What’s Next For Dubai?

December 2009

By Rafi Chaudhury

Almost exactly a year after Iceland’s three largest banks surrendered themselves to the state’s stewardship, the global financial crisis seemed poised to claim its next major victim, the Gulf emirate of Dubai. On November 25, the state-owned holding company Dubai World Group abruptly announced a six-month moratorium on debt servicing. Much of Dubai’s public and private-sector credit flows originate from abroad, not unlike its labor force, of which Emiratis comprise a mere 10 per cent. The bulk of business deals and financing arrangements are negotiated with an implicit guarantee of state backing in the event that the corporation cannot meet its obligations. DWG’s announcement followed its failure to secure a lifeline from the government, spreading panic across financial markets worldwide, which interpreted the state’s cold shoulder as a sign that the public sector itself was nearing bankruptcy.

To compound matters further, the timing of the announcement neatly coincided with the four-day holiday of Thanksgiving in the United States and the three-day holiday of Eid-ul-Azha in the Muslim world. Thus, the region’s largest capital markets were closed while the crisis was ongoing, igniting further rumors of financial collapse. In those four days, it was speculated that the state was negotiating bailouts from Abu Dhabi and the IMF. Dubai World, for its part, was thought to have deliberately timed its announcement to limit the impact on the cost of its debt insurance (priced in securities known as credit default swaps, or CDS) and formulate a comprehensive restructuring plan to reassure its bondholders before the markets reopened on Monday.

In the end, it appeared to be much ado about nothing. On November 29, the UAE Central Bank announced the implementation of a supplementary credit facility and guaranteed bank deposits in all local and foreign-owned banks in the emirate, leaving DWG to sort out its problems without triggering a run on the banking sector and a disastrous flight of capital. Following a sudden 3-5 percent decline in major market indices in the immediate wake of the announcement, the numbers recovered rapidly in the following week. Dubai’s troubles were written off as an overreaction and temporarily aggravated by speculative short selling. While the state’s creditworthiness is likely to remain in question for the foreseeable future, its impact on the world’s financial system, which today appears to yawn at losses not numbering in the hundreds of billions, is judged to be minor. DWG’s debts stand at $59bn, and while that is large by any standards, in a market environment accustomed to the colossal over-leveraging that multiplies debt to many times its intrinsic value, and the usage of non-transparent counterparties to share risk and make the notional value of liabilities difficult to calculate, it is manageable.

For Dubai and its residents however, the troubles are only just beginning. The local market index fell by 8 percent on the Monday after the announcement as fears grew of a deep recession. Dubai World Group has investments in many asset classes, some of which have performed admirably (Dubai Ports World being a leader in the freight industry) and some of which have proved to be less strategic and more speculative, like commercial real estate, which is now estimated to comprise up to 30 percent of the economy, according to the Wall Street Journal. DWG’s largest liabilities lie in the operations of its property arm, Nakheel. On November 30, DWG announced plans to restructure $26bn of its debt, more than a quarter of which is owed by Nakheel. The property arm has stakes in nearly all of Dubai’s notoriously outlandish property projects, such as the globe-shaped batch of man-made islands in the Gulf, another artificial palm-tree shaped island and the massive Burj-al-Arab complex. In the last six years, $475bn has been spent in the sector alone. Part of this massive escalation in spending has been spurred by the royal family’s objective of building world-class transport and financial infrastructure in order to diversify the economy away from hydrocarbon exports. There was further pressure to accomplish this faster than its Gulf neighbors in Qatar, Kuwait, Abu Dhabi and Saudi Arabia, all of whom have oil and gas reserves that dwarf its own. While Dubai can be said to have met its target, success has come at a high price: public sector debt runs from anywhere between $80bn and $150bn. While the state has refused to disclose the actual numbers, even the lowest estimate puts debt at 100% of GDP.

While investment in Dubai has been rapid, it too has not come without problems. The construction boom has led to a massive influx of unskilled laborers, mostly from South Asia, that work in difficult conditions and an opaque labor rights regime. Scaling back on construction and tourism-related projects could lead to large layoffs in construction, transport, landscaping and hospitality. This raises the risk of social unrest, particularly in a conservative society that is sometimes literally segregated along religious, cultural and ethnic lines. Hard figures on laborer numbers are difficult to come by, given the informal nature of the work, but Al-Arabiya estimates the number at 2.5 million, or a staggering 50 percent of the entire population. This number includes workers from poorer Arab nations like Yemen, Jordan and Egypt. The risk of unrest rises further when considering that companies sometimes withhold wages for months on end, dismiss workers without notice, and in extreme cases, confiscate worker passports upon hiring them. Colliers International calculates the decline in Dubai construction to have fallen by 47 percent in Q3 2009 from a year before.

If there is any silver lining at all in Dubai’s fortunes, it is that what appeared to be the world’s most obvious bubble has finally burst. Given the infuriatingly secretive circumstances surrounding DWG’s problems, international capital markets are unlikely to return to lavish the city-state with cheap credit anytime soon. While this will result in a period of painful adjustment for the economy, the emirate has a real chance at a sustained recovery by scaling back non-essential infrastructure projects and continuing its ongoing anti-corruption drive, which has sought to eliminate the link between political influence and business expediency. The fundamental flaw in this system was exposed when the state refused to back the debts of DWG, as it had no legal obligation to do so. Its creditors had nonetheless based their financing on exactly such a guarantee, even if it was implicit and nothing was in writing. It is a mistake they are not likely to make again and is a crucial step towards a more transparent and efficient investment regime in future.

This sort of ex-post ‘tough love’ approach is yet to apply to Dubai as a whole. While the emirate of Abu Dhabi (home to 90 percent of the oil and gas reserves of the entire UAE) initially withheld any guarantee of public sector debt, they stepped forward with a $10bn bailout on December 14, part of which will be used to service payments on a $3.5bn Islamic bond issued by Nakheel. The fiscally conservative city-state had already extended a similar $10bn lifeline in March, and its sovereign wealth fund (estimated to have an asset value of around $900bn) was previously being courted by Western financial institutions desperate for re-capitalization. While the emirate’s official position appears to discourage the enabling of moral hazard, the surprise bailout is likely to be more political than economic: first, it maintains the confidence of Dubai’s Gulf creditors, especially in the wake of the UAE’s withdrawal from the monetary union talks of the Gulf Cooperation Council. Second, it helps protect the credibility of the growing Islamic finance sector (a lucrative market that Dubai hopes will attract capital from Muslim countries in North Africa and Southeast Asia). This will only increase the pressure among Dubai’s rulers to forcefully implement fiscal and financial reform, so as to avoid the mistakes of the past, and their still-unknown fallout of the present.