Rise and Fall in Dubai, An Austrian Economics Perspective
Economics / Global Debt Crisis Dec 16, 2009 - 09:31 AM GMTBy: Fernando_Ulrich
All Is Well - It was January 2008 when I first set foot in Dubai. It was a land full of grandiose, landmark projects. Few cities in the world could match the sheer number of high-rise buildings and skyscrapers being built in the emirate (more than 80 units over 150 meters high are completed or under construction as of this writing).
Shopping malls were cropping up everywhere, and the biggest one in the world, Dubai Mall, was then under construction. Retail and the service sector were booming, not just from the significant increase of population in the last several years but also on account of the boost provided by tourism. Needless to say, hotels were flooded with tourists; occupancy rates were over 80%.[1]
Lastly, the real-estate and construction sectors were just spectacular. Stories of investors profiting over 20% in one day by buying and selling off-plan properties were commonplace.
With such a quickly growing economy, the job market could not handle the demand. Expatriates were encouraged to fly to Dubai, having virtual assurance of employment. After all, since the whole world was in the midst of great financial crises and growing unemployment, there was nothing more sensible than to try your luck in the only seemingly immune city in the world.
Early Signs
After a few days settled in the city, one could already notice the signs that something was out of place.
If you wanted to rent a flat, it was quite easy. Just give the real-estate agent one check equal to a whole year of rent. As absurd as it sounds, the common practice in the rental market was 12 months upfront. A very skilled negotiator could manage to settle in two checks instead. But that was not all. After visiting the potential property, you had to make up your mind in a couple of hours because of the possibility of someone else being quicker and outbidding you. There were just too many buyers in the market.
This upfront cash disbursement could not be met by many just-landed expatriates. Thank God we had the banks to provide just the right financing for those eager to rent a place to live. Many expats couldn't afford to pay 12 months in advance. Credit made it affordable to almost everyone.
Once the place to live was found, you had to get yourself a car, otherwise you risked being trapped in an hour-long queue to get a taxi outside a shopping mall. There were just too many visitors.
Auto sales were also booming and there were plenty of car dealerships. It was a simple task to purchase a car; easy and cheap financing was always there. You needed to decide quickly because, again, someone else could buy the last piece with just the color you wanted. If the price seemed a bit high, well, too bad for you, because there were too many people interested in it.
Living and transportation matters aside, one had to start working. However, with such an increase in demand and higher workload, you needed to hire more staff. After contacting a recruiting firm, screening CVs, and interviewing a few people, a candidate could be selected. Well, maybe not, he'd already been picked by another company. Not a problem. You could go with the second best option.
The new employee would start working as agreed. All seemed well until, after a couple of days on the job, a surprise resignation letter would be waiting on your desk. He had been offered a bit more by another firm. Such a process had to be repeated a couple of times, but eventually a new employee would be hired.
Most likely the same employee would then get frustrated a couple of months later, because his recently joined peer was hired with a 25% higher wage to do the same job.
The same auction-like procedure could be noticed in the cases of office space and the so-called labor camps for blue-collar workers.
In such a scenario, many companies experienced a lot of trouble in managing and planning their operations. How is a manager expected to plan his business if the expected demand, according to market data, is to increase twofold in six months and threefold in a year? Long-term planning in Dubai was 12 months maximum. No one could risk maintaining a plan unaltered in such a drastically changing environment.
Anyone who worked in Dubai during the boom period will identify himself with the examples described above. These are just a few of a myriad of personal stories that lead to the same conclusion: something was not right.
It was a market of extremes. Demand was so high that two-sided competition[2] was virtually nonexistent. It was like an auction, a one-sided competition of buyers.[3] Whenever such two-sided competition is not present, market forces cannot weed out weak competitors, such as badly managed companies.
Consumers had practically no say in the market back then, since if one refrained from buying from a given seller, a hundred others were queuing behind him to guarantee zero inventories. This hindered the process that forces companies to become more efficient and deliver on their promises.
Whenever the bidding processes, the laws of supply and demand, become so unbalanced, one ought to at least reflect on the matter. The question that few raised was whether all this demand was justified and sustainable.
The Bubble Gets Bigger
The House Price Index[4] rose 78% from Q1 2007 to Q1 2008, encouraging even more potential investors to embark on this buying frenzy.
Their appetite for new developments and projects was endless. One could flip through a newspaper and read articles about new project-release events where all units were sold within hours. During one event there was even tumult. Everyone wanted to ensure that an off-plan property could be purchased immediately.
