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COMMITTED TO

IMPROVING THE STATE
OF THE WORLD

Middle East@Risk

A Global Risk
Network Briefing

in collaboration with the Gulf Research Center
This work was prepared by the Global Risk
Network of the World Economic Forum and the
Gulf Research Center

The views expressed in this publication do not
necessarily reflect the views of the
World Economic Forum.

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REF: 100507
Contents

Foreword 4

Introduction: The Global Risk Outlook for the Middle East 5

Executive Summary: Global Asset Price Collapse 8

Executive Summary: Chinese Economic Hard Landing 10

Executive Summary: Retrenchment from Globalization 12

Executive Summary: Geopolitical and Geostrategic Instability 14

3
Foreword

This briefing, in collaboration with the Gulf Research Center,
builds on the global work undertaken by the Global Risk What Are Global Risks?
Network of the World Economic Forum.
Our definition: non-business risks that affect
The Global Risk Network (GRN) is an unparalleled network of business (i.e. not operational, project or
industry, risk and regional experts working with business financial risk)
leaders and policy-makers to: • that can be strategic, exogenous and systemic
• Create a framework for assessing and prioritizing existing
and emerging risks to global businesses over the short • that are highly interdependent (i.e. do not manifest
and long term in isolation)
• Alert key decision-makers to the impact these risks may • that are characterized by uncertainty, sharp
have on their environments discontinuities, non-linearity (power law distributions)
• Assist leaders in their reflection on how risks may be and lack of proportionality
mitigated at the global, regional, industry and company
levels • that can’t be predicted (but can be managed)
• Transform these global risks into opportunities

The GRN was set up in 2004 in response to concern over the It is a central tenet of the work conducted by the Global Risk
rapidly changing nature of the global risk landscape, with six Network and its partners that global risks do not manifest
defining features raising particular concern in the business and themselves in isolation. This was apparent when the domino
policy environment. effects of Hurricane Katrina briefly shook the global system.
More recently, the connections between two of the most
• Interconnectedness: Opportunities for contagion of risk pressing global issues for public policy and private enterprise
across geographies and categories make them harder to – energy security and climate change – have reinforced the
manage, and their consequences harder to predict. Risks sense that many global risks share a common lineage. The
that occur in discrete geographies and with well-known correlation matrix below, drawn from the Global Risks 2007
proximate causes – such as Hurricane Katrina – can report, shows expert views on correlation between a limited
cause unpredictable results elsewhere. list of 23 core global risks.
• Asymmetry: Partly as a result of contagion, apparently small
events can have increasingly disproportionate effects. This At the regional level, the Global Risk Network has undertaken
is particularly true of geopolitical risk. work on regional risk exposures for World Economic Forum
• Time compression: Some risks can develop within the meetings in Turkey, India and Latin America. The purpose of this
decision cycle of decision-makers. The secondary impacts work has not been to create a final list of top risks for any region,
of financial or geopolitical crises can begin to take effect but to draw together an understanding of global risks with their
before businesses and governments have adequately impacts at the regional level, building up a wider picture of
responded to the initial risk event, allowing a limited crisis global interdependence and a broader case for multistakeholder
to expand into a systemic one. Just-in-time processes thinking and action to manage and mitigate global risk.
can leave little built-in resilience.
• Risk extension: Other risks are perceived to
occur outside the decision cycle of decision- The Correlation Matrix
makers, giving rise to the “NIMTOF” (Not-in-My-
Term-of-Office) phenomenon, where mitigation Key:
costs are immediate and known, and mitigation STRONGER
CORRELATION
benefits are long term and/or unclear. Climate
change is a prime example of an extended risk. Current account
Oil price shock deficit/ Fall in US$
• Noise: The profile of an emerging risk is rarely Proliferation of WMD

clear before it occurs, with salient indicators Spread of International terrorism
liability regimes
hidden by surrounding “noise”. Pandemics

