Global markets are overreacting to Dubai World's 'delay' in debt repayment
There is nothing understated about Dubai as I learned during a recent visit. It is hard not to be impressed by the ambition and audacity of this growing city. During the last decade or so, Dubai has embarked on large scale real estate development projects that led to the construction of some of the tallest skyscrapers and largest projects in the world such as the Emirates Towers, the Burj Dubai, the Palm Islands and the world's second tallest, and most expensive hotel, the Burj Al Arab. So how did a city of 1.4 million people with a GDP of roughly $40 billion manage to fund these ambitious projects?
To understand how, one has to think about Dubai as a highly leveraged private equity firm. Dubai has very little oil resources of its own, and under the tutelage of its ruler cum CEO, Sheikh Mohamed, it pursued a bold investment-fueled growth strategy focused on tourism, real estate and financial services. During a four-year construction boom, Dubai borrowed $80 billion, or almost 200% of GDP, to fund outlandish projects that transformed the sheikhdom into a regional tourism and financial hub. At one time it was rumored that Dubai had 25% of the world's cranes, quite a feat for a city that was home to 0.02% of the world's population. Dubai's motto was simple: 'Build, and they will come'. Global capital markets were awash with credit pre-Lehman, and Dubai borrowed heavily on generous terms to fund its expansion. Debt service costs were low, and the high growth/high debt, leveraged private equity model worked perfectly.
Post-Lehman, this house of cards built primarily on investor sentiment came crashing down. It is estimated that property prices have fallen almost 50% in Dubai since then. Quite simply, buyers turned into sellers as panic spread through the financial system, exposing Dubai's glut of over-supply. People who bought several properties as investments with the hope of flipping homes at a profit, suddenly found that their mortgages/liabilities far exceeded the value of the homes they owned (sound familiar?). The cycle of borrow-build-sell-build was thwarted, and a sharp drop in revenues resulted in Dubai's high debt levels becoming an albatross.
Clearly, global markets have overreacted to Dubai's inability to make a debt repayment of $3.5 billion due December 14th. Some believe this could be the largest government default since the Argentine debt restructuring in 2001, while others point to contagion given the exposure of global banks to Dubai's debts. There are also fears of similar 'surprises' emanating from different parts of the world.
The facts would suggest that these fears are unfounded. To begin with, Dubai's problems are unique and its scale of potential defaults very small compared to the $1.7 trillion of global write-downs absorbed by banks due to the global financial crisis. To be sure, Dubai has several prized assets and can sell them to fund debt repayments but it is loth to do so. Besides, Abu Dhabi, the capital city of UAE and Dubai's nemesis, has one of the world's richest sovereign wealth funds with over $600 billion in assets and will not risk a Dubai default. It is most likely going to end up being Dubai's savior, but is currently engaged in a high stakes game of chicken with Dubai's ruler. It will ultimately lend Dubai the money to repay creditors but on its own terms. It will either take large ownership stakes in key Dubai assets & corporations and/or demand a much higher say in running Dubai's affairs. Either way, debts will be repaid and global traders will regain their sanity.
Drunken stupors often lead to prolonged hangovers. This is no different!