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A Warning from the Desert with More to Come

Tuesday, December 1, 2009

Dubai is but one of many ticking economic time bombs likely to explode.

Dubai’s surprise announcement last week that it was seeking a standstill on its $80 billion external debt should be a sober reminder to us of the still-fragile state of the global economy. It should also alert us to the many other ticking economic time-bombs around the world and to the dangers of any premature easing of the global economic stimulus before today’s incipient economic recovery gains greater traction.

In the grand scheme of things, events in as small an economy as that of Dubai should have had no great bearing on the global economy. Yet Dubai’s surprise standstill announcement sent shudders through world financial markets. It did so in a manner all too reminiscent of what had occurred in 2007 when the economic crisis in Iceland, another small economy, sent ripples through global financial markets. Before the week was over, equity and credit markets were pummeled around the globe.

Dubai’s present financial predicament should not have come as any surprise. After all, if ever there was a country that epitomized the excesses of the boom years between 2002 and 2007, it has to be Dubai. For in its quest to become the region’s primary financial center and tourist destination, much in the same way as Singapore and Hong Kong had become such centers for Asia, no expense seemed too great and no loan too large for the emirate’s desert economy.

If ever there was a country that epitomized the excesses of the boom years between 2002 and 2007, it has to be Dubai.

A tell-tale sign for foreign investors that matters were veering to great excess should have been Dubai’s decision to erect a 200-story building that would have made it the world’s tallest structure. Other telltale signs should have been Dubai’s intention to build the world’s largest man-made artificial islands as well as its past construction of a major ski resort in the desert.

As has all too often been the case, investors cognizant of Dubai’s financial excesses were counting on someone to bail out the emirate in the event that the going got tough. In Dubai’s particular case, foreign investors were counting on fellow emirate and oil-rich Abu Dhabi to play that role. It was only when Abu Dhabi appeared to have little appetite for immediately bailing out its fellow emirate that global financial markets started to panic and sell.

More than likely, global financial markets will soon get over their Dubai setback and recoup their losses of the past week. This would particularly be the case should Abu Dhabi have a change of heart and step into the breach to rescue its fellow emirate for the sake of preserving the United Arab Emirates’ financial reputation. It is also more than likely that global policy makers will take comfort from the restored market stability and lapse into their earlier state of complacency. If this occurs, it will be a great pity–around the globe, there remain all too many ticking time bombs that threaten to destabilize the global economy in a much more meaningful way than could Dubai.

In thinking of potential economic flashpoints for the year ahead, one only has to think of the hapless Baltic country states where GDP has been falling at annual rates of close to 20 percent and where budget deficits have been ballooning.

In thinking of potential economic flashpoints for the year ahead, one only has to think of the hapless Baltic country states where GDP has been falling at annual rates of close to 20 percent and where budget deficits have been ballooning. It only seems a matter of time before Latvia, already on IMF life support, will be forced to abandon its currency peg. This must be expected to accelerate the pace of debt default in the Baltic countries, which would have untoward consequences for the Swedish banking system that is overly exposed to that region.

Of even greater moment for the global economy, one might think of the difficult economic predicament of countries such as Spain, Greece, Portugal, and Ireland, whose economies are all many times the size of Dubai’s. These countries are all experiencing deep recessions in the aftermath of the bursting of their respective housing and credit market bubbles, which are causing their budget deficits as a percentage of GDP to climb into double digits. They are also all experiencing outsized external current account deficits as a result of losses in international competitiveness of around 30 percent over the past few years. Markets are already beginning to focus on how difficult it will be for Greece and Ireland to regain competitiveness and to restore fiscal sustainability within the straightjacket of Euro-zone membership.

Yet another ticking time bomb for the global economy has to be the ongoing bursting of the U.S. commercial real estate market, particularly since as much as $500 billion in commercial real estate loans will come due in 2010.

Yet another ticking time bomb for the global economy has to be the ongoing bursting of the U.S. commercial real estate market, particularly since as much as $500 billion in commercial real estate loans will come due in 2010. In the likely event that these loans are not rolled over, one must expect further substantial downward pressure on commercial real estate prices, which would be highly challenging for U.S. regional banks whose exposure to the commercial real estate market exceeds 50 percent of their overall balance sheets.

If nothing else, last week’s events in Dubai should remind us that the global economy is far from out of the woods. It should also remind us how premature it is for policy makers to start implementing exit strategies from the past year’s extraordinary global monetary and fiscal policy easing.

Desmond Lachman is a resident fellow at the American Enterprise Institute. Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney.

FURTHER READING: Lachman also wrote “The Next Economic Shoes to Drop” on what further strains on the financial system to expect in 2009, and “Don’t Repeat Japan’s Mistakes” on the Japanese authorities’ mishandling of their own financial crisis during the early 1990s. Go here to see Lachman’s presentation on the housing market bottom. Lachman also discussed the foreign policy implications of the global economic crisis in Senate testimony this February. He says that U.S. public finances are leading us “On the Fiscal Road to Serfdom” and compares countries’ high debt levels in “The Deficit Endgame.”

Image by Darren Wamboldt/Bergman Group.

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