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Saturday, December 12, 2009

Dubai, or is it bye-bye?

The Gulf city state’s debt problems offer an important lesson – unpredictable, unsustainable and unclear policies are a no-no.

After two difficult years, most come away with the thought that financial markets the world over should have stabilised. Sure, the extraordinary steps taken to stop the panic resulted in flooding the global system with trillions of US dollar liquidity.

In all, governments have spent, lent or guaranteed close to US$12 trillion and central banks held interest rates to near zero to end the financial crisis. Even so, as to be expected, most of the previous excesses were never quite worked off.

They can’t just make all these excesses go away, no thanks to continuing flows of cheap money around the world. So, we should not be surprised to see over-leveraged Dubai stumble towards the end of November.

Inevitably, it had to cut its debt burden down to size. Around the world, financial markets quivered. Investors – mainly banks – found themselves in a flare-up they feared would happen, but had hoped would not.

Dubai’s caustic lesson

The problems of Dubai are already well known. It is a property play that turned into a bubble that burst. The boom was fuelled by easy credit and a poorly regulated market overrun by speculators, and it was cheered on by a go-go Dubai during the heyday of the pre-financial crisis. Since then, residential real estate prices have slumped by nearly 50%. Across the United Arab Emirates (UAE), it has been reported that some US$450bil of construction work had been scrapped.

It all culminated in the recent announcement by Dubai World, the UAE’s largest state-owned conglomerate, that it wanted to impose a six-month standstill on debt repayments.

Because Dubai is not rich in oil, it borrowed heavily to fund its grand ambitions. Nakheel, a government-sponsored developer, used part of these funds to develop the Palm Islands and other spectacular land reclamation projects.

On Monday (Dec 14), Nakheel is due to repay US$3.52bil to holders of its Islamic sukuk bonds. This is part of the US$26bil debt that its parent, Dubai World, is seeking to restructure.

In all, Dubai’s sovereign and its state-controlled companies’ debts could reach US$80bil, in excess of the size of its gross domestic product (GDP) (nobody knows for sure).

Viewed in perspective, Dubai makes up less than 0.1% of the global economy and the UAE, just 0.4% of outstanding global cross-border lending.

What caught investors “feeling wrong and wrong-footed” were reports that Dubai’s ruler had only weeks earlier assured investors that enough funds would be raised to meet “current and future obligations”, the emirate had only hours earlier raised US$5bil from two state-controlled banks in Abu Dhabi, having raised US$10bil from this neighbour in February, and banks in particular felt sure that the emirate would make good on publicly traded papers (particularly Nakheel’s sukuk) rather than lose face and damage the reputation of the Gulf as a business and financial hub.

So, investors can no longer take the “UAE umbrella” for granted. In the end, there are hints that it may still “pick and choose when and whom to assist.”

Over the past year, moral hazard appears to be firmly embedded throughout the global financial system. So for bankers, Dubai offers an expensive lesson. Most had expected the government to stand behind its “ward” (Dubai World).

In the wake of the Dubai debacle, it looks like Dubai is set to make investors share the pain, rather than foster moral hazard. Indeed, lenders are still reeling from the spectacular Saudi defaults not so very long ago.

Fair enough, Dubai World was technically not government-backed. But investors had perceived it to be so and acted accordingly. Dubai’s repudiation of such an implicit guarantee leaves a bitter taste in the mouth of most investors, something they are unlikely to forget anytime soon.

Tail risk resurfaces

Credit worries are back. Two years ago, few investors would worry about “fat-tail” risk. This refers to the occurrence of seemingly remote risky events, carrying with it blotted (hence, fat) devastation. The rest is history.

But the lesson is not easily unlearnt. Indeed, the mere sound of a crack can get everyone running for cover. Little wonder for the knee-jerk reactions to recent developments – from the sharp rise in risk premium for Greek bonds and Turkish as well as Hungarian credit default swaps (following their profound budget mess) to the Dubai debacle when investors fled from risks.

Wall Street tells us government debt is “risk-free.” Don’t you believe it. History is littered with sovereign defaults.

The charade continues. Early this week, reality came home to roost. Greece’s and Spain’s sovereign credit rating were downgraded. Even Britain and the US are not spared.

Moody’s rating for them were set apart from other top-rated sovereigns, calling them “resilient” and not “resistant” (a label kept for Germany, France and Canada).

In Dubai, lack of confidence continued to spread. Tuesday’s tumble in Dubai’s stocks wiped out its whole year’s gain; Moody’s downgraded six Dubai government-controlled companies, citing lack of government support. The carnage goes on.

