‘It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of disbelief, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair (…).’ Much like Dickens’ description of late 18 century Europe, 2010 can be regarded as the stage for the contrasting opportunities and destinies of two frenemies: Dubai and Abu Dhabi. Reminiscent of 18 century United Kingdom and France, today these emirates represent two distinct ways of thinking, two views of the world that are, in more ways than one, pitted against each other.
The events surrounding Dubai World’s (DW) financial troubles are bound to be costly for Dubai. Economically, its position as the economic and political centre of the UAE has been severely undermined. Politically, Dubai has much to loose both domestically and internationally, as Abu Dhabi’s financial support will not be free of charge. Contrary to the message conveyed by many Western media outlets, the bursting of the Dubai real estate bubble is a crisis for Dubai; for the world, it barely constitutes a hiccup. This contained episode will only affect the regional and international economic systems indirectly, if at all. Ultimately, this is a tale of crisis and broken promises, but one that could end well nonetheless.
The Rise of the Phoenix
Dubai has come a long way since its years as the hub of the “Indian gold smuggling trade”. Wittily described by the International Herald Tribune as a “centrally planned free market economy”, the sheikhdom abandoned its oil-backed economic plan in the 1990s in favour of a services-driven economy. Shrewdly foreseeing the inviability of an oil-financed development path—notably in the context of rapidly dwindling reserves—then Sheikh Maktoum bin Rasheed Al Maktoum decided to invest Dubai’s oil revenue in the development of “first world” economic infrastructure. This strategy proved fundamental in enabling Dubai’s transition into a knowledge-based economy.
Amidst the market euphoria of the 2000s, its galloping economy and prosperous services sector, Dubai rose as a phoenix. Skyscrapers sprouted in the desert as if they were mushrooms in a forest. Any conversation with investment bankers and brokers would invariably bring up Dubai as the place to be. The Sheikh’s strategy seemed to have paid off—at least at first glance. Truth be told, as a result of Sheikh Maktoum, and later on, of Sheikh Mohamed bin Rasheed’s policies Dubai has turned into an important tourist destination, one of the most important ports for western manufacture—it has the largest man-made port in the world—and until the outset of the crisis, a vivacious and promising global financial, IT, and media centre. All this came to an abrupt halt on 25 November 2009.
The Genesis of an Arabian Rhapsody
Like Franz Liszt’s Hungarian Rhapsodies, the Dubai crisis is a one-movement incorporation of many local and foreign themes which, although integrated, flow more or less freely within a flexible overarching structure. In this Arabian rhapsody, three main themes feed on one another: the global financial crisis, the geopolitics of oil, and the UAE’s internal balance of power. These themes in turn intermingle rather flexibly within a dazed and traumatized international economic system.
The movement opens in 2007 with the American subprime mortgages crisis. The ensuing credit crunch affects the whole world, Dubai first and foremost. In February 2009 the crisis spread to the real economy eventually forces Dubai to sell US$10 billion worth of bonds to the UAE federal government in order to ease its liquidity needs. Given its dwindling oil reserves, the government had come to rely heavily on the services sector and, in particular, the financial services sector to replenish its coffers.
As the year advanced, financial activities continued to decline, bringing with them Dubai’s fiscal revenue. This dynamic obliged Dubai to resort to another bond issuance, this time targeting international debt markets. In order to render its US$2 billion worth of sukuks more palatable to increasingly suspicious international investors, in October 2009 the government signalled that it was distancing itself from the liabilities acquired by state-owned corporations. International markets interpreted this as a de facto end to the government’s implicit guarantee of these companies’ debts. Although this solved the government’s immediate cash problem, it also left state-owned companies vulnerable. As a consequence, credit rating agencies, such as Moody’s, downgraded most of the six Dubai government-linked corporations.
State-owned companies had been amassing debt since the late 1990s when oil revenues shrunk. As a result, the government and its enterprises had to resort to credit markets to finance their infrastructure projects. At the time, national and international investors were only too happy to indulge these companies’ credit needs under the assumption that the Dubai government stood by as a guarantor. As the credit crunch crunched forward, however, it hit Dubai’s booming real estate sector head-on. This put real estate developers, such as DW’s subsidiary Nakheel, in a very difficult position; Nakheel’s financial situation had already been delicate for over a year when the Government decided to withdraw its implicit backing. On 25 November 2009, the situation became untenable.
- The Performance Day
On the eve of Eid al-Adha, which in 2009 coincided with the eve of American Thanksgiving, the Dubai government announced that DW and Nakheel would demand that their creditors grant a six-month deferral on US$26 billion of its debt. Even though the government received US$5 billion that day from a bond program put in place by the federal government, not only was this sum far short of the US$10 billion expected but the money was also required for other pressing government liquidity needs.
Following the announcement, the Dow Jones lost 1.5% (155 points) in a shortened day of trading. Oil prices plunged by as much as 7%, even if they partially recuperated later in the day. European markets took a hit on 26 November—falling over 3%—and Asian Markets followed on 27 November.
