DUBAI DEBT CRISIS-IS IT CASINO CAPITALISM OR FREE ENTERPRISE?-VRK100-29112009

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If one word epitomizes the last week’s world events, that is, CRASH. The week started with a crash on Tuesday, November 24^th, in the official home of the world’s most powerful CEO, that is, US president, Barack Obama. Then we have witnessed another crash following the Dubai desert sandstorm that was on Thursday. And the third was yesterday, in Russia.

On Tuesday, Barack Obama hosted a state dinner at the White House for India’s Prime Minister. Escaping the scrutiny of Secret Service of the White House, a couple gatecrashed into the White House and had a photo op with Barack Obama and his deputy Joe Biden stunning the world. So, even the impregnable White House also seems to be vulnerable to a socialite gatecrashing couple, Tareq and Michaele Salahi from northern Virginia.

On Thursday, we heard that Dubai Government wanted to postpone repayment of its debt, through its investment arm-Dubai World, by six months. This has sent shock waves across the world’s markets – stock as well commodities. The Asian markets have lost between two and five per cent. While India’s Sensex crashed by over 950 points on Thursday and Friday, but recovered 400 points during mid-day to lose around 550 points in two days and ended at 16,630 on Friday.

Yesterday, media flashed news of another crash. This time it was a train in Russia that got derailed after suspected terrorists planted explosives on a track between Moscow and St. Petersburg. In this crash, more than 40 passengers were killed.

Three crashes in as many days and what a week it turns out to be! While the other two crashes have no impact on financial markets, it’s with the Dubai crash we are most concerned with at this point of time. It seems no one, including the all-powerful and ubiquitous US president, is immune from such crashes. And so are, Indians!

Let us analyse the events, the background thereto and their impact on markets in general with specific reference to India.

What triggered the present debt crisis in Dubai?

Why does such a tiny city-state Dubai attract so much attention of the world media last week? This is a baffling question for many investors across the world. Dubai till Thursday was seen as an ‘Oasis of Opportunity’ by many in the world. Dubai encapsulates free-market economy providing excellent living conditions for foreign employees and workers, with seven-star luxury for the rich classes, zero tax rates for businesses, numerous opportunities for the financial markets, offers superb port facilities, and a safe haven for criminals and the like. That was till Thursday, when the Dubai World, an investment arm of the Government of Dubai, had announced that it wanted to postpone its debt obligations by six months. This has come as a rude awakening for investors, who were in a state of lull till last week at their own peril.

This has unnerved financial markets across the world and had ripple effects on Europe, Asia and the US. The delay in payment obligations is seen as equal to debt default by many in the world. As we know, lenders don’t like such nasty surprises. Till last month, the Dubai Sheikh was assuring that all was well there.

State-owned Dubai World is a holding company having investments in a host of businesses. It has a debt of around USD 60 billion (out of the country’s total debt of USD 80 billion) and it invested heavily in property development across Dubai through its subsidiary, Nakheel. The latter is building properties, like, The World, Palm Jumeirah, etc, on the sea. Dubai World, till now, was the mainstay of Dubai’s economy. Dubai does not get much revenue from oil. It depends on financial dealings, trade, tourism, property development, etc. It has built its edifice on debt and now with the credit crunch across the world following global financial meltdown, it is reeling under debt. The property bubble burst at last with prices in Dubai crashing by more than 60 per cent putting an end to rampant speculation. Dubai attracted international attention for its property development and luxury tourism, embodied in seven-star hotels, like the Burj al-Arab.

Till now, it was assumed by international investors (may be, naively) that Abu Dhabi would rescue Dubai with funding. Abu Dhabi is the richest emirate among the seven emirates in the loose federation of the UAE. It funded Dubai to an extent of USD 20 billion in February this year. But, this time, Abu Dhabi is silent. There seem to be some differences between the rulers of Dubai and Abu Dhabi Kingdom.

The crash in property prices in the world following the US sub-prime crisis has its severe impact on Dubai’s property prices. It is reported in the media that Dubai used to command double the rates of Mumbai till 2008. But now, it seems, Dubai property prices are much lesser than Mumbai property prices – with Hiranandani Group in Mumbai claiming that Dubai is attractive for property investment now!

What we have seen following the Dubai fiasco is that we all live in an increasingly globalised world. Any thing that may happen in some remote corner of the world may come and hit us in the face, that too at a wrong time. As such, investors need to be cautious about their investments in this truly globalized world.

