Dubai Inc : Why did the dream go sour?

Having earlier worked in Corporate Banking in Pakistan, I have lot of colleagues that have moved to greener pastures mainly to Arabian Gulf cities such as Dubai, Doha, Riyadh, Abu Dhabi, Bahrain etc. Whenever we call each other, the topic drifts to job security and the economic health of Dubai and the wider gulf region. The questions that I get asked the most are about future of Dubai and wider gulf region.

Though I have a flair for economics but I am not an economist. I am asked these questions as I boast an active network of finance professionals and wide reading _when the employer is paying me for sitting idle and doing occasional paperwork_ the only thing left to do in office is to browse websites and engage in networking (calling up old colleagues in financial sector and government economic departments for a chat).

Let me focus in this article on Dubai because it causes the most heartburn. Those who have a stake in Dubai, employment and/or an apartment are the most argumentative. They want reassurance that one day soon things will be same as before with the exception of high rents. The amazing thing is that nobody in Dubai complained about overexposure when the world was touting Dubai as a success story and other gulf nations like Qatar were trying to replicate its success. Now if someone points out a negative aspect of Dubai, he is labeled as engaging in “Dubai Bashing”. Recently Johann Hari wrote a very damning piece on Dubai (pronounced as “Do Buy” according to him) in The Independent which one may call Dubai bashing focusing more on social and environmental aspect. However, I will talk from economics and finance perspective.

For the lack of better word, “anchor” describes a certain critical mass usually local population that will stick around for the real estate and continue the demand. Take Karachi for example. During the heydays of stock market boom in Musharraf era, large number of people was investing in property. Though there were speculators, however, actual homeowners outnumbered them by a large margin. So when the boom ended, the prices went down but only little as large number of serious home owners were waiting on the sidelines to buy the property whenever prices become reasonable. These people act as anchors for prices and demand for property.

Local population of Dubai is only 10%. The problem with Dubai was that it was marketed as real estate heaven but no corresponding anchors were targeted to bring stability to the market. The new developments are to be marketed to foreigners from western countries that had nothing to hold them to the country. The government just tended to focus on eye catching headline making high end developments. The only people who could afford those developments were the jet-setters who live around the world without anchoring themselves in any one region. Finding an opportunity, these jet-setters engaged in speculation in Dubai, flipping properties and quickly pocketing profits. A whole class of business developed around these people of real estate agents who made a lot of money in commissions for transferring properties (reminds me of DHA in Karachi in 2005 to 2007).

The middle class expatriates also wanted to enter into the game but with the prevailing prices could not afford those apartments. However, influx of people into Dubai and limited living spaces available meant that rents sky rocketed even in adjacent areas like Sharjah where earlier people working in Dubai used to domicile themselves due to lower rent. With rentals consuming around half of monthly income, buying a highly priced item did not seem an unreasonable idea when the mortgage amount is slightly higher than rental payment while at the same time your ownership of an asset increases. Another set of developers started entering the market targeting the middle class with slightly lower class apartment projects. A new mortgage finance industry developed around facilitating middle class. The mortgage payments would only start after getting possession of the apartment so that it turned out a substitute for rent. The middle class went for it. With only 10% down payment required and development period of 3 years, it meant that no payments for first 3 years. Hence, middle class also entered the game of flipping apartments. The prices started to sky rocket in middle class apartments as well.

The flipping of property gives the illusion of demand. With both upper class and middle class flipping properties, the demand of property appeared to multiply significantly in short period of time bringing in whole new projects to cater to this artificial demand along with associated work force and businesses to support this artificial demand.
Then the property bubble burst. The Russian mafia and the speculators that were flipping the high end apartments left the city. There is only so much upper class you can have in the city but the flipping gave the false impression of Dubai being the haven of ultra rich. With the speculators gone, the upper class apartments became empty, other upper class developments had to be stopped midway and some were canceled altogether. The whole real estate agents industry with their Land Rovers and beautiful offices became redundant and left the country. By one estimate there are 3000 cars left at Terminal 1 of Dubai Airport (a fact denied by Dubai government but anyone living in Dubai can easily verify it).

