Last month North Korea dramatically raised tensions in east Asia when it shelled the island of Yeonpyeong, hitting a South Korean military base and killing four people. South Korea said it was conducting military exercises at the time but insists test firings were not directed toward North Korea.

“In Japan we have a strong sense of crisis over the North Korean artillery attack on the island of Yeonpyeong,” Hajime Hirota, parliamentary vice-minister of defense, told Reuters on the sidelines of a security conference in Bahrain.

“It is an act that we in Japan we cannot tolerate … For other countries of northeast Asia, including Japan, this act is seen as a large threat.”

Hirota said the attack would see Japan forging stronger ties with South Korea and the United States and that the key was to avoid further escalation. “We don’t know how North Korea will react to the situation going forward,” he said.

Japan has long taken a hardline stance against Pyongyang over its nuclear and missile programs and its kidnappings of Japanese nationals in the 1970s and 80s to train North Korean spies — still a highly emotive issue among the public.

The country has pledged to cooperate closely with South Korea and the United States and said it is discussing with them on how to deal with the issue in the U.N. Security Council.

Japan should also increase its defense budget given the growing uncertainty in Asia, Hirota said.

A week after North Korea’s shelling of Yeonpyeong, Pyongyang announced it had made advances in its nuclear program. Japan’s ties with China and Russia also remain fragile after a flare-up in long-standing territorial feuds.

“My personal view is that Japan should increase its defense budget but at the same time Japan’s fiscal condition is the worst among the advanced countries,” he said at the Manama Dialogue meeting of the International Institute for Strategic Studies, a London-based think-tank.

“The environment in Asia surrounding Japan has seen an enhanced level of uncertainty and therefore as a nation we have to have the will to secure a necessary budget.”

(Editing by Mark Heinrich)

In his first trip to the region since WikiLeaks published U.S. diplomatic reports of Gulf Arab worries about Tehran, Foreign Minister Manouchehr Mottaki told a Gulf security conference in Bahrain a more powerful Iran was nothing to fear.

“Our power in the region is your power and your power in the region is our power,” he said in a speech to an audience including Gulf Arab officials and ministers.

“Our growth will only pave the way for others to grow.”

His speech did not mention the publication by the WikiLeaks website last week of hundreds of U.S. embassy cables including several quoting Arab leaders as expressing strong opposition to the possibility of Iran acquiring nuclear weapons.

But he said “We must not allow Western media to tell us what we think of one another …. We have never used our potential to become powerful against any neighbours especially because our neighbours are Muslims.”

“There should be no suspicion or ambition by one country over another because that would undermine efforts to establish cooperation,” he told the Manama Dialogue conference of UK-based think tank the International Institute for Strategic Studies.

One notable WikiLeaks document cited Saudi King Abdullah as urging the United States to attack Iran’s nuclear installations. He was reported to have advised Washington to “cut off the head of the snake” while there was still time.

The leaked U.S. cables underlined the depth of suspicion of Shi’ite Muslim Iran and its nuclear program among Sunni Arab leaders, especially in leading Sunni power Saudi Arabia.

“UNHEALTHY RIVALRIES”

Mottaki said Iran’s neighbours should not submit to pressures from outsiders that stoked “unhealthy rivalries” and weakened the region’s drive for self-sufficiency, and the region had nothing to fear from Iran’s nuclear energy development.

Iranian officials meet major powers in Geneva on Monday in talks expected to cover Iran’s nuclear program, the first such talks in a year. But Iran has made clear it will not negotiate its “nuclear rights,” code for sensitive work the West suspects is aimed at developing an atomic arsenal.

The powers — the United States, Russia, China, France, Britain and Germany — want Iran to curb its nuclear program, which Tehran says is for purely peaceful purposes.

In Tehran, Iran’s chief negotiator said Iran welcomed next week’s talks as a way to start improving relations but would not negotiate away its nuclear “rights.”

Saeed Jalili said the new sanctions imposed on Iran since similar talks in October 2009 failed to bear fruit had proved ineffective and called on the other parties to stop putting pressure on the Islamic Republic through punitive measures.

Giving concrete details about Gulf Arab achievements that Iran supported, Mottaki said Tehran was happy to see Gulf Arab nations discussing economic cooperation among themselves.

He added: “We are happy when we see women enter parliaments in Kuwait and Bahrain, and when the petrochemical industry in Saudi Arabia has become very advanced in the world, and when Bahrain becomes a banking center. We are happy to see the balances of Arab countries reach two trillion dollars and that Iraq is nearing stability and the oil industry is flourishing.”

He said that in recent days on visits around the Gulf he had been told how officials wanted to deepen ties with Iran. he declined to elaborate.

(Editing by Tim Pearce)

The royals, one from Bahrain and one from Saudi Arabia, suggested in a debate at a Gulf security conference that final judgment on the leaks would have to await publication of all the quarter of a million cables obtained by the website.

Cables about U.S. diplomacy in the Middle East have provided some of the most controversial aspects of the disclosures.

One notable document cited Saudi King Abdullah as urging the United States to attack Iran’s nuclear installations. He was reported to have advised Washington to “cut off the head of the snake” while there was still time.

The disclosure that Gulf Arab leaders want Washington to destroy Iran’s nuclear program exposed long-hidden views. The leaks confirmed the depth of suspicion of Shi’ite Muslim Iran among Sunni Arab leaders, especially in Saudi Arabia, the leading Sunni power.

“These are leaks, not official statements,” former Saudi intelligence chief Prince Turki al-Faisal told the debate at the Manama Dialogue conference organized by the British-based International Institute for Strategic Studies think tank.

“They don’t affect decision-making or policy-making or strategic thinking in the area.”

Prince Turki, the brother of Saudi Foreign Minister Saud al-Faisal, added: “It is only when everything is revealed that we can see the whole picture.”

Bahraini Foreign Minister Sheikh Khaled bin Ahmed al-Khalifa noted the cables had shed light on the thinking of Arab countries.

When the full collection of messages was published, the thinking of other regions would be disclosed.

Like Prince Turki, Sheikh Khaled played down the immediate effect of the leaks.

He told the debate: “Is there an impact on national security of citizens? No, never.”

“Is there going to be an impact on policies? I don’t see much of an impact on policies.”

Saudi Arabia said on Tuesday it would not comment on the U.S. diplomatic cables issued by the WikiLeaks website as it was unsure about their reliability.

(Writing by William Maclean, Editing by Andrew Dobbie)

Yemen, a neighbor of top oil exporter Saudi Arabia, shot once more to the forefront of global security concerns in October when two air freight packages containing bombs — both sent from the country and addressed to synagogues in Chicago — were intercepted in Britain and Dubai.

