Who says we are not connected? What clearly is a banking crisis in the United States and Europe has spread like a bad virus throughout the emerging markets of this world, the Middle East being no exception.

In a span of a week, the Morgan Stanley’s emerging market index was down 23 percent. Equity markets from Shanghai to Sao Paolo fell in lock step. It is a pretty nasty tally in the region. Prior to the concerted effort to cut interest rates, Cairo, Saudi Arabia, Dubai and Doha were all down 50 percent or more from their peaks in 2008. Hot money flooded the region to tap into growth, but left local traders and investors stone cold on the way out.

The economies of the Middle East are growing nicely, regionally about seven percent this year. Oil revenues with prices between $85 and $90 a barrel are still strong by historical standards. So why are the major markets of the region drowning in a Sea of Red?

The simple answer is these economies cannot stand alone in isolation with all the chaos around them. They surged in part because investors are enthusiastic about the future. There was a double-whammy if you will since many of investment funds put money in thinking that the Gulf economies would soon abandon their pegs to the dollar. When leaders in the Gulf decided not to scrap that dollar peg, even after a fall of nearly 30 percent over the past few years, foreign investors looked for the exit.

All together now

It took too long for the central bankers of the world to grasp the enormity of the problem. After much delay, the major G-7 central banks cut interest rates by a half percentage point to send a signal of unity. A handful of the region’s central banks followed suit, with rate cuts of different proportions, due to the formal link with the dollar. At this juncture, it is the fear of a liquidity crunch, not inflation that is driving sentiment.

I am old enough to remember the power of speaking with one voice. That art, crafted in large part by Alan Greenspan, has been lost when it has been needed most. The February, 1987 Louvre Accord is a prime example. The G-7 gathered to send a signal that the dollar had fallen too far and they backed it up with coordinated intervention to make the point. A similar response came after the October, 1987 crash. In today’s much larger economy, intervention packs a softer punch, but unity is essential. Market traders usually lose a lot of money betting against central banks.

The recent meeting of leaders from Germany, France, Britain and Italy to discuss the banking crisis was a perfect illustration where coordination was in short supply. They met, went their separate ways and all had a different view of the meeting and their own individual plans to move forward. This does not bode well for the European Union or the future of the single currency. This trend also does not say a great deal about enhancing the roles of the International Monetary Fund and the World Bank. One of the two institutions could serve as the global unifier, where a set of rules for 21st century trading and capital flows can be not only debated, but agreed to and most importantly enforced. This could be the new home for an expanded G-7 that includes: Brazil, Russia, India, China and a seat for the Middle East – especially with all its liquidity.

All told there is an estimated $1 trillion dollars of development projects throughout the region. Sovereign funds in the Middle East have a reported $1.5 trillion dollars under management. That is a lot of capital. While some of that money was used in the past two weeks to inject money into their local markets and banks, it could serve as a great source of funds for Wall Street and for European markets.

This major market correction, if we want to limit the description to that, is a big test for the central bankers of the Middle East. They have been working to expand their tool kit to control money supplies, battle record inflation and keep a lid on borrowing for all real estate projects which sprout up like mushrooms in the desert.

At Cityscape in Dubai, the Middle East developers showed off the latest wares with stands costing up to a reported $8 million dollars each. One new planned development outside of Dubai called Jumeria Gardens has a price tag of some $95 billion dollars spread out over a dozen years. Think about it, that is more than the $87 billion dollar bailout by the British government of their banking system.

But there is a problem in the Middle East that is similar to the challenge throughout the world – there is a lack of confidence in western banks. The sovereign funds came on strong at the end of last year with some high profile investments. After falls of 50 percent or more, they too are in no rush to jump back into this market. Until the expanded G-7 can come together, Middle East investors and sovereign funds seem content to deploy assets closer to home.

The word “contagion” is tossed around a great deal during these periods of intense selling and the word conjures up images of a bad case of the flu which is spreading from time zone to time zone.

It is not far off the mark. The World Bank officially describes contagion as “the transmission of shocks to other countries or the cross-country correlation, beyond any fundamental link among the countries and beyond common shocks”.

Bankers have found out this is no common shock. There was a widespread belief, and one shared by this writer, that the fast-growing developing countries would break out from the shackles of what really is a U.S. banking crisis. The impact of this crisis is directly felt in Europe, especially in London where there is a direct link between the City of London and the health of the British economy. Financial services make up a third of gross domestic product.

That is no surprise and the sluggishness of European and the U.S. economies has been on the cards for months. The Middle East, however, comes into this crisis with a different script altogether. Merrill Lynch’s Turker Hamzaoglu is bullish medium-term, predicting growth of 6.5 percent for the U.A.E. for example, down from the heady days of the last five years of an average 10 percent.

But the real regional concern surrounds the rapid run-up in property prices. Hamzaoglu says it is getting more difficult to manage, “It is certain that there was some kind of a speculation in the prices because I see it as a side effect of this whole macro imbalance in a way, high-inflation, high-liquidity environment, that the government or the central bank has very limited means to control.”

What is emerging is a so-called risk premium factoring in the amount of money borrowed to put more than $300 billion of real estate developments on the books in the U.A.E., a trillion dollars throughout the Middle East. At the same time, regional markets are no longer benefiting from the hot money from the U.S., Europe and Asia which was invested to capture some of the rapid growth.

Former Nomura Securities analyst Anais Faraj who recently relocated to Dubai says the reason for this current contagion is simply down to capital flows, “It is the same liquidity pool. Money invested from the Middle East into Wall Street is taking on big losses.”

Wait and See

Sovereign funds from Kuwait, Abu Dhabi and Qatar put the word out this week that there is no reason to jump and put additional money into U.S. or European banks. As Faraj noted, “No one wants to be a hero catching a falling knife.” All three of those funds have seen their investments slip 40-50 percent since they leapt in at the end of 2007 and early this year. Their forays into the British banks have held up much better.

Which leads us back to what one can expect going forward. The investment fund managers I spoke to see promise in the medium to longer term, but they add it is not a straight line up. The $60 fall in energy prices certainly will impact some of the sky high projections for revenues going forward. And everyone is keeping a watchful eye on the dollar.

The recent recovery in the U.S. currency was taking some of the heat off of regional policy makers to change course to counter record inflation. That concern will move right back onto the front burner and rekindle conversations on whether to peg to a basket of currencies before the launch of a single Gulf currency in 2010.

This story has many more chapters that need to be written, and the word contagion will be part of the text despite the rosy growth scenario still expected.