Business Times

Du-bai or Du-sell?

By a Special Correspondent in Dubai

The phenomenon of emerging markets defaulting on their debt obligations is not new. In 1998, the default on Russian debt drove Long Term Capital Management (LTCM) a very large Wall Street hedge fund run by John Merriwether to the ground. Then in 2001 Argentina defaulted on its debt. In both cases emergency measures instituted by US investment banks (prodded on by then Federal Reserve Bank chief Alan Greenspan) and the IMF restored stability to the financial system.

View of the tallest tower in the world Burj Dubai in Dubai December 1, 2009. The ruler of Dubai said on Tuesday the emirate was "strong and persistent", despite the global reaction to its plans to restructure a conglomerate that he said manifested a lack of understanding. REUTERS

Today, both these countries are issuing billions of dollars of debt once more with seeming impunity and memories of the prior defaults are lost in the mists of time. Indeed the history of the evolution of debt markets, from the time of the south sea bubble, is littered with speculative ventures in emerging markets gone belly up. It is left to the regulators and investors who are still solvent to pick up the pieces and carry on the business of capitalism.

It is not my intention to justify in any way the wilful default, whether by sovereign, corporate or retail borrowers. But a cursory glance at the facts suggests that debt markets take debt defaults pretty much in their stride. Defaults are factored in to the rate of interest charged (the ‘spread’) which subsidises the cost of these defaults to the lenders and hopefully yields them a profit most of the time.

So why was the potential default by a Dubai-registered company, Nakheel, such a big deal last week?
For starters, Nakheel is owned primarily by Dubai World which in turn is majority owned by the Government of Dubai. A cardinal presumption of the vast majority of investors is that governments simply DO NOT DEFAULT on their debt obligations. Never mind several centuries of evidence to the contrary, investors keep being drawn back into the belief that sovereign debt is somehow less default-prone than other forms of private debt.

Assured markets
Investors I spoke to contend that the regulators in Dubai had assured markets back in September 2009, when analysts discovered that Nakheel was finding it difficult to raise the cash to pay back its bondholders, that the government would back the company and support it through a difficult patch. The media carried reports that neighbouring oil-rich Abu Dhabi had lent Dubai a few billion dollars when their two emirs had met and discussed the issue over a cup of Arabic coffee laced with a dose of Islamic neighbourly brotherhood.

Never mind that Dubai World had reputedly taken big bets on acquiring Barneys, a big retailer in the US and real estate projects in Las Vegas and South Africa. Never mind that Nakheel was tasked with building the Dubai Waterfront project out of raw sand near Jebel Ali, converting a beachfront zone twice the size of Hong Kong island into a thriving metropolis of 1.5 million people surrounded by a 75-kilometre moat in the desert. And never mind that these projects were melting down as demand for luxury condominium properties were collapsing in the wake of the US housing crisis.

Add the fact that the grandiose offshore land reclamation projects, in fancy shapes of palm trees, maps of the world etc. were not attracting much interest from well-heeled buyers who were flocking back to their bolt-holes in Belgravia and the Hamptons, you will appreciate that the world was getting a bit impatient with the Sheikhs.

Moreover these purchases were funded for a large measure with leverage, or money raised through the issue of bonds, with minimal legal recourse for lenders to the underlying assets of the company. The Nakheel bond issue, for instance, is a sukuk or Islamic bond which does not pay interest. Isn’t this a contradiction in terms? Aren’t bonds defined as interest-bearing financial instruments?

Then there is the issue of legal jurisdiction. The Nakheel sukuk is issued under Dubai Islamic law. The Holy Koran exhorts lenders to help borrowers in difficult times. Not so English Common law which takes a drier view of human avarice. So the Dubai company and government probably felt justified when they announced that there would be a STANDSTILL on repayment of Nakheel sukuks for six months. Presumably their crystal ball predicted the world would flock back to buy Dubai condos in six months time.

All this begs the question, why had lenders and investors been so generous?
There was the implicit assumption that Dubai and its companies would simply not be allowed to default. It was part of the United Arab Emirates which comprised a number of oil exporting emirates. Never mind that Dubai’s share of oil exports had dwindled to the point where they were insufficient to fund its debt payments.

The Dubai Sheikh’s closest advisors and business buddies owned the company. It was therefore inconceivable that the government, which was the largest shareholder in Dubai World would abandon it.
All this started to unravel sometime in early November 2009. Financial markets are getting more and more inter-connected with the spread of technology and the internet connectivity. The old adage about a butterfly fluttering its wings in one corner of the world causing a hurricane halfway across the globe has found new meaning in financial markets.

Central banks across the globe are grappling with the issue of whether the unprecedented amounts of money printed in the last year should be mopped-up anytime soon, to prevent the inevitable aftermath of an inflationary surge on a global level. Already signs are emerging of the prices of major varied commodities like sugar, coffee, cocoa and gold surging to levels exceeding previous highs.

