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November 30, 2009

Dubai's debt problems: No systemic risk seen
We briefly discuss some of the implications of Dubai's debt problems.

by iFAST Research Team

Untitled Document

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.

Largest impact 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 financial system.

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.


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