Could Dubai trigger another global crisis?

Everyone thought Dubai was past its debt problems after Abu Dhabi bailed out the leveraged emirate last February. Everyone was wrong.

Last Wednesday, the government of Dubai asked Dubai World's creditors for a standstill agreement on interest payments on the company's $59 billion in debt. Government-owned Dubai World controls many of the emirate's corporations, including DP World (the world's fourth largest port operator), Emaar (developer of the 160-storey Burj Dubai) and Nakheel (developer of the Palms).

"Dubai, with sparse oil reserves, built its fortunes on real estate and financial services in recent years, borrowing heavily to finance mega projects, including three man-made islands shaped as palm fronds," said John Sfakianakis, chief economist at Banque Saudi Fransi. "Dubai was above all an interesting real estate play that benefited the early entrants, but which turned out to be a bubble that burst."

This latest development is in sharp contrast to what analysts said in February after the central bank of the United Arab Emirates (UAE) stepped in to underwrite the first $10 billion tranche of a $20 billion bond programme to shore up Dubai's debt. Back then, analysts said the worst of Dubai's problems had past and that the support by the central government was "unequivocal".

The UAE central bank is once again stepping in to support the profligate child of the country's 37-year union. Yesterday, it told reporters that it had set-up a liquidity facility to support Dubai's banks, but the question remains how much this will help? Rating agencies Moody's and Standard & Poor's have already downgraded the company's entities by two to four notches, mostly to non-investment grade status and are keeping them under review.

Notably, the agencies suggested that a debt restructuring could be considered the equivalent of a sovereign default, according to a Standard Chartered Bank report.

If this payment standstill is ultimately categorised a default, Bank of America Merrill Lynch analysts wrote that a sovereign default could "resonate across global emerging markets in the same way that Argentina did in the early-2000s or Russia in the late-1990s".

Of course, Dubai isn't Argentina or Russia but its debt situation is very much representative of the times -- a consequence of the emirate's, one could say the world's, speculative credit-fuelled growth that consumed most of the past decade. And one major sovereign default could be reason enough for investors, who still clearly remember the losses associated with subprime and the collapse of Lehman Brothers, to flee back into cash-based assets to protect the remainder of their savings.

"The on-going Dubai restructuring story, combined with recent restructurings in Kazakhstan and Ukraine, is likely to raise questions over the quality of sovereign support for quasi-sovereign names," Royal Bank of Scotland analysts wrote in a report.

According to the Bank of International Settlements, the UAE has $123 billion in foreign loans with $88.6 billion coming from European institutions and $10.6 billion from their US counterparts.

Hong Kong's Hang Seng Index, led by financial institutions, fell 1,075.91 points, or 4.84%, on Friday. Shares in HSBC, which is reported to have over $3 billion in real estate exposure to the UAE, fell nearly 8%, and shares in Standard Chartered Bank fell almost 9%, after reports said it had over $1 billion in exposure to the UAE mortgage market.

In the US, things were less severe with the Dow Jones index falling just 154 points, or 1.5%, on Friday. The question everyone is asking though is what will happen when Middle Eastern markets open after the Eid holiday this morning. Markets have been closed since last Wednesday.

The bright spot in Dubai's troubles, according to Sfakianakis, is that it makes other members of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, UAE and Saudi Arabia) more appealing to investors.

"In the future, global investors will need to differentiate between those Gulf economies that are debt-burdened and those whose leverage levels are incredibly low by global standards," he said, citing Saudi Arabia and Qatar as low-leverage countries.