The markets today were in a bit of a tizzy because the Dubai World Group, a holding company owned 100 percent by Dubai’s government, and Nakheel, a wholly owned subsidiary of Dubai World, imposed a debt restructuring and debt service standstill - failed to perform on their debt or, in ordinary if not legal language, defaulted on their debt. The combination of the Islamic holiday of Eid and the Thanksgiving holiday in the US boosted the magnitude of the financial market kerfuffle.
I don’t see what the big deal is. Dubai has experienced for most of this decade the craziest construction boom seen in the Middle East since the construction of the Great Pyramids. That boom turned to bust – as booms invariably do. Property developers tend to be highly geared and very procyclical in their revenue flows and access to the capital markets. During construction slumps they drop like flies. Because the property sector is risky (ask Donald Trump), its creditors tend to get better interest rates than the sovereign rate. Dubai is no exception to this rule. If you earn a risk premium during good times, you should not moan when the borrower defaults from time to time when the going gets tough.
The debt of the Dubai World Group and of Nakheel was not Dubai sovereign debt or sovereign-guaranteed debt. The sole shareholder may be the state of Dubai (indistinguishable from its ruling family), but limited liability applies to governments as well as to private entities. The government of Dubai is under no legal or moral obligation to provide an ex-post guarantee of the debts of the Dubai World Group and Nakheel. The creditors will have to manage this contingency the way God meant them to: hoping for the best, but living with the restructuring and taking their losses. Requiring the debt holders to live with their losses will not damage the reputation of the Dubai sovereign. The only way a bail out by the Dubai sovereign of the debt holders of Dubai World and Nakheel would enhance the sovereign’s reputation would be by enhancing its reputation as a sucker.
What would hurt Dubai’s reputation would be unequal treatment between domestic (or UAE, GCC, Middle-Eastern or Islamic) creditors and other creditors from the West or from the non-Islamic East. If Islamic debt were to be interpreted by the Dubai authorities as debt instruments that give preferential treatment – non-contractual seniority – to Islamic creditors, Dubai’s reputation would be damaged severely. But as far as I know there is no evidence that this has happened or is intended.
It is of the utmost importance that governments throughout the world learn the lesson that providing free ex-post default insurance for any debt, including debt issued by 100 percent government-owned companies, is unwise and counterproductive. The sovereign is on the hook only for sovereign and sovereign-guaranteed debt – that’s why they are called that way.
Throughout the advanced industrial countries and in some emerging markets, the sovereign debt situation has worsened dramatically as a result of the financial crisis and, even more dramatically, as a result of the revenue losses caused by the economic contractions that followed the crisis. Public debt to GDP ratios are rising everywhere, and are likely to top 100 percent of annual GDP by 2014 in the US, the UK and in the Euro Area. Structural public sector deficits and primary government financial deficits are at unsustainable levels in many countries, including France, the UK and the US.
Some countries are in a truly disastrous fiscal-financial pickle. Greece’s new government discovered on taking office that its predecessor had fiddled the data (not a novelty in Greece) and that as a result it was stuck with a 12.5 percent of GDP financial deficit for the year instead of the just over six percent fairy tale figure the last government had brandished about. Public debt in Greece is likely to get close to 130% of GDP by the end of 2010 and to go on rising. With euro-denominated public debt and no independent monetary policy capable of inflating that debt away, sovereign default is not just something to scare the children with in the dark.
Other countries, Japan comes to mind, have public debt situations that are in some ways worse than that of Greece, although the low level of Japanese interest rates at all maturities obscures the threat posed by the public debt burden. High private saving rates and a large stock of national financial wealth and of net national foreign assets mean that Japan for the moment only faces a single, internal transfer challenge – shifting resources from the domestic private sector to the domestic public sector – rather than a dual, internal and external transfer challenge. Nevertheless, I would not like to be the Japanese minister of finance when the markets wake up and impart risk premia to the interest rates on newly issued and floating rate Japanese sovereign debt instruments.
Given the severely-impaired fiscal-financial positions and prospects of so many countries, the notion of a sovereign of one of these countries assuming responsibility for any debt that is not sovereign or sovereign-guaranteed is ludicrous. 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.
Fortunately, property companies don’t fall into the systemically important category. Their collapse is painful for their shareholders, creditors and, if the local labour markets are weak, their employees. They are not, however, systemically important. Their collapse will not threaten the delicate fabric of financial intermediation. They are fit to fail. Creditors beware.