The End of Dubai Inc?

Press accounts in recent weeks are raising concern that Dubai might be in serious financial straits. Zawya Dow Jones reported on Tuesday that the government has hired financial advisers to help restructure its economy as it struggles to meet payments on its large debt. Wednesday, the Financial Times reported that Dubai was in talks with Abu Dhabi to arrange for a loan facility that would make state funds available to Dubai firms as international credit markets continue to dry up. Dubai officials later denied the allegations in a report on Al-Arabiya. Still, speculation about Dubai's financial health is rampant. According to local rumors, Dubai might offer Abu Dhabi strategic stakes in some of its largest firms, including Emirates Airlines, Nakheel, and Dubai Proprieties. Rumors have become so persistent that Dubai World CEO Sultan Ahmad bin Sulayem on Tuesday angrily denied that the company was in any kind of financial trouble. He said that the company was studying options for offering stakes in Dubai World for public subscriptions but that the company had not entered into negotiations for selling stakes or received any offers.

It's hard to appreciate how serious the issue of Dubai's indebtedness may become for the emirate. Estimates vary on how much debt they actually hold. Fitch estimates that Dubai's debt level is close to $70 billion, which as the FT notes, puts their debt to GDP level at more than 100 percent. But, in a separate report quoted by Zawya Dow Jones, Standard and Poors estimates that its debt to GDP level is closer to 42 percent. What is not at issue, however, is the seriousness of Dubai's failing economic health. Dubai's once thriving real estate market, which accounts for 30 percent of local GDP, is slowing rapidly. HSBC Global Research found that real estate prices in the secondary market fell in October by four percent in Dubai, with much more substantial price erosions in certain developments. For example, prices at the Pal on Palm Jumeriah fell by 32 percent; and at DIFC (last week rebranded as NASDAQ Dubai in order to attract more business to the fledgling exchange), prices fell by 30 percent. These are the first price declines the emirate has seen in six years. The decline in the real estate sector, along with Dubai's ability to finance its ever growing debt on equitable terms, has caused Citibank to name Dubai as the most vulnerable to an economic downturn in the Persian Gulf in a report released early last week.

Many of the problems confronting Dubai have been long standing. Analysts for years have been concerned about over-building in the emirate itself and a far too aggressive mergers and acquisitions strategy overseas. Rulers of Dubai have always shrugged off these concerns building a modern metropolis out of the dessert to great success. Analysts questioned the viability of Jebel Ali and Port Rashid when MBR's father, Rashid bin Saeed, began building the twin ports in the late 1970s. They continued to question the construction boom from the mid 1990s on. And while many of these doubts appear to have been unjustified as Dubai proved time and time again that it could best the capacity argument, what it could not outrun was the issue of growing too large too fast. What many of the state-owned firms are wrestling with now (even more than the downturn in their home market) is the souring of their investments overseas because of the global downturn and the tight credit market internationally. Like any corporation that undertakes a massive expansion over a short period of time, Dubai entities had to borrow to make it work. And when the market goes down and demand dries up, so goes the rationale behind making those investments. Over expansion has cost many an industry.

What makes Dubai different is that (to borrow a phrase from the US crisis), it is too big to fail. Duabi is not just the crown jewel of the UAE but also for the rest of the Persian Gulf. The belief that business transactions could happen smoothly and profitably was realized in Dubai first. Foreign ownership of property was brought to Dubai first. World class transportation hubs and a hint of western ethos making businessmen comfortable all began in Dubai. If Dubai fails, so does the rest of the region. That is not to say that other Gulf countries will move to bail the emirate out (Abu Dhabi has enough surplus capital for that) but they all have a stake in continuing the dream, even if it is more tarnished than it once was.

How Low Can you Go?

