Gulf oil exporters including Saudi Arabia have been caught in the current, with equity markets showing some weakness this week. However, Gulf oil exporters although not insulated are less vulnerable to any direct contagion effects.

Offshore investors are likely to remain uneasy until political stability returns to Egypt, the Arab world's most-populous country. They will also be watching to see whether similar political standoffs between Arab states and their populations take place in other Arab countries, such as Algeria, Jordan, Morocco and Syria. At this stage, it is difficult to assess how long and how deeply the developments in Egypt will impact equity, debt and currency markets in the Gulf.

The wave of unrest in Egypt indirectly exposes Gulf oil exporters to negative investor sentiment, although there is no reason to question the stability of Gulf political regimes nor does it seem likely that economic fundamentals will be shaken. Equities could continue to suffer from selling by foreign investors liquidating regional positions. However, this does create buying opportunities for local investors confident in macroeconomic fundamentals as oil prices rise and global energy demand grows. Brent crude is almost at $100 a barrel while WTI hovers above $88 a barrel.

Saudi Arabia derives the bulk of public revenues from oil exports and demand growth in Asia is likely to enable the country's economy to grow 4.2 percent this year, according to our forecasts. The central bank (Saudi Arabian Monetary Agency) held SR1.63 trillion ($434.67 billion) in foreign assets as of November. Oil output in Saudi Arabia has risen to around 8.4 million barrels per day, well above the official OPEC allocation of 8.05 million barrels per day. OPEC ministers are set to discuss oil policy in February and could raise output to rein in prices, which bodes well for the Kingdom's fiscal and current account position.
 

Markets continue to differentiate between Middle Eastern countries vis-à-vis their ability to repay debts. The cost of insuring debt through credit default swaps has spiked in Egypt, affecting spreads in other countries although the impact for most Gulf spreads has been limited. At this stage, we do not expect Gulf bond markets to face significant adverse effects from Egypt turmoil, although a continuation of the political deadlock could prompt some issuers to postpone their plans. Numerous sovereign and corporate issuers - including the Saudi civil aviation and Saudi International Petrochemical Co. - have already gone to market or are planning to do so shortly.

Currency regimes in the Gulf remain tied to the US dollar, with no change in this policy on the horizon. The US dollar, viewed as a safe haven, is likely to remain strong should tensions persist or escalate in Egypt.

Meanwhile, since the Saudi riyal market is the largest and most-liquid in the Middle East, investors worried about contagion have been buying into it in larger numbers. Dollar-Saudi riyal one year forward rates have risen to their highest in around two years, and unlike the typical trend, riyal forward reflect depreciation in the currency in 12 months. Trading sources indicate that since forwards have traded at a discount for some time, investors are turning to them as a proxy hedge. Similar patterns in demand for USD/SR occurred during the invasion of Kuwait and first Gulf War in 1990-91.

Gulf investors are heavily involved in the Egyptian economy, through investments in publicly listed firms as well as numerous private sector ventures across real estate, construction, industry, banking and telecoms. The UAE's Emaar Properties has launched projects in Egypt, Abu Dhabi-based telecom company Etisalat operates a 66 percent-owned unit in the North African country, and National Bank of Kuwait is a majority owner in Al Watany Bank of Egypt. Saudi Arabia's largest dairy company by market value, Almarai, has full ownership of Egypt's International Co. Agro-Industrial Projects (Beyti) but earns only 2 percent of revenues from Egypt, while foodstuff producer Halwani Brothers Co. operates wholly owned Halwani Brothers Co. in Egypt.

Egypt is also a key trading partner for Saudi Arabia, with the balance of trade favoring the Kingdom; in 2009, Saudi Arabia imported SR5.37 billion worth of Egyptian goods, such as food and metals, while the export bill was SR8.34 billion, according to central bank data. A prolonged economic downturn in Egypt could cut the flow of Saudi petroleum and chemical products, pharmaceuticals, plastics and building materials to Egypt, although we do not expect a substantial decline in trade flows. Remittances of Saudi Arabia's estimated 1.4 million Egyptian expatriate community are not expected to slow down.

Private Saudi companies, meanwhile, also have important investments in Egypt. Al-Rajhi Group, for one, has launched an agricultural project in southern Egypt to produce wheat and poultry. Saudi businessman Abdel Rahman Al-Sherbatli has also been reported as a key investor in a Cairo-based commercial complex known as City Stars. A prolonged political crisis in Egypt would have severe negative effects for its economy.
 

The events in Egypt thus act as a wake-up call to governments across the Middle East about the pressing need to address serious inadequacies of employment opportunities and income levels, and have shed light on the need to re-build the middle class, which shrunk in size in most countries over the past decade.

Emboldened by the success of Tunisians to oust their 20-year ruler, Egyptians are demonstrating against the soaring cost of living, growing poverty and mounting unemployment. According to the UNDP, at least 90 percent of those unemployed in Egypt are under the age of 30. Inflation in Egypt has held in double-digit levels for about three years - surpassing 20 percent in many months in 2008; even now food inflation is around 17%.

Gulf countries have not faced as steep rates of inflation and in some countries, like Qatar, a deflationary trend persists. Inflation in Saudi Arabia, which had entered double-digit levels in 2008, eased in recent months to 5.4 percent as of December. We expect annual inflation to average 5.1 percent this year, historically high for a country that experienced average inflation of 0.8 percent between 1990 and 2006. Still, the government is capable, if necessary, to step in with measures to ensure that food prices do not rise too substantially this year.

The Kingdom also suffers from an unemployment problem, although less pronounced than is the case in Egypt. Unemployment among Saudi nationals rose to 10.5 percent in 2009, including 30.2 percent youth unemployment based on government data used by the ILO (International Labor Organization).

Such statistics have led the government to dedicate about a quarter of its budget spending allocations to education; the 2011 education budget is triple its size in 2000. Meanwhile, per capita income is much higher in the Gulf than it is in Egypt. Saudi GDP per capita was $16,039 in 2010 - compared with about $2,500 in Egypt. Still, turmoil in Egypt underscores the necessity for faster reforms to fight unemployment and encourage private sector job creation. Saudi Arabia's private sector is not creating enough jobs for nationals, who comprise only about one of every 10 employees. Regional governments are also likely to continue feeling obliged to sustain and introduce new policies, such as price controls or subsidies, to help their populations deal with the rising cost of living. Middle East economies and Gulf oil exporters should take note of events in Tunisia and Egypt as a wake-up call and enact important economic reform policies that are long overdue.