Learning from Dubai’s debt problems

Yesterday, the huge Dubai World conglomerate shocked the world by announcing it needs a 6-month “standstill” on its debt repayments to June 2010. For most of us, what does this mean? CashBench filters through the hype and focuses on what we can learn from Dubai’s problems.

Extravagant Dubai

Dubai is part of the seven emirates that make up the United Arab Emirates (UAE) in the Middle East. Despite its small size, it is arguably the most famous destination in the Middle East with many signature real estate developments. Some of these include the largest mall (Dubai Mall), tallest tower (Burj Dubai), and the most luxurious hotel (Burj Al Arab, pictured above).

Dubai World

Dubai World is a government-holding company of many well-known Dubai companies such as Nakheel and DP World. From this perspective, Dubai World is similar to Temasek Holdings in Singapore.

Nakheel develops the world-famous man-made island Palm Jumeirah, where we can find the huge Atlantis hotel & resort, a luxurious villa owned by David Beckham, and numerous other private homes owned by the rich & wealthy. DP World was the company that outbid Singapore’s PSA in 2006 to take over P&O from the UK, propelling it to the world’s 3rd largest port operator.

Dubai World’s announcement

Dubai World announced yesterday that it needs a “standstill” on its debt repayments for 6 months. This means Dubai World wants to postpone any debt it is supposed to pay between Dec 2009 to end of May 2010.

Why the big deal?

There are 3 key reasons why Dubai World’s announcement shocked the world:

• Just before the announcement, Dubai World has just raised $5 billion from two Middle Eastern banks in Abu Dhabi. This is more than sufficient to pay off the $4 billion debt from Nakheel due for payment on Dec 14. Strange, what other problems are Dubai World hiding?
• Dubai World has $59 billion of liabilities, or about 74% of all debt incurred by Dubai’s government-owned companies. If Dubai World cannot pay up, the majority of banks and other creditors that lent money to Dubai can be in big trouble.
• A credit rating agency has said that Dubai’s announcement may be considered a default on its payment obligations.  Many Dubai bonds are now downgraded to “junk” status. Will Dubai ever pay up? There is no guarantee that Dubai won’t announce another “standstill” if it still doesn’t have the money to pay off its debts in 6 months. Some analysts are beginning to compare Dubai with Iceland that went bankrupt in Oct 2008.

What got Dubai into this mess?

Dubai created a miracle by building a modern city from almost nothing. It was also a trend setter in the Middle East. When other countries and emirates in the region saw the potential benefits of what Dubai is doing with its huge projects, they follow suit.

Those of us far away from the Middle East will assume that Dubai made all this happen with its oil money, but that’s simply not true. In reality, Dubai has very little oil. It knows this but wants to build up a vibrant economy anyway. The solution? Borrow lots of money and build huge malls, hotels & homes that are bigger and better than everyone else. Do this, and people will come to visit and invest, brilliant isn’t it?

The problem with this approach is also simple. Many of Dubai’s developments will take years to complete. Every mega real estate project needs lots of money and will require even more time to generate cash for its owners. This was not a problem as long as Dubai can keep borrowing money from banks or its richer UAE neighbour, Abu Dhabi. But when the world goes into a recession, there is hardly any money floating around, and less people and tourists to spend on big-ticket items. All of a sudden, Dubai becomes less appealing.

What does this mean for investors?

Markets worldwide reacted negatively to Dubai World’s announcement. Banks are directly affected as they will not get a cent from Dubai World for the next 6 months. What’s more, there is a possibility that Dubai World may not pay up eventually, eventhough this is currently less likely. CashBench expects markets to be more volatile over the short-term and investors should continue to keep up with market news. In 6 months, we need to especially track if Dubai World can restart debt repayments.

Dubai World made this announcement when the US markets were closed for the Thanksgiving holiday, with the Middle East and many other countries celebrating the Eid holiday today (Hari Raya Haji holiday in Singapore and Malaysia). European stock markets remained open yesterday and have dropped by about 3% generally. Expect US to open lower when it reopens after Thanksgiving. Stock markets in Asia have fallen yesterday too. As worldwide risk aversion has increased, there is now short-term downward pressure on Gold prices and a corresponding upward lift to the US dollar.

What else can we learn from Dubai?

There are at least 2 lessons that we can learn from Dubai, no matter how near or far away we are from the Middle East:

• Borrow within our means. Don’t over-borrow like Dubai. Whether we are borrowing for a new car, a new home or even for a loved one’s education, we must be pretty confident of paying off the monthly repayments. Using our credit cards is also a form of borrowing. Only buy what we can afford, the credit card bill will always catch up with us at the end of the month.
  
  
• Understand the impact of buying a new home. For most of us, we have to borrow from the bank to buy a new apartment or house. This is a very long-term commitment and is similar to the long-term real estate projects in Dubai. We don’t own the home until we pay up the entire loan!
  
  What’s more, home loans lasts even longer than many marriages. By buying a home, we are committing ourselves to regularly paying off a loan that may stretch for as long as 30 years. During this period of time, the bank expects us to pay up no matter what happens. There may be a recession going on, we may suddenly need to pay huge hospital bills for our spouse or children, or we may even be fired from our job. No matter what happens, we are expected to continue repaying our loans. 
  
  If that’s the case, we also have to make sure that we can repay our home loan regularly, no matter what happens, unless we want to be another Dubai.