Although Greece is one of the smallest countries in the euro zone (accounting for just 2.6 percent of the region's GDP) a default would be a huge problem for the region. In addition to shattering confidence in the single currency, it would put market pressure on those countries with similar debt and budgetary characteristics, notably, Portugal, Spain and Ireland. A default would also have serious repercussions for euro zone banks, which hold 49.2 billion euros ($62 billion) of Greek debt (35.1 billion euros of which held by French and German banks). Therefore, despite a "no bailout" clause in the EU treaty, the EU and the IMF agreed a 110 billion-euro rescue plan.

Although many forecasters had anticipated that the global economy would slow in the second half of this year and remain subdued into 2011, the reaction in markets has been sharp, with some major falls recorded. For the markets in the euro zone, this was not surprising. While issues with Greece had been apparent for some time, the rapid spreading of these problems caught the markets by surprise. For markets elsewhere, the main cause of the decline has been a shift in investor sentiment.
 

The Saudi economy should withstand what is happening in the global economy. The direct impact of slower growth in the euro zone on the Kingdom's exports is manageable and a weaker euro should help by lowering inflation.

The most immediate and potentially significant impact on the Saudi economy and stock market is through the oil price. Oil prices (WTI) have dropped from $86.2 per barrel on May 3 to $65.2 per barrel on May 26, a 24 percent fall. Several factors have contributed to this downward pressure on oil prices. These include the euro zone's troubles, China's efforts to slow its economy, rising inventories of crude oil around the world, the strengthening dollar and declining stock markets.

The Jadwa report said it seems likely that economic growth, and therefore the demand for oil, will slow. This will probably be most pronounced in Europe, which accounts for around 18 percent of global oil demand. Concerns about a slowdown in China are also hitting the oil market. Although China accounts for less of global oil demand than Europe, at 10 percent, it is the fastest growing source of oil demand. Nearly 40 percent of the 1.6 million barrels per day increase in global demand projected by the International Energy Agency (IEA) for 2010 is expected to come from China.

With demand prospects subdued and inventories rising, the ample cushion of excess oil production capacity is also weighing on oil prices. Global spare capacity is around 6 million barrels per day, nearly all of which is in OPEC countries (around 4.2 million barrels per day of this is in Saudi Arabia). The Kingdom's stated oil policy is to maintain about 2 million barrels per day of unused capacity to cushion supply shocks that occur from time to time. We think it would take a decline in spare capacity to below 3 million barrels per day for spare capacity to support higher oil prices, and given the weak recovery in demand, this seems unlikely for some time.

In addition to concerns about physical demand for oil, investment demand has fallen in line with the strength of the dollar and the declines in global stock markets.
 

After oil prices plunged to just over $30 per barrel in early 2009 in the aftermath of the worst of the financial crisis, they were quick to rebound to above $60 per barrel and have been above this level for nearly a year. At the current price and current production levels of around 8.1 million barrels per day, Saudi Arabia remains well ahead of the $53 per barrel level needed to satisfy this year's budget. Even if oil prices drop further, the government retains a huge stock of foreign assets that it will draw down to finance spending. SAMA's (Saudi Arabian Monetary Agency's) net foreign assets have risen for most of the year and stood at $414 billion at the end of April.

Falling oil prices have been a major contributor to the plunge in the TASI over the past few weeks. Although the lower oil prices will affect the government's commitment to its spending program, they do hurt the competitiveness of the petrochemicals sector, which has been the worst performer on the TASI so far in May. In addition, lower global economic growth will hit demand. The psychological impact of falls in global stock markets has also damaged investor sentiment and recent days are reminiscent of the depths of the global financial crisis in late-2008, when local fundamentals had little impact on the moves in the TASI. According to Jadwa, a fair value for the TASI at the end of the year is 7,400, a 28 percent rise from the current level.

The evolution of the TASI is important to track in examining how the ongoing volatility will impact on the Kingdom's economy. Given that the bulk of Saudi nationals are exposed to the stock market and that movements in the value of their investment portfolios have an important influence on their spending decisions, the falls in the past few days could well hit consumer spending.
 

The EU is the Kingdom's largest trading partner. But unlike every other large trading partner, the Kingdom recorded a trade deficit with the EU in 2008 owing to the high level of imports. The EU is the destination for around 11 percent of exports (worth $33 billion in 2008) and 9 percent of nonoil exports (worth $2.7 billion in 2009). Slower growth may well reduce demand for these exports, but with trade dominated by oil and oil prices expected to hold up, it will not have a notable impact on the Kingdom. Exporters of nonoil products to the EU will probably face lower demand and prices and the weaker euro will reduce the riyal value of earnings by Saudi companies from sales in the EU.
 

Nonetheless, given the large proportion of imports that come from the EU, a weaker euro will on balance be beneficial to the Kingdom. Around 25 percent of imports into Saudi Arabia are sourced from the EU. The weaker euro means that these products will be cheaper in riyal terms for importers and therefore probably to consumers as well, reducing inflation. Lower commodity prices will also have a dampening impact on inflation, though food prices, which are the largest component of the cost of living index, are not down by that much. In most cases, imports from the EU do not compete directly with locally produced products, so local companies are unlikely to be too badly hit by cheaper imports.

There will be an impact on local bank lending. The slowdown in lending has been a key factor hampering economic performance over the past 18 months. Saudi banks have minimal exposure to Greece and to those other European countries that markets think could default on their debt. The lack of discomfort in the local financial sector is reflected in interbank interest rates. Interbank rates soared as liquidity dried up in the second half of 2008 and shortly after the collapse of Lehman Brothers the three-month interbank rate peaked at 4.67 percent (267 basis points above the reverse repo rate). In contrast, the three-month interbank rate has remained unchanged since the middle of March and is currently just 0.73 percent (48 basis points above the reverse repo rate). Jadwa therefore continues to forecast a gradual increase in growth in local bank lending to the private sector this year.