The Effect of the Financial Crisis and Implications for Dubai - Essay Example

The effect of the recent financial crisis and regulatory implications for Dubai Table of Contents Introduction 3 2. The financial crisis – causes and effects on markets 5 3. Effects of financial crisis on legal systems and legislative texts 7 4. The financial crisis in Dubai 10 4a. Main aspects of financial crisis in Dubai 10 4b. Regulatory implications in Dubai in the context of the crisis 14 5. Conclusion 18 6. References 20 6.1 Online sources 23 1. Introduction The recent financial crisis has led governments around the world to update their existed regulatory framework in order to minimize – as possible – the duration of the crisis; however, until today, the expansion of the financial crisis seems to be continued; no legislative text has been able to confront the recession; on the other hand, it has been proved that the recession’s effects are stronger in markets that were highly based on faulty financial products – like the subprime products in the USA market. In the case of the recent financial crisis the structure and the principles of the financial markets have been proved to have a critical role in the increase of the pressure against the economies internationally; however, there are countries, like Dubai, which managed to keep their economy strong; The effects of financial crisis can be divided into two different categories: a) the effects referring to the national economy and b) the effects related to the firms and individuals that have interests on specific investments. Failures in the regulation of crisis in regard to the economy and the private sector have been identified; these failures have led to the instability of the markets or firms involved1; at the next level, the financial crisis have led to the differentiation of the role of risk – as a decisive factor in the development of financial policies. In this context, it can be noted that the financial crisis has led to the differentiation of the political decisions in regard to the rules that govern the markets worldwide. On the other hand, Claessens et al. (2010) supported that current crisis has many similarities with the financial crises of the past2; under these terms, the countries that have faced similar crises in the past should be more ready to face the current recession; however, in the case of USA the above ‘rule’ has not been verified. Moreover, the view of Claessens et al. (2010) can lead to the assumption that countries with no previous experiences of financial crisis are likely to fail in handling the recent recession; Dubai had not face such a crisis in the past; the crisis hit the country recently, i.e. after having affected all other countries; this fact cannot be easily explained. However, through the case of Dubai it was revealed that experience in crisis does not guarantee the effectiveness against a crisis; the country managed to exit the crisis even if the relevant pressure was extremely strong. Dubai is country characterized for the power of its economy; the financial crisis affected Dubai indirectly; the pressures on the property market globally led to the gradual reduction of prices in properties across Dubai; the Dubai-world, the company that owns most of the emirate’s properties; it seems that the above company started to face difficulties in regard to the repayment of its debt – which were said to reach the level of $60 billions; the failure of this firm to repay its debt would severely affect the Dubai’s economy; however, soon the above problem was resolved. The restructuring of the country’s existing legal framework had a critical role in the rapid recovery of the emirate’s economy. The effects of the financial crisis on Dubai and the regulatory implications for the emirate because of this crisis will be examined in this paper. Reference will also made to the characteristics and the effects of recession in markets in order to explain clearer the study’s main issue. 2. The financial crisis – causes and effects on markets One of the most critical issues when trying to evaluate the potential effects of a financial crisis is to identify its causes; regarding this issue it is noted that the recent financial crisis can be regarded as a result of the lack of appropriate legislation3; the importance of appropriate regulation for the effective handling of a financial crisis is also highlighted by Praet et al. (2008)4; Mavrotas et al. (2007) note that the intervention of the state is necessary in order for the stability of market to be protected – in the above study emphasis is given on the protection of the deposits in banks as a key target when the stabilization of a market needs to be maintained5. On the other hand, Schooner et al. (2010) make clear that the development of a financial crisis is the result of two different facts/ failures: the lack of effective regulation and the failure of managers in banks to take the necessary measures in order to ensure that the liquidity of their banks will not be decreased6; in other words, a similar role in the development of a financial crisis is given to the regulatory failures and the managerial failures. Blundell et al. (2009) and Chang (2007) highlight other important factors towards the development of a financial crisis; in accordance with Blundell et al. (2009) refer to the contribution of the ‘changes to the Basel rules to the sharp rise in toxic securities’7 while Chang (2007) focuses on the inability of governmental authorities to ensure the quality of information transmitted to the public8 – referring to the influence of information transmitted on the perceptions of foreign lenders in regard to the credibility and the potentials for growth of a specific market. Normally, during periods of recession, the markets develop policies that will help to reduce the effects of the crisis; however, in the case of strong financial crisis, like the recent one, the challenges faced by governments worldwide, in regard to the limitation of the crisis, can be significant. Researchers worldwide have examined the