Any investor aware of the 50% collapse in top stallion stud fees this year (and the Dubai royal family has been among the biggest spenders in top-end horseracing) would have been forewarned of the cashflow crisis gripping Gulf finances. When the Sheikhs can't afford to have their prize mares sired, bond investors have no chance. I last wrote on Dubai almost exactly a year ago, concluding that: '...when the international jet-set lie on the private beaches of their man-made (and sinking) islands made in the shape of miniature countries and gaze at the world's tallest skyscraper rising on the horizon, perhaps they won't notice the untreated sewage lapping at their feet. They gold-plate most things in Dubai, but not the turds.'  And Dubai World bond investors were left holding a few of those yesterday. On a visit to the city few weeks back, I was amazed to see cranes still working on a forest of unfinished skyscrapers, despite 50% occupancy rates on recently finished projects. Despite the fact that developers were selling space at a 33-40% loss on build costs (if they could sell it at all), the cranes were still busier than those stallions.

Now, the clearly unsustainable debt burden ($80bn or over 100% of GDP), with up to $17bn falling due within 12 months, is finally creating a default panic, with CDS spreads  soaring to over 500bps in the last two days. That makes Dubai a worse credit risk than Iceland (which at least has fish and geothermal power to fall back on). Dubai World, the corporate arm of the government, (which includes the property developer Nakheel, whose bonds have now crashed back to February levels, see chart below), has built some of the most ludicrous local projects, such as that 'iconic' artificial island shaped like a palm tree decorated with D list celebrities and a series of (unfinished) islands shaped to represent a map of the earth.

This is the local equivalent of the US government reneging on Fannie and Freddie GSE debt. The conglomerate is shouldering about $60bn in debt and had $4bn falling due next month, with the ability to repay the bond seen as a key test of the state's financial credibility. Suddenly, lenders are being 'asked' to extend maturities until at least 30 May. The Dubai government said it had raised $5bn, as part of a $20bn bond programme launched this year, from two Abu Dhabi-controlled banks. The first $5bn tranche in February was bought by the federal government of the United Arab Emirates, in what was effectively a bailout by the adjoining emirate. Today, Moody's (which like most investors had assumed an implicit sovereign guarantee) has downgraded the ratings of all six government-related issuers (GRI’s) in Dubai and left them on review for possible downgrade. In a country reknowned for its opaque business relationships and finances, it's hard to have much sympathy with analysts or investors 'shocked' at the sudden volte face.  

Trying to peel the potentially solvent local entities (like Dubai Port) away from the hopelessly insolvent (like Nakheel) may be one objective of this announcement, but it will be difficult to achieve without firm and explicit funding support from Abu Dhabi in particular. Abu Dhabi, which unlike Dubai has huge oil reserves, but has been far more financially conservative than its UAE neighbour. So far, Abu Dhabi via its banks has provided just enough new cash to prevent a Dubai default, while making the local elite sweat in their air conditioned palaces.  Royal politics in the UAE is convoluted stuff, but an effective hostile takeover of Dubai by Abu Dhabi is probably the best outcome all around, and may well be quietly underway. That would involve a series of corporate mergers across the two emirates from airlines to real estate, which would hugely dilute Dubai's equity in viable companies like Emirates Airline or Dubai Aluminium. The alternative would be a full sovereign default, with a rapid domino effect on other vulnerable economies, particularly in Eastern and Southern Europe, in a replay of February's panic. The broader implication is that the asset reflation strategy of central banks this year has merely postponed the painful debt restructuring and associated balance sheet write-offs resulting from poor investment decisions made at the height of the credit boom. That risks a repeat of the Japanese 'lost decade'. Improving consumer and corporate cashflows and reducing unmanageable liabilities is now far more important, and ironically in that context extremely low interest rates (which reduce aggregate coupon payments) are part of the problem, not the solution.