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Sovereign Debt: The Next Financial Contagion?

November 28, 2009

This week, the government of Dubai decided to delay payment on the tens of billions of dollars that it’s Dubai World holding owes to various creditors (UBS speculates as much as $80B). Dubai World is the vehicle through which the state has invested heavily in various real estate projects around the world. In order to fund the expansive projects and investments, the government sought billions in debt to fuel their initiatives.

By delaying payment Dubai has not only created serious doubts about its dedication and ability to repay its loans, but also the credit worthiness and risk-level for other sovereigns. The price to insure against debt-default by Dubai more than doubled (from $300M to $675M). Additionally, the price of default insurance rose in general for many sovereigns, including Bulgaria, Abu Dhabi, Hungary, the U.K. and the U.S. (see graphic below).

It’s unclear at this point to what extent concerns for default (or an actual default) by Dubai would act as a contagion, setting off another global financial crisis. On Friday, global markets took a significant hit based largely on investor reaction to the payment delay. U.S. and Asian markets took the biggest hits, with European markets managing to close higher on the on the day.

At first glance, the sell-off for firms linked to Dubai World was contained on Friday. Additionally, the amount of risk at stake in this case is minuscule compared to the financial crises of a year ago. The Financial Times notes:

Credit Suisse, for example, assumes that European banks account for half of Dubai’s debt, estimated at about $80bn. If they lost 50 per cent on their exposure, bad loan provisions would rise by 5 per cent next year, equivalent to a €5bn after-tax hit. Compared with the $1,700bn of toxic assets European and US banks have wiped out in the credit crisis, that is a drop in the Burj Al Arab swimming pool.

It would appear at first blush that, financial speaking, there isn’t a great threat of a Dubai default leading to a global financial meltdown (however, I have not seen data on the holders of credit default swaps [cds] and to what extent they’ve assumed too much risk, as AIG did last year). However, I do wonder about the other major variable in financial crises–the psychological risk. Financial crises are the result of both economic and psychological variables interacting in dangerous ways (namely, a positive feedback loop where negative economic conditions feed into negative views on the market which leads to actions that increase negative economics conditions which feed into negative views on the market, etc, etc). As Mark Gongloff notes:

Every episode of sovereign worry raises market fears of contagion, “reminders that pockets of post-credit-excesses are intact and destabilizing,” Gluskin Sheff chief economist David Rosenberg told clients on Friday.

To me, that is the real risk. With states’ balance sheets in total disarray around the globe, investors will not long for worrisome indicators and troublesome cases to analyze (think of the conditions that facilitate brush fires). We’ll see to what extent this scenario plays out in the coming days. Would love to hear feedback from sovereign debt specialists and global finance experts.

[Cross-posted at bill | petti]

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Petti is Associate Director of Insights and Analytics at Alexion . Previously, he served as Lead Data Scientist in the Decision Sciences group at Maritz Motivation and a Global Data Strategist and Subject Matter Expert for Gallup.