Prepare for a shock from Middle-East

Financial times – Mohamed El-Erian

Global markets paid scant attention to the Egyptian and Tunisian revolutions. Both were seen as lacking systemic economic and financial significance.

This is now changing as youth-inspired uprisings spread to other countries in North Africa and the Middle East. While related political and social issues rightly dominate the headlines, this past weekend could also prove a tipping point when it comes to the implications for the global economy; and there is little that western countries can do to offset short-term stagflationary winds. It is understandable that Egypt and Tunisia had essentially not registered on the markets’ traditional scale of systemic influence. The two countries are not significant global economic powers; they do not owe much money to western banks and governments; and they are not large exporters of commodities. Yet Egypt and Tunisia are catalysts for a broader phenomenon of change that is gaining systemic importance. Over the weekend, protests occurred in a growing number of countries in the region, from Algeria and Morocco in the west to Bahrain and Yemen in the east. Two developments are particularly important when it comes to global demand and price dynamics. With an oil exporter such as Libya now in the grips of a popular uprising, markets will push oil prices higher to reflect much greater supply uncertainties for this key global commodity. And with sectarian issues now on display in Bahrain, geopolitical risks are higher for the region – especially as other countries seek to influence events in the Kingdom.

Unfortunately, this weekend also saw a deplorable change in dynamics; and one that makes this transformational period even more unpredictable and dangerous. Relatively peaceful movements in Egypt and Tunisia regrettably gave way to violence elsewhere as governments applied force to clamp down on street protests. Casualties multiplied alarmingly. Yet the strength and determination of the popular movement became even more apparent for all to see.

In the short run, regional developments will be stagflationary for the global economy due to three main factors: First, higher oil prices will increase production costs and act as a tax on consumers. Second, greater precautionary stockpiling around the world will intensify pressures on commodities as a whole, aggravating the impact of demand-supply imbalances and large injections of liquidity. Third, the region will be a smaller market for other countries’ exports. This economic reality is far from encouraging for western countries that have few options in reacting to what is an increasingly fluid situation.

On the regional stage, they are essentially bystanders to developments in countries where protests are in their early phases. At best, they can only marginally offset tendencies towards violence. Fortunately, they can do more in post-revolutionary Egypt and Tunisia, where both Europe and the US are eager and able to support the peaceful path to democracy, including the important visit to Cairo of David Cameron, the UK prime minister. Domestically, having already countered aggressively the impact of the global financial crisis, western economies have little room left for further demand stimulus. Some have already embarked on fiscal consolidation, while for others it is only a matter of time. Moreover, recent evidence of inflationary pressures is already influencing the narrative of some central banks.

In the next few days, markets will react to the changed outlook for the region and the global economy. Higher commodity prices will be accompanied by greater risk aversion in the equity and credit markets. Over time, however, such market apprehension is likely to give way as the impact of greater long-term stability in a key part of the world is felt. In the long term, after all, democracy and individual freedoms are the best drivers of prosperity.

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