* Adoption of strict Islamic law could hurt investment
* Egyptian assets are a fraction of overall global markets
* Investors holding off awaiting protest resolution
NEW YORK, Feb 4 Investors fear escalating protests against the 30-year rule of Egypt's President Hosni Mubarak could spill over to other Arab countries and lead to regimes more hostile to western investment practices in the region.
A more democratic government in Egypt may encourage investment in Egypt, as the country has until now been seen as the barometer for stability in the Middle East and North Africa.
But Egypt's political situation is fluid, the outcome of the popular protests of the past 10 days is unknown, and investors worry that a new regime will oppose Western capitalism.
Egyptian assets make up just a fraction of global emerging market funds but the country has usually set policy direction and and colored popular sentiment in the Middle East.
"Egypt has long been one of the most tolerant countries toward multiple faiths (in the Muslim world)," said Donald Elefson, co-lead portfolio manager at Harding Loevner Funds, with $210 million under management.
"The Coptic Christians are still very powerful, though they are a minority, and there are many large-scale businesses that are owned by Coptic families. The only risk for the business environment would be if Egypt becomes a Sharia state."
Taking their cue from Tunisia where citizens ousted the president after a 23-year rule, Egyptians have taken to the streets since Jan. 25, demanding President Mubarak leave his post now amid deep frustration with tough economic conditions, corruption and few liberties.
Investors and world politicians worry that an immediate resignation by Mubarak will allow opposition groups such as the Muslim Brotherhood to take power and promote an Islamic political and social system, not to mention a reversal in Egypt's stable relationship with Israel.
An economy based on Sharia-law would interfere with many Western business practices by restricting leverage, as Islamic law bans interest, and stipulates that deals must be based on tangible assets.
Egypt is a relatively small economy, accounting for about 0.3 percent of the MSCI emerging market index .MSCIEF.
The 166 funds worldwide that invest in the Middle East and North Africa, including Egypt, represent approximately $13.4 billion of equity and bond assets under management in mutual funds and exchange traded funds. That is a tiny fraction of the $23.7 trillion invested in mutual fund assets worldwide by the end of the third quarter, according to the Investment Company Institute in Washington.
( FACTBOX-Performance of Egypt-exposed ETFs, regional markets [ID:nN03142397] )
CONTAGION A RISK
But more important than its economic role in the Middle East, Egypt has represented much needed political stability and diplomatic moderation in the region.
"Egypt has been for a long time one of the linchpins of the U.S. diplomacy in the Middle East. So any uncertainty there causes uncertainty not just in the U.S., but to whoever has interests there. Any uncertainty in this region it always causes ripples throughout the globe," said Paul Herber, portfolio manager at Forward Frontier.
Saudi Arabia, Jordan and other authoritarian regimes in the Middle East are watching carefully to see how far the unrest will spread and how much it will impact their own rule.
Yemen, Sudan, Saudi Arabia, Libya, Iran, Afghanistan, Oman and Nigeria are among a list of countries that are run to some degree by Islamic law and many of them have also faced popular protest recently.
Jordan's King Abdullah replaced his prime minister on Tuesday after protests over food prices and poor living condition.
Yemen saw thousands of people on the streets last week to protest against the three-decade rule of President Ali Abdullah Saleh, and although it has not translated into a sustained movement so far, the threat to stability remains.
Gulf Arab rulers have offered their citizens relative affluence in exchange for political submission, but the people realize that a radical change may be taking place in the region.
"Lets not forget that of the 19 high-jackers of September 11, 15 were Saudis, so we can't think that this sort of discontent is confined just to places like Egypt," said Erik Davidson, managing director of investments for Wells Fargo Private Bank.
WHAT LIES AHEAD
Egypt's financial markets have been shaken since the biggest anti-government demonstrations broke out more than 10 days ago, with its stock market falling 7.0 percent in four days and the Egyptian pound weakening to a six-year low. Banks and markets are set to reopen on Sunday.
While Egypt is a small economy, and so the internal turmoil has had little effect on global asset prices, the Suez Canal accounts for 8.0 percent of all global seaborne trade.
"Any signs that the situation in Egypt could lead to a slowdown, or worse, a shutdown, of the canal, could have a significant impact on commodity prices, which would in turn affect global markets," said Eric Fine, head of G-175 Strategies with Van Eck Global, a provider of Exchange traded funds.
For now, investors will wait for Egypt's markets to reopen next week, and for the increasingly violent protests to play themselves out, before deciding whether a country with a population of 80 million will move towards a Sharia-law economy.
"The protesters have a good hand, but the biggest fear is regime change. That could get messy from the stock market stand point because that would hit investors right where it hurts, in the financial statement," Elefson said. (Reporting by Manuela Badawy, additional reporting by Daniel Bases)