Role of Banks in the Real Estate Bubble in Dubai - Coursework Example

Role of banks in the real estate bubble in Dubai Name: Institution: Date: Table of Contents Table of Contents 2 1.1 Background about the Topic 2 1.2 Statement of the problem 4 1.3 Study Questions 5 1.4 Significance of the study 6 1.5 Definition of terms 6 1.6 Limitations of the study 6 2.0 Literature Review 6 2.1 Understanding the Role of Banks in the Real Estate Bubble in Dubai 6 2.2 The Effects of the Real Estate Bubble on the Economy 8 2.3 The policies and strategies adopted by the banking sector leading to the bubble 8 2.4 Extent that real estate bubble was affected by global forces 11 3.0 Proposals and recommendations regarding the strategies and policies that can be adopted by the banking sector to correct the situation 12 4.0 References 14 1.0 Introduction 1.1 Background about the Topic Property bubble or bubbles in real estate is a kind of economic bubble which takes place occasionally within local or international markets of real estate (Renaud, 2012). It is determined by rapid raises in real property valuations like housing to the point where they reach levels that are unsustainable and then decline. When one is a buyer or seller of real estate, it is important to consider the value of market of this business since value changes in dissimilar durations of time. The decline within the developing business comes due to a lot of causes. Correspondingly the real estate’ market is experiencing decline due to a number of reasons which include; the most significant decline point that need to be noted is the elevated real estate’ rates (Al Bawaba, 2008). During the past decades, a lot of people spend their capital in real estate and got profit although currently this investment is somehow not advantageous as the real estate value is quite high that the buyers are not found within the market resulting to the real estate decline (Zembowicz, 2009). Not merely in this market but also in every business when the cost of things is too high buyers are not available and the decline is the business’ future. Therefore real estate which at some point was considered the safest venture is no longer regarded as good. This reduction in buyer leads to the decrease of real estate’s rate. This paper will provide an overview in relation to real estate bubble in Dubai. It will also provide literature review on real estate bubble in Dubai. Lastly the paper will outline some recommendations that banking sector can implement to correct the situation. As stated by Mantell (2010), the government of Dubai declared requiring its creditors to corporate and freeze debt repayment and said that in case the proposal was to be refused, it would sell the real estate assets. He also stated that despite that fact that Abu Dhabi is the wealthiest emirate in the UAE, it extended a loan worth 10 billion dollars with the aim of covering some debts and assisting Dubai to resolve some of its problems (Mantell, 2010). Watts urges that Dubai had conducted an agreement with the majority of its bank lenders to restructure a debt of 23.5 billion dollars with a remaining of 14.4 billion dollars (Watts, 2009). According to Cochrane and Harif (2009), the terms of restructuring the debt embraced the transferring of 8.9 billion dollars of the government debt to equity. The government of Abu Dhabi has assured supporting Dubai Economy in many ways, for instance, the Central Bank of the UAE has given 10 billion dollars for Dubai to reduce the increasing debt default (Jeff, 2010). The economic crisis of Dubai was basically caused by the instability of the market; for example, the appearance of new lines of credit which decreased the money flow and as a result slowing the economic growth in addition to the buying and selling of assets (Jeff, 2010). This had negative impacts on individuals, businesses and financial institutions, as all of them suffered from mortgage, for the reason that the prices of backed assets had dropped and could not able to recover the expected money for loans payment. This resulted in drying up reserve cash in addition to restrict credit. Watts believes that one of the major causes for Dubai crisis was due to the cheap credit that enabled people easily to purchase houses and turning their investments to be based on speculation; which produced more money and as a result increased the spending of customers. The increasing demand for houses resulted in inflation. As well, other causes included speculation on oil prices and higher unemployment rates (Watts, 2009). 1.2 Statement of the problem Dubai faced the challenge of house market overvaluation before few years as the housing prices increased due to easy credit and because people believed that housing prices are in permanent raise (Jeff, 2010). Also, one of the major causes was the financial crisis as the low initial rates put on changeable rate mortgages in addition to the occurred low down payment demands. These motivated short-term speculation where seller looked for encouraging terms in future. As well, the interest rates increased and as a result a poor refinancing environment created. Most of the financial institutions experienced losses because of the decrease in house prices; all together with the housing bubble grew (Hall, 2009).  