Tuesday, October 7, 2008

The looming depression - Can the West be saved by the Gulf States?

Are Gulf states going to save the West? Their investments invited hysterical headlines about Arabs buying out America, but now their intervention may be helpful. They may have to invest, in order to protect their own investments.
Over the past year the hike in oil prices has aroused concern among many in the United States about the potential geopolitical implications of the increased economic clout of the Gulf states. The decision by the Gulf states to diversify their foreign assets and to use billions of petrodollars to buy Western stocks in various corporations and particularly in banks raised the concern that a foreign foothold in the large financial institutions and conglomerates is liable to become a means of political leverage. This concern led to the formulation of various regulations in the United States and several European countries to strengthen oversight of the activities of the foreign sovereign wealth funds.

            The public debate on the political effects of sovereign wealth funds from the Gulf that have become leading players in the capital markets would likely have received additional urgency were one of them to have bought a large chunk of stock in Lehman Brothers in an attempt to save it from collapse. In fact no such acquisition occurred, and judging from statements by fund managers from the Gulf, we will not be witness to moves similar to the ones that took place at the end of 2007 and in the first quarter of 2008, when capital funds and investment authorities in the Gulf injected more than $11 billion into Citi, Merrill Lynch, and UBS.

            Managers of sovereign wealth funds from the Gulf have declared that at present they are not interested in investing in the crisis-stricken American financial institutions. Indeed, it is not hard to comprehend why the Gulf governments have lost their enthusiasm for being the lender of last resort for a crumbling financial system. The drops in stock indices on the Gulf stock exchanges, the concern about a real crisis causing a worldwide decrease in oil demand, and certainly the losses incurred by the Gulf sovereign wealth funds as a result of their investments in financial institutions whose value dropped by dozens of percentage points have all amplified local criticism of the investment policies of the Gulf states over the last two years. The presidents of some of the large Gulf corporations have been wondering out loud why the very funds that hurried to supply liquidity to the American financial market are now dragging their feet in intervening in a significant way in local stock trading, at a time when the market needs liquidity and the indices are falling.

            This criticism may well affect the investment policies of the sovereign wealth funds, which are indeed likely to increase their involvement in local trade in the coming days, and in the long term, decide to allocate larger sources for investment in the local economy. Nonetheless, it would be a mistake to claim that the wealth funds in the Gulf are liable to lose their status as key players on the world markets. On the contrary, the financial system's thirst for liquidity may in fact increase their involvement.

            While oil prices have plummeted from their July high, the price of a barrel of oil is still much higher than the average price in the years 2002-2007, when the Gulf Cooperation Council members (Saudi Arabia, Kuwait, the United Arab Emirates, Oman, Bahrain, and Qatar) increased their foreign assets by about 100 percent. However, even if the cost of oil drops by over 50 percent and is traded at under $50 per barrel, the Gulf states will continue to record surpluses in their current accounts, and will be able to direct billions of dollars towards increasing their foreign holdings.

            Because the sovereign wealth funds do not boast transparent management, it is impossible to know precisely how much money they manage. Most estimates by financial experts in the know put foreign assets in the hands of GCC members at about $2 trillion before the outbreak of the current crisis. This sum – among other assets – includes United States government bonds held by the central banks, as well as a string of financial assets with a higher risk premium managed separately by the government wealth funds.

            The anticipated difficulty of Western corporations suffering from the crisis in getting credit from the banks and the difficulty of raising money on the capital markets are likely to increase the wooing by companies throughout the world of Gulf wealth funds. Indications of this have been evident for some months now; certain multinationals, such as General Electric and Siemens, announced the launch of joint ventures with Gulf states, financed in part by capital held by government funds.

            Private institutions will be forced to compete for capital from the Gulf with the United States government, which needs to find sources for the $700 billion allotted for the emergency bailout package. Even before the crisis, senior members of the American administration made significant diplomatic efforts to ensure that the Gulf states remain interested in acquiring American government bonds and have no intention of surprising the United States with a unilateral announcement that the local currencies will no longer be linked to the dollar. These efforts will go into higher gear in the coming months.

            Last week some fund managers from the Gulf, when asked if they intend to acquire stock in financial institutions in the near future, noted that the hostility and suspicion encountered by their most recent investments in the financial sector curbed their appetite for investing in the West. The concern about legislation that might affect the ability of government funds to invest freely in the various markets is spurring interest in investment opportunities in the East. Nonetheless, the concern is not sufficiently grave to prevent them altogether from looking for good investments in the West, and it is indeed possible that in the near future investment opportunities will again stimulate their appetite for expanding their activities in the United States and Europe.

            Thus, one may assume that as in the past, in the coming months as well we will see many opinion pieces bearing headlines such as "Gulf Funds Buy the West," but certainly now the Gulf governments need not get worked up by such articles. Any attempt to curb or reduce their activity will be more difficult to execute because of the need for liquidity, and will run into vehement opposition on the part of the large corporations that will continue to be loyal advocates for the Gulf sovereign wealth funds.

            Many feel that deepening the economic interdependence between the West and Gulf states is the best insurance policy for continued political cooperation between the sides, because nations whose foreign asset values depend on economic performance in the US and Europe will not makes economic or political moves liable to undermine the stability of the West. Nonetheless, it is important to remember that this logic works both ways: the American administration's need to borrow money from the Gulf, and the political lobby that the Gulf is capable of building thanks to their foothold in influential corporations, is liable to reduce the American administration's room to maneuver when undertaking political moves not to the Gulf's liking.

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