MENA Geopolitical Risks Increase

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There is a concern that the Iraq turmoil has caused a significant increase in geopolitical risks in MENA. The turmoil could also deepen the major fault lines in MENA, says Turker Hamzaoglu, MENA Economist at Bank of America Merrill Lynch. As oil prices are almost back to the day before ISIS took over Mosul and sent shockwaves across the globe, markets have been somewhat complacent lately. The actual risk might not be fully priced in for MENA credits.[wpsr_linkedin]

The Islamic State’s (IS) march to Baghdad after controlling Mosul shocked the world and markets, but these worries have fizzled out somewhat lately. The conflict has reached a stalemate and Baghdad is still fully under Iraqi government control. Oil-rich southern Iraq is largely out of Sunni rebellion’s reach as well, and oil prices are almost back to the day before ISIS took over Mosul.

Can we jump to the conclusion that what happens in Iraq is its own problem and has little spillover to the markets and the rest of the world? Investors need to be cautious. BofA’s analysts believe the turmoil has caused a significant increase in geopolitical risks, which markets keep ignoring. Iraq’s story seems to have many legs to run and could create a major change in the Middle East over the short to medium term. Investors are pricing too little risk premium for MENA credits.

On the other hand, with the U.S. economy firmly on the path to recovery, billions invested in foreign markets will be needed back in the country. The US defense industry, for example, certainly will face a strong demand in the coming five years due to the MENA geopolitical risks.

Look elsewhere for the fall in oil prices
The main driver behind the fall in oil prices seems to be the good news from Libya that rebels returned two oil ports as a goodwill gesture to the new government. Libya can now double its exports, which were around 220k bpd in June according to OPEC. This more than offsets the supply disruptions from the Iraq pipeline.

Iraq’s oil output was down 170k bpd in June and exports lost some pace. Exports from the South slowed to 2.4mn bpd during the month due to technical issues (2.6mn bpd in May). Kurds also started to export through Ceyhan, though only about 1mn barrels over the entire month.

Main spillover from Iraq is increased geopolitical risk
The main spillover from Iraq is not the oil disruptions at this point (until Islamic State makes a move to Baghdad). It is the increased geopolitical risks and deteriorated security situation. Four headlines recently warrant some caution, in our view: 1) increasing Kurdish aspiration for independence; 2) deepening fault lines in MENA, such as increasing Arab-Israeli tensions; 3) reviving and radicalizing Islamist opposition; and 4) increased risk of terrorist attacks.

From Arab Spring to Sunni Spring
In the aftermath of the Arab Spring the MENA region would experience a lengthy and bumpy transition with an unknown direction. The region has gone through numerous liberalization cycles in the past and none led to democracy, according to BofA’s research. Most of these cycles have helped incumbent regimes, which used them to consolidate power via reorganization of elites and co-optation of dissidents.

Middle East’s resilience to change can be broken
According to BofA’s analysts, the Arab world is largely ruled by neopatrimonial regimes, characterized by four features that help them to resist change: 1) the political regimes are largely closed off from societal forces; 2) they can adapt to changing conditions given the prevailing elite groups; 3) they are politically legitimate among key segments in society; and 4) they are rentier states based on patronage and clientism.

So the question becomes what can pacify these dynamics and lead a tectonic change Middle East. There are four factors based on the current regional backdrop: 1) the vanishing colonial borders (Syria-Iraq and Kurdistan); 2) sectarian conflict (Shia-Sunni); 3) intra-sectarian conflict as Sunnis radicalize (Iraq, Syria, Kuwait, Jordan, Saudi); and 4) and Arab-Israel conflict.

Four headlines that warrant caution
Following the diminishing colonial borders between Iraq and Syria thanks to Islamic State, Kurdish independence may send shockwaves to the rest of the region and deepen the fault lines. There are already some heated discussions that a Balkanization of the Middle East could triple the number of countries/autonomous regions. An independent Kurdistan may accelerate the fragmenting of the regional order by paving the way for the breakup of Iraq and Syria, and spreading radical Islamist groups into Jordan and Saudi Arabia.

The Islamist opposition in Kuwait and Jordan has been making headlines with their vocal discontent to the ruling families and public rallies. While there are concerns Islamic State may advance into Jordan, its influence on dissenting local Sunni groups in the region that question their regimes’ legitimacy is evident.

The third fault line is the increased Arab-Israeli tensions. Following the murders of three Israeli teens and a Palestinian teen, tension have increased dramatically within Israel and with Hamas. While the Israeli right wing calls for more radical measures from the government, some groups associated with Hamas have announced allegiance to Islamic State. As a result, there is a risk that the current tensions could escalate into a broader conflict and a 3rd Intifada.

Finally, alerts/fears on terrorist attacks have been making the rounds. Of course this is a recurrent risk, but it reminds once again that the rise of global jihadist movement with the Islamic State may have some far reaching repercussions.

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