(Editor’s note: This is our first post from Di Gestive and we would like to thank her for her contribution and welcome her to the team. We hope this is the first post of many!)

As Dubai’s property bubble burst, it became evident that the only way Dubai could pay its debts was with Abu Dhabi’s cash. Therefore to understand Dubai World’s decision to restructure and default, especially as it came after repeated signs from Dubai indicating that the Nakheel sukuk in particular will be repaid on time, it is imperative to examine Abu Dhabi’s reasoning.

Reasoning:

The total size of the UAE’s Abu Dhabi-controlled SWF is estimated at over USD 300 billion dollars. The obligations of Dubai World total USD 60 billion. The media repeatedly cites USD 80 billion as being the total size of Dubai Inc’s debt. I find this figure highly questionable. Dubai Inc was estimated to have borrowed some USD 60-80 billion before the true extent of DW debt was revealed by Nakheel. The true figure of the debt is likely to be in the region of USD 80 – 120 billion. USD 80 billion should be treated as the lowest estimate, not the most likely estimate.

The cash flow from the investments that led to this debt is likely to be very, very low. Highly leveraged foreign investments were made at the top of the market and have now taken huge losses. Investments in local real estate were made at the peak of global commodity prices, and so construction costs have been inordinately high, meaning that the expected yields from seeing existing projects to completion are low.

Financially, the price of default is denial of access to credit markets until confidence is restored, and increased borrowing costs thereafter. Abu Dhabi holds sufficient assets in its SWF to not have to borrow for a few years. Therefore it can afford to be left out of international credit markets until the repercussions of Dubai’s default blow over. The cost of Dubai’s default for Abu Dhabi is likely to be less than the sum total it would have to pay to rescue Dubai from default.

Politically, the advantage of default for Abu Dhabi is that it terminates Dubai’s political and financial independence, and ends any threat that the Maktoums may have constituted to the Nahyans’ authority. By limiting the default to Al Maktoum’s companies, and not extending it to Dubai’s utilities and logistics arms, Abu Dhabi is seeking to limit the damage from the default at the Federal level while completely discrediting Dubai. This will most likely result in a more centralised political process at the expense of the smaller emirates’ autonomy. This certainly spells the end of Dubai’s ambitions to be a regional or global financial hub.

Abu Dhabi provided Dubai with USD 15 billion in cash over the past year, as part of a USD 20 billion rescue package. Dubai raised another USD 2 billion recently. By defaulting now, and limiting the default to Dubai World, Dubai and Abu Dhabi are telling foreign creditors that the USD 17 billion raised represents the available pool of assets from which lenders can be repaid. Abu Dhabi and Dubai are most likely preparing for acrimonious, prolonged negotiations with local and international creditors who are demanding at least USD 60 billion and who will most likely receive less than USD 20 billion already provided by Abu Dhabi. Abu Dhabi can and most likely will be pressured into providing more money over the coming year or so, but it will almost certainly not come anywhere near providing the entire amount owed by Dubai.

The only card in banks’ hands is that if they do not approve of the standstill agreement proposed by Dubai, they can place Dubai World in technical default. This is a rather weak card and has very limited shelf life: once used by any bank, its value to other banks expires immediately. It is most likely that Dubai and Abu Dhabi were expecting this outcome anyway, and are not unduly concerned by it. Dubai and Abu Dhabi have no incentive to cooperate with international lenders as the damage to Dubai is already done, and as Abu Dhabi’s security comes from its projected cash flow coming from oil wealth, not from its reputation. As such, any notion that Dubai will strive to be “creditor friendly” is completely misguided.

Implications:

The Government of Dubai, and, more importantly, the Government of the UAE represented by the main power in the Federation, Abu Dhabi, will prioritise transport and logistics, and certain infrastructure, over all other obligations. This is reflected in the treatment of JAFZ and DP World, which were left out of the announced restructuring. Other investments will be allowed to sink or swim based mainly on their projected cash flows. Dubai’s foreign holdings will be claimed by the banks and funds that provided the leverage for Dubai to acquire these holdings, and therefore are unlikely to be available to other Dubai creditors.

The future of Dubai utilities is also in doubt. The population exodus is going to increase as a result of the default and their debt-financed expansion plans will seem more and more unrealistic. Any projects not bringing in immediate revenue are almost certainly indefinitely on hold and probably cancelled. This will probably include the airport and seaport expansions, highways and infrastructure projects. The same will happen in Abu Dhabi as the plans for population growth (Plan 2030) are shelved. There will be no need for the increased capacity as the whole region will face a much larger liquidity crunch, and this will affect Kuwait, Dubai, Bahrain, Abu Dhabi, and to a lesser extent Saudi Arabia. Qatar is exempt to some extent, but its real estate market also looks over-priced and over-supplied.

Bahrain is especially at risk now, as its situation is similar to Dubai’s although it had not showed the same level of exuberance. But it also has banking and financial sectors, and a real estate sector, that are far larger than the size of its economy merits and that follow a model similar to Dubai’s, These sectors are highly exposed to the downturn and are highly leveraged. Like Dubai, Bahrain’s oil income is small and its reserves are running out. Unlike Dubai, the demands from the locals for a better distribution of wealth ties the government down to a high spending programme that may not be sustainable.

Any increase in oil prices will now go to financing existing projects from which immediate revenue is expected. As such, new investment and a recovery are unlikely in the coming year. This is a period of retrenching and rebuilding of reserves until confidence is restored. This applies to the GCC as a whole. The losses from Dubai’s defaults will extend to regional banks and will limit their ability to invest. The appetite for foreign banks to finance investments in the region is now most likely absent entirely, with the exception of oil and gas investments in Saudi Arabia and Qatar. Banks financing projects outside Dubai will have to increase their reserves to compensate for losses in Dubai, and will limit their overall exposure to the region as the perceived risk of the region goes through the roof. Expect more cracks to show in Bahrain and Qatar’s real estate markets, further complicating the lending situation. The property crash in Dubai will affect all GCC city-states, seeing as international companies look at the entire region and select regional headquarters. Dubai will become much more affordable now, and as this is certainly a long term trend it will seriously impact Qatar, Bahrain and Abu Dhabi markets. Bahrain’s plans for new business centres and the like, which were humming along nicely until now, will be severely impacted as they suffer a huge loss of confidence and as their Kuwaiti, Saudi and local backers take huge losses from Dubai.

Project cancellations in Abu Dhabi are likely to spike in the near future, as financing becomes much more difficult. International lending to the UAE will most likely freeze completely for the coming year. Banks who want business done with Abu Dhabi will pressure Abu Dhabi to repay some of the money Dubai owes them as a precondition for their sinking more funds in the UAE. However, as mentioned above, the UAE can afford to not borrow until this storm blows over. And since it is now clear that many of the planned projects offered very little real economic value anyway, this is a price Abu Dhabi is prepared to pay.