Last weeks news that Dubai World defaulted on a significant portion of its debt initially caused concerns over financial system stress and the markets reacted negatively. It is expected that debt refinancings will require reorganizations and equity injections for the next three years or so. The debt restructuring by Dubai World, which appears unable to refinance a large bond maturity next month, is precisely the sort of activity that we expect to see.
Dubai was the poster child for extravagant debt financing and conspicuous consumption – with palm leaf islands and towers to the sky – and its default should not be huge surprise.
U.S. financial institutions are not big players in the Gulf. Asian, European, local banks and insurers were the major lenders and are the ones most exposed to the risk. Overall, the debt refinancing problem in Dubai is a positive development for the U.S. since it will likely dampen blind and fearless enthusiasm for emerging markets.
A recovery in the U.S. depends primarily on interest rates staying low for an extended period of time to support the affordability of housing. But low interest rates were at risk of causing an asset price bubble in emerging markets. In some emerging markets, foreign speculative capital rushed in and caused overheated conditions. Policy makers needed and wanted a disruption in speculative flows.
Underlying these risk-seeking inflows were outflows from America. Associated U.S. dollar weakness was fueling inflation expectations as evidenced by the rising price of gold and other commodities.
We believe the real risk would be to have no shock occur to break this cycle. No shock would result in accelerated U.S. dollar declines, commodity increases and potentially cause a premature rate hike in the U.S. If American consumers were faced with rising commodity prices, particularly oil, and rising interest rates, they would be in trouble. The default of Dubai World buys more time for the U.S. Federal Reserve to heal the housing market without putting pressure on the dollar, interest rates or causing increases in commodities.
These short-term shocks and corrections to the market will help to keep speculation in check and build a longer, slower, and likely more sustainable recovery.
Source: Eric Bushell, James Dutkiewicz, Drummond Brodeur, Signature Global Advisors
