Home > The Thinking > Articles > A Report on the Implications of the Global Financial Crises for the UAE and Dubai in Specific - Nov 2008

A Report on the Implications of the Global Financial Crises for the UAE and Dubai in Specific - Nov 2008


01-10-2011
English | العربية

Ibrahim Karsany

Former Director, Public Policy Division


Tag: economy Government Policy United Arab Emirates
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By Dr. Ibrahim Kursany, Director
Economic Studies Division
1. The causes of the global financial crisis
The signs of the current financial crisis in the United States of America started in 2007 when some investment institutions working in the mortgage market encountered problems in collecting debts from several categories of debtors. The problem grew severe when banks refused to loan to each other to facilitate normal lending thereby drying up funds not only for mortgages but for ordinary daily business. This situation - the deficit in debt collecting as well as the reduction in access to credit caused the bankruptcy or near collapse of financial institutions including, in the forefront, the largest U.S. investment banks: Lehman Brothers (which collapsed), J.P. Morgan Chace, Bank of America/Merrill Lynch, and Goldman Sachs (whose former CEO, as then U.S. Treasury secretary, helped rescue the company).
 The main cause of the distress of those financial institutions was that their executives had granted loans for property but, freed by newly-passed US legislation in 1999, held too small a reserve to guarantee the securities. Further, also in response to encouragement from federal regulatory rulings, they went beyond reducing the interest rate on loans and extending the repayment and grace periods. They offered loans on a propertys current market value in what is known as the subprime or secondary mortgage market. This allowed many low-income property owners to borrow using not only the already-mortgaged property itself as a security guarantee, ignoring the borrowers inabilities to repay. Banks raised a potential borrowers credit-worthiness by using the propertys supposed market value as well (a value only on paper); this figure had increased significantly from the original value of the property because the banks quickly had bundled each of these loans into assets which they in turn sold at a profit. Home ownership, long an important step toward living decently, turned into underregulated run-away profit-generating for the banks and mortgage companies. The bank debt rate increase exceeded all expectations. And when the economy slowed and debtors and lenders alike realized default lay ahead, borrowers began walking away from the homes they could not afford and banks found their mortgage asset bundles worth only a fraction of the traded price, capital for new mortgages and rolling over older ones evaporated, and bankruptcy came in the door.
The bankruptcy of these investment institutionstheir inability to meet their debts and financial obligations to banks and creditor institutionsexpanded the crisis to the insurance sectorthe main guarantor of those loans. The largest American insurance company, even the largest globally, American International Group (AIG), almost failed. Its bankruptcy would have had catastrophic effects not only on the U.S. economy but the whole global economy. The U.S. administration did not dare to take such a risk so it stepped in to protect the U.S. financial sector and banks. It used a set of actions that allowed it to acquire a high percentage of the assets and shares of these banks and institutions in order to preserve investors and customers confidence on which the banking system depends.
2. The size of the global financial crisis:
The Bank of England appraised the global financial losses resulting from the current financial crisis at approximately 2.8 trillion dollars. This is equivalent to 45 times the amount of the British public debt in the third quarter of 2008 or three times the size of the annual government spending in Britain.

3. Globalization and the Global Financial Crisis:
Bankruptcy and financial losses of major U.S. investment banks and insurance companies resulted in share price declines to book value in many cases. This led directly to the unprecedented run on supposedly safe U.S. money market and flight to U.S. treasuries. The globalization of the international economy prevented containing the crisis within the U.S. economy. All of the world's economies from Japan through South East Asia and the Middle East and European countries caught the U.S. economys flu. Economies of advanced industrial countries experienced defaults in their banking systems and money markets, even the Swiss banks which are the core of the global banking system.
4. The effects of the global financial crisis:
The most important effects of this crisis were:
A. Loss of confidence in the banking system:
The bankruptcy and value loss of banking institutions robbed many people losing of substantial portions of their invested savings whether in the form of shares in those institutions or as deposits in them. Those serious financial losses led to many investors' loss of confidence in those institutions, confidence they need to perform their work.
B. Lack of liquidity within the banking system
The financial crisis led most banks to re-examine the policies and regulations that they follow in granting loans. Most of those banks even refused to grant loans to anyone, including other banks working with them. The most serious decision taken by those banks was withdrawal from inter-bank lendingwhen banks lend to each other which is the backbone of the performance of the banking system as a whole. The depletion of liquidity had many negative effects in the real economy (the economy of producing goods and services).
C. Recession:
Many feared the spillover of the financial crisis effects on the real economy (goods and services). The lack of liquidity will stand as a stumbling block for many investors and businessmen in industry. Without the funds they require to continue their work production will slow or stop, they will close their doors, and their workers will lose their jobs. This happened on a large-enough scale to put the U.S. economy into a recession from which it has yet to recover.

