Gavan Nolan of Markit wrote this CDS report
Last week we asked is “Greece the only sovereign on a slippery slope?” We did not have to wait long for our answer. But it did not come from the less creditworthy regions of the eurozone, or even the fragile transition economies in eastern Europe. It came from the Middle East, a region renowned for huge natural resource assets and concomitant current account surpluses. This took investors by surprise and caused a reversal in the rally for risky assets. Should it have?
The government of Dubai, a city state within the United Arab Emirates, announced that it is restructuring Dubai World, an investment company wholly-owned by the state, with immediate effect. It has asked creditors for a six-month standstill on its obligations until at least 30 May 2010. Nakheel, a real estate subsidiary of Dubai World, has a $4 billion sukuk, or Islamic bond, due next month. Spreads ballooned out after the announcement and have continued to widen today. The government has been less than forthcoming with information on the restructuring and the shambolic handling evident so far has accentuated the risk premium.
But it should be made clear that the Dubai sovereign is not in any immediate danger of a default. The standstill, if it is mandatory, may constitute a technical default on Nakheel and Dubai World. However, the Dubai government did not make an explicit guarantee on the companies’ debt, and are under no legal obligation to honour the debt. This is clearly the position Dubai’s wealthy sister emirate Abu Dhabi favours. Its actions this week seem to indicate that, while it will support the sovereign, its backing is conditional. The funds are available – Abu Dhabi has immense oil resources and the world’s largest sovereign wealth fund. Indeed, Dubai has already been advanced funds by Abu Dhabi. But it was quite clear that Nakheel and the rest of Dubai World will not be allowed to benefit from the largesse.
The debacle in Dubai caused spreads to widen throughout the Middle East region. Unsurprisingly, Abu Dhabi saw its cost of protection rise on expectations that Dubai will have trouble returning to the capital markets without firm support from the senior emirate. But others such as Qatar, Bahrain and even Saudi Arabia have also widened. Is it justified or is it guilt by association? The sovereign CDS market sometimes has a habit of conflating geographical proximity with economic similarity (eastern Europe earlier this year springs to mind). Unlike Dubai, the countries mentioned above have significant natural resources and their public finances are in better shape. To an extent this has been reflected in CDS spreads for some time (see chart above). It seems that Dubai is something of a special case and its problems are not necessarily found elsewhere.
Nonetheless, investors feared that the opening of US markets after the Thanksgiving holiday would cause a wave of short positions. It hasn’t really materialised. The Markit CDX IG index opened at 109bp, 7bp wider than Wednesday’s close. But it has since settled at 106bp and the stock markets are only down 1%-1.5%, a relatively modest move given the sell-off in Europe and Asia in the past two days. Thin liquidity may be a factor in a shortened session. But it could be that investors are reassessing Dubai as a relatively isolated incident. Gordon Brown thinks so. “We can be sure that this is something that is both containable and is localised”, the UK PM told reporters today. We will find out if he is right soon enough.