Saturday, April 3, 2010

Dubai's debt woes expose flaws in governance model

© Bloomberg via Getty Images
Dubai's Burj Khalifa is the world's tallest building at over 800 metres and was officially opened by Shaikh Muhammad bin Rashid Al Maktum on 4 January 2010

The debt problems of Dubai World, an investment company owned by the Emirate of Dubai, have cast a pall over economic activity in the United Arab Emirates (UAE) and the Gulf. They have raised questions about relationships between the seven Emirates that constitute the UAE, as well as about Dubai’s ambitious economic model and the unclear boundaries between the public finances and those of the ruling Al Maktum family. As negotiations continue on restructuring $26 billion of debt, it is clear that greater transparency in governance may be needed in the Gulf to restore business confidence over the longer term.

The confused situation surrounding Dubai World has highlighted the stresses involved in integrating regional political, regulatory and commercial practices with a global investment marketplace that places an increasing premium on disclosure and compliance. The extent of such tensions in the future may depend on how well the fall-out from Dubai World and difficulties in the Gulf property market can be contained.

Payments halt

Dubai World’s near-default was one of the aftershocks of the global economic downturn. It resulted from the collapse in real-estate prices, first in the US, triggering the 2008 financial crisis, and later in Dubai where prices had previously been spiralling. The company became unable to service the debts it had taken on to finance its heavy investment in property. On 25 November 2009 it requested a freeze on payments on $26bn of loans and bonds, and said it would seek to restructure the debts. Amid turmoil in local financial markets, a $10bn bailout loan from Abu Dhabi enabled Dubai World to meet Islamic bond (sukuk) obligations worth $4.1bn for its property-development subsidiary Nakheel that fell due on 14 December. Negotiations with about 100 creditors have since been under way, with a de facto payments standstill in place. According to media reports on 17 March, creditor banks are to be offered full repayment over seven years but at adjusted interest rates that would force banks to take losses in 2010. It is not yet clear whether this arrangement would be backed by a Dubai Emirate guarantee. The next key date is in May when another $980m Nakheel bond becomes due – a debt not guaranteed by its Dubai World parent. Some $12–13bn of Dubai’s debts fall due in 2010, and $25bn in 2011.

Dubai World’s total liabilities are believed to be as much as $59bn and, according to Moody's Investors Service, it owes $15bn to banks in the UAE. Its assets are shrinking, as its overseas investment arm al-Istithmar has been losing prime New York properties to creditors following defaults in payments, including the former Knickerbocker Hotel building in Times Square. Meanwhile, the cost of insuring Dubai’s debt through credit default swaps has risen sharply, and prices of sukuk issued by Dubai have fallen. The total debts of all Dubai-related entities may exceed $100bn, more than Dubai’s GDP, but the precise figure is not known. Question marks hang over other conglomerates owned by the Emirate and its ruler, Shaikh Muhammad bin Rashid Al Maktum. These include the Investment Corporation of Dubai, owner of Emirates airline (with $28.3bn in bonds and outstanding loans), and Dubai Holding (with total debts of $15bn).

Dubai World’s problems have raised a question mark over the Emirate’s model for economic development, with its emphasis on grandiose property schemes. Lacking oil and gas, Dubai has since the 1950s based its prosperity on all forms of private enterprise and its role as a laissez-faire city state serving the private-sector interests of its neighbours and the area. Its ambition is to become an international, not just a regional, hub – a goal it has supported by its impressive infrastructure. It has been run as a corporation, with the Emirate’s interests intermingling with those of the Al Maktum family so that the two have become hard to distinguish and disentangle. This mixing of corporatism and personal fiefdom into an unusual form of capitalism inhibits a more transparent approach and complicates debt restructuring.

Abu Dhabi’s role

The crisis has thrown a spotlight on the uneasy relationship between Dubai and Abu Dhabi, which supplies most of the UAE Federation’s income. Abu Dhabi is the capital of the UAE and its ruler is the Federation’s president. Following Dubai World's November announcement, the responses of both Dubai and Abu Dhabi were initially hesitant, confused and opaque. Abu Dhabi, which may not have been aware of the scale of the impending debt crisis, took more than two weeks to step in and questions remain about the conditions upon which its support rests.

