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.