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How Worried Should We Be About Dubai?

by rziemba
February 17, 2009

Note: This post is by Rachel Ziemba of RGE Monitor, filling in while Brad is off in the mountains.

Many thanks to Brad for letting me fill in again.  I pay attention to macro events in China and several  oil exporters and the whole portfolio of sovereign investors for RGE monitor where this post first appeared. I’ll chime in on a few things related to sovereign investors (including their role in financing the US) this week while Brad is out.

In recent weeks CDS spreads on the debt of Dubai’s largest State-linked vehicles like Dubai Holding etc shot up dramatically after Abu Dhabi announced a unilateral recapitalization of its banks. The cost to buy prrotection on the 1 year bond has doubled since late January and now stands at 1073bps. The jump in the 5 yr has been less sharp but stands at over 1400bps. Since Dubai has limited sovereign debt (about $10b and maybe climbing given the likely fiscal deficit) so these large state-linked companies provide a proxy for the perceived credit worthiness of Dubai’s government. Given Dubai’s debt stock ($80b or 148% of GDP), its vulnerability to global liquidity and the worsening outlook for its domestic property market despite the ability to control supply, it is perhaps not a surprise that the outlook for the emirate seems much more precarious, particularly in contrast to its cash rich neighbour, Abu Dhabi. Given the links of these debtors to the government, and the effect that their vulnerabilities could have on the UAE federation, it has widely been assumed that the UAE govt (or rather Abu Dhabi) would come to the aid of Dubai when the crunch came. However, there has been more uncertainty than some expected. Key tests are ahead in coming months as Dubai adjusts to a world where leverage remains scarce.

Around $20b of the outstanding debt ($80b) comes due in 2009, including several large syndications like that of Borse Dubai which was having trouble rolling over its $4b loan that expired at the end of February. Breaking views notes that the $4b capital needed is a test case as allowing the institution to implode would have broader reverberations. It now seems that the UAE federal government might be coming to the rescue. Meed suggests that it will loan Borse dubai $1b to make up the shortfall. Borse Dubai only managed to secure $1.25 billion of commitments from commercial banks, although some further commitments from banks could bring the final bank tranche to $1.5 billion. Even the capital that Dubai attracts will come at a higher cost. Borse Dubai might have to pay 430bps above Libor rather than the 130bps the maturing loan carried.

Unlike some of its neighbours (especially Abu Dhabi) Dubai’s growth was primarily debt financed, making it more vulnerable to the global liquidity crunch and more local liquidity tightening triggered first by the withdrawal of speculative capital and – later by the fall in the oil price. Although Dubai has little oil, it was clearly a petrodollar recycling hub. It accounted for much of the UAE’s external debt stock (some of Abu Dhabi’s state investors like Mubadala and others accounted for the rest ). Dubai based banks likely also accounted for much of the bank lending to the UAE. Moodys vulnerability indicators show that the UAE is among the most vulnerable in the MENA region (if much less vulnerable that Eastern European countries that are being forced to rapidly and painfully adjust.

Data from the BIS (see chart below) show that loans extended to the UAE first tapered off and then fell in Q2 and Q3 of 2008 (the most recent data)  This is consistent with the outflows of short-term capital once dirham revaluation was taken off the table that contributed to a local credit crunch as well as the the escalation of credit crunch on a global scale and a reluctance to lend to the Gulf as the oil price began to fall. Of remaining loans, UK banks are most exposed. Looking at shifts in the UAE’s central bank reserves details the scale of this flows. The UAE’s reserves doubled to almost $100 billion but have subsequently fallen to $44 billion at the end of Q3 (most recent data). No wonder the project finance costs and domestic interbank rates shot up.

Liabilities of BIS banks to UAE

Liabilities of BIS banks to UAE

The following gives an outlook of how net flows of funds (deposits abroad – loans) of the UAE compare to the rest of the GCC. the UAE has consistently borrowed more from foreign banks than it has borrowed abroad for the last 18 months. Despite the drop in loans extended to the UAE, it continued to be a net borrower from the international banking system – unlike for example Saudi Arabia or Kuwait.

Dubai is experiencing a property bust. Prices and volumes have been falling for some time and even efforts to control the supply (by merging and providing capital to the main mortgage lenders or pulling back on projects have had limited effect.) The secondary market in particular has dried up. Meanwhile with a number of foreigners losing their jobs will be another blow to consumption and property markets.

