November 2009 will surely go down as one of those great months of mystery. Conspiracy theorists will be at their most creative, attempting to explain the great puzzles of our age. How did Jedward survive for so long on The X Factor? Did Thierry Henry handle the ball intentionally? How did Elin Nordegren make use of a golf club to remove Tiger Woods, her husband, from his SUV after his unfortunate accident? What will become of Gillette's global marketing campaign: will Thierry and Tiger be airbrushed from the advertisements leaving Roger Federer all on his own? And why is Dubai suddenly in such deep financial trouble?
Investors certainly knew there had been huge amounts of spending in Dubai funded by heavy borrowing in an earlier age of cheap and plentiful liquidity. They could see the evidence in front of them. The Burj Dubai is the world's tallest building. Past holders of the "tallest building" accolade have also typically been conceived and funded during boom times and then opened in the bust which followed. The Empire State Building was conceived at the height of the "Roaring Twenties", began to be built in 1930 and was opened in 1931, in the middle of the Great Depression. Kuala Lumpur's Petronas Towers, constructed during the boom of the mid-1990s, were finally opened in 1998 in the depths of the Asian crisis.
Given the size of its buildings, and the sheer amount of construction that's taken place in recent years, it's no great surprise that Dubai is heavily in debt. Investors hoped, however, that Dubai would ultimately remain creditworthy, if only because it would be able to rely on Abu Dhabi, its oil-rich neighbour, for a bailout every so often. That bailout may still happen. If it does, investors will doubtless breathe a huge sigh of relief. The Dubai episode surely reveals, however, that the global financial crisis is not yet over. If the crisis was ultimately the result of excessive debts, those debts haven't yet gone away.
The worrying feature of the Dubai episode, however, is that it's not just private debtors at risk. Dubai World, the company in trouble, is government-owned. Dubai's misfortune could turn into misfortune for governments all over the world. Fiscal positions more or less everywhere have dramatically deteriorated over the last few years, partly because of the depth of the global recession and its impact on tax revenues and partly because governments have deliberately turned on the fiscal taps to offer a Keynesian fiscal stimulus. If Dubai is in trouble, could other governments also find themselves in difficulty? And, if so, what then happens?
Let me put this slightly differently. Governments can run commercial operations (as is the case in Dubai). They can bail out commercial operations (as we've seen in the West). But who bails out the governments themselves? In the past, the International Monetary Fund has performed that role. The Fund's success, however, has been dependent on an adequate supply of funds. Those funds have in turn depended mostly on the maintenance of reasonable fiscal health in the developed nations. Many developed nations are, however, looking fiscally rather sickly. In truth, there are only so many ways that governments can cope should they find themselves in a fiscal mess.
Option one is to deliver years of austerity, something which Ireland is trying to get to grips with and something which the UK may have to live with after the forthcoming General Election. Ultimately, it's the right approach: if a country has been living beyond its means, a bit of belt-tightening seems entirely appropriate. However, what might be right economically is a lot more difficult politically: tax increases and spending cuts are never popular and, should the UK end up with a hung Parliament next year, might be impossible to implement on the appropriate scale.
Option two is to create inflation. If the creditors are mostly domestic, unexpectedly high inflation will reduce the "real" interest rate paid by the government to its bondholders. Inflation thus operates as an implicit tax, defrauding the creditors at the expense of the debtors. As far as the Western world is concerned, these tricks were last employed in the 1970s, even though the approach is still being pursued with vigour in Zimbabwe. Some investors think the whole world is heading in this direction but, somehow, I doubt it. Japan's government has had the incentive to create inflation for many years yet has steadfastly refused to go down that particular route. With an ageing population, the creation of inflation is hardly going to be a vote winner: older voters will not take kindly to a world where their savings are being destroyed via higher inflation.
Option three is to devalue. This will work only if the devaluing nation has borrowed from the rest of the world in its own currency. In these circumstances, devaluation reduces the amount of money to be paid to foreign creditors in their own currencies. For example, should the US dollar or sterling fall significantly, Treasuries and gilts would be worth less in euros than before: German holders of Treasuries and gilts would therefore be worse off. Like the creation of inflation, devaluation requires a very loose set of domestic monetary conditions, preferably with the gentle hum of the printing press in the background. So long as there is plenty of spare domestic capacity – as there is in the US and the UK today – devaluing the currency is unlikely to create much of a pick-up in domestic inflation. Devaluation is, thus, a neat way of damaging foreign creditors without directly hitting domestic creditors.
Option four is to default. Countries which borrow from the rest of the world in foreign currency often have no choice. For them, devaluation doesn't work, because it increases their debts to foreigners in domestic currency terms, as Argentina discovered in the early years of this decade. Other countries may have no control over their currencies or their inflation rates, as is the case with members of the euro, so the only choice to be made is between option one and option four. Similar arguments apply to Dubai, unless Abu Dhabi really can be a knight in shining armour.
Governments have, of course, been known to rack up huge debts without any kind of sovereign risk. The US and the UK had massive debts at the end of the Second World War. Japan has huge debts today. Other nations have been able to borrow heavily without bumping into any kind of immediate fiscal crisis as a result of a temporary monetary distortion. The Greek government, for example, has carried on borrowing because the European Central Bank has provided Greek banks with very low interest rate loans which can then be re-invested in Greek government bonds offering much higher yields (which makes the Greek fiscal arithmetic vulnerable to any future monetary tightening from the ECB).
All these borrowings, however, depend on the critical assumption that governments have the political power to repay their creditors. Should the pain associated with repayment rise too far – and should the perceived risk of default go up – we will end up with another financial crisis, not associated with sub-prime but, instead, with the pieces of paper - cash and government bonds - which ultimately provide the backbone of our financial system. The Burj Dubai will still no doubt be standing in a few years' time, but our financial system could well be on its knees.
stephen.king@hsbcib.com
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