A neighbor who had just purchased a villa recounted to me that his real-estate agent called him three days later to say that she had a potential buyer who would buy the property at a 20% markup. After so much trouble in finally finding a place, he had to decline the offer by replying to the agent, "I actually want to live in this house."
The market sentiment was that prices could just go up. Dubai's economy was sound and strong, according to analysts. The construction sector was booming and attracting more foreign investors each day.
In September 2008 everything was still unshakable, and even celebrities like tennis pro Boris Becker and Indian actor Shah Rukh were announcing projects worth billions of dollars, and the House Price Index reached its peak at a 116% increase[5] since Q1 2007.
Despite visibly high vacancy rates in many areas, new residential and commercial projects were appearing every day with promises of even more residential and commercial space.
One had to drive through the city of Dubai to try to grasp how such a thing could happen. If there were so many empty flats and offices, why were developers still building more and more before the oversupply could actually subside?
It seems that the main motive of buying was quick profit. Flipping real-estate property was becoming a sport. Obviously, such patterns bear much resemblance with the US housing debacle.
In October 2008, Cityscape Dubai, the seventh edition of the already-famous real-estate-investment and -development event, opened its doors to the public.
Meraas Development, a then-new, Dubai-based company, unveiled its grand design for Jumeirah Gardens, a $95 billion city within a city.
Visitors were able to see the status of the Arabian Canal, a $50 billion, 120-square-kilometer city to be built in 15 years, for up to 2.5 million people.
And lastly, Nakheel, the developer responsible for the Palm Islands project, in an official announcement at the dawn of Cityscape, told the press it would construct a "tower more than a kilometer high," which would be unrivaled the world over, eclipsing the Burj Dubai tower.[6]
With such megaprojects in the pipeline, Dubai aimed to be the home of roughly 5 million people by 2020. Population stood at 1.6 million by the beginning of 2008.
Symbolically, the Dubai boom reached its height on November 30, 2008, at the launch of the landmark hotel, Atlantis, located at the tip of Palm Jumeirah, the first of the Palm projects. The $20 million celebration extravaganza drew top music, movie, and sport celebrities, and a record-breaking $3 million in fireworks.
Pricking the Bubble
It is always difficult to identify which precise event caused the chain reaction that led market participants to face reality.
In hindsight, it could be argued that Nakheel's announcement of its decision to lay off 500 employees in order to cope with "short-term business plans and accommodate to the current global environment" was one such triggering event. This occurred a few days after the launching of the Atlantis hotel.
On the following day, the Trump Tower luxury project on Palm Jumeirah was suspended, raising even more concerns that the party was indeed over.
These events paved the way for massive speculation among all parties involved in the construction boom. Suddenly, panic was dominating the market. Everyone was trying to figure out how they could be affected and which measures they should take.
Further projects were either put on hold, suspended, or delayed. Additional redundancies ensued.
Cash, which had flowed freely in the sector, suddenly froze. Developers blocked payments, which had a crippling impact on the whole supply chain.
Several companies were required to operate in a kind of standby mode, barely being able to cover fixed expenses such as payroll.
The House Price Index depicted an even grimmer picture. By the end of 2008 it had already declined 8% over the previous quarter. It plummeted 41% in the first quarter of the following year, dropping a further 9% by July. Due to the impact of the Burj Dubai development, the price index rose 7% during the Q3 2009. If the Burj is left out of the index, an actual additional decline of roughly 10% can be observed.
During 2009, the sentiment in the business community was one of solitude. Without proper information from government and master developers, no one was able to guess where the economy was heading and adjust their operations accordingly.
What took many international investors by surprise was long expected by the local market. Dubai World, the holding company of Nakheel, finally came forward and declared it needed a standstill on its debt obligations until May 30, 2010.
As Mises put it almost a century ago, "every boom must one day come to an end."[7]
Causes
The narrative and events above vividly depict all the effects, but not clearly the underlying causes, behind the emirate's boom.
With a currency pegged to the dollar, the United Arab Emirates' Central Bank pursued the same harmful monetary policies as its American counterpart, the Federal Reserve.
Interest rates in the United Arab Emirates were kept artificially low for too long, following the Fed in every move. Reckless lending standards obviously helped to give a boost to the damaging credit expansion.
