The Debt Crisis That Dubai Faced in 2009 - Case Study Example

Introduction: This report is about the debt crisis that Dubai faced in 2009 and how the global financial crisis of 2007-08 impacted it. owned Dubai corporations like the Dubai World had piled massive amount of the debt during the boom years of 2000 to 2007. These debts were used to make huge investments in real estate projects like the Burj Khalifa building ( the tallest building in the world), Atlantis Hotel etc. Things went sour when the global financial crisis started in the second half of 2007. Because of the freezing of credit, corporate and investment activity slowed down and Dubai found itself with massive real estate inventory with no takers. Buildings like the Burj Khalifa remained largely unoccupied. In 2009, Dubai suggested that it may not be able to pay the impending six month interest payments on its loans. Abu Dhabi then came to its rescue with a $ 10 billion bailout. What happened to Dubai: In the year 2009, Dubai stumbled into a debt crisis. During the years of economic boom before 2008, the investment arm of Dubai, Dubai World had borrowed heavily. It had racked up more than $ 59 billion in debt. Dubai World had borrowed hugely to invest in lavish projects in Dubai. These included Las Vegas casino style glittering properties and a giant island that was shaped like a palm tree; besides the tallest building in the world: the Burj Khalifa. Nakheel is the real estate developer owned by Dubai World, the investment arm of the state of Dubai. Prominent among the constructions of Nakheel are palm-shaped islands and the Atlantis Hotel. $ 3.52 billion of the Islamic bonds of Nakheel also became due and Nakheel had no liquidity to pay them off. It was part of one of the largest tranches of Islamic bonds that Nakheel had sold to Western investors (Landon Thomas Junior, 2009). The investors had no idea that Dubai was facing a risk of default. A week before Dubai announced its possible incapacity to pay the interests on bonds, the bonds were trading at a 10% premium on their face value. After the announcement they were trading at a discount of 50% on their face value. The total debt of Dubai is distributed among a number of different state owned companies. Majority of these companies are owned by the three main investment arms of the state of Dubai. These three investment arms are: i) Dubai world. ii) Investment Corporation of Dubai. iii) Dubai Holding. What were the causes of the Dubai debt crisis: When the global financial crisis started and the property market in United States and around the world crashed, Dubai found itself left with an abundance of costly real estate that no one wanted to buy or rent. Dubai had to request that the impending six months interest payment on the debt of Dubai World be deferred. This sent ripples of a shock wave in the global financial world, already reeling under the global financial crisis (David Prosser, 2009). On March 17th 2009, rating agency Standard & Poor’s lowered its rating on a number of government linked companies of Dubai because of the deteriorating economic outlook of the emirate. The credit rating agency also put four Dubai based banks on review for downgrade, predicting that a contracting economy and wilting property market will also weigh on the financial institutions of the emirate. More than 50% of on-going civilian infrastructure projects were put on hold. These included such projects like (http://www.uaerush.com/2009/02/10/list-of-projects-currently-on-hold) : i) Nakheel Harbor and Tower Project worth $ 38 billion. ii) Al Salam city project worth $ 8.2 billion. iii) Asia-Asia hotel worth $ 3.27 billion. iv) Al Salam city ( Phase 1) worth $ 2.70 billion. v) Dolphin city project worth $ 1.70 billion. The crisis in Dubai was exacerbated because of the global financial crisis. As the credit froze, the demand for the real estate in Dubai went crashing down. The news of Dubai on the brink of default soon affected the Wall-Street. The Dow Jones Industrial Average was down by more than 150 points. Dubai World, before falling in the debt mire, was the corporate face of the Emirate of Dubai. The company had made investments in real estate and ports around the world. The list of its global investments included such properties like the Barneys in New York (Paul Lewis, 2009). Dubai was a state that was heavily indebted in foreign currency debt. The interest payments were too high. Unlike its neighbors, Dubai enjoys little oil wealth. Dubai’s source of revenues came from its ports, trades, tourism and it being the financial center of the United Arab Emirates. According to the data of Bank of International Settlements, Basel, at the time of the debt crisis, foreign banks had total exposure of around $ 100 billion in Dubai. Britain had the largest exposure with the British banks giving out debts equaling to $ 51 billion. The banks of United States had given debts of $ 13 billion. The largest creditors of Dubai World were mainly local banks of Dubai and Abu Dhabi. Among the British banks, Royal Bank of Scotland (RBS) was the biggest lender to Dubai world with total outstanding loans being $ 2.3 billion (J.P.Morgan, 2009). Standard Chartered and Barclays had together lent around $ 10 billion to Dubai World while HSBC had an exposure of $ 17 billion. Because of the limited exposure of banks to Dubai, the crisis posed no threat of triggering a banking crisis. However, the prospect of Dubai defaulting, brought crude oil prices to a six week low and the price of gold fell on the back of huge selling by investors. The Credit Default swaps on the debts of economies like Greece and Lithuania increased by 16 percent and 6 percent respectively. Investors feared that the default by Dubai would have a domino effect with other debt ridden economies like Greece also defaulting. The credit default swap on Dubai debts increased by a whopping 67%. The British pound depreciated against the dollar. This happened because Britain too had high debt which was around 12% of the Gross Domestic product (GDP). Spain and