A New Future

The crisis has hit the emirate hard, but it is wrong to write it off

AFP

THE first glamorous residents have already made a home for themselves at “The World”, an archipelago of 300 artificial islands (pictured above) created off the coast of Dubai by Nakheel, one of the emirate’s big three developers. Pilot fish and parrot fish have colonised the man-made reef surrounding the islands. The reef, built from 34m tonnes of rock, forms a protective ring around the islands—a breakwater that stops the Gulf’s currents from slowly washing The World away.

To its many critics, Dubai’s economy is as artificial as Nakheel’s islands. The emirate borrowed capital and labour to make speculative bets on real estate, of which The World is only one outlandish example. Now policymakers are scrambling to build an economic breakwater that might protect the emirate’s prosperity from adverse tides: plunging property prices, ebbing trade and tourism, and the unaccustomed difficulty of refinancing its ambitions.

The debt of Dubai’s government and government-controlled companies is about $80 billion. Almost $11 billion comes due this year (including interest) and $12.4 billion next. Nakheel alone must refinance a $3.52 billion bond in December and another worth 3.6 billion dirhams ($980m) five months later, according to EFG-Hermes, an Egyptian investment bank.

The rocks for Dubai’s breakwater have been provided by its neighbour Abu Dhabi. The wealthiest of the seven members of the United Arab Emirates (UAE), Abu Dhabi sits on 94% of the federation’s oil reserves. Through the central bank, it bought $10 billion of Dubai’s bonds, half of a proposed $20 billion issue. This bail-out, announced in February, has restored calm, as shown by the falling cost of insurance against default (see chart). The economy has shifted “from the crisis mood to the solution mood,” wrote Dubai’s ruler, Sheikh Muhammad bin Rashid al-Maktoum, in an online discussion with reporters on April 18th, his first in eight years.

The solution includes reshaping the archipelago of quasi-government companies known loosely as “Dubai Inc”. These enterprises mostly fall into one of three holding companies: Dubai World, Investment Corporation of Dubai, and Dubai Holding, which belongs to Sheikh Muhammad himself. Each holding company boasts its own master-developer: Nakheel, Emaar and Dubai Properties.

The ruler was happy to devolve power to these companies, which were run like personal fiefs. The competition between them kept them on their toes, unlike sluggish ministries of urban development elsewhere. But the developers also fell prey to one-upmanship. Emaar is building the world’s tallest building, so Nakheel announced a 1km tower that would surpass it. The government stood behind these companies, giving them the confidence to overreach. But the authorities did not stand over them, ensuring their plans cohered with each other and with reality.

During the boom, supply seemed to create its own demand. Developers sold properties before ground was even broken, asking for first instalments of 10% or even lower. This allowed speculators to buy ten apartments for the price of one, with the aim of selling them at a profit before the second instalment fell due.

The market peaked in September 2008, about 30 months after Dubai allowed foreigners from outside the Gulf to buy freehold properties in designated areas. Prices fell by about 25% in the last quarter of 2008, according to several of the private indices compiled in the absence of sound official data. They may have fallen by the same amount in the first quarter of 2009.

The market is sending a signal that even Dubai’s bullish developers cannot mistake. In March, Middle East Economic Digest (MEED), a business journal, calculated that UAE developers had postponed $335 billion-worth of construction projects. One two-year project was proceeding so slowly that it would take 20 years to complete. Three months after announcing its 1km tower, Nakheel postponed it.

The restructuring of Dubai Inc has begun. Nakheel shed 15% of its staff in December and has continued to pare its numbers since. Sheikh Muhammad’s own Dubai Holding has also cut staff. “Last year, people would talk about how many houses they owned,” says one Dubai veteran. “Now, they talk about how many friends have lost their jobs.” Other economies benefit from automatic fiscal stabilisers as the unemployed stop paying taxes and start spending welfare benefits. The UAE suffers from an automatic destabiliser: 30 days after a foreigner loses his job, he loses his right to stay. Once they leave, Dubai’s ex-expats will spend nothing in the economy they leave behind.

