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Sun 1 Apr 2007 12:00 AM

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The butterfly effect

The fact that Middle East markets did not suffer on Grey Tuesday is not as positive as it might appear.

A butterfly flapping its wings in China can cause a hurricane on the other side of the world, or so the saying goes. The events in world stock markets over the past month showed that not all economies suffer from butterflies.

When shares in Shanghai plunged 9% on February 27, following suggestions by the Chinese government that it would implement capital gains tax, it had a knock-on effect in many of the world's markets. The Dow Jones dropped 3.3% over the course of Grey Tuesday, while London's FTSE 100 lost 1.8% in value, with the French and German exchanges falling similar amounts.

The affected markets soon picked up, but it was notable that Middle East markets did not seem to suffer in the wake of a worldwide sell-off. Any losses made on the region's bourses that week were likely to be a result of local factors.

At first thought, that sounds like good news. After the GCC markets corrected last year, it seems that stocks have bottomed out and are now priced at reasonable levels.

That is probably true, but the lack of any impact from the Chinese wobble just goes to show that Middle East stock markets have very little correlation with Western markets.

Due to their depth and range of instruments, the Western stock exchanges were able to recover quickly from the shock sell-off, but the Middle East markets are still fairly vulnerable. Risk is easy to diversify in the more mature markets - investors can buy and sell derivatives based on a variety of underlying assets and have many more ways to hedge against price declines.

Middle East markets also need to broaden their investor base and welcome in foreign money, something which the UAE markets are perhaps the closest to achieving.

An increased level of investor sophistication and a move towards longer-term investments, rather than looking for short-term gains, could create more stability. The development of pension funds and infrastructure projects are helping to drive demand for long-term investment.

And of course all of the region's stock markets could benefit from greater depth. Every additional listing is a step towards greater stability, and Middle East markets are certainly moving in the right direction, helped by the willingness of family-owned companies to seek expansion capital. The addition of more heavyweight stocks and instruments will help to make markets more resilient.

Middle East capital markets are moving in the right direction, and moving quickly. But progress will need to continue if they are to weather the storms to come.

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