Dubai No Longer Flying High

It is hard to imagine a topic more esoteric than a Persian Gulf property developer seeking a freeze on its debt payments. And yet newspapers are aflutter with special crisis sections, world markets are trembling, and analysts are opining on inter-emirate relations in the UAE. Why do we care?

The financial teetering of Dubai World looks like the next big chapter in the global financial crisis. It bears striking resemblance to some of the earlier chapters: Easy credit financed outlandish property investments (including, in this case, a ski resort in the desert). When property markets declined, it proved difficult to make payments. We discover that banks and other important financial institutions are owed tens of billions of dollars. These important institutions then turn their doleful eyes to a rich government and plead, "Help."

But here the new chapter takes an interesting turn. The governments who might plausibly help are those of Dubai and its fellow emirate Abu Dhabi. A major reason investors were willing to fund the corporate fantasies of Dubai World was its apparent backing by the well-endowed local governments. What could go wrong with a $60 billion loan to Dubai World, when nearby Abu Dhabi has a $900 billion sovereign wealth fund?

Unlike Dubai and Abu Dhabi, the U.S. government ultimately picked up the tab.

There were not explicit promises of government backing, but who has time for fine print or disclaimers? Those caveats, particularly opaque in this case, read:

The government was "not legally obliged" to meet the obligations of related entities--what is commonly referred to as Dubai Inc--but might at its sole discretion decide to extend such support.

Almost a week after the company announced it could not make its payments on time, there was helpful clarification from Dubai:

The heavily indebted Dubai World is not guaranteed by the emirate's government, a top financial official from the city state said Monday . . .

Abu Dhabi said it might step in with a little assistance on a "case-by-case" basis.

This stiff-arm from the governments is the novelty. It is not unprecedented; the United States tried it with Lehman Brothers back in September 2008. Even then, the rationale was that the U.S. government did not have the tools to take a gentler approach. The disastrous aftermath of Lehman Brothers' failure was interpreted to mean that big, financially-interconnected institutions could not be left to the mercy of the markets. To address problems of moral hazard, Western governments decided they would just need to supervise big financial firms sufficiently closely that they would stay out of trouble. The Financial Stability Board, an entity promoted to deal with the crisis, just today put forward a list of thirty global banks and insurers who could pose a systemic risk. Not a single property developer made the cut.

Military planners are sometimes criticized for planning to fight the last war, not the next one. In the case of the financial planners, it is not even clear which war they are addressing. While U.S. banks have certainly received billions in bailout funds, the really big money went to government-sponsored enterprises such as Fannie Mae and Freddie Mac. As with Dubai World, they racked up substantial liabilities through unwise property investments. As with Dubai World, they were able to gain easy and cheap access to credit because it was widely assumed that the government stood behind them. As with Dubai World, that backing was not explicit. Unlike Dubai and Abu Dhabi, the U.S. government ultimately picked up the tab.

Thus, a major lesson of the financial crisis is the danger of having institutions that are too big to fail. Implicit government guarantees encourage foolish lending on the part of investors. And yet, as my colleague Peter Wallison has written, current legislation on financial reform moving through Congress would establish "too big to fail" as national policy.

That is what makes the case of Dubai World so interesting. If the governments of Dubai and Abu Dhabi keep their wallets closed, it will be a rare test of the proposition that big, financially interconnected institutions must be bailed out. As with the other chapters of this financial crisis, it may have its scary parts, but it could also deliver a new moral to the story.

Philip I. Levy is a resident scholar at AEI.

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