middle east @ risk

19
COMMITTED TO IMPROVING THE STATE OF THE WORLD Middle East@Risk A Global Risk Network Briefing in collaboration with the Gulf Research Center

Upload: worldeconomicforumdavos

Post on 18-Nov-2014

1.275 views

Category:

Technology


0 download

DESCRIPTION

 

TRANSCRIPT

Page 1: Middle East @ Risk

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Middle East@Risk

A Global RiskNetwork Briefing

in collaboration with the Gulf Research Center

Page 2: Middle East @ Risk

This work was prepared by the Global RiskNetwork of the World Economic Forum and theGulf Research Center

The views expressed in this publication do notnecessarily reflect the views of the

World Economic Forum.

World Economic Forum91-93 route de la CapiteCH-1223 Cologny/GenevaSwitzerlandTel.: +41 (0)22 869 1212Fax: +41 (0)22 786 2744E-mail: [email protected]

©2007 World Economic ForumAll rights reserved.No part of this publication may be reproduced or transmittedin any form or by any means, including photocopying andrecording, or by any information storage and retrieval system.

REF: 100507

Page 3: Middle East @ Risk

Foreword

Introduction: The Global Risk Outlook for the Middle East

Executive Summary: Global Asset Price Collapse

Executive Summary: Chinese Economic Hard Landing

Executive Summary: Retrenchment from Globalization

Executive Summary: Geopolitical and Geostrategic Instability

4

5

8

10

12

14

Contents

3

Page 4: Middle East @ Risk

This briefing, in collaboration with the Gulf Research Center,builds on the global work undertaken by the Global RiskNetwork of the World Economic Forum.

The Global Risk Network (GRN) is an unparalleled network ofindustry, risk and regional experts working with businessleaders and policy-makers to:• Create a framework for assessing and prioritizing existing

and emerging risks to global businesses over the shortand long term

• Alert key decision-makers to the impact these risks mayhave on their environments

• Assist leaders in their reflection on how risks may bemitigated at the global, regional, industry and companylevels

• Transform these global risks into opportunities

The GRN was set up in 2004 in response to concern over therapidly changing nature of the global risk landscape, with sixdefining features raising particular concern in the business andpolicy environment.

• Interconnectedness: Opportunities for contagion of riskacross geographies and categories make them harder tomanage, and their consequences harder to predict. Risksthat occur in discrete geographies and with well-knownproximate causes – such as Hurricane Katrina – cancause unpredictable results elsewhere.

• Asymmetry: Partly as a result of contagion, apparently smallevents can have increasingly disproportionate effects. Thisis particularly true of geopolitical risk.

• Time compression: Some risks can develop within thedecision cycle of decision-makers. The secondary impactsof financial or geopolitical crises can begin to take effectbefore businesses and governments have adequatelyresponded to the initial risk event, allowing a limited crisisto expand into a systemic one. Just-in-time processescan leave little built-in resilience.

• Risk extension: Other risks are perceived tooccur outside the decision cycle of decision-makers, giving rise to the “NIMTOF” (Not-in-My-Term-of-Office) phenomenon, where mitigationcosts are immediate and known, and mitigationbenefits are long term and/or unclear. Climatechange is a prime example of an extended risk.

• Noise: The profile of an emerging risk is rarelyclear before it occurs, with salient indicatorshidden by surrounding “noise”.

• Rise of “infodemics”: The rapid and uncontrolledspread of information – including inaccurateinformation from new, unreliable and uncontrollablesources – can skew responses, generatinginformation-driven impacts greater than those ofthe primary risk event.

At the global level, the Global Risk Network hasidentified some 23 global risks to the internationalcommunity over the next 10 years. It has advancedthinking on how to conceptualize their interaction andhow to design strategies to mitigate them includingthe “5i” framework. The Global Risks 2007 report,released at the Annual Meeting 2007 in Davos, andother publications by the Global Risk Network, areavailable at www.weforum.org/en/initiatives/globalrisk.

It is a central tenet of the work conducted by the Global RiskNetwork and its partners that global risks do not manifestthemselves in isolation. This was apparent when the dominoeffects of Hurricane Katrina briefly shook the global system.More recently, the connections between two of the mostpressing global issues for public policy and private enterprise– energy security and climate change – have reinforced thesense that many global risks share a common lineage. Thecorrelation matrix below, drawn from the Global Risks 2007report, shows expert views on correlation between a limitedlist of 23 core global risks.

At the regional level, the Global Risk Network has undertakenwork on regional risk exposures for World Economic Forummeetings in Turkey, India and Latin America. The purpose of thiswork has not been to create a final list of top risks for any region,but to draw together an understanding of global risks with theirimpacts at the regional level, building up a wider picture ofglobal interdependence and a broader case for multistakeholderthinking and action to manage and mitigate global risk.

4

Foreword

Our definition: non-business risks that affectbusiness (i.e. not operational, project orfinancial risk)

• that can be strategic, exogenous and systemic

• that are highly interdependent (i.e. do not manifestin isolation)

• that are characterized by uncertainty, sharpdiscontinuities, non-linearity (power law distributions)and lack of proportionality

• that can’t be predicted (but can be managed)

What Are Global Risks?

