Dr. Henry Tawfiq Azzam

The Economic Risks associated with the US mortgage crisis recently subsided when the US Federal Reserve lowered the federal funds rate by 50 basis points. But the impact of this crisis on global financial markets will remain visible during the coming weeks and months. The crisis that began in the US soon turned into a financial crisis threatening most global markets. Housing loans were converted to collateralized debt obligations and sold to investment institutions in Europe, South America and other parts of the world. This caused these institutions to incur different losses and get exposed to the risks associated with these debts.

Arab Financial Institutions

Arab equity markets have remained immune from what is happening in the global markets, and during the past few weeks have witnessed semi-natural fluctuations. The reason is that the majority of the players in these markets are individual investors who do not have a notable presence in the global arena, in addition to the lack of coherence between the Arab and international markets.

The vulnerability of Arab Banks to the US subprime mortgage crisis and its financial instruments is limited. Most Arab banks invest little in such tools. But, investors from banks, institutions and global companies, who invested in real estate covered bonds or in hedge funds that are invested in real estate covered bonds that were directly affected by the current financial crisis, would incur losses in the amount of their holdings of such assets.

According to a recent "Standard & Poor’s" opinion poll, the total investments of the [Arab] regional banks in the real estate mortgage bonds with low credit ratings do not exceed 1% of the total assets of these banks, since the majority of their investments are focused on financial instruments and derivatives with a good credit rating of (AAA) or (AA). In general, the good financial performance of Arab banks in recent years and their strong capital base and high profitability would enable these banks to absorb any losses that they might be exposed to, due to this crisis.

Debt Securities and Sukuk

One of the crisis’ negative impacts is the postponement in issuing and marketing debt securities or sukuk (Islamic bonds) issued in the region or re-pricing these bonds in a way that reflects a decline in the liquidity in the market and weakness in the domestic and global demand of these borrowing tools. The contraction that was recorded in the margin of difference between the interest rate on bonds issued by developing countries and their companies compared with the interest rates on debt instruments issued by developed nations is expected to increase again to match the rising risks' rate that the markets have recently experienced. It is worth mentioning that the interest rates on debt instruments issued by developed nations had reached its lowest level before the current crisis.

Financing Merger and Acquisition Deals

Direct investment companies operating in the (Arab) region are less dependent on borrowing for their mergers and acquisitions’ operations compared with those in developed countries. But these firms have recently experienced a difficulty or a rise in the costs of financing new acquisition deals. The process of reducing the excessive reliance on borrowing to finance mergers and acquisitions would also have its impact on the domestic markets. Arab Banks are now more cautious and selective in providing the required funds for direct investment firms.

This means that deals of mergers and acquisitions that rely excessively on borrowing from local or regional sources might be re-priced or canceled, and there will be more focus on deals that can be financed in large part from cash flow of the targeted companies and from the bridge loans that the banks offer. More direct investment funds will refer to investment banks that can provide sophisticated Islamic lending structures to finance these acquisitions.

Investments in Arab Markets

The fluctuations that are taking place in the international capital markets will have some impact on Arab bourses, especially equity markets, which allow global portfolios to invest in them. In periods of crisis, investors tend to reduce risk and shift from emerging markets to more liquid and safer investments such as government bonds. In spite of the small volume of the global flows of investment portfolios to Arab domestic markets, they did eventually contribute in determining the orientation of the Arab bourses. It is noteworthy that the largest regional equity markets in terms of market value, namely the Saudi equity market, only allows foreigners to hold shares indriectly, through investment funds managed by local banks [Saudi Arabia has recently lifted remaining restrictions on share trading by Gulf Arab citizens, as nationals of Kuwait, the UAE, Qatar, Oman and Bahrain can now trade in all Saudi stocks]; while the UAE, Kuwait, Egypt, Qatar and Jordan markets are experiencing a rising increase in the volume of foreign investments in their bourses.

The global hedge funds, which have recently become more active in the Arab equity markets, have sold part of their holdings in these markets in an attempt to support their financial performance and provide the needed liquidity. Furthermore, the region's equity markets were negatively affected by the decline in acquisitions by the listed companies with the rise in borrowing costs for the implementation of such operations.

Economic Slowdown

The biggest risk that may arise from the current financial crisis is the possibility of a global economic slowdown. The monetary policy makers of the regional countries would feel obligated to keep up the expansionary monetary policy that the US had recently pursued. This would lead to a decline in domestic interest rates and exchange rates of the dollar-pegged Arab currencies and would increase the inflationary pressures that have recently emerged in a number of countries in the region.

The Way Forward

In conclusion, it can be emphasized again that the current crisis in the global financial markets is not expected to have any notable effect on the regional financial markets, but its impact will be greater in the event that it would turn from a financial crisis to an economic crisis. Even if there is to be a slowdown in global economic growth, oil prices are not expected to drop to below $60 a barrel from their current record peak. This means that the economic performance of the GCC countries, which serves as the main engine of the economies of other regional countries, would remain strongly backed by an expansionary fiscal and monetary policy. Add to this the implementation of many projects in infrastructure, and growth and expansion occurring in the private sector by the regional countries.

al-Khaleej, UAE, September 25, 2007. The article originally appeared in Arabic, and excerpts from the article were translated by the staff of www.memrieconomicblog.org.