What is the impact on Foreign Banks?

British banks, Barclays, HSBC, RBS and Standard Chartered Bank have heavy exposure, to an extent of up to USD 30 billion, to Dubai and these banks may be impacted severely by the problems associated with the debt crisis in Dubai World. Citigroup too seemed to have heavy exposure to Dubai World. And it may face some sort of default risk.

Will there be light at the end of the tunnel?

Kingdoms of Abu Dhabi and Saudi Arabia may come to their rescue, it is hoped. Because, these countries have their own interests in propping up Dubai’s economy. Several Abu Dhabi banks have invested heavily in Dubai. Media reports indicate the Abu Dhabi would come to the aid of Dubai, on a ‘case-by-case basis.’ If they do that, this is an optimistic trigger for Dubai World. After all, Abu Dhabi may not be willing to give a ‘blank cheque’ to Dubai.

What is the impact on Indian Economy?

The global downturn left many financial workers unemployed. The population fell an estimated 17%, meaning there was little demand for new properties.

There was also less demand for luxury holidays. Dubai companies have borrowed money to fund huge building projects such as "The World" and are now unable to repay it.

There are jitters on financial markets about who lent all the money. European banks are estimated to have lent more than £50bn to the whole of the United Arab Emirates.

Dubai state-backed companies may also have to sell-off some of their assets overseas such as luxury property in London and the Turnberry golf course in Scotland.

 A large number of Indian workers, especially from Kerala, work in Dubai. To that extent, the inward remittances from them may come down. Some construction workers are likely to lose their jobs in Dubai. It may have some repercussions on Kerala’s economy, which is substantially dependent on Gulf money. Since the global financial meltdown, many low-paid workers in the Middle East have already lost their jobs. The Dubai debt crisis may further worsen their woes. India’s property markets have deeper links to Dubai and Indian real estate may bear the brunt of Dubai’s financial woes, even though many property developers are denying any such problem. India has got significant exposure to Dubai through exports and imports. Even gems and jewellery industry may be impacted negatively with many Indian firms having links to Dubai’s world-famous bullion markets. A substantial portion of India’s inward NRI remittances come from UAE.

What is the impact on Indian Ports?

DP World is a Dubai-based port operator and it is the world’s fourth largest port operator. It has got a market share of 40 per cent in India’s container traffic. And it operates container terminals in Nhava Sheva, Kochi, Chennai, Mundra and Visakhapatnam ports. It is also setting up terminals in Kulpi and Vallarpadam. The company invested over USD two billion in India and it planned to spend another USD 12 billion in India in the next five years. DP World is a subsidiary of Dubai World, which is caught in the debt trap. DP World operates 45 terminals in 29 countries. Some experts opine that the travails of the parent may not have any significant on DP World’s India operations.

How are Indian Banks affected by the present crisis?

Bank of Baroda:  Bank of Baroda has some real estate exposure to Dubai accounting to around five per cent of its loan book, but its CMD says there won’t be any impact. The bank’s CMD added that the bank also has exposure in Abu Dhabi , Ras-Al-Khaimah and Bahrain . Out of the bank’s total loan book of Rs 150,000 crore, Dubai accounts for Rs 4,000 crore. BOB has six branches in the UAE. Bank’s total exposure to real estate projects in UAE is around Rs 600 crore. The bank claims it does not have any exposure to Nakheel – the real estate arm of Dubai World.

State Bank of India: The bank has an exposure of Rs 1,443 crore or 0.2 per cent of total assets in the UAE, which the bank claims as insignificant.

Even as banks are denying that they will be impacted materially by the present Dubai debt crisis, RBI has directed banks to reveal their exposure to Dubai World.

What is the extent of Indian companies’ exposure in Dubai?

3i Infotech:

The company says it has an office in Dubai, but has no exposure to Dubai World. Its Dubai office oversees operations in other countries. However, if the Dubai crisis spreads to other parts of UAE or Middle East countries, then, it may have some impact on the company.

Aban Offshore: The oil exploration company has deployed six rigs in West Asia

DLF: According to the company, it had not exposure to Dubai real estate.

Emaar MGF: The company denies any impact of Dubai crisis on its India operations. However, it may have some repercussions in its plan to come out with an IPO in India in the next few months. It has already submitted a preliminary draft prospectus with SEBI for its forthcoming IPO.

HDIL:  According the company, it has no exposure to Dubai.