Retrenchment from globalization

Asset prices/ excessive indebtedness

Current account deficit/ Fall in US$

Climate change

Spread of liability regimes

Developing world disease(HIV/AIDS, TB, malaria)

Loss of freshwater services

Failed and failing states

Proliferation of WMD

International terrorism

Oil price shock

Comingfiscal crises

NatCat:Tropical storms

NatCat: Earthquakes

NatCat: Inland flooding

Emergence of nanotech risks

Middle East instability

China economichard landing

Transnational crimeand corruption

Breakdown of CII

Chronic disease indeveloped countries

Pandemics

Interstate and civil wars

Key:STRONGER CORRELATION

The Correlation Matrix

Source: World Economic Forum Global Risks 2007

Page 5: Middle East @ Risk

5

The Middle East is a focal point for global risk and itsmitigation. This is particularly clear with geopolitical risk – witha high concentration of destabilizing geopolitical events havingtheir origin in the wider Middle East region. But it is also trueof two of the great intersecting global risks of the early 21stcentury – energy security and climate change – and of therisks relating to global economic imbalances: Middle Easternexternal surpluses far exceed those of China.

Some Middle Eastern economies (particularly those of theGulf region) are heavily integrated into global trade andfinancial flows. Others, often the largest economies in theMiddle East, have not yet overcome the dominance of thestate sector and remain relatively unattractive to foreigninvestment. The vulnerabilities of these different economies –and of different political structures, geographies and religiouscompositions across the region – inevitably mean that globalrisks will play out differently.

However, the Middle East shares a number of global risks,and a number of solutions to those global risks. The region isinterconnected by webs of investment, of geopolitics ofreligious affiliation – as well as physical infrastructure ofpipelines for oil and sources of water, an increasingly preciousresource. Many of the possible mitigation measures to dealwith the consequences of global risks stem from within theregion. Indeed, many of the mitigation measures can only bemanaged and controlled by acting in frameworks of regionalcooperation.

This briefing does two things. First, it provides a brief overviewof a range of 9 of the most salient of the 23 global risksextracted from Global Risks 2007, and outlines major trendsas well as the impact on the Middle East region. Second, itprovides a deep dive into four areas identified as being ofparticular interest: a global asset price collapse, a Chineseeconomic hard landing, retrenchment from globalization, andwider geopolitical and geostrategic instability in the MiddleEast. The intention is not to provide a prioritization of risks tothe Middle East, but to highlight some of the commonchoices that the region faces and the common risks toprosperity and security, from the future of freshwater servicesto the future of the Middle Eastern currencies’ peg to thedollar.

Raising awareness of common risks raises the bar for sharedresponsibility for action and opportunities that will derive fromtimely, proactive policies to prevent global risks overwhelmingthe Middle East region.

Introduction: The Global Risk Outlookfor the Middle East

Page 6: Middle East @ Risk

6

Oil priceshock/energysupplyinterruptions

US currentaccountdeficit/fall inUS$

Chineseeconomic hardlanding

Blow up inasset prices

Climatechange

In the short term, ahydrocarbon price spikecaused by geopoliticaltension or terrorism –disruption to secureenergy supply.

In the longer term, aplateau of highhydrocarbon prices asthe supply of productsfails to keep up withdemand, particularlyfrom emerging markets– unsustainability ofsecure energy supply.

Unsustainability of theUS current accountdeficit, triggering amajor fall in the USdollar, with impactsthroughout the financialsystem.

Sharp slowdown ofChina’s economy –potentially as a result ofprotectionism, internalpolitical or economicdifficulties.

Collapse in houseprices (e.g. in US andsouthern Europe) andother asset pricescausing recession, withcontagious effectsglobally.

Increased temperaturesaround the globe, withimpacts on rainfallpatterns.

Increasing frequency ofextreme weather eventsfrom man-made climatechange with severeimpacts on criticalinfrastructure,

Rapidly expanding demand, 80% driven byBRICS; fears that underinvestment incapacity (in the Middle East and elsewhere)will mean production shortfall.

In gas, discussions of a possible producers’agreement – including Iran, Russia and Qatar– remains complicated by internal differencesand existing bilateral supply agreements.

Increasing concentration of hydrocarbonresources driving geopolitical attempts to“lock in” future supplies.

Debate over possible “peak oil”, includingsome doubts about official Middle Easternreserves.

Growing awareness of anthropogenic climatechange.

Models of future oil demand are subject tomajor uncertainties around China, including apossible decision to invest in nuclear poweror coal-fired generation or any mandatedimprovement in vehicle emissions standards.

Any movements towards effectivehydrocarbon substitutes for transport.

Global picture of high US current accountdeficit sustained by Asian savings andMiddle Eastern petrodollars.

US dollar remaining the global reservecurrency; other currencies (e.g. the euro)playing an increased portfolio role or evenacting as denominating currency for somecommodities.

Debate around the long-term sustainability ofChina’s current growth given infrastructureconstraints, environmental concerns andpolitical risk.

