The Dubai World Crisis & Standard Chartered Bank - Essay Example

The Dubai World Crisis & Standard Chartered Bank Introduction On November 26, 2009, the major investment conglomerate Dubai World shocked the financial world by requesting a “debt standstill” until May 2010 on $26 billion worth of its $59 billion debt, pushing the Emirate of Dubai to the brink of a sovereign financial crisis and exposing the counter-party risk of banks and investors worldwide (Khan, 2009). One of the largest lenders exposed to the growing crisis was the Standard Chartered banking group, which does a significant proportion of its business in the Middle East and was heavily invested in Dubai. In this essay, the chain of events leading up to the crisis and its eventual resolution – though one which, as it turns out, is not quite completed – will be discussed, with particular focus on the implications of the crisis to the global financial system and lenders such as Standard Chartered. Some possible alternative solutions that might have been used will be suggested, and compared with the actual steps taken by the government of Dubai and other key players in the financial drama. Causes of the Crisis The conditions that led to the Dubai World debt crisis were laid in the ‘boom period’ of 2004 to mid-2008 in Dubai, which was driven by rising oil prices and an average annual GDP growth rate of 6%. During that period, Dubai sought a “high-speed” growth strategy and diversified its economy away from a trade-based system to one reliant on Services and Tourism, which caused a rapid and initially very profitable expansion in the Real Estate and Property sector (Khan, 2009). There were a number of conditions that collided to cause the debt crisis. First, because the Emirate of Dubai does not have significant oil and gas reserves of its own (unlike neighbouring Abu Dhabi), the government borrowed heavily to finance economic expansion, and increased its ‘monetary pumping’ into the Dubai economy by forty times between October 2006 and December 2007 (Shostak, 2009). Property values in Dubai increased as long as oil prices kept rising, and the rapid development in the emirate attracted many global investors who had excess liquidity produced by booming financial markets in other parts of the world. Plus, there was also a belief that the credit of Dubai World – which is a government-owned corporation, but not actually a part of the Dubai government – was backed by the government, even though the government and Dubai World explicitly told investors that was not the case (“Could Dubai World's Debt Default Spark a Crisis in the Middle East and Beyond?”, 2009). When the collapse of US real estate prices beginning in late 2007 destroyed the value of the world’s huge derivatives market, three things happened: Oil prices declined, investors began pulling their money back from Dubai to make up for losses elsewhere, and the credit market dried up. All of these things caused property values in Dubai to plummet, and without the cash flow from investors in real estate or the continued availability of credit, Dubai World and its property arm Nakheel suddenly found themselves unable to pay their debts (Khan, 2009). The Dubai Government Reaction The initial response of the government of Dubai was to clarify that it would not guarantee Dubai World’s debt, and in fact, the implication was that lenders had only themselves to blame if they found themselves holding bad loans to Dubai World. In an interview on Dubai Television, Finance Minister Abdulrahman al-Saleh commented that “Creditors need to take part of the responsibility for their decision to lend to the companies” (Thompson [1], 2009). In hindsight this seems like a not-particularly subtle way for the government to let Dubai World’s large creditors like Standard Chartered, RBS, and HSBC know that they should agree to the proposed repayment moratorium and debt restructuring, or face huge write-downs. Another thing to consider is that the government of Dubai was likely in poor condition to actually back Dubai World’s debt even if it had been inclined to do so. It was heavily-invested in the company and the property sector itself, and the loss buyers and tenants for all the new projects meant that tax revenues would have significantly declined as well. In addition, the currency of the UAE is pegged to the US Dollar, which declined in value sharply after the onset of the financial crisis in the US. And of course, with the general economic downturn across the world, other staples of the Dubai economy such as shipping and tourism also declined significantly (Khan, 2009). Implications of the Crisis The most immediate implications of the crisis were the shocks it caused to the world financial system. Six government-related enterprises in Dubai were immediately downgraded by Standard & Poor’s, oil prices dropped, and stock markets in Europe and the US dropped as well – the Dow Jones Industrial Average lost 155 points, or 1.5%, the day after Dubai World’s announcement about its planned debt suspension (Khan, 2009). Any lender with significant exposure to Dubai World, or even other investments in the region, had their credit-worthiness placed under question because of the possibility they might suffer big losses if Dubai World defaulted. The Dubai World crisis also affected the credit of unrelated businesses throughout the Gulf States, because credit risk premiums increased; this hurt the economy in Dubai and in neighbouring states because it reduced the ability of businesses to access credit to keep operations and expansion moving forward to compensate for the downturn in the property, trade, and tourism sectors (Al-Saidi, 2010). For a lender like Standard Chartered, there was potentially a very dangerous chain reaction that could have occurred, and actually did to some extent, although the final outcome was not as bad as everyone first feared it would be (Al-Saidi, 2010). The risk of loss to Standard Chartered if Dubai World defaulted put