Comprehending the Incomprehensible

What is it like to live through a revolution?  Do you appreciate what's happening in the midst of change or is it only in hindsight that you truly understand how comprehensive the change actually was?  A few pieces of news and an op-ed today in the Washington Post finally brought the magnitude of this recession home to roost.  The idea that we could possibly emerge from this economic crisis looking much like we did going into it seems increasingly unlikely.

First, the news that Citicorp has agreed to essentially be nationalized with the federal government converting its preferred shares to common stock and upping its holding to 40 percent is almost incomprehensible.  It's not just that the US is nationalizing one of its banks, but Citicorp is a global institution.  Presumably the federal government will act much like a private equity investor- get the institution functioning again, stream line, and sell off.  Depending on how Washington does it, there will certainly be repercussions throughout the global financial community.  

Second, and perhaps more remotely, is this report in Business Middle East.  The Gulf's raft of Islamic banks have taken a big hit in the past year due to the downturn in the real estate market in the region.  Because Islamic banks' operating principles dictate that they underwrite loans with tangible assets, many of them are directly exposed to declining home values in the Persian Gulf.  While this has prevented these banks from the same kind of exposure to structured products (like CDOs) that banks globally are facing, it still exposes a significant vulnerability to this system of banking.  It would appear then, that it's not only traditional banking models that needs to be rethought but also more recent innovations like Islamic banking.  Going back to the theme of this blog entry, it's hard imagine how a new vision for banking evolves, especially one that it is likely to be an across the board effort.

One last thing for today- I'd recommend this op-ed.  It does wander a bit, but the observations of Edmund Wilson might definitely be worth perusing.  

Dubai's Knight in Shining Armor

Abu Dhabi yesterday announced a $10 billion loan to Dubai to help the emirate with its substantial debt obligations. The loan would come in the form of bond holdings. Dubai plans to issue $20 billion in 5 year notes with the first installment of $10 billion completely accounted for by the UAE central bank.

So ends weeks of speculation about whether or not Abu Dhabi would again come to Dubai's rescue. Last week, Zawya Dow Jones posted an article speculating that Abu Dhabi would not, in fact, bail Dubai out short of some major concessions in the form of shares in Dubai's most profitable businesses. Worry over a bailout grew so pronounced that the spread on Dubai's credit default swaps were second only to Iceland globally.

The terms of the deal, at least as announced yesterday, seem pretty benign. The bonds will be unsecured with a fixed rate, yielding a 4 percent return annually. No quid pro quo was listed in the announcement. Still, the ease of the deal makes me wonder if there is something in the fine print we're missing. Certainly Abu Dhabi was willing to prolong the speculation to some extent, perhaps to test the waters to see if Dubai could come up with international refinancing. When it was clear that it couldn't (the best it could do was to recently refinance one loan for $3.8 billion), perhaps the capital was spurned into action. But the relationship between Abu Dhabi and Dubai has never been easy and the fact that Abu Dhabi let Dubai off with nary a wrap on the wrist seems unusual.

But no means is the problem over, however. It's far from unclear that Dubai will be able to recover in any measurable way in the short term as its local real estate market continues to spiral downwards. The combination of the mass out-migration of its labor pool as well as structural changes in the state-owned companies (for example, Dubai Holdings' decision to stream line its back offices) will only create an even greater stock of available housing. As the Wall Street Journal article linked above also suggests, the stock of half-finished and abandoned projects also continues to grow. At the end of the day, it's unclear whether Dubai can settle its debts with the $10 billion loaned from Abu Dhabi and if it's not enough, will more be forthcoming?

Long Live the Labor Force

It would seem that the troubles in the Gulf, which until now have been focused in financial markets and oil prices, are beginning to trickle down to the grassroots level. Specifically- jobs are at risk. This is not necessarily new. In UAE, firms have been laying off workers left and right. Until now, however, most of these workers have been expats. A 12 February article in the New York Times detailed how expat workers are being put in a bind in Dubai- left without a job but with debt (many times mortgage related), many expats have just up and left the country. A new report put out by National Bank of Kuwait suggests that unemployment among Gulf nationals will also soon be on the rise. NBK forecasts that contraction in the private sector will be significant across the Gulf in the next year limiting the number of jobs being created. It's worth noting that the significant expansion in jobs across the Middle East in recent years has come from the private sector. NBK estimates that in the Gulf, private sector employment opportunities were rising at a rate of eight percent annually between 2003-2007. These jobs went largely to expats, but a gradual shift of the Gulf national workforce out of the public sector and into the private sector had begun: according to the same NBK report, across the Gulf, 58 percent of nationals employed worked for the public sector while 42 percent worked for the private. This is a significant increase even over five years earlier.

This decline in employment opportunities has obvious ramifications as the region continues to work through its demographic boom. It also has worried local governments, particularly in UAE. Gulf News reported today that the UAE Ministry of Labor introduced new regulations "guiding" the firing of UAE nationals. Farouk Soussa, head of the division that handles sovereign ratings for the region for Standard & Poors, cautioned Dubai's government from going ahead with all the planned reorganizations of it's state-owned companies, such as Dubai World, since it would only further aggravate the unemployment picture in the emirate.