Credit motivates economy growth and increases employment opportunities; however, it turns to be disastrous once it is poorly used like what happened in the financial crisis of 2008-2010. This resulted in considerable changes in lending regulations. According to Mantell, the 10 billion-rescue package from the UAE Central Bank was not adequate; thus, Dubai had to keep on fighting its debts resulted from the huge construction projects (Mantell, 2010). The major issue in this respect was the shortage in transparency seeing that the government was not clear and didn’t state the direct causes of the debts. In 2009, the market of the real estate investment experienced a dramatic drop after the annual returns in 2007 (Jeff, 2010). The economy of Dubai recovered dramatically in 2011 and this was a part of the UAE recovery. Also, the economy of Dubai has supported by growth in deposits, improved bank liquidity and growth within the domestic demand. As well, Dubai has recovered its market access as the improvement of transparency and governance has smoothed the progress of economic growth. The construction booming in Dubai is the major contributor in diversifying the economy and enlarging the activities of commerce and business. 1.3 Study Questions This research paper will mainly answer the following questions: 1. What is the role of banks in the real estate bubble in Dubai? 2. What are the policies and strategies adopted by the banking sector leading to the bubble? 3. What are the effects of the real estate bubble on the economy? 4. To what extent the real estate bubble was affected by global forces? 5. What are the proposals and recommendations regarding the policies and strategies that can be adopted by the banking sector to correct the situation? 1.4 Significance of the study This study helps in understanding causes of bubbles in real estate and what can be done to correct the situation. 1.5 Definition of terms Real Estate Bubble: Overvaluation in the house market 1.6 Limitations of the study Only few challenges have been faced throughout writing this research paper including: 1. Time Limitations 2. Reliable Resources Limitation 2.0 Literature Review 2.1 Understanding the Role of Banks in the Real Estate Bubble in Dubai According to Shiller (2005), rates of interest are basically the main cause of the real estate’s bubble bursting as in the preceding rates of interest were low therefore people were in a position to purchase new real estate. People were not afraid of inflation or expensive houses but nowadays the rates of interest are so high and to a greater extent they are still increasing. This will thereby reduce buyers within the market and turn out to be the main reason behind bubble bursting. Investment in real estate is a major contributing factor to household welfare, economic development and urban development. One the key sector that has great effect on economical growth is construction. It intensifies and makes the system of finance more resourceful by helping to expand access, mobilize savings and decrease informal finance sources (Zembowicz, 2009). However, it is very challenging to finance investments of real estate. Housing is basically made affordable by a strong system of lending that can ease lasting transactions, expand large costs of investments, and use interest rates that are fixed for the purposes of stability (Shiller, 2005). On the contrary, these elements are not available in several upcoming economies and are not east to build. Without systems like these, however, lending is still restricted and short term. Lending real estate, including business and development investments, are likely to weaken the financial system, specifically if connected to cyclical and occasionally rough market risks, as the present international financial crisis demonstrate. Regardless of the petite size of the sector of real estate and housing finance in MENA, bubbles in real estate risk banking system’s parts. These risks need to be dealt with when promoting finance mechanisms of real estate to make sure that their growth is sound as well as sustainable. As with every kind of bubbles in economy, whether bubbles in real estate can be recognized or prevented is debatable. Bubbles are basically not debatable in observation, following a climax and crash. In the conventional economics, a couple of people argue that bubbles in real estate are not able to be identified as they take place and should not or cannot be prevented, with central bank and government policy relatively cleaning up following the bursts of bubble (Al Bawaba, 2008). Some argue that indicators of housing market are likely to be used to spot bubbles of real estate. A number argue further that central banks and governments can and should implement actions to avert formation of bubbles, or to deflate bubbles that already exist. 2.2 The Effects of the Real Estate Bubble on the Economy Occurrence of an economic bubble brings about economic harm to many people. In the real estate bubble’s case, this includes owners of home, specifically owners of new homes who purchase homes in the course of peak period of the real estate bubble. Nevertheless, the harm also expands to labor due to unemployment, and brings about a value loss to capital owners, predominantly in industries that are related to housing (Hamada et al, 2011). At the level of an individual, a lot of people are enforced into bankruptcy. On the level of macroeconomic, the housing bubble bursting can force the general economy into depression or recession (Hamada et al, 2011). Housing bubbles focus their impact within the home building furnishings and materials, mortgage businesses, and sales in real estate. Additionally, individuals suffer psychological effects (Meyer, 2003). 