Emerging market assets attracted risk-takers and were early to rally even during the darkest days of the financial crisis and the recession earlier this year. Now, with news that Dubai has requested a standstill on $26 billion in debt including $3.5 billion that comes due in December and may default on $60 billion in debt, investors may be taking a harder look at emerging market assets.
The big fear is how much potential there is for contagion to other markets or assets if the emirate's investment arm, Dubai World, defaults on its debt. We have learned the hard way in the current financial crisis that risks around real estate aren't necessarily limited to that particular asset class.
Nick Chamie, head of emerging markets research at RBC Capital Markets, sees Dubai's extravagant overbuilding spree as endemic of the credit boom earlier in the decade and its possible default as another ripple effect from the global credit crunch. "Dubai is just another victim of the return to stricter credit standards," he says.
Compounding Selling Pressure As the end of 2009 approaches, investors will probably insist on getting paid a larger premium to invest in higher-risk assets such as emerging market debt, he says. "A lot of [investment managers] booked big profits and will be looking to pare down their risk going into yearend in order to lock in profits, as they get ready to report returns to their clients," Chamie says.
The events in Dubai will simply provide added incentive for that and will likely compound the selling pressure on debt and equity assets in emerging markets, he adds. But he expects the impact of Dubai to last weeks rather than months.
Since Dubai's bonds were regarded as quasi-sovereign, the government's statement that they aren't guaranteed could alert some investors to reevaluate how strong a foundation similar bonds they may own actually have, says Arigit Dutta, a mutual fund analyst at Morningstar (MORN).
Wither Abu Dhabi? Since Dubai was never considered an emerging market, just as Saudi Arabia isn't thought of as an emerging market, the crisis shouldn't smudge the reputation of emerging markets in the minds of investors, says John Chambers, deputy head of the sovereign ratings group at Standard & Poor's. "Dubai is a high-income emirate, so it doesn't really fit [the emerging market] category at all," he says. "It had a property boom and the property boom went bust. I'd compare it to Houston [Texas] in 1982."
Though it may not hurt emerging markets, the Dubai crisis certainly won't boost confidence in the United Arab Emirates, says Chambers. There had been some thought that the richer Abu Dhabi would come to Dubai's aid, but that now looks less likely, he adds.
James Patti, a partner in the Chicago office of Mayer Brown who specializes in emerging-markets finance, believes Dubai's crisis is unique because its economy relied on limited, related businesses—real estate, tourism, and finance—and won't have widespread repercussions. "I think investors are not letting the Dubai situation color their view of China or Brazil or India or Vietnam," he says. "Those are each very different countries with very diverse economies and huge populations, that, because of their diversity, are more insulated in certain arenas."
"Crossover Investors" Exposed In a Nov. 30 research note, Chamie at RBC said he doubts that hedge funds and dedicated emerging market investors were that heavily invested in Dubai or related debt. Banks and "crossover investors," who invest in assets at various stages of their business life cycle, were probably the primary holders of Dubai debt, he said.
After six days of silence, Dubai World announced early on Dec. 1 that it's in negotiation to restructure $26 billion in debt—including roughly $6 billion in Islamic bonds issued by the state-owned conglomerate—and expects to come to an agreement with creditors soon. Standard & Poor's estimates that almost $50 billion of Dubai World's debt and that of its affiliated entities is set to mature over the next three years. In the RBC research note, Chamie said that an effort to restructure a much bigger portion of the debt than the $3.5 billion maturing this month could result in extending the amortization schedule across the next five or 10 years.
The risk around emerging market debt has generally been diminishing for some time, with countries such as Russia, Brazil, and Mexico on "a sustained path of improved credit ratings," according to Dutta at Morningstar. Some credit ratings, like Argentina's, were challenged over the past year but have rebounded strongly with the economy, he says.
Inflation Risks an Issue Since the reliability of sovereign debt depends mostly on the strength of a country's fiscal position, it's hard for Dutta to see how Dubai's circumstances would affect the economic fundamentals of other emerging market countries.
There are other concerns for emerging markets, however, such as the likelihood they will face inflation risks sooner than developed countries in the West, BNP Paribas (BNP:FP) said in a Nov. 30 research note. The reluctance by some emerging market governments to see their exchange rates rise could also increase the risk of those economies overheating in the form of asset bubbles or inflation, the note said.
David Cohen, director of Asian economic forecasting at Action Economics, said in a Nov. 30 report, however, that he expects Asian central banks to lead the way when it comes time to boost interest rates. That won't happen until mid-2010, he thinks, except for South Korea and India, which should start tightening policy in the first quarter.
Slowing Trend of Globalization A bigger concern for Chambers at S&P is how global international trade imbalances will be worked out and what that may mean for emerging markets. He points to signs of a slowing trend toward globalization and worries that international trade flows and cross-border investments might start to reverse.
The continued growth of emerging market economies depends on their ability to increase their exports. Any protectionist measures that other countries adopt will hurt emerging economies disproportionately, says Chambers. "It may all reverse because [governments] are tired of running large current account deficits and they think countries [that run trade surpluses] need to do more to rebalance their own economies," he says.
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