In addition to the aggressive lending by international institutions to Dubai's enterprises, the UAE Central Bank and the banks operating in the country also played a crucial role in fueling the construction bubble.
The Central Bank balance sheet[8] spiked in 2007, reaching a staggering 177% increase over the previous year.
Although the monetary authority trimmed down the money pumping in 2008, decreasing its balance sheet 32% at the end of that year (still double its size in December 2006), the damage had already been done.
Money supply measured by M3 had an annual growth rate of 29.4% in the period from 2006 to 2008.
With further scrutiny of the UAE's key indicators, we can verify the extent of the malinvestments encouraged by the banks operating in the United Arab Emirates. The aggregate balance sheet of banks operating in the country grew 31.4% annually in the same timeframe above.
After the UAE Central Bank's massive monetary pumping into the economy in 2007, we may infer that the next great damage was orchestrated by the private banks in 2008.
Loans extended to the construction sector grew 41.7% annually from 2006 to 2008. In 2008 alone such loans increased a whopping 80.7% over the previous year. With all this funding, new projects were being launched constantly. Nevertheless, with all this supply, where was all the demand coming from?
In this regard, banks also ensured there would be enough demand available through the usual means, credit.
In 2006, mortgages to residents climbed 80.1%. During 2007, the increase was 82.1%. Finally, 2008 ended with $18.9 billion worth of additional loans, 122.8% growth over a year.
It can hardly be argued that this demand was real. The United Arab Emirates' population stood at 4.76 million by the end of 2008, an approximate increase of 277 thousand in comparison to the year before.
Taking into consideration that a disproportionately large part of the population are blue-collar workers (mainly from the Indian subcontinent), of whom the vast majority reside in labor camps, one may conclude that mortgages were concentrated in very few hands, suggesting the demand was indeed due to investment rather than ownership.
If there had been no credit expansion, people would not have been able to buy on this massive scale. Without the potential buyers, developers would not have been able to launch so many projects. Likewise, if credit hadn't been readily available for developers, they also wouldn't have been able to fund so many projects. So did credit to consumers lead to more credit to contractors, or was it the other way around?
Instead of trying to solve this conundrum, it suffices to conclude that credit expansion exerted a drastic force in promoting unviable projects.
Production and saving cannot keep up with the pace of credit expansion, because production takes time and labor. The creation of additional money out of thin air does not add to the available amount of goods and services in the economy. If more credit is extended to construction companies, it does not mean there will be enough steel, cement, etc. — certainly not at prices that make the developments profitable. As soon as each company starts bidding for the same resource, it will tend to increase in price, rendering some projects unviable.
Resources are scarce. Printing more money can never alter this fact.
With extremely low nominal interest rates and negative real interest rates (inflation is estimated at over 10% for 2007 and 2008), the rational behavior was to borrow and invest wherever it is possible. A booming real-estate market seemed to be the obvious choice most of the time.
Under these conditions, everyone becomes a brilliant businessman. Entrepreneurial errors seem seldom while credit is abundant.
Psychology clearly plays a role in stimulating a bubble, but only monetary inflation enables it. It is difficult not to succumb to the temptation of profiting astronomic amounts in a short period of time. Resistance is even more difficult if the means to engage in the bubble are easily available at the nearest bank.
In the case of the housing sector, people failed to understand that demand for real estate is only sustainable if the ultimate reason for purchasing a property is to actually reside in it.
Former Fed chairman Alan Greenspan would suggest that "irrational exuberance"[9] has the power to escalate asset prices. He could certainly claim exuberance, but there is nothing irrational in investing in higher-yield projects instead of watching your idle savings lose their purchasing power because of inflation.
In addition to the damage caused by the UAE Central Bank and banks operating locally, state-owned and private ventures from the Sheikh were able to cheaply borrow enormous amounts from financial institutions abroad, fueling the malinvestments even further. Dubai World's standstill request on its immediate debt obligations only made the emirate's underlying complications come to surface.
Dubai's false boom, its unreal prosperity, was based on the illusion of cheap money. It was based on the illusion that credit expansion generates wealth — that money is wealth. Following the Austrian Theory of the Business Cycle, one could clearly see that the emirate's boom had to come to an end.
Further Developments
On the wave of Dubai's opulence, the neighboring emirates also wanted to diversify their economies, embarking in extravagant real-estate projects, many of which were extremely questionable ideas from the outset.
