If the world economy has you feeling queasy, there’s good reason. We’re still in the heaving seas typical of the zone between recession and recovery, hoping that the next wave will be the last, and that it won’t swamp us. Dubai World’s announcement last week of suspended payments on $60 billion of debt is a huge wave we are still navigating, and the jury is still out on its lasting effects.
In general, financial market turbulence should come as no surprise. At this stage of the economic cycle, the unemployment rate is rising. Higher joblessness is pushing up defaults on what were good credits just weeks ago, increasing the strain on financial institutions. US bank failures surged in the second half of 2009, with the count now 124, and rising. Mid-level European financial institutions are also under duress, and Japan’s banks are showing signs of strain. This is normal, and will continue in the weeks following the first-quarter, 2010 peak of unemployment rates in developed economies.
Adding to financial market strain are commercial real estate markets. They also lag behind the economic cycle, given lengthy project lead-times. Vacancy rates in most major Western markets are high and rising, rents are falling, and new floorspace is adding to pressure on owners of commercial properties and the banks that stand behind them. But again, this is usual at this point in the cycle.
In this context, Dubai World’s troubles make sense. Its assets are concentrated in both residential and non-residential properties, and in international trade infrastructure, both at home and abroad. These sectors are highly vulnerable to cyclical swings, especially in the current exaggerated cycle. As such, Dubai’s financial difficulties were broadly known well ahead of last week’s announcement.
If these recent events make so much sense, then why all the worry? First, large Western financial institutions were brought close to the brink early in the recession, with the Lehman collapse and the ensuing freeze-up of liquidity. As such, the capacity to handle late-cycle credit deterioration was greatly eroded. Recent analysis shows that, in spite of stress-testing exercises, sizable Western institutions, many with exposure to Dubai, have capitalization concerns and are vulnerable to shocks.
Second, the response of Dubai world was not anticipated. The UAEs sovereign wealth fund is by far the largest as a share of GDP on the planet. It was assumed that this financial heft would be utilized to shield the Emirate’s sizable debts from suspension or default. Not so – and in addition, key leaders in Dubai World’s various companies were removed from their positions, putting dissatisfaction with management on full display. As such, Dubai 5-year CDS spreads shot up 200 basis points, there was a sharp flight to quality bonds and the USD, and bank stocks came under downward pressure.
The action has broader implications. If Dubai, with its supposed financial backing, could suspend debt payments, then what about other nations whose risk ratings were inferior to Dubai’s? In the wake of the announcement, increased scrutiny of more risky sovereigns was palpable – suggesting that a broad reassessment of risk is possible as the global economic recovery is again in question.
The bottom line? Dubai’s circumstances were well known, but its actions were a shocker. They have rekindled regional and global uncertainty, and until resolved, will likely increase short-term reticence.