• Rise of “infodemics”: The rapid and uncontrolled Loss of freshwater
services Climate change
spread of information – including inaccurate
information from new, unreliable and uncontrollable Breakdown of CII
Retrenchment from
sources – can skew responses, generating globalization
information-driven impacts greater than those of Coming
fiscal crises
the primary risk event. China economic
hard landing
Failed and
failing states
At the global level, the Global Risk Network has Middle East instability
identified some 23 global risks to the international NatCat:
Tropical storms
community over the next 10 years. It has advanced Developing world disease
(HIV/AIDS, TB, malaria)
thinking on how to conceptualize their interaction and Emergence of
nanotech risks
how to design strategies to mitigate them including NatCat: Inland flooding

the “5i” framework. The Global Risks 2007 report, Asset prices/ excessive
indebtedness NatCat: Earthquakes
released at the Annual Meeting 2007 in Davos, and Transnational crime Chronic disease in
other publications by the Global Risk Network, are and corruption Interstate and developed countries
civil wars
available at www.weforum.org/en/initiatives/globalrisk.

Source: World Economic Forum Global Risks 2007
4
Introduction: The Global Risk Outlook
for the Middle East
The Middle East is a focal point for global risk and its
mitigation. This is particularly clear with geopolitical risk – with
a high concentration of destabilizing geopolitical events having
their origin in the wider Middle East region. But it is also true
of two of the great intersecting global risks of the early 21st
century – energy security and climate change – and of the
risks relating to global economic imbalances: Middle Eastern
external surpluses far exceed those of China.

Some Middle Eastern economies (particularly those of the
Gulf region) are heavily integrated into global trade and
financial flows. Others, often the largest economies in the
Middle East, have not yet overcome the dominance of the
state sector and remain relatively unattractive to foreign
investment. The vulnerabilities of these different economies –
and of different political structures, geographies and religious
compositions across the region – inevitably mean that global
risks 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 is
interconnected by webs of investment, of geopolitics of
religious affiliation – as well as physical infrastructure of
pipelines for oil and sources of water, an increasingly precious
resource. Many of the possible mitigation measures to deal
with the consequences of global risks stem from within the
region. Indeed, many of the mitigation measures can only be
managed and controlled by acting in frameworks of regional
cooperation.

This briefing does two things. First, it provides a brief overview
of a range of 9 of the most salient of the 23 global risks
extracted from Global Risks 2007, and outlines major trends
as well as the impact on the Middle East region. Second, it
provides a deep dive into four areas identified as being of
particular interest: a global asset price collapse, a Chinese
economic hard landing, retrenchment from globalization, and
wider geopolitical and geostrategic instability in the Middle
East. The intention is not to provide a prioritization of risks to
the Middle East, but to highlight some of the common
choices that the region faces and the common risks to
prosperity and security, from the future of freshwater services
to the future of the Middle Eastern currencies’ peg to the
dollar.

Raising awareness of common risks raises the bar for shared
responsibility for action and opportunities that will derive from
timely, proactive policies to prevent global risks overwhelming
the Middle East region.

5
Middle East@Risk Matrix

Risk Description Trends to watch Impact on the Middle East

Oil price In the short term, a Rapidly expanding demand, 80% driven by Any short-term supply disruption –
shock/energy hydrocarbon price spike BRICS; fears that underinvestment in for example as the result of a
supply caused by geopolitical capacity (in the Middle East and elsewhere) terrorist attack – would undermine
interruptions tension or terrorism – will mean production shortfall. the economic foundations of current
disruption to secure economic growth in the Middle East.
energy supply. In gas, discussions of a possible producers’
agreement – including Iran, Russia and Qatar Excess capacity needed to manage
In the longer term, a – remains complicated by internal differences oil prices is low, and the resurgence
plateau of high and existing bilateral supply agreements. of non-OPEC supply has led to some
hydrocarbon prices as to question the ability of Middle East
the supply of products Increasing concentration of hydrocarbon oil producers to achieve price targets.
fails to keep up with resources driving geopolitical attempts to
demand, particularly “lock in” future supplies. The growing concentration of future oil
from emerging markets and gas supplies in the Middle East
– unsustainability of Debate over possible “peak oil”, including has strengthened NOCs compared
secure energy supply. some doubts about official Middle Eastern to IOCs and may lead to renewed
reserves. downstream NOC investments.

