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By Andrew Torchia

DUBAI (Reuters) - At an economic summit of Arab leaders in Riyadh last week, Saudi Arabia's crown prince called for a minimum 50 percent increase in the capital of a fund that lends money for development projects around the region.

Prince Salman, next in line to the Saudi throne, said the kingdom was ready to pay its share in any expansion of the Kuwait-based Arab Fund for Economic and Social Development, now capitalized at 2 billion Kuwaiti dinars ($7.1 billion).

The pledge illustrated a shift in the way Gulf Arab states are deploying the hundreds of billions of dollars which they earn annually through oil exports: More of the money is being used in their own countries and inside the region, rather than being invested automatically in Western markets.

Both push factors and pull factors are at work, said Shawkat Hammoudeh, a former economist with the Kuwait-based Organization of Arab Petroleum Exporting Countries who studies petrodollar flows at Drexel University in the United States.

The U.S. credit crisis of 2008-2009 and the 2010-2012 euro zone debt crisis have made the Gulf states more wary of investment in the West, traditionally the place where they park the vast bulk of their petrodollars.

Meanwhile, the Arab Spring uprisings over the past couple of years are diverting some petrodollars to the Middle East. Although most of the Gulf states escaped serious unrest, the political turmoil persuaded Gulf leaders of the need to spend more of their wealth on buying social peace in the region.

The changes in petrodollar flows are gradual. Markets outside the West won't become deep enough to absorb the bulk of the Gulf's money for years. Gulf countries' currency pegs to the U.S. dollar mean it makes sense for them to buy dollar assets.

But the fund shifts could eventually slow Western markets that have been lubricated for decades by flows of money from the Gulf. Petrodollars could also bring Arab states closer together diplomatically - a goal that governments have proclaimed for decades but struggled to achieve without economic integration.

"The changes in the distribution of the petrodollar savings have implications for the stability of the global financial markets and international trade," said Hammoudeh.

MONEY FLOWS

High global oil prices mean the Gulf is swimming in petrodollars. A measure of that is the region's combined current account balance, its surplus in trade of goods and services.

The six states in the Gulf Cooperation Council - Saudi Arabia, the United Arab Emirates, Qatar, Kuwait, Bahrain and Oman - posted a record surplus of about $350 billion last year, more than 80 percent larger than China's surplus, the International Monetary Fund estimates.

Traditionally, petrodollars earned by the Gulf's state-owned oil industries are deposited at their central banks, which invest many of them in safe international instruments such as U.S. Treasury bonds. Some of the money is sent to the Gulf's sovereign wealth funds, which invest it actively in foreign assets. Some ends up being used for government spending.

Although new flows of petrodollars into Western markets aren't stopping, there are signs that a larger proportion of the money is being diverted to other destinations.

Asian oil exporters - a group dominated by the GCC countries - held $426.5 billion of long-term U.S. securities in September, up from $345.9 billion a year earlier, latest U.S. Treasury data shows. While that is a large rise in absolute terms, the increase accounts for only a small fraction of the GCC's current account surplus.

U.S. banking liabilities to Asian oil exporters, an indicator of Gulf deposits in U.S. banks, were flat at around $130 billion last year after growing steadily for most of the past decade, according to the U.S. Treasury.

The secrecy surrounding Gulf central banks and sovereign wealth funds means there is no comprehensive data for the GCC's investment in Europe. But commercial bankers in the Gulf say privately that it is smaller than U.S. investment, and that it slowed in the past several years as the euro zone crisis hit.

Instead of going to the West, some petrodollars are now being spent on other Arab states, in an effort to support their economies and restore political stability after the Arab Spring.

Qatar and Saudi Arabia, for example, have provided a combined $9 billion of financial aid to Egypt since its revolution in early 2011. Aid is also flowing from the richest to the poorest states within the GCC; Bahrain and Oman have each been promised $10 billion over 10 years from other GCC members.

Ayham Kamel, Middle East analyst at New York-based consultancy Eurasia Group, said that in addition to official aid, he expected Gulf governments to press their prominent businessmen to invest more in needy Arab countries.

"Arab leaders hope that they can use their sovereign wealth funds and government investment arms to increase regional business cooperation," he said after last week's Riyadh summit.

BUDGETS

Domestic spending is also demanding more of the Gulf's oil wealth. Military expenditure has been rising, partly because of tensions over Iran's nuclear program.

Defense spending by GCC countries climbed about 9 percent to $74 billion last year, estimated Nicole Loeser, Middle East analyst at U.S.-based consultants Forecast International. She predicts it will hit $86 billion in 2017.

These amounts are dwarfed, however, by Gulf states' rising spending on welfare and job creation, to preserve social peace, and on developing non-oil parts of their economies, in the hope of becoming less vulnerable to the next oil price downturn.

The Saudi government said last month that it planned to spend a record 820 billion riyals ($219 billion) in 2013, up 19 percent from the 690 billion riyals budgeted for 2012.

Rising spending is pushing Saudi Arabia and other GCC states closer to the point at which they will no longer run budget surpluses, even with high oil prices. At that point, most newly earned petrodollars may have to be spent at home, rather than invested abroad.

Analysts polled by Reuters estimate Saudi Arabia will need a Brent crude oil price of $82.50 a barrel this year to balance its budget. That is well below the current market price of around $110, but up sharply from $74.80 last year.

But Saudi Finance Minister Ibrahim Alassaf made clear at the Riyadh summit that he did not feel pressure to slow spending.

"We have the reserves, as well as we are reducing our debt almost to zero. So we can continue in the medium term and even beyond that," he told reporters.

(Editing by Jeremy Gaunt)

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