Al Qaeda’s Yemen-based regional branch, al Qaeda in the Arabian Peninsula (AQAP), claimed responsibility for the parcel plot, just under a year after the group’s failed attempt to bomb a U.S.-bound plane that also caused global alarm.

Worries about instability and corruption have deterred significant foreign investment in Yemen beyond the oil industry, limiting economic growth and worsening unemployment.

Nearly a third of the workforce is out of a job. More than 40 percent of Yemen’s 23 million people live on under $2 a day.

AL QAEDA AND ISLAMIC MILITANCY

The parcel bomb plot sealed AQAP’s reputation as one of the most aggressive arms of al Qaeda’s globally scattered sympathizers and affiliate groups. Its most recent attack outside Yemen had been a failed attempt by a Nigerian Islamist to down an airliner heading for Detroit on December 25, 2009.

The device, hidden in the underwear of Umar Farouk Abdulmutallab, failed to detonate. Abdulmutallab had visited Yemen and had been in contact with militants there.

In another audacious, if unsuccessful hit, an al Qaeda suicide bomber tried to kill Prince Mohammed bin Nayef, Saudi Arabia’s anti-terror chief in August 2009.

The group had also been more active locally. In recent months, clashes between al Qaeda and Yemeni security forces have risen as it staged numerous attacks on foreign and government targets inside the country in response to a U.S.-backed crackdown against the militants.

In April, a suicide bomber tried to assassinate the British ambassador to Yemen and since June, militants have attacked several state targets in the south, including a raid on an intelligence headquarters in Aden which killed 11 people.

Western powers and Saudi Arabia have long feared al Qaeda wants to turn Yemen into a launchpad for attacks in the region and beyond. Washington has stepped up training, intelligence and military aid to Yemeni forces, helping them stage raids on militant hideouts, some of which have also killed civilians.

A U.S. diplomatic cable leaked last month confirmed the United States was itself carrying out air raids on al Qaeda targets in Yemen and was in an agreement with Yemen to conceal this from the public.

“We’ll continue saying the bombs are ours, not yours,” President Ali Abdullah Saleh was quoted as saying in the cable.

But Al Qaeda’s actions over the past year have raised doubts about whether the campaign against AQAP was working.

The government has combated al Qaeda on and off since before the September 11, 2001 attacks on the United States, often in concert with Washington, but its approach to dealing with militants has come under fire in the West as half-hearted and ineffective.

Al Qaeda’s activity picked up in 2009 after the group’s Saudi wing, hit hard by a crackdown in the kingdom, merged with the Yemeni arm to create the Yemen-based regional organization.

The leaders of the Al Qaeda in the Arabian Peninsula include Nasser al-Wahayshi, once a close associate of Osama bin Laden.

Its declared aim is to target Westerners in the oil-exporting Gulf region and bring down the Saudi royal family.

What to watch:

- More attacks on international and domestic targets

- Public backlash against U.S. role in fighting al Qaeda

SOUTHERN SEPARATISM

Growing violence in south Yemen in recent months, from separatist ambushes to armed clashes with security forces, has raised fears of a sustained insurgency.

North and South Yemen formally united in 1990 but some people in the south, where many of Yemen’s oil facilities are, complain northerners have used unification to seize resources and discriminate against them.

People in the south say the government deprives them of jobs and usurps their land. Leading positions in the south are typically assigned to Sanaa government loyalists, often brought in from the north.

Many southerners believe they were better off before unity, when South Yemen had a welfare state established with Soviet aid. They say discrimination became worse after a brief 1994 civil war, sparked by an attempt by southern leaders to break away from a unified Yemen.

Violence earlier this year was the worst the south has seen since the 1994 war and could escalate.

Sanaa has offered dialogue with Yemen’s opposition, including southerners, but efforts to calm southern unrest have included widespread arrests and extra troop deployments to the region that have heightened hostility toward the north.

Suspected separatists have attacked state vehicles. The army has surrounded and shelled the flashpoint southern town of Dalea and clashed with separatist protesters.

Both sides trade blame for the violence in a heavily armed society where state control is weak. Separatists insist their movement is peaceful and any fighting is in self defense against a disproportionate clampdown by security forces.

Meanwhile, the government of President Ali Abdullah Saleh says armed separatists are a minority of outlaws who indiscriminately and sometimes brutally target northerners.

What to watch:

- Spiraling violence as a growing number of southerners, angered by government security clampdown, take up arms.

- Poverty and unemployment may fuel any insurgency

CONFLICT WITH NORTHERN SHI’ITE REBELS

Yemen is working to cement an increasingly shaky truce with northern Shi’ite rebels sealed in February to end a civil war that has raged on and off since 2004. Saudi Arabia intervened militarily last year after rebels seized some Saudi land.

The rebels, who belong to the minority Zaydi sect of Shi’ite Islam and who are known as Houthis after their leaders’ clan, complain of religious and socio-economic discrimination.

The ceasefire, along with prisoner releases by both sides, has halted major combat, but sporadic violence persists.

In August, the government and the Houthis signed a Qatari-mediated deal to start a dialogue to end the conflict. But previous truces in a war that has displaced 350,000 people have not endured, and no lasting peace is yet in sight.

What to watch:

- Sporadic violence may deteriorate to full-blown conflict

- Rebels regroup and restart their campaign

DECLINING ECONOMY, RESOURCES CRUNCH

Almost a third of Yemen’s inhabitants suffer chronic hunger, jobs are scarce, corruption is rife, and oil and water resources are drying up, further straining the economy.

The cash-strapped government is almost powerless to meet the needs of its expanding population and there are fears that Yemen may tip into chaos if it cannot pay public sector wages.

Oil revenues are declining steeply and the government said earnings from Yemen’s multi-billion dollar Total-led liquefied natural gas (LNG) plant will be less than expected in 2010 due to a delay in the production start-up.

A recent tumble in the Yemeni rial further added to the country’s economic woes, forcing the central bank to inject some $850 million — around 15 percent of its reserves — into the market in 2010 to support the currency.

Despite some Western and Saudi support, donor money is hard to come by and slow to reach those who need it most. Only a fraction of $4.7 billion promised at a donor conference in 2006 has been distributed so far.

Corruption is also pervasive. Yemen is near the bottom of Transparency International’s corruption index, ranking 154 out of 180 countries last year.

As part of badly needed economic reforms, Yemen has begun reducing fuel subsidies, a huge burden on state finances, but is having to do this gradually to avoid stoking public anger. Previous moves to raise fuel prices provoked riots.