The Gulf's labor market has for a long time harbored serious structural inefficiencies with an over dependence on foreign labor and a domestic labor pool that is payed more and has less skills than some of its regional counterparts. On the face of it, the expat community taking the first hit in the declining economy should be a good thing by opening up opportunities for local labor. Unfortunately, when the expat labor is more efficient and lest costly, it's unlikely that those businesses laying off employs will rush to fill the bill with local hires. And so the situation gets worse for everyone.

Can Infrastructure Really Save Us?

Yesterday I attended a luncheon at the Peterson Institute for International Economics to hear Dr. Justin Lin, chief economist at the World Bank, discuss the current economic crisis and its impact on emerging markets.  Dr. Lin took the opportunity (which he noted was his first outside speaking engagement since assuming the position of chief economist) to posit some ideas of how the world might effectively get out of its downward growth spiral.  Dr. Lin proposed something he termed a "Global Recovery Fund" in which developed countries would allocate a percent of their resources intended for stimulus purposes domestically to a fund which would be used to provide stimulus in those less developed countries that could not afford to take such measures themselves because of fiscal constraints.  He further argued that the less developed countries should follow China's model (I will note here that Dr. Lin is a Chinese national), and use the stimulus funds to address infrastructure deficits and bottlenecks so that when the world begins to recover, the LDCs will have more efficient economies and more capable export resources.  Here is a link to USA Today's coverage of the talk: "World Bank Economist Urges New Marshall Plan."

Leaving aside the political impracticalities of Dr. Lin's proposal (I have a hard time believing that anyone in Congress, the White House, Beijing, or Riyadh for that matter would listen to the proposal for more than 1 min), I was struck that Dr. Lin focused on infrastructure development as a panacea to all that ails the global economy.  Infrastructure is everywhere these days.  Beyond the widely discussed portions of the stimulus package in the US which devotes funds to infrastructure, China, Saudi Arabia, little Bahrain, Egypt, and multitudes of other countries have all announced their intentions to use budget resources to fund infrastructure projects in their domestic markets.  The fact that so many policy makers of so many stripes across the globe have focused on infrastructure makes me deeply wary that we're pushing ourselves into another bubble situation at best or wasted money at worse.  Here's why-

As Dr. Lin pointed out in yesterday's talk, infrastructure can only get you some bang for your buck if you have actual structural inefficiencies that can be remedied by adding the road or improving telecommunications.  In much of the developed world, this is rarely the case.  As much as people in Minnesota would cringe to hear this, totally rebuilding the bridge that collapsed won't bring you much in terms of extra efficiency unless it was somehow rebuilt in a way that would allow for more than just automobiles and trucks to take advantage of it.  Connecting two cities in Africa through rail or road links would bring much more tangible benefit, however.  I would agree with Dr. Lin that money used towards "green" technology might be the exception to this since it offers a way to re-industrialize much of the world in a way that is more environmentally sustainable.

Beyond what you do with your infrastructure investment capital, it makes no sense for everyone to pursue the same kind of development at the same time.  First off, you risk creating massive redundancies- do all countries need to rehab their air and sea ports and if everyone develops super efficient export capabilities to whom will you export?  If your infrastructure improvements help stimulate domestic demand because goods can be shipped cheaper and faster internally, than good for you.  But if you only look to improve your export capabilities, we're looking at another situation of global imbalances.

Second, let's face it, there is only so much material in the world that can be devoted towards infrastructure development.  In 2007, long before infrastructure development became the "du jour" option it is today, the world was looking at a shortage of construction cranes because Dubai and China had sucked global supply dry.  That's right- China and Dubai.  Not China, the US, Saudi Arabia, half of the rest of the Middle East, and the developing world.  Imagine how desperate and expensive the situation could get if everyone with some cash is looking for cement, electricity, engineers, and architects?  Here's an interesting little article on looming shortages:  Materials industries face a "perfect storm" of long term challenges  

Finally, I think it's very possible to overdraw lessons from what China accomplished between 2003-2008.  Dr. Lin argued for infrastructure development by citing China's incredibly strong growth rate of more than 10 percent annually during this time frame (up from averages of 8 percent in the previous decade) and posited that this growth improvement came about because of infrastructure development.  I say that this is a bit of hooey.  Dr. Lin's argument ignored two critical factors- rising US demand for Chinese products during this time frame and China's own domestic spending on the Olympics.  Both led to improvements in infrastructure (particularly in the latter case) but this was an extraordinary circumstance.  Time will tell if these infrastructure investments will actually pay off in the long run for China.  I think the only way it could is if it stimulates internal domestic demand.  Most of the time, infrastructure, while constituting necessary spending, only marginally contributes to growth.  Dr. Lin himself used the example of Japan repaving roads in the 1990s.

