Dubai Indicative of Global Deflationary Spiral

Posted by Michael A. Kamperman on November 28, 2009

Dubai dropped a debt bomb on unsuspecting speculators and this will set off another round of dominoes falling into each other one by one.  The Islamic bonds Dubai wants relief from were trading at a 10% premium to face value and were of course were highly rated by Standard & Poor’s when Dubai said it needed more time to pay.  Now those same bonds are priced at 50 cents on the dollar.  Everyone apparently assumed Dubai’s oil rich neighbor Abu Dhabi would bail it out even though it had no contractual or implied arrangement to do so.  Without a bail out it was obvious Dubai couldn’t pay its debts.  The city-state borrowed heavily to build a beautiful city by the sea.  The problem is the buildings are mostly empty and neither buyers nor renters can be found at almost any price.  Property values officially fell in half before the debt bomb was dropped.  As construction crashes to halt in Dubai for the foreseeable future it will further detract global GDP.  And, it will decrease the demand for steel and cement and engineering firms and construction workers in an industry already massively oversupplied.  Furthermore, it will tighten credit markets making it more difficult to start a new venture.  If Dubai were an isolated incident all of this could be absorbed and would amount to a hiccup.  But the Dubai story is both common and global.

 

Dubai shares it currency the dirham with the other city-states of the United Arab Emirates and doesn’t directly control the United Arab Emirates Central Bank.  Hence, Dubai cannot print away its problem.  Consider that the countries that share the euro have the same problem as Dubai; they cannot print away collapsing real estate bubbles.  Also consider that some of the same investors in Dubai bonds that assumed Abu Dhabi would step in are some of the same investors in Irish, Spanish, Italian, and Greek bonds who are assuming some form of support will be coming from France and Germany in a pinch even though there is no contractual or implied reason to think so.  Dubai’s default also raises questions about implied guarantees from various agencies of a multitude of nations when no contractual arrangement to step in exists.  The Dubai debt bomb has ended a wink and a nod lending. 

 

The longer shadow cast by Dubai’s default will not be the questions surrounding assumptions of what governments will and won’t step in to resolve a crisis not of their own making.  The real shadow is unsustainable and imprudent overbuilding when there is no reason to believe demand exists for the new infrastructure.  The Dubai economic miracle was a mirage just like the U.S. housing bubble fueled by AAA rated subprime mortgage-backed securities was a mirage.  But the biggest economic mirage in the world soaking up huge amounts of commodities is China.  Like Dubai, China has massively overbuilt its real estate markets far beyond actual demand and it keeps building.  In inner-Mongolia China has built the beautiful modern city of Ordos for the one million residents of the old city of Ordos.  But the new city is so expensive none of the residents can afford to live there and the city literally sits empty and no one lives in it.  Non-economic projects continue to sprout all over China.  All mirages eventually vanish.  It is only a matter of time before China drops its own bomb on the global economy and deflation hits commodities like it is hitting real estate, consumer goods, and wages.