Evidence of some backlash against Chineseexports (in the form of anti-dumping duties);concerns about the stability of the Chinesefinancial system and the extent of potentialdefaults.

A correction in house prices is underway inthe US, and in some European markets;questions over particularities of the USmarket compared to other markets. The rateof a US slowdown, and its wider globalconsequences are not yet known.

Financial market volatility remains low andrisk appetites high, despite minor correctionin February 2007, but market complacencymay not last the year.

Consensus around climate change movingto a debate around impacts, possiblemitigation or adaptation measures.

Success or failure in involving major futureemitters in any future post-Kyoto agreementover the next few years will likely determinethe overall emissions pathway, and thus theextent of climate change.

Any short-term supply disruption –for example as the result of aterrorist attack – would underminethe economic foundations of currenteconomic growth in the Middle East.

Excess capacity needed to manageoil prices is low, and the resurgenceof non-OPEC supply has led to someto question the ability of Middle Eastoil producers to achieve price targets.

The growing concentration of future oiland gas supplies in the Middle Easthas strengthened NOCs comparedto IOCs and may lead to reneweddownstream NOC investments.

But, in the long term, concentrationof hydrocarbon resources in theMiddle East may hasten the end ofthe oil era, as major Westerncountries cite geopolitical concerns.“The oil age will end long before theworld runs out of oil.”

Whether prices remain high or eventuallyfall back, economic diversificationmust remain a top priority.

Many Middle Eastern currencies arepegged to the US dollar and MiddleEastern investments are held indollar-denominated assets. A sharpdecline would import inflation, lead toquestions about long-term viability ofpegging to the dollar anddenomination of oil prices in dollars.

See deep dive on Chineseeconomic hard landing below.

See deep dive on global asset pricecollapse below.

Besides indirect effects of reducedGross World Product as a result ofunmitigated climate change, thechief indirect impacts from climatechange come from potentialchanges in rainfall patterns and theoverall rise in temperatures expectedacross the region.

Risk Description Trends to watch Impact on the Middle East

Middle East@Risk Matrix

Page 7: Middle East @ Risk

7

Loss offreshwaterservices

Internationalterrorism

Proliferationof weapons ofmassdestruction

Retrenchmentfromglobalization

agricultural yields andhuman lives.

Growing penury offreshwater supplies,partly as a result ofclimate change, partlyas a result of increasingburden of overuse.

Acts of terrorism (bothinternationally organizedand inspired, and local)with the capacity tocause extensivephysical damage,spread terror andundermine socialcohesion.

Proliferation of weaponsof mass destructionand the likelihood oftheir use, inviting majorretaliation, furtheringglobal insecurity andthreateningglobalization.

A two-way risk: aprotectionist impulse indeveloped countriesand rising nationalism indeveloping countries(and evidence of globalinequality), driving bothto attempt to slow orreverse globalization.

Leading indicators of the impacts of climatechange in most affected regions, causingpopulation movements, tension withincountries and between countries.

Any movements towards effectivehydrocarbon substitutes for transport.

The two main factors affecting future waterscarcity in the Middle East are water use,and patterns of supply. Without greater publicaccountability, and without moves toreallocate water supplies, demand will increaseas populations expand. If climate changepatterns accelerate, freshwater servicesupplies are likely to become more erratic.

MENA countries are already using morewater than they receive each year; growingawareness of the need to managefreshwater throughout the cycle, as opposedto managing discrete portions of supply.

In addition to the spread of the Al Qaeda“franchise” – including to North Africa – thereare fears Al Qaeda may be regainingorganizational strength. This would imply theability to carry out attacks beyond thosewhich are locally planned and executed.

Iraq has become a major recruiting andtraining ground for international terrorism;should the situation continue to deteriorateits role in international terrorism will mostlikely increase.

Key short-term issue: the management ofIran’s alleged attempt to build a nucleardevice.

Key long-term issues: future of the NuclearNon-Proliferation Treaty, expansion of theProliferation Security Initiative, prevention ofweapons’ capacity while allowing spread ofnuclear power.

Failure to achieve agreement in discussionson world trade; growth of bilateral tradeagreements.

Increasing use of anti-dumping measures inthe developed world; spread of nationalizationsin key industries in developing countries.

Rise of political populism in both thedeveloped and developing world.

Agriculture in the Middle East islikely to become increasinglymarginal; some inland regions maybe no longer habitable; overall costsof living and doing business arelikely to be increased withadaptation no longer a viable option.

Climate change may encourage useof hydrocarbon substitutes,undermining the Middle East’s mostvaluable export.

World Bank suggests wateravailable per person in the MENAregion could fall by half by 2050.

The Middle East is well experiencedin managing water scarcity, butincreased penury is likely to divertdevelopment funds to desalinizationand water transport schemes, andpromote geopolitical conflictbetween headwater and tributarycountries.

The Middle East region suffers frominternational terrorism on multiplelevels: as a direct victim of attacks,as a perceived centre of instability(reducing foreign investmentappetites) and as a perceivedsource of terrorism in terms ofpersonnel, training and ideologicalbackground (reducing opportunitiesfor knowledge transfer and personnelexchange with Western countries).

