How Worried Should We Be About Dubai?

Note: This post is by Rachel Ziemba of RGE Monitor, filling in while Brad is off in the mountains.

Many thanks to Brad for letting me fill in again.  I pay attention to macro events in China and several  oil exporters and the whole portfolio of sovereign investors for RGE monitor where this post first appeared. I’ll chime in on a few things related to sovereign investors (including their role in financing the US) this week while Brad is out.

In recent weeks CDS spreads on the debt of Dubai’s largest State-linked vehicles like Dubai Holding etc shot up dramatically after Abu Dhabi announced a unilateral recapitalization of its banks. The cost to buy prrotection on the 1 year bond has doubled since late January and now stands at 1073bps. The jump in the 5 yr has been less sharp but stands at over 1400bps. Since Dubai has limited sovereign debt (about $10b and maybe climbing given the likely fiscal deficit) so these large state-linked companies provide a proxy for the perceived credit worthiness of Dubai’s government. Given Dubai’s debt stock ($80b or 148% of GDP), its vulnerability to global liquidity and the worsening outlook for its domestic property market despite the ability to control supply, it is perhaps not a surprise that the outlook for the emirate seems much more precarious, particularly in contrast to its cash rich neighbour, Abu Dhabi. Given the links of these debtors to the government, and the effect that their vulnerabilities could have on the UAE federation, it has widely been assumed that the UAE govt (or rather Abu Dhabi) would come to the aid of Dubai when the crunch came. However, there has been more uncertainty than some expected. Key tests are ahead in coming months as Dubai adjusts to a world where leverage remains scarce.

Around $20b of the outstanding debt ($80b) comes due in 2009, including several large syndications like that of Borse Dubai which was having trouble rolling over its $4b loan that expired at the end of February. Breaking views notes that the $4b capital needed is a test case as allowing the institution to implode would have broader reverberations. It now seems that the UAE federal government might be coming to the rescue. Meed suggests that it will loan Borse dubai $1b to make up the shortfall. Borse Dubai only managed to secure $1.25 billion of commitments from commercial banks, although some further commitments from banks could bring the final bank tranche to $1.5 billion. Even the capital that Dubai attracts will come at a higher cost. Borse Dubai might have to pay 430bps above Libor rather than the 130bps the maturing loan carried.

Unlike some of its neighbours (especially Abu Dhabi) Dubai’s growth was primarily debt financed, making it more vulnerable to the global liquidity crunch and more local liquidity tightening triggered first by the withdrawal of speculative capital and – later by the fall in the oil price. Although Dubai has little oil, it was clearly a petrodollar recycling hub. It accounted for much of the UAE’s external debt stock (some of Abu Dhabi’s state investors like Mubadala and others accounted for the rest ). Dubai based banks likely also accounted for much of the bank lending to the UAE. Moodys vulnerability indicators show that the UAE is among the most vulnerable in the MENA region (if much less vulnerable that Eastern European countries that are being forced to rapidly and painfully adjust.

Data from the BIS (see chart below) show that loans extended to the UAE first tapered off and then fell in Q2 and Q3 of 2008 (the most recent data)  This is consistent with the outflows of short-term capital once dirham revaluation was taken off the table that contributed to a local credit crunch as well as the the escalation of credit crunch on a global scale and a reluctance to lend to the Gulf as the oil price began to fall. Of remaining loans, UK banks are most exposed. Looking at shifts in the UAE’s central bank reserves details the scale of this flows. The UAE’s reserves doubled to almost $100 billion but have subsequently fallen to $44 billion at the end of Q3 (most recent data). No wonder the project finance costs and domestic interbank rates shot up.

The following gives an outlook of how net flows of funds (deposits abroad - loans) of the UAE compare to the rest of the GCC. the UAE has consistently borrowed more from foreign banks than it has borrowed abroad for the last 18 months. Despite the drop in loans extended to the UAE, it continued to be a net borrower from the international banking system - unlike for example Saudi Arabia or Kuwait.

Dubai is experiencing a property bust. Prices and volumes have been falling for some time and even efforts to control the supply (by merging and providing capital to the main mortgage lenders or pulling back on projects have had limited effect.) The secondary market in particular has dried up. Meanwhile with a number of foreigners losing their jobs will be another blow to consumption and property markets.

