It now appears that the Gulf, in the face of all the predictions to the contrary, might now be in the throes of a full-fledged credit crunch. With bond yields rising and interbank rates rising, a policy response may be in order to prevent banks from being forced to call in real estate loans and puncture the housing bubble. One response may be to jawbone up regional currencies. Simply opining on the wisdom of ditching the peg seems enough to reopen the hot money taps. Lowering deposit reserve requirements might be another. The first question that needs to be asked is whether or not this is a credit crunch or a welcome tightening that could help cool money supply growth and inflation. The danger here is that limits on real-estate lending will force banks to reel in credit to the property market as their asset base shrinks. Any borrower without adequate cash on hand might be forced to start liquidating or, worse, default. The market will now be scouring the landscape for any borrowers who look highly over-leveraged or highly over-exposed to property. Exacerbating matters are ongoing efforts to cool property speculation, particularly Dubai's announcement that it will try to restrict flipping of property. Keeping an eye on the stocks of any property developers, banks or anyone else with lots of real estate on their books might be in order. Property analysts say regional investors are highly over-exposed to real estate, so any jitters in the property market may have wide repercussions, eliciting an immediate and dramatic government response. Luckily, the deluge of petrodollars leaves governments with an ample stock of liquidity to provide should things go wrong. The trick will be the mechanism by which they unlock it. Oil revenues are accumulated by government-owned corporations, not central banks. With hot money dissipating, central banks might have fewer reserves with which to combat a liquidity crunch. It seems highly doubtful that the outflow of hot money could grow so severe as to create any balance of payments pressure, however. If a credit crunch does unfold, it could follow a pattern roughly similar to what we saw in the US and Asia last August. Hedge funds, high-risk borrowers, and new loans made that have yet to build much equity will be the first to falter, creating a wave of sell-offs across broad and unrelated asset classes. Subprime borrowers will default. The resulting pressure on banks' balance sheets could create a liquidity crunch in which banks are reluctant to lend to each other and interbank rates spike even higher. Tighter credit and falling asset prices would then reverberate into healthy borrowers' balance sheets, causing waves of defaults and an economic slowdown. In the US, mortgage defaults are continuing to rise, putting further pressure on proerty prices and doubtless forcing down the value of the US real estate holdings of Middle Eastern investors, most of which are likely SWFs. Key differences in the Gulf could be that rates aren't climbing enough to actually put pressure on cash-rich borrowers. Even if it does, this will put to the test the theory that investors here are not highly leveraged. If they aren't, they will pay the higher rates and life will move on, with markets simply adjusting to the higher cost of funding. Also, fewer of Gulf properties are securitised, meaning the risks will be more localized, with severe pain for those in trouble, but without the same kind of blast range as the US subprime crisis. Keep in mind that many local investments are made in cash, with no leverage at all. On the other hand, many foreign borrowers are leveraged up to 97% on their purchases, even borrowing their down-payment money. If a divergence develops and foreign borrowers are hit more than domestic borrowers, it will be interesting to see if the government responds very aggressively to protect banks and domestic property investment values from defaults by foreigners. It will also be interesting to see how rapidly banks are able to foreclose in the local legal environment - a key to the rapid unwinding of the US crisis and, eventually, its more rapid recovery. Yet Gulf investors will undoubtedly be put under pressure by what some economists are saying is a looming recession in developed markets. This will bite the value of their overseas holdings, and could curb oil demand, pinching the region's lifeblood. Nouriel Roubini, the economist who predicted the housing downturn, is now predicting that the recession in G7 economies will result in a sharp slowdown in emerging markets.