Growing awareness of anthropogenic climate But, in the long term, concentration
change. of hydrocarbon resources in the
Middle East may hasten the end of
Models of future oil demand are subject to the oil era, as major Western
major uncertainties around China, including a countries cite geopolitical concerns.
possible decision to invest in nuclear power “The oil age will end long before the
or coal-fired generation or any mandated world runs out of oil.”
improvement in vehicle emissions standards.
Whether prices remain high or eventually
Any movements towards effective fall back, economic diversification
hydrocarbon substitutes for transport. must remain a top priority.

US current Unsustainability of the Global picture of high US current account Many Middle Eastern currencies are
account US current account deficit sustained by Asian savings and pegged to the US dollar and Middle
deficit/fall in deficit, triggering a Middle Eastern petrodollars. Eastern investments are held in
US$ major fall in the US dollar-denominated assets. A sharp
dollar, with impacts US dollar remaining the global reserve decline would import inflation, lead to
throughout the financial currency; other currencies (e.g. the euro) questions about long-term viability of
system. playing an increased portfolio role or even pegging to the dollar and
acting as denominating currency for some denomination of oil prices in dollars.
commodities.

Chinese Sharp slowdown of Debate around the long-term sustainability of See deep dive on Chinese
economic hard China’s economy – China’s current growth given infrastructure economic hard landing below.
landing potentially as a result of constraints, environmental concerns and
protectionism, internal political risk.
political or economic
difficulties. Evidence of some backlash against Chinese
exports (in the form of anti-dumping duties);
concerns about the stability of the Chinese
financial system and the extent of potential
defaults.

Blow up in Collapse in house A correction in house prices is underway in See deep dive on global asset price
asset prices prices (e.g. in US and the US, and in some European markets; collapse below.
southern Europe) and questions over particularities of the US
other asset prices market compared to other markets. The rate
causing recession, with of a US slowdown, and its wider global
contagious effects consequences are not yet known.
globally.
Financial market volatility remains low and
risk appetites high, despite minor correction
in February 2007, but market complacency
may not last the year.

Climate Increased temperatures Consensus around climate change moving Besides indirect effects of reduced
change around the globe, with to a debate around impacts, possible Gross World Product as a result of
impacts on rainfall mitigation or adaptation measures. unmitigated climate change, the
patterns. chief indirect impacts from climate
Success or failure in involving major future change come from potential
Increasing frequency of emitters in any future post-Kyoto agreement changes in rainfall patterns and the
extreme weather events over the next few years will likely determine overall rise in temperatures expected
from man-made climate the overall emissions pathway, and thus the across the region.
change with severe extent of climate change.
impacts on critical
infrastructure,

6
continued
Risk Description Trends to watch Impact on the Middle East

agricultural yields and Leading indicators of the impacts of climate Agriculture in the Middle East is
human lives. change in most affected regions, causing likely to become increasingly
population movements, tension within marginal; some inland regions may
countries and between countries. be no longer habitable; overall costs
of living and doing business are
Any movements towards effective likely to be increased with
hydrocarbon substitutes for transport. adaptation no longer a viable option.

Climate change may encourage use
of hydrocarbon substitutes,
undermining the Middle East’s most
valuable export.

Loss of Growing penury of The two main factors affecting future water World Bank suggests water
freshwater freshwater supplies, scarcity in the Middle East are water use, available per person in the MENA
services partly as a result of and patterns of supply. Without greater public region could fall by half by 2050.
climate change, partly accountability, and without moves to
as a result of increasing reallocate water supplies, demand will increase The Middle East is well experienced
burden of overuse. as populations expand. If climate change in managing water scarcity, but
patterns accelerate, freshwater service increased penury is likely to divert
supplies are likely to become more erratic. development funds to desalinization
and water transport schemes, and
MENA countries are already using more promote geopolitical conflict
water than they receive each year; growing between headwater and tributary
awareness of the need to manage countries.
freshwater throughout the cycle, as opposed
to managing discrete portions of supply.