In Ajman, several projects have been canceled as developers have run out of cash, leaving many investors with deposits paid on projects that may never be built.
Led by Dubai, the construction frenzy in the UAE naturally attracted loads of foreign investors looking to diversify. In a world still trapped in a major crisis wherein investment opportunities were scarce, Dubai seemed rather appealing.
Although credit expansion did indeed play a fundamental role, actual saved resources were also drawn into the UAE market, further fueling the malinvestments.
A significant portion of those savings will unfortunately be lost, since many investment decisions were carried out anticipating a continuation of the economic scenario of the boom period.
What remains to be seen is the extent of the total damage in the economy. It is still too early to predict the depth of Dubai's necessary recession, the needed adjustment for its scores of malinvestments. Dubai's government companies and local and foreign private developers embarked on many projects that could only be economically viable under the boom conditions of 2008.[10]
There are two ways to finance a project, through one's own capital (personal savings) or through borrowing. If the developer uses his own capital, and the project turns sour, he can either consume his own capital and complete the development in spite of the losses he will incur or cancel the development altogether and take the current pain, avoiding an even greater loss after completion.
However, when a company borrows to fund projects that prove unviable, there is another party involved in the mess.
Numerous developers are trapped in a situation where ongoing projects are turning red, and customers who purchased for investment purposes are defaulting in fear of not being able to profit from a resale or in true inability to meet the payments. This is all the worse if such a developer is leveraged, like Nakheel.
Analyzing from the perspective of a buyer, pulling out is just the sensible attitude. However, if you have bought an apartment to live in, it matters very little if the expected value of the property declines. In the end, you want to live in it.
However, it's quite another story if you have purchased it as an investment, obviously expecting to sell dear, but are caught off guard with a sudden slump in the expected sale value. Should you fulfill the commitment and face an unknown loss, or take the hit now and cancel the contract outright? In the case of developers it might be even more problematic if the buyer is residing abroad and decides to breach the contract. What is the likelihood of UAE jurisdiction being enforced internationally?
Dubai World's acknowledgment of its financial ordeal is the first step in healing the problems caused by the boom. Once projects finally start being canceled, as some will inevitably have to be, a chain reaction begins that will lead some contractors, subcontractors, and other parties related to the sector to the verge of bankruptcy.
As hurtful as it sounds, many companies need to go out of business so the economy can readjust and leave only the real, profitable companies intact.
The office-space vacancy rate in prime locations is estimated at around 40%. Other sources' estimates arrive at a total 74% occupancy rate in residential and commercial space. Due to the lack of accurate statistics in the market, it is a complex job to reach a precise figure. Ongoing and planned constructions are set to increase real-estate supply even further in 2010. Even if these ongoing developments end up being suspended, the current oversupply combined with declining economic activity will exert a substantial downward pressure on real-estate prices, and there is nothing government or any other entity can do to repeal the law of supply and demand.[11]
Nevertheless, the length and depth of the recession also depends on the monetary policies that the UAE Central Bank will pursue. If it tries to prop up companies that cannot prosper, this readjustment process will just extend itself or even be completely neutralized.
Another piece of the puzzle is the exposure of banks to bad loans.
When someone borrows and doesn't fulfill his commitment in his own country, he might get into trouble. However, in Dubai, expatriates can just leave and never repay their debt: banks in the UAE have very few ways of attempting to recover such bad loans. The abandoned cars in Dubai's airport illustrate this point. In fact, local laws end up encouraging flight from the country since one faces incarceration if one fails to honor issued checks on debt.
In addition to the debt issue, the recession and readjustment of business may result in downsizing, meaning redundancies. Since 90% of the workforce comes from abroad, chances are that the laid-off employee is a foreigner. According to UAE law, if a foreign worker loses his job, he has to find a new position or leave the country within 30 days.
Therefore, a recession in Dubai can also cause a decrease in population, which could have broad effects in the retail sector too, although to a lesser extent. This scenario is very unlikely to occur in the developed countries facing recession, such as the United States or Spain.
Abu Dhabi and International Investors
There are many lessons to learn from Dubai. Every investor should know by now that he must do his homework and only invest when he's fully aware of the reality of the underlying investment. Many just relied on the Dubai government's backing of debt and if that failed, well, the UAE government in Abu Dhabi would just step in. Now that the former has failed and the latter's extent of help is yet unknown, investors are left scratching their heads to figure out an exit plan. It will be a fresh wake-up call that profit and risk always go hand in hand.
