GLOBAL capitalism is in a phase in which it must deal with the fruits of the overextension during the previous boom, and there is no doubt that this is going to be painful. The financial crisis in the United States and some other developed countries was perhaps the start, but it was by no means the end. Despite all optimistic talk of global recovery, it is now clear that this process has a long way to go. The recent indeed ongoing crisis in Dubai is the latest example of how this may affect the developing world. Dubai exemplified the materialist ambition and over-accumulation of the boom and now has become an apt symbol of the inevitable crash that must follow. There is much about Dubai that is artificial and based on illusion: the man-made islands designed to represent a map of the globe; the indoor ski slope in the midst of desert; the incredible hotel with glass walls looking onto a sea aquarium mimicking the surrounding ocean; and so on. Recently, Dubai had also become synonymous with excess: building the tallest tower in the world and the biggest and most expensive luxury hotels, residences, shopping malls and office complexes; providing the market and the sales venue for the most outlandish and flamboyant luxury goods; redefining grandiose expressions of opulence for the world as a whole.
Its very brashness was both a sign and cause of its success. Even the opacity of its political system became a source of economic magnetism. Expatriates flocked to its dynamic construction and tourism industries and relished the tax-free incentives. And Dubai emerged as one of the developing worlds new global financial centres.
In the early phases of the global financial crisis, the persistent myth of decoupling made all this even seem to be an advantage as investment activity and construction continued at a feverish pace. In a telling example of the relationship between height and hubris, plans for constructing the worlds tallest building (near its closest competitor Burj Dubai) were unveiled just after Lehman Brothers collapsed in the U.S. Continued growth in Dubai was heralded as another sign of Asian economic delinking from the problems in the core of international capitalism. But now it turns out that this, too, like so much else in Dubai, was based on illusion. The sudden declaration on November 26 that the state-owned conglomerate Dubai World, which typified the apparently insatiable appetite for accumulation in the small Gulf emirate, would unilaterally suspend its debt payments for at least six months came as a sign that the improbable honeymoon was finally over.
Global stock markets and especially emerging markets in Asia went into shock at this announcement, raising fears of a replay of the aftermath of the Lehman Brothers collapse a little more than a year ago. So far that has not happened, but this is clear evidence of continuing financial fragility across the world and a reminder that (despite all attempts by policymakers to talk up the markets) the financial crisis is really far from over.
What is the story behind the rapid economic rise and fall of Dubai? Dubai is one of seven small states that make up the United Arab Emirates (UAE), and it is second to Abu Dhabi (which is the richest and has most of the oil reserves) in terms of the size of its economy. Although the economy of Dubai, like those of its neighbours, was originally built on oil, currently oil revenues account for less than 6 per cent of its total revenues. In any case, Dubais oil reserves have diminished significantly and are expected to run out within the next 20 years.
Dubais strategy has been to diversify its economy away from exposure to oil and shift to trade, tourism and finance as engines of growth. It did that by encouraging Dubai World to buy up companies around the world and inviting multinationals to use Dubai as the West Asian base for their activities in Asia and elsewhere. DP World, a subsidiary of Dubai World, purchased the British ports operator P&O in 2005, thereby becoming the fourth largest ports operator in the world. It also bought the department store group Barneys New York in 2007 and has since invested heavily in construction projects in Las Vegas in the U.S.
Dubai World also includes the property developer Nakheel, which is behind some of the most ostentatious commercial projects ever built on this planet. These include the Palm Jumeirah, a man-made island stretching into the ocean, which is to serve as the base for luxury hotels and villas, and the World Islands, a series of islands shaped to represent a map of the earth.
During the recent boom, it seemed that this heady and hedonistic expansion would never end. And it was hugely based on global integration, not only in terms of trade and financial flows but also the movement of people. Of Dubais resident population, more than 80 per cent are expatriates, including around 1.5 million from India. Indian tourists from the Bollywood crowd to the newly affluent middle classes have also contributed to Dubais boom.
The global crisis, which began with the decline in real estate values in the U.S., inevitably had its effect as the global markets for luxury goods and services and for real estate both shrank simultaneously. But Dubais fall began with the flight of capital as investors anticipated that emerging markets would be impacted by the recession and because they needed the money to cover their losses in the U.S. market. Thereafter, the collapse of non-tradable sectors, especially real estate and construction, was swift. Property prices in Dubai have fallen by more than 50 per cent in the past year. Many construction projects have been held up or even abandoned because of lack of easy finance initially and fears about future prospects later.
The economy slumped from the second half of 2008. At the start of the financial crisis, GDP growth expectations in 2009 for Dubai were 4 per cent, but this was lowered to 2 per cent in the middle of the year. The current account balance also entered sharply negative territory.
Even so, there was official denial of the downturn, with the government spokesman claiming that the Dubai Strategic Plan, which projects economic growth at an average 11 per cent annually through 2015, would be fulfilled. Early in November 2009, the ruler of Dubai, Sheikh Mohammed bin Rashid al-Maktoum, who is also Prime Minister of the United Arab Emirates, broke into English at a press conference: I want to tell those people who nag about Dubai and Abu Dhabi to shut up. He also announced that he was proud of Dubai World and its long-term commercial success, feeling that the worst was now over for its financial problems.