5. The financial crisis and the role of the country
The philosophy of those at the helm of the U.S. economy and public policy have faith in the principles of "free market" and the "market mechanism" as the preferred means of adjusting economy. These principles, they believe, can track and repair any defect in the economys performance and return it to health through the operation of supply and demand.
The current financial crisis has shown the risk of this philosophy. This style of the market mechanism in dealing with this crisis was necessarily leading to a collapse of the U.S. banking system and possibly the collapse of the U.S. economy as a whole. When this reality loomed, the U.S. government intervened powerfully by pumping an initial 800 billion dollars into the banking system which later totaled more than a trillion dollars.
All this money went to buy assets and shares of the collapsed banks and financial institutions and provide working capital for major industries such as automobile production. U.S. government acquired stocks and assets of these firms without formally nationalizing them, behaving rather in tune with socialism and centrally planned economies in the minds of many observers. The U.S. government applied concepts that its vocal leaders had rejected. And these leaders returned quickly to advocating government non-intervention in managing the private sector, underscoring their commitment to "deregulation".
To rescue the executives who caused the bankruptcy the U.S. government used money from U.S. taxpayers. Commentators in the U.S. have questioned the ethics of this bailing out approach. For example, they point to the Executive Director of Lehman Brothers Bank who had received an incentive bonus of four million dollars in April 2008; some analysts claim that he knew at that time about a possible bankruptcy of his firm in the near future but accepted the bonus.

6. Global financial crisis and the Gulf Cooperation Council
Most observers expected that this crisis would pass without a significant impact on the GCC because of its available financial reserves worth hundreds of billions of dollars obtained through the unprecedented rise in oil prices just before the crisisprices which reached in some cases to nearly $150 per barrel. But what slipped from these observers minds is that most of this money and wealth was being invested in industrialized and developing countries, particularly in the U.S., and particularly within the sectors of money and real estate. Thus any crisis in those sectors would necessarily have negative impact in the economies of the GCC. This is in addition to the psychological impact caused by the collapse of the U.S. stock market, and then other international stocks markets, which, in turn, affected all GCC stock markets and reverberated through all GCC economies and polities.
All the GCC officials affirmed their economies immunity against any global financial crisis. But their optimism did not last long. For example, when Gulf Bank of Kuwait, the second largest bank in Kuwait, announced a debacle, the government of Kuwait to intervene to protect the bank from bankruptcy. As the crisis rose, the UAE government announced guarantees of bank deposits for three years and pumped about 120 billion Dhs into the economy. These and other countries actions revealed the Gulfs initial over optimism.

7. Dubai model and the global financial crisis
The Dubai model for development depends heavily on deficit financing to ensure the implementation of the investment projects in all sectors, particularly in the real estate and services sectors.
The economic renaissance in Emirate of Dubai required governments debts which reached approximately $50 billion, or about 50% of the total gross domestic production, which is very high; $30 billion went to Emirates Airlines alone.
Also the size of loans on real estate sector was an estimated 11% of the total assets of banks operating in the country and 18% of the total deposits. Although this ratio is less than the proportion of the 20% that the UAE law sets as a maximum lending of the total deposits, it is very high. Exceeding this limit presents a big risk for the overall economy whose banks assets are an estimated 1.3 trillion AED.
For Dubai to maintain its developmental achievements and the global reputation that it gained through its creative performance and excellence in various fields, it will have to improve the performance of its banking institutions and end its practice of granting loans without sufficient guarantees, especially personal loans. Granting of personal loans irresponsibly appears to be a main cause of the current global financial crisis. Also the country must halt the practice of allowing persons to set up phantom investment portfolios; collapse of these robbed millions of Dhs from the savings of thousands of middle-class in the country.

