Dubai Default Damages Real Estate Glut Denial

by: Daryl Montgomery

Real estate bubbles and their subsequent collapses frequently accompany financial crises, especially the ones that linger and last a long time. The current Dubai default is merely the latest episode in the unwinding of a global real estate glut. Local authorities denied there was any problem right up to the end. Until the excesses are wrung out of the system, sustainable economic recovery is not possible - and even then it's not guaranteed. The crisis in Japan began 19 years ago and they have yet to get their economy fully functioning again. Japan also provides the worse case scenario for a drop in real estate prices - 90% for residential real estate and 99% for class A office buildings in Tokyo. While Dubai might not get that bad, real estate price drops there could be considerable.

The UAE central bank has pledged to provide funding for both domestic and foreign banks in an attempt to prevent bank runs in the region. It is estimated that a quarter of Dubai's $80 billion in real estate debt came from UAE banks. British and eurozone banks may hold as much as 70% of the remaining $60 billion. Exposure in the U.S. and Japan seems to be fairly minimal. Stock markets have been closed in the Gulf region due to an Islamic holiday since the crisis unfolded on Thanksgiving day. Dubai and Abu Dhabi opened on Monday and were down 7% and 8% respectively. The extent of contagion to other bourses in the region remains to be seen. Dubai is particularly vulnerable because it is not an oil producer; the other oil-rich countries in the region should ultimately be in much better shape.

The price of oil is recovering Monday and briefly peaked above $77 a barrel. Light sweet crude was down as much as 7% at one point the day after Thanksgiving. Oil is in a seasonally weak period until next March however, so this is likely to keep a cap on any possible rally for the next few months. Even at current levels, oil is causing inflation to return to Western countries. The eurozone just announced that year over year, consumer inflation turned positive in November for the first time since last April (this inconvenient news seems to have gotten buried in U.S. mainstream media coverage). Rising oil prices were cited as the cause. The inflation figures will start increasing soon in the U.S. for the same reason. The eurozone monetary authorities, just like the U.S. monetary authorities, consistently deny that inflation will be a problem. Nevertheless, the ultimate inflation indicator - gold - keeps hitting new all-time highs.

The U.S. dollar spiked higher on Thanksgiving day and Friday as a safe-haven trade. The move was exaggerated by low volume with most American traders gone for the holiday. The trade-weighted dollar got well above the 75.00 support level that it broke decisively early last week. However, in early Monday morning trading, it once again fell below this level, dropping as low as 74.49 before starting a new rally. The dollar can't seem to stay up for more than a day or two and it consistently hits new yearly lows. The U.S. government denies it has a weak dollar policy. The market seems to disagree.

Disclosure: Long gold.