High debt risks leaving Dubai up the creek

Wednesday, Apr 02, 2008

In 1958 the grandfather of Sheikh Mohammed bin Rashid, Dubai’s current ruler, borrowed £500,000 from oil-rich Kuwait to dredge the silted-up creek and allow larger ships to anchor.

Much scepticism greeted the decision at the time although its value eventually became apparent, as the Gulf emirate claimed a role as a regional trading hub.

The next ruler, Sheikh Rashid, was equally fearless about leverage, borrowing heavily – from the banking group that is now HSBCHSBC and from the Saudi government – to finance initiatives such as Jebel Ali port, which diversified the economy from oil. This project in particular was widely derided as too ambitious. But business activity today at Jebel Ali free zoneJebel Ali free zone accounts for about 26 per cent of Dubai’s more than $50bn (€32bn, £25bn) annual gross domestic product, as well as a third of its trade.

The city state’s admirers cite this history to rebuff warnings that its gaudy buildings and grandiose projects could be a debt-fuelled bubble. Unlike its oil-rich neighbours, Dubai – where hydrocarbon revenues make up less than 5 per cent of GDP – has had little choice but to rely on debt to transform itself from sleepy fishing village to global metropolis, they argue.

Yet the lack of transparency over Dubai’s finances and its massive expansion still lead to questions about over-leverage. In a sign of unease among investors, the cost of insuring the emirate’s corporate debt against default has doubled since the credit crunch started last August. Some worry that Dubai could wind up in such trouble that neighbouring Abu Dhabi, the richest of the city states making up the United Arab Emirates, might have to bail it out.

Dubai’s sprawling business empire spans government institutions and private companies owned directly by Sheikh Mohammed but acting as quasi-government bodies. The ruler has instituted a culture of competition among state-backed companies and insisted they run themselves as private sector entities.

In their quest to satisfy his ambitions, the business groups have come to rely heavily on debt – leveraging myriad commercial ventures, from domestic property developments to international acquisitions. Along the way, Dubai’s finances have become complicated and the line between ruler and government assets blurred.

As one consequence, the emirate’s efforts to secure a sovereign rating for its debt have stalled. Analysts say the government is in some cases reluctant to share financial information but in other cases simply does not have the figures rating agencies need to assess its creditworthiness. “As Dubai grows, it becomes more difficult to manage – each tentacle turns into a beast of its own,” says one financial analyst, wishing to remain anonymous.

The government argues that it has reported an average fiscal surplus of 10 per cent since 2000, with limited recourse to debt. The finance department puts current outstanding debt at only 10 per cent of GDP. Standard & Poor’s, the rating agency, estimates the gross debt of the main arms of Dubai government-related entities at about 50 per cent of GDP – but still below 20 per cent of these companies’ equity.

This compares with debt-to-GDP rates of 11 per cent in Saudi Arabia and only 2 per cent in Abu Dhabi – even before large foreign exchange reserves and sovereign wealth fund assets are counted. Tristan Cooper, sovereign risk analyst at Moody’s, says that from the limited information available, “it does seem that Dubai’s net public debt is climbing quickly given state-owned companies’ ambitious expansion plans”. This, he says, warrants careful monitoring, because Dubai “does not have the same magnitude of offshore sovereign financial assets as other Gulf peers”.

Farouk Soussa, director of sovereign ratings at S&P, calculates that Dubai’s debt is still “very manageable” at this stage and its assets are substantial. “But, more than other Gulf Co-operation Council countries, the balance sheet is dependent on the domestic economy,” he says.

One main concern is that a shock such as a regional war, a big terrorist attack or a significant downturn in global trade could begin to unravel Dubai’s success, driving foreigners away and hitting the property market, the backbone of the emirate’s current wealth. Since the government opened up property ownership to foreigners in 2002, prices have risen as investors from the region seek places to park capital and expatriates snap up homes in Dubai. As one banker asks: “What happens if the real estate collateral turns back into dust?”

To get a better handle on its finances, the government has been seeking to institutionalise “Dubai Inc”. The recently established Investment Corporation of DubaiInvestment Corporation of Dubai groups more than 30 *government-owned entities in a holding company that includes Dubai Aluminium CompanyDubai Aluminium Company and Emirates AirlinesEmirates Airlines.The umbrella corporation is to help its businesses raise debt and, when seen as appropriate, spin off companies in initial public offerings.

Meanwhile the finance department in February set up a debt management office, which requires some state-owned operations to apply for approval before they issue debt. “The mandate will improve government entity co-ordination,” the department says. Bankers say they hope the creation of the debt office will limit the risk of various Dubai entities vying with one another for funding.

Dubai WorldDubai World, one of the leading groups in the emirate, last year sought a $2.7bn Islamic bond, or sukuk, at the same time as DP WorldDP World, its sister company, was raising a large loan. Dubai WorldDubai World eventually closed the deal at $5bn but at a significant premium to the prevailing spreads on Dubai corporate debt, bankers say. When Dubai Electricity & Water AuthorityDubai Electricity & Water Authority tested the debt market a month later, the deal failed as the utility was not willing to pay so high a price.

But the effort at co-ordination and consolidation is not as extensive as some analysts would have hoped. Big groups such as Dubai WorldDubai World and Dubai International Financial CentreDubai International Financial Centre fall outside Investment Corporation of DubaiInvestment Corporation of Dubai – as do the ruler’s private assets, grouped under the Dubai HoldingDubai Holding conglomerate. On the debt side, meanwhile, only government activities dedicated to infrastructure development – such as utilities and transport – will have to seek formal approval from the new management office before tapping the capital markets.

As it tries to put its house in order – at a time when turmoil in global credit markets and volatility in equity markets are starting to be felt in the Gulf – Dubai may be forced to rein back its ambitions. For one, bankers are concerned about the exposure of Dubai International CapitalDubai International Capital, Sheikh Mohammed’s private equity vehicle, to losses on underperforming stocks. More*over, spreads have doubled in the limited secondary market for Dubai debt and it has become more expensive for companies to fund cross-border acquisitions.

“The heady rate of overseas expansion by government-owned companies in Dubai may be tempered by the cooling global economy,” says Mr Cooper at Moody’s. But public sector indebtedness may rise further, “given the emirate’s ambitious plans for domestic investment”.

By Simeon Kerr and Roula Khalaf