After an initial shock, conventional wisdom is downplaying Dubai?s mishaps. Shukran, Abu Dhabi, thank you. Dubai?s wealthier neighbour will, after all, bankroll the emirate?s largest state-owned conglomerate and stave off default. The scale of the support proffered to Dubai is huge?it has received some ?25bn from Abu Dhabi, equivalent to about a third of the emirate?s GDP.
Of Abu Dhabi?s latest $10bn injection, just over $4bn will be used to settle Nakheel?s Islamic bond. Much of the rest is to pay Dubai World?s trade creditors and contractors. This buys Dubai time, but hinges on creditors agreeing to a restructuring. If that fails, a new bankruptcy law will roll into action.
In totality, the losses involved in Dubai are tiny compared with the trillions of dollars of red ink spilled over the past couple of years. Analysts have been quick to point out that the emirate, with $50bn of gross domestic product, is a small fry in the vast oceans of global finance.
It is believed that the banks? overall exposure needs to be kept in proportion. It is also believed that European banks account for half of Dubai?s debt, estimated at about $80bn. If they lost 50% on their exposure, bad loan provisions would rise by 5% next year, equivalent to a 5bn euros after-tax hit. Compared with the $1,700bn of toxic assets European and US banks have wiped out in the credit crisis, that is a drop in the Burj Al Arab swimming pool.
Sukuk refers to a financial instrument that complies with Islamic investment principles, which prohibit interest payments. Although the market for such dollar-denominated debt-like instruments has grown in the past decade, just over $19bn has been raised in the sukuk market so far this year. Activity peaked in 2007 at nearly $25bn.
Besides, sukuk are a mere drop in the global bond ocean. Indeed, with less than $1,000bn of debt outstanding, the market size is smaller than the amount of new bonds sold by non-financial companies globally this year alone.
However, size is not what always matters. This is to miss an important point. Dubai?s debacle demonstrates how loose liquidity conditions when combined with grandiose state-directed economic development produce a potentially toxic mixture.
Many commentators initially dismissed losses on sub-prime mortgages because of their relatively small share of the US mortgage market. Yet the sub-prime fiasco turned out to be significant because the irresponsible practices it revealed turned out to be commonplace.
Likewise, minuscule Iceland, with its outsized foreign liabilities and giant current account deficits, revealed the worst excesses of international finance. Despite its diminutive size, Dubai provides another cautionary tale.
Fixed exchange rate regimes have contributed to several financial crises over the years. Dubai is part of the United Arab Emirates, whose currency the dirham, is pegged to the US dollar. In the early years of this decade, the low interest rates set by the Federal Reserve fuelled strong liquidity growth in the UAE. The money supply grew at an annualised rate of 30% from 2005 to 2008. Inflation picked up and interest rates turned negative.
Negative real interest rates were a fillip to the Dubai real estate market. The negative real interest rates act as a disincentive to deposit money in bank accounts, and incentivise investors to invest in high-yielding assets like real estate and equities.
In the four years to the end of 2008, Dubai property prices doubled. Commercial and residential real estate became expensive even by the standards of New York and London.
In the 1990s, the Asian ?Tiger? economies also experienced real estate bubbles as a consequence of their pegged currencies and loose monetary conditions. Foreign bank loans also fuelled their booms. Yet Dubai?s story differs owing to the central role played by the state in economic development. The emirate?s rulers had an ambitious plan to diversify the economy away from oil exports by turning the country into a financial and tourist centre. They also targeted an annual GDP growth of 11% to 2015.
Dubai?s ambitions weren?t merely domestic. Dubai World and its subsidiaries, with their assumed government backing, went on a debt-fuelled global buying binge. When the music stopped, property prices crashed. It is estimated that the vacancy rate for Dubai office buildings is 40%. Yet the planned new construction is set to double the city?s office space over the next couple of years.
As there is no official debt data on both emirates and federal level, I have used the outstanding loan and bond information on the SDC debt database and Bloomberg to estimate Dubai and UAE?s debt burden. I estimate that UAE?s total debt amounts to $184bn as on end 2009, of which $88bn belongs to Dubai.
Abu Dhabi accounts for $90bn and the other emirates hold the remaining $5.6bn. Note that the debt service will be higher as my numbers only include the principal payments.
Upcoming scheduled debt redemptions are a major concern for UAE and for Dubai in particular?Dubai faces almost $50bn of debt amortisation in the next three years: $12bn in 2010, $19bn in 2011 and $18bn in 2012. I estimate the total debt for Dubai World to be $26.5bn, 80% of which needs to be paid back in the next three years. The restructuring is likely to make the new issuances for UAE much harder in the short term, and the implicit Abu Dhabi support is no longer taken for granted. Hence, I expect a further pressure on the banking sector.
