British banks at contagion risk from Dubai crisis fall-out

Dubai World’s biggest creditors are the British banks and half of them are effectively state-owned after the financial crisis. This is the contagion link between an isolated debt problem, albeit a large one, in a small Gulf city state and the rest of the world.

The global financial crisis was all about declining house prices and their impact on dodgy loans, or so called de-leveraging. The Dubai debt crisis is a part of the same de-leveraging process as loans made against some incredibly ambitious real estate schemes have gone wrong.

Dubai World business plan

Dubai World chose to develop two more palm islands and a map of the world picked out in islands, before it had completed its first palm island. UK banks apparently thought that Dubai World had found a great way to make money.

In fact it is now apparent that Dubai World had instead found a great way to borrow a great deal of money from British banks. What remains of that money, apart from the abandoned island projects, will only become clear as the new Chief Restructuring Officer completes his work.

Abu Dhabi has clearly decided that it does not want to take on the assets of Dubai World. That has left Dubai with seemingly no option but to restructure this operating company and suspend debt payments.

What follows is going to be a high stake battle of commercial interests. The banks will not want to see Dubai World become insolvent because the cost in bad debts would be disastrous to them.

Debts suspended

Equally Dubai World is not able to repay on schedule, and may not be able to repay principle either. And as the Dubai Government is not standing behind these loans, as the banks might have expected, then they may have no choice but to accept a hair-cut, and take so many cents in the dollar.

Will these bad debt provisions for British banks then be large enough to cause a domino effect in global markets? Hopefully we will never find out and behind the scenes negotiations at the very highest levels will sort this out.

In the meantime, financial markets are bound to discount the uncertainty that this evolving situation represents. It is also a reminder of the scale of the de-leveraging problem facing banks all over the world, and that government bailouts have papered over the cracks in the system without tackling the fundamental bad debts.