Dubai Crisis: Islamic Bonds the Problem? Before and After the Bailout

By Dr. Zubair Hasan

Professor of Islamic Economics and Finance -( INCEIF ) Malaysia

The government of Abu Dhabi and the UAE Central Bank stepped in with a $10 billion bailout offer for the state-run Dubai World, which has recently been in debt.

Out of the allocated amount, $4.1 billion is meant to take care of the World's immediate debt obligations comprising Shari'ah-compliant bonds (sukuk) of the Nakheel, the property development arm of the company, which was due on December 14, the announcement date.

The company announced to meet its obligation within the next 14 days. The remaining $5.9 billion of the bailout will help meet the obligations to trade creditors and contractors of the Dubai World.

Though it was not an unexpected step, many, including the International Monetary Fund (IMF), hailed the UAE move to address the crisis.

Dubai World had suddenly asked for time from its creditors until the end of May 2010 to repay their loans of about $59 billion.

The announcement caused a quiver in global financial markets. The reason in part was a failure to distinguish between delay and default.

The Bailout

The debacle started with Dubai's booming real estate industry going bust at the start of 2008.

The bailout announcement came in time. It has calmed the nerves, reassuring investors, financial and trade creditors, employees, and common people that the government will always act to uphold the market principles and globally acceptable business practices.

Stock markets have since turned their tails up. The US dollar looked up against the Yen; the Euro rode on the back of both.The yen fell sharply against other currencies on the news, and the dollar shot up to 88.90 yen and the euro also jumped to 130.43 yen. Asian credit default swaps tightened after the news, and risk appetite got boosted.

When Dubai World declared postponing payments on $26 billion in debt, the Dow Jones Industrial Average fell 155 points, or 1.5 percent, European stocks dropped, and oil prices plunged.

Dubai economy was initially raised on petrodollars, but the fast-dwindling reserves of the Emirate helped it to diversify its economy.

The Emirate (Dubai) decided to develop service and tourism sectors, and it has positioned itself as an international finance, trading, and sports center.

High-rise buildings, grand hotels, and luxury resorts soon dotted the land all around.
Property prices were at a full gallop until the close of 2006. Then the tide of global crisis has also reached this tiny outpost.

The debacle started with Dubai's booming real estate industry going bust at the start of 2008.

In an exuberant market, competition created excess supply, property prices crashed — the average fall being around 40 percent of their value in 2009 alone, takers are thinning, and profit margins are vanishing.

The abrupt declaration on November 26 by Dubai government asking the creditors to reschedule repayment made the financial world panic, and shares went tumbling across the world.

The reaction was sharper in the West as boom Dubai was heavily financed by foreign funds, especially from the European banks like the Royal Bank of Scotland (RBS) and Standard Chartered.Four British banks( HSBC, Lloyds, RBS, and Standard Chartered) are said to have exposure of $5bn to Dubai World.

Developing countries did not express much concern. India feared the unemployment that the crisis could cause to its workers in Dubai, but the overall feel was that mountain was being made out of molehill.

The Rupee amount involved was small, and the exposure of the Indian banking system to Dubai was limited.

Sukuk's Security

Dubai was in part a victim of global meltdown and was in part overtaken by unguarded optimism and mismanagement.

Sukuk have been under cloud since the time Taqi Usmani, a prominent scholar on Islamic economy, questioned that their Shari'ah compliance in most cases (85 percent) slows down sukuk's popularity.

One consequence is that experts tend to tell about whatever adversity they find in sukuk. Dubai crisis has been no exception. Most comments, including some coming from the more sober academic world, contained disproportionate voicing of alarm and warning on the role of the Islamic bonds in Dubai turmoil.

The reason why sukuk attracted in the crisis the attention of the market was that their payment due on December 14 was the center of time-resetting negotiations; Islamic bonds, so to say, triggered the crisis.

The government announcement of its intention to enforce payment rescheduling immediately led both Moody's and Standard services to heavily downgrade the bonds — let alone sukuk — of various government-related entities in Dubai.

A more realistic approach could not have missed the point that the amount due was no more than 6 to 7 percent of the total money involved, and failure has not yet taken place.

Rating agencies could have shown little restraint in their decisions. They wield enormous power in the global bond markets, and they can literally force any government regarding debt issues.

There are increasing murmurs as to why these agencies are allowed to continue rating debt issues.

As bond issuers themselves have to pay for the evaluation exercise, there candidly is scope for the ratings moving in tandem with the payments.

It is not very clear what rules of conduct these agencies follow, who design these rules, and who oversees their observance. There is presumably a case for setting up regulatory frameworks for the rating agencies even for establishing separate ones for Islamic bonds.

Important Aspecsts

Sukuk was not so much the issue in Dubai crisis as some have tried to make it.

Some analysts see the Dubai fiasco from a historical angle; to them, the causes of Dubai turmoil were noticed the moment Sheikh Mohammad Al-Maktoum, its ruler, took the decision to invest his, as also the Emirate's, wealth in US real estate markets through the foreign arm of Emaar; the second largest property developer in Dubai.

The company ultimately went bankrupt, extending the US subprime crisis to the Emirate.
The Washington DC and Abu Dhabi connection has pressured Dubai to join the "international community" in taking a tougher stance against Iran,which is one of the main trade partners of the Emirate.

Dubai has also decided to enact an insolvency law on the US-British model to provide protection to local companies, like the World, from its creditors.

Abu Dhabi may also be looking for some concessions from Dubai in return for its bailout. It may, for instance, seek concessions on trade with Iran and on the future of the Emirates Airline.

Sukuk was not so much the issue in Dubai crisis as some have tried to make it. Sukuk market remained calm and unaffected across countries, including the leading market of Malaysia. Dubai was in part a victim of global meltdown and was in part overtaken by unguarded optimism and mismanagement.

The crisis has compromised Dubai's reputation as an economic power house in the region it may find difficult to retrieve. It still faces the daunting task of restructuring the remaining $22 billion of Dubai World's debts.

Important the issue is what is going to be the fate of Dubai's huge investments sunk in high-value property mostly in anticipation of foreign demand, especially from the West.

The future is quite uncertain, if not bleak. The Emirate must proceed with caution.

Link: http://www.islamonline.net/servlet/Satellite?c=Article_C&cid=1260258086411&pagename=Zone-English-Muslim_Affairs%2FMAELayout