Hamish McRae: Shifting sands: Will the emirate's default push us into another crash?
Sunday 29 November 2009
I like Dubai. That may not be the sort of confession you want to make right now and on my most recent visit last year the boom was only just turning into a bust. But for all its excesses, I feel, there is a lot to learn from the place and to sneer at its nouveau riche ambitions, as some Britons do, is rather unpleasant.
Yet after the events of the past week you have to answer a question: is Dubai World the new Lehman Brothers? Or to put the question more specifically, just as the collapse of Lehman made the first leg of the recession much deeper than it otherwise would have been, might the default of Dubai World plunge us into a second downward dive?
The answer, mercifully, will turn out to be "no" for a number of reasons. Nevertheless, it does raise concerns about sovereign risk and the burden of debt taken on, particularly by developed country governments. Growth will probably be disappointing during the next couple of years and events such as this will make it harder to engineer a sustained recovery. But first the parallel with Lehman.
The failure of Lehman led to a wider collapse of confidence in the global banking system. Such a collapse had been unthinkable even a few months earlier, even though people were aware of weaknesses at the bank, because it was assumed that the US authorities would rescue it if necessary. Their failure to do so now seems a clear mistake for the costs of the subsequent actions were far greater than they need have been.
As with Lehman, everyone knew of the weaknesses with Dubai World, and indeed many others involved with Dubai property. But the markets assumed that the emirate had the resources and determination to meet obligations as they fell due – and if the worst happened, Dubai's oil-rich neighbour Abu Dhabi would bail it out. The markets felt that the costs of rescuing Dubai – in terms of the damage to the creditworthiness of the Gulf region – would be smaller than the costs of not rescuing it. I expect that not rescuing it will prove a mistake.
But here the parallels stop. There will be no systemic breakdown of the regional economy. Dubai World has not collapsed in the way that Lehman did; it is merely seeking to roll over bonds due for repayment. The bonds are not worthless, though they are trading at only 70 per cent of their face value. There will be knock-on effects for international businesses active in the region, and naturally the ex-pat community in Dubai has reason to be concerned. There will be a rough period. But Dubai is quite small, the region as a whole is rich and as it will get even richer, it will need the services that Dubai offers. So on balance, this will have only a temporary regional impact and five years from now a chastened Dubai will be growing again in what I hope will be a more sustainable manner.
There is, however, one other worry. This event undermines the central notion that countries will honour their debts. In some regions of the world, we know of countries that may not do so. Step forward Argentina and other parts of Latin America. But no-one thought a place in the oil-rich Middle East came into that category. Two years ago, lenders were queuing up to pump money into Dubai. Now that enthusiasm looks a bit, well, over-enthusiastic.
That shift of mood should be a lesson to every other indebted country, including Britain. For the moment, the Government is able to sell its debt at a reasonable interest rate, though that must in part be because the Bank of England is printing the money to do so. But things change. There is a strong possibility that we will lose our top AAA credit rating if the next government does not bring forward a medium-term plan to cut back the debt. The developed world as a whole will have doubled its national debt as a result of this economic downturn, so questions will be asked about other countries too.
The most important of those questions will be this: what does each country need to do over the next generation to get its debt back to the level it is now? If a country is trying to borrow for, say, 30 years, the lender needs to have some assurance that come 2040, it won't be bust.
A country's ability to pay its debts depends on a number of things. These include how big those debts are now, the age structure of its population, the projected growth path for the economy and so on. Then you look at their present fiscal policies. From that you can then calculate how much each country needs to cut spending and/or increase taxes to get debts under control. Goldman Sachs has just done such an exercise, looking at what changes are needed to get debts back to their present level by 2050. You might think that this is not a particularly ambitious target but it shows some pretty sensational results.
As you can see, two countries could afford to cut taxes or increase public spending, Norway and Denmark. Sweden's position looks sustainable too. But as you move along the line, you climb the scale of fiscal implausibility. Some outcomes are surprising: Italy is in better shape than France, and much of Continental Europe is coping better than Australia, Canada and the US. But then, on the right-hand side, is the hall of shame: the UK, Greece, Spain, Japan and Ireland. In the case of the UK, we need an adjustment of something between 8 per cent and 9 per cent of GDP, which would have to come in the form of higher taxes or lower public spending, or some combination of the two.
That is huge. If you want a round number, think £100bn. It cannot be done right away; indeed it will probably take two full parliaments before finances are back on a sustainable level. We don't have to start right now but as Goldman points out, the costs of delay are quite high, even assuming the markets would permit a delay. The absolutely central thing is that there has to be a credible medium-term plan. That goes for Britain, but it is also true for everyone else. Greece, Spain and Ireland appear particularly vulnerable as they are in the eurozone and cannot accordingly devalue their currencies to cut the real burden of the debt.
What worries me is that Dubai will have a knock-on effect on sovereign credit ratings everywhere. There could be a run on Greek, Spanish or Irish debt and the European Union might have to make some statement of support. There might even need to be an explicit guarantee, though it is hard to think through the politics of that. As for us, well, I do not think we should rule out the need to get some kind of seal of approval for our fiscal programme from the International Monetary Fund. Let's hope it doesn't come to that.
Canadian banks are still standing: A model of governance and regulation
Why have the banks in some countries, particularly Canada, come through the financial crisis in so much better shape than those in others?
There is a pat answer, which is better regulation, but that does not really wash. After all, HSBC has emerged as the most powerful bank in the world, while Royal Bank of Scotland came within an ace of going under – the full scale of the catastrophe only being revealed last week. Both were regulated in the UK. Does the complexity of the business mix matter? Northern Rock was in a very simple business: home loans. Governance matters of course, but many of the banks that went down ticked all the boxes, with strong independent directors, diversified experience on the board and so on.
But the fact remains that Canada did much better than we (or the US or most European countries) did.
I got an insight into Canada's secrets at the Canada-UK Colloquium last Friday in London. The speakers were bankers and regulators from both countries and while there was no "this is how you do it" map, at least half a dozen things contributed to the success.
One was the structure of Canadian banking. Giant mergers had been blocked and banks, while big, had not grown so swiftly as to be hard to manage. A second was the innate conservatism not just of managements but also of customers.
Another was transparent reporting structures and the seriousness with which directors took their duties. A large portion of remuneration for high-flyers was deferred in the form of shares that could not be sold for some time. There was good regulation too, but finally, Canada had a run of luck – the wealth from being energy-rich must have helped it through the crisis.
So there are lots of lessons. And that seems to me to be a sensible approach to re-regulation. There has to be a balance between good regulation and good governance. As one participant asked: "Where were the directors?" We will get more regulation but, call me cynical, I expect that will be sub-optimal. But if we have good governance – managers, directors, shareholders and customers – that surely will better safeguard our pennies.
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