An attempt by local developer Meydan to cash the performance bond of the contractor on the AED4.6bn ($1.25bn) grandstand at the Nad al-Sheba racecourse is raising fears among Dubai-based contractors that they could soon be facing a string of project disputes and soaring costs.

A performance bond is paid by the contractor to the client to act as a guarantee against any failure by the contractor to meet obligations specified in the contract, such as completion dates.

It is understood to be the first time a client has moved to cash a performance bond in Dubai during the current slowdown.

Contractors now fear they will lose more bonds as they are blamed for delays. They also fear they will have to raise larger and more costly bonds to secure future contracts.

Meydan elected to call the bond, which is understood to be worth 10 per cent of the total value of the contract, after cancelling its contract with the local Arabtec Construction and Malaysia’s WCT in early January. It blames delays for the cancellation, which it says are the fault of the contractors.

The construction schedule was one of the most aggressive in the emirate as the grandstand is planned to be in use for the Dubai World Cup horse race in 2010.

It is understood that the bond, which was provided by the local Mashreqbank, has now been frozen by the Dubai courts after a legal challenge to Meydan’s move by the contractors.

As Dubai’s real estate crash continues, it is possible that clients will call more performance bonds, claiming to be dissatisfied with their contractors. Some contractors also fear that clients will view bonds as a ready source of cash at a time when most are struggling to raise revenues through the sale of developments.

“It is no secret that clients have cash flow problems, so the worry is that clients may think that performance bonds are an easy source of cash,” says one Abu Dhabi-based contractor working in Dubai. “Most projects have unrealistic delivery schedules and are delayed, so we are all at risk.”

The boom in the construction industry in recent years had led many banks to consider performance bonds as essentially risk-free investments. Sources in the UAE banking sector say this is now being reviewed and it could become difficult for contractors to raise finance for new bonds.

One contractor, who wishes to remain anonymous, says he was recently refused a performance bond by banks for a new project in Dubai.

The interest rate on bonds issued could also rise steeply. “What we will see now is a drastic repricing of the risks associated with these bonds,” says one Dubai-based banker. “Interest rates could shift from about 15 basis points over the London interbank offered rate (Libor) to about 250 basis points over Libor.”

The risk of more clients cashing in bonds means that banks are also asking contractors to maintain far larger deposits with them, as a partial guarantee of the bonds, adding to contractors’ cash flow problems.

“In the past, we had to maintain deposits as part of our balance sheet that were worth about 10 per cent of the value of our bonds,” says one European contractor. “This has now been increased to 60 per cent, which has a massive impact.”