Thursday, November 26, 2009

Is Dubai's Sovereign Risk Overblown?

Laura Cochrane and Tal Barak Harif of Bloomberg report that Dubai Debt Delay Rattles Confidence in Gulf Borrowers:
Dubai shook investor confidence across the Persian Gulf after its proposal to delay debt payments risked triggering the biggest sovereign default since Argentina in 2001.

The cost of protecting government notes from Abu Dhabi to Bahrain rose, extending the steepest increase since February as Dubai World, with $59 billion of liabilities, sought a “standstill” agreement from creditors. Its debt includes $3.52 billion of bonds due Dec. 14 from property unit Nakheel PJSC. Dubai credit-default swaps climbed 90 basis points to 530 after yesterday increasing the most since they began trading in January, CMA Datavision prices showed.

“There is nothing investors dislike more than this kind of event,” said Norval Loftus, the head of convertible bonds and Islamic debt at Matrix Group Ltd. in London, which manages $2.5 billion of assets including Dubai credits. “The worst-case scenario will, of course, be involuntary restructuring on the Nakheel security that brings into question the entire nature of the sovereign support for various borrowers in the region.”

Dubai World’s assets range from stakes in Las Vegas casino company MGM Mirage to London-traded bank Standard Chartered Plc and luxury retailer Barneys New York through asset-management firm Istithmar PJSC. The Dubai government’s attempt to reschedule debt triggered declines in stocks worldwide that had been rebounding from the worst financial crisis since the Great Depression.

Many investors didn't foresee the scale of Dubai's debt problems. I spoke to a consultant today who told me that lawyers and accountants he knew working in Dubai kept telling him how Dubai's investment authorities are aggressively financing their purchases of global assets.

So will Dubai's debt problems plunge global markets to new lows? I strongly doubt it. Jan Randolph, head of the sovereign risk group at IHS Global Insight, talked with Bloomberg's Mark Barton about Dubai's proposal to delay debt payments and the role neighboring emirate Abu Dhabi may play in easing the crisis.

Mr. Randolph thinks Dubai's sovereign risk is overblown and I agree. He says this is essentially a liquidity problem and the debt represents 20% of GDP. He mentioned that Abu Dhabi which is the real cash cow, can easily bail out Dubai. Abu Dhabi's sovereign wealth fund is the world's largest, with over $600 billion in assets. It can easily support Dubai's debt problems.

What does all this mean for global investors in the next few days? Nothing much except that you'll have another opportunity to buy a dip, which is what you'll do if you're intelligent (that's what Goldman and JP Morgan will be doing). Nothing has fundamentally changed. The Fed is staying on the sidelines for the foreseeable future and they'll let this bubble blow. The global liquidity rally has legs to run, so don't get too flustered by Dubai's debt woes.

Another interesting trend is what's going on in China. Kevin Hamlin of Bloomberg reports that China Overcapacity Wreaks Global Harm, EU Group Says:
China’s excess industrial capacity is “wreaking far-reaching damage on the global economy,” stoking trade tensions and raising the risk of bad loans, the European Union Chamber of Commerce in China said.

A 4 trillion yuan ($586 billion) stimulus package is worsening overcapacity, especially in the steel, aluminum, cement, chemical, refining and wind-power equipment industries, according to a study by the chamber and Roland Berger Strategy Consultants, released in Beijing today.

The world’s third-biggest economy has rebounded this year on stimulus spending and a $1.3 trillion credit boom. China is adding capacity when global demand is yet to recover from the financial crisis, increasing the risk of trade frictions undermining commerce and making the threat of non-performing loans within the nation “ever larger,” the EU Chamber said.

“The Chinese stimulus package has poured credit into increasingly questionable projects,” the business group said, without identifying specific ventures. “The global impact already can be felt in the form of growing trade tensions.”

U.S. President Barack Obama and Chinese President Hu Jintao pledged this month to work to ease frictions, exacerbated by U.S. duties on Chinese tires.

The chamber recommended 30 measures to cut overcapacity, including letting an undervalued yuan gradually appreciate, reducing a “subsidy” for Chinese manufacturers.

Energy Prices

It also proposed lowering energy-price subsidies, raising interest rates to reduce easy credit, increasing dividend payments by state-owned enterprises, and spending more on health care and social security to encourage consumption and cut precautionary savings.

No comment was immediately available today from China’s commerce ministry.

In September, China’s State Council approved plans to curb expansion in industries including steel, cement, glass, coke, wind turbines and shipbuilding. The government has also introduced measures to limit land supply to sectors with excess capacity. So far, the government’s efforts have been ineffective, the chamber said.

China’s excess capacity is an “international concern” as goods that can’t be sold locally may be sent to markets that shrank because of the global slump, European Union Trade Commissioner Catherine Ashton said in Beijing Sept. 9. Ashton has since been named the EU’s top diplomat.

‘Unfounded’ Criticism

Yu Yongding, a former adviser to the Chinese central bank, said yesterday in Melbourne that that the “worrying” long-term effects of China’s expansionary policies include overcapacity, bad loans, and inefficient investment.

Not everyone agrees with the EU Chamber’s assessment. Isaac Meng, a senior economist at BNP Paribas SA in Beijing, said industries including steel and cement are not big exporters and claims of damage to the global economy are “unfounded.”

“In sectors where China is a massive exporter, like electronics, there’s no overcapacity because when exports collapse factories just close,” he added.

Increasing trade tensions between China and the U.S. are the result of high unemployment in the U.S., which is creating “political pressure to reduce China’s exports,” Meng said.

China as ‘Victim’

China’s own economy is the main “victim” of excess capacity, the chamber said. Lower profits mean companies lack cash to invest in research and development and develop more valued-added goods, it said. Businesses are also forced to cut costs, contributing to slower wage growth and less consumption, the report added.

“This is a major obstacle on the government’s path to become both an innovative and sustainable economy,” the report said.

China’s lending surge this year focused mainly on expanding production at state-owned enterprises, the report said. This led growth in fixed-asset investment by manufacturing companies to jump to 50 percent by mid-year from 25 percent in January and February, the chamber said.

Companies in industries with overcapacity will struggle to repay credit, increasing the risk of a repeat of the 1990s surge in non-performing loans, the chamber said.

China’s five largest banks have submitted plans to regulators for raising money after unprecedented lending eroded their capital, according to four people with knowledge of the matter.

It’s “particularly troubling” that more than 140 billion yuan was invested in the steel industry in the first half of this year and that 58 million tons of capacity are under construction when global demand may decline 14.9 percent in 2009, the report said. The chamber also warned of “a looming deluge” of extra cement capacity in the nation.

On the one hand you have the Fed flushing the financial system with liquidity and on the other you have massive Chinese stimulus leading to huge excess capacity in some sectors. Will China export inflation or will it once again export another wave of goods deflation? It sure looks like the latter.

Finally all this talk of sovereign risk, Dubai debt, China overcapacity, and global financial nervousness is really trivial. For a second year in a row, I watched CNN's Heroes. If you want to know the real meaning of life, stick your nose out your Bloomberg screen and read up on these remarkable individuals who through their selfless actions make a real difference in people's lives.

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