aspects of the recession; it is concluded that the initial signs of the crisis were not taken into consideration; as of this issue, the responsibility of governments worldwide cannot be ignored. On the other hand, the power of the banks and other financial institutions to affect economies internationally cannot be doubted9; in fact, it was the lack of control on the financial institutions’ activities that led to the development of the crisis. In accordance with Kroszner et al. (2007) the level of dependency of a country’s industrial sectors on external finance is likely to affect their responses to the crisis10; these sectors are more likely to be affected by the crisis compared to those sectors where external finance has not a key role in the development of these sectors’ activities; in other words, the independency of an industry sector from the external finance – referring especially to the financing of various industrial projects by the financial institutions operating in a specific market. On the other hand, it has been supported that the external financing during the crisis can help to the limitation of the crisis – in terms that ability of investing is increased. Towards the same direction Campello et al. (2010) noted that ‘the inability to borrow externally caused many firms to bypass attractive investment opportunities’11; in accordance with the above, external finance can increase a market’s resistance to the crisis; however, the dependency on external finance indicates the dependency on banks. The most effective measure to limit the effects of the financial crisis seems to be the introduction of effective regulatory texts; this issue is discussed in the study of Goodhart (2008); the above researcher noted that the aspects of financial regulation in the context of a financial crisis could be summarized as follows: a) the risk management, b) the management of deposits- referring also the protection of deposits through appropriate insurance programs, c) the management of cash and the liquidity management and d) the relationship between the local market and the foreign markets12; it is not made clear however whether the choice of one of the above aspects of financial regulations has to be based on specific criteria or whether it is depended on the personal perceptions of the individual/ team of managers who are involved in the effort of the crisis’ limitation. 3. Effects of financial crisis on legal systems and legislative texts Traditionally, the regulation developed in the context of a specific financial crisis enters a market with delay; the issues that are likely to be regulated by the legislative texts introduced in the context of a crisis are related with the competition and the management of funds; in most cases, the introduction of laws that can help to the prevention or the limitation of the crisis is not considered as an adequate measure; governments internationally may proceed to the development of appropriately customized methods of intervention controlling the bureaucracy13; in other words, the effects of a financial crisis on a country’s legislative framework are not likely to be extended; rather, the regulation of specific issues is attempted aiming to avoid the development of strong conflicts which could lead to severe turbulences in the national or the global market. It is for this reason that alternative methods of dispute resolution are developed – referring to the disputes appear in regard to the decisions of intermediaries (agents) on specific investment schemes – in the context described above by Cook (2004). Towards the same direction, Adams et al. (1999) noted that ‘national supervision and regulation in many countries is being challenged by the increased blurring of commercial banking, investment banking, insurance and asset management’14; in other words the banking and investment activities have caused difficulties in the application of law in a particular market; therefore, the appearance and the development of the crisis can be characterized as unavoidable; the legal framework of countries around the world had been already tested by the radical increase of financial services available to the market; the development of appropriate legal rules for the regulation of these activities would be an extremely difficult target15. The recent financial crisis showed that priority should be given in the regulation of social, political and economic issues; appropriate policies would be developed aiming to protect both the local (region) and the national economy. Generally, the regulation developed in regard to financial activities can be characterized as satisfactory – referring at least to the cases of the countries that are well-established centers of commerce like USA, Britain and China; however, the existing laws on the particular field may not respond to the needs of their market; the volume of the legislation available on this sector may be important but if the relevant laws do not refer to mechanisms that would support their application on actual market conditions, then there would be no point for referring to the relevant rules; for this reason, in the study of the International Monetary Fund it is made clear that the regulation of financial markets worldwide should be improved16. The main effect of financial crisis on existing regulation is the highlighting of these laws’ failures in regard to the subject to which they refer. In a similar context, the efforts to support a market’s recovery may require the avoidance of privatization as a method for improving the profits of the state and support the freedom in the development of entrepreneurial activities17 that can cause turbulences in the national or the international market; this requirement – which does not necessarily reflect the market trends – is of importance for firms that have developed a series of strategic alliances in its sector of operations. The understanding of the effects of the crisis on the existing legal systems can be achieved by referring to actual market conditions; in accordance with Edwards (1996) two are the