UAE shows unity

For a few days in February the world lost faith in Dubai. Its credit score rivalled that of Iceland's and speculation focused on what the emirate would look like post-default.

On February 17, the credit default swaps (CDS) for Dubai's five-year sovereign debt surpassed the 1,000 basis point threshold. Before the economic crisis, Dubai's CDS spread was in the 100bp to 200bp range.

"When that happened, bankers and people in the financial system panicked," said a local banker. "They realised if a credit score of more than 1,000bp is going to be the prevalent view of the world on the credit worthiness of Dubai, how would you ever be able to finance anything? At those levels no one is ever going to lend you money. You cannot sustain an economy on such a lack of confidence".

The following week, the United Arab Emirates' (UAE) central bank stepped in with a solution. Dubai would launch a $20 billion bond programme to finance its 2009 debt payments with the first $10 billion tranche fully underwritten by the UAE. Markets rose and Dubai's CDS spread narrowed to a more manageable 720bp.

"Levels of anxiety were such that news of the bond issue eased many concerns, [but] the market is still looking for more clarity," said Simon Williams, HSBC's chief Gulf economist. "The market wants to see the funds actually dispersed. It will take some time for the nerves to settle."

By April, Dubai's CDS spread was hovering in the mid-500bp range.

What came out of Dubai's moment of need was the unequivocal show of support from its sibling Abu Dhabi. While it was the UAE central bank that underwrote the bond issuance, Abu Dhabi provides more than half of the central bank's funding. That makes it the true guarantor of Dubai's financial future.

According to the government, Dubai's total debt stood at approximately $80 billion in February. Of that, $8 billion to $12 billion is due to be refinanced this year. Without the necessary cash on hand, investors were unsurprisingly skittish about the future until the emirate's bond issuance and Abu Dhabi's show of support.

Unconditional support

"Of importance was the broader issue: does Dubai stand alone or is Dubai part of the UAE federation with the ability to draw on federal wealth?" said Williams. "The answer we got was an unequivocal statement that Dubai does not stand alone."

Abu Dhabi's economic situation stands in stark contrast to that of Dubai. Home to nearly 90% of the UAE's oil, Abu Dhabi has more than $280 billion in offshore assets and lacks its neighbour's high level of debt. Even with the drop in oil prices since last summer, Abu Dhabi has implemented an expansionary budget for 2009.

In its recent Aa2 rating notice for Abu Dhabi's own upcoming bond issue, Moody's cited Abu Dhabi's "exceptionally strong balance sheet ... extensive hydrocarbon resources, a very high level of GDP per capita, and its stable domestic politics" as reasons for its fiscal strength.

Without Abu Dhabi's support, Dubai would likely have been forced to default on its debt obligations. Such a possibility prompted dire speculation, including the possible dissolution of the UAE's 37-year union. Of course, what might have happened is no longer a concern; the UAE central bank, with the financial support of Abu Dhabi, underwrote Dubai's bond issuance and demonstrated in no uncertain terms that Dubai is a full-fledged member of the union.

Dubai's built-in weaknesses

Dubai's boom was built, literally and figuratively, on sand. What characterised the emirate's well-documented rise was not technological innovation or manufacturing prowess but unchecked real estate speculation and the funnelling of funds into nascent capital markets.

"This region only has two asset classes: property and equity markets," said one Dubai-based banker. "These two asset classes are in a progressive corrective mode."

But other bankers disagree. "The criticisms are bull," said HSBC's Williams. "There is real substance to Dubai's economy that many people have missed as they have become fixated on real estate development. Dubai is a world-class supplier of services to an enormous, wealthy region that previously hasn't been able to access those services."

While that is certainly true, the Dubai Financial Market is made up of 40% banks and financial institutions and 17% real estate and construction companies. Not only do they dominate the number of company listings, but financial institutions and property companies comprise four of the five top stocks in terms of market value.

In 2008, 75% of the UAE's $1.3 billion worth of announced projects were in real estate, according to a report by Standard Chartered analyst Marios Maratheftis.

Such a strong concentration of economic activity is rarely good for a city. Locales dominated by one or two economic drivers historically perform poorly; one only has to look as far as Britain's moribund industrial north or America's rust-belt to find proof. Academics, including acclaimed urbanist Jane Jacobs, have repeatedly espoused the need for economic and social diversity in a city to drive innovation and growth.

Dubai's 2009 budget increases spending by 42% -- essentially a fiscal stimulus to boost the economy. The majority of the extra spending is likely to go to infrastructure projects; the emirate is in the process of building a metro system, a new airport, a new port and is making numerous road improvements. Based on its initial projections for the Dh135 billion ($36.75 billion) budget, Dubai expects a Dh4.2 billion deficit -- equal to 1.3% of GDP.

Despite the drastic impact of the economic crisis on Dubai, including the freezing of credit markets and the precipitous drop in property values, its outlook remains positive. Major projects such as the Burj Dubai tower and Dubai metro will be completed this year and, according to the IMF, the UAE economy is expected to grow at 3.3% in 2009.

The crisis will initially hurt Dubai, that's for sure. But it also may help it revitalise its economy to rely on more than just banking and property.