Nouriel Roubini Note: After Dubai

Greetings from RGE!

This week we turn our attention to the fallout from the debts of Dubai Inc that roiled global markets last week. Today’s note is excerpted from two pieces of analysis available in full to RGE clients: “Dubious Dubai: Castles in the Air, Heads in the Sand?” and “Rerisking after Dubai: The End of 'Quasi-Sovereigns?'”

Last week, state-owned Dubai World requested a six month standstill on its debts, calling into question the emirate’s ability and more importantly willingness to service the debt of its state-owned enterprises. While the debt in question, including a US$3.5 billion bond issued by a property development subsidiary, was not sovereign-guaranteed, investors had treated it as such, relying on the fact that the size of Dubai World and the profile of the underlying projects would imply a government rescue. Uncertainty was heightened by illiquidity and poor price action from the holiday period while the lack of information and communication at the time of the request added to concerns about the complete scale of Dubai's implicit and explicit obligations—with on and off balance sheet debts by some estimates as high as $200 billion, or over 400% of GDP. Despite capital support that makes an outright default of Dubai World’s debt unlikely, the ongoing restructuring implies that the creditors will take a share of the pain for the most distressed assets in the holding company’s portfolio. The Dubai property development model in particular needs to be reassessed in a lower-leverage world.

At the heart of the saga is a clarification that investors shouldn't assume implicit government support. Credit ratings for Dubai-owned companies now reflect this lesson, based on a fundamental credit outlook, not an implicit government backstop. Dubai World's request for a standstill follows months of the emirate reassuring creditors and issuing over US$15 billion in sovereign debt. The debt standstill suggests the emirate had run out of options for a preemptive comprehensive bail-out from the well-resourced region. Apparently, things had to get worse before they got better. Or rather the severity of the situation had to be impressed on bond holders. Although the risk from Dubai is not systemically important on a global level, it is significant on a UAE and GCC level, underscoring the central bank’s response to support domestic financial institutions. Beyond the UAE, the reassessment of government support could draw further attention to other countries where state support is murkier, with obligors pricing in the real likelihood of support.

Although Dubai World’s financing issues are not a surprise and are relatively small given global credit losses, they are a reminder that the vulnerabilities and imbalances that contributed to the credit crunch have not disappeared. Coming when investors already are concerned about the strength and duration of the economic recovery, and the cost of the fiscal policies that led back to growth, Dubai World’s default risk may be only one of the risks that market actors were underpricing. In particular, attention has returned to sovereign credit risk, particularly in the eurozone and its periphery, where weaker countries, like Greece and the more indebted of the Central and Eastern European countries, are under pressure.

Most markets—beyond the most exposed local markets—have shrugged off the news this week as the size of exposures became clear and hopes of support from Abu Dhabi rose. Globally some of the liquidity conditions that supported risk appetite, including core central bank policy accommodation, show no signs of being removed. UAE banks, which are already challenged by losses on mortgages as well as exposure to quasi-private companies that are undergoing restructuring, can access a new facility if needed, though the terms of this liquidity facility (beyond the price 50 basis points above the local interbank rate) remain unknown. EU banks’ exposure to the UAE, and even the exposure of UK banks, seems manageable but adds to pre-existing vulnerabilities including Eastern European exposure.

Lessons for the global economy and financial markets are mixed. Firstly, the Dubai debacle reminded investors that all is not yet well in the global financial system. Although exposures to Dubai World were relatively diffuse and containable, despite some concentrations in UK and UAE banks, they are a reminder of the remaining losses stemming from the credit boom, some of which have been obscured by the removal of mark-to-market accounting. Finally, the episode underscores the fact that despite a liquidity glut, some countries and companies will find it difficult to access credit. Not all countries have even the prospect of even partial support from a richer neighbor.