The Dubai Aftershock - London's Vulnerability
Friday 27 November 2009 at 01:59 If you get a major earthquake, you should expect aftershocks. The collapse of Lehman Brothers was an earthquake for the global financial system. What is happening in the Gulf now is an aftershock.
The Problem of Dubai World
The trigger for the latest crisis, which has seen major banking share price falls across the world, is not a crash as such but a rescheduling of debt. Dubai World has $59bn of debt (the bulk of Dubai's $80bn debt) and repayments to all lenders are being put on 'standstill' for six months.
If something is state-backed, especially when the state involved (Dubai) is understood by the market to be backed by a much wealthier energy-rich State (Abu Dhabi) within a sovereign confederation, it is supposed to be copper-bottomed.
Dubai World's delay to the repayment of some of its debt not only suggests that Dubai itself may be in trouble. It raises questions about the extent to which Abu Dhabi will come to the rescue not only of its sister state but of the many banking, property and construction interests who are in over their heads.
The Gulf Financial System
Markets are built on confidence. The financial system that had been propping up this deck of cards in the desert had assumed that the Gulf was playing to the same rules as Wall Street, the City of London and all the other financial centres that keep capitalism chugging along for good or ill.
But, whereas the rest of the capitalist world has a semblance of democratic and quasi-competent bureaucratic scrutiny that keeps everyone within certain 'rules', the Gulf is late to the game. Its policies are still driven by dynastic whim and an uncertain professionalism amongst technocrats and regulators.
Old Middle East hands have always been aware of uncertainty of outcome in the Gulf and have discounted matters accordingly. The Boards of some major construction companies and get-rich-quick professional and financial service advisers may not quite have understood the 'risk profile' as well.
Uncomfortable Risks
This crisis is not going to bring down capitalism by any means but it presents some very uncomfortable risks for London in particular. Hysteria about a second global crunch can be discounted but we should not be complacent.
David Cottle on the Wall Street Journal Blog puts things into some perspective today but he notes that:
"Dubai did as many larger, older countries have done and carried on borrowing and splurging through the economic downturn ... [the current crisis] does serve as a reminder that, no matter where you are, the money runs out in the end."
There are two issues here for London. The first is that money does run out in the end. This lesson must strike home in the week that the public found out that the Bank of England had secretly printed £61bn of cash (later repaid) to help two rocky Scots bank get out of the hole they had dug themselves.
Promoting Dubai
The second is that, in its national business model of heavily promoting the City of London to overseas capital centres in order to increase tax take, the British Government encouraged a lot of construction and service sector companies to ignore some fundamental risks in supporting Dubai's megalomania.
Banks and Government have probably been deluding themselves that everything might go to the wire but that Abu Dhabi would eventually cover all Dubai's financial liabilities, after extracting some political advantage, and that all accumulated local debts to British companies would then be paid.
These latter have not been quantified but they are very worrying. Most big companies have been able to make appropriate banking arrangements on an implicit sovereign promise to pay so the decision by Dubai to declare a unilateral holiday on debt repayments will have shaken some banks badly.
Knock-On Effects
This is represented by the falls in bank shares in London but there are many mid-sized law firms and other advisory firms and payment-on-payment suppliers to the larger companies who cannot last out much longer and for whom the expectation of payments and new business restarting soon was vital.
The knock-on effect to some over-stretched City of London professional and financial services firms and small export-led businesses could be considerable. We cannot be sure of this because there are no figures but the British commitment to the region has been substantial.
We had advised our contacts to be cautious about the Gulf after the 'credit crunch' but some desperate service firms felt they had nowhere else to go as business dried up in London. They certainly seemed to be backed up by the positive talk from Government and banks about prospects.
London's Vulnerabilities
This need not, by any means, turn out to be a complete disaster. Abu Dhabi is still likely to step in after exacting whatever leverage it requires but the assumption that all will be settled by dynastic whim has been replaced with a dangerous uncertainty that these people actually know what they are doing.
But what is the worst case for London? There are several risks here. The first is the obvious one that some British companies will crack, reducing the tax base and the reputation of the City of London.
A second is that the pressure on banks involved in the Gulf will require another round of financial assistance from the Bank of England which will not be so easy to keep secret and may not be so easily repaid if recovery falters.
Investor Assessments
What this means is that the Bank of England could start unnerving investors about how much it is prepared to print money and how much it is prepared to be open about its policies. King's decision on the secrecy of the £61bn appears to have been accepted but future secrecies may not be.
If the vast overhang of existing debt is to be managed, it can only mean massive spending cuts, increases in taxes ... or dealing with the problem by printing money. The investment community does not care about the first two but it does care deeply about inflation, let alone hyper-inflation.
If the democratic political process severely limits Government's ability to recoup its expenditure on (as the public may see it, possibly unfairly) ensuring bankers keep their jobs and their bonuses, the temptation to print money must eventually become overwhelming.
Inflation
As Cottle implies, the international investment community has, to date, given the benefit of the doubt to the Keynesian strategy of spending your way out of crisis into recovery, recouping the costs later on tax revenue and a return to sound financial management. But this is predicated on sustained recovery.
The Dubai case is definitely not comparable with developed Western economies but it must unnerve some investors on the very grounds that Cottle suggests - eventually the money runs out and (though he does not say this) you have to print it. Without adequate asset-backing, it becomes worthless.
The oil price fell on the news from Dubai but the British case may be complicated by the expectation that, while the crisis might hit global recovery somewhat, an eventual recovery is coming and it will increase food and oil prices.
If the UK is lagging because it is still clearing up the disproportionate mess in its own books then we may get a period when Government is forced to 'print money' while commodity prices are rising. This would bring back 'stagflation' - not seen in the UK since the 1970s.
Disproportionate UK Risk
The Dubai crisis also hits the UK disproportionately because of its past policy of supporting Dubai's pitch to be the natural 'time zone' financial centre without fully understanding that dynastic megalomania might have been undermining that ambition at another level.
There is an even bigger picture here which goes back to the oddities of British foreign policy in the wake of Tony Blair's disastrous and somewhat private decision to be the US' out-rider in the region - a story painfully being unravelled in the current Iraq Inquiry.
Two policies have converged on Dubai. The first is the UK's determination to be an export led services provider to the world in order to maximise tax take from the City of London. This must be seen as central to its active encouragement of what may turn out to be over-investment in Dubai.
The second is the effect on its foreign policy of a determination to buttress the dynasts who maintain the stability necessary to build mega-projects that hire British construction companies and develop the infrastructure for a financial hub that gives business to expert services.
Unfortunately this has also meant that the UK has become the Gulf's voice in Washington regardless of its lack of democracy and adequate human rights cover and that it has developed a forward policy on Iran that places it as an enemy of a country that might have been a market.
Where We Are
The choice of the Gulf over Iran is not so much of a moral choice as liberal-progressives would like us to think. It has been a choice for a services export approach based on the City over the export of more general consumer manufactures and capital goods.
So the crisis in Dubai is significant at many levels. It shows us that the world economic crisis is not yet over, that dynasts are still only half-baked members of the Western system and that the UK's economic and foreign policy are dangerously entwined.
Like Cottle, we do not think this crisis is shattering. The spinners are determinedly, and probably rightly, referring to it as a 'sideshow' as far as the global financial system is concerned. But the UK is particularly exposed to this one and all the 'spinning' from London will not change that fact on the ground.
We do not think this crisis will shatter the British economy but it is another blow to it in its weakened state. It may further limit policymakers' room for manouevre. What we have to do now is ask how we ever got into this position in the first place?