Yemen also faces a water crisis, deemed among the worst in the world and aggravated by excessive irrigation by farmers growing qat, a mild narcotic leaf chewed by most Yemenis and whose consumption weighs on productivity.

What to watch:

- Any signs the central government may run out of cash

(editing by David Stamp)

From Saudi Arabia, the world’s biggest oil exporter, to tiny Bahrain, Gulf Arab rulers revealed a reality they had spent years trying to hide publicly.

The views in the cables released by the WikiLeaks website contrast with the public stance of those Sunni rulers whose statements on their religious rivals in Shi’ite Iran and its nuclear programme have until now been far more conciliatory.

The revelations, however, do confirm the depth of suspicion and hatred of the Shi’ites among Sunni Arab leaders, especially in Saudi Arabia, the leading Sunni power and which regards Iran as an existential threat.

That concern was intensified by the rise of the Shi’ites in Iraq after the U.S.-led invasion of 2003 — the first time the Shi’ites have controlled an Arab heartland country for nearly a millennium.

For Sunni Gulf rulers, seeing Iraq fall under Shi’ite influence was shocking enough, but the fear of a nuclear Iran is something they find even more alarming.

According to the leaked cables, Saudi Arabia’s King Abdullah repeatedly exhorted the United States to “cut off the head of the snake” by launching military strikes to destroy Iran’s nuclear programme. He has never publicly called on Washington to use force against Iran.

The Bahraini king also said Iran’s nuclear programme should be halted by any means, and the crown prince of the emirate of Abu Dhabi saw “the logic of war dominating” when it comes to dealing with the Iranian threat.

“I think it confirms that the GCC (Gulf Cooperation Council) states are all more united on the anti-Iranian front than previously disclosed,” said Theodore Karasik, a Dubai-based analyst.

DEEP MISTRUST

Saudi analyst Khaled al-Dakhil said the cables were a reminder of the deep mistrust between Iran and Saudi Arabia as well as other Gulf Arab states.

“I don’t think Iran takes at face value public declarations coming from the Gulf, whether for a war or not — just as Gulf leaders do not believe declarations about how peaceful the Iranian nuclear programme is,” he said.

The leaks show the extent of the worry that Iran’s nuclear programme is causing in the region.

“Iran should take note of the distress that its nuclear programme is causing in the region — this is not something that should be ignored,” said Salman Shaikh, director of the Brookings Doha Centre.

Iran denies its nuclear programme is a cover to build a nuclear bomb and says it is purely for peaceful purposes.

President Mahmoud Ahmadinejad on Monday appeared to play down the impact the WikiLeaks disclosures, saying they would not hurt Tehran’s relations with its Gulf neighbours.

The United States has repeatedly said the military option to halt the Iranian nuclear programme is on the table, but U.S. military chiefs have also made clear it is a last resort, fearing it could ignite wider conflict in the Middle East.

“These revelations show that the Gulf Arab region is concentrating on Iran to the level that we want a war with Iran,” said Sami AlFaraj, head of the Kuwait Centre for Strategic Studies.

Analysts say the Gulf rulers’ desire for military action against Iran could add to wider Sunni-Shi’ite tensions and undermine Saudi Arabia’s efforts to mediate with Iran to ease sectarian tensions in Iraq and Lebanon.

“It depends how people receive this. If they play it up and manipulate it, in terms of Sunni-Shi’ite relations it could find some fertile ground,” Shaikh said.

“But in terms of policy I don’t think it’s going to have great impact — they are dominated by other interests,” he added, echoing comments by Dakhil who saw limited implications.

Animosity between Sunnis and Shi’ite goes back to a centuries-old religious schism that still poisons relations.

Hardline Sunnis regard Shi’ites as “rejectionists” who strayed from true Islam. Until recently Gulf states banned Shi’ites from performing religious rituals in public. In some countries they are denied government and security jobs.

No Gulf Arab government has commented on the Gulf leaks, which had on Monday not been widely covered by local media.

(Editing by Samia Nakhoul and Giles Elgood)

From Saudi Arabia, the world’s biggest oil exporter, to tiny Bahrain, Gulf Arab rulers revealed a reality they had spent years trying to hide publicly.

The views in the cables released by the WikiLeaks website contrast with the public stance of those Sunni rulers whose statements on their religious rivals in Shi’ite Iran and its nuclear programme have until now been far more conciliatory.

The revelations, however, do confirm the depth of suspicion and hatred of the Shi’ites among Sunni Arab leaders, especially in Saudi Arabia, the leading Sunni power and which regards Iran as an existential threat.

That concern was intensified by the rise of the Shi’ites in Iraq after the U.S.-led invasion of 2003 — the first time the Shi’ites have controlled an Arab heartland country for nearly a millennium.

For Sunni Gulf rulers, seeing Iraq fall under Shi’ite influence was shocking enough, but the fear of a nuclear Iran is something they find even more alarming.

According to the leaked cables, Saudi Arabia’s King Abdullah repeatedly exhorted the United States to “cut off the head of the snake” by launching military strikes to destroy Iran’s nuclear programme. He has never publicly called on Washington to use force against Iran.

The Bahraini king also said Iran’s nuclear programme should be halted by any means, and the crown prince of the emirate of Abu Dhabi saw “the logic of war dominating” when it comes to dealing with the Iranian threat.

“I think it confirms that the GCC (Gulf Cooperation Council) states are all more united on the anti-Iranian front than previously disclosed,” said Theodore Karasik, a Dubai-based analyst.

DEEP MISTRUST

Saudi analyst Khaled al-Dakhil said the cables were a reminder of the deep mistrust between Iran and Saudi Arabia as well as other Gulf Arab states.

“I don’t think Iran takes at face value public declarations coming from the Gulf, whether for a war or not — just as Gulf leaders do not believe declarations about how peaceful the Iranian nuclear programme is,” he said.

The leaks show the extent of the worry that Iran’s nuclear programme is causing in the region.

“Iran should take note of the distress that its nuclear programme is causing in the region — this is not something that should be ignored,” said Salman Shaikh, director of the Brookings Doha Center.

Iran denies its nuclear programme is a cover to build a nuclear bomb and says it is purely for peaceful purposes.

President Mahmoud Ahmadinejad on Monday appeared to play down the impact the WikiLeaks disclosures, saying they would not hurt Tehran’s relations with its Gulf neighbors.

The United States has repeatedly said the military option to halt the Iranian nuclear programme is on the table, but U.S. military chiefs have also made clear it is a last resort, fearing it could ignite wider conflict in the Middle East.

“These revelations show that the Gulf Arab region is concentrating on Iran to the level that we want a war with Iran,” said Sami AlFaraj, head of the Kuwait Center for Strategic Studies.