This was clearly not so. On November 26, barely two weeks after his brave statement, Dubai World announced that it was seeking a debt standstill for $15 billion of repayments on its $59 billion of external debt until May 2010, and had hired Deloitte to help it restructure to move into financial viability. This surprise announcement, coming on the eve of the Bakrid holiday, reverberated across global markets.
After the sub-prime crisis in the U.S., people know that it is not only the banks, which have directly lent to a defaulting customer, that are affected because of the complex and often opaque patterns of interlinkage across banks and other financial institutions. So, there are concerns about counter-party risk for the European and Asian banks that lent to Dubai World. As we have found over the past year, getting accurate numbers from any financial player about the true extent of liabilities is next to impossible. The official estimate of the UAEs sovereign debt is $80 billion, but some analysts say it is much more and could be even twice that amount. European banks are heavily involved: according to The Wall Street Journal (using data from the Bank for International Settlements), European banks alone have almost $84 billion in exposure. Banks of the United Kingdom (including HSBC, Standard Chartered, Barclays and Royal Bank of Scotlands ABN Amro) have by far the largest exposure at $49.5 billion, while French and German banks are also implicated.
Among the Indian banks, Bank of Baroda has an exposure of about Rs.5,000 crore in Dubai, which accounts for half of its loans in the UAE. Several Indian companies (Nagarjuna Constructions, Larsen & Toubro, Punj Lloyd, Voltas, Omaxe, Aban Offshore, Spicejet and Indiabulls Real Estate) have investment and business exposure in Dubai, but they have generally rushed to declare their exposure to be marginal. But the most direct impact on India is through its workers. Most of the Indian workforce in Dubai consists of blue-collar workers in construction or low-grade services who typically have temporary contracts and have to live in rooms housing six to 10 other workers. In a country with no unions, it is easy for companies to lay workers off. For that reason alone, it is hard to estimate the extent of job loss after the crisis, but it is estimated that tens of thousands of workers in the construction and real estate market alone have lost their jobs over the past few months.
Recently, a further shock to the financial system came from the announcement that Nakheel Properties will seek a substantial restructuring of its bond issue, which will dominantly affect the hedge funds that held a significant part of this. The company is furious, of course, but that is not the point. The irresponsibility of the funds that purchased such bonds was no less than the company that issued them, but as usual, the financial players assumed they would be bailed out. They took this for granted even though the bond issue was not officially guaranteed by the state of Dubai because Nakheel is a publicly held company and so its bonds came into a category known as quasi-sovereign debt.
Over the past series of financial crises, financial institutions even those that explicitly deal in risky assets have come to expect that the capitalist system will continue to ensure that their losses are covered. They are now crying foul. This will definitely affect other quasi-sovereign debt in both developing and developed countries.
Some idea of market scepticism about Dubais immediate prospects is to be found in the movement of the credit-default swaps (CDS), which are tradable, over-the-counter derivatives that function like a default insurance contract: if a borrower defaults, the protection buyer is paid compensation by the protection seller. The five-year CDS for DP World increased more than four times in two days, to hit 810 basis points on November 27, which put the emirate in the same league as Iceland. The rates have remained high thereafter.
Dubai is relatively fortunate, however, in that investors still believe that it will ultimately be bailed out by its elder brother Abu Dhabi, which already granted Dubai a $10 billion loan in February 2009. Some analysts have argued that it is not a question of whether, but when, Abu Dhabi will step in. After all, Abu Dhabis sovereign wealth funds have reserves estimated at over $700 billion, so bailing out Dubai World will not be that difficult. It is also in its own interest, not only because the costs of insuring Abu Dhabis sovereign debt have shot up in the past week but because it cannot afford damaged financial credibility in the region.
Even if Dubai manages to survive the current crisis, broader questions remain. Dubai is not unique in being tripped up by its earlier irrational exuberance, especially in housing and real estate. The rotten fruits of the earlier phase of over-accumulation are still waiting to be collected, and as a result, there are plenty of potential banana skins waiting to trip up investors in financial markets across the world. Real estate in the U.S. continues to fall, especially, but not just in luxury markets such as Florida, and default and dispossession continue to increase.
So it is likely that there will be further cases of restructuring, default and forced sale as housing debt matures and comes up for final repayment. It is estimated that around $3,500 billion of commercial property debt is outstanding in the U.S. alone. Of that, about one-quarter was securitised, where groups of loans are packaged and sold to investors in tranches offering different levels of risk and profit. This means that investors holding mortgage-backed securities are going to be hit. Thus far, such securities have been implicitly underwritten by the U.S. government, but there are doubts about the extent to which it can continue to do so.
Many of these securities were picked up in the U.K. and Germany, which makes their financial systems still vulnerable. The U.K. has its own housing problems HSBC estimates that 85 per cent of U.K. loans made in the past five years are in breach of lending agreements. But banks are ignoring such problems, and simply rolling over loans as these near maturity, in the hope that housing prices will rise enough to make repossession a viable alternative. Currently, that is far from the case. Problems at the larger multinational banks will persist and even grow in the next few years.
In many other countries, the multiplier effects of the collapse of the construction and real estate sectors are still working their way through the economy. The latest fear of sovereign default is from Greece, and Ireland is also in trouble. So financial markets may have good reasons for reacting the way they have. The collapse of the Dubai dream is not a sui generis event without any implications for wider markets. Rather, it may be a straw in the wind indicating that the travails of finance capitalism in the current period are far from over. It remains to be seen how long governments in both developed and developing worlds will remain in denial about these problems.
