In October 2008, Sultan Ahmed bin Sulayem, chairman of Dubai World, stood before a room full of bankers in Dubai and insisted that his company, and the emirate’s wider economy, were unfazed by the global financial crisis, which was wreaking havoc in world markets elsewhere.

Dubai real estate prices would not drop, he said, and work on the development of landmark projects such as Palm Deira, being built by Dubai World subsidiary Nakheel, would continue.

But on 25 November, little more than 12 months later, Dubai World announced it was requesting a debt ‘standstill’ agreement with its creditors, which would freeze repayments on its estimated $25bn debt for six months.

The fact that Dubai World appears unable to meet its financial obligations was seized on by critics as symbolic of the collapse of the emirate’s economy, with real estate prices having fallen by up to 50 per cent since their peak, and work all but stopped on Palm Deira and other major projects.

The impact of the Dubai World statement is being felt in the wider economy. Already, companies owed money by Dubai World subsidiaries are reporting payment problems.

“The financial markets are not making any distinction between a voluntary restructuring and default”

Dubai-based banker

“We signed a deal with Nakheel earlier this year,” says a source at one international construction company. “We gave Nakheel a discount and we got a few payments, but the latest instalment is late, and I do not expect it to pay at all. It is completely out of their hands [the people we made the agreement with]. We do not even know who is running Nakheel anymore.”

Nakheel could not be reached for comment.

There are signs that other companies further down the supply chain are refusing to pay bills, perhaps because they themselves are still owed money. “This standstill agreement is the last thing we need,” says one construction equipment supplier in Dubai. “Customers have already told us it means they cannot pay us now, because they will not get paid.”

On the day of the Dubai World announcement, the markets pushed the cost of credit default swaps (CDS) – an instrument for insuring against a default – up by 38 per cent from 320 basis points to 440 basis points for Dubai sovereign debt. It was a clear reversal of the previous trend of CDS prices declining since reaching close to 1,000 basis points in January.

Uncharted territory

The reversal shows how surprised the financial markets have been by the Dubai World statement. But it also reveals the level of confidence investors had placed in the optimistic messages delivered by Bin Sulayem and other key Dubai figures, including the ruler of Dubai, Sheikh Mohammed bin Rashid al-Maktoum, that Dubai was past the worst of the slowdown.

In the short term, how much worse it will get will depend on how investors react to the possible restructuring of Nakheel’s $3.5bn sukuk (Islamic bond), which is due to be repaid on 14 December.

If investors agree to a debt standstill, then a default can be avoided. If not, and if Nakheel does not repay its bond on schedule, the property firm will be in default and Dubai will be in uncharted territory.

But a lot of damage has already been done to confidence in Dubai, and some investors will act as if Dubai has already defaulted. “The financial markets are not making any distinction between a voluntary restructuring and a default,” says one Dubai-based banker.

In one sense, the Dubai World announcement simply expands on what was already known about the government’s policy towards companies it controls, which it calls ‘government-related entities’. In October, the government issued a prospectus for a $2.5bn sukuk in which it stated it was “under no obligation to extend support to any government-related entity”.

“The government has [effectively] announced it is willing to allow a state-backed company to default,” says Philipp Lotter, analyst at credit ratings agency Moody’s Investors Service in Dubai.

Following the Dubai World announcement, Moody’s, Fitch Ratings and Standard & Poor’s downgraded a raft of Dubai entities. Standard & Poor’s and Moody’s both took action against DP World, Emaar Properties, DIFC Investments, and Dubai Holding, among others. Fitch downgraded Dubai Holding and Dubai Electricity & Water Authority (Dewa).

The downgrades will hamper any future fund-raising activities by these firms, say observers. “If Dewa wants to issue, it will have to be prepared to pay over 600 basis points above Libor [the London interbank offered rate],” says the head of fixed income at one international bank in Dubai, referring to an expected bond issue early next year.

In April, Dewa paid 300 points above Libor for a $2.2bn bond.

Bankers say a planned bond issue by the UAE’s largest bank, Dubai-based Emirates NBD, which was pulled from the market in early November because the pricing was too high, will also face further delays. “Investors will have a bitter taste in their mouths for several months [about Dubai],” says one London-based bond analyst.

But the impact could also hit issuers in the wider region. Bahrain-based Gulf International Bank has dropped plans to issue a bond, which was expected to be finalised by early December, after the markets were spooked by Dubai’s announcement. Only Dubai-based companies with “sound cash flow-generating business models, away from speculative activities” will be able to issue bonds, according to Lotter.

A lack of new funding will have a major impact on Dubai companies’ ability to refinance debts that are due to be repaid next year, estimated at $13.1bn by Egyptian investment bank EFG-Hermes. On top of that, the expectation of an economic recovery in 2010 has been severely dented. “The lasting impact of this will be negative sentiment and lower private consumption in 2010,” says Fahd Iqbal, Gulf strategist at EFG-Hermes.

The authorities appear to have dealt with one risk, at least in the short term. Fears of a run on the banks were addressed when the Central Bank of the UAE said on 29 November it would provide emergency liquidity to local banks.

But the risks for other sectors remain, particularly real estate and construction, in which Dubai World companies are heavily involved. The construction industry has already experienced a tough year and now chances of a revival are even further away.

According to regional projects tracker MEED Projects, only $6.4bn-worth of construction contracts have been awarded in Dubai this year, compared with $30.4bn in 2008 and $21.7bn in 2007.

The deflated real estate sector is also facing further pressure as investor sentiment worsens. “Investor activity will fall until there is clarity about the action Abu Dhabi will take [to support Dubai], and what Dubai really means by a ‘standstill’,” says Nicholas MacLean, managing director of US-headquartered property consultant CB Richard Ellis Middle East. “Key institutional investors will not take the chance of putting their money here at the moment.”

Delaying recovery

Even with the slowdown in new projects, there is a glut of residential supply. An estimated 50,000 new residential units will be delivered in 2010, in addition to the 30,000 units delivered this year, although the emirate’s population is thought to be declining.

“I do not expect much future for construction in Dubai. It is already over-built,” says one regional contractor. “The future will be more geared towards the services Dubai can provide once the global economy starts to recover, so we are concentrating on other markets.”

Restructuring the emirate’s debt will be a slow and painful process. Dubai World alone has liabilities of about $59bn, and it is not clear how much of this needs to be restructured.

While the Dubai government has stated that the debts of Dubai World are not a sovereign obligation, it still needs to ensure the situation is dealt with in an orderly way for the sake of the wider economic health of the emirate, whether it is with the help of its richer neighbour, Abu Dhabi, or otherwise. In its bond prospectus in October, it said the government-related entities “in many cases support or facilitate the Dubai government’s strategic plan”.

In the long term, a clearer separation between the Dubai government and the activities of the emirate’s major holding companies would reassure investors. But for now, many will be wishing that it remains closely involved in trying to solve the problem.