8. What is the way out of the current financial crisis:
The U.S. financial crisis has evolved to a recession in which the U.S. economy may stagnate or shrink. The U.S. government tried to minimize the effects of this crisis on the real economy, tried to restrict it within the financial sector by pumping a trillion dollars into the economy to achieve the following:
A. Acquisition of assets and shares of the collapsed financial institutions and banks in order to save the U.S. banking system and capital markets from total bankruptcy which would reverberate throughout the global economy.
B. Provide the liquidity banks need to perform their functions and granting loans to those who deserve them, whether investors or consumers, and thus put the economy on track and save it from falling into a deeper recession.
The current U.S. economic crisis is basically a crisis in total demand. Thus actual demand, i.e., demand backed by purchasing power, must increase to regenerate the economy. But is the amount of liquidity that the U.S. authorities injected into the economy initially was not enough.
The U.S. economy has three possible main sources to increase the size of the effective total demand to create a suitable way out of the current crisis:
A. Increase the size of governmental spending.
B. Increase the volume of consumption and private investment.
C. Increase the size of exports.
As for the second factor, the volume of consumption and private investment, the increase in rates depends primarily on the ability of U.S. banks to grant consumer and investment loans, which faces real difficulties.
The third factor is the volume of exports. As in the case of the inability of banks to provide appropriate loans for investors, companies will have to reduce their productivity or close down their factories, and thus it would be impossible to increase up the export volume, even if the demand in the global markets were available.
This series of dilemmas facing the U.S. economy can be termed as the "vicious circle" where its most important elements shown in the following:( see image below)

The way out of this vicious circle for the United States is external borrowing or attracting foreign investments, or both. The potential external sources that can provide loans for the U.S. economy or direct investment in various sectors are only two: China and the Arabian Gulf Countries.
A. China and the U.S. economic crisis
China is one of the key partners for the United States because its economy grows at an annual rate ranging between 7% and 9%, and therefore it is a huge market for U.S. exports, especially for capital goods and technology. In addition, China is one of the biggest investors in the U.S. financial sector where it owns an estimated $500 billion of U.S. Treasury bonds. But resorting to borrowing further from China will entail considerable political risks because China is a major competitor in the economic and political spheres. Borrowing from China will strengthen it particularly where primary and necessary resources for the global economy arein Asia, Africa and Latin America. Though seeking help from China is an option, it is not the better option.
B. Gulf Countries and the U.S. economic crisis:
Gulf Arab countries represent a strategic ally, after Israel, for America in the Middle East. Since these countries are considered as the main source of oil resources and exports in the world, and since the region has accumulated large amounts of financial resources by the unprecedented rise in oil prices. It is a source of financing that is easy and safe for the U.S. economy.
The Deputy U.S. Treasury Secretary announced at the pulpit of Dubai International Financial Exchange, during his tour that included the countries of the region, that the Gulf Arab Countries will play a key role in the worlds exit from the current financial crisis. He referred to the sovereign funds specifically, even making an explicit invitation to invest in the U.S. economy.
This invitation came when the world had not forgotten the fierce battle in the U.S. Congress to deprive Dubai World of the company it had acquired for the management and operation of some U.S. ports by discrediting the company, the UAE federal government, and the Emirate of Dubai as direct threats to U.S. national security if it succeeded in acquiring those ports. It is ironic, then, to see the U.S. government turn around and seek security from the financial institutions of a country it accused of threatening U.S. national security. It's a game of the higher national interests, and therefore the Gulf Arab countries should be very careful in accepting an invitation to invest in financial institutions that failed and bankrupted at the time the UAE firm was prevented from investing in the real sectors.

