Dubai is not a case of sovereign default

The Australian financial press today pushed the message “Dubai shook investor confidence across the Persian Gulf after its proposal to delay debt payments risked triggering the biggest sovereign default since Argentina in 2001”. Last time I knew, Dubai was an emirate and Argentina a sovereign nation. While the current crisis in Dubai is clearly an issue it is not an instance of sovereign default. Some research is required.

Recently I was in Dubai and there were signs of wealth oozing all over the place. The thing I noticed most was the gangs of men (mostly from Bangladeshi – I made enquiries) all dressed up in the same work clothes and caps with their backs, hats and bags embossed with ABC Construction Co logos (or whatever). They were sitting in big packs waiting for flights back home for holidays or after the termination of their contracts. These are the guest workers that prop up the construction industry.

The construction boom sought to build infrastructure (marinas, sporting facilities etc), luxury hotels and housing for the millionaires that frequent the place.

But the dream has been heavily reliant on massive foreign-currency denominated borrowing and that is now causing headaches.

Dubai World has the slogan The sun never sets on Dubai World and is “Dubai’s flag bearer in global investments”. It is a “holding company” and is involved in a “wide spectrum of strategic industries and sectors ranging from Ports Management, Property Development, Hospitality and Tourism, Free Zone Operations, Private Equity Investment, Retail to sectors as diverse as Aviation, Commodities Exchange and Financial Services.”

Yesterday, after the markets had closed, Dubai World released a statement that said:

As a first step, Dubai World intends to ask all providers of financing to Dubai World and Nakheel to “standstill” and extend maturities until at least 30 May 2010.

The specific item in question is the so-called Nakheel 09 Bond which is due to mature in 2 weeks. Nakheel is a division of Dubai World and created the Middle East Caribbean (Palm Islands) and many other opulent land-reclamation housing projects.

While many will be confused about the nature of this request by Dubai World, it is clear that it cannot yet even be called a default, even though the Australian financial press says that that “Moody’s Investors Service and Standard & Poor’s cut the ratings on Dubai state companies yesterday, saying they may consider Dubai World’s plan to delay debt payments a default”.

What is even more important to state it that this is not a sovereign default – that is, a currency-issuing government defaulting. As far as I can work out from examining financial reports and related statements, the United Arab Emirates government does not provide a guarantee for Dubai World.

The Economist Magazine has suggested that the debt is government-guaranteed by saying that “The emirate’s government asked creditors of Dubai World, one of three big government-backed conglomerates, to agree to a standstill on repayments until May 30th 2010 at the earliest”.

Further, while the “markets” have interpreted statements by Sheikh Mohammed Bin Rashid Al Maktoum, the Dubai ruler, that his government supported the debt as a guarantee, it is clear that the Dubai emirate government does not underwrite Dubai World’s debt.

The financial asset in question is a so-called sukuk – which apparently complies “with a Shariah (Islamic law) prohibition against the payment of interest on money.” (Source).

This manipulation of the asset structure has always intrigued me, and, seemingly reflects our infinite capacity to construct things any way that we find convenient even when there are principles at stake. Very few go to the stake!

According to a report in The Australian today:

Islamic finance has five pillars: a ban on interest, a ban on speculation, a ban on haram (forbidden) investments, such as pork or gambling, the requirement of partnership or sharing of profit and loss and the requirement of asset backing. Getting round the ban on interest is the problem and opportunity of Islamic finance … Typically, interest is expressed as a share in a profit, such as the rent paid for use of a property or asset.

As an aside, one might query how buying bonds (lending) to land developers is not speculating, especially when the transactions cross currency borders? How is there asset backing when the assets can plunge in value? Further, given that businesses pay interest by making profits, and the lenders are hardly “business partners” in these ventures, the distinction between interest as the West knows its and profit-sharing which complies to the Islamic laws is rather wan. It all sounds like pragmatism to me but I am not here to pontificate about the ins-and-outs of Islamic finance.

To understand why this is not a sovereign (currency issuing) default you have to come to terms with the concept of an emirate, which “is a political territory that is ruled by a dynastic Muslim Monarch styled emir”.

This overview is of use although a little dated.

The United Kingdom announced in 1968 and reaffirmed in 1971 that it would end its treaty relationships with the seven Trucial Coast states, which had been under British protection since 1892. Following the termination of all existing treaties with Britain, on December 2, 1971, six of the seven sheikhdoms formed the United Arab Emirates (UAE). The seventh sheikhdom, Ras al Khaymah, joined the UAE in 1972.