International Acts of terrorism (both In addition to the spread of the Al Qaeda The Middle East region suffers from
terrorism internationally organized “franchise” – including to North Africa – there international terrorism on multiple
and inspired, and local) are fears Al Qaeda may be regaining levels: as a direct victim of attacks,
with the capacity to organizational strength. This would imply the as a perceived centre of instability
cause extensive ability to carry out attacks beyond those (reducing foreign investment
physical damage, which are locally planned and executed. appetites) and as a perceived
spread terror and source of terrorism in terms of
undermine social Iraq has become a major recruiting and personnel, training and ideological
cohesion. training ground for international terrorism; background (reducing opportunities
should the situation continue to deteriorate for knowledge transfer and personnel
its role in international terrorism will most exchange with Western countries).
likely increase.
A number of Middle East regimes
are specific targets of Al Qaeda as
the “near enemy”.

Proliferation Proliferation of weapons Key short-term issue: the management of Iran is several years away from
of weapons of of mass destruction Iran’s alleged attempt to build a nuclear being able to test a nuclear device,
mass and the likelihood of device. and denies that this is the purpose
destruction their use, inviting major of enrichment. However, should
retaliation, furthering Key long-term issues: future of the Nuclear international and regional pressure
global insecurity and Non-Proliferation Treaty, expansion of the fail to bring greater transparency to
threatening Proliferation Security Initiative, prevention of Iran’s nuclear programme, several
globalization. weapons’ capacity while allowing spread of Middle Eastern countries will feel
nuclear power. compelled to develop contingency
plans, including boosting domestic
understanding of nuclear technologies.

The wider impact on the region
would be disastrous, removing the
prospect of a nuclear-free Middle
East, potentially pushing Israel to
declare nuclear status, and requiring
massive funding which would
otherwise have been spent on
economic and social reform.

Retrenchment A two-way risk: a Failure to achieve agreement in discussions See deep dive on retrenchment
from protectionist impulse in on world trade; growth of bilateral trade from globalization below.
globalization developed countries agreements.
and rising nationalism in
developing countries Increasing use of anti-dumping measures in
(and evidence of global the developed world; spread of nationalizations
inequality), driving both in key industries in developing countries.
to attempt to slow or
reverse globalization. Rise of political populism in both the
developed and developing world.
7
Middle East@Risk

COMMITTED TO
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OF THE WORLD

Executive Summary:
Global Asset Price Collapse

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

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, may
be one reason why investors remain confident. But risk factors around global asset prices and potential risks
for the Middle East in particular cannot be ignored. In any future collapse, central bank capacity, diversification
and the future of the US dollar will be key questions.

Risk Prices for real estate, stocks, commodities and gold are all at, or near, historic highs, while global interest
rates are low and bond markets are doing well. Historic correlations (such as those between high oil prices
and falling equities, or high gold prices and inflationary pressures, rising interest rates, and lower bond and
real estate prices) have weakened. There are two possible explanations: the market has fundamentally
changed 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 are
global in nature and sometimes unregulated (e.g. OTC derivatives). Cracks in these chains thus have the
potential to spread across countries and regions, leading to major demand slumps and supply surges of
securities via distressed selling, ergo asset devaluations.

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

Important Trends 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 account
of the Gulf Cooperation Council (GCC) countries (US$ 176 billion) rivalled that of China, and is
considerably 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 with
high net worth. The role of some Middle Eastern economies in maintaining global imbalances and the US
twin deficit is less well understood than that of China because a share of external surpluses are not held
as official reserves, and buying patterns are more complicated. Sovereign wealth funds such as the
investment authorities of Abu Dhabi and Kuwait are major asset holders; with the exception of Saudi
Arabia (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 private
equity, hedge funds and structured bonds play a major role. This differs both from the dominance of deposits
in 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 currencies
pegged to the dollar, as are many leading Middle Eastern currencies, have not become meaningful reserve
currencies. 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 their
economic structure and a local investment boom pushing up prices for equities and real estate. In 2006, key
GCC stock markets collapsed and real estate markets of the UAE and Qatar raised concerns of
overheating. But in both boom and bust, GCC markets have not been meaningfully correlated with other
8 emerging markets.
Consequences The primary consequences of any sharp decline in US asset prices would be felt in slowing US
consumption and growth. The secondary consequences would be on Asian exporters and, to a lesser
degree, European economies. The rate of any slowdown would determine its contagion. Faltering demand
would depress oil prices unless supply is further constrained by (a) OPEC management resulting from
regained 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 the
sovereign wealth funds and social projects they are designed to fund (e.g. infrastructure, pension
schemes) would be in jeopardy. Economic diversification strategies for the post-oil age would be put on
hold as oil savings evaporate. Across the Middle East a window of opportunity to reform state-centric
economies would close.