Outsiders find it hard to judge the personal and institutional dynamics in relations between the two Emirates and so were shocked by Abu Dhabi’s slow and grudging response. While each Emirate projects a different image and adopts divergent policies (especially towards Iran), the trend since full independence from Britain in 1971 has been towards federalisation and increased centralisation in Abu Dhabi. Against this background, most commentators assume that Abu Dhabi's December rescue will cost Dubai more than renaming the new and tallest tower ‘Burj Khalifa’ after Abu Dhabi’s ruler, Shaikh Khalifa bin Zayid Al Nahayan. The delay may have reflected a determination to drive a harder bargain, and to exert greater political and commercial leverage over Dubai in future. It is clear that Abu Dhabi does not intend to back all Dubai's past commitments and, despite the potential damage to the UAE's overall reputation, may be ready to see some Dubai government-related entities and large corporations go down if they are not commercially or financially viable.

In the future, investors and lenders will differentiate more clearly and carefully between individual Emirates and between government and corporate entities, and will tend to evaluate the latter on a stand-alone basis. They had believed that Dubai stood four-square behind Dubai World and that Abu Dhabi stood behind Dubai – assumptions that government-related entities and Dubai itself had exploited in the past. Contractors and investors are now likely to insist on explicit government guarantees.

One consequence has been that Abu Dhabi-linked entities, including the investment agency Mubadala Development Company and International Petroleum Investment Company, are being downgraded by international credit-rating agencies because of the lack of explicit guarantees of Emirate support under all circumstances. This increases their borrowing costs. However, in response to heightened international scrutiny, Abu Dhabi has established a debt-management office, recognising the need to be more professional and improve performance,asrecommended by the International Monetary Fund (IMF) in February.

Ruling families

A further consequence of Dubai World’s problems may be to accelerate the long drawn-out process of disentangling the personal interests of Gulf ruling families from those of the states they oversee. This traditional interweaving has included relationships between individual Gulf governments and enterprises with close but unformalised links to senior family members. The delineation between public and privy purses has been uncertain. Establishing clearer boundaries will be not only an economic but a highly political process.

In several countries, senior members of ruling families have occupied prominent positions in commerce. Both local and international investors have naturally presumed that their activities enjoyed government backing, but such support was never articulated. In some instances the relationship between a commercial or financial enterprise and the ruler or his close relatives might never be formally or publicly acknowledged, with both sides benefitting from the privacy of these arrangements, and outsiders were content to assume government support. The easy availability of oil revenues in most Gulf countries compounded the problem of an opaque boundary between government and family funds.

However, economic, fiscal and political pressures, as well as changing attitudes, are all encouraging greater transparency and scrutiny. For example, the IMF has suggested restructuring both the Investment Corporation of Dubai and Dubai Holding, Shaikh Muhammad’s personal investment vehicle, which has been downgraded by several credit-rating agencies because of a lack of transparency. The economic downturn and tighter international scrutiny and compliance will cause locals and outside investors to inspect Gulf government income, spending, and financial and business practices more carefully. Dubai World’s problems have illustrated the consequences for government- or ruling-family-related entities, which have traditionally been privately managed, of going to the international bond market. They may therefore prove an important step along the road to greater openness and accountability. The episode has shown how traditional ambiguities that appear acceptable, and even a potential source of strength, in good economic times can become sources of vulnerability and reputational damage when the tide turns.

Investment climate

Finally, the crisis has raised urgent questions about Gulf financial markets and regulation, and, in particular, about sukukas viable traded securities. Islamic bonds are structured to pay investors a return without violating Islam’s bar on interest payments. Local doubts about sukuk, based on the lack of any generally recognised Islamic authority to evaluate and standardise Islamic banking products, were compounded by a challenge to their compliance with Sharia law by Bahrain-based scholars in 2008. Because of the immaturity of the market, there is no established mechanism for resolving defaults, and the option available to partiesto English law for disputes to be heard in local courts must be open to doubt. Anxiety over the availability of legal recourse is preventing a secondary market in Dubai’s debt from developing.

Whether or not Dubai World’s problems trigger a broader quasi-sovereign debt crisis in the region, the economic downturn and credit squeeze will increase pressure in the years ahead for greater transparency in the Gulf. This will come not only from foreign investors, but also from local business people and financiers who are conscious of international trends and eager to adapt local dispensations to the global climate. Forms of governance prevalent in the Gulf since the 1970s, which have developed fitfully and unevenly since, no longer seem well matched for the economic development activities, plans and ambitions of regional states. It is questionable whether the region can achieve its development goals without greater integration and rationalisation of its infrastructure, as well as of the roles championed by each individual Gulf state. These states may need to refashion their governance models and approach to each other if they and the region as a whole are to achieve their full potential.

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