It has been widely assumed that oil-rich Abu Dhabi would come to Dubai’s aid in one way or another, providing the needed capital and solidifying Abu Dhabi’s role within the power structure of the UAE. It seemed likely that federal institutions were taking the upper hand – including the central bank. In fact the first UAE government responses to the financial strains on UAE banks seemed to be evidence enough. But the next stage has been less unclear.

Moreover the structure of some of the liquidity provided including the temporary ‘repo window’ still created disincentives for banks to take advantage of the funds – likely because authorities wanted to force regulatory changes to stem the significant credit growth. While most UAE banks received long-term deposits back in the fall from the central bank, they remain undercapitalized given the loss of whole sale financing and the fact that the property bust is undermining the quality of underlying assets – property, credit card debt etc. Standard chartered suggests that UAE banks need an additional $27 billion to be adequately capitalized. Other institutions like a permanent repo window and other tools to control the money supply are also needed. These capital needs persist despite Abu Dhabi’s injections to its banks, however, the support of the emirate’s government does add to the stability of financial institutions there and reduce the risk of systemic risk. Abu Dhabi provided capital injections to five banks operating in the emirate in the form of 5 year deposits. Yet allowing a default of a major state-linked banks could have broader reverberations in the region.

Why hasn’t Abu Dhabi made more funds available to Dubai given that the uncertainty undermines UAE asset quality and the “UAE brand”? One explanation might be politics between the emirates. Reportedly Dubai has not actually asked for funds, perhaps fearing a loss of autonomy.

However, even Abu Dhabi’s stock of liquid assets might not be quite as high as it might like. In a recent paper, Brad Setser and I argue that the funds of the Abu Dhabi Investment Authority (ADIA) may never have been as large as some observers thought (we peg its peak at close to $480b early in 2008 and suggest it may have suffered valuation losses that took its AUM down as low as $300b (watch later in the week for some updated calculations on a range of sovereign funds). The calculations are based on an index based portfolio so we might be a bit off. However, given that liquidity is at a shortage and Abu Dhabi may also run a fiscal deficit, it may prefer to preserve its capital for investments prioritized for domestic development.

Yet it is not in its interest to let too large a gap in credit worthiness emerge with Dubai particularly as its banks and institutions are exposed to Dubai’s property markets (perhaps accounting for the extra liquidity injection.) Furthermore there are risks that the property markets and financial institutions throughout the region even if most countries are more insulated. Abu Dhabi may prefer to avoid such a bust. But as Moody’s notes, the corporate sectors of the GCC have not been tested in this way in the past and do face significant financing needs.

Broader cost cutting is going on in Dubai including several mergers in the property sector and job reductions. Dubai International Capital and Dubai Group, investment focused entities belonging to Sheikh Mohammed plan a quasi merger. This seems to make sense and may reduce overcapacities. In fact these two entities always seemed to be encroaching on each others turf (investment in financials, private equity holdings etc) in a UAE that was serving as a laboratory for investment abroad, though recently Dubai group was reportedly branching into Islamic finance. Furthermore like others relying on leverage their business model has come under challenge. The sharing of back office support may be the first step to a re-merger. Needless to say, any funds and projects overly reliant on leverage should continue to be very quiet (the QIA might be one exception)

The combination of much more subdued credit growth, reduction in oil production and reduction in non-oil trade and services will keep the UAE’s growth weak in 2009. The country’s non-oil diversification has exposed it to sectors that are faltering globally (shipping, tourism, property, finance). Government support and the fact that many sectors are centralized can cushion the blow somewhat – fiscal policy is expected to be expansionary, the budgets of the UAE federal government (which spends mostly in the smaller five emirates) and Dubai show expenditure growth in 2009. Abu Dhabi will likely do so also though its budget has not been disclosed. Yet there is a broader question where will the funds come from or what price will be charged to get there. Yet given the direct linkages between the UAE’s borrowers and the national and sub-national governments, funds should be forthcoming even if they are pricy and become more so with oil at $35 a barrel.