Just a few months ago, bankers were talking excitedly of a return to the Middle East by international investors. In the wake of political turmoil across the region, that optimism has quickly dissolved.

The political risks associated with doing business with the autocratic regimes of the Middle East have been worryingly exposed. Investors are worried. Equity markets are falling and foreign investors are nervous about signing new deals.

Some investors are starting to get a bit nervous about how far this wave of protest will spread

London-based trader

Kuwait’s stock market is already 7.7 per cent lower since the start of the year. Saudi Arabia’s is down 5.2 per cent and the Dubai Financial Market is down 5.8 per cent. Despite the unrest in Bahrain, the local stock market is up 2.5 per cent since the beginning of the year.

For the projects market, public-private partnership schemes in Egypt are facing delays, as are projects in Morocco and Bahrain due to the unrest. This will further hit foreign direct investment (FDI) into the region.

Risk markets

Credit default swaps (CDS), which measure the cost of insuring against a sovereign default, jumped for Bahrain and Saudi Arabia. The CDS rates for Bahrain rose from 212 basis points at the end of January to 305 basis points on 21 February. For Saudi Arabia, the CDS rate rose from 119.7 basis points to 140 basis points.

If it makes the right decisions, we believe Egypt could well end up with a structurally stronger economy

Hans Zayed, Rasmala Investment Bank

“Although Egypt is entering a new political phase we doubt that investors will come rushing back to the risk markets for the moment,” says Gary Dugan, chief investment officer for private banking at the UAE’s Emirates NBD. “Military governments plus other pockets of political uncertainty around the Middle East and North Africa (Mena) region will in our view make investors hesitant to commit new money to the markets.”

The fear of unrest spreading to other oil producers in the Gulf is hitting the price of oil, which has now risen to $104 a barrel for April deliveries of Brent crude – the highest in two and half years. That will be a boon for oil producers, especially Bahrain, which at $80 a barrel, has one of the highest oil price assumptions in its budget calculations. The downside is state handouts to try and appease citizens will eat into oil revenues.

On a macroeconomic level, most analysts say it is difficult to assess the impact of the protests so far. “From the perspective of the region’s economic fundamentals, there has not been much change,” says Farouk Soussa, a Dubai-based economist at the US’ Citigroup. “But these events are raising investors’ perception of risk in the Middle East and will be more nervous as they see public airing of grievances against the ruling authorities.”

Ratings downgrade

International ratings agencies have already started to review their opinions of some countries that have been hit by protests. Standard & Poor’s (S&P) has downgraded Bahrain by one notch to A- from A and put that rating on a negative credit watch. Moody’s Investors Service has done the same. S&P has also downgraded Egypt and Moody’s has downgraded Egypt to Ba2, with a negative outlook.

Fitch Ratings has also put its Egypt and Bahrain ratings on negative outlook. Moody’s has also put Jordan’s Ba2 rating on a negative outlook because of unrest in the country.

The downgrades come as a result of the political unrest, but they also stem from the fact that so far the places where protests have broken out have been in countries with more constrained public finances. A government that pursues populist measures, such as wage hikes and increases in subsidies, will put further pressure on their financial situation.

Following the ratings action, a raft of banks and other state-related corporates have been hit by downgrades. Bond investors will be getting nervous about their exposure to the region.  “After so much interest in Middle East names last year, some investors are starting to get a bit nervous about how far this wave of protest will spread,” says a London-based bond trader.

For equity investors, the decision not to invest in a country or a market can be quickly reversed once stability returns. In the case of FDI in projects, these decisions often take longer to be made. In the case of changes to top leadership, decisions can be held up for a long time getting approval from new bureaucrats.

Egypt is a good example of this. Although the PPP Central Unit has been proactive in its communication with bidders on the projects it has planned, it is difficult for it to give any firm information. “There is still a lot of interest from the bidders in the projects Egypt has planned, and an assumption that things will be back on track in the future, but it’s impossible to know how long that may take, and if new ministers are appointed how long it will take them to give approvals,” says a source close to several of the projects.

Socio-economic challenges

“A new government [in Egypt] will face the same socio-economic problems that contributed to the recent revolt,” says Hans Zayed, an analyst at Dubai-based Rasmala Investment Bank.

“It will have to balance appeasing the population without alienating foreign investors, stretching government finances and damaging growth prospects beyond 2011 too much.

“If it makes the right decisions, we believe Egypt could end up with a structurally stronger economy, and a more interesting place for FDI and capital market investors than before.”

Egypt’s open capital markets and large population have long made it one of the most attractive places to invest. But it could be some time before the political risk decreases. “No-one knows how a new elected leadership in Egypt will take on the challenges in the country and it may take up to two years before we find out if they can make a better country,” says Yazan Abdeem, equities fund manager at Netherlands based ING Investment Management.

The same will be true elsewhere in the region, where significant changes to the ruling authorities have occurred. Egypt’s and Tunisia’s new presidents, and potentially a Bahraini leadership that is more representative of the islands’ demographics, will all take time to establish themselves and really start to make a difference to the running of the country.

In the longer term, the shift towards more transparent democracies in the region could boost the attractiveness of investing in the Middle East, but that is not something to be taken for granted. “The assumption that a democratic government will put in place the structure necessary to attract foreign investors is not a given, and populist measures could well make some countries less attractive than they are now,” says a regional analyst.

If the revolutions succeed in installing governments that tackle corruption and manage to address public finance issues by limiting things like subsidies and embracing a vibrant private sector, then foreign investors will find them even more attractive than they have done in the past.

Dubai benefit

In the meantime, stable countries in the region stand to benefit from turmoil elsewhere. Dubai, in particular, stands to benefit from the turmoil in Bahrain, as the two have for many years vied for the crown of regional finance hub.

“The UAE and Qatar are being perceived as safe havens in the region because they don’t have a large unemployment problems and are open economies that benefit from relatively large investment inflows,” says Soussa.

For decades, authoritarian leaders have provided stability to the Arab world. Coupled with the past decade of rising oil prices, it has made the Middle East a hugely attractive region for FDI. It has also led to an investment bubble and the rehabilitation of the Middle East economically and politically.

But now, uncertainty reigns and no-one knows where the protest movement will end and if it will cause more regimes to collapse. It will be a further blow to the region still struggling to emerge from the financial crisis, and one that could take much longer to overcome.