Editor: Bruce Maddy-Weitzman December 9, 2009
The Rise and Fall of Dubai
In 1954, the Ruler of Dubai and father of the current ruling Amir
Sheikh Mohammed bin Rashid Al Maktoum, borrowed 400,000 pounds
sterling from Kuwait to clear the Dubai creek and create the port
that would become the basis of its remarkable economy. It is
significant that the earliest stage in Dubai's development was made
possible by borrowing and that the first steps were taken by the
Ruler: leverage and government-initiated development have largely
been the story ever since. Construction of the port at Jebel Ali, 35
kilometers southwest of the city of Dubai, commenced in the late
1970s: today it is the largest man-made harbor in the world and the
biggest port in the Middle East. In 1985, the Jebel Ali Free Zone
(JAFZ), an industrial area surrounding the port, was established.
International companies were lured there by exemptions from corporate
and personal income taxes, import and export duties, the absence of
restrictions on the movement of funds and easy recruitment of labor.
As a result, hundreds of firms opened facilities there. The
combination of a huge port and a tax-free industrial zone enabled
Dubai to become a major entrepot center: a tax-free transshipment
zone serving the Gulf at a time when its appetite for imports was
growing exponentially as a result of the rise of oil wealth.
Everything Dubai did was tied to oil, usually someone else's.
Subsequently, the government created holding companies that spanned
the public and private sectors: Dubai Holdings (founded in 2004) a
company directly controlled by the ruler; Dubai World (2006); and the
Investment Corporation of Dubai (2006). The latter two are both fully
owned by the government, which the Ruler effectively runs. These
three groups control Dubai's quasi-government-owned companies, all of
which pursue business activities designed to achieve economic growth
and generate profits for private sector investors.
An integral part of Dubai's strategy of encouraging foreign companies
from East and West to establish their presence in Dubai was the
adoption of much more liberal policies towards dress, drink and other
matters of personal decorum and norms than other states in the Gulf,
including its partners in the seven-member United Arab Emirates
(UAE). This approach proved to be a dramatic success, turning an
already thriving city-state into an international financial center.
But on November 25, 2009, Dubai World announced that it would ask
its creditors to extend the maturity of its obligations to them: it
could not pay what it owed them on time. The announcement sent shock
waves through the international financial system. The crisis centered
on its subsidiary, Nakheel, that had borrowed vast sums to finance
rapid growth, especially in real estate.
UAE members publish little economic data but the recent IMF report on
the UAE economy reveals what went wrong in Dubai. The boom had been
partly funded from an increase in borrowing from abroad. Dubai-based
corporations were the main borrowers on international capital
markets. Although the UAE banking system had adequate capital and was
highly profitable until mid-2008, the acceleration of the growth of
credit to the private sector, from a year-on-year growth of 40% in
2007 to 50% in 2008, increased the risks from the growth of
non-performing loans. This was particularly true because of the
rising exposure of the financial system to consumer and real estate
loans and the uncertain outlook for asset prices following strong
speculative increases in the value of real estate and stocks. The
banking system's loans-to-deposits ratio continued to rise even after
it had exceeded the regulatory limit of 100% by the end of 2007.
Dubai's success stemmed from its role as a transshipment center. It
imports billions of dollars of goods that are subsequently sold
mainly in Iran and Russia. Consequently, Dubai has attracted Iranian
investments and tens of thousands of Iranian residents, some
permanent, some semi-permanent. The economy doubled in size between
2002-07, thanks to labor inflows that increased the population by
about 50 percent and huge inflows of capital. Little of this growth
was directly due to oil income: Dubai produces scant amounts of oil
and its development effort was designed to compensate for this lack.
It did, however, rely on investments by oil producers, notably Iran
and Abu Dhabi.
The strong growth of the economy and high inflation would normally
have called for a tightening of monetary policy. Between 2005-07,
Dubai's GDP grew by an annual average rate of 7.8% in real terms,
while imports and exports increased from $206 billion to $481
billion! Inflation doubled, from 6.2% in 2005 to 12.3% in 2008. The
UAE, however, maintains an exchange rate pegged to the US dollar and
an open capital account. From mid-2007, it was therefore forced to
follow the United States' easing of monetary policy. As a result, the
UAE's monetary policy acted as a further stimulus to the economy with
negative real interest rates providing additional momentum to an
already powerful boom in private sector credit. As oil export prices
continued to rise in 2007 and the boom in the UAE showed no signs of
easing, speculation on a revaluation of the Emirati dirham developed.
This triggered large capital inflows into the UAE, further
exacerbating credit growth and inflationary pressures. As a result,
the outstanding stock of credit to the private sector, already the
highest in the GCC, rose further. A vast speculative bubble in real
estate, stocks and bonds was thus created. But as the world economy
went into its worst recession since the 1920s, the bubble eventually burst.
Unlike Dubai, Abu Dhabi, its main rival in the UAE, possesses huge
oil reserves. One of the motives for Dubai's development effort was
to reach Abu Dhabi's income levels, which it did, at least until
recently. Internal political dynamics of the UAE, like that of its
component emirates, are secretive. This lack of transparency may have
advantages in the political sphere, but in the economic one it has
proven disastrous. The relationship between the holding companies set
up in Dubai and the government of Dubai only became clear (or
clearer) in recent months when the latter refused to underwrite them.
The relationship between Abu Dhabi and Dubai only became clear (or
clearer) when the former refused to bail out the holding companies
owned by the Dubai government. Abu Dhabi has oil revenues currently
estimated at over $65 billion annually; the Abu Dhabi Investment
Authority, its sovereign wealth fund, is one of the largest in the
world, with assets of $750 billion. Dubai's foreign debt of $80
billion and Dubai World's share, worth $24 billion, of which the $3.5
billion due to be repaid in December 2009 has been defaulted on, are
small in comparison. However, Abu Dhabi offered only limited
financial assistance to its suddenly struggling fellow UAE member.
Several explanations for Abu Dhabi's coolness have been put forward.
The first is the traditional rivalry between the two emirates and Abu
Dhabi's desire to bring Dubai to heel. The second is the aim of the
United States and Abu Dhabi to pull Dubai away from Iran. Dubai is
not only the home of many Iranians and their funds; it is also the
bunkering station for Iranian gasoline imports.
The crisis in Dubai not only threatens speculators with large losses
but also represents a setback, if not a defeat, for Amir Al Maktoum's
development philosophy, which had consciously sought to move Dubai
away from religious conservatism and the state's exclusive control
over the economy towards a more liberal economic model. The state
continued to play an important role but the private sector was
encouraged to do as much as it could. One sector after another was
opened to it and the level of foreign investment was unprecedented.
However, liberal economics needs transparency and that, among other
things, is still lacking in Dubai.
TEL AVIV NOTES is published with the support of the V. Sorell Foundation
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