Will the Bubble Burst on Dubai?
by Rex Motes
Photo by Joi Ito
Although the original stimulus for Middle Eastern economic expansion is the huge revenue surplus from oil exports, more recently, billions of dollars in investor capital have been flowing into the United Arab Emirates (UAE) to further fuel the country’s economic boom. Some economists are predicting Dubai, UAE, to sustain eight consecutive years of 11 percent annual growth in real gross domestic product regardless of the global credit crunch.1 It is anticipated that the main driver for the surge in economic growth will be attributed to the non-oil sector, helping Dubai outpace growth rates of other Gulf Cooperation Council countries.2 In fact, foreign trade grew by 30 percent in 2007, not including oil.3 Approximately 80 percent of the residents are expatriates, and a large population of internationals continues to rush to Dubai as it establishes itself as an international financial center. Twenty thousand American citizens, along with Europeans, Russian oligarchs and wealthy Indians, tolerate censored media and mail surveillance in an effort to gain their share of rapid economic development rewards.4 The Rady School of Management is also active in the region via the Beyster Institute and its Middle East Entrepreneur Training program. With recent coverage by “60 Minutes” and National Public Radio bringing even more attention to the relevance and surge of Dubai as a financial hub, one must take note. Can the trend of massive economic development be sustained in Dubai, or is there fragility in its economy that puts it at risk of financial crisis? It remains to be seen if the exuberance concerning Dubai is rational, and whether its assets are accurately valued or grossly overvalued. Global illiquidity alongside the rush of capital to Dubai raises yet more concern as investors re-allocate capital out of dry markets and into Dubai's. Perhaps the Japanese banking crisis of the 1990s and the recent global credit crunch can provide insight to help evaluate current trends in Dubai.
Japan’s Banking Crisis of the 1990s
Japan’s troubles in the 1990s followed on the heels of tremendous optimism and economic growth in the 1980s. The 1980s marked a period of speculative excess in the Japanese stock and real estate markets, due largely to the deregulation of the Japanese financial system and the search for high-return investments. Deregulation created an environment that no longer favored the few government-ordained banks that became accustomed to guaranteed credit returns. All banks were therefore forced to compete with one another in order to win wealth-gaining assets and projects. This competition resulted in loans to higher-risk clients in an effort to earn the consummate returns and achieve banking industry leadership. Simultaneously, however, the increased competition and demand for borrowers depressed the return rates. Investments shifted from export-based sectors and into real estate development and nontraditional projects such as golf courses.5 These riskier clients then submitted the overvalued real estate assets and securities as collateral for the loans.6 This method, consistent with standard practice since World War II, in turn further drove up real estate prices. In fact, an article from the Columbia Business School claimed that “Japanese real estate prices in the leading cities became so overvalued that the value of the land on which the Japanese Emperor’s palace is situated became worth more on paper than the entire state of California.”7 Equity assets held in Japan were also excessively overvalued. Japanese banks played a major role in inflating the stock prices by holding large amounts of stock in their main clients.8 When the bubble burst, the value of the real estate and equity collateral tumbled, and banks were no longer able to recover their loans. This led to bank failure and the spiral of market decline from which Japan is still recovering.
The Current U.S. and Global Credit Crisis
In September 2007, Mervyn King, Governor of the Bank of England, described the cause of the U.S. and global credit crisis in a letter to the Treasury Committee.9 In line with the common understanding of financial market experts, Mr. King explained that the source of turmoil is due to illiquidity resulting from a misunderstanding and mis-pricing of risks in the financial system. The primary instruments at fault for instigating the crisis were securitized sub-prime mortgage loans sold to investment vehicles in the form of structured credit. With credit ratings on the instruments from recognized rating agencies such as Moody’s, investors felt secure in investing into what they believed was a stable asset class. As a means to finance the purchase of the structured credit instruments, investors issued short-term commercial paper. In essence, investors were taking positions typical to that of banks: they borrowed short to lend long. The huge positions by both banks and investors in structured credit instruments created an illiquid market as uncertainties about the quality of credit in the instruments began to spread and owners sought to rapidly unwind their positions. Demand for such instruments waned while supply steadily increased. To make matters worse, just as the market dried up, many banks were in the process of securitizing pools of their issued loans in preparation to sell them on the market. This created an even greater crisis, as the illiquid and overvalued assets led some banks to struggle in meeting capital requirements. Banks subsequently cut their lending in an attempt to relieve the pressure. Similar to Japan in the 1990s, severe miscalculation of risk, an overly liquid market and large-scale investment in risky assets was countered by illiquidity, bank failure and a full-fledged financial crisis.
