Dubai World's debt crisis and economic strategy for the emirate

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.

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 does not have a direct obligation to support Dubai World's debt. The third alternative therefore is to walk away from Dubai World's debt problems. There are some advantages to this. The first is that Dubai World is not subject to normal bankruptcy proceedings, which may help to further insulate both Dubai World and Dubai from creditors. However, the Dubai World and the other SOHCs gained easy access to capital as a result not of their own financial strength, but the purported financial strength of the Dubai government itself. Without that backing, two things would happen. The first is that the cost of credit for the SOHCs would skyrocket, to reflect the Dubai World debt crisis. The second is that since the world is already in a credit crunch, Dubai would no longer be considered a safe haven and ultimately none of the SOHCs, and possibly not even the government of Dubai itself, would have access to credit at anything close to a reasonable price. Dubai's growth would be stunted forever, which in theory could exacerbate the debt crisis, bringing down the entire emirate with it.

Dubai needs to weigh both the short- and long-term implications of its actions. Essentially it is left with a decision to double down or fold. If it guarantees the $4 billion, this creates an implicit guarantee on other SOHC debt. It may allow Dubai to control its cost of borrowing, but ultimately it does not address the weaknesses in Dubai's economy that have lead to this situation in the first place. Of critical importance is the impact of guaranteeing the loan on the rest of Dubai World's debt.

While restructuring seems like the worst of both worlds in that it costs money and may have little impact on credit markets' views of Dubai, walking away would create a catastrophe for all of Dubai's SOHCs. This would have long-lasting impacts not only financially but strategically for Dubai. The country would take years if not decades to restore investor faith, and in the meantime would fail to develop the post-oil economy Dubai so desperately needs. Strategically, a failure to back this $4 billion would squash Dubai's entire economic development strategy. While the emirate would be within its legal rights to avoiding covering this debt, it would put itself in a very negative position with respect to its ability to grow going forward. That said, Dubai needs to evaluate whether moving forward with Dubai World is truly the right course of action -- it has invested a lot in a strategy that may be in trouble specifically because it is a bad idea to place such heavy bets on real estate projects for which there is little genuine demand.

Dubai can also take the risk that it will get help from Abu Dhabi. While the economic fundamentals of the two are quite different -- the latter having oil wealth -- they are part of the same country and they share the same currency. In addition, historic reasons give Abu Dhabi incentive to leverage this situation to gain political power and/or assets from Dubai. Abu Dhabi may also act on the basis that its sovereign debt could become more expensive if Dubai's debt fails. Abu Dhabi currently has the strongest credit rating in the region, and most Gulf States have low degrees of leverage. Thus, the risk of a cascading debt crisis in the Middle East in minimal, but damage to Dubai may impact on Abu Dhabi's cost of borrowing and its international reputation. If Dubai believes that Abu Dhabi will be an angel and cover the $4 billion, it could simply choose to wait for this to happen. Already, most Dubai-related SOHCs have seen their debt downgraded, which has increased their cost of capital. Of interest is that Aldar Properties has not had its debt downgraded, which may indicate that investors will spare Abu Dhabi as well, on the basis of its significantly different fundamentals. This would decrease the likelihood of an Abu Dhabi bailout of Dubai World.

Dubai also must consider its future debt payment situation. While the government of Dubai does not have substantial debt, its SOHCs do. If markets see a guarantee as implicitly guaranteeing all SOHC debt, this might allow Dubai to continue borrowing, but it will also put the government on the spot to cover other SOHC debt. Given the internal and external economic environments and the high level of debt that is due in the coming years ($57.955 billion by the end of 2014) it is important that Dubai send the right signals to the market. Its cost of debt could skyrocket if the markets believe that the emirate itself is on the hook for this debt and has no way to pay.

It is also worth noting that $75.9 billion in projects had been cancelled or put on hold by the end of February 2009 in the UAE. This indicates two things. The first is that the existing capacity in UAE real estate is sufficient. Not only Nakheel but other prominent Emerati developers have cancelled projects because they are no longer financially viable. Many other projects have seen steep decreases in value, as it has become apparent that demand for those projects was heavy reliant on speculators. The second reason for these projects being cancelled is a lack of investment capital. While some projects are still able to find investors, in the current economic climate this is becoming more difficult. Nakheel still has some fairly ambitious projects, and ultimately these projects are going to be subject to a difficult financing environment as well as a difficult sales environment.

Recommendation

It is recommended that Dubai pay the $4 billion. This option has two main benefits. The first is that it restores investor confidence in Dubai and specifically in the SOHCs. Dubai is going to need ongoing access to capital markets. If the time comes that debt must be restructured, it will need a good credit rating in order to make that happen. The first $4 billion crisis is not the point at which drastic action will need to be undertaken -- that point is coming in the next few years. The second benefit of this action is that it allows for Dubai to at least have the hope of future growth. If Nakheel defaults here, it will not only confirm the worst fears of the investment community that Dubai plans to hide behind its weak bankruptcy laws to avoid its debts, but it will also send a signal that Dubai's leaders have no faith in the emirate's economic future.

Restructuring the debt makes little sense. A compromise position, it suffers from the curse of compromise positions in that the benefits are minimal and the costs are high. If the economic outlook was better, a compromise might assuage the markets. However, the economic outlook for Dubai for the next few years is terrible. The emirate has overcapacity in real estate, its oil revenues are set to run out, major debt repayments are looming, demand has fallen off a cliff and it can't even become more competitive through devaluation because the dirham is tied tightly to the U.S. dollar, leaving Dubai with rapid inflation and no control over the currency given that Abu Dhabi holds the bulk of the economic and political power in the region. Given this set of circumstances, investors are likely to retain a dim view of Dubai's capacity for debt even if it does restructure. The restructuring will buy time, but for what?

Allowing the debt to lapse also makes little sense. For the price of $4 billion -- which Dubai holds in its sovereign investment fund and which Dubai World has in assets several times over -- Dubai would lose all credibility on global financial markets. The country is dependent on these markets for its transition to a post-oil economy. Given that Dubai's growth has thus far been sparked by growth in retail (largely the result of a burgeoning expat population) and real estate (fueled by speculators), it is reasonable to suggest that the transition to a post-oil economy is not yet complete. Losing credibility now would make any credit available to Dubai in the future cost prohibitive -- if it can acquire credit at all. As such, allowing this debt to lapse would be catastrophic to Dubai's economic future.

Thus, the only reasonable option is to cover the $4 billion. The debts looming in the future can be dealt with at a later time -- a plan would be good -- but the immediate concern should be to stabilize the cost of Dubai and SOHC debt, and to reassure Dubai's financial backers that the country is still worth investing in. It does not make sense for Dubai to sacrifice its entire long-term economic growth strategy for $4 billion, unless the emirate's rulers have already given up on that strategy entirely. The stakes are too high for Dubai to allow this debt to go uncovered, even if the structure of that debt and the bankruptcy laws allow it. The cost is going to be $4 billion, payable now, and hopefully that keeps the cost of debt at its present level.