Prominent international figures like German leader Angela Merkel and the Governor of the Peoples’ Bank of China (China’s central bank) have publicly criticised the US Federal Reserve Bank and Treasury for jointly creating a global financial bubble by issuing too much US government debt and printing US dollars to buy it back. This, they contend, is creating conditions for high future inflation and/or another financial bubble similar to that which brought the US housing sector to its knees.

The Federal Reserve Bank Governor, Ben Bernanke, retorts that he sees no signs of a bubble anywhere. This is a bit rich coming from a man who was on the board of the Bank while the housing crisis was fermenting. But the debate underlies the critical role the US dollar plays as an international currency of exchange and the seeming helplessness of the rest of the world to countenance the financial misbehaviour of the US.

Market shock
Some central banks have decided to act anyway, on their own. In early November the Reserve Bank of Australia shocked markets by raising interest rates by a quarter of one percent. No one had expected such a move especially since it would serve to further strengthen the Aussie Dollar which is already becoming very strong and threatening to hurt aussie exports. But the Bank was very forthright. It said it considered it its duty to prevent future inflation from rearing its head in Australia and by last week it had further raised its base interest rate twice more.

Soon other central bankers in countries as varied as India and South Korea were publicly warning markets that they too would be compelled to tighten money availability in their markets too.
What all this means is that the availability of credit and bank loans, which was already shrinking after the US housing bubble burst in 2007, is now going to shrink at a faster pace. And that means that potential buyers for luxury homes in the Dubai Palm and World islands, or indeed in any of its other assets around the world, are having second thoughts about putting their money down. Or at least their bankers are.

Paltry prices
According to media reports, Nakheel was offered paltry prices when it offered some of its investments to potential buyers. Meanwhile its friends and cousins in Abu Dhabi were getting tetchy about throwing good money after the earlier sums which seemed to be sinking into a bottomless pit of debts gone bad.
Meanwhile, A COUPLE OF BILLION DOLLARS WAS COMING DUE FOR Nakheel on 14 December 2009. Buyers were thin on the ground for their prize assets.

What was to be done?
The Dubai Sheikh was getting a bit irritated with some of his loyal henchmen. Bickering among them was evident from snide reports leaked to the normally secretive media about the financial mismanagement of some projects. Besides, having to face the ignominy of a financial rebuke from their cousins in Abu Dhabi brought a whole new meaning to the concept of loss of face.

Things came to a head a few weeks ago when the Dubai Sheikh decided to sack some of his most senior and hitherto trusted advisors from their sinecures in large state-owned companies and regulatory agencies. Included was the boss of Dubai World who was sent packing. The few remaining favourites had a look at the books left behind by their departing colleagues and got the shock of their lives. The financial mess was indeed worse than originally portrayed, it seemed.

Shame and anger soon turned to outrage. How dare those blue-eyed western bankers and their arab collaboraters keep issuing deadlines on the repayment of debts by Dubai World, Nakheel and assorted Dubai entities. Surely in such situations there should be room for re-negotiating the terms of the loan with one’s bankers/creditors?

When he wrote the concept of the clash of civilisations, Samuel Huntington was probably more focused on the concept of military confrontation between the followers of Islam and Christianity, which has been going on for millennia. What he probably didn’t focus enough attention on was the fact that, by a curious quirk of fate, almost all the easily accessible reserves of crude oil on the planet were placed in Islamic states. Some divine entity has indeed been beneficient. But perhaps not so merciful.

In financial markets, no expletive can capture the obscenity of default. The concept of sticking to loan covenants is firmly embedded in the protestant/anglo-saxon value system which provides the stablest possible underpinnings of the rules-based capitalist system. That is a cardinal rule that habitual defaulters ignore at their peril.

The Dubai sheikh and his remaining advisors surveyed the options and decided to cock a snook at their blue-eyed bankers. They simply declared that they were not going to offer government guarantees to Dubai World or Nakheel. In a tersely worded press release, they said so much in so many words.
Financial markets, which have had a pretty easy run for most of 2009, were looking for an excuse to get nervous. Dubai presented them that excuse on a platter. The predictable knee jerk reactions ensued. Wet-behind-the-ears traders in mid-western American pension funds dumped any bit of financial paper that SMACKED OF THE MIDDLE EAST. For a while it seemed that the crash of 2008 was about to see part B enacted. Eventually markets recovered their equanimity. After all, the amounts involved were quite small, US$ 60-odd billion which was peanuts compared to the US$ 3 trillion that went up in smoke last year.

Panicky investors
So intrepid investors went in and bought all the shares and bonds which panicky investors were selling and this week they saw nice gains on those forced sales.

The moral of the story is manifold:

1. Dubai will find it very hard to borrow money for a few years
2. A fair number of foreign construction workers and maids will be sent packing in the months and years to come
3. Any governments which have recently entered the weird and wonderful world of international debt markets had better make sure they can service the debts they have accumulated. Or the wet-behind-the-ears trading fraternity will exact their revenge.

(This piece was exclusively written for the Business Times. The writer is a specialist in banking and financial matters with a local and international perspective).

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