Analysts say the Gulf rulers’ desire for military action against Iran could add to wider Sunni-Shi’ite tensions and undermine Saudi Arabia’s efforts to mediate with Iran to ease sectarian tensions in Iraq and Lebanon.

“It depends how people receive this. If they play it up and manipulate it, in terms of Sunni-Shi’ite relations it could find some fertile ground,” Shaikh said.

“But in terms of policy I don’t think it’s going to have great impact — they are dominated by other interests,” he added, echoing comments by Dakhil who saw limited implications.

Animosity between Sunnis and Shi’ite goes back to a centuries-old religious schism that still poisons relations.

Hardline Sunnis regard Shi’ites as “rejectionists” who strayed from true Islam. Until recently Gulf states banned Shi’ites from performing religious rituals in public. In some countries they are denied government and security jobs.

No Gulf Arab government has commented on the Gulf leaks, which had on Monday not been widely covered by local media.

(Editing by Samia Nakhoul and Giles Elgood)

“If a panic happens, it will be a catastrophe … it is a miracle that nothing has happened,” said Bishop Camillo Ballin.

These churchgoers represent only the tip of the iceberg. Ballin reckons his flock in Kuwait numbers around 350,000 out of a total of half a million Christians in the country.

At least 3.5 million Christians of all denominations live in the Gulf Arab region, the birthplace of Islam and home to some of the most conservative Arab Muslim societies in the world.

The freedom to practice Christianity — or any religion other than Islam — is not always a given in the Gulf and varies from country to country. Saudi Arabia, which applies an austere form of Sunni Islam, has by far the tightest restrictions.

“In the Gulf, excluding Saudi Arabia, government attitudes are more religious tolerance than religious freedom,” said Bill Schwartz, canon of the Church of the Epiphany in Doha, Qatar, an Anglican church serving Protestants of various denominations.

Christians in the Gulf are almost all expatriate workers, mostly Catholics from the Philippines and India.

Christian leaders fret that their ability to worship is often compromised by lack of access or space, an issue they will raise at the Vatican next week during a synod of bishops called to discuss the fate of Christian minorities in the Middle East.

VARYING FREEDOMS

The welfare of Christians in Saudi Arabia, the world’s top oil exporter and a close U.S. ally, is a pressing issue for church leaders, but progress is slow as the Saudi monarchy tussles with its powerful religious establishment over reforms.

Almost all the kingdom’s clerics follow the strict Wahhabi school of Islam, and some believe non-Muslims should be barred from the Arabian peninsula, a view shared by al Qaeda which has threatened attacks against Christians in the region.

In Saudi Arabia, home to Islam’s holiest sites, any form of non-Muslim worship takes place in private. Converting Muslims is punishable by death, although such sentences are rare.

Services and prayer meetings are often held in diplomats’ homes, but access to these is very limited, so Christians meet to worship in hotel conference rooms — at great risk.

This week, Saudi media said 13 Filipinos had been charged with proselytizing after a raid on a Riyadh hotel where nearly 150 people had been attending a private Roman Catholic mass.

Diplomats say priests regularly visit Christians in Saudi Arabia. Even though their visas do not state their purpose, the authorities are aware of their presence.

The Catholic Church, which estimates it has 1.5 million adherents in Saudi Arabia, has urged Riyadh to lift curbs on Christian worship and allow churches to be built, just as Muslims can build mosques in Western countries.

The pace of change may be glacial, but Christians and rights activists note some improvements as the kingdom slowly opens up to the world and heeds international pressure on human rights.

“Ten years ago a Saudi who said he was a Christian would have had his head cut off,” said Ibrahim al-Mugaiteb, head of the Saudi-based, independent First Human Rights Society.

“The problem is not the government, but the religious police,” he said, referring to the morals squad that roams the streets implementing the dictates of the clergy.

DIFFERENT STORY

Elsewhere in the Gulf, things are easier, but restrictions still apply. Christian leaders say governments struggle to strike a balance between the needs of their ever-growing foreign communities and the demands of their more conservative citizens.

In the United Arab Emirates, Christians may only worship in places with special licences. The authorities are slow to hand these out or to grant permission for new churches to be built.

Every Friday in Dubai, the UAE’s business and tourism hub, crowds of worshippers swamp the few churches and licensed compounds.

“We have something like 16,000 cars trying to park around here on a Friday,” says the Reverend Canon Stephen Wright of Christ Church Jebel Ali, an Anglican church in a compound on the outskirts of Dubai that accommodates six other denominations.

Next door to Christ Church is the Dubai Evangelical Church Center, a complex of evangelical churches with big prayer halls, meeting rooms, library and an outside baptism pool.

“”We’d love to have a lot of small churches across Dubai rather than one big one, but unfortunately in Dubai you can’t do that,” said Roy Verrips, the South African administrator of the United Christian Church of Dubai.

He says his church has about 500 members, but the complex draws around 3,000 Christians on Fridays for services in at least six languages from Tagalog to Korean, Nepali and Chinese.

“If this place wasn’t here, we wouldn’t be able to stay here. For me it’s the most essential, most significant thing that we have as believers,” said a Filipina Christian who works in Dubai as a housemaid and gave her name only as Gerry.

Verrips says his members do not try to convert Muslims, something forbidden in the UAE as in most Gulf Arab countries.

“We respect and work within the boundaries that they set for us,” he said, adding that his church did nonetheless encourage its members to talk to people about Christianity.

Evangelical Christians who do proselytize end up creating difficulties for all the churches, as the angered authorities clamp down on everyone, several Christian leaders said.

Most are grateful for the limited freedom on offer. “There’s no financial support, but otherwise I couldn’t criticize the government for not being helpful,” Qatar’s Schwartz said.

“We’re just thankful for what we have,” said Verrips.

(Additional reporting by Ulf Laessing in Riyadh, Raissa Kasolowsky and Tamara Walid in Dubai, Regan E. Doherty in Doha; writing by Raissa Kasolowsky; editing by Alistair Lyon)

As they pore over the detritus of last year’s debt crisis, the city-state’s accountants and lawyers face a task as huge as Dubai’s ambitions. The emirate’s flagship firm Dubai World has agreed to repay $25 billion of debt — borrowings that nearly brought down the emirate’s economy.

The auditors’ task is to investigate exactly where the money went, who lined whose pockets, and what other financial landmines might lie in store. Forensic audits at state-linked firms, such as Dubai Holding, are part of a wider corruption probe that has targeted senior figures from Dubai’s boom years.

