Dubai debt scare shows fragility of global rally
I could never quite shake off the impression that it was all an illusion, that all those glittering skyscrapers, eight-lane highways and artificial islands were being generated by a huge virtual reality machine,' recalls one long-time resident of Dubai who moved to Hong Kong last year.
'I couldn't help feeling that one day someone would flick a switch and the whole city would shimmer briefly and then disappear, leaving me standing alone on a bare sand dune, surrounded by nothing but the empty desert.'
Last week that switch got flicked. And it wasn't just the shining towers of Dubai that suddenly looked insubstantial, but the foundations of the whole rally in global asset markets.
On Wednesday, government-owned holding company Dubai World asked creditors to accept a six-month hiatus on payments while it restructures its US$59 billion debt mountain.
In Hong Kong, Dubai World is perhaps best known through its DP World subsidiary, which operates two berths and a logistics centre in the Kwai Chung container port.
But globally, Dubai World is known mainly for its Nakheel property arm with its bizarrely shaped artificial islands and grandiose plans to build a 1,400-metre tall skyscraper.
For years, enthusiasts dismissed fears over Dubai's financial follies, arguing that the indebted statelet would always be bailed out by oil-rich Abu Dhabi next door.
Last week's announcement called those certainties into question. Suddenly, financiers woke up to the realisation that lending vast sums of money to a city with no natural resources and an indigenous population of just 100,000 to fund the construction of thousands of towering offices, apartment blocks and shopping malls may not be the most sensible investment strategy. Instantly, the price of Nakheel bonds maturing next month plunged and the cost of credit derivatives insuring against a default by the Dubai government rocketed as investors decided the emirate's sovereign debt is an even riskier proposition than bankrupt Iceland's (see the first chart below).
Investors also rushed to mark down the share price of banks with exposure to borrowers in Dubai. In Hong Kong, HSBC Holdings shares ended the week down 9.3 per cent from their level immediately before Wednesday's announcement. Standard Chartered, with about 6 per cent of its loan book in Dubai, slumped 13.1 per cent (see the second chart below).
But the wider impact of Dubai World's announcement was even more alarming, as news of the debt standstill triggered a wholesale flight out of risk assets towards safe-haven investments.
In Asia, stock markets fell across the board. Regional currencies also retreated as unnerved investors sought safety in the US dollar. Commodity prices slumped too, with gold ending the week 2.5 per cent down from the record high set just a few days earlier.
The way assets that should otherwise have little in common reacted in unison to the scare emphasises the extent to which the recent recovery in global markets has been driven primarily by a wave of carry-trade liquidity rather than by solid fundamentals.
And as Friday's flight demonstrated, carry-trade liquidity can evaporate in an instant in response to external shocks, leading to abrupt falls in the price of risk assets.
Happily, it is likely Dubai World will turn out only to be a warning, rather than the trigger for a sustained correction in global markets.
For all its pretensions to the financial first division, Dubai's crisis is on a relatively small scale. International bank exposure to the city is limited, and fully discounted following last week's sell-off.
And it remains likely that Abu Dhabi will contribute to a bail-out of its brother emirate, albeit reluctantly.
But the shiver that ran through global markets last week serves as an important reminder that the recovery in global asset prices remains a fragile thing and that a sudden shock could easily trigger a major reversal, just as if someone had flicked a switch.