Yesterday, oil dropped below $50/barrel, its lowest level since May 2005.  In four short months, oil has shed close to a $100 off the per barrel price.  It's a fall that is almost inconceivable.  Even those hawks (few and far between over the summer) who were arguing that $140 was unsustainable and would not last have been dumbfounded by the drop.  In fact, this sudden and severe deflation has gotten folks of every stripe a bit unnerved and few consumers are celebrating as the weight of the economic downturn is playing a larger role in household decision-making than are the fall of gas prices.  Suddenly, talk has turned to the evils of deflation rather than the evils of inflation that was all the rage in the spring and early summer.  Citibank warned in a report released Monday of the fiscal consequences for Persian Gulf oil producers of oil prices averaging in the $50/barrel range.  Citi forecasts that at that level only Kuwait would be able to maintain a surplus.  Speculation has it that Iran is looking for some measure of reconciliation with the US as it begins to feel the vise of lower oil prices and sanctions.  High cost oil producers are being squeezed with supply at risk for being shut in as many of these producers have fairly high break even points.  Several years ago, Wall Street analysts estimated that the break even point for Canadian tar sands was about $50/barrel. Surely that has risen as costs throughout the industry continue to increase.

Are we witnessing a trend that will take us back to 1998 when oil prices fell to $10/barrel?  Speculating on oil prices movements is always a dangerous game but to many people (myself included) it's just too tempting to resist.  So here's my bet: just as markets were overshooting at the beginning of the year and had so far separated themselves from the physical market fundamentals that $140/barrel not only seemed plausible, it was reasonable; so too are markets overshooting the downside risk now.  Again, the market mentality seems stuck.  Until the end of this summer, the market saw no downside risk to prices and prices just kept rising, even in the face of declining demand from the OECD.  Market analysts (many of whom worked for firms that had ties to the trading side) prophesied that even though demand was being met now by adequate supply, soon the world would be short on oil because of growth from non-OECD countries.  $140/barrel was completely justified.  In November, the call is just the opposite: the world is in a deep recession and oil demand is not going to come back.  This even though we still don't have a good handle on where Chinese demand (the big villain during the summer months) is currently.  Chinese consumption has slowed but is still growing.  And the effects of a Chinese stimulus package announced last week are still to be determined.

So where is the "fair" price for oil?  Of course, it's anyone's guess but future contracts point to a range of $80-$85/barrel, suggesting that traders remain bullish on the long term outlook for the oil market.  And, although I reject the notion of a "virtuous" price for oil, $80 seems a bit more reasonable for multiple agendas: low prices contributed to excessive consumption in the US.  A long term sustainable price of $80 would help conservation, the development of energy alternatives, and the long term fiscal health of the oil producers.  Convincing Wall Street of this is another story. 

Dragon, Meet Camel

The news of China's $586 billion "bailout" package for its domestic economy raises some interesting prospects for growing ties along the new Silk Road. According to press accounts of Beijing's plans, the money would be spent on infrastructure development--specifically, building railways, subways, and airports--and rebuilding the earthquake-devastated Sichuan province. Unlike fiscal stimulus packages in the US, the money for these projects will not come from the central or local governments but will be financed by state banks and state-owned companies. The Chinese government designed the plan to stimulate economic growth and consumer spending as the country faces a rapidly slowing economy. The latest projections put Chinese growth at 5.8 percent in the fourth quarter, or close to half of what it was towards the beginning of the year.

You might wonder what this has to do with the Middle East. During the period of the most recent global economic boom, trade and investment ties between China and the Middle East, particularly the Persian Gulf, grew rapidly. As Chinese consumption of Middle East oil grew, Middle East investment capital also began to swell and head east. Much of this investment was destined for infrastructure projects, albeit largely in real estate. With Middle East companies, such as DP World of the UAE and Agility of Kuwait, having a competitive advantage in logistics, could we see an expansion of such ties? With one market drying up in the West, will China turn to its nearer neighbors for capital and know-how for its development?

