There is much about Dubai that is artificial and based on illusion: the man-made islands designed to represent a map of the globe; the indoor ski slope in the midst of desert; the incredible hotel with glass walls looking onto a sea aquarium mimicking the surrounding ocean. And recently Dubai had also become synonymous with excess: building the tallest tower in the world and the biggest and most expensive luxury hotels, residences, shopping malls and office complexes; providing the market and the sales venue for the most outlandish and flamboyant luxury goods; redefining grandiose expressions of opulence for the world as a whole.

Its very brashness was a sign of, and a cause for, its success. Even the opacity that has characterised its political system became a source of economic magnetism. Expatriates flocked to its dynamic construction and tourism industries and relished the tax-free incentives. And Dubai emerged as one of the developing world's new global financial centres.

In the early phases of the global financial crisis, all this even seemed to be an advantage, as investment activity and construction continued at feverish pace. For example, plans for constructing the world's most newest tallest building (near its closest competitor Burj Dubai) were unveiled just after Lehman Brother collapsed in the US. Continued growth in Dubai was heralded as another sign of Asian economic "de-linking" from the problems in the core of international capitalism. But now it turns out that this too, like so much else in Dubai, was based on illusion. The sudden declaration that the state-owned conglomerate Dubai World, which typified the apparently insatiable appetite for accumulation in the small Gulf Emirate, would unilaterally suspend its debt payments for at least six months came as a sign that the improbable honeymoon is finally over.

Global stock markets—and especially emerging markets in Asia—went into shock at this announcement, raising fears of a replay of the aftermath of the Lehman Brothers collapse a little more than a year ago. So far that has not happened, but this is clear evidence of continuing financial fragility across the world, and a reminder that (despite all attempts by policy makers to talk up the markets) the financial crisis is really far from over.

What is the story behind the rapid economic rise and fall of Dubai? Dubai is one of seven small states that make up the United Arab Emirates (UAE), and it is second to Abu Dhabi (which is the richest and has most of the oil reserves) in terms of the size of its economy.

Although the economy of Dubai, like those of its neighbours, was originally built on oil, currently oil revenues account for less than 6 per cent of its total revenues. In any case, Dubai's oil reserves have diminished significantly and are expected to run out within the next twenty years.

                                                    Chart 1

                   

Dubai's strategy has been to diversify its economy away from exposure to oil, and shift to trade, tourism and finance as engines of growth. It did that by encouraging its state-run conglomerate Dubai World to buy up companies around the world and inviting multinationals to use Dubai as the Middle Eastern base for their activities in Asia and elsewhere. A subsidiary of Dubai World (DP World) purchased the British ports operator P&O in 2005, thereby becoming the fourth largest ports operator in the world. It also bought the department store group Barneys New York in 2007, and has since invested heavily in construction projects in Las Vegas in the United States.

Dubai World also includes the property developer Nakheel, which is behind some of the most ostentatious commercial projects ever built on this planet. These include the Palm Jumeirah, a man-made island stretching into the ocean which is to serve as the base for luxury hotels and villas and the World Islands, a series of islands shaped to represent a map of the earth.

During the recent boom, it seemed that this heady and hedonistic expansion would never end. And it was hugely based on global integration, not only in terms of trade and financial flows, but also the movement of people. Of Dubai's resident population, more than 80 per cent are expatriates, including around 1.5 million from India. Indian tourists—from the Bollywood crowd to newly affluent middle classes—have also contributed to Dubai's boom.

Is there a relation, as some have argued, between height and hubris? In any case it is clear that Dubai is an apt symbol of the recent over-extension of capitalism, and the over-accumulation that typically characterises unfettered market behaviour in any period of boom.

The global crisis, which began with the decline in real estate values in the US, inevitably had its effect, as the global markets for luxury goods and services and for real estate both shrank simultaneously. But Dubai's fall began with the exodus of capital, as investors anticipated that emerging markets would be impacted by the recession, and because they needed the money to cover their losses in the US market. Thereafter, the collapse of non-tradable sectors, especially real estate and construction was swift. Property prices in Dubai have fallen by more than 50 per cent in the past year. Many construction projects have been held up or even abandoned, first because of lack of easy finance and then fears about future prospects.

                                                         Chart 2

                 

The economy slumped from the second half of 2008. Chart 1 indicates the extent of the likely decline in GDP growth. At the start of the financial crisis, GDP growth expectations in 2009 for Dubai were four per cent, but this was lowered to two per cent in the middle of the year. The current account balance (Chart 2) also entered sharply negative territory.

