* Qatar showing it can keep imports flowing, banks operating
* Economy may face higher costs, delays
* But unlikely to stop functioning in any fundamental way
* Credit default swaps fall, stock market stabilises
* Finance minister says asset sales not on the cards
By Andrew Torchia and John Davison
DUBAI/DOHA, June 12 (Reuters) - Qatar's financial markets stabilised on Monday after a week of losses as the government showed it had ways to keep the economy running in the face of sanctions by other Gulf states.
Saudi Arabia, the United Arab Emirates, Bahrain and Egypt cut diplomatic and transport ties a week ago, accusing Doha of backing terrorism. This has disrupted imports of food and other materials and caused many foreign banks to scale back business with Qatar.
But on Monday, it was becoming clear that Qatar could prevent the economic damage from becoming critical. Some of its food factories are working extra shifts to process imports from nations outside the Gulf, such as Brazil, and shipping lines are operating via Oman instead of the UAE.
These measures may be inconvenient, involve delays and raise costs for Qatar; on Monday Fitch put Qatar's AA credit rating on Rating Watch Negative, saying a sustained crisis could hurt its credit outlook. But they are unlikely to prevent the economy from functioning in any fundamental way.
In the local money market, where Qatari banks have often depended on loans and deposits from foreign banks, local institutions made up liquidity shortfalls by borrowing from the central bank's repo facility, bankers said.
In an interview with CNBC television, one of the first public appearances by a Qatari economic policy maker since the crisis erupted, Qatari finance minister Ali Sherif al-Emadi sounded confident.
He said the energy sector and economy of the world's top liquefied natural gas exporter were essentially operating as normal and that there had not been a serious impact on supplies of food or other goods.
Qatar can import goods from Turkey, the Far East or Europe and will respond to the crisis by diversifying its economy even more, he told CNBC.
"Our reserves and investment funds are more than 250 percent of gross domestic product, so I don't think there is any reason that people need to be concerned about what's happening or any speculation on the Qatari riyal."
In the Gulf's tense political climate, many independent analysts in the region decline to discuss Qatar's economy publicly for fear of irritating their governments.
But Jason Tuvey, Middle East economist at London-based Capital Economics, said that as long as the other Gulf countries did not interfere with Qatar's LNG exports, which would be a major escalation of the crisis, the tiny state would probably be able to carry on without a serious recession.
"It seems Qatar would be able to weather quite a prolonged period of sanctions," he said, adding that economic growth, fuelled by government spending and infrastructure projects, was "highly unlikely to grind to halt".
Qatar's riyal currency, pegged at 3.64 to the U.S. dollar, was under pressure last week as banks reacted nervously to the diplomatic rift. On Monday, the currency came off last week's lows in the spot and offshore forwards markets.
Bankers said the central bank, which has $34.5 billion of net foreign reserves, backed by an estimated hundreds of billions of dollars of assets in Doha's sovereign wealth fund, was supplying enough dollars to the spot market to keep exchange rates under control.
The cost of insuring Qatar's sovereign debt against default fell back for the first time in a week, while yields on Doha's international bonds dropped almost 10 basis points and the stock market stabilised after sliding 8.7 percent in the past week.
One result of the sanctions has been a severe shortage of U.S. dollar cash at Qatar's money changers; supplies used to be flown in from the UAE but that route is closed. The shortage persisted on Monday although some dealers said efforts were underway to obtain supplies from elsewhere, such as Hong Kong.
Tuvey said the main threat to the economy was that Qatari banks could find it much harder to obtain wholesale funding from other banks to sustain growth in their loan portfolios. This could force them to call in loans, hurting the economy.
However, if the situation becomes critical, the Qatari government can liquidate some of its overseas assets and provide the funds to its banking system, much as Saudi Arabia did last year when its banks faced a funding squeeze due to low oil prices, he said.
Qatar's sovereign wealth fund has major stakes in top Western companies such as Credit Suisse. Asked by CNBC whether it might now sell some of these stakes to raise money, Emadi indicated this was not on the cards at present.
"We are extremely comfortable with our positions, our investments and liquidity in our systems," he said. (Additional reporting by Hadeel Al Sayegh in Dubai; Editing by Raissa Kasolowsky)