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Dubai's difficulty is a warning to all big spenders

By Stephen King

November 2009 will surely go down as one of those great months of mystery.

How did Jedward survive for so long on The X Factor? Did Thierry Henry handle the ball intentionally? How did Elin Nordegren make use of a golf club to remove Tiger Woods, her husband, from his SUV? And why is Dubai suddenly in such financial trouble?

Given the size of its buildings, and the sheer amount of construction that's taken place in recent years, it's no great surprise that Dubai is heavily in debt. Investors hoped, however, that Dubai would stay creditworthy, if only because it would be able to rely on Abu Dhabi, its oil-rich neighbour, for a bailout.

The worrying feature of the Dubai episode, is that it's not just private debtors at risk. Dubai World, the company in trouble, is government-owned. If Dubai is in trouble, could other governments also find themselves in difficulty? If so, who bails out the governments?

In the past, the International Monetary Fund has performed that role. The Fund's success, however, has been dependent on an adequate supply of funds. Those funds have depended mostly on the maintenance of reasonable fiscal health in the developed nations. Many developed nations are, however, looking fiscally rather sickly.

Option one is to deliver years of austerity, something which Ireland is trying to do and something which the UK may have to live with after the forthcoming General Election. If a country has been living beyond its means, a bit of belt-tightening is appropriate. However, what might be right economically is a lot more difficult politically.

Option two is to create inflation. If the creditors are mostly domestic, unexpectedly high inflation will reduce the 'real' interest rate paid by the government to its bondholders. Inflation thus operates as an implicit tax, defrauding the creditors at the expense of the debtors. Some investors think the whole world is heading in this direction but I doubt it.

Option three is to devalue. This will work only if the devaluing nation has borrowed from the rest of the world in its own currency. In this case, devaluation reduces the amount of money to be paid to foreign creditors in their own currencies.

Option four is to default. Countries which borrow from the rest of the world in foreign currency often have no choice.

For them, devaluation doesn't work, because it increases their debts to foreigners in domestic currency terms, as Argentina discovered in the early years of this decade.

Governments have, of course, been known to rack up huge debts without any kind of sovereign risk. The US and the UK had massive debts at the end of the Second World War. Japan has huge debts today. Other nations have been able to borrow heavily without bumping into any kind of immediate fiscal crisis as a result of a temporary monetary distortion.

All these borrowings, however, depend on the critical assumption that governments have the political power to repay their creditors.

Should the pain associated with repayment rise too far - and should the perceived risk of default go up - we will end up with another financial crisis, not associated with sub-prime but, instead, with the pieces of paper, cash and government bonds which ultimately provide the backbone of our financial system.

The Burj Dubai will still no doubt be standing in a few years' time, but our financial system could well be on its knees


From Belfast Telegraph