But even as the accountants work to get to the bottom of the financial mess, Dubai is changing. Its rescue last year by Abu Dhabi — details of which Reuters reports here for the first time — has encouraged the city-state to become more conservative, both politically and socially. Dubai’s crisis prompted a shift of power to the rulers in Abu Dhabi, the wealthiest of the seven states that make up the United Arab Emirates.

Now a chastened Dubai is recovering some of its confidence as it seeks to convince international investors it can deliver now where last year it failed.

Questions remain. With Dubai’s old guard at the helm rather than the young high-flyers who many blame for the crisis, can Dubai ever achieve the sort of growth it once boasted? Or, given that the economy depends so heavily on trade and tourism, could it be tempted to return to the excesses of the past?

“The Dubai growth model that was talked about so much and propagated in the media — all that has changed now,” says Christian Koch, director of international studies at the Gulf Research Centre. “The crisis forced Dubai to take on a much more realistic approach.”

Dubai’s credit default swaps:

here

THE SHOCK OF NAKHEEL

Abu Dhabi’s ascendancy began in the wake of 2008′s global credit crunch. Reports about debt trouble in Dubai’s flagship companies had been circulating within government from as early as 2005, though most people seemed happy to ignore them. In 2008, the end of a six-year oil-fuelled boom burst Dubai’s real estate bubble while the global financial crisis left the emirate unable to refinance looming debt obligations.

To help Dubai support its state-linked firms, the national central bank, which is based in Abu Dhabi, had bought $10 billion in Dubai bonds in February, 2009. But Dubai, which has little oil of its own and had embarked on a series of massive building projects to promote its trade and tourism, had much bigger problems.

Chief among them was Dubai World, which was struggling to pay its debts. Dubai World’s lenders had been quietly rolling over loans since early 2009 and the state-linked company hoped to renegotiate terms, extend maturities and keep paying interest as it worked out a restructuring.

But that plan depended on knowing how much government support the company could obtain. Over the summer and through the Muslim holy month of Ramadan, the state committee set up to support Dubai’s corporations was ominously quiet on the matter.

On Nov. 25, when Dubai’s liabilities had reached $59 billion, or nearly a quarter of the United Arab Emirates’ federal Gross Domestic Product, officials finally sounded the alarm. The definitive story of how the rescue came together may never be written, but Reuters has pieced together some of the key details of those days.

At 6 p.m., as many Emiratis and expats were winding down after work, the Dubai government summoned advisers and senior Dubai World executives to the offices of government lawyers Latham & Watkins. Government officials told the gathering that they had sought a stay of payment on Dubai World’s debts.

“No-one had anything to say,” says one person who was present. Like most people involved in the rescue, they refused to be identified, either for fear of tarnishing their reputations or because they remain involved in the process and are not authorised to speak publicly.

“The announcement was a disaster for Dubai. They were told ‘don’t worry, Argentina has done this, Venezuela has done it. People forget and they start lending again.’ But what they didn’t take into account was that those are real economies. This is not a country.

“Dubai relied on global goodwill, if you will, and that was shattered.”

The first repayment to be affected — a $3.5 billion Islamic bond from Dubai World’s real estate company Nakheel — was due on Dec. 14. But those in the meeting knew the payment was one that Nakheel, a developer of islands shaped like stylised palm trees and a map of the world, would never be able to make.

A former adviser to Dubai World puts it succinctly: “Nakheel was a pyramid scheme, basically. They took money from selling one big project, one palm island, and used it to pay for another.”

The silence in that Dubai meeting became the standard setting over the next few days. Despite rumours in the global markets of a looming default, no official came forward to explain the situation until Nov. 30. Financial markets looked to Dec. 14 as a major test; bondholders, including aggressive hedge funds, smelled blood.

There was another option: Abu Dhabi. Officials in Dubai began hammering out a proposal to put to the larger emirate on how to deal with the looming default. On the evening of Dec. 13, the night before the payment was due, they agreed on what the final proposal should say. Crucially, it would not involve a full repayment of the bond.

“Nakheel was a big massive shock,” says a source familiar with the restructuring. “Dubai went to Abu Dhabi and said, we have this company called Nakheel that’s so messed up it could take our whole economy down, and nobody knew about it.

“Nakheel’s books were so screwed up it wasn’t even funny.”

As they pore over the detritus of last year’s debt crisis, the city-state’s accountants and lawyers face a task as huge as Dubai’s ambitions. The emirate’s flagship firm Dubai World has agreed to repay $25 billion of debt — borrowings that nearly brought down the emirate’s economy.

The auditors’ task is to investigate exactly where the money went, who lined whose pockets, and what other financial landmines might lie in store. Forensic audits at state-linked firms, such as Dubai Holding, are part of a wider corruption probe that has targeted senior figures from Dubai’s boom years.

But even as the accountants work to get to the bottom of the financial mess, Dubai is changing. Its rescue last year by Abu Dhabi — details of which Reuters reports here for the first time — has encouraged the city-state to become more conservative, both politically and socially. Dubai’s crisis prompted a shift of power to the rulers in Abu Dhabi, the wealthiest of the seven states that make up the United Arab Emirates.

Now a chastened Dubai is recovering some of its confidence as it seeks to convince international investors it can deliver now where last year it failed.

Questions remain. With Dubai’s old guard at the helm rather than the young high-flyers who many blame for the crisis, can Dubai ever achieve the sort of growth it once boasted? Or, given that the economy depends so heavily on trade and tourism, could it be tempted to return to the excesses of the past?

“The Dubai growth model that was talked about so much and propagated in the media — all that has changed now,” says Christian Koch, director of international studies at the Gulf Research Center. “The crisis forced Dubai to take on a much more realistic approach.”

THE SHOCK OF NAKHEEL

Abu Dhabi’s ascendancy began in the wake of 2008′s global credit crunch. Reports about debt trouble in Dubai’s flagship companies had been circulating within government from as early as 2005, though most people seemed happy to ignore them. In 2008, the end of a six-year oil-fueled boom burst Dubai’s real estate bubble while the global financial crisis left the emirate unable to refinance looming debt obligations.

To help Dubai support its state-linked firms, the national central bank, which is based in Abu Dhabi, had bought $10 billion in Dubai bonds in February, 2009. But Dubai, which has little oil of its own and had embarked on a series of massive building projects to promote its trade and tourism, had much bigger problems.

Chief among them was Dubai World, which was struggling to pay its debts. Dubai World’s lenders had been quietly rolling over loans since early 2009 and the state-linked company hoped to renegotiate terms, extend maturities and keep paying interest as it worked out a restructuring.

