Should Gulf Investors Abandon the Eurozone?

London, Asharq Al-Awsat- This week Eurozone crisis extended further as spreads between Bunds and the bonds of AAA-rated core Eurozone countries such as France, Netherlands and Austria widened substantially. Gulf investors, particularly sovereign wealth funds, will be asking themselves whether they should remain invested in the Eurozone. The answer is most emphatically yes.

The GCC sovereign wealth funds have stated aims of investing for future generations and diversifying the region’s sources of income away from oil. An unstated but equally important function of the sovereign wealth funds is recycling oil wealth back into important trading partners. On the basis of both of these objectives, GCC sovereign wealth funds should retain their existing investment strategy towards the Eurozone.

The Eurozone is the GCC’s largest trading partner, with a positive trade balance for the GCC in 2010 of $40 billion. The Eurozone is also the largest economy in the world, with 25% of world GDP just ahead of the US with 24%.  With foreign currency reserves of $558 billion in 2010, of which $140 billion are likely to be held in Euros, and with assets of $1.4 trillion held by its sovereign wealth funds, the GCC must necessarily remain invested in the largest and most mature markets, the US and the Eurozone.  No other markets have the depth and maturity to absorb this level of investment.  Moreover, recycling a substantial portion of positive trade balances with trading partners is essential to the continued well being of the trading partners and the trading relationship.

The GCC’s policy of shifting from a US dollar peg to a basket including the Euro will require holding large Euro reserves. Even though GCC investors may start directing more investment toward Asia and Africa as well as regional and domestic investment, a substantial portion of investment will need to remain committed to the Eurozone.

As a currency, the Euro has proved resilient despite a serious crisis. During this year, the Euro has remained flat against the US dollar and sterling and has depreciated less than 5% against the yen and 8% against the Swiss Franc.  The Swiss National Bank has implemented a policy of preventing further appreciation of the Swiss Franc against the Euro, so there is little benefit of holding Swiss Francs instead of Euros to benefit from currency appreciation. The Euro, moreover, has appreciated this year against a number of emerging market currencies such as the Brazilian real, the Turkish lira, the Polish zloty and other Eastern European currencies.

Selling Euro assets in expectation of a disintegration of the Euro is in itself a speculative bet on a possible but unlikely outcome. Currently there is no legal mechanism for ejecting member countries from the Euro or for member states leaving the Euro. Any such mechanism would need to be agreed by all member states or at least all member states of the Eurozone.  Furthermore, there is overwhelming political commitment to preserve the Euro and no significant political support for abandoning the Euro.  In the event that any weak members were to end up leaving the Euro, the result is likely to be a stronger Euro, notwithstanding very negative consequences for the economy of the region and the world.

The consequences of the Euro crisis are being felt throughout the entire world; therefore, avoiding Eurozone assets will not adequately protect investors from the consequences of the Eurozone crisis. The appropriate response is to de-risk investment portfolios, ensure appropriate risk-return relationships and implement suitable diversification among uncorrelated or lowly correlated asset classes. This should include the usual categories of property, private equity and infrastructure.

The crisis is providing investors with opportunities to undertake strategic or opportunistic acquisition of attractive assets in the Eurozone.  Opportunities will arise as banks sell assets to increase their capital ratios and as over-leveraged groups seek to deliver. Private equity firms will feel some pressure to exit existing portfolio companies and return money to investors before embarking on their next round of fundraising. Already, we have seen Qatari investors purchase Dexia’s Luxembourg private banking unit, invest $1 billion in a Greek gold mining project and $670 million investment in Greek banks.

This is a time of opportunity as well as crisis. Fleeing the world’s largest economy is not an adequate response. GCC investors will need to engage with the Eurozone and address the crisis proactively and intelligently.