Hiranandani Group: The chairman of the Group said that the unlisted group is constructing a project in Dubai, 97 per cent of which was already sold and 65 per cent payment had been received. He added that Indian property prices should go up because of the Dubai market crash.

Indiabulls Real Estate:  According to the company, it does not have any direct/indirect investment in Dubai and West Asia.

Larsen & Toubro : L&T has around Rs 90-115 crore exposure, in the form of receivables, from its clients in Dubai, mainly in civil construction. Larsen & Toubro’s total exposure to  the Middle-East over the last two years is to the tune of USD 200 million. Overall, the Dubai Crisis may not materially impact L & T’s earnings or profitability.

Nagarjuna Construction Co Ltd:  The company has got one venture in Dubai, a 440-apartment project worth Rs 1,500 crore and it seems to be going slow on it. And the company has got another venture, a water pipeline project in Dubai worth around Rs 100 crore.

Omaxe: The company wanted to invest Rs 2,850 crore in Dubai and now it may exit the real estate projects there. The company already paid Rs 50 crore to Nakheel as first instalment and however it is yet to get possession of the land.

Punj Lloyd: The company claims it has no exposure to Dubai. The company is doing some oil and gas projects in Abu Dhabi where there are no concerns, it claims.

Rolta: Anaysts believe the events in Dubai may have some revenue implications for the company.

Spicejet: Dubai Government-owned Isthimar owns 13 per cent stake in Spicejet.

  

Unitech : According to the company, it had not exposure to Dubai real estate.

Voltas : The company is executing a Rs 900-crore project in Dubai for Emaar and the client has fully funded the project, according to the company. Voltas’ order book primarily comes from Abu Dhabi and Qatar.

Note: Please note the above list of Indian companies is only illustrative, but not exhaustive.

What lessons have we learnt from previous crises?

The world has gone through such sovereign debt crises in the past from several countries. The recent one is Argentina. At the end of 2001, it defaulted on its foreign debt of around USD 80 billion. The country devalued its currency at that time. Argentina, which defaulted on its foreign debt at the end of 2001, bounced back in relatively less number of years. Of course, the fall in the value of Argentine peso, helped revive the country’s export markets and this in turn gave the country’s GDP a big boost. The peso was pegged to the dollar at one-to-one rate for a decade till January 2002, when the peg was removed after the country’s forex reserves dwindled completely. Later, the peso collapsed to an exchange rate of three pesos against the US dollar.

Previously, in August 1998, Russia defaulted on its external payments in dollars. The default was precipated by the collapse of oil to USD 11 a barrel, the lowest in 25 years in 1998. The collapse of central planning system in the then Soviet Union also did not help the economic matters either. Earlier in July 1998, IMF announced a USD 23-billion package for Russia and after receiving first instalment from IMF, Russia declined to honour the conditionalities of IMF. Russian central bank withdrew its support to the ruble and the local currency fell by 38 per cent overnight. Later, IMF also withdrew its Russian package.

The shock waves from Russia reached across the Atlantic and hit Wall Street strongly and led to the collapse of LTCM, Long Term Capital Management, a successful hedge fund floated by three Nobel economic laureates and became well known for its state-of-the-art trading strategies in derivatives based on complex mathematical models using computer-aided algorithms. LTCM, before its dramatic collapse, was managing assets worth USD 125 billion. It had a gross exposure of USD 1.25 trillion in derivatives. As US Fed chairman, Alan Greenspan, had come to rescue the stakeholders in LTCM through a gradual winding of derivatives positions over a prolonged period. LTCM’s collapse led to flight of safety by investors and who lapped up the US treasury securities heavily forcing the US bond yields to go down dramatically. The Fed worked feverishly with the top officials of 16 of the world’s most powerful banks and investments houses and facilitated the gradual liquidation of LTCM’s assets.

The Fed received brickbats from the US Congress for its unusual and unprecedented intervention in the LTCM collapse. This is a classic case in Risk Management or rather the lack of it. Still, bankers do not seem to have learnt any lessons in Risk Management. These kind of recurring debt crises tempt one to conclude that bankers, in general, are poor at judging systemic risks.

The story did not end there. The price of oil and natural gas rebounded in the early 2000s and it was an excellent opportunity for Russia to rise like a Phoenix from the ashes. Its forex reserves touched USD 300 billion by 2007 from a low of USD 10 billion in 1999. The Russian government had paid off its foreign debt substantially.

What is in store for Dubai?

