Just when the stock market was trading at new highs and people thought we might be in for a soft landing, Dubai threw a huge and very shiny spanner into the works.
The immediate cause for concern was the request for a standstill on interest payments on debt issued by Dubai World – a private, though state-backed, corporation. This, you might have thought, was a standard corporate bust.
Not so. Three things made it particularly critical. First, property prices in Dubai had already fallen by as much as 60% – while the economy clearly was still suffering, many people thought the pain had already been taken and the emirate could now spend its efforts on moving forwards. Apparently not.
Secondly, there was an implied state guarantee Nigerian Music for the debts of Dubai World and its subsidiary Nakheel. If Dubai wasn’t backing its bonds, that could be construed as a sovereign default (though Moody’s pointed out that there was no explicit guarantee, and in fact it had downgraded DW bonds because of that).
Thirdly, the timing of the news – which came out just ahead of the Eid al-Adha holiday, when stock markets around the Gulf would be closed. No information, no traders, no liquidity, and a potential default- not the best recipe for happy investors. Some bears have suggested this is the beginning of the real financial collapse.
However, there have been a number of ‘voices of reason’ insisting that the damage can be limited to a few bonds, and that Abu Dhabi will step in as fairy godfather.
I suspect the truth lies somewhere between the two opposites. But to see what’s going on you have to know how Dubai got into the situation it’s in.
Dubai isn’t a petrodollar state. It doesn’t have an awful lot of oil – enough to have got started on modernising its economy, but oil and gas revenues contributed less than 6% of GDP in 2006 and probably a good deal less than that now. Its strategy has been to become a Gulf ‘hub’; and that’s not worked out badly, with Jebel Ali port one of the top ten container ports worldwide, and trade, entrepot and financial services accounting for over 40% of the economy.
Real estate growth was originally driven by the services economy. However, over recent years, real estate has managed to get into the driving seat; by 2005, construction and property contributed 25% of total GDP. After Dubai relaxed a bar on foreigners buying property in 2006, a huge, debt-driven asset boom began; millions of dollars went into promoting Dubai developments to UK and Irish buyers, and promoting the city as a tourist hot spot.
In some ways, Dubai is very similar to Iceland – debt driven asset price inflation, a tiny population (fewer than 200,000 Emiratis, though the total population is about 2m).
But there’s one big difference. Dubai, though acting in many ways as a sovereign state, is part of the United Arab Emirates – a somewhat ambiguously constructed federation in which the largest single economy is Abu Dhabi’s. That’s led to hopes that Abu Dhabi will bail out Dubai – but the evidence suggests that if it does, it will drive a hard bargain.
Abu Dhabi has always considered itself the big brother in this relationship. It’s more conservative both socially and financially, and hasn’t been completely happy with Dubai upstaging it economically – nor with Dubai’s relatively relaxed lifestyle choices. Abu Dhabi has said it will back banks – both Emirati and foreign owned – operating in the Gulf. But it has said nothing about Dubai World. And it certainly hasn’t said anything that could be construed as writing a blank cheque.
There are rumours that it will drive a hard bargain by seeking to control assets such as Emirates airlines and the Dubai World ports business. But equally, it might strike a hard political bargain. Besides, I suspect Abu Dhabi’s not exactly happy with the way the announcement was made – you could interpret it as Dubai trying to ‘bounce’ Abu Dhabi into writing them that blank cheque.
According to reports, Dubai has USD 19bn of debt coming due this year and next. That stands against GDP of USD 90 bn or so (based on this year’s first quarter GDP); that’s over a fifth of GDP taken up by repayment, before debt servicing, and total debt stands at close to 100% of GDP.
The big problem here is that GDP is going to shrink. There’s been a massive emigration of expats, both professional Brits and blue collar Indian workers, and that’s not just from the construction sector; it’s also from bank head offices, magazines and newspapers, just about every sector of the economy. So Dubai will be trying to service that debt on a lower GDP. That’s going to be tricky, and I don’t think the Nakheel/Dubai World bonds are the last we’ll hear of it.
However, the crisis theoretically could be contained within UAE, with a few knock-on impacts outside. For instance HSBC, which got hammered last week, actually has a 2% total exposure to Dubai – way less than its exposure to US subprime.
The impact on the markets, though, I think will prove to be longer lasting, because Dubai has put an end to an Indian summer of stock trading. Many analysts and fund managers were already worrying that the bull run of 2009 might be getting over-extended; Dubai is likely to tip the balance for many of them on the side of greed rather than fear. Dubai has also reminded us very powerfully of the lack of transparency of some of the markets investors have moved into, seeking to improve returns in an era of low base rates.
But Dubai has also got rid of the easy consensus that we were going to ride out this recession without any sovereign defaults. Remember, 1998 saw Russia default, 2002 saw Argentina do it. So far, further defaults have been prevented – but many economies are looking rocky. Ireland, Hungary, the Baltic States, are all highly exposed. Governments’ resource to huge economic stimulus programmes and quantitative easing has in fact exacerbated their financial vulnerability, so that most governments will enter 2010 much weaker than they started 2007.
The market in credit default swaps reacted fast to the Dubai crisis – put simply, the cost of insuring against sovereign default has risen dramatically. The cost of insuring Dubai bonds doubled, Saudi debt is up 20%, Qatar up 10%. The effect isn’t restricted to the Middle East, either; emerging markets have suffered, and Greece has been in the spotlight too. The price of debt has also been impacted. The sukuk (sharia style bond equivalent) in question fell from USD 1.10 to 57 cents on the dollar on Wednesday. That’s scary for investors who have moved into bonds as a ‘safe haven’ from equities markets.
It’s likely that even if markets recover, borrowing costs for highly indebted governments will rise. That could include the US and UK – which will limit the amount of stimulus they can feed through to the economy, and lead to a much slower recovery than would otherwise have been the case. If the bounce that analysts have expected doesn’t occur, stock markets look stretched – so even if Dubai doesn’t bring about the collapse of the world economy, my feeling is it will probably lead to softer equity markets.
Even if Abu Dhabi pays all Dubai’s debts, the problem is that you can’t put the spectre of default back in the box – investors’ mentality and their risk aversion will have been affected by the events of last week. In particular, the ‘bargain mentality’ that saw many investors buying up ‘junk’ stocks and re-entering the UK housing market earlier this year could recede.
After all, if you thought that a 50% fall in real estate prices meant that Dubai was a bargain, you’ve had your fingers very badly burned.
I suspect this could be the end of the ‘back to business as normal’ phase of the recession. The fact is, economies like Dubai and, dare I say it, the UK need some dramatic restructuring before they can resume growth.
You can’t be an ostrich and stick your head in the sand. Though, that said,