On the one hand, both the Middle East and China could be served by drawing on each other's strengths as the rest of the world falters. Persian Gulf oil producers and China offer more complimentary production capabilities than competitive. The Gulf supplies the oil, the capital, and, in some cases, the ability to manage multi-billion dollar projects. China grows, buys more oil and more contracts. Everyone is happy. But, on the other hand, China's decision to focus on infrastructure does directly clash with Middle East development goals since many of those countries are focusing intensely on infrastructure development as well. In a world of limited investment capital, human capital (a shortage of engineers, architects, and skilled foreman has plagued the Middle East in recent years), and material (such as steel), China's development plans make the country a direct competitor of the Gulf. It may be possible to reconcile the two region's goals. China's plan is very short term--according to the New York Times on Monday, Beijing's idea is to spend the money over a two-year period. With such a tight schedule to identify projects, put out bids, and then contract, it may be possible for both regions to have their cake and eat it too if the Gulf is willing to delay some of its projects with an eye to the longer term.

Things might be looking up for the Gulf producers.

A New Day for the US and a New Chance for Middle East Relations

I generally refrain from commenting on US-Middle East relations since the topic honestly bores me a bit. It seems to me to be a never-ending chain of recriminations, dashed hopes, unmet expectations, and a constant misread of the others' intentions. That's not to say that the US and Middle East governments always fail to get it right (and in some important instances they do make bilateral relationships work.)

It is hard, however, to let the election of Barack Obama pass without some comment on the possibility of altering the dynamic between the US and the Middle East even just a little. The New York Times on Wednesday morning was filled with uplifting stories of international reaction to the US election. And it would seem, to Times reporters, that there is an optimism in the Arab world that an underclass black man born to a Muslim father might be more willing to make things right in the Arab world than his predecessor was. At the same time, there is a certain amount of cynicism that, at the end of the day, politics is politics and even if Obama wanted to do the right thing by the Palestinians, for example, there are huge obstacles that stand in the way domestically in the US.

I wouldn't argue them on that point, but I do think that a new Obama administration has the opportunity to change the dynamic fundamentally and make the relationship more productive from both perspectives. A very simple way to begin this is to shift the focus a bit to concentrate on economics. Prime Minister Gordon Brown was in the Gulf this week promising the Gulf states for a larger say in international institutions like the IMF if they would lend a hand in recapitalizing failing banking systems and adding to financial stability globally. I think this is an excellent idea and one that Obama's future administration should take seriously. By giving the Gulf states a bigger say, it elevates their status both domestically and globally and shows that that we can treat Arab governments with respect. Also, I think the new administration should dust off one of the Bush administration's best policies that they let wither on the vine: MEFTA. I know there are many naysayers out there over this idea, but I doubt that even Bob Zoellick appreciated how brilliant the idea was when he conceived it. Incremental change with the promise of free trade has led to institution building, more transparency, and some measure of government accountability in those countries that have FTA with the US. Increasing trade is almost beyond the point from a US foreign policy perspective. Bringing partners like Egypt, the UAE, and Kuwait closer and encouraging them to further reform can only be a good thing and contributes to more good will in the region. Finally, our export promotion programs should be spruced up and made to include foreign investment promotion. The US has been losing out to European, Asian, and other Middle Eastern companies in breaking ground in the Arab world. It's hard to imagine any room for expansion in the face of global contraction, but the Arab world may be one of the regions that does not suffer as harsh a setback as other emerging markets.

The Middle East writ large is in a period of transition and while we are bound to disappoint politically it is within our means to succeed economically. And in the long run, there is no better good will than helping to economically equip young populations for their future.

How Bad Will the Middle East Hurt?

