UAE: Sovereign risk concerns look overdone

Since the announcement in late November that Dubai World (DW), a quasi-public
holding company in the United Arab Emirates (UAE), was seeking a standstill and
restructuring of some US$26bn in debt obligations, concerns have deepened about
future debt repayments across the country, with particular focus on the emirate of
Dubai. Unsurprisingly, bond prices plummeted in the wake of the announcement –
particularly on issues from Dubai World subsidiaries, such as Nakheel – with many
discounting haircuts of at least 50%. At the same time, CDS spreads on the
sovereign issuers of Dubai and, to a lesser extent, Abu Dhabi have widened (Figure
1), implying an increase in the market’s perceived risk of default by both issuers.
A world of uncertainty
A lack of clarity with regard to Dubai World’s ownership structure and its implications
for the outstanding liabilities of affiliated companies lies at the heart of the market’s
concerns. The holding company was established by government decree, is owned
by the government of Dubai (GD) and chaired by the emirate’s ruler, Sheikh
Mohammed bin Rashid al Maktoum, who is also prime minister of the UAE.
Because of DW’s close connection to the government through its opaque ownership
structure, creditors had previously assumed that its liabilities were implicitly backed
by the government and, by extension, that its obligations represented public sector
debt.
But the revelation that the government does not consider itself legally responsible
for DW’s debt obligations has created uncertainty on a number of fronts: about how
poor the company’s underlying finances may actually look (consolidated financial
information at the holding company level is not available); about which other quasigovernment
entities may also be troubled; and about the potential cascading effect
that debt defaults by quasi-sovereign institutions could have on the country’s
financial sector.

As debt worries have intensified, the broader economic outlook for Dubai has also

come into question, exacerbating the deterioration in the market’s sovereign risk

assessment. Growth was already suffering from the impact of the bursting real

estate bubble, which has seen prices in many areas decline by 50% or more, while

the rental market has collapsed. Spillover effects from the global recession and the

contraction in world trade have also weighed on the transport and logistics sectors.

Now the concerns about debt servicing are leading to projections of a protracted

decline in access to credit, particularly from international sources, which will further

limit the prospects for a robust recovery.

Underlying economic strengths should provide comfort

Despite the deterioration in the outlook for Dubai, the flush state of UAE’s finances

at the federal level means that the risks of a default on sovereign debt are limited, in

our view. After running a modest budget surplus in 2009, the country should see a

return to a double-digit surplus (as a percentage of GDP) this year on the back of

rising oil prices and increased output (Figure 2). While it is true that the country’s

vulnerability to the outlook for oil prices can introduce considerable volatility to future

economic performance (in terms of yearly GDP growth), its high per capita GDP

(more than US$35,000), extensive hydrocarbon reserves and its plentiful offshore

financial assets all provide a considerable buffer.

external position in aggregate reveals that it remains one of the world’s largest

creditors, at a level of more than 100% of GDP, leaving it with ample room to

service its debts.

The market’s assessment of Abu Dhabi’s risk of default also looks exaggerated, in

our view. While spreads on credit default swaps have arguably not widened to levels

similar to those of Dubai, even the 50bp in widening since the restructuring

announcement seems excessive. At current prices, markets are implying a greater

risk of default on Abu Dhabi’s sovereign debt than on that of Poland, Brazil or

Mexico. Given the above-mentioned strength of fiscal finances, and a continued

strong willingness to service its debt, such spread differentials appear unjustified.

Using our fiscal sustainability scorecard helps to illustrate the point that the UAE

ranks as one of the world’s strongest countries by these metrics.

strength, low levels of debt and longer maturity profiles (at the sovereign level) all

contribute to a comfortable rating, compared with both emerging markets and

industrialized countries. (See Figure 3). We also look at current CDS pricing versus

the scores, and note that both Abu Dhabi and Dubai both trade wide of the spreads

that would be implied by their fiscal sustainability alone. (See Figure 4)

What other forces may be at work? In addition to pure economic considerations,

assessing sovereign-default risk in the UAE also involves a measure of political

judgment. As the liability for sovereign debt lies at the emirate level, one must

assess whether, if necessary, federal transfers will be made to cover emirate-level

debt. Unlike in other countries with codified rules on fiscal federalism, transparency

around when and how such transfers might be made remains elusive. Indeed, the

ongoing process of disentangling sovereign risk from credit risk through ad hoc

announcements, such as on the recent standstill, has arguably raised more

questions than it has answered about federal willingness to back Dubai’s debts at

any level.

It is also important to note that not all government run institutions would appear to

have debt and liquidity challenges on the order of Dubai World. Many entities have

significant assets which are held against their liabilities, and indeed we have already

1

gross national income, providing additional diversification from the oil sector.

2

components, including Debt/GDP level and trend, vulnerability to growth and interest rate shocks,

as well as foreign exchange exposure of government debt

The economic slowdown

has not helped

Country-level fiscal

accounts are strong…

…but political

considerations also

matter

Clarification of which

obligations will receive

gov’t support should

help sovereign risk

Nomura Global Economics | EEMEA

Nomura International Plc 3 01 March 2010

begun to see some come to market. Moreover, by clarifying that obligations of DW

(and potentially other quasi-sovereign entities, by extension) do not carry an implicit

government guarantee, the government of Dubai’s contingent liabilities should

theoretically be lower. Viewed in isolation, this could actually be a net positive for

the emirate’s debt profile (though admittedly it is unclear whether any revenues from

holding companies such as DW have contributed to the budget in the past).

Although the prospect of DW defaults naturally increases the risks for local bank

balance sheets (given that they are large holders of DW subsidiary debt) and raises

the possibility that further government funding may be needed to support the

financial sector, such support has come from the central bank in the past and should

therefore be evaluated at a federal level.

In addition, Abu Dhabi has already shown its willingness to provide financial support

to Dubai, pledging some US$20bn to the government of Dubai for the Dubai

Financial Support Fund (DFSF) in an effort to contain contagion stemming from debt

problems and to protect Dubai’s economy and supply chain.

tempered by official concern over moral hazard risks implicit in supporting nonviable

institutions, such concern is far less likely to hold sway at the level of

sovereign—or emirate—debt, we believe. Commitment at the federal level to honor

sovereign debt remains unshaken, in our opinion, and a recent trip to the region and

meetings with officials there has underscored this belief.

Even in the face of these misperceptions, we would caution that the opaqueness of

the current restructuring process and the lack of information leave markets

susceptible to negative headline risk. There are few near-term triggers, save the

announcement of clearer restructuring details surrounding Dubai World or any news

of further transfers to the DFSF, that are likely to change investor perceptions or .

As such, any improvement in spreads could take some time to materialize. Another

important consideration for Dubai spreads in particular is the degree to which CDS

are being used as a hedge for other long exposure to local corporate or quasisovereign

debt.