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

Domestic markets would fall, but the direct spillover from financial markets outside the Middle East would
be limited by regulatory barriers which would leave domestic markets only partially open. Contagion would
be mostly limited to stock markets, but, as Gulf bonds and sukuks have become more popular with
foreign 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 world
production by 2010) and tourism would be hit. Cyclical industries such as the construction industry would
enter sharp decline.

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

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

Controlled diversification of currency reserves from dollars to euros, sterling and gold, an increased cash
reserve 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. This
might evolve to a managed float, enhancing the means for Middle Eastern countries to conduct
independent monetary policies, but requiring considerable improvements in the administrative capacity of
Middle Eastern central banks.

Use of any regained OPEC spare capacity to attempt to manage oil prices in the long term in the OPEC
target 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 imposing
strict lending ceilings. Enhancement of transparency of domestic credit markets by the establishment of
credit bureaus and improved corporate governance in banks.

Examples Discussions of alternative currency schemes and asset diversification have begun in some Middle Eastern
countries.

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

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

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Middle East@Risk

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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?

China’s economic growth over a quarter of a century has shifted global patterns of production and
consumption, altered the relative strength of labour and capital, and driven a super-cycle boom in the
prices 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 a
crucial 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 source
of imports of consumer goods. A Chinese economic hard landing could have unpredictable consequences.

Risk China’s economic growth over the last decade has exceeded that of any other major economy, ranging
from 7.6% to 10.7%. Its cheap exports have contributed to the moderation of global inflation, while its
growth 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 US
and elsewhere. Domestic overinvestment, a slump in global demand, social unrest or a major geopolitical
upset could undo the current positive outlook for the Chinese economy with major implications for the
world economy and for global oil demand.

Important Trends 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 other
Western 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 remains
high, both between social groups and between rural and urban geographies. Consumption is only equal
to 54% of GDP.

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

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

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

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

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

10
Consequences Should demand in oil slump, oil prices could
fall. However, the fall in demand required to
depress oil prices, given current supply
constraints, would have to be sharp.

Upstream investments to enhance production
and refining capacity could be put on hold. In
the long term, however, if Chinese economic
growth resumes at previous rates, any major
cutback in investment would accentuate future
supply constraints.

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

Faced with a domestic recession, China would
probably react by closing off potential foreign
investment of interest to oil-exporting countries
of the Middle East, not least in petrochemicals.

Middle Eastern assets in China would
depreciate, but despite prominent media
coverage their importance as a share of overall
asset portfolios is limited.

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

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

Mitigation 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 rise
and increase domestic demand.

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

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

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

GCC countries have started to discuss alternative currency schemes and asset diversification, although
at 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 this
important market.

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Middle East@Risk

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OF THE WORLD

Executive Summary:
Retrenchment from Globalization

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

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

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

Banking, insurance and services industries across the Middle East are less competitive. Should
retrenchment against globalization continue, governments could be tempted to continue protective
measures 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 the
Middle 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, and
to the European Union.

Important Trends The Doha Round of trade talks, which started in 2001,
has failed to achieve further liberalization. The major
stumbling blocks have been market opening
measures for industrial goods and services insisted
upon by leading Western economies in return for
limited concessions on agricultural subsidies. As a
result, the G20 trade ministers’ group has attempted
to revive the talks.

Resource nationalism has led to the exclusion of some
Western companies from investments in Venezuela,
Bolivia and Russia. The Middle East hydrocarbon
sector has long been off-limits for Western investment
with only minor cooperation in oil (in the UAE) and gas
sectors (Saudi Arabia, Qatar). A recent report saw
resource nationalism as the greatest barrier to
adequately meeting future oil demand.

The Middle Eastern banking and insurance markets
continue to be heavily protected despite moves to
open the market.