The consensus opinion at this point of time is that the present sandstorm in Dubai may not be a serious threat to the world’s financial system. After all, when they could absorb thousands of billions of dollars, why not a mere USD 60 billion, some argue. But the global financial markets are more worried that other countries, like, Ireland, Greece, which are heavily indebted may suffer terrible consequences. Such kind of repercussions is the real worry for the markets.

It is, however, feared by some that Dubai government could go bankrupt if it does not receive support. Everyone in the markets thought that, in the end, the federal government in Abu Dhabi would stand by all of Dubai's bad bets. But Abu Dhabi is watching the events closely and carefully. It's also worth noting that Abu Dhabi itself owns a large chunk of Dubai World bonds. Latest media reports suggest that Abu Dhabi Government will come to the rescue of Dubai on a “case-by-case basis.” This may assuage the raw nerves of financial markets to some extent.

However, Mark Mobius, Franklin Templeton, cautions that stock markets may lose up to 20 per cent due to the rise in risk aversion following the Dubai crisis.

What is rattling the markets, however, is the lack of information from Dubai Government about its future course of action except some rhetoric from the rulers. Rescheduling debt itself may not tantamount to debt default, per se. Russia defaulted in 1998 which led to the collapse of LTCM and the US Fed led by Alan Greenspan had to rescue other US banks in a bailout that is structured innovatively. Even Argentina, which defaulted on its foreign debt at the end of 2001, bounced back in relatively less time aided by a hugely devalued local currency as described above.  

As we have learnt from the Russian and Argentine crises, such extreme debt crisis situations present an opportunity for the policy makers to fix their economies and bounce back in style. It remains to be seen whether Dubai will take this an opportunity to correct its past excesses. In fact, at some point of time, Abu Dhabi may help Dubai in a substantial way. There lies the optimism for Dubai in future.

References:

1. “The Age of Turbulence: Adventures in a New World” by Alan Greenspan

2. “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein

More on the collapse of LTCM, a classic case of total failure in Risk Management…

Sourced from Amazon.com:

On September 23, 1998, the boardroom of the New York Fed was a tense place. Around the table sat the heads of every major Wall Street bank, the chairman of the New York Stock Exchange, and representatives from numerous European banks, each of whom had been summoned to discuss a highly unusual prospect: rescuing what had, until then, been the envy of them all, the extraordinarily successful bond-trading firm of Long-Term Capital Management. Roger Lowenstein's When Genius Failed is the gripping story of the Fed's unprecedented move, the incredible heights reached by LTCM, and the firm's eventual dramatic demise.

Lowenstein, a financial journalist and author of Buffett: The Making of an American Capitalist, examines the personalities, academic experts, and professional relationships at LTCM and uncovers the layers of numbers behind its roller-coaster ride with the precision of a skilled surgeon. The fund's enigmatic founder, John Meriwether, spent almost 20 years at Salomon Brothers, where he formed its renowned Arbitrage Group by hiring academia's top financial economists. Though Meriwether left Salomon under a cloud of the SEC's wrath, he leapt into his next venture with ease and enticed most of his former Salomon hires--and eventually even David Mullins, the former vice chairman of the U.S. Federal Reserve--to join him in starting a hedge fund that would beat all hedge funds.

LTCM began trading in 1994, after completing a road show that, despite the Ph.D.-touting partners' lack of social skills and their disdainful condescension of potential investors who couldn't rise to their intellectual level, netted a whopping $1.25 billion. The fund would seek to earn a tiny spread on thousands of trades, "as if it were vacuuming nickels that others couldn't see," in the words of one of its Nobel laureate partners, Myron Scholes. And nickels it found. In its first two years, LTCM earned $1.6 billion, profits that exceeded 40 percent even after the partners' hefty cuts. By the spring of 1996, it was holding $140 billion in assets. But the end was soon in sight, and Lowenstein's detailed account of each successively worse month of 1998, culminating in a disastrous August and the partners' subsequent panicked moves, is riveting.

The arbitrageur's world is a complicated one, and it might have served Lowenstein well to slow down and explain in greater detail the complex terms of the more exotic species of investment flora that cram the book's pages. However, much of the intrigue of the Long-Term story lies in its dizzying pace (not to mention the dizzying amounts of money won and lost in the fund's short lifespan). Lowenstein's smooth, conversational but equally urgent tone carries it along well. The book is a compelling read for those who've always wondered what lay behind the Fed's controversial involvement with the LTCM hedge-fund debacle.

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