As everyone now knows, Dubai World sought to delay payment on its enormous debt last month. Markets throughout the world dipped on the news, with Asian stock markets most affected. Once the central bank of UAE stepped in to provide an emergency liquidity facility, however, many of these markets bounced back. Commentators attributed the dip in world markets to fears that Dubai?s default could kick off a second round of investor panic with potentially disastrous consequences, and the subsequent recovery in world markets to the assuaging of those fears by prompt action by the central bank of UAE. Movements in global risk aversion, according to this interpretation, are the proximate cause of the spread of crises across markets. In other words, in this rendition of events (which seems popular, perusing several accounts from different sources), the Dubai fiasco was like an unexpected and loud scream in the ear of a patient recovering from a recent nervous breakdown.
The interpretation of global market movements following Dubai is important for a number of reasons. If we believe the version of events outlined above, for example, then there isn?t much scope for regulators to do anything about it. Investors all over the world take fright at events like Dubai, regardless of whether they were directly or indirectly exposed to the event, and valuations are automatically affected. When investors recover from their fear, so will markets, according to this view. But is it really the right way to think about what happened? With a potential Greek default looming after Standard & Poor?s and Fitch cut ratings and a widely expected similar move by Moody?s, this is an important question to answer.
Let?s consider another view about why markets moved and recovered following Dubai?s news. The important question when thinking about whether and how Dubai would be transmitted to other markets, according to this second view, is the identity of the investors that were exposed to Dubai (let?s call them ?Dubai investors?). If Dubai investors are not well-capitalised, they cut positions in the other markets that they hold, to rebalance their portfolios and to meet margin calls. The selling pressure from these cuts in positions causes declines in stock prices in seemingly unrelated markets and spreads the shock of Dubai further than the emirates? shores. This also means that by looking at the other markets in which Dubai investors are most invested, we may be able to get a sense of where the trouble is headed next. According to this view, it?s the exposures that count, not just movements in risk aversion caused by jitters in any given market.
Think about the investors that were exposed to Dubai. Some of the creditors were well-known financial institutions such as RBS, Lloyds Banking Group, Standard Chartered and HSBC. Many of these institutions were relatively well-capitalised despite the credit crunch, courtesy the bailout by the UK taxpayer. What about equity investors in Dubai?s stock market, who suffered most from declines in Dubai?s stock index following the announcement? It?s hard to say, but by looking at the severe declines in stock markets in the region (Egypt, Bahrain, Qatar), it?s not a bad assumption to make that they were predominately investment funds with Middle-East mandates. Not that much to worry about, then, perhaps? Maybe Dubai does end with Dubai. Certainly, the quick recovery in other, unconnected stock markets seems to suggest that even if there was a jolt to risk aversion occasioned by the troubles of Dubai, it was short-lived once it was clear that the exposure channel wasn?t really a factor in this case.
If you accept this view of what happened, there isn?t much cause for concern about Dubai any longer. But we?re not out of the woods yet. What?s more worrying, by far, is the spectre of Greece. The Athens stock market has a capitalisation of around $100 billion, and European creditors hold around euro 200 billion worth of Greek debt. Many of these European creditors are still overstretched from the credit crunch. Perhaps of most concern, plenty of funds that invest in Greece have pan-European and broader emerging market mandates, meaning that the shock will be spread far and wide. And once emerging Europe starts to go, what next?
India?s participation in the crisis has, thus far, been relatively limited, with initial troubles followed by an astronomical recovery. There seems to be a renewed understanding that real decoupling does exist (that India isn?t totally dependent on the developed world as the engine of growth). This realisation has been followed by increased allocations from foreign institutional investors and the consequent bidding up of Indian stock market valuations. The election outcome provided a reduction in uncertainty and a boost at just the right time. But if the exposure channel does kick in, and other emerging country dominoes begin to fall, it?s worth thinking hard about what?s likely to happen to Indian markets. We could be in for a bumpy ride.
The author is a financial economist at Sa?d Business School, University of Oxford