Yesterday markets convulsed as news came out that Dubai was unable to meet the payments on its large property debt. At a previous time of stress Abu Dhabi had come to its aid. This time there are limits to how much support there will be for companies owned by the Dubai government.
It is a timely reminder of two things. The first is that the banking crisis is not yet worked through or fully resolved. It is likely that RBS, for example, has lent money in Dubai and will have to reassess the value of its loans. The second is that governments and government backed entities are not always AAA rated or entirely reliable credits.
Traditionally leading governments meet their interest and capital repayment schedules, but often reduce the costs by encouraging or allowing inflation to erode the sums involved. Lesser governments may default on payments or walk away from government sponsored entities that investors thought had an implicit government guarantee.
This is a time to consider sovereign risk more seriously. Many governments have been borrowing too much. Many governments were caught up in the euphoria of off balance sheet financing prior to the Credit Crunch, helping the innovators in the financial markets. Governments themselves liked being able to do more and buy more without apparently swelling their own debt ridden balance sheets by as much as the total borrowing. In these tougher times all those off balance sheet and government owned company debts fall due or need servicing as well, out of more restricted tax revenues following the slump in activity.
We have cut risks in portfolios in recent weeks. We recommend continuing to avoid UK and US government debt, where prices are distorted by both quantitative easing and year end balance sheet window dressing by banks and others. One of the losers from the Dubai experience will be the British government, as owner of two large banks. The banking crisis may be over its most severe phase, and governments are likely to continue to stand behind the big banks. There is however still plenty of scope for further losses, as this mini crisis reminds us.