It has been widely assumed that oil-rich Abu Dhabi would come to Dubai’s aid in one way or another, providing the needed capital and solidifying Abu Dhabi’s role within the power structure of the UAE. It seemed likely that federal institutions were taking the upper hand – including the central bank. In fact the first UAE government responses to the financial strains on UAE banks seemed to be evidence enough. But the next stage has been less unclear.

Moreover the structure of some of the liquidity provided including the temporary ‘repo window’ still created disincentives for banks to take advantage of the funds – likely because authorities wanted to force regulatory changes to stem the significant credit growth. While most UAE banks received long-term deposits back in the fall from the central bank, they remain undercapitalized given the loss of whole sale financing and the fact that the property bust is undermining the quality of underlying assets – property, credit card debt etc. Standard chartered suggests that UAE banks need an additional $27 billion to be adequately capitalized. Other institutions like a permanent repo window and other tools to control the money supply are also needed. These capital needs persist despite Abu Dhabi’s injections to its banks, however, the support of the emirate’s government does add to the stability of financial institutions there and reduce the risk of systemic risk. Abu Dhabi provided capital injections to five banks operating in the emirate in the form of 5 year deposits. Yet allowing a default of a major state-linked banks could have broader reverberations in the region.

Why hasn’t Abu Dhabi made more funds available to Dubai given that the uncertainty undermines UAE asset quality and the “UAE brand”? One explanation might be politics between the emirates. Reportedly Dubai has not actually asked for funds, perhaps fearing a loss of autonomy.

However, even Abu Dhabi’s stock of liquid assets might not be quite as high as it might like. In a recent paper, Brad Setser and I argue that the funds of the Abu Dhabi Investment Authority (ADIA) may never have been as large as some observers thought (we peg its peak at close to $480b early in 2008 and suggest it may have suffered valuation losses that took its AUM down as low as $300b (watch later in the week for some updated calculations on a range of sovereign funds). The calculations are based on an index based portfolio so we might be a bit off. However, given that liquidity is at a shortage and Abu Dhabi may also run a fiscal deficit, it may prefer to preserve its capital for investments prioritized for domestic development.

Yet it is not in its interest to let too large a gap in credit worthiness emerge with Dubai particularly as its banks and institutions are exposed to Dubai’s property markets (perhaps accounting for the extra liquidity injection.) Furthermore there are risks that the property markets and financial institutions throughout the region even if most countries are more insulated. Abu Dhabi may prefer to avoid such a bust. But as Moody’s notes, the corporate sectors of the GCC have not been tested in this way in the past and do face significant financing needs.

Broader cost cutting is going on in Dubai including several mergers in the property sector and job reductions. Dubai International Capital and Dubai Group, investment focused entities belonging to Sheikh Mohammed plan a quasi merger. This seems to make sense and may reduce overcapacities. In fact these two entities always seemed to be encroaching on each others turf (investment in financials, private equity holdings etc) in a UAE that was serving as a laboratory for investment abroad, though recently Dubai group was reportedly branching into Islamic finance. Furthermore like others relying on leverage their business model has come under challenge. The sharing of back office support may be the first step to a re-merger. Needless to say, any funds and projects overly reliant on leverage should continue to be very quiet (the QIA might be one exception)

The combination of much more subdued credit growth, reduction in oil production and reduction in non-oil trade and services will keep the UAE’s growth weak in 2009. The country’s non-oil diversification has exposed it to sectors that are faltering globally (shipping, tourism, property, finance). Government support and the fact that many sectors are centralized can cushion the blow somewhat – fiscal policy is expected to be expansionary, the budgets of the UAE federal government (which spends mostly in the smaller five emirates) and Dubai show expenditure growth in 2009. Abu Dhabi will likely do so also though its budget has not been disclosed. Yet there is a broader question where will the funds come from or what price will be charged to get there. Yet given the direct linkages between the UAE’s borrowers and the national and sub-national governments, funds should be forthcoming even if they are pricy and become more so with oil at $35 a barrel.