the banking group’s own profitability at risk, which would cause a drop in its stock price as market investors worried about a loss would sell their shares. This loss of value, plus the need to prepare for a possible loss of the money it had loaned in Dubai would mean Standard Chartered had less money available to lend elsewhere, and that would only aggravate the uncertainty about the bank’s profitability; after all, a lender cannot earn interest from loans if it cannot make loans in the first place. Standard Charter’s own credit-worthiness would be hurt as well, because its lenders would be uncertain if the banking group would be able to earn enough to pay its loans; at best, credit would become more expensive as lenders demand greater insurance against risk, and at worst, credit would not be available at all. Solutions to the Crisis Despite initially stating that Dubai World would not receive a “bail-out” from the government, the eventual solution to the crisis did involve a considerable amount of government intervention, helped in large part by a $10 billion donation to Dubai from neighbouring Abu Dhabi (Thompson [2], 2009). Dubai World received $9.5 billion from the government of Dubai, of which $8 billion went to Dubai World’s Nakheel property business; in exchange, the government converted $8.9 billion of Dubai World’s debt into equity, thereby taking a greater ownership stake in the company (Al-Saidi, 2010). This allowed Dubai World to immediately service bonds, which was important because bonds are widely-held as opposed to loans which are due to individual creditors; the remaining amount of debt was reorganised into two new tranches due in five and eight years, respectively (Borthwick, 2010). This bought Dubai time to raise funds to pay off the debts, and avoided having to ask creditors to submit to “haircuts” reducing the value of the debt (Al-Saidi, 2010). Alternative Solutions The $10 billion capital infusion from Abu Dhabi made the recovery program possible and might have in fact made any other solution impossible. One alternative that might have been attractive to the government of Dubai – regardless if the bail-out from Abu Dhabi had been granted or not – would have been to offer Dubai World’s creditors the debt-for-equity exchange on at least part of the debt, instead of the government’s taking on the equity, and the accompanying risk, themselves. Of course, there is no guarantee any of the creditors would have agreed to this, and the idea does not take into account any political concerns; for example, it may have been politically undesirable to allow that much foreign ownership of an important Dubai enterprise. On the other hand, for a creditor like Standard Chartered with a heavy concentration of its business in the region, a debt-for-equity exchange might not have been an unattractive option, particularly if the alternative was a default on Dubai World’s debt. An ownership stake would give Standard Chartered some influence on the management of the company, so that other financial problems could be corrected. And an equity stake would give Standard Chartered the option of passing the problem to someone else, simply by selling the stock; this would probably result in a loss, but again, it would still be a better option than a bigger loss in the case of a default. Conclusion So far, the major financial disaster that everyone feared would be caused by Dubai World’s debt crisis has been avoided. With help from Abu Dhabi, the government of Dubai was able to convert some of Dubai World’s debt and restructure the rest to at least postpone the problem. But the problem was not eliminated entirely. The rescheduled debt repayments will eventually become due, and as far as is known, there has been little action in Dubai to reduce the size of the debts through getting creditors to agree to “haircuts” or by selling assets (Ijtehadi, 2011). Standard Chartered in particular is monitoring the situation closely; with a number of bond issues from various Dubai entities becoming due in 2012, the banking group’s assessment is that the pattern of the Dubai World bail-out might be repeated, with debt restructuring on loans in order to service bonds, but that the emirate may still need outside assistance to cover the obligations (Ijtehadi, 2011). If that is the case, then the alternative solution of trading a greater stake in Dubai enterprises in exchange for forgiveness of debts might actually become a possibility. References Al-Saidi, N. (2010) “Dubai: Crisis and recovery”. Arabian Business.com, 28 April 2010. Available from: http://www.arabianbusiness.com/dubai-crisis-recovery-159116.html. Borthwick, M. (2010) “Dubai World gets $9.5bn government backing”. BBC News, 25 March 2010. Available from: http://news.bbc.co.uk/2/hi/business/8586473.stm. “Could Dubai World's Debt Default Spark a Crisis in the Middle East and Beyond?” Knowledge @ Wharton, University of Pennsylvania, 9 December 2009. Available from: http://knowledge.wharton.upenn.edu/article.cfm?articleid=2399. Ijtehadi, Y. (2011) “Dubai Debt Pile In 2012”. Business Insider, 15 June 2011. Available from: http://articles.businessinsider.com/2011-06-15/markets/30078601_1_dubai-world-nakheel-dubai-holding. Khan, M.A. (2009) “Economic Crisis in the Gulf - Lessons learnt”. Seminar presentation, Institute of Chartered Accountants of Pakistan, 17 December 2009. Available from: http://www.icap.org.pk/userfiles/file/presentation/MAK_Gulf_%20Economic_Crisis_ICAP.pdf. Shostak, F. (2009) “What’s Behind the Dubai’s Financial Crisis?” Ludwig Von Mises Institute, 30 November 2009. Available from: http://blog.mises.org/11119/whats-behind-the-dubais-financial-crisis/. Thompson, B. (2009) [1] “Dubai World debt ‘not guaranteed’ by government”. BBC News, 30 November 2009. Available from: http://news.bbc.co.uk/2/hi/8385164.stm. Thompson, B. (2009) [2] “Abu Dhabi gives Dubai $10bn to help pay debts”. BBC News, 14 December 2009. Available from: http://news.bbc.co.uk/2/hi/business/8411215.stm. Read More