main strategic criteria for the development of the performance of banks during a crisis: a) its competitive position and b) its level of risk18; as the performance of banks in a particular market can strongly affect the market’s performance it is necessary that the policies adopted by the banks during the crises are carefully chosen in regard to the above criteria. In other words, the control of the banking activity is considered as one of the most important roles of regulation. In this way, regulation needs to be continuously updated in order to respond to the needs of the particular sector19. However, the level at which the regulation interferes in the development of financial transactions in a specific country will affect the performance of the financial services sector within this country. Despite the fact that financial services can be available worldwide through the Internet, the performance of legal rules in regard to the control of these activities are still not clear20; moreover, the level and the type of regulation developed within a specific country is likely to affect the decision of investors (firms or individuals) to enter this country, in other words the country with the ‘less restrictive regulation’21 will be preferred by investors and the firms that provide financial services in the international community. 4. The financial crisis in Dubai 4a. Main aspects of financial crisis in Dubai The investment policies and the terms of trading in Dubai have been characterized as major factors for the stability of the emirate’s economy – compared to other countries in the international community. In fact, it is noted that Dubai can be considered as belonging to those trading centers that ‘emerged essentially as centers of stability in the context of instability of neighbouring major economies’22 – Dubai is characterized as a centre of commerce offering stable economic conditions compared to the instability held in the overall Middle East region. However, the growth of the Dubai’s economy is heavily based on the export of oil; this means that a potential radical decrease in the price of oil could lead to severe financial turbulences in Dubai and the other countries that are based on the specific product; the problem would be severe as the decrease in the price of oil could be followed by the decrease in the prices of properties and the stock prices across the emirate23. The appearance of the financial crisis in 2008 was not considered as a threat for the economy of Dubai; in fact the country’s market was not directly affected by the crisis; the first signs of the crisis in Dubai appeared near the end of 2009. Dubai economy is strongly based on the property market; the reduction of prices in properties worldwide – because of the crisis – has also affected the property market in Dubai. The development of the property sector in Dubai has been the result of the increase of the country’s profits due to the export of oil. The investment on property has been a common practice for countries in the Gulf area, like the Kuwait, the Saudi Arabia and the UAE that use to choose their investment in accordance with the level of security offered aiming to reduce the investment risk – as possible24; The use of property as an investment tool in Dubai has been highlighted by Shiller (2008); the above researcher noted that property can be an important investment option offering the advantage of its limitation – no further properties are allowed to be developed in many areas worldwide while existing options for property development are limited – in terms of the countries’ urban structure; it is noted that Dubai has been an exception from the above rule25; in Dubai, properties were developed while there was no land available, a fact indicating the power of the local authorities to proceed to dynamic plans of investment in case that prospects of growth are identified. Despite the global pressure on the prices of properties, the property market in Dubai is not under severe threat – the pressures on the emirate’s property market at the end of 2009 were temporary and were faced with appropriate measures; it should be noted that currently the demand for new units has been increased up to 50,000 on an annual basis26; The property market in Dubai is expected to offer a significant support in the near future; about 15 million tourists are expected to visit the Dubailand in the emirate up to 2015; the profits from the tourism would help to balance the losses in the property sector because of the crisis in 2009; the continuous improvements on the country’s infrastructure are also expected to help towards the limitation of the effects of the crisis on the emirate’s economy27. One of the major effects of the crisis on the emirate’s market has been the limitation – even temporary – of this market’s strength; in any case, the above problem has been expanded across the Middle East region, i.e. Dubai has not been the only country of the region (which is based on the export of oil) suffering from the crisis28. In the past – referring to the pre-recession period, Dubai’s economy has been characterized by a continuous and rapid development; the prices of properties have presented a continuous increase from 2004 onwards; there could be no prediction for the limitation of this growth – especially if taking into consideration the fact that Dubai’s needs in properties are high – as explained above. In a recent study published by the Oxford Business Group (in 2009) it is noted that the potential negative effects of the crisis in Dubai – recession could still influence the market’s performance – would be limited because of the development of the Islamic banking worldwide29; this could offer a significant support to the banks of the emirate – and of other countries that use the specific system of banking – and lead to a growth irrelevant from the oil30; the independency from the oil would be a major factor for the stabilization of the Dubai’s economy – especially if taking into consideration the fact that the crisis still influences the international