Ireland too were other debt ridden economies where the real estate collapse happened at just the time when it happened in Dubai. Dubai was saved from default by a $ 10 billion bail-out by its neighbor Abu Dhabi.Dubai didn’t default and returned to the bond market in September 2010, with an unrated but heavily oversubscribed issue- showing that investors have once again reposed their confidence in Dubai (Economist, 2010). How did Dubai get from there to here - on road to economic recovery: Since then Dubai has set well on the path of economic recovery. The real estate market has still not recovered fully because of supply still outstripping demand. Burj Khalifa, is still more than half empty. Rents on office buildings continue to be low. However, on other fronts economic recovery is fast. Tourism is high, with Dubai becoming a sort of global shopping destination. Trade with its traditional trading partners like India and China is picking up (Economist, 2010). The private sector of Dubai is confident about the future of Dubai. This confidence is based on Dubai’s sophisticated infrastructure and low rents. However one concern that still overhangs is that how Dubai would pay on its future debt obligations (Richard Spencer, 2009). Its debt obligations were restructured in 2010 rather than being repaid. Payments worth $ 18 billion on the state-owned Dubai corporations will become due in 2011. During the last crisis Abu Dhabi came to rescue with $ 10 billion. But this may not be the case as many of the real estate companies of Abu Dhabi are also suffering( Economist, 2010). The only option that seems viable for Dubai in such a scenario is to resort to the sale of its strategic and valuable assets. These valuable and strategic assets include the docks, hotels and the airline company of Dubai ( Economist, 2010). The Dubai debt crisis was temporarily overcome by the support of Abu-Dhabi and by the restructuring of $ 25 billion debt of Dubai world. Dubai World is confident that it can now pay-off its debt obligations by selling its assets. The company expects to raise over 19.4 billion in eight years by selling assets such as its holdings in DP World- its port business- and casinos in Las Vegas. However, according to one estimate of JP Morgan only around $ 11 billion can be raised from the sale of the assets. Nakheel has offered its creditors the option to receive 40% of what was owed to them in cash and the remaining 60% in Islamic paper. Many creditors, having no other option, are accepting this. Out of the three investment arms of Dubai, the Investment Corporation of Dubai is the soundest one financially. It owns the highly profitable Emirates airline, which reported profits in excess of $ 1 billion in 2010. The other investment arm, Dubai Holding is already in dire straits financially. Its estimated debt exceeds $ 12 billion and in the year 2010, it postponed on the payments of some of its debt obligations. International banks are bracing themselves to write billions of dollars linked to the Dubai state owned companies. They cannot complain much because of the fear of losing future business and investment opportunities in Dubai and United Arab Emirates. Dubai will continue to be the major financial hub of the United Arab Emirates in the years to come. However, if it wants to avoid debt crises like the present one in future, it needs to revamp its model of development (Economist, 2010). Expatriate professionals, still prefer Dubai over other Middle Eastern cities and states. But the competition from neighbors like Qatar is catching up. The country is doing everything- from winning the bid for 2022 world cup to constructing new museums- to replace Dubai as the top commercial and investment destination of the region. What the governments and central banks of the world should do to prevent such debt crises: Governments and central banks should adopt a more centralized approach to financial management. This can be done by taking such steps as establishing debt management units. These centralized debt management units can oversee the management of the debt of the government and that of the state owned companies. In the case of Dubai, the borrowing had become so decentralized that it took many months to ascertain the total amount of debt of Dubai World alone. The central banks should take steps in time to check real estate and property bubbles. This can be achieved by using monetary policy tools like increasing the interest rates. What will be the future of the global financial markets- the impact of a possible default by Dubai materializing: If Dubai defaults on its debt obligations due in future, it will be an adverse shock to the process of global economic recovery. Market sentiments will be hurt and because of psychological factors the market will be down for sometime. The stocks of the banking sector will be particularly hit because of the exposure of many large banks to Dubai. So will be the companies of the already troubled real estate sector. Property prices may further crash. Conclusion: Dubai will have to sell some of its assets to pay for its huge debt obligations. Economic recovery can be continued by returning to the basics and focusing on the traditional strengths like tourism, trade and logistics of Dubai. State owned corporations should be discouraged from using excessive leverage in future. The massive and sophisticated infrastructure of Dubai will ensure that it will continue to be the business and financial hub of United Arab Emirates in the near future. References: Dubai’s finances: Debt forgetfulness,2010, The Economist. Landon Thomas Junior, 2009, Dubai debt woes raise fear of wider problems, The New York Times. Richard Spencer, 2009, Dubai Financial Crisis, The Telegraph. Paul Lewis, 2009, Dubai’s six year building boom grinds to halt as financial crisis takes hold, The Guardian. David Prosser, 2009, Dubai slides further into financial crisis, The Independent. Vir Singh, 2009, Dubai Financial Crisis, The New York Times. www.economist.com ( accessed on 11th May, 2011) www.uaerush.com. Read More