The reaction to Dubai’s announcement for
a debt “standstill” was most profoundly seen in European
financial stocks on 26 November 2009. European bank stocks slumped 4.9%
that day, outpacing a 3.3% decline on the broader DJ Stoxx 600 index
(returns in EUR terms). A rout in Asian markets followed the next day,
as the MSCI Asia ex-Japan lost 3.6% (in USD terms).
We briefly discuss some of the implications.
Local (Dubai) banking crisis
likely to be averted
Banks with local presence in Dubai have the
most direct exposure to the troubled loans. However, Middle Eastern
banks with operations in Dubai have already been promised funding from
the United Arab Emirates central bank, as a measure to prevent a
systemic failure of the Middle Eastern banking system. This should go
some way to boosting bank capital in the event of write-downs related
to the loans, but more importantly, will serve as a confidence boost
for investors and depositors, preventing a swift flight of capital out
of the UAE.
on European banks
As evidenced from the sharp fall in the European financial stocks last
Thursday, European banks are also another key party disadvantaged by
the announced postponement of debt payments. According to data from the
Bank for International Settlements, UK banks own approximately US$50
billion of the United Arab Emirates’ US$123 billion foreign debt.
This is no surprise, given that banks like Standard Chartered and HSBC
have long-dated lending relations with the Middle East.
There has not yet been any announcement
confirming individual banks’ exposure to the Dubai World loans,
but Dubai’s debt has been recently estimated at US$80 billion.
According to the Financial Times, an assumption of a 50 per cent loss
would cause European bank loan loss provisions to increase a paltry 5
per cent in 2010, a far cry from the US$1.7 trillion written-down by
European and US banks in the recent economic downturn. We do not rule
out any individual bank requiring additional capital due to
overexposure to Dubai World debt, but such recapitalisation would not
be on a significantly large enough scale to pose systemic risk to the
Increased risk aversion
As a result of Dubai World’s debt
“standstill”, a higher risk premium may be demanded from
emerging markets, which are traditionally seen as more risky regions to
invest in. The MSCI Asia ex-Japan responded with a 3.6% fall last
Friday, while Emerging Market equities lost 3.8% over two days (returns
in USD terms). Investors also fled into the safety of US Treasuries,
driving up the US dollar.
More clarity to come, Abu
Dhabi still an option
We do not expect this risk aversion to remain,
given that Dubai’s economy is relatively insignificant on a
global scale. The market’s adverse reaction stems from the
shocking nature of the debt standstill: Dubai World implicitly has the
backing of its rich Abu Dhabi neighbour, and problems with debt
repayments would be far from anyone’s mind. Also, there is
substantial uncertainty associated with the debt standstill; Dubai has
not yet defaulted, but has asked creditors for an
“extension” until May 2010 for debt repayment.
While things appear hazy at present, we believe
that more clarity will be shed over the next few days, if not weeks, on
how the debt restructuring will take place. Such information will
undoubtedly quell the uncertainty in the financial markets. Also, it is
in the best interest of the neighbouring oil-rich (and cash-rich) Abu
Dhabi government to assist Dubai in the repayment of its debt, given
the contagion impact of a lack in confidence in the Middle Eastern
region. Prior to the debt standstill announcement, Dubai raised US$5
billion from two Abu Dhabi controlled banks, indicating that
Dubai’s rich neighbour may still step in to provide assistance
should Dubai be unable to refinance debt on its own.
A welcome correction
The Dubai debt crisis has resulted in a
long-awaited correction in global stock markets, which have been on an
uptrend since March. With all available information at this juncture,
we do not expect the problem to threaten the global economic recovery,
and would expect the problem to blow over as soon as more clarity
emerges on restructuring details. With the global economic recovery
still on track, we think there is substantial potential left in equity
markets and encourage investors to see the Dubai incident as an
opportunity, rather than a crisis.