market. Even if the prospects for the development of the Dubai’s economy are many, still measures should be taken for the increase of the foreign direct investment in the country; the fact that the neigbouring countries face financial turbulences because of the crisis would negatively affect the potential investors who are interested in investing in the emirate; false assumptions would be made on the emirate’s economy under the influence of the recession in the neighbouring countries31; tourism also could be negatively affected32; the above view is in accordance with the figures released by United Nations (2009) in regard to the effects of the crisis on the Middle East region; in the relevant study it is noted that the UAE is the country of the Middle East Region that was most affected by the global recession – it’s GDP in 2009 was just 0.5% compared to the 7.4% of 200833; the above figures reveal a strong impact of the recession on the economy of UAE – it is clear that the potentials of Dubai’s economy to be developed independently need to be highlighted to the potential investors. 4b. Regulatory implications in Dubai in the context of the crisis The regulation of financial services in Dubai has been affected by the crisis; in fact, the crisis revealed the weaknesses of the country’s regulatory framework specifically in regard to the financial services. In the past, the above framework has been considered to be particularly safe – taking into consideration the level of development of the country’s economy; the expansion of the recession in Dubai proved the lack of readiness of the local authorities to handle such crises. Financial services in Dubai are regulated and monitored by the Dubai Financial Services Authority (DFSA), an authority which has the power to administer the provision of financial services across the country; DFSA was established by the Dubai Law no.934; the above authority – like other relevant authorities of the Arab countries – is a member of the ‘International Organization of Securities Commission, (IOOSC)’35; financial services can be provided in Dubai within a specific zone, a separate jurisdiction, or else a ‘financial free zone’36 which was established by the Federal Law no. 8 of the United Arab Emirates; the above law introduces the rule that the financial services in Dubai need to be carried out in a different currency – i.e. Dirham cannot be used in banking transactions in Dubai37; the ‘financial free zone’ is located in Dubai’s 110 acre area and its use has been clearly described in the Federal Decree No 35, in 200438. The development of a separate zone of financial activities within Dubai has the following implications: a) the development of the various financial activities can be easier controlled but the availability of options – referring to the options available to the investors – may be limited; b) the rules required for the regulation of transactions in the Dubai’s market cannot be based on similar rules of the international bodies- similarities would exist though at the level that the relevant financial transactions refer to similar investment products – Dubai is not a member of the Basel Committee but still the documents of IOSCO could be used when developing the rules of the Dubai exchange market, c) potential investors could avoid to visit other areas of Dubai – concentration in the Dubai’s tourist development could be faced by using the emirate’s tourist transactions, like the Dubailand, d) Dubai is under the regulatory control of UAE; this means that the region in which the financial services of Dubai are offered is not under the direct control of the Dubai’s government – a problem that would not exist if the provision of financial services would be allowed across the emirate, e) Dubai is based on the Islamic banking system; in the context of the specific system, the moral hazards in the management of funds are limited – due to the principles that govern the specific system; for this reason, if Dubai’s existing rules on the regulation of banks are set under review, then existing rules on banking supervision as applied on the country’s of the West could be used only as a point of reference – there could be no direct application of these rules on the Dubai’s banking system. However, as for the practices that could be possibly introduced in regard to the control of the exchange market’s performance and operations, the policies adopted by authorities in other important exchange markets internationally – like the US exchange market and the London Stock exchange would be used – as these practices are published by the relevant organizations (US Securities and Exchange Commission, UK Financial Services Authority and Organisation for Economic Cooperation and Development). In order to understand the role of the regulatory framework of Dubai in the limitation of the effects of the crisis on the emirate, it is necessary to refer to the structure of the Dubai’s market; investors in Dubai can choose among a series of different financial products39; two different exchange markets: the DFM – related to assets – and DIFX – it is available in the context of the financial services free zone40; by separating the trading areas, the terms of trading can be easier controlled and evaluated. As for the regulation of the emirate’s exchanges, this has been delegated to two different authorities: the DFSA and the ESCA41; again, the separation of powers in controlling the emirate’s exchanges is regarded as an effective strategy in order to ensure the application of the trading ethics. The fact that the principles of the Basel Committee on banks’ supervision (2004, as revised in 2009) do not apply on the financial services provided in the context of the Dubai market does not seem to affect the potential development of the crisis in the emirate – UAE is not among the members of the Committee. In any case, Dubai is based on the Islamic banking system which offers to the country’s banking sector an advantage compared to the other markets – based on the Western banking sector; in 2009 suggestions were made