Companies often keep people on their books (unpaid) while they look for alternative employment. But EFG-Hermes forecasts that Dubai’s population will fall by 17% this year. Its workforce will shrink to fit a contracting economy, just as it grew to fit an expanding one. One architect in Dubai has proposed turning vacant labour camps, where migrant builders once lived eight to a room, into affordable housing for people who can no longer rent the apartments the labourers were hired to build.

Dubai lives in a good neighbourhood, however. Abu Dhabi, the next-door emirate, has 92 billion barrels of oil reserves and a sovereign-wealth fund with probably over $300 billion of assets. The consolidated balance-sheet of the UAE is not overly stretched. It is just that one emirate has most of the assets; its neighbour has most of the liabilities.

Good-neighbour policy

As Dubai’s crisis deepened, everyone waited for its oil-rich neighbour to bail it out. The wait lasted an agonising few months, from the onset of the crisis in September until the central bank’s decision to buy Dubai’s bonds was revealed in February. What accounted for the delay? Many commentators argue that Dubai was reluctant to ask for help, and that Abu Dhabi asked for something more than 4% interest in return. Abu Dhabi was perhaps not unhappy to see Dubai’s wings clipped and the federation tightened.

But Georges Makhoul of Morgan Stanley thinks it is wrong to describe the federation’s deliberations as if they were a “family soap opera”. He adds: “It’s not as if people in Abu Dhabi are scheming about how to make Dubai suffer, and the people in Dubai are scheming about how to wring money out of Abu Dhabi.” The offer of help was extended in November, he says.

In his online interview, Sheikh Muhammad denounced “vicious attempts” by the media to “fabricate differences between Abu Dhabi and Dubai.” He complained about a “media bombardment” of the UAE since the crisis broke. “I know that some people from outside the region have wished that [the] Dubai model will go down the river,” he says.

The critics of Dubai have indeed been as prone to overstatement as the Dubai developers they disdain. The Dubai model has deep roots. The emirate has, after all, been borrowing to invest in infrastructure since the 1950s, when it sold a bond to Kuwait to finance the dredging of its creek. The results of this investment are sometimes hubristic, but often impressive. The Jebel Ali Port, for example, is one of the biggest container docks in the world.

Dubai has also put similar efforts into its “soft infrastructure”. For example, the Dubai International Financial Centre has imported English law and international arbitration from London—even if it lacks the institutional history to back it up.

The skills Dubai needs to prosper are most abundant in the West. To attract these skills, it has turned itself into a country Westerners can enjoy, notes one Saudi onlooker. Saudi Arabia is a bigger economy offering more interesting work. But it struggles to attract the lawyers, financiers and other professionals it needs.

Not everyone is fresh off the plane, or booking their flights home. Dubai’s older family businesses, which trace their origins to Iran, India and Zanzibar, will not abandon the emirate during its downturn, any more than they were carried away by the boom. Dubai attracts people from 202 nationalities, according to the Ministry of Labour. Some of these people are footloose and flighty. But for others, the emirate is the only place in the region they would want to live. Dubai was a microcosm of the world even before Nakheel decided to build its island replica.

Trade Exchange Rates Budget balances

Trade, exchange rates, budget balances and interest rates

Apr 23rd 2009
From The Economist print edition

Global downturn: In graphics

This is one of the most tumultuous times on record in the global financial markets.

TRILLION-DOLLAR BAIL-OUTS

Huge amounts of money have been committed in financial support for banks.

BILLION-DOLLAR STIMULUS PACKAGES

Governments are spending billions of dollars to kick-start economic growth. Measures include tax cuts and building projects.

VICTIMS

The financial landscape has changed dramatically, with several giants of the business world disappearing.

UK BANK BAIL-OUT PACKAGE

The UK has spent £94bn to prop up Royal Bank of Scotland, HBOS and Lloyds TSB as well as nationalised Northern Rock and parts of Bradford & Bingley.

The Treasury and the Bank of England have pledged hundreds of billions of pounds of further support for the fragile banking system.

A £250bn credit guarantee scheme announced in October is being expanded to encourage banks to lend more, with a commitment of up to £50bn.

US BANK BAIL-OUT PACKAGE

There has been an array of measures to provide support to the battered US financial system.

A $700bn scheme approved last year, known as the Troubled Asset Relief Programme, was used to help lenders like Citigroup and Bank of America as well as the automobile industry.