A number of Middle East regimesare specific targets of Al Qaeda asthe “near enemy”.

Iran is several years away frombeing able to test a nuclear device,and denies that this is the purposeof enrichment. However, shouldinternational and regional pressurefail to bring greater transparency toIran’s nuclear programme, severalMiddle Eastern countries will feelcompelled to develop contingencyplans, including boosting domesticunderstanding of nuclear technologies.

The wider impact on the regionwould be disastrous, removing theprospect of a nuclear-free MiddleEast, potentially pushing Israel todeclare nuclear status, and requiringmassive funding which wouldotherwise have been spent oneconomic and social reform.

See deep dive on retrenchmentfrom globalization below.

Risk Description Trends to watch Impact on the Middle East

continued

Page 8: Middle East @ Risk

8

Executive Summary:Global Asset Price Collapse

Will oil savings evaporate? How would an ensuing economic slowdown affect the economies of the Middle East?

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Middle East@Risk

Risk

Important Trends

As the Global Risks 2007 report suggested, the financial markets are complacent as regards risk levels.Despite turbulence in the financial markets in February 2007, investors’ appetite for risk remains relatively high,volatility remains historically low, and market expectations seem to point to a benign economic scenario.Global market liquidity, including investments from Middle Eastern countries enjoying financial surpluses, maybe one reason why investors remain confident. But risk factors around global asset prices and potential risksfor the Middle East in particular cannot be ignored. In any future collapse, central bank capacity, diversificationand the future of the US dollar will be key questions.

Prices for real estate, stocks, commodities and gold are all at, or near, historic highs, while global interestrates are low and bond markets are doing well. Historic correlations (such as those between high oil pricesand falling equities, or high gold prices and inflationary pressures, rising interest rates, and lower bond andreal estate prices) have weakened. There are two possible explanations: the market has fundamentallychanged in nature, or many market participants have misread it.

Many of these high asset prices have been financed by unprecedented levels of debt. Total US debt(US$ 48 trillion) is 460% of national income, compared to 186% in 1957. Corresponding debt chains areglobal in nature and sometimes unregulated (e.g. OTC derivatives). Cracks in these chains thus have thepotential to spread across countries and regions, leading to major demand slumps and supply surges ofsecurities via distressed selling, ergo asset devaluations.

Any asset devaluation would have major effects on the real global economy, as borrowing against highasset prices and low interest rates has been a motor for consumption in recent years (e.g. US consumerstaking out loans on their ever-rising house prices). Were an asset price devaluation to lead to a majorcontraction in consumption, the expected scenario of smooth economic growth would be sharply disrupted.

In the 1990s low oil prices meant that many Middle Eastern countries became net importers of capital.Higher oil prices in recent years have radically reversed the situation. The combined 2006 current accountof the Gulf Cooperation Council (GCC) countries (US$ 176 billion) rivalled that of China, and isconsiderably greater as a share of GDP. Medium-term prospects for oil prices suggest external surpluses– at least of hydrocarbon-exporting Middle Eastern economies – will remain high.

Foreign assets of GCC countries have risen to US$ 1.1 trillion, without taking into account individuals withhigh net worth. The role of some Middle Eastern economies in maintaining global imbalances and the UStwin deficit is less well understood than that of China because a share of external surpluses are not heldas official reserves, and buying patterns are more complicated. Sovereign wealth funds such as theinvestment authorities of Abu Dhabi and Kuwait are major asset holders; with the exception of SaudiArabia (Sama) central banks play a smaller role.

There are attempts at diversification. In currency terms, 65-70% of assets remain dollar-denominated,though the euro has retained some ground. In asset class terms, alternative investments such as privateequity, hedge funds and structured bonds play a major role. This differs both from the dominance of depositsin Western banks during the previous 1970s windfall and from China’s investment directly in US treasuries.

Investments in Asia attract considerable media attention, but lag behind growth in trade. Asian currenciespegged to the dollar, as are many leading Middle Eastern currencies, have not become meaningful reservecurrencies. Over 80% of petrodollar recycling continues to be directed to Western markets.

Some Middle Eastern countries, particularly in the Gulf region, have seen increasing diversification of theireconomic structure and a local investment boom pushing up prices for equities and real estate. In 2006, keyGCC stock markets collapsed and real estate markets of the UAE and Qatar raised concerns ofoverheating. But in both boom and bust, GCC markets have not been meaningfully correlated with otheremerging markets.

Page 9: Middle East @ Risk

9

Consequences

Mitigation

Examples

The primary consequences of any sharp decline in US asset prices would be felt in slowing USconsumption and growth. The secondary consequences would be on Asian exporters and, to a lesserdegree, European economies. The rate of any slowdown would determine its contagion. Faltering demandwould depress oil prices unless supply is further constrained by (a) OPEC management resulting fromregained spare capacity, (b) geopolitical unrest or (c) accelerated depletion of “peak oil” regions of the US,North Sea, China (Daqing) and Mexico (Cantarell).