to the Committee for increase the support towards the banking sector42. It should be noted that legislative texts available for the regulation of the exchange markets worldwide would be also used by the Dubai’s authorities in order to increase the level of security related with the financial services provided across the emirate. International Organization of Securities Commissions (IOSCO) is an international body that has the power to set rules that can be enforced in markets worldwide. In April of 2010 the above organization published an updated series of principles for public offerings; authorities in Dubai could use other documents of IOSCO in order to cover potential gaps of the existing financial services regulation. As for the International Monetary Fund, this organization would not be required to participate in the recovery of Dubai’s economy since its intervention is based on specific terms and it is most likely to be necessary in the case of developing countries that are trying to stabilize their economy43. The importance of appropriate regulation for the protection of investors in the context of current crisis is emphasized on a report published by the Financial Stability Board in September of 2009; it is noted that existed financial regulation should be improved at the following points: a) increase the support to the banks – referring mostly to their liquidity, b) improve the accounting standards and c) develop appropriate policies for the elimination – if possible – of the moral hazard44. The above suggestions would be taken into consideration by legislators in Dubai when the emirate’s regulations on the financial services sector are to be updated. The fact that Dubai has a different banking system – compared to the countries of the West – i.e. the Islamic banking system needs to be set as a criterion if the rules regulating the practices of the banks across the emirate are set under revision. Currently, the pressures on the economy of Dubai because of the recession are reduced – compared to the conditions of the end of 2009; however, it is not sure that the country managed to exit the crisis. For this reason it is noted by Schwab (2009) that the ability of the country’s government to protect the local economy from the crisis has been doubted45. In 2007 the Hedge Fund code of practice was introduced by the DFSA; the above code set the rules ‘of best practice of hedge funds operators’46; the above initiative has been quite importance for the protection of Dubai’s economy from potential unethical practices in regard to the management of hedge funds in the emirate. 5. Conclusion The global financial crisis has affected Dubai – even with a delay compared to the other countries worldwide; Currently, the emirate’s financial status seems to be quite satisfactory leading to the assumption that Dubai could highly developed its exchange market and become a competitive financial center47; it could be noted that the above report reflects the views of economists on the economy of Dubai before the appearance of the crisis in that particular country; however, the overall performance of the country’s economy up to now can lead to the assumption that the further growth of Dubai’s economy could be considered as expected; it would be necessary, though, that specific measures are taken in order for the emirate’s economy to become stronger towards the global financial turbulences. In the modern market, the appearance and the development of financial crises is difficult to be controlled; in fact, through the material examined in the context of this study it has been proved that all financial crises are likely to be depended on a series of factors that are not directly related with the economy; on the other hand, the measures taken are often proved inadequate or inappropriate; under these conditions, the crisis is expanded and the immediate intervention of the state is required for its effective control; it is for this reason that Daniel et al. (2007) noted that the liberalization of a financial market can often lead to a crisis – especially when the growth involved is not appropriately controlled48. It should be noted that Dubai is based on the Islamic banking system; this means that loans are not permitted – only appropriately customized schemes of financial support are available; this fact reduces the chances for the extensive financial losses because of the crisis – the lack of effective management policies in regard to the existing loans49 has been proved to be the main cause of two crises, the one of Asia of 1997 and the one of USA in 2008. Under these terms, Dubai and the other countries that use the Islamic banking system are less likely to face severe turbulences because of the recession, even if this condition is not applied on all countries of the specific banking system; at the next level, it has been proved that Dubai did not manage to avoid the indirect effects of the crisis: the reduction of the prices of its properties during the relevant limitation in the value of properties worldwide. Moreover, the emirate’s neighbouring emirates are still under the influence of the recession – see the figures presented above in regard to the radical decrease of the GDP of the UAE between 2008 and 2009. Dubai needs to develop an independent policy for the control of the financial crisis – referring to the independency from other emirates and countries of the Middle East. The improvement of existing regulation would be an important initiative towards the above direction. 6. References / Bibliography Abdmoulah, W., 2010. Testing the evolving efficiency of Arab stock markets. International Review of Financial Analysis, Volume 19, Issue 1, pp. 25-34 Adams, C., Mathieson, D., 1999. International capital markets: developments, prospects, and key policy issues. International Monetary Fund Blundell, A., Atkinson, P., 2009. Origins of the financial crisis and requirements for reform. Journal of Asian Economics, Volume 20, Issue 5, pp. 536-548 Bungenberg, M., Meessen, K., 2009. 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