Implications of Dubai's Financial Crisis
A storm broke out last week, emanating from the part of the world that is widely seen as a major beneficiary of the rise in oil prices. Yet Dubai's story is not about oil. Indeed it is precisely the absence of oil and natural gas (less than 6% of GDP) that prompted this emirate go down the path of tourism, hospitality, and commercial real estate development, that lies at the heart of the matter now.
Perhaps it is another case of being tricked by randomness, butit does look the financial crisis in Dubai continues the Tower of Babel curse. Attempts to build the tallest building in the world require such investor euphoria and access to capital that they frequently mark a top of the cycle. Burj Dubai, which was topped earlier this year did not just edge out the former giant Taipei 101, but leapt above it (at 818 meters vs 509 and 162 floors vs 101)
Twice Told Tale
It has been clear for some time that Dubai's opulent construction of an adult play ground in the Middle East was a bit over the top and that its projects were designed for radically different economic conditions. There have been reports of largely empty luxury hotels, unfinished projects, partially built buildings, and more difficult credit conditions.
Construction companies, suppliers and foreign workers have reported that the commercial real estate bubble has popped. Earlier this year, Nakheel, the property company owned by Dubai World, which is the chief protagonist, received financial support.
Like the similar reasoning that the US Federal Deposit Insurance Corporation (FDIC) often uses in announcing bank closures after the markets have closed on a Friday, Dubai World's request for a six month standstill on the servicing of its $59 bln of debt, including a $3.5 bln sukuk (Sharia compliant bond-like instrument) that was to mature in December, while it restructured took place on the eve of the Eidal-Adha religious holiday November 23.
The usual lack of transparency, coupled with the region religious holiday and the Thanksgiving Day holiday in the United States, made for extremely thin market conditions and encouraged risk-minimization and defensive actions.
Matters were further complicated by the postponement of a Dubai World press conference and a computer glitch at the UK's London Stock Exchange, which incidentally but unrelated is reportedly a fifth owned by the Dubai.
Many believe that as goes Dubai World so goes Dubai, and expect its larger and richer cousin, Abu Dhabi to exact political concessions in exchange for providing support. Dubai World accounts for roughly three quarters of Dubai's debt and about half of Dubai's $25 bln remittances.
There are seven emirates in all that make up the United Arab Emirates (UAE). Dubai's GDP of roughly $40 bln accounts for something on the magnitude of 2% of UAE's GDP. Yet what ails Dubai appears to be affecting the UAE as whole. Some reports indicate that nearly half of the $582 bln construction projects are on hold or simply cancelled.
Implications
There are a number of channels by which the events in Dubai can have a material impact on the global capital markets even for those who are not directly exposed. However, we judge the immediate reaction excessive, while at the same time recognizing that the panicked reaction confirms our suspicion that despite (and perhaps partly because of) the rally in risk assets since late March, market sentiment remains fragile and jittery.
First, a review of data from the Bank for International Settlements suggests that outside of the UK, foreign bank exposure to the UAE itself is rather diversified, though as one might have suspected, they are concentrated in Europe. Of the roughly $123 bln UAE foreign obligations, UK banks are responsible for about $50 bln and Europe as a whole almost $90 bln. US banks account for about $10.6 bln, while Japanese banks have just shy of $9 bln exposure.
Trying to drill down to the emirate level and company level are a bit more difficult as the data is hard to find and what is available appears few years old at best. Nevertheless, while a default by Dubai, should it come to that and would be the largest sovereign default since Argentina in 2001, would do the beleaguered banks no favors, it probably will not undermine capital ratios in any material sense.
A second potential impact is on the monetary policy of the major central banks. Central banks in the developed countries for the most part, with the UK a notable exception, are unwinding some of the extraordinary measures associated with the crisis, though for the most part (Australia and Norway are the exceptions) stopping shy of actually raising interest rates. The new albeit mild shock for their troubled banks and, should the heightened volatility in the global capital markets be sustained, would seem to encourage policy makers, in anything, to move slower and more cautiously perhaps than before. We think this is of marginal significance at the moment.
A third potential impact is on the UAE's peg to the dollar. While the Saudi's stance toward the dollar peg has been unwavering, the UAE's central banker has been all over the board. In mid-November, Kuwait's basket approach was seen favorably as an alternative to the dollar-peg, but late in the month, desire to drop the dollar appeared to have cooled off significantly. The dollar's peg among the Gulf Cooperation Council, except for Kuwait, is an element of stability and may be marginally less likely to be jettisoned now than before.
Butterfly Effect
Appreciating that butterflies flapping their wings in Rio can impact the monsoon in India, it is possible that Dubai's financial crisis prompts larger market moves. There have been significant equity market rallies this year and risk assets in general have outperformed. This could be the spark to encourage investors to reduce risk and leverage by taking realizing some profits.
It may also prove to be a distraction. We have identified the vast liquidity that central banks have provided as the key mover of the markets. We have suggested that liquidity more than valuation has driven asset prices this year. And the central banks of the US, Europe, Japan and China do not appear poised to take away the punch bowl for the next several months at least. This driver remains in force.
ECB officials have underscored the importance of this week's meeting. President Trichet is expected to provide details of what will likely prove to be the last of the 12-month repo operations and some indication of what to expect in the coming quarter. While there would be some benefits to a variable rate repo instead of the 1% fixed rate that government the last two 12-month operations, our contacts report the many ECB officials fear that it could be more disruptive that constructive. We suspect the most likely scenario is for the ECB to replace the 12-month repo operations with six-month repos in the early part of next year.
The euro has established a shelf over the past three weeks or so near $1.4800. A convincing break is required to signal a move to $1.46. Only a break of $1.46 would signal a more significant high may be in place. Just before the weekend, the dollar spiked down below the JPY85 level. Market participants are wary of official action, given the pace and magnitude of the move and unlikely to be particularly aggressive. A move back above JPY88 would help stabilize the tone.
The 5 and 20 day moving average cross over system we often use to help identify the near-term trends made a bearish crossing at the end of last week for the Australian dollar and the British pound. The Reserve Bank of Australia meets this week and it is clearly in a tightening mode having lifted rates at the previous two policy meetings. The most recent economic data has been stronger than expected and Australian dollar's upside momentum has stalled over the last couple of weeks. We retain a constructive outlook for the Australian dollar, but see enough policy uncertainty over the RBA see it as a risky entry opportunity.
On the other hand, there is much less uncertainty over the outcome of the Bank of England's MPC meeting. Yet sterling has already fallen five cents from its peak in mid-November and there is a strong band of support in the $1.60-$1.62 area. We do not think fundamentals are supportive for sterling, even though investors from Norway to South Korea may be attracted to some UK retail investments and there continues to be talk of M&A activity. However, current prices do not look like attractive opportunities to establish fresh short positions.
