As the war in the Middle East begins its fourth week, it has entered a costly new phase as the focus moves to destroying energy production and refining capacity.
With that shift, it is time to start considering the downside risks and the potential sources of contagion through the financial channel.
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One remarkable fact, given the quick escalation of the conflict, is that financial markets remain remarkably well behaved and balance sheets of the global systemically important banks look solid.
Despite the recent sell-off across global equity markets and declines in valuations of important global financial intermediaries, financial markets continue to function properly. Liquidity has not been a problem even as interest rates increase along the curve in the major economies.
But the targeting of the Ras Laffan natural gas field in Qatar will cause a $20 billion annual revenue loss. Qatar recently invested $26 billion into the field and estimates a $23 billion repair bill that will take three to five years.
The exposure to significant losses like these, be it a country, private financial intermediary or insurance company, will be in focus as the war endures.
Credit default swaps
The targeting of economic and energy infrastructure in the region requires challenging questions about the credit quality of those nations and institutions with exposure to the conflict.
One place to start is credit default swaps. These financial instruments help signal credit risk for governments and companies.
With a credit default swap, one party pays a fee to another party in exchange for a promise to be compensated if a loan or bond defaults or is ensnared in other credit problems like sovereign defaults.
Credit default swaps help investors reduce or transfer credit risk on bonds and loans.
State of play
A look at five-year credit default swaps of Bahrain, Oman, Qatar, Saudia Arabia and the UAE is instructive. Global investors as of now have only marginally priced in a probability of default for all but Bahrain.
Given the targeting of Dubai, one would have thought that investors would have pushed the risk of default higher in the UAE. Yet, they have not, so that should be interpreted as a sign of global financial resilience.
Banks that operate in the Gulf Cooperation Council—which includes Saudi Arabia, UAE, Qatar, Kuwait, Bahrain and Oman—are opaque, and financial stress in the petro states is often masked because of the assumption that those institutions are too important to fail.
As of now, the risk of default is minimal and credit default swaps have moved only marginally in banks.
But as earnings season approaches, investors will be trying to ascertain how global corporate banks have reduced exposure to the region since the war began.
To be sure, exposure to private credit as well as Gulf Cooperation Council economies and institutions are at play when one looks at credit default swaps. One can observe a modest upward movement in that metric.
First-quarter earnings statements that will be released in the coming weeks will provide insight into the scale of exposure that is hedged.
As with the financial crisis, clear identification of risk among globally systemic important banks as well as secondary players will be part of the international economic and financial narrative as the conflict escalates and its duration remains uncertain.
