Oh, who jilted me; sublime images with me remained, oh, who jilted me. Follows you a heart whose owner, for love, owns it not …
From the poem Jilted, by Sheikh Mohammed bin Rashid al-Maktoum, ruler of Dubai.

Just as America hunkered down for its Thanksgiving holiday last week and the Muslim world sat down for the long Eid weekend, a bombshell announcement from the rulers of Dubai, one of the seven emirates that comprise the United Arab Emirates, flashed across screens globally. Barely a few hours after receiving US$5 billion in fresh funds from the capital of the UAE, Abu Dhabi, for Dubai’s government debt obligations, the rulers of Dubai had decided to push the tiny emirate’s biggest company – Dubai World – into the perilous world of debt restructuring.

The reasons for the news being a surprise were manifold, not the least that the government had constantly assured investors (verbally – never in writing of course) that it would stand behind the Dubai World conglomerate under all circumstances. In the event, they appeared only to stand behind the company in order to push it over the cliff edge and into the creditors’ abyss.

Early this year, I wrote:

One of the more interesting stories deals with Dubai, the previously sleepy smugglers’ port in the United Arab Emirates (UAE) that suddenly had aspirations to global dominance, as exemplified by the Burj Dubai, the world’s tallest building (as an aside, building the world’s tallest building almost always condemns the country to an economic downturn; the skyscraper curse is not urban legend).

Anyway, for a country with global aspirations and supposedly $100 billion in asset values through the stock and property markets, Dubai found it well-nigh impossible to fund the ruling family’s hobby horses in banks, hotels and ports around the world, not to mention the real-estate boom that has been ongoing from 2002.

The ruling al-Maktoum family of Dubai reportedly approached their cousins, the al-Zayed family, running Abu Dhabi, for terms of a bailout. Initial conversations were allegedly heated, with the latter demanding that Dubai hand over control of its iconic airline, Emirates, as well as stakes in its biggest property firms, including Emaar and even Dubai Holdings (the ruling family’s in-house collection of vanity businesses). With oil prices down and nursing its own losses on ill-fated investments in American and European financial firms in 2008, the al-Zayed family was reportedly not very keen on being on the delivering side of charity. (See Beggar, I thy neighbor, Asia Times Online, February 2009).

And later in the article:

The more puritanical rulers of Abu Dhabi now control a greater proportion of the UAE federation, after subscribing to $10 billion of a bond issue launched by the Dubai government this week. With the property market looking to face a multi-year slowdown and its banks beaten down by losses on global investments, it is highly likely that Dubai will default on the terms of this bond, among others over the next five years or so, in turn providing even more control to Abu Dhabi directly.

As it turned out, we didn’t have to wait five years or anything of the sort. Needing a further $10 billion in funding by the end of the year, the rulers of Dubai appear to have spoken again to their cousins in Abu Dhabi, only for the previous conditions – namely Dubai’s corporate jewels to be handed over to the latter – to have been mentioned again.

We will probably never find out quite what happened in these negotiations, but the upshot of receiving $5 billion for the government of Dubai last Wednesday, November 25, appears to have been an immediate announcement of a “standstill” on the debts of the conglomerate Dubai World for a period of six months.

In the total debt pile of $59 billion attributed to Dubai World, a large amount comes under the name of Nakheel, the construction company behind some of the most iconic developments in the city, such as palm-shaped reclamation off the coast and a host of reclaimed islands in the shape of a map of the world.

The real trouble with the announcement though is that Nakheel has an Islamic bond (sukuk) due in the middle of December to the tune of $4 billion or so. This is almost sure to default because time is too short for investors to get together and agree to a standstill. Also, there is no specific clause such as “standstill” in the debt world, just an agreement to restructure.

At the weekend, the UAE’s central bank said it stood behind the country’s banks, easing some concern about a possible default by Dubai World. The Abu Dhabi-based central bank of the UAE said lenders would be able to borrow using a special facility tied to their current accounts, Bloomberg reported.

TBTF and real estate

Even so, with the events in Dubai, one of the central tenets of the so-called recovery from the global financial crisis was broken. This relates to the concept of “too big to fail”, implying that governments and central banks will always protect systemically important entities.

For the tiny city-state of Dubai, it would be no exaggeration to suggest that Dubai World was for all intents and purposes “too big to fail”. Being state-owned, run by the right-hand person of the ruler himself (until early last week), and in the limelight for the most eye-catching tourist/expatriate/investment properties in the world, Dubai World served as an extension of the ruler’s ambitions in every direction.

Still, although the company owns some globally cash-rich businesses, such as Dubai Ports, and is famous for other businesses, such as Emirates Air, Dubai World has been held down by the weight of its over-ambitious real-estate ventures under the umbrella of Nakheel. Announcing a grand property venture is easy, finishing it on time and delivering the real estate profitably to one’s customers isn’t quite that.

