Quantifying Dubai's woes

The problem for some offshore European banks is serious but we think manageable

Peter Esho 01.12.2009
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The current situation
Dubai's surprise request to defer payment until May on a maturing $3.5 billion Islamic bond caught many by surprise. The emirate successfully raised $5 billion from bonds just hours before the request to postpone payments was made. Dubai's ability to successfully raise money over the past few months restored credibility and confidence with investors. The situation is complex and not as straightforward as markets indicated over the past few days. There doesn't seem to be any large-scale contagion across the Gulf region at this stage. Instead, we think Dubai's situation is a financial problem with social and political ramifications.

Dubai is one of seven emirates federated under the United Arab Emirates (UAE) and over the past decade has established itself as a significant regional player. Dubai's growth was driven by its ability to binge on cheap debt and attract foreign investment. It accumulated known debt of around $80 billion, which is close to 100% of GDP. The rising oil price through 2008 saw petrodollars recycled in regional projects, with some of it making its way to Dubai's booming construction industry.

Perhaps the most important factor in Dubai's recent growth was the decision to allow foreign investment in its real estate sector, setting the stage for arguably one of the largest post-war property bubbles. At one stage Dubai had around 25% of the world's cranes working on its vast construction projects.

Dubai's development also brought with it rapid social and cultural change. A large foreign workforce and rising tourist numbers overwhelmed the small local community, which represents only 20% of the total population. Skilled staff from around the globe quickly became attracted to this tax-free oasis.

The relatively pro-western culture was constantly criticised by more conservative regional players. Neighbouring emirate UAE capital Abu Dhabi was vocal in criticising Dubai's unwillingness to contain or at least moderate the social change. With very little energy revenue and heavy resilience on real estate and tourism, Dubai feared changes would deter its global attractiveness.

These issues and Dubai's global reputation for development saw Abu Dhabi fall into an uncomfortable second place. Abu Dhabi was always wealthier but Dubai got headlines and become better known in the west. Dubai's debt problems now reverse the position in Abu Dhabi's favour. This is very significant.

Abu Dhabi's sovereign wealth is estimated in be excess of $500 billion. It holds more than 90% of the UAE's oil and gas reserves and exports around 3 million barrels of oil per day. Abu Dhabi has the capacity and ability to bail out Dubai but its willingness is discretionary. There have been circumstances where Abu Dhabi has pledged to support Dubai over the past year as the global financial crisis worsened. Despite prior support, we don't think Abu Dhabi's role in future bailouts will be as straightforward.

Going forward
We think Abu Dhabi will pick and choose the assets it wants to bail out, leaving the rest for others to worry about. Dubai's demise will shift power and dominance back to Abu Dhabi's ruling Al Nahyan family. Geopolitical interests are more important than short-term economic losses. Abu Dhabi probably figured any short-term Dubai defaults won't have a significant impact on its own credit rating or that of the UAE, which will be judged on their own merits.

Dubai's debt is different to UAE sovereign debt, so comparing it with other sovereign defaults is inaccurate and misleading. Credit ratings agencies have already moved to downgrade Dubai government-owned entities, but so far there seems to be no impact on Abu Dhabi or UAE-controlled entities.

The problem for some offshore European banks is serious but we think manageable. Regional Gulf players need to ensure there isn't too much long-term damage caused. Short-term pain in Dubai is good for its regional competitors. Long-term pain is in nobody's interest. Gulf investors with significant wealth played an important role in recapitalising western banks throughout the financial crisis. They are unlikely to walk away from any significant problems in their own backyard. In October, Qatar's sovereign investment fund doubled its money on selling a $2.1 billion stake in Barclays. It had been approached in a capital raising a year earlier.

Dubai still holds some very attractive strategic assets. Its 80% stake in ports operator DP World makes it one of the largest infrastructure and transport operators globally. Emirates Airlines has built an extensive global network, which many western comptitors can only envy. Dubai's venture capital investment arm--Istithmar--holds strategic interests in global real estate and listed companies.

We think petrodollars will come to Dubai's aid--probably quite quickly--but at a very high price. Dubai will most likely have to part with its most prized strategic assets in some shape or form. It will emerge bruised from the downturn but lessons learnt will no doubt be valuable for future growth aspirations. Despite all its problems, Dubai's financial reforms encouraged others across the region to become more proactive in opening up their markets to foreign investors. Places like Saudi Arabia, which is by far the largest regional stock market, eased foreign ownership restrictions from a very restrictive base. We think Dubai's tourism and financial industry will resume once near-term problems are contained.

Abu Dhabi will reassert its dominance and continue to invest heavily in essential infrastructure development. Hospitals, roads and schools are still needed while the race for building the world's tallest building or underwater hotel might wind down. It's also worth noting other regional Gulf peers outside of the UAE will continue to progress with their long term economic diversification and development plans. Essentially, we don't think the Gulf region will suffer too much from Dubai's problems. There will be losses by financial institutions but that is containable.

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