Dubai’s Debt: Why It Matters

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Dubai’s Debt: Why It Matters

Are financial tremors in Dubai a sign of a massive earthquake to follow?

Dubai World’s debt crisis is already old news. The state-owned company has announced that it is seeking to renegotiate “only” the $26 billion of debt obligations held by its real-estate developer, Nakheel, rather than the entire $80 billion that it owes. Investors have breathed a sigh of relief and moved on.

Yet Dubai World’s collapse still holds important warnings. For the first time since Iceland collapsed at the end of 2008, a sovereign state went to the brink of bankruptcy.

Many in the West assumed that the emirate of Dubai would guarantee Dubai World’s financial obligations. That proved a dangerous assumption. Other governments may soon be more than unwilling to prop up even state-owned firms. They may also be unable.

Because of Dubai World, the emirate had a lot of bad debt on its hands. Rather than take the hit, it decided not to honor the implicit understanding that it would back up the company. Dubai can get away with that—but Western governments have actual contracts that bind them to the bad debts they have taken on through privatizing banks.

“[T]he important question for markets today is not whether Dubai and Sheikh Mohammed can survive the sandstorm; in fact, that is almost irrelevant,” wrote Jeremy Warner, assistant editor of the Daily Telegraph. The issue is whether this incident “is just an isolated, and therefore containable, incident, or a more worrying outrider for a wider sovereign debt crisis which might eventually engulf major, advanced economies. Everyone thought the financial implosion of the last two years was largely behind us—yet Dubai has reminded us that if nations start defaulting, then it may be about to enter a new and even more frightening phase.

“Think of Dubai not so much as the hors d’oeuvre as the pre-dinner canapé, with the starter reserved for larger economies with distressed fiscal positions, such as Greece and Ireland, moving for the main course on to Japan and possibly even Britain and the U.S.” (November 27).

Moody’s credit rating agency estimates that from the start of the financial crisis in 2007 until the end of 2010, worldwide sovereign debt will have risen by over 50 percent. Current projections show this rising by another 50 percent over the next four to five years. The financial crisis has transferred huge levels of debt from the banks to governments—many of them already heavily indebted.

“These are uncharted waters, quite without precedent in peacetime,” wrote Warner. “In seeking to address the financial and economic crisis of the past few years, countries have come close to bankrupting themselves. It is as if, in treating the patient, a physician has infected himself with the same deadly disease.”

Warner pointed out that the banking crisis also began with smaller, more obviously flawed banks, before spreading to larger, better known ones. Could this now be happening with countries?

“If Dubai is the sovereign debt equivalent of Northern Rock, then Greece might be its Bear Stearns and Japan its Lehman Brothers,” wrote Warner. “But why stop there? For Citigroup, think the U.S., and for rbs and hbos, think Britain. Only there would be no one to bail out their creditors if America or Britain showed signs of defaulting.”

Many believe this is unlikely. But then, once no one believed that major banks would need government bailouts either.

Investment bank Morgan Stanley warned this week that Britain could be the first major economy to suffer a sovereign debt crisis in 2010. Greece is already in a precarious position. Could the economic dominoes begin toppling very soon? The economic tremors in Dubai could indicate a massive earthquake to follow.