Dubai is looking to diversify the source of its financial wealth away from oil as it contemplates its post-oil future. The effort to transform itself into a center for tourism and a financial hub is in response to Dubai's expectation that it will run out of oil within the next few decades.10 A small land mass of 1,500 square miles erected from the desert, there are no natural treasures like the Grand Canyon, Niagara Falls, or the Alps. Arid land and temperatures in excess of 120 degrees Fahrenheit are hardly enough to draw in the tourism levels capable of sustaining an economy. Nor does Dubai have a manufacturing-based, export-centric economy on which to rely, aside from its declining oil natural resource. What Dubai does have is capital to invest globally and in the re-creation of its identity, and a geographic location favorable to integrate Western and Eastern commerce. By leveraging its location, Dubai not only facilitates commerce but also provides a range of tailored financial instruments that are desirable to broad demographics. It follows that the chosen remedy is international investment, investment in premium real estate development and incentive provisions to companies that conduct business based in Dubai. Immense construction projects and the rise of its markets indicate the efforts are indeed attracting investment.
For global investments, the past few years have marked Dubai spending billions of dollars in acquisitions and holdings through its government-owned holding company, Dubai World. Examples of Dubai using its sovereign wealth for a global presence includes investments in the cruise ship Queen Elizabeth 2, in luxury retailer Barney's and a minority stake in the MGM Mirage hotel and gaming enterprise. Dubai World was able to close the deal with MGM Mirage using $5 billion in cash, a signal that liquidity is a non-issue. In addition, Dubai has considered acquiring troubled U.S. banks through its Dubai International Finance Center Investments branch.11 Dubai Bourse is also in on the mix, having worked with Nasdaq on an intricate deal to buy the Nordic OMX Exchange group.12
Photo by Joi Ito
Construction in Dubai is monumental. One of every five construction cranes in the world is in Dubai.13 It’s already the home of man-made islands, such as the Palm Islands Dubai, populated by multi-million dollar beachfront homes. Al Nakheel Properties, the state-owned company that is responsible for the Palm Islands, recently completed construction on a set of man-made islands in the shape of the world’s continents and has begun a project to build islands in shapes of planets and galaxies. Another area of Dubai is dubbed by some as “the largest construction site on earth,” collectively employing a half million laborers working 12-hour shifts on a reported $300 billion worth of projects.14 For recreation, Dubai couples its man-made beaches with the world's tallest indoor ski slope on the site of one of its shopping malls. Dubai has also created conditions favorable for commerce in an effort to encourage foreign investment. The tax-free zones have attracted more than 2,000 companies from over 70 countries looking to take advantage of the enabling infrastructure.15 To put it in perspective, the following is a list of the incentives in the tax-free zones offered by the government of Dubai:16
- 100 percent foreign ownership.
- Exemption from all import duties. 100 percent repatriation of capital and profits.
- Freedom from corporate taxation, as applied throughout Dubai, with the added bonus of a renewable 15-year guarantee in the tax-free zone.
- Abundant, inexpensive energy.
- Simple and efficient recruitment procedures ensuring the availability of a competitively skilled and experienced workforce.
- A high level of administrative support from the tax-free zone authorities.
Notable companies that have taken advantage of the incentives include Sony, IBM and, not surprisingly, the oil company with Dick Cheney in its lineage, Halliburton.
Is Dubai Susceptible to Crisis?
In forming an opinion on whether Dubai is susceptible to similar crises as those exemplified in 1990s Japan and in the current global credit crunch, one can look at the respective historic events leading to each crisis. In doing so, one might raise concern regarding the exuberance in Dubai and real estate value speculation, inflation and the effects of the global credit crunch on Islamic financial markets. A major issue adding to the difficulty in discerning fact from speculation is the lack of transparency on behalf of the Government of Dubai and the UAE. Transparency issues make it difficult to determine if the sheikdom can withstand a dramatic financial downturn. For example, it’s unclear if Dubai would be able to inject the capital needed to stabilize the market in the event of a downturn caused by illiquidity. Nonetheless, one can look at evidence in some of the aforementioned indicators.