If the trickle down effect is still not clear, it means that real estate agents were laid off, they stopped payments on their own cars and apartments, which means people working in car financing and mortgage financing in banks were laid off, which led to a large drop in car sales and new construction work, which led to redundancy in construction industry of high end apartments. This led to drop in high end apartment prices translating into a drop in medium end apartments. And the same cycle was repeated. Construction industry had become the largest employer in Dubai and as such, now became the largest employment terminators.

With the residency laws as they are in Dubai, a lot of people had to leave within 3 months of termination. Moreover, expatriate in neighboring countries had also bought a lot of property in Dubai under false marketing campaign that ownership will grant them permanent residence in Dubai. The government recently clarified that this is not the case and as such a lot of people who had bought or thinking of buying property in Dubai for this reason were turned off. Moreover, Dubai government has recently introduced new property law which favors the developer thus putting the property buyer at a further disadvantage.

Now the middle class because of the new laws wants to get rid of the property. A lot of people I have talked to want the projects canceled altogether so that they can get their down payment back or don’t have to pay the exorbitant mortgage as it does not make sense anymore since the rents have come down significantly.

The business model of Dubai of targeting rich whites has gone bust. The property bubble has burst and is taking down Dubai with it. However, during this short time, Dubai has built excellent infrastructure, roads, metro, airport etc and are a decade ahead of the neighboring countries. If maintained properly, this infrastructure will remain and still give Dubai an advantage over neighboring destinations. But they can use the current infrastructure as a launching pad for a different business model.

There is a caveat, however. Spending on infrastructure is done through cost-benefit analysis. Though countries world over occasionally spend huge sums in beautiful bridges and roads and metros but there is an analysis of the benefits (financial as well as spillovers into social, economic areas) as well as costs of constructing them and more importantly maintaining them. You can run a bullet train as an inter city metro but you have to worry about costs of maintaining it and will the benefits justify it. A lot of infrastructure in Dubai is state of the art and expensive to maintain. The jury is still out whether the costs justify the benefits.

This was the asset side of Dubai. Dubai also screwed up on the liability side by borrowing in foreign currency. Unlike US, it can not repay its debt by printing its own currency. It has to use its non-existent reserves to pay down those debts. It has already been bailed out for $10billion by Abu Dhabi in early 2009. Another $10 Billion bond of government owned Nakheel (developer of Palm projects) is coming due in December. At the moment, it is not clear where the money to repay that loan will come from. In case Dubai tries to restructure the loan or there is a delay in payment, it will count as default and bond of Dubai as junk investment.

To a lot of Dubai lovers it seems preposterous that we talk about default of Dubai as they point towards high rises and infrastructure, claiming that defaulting countries don’t look like this. But that is the irony of borrowed money. You can live large on it for only so long. Recently Minister of Trade for UK was in Dubai as the Dubai government (not private investors) have not paid money of UK based contractors and consultants for more than six months with over half a billion dollars outstanding. In light of this, everybody is looking towards the $10 billion bond maturity in December to think about Dubai.

Dubai government has stakes in number of banks which have grown huge by lending to real estate developers on one side and real estate buyers (mortgages) on the other side. With the current wave of defaults with developers going out of the country or cancelling projects midway and people leaving the country with cars at airports, credit card bills outstanding, mortgages midway, quite a few banks intend to lose in a big way and hence Dubai.

Abu Dhabi has bailed them out so far and it may bail them out again but it’s not going to do that for free. Despite official denials, it’s an open secret that Abu Dhabi now owns part of the Dubai based Emirates airline and other prestigious projects.

What makes matter worse is transparency or lack of it? Not that western government had not tried to brush their problems under the carpet by artificially propping up banks etc., but at least western governments have accepted that they have a problem. In Dubai, the government keeps a tight leash on the media with different real estate agencies issuing press releases every week the property prices have started rising. Every fortnight some economist of a Dubai branch of foreign bank issues a research that paints every thing hunky dory like that is going to fool anyone. I am not asking Dubai to open its books and be very transparent. But at least get out of the denial mode.

When people ask me if Dubai is going to achieve earlier heights, my answer is a firm “No”. Should we write off Dubai? Again the answer is “No”. If they change their business model and make certain reforms, we won’t have to write off Dubai just now.