The New York Times ran a front page story on its website Wednesday reporting on the spread of the global crisis to the Gulf. The Wall Street Journal ran a similar story on Tuesday. Both stories focused on the impact of lower oil prices on the Gulf economies and suggested that while the Gulf could withstand the lower prices, the real losers in this scenario were the Gulf's new dependent states- i.e., the Egypts and Jordans of the world. This is a theme I briefly touched on in my previous posts and one to which I will surely return in future posts. The theory here is that although Egypt, Jordan, and other non-oil producing states will benefit from a decline in inflation with a reduction in oil prices (and also, I might note, an easing of their fiscal accounts since both countries still heavily subsidize commodity prices despite modest reforms in recent years,) the potential for a slowdown in remittance payments and investment flows will have an overwhelmingly worse effect on their macro positions than high oil prices had.

Although I think the impact on the non-oil producers is definitely interesting and worth considering, I think we need to challenge the notion that the oil producers' only real problem is the decline in oil prices. In fact, I think at this point, oil prices should be the least of their concerns. Much like Bear Sterns was a sort of prophetic symbol of what was to come down the pike for Wall Street, I wonder if Gulf Bank is not serving the same function for Gulf financial institutions. Here are the things that concern me: First, we just don't know how exposed not only Gulf commercial banks but also central banks are to the West. You would think by now some of their positions would have begun to unwind, and certainly, banks in the UAE and Bahrain, for example, have admitted to losing significant cash in the subprime mess. But if Gulf Bank can admit to losing $800 million seemingly overnight as recently as late October, who else might be similarly exposed? Remember that Gulf banks (both commercial and central) have traditionally invested heavily in US and European markets. In fact, SAMA has resisted forming a sovereign wealth fund believing that the slow and steady course of holding US sovereign and corporate bonds would serve them better than holding physical assets in the long run. But because the Gulf has traditionally resisted transparency when it comes to where it's putting its money, we just don't know how bad it might get for them. Second, Gulf banks and other financial institutions aren't just exposed to the West but they are also exposed to their local markets. In almost the entire Gulf, the non-oil economy has been growing at a faster rates than oil revenue. And that growth has been on the back of foreign investment or borrowing. A large chunk of Dubai is highly leveraged as are many Qatari institutions. With credit drying up around the world and businesses of all ilk facing some measure of retrenchment, who will be left to lend money to Gulf businesses? Or, on the other hand, who will want to open new offices in the Gulf? Sure, the governments have fairly deep pockets but not even they will be able to completely bail out their private sectors.

Finally, and in my mind most worrying over the long term, is something a bit more intangible. Gulf governments, led chiefly by Muhammad bin Rashid, have tried to upend the conventional development model by building economies chiefly centered on service industries. Shipping and logistics, tourism, business travel, retail, telecommunications- build it and they will come. And they have come- in droves in fact. It's a model being emulated throughout the Gulf and now by other Middle East countries as Gulf companies pour hundreds of billions of dollars into developing real estate ventures and tourism developments from Morocco to Syria. Here's the problem though- all of these new industries are predicated on attracting consumers of a certain economic status. To put it simply, Gulf companies have been banking on wealthy customers who demand what might be considered luxury goods and services. They are developing billions of dollars in delights for people can afford it. Superiority in logistics implies that people need and want to ship goods. Telecom implies that people can afford to purchase cell phones. Tourism implies that people can not only afford to travel but want to stay at your resort. It's easy to nay say this idea now, but given that these ideas were conceived of during a period of unprecedented global expansion, when each year groups like Global Insight were benignly calling for another year of "Goldilocks," you can't really blame them. Lots of people were getting rich, particularly in the developing world. And it was the developing world the Gulf was really trying to key into while maintaining some presence in the West. Unfortunately, if Roubini and others like him are right, it was a period that may be coming to an end.

Does this mean the end to the golden period in the Gulf? Insofar as the rest of the world is "girding their loins" (to quote Joe Biden) for a multi year recession, the Gulf should not and will likely not be immune. Still, I tend to think that all is not for naught. The global economy will eventually recover and people will once again want to ship goods, buy cell phones, travel, and consume more oil. And the Gulf should be pretty well prepared to serve those needs then.