The news that creditors of Dubai World will not be made whole by either the governments of Dubai or Abu Dhabi is still being absorbed by the markets and journalists, many of whom assumed that a bailout was in the works.
We were sceptical from the start of a talk of a bailout, not least because relieving creditors of their risk without also relieving them of profits seems to violate what we understand of Islamic finance rules. It seemed that westerners had just become so accustomed to bailouts of government sponsored entities that we just thought those sheiks would rattle and roll like the US Treasury and the Federal Reserve.
As Mavercon Willem Buiter has explained in his FT blog, Dubai and Abu Dhabi are doing the world a huge favour. For years, US policymakers—Barney Frank, especially—insisted there was no implicit guarantee of Fannie Mae and Freddie Mac. But he was wrong. When push came to shove, the guarantee became explicit.
We’re now all suffering with how to restore the credibility of our government when it comes to letting the creditors of systemically important financial institutions suffer when one of them goes bust. Even our non-government sponsored entities are now backed by either implicit or explicit guarantees.
So here’s how Dubai shows us the way forward:
Given the over-the-top reaction of creditors and the western media (including the Financial Times) to the possibility that the Dubai and Abu Dhabi sovereigns might not stand behind the debt of Dubai state-owned companies, it is clear that a debt deferral or a debt default by Dubai World or by Nakheel would indeed be news for a number of market participants. They will have learnt that only sovereign debt is debt of the sovereign and that only sovereign-guaranteed debt is debt guaranteed by the sovereign. A simple lesson but a useful one.
So in the future they will lend to Dubai World or Nakheel or to other state-owned companies in Dubai on terms that reflects the likely absence of sovereign support, should these companies get into difficulties. Those terms are likely to be rather less favourable than terms extended earlier on the belief (wishful thinking) held at the time, that debt of state-owned companies is sovereign guaranteed. The notion that companies from Dubai, state-owned or not state-owned would not have access to the international markets for an extended period of time following a debt deferral, debt restructuring or debt default by Dubai World or Nakheel is ludicrous and counterfactual to a vast range of historical experience.
Ironically, it looks like Dubai has finally become the financial centre of the future—leading the world back to risk based lending rather than socialized losses. The future of finance isn’t what it used to be. But it may not be quite as dark as the bailouts by US and European governments had promised.