Dubai’s Debt Not A Threat To Global Financial System

Dubai’s recent debt crisis exemplifies the dangers of excess and over-leveraging, however, it is not representative nor a portent of doom for the rest of the world’s recovering …

Dubai’s recent debt crisis exemplifies the dangers of excess and over-leveraging, however, it is not representative nor a portent of doom for the rest of the world’s recovering economic markets. While Dubai’s woes aren’t likely to precipitate a domino of defaulting government debt, they point out the market’s lingering fragility, and serve as a clarion call for fiscal responsibility. See the following article from Money Morning for more on this.

While American investors were busy enjoying their Thanksgiving dinners, global markets were shaken by word that Dubai asked for a payment holiday on the $59 billion it owes via its investment vehicle, Dubai World. The move, which comes as oversized bets on Persian Gulf real estate sour, was considered a default by the major rating agencies.

Last week’s “standstill” request puts at risk up to $80 billion in debt linked to the emirate. While this is small in the context of the $3 trillion in losses written down by global banks since the credit crisis began, it may very well result in the largest country debt default since Argentina in 2002.

So while Dubai is insignificant on its own, and will likely be bailed out by its larger and much wealthier neighbor and fellow United Arab Emirates member, Abu Dhabi, it ignited much larger concerns over the fiscal health of governments around the world. I discussed these concerns early last week in an in-depth discussion over rising insurance costs on government bonds.

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This highlights concerns over the ability of governments to service their rapidly rising debt loads. Those on the hot seat include Greece, Japan, and much of emerging Europe. I wrote about these concerns last week when we discussed the recent rise in the cost to insure against default on public debt.

So, is this the beginning of a new crisis? The team at Capital Economics in London doesn’t believe it is: “Dubai’s current problems are a long overdue consequence of the bursting of the global property bubble rather than the start of a new financial crisis. Nonetheless, they are a timely reminder that the legacy of past excesses in heavily-indebted economies will linger for many years to come.”

In other words, imagine that the global financial system is like a patient recovering from a near fatal case of pneumonia. After being pumped with fluids and antibiotics via stimulus spending and ultra-low interest rates, the patient is on his feet again. But that doesn’t mean he isn’t vulnerable to a persistent cough and a low-grade fever.

Plus, Dubai was the country-sized equivalent of a full-tilt Miami condo flipper. The United Arab Emirates pegs its currency to the U.S. dollar, which means that it imported interest rates that were too low for its fast growing economy — resulting in a credit bubble and asset boom. Property prices have since fallen by 50% over the last 12 months. What’s worse is that efforts to diversify its economy away from fossil fuels via free-trade zones made the country extremely vulnerable to a slowdown in global trade and a decline in financial markets.

It was an extreme case of the kind of overleveraged excesses that resulted in the 2007-2008 financial crisis in the first place. The country’s investment arm spent billions on artificial islands reclaimed from the Persian Gulf in the shape of palms. It took a stake in a new $8.5 billion MGM Mirage (NYSE: MGM) hotel in Las Vegas. It invested in Canadian performance troop Cirque du Soleil. It bought stakes in Aspen ski resorts. It bought the Queen Elizabeth II ocean liner.

In other words, imagine that the global financial system is like a patient recovering from a near fatal case of pneumonia. After being pumped with fluids and antibiotics via stimulus spending and ultra-low interest rates, the patient is on his feet again. But that doesn’t mean he isn’t vulnerable to a persistent cough and a low-grade fever.

While the impressive rally over the past few months have brought a period of relative calm, it has merely masked the vulnerabilities that still remain. Investors were lulled into a sense of false security and Dubai’s rulers rudely awakened them. But apart from the jarring psychological effect, the risk that Dubai’s debt restructuring will result in a global “contagion” that pulls down financial markets and undermines the nascent economic recovery remains low.

This article has been republished from Money Morning. You can view the full article at
Money Morning, an investment news and analysis site.

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