Why Europe could get a lot more important for the GCC

By Kathleen Brooks, Research Director

Forex.com

We would say absolutely not. Europe may have stepped back from the edge, but it is not out of the woods yet, and Europe will still be a chief concern for the global economy as we head towards the end of the year.

Not only do we still need to find out if each European government will support last week's plans, but we also don't know how the enlarged bailout fund will be paid for or by whom, and that is where the Middle East comes in.

The European Financial Stability Facility (EFSF) is being increased in size to the tune EUR 1 trillion. However, this doesn't mean that each of the 17 members of the Eurozone contribute a certain amount each - in fact the fund will never actually hold EUR 1 trillion. Rather, Eurozone countries have all guaranteed a specific amount to the fund, and these contributions will not be increased.

Instead the fund will be structured in two ways: firstly, it will act as an insurer of European debt and guarantee the first 10%-20% of losses if a member of the currency bloc was to default. Secondly, a Special Purpose Investment Vehicle (SPIV) will be set up that aims to attract foreign cash to invest in the fund, which then purchases the debt of Italy, Spain, France etc. If a country is to default then these investors will get the guaranteed portion of their money back direct from the EFSF, rather than have to rely on a Greece or an Italy to recover their losses from. Since the EFSF is backed by rich, powerful states like Germany this should be considered a safe way for outside investors to buy the debt of European sovereigns.

Benefits of re-entering Euro support fund

So where does the Middle East come in? The cash-rich oil producing states are probably getting courted by European officials to invest in the EFSF as I write this. China is apparently happy to invest in the fund to the tune of EUR 100bn, and it is likely that other states will follow suit. So what are the benefits?

The benefits are two-fold: firstly, oil producers need a strong Europe to ensure stable demand for oil in the future. A disorderly default or a collapse of the Eurozone would hit the Middle Eastern economy hard, so if it can help to prop up growth in Europe then it is doing itself a favour.

The second point is that in the current environment of low global interest rates some European debt offers very attractive yields. US 10-year bonds yield a miserly 2.3%, also after appreciating more than 10% since February they are starting to look expensive. The dollar is also looking fairly vulnerable and has reached record lows versus the Japanese yen in recent days, so an alternative investment in the West may reap benefits. If you think that Italy will avoid default then its 10-year bonds are yielding nearly 6%, and the euro is higher by more than 10% versus the dollar since the start of the year. This investment is not for the faint hearted, but in recent weeks it looks like the EU authorities have a better grasp of the problems facing the currency bloc than they did 6 months ago.

Of course there are risks; if the bond insurance programme goes ahead there is always counterparty risk for SPIV investors. For example, what if Germany decides not to pay the "insurance" of other countries' debts?

This needs to be considered and proper risk premiums paid to try and account for this event happening. But one of the upsides that hasn't been covered in much detail is the political and economic benefits of helping Europe out in its hour of need. The Middle East could see enhanced trade links with Europe and more access to markets in the region, but added to this there could be a less obvious benefit for the Gulf.

Money from the GCC helped to save the financial system in 2008, however, some of that money failed to produce the required return. This time Middle East investors may be less tolerant. If Europe fails to deliver much needed reform on the fiscal and growth fronts then EFSF SPIV investors could insist they have more say on how Europe works. That could boost the profile of the Middle East on the world stage.

So investing in Europe comes with risks, but there may be some hidden benefits too.