But that plan depended on knowing how much government support the company could obtain. Over the summer and through the Muslim holy month of Ramadan, the state committee set up to support Dubai’s corporations was ominously quiet on the matter.

On November 25, when Dubai’s liabilities had reached $59 billion, or nearly a quarter of the United Arab Emirates’ federal Gross Domestic Product, officials finally sounded the alarm. The definitive story of how the rescue came together may never be written, but Reuters has pieced together some of the key details of those days.

At 6 p.m., as many Emiratis and expats were winding down after work, the Dubai government summoned advisers and senior Dubai World executives to the offices of government lawyers Latham & Watkins. Government officials told the gathering that they had sought a stay of payment on Dubai World’s debts.

“No-one had anything to say,” says one person who was present. Like most people involved in the rescue, they refused to be identified, either for fear of tarnishing their reputations or because they remain involved in the process and are not authorized to speak publicly.

“The announcement was a disaster for Dubai. They were told ‘don’t worry, Argentina has done this, Venezuela has done it. People forget and they start lending again.’ But what they didn’t take into account was that those are real economies. This is not a country.

“Dubai relied on global goodwill, if you will, and that was shattered.”

The first repayment to be affected — a $3.5 billion Islamic bond from Dubai World’s real estate company Nakheel — was due on December 14. But those in the meeting knew the payment was one that Nakheel, a developer of islands shaped like stylized palm trees and a map of the world, would never be able to make.

A former adviser to Dubai World puts it succinctly: “Nakheel was a pyramid scheme, basically. They took money from selling one big project, one palm island, and used it to pay for another.”

The silence in that Dubai meeting became the standard setting over the next few days. Despite rumors in the global markets of a looming default, no official came forward to explain the situation until November 30. Financial markets looked to December 14 as a major test; bondholders, including aggressive hedge funds, smelled blood.

There was another option: Abu Dhabi. Officials in Dubai began hammering out a proposal to put to the larger emirate on how to deal with the looming default. On the evening of December 13, the night before the payment was due, they agreed on what the final proposal should say. Crucially, it would not involve a full repayment of the bond.

“Nakheel was a big massive shock,” says a source familiar with the restructuring. “Dubai went to Abu Dhabi and said, we have this company called Nakheel that’s so messed up it could take our whole economy down, and nobody knew about it.

“Nakheel’s books were so screwed up it wasn’t even funny.”

‘LET’S JUST PAY THIS THING OFF’

That evening, the weather in Dubai took an apocalyptic turn. Clutching the proposed deal and other documents, a banker from Moelis & Co, a U.S. investment bank that was advising Dubai, climbed into a waiting helicopter and took off for the capital.

Expecting him in Abu Dhabi were officials of the highest level, including Sheikh Mansour, half-brother of the ruler of the UAE and one of the most influential people in the federation today.

Rain and wind lashed the windowpanes of Dubai International Financial Center as the officials huddled, waiting. The banker had been instructed to call his team as soon as he left the Abu Dhabi meeting. Three hours on, there was still no word from him.

“We were so nervous, none of us had eaten all day,” says the source familiar with the restructuring.

The phone call never came. Instead, they heard the returning helicopter. Landed, the banker was whisked off into a meeting room to confer with the two top officials of Dubai’s Supreme Fiscal committee. Finally, the rest of the team were called in.

To everyone’s astonishment, Abu Dhabi was offering to pay off the bond in its entirety.

“Abu Dhabi said, let’s just pay this thing off until you come up with a better plan,” the source familiar with the restructuring says. “They always said we are happy to help, we just want to see a plan.”

A NOD AND A WINK

With hindsight, perhaps the officials need not have been surprised. Rightly or wrongly, lenders had always assumed Dubai World’s government links would ensure repayment. Dubai later stated that its government had never backed the debts of state-linked firms such as Dubai World, and blamed investors for not reading the small print. But lenders put the blame firmly on the government.

In the UAE, ruling families keep their private lives out of the public domain aside from major weddings and funerals, and questions about who’s really pulling the strings make intriguing gossip. But from a creditors’ viewpoint they are crucial, because the buck stops with the highest guarantor.

It’s common practice in the Middle East for borrowing to consist of loans signed with a nod and a wink on a ‘name lending’ basis.

In Dubai “in a sense the red line, the differentiator between the trader and the government institutions, became very murky,” says Mohamed Yasin, chief investment officer at CAPM Investment in Abu Dhabi.

It’s still uncertain how much Dubai’s ruler, Sheikh Mohammed bin Rashid Al Maktoum, knew about the growing debt crisis. Some of those involved say he was only informed of the magnitude of the debt problem very late in the game. In his rare comments on the crisis, Sheikh Mohammed has maintained a stiff upper lip, saying the problem has been overcome.

“No-one knew the magnitude of what was owed, then the complexity of it,” the former adviser to Dubai World says. “A lack of experience — and ego — made it hard to admit defeat.”

The emirate’s transformation into a boom town had relied on a generation of Emirati executives armed with big ideas and Western business degrees. Dubai’s model involved ‘soft support’ — free land, a high-profile appearance at the opening — for people who came up with a project and funded it themselves. So they specialized in leverage to build “real estate, real estate, real estate, but with a different flavor or headline,” says Yasin. State-linked firms borrowed at an alarming rate, with little oversight or coordination. Corruption was rife.

“Nobody at the time was going to the Dubai government and saying, ‘this borrowing is happening based on the assumption that you are going to settle if we don’t pay the money,’” Yasin says. “Who assumed that model? it was the lender.”

So ultimately Dubai’s debts were accrued on the assumption that in the event of distress, the government — or big brother Abu Dhabi — would pick up the tab. When Dubai’s government distanced itself from the problem, it gave the larger emirate responsibility — and power.

NO ILLUSIONS

In return for saving its ‘kid brother’ from the embarrassment of default, Abu Dhabi’s authority quickly became apparent. In what was seen by some as a gesture of humility, in January Dubai’s ruler named the world’s tallest structure Burj Khalifa, in honor of Abu Dhabi’s ruler and the UAE president, Sheikh Khalifa bin Zayed al-Nahayan.

Seasoned UAE observers say the more outlandish rumors that circulated in the months after the Dubai World debacle — that Abu Dhabi would swoop in and seize Dubai land and assets or that the ruling families were embroiled in interpersonal rivalries — were always nonsense.

“The ruling families have no illusions whatsoever about what the role of each one is, who is the big guy and who is the second in line and so on,” Yasin says. “In my opinion, it was the middle management, the second tier, the business people, those who are not related to the ruling families but who work for them, who generated these ideas.”

Sometimes Abu Dhabi doesn’t have to throw its weight around because Dubai has realized what it needs to do without being told.

