Will Europe's woes spark new crisis in Middle East?

European banks are teetering on the brink of a full-blown crisis, with investors concerned that a liquidity squeeze would leave some institutions vulnerable to collapse, and fears that some lenders have been shut out of the international money markets. But what would trouble in Europe spell for the Middle East?

EU countries responded to the global economic downturn in 2008 with economic stimulus measures and aid for banks. When the global economy started to recover in 2009, that help was gradually withdrawn, and the European Central Bank (ECB) began to raise benchmark interest rates. However, eight lenders failed European Banking Authority stress tests in July and many more only just limped over the finish line.

Greek and Portuguese banks are reeling as sovereign debt worries mount, while Bank Intesa in Italy and Societe General in France also have suffered heavy downturns in their share prices. Jean-Claude Trichet, the president of the ECB, has said repeatedly in recent weeks that the banking system is healthy, but the ECB nevertheless voted to hold benchmark interest rates steady in a meeting on September 8th - after having already raised them twice this year, to 1.5%.

Last month Christine Lagarde, the new head of the International Monetary Fund, warned that Europe's banks needed an urgent injection of fresh funds to prevent a "debilitating liquidity crisis". She added that that the recapitalisation of banks should become mandatory, using the bailout funds set aside for Greece, Ireland and Portugal if private money could not be found, amid reports that policymakers at the ECB and the European Commission have already begun studying a radical plan to stave off another banking crisis.

Gulf banks less vulnerable to crises

Most analysts agree that even in the event of some of Europe's banks collapsing, Middle East interests are unlikely to suffer too greatly - at least directly. "The previous financial crisis was a huge contagion where all the different banks were all linked in some manner," says Gary Dugan, Chief Investment Officer, Private Banking, at Emirates NBD.

"However banks here don't have the exposure this time around, let's say to the Italian bond market or the property market in Germany," he continues. "The links aren't particularly strong, and neither is the volume of business, so if a European bank goes down then you're not all of a sudden going to find that a bank over here has to take a massive provision on the business it was doing."

Raj Madha, MENA Banking Analyst at Rasmala Investments, agrees that there is unlikely to be a funding problem. The steps taken in the aftermath of the last crisis, to address issues including loan-to-deposit ratios and reliance on short-term debt, appear to have been effective in reining in Gulf banks. He notes also that in the UAE, for example, the property market is in a "less precarious" state than in 2008, and has prices already far below international levels. Developers have already faced the reality of life with next-to-no new sources of cashflow, and so the system is less vulnerable to the banking difficulties currently being suffered in Europe.

"You would expect some losses on the investment book if things continued to deteriorate in Europe, but there's no reason at the moment to believe that would be disproportionate," he notes. "The investment book is not going to be the critical issue; the concern was always about whether there would be a funding or liquidity problem, and the reality there is that Middle East banks should be relatively secure."

Eurozone crisis could have knock-on effect

And yet Middle East banks and their investors can't yet share a sigh of relief. The impact of the eurozone crisis on risk aversion around the world could still cause significant damage in a region that many investors still treat with suspicion.

Rather than a European collapse forcing an overexposed Middle East bank to shut up shop or write down hundreds of millions of dollars, we could see investors pulling their money out of the Middle East and North Africa (MENA) region simply because they are acting on sentiment as opposed to fundamentals.

"If you take the Dubai general bond market, it has a credit default swap value of around 400 basis points, which is around the same as Italy," says Dugan at Emirates NBD. "Unfortunately with regards international investors, most of them still don't know where Dubai is, but they might think that it's a bit of a dodgy place [due to previously-held negative perceptions].

"So if someone says they don't like Italy and they don't like Spain, then they might decide to sell their MENA credits too because they see it as a risky place as well," he continues. "It would be very unfair, but if people are forced to liquidate things, then they might sell their Middle East bonds."

Dugan outlines a scenario wherein, even without any dramatic further economic downturn in the Middle East, some regional bonds endure a significant setback of as many as five or ten points, purely as a result of heightened risk aversion among international investors.

"It isn't going to break the bank or create another financial crisis - we're not talking about Dubai Debt II - but it will be a painful period in which the economy goes nowhere and everyone's just waiting for the eurozone to solve its problems before it can move on," he suggests.

"Any corporate or bank that is thinking of raising money, wants to do an IPO, or wants to restructure its financing over the next 12 months, must be wary of taking decisions now," Dugan adds. "It will create an environment in which it is difficult to get financial deals done, at a time when people are very risk averse around the world. It would be undeserved, but it is a real danger."