Dollar-based foreign assets of Middle Eastern countries would fall in value. The asset/liability plans of thesovereign wealth funds and social projects they are designed to fund (e.g. infrastructure, pensionschemes) would be in jeopardy. Economic diversification strategies for the post-oil age would be put onhold as oil savings evaporate. Across the Middle East a window of opportunity to reform state-centriceconomies would close.

The dollar would fall and domestic interest rates rise. In one scenario the dollar could lose its position asa global reserve currency. Middle Eastern countries pegged to the dollar would import inflation, leading tofurther upward adjustment of interest rates and limiting investment. Some countries might considermoving towards a flexible exchange rate regime.

Domestic markets would fall, but the direct spillover from financial markets outside the Middle East wouldbe limited by regulatory barriers which would leave domestic markets only partially open. Contagion wouldbe mostly limited to stock markets, but, as Gulf bonds and sukuks have become more popular withforeign investors, there might also be some contagion in nascent bond markets.

Demand for alternative Middle Eastern exports such as aluminium (GCC countries project 10% of worldproduction by 2010) and tourism would be hit. Cyclical industries such as the construction industry wouldenter sharp decline.

Finally, any broad economic slowdown could stoke considerable social tensions, particularly in countrieswith high youth unemployment such as Saudi Arabia and Bahrain. Questions of inter-generational equitycould become more acute, and political divisions would inevitably be sharpened.

Given the relatively small size of Middle Eastern economies, their dependence on dollars and themagnitude of global economic imbalances, effective policy options are limited.

Controlled diversification of currency reserves from dollars to euros, sterling and gold, an increased cashreserve and increased holdings in blue-chip equities are less likely to be affected.

Revaluation of local currencies, pegging them to a more diversified trade-weighted currency basket. Thismight evolve to a managed float, enhancing the means for Middle Eastern countries to conductindependent monetary policies, but requiring considerable improvements in the administrative capacity ofMiddle Eastern central banks.

Use of any regained OPEC spare capacity to attempt to manage oil prices in the long term in the OPECtarget range, considerably higher than during the 1990s but below current levels.

Avoidance of overtly leveraged investment positions in local stock and real estate markets by imposingstrict lending ceilings. Enhancement of transparency of domestic credit markets by the establishment ofcredit bureaus and improved corporate governance in banks.

Discussions of alternative currency schemes and asset diversification have begun in some Middle Easterncountries.

OPEC successfully implemented production cuts during the recent oil price declines from US$ 78 (WestTexas Intermediate) to US$ 50, pushing prices back above US$ 60.

Several Middle Eastern countries have curbed lending after recent stock market declines, are working oncorporate governance codes and are expanding the capacity of regulatory authorities.

Page 10: Middle East @ Risk

10

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Executive Summary:Chinese Economic Hard Landing

Could a Chinese demand slump bring oil prices down? How would a Chinese economic hard landing affect the Middle East?

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Middle East@Risk

Risk

Important Trends

China’s economic growth over the last decade has exceeded that of any other major economy, rangingfrom 7.6% to 10.7%. Its cheap exports have contributed to the moderation of global inflation, while itsgrowth and that of other BRIC economies constitute two-thirds of incremental demand for oil.

China’s long boom has been spurred by high liquidity, low interest rates and high consumption in the USand elsewhere. Domestic overinvestment, a slump in global demand, social unrest or a major geopoliticalupset could undo the current positive outlook for the Chinese economy with major implications for theworld economy and for global oil demand.

The share of exports as a proportion of the Chinese economy is a cause for concern, jumping from 20%in the period 1996-1999 to 34% in 2004, and now approximately 40% with growth unsustainably high.

Net exports represent 7% of GDP, but much of China’s imports are capital goods from other Asian NICs(newly industrialized countries) and Japan, which are used to manufacture goods for the US and otherWestern export markets. Moreover, the rising middle class, and the domestic demand they generate,depends ultimately on the export sector. US deficit spending drives the Chinese economy.

Despite the extraordinary achievements of China’s economy in reducing global poverty, inequality remainshigh, both between social groups and between rural and urban geographies. Consumption is only equalto 54% of GDP.

China’s current account surplus totals US$ 238 billion and its central bank holds foreign reserves ofUS$ 1.2 trillion, of which 70-75% are dollar-denominated, acting as a major support to the US twindeficits.

The bad loan problem has been subdued since a government bail-out in 2003/2004, but could re-emergeshould the export-led economic model falter.

The US Energy Information Administration (EIA) expects Chinese oil consumption to triple between 2003and 2030. Satisfying this future demand will put pressure on Gulf suppliers, not least as Europe and theUS become increasingly dependent on Middle Eastern supply.

Some Gulf countries are already investing in refining capacity in China and South Korea and assisting instrategic storage solutions for crude oil.

Gulf countries are venturing beyond the oil sector, purchasing stakes in Chinese banks, containerterminals and real estate, though Chinese capital markets do not yet constitute a major alternative forpetrodollar recycling. In turn, Chinese investments in the Middle East include oil production in Syria, theDragon Mall in Dubai (showcasing Chinese manufacturing goods), natural gas and planned aluminiumprojects in Saudi Arabia.

