Dubai World, a venture funded by the emirate of Dubai, announced that it would place a six-month "standstill" on $4 billion out of $26 billion of its outstanding debt. The move had dramatic repercussions for global financial markets, and the rulers of Dubai needed to evaluate the best strategy with respect to how to proceed following the announcement. The decision had major ramifications for Dubai as a nation-state. Dubai's economic growth has been strong for several years, but unlike the wealth of neighboring Abu Dhabi, the growth in Dubai is not based on oil wealth. Dubai's wealth essentially comes from its ability to convince investors to put money into the country -- there is no genuine wealth in Dubai, it is all borrowed. This makes the issue of the Dubai World debt critical for the future of the emirate. The country's position as one of the Middle East's most open trade centers was critical to its wealth, and Dubai World was ultimately backed by the Dubai government. If it walked away, the country's credit rating would suffer and investors would be reluctant to put their money into the country. Dubai's economy could collapse. However, if they guaranteed those debts, the result might be financial hardship for Dubai. Even then, there was also the question of the strategic merit of the Dubai World project in the first place -- was it worth saving?

Background

The Dubai economy has gradually become less dependent on oil. With limited reserves, oil was only 5% of Dubai's GDP by 2009 and reserves were only expected to last a few more years. For a decade or more, Dubai had been working to diversify its economy away from oil in an attempt to sustain its economic base beyond the oil years. This strategy included a focus on trade and banking, but also on tourism and splashy showcase projects that were meant to help promote the image of a world city. Trade accounted for 38.4% of GDP, while construction and real estate accounted for 17.8% of GDP as of 2008.

Dubai's development has been led by state-owned corporations. Dubai development corporations such as Jumeirah and state-owned banks played a critical role in developing the country. Dubai World was one such state-owned holding corporation, and it was established in 2006 with over 50,000 employees in 75 cities around the world. While Dubai World was largely believed to be backed by the credit of Dubai, Dubai itself did not have a rating on its sovereign debt. Thus, discerning the risks associated with Dubai World debt was a difficult challenge, but the assumption in credit markets was that it would have the backing of the Dubai government. Dubai World used its assets to make investments around the world, in retail, ports and other industries.

The economic environment for the conglomerate, however, proved challenging. For the most part, SOHCs such as Dubai World are financed through local consumption taxes, oil revenues, and duties, as well as debt financing. With diminishing oil revenues, these companies became increasingly leveraged. Increasing leverage, however, implies increasing risk. These entities, including Dubai World, sought their own credit ratings, but investors understood them to be backed by Dubai. This debt was then used to finance construction, the demand for which had become largely driven be speculators.

The 2007 and 2008 real estate crash and subsequent global recession created two problems for Dubai World. The first was that demand for its project, which was never based on actual demand for a giant amusement park in the desert, dried up. There were few people willing to invest in the project once the speculators left. The second problem is that credit markets also began to dry up. The SOHCs were unable to borrow and build their way out of their debt problems. In addition, the decline in the global economy, combined with reduced oil production, reduced most of Dubai's key revenue streams. This eventually led to the current problem with Dubai World. Dubai's sovereign debt levels remained relatively low at this point, but debt levels including the SOHCs were at crisis levels.

Internal and External Environment

At the time of the debt crisis, Dubai's economic strategy has been implemented intensely. Nakheel, the property arm of Dubai World and the issuer of the $4 billion in debt, has numerous developments around Dubai. These include an ambitious series of artificial archipelagos such as the Palm Islands, The World and The Universe, along with shopping developments...

Real estate, construction and retail are the three fastest growing sectors of the Dubai economy, accounting for 62.7% of the emirate's economy in 2009, up from 57.9% in 2007. Most other sectors are in decline. Each of these sectors has also enjoyed real dollar growth in the past three years, despite the economic downturn. However, real estate in particular is noted for being overcapacity, with real demand much lower than the apparent demand from speculators, and prices on existing housing stock are declining.
If Dubai wants to cover this loan, it must do so on the basis of its projected tax receipts. At present, oil and gas revenues are only 2% of Dubai's revenue stream, although this is expected to increase slightly, largely due to oil and gas price increases that are projected, combined with an estimated decrease in the GDP. Tax revenue as a percentage of GDP is expected to be relatively stable, but in total is expected to go into decline over the coming years. The government is already projecting some cost increases, including those for interest expense, a function of higher rates on sovereign debt. Overall, it is estimated that the GDP of Dubai is to decrease from its 2008 high and more or less stabilize at that decreased level. While this level remains nearly double what the GDP was in 2005, the country's cost structure has also doubled, and only minor decreases are planned.

Dubai is also susceptible to fluctuations in the external economy. This is largely because most of the emirate's money comes from external lenders, including hedge funds and foreign investment banks. With more challenging credit markets and higher cost of debt as a result of this crisis, borrowing costs are expected to rise for Dubai in the coming years. In addition, investors are likely to be more wary about taking on Dubai-related debt, meaning that no matter what course of action Dubai takes, it may have a more difficult time acquiring debt in the future, at least until fundamentals such as genuine demand begin to improve.

Analysis of Alternatives

The first alternative is to guarantee the debt. This would have a number of benefits. For one, it would help to salvage the bond rating of Dubai, Abu Dhabi and the SOHCs. At present, there is significant risk associated with allowing Nakheel/Dubai World to default on the $4 billion, as it would send a signal that debt from Dubai or even the UAE was not backed. This could not only create significant problem with respect to future growth for Dubai, but it may also cause trouble with its relationship to Abu Dhabi, which may feel that it has to step in and guarantee the debt in order to avoid creating a debt crisis for itself. The cost of guaranteeing this debt, however, is significant. For its part, the government of Dubai may have trouble financing the $4 billion payment, and may need to tap into its sovereign wealth funds in order to do so. Dubai World could also finance the payment, but it would need to liquidate assets in order to do so. This runs counter to the firm and nation's strategy, and it also would likely lock in a loss on some of these assets, as the value of much of Dubai World's fund had dropped as a result of the economic crisis. However, the markets are aware that Dubai World has the assets to cover the $4 billion payment, and would take a dim view of any approach that did not involve upholding the debt.

The second alternative is to restructure the debt. Without a sovereign guarantee, Dubai World is within its rights to restructure the debt. It could also add a sovereign guarantee as a sweetener to convince creditors to accept a restructuring plan. Restructuring would help to assuage financial markets in the short-term, but if those markets believed that Dubai World's financial condition was not going to improve, the cost of borrowing could remain high and investor confidence in either Dubai World or Dubai may remain low.

There are also costs involved in restructuring. Much of the burden of restructuring is expected to fall onto Dubai's banks, which hold 13% of the debt in question. It would open Dubai World to legal action, could still result in a significant downgrade, and a restructuring of the $4 billion would not address the long-term problems associated with Dubai World -- overcapacity, lack of buyers, a bad idea and $56 billion in debt set to come due in 2015.

Financially, the decoupling of Dubai's sovereign debt from SOHC debt means that Dubai…