The moral of the Dubai saga is clear: nasty fiscal shocks are not confined to just emerging nations. Markets soon realised that debt fundamentals in Dubai are no different from those in developed nations, even Britain and the US. Indeed, the line between emerging and developed gets more blurred; the rush to judgement that stability has returned is premature; fundamental imbalances created during the crises (for example, excess leverage) have yet to disappear. Beneath it all, huge vulnerabilities remain. The Dubai saga is a welcome wake-up call.

Sukuk’s dilemma

No doubt, the problems of Dubai will have a chilling impact on the market for sukuk bonds.

These are a class of financial instruments that complies with Islamic investment principles, which prohibit the payment of interest (ironically, bonds theoretically are associated with interest payments).

In the past decade, the market for such US dollar denominated debt-like instruments has gained popularity. This year, US$19bil was raised in the international sukuk market; it peaked in 2007 with US$25bil.

The range of issuers, investors and instruments has since widened and deepened. About a month ago, General Electric’s financing arm became the first western industrial company to issue a sukuk bond for US$500mil. It attracted a new source of investors.

The debt standstill sought by Nakheel has thrown a spanner in the works and so close to the repayment date of Dec 14. In the past week, activity in sukuk bonds came to a virtual standstill in the face of its potentially biggest default.

By any standard, sukuks are small potatoes in the bond world. Less than US$1 trillion of such debt is outstanding – smaller than the amount of new bonds sold by non-financial institutions this year alone.

Nevertheless, it’s a big deal since it is now unclear how sukuks can be restructured. It will be a test case for how well investors are protected because these are viewed as quasi-sovereign credit, i.e. akin to government debt.

There have been at least two defaults so far – one in Kuwait and the other in the US by a small oil and gas company. At issue is whether investors can take possession of the underlying assets or are simply entitled to the assets’ cash flow.

There are no precedents in the Dubai courts. Further, sukuks are structured to comply with Islamic law but are created under English law. Further complications can arise since Nakheel’s assets are situated in the UAE. Moreover, investors have the benefit of Dubai World’s guarantee whose enforcement is subject to some local law issues.

Be that as it may, the episode looks likely to be long drawn out. Bankruptcy in UAE do allow for a protective monitorium, which can be a double-edged sword. Whatever the outcome, Dubai’s action has done the sukuk market a great disservice.

While Islamic finance wasn’t at the root of Dubai World’s problems, investor reaction so far in the face of delicate markets and an uncertain global recovery make people nervous about the future.

At the very least, short-term activity in sukuk will remain stalled. Credibility in the manner restructuring is being handled will determine the future. Indeed, investors are fast learning that no matter how buoyant potentials look, resources are not limitless.

Looking past the sandstorm

As it now stands, the Gulf markets are soft and under continuing pressure. To be fair, the structural underpinnings of these markets need to be viewed in perspective over the longer term.

Lest it’s forgotten, Dubai’s hydrocarbon-rich neighbours – Saudi Arabia, Kuwait, Qatar and Abu Dhabi – command two thirds of the world’s oil and 45% of gas reserves.

Debt levels are very low and high oil prices have enabled them to accumulate more than US$1 trillion in reserves. A few key elements set the stage.

These Gulf nations need some US$2 trillion in infrastructure spending to diversify from oil. This fiscal spending can be financed out of current reserves (viable even at US$40 oil price); offer strong benefits viz no taxation, cheap feedstock, and virtually free land; give rates of return on equity hovering historically around 25%, as against 10%-15% in other emerging markets; and provide access to low-cost funds made possible by accommodative monetary policy, with Gulf currencies pegged to the US dollar.

As with any market, risks loom large. It is always possible for oil prices to fall below US$40 per barrel; geopolitical risks don’t lend readily to being well managed; and opaque family groups dominate markets that are not really transparent.

But these oil-rich nations are known to be basically conservative. No doubt the Dubai excesses present lessons to be learnt. Throughout history, nations have defaulted and live to fight again, and succeed, even prosper.

To regain confidence, a number of things need fixing: call for fiscal transparency, opaque family business groups need to heed the lessons of Korean chaebols, and clarity on the road-map to government prudence over the longer term. This includes a credible plan on debt management once global recovery becomes sustainable.

Dubai teaches an important lesson. Unpredictable, unsustainable, unclear and uncertain policies are a no-no.

Former banker, Dr Lin is a Harvard-educated economist and a British chartered scientist who now spends time promoting the public interest. Feedback is most welcome at

By The Star (by TAN SRI LIN SEE -YAN)

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