So the UAE is a federal state with seven federal emirates. Each emirate is a constitutional monarchy and the monarchs determine in an electoral college the UAE President and Prime Minister.

The UAE government has a federal budget and monetary policy is conducted via the central bank. To understand how the central bank operates in the UAE this document is useful.

The Federal National Council (FNC) approves the UAE budget which is produced by the Ministry of Finance. The federal budget accounts for around 25 per cent of all UAE fiscal transactions, with the individual emirates conducting their own affairs, accounting for the rest. Given the income (GDP) of the UAE is dominated by oil revenue (around 60 percent) the budget outcomes fluctuates with world oil prices. In recent years the budget has been in surplus but that hasn’t always been the case (from the mid-1980s deficits were common as the nation-building phase was underway).

The UAE Government also under reports its revenue by moving export revenues into sovereign funds (reserve accounts). Further, the Government has very large investments abroad. Neither income source are included in the formal budgeting process. Taken together it is hard to determine whether the budget is in surplus or deficit but the fact remains that this is not a country that is short of foreign currency reserves.

The UAE central bank administers monetary policy just like any central bank although significantly the currency unit the Dirham is a fixed peg to the US dollar. This means that they run a currency board and local interest rates have to be aligned to those of the dollar across the yield curve. So monetary policy becomes tied to the need to maintain the peg.

This is not insignificant. The UAE central bank conducts USD swap arrangements with the commercial banks to ensure there is enough Dirham liquidity in the system. So a commercial bank sells a foreign currency denominated asset at a spot price and the central bank injects Dirhams into the economy to match. The commercial banks have to buy back the foreign currency denominated asset at an agreed date (usually 1 week, 1 month or 3 months).

So there are constraints on the UAE government which could render it insolvent in the same way that Argentina became insolvent when its currency board collapsed in 2001. The difference between the two situations though is that the UAE government is sitting on massive oil reserves and already holds massive foreign currency reserves with further access to foreign currency earnings via the reserve funds and other investments.

Argentina did not have that luxury and had to default and float its currency before it could reassert its sovereignty. I cover that issue in this blog – Why pander to financial markets

While there is some remote risk of default given the currency board arrangements, the main uncertainty at present is that there is no real protocols established as to the protection that sukuk holders (creditors) have in the case of a corporate default. While the debt instrument is asset-backed it is not clear that the creditors have a claim on that asset.

Further, informed comment I received (privately) today said that “this is a UAE specific situation, no read across to any other markets. We are not in 2008, no contagion here.”

The main point is that Abu Dhabi (a very rich emirate) will never let Dubai, which is “no different from a very large Euro Disney” (Source), become insolvent.

In this context, The Economist magazine makes an interesting point when it says the request for a delay is an sign of:

… the influence of Abu Dhabi. Rich in oil and conservative in outlook, its rulers have viewed Dubai’s penchant for frolic and folly with distaste and occasional envy. It is possible they are now putting their foot down, fearful that if Dubai does not take its share of pain, it will be back for more money in the next downturn.

Meanwhile, in the same edition as the Dubai story appeared, The Economist magazine (November 26, 2009) wrote that there was a “load to bear” in Tackling Japan’s debt. They said:

The trouble is that Japan has a fiscal hole likely to approach 10% of GDP next year, or about ¥50 trillion ($500 billion). Such gestures are like using a toothpick to fill it in …

The prospect of more borrowing has spooked the government-debt market recently. The jitters reflect the sheer size of Japan’s public-sector debt, which next year is expected to be twice as big, on a gross basis, as the country’s GDP. On a net basis (offsetting the government’s financial assets), it is smaller but still among the highest in the OECD.

As bond yields edged higher recently, several Wall Street banks issued warnings about potentially crippling debt-service costs. Their case was strengthened by evidence of mounting deflationary pressures and expectations that Japan, with its shrinking population, will be unable to grow fast enough to pay down its debt.

So this is the conventional beat up. Note we have found another hole! See this blog – We are in trouble – squirrels are falling down holes – for evidence of other holes that have been discovered in recent days.

The Japanese Government is not in the same situation as the UAE. It is totally sovereign because it floats its exchange rate as well as issuing its own currency.

Further, it retired is last foreign currency bonds in 1983 (Source).

It has huge domestic savings and the local investors are “loyal” and thus soak up the public debt with relish. There are very few foreign investors buying Japanese government debt. The Japanese government is also sitting on huge stocks of foreign exchange reserves.

So to suggest that there is any notion of default in the Japanese case is ludicrous.

