Lessons from Dubai

The global tremor that followed last week’s announcement from Dubai that the state-owned Dubai World was asking, indeed demanding, that creditors agree to a six month moratorium on the repayment of its debts is abating as it has become clearer that the problems in Dubai are containable and manageable.

While the markets’ preferred solution – a bailing out of Dubai by its richer neighbour, Abu Dhabi – appears unlikely, this morning’s statement from Dubai World has calmed markets, as have disclosures of minimal individual exposures from banks around the world.

The United Arab Emirates' action in providing liquidity to local and foreign banks has also contained the risk of contagion throughout the region.

While Dubai World has $US60 billion of borrowings, the statement said it was having constructive talks with lenders in relation to $US26 billion of debt within its most troubled subsidiaries. Dubai World is looking for a moratorium on repayments of its loans until at least May next year.

Earlier, the government of Dubai had made it clear that, while it owns Dubai World, it doesn’t guarantee its borrowings and therefore the creditors would have to accept responsibility for their own judgments in lending to the group.

Given that prospectuses for Dubai World’s Nakheel property group explicitly stated that its borrowings weren’t guaranteed by the state, that does tend to illustrate again how bank credit standards deteriorated during the credit bubble.

No doubt bankers around the globe are now poring over their loan agreements with sovereign wealth funds and other state-owned enterprises to determine whether there is explicit government support for their exposures. The Dubai World implosion says that implicit state backing as a consequence of state ownership can’t be assumed in a crisis.

From the outset it was apparent that, by itself, even a complete collapse of Dubai World wasn’t a threat to the stability of the global financial system, in itself. However, it was an unpleasant reminder to markets and lenders of the continuing fragility of the system and a step too close to the potential for a sovereign default.

For much of this year there has been a false sense of comfort in global markets that a financial catastrophe had been averted and stability restored. Dubai World, and Dubai’s explicit distancing of itself from any responsibility for the state-owned enterprises’ debts, is a demonstration of how thin that veneer of stability remains.

A particular concern for markets and the banks will be the fragility of some of the smaller European economies – Greece is the one most singled out – with large borrowing requirements looming next year. Greece’s public sector debt is about 135 per cent of its GDP.

Dubai World provides a disconcerting preview of more significant issues to come, magnifying the focus on the prospect of actual defaults on sovereign debt and the particular and peculiar complexities of trying to manage economies on the brink within the Eurozone.

The markets may have stabilised and their worst fears might have receded quite rapidly, but the episode ought to be a sobering reminder that while the global system is edging away from the abyss into which it peered in the aftermath of the Lehman Brothers’ collapse, it still remains too close to it for complacency.