  • Posted by Harold

    It doesn’t seem that the shariah prohibition against interest doesn’t get involved here — the loan to Abu Dhabi to its banks explicitly has an interest component. Does this issue ever present a complication?

  • Posted by DJC.

    Wall Street Finance Capitalism Hits a Wall

    The financial “wealth creation” game is over. Economies emerged from World War II relatively free of debt, but the 60-year global run-up has run its course. Finance capitalism is in a state of collapse, and marginal palliatives cannot revive it. The U.S. economy cannot “inflate its way out of debt,” because this would collapse the dollar and end its dreams of global empire by forcing foreign countries to go their own way. There is too little manufacturing to make the economy more “competitive,” given its high housing costs, transportation, debt and tax overhead. A quarter to a third of U.S. real estate has fallen into negative equity, so no banks will lend to them. The economy has hit a debt wall and is falling into negative equity, where it may remain for as far as the eye can see until there is a debt write-down.

  • Posted by DJC.

    Is Eastern Europe Primed to Explode?

    Eastern Europe is about to blow. If it does, it could take much of the EU with it. It’s an emergency situation but there are no easy solutions. The IMF doesn’t have the resources for a bailout of this size and the recession is spreading faster than relief efforts can be organized. Finance ministers and central bankers are running in circles trying to put out one fire after another. Its only a matter of time before they are overtaken by events. If one country is allowed to default, the dominoes could begin to tumble through the whole region. This could trigger dramatic changes in the political landscape. The rise of fascism is no longer out of the question.

    Foreign capital is fleeing at an alarming rate; nearly two-thirds gone in matter of months. Deflation is pushing down asset prices, increasing unemployment, and compounding the debt-burden of financial institutions. It’s the same everywhere. The economies are being hollowed out and stripped of capital. Ukraine is teetering on the brink of bankruptcy. Poland, Latvia, Lithuania, Hungary have all slipped into a low-grade depression. The countries that followed Washington’s economic regimen have suffered the most. They bet that debt-fueled growth and exports would lead to prosperity. That dream has been shattered.

  • Posted by Rachel

    Harold. most sovereign borrowers in the gulf have conventional interest based loans. there have been some Islamic loan syndications in recent years as the Islamic market became more extensive and is likely one of the reasons that many regional governments have sponsored Islamic banks. Definitely an important question to follow and track

  • Posted by Twofish

    I think the question is now “how worried should we be able Dubai?” but rather “what should we be worried about?” There are two worries that I can see

    1) First, what are the likelihood and consequences of a default?

    2) Second, Dubai has been cited as an example of what a “post-oil” Arab world could look like. If this turns out to be not-viable then this has a lot of other ramifications.

  • Posted by jonathan

    Neat post. I’m wondering about a couple of things:

    1. Loss of honor. You mentioned loss of autonomy but loss of honor in that society is very important.
    2. Those societies also punish those who move first or who move publicly. They would prefer not to be known to act and would prefer not to be seen as acting out of necessity. They aren’t likely to approach this as a Westerner would, as a financial matter without much cultural overtone.
    3. I’ve long felt Dubai is one of the biggest bubbles (ratholes) in human history. The economy is nearly all construction, real estate and tourism and investment related to real estate. It is over-built on a scale never before seen. Example: London Docklands were over-built but they are part of London and the slack was taken up. Example: Miami has been boom and bust but since a/c was invented the population growth has been steady so the slack gets eaten. Why will the slack get eaten in Dubai? (Perhaps more people moving there from other Arab nations?)
    4. Abu Dhabi (and other Arab investors) must be wondering about the long term. Is it sensible to put in cash when the future looks bleak for quite a while? My experience with the culture says they’ll wait and wait and wait as long as they can as they watch what happens elsewhere. If oil stays low, if demand in Europe and Asia remain down, instead of propping things up I suspect they’ll back off.

  • Posted by Rachel

    twofish – good point. my feeling is that an outright default on debt is unlikely as the government may be forced to assume a portion of it. but it

    this takes us to jonathan’s point. yes they may wait as long as necessary or provide some funds at higher cost so as not to further boost moral hazard or to spend limited resources.

    In the emirates, they have shied away from the measures like equity stabilization funds or ordering government entities to buy stocks like those used by some GCC countries

  • Posted by Rachel

    twofish – we are now seeing the test case of how well economies diversified from oil and how much they built up human and physical capital during the boom. One problem is that Dubai was never really able to diversify away from being an oil wealth recycling hub. Furthermore the non-oil sectors are exposed tremendously to global trade and liquidity.

