Saturday, November 28, 2009

Economics 28/11/2009: What if... Carry Trades bite the dust in Dubai

Carry trades, Dubai and the direction of the dollar:

Dubai's impending collapse shows that the epicenter of 'Development on Drugs' model implosion is now finally shifting from the US into Middle East and is risking new wave of contagion into Europe. Most of Dubai development has been financed by petrodollars (domestic and inter-regional), but also via carry trades from Europe (intraregional) with Euro area banks dominating the entire Emirate's landscape in foreign banking. This is bound to have long-reaching impact, with as far on-shore as Irish Nama potentially being possibly saddled with loans cross-linked to Dubai property. Bank of Ireland took part in a $5.5 billion (€3.7bn) syndicated loan facility to Dubai World in June 2008, according to stockbroker Davy. Per report in Irish Times today: "The firm said its initial participation in the facility was $93 million (€62 million) but it is understood that the bank’s debt currently stands at about €50 million."

Am I the only one who noticed that Irish investors, semi-states - e.g Aer Lingus, corporates - see here, even Enterprise Ireland succumbed to Dubai's lure: here - have financed the peak of this bubble?

Oh, and is Nama going to end up holding any of this (more here)? Nama folks are saying they know nothing about the Bad Bank taking on Dubai-related loans... Sure... they would know! And what about cross-linked loans? Developers with dual exposures?

So what does Dubai debacle mean globally?

Start with oil: the only way the Emirates are going to escape a meltdown (with domino effect spreading from Dubai to Abu and so on) is by turning on oil taps. An added incentive here is that while autocratic rulers of the Emirates would not blink twice before saddling Western investors with all debts, the structure of Islamic finance used in Dubai developments implies that although junior debt holders have no explicit guarantees on their debt, Emirates simply will not be able to stomach defaulting on Islamic loans. Oil prices will be under pressure for a long period of time before Dubai's debt mountain is cut to size and this will give support to the weakened dollar on asset demand side of the dollarised carry trades involving commodities.

Bigger question is whether Dubai events might trigger the unwinding of the carry trades. This, of course, depends on the value of UAE currency and the main currency pairs used in the region. In my view, devaluation of massive proportions will be required in the short run, putting pressure on the Euro and, again, aiding the dollar.

Another force acting here will be investor confidence. If Dubai served as an island for divestment out of dollar assets in the region, this island is now fully submerged under financial tsunami. Treasuries are to firm up and dollar alongside these. Ditto for gold.

On a separate note, another net positive (longer term) for the dollar is China. President Obama's visit played out as a play of avoiding the issues of yuan, and yielded absolutely no commitment to revalue Chinese currency. This, strangely enough, implies that once revaluation does take place, it will be much more pronounced and abrupt than if the Chinese authorities were to offer President Obama some concessions this month. Here is why. Absent Chinese commitment to play cooperative game with the US on currency front, Obama Administration will let Europeans put pressure on China through bilateral channels and G20. Europe cannot afford to hold the bag in the global devaluation game as it is exports oriented economy. Developing and emerging economies will fight by imposing capital controls, but EU will have to bring this battle to Chinese shores. Thus, in the long run, the stage is now set for overshooting revaluation of the yuan well above its long-term target and firming up of the dollar.

In the medium term, all this uncertainty about the ultimate rebalancing of the FX markets will be pushing on gold. This is likely to coincide with the emerging markets shocker from Dubai and capital controls impositions, further enhancing demand for the store of value assets such as precious metals. Not to be sensationalist, but if we are at the starting point of Wave II of the crisis (even if it is only a smaller aftermath to the 2008 one), is gold at $1,500-$1,700 oz a possibility?

Just asking...


Anonymous said...

If the dollar appreciates as I think you are suggesting then whereto for the dollar carry trade which I understood to be a bigger bubble than the euro one?

As regards the financing of the dubai bubble at its peak remember it was this time last year that the minister for trade mary coughlan lead a trade mission to the area.

Also RBS are in the hole for 2.3 billion dollars since 2007 to dubai.As RBS has been nationalised I presume this liability will be picked up by the british taxpayer.

No wonder gold has been climbing steadily recently and no wonder central banks such as india have been loading up on gold and now its rumoured germany is also ready to purchase gold.


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