Major changes to the programme have been announced by the new administration, including a partnership with the private sector to buy toxic assets from banks.

ECONOMIES HIT

World economic growth is expected to slow sharply, with the UK among the hardest hit. Developing countries such as China and India should fare better.

LEGACY OF DEBT

As countries try to spend their way out of recession, debt levels are forecast to rise.

Losses from Meltdown to reach 4 Thrillion USD

The International Monetary Fund (IMF) has warned that potential losses from the credit crunch could reach $4 trillion (£2.75tn) and damage the financial system for years to come.

It says that even if urgent action is taken to clean up the banking system, the process will be "slow and painful", delaying economic recovery.

It says that banks may need $1.7 trillion in additional capital.

But it warns that political support for further bank bail-outs is waning.

WHY $4TN LOSS MATTERS The banks' huge losses have made them reluctant to lend The lack of lending has pushed the world economy into a deep recession Government budgets are strained by the cost of the bail-outs, hitting taxpayers

One year ago, the IMF estimated that total losses from the credit crunch would be $1 trillion, which has been exceeded, showing how rapidly the financial meltdown has escalated.

The IMF now says that banks are likely to lose $2.7 trillion, but other financial institutions such as insurance companies and pension funds are also now coming under strain.

And it says that emerging market economies, which will need $1.8 trillion in refinancing next year, will be hard-hit by the collapse of cross-border lending, and it predicts that there will be no net private lending at all to developing countries this year.

The report comes as the IMF and World Bank are beginning their spring meeting in Washington, after receiving a promise of $750bn in fresh funds agreed at the G20 summit.

Policy response

The IMF's latest Global Stability Report says that the banking system has not yet been stabilised, despite the billions of dollars spent by governments.

Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested IMF

But it warns that they may be "a real risk that governments will be reluctant to allocate enough resources to solve the problem" because the public has become "disillusioned by what it perceives as abuse of taxpayer funds".

This is the situation especially in the US, where Congress appears reluctant to allocate additional bail-out funds above the $700bn approved last autumn despite the inclusion of another $750bn in President Obama's latest budget proposal.

The US Treasury has instead proposed a private-public partnership to buy up troubled assets underwritten by loans from the Federal Reserve.

But the IMF comments that "uncertainty about political reactions may undermine the likelihood that the the private sector will constructively engage in finding orderly solution to financial stress."

Deeper recession

The IMF says that restoring the banking system so that it functions normally is likely to take several years, and this will make the recession longer and deeper than usual.

COST OF REBUILDING BANKS US banks: $275bn Eurozone banks: $725bn UK banks: $250bn Other European banks: $225bn Source: IMF, based on 6% capital/assets ratio

But it warns that if policies are unclear or not implemented forcefully and promptly, "the recovery process is even more delayed and the costs, in terms of taxpayer money and economic activity, are even greater."

It says that the worldwide recession has deepened the financial crisis.

"Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning.

"Further effective government action - particularly geared toward cleansing balance sheets and strengthening institutions - will be required to stabilise the global financial system and to provide the foundation for a sustainable economic recovery."

On Wednesday, the IMF will present its world economic forecast.

It is expected to be the gloomiest for 60 years, with the world falling into a global recession, and an even sharper decline in output in the rich countries.

The rise and fall of the Filthy rich

The rich under attack

Apr 2nd 2009
From The Economist print edition

Going for the bankers is tempting for politicians—and dangerous for everybody else

The Bridgeman Art Library

STONES thrown through a banker’s windows in Edinburgh, workers “bossnapping” executives in France, retrospective 90% tax rates proposed in Washington, and now a riot in London as G20 leaders arrived for their summit (see article). A sea change in social attitudes that could have profound effects on politics and the world economy is under way.

The rich are certainly not the only targets in the current populist backlash. Frightened by the downturn, people are furious with politicians, central bankers and immigrants. But a rising wave of anger is directed against the new “malefactors of great wealth”. Today’s villains are a larger and more global bunch than the handful of American robber barons Teddy Roosevelt denounced a century ago; and most of them are bankers and fund managers, rather than owners of trusts and railroads. Yet the themes are similar to those at the end of that previous gilded age: rising inequality—the top 0.1% of Americans earned 20 times the income of the bottom 90% in 1979 and 77 times in 2006—and a sense that the greedy rich have cheated decent working people of their rightful share of the pie.

