The fallout of the Dubai World default, delaying payment on their debts until May 2010 or so, has not yet unfolded. However, three things are apparent: First, the debts of Dubai World, a large corporation dedicated to Dubai’s development, have been referred to interchangeably with the debt of the sovereign state Dubai. Second, the other emirates of the UAE have refused to bail out Dubai/Dubai World. Third, the marketplace is responding in a way that indicates fragility and that it is bracing for more such defaults.
On the first point, the debts of corporations causing the insolvency of sovereigns is a growing trend that seems to have essentially started with the private capital flight from Thailand in the late 1990’s. The bankruptcy of Iceland’s banks causing the Icelandic sovereign crisis this year is another instance of this, as is this default of Dubai World/Dubai. Much of the media refer to this as a Dubai crisis, and where the media has pointedly acknowledged the distinction between Dubai and Dubai World, it has often noted that creditors are unaware of or fail to acknowledge the distinction.
The flip-side of the sovereign-corporation debt is that sovereigns have begun bailing out their “too big to fail” corporations (I call them “culturally significant”). Historically many culturally significant companies have been politically bailed out, notably numerous national airlines. This is hardly a novel activity, then, but the size of the corporations seems to have become larger of late as has the frequency of bailouts. Recent bailouts include RBC’s by the United Kingdom, Fannie Mae, Freddie Mac, AIG, Bear Sterns, General Motors, Chrysler, etc. by the United States federal government, and others. Bailouts of this nature, of course, create a moral hazard: the incentive to borrow recklessly on the basis that a taxpayer bailout will insure against the risk of the borrowing. The novel attribute to this activity is that for the first time observers have noted that bailouts of this nature can create systemic risk to a sovereign’s currency (and bond rating) where the corporate debts absorbed by the sovereign bring into question the credibility of the sovereign’s promise to repay its debts.
On the second point, it would be pure speculation on my part to suggest why the UAE and others near Dubai have refused to bail out Dubai World, though I understand that Abu Dhabi has more than adequate reserves to do so, and has already bailed out “Dubai” (country or company, I know not) once this year. The unwillingness to bail out Dubai/Dubai World suggests the other UAE emirates are not overly concerned with regional spillover of the default, or unable to pay.
On the third point, the headlines made by the Dubai World default highlight the state of mind of those in the marketplace/media. There is an expectation of further fallout in the crisis, and that Dubai is simply one of many sovereign defaults or sovereign-by-proxy defaults (as I now call sovereigns who de facto become insolvent or default because of the obligations of their private corporations) that could percolate in the coming months and years.