What the eye can't see is the Gulf's big worry

Europe's debt woes are hindering growth prospects worldwide, but for the Gulf region it is the indirect consequences of the crisis that pose the biggest challenge.

It is the indirect consequences of the euro-zone crisis for the Gulf countries that are potentially the most worrying. Hannelore Foerster / Bloomberg News

Overshadowing all global and regional issues is the euro zone's sovereign-debt crisis.

Global growth prospects are being hindered by the lack of resolution of this issue, and financial markets the world over are reflecting the increase in anxiety and in risk-aversion.

Somewhat surprisingly, the GCC appears to be bucking some of these trends, with regional growth prospects for this year looking quite good and consensus forecasts at the start of the year likely to be subject to upward revisions.

A further deterioration in the euro zone, with a possible break-up of the single currency, would be much harder to ignore, however, as it could have consequences for the region through a series of linkages. In particular, the Gulf could be affected through trade flows, financial market linkages as well as through the broader impact on global activity, which in turn could hurt regional sentiment.

Of these, the financial linkages are perhaps the most worrisome, as their consequences could be among the most severe, but the precise connections remain difficult to identify and to quantify.

The Lehman-triggered banking crisis of 2008 certainly taught us that these connections should not be underestimated, however. The risk to the GCC may be less about direct linkages and more about indirect ones.

GCC exposure to the euro zone is quite small, while euro-zone financial institutions are already reducing their assets to meet new capital requirements, a process that would likely accelerate if the sovereign-debt crisis worsened.

Most of this deleveraging will probably take place through reducing domestic assets, but foreign assets will not be immune, especially foreign assets that are not considered central to an institution's core activities.

While most of the European exposure to the region comes from British banks rather than from euro-zone ones directly, it is likely that the United Kingdom's banking system would also undergo significant deleveraging in coming years as it is itself heavily exposed to the euro zone.

The withdrawal of European banks from the region would also leave local institutions having to pick up the credit not renewed by European entities, which could in turn crowd out the credit available for new businesses.

In fact a structural shock to the euro zone, and to its financial system, could lead to a continuing drying up of available credit to the GCC from European banks and financial institutions as they enter a period of substantial deleveraging that could last for a number of years.

Furthermore, as we saw during the Lehman crisis, as liquidity in global markets dries up, access to funding by regional financial institutions is likely to become more challenging.

Although regional banks are probably less dependent on foreign-bank borrowing than they were immediately after the global banking crisis began, the likely freezing up of the interbank market could lead some regional banks to have to seek funding elsewhere, or at least to pay a premium to receive it.

Credit default swap spreads would almost certainly rise in unison, at least until the markets gain a clear picture of the genuine credit market landscape.

The transmission of the economic downturn in the euro zone into to the Gulf would come primarily through trade flows.

Again, on the surface, the direct impact of these may actually be quite limited, as the euro zone accounts for a relatively small share of the region's trade flows. For instance, for the UAE, which is the most open economy in the region, the euro zone accounted for just 10 per cent of trade values last year and less than 6 per cent of trade volumes.

For the region as whole, the picture is broadly similar, and represents a sizeable decline in Europe's importance as a trade partner from 30 years ago, when the figure was closer to 30 per cent.

However, it is in the realm of indirect linkages where the euro-zone crisis could again bite.

India and China have risen in importance as regional trade partners in recent years, with the Asia-Pacific region collectively accounting for about half of the UAE's trade values last year.

Clearly, the deepening sovereign-debt crisis in Europe would impair the growth of these countries as well, which would potentially dampen demand for the region's exports to these key markets.

To the extent that the US dollar strengthens further as well, driven by haven flows and risk aversion, this would further hinder GCC exports around the world, while making regional imports cheaper, which could at least cause inflation to fall.

As we can see, in terms of the two major transmission mechanisms by which a euro-zone crisis could affect the Gulf, financial and economic, it is the indirect consequences that are potentially the most worrying, leaving the exact impact harder to quantify and to measure.

It is precisely because of this that the euro zone represents the biggest challenge to the region, in common with the threat it poses to the rest of the world.

Tim Fox is the group head of research and the chief economist at Emirates NBD. He writes here in a personal capacity