More importantly, unlike cash-flow based lending (such as loans to a factory), lending for real estate is termed as asset-based lending; it depends much on the ability of the company to sell its properties for above cost, or to secure a running rental income in excess of borrowing costs. Unfinished properties don’t let you do either, so it is clear that Nakheel was always going to be a challenge.

Real and unreal guarantees

The next question that popped up in the market’s mind was that the rulers of Dubai had somehow violated their implicit guarantee on Dubai World. Unfortunately, that very notion is wrong in the world of credit (that is, debt): there is no such thing as an implicit guarantee; what really matters is if there is an explicit guarantee. In this case, there wasn’t. So the rulers of Dubai may have decided to take advantage and escape the debt load. Essentially, this implies they had no expectation or belief that the property projects will be completed, much less that they would be profitably completed.

As the Financial Times reported on November 26, the following statement was issued by the ruling family of Dubai to debunk any of the stories of the Dubai World standstill being the result of a capricious action by one or more of its princes:

Our intervention in Dubai World was carefully planned and reflects its specific financial position. The government is spearheading the restructuring of this commercial operation in the full knowledge of how the markets would react. We understand the concerns of the market and the creditors in particular. However we have had to intervene because of the need to take decisive action to address its particular debt burden. Like most global cities, Dubai has experienced its share of economic and social challenges in this global downturn. No market is immune from economic issues. This is a sensible business decision. We want to ensure resources are deployed in the full knowledge that they are used to enhance the businesses of the Dubai World Group, build on the restructuring that has already been taking place and ensure long-term commercial success. Further information will be made available early next week.

As one of my friends remarked after reading the statement, “If this is them being ‘carefully planned’, imagine what they would be doing in the case of an impulsive action.” In any event, whatever idea the rulers of Dubai professed to have about the “full knowledge of how the markets would react”, it must have been from sources quite removed from reality, as Thursday’s big declines in global stock markets led by Asia and Europe showed. Or perhaps they had sold some puts on the Hang Seng Index – what do I know?

Contagion?

While much of the European market reaction was tempered on Friday, declines in Asia suggested that fears of a fresh bout of contagion – the notion that all emerging markets would suffer from the fallout from Dubai – could be on the horizon. There are many reasons for this fear, not the least of which would be the stunning performances of such emerging markets over the past year or so; but also because of fears that many a Dubai lurks in this part of the world.

In the same week, we had Vietnam devaluing its currency and bumping up interest rates – taking up the dubious distinction of the only Asian country that needed to do so in 2009.

From a purely top level perspective, the idea is nonsensical. The total size of Dubai obligations, at $80 billion or so, represents a boil on the backside of the debt monster running amok in the developed and developing markets. For example, it represents barely 5% of the mortgage obligations of the US market alone; a paltry 10% of the sovereign wealth fund in neighboring Abu Dhabi; a smallish 3% of the foreign exchange reserves of China, and so on.

Then again, there is the normal contagion with which the likes of the International Monetary Fund and World Bank are familiar (being the root causes of the same); then there is the “contagion from extrapolation” that markets are more familiar with. This is where things actually get hairy.

Let us remove all the drama from the Dubai saga, and consider the facts:
1. High debt levels.
2. Poor performing collateral for debt.
3. Markets that expect continuing “strategic” bailouts.
4. A fractious political climate around debt discussions.
5. No real (sector-specific) growth to support future repayment.

If I read just the above and was asked to guess what exactly was the subject being discussed, a large number of options would spring up:
a. US mortgage debt.
b. Senior and subordinated debt of global banks.
c. Smaller European governments (Greece, Ireland etc).
d. Leveraged loans and high-yield bonds in the US and Europe.
e. Chinese bank lending to the property sector.

Don’t be put off by the lack of specifics (there isn’t the space to go into all of them); what really matters is that the rough, back-of-the-envelope calculation for the above five sectors alone is $4 trillion to $5 trillion. When considered in that light, the Dubai debacle suddenly becomes a mere portent of things to come; the thin end of the wedge as fundamentals reassert from the perilously slippery slope of systemic liquidity-driven prices.

Over the weekend, a number of more supportive headlines have sprung up in the financial press with respect to the Dubai story: that Abu Dhabi is “willing to help on a case-by-case basis”; that, as noted above, the “UAE central bank has agreed to provide emergency liquidity”; and even more fantastically, that the Gulf Cooperation Council (composed of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) will ride to the rescue of Dubai. All that may indeed come through, but, whatever happens, Pandora’s Box has now been opened.

https://web.archive.org/web/20100114130620/http://www.atimes.com/atimes/Global_Economy/KL01Dj04.html