9. An alternative strategy for the UAE to deal with the global financial crisis:
The UAE central bank governor said that the countrys banks have used only 15% of the total liquidity the Central Bank offered. This seems to indicate that the countrys banks do not suffer a liquidity crisis. Thus the UAEs economic recovery strategy needs to be qualitatively different from that of the U.S. or much of the rest of world.
We believe that the proper approach to cope with the crisis locally must begin with the effects of a decrease in the international oil price. The decline in oil prices has occurred for at least two reasons: one is that the pre-recession run-up in price was a function of speculators seeking safer a place for their capital when they foresaw a decline in the profitability of other investments. And, second, demand in the global markets has lowered with the recessions onset. The speculation could return when gold bug fever abates; the demand could rise if economies of the industrialized world re-energize. The speculative side is risky because its produced unstable pricing that discourages recovery of economies. Thus the UAE challenge is in the low demand on our most important export commodity. Therefore, we propose a two-pronged strategy to deal with this crisis in order to protect the higher interests of the country and emirate, namely:
First: Work on providing the strategic commodities such as food, water and energy, because these basic goods are strategic to protecting the national security of any country. Failing to provide these to its citizens indicates that a country faces a potentially serious social and political shock which would have a devastating impact on the countrys security and political stability. As Henry Kissinger said in framing U.S. national security strategy decades ago, "Take control of the oil to dominate the countries, take control of the food to control the peoples".
Second: Fund development projects in all vital sectors, especially education and health, providing a solid foundation of key staff and qualified and trained human resources. All international experience shows that this serves as the main guarantor of the continuity of sustainable development.

10. Recommendations:
A. Channel the estimated 120 billion Dhs that the judicious government pumped into the economy to the implement the two-pronged strategy outlined above: (1) provide the necessary goods of food, water and energy for a period of six months at least, and (2) improve and upgrade the performance of health and education sectors to ensure that they can provide qualified local human recourses.
B. Provide financial liquidity for development projects in other vital sectors in order to assure that the process of sustainable development and the current economic boom will not face setback.
C. Prevent creation of fake portfolio mock financial institutions that usurp funds of ordinary people under the pretext of investing it for them in interest rates as high as 30% or even 40% . These frauds form a real risk on the positive investment environment and the good economic reputation that the country enjoys at the moment.
D. Be fully prepared to face the risks of inflation in prices that could be a result of oil sales pumping a large volume of funds if it were not allocated to support sectors and productive activities, or if it went mostly to increase the consumers spending. Inflation would threaten the security and the economic stability in the country.
E. Respond with utmost caution to the call made by Deputy U.S. Treasury Secretary for the UAE to invest sovereign funds in the U.S. financial sector; investing in semi-collapsed financial institutions first on its investment in those collapsed institutions and now of their final total demise.
F. Do not open the door to accommodate the crowd of the unemployed, ex-employees of the collapsed financial institutions. The former "experts" within the institutions of the financial sector in the country are currently looking for jobs in all parts of the world, and most reports indicate that they are targeting the Arab Gulf Countries as a place to get a decent job in the shortest time possible. If these experts have real capability they would be using it to rescue their collapsed financial institutions.
G. Work to identify and monitor the financial and economic indicators that could warn of another crisis. This will require a high degree of leadership, transparency in government and economic management, and responsible professionalism that accepts criticism and advice.
H. Consolidate efforts among the countries of the Gulf Cooperation Council to mitigate the effects of the global financial crisis on their economies, societies and national security through policies and strategies such as the completion of the consolidated Gulf market and unified Gulf currency.
I. Provide incentives to encourage the sovereign wealth funds to invest in the Gulf countries economies; this will have very positive impact on the performance of those economies, and will certainly contribute to achieving economic stability, and thus the security of the Gulf Arab countries. These funds can support any public company that stumbles, for example, by purchasing some portions of it or possessing part of its shares.
J. Postpone some major real estate projects and focus on infrastructure projects in energy, water and sanitation.

 

 

 


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