All this being said, I don't think spending on infrastructure is a bad thing.  In fact, it is necessary in the same way that having your teeth cleaned twice a year is necessary if you want to prevent cavities.  It doesn't get you much in the short term, but if you want to prevent long term system failures, it needs to be done.  The idea of infrastructure as a panacea, however, needs to be taken with a grain of salt.

I wish someone would come up with another idea... 

The Coming Catastrophe

I offer a small disclaimer before I formally launch into this post: I'll admit here that I tend to be much more of an intuitive thinker than a rationalist, especially when it comes to economics. I tend not to need reams of data to believe something to be true. Not relying on reams of data is of course dangerous since you can read a trend the wrong way just as easily as you can read it correctly. With all this said, I've suddenly become very worried about UAE and Kuwait.

Conventional wisdom is that as bad as things get in both Dubai and Kuwait, local governments and financial markets can always fall back on "big daddy" oil funds to stabilize the situation. For example, despite a significant default in one of the region's largest investment banks and an earlier multi billion dollar loss by its second largest bank, Kuwait still maintains pristine sovereign risk ratings based on its savings and still significant oil income. But a number of reports have been recently released that makes me wonder if the situation in both Dubai and Kuwait could unwind so quickly that not even Abu Dhabi or the Kuwait central government can fix it.

Dubai first. A whole slew of more bad news has been hitting the emirate. Today, Business Middle East is reporting that 20,000 Indian construction workers are being sent home from Dubai on bulk flights in March. They are being sent home on long leave or redeployed to other Gulf countries. Dubai-based property analysts Proleads reported late last week that 52.8 percent of projects, worth $582 billion, have been put on hold in UAE with more expected in 2009. (The remaining ongoing projects are estimated to be worth $698 billion.) Dubai World again went on the defensive yesterday, attempting to squash reports that it would have to sell Barneys to pay down some of its outstanding debts. But perhaps most worryingly, the spread on Dubai's credit default swaps grew by 75 basis points between Wednesday and Thursday last week after Abu Dhabi announced a plan to inject $4.36 billion into 5 of its banks. Traders feared that Dubai might not be able to take similar steps to provision its banks against the almost certain defaults from mortgages and consumer loans.

In my mind, Dubai's troubles offer a double whammy which have fairly broad and serious consequences globally. That's because both the government and the private sector in Dubai went on a spending spree during the last 5 or 6 years. Banks and other financial institutions made massive amounts of loans to support the booming real estate market as well as huge jump in domestic consumption. The government borrowed to finance the large expansions of its state-owned companies, such as Dubai World. The list of companies that the government of Dubai has stakes in is quite large. In fact, foreign investment by Dubai entities drove increased FDI in the rest of the Middle East, Africa, Asia, and parts of the western world. Should these entities begin to default, the fallout could be quite significant. (I'll explore Dubai investment patterns and potential fallout in a blog entry later this week.) If both the government and private financial sector in Dubai were to face imminent danger, would Abu Dhabi have the wherewithal to intervene? It's a question that should start concerning more people.

On to Kuwait- I honestly don't know entirely what to make of the situation but recent reports suggest that many Kuwaitis are becoming frightened and that frightens me. Why Kuwait remains a conundrum is two-fold: the economy (and the government) generally remains opaque. You're not likely to know about a problem until it hits you full in the face. Sadly, I think this applies as much to government oversight of Kuwait's financial markets as it does to external observers' ability to discern what in fact is going on within the country and its investments overseas. Second, relations between the government and National Assembly also remain deadlocked which suggests that any moves to correct a crisis could easily become wrapped up in politics. That seems to be already happening. The Kuwaiti cabinet approved a a stimulus package last Thursday intended to prevent a serious domestic fallout from the global crisis. The plan would guarantee $13.8 billion in new credit facilities to local companies. The plan, which is estimated to cost public investment funds around $5.2 billion, would also guarantee against loss in local bank's investment and real estate portfolios for up to 15 years.

Debate over the plan is intended to begin tomorrow in the National Assembly. Fast passage does not seem assured. One parliamentarian, Dr. Hassan Johar, predicted in an interview with a local paper that Kuwait would be close to an economic catastrophe in the coming months. MP Abdul Al-Wahid Al-Awadhi, chairman of the parliamentary committee, said the National Assembly would not offer criticism on the proposal but that it would need time to study it, given the enormity of the scope of the package. This, of course, does not bode well for things moving quickly in the country.

My assumption on Kuwait has always been that the private sector is so small and almost meaningless when it comes to economic activity in the country that surely the government could handle any bad debts private Kuwaiti citizens and institutions might have. And I am still not convinced this has changed in any meaningful way. But how much has Kuwait sovereign investment been compromised in the global crisis and at what cost will the government face bailing out its citizens? In both the case of Dubai and Kuwait, the sums could be rather large.

Somehow, I don't think this issue is going away anytime soon.