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Mirage in the Desert

by John Browne, Senior Market Strategist, Euro Pacific Capital. December 2, 2009
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In recent days, world attention has focused on the potential debt default of Dubai World, the main government-owned corporation in the emirate of Dubai. The transformation of the city-state from a Persian Gulf backwater into the glittering financial capital of the Middle East can only be fully appreciated by those who watched it grow over the last 15 years. But as palm-shaped islands sprouted and spires shot up into the clouds, few spectators realized that Dubai was constructing the perfect metaphor of the 21st century economy: a mirage built on debt.

Dubai was put on the global economic map by Sheikh Rashid al Maktoum, father of the current ruler. Known as "the Fox," the Sheikh shunned outward flamboyance and focused his energy on improving the lot of his kingdom.

I first met the Sheikh in 1972, as Director of Middle East Operations for a London-based merchant bank. Back then, Dubai was nothing more than a desert settlement beside a beautiful, deep-blue port. But the Sheikh was a real frontiersman, like the settlers of America's Wild West - with shrewd business acumen built over a lifetime of hard knocks. He surrounded himself with wise advisors from Britain and the Western World, and sought to build a strong capitalist economy on top of the natural oil wealth.

He succeeded, and his heirs grew up in a period of growth never before seen in that part of the world. They attended the world's finest business schools and eventually moved into positions of power. Slowly, however, this generation shifted away from the understated sagacity of the Fox and toward a vision of Dubai as the dashing fantasyland of the Middle East - a dream to be financed by debt, based on the massive pool of cheap U.S. dollars, and secured by the continued rise in the price of real estate. After all, over these young rulers' lifetimes, real estate values had never declined and, it was assumed, never would.

This particular scenario may sound familiar to those who followed the implosion of the American real estate market and its subsequent impact on credit markets. The reckless lending and sanguine use of derivatives to pass off risks was a hallmark of that debacle. The same methods were employed in Dubai.

The greed of some bank executives drove them to the casual but dangerous assumption of an implicit government guarantee backing Dubai World's debt. It was the same assumption that led those same banks to lend to mortgage giants Freddie Mac and Fannie Mae. But the parallel only goes this far.

In contrast to the never-ending bailouts by the U.S. Administration, the Dubai government seems to be drawing a line in the sand. Even though an 'implicit' guarantee was assumed by investors, the Dubai government has refused to bail out Dubai World. It correctly restated that a guarantee was never put forward, and that any losses are thus the creditors' to bear. The U.S. has shown no such resolve to force risk-takers to face their losses, choosing instead to socialize losses at great cost to world financial stability.

While the Dubai regime is acting more responsibly, that does not mean that a Dubai World default is without consequences. While the absolute size of the company's debts is not a major concern (the present estimates are only $25 to $60 billion), their effect on the major money center banks might be the straw that breaks the camel's back.

The holders of Dubai's real estate assets and sovereign debt are the major Western financial institutions already weakened by their escapades at home. Though the government of Dubai has distanced itself from the mess, the bursting of the 'Dubai bubble' will mean even more write-downs for Anglo-American investment banks.

This may prove to be the first of a new wave of defaults as the commercial mortgage markets begin to buckle. Worse still, any new series of major defaults could spread rapidly to and within the derivatives market. If that were to happen, a sudden cascade of settlement defaults could cause a devastating implosion of international financial markets - one that central banks may be powerless to contain.

In such a world, wealth will retreat into the historic havens of safety - gold and silver. Today, with gold at $1,215 and silver at $19.25, this process seems well underway.

© 2009 John Browne

John Browne is Senior Economic Consultant for Euro Pacific Capital, Inc. Mr. Browne is a distinguished former member of Britain's Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. For a more in depth analysis to protect your wealth and preserve your purchasing power before it's too late and subscribe to our free, Global Investor newsletter.

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