THE STASH NOVEMBER 27, 2009
Traders are racing to figure out what the default by Dubai World Group on $60 billion of debt means for their portfolios and the global economy. Dubai World is a conglomerate with large holdings of commercial real estate and ports across the globe, among other assets. The government of Dubai, one of seven states that form the United Arab Emirates, owns 100 percent of the company, but has no obligation to back its debt.
At this point, I see four potential consequences for the United States:
1.) A stronger dollar and lower interest rates. The immediate effect was for investors to shun risk and flee to safety. That benefited the U.S. dollar* and U.S. government debt, which suddenly became very attractive amid all the turmoil. Conversely, the debt of other Middle Eastern countries took a hit, as did the debt of countries like Greece, Turkey, Russia, and Ireland, which investors had already viewed somewhat skeptically.
2.) The end of financial bailouts abroad. This sounds like a bargain for us--the U.S. government can borrow on cheaper terms than it could before, which was already pretty cheap. That can hardly be a bad thing in itself at a time when we're borrowing trillions to prop up our fragile economy. The problem derives from the rising interest rates in countries investors are fleeing. If those countries need to issue more debt--say, because a big bank collapses and they need to bail it out--they will find it much, much harder to do so. As the FT's Willem Buiter puts it today:
Even banks and other financial institutions that would in the past (when fiscal pockets were deeper) have been considered too big and too systemically important to fail are now too big to save. Ireland’s government could not today afford to guarantee virtually all of the liabilities of its banking system, as it felt compelled to do at the beginning of this year.
If too-big-to-fail banks abroad are suddenly allowed to fail, that could depress foreign economies and--since many of them are markets for U.S. exports--act as a drag on growth in this country.
3.) A global asset sell-off. Why would foreign banks start failing abroad? As Dubai World scrambles for cash, it will sell off its portfolio of commercial real estate. This could depress commercial real-estate prices around the world at a time when that market is already very weak. Banks that gorged on commercial real estate during the boom--a not insignificant number of banks--could suffer steep losses.
The big question is the size of Dubai World's commerical real-estate portfolio. I haven't seen any numbers on this. But even if it were, say, $100 billion (which strikes me as very high), it shouldn't be that hard to aborb in a global commercial real-estate market worth trillions of dollars. Particularly if Dubai World's real estate holdings are mostly confined to Dubai itself, which looks likely. In that case, the local economy would suffer intensely, but the global fallout would be minimal.
Similarly, the financial institutions that own some of Dubai World's $60 billion in debt could suffer big losses if they get stiffed by the company. (Most of the banks that lent to Dubai World are European--British in particular.) Fortunately, it doesn't look like any one financial institution was massively exposed to Dubai World debt. According to this Wall Street Journal piece, Britain's Standard Chartered is the only bank whose exposure to Dubai World seems to be "material"--which is to say, a significant portion of its balance sheet. But it looks Standard Chartered has a big enough capital cushion to absorb the losses. On top of which, many are now speculating that Abu Dhabi, Dubai's oil-rich fellow Arab Emirate, may bail its neighbor out. In which case the losses would either be small or non-existent.
4.) Pressure on U.S. banks. Of course, it's not just foreign banks that are at risk. U.S.-based financial institutions could take a hit, too. For one thing, a lot of U.S. banks are already struggling under the weight of their troubled commercial real-estate portfolios. If Dubai World's firesale damaged the global commercial real-estate market, it would create losses at U.S. banks and make them even stingier about extending credit to consumers and businesses.
Second, any asset sell-off by European banks with large exposure to Dubai World debt--suppose Standard Chartered and its ilk started dumping mortgage-backed securities to raise cash amid their losses--could put pressure on U.S. financial institutions that own similar assets. That could bring the financial-sector recovery to a halt in this country and require a new round of bailouts.
Overall, the damage seems pretty containable at this point. On the other hand, we still don't have all the numbers in front of us--the defining feature of this crisis so far is the opacity of the company (and country) at the center of it. So, after the year we've just been through, you can hardly blame the financial markets for getting a little antsy.
*As Felix Salmon points out, it was the yen and not the dollar that acted as a safe-haven currency--the dollar slumped while the yen rose. On the other hand, U.S. government debt has benefited from the same safe-haven dynamic, with long-term rates dropping significantly since the Dubai news broke.
Update: One problem with currency movements: We measure them relative to other currencies, so it depends what we're measuring against. The dollar did slump against the yen beginning Thursday morning (though it's been rallying most of the day). But it was up against the Euro and the pound on Thursday (before losing ground a bit this afternoon--Friday).