Opinion A house built on sand

The obvious question,of course,is why the long lag between the global bust and Dubai’s bust? The answer lies in the nature of the global recovery over the last six and more months. What happened after Lehman in terms of the freezing up of credit and collapse of demand is well known. Governments reacted promptly by injecting vast amounts of cheap liquidity into the economy with a combination of monetary and fiscal policy. Obviously,the stimuli were the biggest where the crisis hit worst — in the US and the advanced economies. Banks,on the verge of collapse,in particular were pumped with a lot of cash — essentially at no cost. These actions,out of a Keynesian textbook,prevented a deep global recession — that’s unambiguously good. However,like with strong medication,there was a powerful side effect.

It is a well-acknowledged fact that the real economy takes longer that the financial sector to bounce back after a crisis. In the meanwhile,there is plenty of cheap money floating around which needs somewhere to go. Since,the real economy cannot absorb enough,it ends up going to fuel bubbles in stock markets and real estate in particular. And that is what has been happening in the last six months. The kind of comebacks made by global stock markets,including the soaring Sensex,are not justified by the fundamentals of the real economy. The kind of property bubble which continued to be fuelled in Dubai,among other places over the last few months,was also not justified by fundamentals — there was never going to be a revival of consumption and demand to the level required to continue selling private islands off Dubai. So the bubble was fuelled until the lack of demand finally caught up and busted the developers,Dubai World. Now,there is danger of contagion — other such bubbles in other parts of the world may also get pricked. Given the exposure of major banks and financial institutions to Dubai World and other such bubbly enterprises,there remains a risk of the global financial system taking another hit just when it can least afford it.

Some countries will be more vulnerable than others — a lot depends on the structure and diversification of the economy. Dubai,as an emirate,was always vulnerable if the real estate bubble burst because there is little other economic activity there. There was an attempt to build a financial sector,but after the global collapse,there isn’t much hope of a boom in finance anytime soon. In any case,over-dependence on finance doesn’t pay rich dividends all the time. Recall what happened to Iceland last year. Iceland grew prosperous in the heady days of financial globalisation,through the development of a gigantic financial sector with liberal rules — the size of Iceland’s financial sector was many times it GDP. So,when the crisis bankrupted the banks in Iceland,the government,even in theory using all its GDP,could not bail them out. The reason why Iceland hasn’t recovered strongly even a year later is because there are no sectors other than fishing the economy can turn to. Of course,the crisis in Iceland caused problems for other small European economies like Hungary and Ukraine which needed IMF help. In Dubai,of course,it’s a sovereign,government backed fund which is bankrupt,so obviously the government isn’t in a position to bail it out. Now,the trouble in Dubai could potentially have a contagion effect on other countries. Small over-leveraged countries with bubbles in real estate and finance are vulnerable. There may also be the additional impact on creditor banks and financial institutions as well as the knock-of-confidence impact on stock markets.

There may be a silver lining for Dubai though. Dubai World could yet get a quick cash bailout,with very few conditions attached (other than perhaps loss of face for Dubai’s Sheikh Maktoum),from the Abu Dhabi emirate,which is sitting on surplus cash. The two emirates are after all part of the same country even if the rulers are from rival clans. That may yet be the best outcome in the short run for Dubai,global creditors and the global economy. We are still at that stage of recovery when we can’t afford a serious loss of confidence. Dubai,of course,will need to think harder about its long-term economic future after this fiasco.

dhiraj.nayyar@expressindia.com