The document for Dubai World’s debt restructuring, seen by Reuters and agreed to by most of its creditors this month, outlines the city’s plans to sell assets over eight years to generate as much as $19.4 billion and lists “investment assets” such as stakes in luxury retailer Barney’s, Dubai-based Atlantis Hotel, and casino operator MGM Resorts International among those that could be included. Ports operator DP World is among the “strategic assets” which may generate up to $11.8 billion if put on sale.

Dubai’s government has tightened the leash on borrowing for state-linked companies. Where previously, they were able to borrow unchecked, now they need to jump through a whole series of hoops before being given the green light for a loan.

Almost two-thirds of Dubai World’s debt is held by six banks, four of them British: HSBC, Lloyds, Royal Bank of Scotland, Standard Chartered, and local lenders Emirates NBD and Abu Dhabi Commercial Bank.

IRAN

Has Dubai’s payback gone beyond finances? Some observers believe so.

A U.S. ally, the United Arab Emirates has taken a tougher posture toward Tehran over the past year, under increasing scrutiny from Washington but also out of concern of the risks of a nuclear Iran on its doorstep. Dubai, which has a substantial population of Iranian expatriates and last year generated $5.8 billion in re-exports to Iran, has followed that lead.

Since a new round of United Nations sanctions against Tehran was agreed in June, the UAE central bank has asked financial institutions in the federation to freeze accounts belonging to dozens of Iran-linked firms, and a number have been closed down.

Ships visiting the UAE’s ports are undergoing much more stringent cargo checks.

“I think (the crisis) has been good on a federal level, for example in terms of foreign affairs,” says the Gulf Research Centre’s Koch. “The emirates are working much more closely together. There is certainly a clear commitment in terms of implementing and meeting the requirements of the U.N. sanctions against Iran, and this effort is more centrally controlled.”

Christopher Davidson, a historian at Britain’s Durham University, goes further. “After November we saw a huge shift in what Abu Dhabi feels it can do on the international stage with regard to Iran and how close it can position itself with the United States,” says Davidson, who believes that would not have been possible before the debt crisis, because Abu Dhabi would then have had far less leverage over Dubai.

“We’ve seen some incredibly hawkish comments which do everything to undermine Dubai’s business links with Iran, so Abu Dhabi is in full control of the UAE foreign policy.”

Not everyone shares that view. Some, including David Butter at the Economist Intelligence Unit, think the change simply coincided with a toughening of the international community’s stance toward Iran.

Still, Dubai’s ongoing debt problems mean the emirate has little power to deviate from Abu Dhabi’s line. There is also no doubt that the Gulf Arab region as a whole is seriously concerned about the possibility of a nuclear-armed Iran. A rising number of countries have announced big new purchases of weapons in the past year, including Saudi Arabia which plans a $60 billion arms deal with the United States. Analysts say the six Gulf Arab states could spend as much as $100 billion in coming years to overhaul their armed forces.

A LINE IN THE SAND

Back in Dubai, there are signs confidence is beginning to return. Developer Nakheel, whose near-default propelled Dubai’s banker on the November chopper ride to Abu Dhabi, has said it will begin building again next month.

After a year away, Dubai’s government has returned to bond markets, launching a dual-tranche $1.25 billion bond. Early talk indicates the issue is heavily oversubscribed.

“The hard work has been sorting out Nakheel and Dubai World, and investors are more positive on Dubai because of its strong relationship to the rest of the UAE and as the legacy issues have been or are being addressed,” says Aviva fund manager Jeremy Brewin in London.

Dubai World’s debt repayment agreement on September 10 “draws a line in the sand to a significant part of the debt restructuring story,” says V. Shankar, chief executive of Standard Chartered’s Middle East, Africa, Europe and the Americas operations. “There are issues still to be sorted out with Dubai Holding but I think on the back of this, Dubai has a powerful tail wind.”

Dubai seems focused on its core operations of logistics and trade. It recently opened the first phase of Maktoum international airport — part of Dubai World Central’s so-called “aerotropolis” complex, a shipping, air and road hub.

“Whilst no government can rule out future issues, we believe the most significant restructuring is behind us,” a government representative responded to emailed questions.

Advisers to Dubai say Abu Dhabi is no longer as closely involved in its neighbor’s financial affairs as immediately after the debt crisis. At the peak of the Dubai World turmoil, Dubai representatives were meeting with their Abu Dhabi counterparts on a weekly basis. These meetings have been scaled back to become, as one adviser put it, “courtesy” updates.

The government has embarked on a big push to create corporate governance structures, and most of its high-profile young executives are gone, sidelined in a putsch last November. Some, such as the head of Dubai’s flagship Dubai International Financial Center, fell prey to corruption probes. Into their place have come more trusted, established and older names pushed aside during the boom years but now back in favor.

“The only criteria now is ‘personal hygiene,’ people who are clean,” says a long-time Dubai observer, declining to be identified so he can speak freely about a sensitive topic. He argues that some of the old guard’s lack of experience in modern finance may make them poorly equipped for the task of rebuilding Dubai’s companies. Strategic, “bold, hairy, audacious” initiatives are needed, he says.

“Right now, it’s the blame game.”

HOW FAR CAN YOU GO?

There is no doubt Dubai needs to encourage entrepreneurship, and continue to give ambitious Emiratis who do not come from wealthy families the chance to make their own fortunes. Its past model is now cited as one of the causes for the endless real estate projects that led to its debt crisis, but parts of it may have to be reinstated if Dubai is to grow. How easily could Dubai slip back into its bad old ways?

“They believe that now the problem is solved,” says the former Dubai World adviser, who is critical of creeping complacency just a year after the crisis. “The problem is not solved, they still owe the same amount of money. They will have to pay the same amount, only a little later.”

Even with its wings clipped, the emirate is still making big plays. In July, Emirates airline — one of Dubai’s crown jewels and already the biggest customer for Airbus A380 superjumbos — placed an order for 30 Boeing 777 jets in a deal worth potentially more than $9 billion.

“Everything is now very conservative, it’s meant to be based on in-depth analysis of actual sectors,” says the source familiar with the restructuring. “Given the chance, Dubai will take it to the same level as before. They will always try to go as far they can with something.”

(Editing by Simon Robinson and Sara Ledwith)

Yemen, also trying to cement a truce to end a northern civil
war, has been a major Western security concern since a
Yemen-based regional arm of al Qaeda claimed responsibility for
a December attempt to bomb a U.S.-bound plane.

Worries over instability in Yemen along with widespread
corruption mean there is no significant foreign investment
outside the country’s oil industry and little chance of
attracting any in the near future.