China’s economic growth over a quarter of a century has shifted global patterns of production andconsumption, altered the relative strength of labour and capital, and driven a super-cycle boom in theprices of commodities, including oil. But China’s economic success includes a number of warning signals– from the existence of bad loans to overinvestment and stock market volatility. China has made itself acrucial part of the Middle East’s economic future – as a market for Middle Eastern products including oil,as competition to Middle Eastern manufacturers, as a limited investor in the Middle East, and as a sourceof imports of consumer goods. A Chinese economic hard landing could have unpredictable consequences.

Page 11: Middle East @ Risk

11

Consequences

Mitigation

Examples

Should demand in oil slump, oil prices couldfall. However, the fall in demand required todepress oil prices, given current supplyconstraints, would have to be sharp.

Upstream investments to enhance productionand refining capacity could be put on hold. Inthe long term, however, if Chinese economicgrowth resumes at previous rates, any majorcutback in investment would accentuate futuresupply constraints.

Geopolitical tensions between China the US,Europe and Japan over future strategic controlof oil supplies would ease in the short term.

Faced with a domestic recession, China wouldprobably react by closing off potential foreigninvestment of interest to oil-exporting countriesof the Middle East, not least in petrochemicals.

Middle Eastern assets in China woulddepreciate, but despite prominent mediacoverage their importance as a share of overallasset portfolios is limited.

Should China decide to revive its economy by export dumping, aspiring Middle Eastern manufacturingindustries would be particularly hard hit, already under pressure from Asian competition in sectors suchas textiles.

Should China sell part of its dollar holdings to mitigate economic downturn at home, this would lead to asteep depreciation of the dollar and would negatively impact predominantly dollar-based foreign assets ofMiddle Eastern countries.

Use regained OPEC spare capacity to manage oil prices for the long term, within the range set by OPEC.

Diversify oil exports to Europe and the US.

China: Curb Chinese liquidity growth and supply of land to cool down investment and property boom.

China: Real effective exchange rate appreciation and rising minimum wages to generate general wage riseand increase domestic demand.

Cooperate with China and other Asian countries in finding alternatives to dollar-focused investments andredress global imbalances.

Lead a political dialogue with China on the protection of Gulf investments in the country and access to itsmarkets.

China has raised lending rates four times and reserve requirements six times over the last year. It has alsorestricted the supply of land for development.

GCC countries have started to discuss alternative currency schemes and asset diversification, althoughat a slow pace.

OPEC has successfully implemented production cuts during a recent oil price correction from US$ 78(WTI) to US$ 50.

Saudi Arabia still keeps up its discount for oil deliveries to the US in order to remain a presence in thisimportant market.

Page 12: Middle East @ Risk

12

COMMITTED TO IMPROVING THE STATE

OF THE WORLDCOMMITTED TO

IMPROVING THE STATE OF THE WORLD

Executive Summary:Retrenchment from Globalization

Will Middle Eastern economies lose export markets in petrochemicals and aluminium? Will they protect their banking, insuranceand services industries? Will Middle Eastern investors face restrictions on foreign equity investments?

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Middle East@Risk

Risk

Important Trends

The Global Risks 2007 report, and discussions at the Annual Meeting 2007 in Davos, both suggested thatglobalization is entering an extremely challenging phase. Global inequality, concerns in some Westerneconomies that globalization threatens existing social structures, and the imperative to ally economic growthwith environmental protection are driving a potential retrenchment from globalization. Far from being aninevitable process, globalization can be slowed and may be reversed. Both the current architecture of globaltrade and the underlying political consensus backing globalization are more fragile than often realized. SomeMiddle Eastern economies have gained little from globalization; others depend on globalization to secure theireconomic future.

Gulf economies in particular are very competitive in petrochemicals and energy intensive industries suchas aluminium. Should current trends of protectionism gain momentum, exports and expansion plans inthese industries could be threatened.

Banking, insurance and services industries across the Middle East are less competitive. Shouldretrenchment against globalization continue, governments could be tempted to continue protectivemeasures for these industries against foreign competition.

In the wake of the events of 11 September 2001, and with a rapidly expanding current account deficit,the US has demonstrated occasional unwillingness to allow companies from the creditor nations of theMiddle East and Asia to hold sizeable equity stakes in “strategic sectors” of the economy including ports(Dubai World Ports’ bid for P&O) and oil (Unocal). This trend may expand to other economic sectors, andto the European Union.

The Doha Round of trade talks, which started in 2001,has failed to achieve further liberalization. The majorstumbling blocks have been market openingmeasures for industrial goods and services insistedupon by leading Western economies in return forlimited concessions on agricultural subsidies. As aresult, the G20 trade ministers’ group has attemptedto revive the talks.

Resource nationalism has led to the exclusion of someWestern companies from investments in Venezuela,Bolivia and Russia. The Middle East hydrocarbonsector has long been off-limits for Western investmentwith only minor cooperation in oil (in the UAE) and gassectors (Saudi Arabia, Qatar). A recent report sawresource nationalism as the greatest barrier toadequately meeting future oil demand.

The Middle Eastern banking and insurance marketscontinue to be heavily protected despite moves toopen the market.