12
Consequences Some Middle Eastern economies have gained little of the upside from globalization. The effects of any
long-term retrenchment from globalization on the downside are likely to be felt most strongly in the most
open 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 are
extremely unlikely given their strategic importance and current constraints on supply. However, over the
medium to long term there are major questions as to whether Middle Eastern oil and gas exports can
sufficiently expand capacity to meet demand without capital and expertise from Western investors. The
recurrent 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 increasingly
focused 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 be
hindered; Sabic’s announcement that it could withdraw an intended US$ 5 billion investment in China due
to stalling over procedures could be suggestive of future problems for Middle Eastern companies in
achieving global scope. The Middle East’s tourist industry would almost certainly suffer from any long-term
retrenchment from globalization.

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

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

Diversification of foreign investments.

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

Examples The GCC already has FTAs with Lebanon (2004) and Syria (2005). The GCC is currently negotiating
several 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 process
of negotiating.

Mediterranean Middle Eastern countries have privileged access to the EU market through the
Euromediterranean 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 on
trade between 17 Arab countries. However, individual states still have a “negative list” of trade items which
do not qualify for exemption.

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

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Middle East@Risk

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Executive Summary:
Geopolitical and Geostrategic Instability

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

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

Risk Unless a solution is found to the alleged militarization of Iran’s nuclear programme, other Middle Eastern
countries may feel compelled to build up domestic capacity in nuclear technologies. Doubts about long-term
intentions could ultimately cause a wide-ranging arms race. Whatever the ultimate outcome, spending on
such 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, and
could lead to widespread sectarian tensions should Iraq split further along sectarian and ethnic lines. Iran
and Turkey could engage in more active attempts to broaden spheres of influence, while global terrorist
groups could be emboldened.

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

Important Trends At their December 2006 Riyadh summit meeting, GCC member states announced a nuclear energy
research programme, partly in response to Iran’s unwillingness to adhere to UN Security Council
resolutions regarding its uranium enrichment programme. Egypt, Jordan, Syria, Turkey and Yemen have
also expressed interest in developing atomic energy. Turkey is proceeding with its first nuclear plant, while
Egypt’s plan to build a reactor on its Mediterranean coast has received US backing. In March 2007, the
Arab League warned that Iran's drive for nuclear technology could result in the beginning of “a grave and
destructive 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 a
US$ 70 billion deal to buy Typhoon Eurofighters in 2006. Other states have declared similar increases in
defence spending.

The future of the US military presence in Iraq – and therefore of a significant, standing troop presence in the
region as a whole – has been brought into doubt by the domestic US political struggle between President
Bush 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 from
Iraq; 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 and
intensity. April 2007 was one of the worst months for US casualties since the beginning of the war, and
also the worst month for British casualties.

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

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Consequences Without noticeable improvement in the security situation in Iraq, calls for some form of US troop
withdrawal 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 and
the split of the country into three parts. The possible independence of the Kurdish north would bring about
active 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 radical
Islamic 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 advantage
of the weakness of the US and uncertainty about its long-term role in the Middle East. However, divisions
with Iran, including the growing weakness of the president, may lead to moderation in Iranian policy and
rhetoric.

Should the situation considerably worsen either with regard to Iran or Iraq, the prospects for peace in the
Arab-Israeli conflict will suffer through the use of proxy forces to demonstrate political will or through an
increased disconnect between the nationalist and Islamist strains in Palestinian politics. Should Iran come
under 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 place
funds outside the region, increase the volatility of oil prices, and decrease the willingness of external
investors to invest in the region.

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

Mitigation Given regional complexities, a combination of national, regional and international level involvement is
needed to mitigate the deterioration of the Middle East’s geopolitical situation. Given the complicated role
of 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 the
case for pragmatism in Tehran; the European Union, a potential future market for Iranian gas, may be able
to play a stronger role in offering long-term commercial arrangements with Iran; the United States, still the
principal security actor in the Middle East, should find ways of engaging in a broader dialogue with
pragmatic elements in Iran, without compromising them.

Regional leadership is urgently required, in particular from the Arab Sunni states, as a means to
maintaining momentum towards Arab-Israeli peace and preventing a damaging split between the Sunni
and 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 should
be 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 youth
which may boost long-term economic growth, reduce social tensions and create the conditions for
controlled political reform.

15
Acknowledgements
This report was prepared by the Global Risk Network, in close collaboration with the expertise of the
Gulf Research Center

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

16
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