This is further exacerbating high unemployment in Yemen,
with nearly a third of the workforce out of a job, leaving more
than 40 percent of the country’s 23 million strong population
surviving on under $2 a day.

“Yemen’s problems are all simultaneous and would be
overwhelming for any state,” said Theodore Karasik of the
Institute for Near East and Gulf Military Analysis.

“Only after the central government is able to address some
of these issues more sharply will they start to go away. A lot
of the international aid promised is not materialising so Yemen
will remain a basket case, if you will, in the short term.”

AL QAEDA AND ISLAMIC MILITANCY

Al Qaeda and the Yemeni government have clashed for many
years, but bloody confrontations between militants and security
forces are on the rise again as the group stages increasingly
bold attacks on international and domestic targets alike.

Since June, al Qaeda militants have carried out a number of
attacks on state targets in southern Yemen, including a hit on
the headquarters of an intelligence agency in the port city of
Aden, in which 11 people died.

Yemen’s poorly equipped security forces are easier to strike
than many Western targets, and the group may hope to capitalise
on anti-government sentiment in the south, home to a strong and
growing separatist movement.

Yemen’s Western allies and Saudi Arabia have long feared al
Qaeda is exploiting unrest to turn the country into a launchpad
for destabilising attacks in the region, and the failed December
plane attack set off alarm bells across the globe.

Sanaa subsequently declared war on al Qaeda, and Washington
stepped up training, intelligence and military aid to Yemeni
forces, helping them stage deadly raids on suspected militant
hideouts, some of which have also killed civilians.

But an assassination attempt against the British envoy to
Sanaa in April and June’s brazen suspected al Qaeda assault on
the southern headquarters of a Yemeni intelligence agency raised
doubts over the reach of the government’s crackdown.

Sanaa has battled al Qaeda since before Sept. 11, 2001
attacks on the United States, often in concert with Washington,
but many saw the Yemeni government’s approach to dealing with
militants as half-hearted and ineffective.

Al Qaeda activity in Yemen picked up in 2009 after the Saudi
branch of the militant group, licking its wounds from a
crackdown by Riyadh, merged with the Yemen arm to create a
Yemen-based regional wing, now mounting a resurgence.

The leaders of the Al Qaeda in the Arabian Peninsula include
Nasser al-Wahayshi, once a close associate of Osama bin Laden.
Its declared aim is to target Westerners in the oil-exporting
Gulf region and bring down the Saudi royal family.

In August 2009, an al Qaeda suicide bomber tried to kill
Prince Mohammed bin Nayef, Saudi Arabia’s anti-terror chief.

What to watch:

– More violent attacks on international and domestic targets

– Increased foreign assistance in Yemen’s fight against al
Qaeda may backfire as public opinion swings against the state.

SOUTHERN SEPARATISM

Mounting violence in south Yemen, from separatist ambushes
to armed clashes with security forces, has raised fears that a
sustained separatist insurgency may be brewing.

North and South Yemen formally united in 1990 but some in
the south, where many of Yemen’s oil facilities are located,
complain northerners have used unification to seize resources
and discriminate against them.

People in the south say the government deprives them of jobs
and usurps their land. Key positions in the south are typically
assigned to Sanaa loyalists, often imported from the north.

Many southerners believe they were better off before unity,
when South Yemen was part of the socialist bloc and a welfare
state established with Soviet aid. They say discrimination
became worse after a brief 1994 civil war, sparked by an attempt
by southern leaders to break away from a unified Yemen.

Sanaa has offered dialogue with Yemen’s opposition,
including southerners, but efforts to calm southern unrest have
included widespread arrests and extra troop deployments to the
region that have actually heightened hostility toward the north.

Suspected separatists have attacked state vehicles while the
army has surrounded and shelled the flashpoint southern town of
Dalea and clashed with separatist protesters.

Both sides trade blame for the violence in a heavily armed
society where state control is weak. Separatists insist their
movement is peaceful and any fighting is self defence.

Meanwhile, the government of President Ali Abdullah Saleh
says armed separatists are a minority of outlaws who
indiscriminately and sometimes brutally target northerners.

What to watch:

— Spiralling violence as more southerners take up arms

— Grinding poverty and unemployment may also push more
southerners to join armed secessionists.

CONFLICT WITH NORTHERN SHI’ITE REBELS

Yemen is working to cement an increasingly shaky truce with
northern Shi’ite rebels sealed in February to end a civil war
that has raged on and off since 2004 and drew in neighbouring
Saudi Arabia last year after rebels seized some Saudi land.

The rebels, who belong to the minority Zaydi sect of Shi’ite
Islam and who are known as the Houthis after the clan of their
leaders, complain of religious and socio-economic
discrimination.

The ceasefire with the rebels, which has included prisoner
releases by both sides, has largely held but is growing more
fragile and has been punctuated by sporadic violence.

In August, the Yemeni government and the Houthis signed a
Qatari-mediated deal to start a dialogue to bring their six-year
war to an end. But previous truces to end the war, which has
displaced 350,000 people, have not lasted and analysts are
sceptical whether this one will hold for the long term.

What to watch:

— Sporadic violence may deteriorate to full-blown conflict.

— Rebels regroup and restart their campaign.

DECLINING ECONOMY, RESOURCES CRUNCH

Almost a third of Yemen’s 23 million inhabitants suffer
chronic hunger, jobs are scarce, corruption is rife and oil and
water resources are drying up.

The government, increasingly strapped for cash as oil
revenues decline steeply, is almost powerless to meet the needs
of its expanding population and there are fears that if the
state cannot pay public sector wages Yemen may tip into chaos.

A tumble to record lows in the Yemeni rial further added to
the country’s economic strain, forcing the central bank to
inject more than $850 million into the market in 2010 to support
the currency, which has since strengthened.

Despite some Western and Saudi support, donor money is hard
to come by and once obtained is slow to reach those who need it
most. Only a fraction of $4.7 billion pledged at a donor
conference in 2006 has been distributed so far.

As part of badly needed economic reforms, Yemen has begun
reducing fuel subsidies, a huge burden on state finances, but is
having to do this gradually to avoid stoking public anger.
Previous moves to hike fuel prices resulted in violent riots.

Yemen also faces a water crisis, deemed among the worst in
the world and worsened by excessive irrigation by farmers
growing qat, a mild narcotic leaf that dominates life in Yemen
and whose consumption weighs on productivity.

What to watch:

— Any signs the central government may run out of cash
(For political risks to watch in other countries, please click
on [ID:nEMEARISK]))
(Editing by Samia Nakhoul)