On 30 November in a public statement on Al-Jazeera television, Dubai’s Finance Department Director-General Abdul Rahman al Saleh further distanced the government from DW by reiterating that its debts were “not guaranteed by the government”. He explained that this position reflected the legal statute of DW, since there were no contractual obligations between lenders and the government regarding the conglomerate’s debts. This rattled markets even more. On the same day, shares dropped by a further 7.3% in Dubai and 8.3% in Abu Dhabi.
On 1 December, with the intention of calming investors, DW issued a statement saying that it had hired Moelis & Company (led by a former UBS banker and trusted figure of the finance world) and the powerful Rothschild House to oversee restructuring and renegotiation of US$26 billion worth of obligations held by Nakheel.
On 14 December, the maturity day of US$4.1 billion worth of Nakheel’s Islamic Bonds, the Government announced a US$10 billion aid from Abu Dhabi to help ease the pressure on DW. The Dubai Government further highlighted that the remaining US$5.9 billion could support DW until April 2010. Fitch Ratings affirmed that Abu Dhabi’s support was most likely “a tactical step to permit an orderly restructuring of obligations within Dubai …”. According to John Sfakianakis of Banque Saudi Fransi-Credit Agricole, Abu Dhabi’s gesture was key in calming markets since until then the neighbouring sheikhdom had distanced itself from the events in Dubai.
That same day, Sheikh Ahmed bin Saaed al-Maktoum, chairman of Dubai’s Supreme Fiscal Committee, declared that the government was committed to “act[ing] at all times in accordance with market principles and internationally accepted business practices”. Sheikh Ahmed also announced the implementation of new bankruptcy laws which, according to him, would “be available should DW and its subsidiaries be unable to achieve acceptable restructuring of its obligations”.
At the time of writing, DW has yet to formally request a debt standstill. This month the conglomerate is expected to ask more than 90 creditors to delay bond repayments while it puts together a debt-restructuring plan which, according to Reuters News Agency, should be done by the end of April.
Crime and Punishment
Although the Dubai crisis remains a limited episode for the world economy, it could prove path-breaking in the realm of ideas. As a paragon for post-oil developmental strategies, many specialists saw Dubai as the state embodiment of the one-eyed king in the land of the blind. Until the outbreak of the credit-crunch, it had seemingly succeeded in transitioning from an oil-based economy into a vibrant services and knowledge-based economy. Politically, Dubai also represented one of the last defenders of local government in an increasingly centralized United Arab Emirates. Much of this will now change, however, and Dubai has only its policies to blame.
- Crime
Dubai is doubly responsible for its troubles: it faulted in both substance and process. First, although Dubai succeeded in creating a relatively sound post-oil development strategy, the government based it on unreliable economic institutions. Second, although no direct responsibility for the crisis can be ascribed to any specific member government—or Sheikh Mohamed for that matter some officials showed little professionalism in dealing with the crisis. These failures undermined whatever confidence was left in the market.
Notwithstanding its strong capitalist credentials, the relation between the government and the economy can best be described as cronyism. Indeed, some analysts go as far as likening the government to a hub for a network of corporations linked by varying degrees of friendship and family ties. Contrary to the view held by what David Henderson calls “new-millennium collectivists”, more often than not close involvement between the government and the private sector breeds opaqueness and populism, not transparency and accountability.
As a case in point, even today not much is known about the government and state-owned corporations’ consolidated debt. According to Eckart Woertz from the Gulf Research Centre, private estimates put consolidated debt at between US$80-100 billion. If one adds to this bilateral bank loans, estimates climb as high as US$120-150 billion. Debt, therefore, could represent between 100 and 200% of GDP. The lower end of these estimates corresponds to nine times Dubai’s 2008 fiscal revenues.
According to Woertz, there are two worrisome factors regarding Dubai’s debt load. First, US$50 billion is due over the next three years. Despite Abu Dhabi’s help, in the best case scenario Dubai will face much higher refinancing costs in light of recent events; in the worse case, Dubai might find it impossible to secure any refinancing at all. Second, according to Moody’s, there is a non-negligible amount of debt (around US$25 billion) that is no longer backed by viable assets or a sound business model. This raises questions of who will foot the bill.
The magnitude of these figures is a good illustration of the calamitous results that poor corporate governance standards nurture. Cronyism and a lack of data availability forced credit rating agencies to treat state-owned corporations (such as DW) or other privately owned (Dubai Holding) as quasi-sovereign entities. Given the low levels of government debt, these ratings were steadily favourable and thus badly misleading for investors. When the implicit government backing disappeared, investors were left holding the bag.
The behaviour the government exhibited during the crisis also stands at odds with the behaviour one would expect from a city aspiring to become an international financial centre. Two faux pas readily illustrate this amateurism.
First, although the choice of announcing DW’s debt standstill demands before a major holiday may not be uncommon—since it gives market players time to absorb the information before reacting—the timing of this announcement was misleading at best. It was made only two hours after two Abu Dhabi banks with strong government ties announced the release of US$5 billion for the Dubai Economic Support Fund. Investors were shocked to see their subsequent vote of confidence in Nakheel bonds translated into a 30% loss in only two hours by the standstill announced by the Government.
