Goodbye, Dubai?

The Thread

The Thread is an in-depth look at how major news and controversies are being debated across the online spectrum.

What’s tiny, dry and poised to bring down the entire global economic system? If you answered “Dubai,” you’ve been reading the papers over this extended holiday weekend. Landon Thomas Jr. of The Times sets the stage:

Of the many economies that gorged on debt in the boom years, Dubai stood out. In the space of a few years the emirate’s investment arm, Dubai World, racked up $59 billion in debt, borrowing to build lavish developments like a giant island shaped like a palm tree to entice celebrities like Brad Pitt, and to invest in glittery properties like the MGM Grand Casino in Las Vegas.

Now that the boom has gone bust, both in Dubai and in the United States, Dubai is stuck with a glut of real estate that no one wants to buy or rent. Creditors and markets had always assumed that when push came to shove, its oil-rich neighbor Abu Dhabi would bail out Dubai. But that assumption was called into question this week, and the resulting fear that Dubai might not be able to pay its bills sent a wave of uncertainty rippling through markets just as investors thought the worst of the global financial instability was over.

The anxiety reached Wall Street on Friday, sending the Dow Jones industrial average down more than 150 points, as investors worried about hidden debt bombs in other countries and institutions — heavily indebted nations like Greece and even Britain, high-flying emerging markets and even European and American banks that had lent Dubai money.

In a worst-case contagion, Bank of America analysts wrote Friday, “One cannot rule out — as a tail-risk — a case where this would escalate into a major sovereign default problem, which would then resonate across global emerging markets in the same way that Argentina did in the early 2000s or Russia in the late 1990s.”

“Emerging markets”? So, nothing to worry about for us big boys, then? Right? Please? Gillian Tett of The Financial Times says not to feel too cozy:

Two years ago, global investors generally did not spend much time worrying about so-called “tail risk” (a banking term for the chance that seemingly remote, nasty events might occur). After all, before 2007, when the world was supposedly enjoying the era of the “Great Moderation,” the world seemed so stable and predictable that it was hard to imagine truly unpleasant events occurring. But in the past two years, a seemingly safe financial system has crumbled, and — to paraphrase Lewis Carroll — investors have repeatedly been asked to believe six impossible things before breakfast, ranging from the collapse of Lehman Brothers to the implosion of Iceland (and much else). Tail risk, in other words, has leapt into investor consciousness. And while the financial markets have stabilised in the past six months, that lesson about tail risk cannot be easily unlearnt … has left investors looking like veterans from a brutal war. Long after the fighting has stopped, the mere sound of a “bang,” is apt to leave them running for cover.

All this does not mean — let me stress — that it is correct to expect the world to melt down imminently …. [But t]ail risk has resurfaced with a vengeance …. For while investors used to assume that it was just emerging market countries that were prone to suffering truly nasty fiscal shocks, the debt fundamentals in Dubai are not necessarily so different from those in developed nations … the fundamental imbalances that created the crisis in the first place — such as excess leverage — have not yet disappeared. Beneath any aura of stability huge potential vulnerabilities remain. If Thursday’s events prompt investors to remember that, so much the better; not just in Dubai but in Greece, too.

While Marc Ambinder of the Atlantic thinks the panic may be overdone, but the worry is real:

Stocks plunge! The yen crashes! Crude oil slides down! Investors flee to the safety of the U.S. Treasury. The world’s economic establishment is taken by surprise (an exogenous shock) as the Dubai emirate suddenly decides to deal differently with its debt. On a broad level, one would assume that if Dubai could have handled its debt problems privately, it would have — and the mere fact that it could not justifies the fears that are moving the markets.

High-flying Dubai wasn’t supposed to default this way (although why that magical supposition existed is beyond my ken). Countries aren’t supposed to change the rules (but they’ll do it if they need to do it to survive, as investors in this country found out earlier this year). Of course, countries that don’t have natural resources (Dubai didn’t have much oil itself) and were ridiculously overdeveloped aren’t supposed to weather a global recession.

The New York Times calls Dubai’s move “the global high-finance equivalent of a homeowner asking the bank to allow six months of skipped mortgage payments because of a shortage of cash.” An analyst blithely points out that Dubai’s debt restructuring won’t be nearly as difficult to recover from as the prospect of, say, the commercial real estate market collapsing in the U.S. The point, though, is that this global kluge of an economy isn’t strong enough to simply notice something like this and move on.

Edward Harrison at Credit Writedowns agrees that the real threat lies down the road:

I think of the events in Dubai as having a bit of the butterfly effect to it — with everything selling off because of this one isolated incident. That was my thinking when I wrote the paragraph above 10 months ago, but I had since lost this particular storyline out of sight. If there was to be any global butterfly-effect contagion, I have been looking more to the Baltics and their property bubble (see this October post for an example).

But now that Dubai is back in the news, I have looked back in my archives to see what (if any) links I have had on the situation in the country. The last two were in April about developers defaulting and in May about an S&P debt downgrade. Since then — as the global equity markets have turned up — nothing.

