By Saeed Azhar, Davide Barbuscia and Katie Paul
DUBAI/RIYADH (Reuters) - Qatar's rift with its Arab neighbors is threatening to puncture investor appetite for the Gulf region as a whole, translating into potentially higher debt costs for governments and possibly slowing the pace of Saudi Arabia's economic reforms.
Saudi, United Arab Emirates, Bahrain and Egypt broke relations and transport ties with Qatar on June 5, alleging it finances terrorism, something Doha vehemently denies.
The move has thrown the region -- which has been relatively stable, if troubled by Sunni and Shi'ite Muslim rivalry -- into diplomatic turmoil that is now putting off investors.
"We were used to a relatively peaceful region and now the landscape has changed," said Brigitte Le Bris, head of emerging debt and currencies at Paris-based Natixis Asset Management, which manages about 350 billion euros ($392 billion) in assets.
"We are not yet ready to increase our exposure to the region. We need to know whether this crisis is isolated to Qatar or it can spread and affect other countries or the crisis can worsen."
One obvious area is sovereign debt, where the crisis has the potential of raising borrowing costs.
Following the sanctions, rating agency Standard & Poor's downgraded Qatar while Fitch put it on its watchlist for a potential downgrade.
To date, foreign investors still appear to be comfortable holding Qatar paper due to the size of the country's reserves and assets held by its sovereign wealth fund, Qatar Investment Authority.
Yields on Qatar’s sovereign dollar bonds maturing in 2026 spiked over 40 basis points after the sanctions were announced on June 5 but have now recovered nearly 20 bps.
Other Gulf Cooperation Council countries' sovereign bonds saw some weakness in the immediate aftermath of the diplomatic crisis, but again have largely gone back to their pre-crisis levels.
How long this lasts, however, may depend on how long the crisis goes on, which may be "for years" according to one UAE minister..
The market's take, however, is that the diplomatic crisis will be resolved via political mediation, said Max Wolman, senior portfolio manager at Aberdeen Asset Management in London.
"But if the likes of Bahrain, Oman or even Saudi Arabia were to issue these days, I think there would be a slight risk premium of 10 to 15 basis points in the primary to the secondary market because of current political uncertainty," he said.
SAUDI REFORMS
Another risk could be to Saudi Arabia's economic reforms, many of which depend on investor cash flowing in.
"Investors may become concerned about Saudi over-extending itself, as the war in Yemen continues and domestically reforms have adversely impacted consumer sentiment," Asha Mehta, portfolio manager at Acadian Asset Management.
A senior banker, who has done extensive investment banking work in the Middle East, pointed to the high-profile listing of oil company Aramco as a potential issue.
"If the situation continues like this and they planned their IPO, they would be bombarded with questions on this (political upheaval)," he told Reuters, asking not to be named.
Even though the Aramco IPO is not expected until 2018, Saudi Arabia was preparing the sale of government stakes in airports, healthcare and educational firms, aiming to raise $200 billion.
The privatization is part of the reforms to reduce Saudi Arabia's dependence on oil, after its price plunge hurt the kingdom's economy and stretched its finances.
Bank of America Merrill Lynch in a recent note said geopolitics may delay the reforms, although not derail them.
Saudi's reform process could get some impetus, however, from the announcement on Wednesday that Mohammed bin Salman will become the crown prince, replacing his cousin in a sudden announcement that confirms Saudi Arabia King Salman's 31-year-old son as next ruler of the kingdom.
MBS, as he is known, was behind the sweeping economic reforms aimed at ending the kingdom's "addiction" to oil, part of his campaign.
Brent was unchanged at $46.02 barrel at 0651 GMT on Wednesday at multi-month lows after falling nearly 2 percent in the previous session to its lowest settlement since November as investors discounted evidence of strong compliance to a deal to cut a global output.
(additional reporting by Marc Jones in London, and Tom Arnold in Dubai Editing by Jeremy Gaunt)