Moreover, the announcement of the 14 December Abu Dhabi bail out turned out to be disingenuous. Later that month the government corrected itself, highlighting that half of the US$10 billion referred to an older debt deal. Analysts interpreted these events in two ways: first, that this was symptomatic of the Emirate’s poor market communication skills and lack of transparency; second, that it indicated that Abu Dhabi demanded more evidence of Dubai’s fiscal health. Whatever market trust there was left in the Dubai government was gone within barely three weeks of the crisis.
This type of recurrent mixed signalling from the Dubai government, according to the head of Middle East government ratings at Standard and Poor, Farouk Soussa, only heightens uncertainties surrounding the coherence of the sheikhdom’s policymaking process.
- Punishment
One of the differences between concertos and rhapsodies is that rhapsodies are one-movement pieces while concertos are composed of several movements. Unlike the media, markets soon realized that these events were the making of a one-movement piece; they were not part of a world bang but rather part of a world whimper. As Woertz points out, contrary to Lehman Brothers or AIG, “Dubai World was not a counter party for deals in trillions of dollars of OTC derivatives”. As such, markets soon confined their reactions to the events in Dubai and the UAE.
The fear of contagion following the November and December events had more to do with the delicate conditions of world financial markets than the potential for contagion. The global financial crisis was partly born out of derivatives trading, a tool devised to minimize risks. This turned out to be a colossal failure. As such, markets became exceedingly jumpy at any sign of unanticipated risk. Given the lack of corporate transparency in Dubai, this is just what the end of the government backing of DW debts meant.
Foreign investors still have significant stakes in Dubai, however. According to a November 2009 equity research study by JP Morgan, HSBC (US$17 billion), Standard Chartered (US$7.8 billion), Barclays (US$3.6 billion), RBS/ABN Amro (US$2.24 billion) and BNP Paribas (US$1.7 billion) are the most exposed foreign investors. Their large stakes in Abu Dhabi, however, may have restrained their willingness to press Dubai for quick reimbursements—given that such actions could undermine the economy of the whole UAE. Investors from the Middle East also face significant exposure, but the fiscal health and low debt of these Middle Eastern countries put them in a much better position to absorb the shock.
Nevertheless some good news has surfaced since December. According to Reuters, as of 24 January estimates put DW’s property assets—which include the Queen Many II and a significant share of the Cirque du Soleil—at around US$120 billion. Given that the company’s obligations (which include not only consolidated debt, but also payment to contractors) are around US$59 billion, the risk of insolvency is reduced. This considerably diminishes the risk of contagion.
- He Who Pays the Piper Calls the Tune
Dubai will soon realize that if one pays peanuts, one gets monkeys. Indeed, by failing to pay the internal political costs of building efficient economic institutions, it not only created a perverse corporate and economic system but also jeopardized its stakes in the broader context of the UAE internal balance of power.
Since the end of the British Protectorate of the Trucial States in 1968, Dubai and Abu Dhabi have been at odds as to the direction and shape a future United Arab Emirates should take. These brotherly spats have gone so far as taking the two sheikhdoms to war in 1947 with the resulting border disputes only solved in 1979—eight years after the creation of the UAE—with the help of the UK.
In the compromise, Dubai also decided to enter into federal politics: its ruler would be the UAE prime minister and preside over the council of ministers. Under this system, oil-rich Abu Dhabi’s preference for a more centralized federal government clashed with the more confederate tastes of Dubai. Dubai’s independence in the federation was so solid that it was able to maintain an independent military force until 1996.
The Dubai crisis’ result of limited access to international capital markets is bound to make Dubai increasingly dependent on its oil-rich neighbour. Aware of the change in the UAE’s internal balance of power, Abu Dhabi has made sure to convey the message that its support of Dubai will be limited and conditional. Indeed there are widespread rumours about the existence of a secret buy-out agreement in which the Dubai government agreed to a greater degree of centralization in federal politics. Rumours also include the federalization of Dubai’s customs. This would prove a substantial gain for Abu Dhabi as it would help it to enforce trade sanctions against Iran—an issue toward which Dubai has been ambivalent at best.
Ahead Lies the Unknown
In Charles Dicken’s Tale of Two Cities, the reader is left in the dark as to what future lies ahead for Great Britain and France. The same is true in this tale about Dubai’s predicaments and broken promises. What is certain is that much will change for the UAE’s economy and politics.
The Sheikhdom of Dubai is not likely to become irrelevant, however. Unlike the idea conveyed by the first Western media reports, expatriates have not fled en masse and the city has not become a ghost town. But much remains to be done to address the sheikhdom’s battered real estate market before it can be viewed as safely out of the woods.
What is clear, however, is that the UAE needs to improve its corporate governance and transparency policies. Notably, as stressed by James Hammond III, Executive Vice-President of Marketing and Product Development at ISI Emerging Markets, it needs to make economic statistics more readily available in order to foster a dynamic and accountable economic environment. More unified and centralized control of the judicial system could contribute to the improvement of such economic legislation. Yet too much centralization and interventionism could end up backfiring. As the newly reinforced political centre of the Federation, Abu Dhabi must fight against its tendency toward government dirigisme of the economy.
Daniel Capparelli