Even so, there was official denial of the downturn, with government spokesman claiming that the Dubai Strategic Plan, which projects economic growth at an average 11 per cent annually through 2015, would be fulfilled. Early in November 2009, the ruler of Dubai, Sheikh Mohammed bin Rashid al-Maktoum, who is also prime minister of the United Arab Emirates, broke into English in a press conference to declare "I want to tell those people who nag about Dubai and Abu Dhabi to shut up". He also announced that he was proud of Dubai World and its "long-term commercial success", feeling that the worst was now over for its financial problems.

This was clearly not so. On November 26, barely two weeks after his brave statement, Dubai World announced that it was seeking a debt standstill for $15 billion of repayments on its $59 billion of external debt until May 2010, and had hired Deloitte to help it restructure to move into financial viability. This surprise announcement, coming on the eve of the Bakri-Eid holiday, reverberated across global markets.

Currently there are concerns about counterparty risk for the European and Asian banks that lent to Dubai World. As we have found over the past year, getting accurate numbers from any financial player about the true extent of liabilities is next to impossible. The official estimate of the UAE's sovereign debt is $80 billion, but some analysts say it is much more and could be even twice that amount. European banks are heavily involved: according to the Wall Street Journal (using data from the Bank for International Settlements) European banks alone have almost $84 billion in exposure. UK banks (including HSBC, Standard Chartered, Barclays and Royal Bank of Scotland's ABN Amro) have by far the largest exposure at $49.5 billion, while French and German banks are also implicated.

Among the Indian banks, Bank of Baroda has an exposure of about Rs. 5,000 crore in Dubai, which accounts for half of its loans in the UAE. Several Indian companies (Nagarjuna Constructions, Larsen & Toubro, Punj Lloyd, Voltas, Omaxe, Aban Offshore, Spicejet and Indiabulls Real Estate) have investment and business exposure in Dubai, but they have generally rushed to declare their exposure to be marginal. But the most direct impact in India is through workers. Most of the 1.5 million Indians in Dubai are blue collar workers in construction or low-grade services, who typically have temporary contracts and have to live in rooms housing six to ten other workers. In a country with no unions, it is easy for companies to lay off workers. For that reason alone, it is hard to estimate the extent of job loss after the crisis, but it is estimated that tens of thousands of workers in the construction and real estate market alone have lost their jobs over the last few months.

Some idea of market scepticism about Dubai's immediate prospects is to be found in the movement of the credit-default swaps (CDS), which are tradable, over-the-counter derivatives that function like a default insurance contract: if a borrower defaults, the protection buyer is paid compensation by the protection seller. The five-year CDS for DP World increased more than four times in two days, to hit 810 basis points on 27 November. This puts the Emirate in the same league as Iceland.

Dubai is relatively fortunate, however, in that investors still believe that it will ultimately be bailed out by its "elder brother" Abu Dhabi, which already granted Dubai a $10 billion loan in February 2009. Some analysts have argued that it is not a question of whether but when Abu Dhabi will step in. After all, Abu Dhabi's sovereign wealth funds have reserves estimated at over $700 billion, so bailing out Dubai World will not be that difficult. It is also in its own interest, not only because the costs of insuring Abu Dhabi's sovereign debt has shot up in the past week, but because it cannot afford very damaged financial credibility in the region.

But even if Dubai manages to survive the current crisis, broader questions remain. Dubai is not unique in being tripped up by its earlier irrational exuberance especially in housing and real estate. The rotten fruits of the earlier phase of over-accumulation are still waiting to be collected, and as a result there are plenty of potential banana skins waiting to trip up investors in financial markets across the world. Real estate in the US continues to fall, especially in luxury markets such as Florida, and default and dispossession continue to increase. Elsewhere too, the multiplier effects of the collapse of the construction and real estate sectors are still working their way through the economy. The latest fear of sovereign default is from Greece, as the CDS spread for Greek bonds has swung from 5 to 200 basis points in a few weeks. Ireland is also in trouble.

So financial markets may have good reasons for reacting the way they have. The collapse of the Dubai dream is not a sui generis event without any implications for wider markets. Rather, it may be a straw in the wind indicating that the travails of finance capitalism in the current period are far from over.

December 3, 2009.