2.3 The policies and strategies adopted by the banking sector leading to the bubble Dubai’s real estate bubble burst happened in 2008. According to Renaud (2010), the bursting of Dubai’s real estate bubble had been influenced in a substantial way by the international financial crisis. The key factor behind this bubble is the lack of effective planning from the real estate industry as well as the banking sector. The key reason behind this is that several banks within Dubai provided loans to young expatriate experts who for a long duration had not been in the country. Cummins (2012), states that these experts were just fascinated by the living standard as well as luxuries within Dubai. They also did not have the financial solidity to make a venture into the sector of housing. On the other hand, Dubai banks gave away loans on housing and other various kinds of loans with no imposition of strict credit necessities on borrowers (Renaud, 2010). Generally, this was amongst the reasons behind the Dubai’s bursting of the bubble in real estate. Real estate and credit interactions are able to create a contradictory condition with low penetration and huge risks exposure. The Economist (2008), states that the role of banks following the overheating of markets in real estate has been under analysis after the collapse of a number of housing markets in economies that are developed as well as the Dubai’s price bubble burst. Since credit development and increase in price formed in parallel in MENA from the 2000s, and occasionally very rapidly, an unthinking conclusion states that the former is accountable for the latter. The connection is actually complex and is not understandable in a consistent analysis. According to Zembowicz, (2009), bank lending is simply one method to finance an economic improvement, and possibly for Dubai the revitalization will be the entire extra firm without it. On the contrary, Moody’s which is the rating agency downgrading of Commercial Bank of Dubai, Emirates NBD and Mashreqbank on a watchlist being Dubai Islamic Bank, is a continuing reminder that the previous boom’s bad debts continue to reflect on the economy of Dubai. Moody’s underscored NPLs ranging within 15 and 17% at the end of 2011 in comparison with the GCC average of approximately 6.1% (Arabianbusiness.com, 2011). Its report claimed problem debts might stay high due to large, stressed debt restructuring that are government related. Between 2014 and 2016, approximately $50 billion of restructuring was due (Arabianbusiness.com, 2011). During the 1980s prior to the idea of freehold property and implementing consumerism was just a sparkle in the emirate leader’s eye, a number of the banks within Dubai experienced a minor financial meltdown. The government then stepped in, picked them up, secured them and they were renamed Emirates Bank International (Global Investor, 2012). This completely set the accurate precedent that the government of Dubai will comply to in case any factor seem to weaken its general economy, the reason why a lot of people have resolute faith in the general and lasting emirate’s success. According to Balasubramanian (2010), in case the present financial havoc impact on banks in Dubai and hinder them from lending to one another, the buyers as well as constructors, the state will infuse cash. Or better still, the United Arab Emirates’ central bank will. For instance, a number of weeks ago, they injected USD 13.6 billion into the economy of UAE to facilitate credit issues (Zembowicz, 2009). Banks actually continue to be in the reining business in the activity of lending. In the financial and banking world, Dubai is being taken seriously as an international player, thus lending as well as spending is not merely allowed. Balasubramanian (2010), stipulates that Dubai is trying to correct the problems that lead to the bubble in real estate, enacting regulations that would decrease speculation of property and, merely recently, offer landlords the right to select their own firms of property management. However, consumer confidence is still low, as terrifying stories regarding the harsh outcomes of falling behind on payments of mortgage in the UAE have turned out to be legend. Stuck amid wary customers and ambivalent lenders, those involved in Dubai’s real estate claim that they are happy to still be functional, and are continually reassessing their strategies, attempting to work out how to move forward the best way. Research shows that a bubble may result in a general negative effect, a positive effect, or just income redistribution. A number of potential factors or characteristics that frequently happen in bubbles have been established. For instance, massive speculation/investment, supreme price rise, a context of an outstanding investment but surrounded with insecurity, leverage, and roles of the government (Cummins et al, 2009). Even though the market in Dubai’s real estate remains within the despair, it assists to obtain perspectives from various people who have turned out to be successful in bust cycles previously. Central policy directed on real estate needs to be guided by the regulations neutrality and do no destruction. 2.4 Extent that real estate bubble was affected by global forces Real estate bubble was greatly affected by global forces like globalization. Research indicates that as globalization increases, the chances of getting bubbles in the economy world, specifically, in a country that is financially developed like Dubai, increases. Globalization effect on prices of house is based on the type of asset the bubble is linked to. For instance, in the Dubai’s real estate bubble, the rates of interest remain steady and globalization influenced prices of the house merely by increasing the bubble size. The bubble size influences demand of housing only when the bubble is linked to houses (The Economist, 2008). Therefore, during the Dubai’s real estate bubble, a rise in globalization increased prices of the house to a great extent. Dubai received $20 billion from Abu Dhabi following the real estate bubble burst in 2008 (Cummins et al, 2010). This year, research indicates that the emirate