Page 13: Middle East @ Risk

13

Consequences

Mitigation

Examples

Some Middle Eastern economies have gained little of the upside from globalization. The effects of anylong-term retrenchment from globalization on the downside are likely to be felt most strongly in the mostopen economies in the region – those of the Gulf.

Up to 90% of Gulf exports are in hydrocarbons. Increased trade barriers for crude oil and natural gas areextremely unlikely given their strategic importance and current constraints on supply. However, over themedium to long term there are major questions as to whether Middle Eastern oil and gas exports cansufficiently expand capacity to meet demand without capital and expertise from Western investors. Therecurrent postponement of “Plan Kuwait” investments in the northern oil fields may be an example of this.

External surpluses of Gulf economies, should hydrocarbon prices remain high, may become increasinglyfocused on the region, raising the risk of overinvestment and a lowering of aggregate rates of return.

Plans for the global expansion of Middle Eastern petrochemical and aluminium industries could behindered; Sabic’s announcement that it could withdraw an intended US$ 5 billion investment in China dueto stalling over procedures could be suggestive of future problems for Middle Eastern companies inachieving global scope. The Middle East’s tourist industry would almost certainly suffer from any long-termretrenchment from globalization.

A backlash from globalization would most likely reduce exposure to global competition, allowing protectedindustries to remain uncompetitive and reducing productivity growth as a result.

Successful conclusion of GCC free trade agreements (FTAs), continuance of regional integration andfurther pursuit of the Euromediterranean Partnership process. Tackling of contentious issues likepetrochemicals, aluminium, services and agriculture.

Diversification of foreign investments.

Acquisition of foreign technology to maintain and expand upstream capacity – possibly not by giving outequity stakes via Production Sharing Agreements (PSA) but by takeovers of foreign engineeringcompanies and buy-back arrangements.

The GCC already has FTAs with Lebanon (2004) and Syria (2005). The GCC is currently negotiatingseveral further FTAs, with China, the EU and Japan. Framework agreements with India, Mercosur,Pakistan and Turkey have been signed. FTAs with Singapore and South Korea have also been suggested.Bahrain and Oman have signed bilateral FTAs with the US, while the UAE and Qatar are still in the processof negotiating.

Mediterranean Middle Eastern countries have privileged access to the EU market through theEuromediterranean Partnership. The US has bilateral agreements with Israel, Jordan and Morocco;negotiations with others, including Egypt, are planned.

The Arab Free Trade Zone came into effect in January 2005 marking the elimination of customs duties ontrade between 17 Arab countries. However, individual states still have a “negative list” of trade items whichdo not qualify for exemption.

A number of Gulf companies have shown an appetite to expand internationally and acquire strategicequity stakes (e.g. Sabic, Emaar, KPC, Etisalat).

Page 14: Middle East @ Risk

14

COMMITTED TO IMPROVING THE STATE

OF THE WORLDCOMMITTED TO

IMPROVING THE STATE OF THE WORLD

Executive Summary:Geopolitical and Geostrategic Instability

Is the Middle East faced with a new arms race? Will US withdrawal throw the region into crisis?

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Middle East@Risk

Risk

Important Trends

Unless a solution is found to the alleged militarization of Iran’s nuclear programme, other Middle Easterncountries may feel compelled to build up domestic capacity in nuclear technologies. Doubts about long-termintentions could ultimately cause a wide-ranging arms race. Whatever the ultimate outcome, spending onsuch programmes would divert income from urgent infrastructure projects and slow prospects for growth.

A precipitous US withdrawal from Iraq would severely destabilize the geopolitics of the Middle East, andcould lead to widespread sectarian tensions should Iraq split further along sectarian and ethnic lines. Iranand Turkey could engage in more active attempts to broaden spheres of influence, while global terroristgroups could be emboldened.

While there have been a number of positive moves towards peace between Israel and the Palestinians inrecent months, questions over the survival of the Israeli government, the sustainability of Palestinian powersharing and the intentions of Syria and Iran mean that the situation remains fragile.

At their December 2006 Riyadh summit meeting, GCC member states announced a nuclear energyresearch programme, partly in response to Iran’s unwillingness to adhere to UN Security Councilresolutions regarding its uranium enrichment programme. Egypt, Jordan, Syria, Turkey and Yemen havealso expressed interest in developing atomic energy. Turkey is proceeding with its first nuclear plant, whileEgypt’s plan to build a reactor on its Mediterranean coast has received US backing. In March 2007, theArab League warned that Iran's drive for nuclear technology could result in the beginning of “a grave anddestructive nuclear arms race in the region.”

Military sales in the Middle East are on the rise. In the largest example of this, Saudi Arabia announced aUS$ 70 billion deal to buy Typhoon Eurofighters in 2006. Other states have declared similar increases indefence spending.

The future of the US military presence in Iraq – and therefore of a significant, standing troop presence in theregion as a whole – has been brought into doubt by the domestic US political struggle between PresidentBush and the Congress. Middle East security will play a crucial role in the 2008 US presidential campaign,with likely effects for US engagement in the Middle East. 58% of US respondents favour withdrawal fromIraq; surveys suggest that only half of the members of the US armed forces think the war in Iraq can be won.