What does this tell me? First and foremost, it hints at the fragility of this recovery and the real risk exogenous shocks pose. We are barely recovering now and a lot of debt and unemployment put us at stall speed, making the risk posed by events of this nature that much greater.

More importantly, however, the Dubai World events underline the unpredictability of exogenous shocks. All of these potential crisis situations — dollar carry trade unwind, debt crisis in the Baltics, oil price spike, an unexpected surge in interest rates, war in the Middle East — are still there lurking in the background. We don’t see coverage in the press on them everyday, but they are still there.

I have been optimistic about the near-term prospects for the global economy in large part due to the myriad pro-cyclical effects of recovery. Longer-term, however, there are some serious obstacles to a sustainable recovery. This is not a garden-variety recession and recovery. It is a recession within a longer-term depression. And while we are in a technical recovery, I believe much of the fundamental problems which triggered this downturn are still there, lurking. The debt troubles at Dubai World bring this point home.

Well, it may not be fair to criticize the news media for failing to cover things that haven’t happened yet, but point taken: there are pitfalls on all sides of this path to recovery. And Max Boot, writing at Commentary, feels that schadenfreude over Dubai’s fall from grace is one of them:

It is easy to look down one’s nose at the excesses of this global parvenu, which is trying to become the Hong Kong or Singapore of the Middle East, thereby usurping Beirut’s traditional position as the place where Arabs unwind. When I visited Dubai a couple of years ago with a group of foreign-policy analysts, we were all amazed by the frenetic pace of construction. A sizable proportion of the world’s building cranes had been arrayed in this city-state and they were putting up too many skyscrapers to count. It was pretty obvious that the good times wouldn’t last forever, and they haven’t. The result of a building boom, we all know, is a glut of new structures, a lack of tenants, and a crash. That’s what has happened in the U.S. with residential homes in the past few years and now it appears to be happening with commercial real estate in Dubai.

So much, so familiar. But still for all of Dubai’s excesses it is a wonder that it has gotten this far. It deserves not ill-disguised glee at its misfortunes but a degree of respect for its willingness to flout traditional Arab taboos. It is, for example, a place where Emiratis in white robes rub shoulders with Russian hookers in mini-skirts — a place where it’s perfectly possible to get a nice cocktail (and not a “mocktail,” as in Kuwait) in a public bar, and to do so in the middle of Ramadan if you’re feeling parched at that point. No doubt some of Dubai’s competitors, the likes of Doha and Kuwait City and its sister emirate Abu Dhabi, are licking their chops at the prospect of benefitting from Dubai’s downturn but they will be hard put to it to match its dynamism because they remain much more in thrall to traditional Arab/Muslim pieties: a combination of religious and tribal traditions that have made the Middle East a laggard in many dimensions of development. Dubai has been a leader in the Arab world with respect to embracing modernity — which has repercussions both good and bad but in general is a force for positive change. We should all hope that it will get on its feet again soon. The Middle East needs Dubai.

I’m not sure that “an artificial archipelago that would reconfigure the Persian Gulf coast into a thicket of trees, a map of the world, a whirling galaxy, a scythe and a sun that looks like a spider” (as The Times described one of Dubai’s more outlandish construction projects) is exactly the sort of “beacon” of Western democratic values that George W. Bush was so fond of talking about, but I suppose most Americans would consider it a big improvement over the religious police.

Back to the economic importance of them matter, the Times Op-Ed columnist Paul Krugman lays out some choices on his blog:

As far as I can tell, there are three ways to look at it — three stories, if you like, about what Dubai means.

First, there’s the view that this is the beginning of many sovereign defaults, and that we’re now seeing the end of the ability of governments to use deficit spending to fight the slump. That’s the view being suggested, if I understand correctly, by the Roubini people and in a softer version by Gillian Tett.

Alternatively, you can see this as basically just another commercial real estate bust. Either you view Dubai World as nothing special, despite sovereign ownership, as Willem Buiter does; or you think of the emirate as a whole as, in effect, a highly leveraged CRE investor facing the same problems as many others in the same situation.

Finally, you can see Dubai as sui generis. And really, there has been nothing else quite like it.

At the moment, I’m leaning to a combination of two and three. For what it’s worth (not much), US bond prices are up right now, suggesting that the Dubai thing hasn’t raised expectations of default.

Anyway, we continue to live in interesting times.

That last line may be the least controversial thing Krugman has ever written. Even The Atlantic’s Megan McCardle isn’t going to argue:

I agree with Professor Krugman — it’s hard to see this presaging a sovereign debt default by, say, the United States. On the other hand, emerging markets are subjects to runs on their currencies, and debt, and I’m not so sanguine that we won’t see effects there. We might get a split in sovereign debt prices, with developing world debt being shunned by investors who have suddenly remembered what a risk premium is, while US debt and that of other developed countries becomes more valuable. A positive movement in US bond prices agrees with that theory.

Which is not to say that this won’t hurt us. The global economy is not really robust enough to stand up to repeated blows. Presumably that’s why stock indices are off on worries about what follows.

As this little roundup shows, stock indices aren’t the only ones off on worries this weekend. Interesting times, indeed.