Quasi-sovereign credits
The Dubai episode may have longer-term consequences for one asset class: quasi-sovereign credits. Dubai?s failure to guarantee the debt of its flagship government holding company challenges assumptions that emerging market governments always stand behind state-owned and systemically important companies. Yield-hungry investors have poured into such quasi-sovereign assets in recent months since, while offering spreads above sovereign bonds, they were thought to carry an implicit sovereign guarantee.
The problem with Dubai World is that it is unclear which creditors in the complex web of companies linked to Nakheel will take a hit from any restructuring?and why.
Some market theories suggest local banks will be furtively protected from any restructuring to stave off regional unrest; others say foreign bondholders will be rescued first as Abu Dhabi wants to protect the region’s reputation and prevent the (very real) threat that a formal Dubai World default would trigger cross-defaults of other bonds.
Either way, predicting the path of any restructuring is hard, because of the uncertainty surrounding the implicit?or unwritten?guarantees between the state and Dubai World, and the lack of transparency about cross- default risks. That makes it hard for investors to put a price on bonds linked to Dubai, or indeed the UAE, since they do not know how to assess the relative positions of creditors.
This has implications that go well beyond Dubai. Dozens of other countries have large debt burdens. Many also have a complex network of implicit guarantees between state and non-state entities, with the potential for complex, poorly understood cross-default risks. There are plenty of governments that might be tempted to break implicit guarantees and overturn the normal rules on which creditors get paid first in a crisis, particularly if they see an emirate such as Dubai do this first.
Dubai is by far the biggest example of such a situation, but not the first. Ukraine?s Naftogaz, the state-owned gas company, and Ukrzaliznytsya, state railway, both in recent weeks have pushed creditors to restructure debt. Other governments might now be tempted to break implicit guarantees.
In a more subtle sense, countries such as the US have set a precedent for messing around with long-cherished concepts of the seniority of creditor rights. Look at the way the debt restructurings of, say, General Motors was organised.
Thus the risk is that in the aftermath of the Dubai saga, investors will rethink their exposure to a wide range of quasi-sovereign and sovereign entities. If that prompts them to demand a premium to offset their rising sense of uncertainty, borrowing costs will rise?at a time when many quasi-sovereign borrowers can ill afford it.
So investors in quasi-sovereigns are likely to demand a higher risk premium. Rating agencies may review assumptions on sovereign support, potentially bringing a wave of downgrades. In that case, the effects could be felt far and wide, from Russia?s Kremlin Inc companies such as Gazprom and Russian Railways, to South African or Israeli utilities. Borrowing costs will rise, at an awkward time for quasi-sovereign borrowers.
For investors, Dubai is a reminder of the need for careful homework. And that if bonds offer a higher yield than sovereign debt, there is good reason.
Fire sale of assets
Istithmar, the private equity arm of Dubai World, the debt-laden conglomerate, is coming under increasing pressure from creditors as it loses control of key assets and breaches loan covenants.
Spurred by its ambitious parent company, the private equity firm went on a multibillion-dollar acquisition spree, snapping up assets such as Barneys, the New York retailer, the QE2 cruise liner, Cirque du Soleil and trophy real estate in London and New York.
Istithmar was fuelled by debt rather than oil revenue. Between 2003 and 2007 it invested $3.8bn of its own capital in trophy assets, which it leveraged up to $14bn.
On December 8, Istithmar lost control of the W Hotel Union Square in Manhattan in a foreclosure auction. The company recently breached covenants on a ?253mn ($411mn, 280mn euros) loan behind the acquisition of the Adelphi on the Strand in London. The building was bought for over ?300mn in November 2006, but the property crash caused a breach of conditions on the securitised loan.
Dubai Electricity and Water Authority?s $2bn securitisation programme, Thor Asset Purchase Company, an instrument originally maturing in 2036, may have to be redeemed in full shortly. The payment acceleration underlines how Dubai?s attempts to restructure $26bn of debts at the Dubai World conglomerate are spreading to other, healthier parts of the economy.
Just a reminder of what Dubai ruler Sheikh Mohammed said two weeks ago: investors had completely misunderstood the distinction between being a state-owned company and being a state-backed company.
?This company is independent of the government. This exaggerated media uproar will not affect our determination. It is only natural that we should oppose this campaign (to provide state support to Dubai World) and this huge media uproar.?
There is an important lesson from all this, and?strangely?it was put correctly by Sheikh Mohammed: ?This company is independent of the government.? Investors need to learn that they can lose their shirts by betting on government bailouts. This time the bailout was favourable; it is equally likely it may be adverse next time.
The Abu Dhabi aid is designed to limit the fallout. Indeed, Dubai is sticking by its ambition to be a global financial centre. ?Our best days are yet to come,? it says, just as the prospectus of its quasi-sovereign entity started with the now infamous words ?The sun never sets on Dubai World?.
The author is a Wharton Business School MBA and CEO, Global Money Investor