In the fourth month of the new “surge” strategy, suicide bombings have increased both in scope andintensity. April 2007 was one of the worst months for US casualties since the beginning of the war, andalso the worst month for British casualties.

On the positive side, some Middle Eastern countries have taken an increasingly prominent role in peaceattempts between Israel and the Palestinians. Saudi Arabia sponsored a Palestinian unity government aftera long period of tension and violence; a broader Arab peace plan has been received seriously by Israel.

Geopolitical risk is the most difficult of all risk categories to adequately assess. The range of differenttrajectories along which geopolitical risks can develop – contingent on human decision-making on a range ofother factors – makes their outcomes hard to predict with accuracy. For example, while the conditions for theoutbreak of war may be easily identifiable, the exact sequence (and timing) of events which turn conditionsinto reality are impossible to predict. In the Middle East, geopolitical and geostrategic instability is a keyeconomic consideration. In the short term, any instability in the Middle East is a guarantee of broader financialmarket volatility. Over the longer term, instability in the Middle East may actually reduce the region’s geopoliticalsalience as arguments for diversifying away from hydrocarbon resources will be strengthened in major consumingeconomies. A high level of instability is already “priced in” to Middle Eastern economies, but making progress onthe region’s geopolitical and geostrategic issues could open a range of economic opportunities.

Page 15: Middle East @ Risk

15

Consequences

Mitigation

Without noticeable improvement in the security situation in Iraq, calls for some form of US troopwithdrawal will gain further momentum, with the issue firmly on the 2008 US election agenda.

Any US withdrawal would have a number of potential consequences. One is the disintegration of Iraq andthe split of the country into three parts. The possible independence of the Kurdish north would bring aboutactive Turkish intervention. Iran would use the event to spread Shi’a radicalism throughout the region,including Saudi Arabia’s Eastern Province and Lebanon. A second option is the establishment of a radicalIslamic state in Iraq as the internal political process disintegrates.

A confrontation between the US (or Israel) and Iran remains possible should Iran choose to take advantageof the weakness of the US and uncertainty about its long-term role in the Middle East. However, divisionswith Iran, including the growing weakness of the president, may lead to moderation in Iranian policy andrhetoric.

Should the situation considerably worsen either with regard to Iran or Iraq, the prospects for peace in theArab-Israeli conflict will suffer through the use of proxy forces to demonstrate political will or through anincreased disconnect between the nationalist and Islamist strains in Palestinian politics. Should Iran comeunder pressure, a replay of the 2006 Lebanon war cannot be excluded.

Increased geopolitical tensions are likely to increase the willingness of Middle Eastern investors to placefunds outside the region, increase the volatility of oil prices, and decrease the willingness of externalinvestors to invest in the region.

Should defence spending increase across the region, resources will be diverted from urgent reform andeconomic development projects, further reducing the probability of dealing with pressing social problems(particularly among the young) throughout the region.

Given regional complexities, a combination of national, regional and international level involvement isneeded to mitigate the deterioration of the Middle East’s geopolitical situation. Given the complicated roleof the US, broader engagement of European and Asian states is critical.

Intra-regional dialogue between Arab states and Iran may help to strengthen those Iranians arguing thecase for pragmatism in Tehran; the European Union, a potential future market for Iranian gas, may be ableto play a stronger role in offering long-term commercial arrangements with Iran; the United States, still theprincipal security actor in the Middle East, should find ways of engaging in a broader dialogue withpragmatic elements in Iran, without compromising them.

Regional leadership is urgently required, in particular from the Arab Sunni states, as a means tomaintaining momentum towards Arab-Israeli peace and preventing a damaging split between the Sunniand Shi’a communities. Jordan has taken a historic bridging role between the West and the Middle East.Saudi Arabia has taken the lead in active diplomacy within the Middle East in recent months. Both shouldbe encouraged.

The business community can play a role in the political process by encouraging pragmatic moderation.Greater communication among business sectors in opposing states can help alleviate tensions.

The business community may play a particular role in designing strategies to employ Middle Eastern youthwhich may boost long-term economic growth, reduce social tensions and create the conditions forcontrolled political reform.

Page 16: Middle East @ Risk

Acknowledgements

16

This report was prepared by the Global Risk Network, in close collaboration with the expertise of theGulf Research Center

Charles Emmerson, Global Leadership Fellow, World Economic ForumChristian Koch, Director of International Studies, Gulf Research CenterEckart Woertz, GCC Economic Program Manager, Gulf Research Center

Page 17: Middle East @ Risk

For Your Notes

COMMITTED TO IMPROVING THE STATE

OF THE WORLD

Page 18: Middle East @ Risk

For Your Notes

Page 19: Middle East @ Risk

The World Economic Forum is an independentinternational organization committed to improvingthe state of the world by engaging leaders inpartnerships to shape global, regional andindustry agendas.

Incorporated as a foundation in 1971, and basedin Geneva, Switzerland, the World EconomicForum is impartial and not-for-profit; it is tied tono political, partisan or national interests.(www.weforum.org)