has generally grown by approximately 4%, its best economic development from the time of the crisis. The revival has been motivated by an expansion in trade, transportation, and tourism, all essential sectors of the domestic economy, together with real estate and retail spending (Renaud, 2010). The major issue therefore is how to finance the gathering economic revival going forward. Domestic and for that matter international bank loans are not possibly going to be available. The Central Bank in UAE has as well put a limit on new lending to entities that are government-related (Katzeff, 2009). On the other hand, debt from banks is not simply the way to finance a revival. Certainly, it is quite classical following a major crash in real estate for the domestic sector in banking to be left in serious distress. The exercise that is credit stress-testing highlights the need to moderate increasing credit focus to reinforce capital. The CBU needs to make sure that banks be familiar with NPLs fully and to conditions effectively, while assessing the performance of loans that are restructured. The focus of risk in a couple of banks in Dubai demonstrates the importance for close management of such banks and also closer supervision of their domestic and cross-border interbank exposures. Implementing a risk assessment culture that is more forceful, carrying out habitual banks’ stress testing, and reinforcing the structure for an early threatening system would aid alleviate risks to the system of banking and toughen financial stability. 3.0 Proposals and recommendations regarding the strategies and policies that can be adopted by the banking sector to correct the situation The financial system in the UAE is highly incorporated and is still exposed to international economic vulnerabilities. Even though vulnerabilities have reduced since 2008, it is suggested that the systems need to continue to be vigilant to international shocks and continue to reinforce buffers. It is recommended that the central bank continues to strictly observe the liquidity of banks at an individual level and to persuade them to proactively control liquidity risks. The international outlook and the increased insecurity in foreign funding underscore the need to create local debt markets. Local debt markets would ease management of banks’ liquidity, help decrease dependence on foreign funding, and finally allow organizations to raise funds from capital markets that are domestic. From 2008, the United Arab Emirates’ (UAE) authorities have put into consideration some measures to reinforce a number of the feeble links within the system. For instance, banks have been greatly recapitalized and the adequacy ratio of capital of the system of banking has build up to approximately 21 percent (Zembowicz, 2009). Financial institutions that are weaker, not excluding banks, have been joined together with powerful institutions. Even though banks have greater nonperforming loans (NPLs) compared to what they had during the pre-crisis era, they should be more risk-reluctant in their lending (The Economist, 2008). 4.0 References Balasubramanian, A. (2010). "Rebuilding Dubai: Post-Bubble Economic Strategy." Harvard International Review. Vol. 31. Issue 4. pp 10-1. ABI/INFORM Complete; ProQuest Research Library. Cummins, C. et al. (2010). "Creditors Back Dubai World Deal. Restructuring of nearly $25 Billion in Debt to Proceed After Months of Talks." Wall Street Journal: ABI/INFORM Complete. Cummins, C. et al. (2009). Stefania Bianchi and MirnaSleiman. "Dubai: A High Rise, then a Steep Fall." Wall Street Journal: ABI/INFORM Complete. Cochrane, L. & Harif, Barak. (2009). Dubai debt delay rattles confidence in gulf borrowers. Retrieved on 24th October, 2012 from Dubai: Paradise Postponed. Global Investor (2012): ABI/INFORM Complete. (Dubai: Para Dubai Real Estate seen in Doldrums Until 2016. Arabianbusiness.com: n/a. (2011). ABI/INFORM Complete. Hall, C. (2009). Dubai government statements on Nakheel, $5 Billion. Retrieved on 24th October, 2012 from Hamada, K., Kashyap, A. K., & Weinstein, D. E. (2011). Japan's bubble, deflation, and long- term stagnation. Cambridge, Mass: MIT Press. "International: Has the Bubble Burst?; Dubai." The Economist Nov 29 2008: 52,n/a. ABI/INFORM Complete; ProQuest Research Library. Jeff, J. (2010). The Dubai financial crisis: An oasis of debt, the Palm Islands, Dubai World and the BurjKhalifa. Retrieved on 25th October, 2012 from Katzeff, P. "Emerging Markets Solid Despite Dubai, Big Investors Argue." Investor's Business Daily: Dec 01 2009. ABI/INFORM Complete; ProQuest Research Library. Meyer, C. (2003). The Housing Bubble. The Free Market (August). Retrieved on 11 December 2012, from Mantell, R. (2010). Home prices off record 18% in past year, Princeton University Press. Renaud, B. "Dubai's Real Estate Boom and Bust of 2002 - 2008: Dynamics and Policy Responses." Housing Finance International (Online) 24.4 (2010): 6,17,5. ABI/INFORM Complete. Renaud, B. (2012). "International Articles: REAL ESTATE BUBBLE AND FINANCIAL CRISIS IN DUBAI: DYNAMICS AND POLICY RESPONSES." Journal of Real Estate Literature Vol 20.Issue1. pp 51-77. ABI/INFORM Complete; ProQuest Research Library. Shiller, Robert J. (2005). Irrational Exuberance. 2nd Edition. Princeton, N.J.: Princeton University Press. The Growth of the Real Estate Market in Dubai. Al Bawaba: n/a. Apr 08 2008. ABI/INFORM Complete. Watts, W. (2009). Dubai woes roil financial markets: Stocks fall and government bonds rise on flight to quality. Market Watch. Retrieved on 25h October, 2012 from Zembowicz, F. "Remodeling Dubai: The Emirate's Housing Market." Harvard International Review 30.4 (2009): 12-3. ABI/INFORM Complete; ProQuest Research Library. Read More