A bad omen in Dubai
No other country built a ski resort in a desert. No other country constructed an archipelago of 300 artificial islands, complete with a man-made reef colonized by parrot fish. But even if Dubai is a gaudy outlier -- a sort of Donald Trump of a nation -- the bankruptcy of its flagship investment company, Dubai World, holds a warning for others. The nonchalance with which global financial markets have reacted is not reassuring in the least. The lack of alarm is alarming.
Start with the size of the Dubai bankruptcy. Most analysts reckon the emirate will end up defaulting on more than $30 billion. That's up from the $26 billion advertised at Dubai World but perhaps less than half of the city-state's accumulated $80 billion debt. Dubai's bust will be larger than South Korea's 1998 debt restructuring, which involved $22 billion worth of loans, and not much smaller than Russia's default that year (which affected loans worth $40 billion). The South Korean and Russian traumas spread panic around the world. Nowadays, investors yawn at losses that don't run into the hundreds of billions. This is a touch complacent.
Dubai's bust also signals that other leveraged commercial real estate players may be in deep trouble. Dubai World borrowed to buy ventures such as the former Knickerbocker Hotel in Times Square, the Fontainebleau Hotel in Miami and (more shades of Trump) a stake in a Las Vegas casino. Its debts have finally caught up with it. Meanwhile, J.P. Morgan estimates that U.S. commercial real estate prices will keep falling until late next year, raising the risk of more defaults and undermining the collateral that secures a large slice of banks' loan books. The banks will continue to bleed money, curtailing their ability to extend fresh loans to other businesses.
Then there is the broader message in Dubai's bankruptcy: Governments are tired of playing fireman. The past year may have accustomed us to governments rescuing banks, insurers, money-market funds and carmakers, but history is full of crises in which governments were the source of the trouble -- it was they that defaulted. In February, the rulers of next-door Abu Dhabi rescued Dubai with a loan of $10 billion. This time Abu Dhabi refused, so Dubai's government has told lenders not to count on their next payment.
Because of the global financial crisis, plenty of other governments have overextended themselves so much that they threaten financial trouble. Greece, for example, has debt equivalent to 99 percent of its gross domestic product and is borrowing a further 8 percent of GDP this year to finance its budget deficit. The normal response to this predicament is to devalue the currency and inflate the debt away. But Greece is shackled to the euro, so the risk of default is rising.
Meanwhile, governments that are not hopelessly indebted may also quit providing safety nets. Russia, for example, is sitting atop $450 billion in foreign currency reserves. Yet it has refused to honor debts of Finance Leasing Co., a state-owned company -- never mind that investors who bought the company's bonds thought they were buying a quasi-sovereign credit. The Russian attitude seems to be that if you can walk away from your creditors -- hey, why not? But even governments with more respect for their lenders may stop playing rescuer. In the worst months of the credit crisis, authorities in the rich democracies felt that they had no choice but to backstop private firms; the failure to do so in the case of Lehman Brothers proved disastrous. But now that things have calmed down, governments may be approaching the point at which they allow investors to take losses.
The threat of sovereign defaults, disowned state-company debts and continuing commercial real estate troubles comes amid a recovery that is extraordinarily precarious. It is based on fiscal stimulus from governments, but government debt ensures that this game has to stop at some point. It is based on the printing of money by central banks, but a combination of political backlash and inflation fears will eventually close down this game also. To rescue the global economy, governments have exacerbated the flaws responsible for making the system weak. China has too much export capacity; it is building more. China has an undervalued currency; it is weakening further. Meanwhile, the United States has a low national savings rate and is home to financial behemoths that are "too big to fail." But the U.S. government has been forced to add to the public debt and broker consolidation in the banking business.
Given these troubles, Dubai should have been a wake-up call. Instead, global stock markets have risen since last weekend. We are witnessing the sort of rally that chart-watching traders know well: the kind where investors shrug off most bad news, so you might as well jump on the bandwagon. When this mentality sets in, prices inevitably rise too far. At the end of the trend there is usually a bubble.