Some of this cheating has been of an old familiar sort: building Ponzi schemes and bribing politicians to secure favourable deals. There are greyer areas, in which the rich hide their cash in tax havens and get tax law written to their advantage—witness the indefensible treatment of private-equity profits. But what makes the rich’s behaviour so galling for many critics is that their two greatest crimes were committed in broad daylight, as they were part of the system itself.

The two great cheats

The first charge is that the rich created a new form of heads-I-win-tails-you-lose capitalism. Traders and fund managers got huge rewards for speculating with other people’s money, but when they failed the parent company, the client and ultimately the taxpayer had to pay the bill. Monetary policy contributed to this asymmetry of risk: when markets faltered central banks usually rescued them by cutting interest rates.

The second charge is that the bankers and fund managers were not doing anything useful. Unlike the “deserving” rich entrepreneurs who set up Microsoft and Google, the “undeserving” traders and brokers just shuffled money around the system to nobody’s profit but their own. The faster the money went round, the larger the financial sector loomed in the rich countries’ economies. At its peak it contributed 41% of domestic American corporate profits, more than double the rate two decades ago. As finance grew, the banks got ever bigger—too big to fail, eventually, so when they tottered taxpayers had to prop them up. Far from epitomising capitalism, the undeserving rich undermined it: it was socialism for the wealthy.

These two charges run together, but the second has much less justification. Enormous though the cost of bailing out the banks has been, there is nothing inherently undeserving about finance; even in their flawed state, more liquid markets have brought huge benefits to the rest of the economy. The lower cost of capital has made it easier for industry to invest, innovate and protect itself against interest and exchange-rate risk. Trying to single out financiers from entrepreneurs is a fool’s errand: you will end up hurting both.

The heads-I-win charge is not entirely proven, either: some of the people who ran banks did lose when they went bust. Yet even a newspaper as inherently pro-business as this one has to admit that there was something rotten in finance: the basic capitalist bargain, under which genuine risktakers are allowed to garner huge rewards, seems a poor one if taxpayers are landed with a huge bill for it all. Hence the anger.

A time for correction and brown paper bags

Periods of excess, when inequality has grown, tend to be followed by eras of reform: Roosevelt bust the trusts and shortly afterwards Congress moved towards introducing a federal income tax. Part of the genius of capitalism is its ability to adjust to disruption from within and attacks from without.

Indeed, the system is already beginning to correct itself. As our special report this week points out, the rich are not as rich as they were: some $10 trillion, around a quarter of the wealthy’s assets, has been lost. Inequality will decline. Investment banks and hedge funds are shrinking; private-equity groups are struggling to finance takeovers. Having discovered how volatile markets can be, banks will be less keen on trading in the future. There is even a correction going on in conspicuous consumption: Net-a-porter, a pricey website, offers to deliver designer outfits to its customers in brown paper bags.

The market’s self-correction will not be enough, however. Higher taxes will eventually be inevitable, since so many governments have lurched heavily into deficit. But politicians must tread carefully. Tax rises right away would be a rotten idea, since for the moment fiscal stimulus is needed. And even when governments raise the money, they should first get rid of deductions and reverse unmeritocratic measures (such as George Bush’s repeal of America’s death tax) rather than jacking up income-tax rates to punitive levels. Squeeze the rich until the pips squeak, and the juice goes out of the economy.

As for heads-I-win capitalism, the problem of asymmetric risk should shrink, because the rule changes needed to make the financial system safer will also remove unwarranted profits. Contra-cyclical capital requirements, forcing banks to build more reserves during good times, will leave them less cash to splurge on bonuses. Many of the sweetest sources of profit sprang up in the cracks between regulatory systems; governments are now filling in these gaps. If central banks focus on asset markets when they rise as well as when they fall, they will remove much of the froth. Treat a bank that becomes too big to fail like a utility, and it will make less money.

Curbing the excesses of wealth, then, will be a side effect of regulations designed to make capitalism work better. Such measures will not provide the lyrics to revolutionary anthems, but they are going to be better than going after the wealthy. The rich are an easy target. But when you try to bash them, you usually end up punching yourself in the nose.