti traders, who for the second time in as many days staged a walkout to protest for more government intervention in the falling stock market.

The Kuwaiti government on Sunday introduced an emergency bill into the National Assembly guaranteeing all bank deposits. The government had been resisting such a move and as late as 24 October said it would not offer any guarantees as the banks were in good shape. Kuwait's moves follow those of Saudi Arabia, who on the 21st of October deposited between $2-$3 billion into local banks to ease a shortfall of funds. The Saudi government also guaranteed bank deposits and reduced compulsory bank reserves from 13 to 10 percent. Qatar, on the other hand, pumped $5.3 billion into its financial system by acquiring shares of listed local banks. Most GCC governments have also lowered interest rates in recent weeks.

All of these moves follow another wretched month for local stock markets. The most recent estimates put stock market losses in the Gulf at $200 billion in October so far, topping September's abysmal losses of $150 billion. Gulf finance and economy ministers met over the weekend to discuss a common strategy for dealing with the crisis. As expected, nothing substantial came out of the meeting with all governments claiming unity but choosing unilateral action instead. Although no one was surprised by this outcome, the IMF director for the Middle East and Central Asia warned in an interview with the UAE's Khaleej Times that "a coordinated approach to the issue by all member states is the need of the hour." One can't help but agree as it seems likely that Gulf Bank's losses will be only the tip of the iceberg.

If Gulf governments learn any lesson from the financial crisis as it unfolds in the West, it should be to come clean as quickly as possible. Trying to hide the existence of losses or deny problems will only prolong the crisis and increase its scope as investors try to guess where the bottom might be. US, European, and Asian markets are largely still in a downward spiral set off by Lehman's failure. (Performance in recent days excluded.) Sadly, early moves by Gulf governments appear to be following the opaque, deny all problems approach. Saudi Finance Minister Assaf's statement over the weekend that the Gulf economies are showing "strong indications of relatively higher growth rates" is weirdly reminiscent of comments made on the US campaign trail. Later in the statement Assaf puts Gulf growth rates at between 4 to 6 percent in 2008. If achieved, such growth rates do put the Gulf ahead of most of the rest of the world but are down signficantly from where the IMF forecast the Gulf to be at 7.1 percent. Assaf and the CBK should be more upfront about the problem. In this current environment, better to swallow the hard pill up front than to have to guess at the size of the dose down the road.

The Other Liquidity Crisis

Overlooked in the past month in all of the horrible news coming out of the US and Europe is the liquidity crisis hitting the emerging markets of the Gulf. Dubai, in particular, has seen private credit dry up almost overnight as local markets have tanked in line with global markets and currency speculators have withdrawn funds en masse after the strengthening of the US dollar made it unlikely that any of the Gulf governments would adjust their currency pegs. In the month of September alone, the GCC markets lost $153 billion off their collective market cap. In response, the UAE central bank created a pool of $13 billion to inject into the banking system to ease the tightness of local credit markets. Other GCC governments have promised similar moves if credit markets in those countries become too tight.

Compared to the situation in the US, the credit crisis in the Gulf looks somewhat paltry. But when you consider that the Gulf markets, along with China, were supposed to remain one of the few places globally left unscathed by the US financial crisis, the situation takes on a somewhat different perspective. Granted, the credit crisis in the Gulf, particularly in the UAE, is largely of its own making. In its latest report, issued on 16 October, Standard Charter points out that much like the situation in the US in the late 1990s and early 2000s, the combination of low interest rates and high liquidity led to rampant speculation in property markets. Prospective investors took on highly leveraged positions in order to flip properties, which in turn led to asset inflation. This should sound very familiar to US readers. And, like the current situation in the US, we should expect to see heavy government intervention to bail out local markets. Most national governments in the Gulf continue to enjoy very deep pockets thanks to a seven year bull run in commodity markets. Standard Charter estimates that despite OPEC's worry over the current trajectory of oil prices, the break even price for the Gulf oil producers is in the $45-$55/barrel range.

Still, any slowdown in the Gulf adds additional wrinkles that should be considered: first, the Gulf economies have been fueling growth in the construction industry with their vast development projects. A slowdown there, particularly if coupled with a slowdown in Asia, will mean even more widespread pain for construction and infrastructure developers. Second, Gulf growth has fueled expansion in the Middle East and parts of Africa through robust foreign investment flows. Even Egypt, considered to be among the most promising emerging markets in North Africa, is largely beholden to Gulf investors. Lastly, what becomes of sovereign wealth funds in the face of a Gulf slowdown? The Gulf Research Center, a UAE-based think tank, estimated on 15 October that Gulf sovereign wealth funds have been more exposed to the financial turmoil in US markets than local banks despite SAMA's recent denial of having suffered any loses as a result of the US downturn. This may mean an even further tightening of liquidity globally if one considers that the Gulf funds have been of one the last bastions of easy money.

All in all, not a pretty picture.