The Economist tries to draw another long bow by saying that with the ageing population and the rising dependency ratio, Japan will become an net importer around 2014:

That could make Japan more dependent on foreigners for its borrowing needs.

Excuse me, they are not dependent at all now, so how can you be “more” dependent. However, this misses the point. The Japanese government will never be dependent of foreigners because its spending is not revenue-constrained. It supplies and spends in the Yen. If the local market stopped buying the bonds, then the voluntary constraint the government imposes on itself (to issue debt to match net spending) could be abandoned. I would recommend that.

It might transpire that the private sector starts to spend more than it earns (highly unlikely) and start net importing. But that will just mean that foreigners are desiring to acquire yen-denominated financial assets. It won’t happen unless that desire is there. Why? It is that desire that would motivate foreigners to net ship real goods and services to Japan (that is, the CAD).

But all these transactions would be voluntary which means that both parties would be better off. The Japanese get the wider access to material goods and services and the foreigners satisfy their financial investment plans. While I think it is unlikely that this will occur it is hardly a sign of “becoming dependent of foreigners”.

Finally, I think this passage in The Economist article is worth reflecting on:

Even the bears acknowledge that there is scant likelihood of Japan blowing up in the short term. There are several reasons to remain calm, notably the remarkable loyalty of Japanese debtholders over the past 15 years. By some estimates more than 93% of Japanese debt is held domestically, which means that the government need never default because it could simply print money to pay the debt off.

This home bias also helps explain why, though the stock of debt is huge, debt-servicing costs as a percentage of GDP have been relatively low compared with Japan’s OECD peers … Even at the peak of their recent run-up, ten-year Japanese-government bonds only yielded a miserly 1.43%, but in a deflationary environment they were still attractive to Japanese investors in real terms. What’s more, the government is the world’s largest creditor, with plenty of foreign assets to sell. And Japanese citizens are sitting on another {Yen}1,410 trillion of financial assets. These comfortably exceed the government’s debt …

So why would they ever write a piece implying that the massive debt burden was a sign that default was possible?


Any stories that claim Dubai is a sovereign default are misleading. Dubai is sort of like a state government in a federal system and does not issue its own currency. While Dubai World is close to government it is not as far as I can tell government guaranteed.

But anyway, the structure of the UAE is such that the other emirates (particularly Abu Dhabi) are unlikely to see any major insolvencies occur anywhere in the federation.

However, potentially the UAE could collapse (very unlikely) under the strain of its currency board. Overall, the debts that are owed by Dubai firms to outsiders (in foreign currencies) are huge and it is possible (but not probable) that the country’s currency could fail trying to bail these companies out.

No such possibility exists in the case of Japan.

Saturday Quiz

Will be back tomorrow. Too many people are boasting they now score 100 per cent. So I have to deal with that (-:.

This Post Has 11 Comments

  1. Excellent post. Dispels a lot of the nonsense in the media.
    Any thoughts on why the dollar did not strengthen when the global markets started tumbling?

  2. The headlines were certainly misleading however this issue highlighted in the case of Dubai proves the bonds are also exposed today as the stocks have been all along this last couple of years to the potential of loss.
    Marc Fiorentino (who wrote “Un Trader ne meurt jamais” = “A trader never dies” had mentioned the next bubble to blow would be the Bonds. Dubai, as an “avant gardiste” place, may very well be leading the path for it on a multitude of other ones to be defaulting and to be disclosed very soon…

  3. Dear Gary

    Welcome to my blog and thanks for your comment.

    I do not disagree that Dubai World’s debt exposure is a major issue for investors (and the emirate). And it could start a corporate bond meltdown (although I doubt it). But the point is that it is not a sovereign default yet and should the company finally not pay up then it will be a corporate failure. Even though the company is intrinsically linked and part-owned by the Government of Dubai it remains a private company and the Government of Dubai is not sovereign being an emirate within a federal system.

    best wishes

  4. Dear Mike

    Welcome to my blog and thanks for your comment.

    On the dollar: you might have expected the uncertainty in the last week relating to Dubai to see a flight back to “quality”. But there are a lot of counter trends going on at present with several nations (for example, Russia) indicating they are broadening their foreign exchange portfolios away from the USD. The balance of these trends determines the parity clearly.

    best wishes

  5. Hi Bill,

    It’s pretty clear that this does no constitute a sovereign default. Dubai World is wholly-owned by the Government of Dubai but is a limited liability company. Limited liability applies to governments as well as other entities, so the government of Dubai is under neither a moral nor a legal obligation to compensate debt-holders. Willem Buiter fleshes out this argument in his blog:

    All the best,

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