The current state of hesitation on the part of the UAE Federation to underwrite a general bailout to the creditors of Dubai World (DW), and the inability of the city state to bail out DW directly indicates that much of the adjustment will fall back on the creditors themselves in the coming days, once the debt restructuring process begins. The apparent reluctance by the other six members of the UAE to infuse liquidity also illustrates the classic problems inherent in every financial crisis?lack of co-ordination and readiness to resolve problems of an individual country, city state or institution on a collective basis.

Speculation is rife about Abu Dhabi?s exact role in this restructuring process. The alleged cultural differences between Abu Dhabi and Dubai are cited as barriers to the former?s unwillingness to act as its neighbour?s saviour. However, the primary reason for inaction is cold calculation of costs and benefits associated with such an endeavour. The costs will be Abu Dhabi?s, and the immediate gains will mostly go to Dubai and DW. To give a concrete example, the price of the $3.5 billion sukuk, or Islamic bonds, issued by DW?s subsidiary fell from 110 cents to 55 cents last week in three days following the news that DW wanted to defer its interest payments. Any news of assistance will certainly make the price of these bonds a bit higher and will help investors who are holding these bonds as well as their issuer, DW, but the cost will be shared by other parties.

Hence, either free riding or general inaction is the very natural response of other partners and this is an endemic problem in every debt crisis, irrespective of time and place. Usually, one or two institutions take the role of funding a rescue operation and provide the leadership.

Rescues of AIG in recent times, hedge fund Long-Term Capital Management in 1998, or Latin American debt issues in the 1980s are examples of such a co-ordinated rescue from either a consortium of bankers (LCTM), by government (AIG) or at times, IMF or the World Bank. It all started with JP Morgan?s single-handed contribution in injecting liquidity to stop contagion in NY stock markets back in 1907. Hence, as of now, Dubai, too, will be a creditor-led reorganisation.

However, issues in Dubai are more complicated because at this point, it is not liquidity but insolvency that is at the heart of the problem. And the problem is also the structure of Dubai?s economy. Unlike its neighbours, it lacks oil reserves and activities like trading (wholesale, retail etc). Financial services and construction sectors constitute almost 55% of its GDP. These are mostly service-related sectors that would do well only when the economy around Dubai fares better and that?s not happening soon. Hence, there is nothing much that this city state can promise to its current and future creditors against a concession and this immediately hinders the process of smooth rescheduling of its debt.

Still, restructuring of its debt will begin soon and at the ground level; it will involve both assets and liability restructuring. TDW will be forced to sell many of its prized assets, like ownership of the port and other real estate properties, and scrap many of its current projects. On the liability side, a part of the debt will be converted to equity, or trade credit will be arranged together with some waiver for a part of the principal or interest. However, there are two basic impediments to the process of liability adjustments that may make the problem worse in the coming days. First, it is sovereign debt. Hence, no country-specific law (bankruptcy or otherwise) will hold in the process of debt restructurings. Second, there are multiple creditors and it is not clear which creditor has the priority claims in the structure of debt contracts between DW and its vast network of creditors. The priority rule does not matter in good times because every creditor gets paid off but will certainly be a bone of contention in times of default unless an independent body (UAE central bank) cooperates with the creditors in charge of the restructuring process.

As far as the long-term effects are concerned, the effect on the capital markets of the rest of world will not be significant, other than a minor contagion-related fear that will make costs of insuring sovereign debt of emerging markets higher, leading to some short-term tremors.

Lacking vast tracts of oil, Dubai has tried to carve a niche by combining trading, tourism, financial sectors and real estate, and created a market for immigrant labour from a wide array of countries. Finance has followed from interested quarters but the script here is the same as with other bubbles. People in higher office simply forget that it is the real wealth that lends life to the financial assets and not the other way around.

The author is reader in finance at Essex University