It is only when the tide goes out that you find out whose artificial islands are built on sand. Dubai, the glitzy debt-fuelled emirate famous for its its extravagant sky-scrapers and man-made lagoons, announced this week that it is seeking a standstill on repayment of part of the debt of Dubai World, a state holding company.
The announcement was amateurish: it was unclear, and made on the eve of Eid, as the country closed down for four days. Regardless of its intentions, the emirate’s botched messaging created and then fanned fears about the solvency of the state of Dubai itself.
During the boom, the government of Dubai and its enterprises ran up at least $80bn of debt obligations. This may be a lot of money for a small country, but it pales in comparison to Lehman Brothers’ $613bn of liabilities. Dubai is a big property developer and a heavily indebted government, but a small financial player.
Still, this little pebble in the Gulf created big waves in markets. By week’s end, the FTSE 100 had fallen by 2.3 per cent and the Nikkei by 3.8 per cent. Spooked investors sought safety: yields on 10-year US Treasury bonds and UK gilts fell by 12 basis points and 9 basis points respectively.
Such nervousness is the result of continuing financial fragility. The economic crisis was caused by a build-up of leverage. As the crisis unfurled, policymakers rescued debtholders, rightly betting that the best escape route was to meet obligations to creditors and then rely on future economic growth to make debts manageable.
As a result, the financial system remains over-leveraged and undercapitalised. Growth may be returning and green shoots breaking through, but this week has confirmed that the world is not yet in the clear. The financial system remains fragile. Losses and clouds of uncertainty, such as those now hanging over the Gulf, can still trigger skittish sell-offs.
Markets will not soon return to the panic of September 2008: the financial sector now has state backstops. But, because of these guarantees, fearful investors have started to worry about how safe sovereign debt is. Investors are growing nervous about Greece and Ireland, in particular.
Dubai must sort this mess out. It will not now be able to restore confidence in its solvency without support from Abu Dhabi, its oil-rich investor, neighbour and the more conservative senior partner in the United Arab Emirates.
For its part, Abu Dhabi should give whatever help is needed to bring this episode of incompetence to a close. Abu Dhabi allowed it to be believed that it was backstopping Dubai, so it should make good its promises. This will require a public guarantee of Dubai’s debts – and soon. The reputation of the whole UAE depends upon it.END
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