Dubai's great crash

Financial Express, 28 November 2009

Dubai's debt default underlines what has been apparent to careful Dubai-watchers for a while: that such an attempt at creating an international financial centre out of thin air was not going to work. It is an opportunity to carefully understand the critical ingredients required for exporting financial services. And, it is a reminder that the market economy is surprisingly lenient for a surprisingly long time when presented with the spectacle of an entrepreneur trying to puff himself up to look bigger than he is.

For a full two decades, Dubai's rise out of the desert was a surprise. As with China, opinions were divided on whether this was a sham which will ultimately come apart, or whether this was a new success story of what can be done by imagination and pluck.

As with all such miracle stories, it started with a kernel of truth. Dubai did the right things at the outset, with public investment in a good port and airport, and a relatively liberal atmosphere for foreign business. Through this, it became a gateway for the world to access the Middle East market and a gateway for people in the Middle East to step out of stifling conditions at home for a weekend.

This excellent starting point morphed into two things. The first was a real estate play. It was almost too easy to build grandiose buildings in the desert and sell them at fabulous prices. The second was the hope of Dubai as an international financial centre (IFC).

On a good day, the sales pitch that Dubai could make was as follows. With a zero income tax and infrastructure to beat Bombay, Dubai could bring in the best finance talent from Bombay to live and work in Dubai. The rich all over the Middle East did not like to keep money at home, and would prefer to deal with private bankers in Dubai when vacationing there on weekends. Corporations in the Middle East needed a place to do corporate finance. A two-hour plane ride took you to Bombay, where the companies were outgrowing the shackles of the domestic market and needed a place to do sophisticated finance.

The reality is that IFCs are genuinely hard to create. They cannot be willed into place; they involve a complex ecosystem of many individuals and firms coming together. Deeper legal and regulatory reform was not even attempted in Dubai (as was done in Qatar): DIFC is an enclave with its own rules, and there is legal risk about the extent to which the rules within DIFC are grounded in constitutional law.

The rich in the Middle East did not like to keep money at home - but they mistrusted Dubai (an autocracy) and preferred the political stability of London. The corporations of the Middle East got their corporate finance done in London. The shaky foundations of economic growth in the Middle East meant that neither personal wealth nor corporate success made headway beyond oil. For a while, many expats liked to go live in Dubai, but eventually, the fact that this was a police state started getting out.

The great IFCs of the world -- London and New York -- have a combination of factors which makes possible export of financial services: a high quality English speaking labour force, good quality financial regulation, macroeconomic stability, rule of law located in a democracy with unstinting adherence to freedom of speech, a large natural hinterland with a significant fiscal capacity to cope with financial crises. When we pause to think carefully about these preconditions, Dubai really never fit the bill.

Which brings us to the leniency that the market economy exhibits towards showmen. Again and again, we see puffery getting taken seriously. It seems easy for an entrepreneur to make a splash, buy coverage from a corrupt media, get endorsements from a few celebrities, and kick off a ponzi story. It is easy to sink money into building glass towers, buy a few computers, set up a few financial exchanges, and produce fake turnover by having a few accomplices buying and selling on screen. The early investors make a lot of money in selling to the second crop, and good stories start getting around. Glossy analyst reports soon start flowing out, particularly from financial firms who are themselves invested in the project.

So capitalism does wrong in giving too much rope to these tactics. But capitalism is also harsh in that it is not possible to fool all the people, all the time. It takes a while - and in Dubai's case the party lasted a full twenty years - but in the end it is hard to keep up the facade. Dubai has a bright future as a port, airport, trading centre and vacation spot for the Middle East. Much of the effervescence beyond that might now come apart.

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