According to a February 2008 survey issued by ArabianBusiness.com, almost half of the respondents suspect that Dubai’s real estate market is a “bubble waiting to burst.”17 An additional 25 percent of the respondents believe the market is “obviously going to decline.” In addition to the surveys, some homeowners are claiming notoriously poor quality. One example describes water pouring in when it rains.18 The famous Palm Islands Dubai are also receiving attention. The news magazine “60 Minutes” visited the islands one month after the official opening in 2007 and reported that the island resembled a ghost town, despite houses that initially sold for $1 million being resold on the market for $5 million.19 The dramatic rise in value within such a short time period may not be justified, raising suspicion of irrational exuberance.
In terms of inflation, the UAE Central Bank reported that the money supply increased by 36.7 percent in 2007. The dramatic increase in excess money supply lends further support to inflationary concerns. The International Monetary Fund recently revised estimates of Dubai’s 2007 inflation rate from 8 percent to approximately 11 percent, compared to the U.S. 2007 inflation rate of below 3 percent. Regional head of research at Standard Chartered Bank, Marios Maratheftis, claims that the growth in the UAE's money supply is both “excessive and alarming.”20
Debt levels and the effect of the global credit crunch are also raising concerns about Dubai. According to Chip Cummins’ December 2007 article in the “Wall Street Journal,” Dubai’s debt levels are four times the average of other Persian Gulf states, and credit rating companies are asking for more information to aid in determining how sound the government’s fundamentals really are.21 Recent declines in Dubai’s Financial Market Index may also gain attention.22 This news, combined with recent price movements in the Dubai 2009 Sukuk (sukuk describes shari'a-compliant bonds) and a widening spread over LIBOR could be an indication that Dubai’s market is feeling the effects of the global credit crunch.23
Although the provided examples could serve as early indicators of future financial troubles for Dubai, there also exist counterexamples and explanations to dispel the concerns. For example, the demand for real estate in Dubai is still booming. With such high demand, rent prices are driven up but consistently capped by Dubai's policy to allow only a 5 percent increase. Also, the currency in Dubai, the UAE Dirham (AED), is pegged to the U.S. dollar. The weakening dollar, the demand for real estate and the increase in the price of oil all help explain the rise in inflation. Banking appears to be strong in Dubai, as well. In January 2008, the Noor Islamic Bank was launched with an initial capital of $1 billion. Consistent with Dubai's strategy to invest sovereign wealth, ownership in Noor Islamic Bank is 25 percent by the government and 25 percent by the ruler, Sheikh Mohammed bin Rashid al-Maktoum. As for credit, the UAE’s largest Islamic lender is Dubai Islamic Credit, with a market capitalization of $9 billion.24 Last year also marked tremendous growth in the selling of sukuks. Bloomberg data indicates that sukuk sales jumped from $18 billion in 2006 to $30.8 billion in 2007.25
The fact remains that it is difficult to predict crises even if some metrics hint at one. The lack of transparency on behalf of government makes predicting a crisis an even more daunting task. Certainly, past crises such as Mexico 1982, Mexico 1994, Asia in 1997-1998, Russia in 1998 and Argentina in 2001, can help analysts understand the causes ex post. Japan’s banking crisis of the 1990s and the current global credit crunch assist in that understanding, as well. Ex ante, however, even the most skilled financial analysts can misread the indicators as exhibited by Bear Stearns' troubles. To add even more complexity, globalization and the world’s integrated economies send shockwaves throughout a domestic economy, even if the fundamentals of the domestic economy appear sound. Is crisis going to follow on the heels of tremendous optimism as it did in Japan? Could Dubai be the next in a series of economies struck by the global credit crunch? Only time will tell if Dubai's economic business plan will prove robust or fragile.
52003, Peter Epsig, Columbia Business School, "The Demise of a Banking Dinosaur, Long-Term Credit Bank "
62000, HBS case, "The Japanese Financial Crisis and the Long-Term Credit Bank of Japan"
7See note 5 above.
8See note 6 above.
9 2007, Mervyn King, "Turmoil in Financial Markets: What Can Central Banks Do?"
13See note 3 above.
25See note 23 above.
Rex Motes (’08) graduated from the Rady School with a concentration in finance. His interests are in the energy sector, with recent work in algae-derived biofuels and gasification of municipal waste for renewable power. Before attending Rady, Rex developed enterprise business intelligence and data warehouse solutions.