  • Posted by Ken (in Dubai)

    This is wonderful!!

    I have lived here in Dubai for the past 4 years and seen it cycle through a huge boom and now this bust.

    To me the fundamental business model has always been the field of dreams. If you build it they will come. The primary industries are real estate and consumerism related to real estate wealth. They do not innovate anything here, everything is imported (including all the crazy architecture).

    So I guess my question is, what happens when the story of Dubai is not a positive one. Will migrant workers keep coming in (no chance of immigration) if they hear about job losses and a crashing market?

    If the net population goes negative and all this real estate is left unoccupied or unfinished, what happens then?

    The emirate’s transient nature makes it hard to model. Singapore is the closest I can think of but there indiginous population is a far greater % of the total and also far more productive than Dubai’s.

    What if on top of the Asset bubble there was a population bubble?

  • Posted by rziemba

    Ken – good point. one way of looking at it is to see the development is as a series of bubbles that fed on each other. In a sense the availability of capital and politically directed development contributed to price bubbles and labor bubbles – the rate of growth was so great that it was hard to to keep growing at that pace.

    Already the flow of migrants seems to have been curtailed. some migrants were already being squeezed by inflation and depreciation of the dirham reducing their remittances. this trend is likely to continue despite the reduction in inflationary pressures given the cost-cutting underway. But you’re there on the ground and can probably see things better than me

    the question is whether there can be a needed cooling or whether it will be a deep freeze. In optimistic moments, I hope that the investments made in recent years have increased the capacity. but 2009 (and possibly 2010 will be tough years

  • Posted by ernest

    not sure if this is such a big deal

    $80 bn of outstanding debt – say you took a write-off of 50% (which is a huge assumption) and i’m guessing most of this debt is tied to US$ rates which are ultra-low

    then maybe $40bn of losses.. which most of the Royal Families private funds could pay off quite easily.. the Dubai royal families were quite clever, in that they outsourced most of their debt to the corporate level.. but still retained a considerable amount of net wealth at the personal level

    sure Dubai is a Vegas crossed with Miami..but its still the only tax-haven in the Arab world that isn’t expecting their neighbours to invade

  • Posted by jonathan

    I wonder what the effect on the migrants’ home economies will be? Example: for a period, Mexico’s largest monthly earning, more than oil & gas, was money sent back from the US. The Dubai migrant worker payments home must have driven investment and consumption in their parts.

  • Posted by Ken (in Dubai)

    People here are in complete denial. I am in project finance and the number one question we get is, when is it going to all turn around? People are just sitting on lands and frozen projects waiting for the real estate boom to start again.

    Some time ago Singapore saw an 80% drop in property values. What if that happened here? What if as you say, this spreads into 2010? Sure the government can control supply and bail out the big companies that run short on cash, but that doesn’t fix the problem. I think the biggest issue here is going to be the government policy response. Propping up the failed real estate market is not going to bring Dubai back. They need to let commercial and residential real estate prices fall, tackle inflation (as you rightly pointed out this was a HUGE story here until October), and then offer people and companies a “best-in-region” infrastructure and free society for all types of organizations to grow. Kind of like taking a company private, cutting the fat, and then floating the new, streamlined organization.

    I am afraid that this is going to be politically difficult and the government will default to trying to keep pushing the boulder up the hill.

  • Posted by Simon Stock

    ken has given a way out for dubai- start at the bottom. Reduce rent of simple apartments so that the ordinary middle class families have cash to spend- that more people will feel safe to be here; rent reduction of shops will bring donw prices of essential goods. The higher ups who have been led by greed and which has brought about the present disasterious situation- will they agree for rent reduction.They should realise that by not doing so in the present crisis is like cutting the branch on which they are sitting.

  • Posted by Dubai Property

    Dubai is now a major story on a number of fronts.There is a lot of stuff about Dubai at this moment.

  • Posted by Arcus Properties

    Dubai ruler Sheikh Mohammed Bin Rashid Al Maktoum recently said

    “I assure you we are alright, the U.A.E is alright, and we are not worried”