Europe November 27, 2009, 7:03AM EST

Dubai Debt Shock Sends Markets Reeling

The revelation that Dubai World is seeking to postpone huge debt payments smacked European markets and especially bank stocks on Nov. 26

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Dubai was the poster child of the economic boom: a world of unimaginable luxury, impossibly tall towers, and islands shaped like palm trees. This week it became the epitome of recessionary bust.

Global stock markets were left reeling yesterday after the city-state's spectacularly debt-ridden Dubai World holding company asked for an extra six months to pay the $4bn (£2.4bn) chunk due next month. In London, the stock market dropped by 3 per cent, its worst day since March. [Ed. note: The selloff continued Nov. 27, with the FTSE down another 1.5% early on.] The French and German markets fared little better, and America's Dow Jones was only saved by being closed for Thanksgiving. Even sterling wavered, falling to its lowest rate against the euro for a month. But it was Britain's battered banks that were the worst affected. Fears over the extent of their exposure to Dubai's $80bn debt knocked nearly £14bn off their value by the end of the day.

The Gulf emirate's financial problems come as no surprise. It has already been bailed out to the tune of $10bn by fellow United Arab Emirates (UAE) member Abu Dhabi, and it had managed to scrape together another $5bn from two Abu Dhabi banks hours before the request for a "standstill agreement" to give Dubai World time to "restructure" itself. But global financial confidence is only just starting to recover from last year's banking crisis. And it is not yet known how much is at risk, and where.

Part of the problem is the scale. Dubai World's reach is truly vast. Within the main holding company are 10 subsidiaries, each a monster in its own right. The highest profile is the Nakheel property group, which owes the $4bn due next month. Nakheel is behind the Palm project that has become synonymous with Dubai's ballooning property market. The three palm-shaped islands, built in the waters of the Gulf, looked like a developer's triumph. The first island – the self-proclaimed Eighth Wonder of the World – sold its initial 2,000 villas within a month and included David Beckham and Brad Pitt on its star-studded list of buyers. But Nakheel is just one part of the sprawling empire. DP World (DPWRF.PK), another division, is the world's fourth biggest ports operator, which includes the UK's London Gateway, Southampton and Tilbury facilities in its global portfolio. Other divisions span everything from hedge funds to Scotland's Turnberry golf course.

By yesterday lunchtime, Europe's financial markets were awash with rumours about which banks are the most in danger from the Dubai debt and what the implications might be. But while estimates of European institutions' exposure gyrated from $13bn to $40bn, there was widespread agreement that the British are the most exposed. "Everybody is looking at who is affected the most and the UK banks are standing in the front line," Shahin Vallée, BNP Paribas's head of Middle East strategy, said.

Nobody expects Dubai to default on its debt, and there is little immediate danger for the state's holdings abroad. But the shock has real financial repercussions, and even if Abu Dhabi does step in with more funding, Dubai World's reorganisation will cost its creditors money. Beyond that, the bigger danger is the blow to global economic confidence, not least because no one knows the scale of the problem. "There are layers of cloud and uncertainty," Mr Vallée said. "Dubai World is not a company, it is a conglomerate with very limited corporate governance and financial transparency so no one knows what its assets are or what the real debt is." The danger is that the crisis stamps out the signs of life helping lift the world's economies out of recession. "The consequences could be to slow down global capital flows again because banks are reluctant to stretch their balance sheets," Mr Vallée said.