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Castles in the sand

The biggest mystery of the Dubai debt crisis is not why this desert dream has turned into a nightmare, but why it took so long. Ever since United States homeowners started defaulting on subprime mortgages two years ago, the tightening of international lending conditions has put the squeeze on investment bubbles around the world. Some, like Iceland or the British housing boom, popped relatively quickly, but others have been slower to collapse.

The common feature is that an excess of cheap borrowing lulls investors into thinking that more permanent wealth is being created. Like any investment bubble, it works well as long as more money is sucked in to keep inflating asset prices, but fails when that new money disappears.

The key difference with a debt bubble like the one bursting around us now is that there can be a significant time lag between asset prices beginning to fall and investors acknowledging their losses. Unlike the dotcom share bubble, for example, which drove stockmarkets up and then quickly down again at the turn of the century, credit bubbles often take a while to fully deflate.

The developers who built those skyscrapers in Dubai knew it was getting harder to fill them, and that property prices were falling, but as long as they could pay their interest bill to the banks it made sense to try to hang on, in the hope things would improve.

The banks had no incentive to foreclose because it would only force more property on to the open market and further depress the price of their remaining assets.

If anything, it has become easier to keep hanging on because governments around the world have driven down interest rates and pumped fresh money into the markets.

Yet the fragility of Dubai’s castles in the sand was hard to ignore for ever. With little prospect of a new boom to replace the old one, property developers have finally acknowledged the unpalatable truth. The big fear now is that international banks will no longer be able to pretend that these half-empty office blocks are worthy collateral for the billions of dollars of debt that has been extended.

Banking analysts at UBS estimate that the emirate’s total debt burden is well above the $80-billion to $90-billion admitted so far, with sizeable off-balance sheet liabilities lurking in the shadows.

Not only does the Dubai crisis threaten to further destabilise the West’s battered banks, but it also points to the danger of thinking that the world economy is through the worst.

From Dublin to Shanghai, there are plenty of property bubbles that have yet to fully burst. In Britain, many think the commercial property market is also hiding some painful horrors, with banks unwilling to accept that many developers are insolvent.

The Dubai crisis has also thrown a new name into the lexicon of toxic instruments. Just as credit derivatives helped to exacerbate the subprime crisis by obscuring who was ultimately exposed to losses, the use of Islamic finance has complicated the reckoning. “Sukuk bonds” are designed to get around religious laws banning the payment of interest for money lending. But one of the most volatile debts in the Dubai World standstill is a $3,5-billion Islamic bond due to be repaid in December.

Because Sukuk bonds replace interest payments with a promise to share profits, investors are effectively owners of the underlying assets, rather than traditional secured creditors.

Default on this scale has never been tested before, echoing the nervousness in derivative markets when the banking crisis first started. HSBC estimates there is $822-billion Islamic finance debt outstanding in the world. –

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