Unlike Dubai, Abu Dhabi derives more than half of its GDP from oil revenues. It owns substantial income-generating assets as well as an impressive sovereign-wealth fund. The means to rescue Dubai are certainly there. However, Abu Dhabi is reluctant to write a blank check and assume all of Dubai's debt, and rightly so. The recent extra $10 billion granted by the capital to help honor Nakheel's maturing bond may have calmed some investors. Nonetheless, the underlying malinvestments are still there. Instead of owing foreigners, Dubai now has an extra debt with Abu Dhabi (though the conditions of this emergency loan are still unclear).
In 2008, the last boom year for Dubai, the emirate's GDP is estimated to have reached $80 billion, while Abu Dhabi's was $142 billion, according to government statistics. It is claimed that Dubai's government debt is well over $80 billion. While the debt-to-GDP ratio truly deserves attention, most important of all is the ability to service the debt. Dubai's assets have declined considerably in value and its ongoing operations' capacity to generate enough income to pay off its debt is severely impaired. As with any investment decision, the UAE is carefully thinking through Dubai's rescue.
Reckless lending by international banks to Dubai Inc. was a major stimulus to the emirate's debacle. When everything was going fine, few questions were raised. Now, after the derailing of the economy, many are left unanswered.
The UAE has never experienced such a crisis before. It is the first severe economic downturn since the federation was formed in the early 1970s. Bankruptcy laws are underdeveloped, partly because they were never really needed. The importance of solid institutions is now clear and UAE's judicial system will be tested to its full extent.
Private companies operating in Dubai may have to seek legal action against developers, which in many cases might be state-owned or -linked enterprises. The success of Dubai in attracting foreign capital will also depend on how Dubai courts act and are perceived by the international community.
Conclusion
The similarities of the real-estate bubble in Dubai with those in other countries like the United States and Spain are enormous.
Only savings can allow for sustainable economic growth. Through inflation, credit flows excessively and distorts the production structure, allocating resources to projects that should have never existed in the first place and paving the way for the ensuing recession, that is, the adjustment of all the malinvestments. Entrepreneurs can and will make mistakes even in the absence of inflation. But it is only through undue monetary expansion that the distortion occurs on a massive scale throughout the economy.
By midyear 2009, whoever flew to Dubai with Emirates Airlines could also have been misled into thinking that credit was not a problem, as one of the airline's video promos before landing read, "Forget the credit crunch … shop."
Unfortunately, Dubai Inc. took its own words too seriously.
Born and raised in Brazil, Fernando Ulrich is a full-time student in Jesus Huerta de Soto's Masters in Austrian Economics program in Madrid, Spain. Send him mail. See Fernando Ulrich's article archives. Comment on the blog. 
Notes
[1] "Dubai Retail Snapshot — Second Quarter 2008." Colliers International, UAE, p. 1.
[2] Eugen von Böhm-Bawerk, The Positive Theory of Capital (New York, Cosimo Inc., 2006), pp. 203–13.
[3] Ibid., pp. 200–2.
[4] "House Price Index — First Quarter 2008." Colliers International, UAE, p. 1.
[5] "House Price Index — Third Quarter 2009." Colliers International, UAE, p.3.
[6] For a very interesting economic study of skyscrapers see Mark Thornton's article "Skyscrapers and Business Cycles." The Quarterly Journal of Austrian Economics. Vol. 8, no. 1 (Spring 2005).
[7] Ludwig von Mises, Causes of the Economic Crisis, (Alabama, Mises Institute, 2006), pp. 148.
[8] UAE Central Bank Annual Reports.
[9] Remarks by Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996.
[10] "In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful. Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest. The 'boom,' then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market. The 'crisis' arrives when the consumers come to reestablish their desired proportions. The 'depression' is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816–1818 and deserted during the panic of 1819); others will be shifted to other uses." Murray Rothbard, America's Great Depression, (Alabama, Mises Institute, 2005), pp. 11–12
[11] "Demand and supply are the outcome of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price." Ludwig von Mises, Human Action, (Alabama, Ludwig von Mises Institute, 1998), p. 330.
And "trees don't grow to the sky, stock markets don't go up forever, and high prices cut back demand. With prices high, a million guys pile in to figure out how to take advantage of all that money, bringing in supply and eventually driving down the price. No one has ever repealed the law of supply and demand, and no one ever will — not Republicans, Democrats, Communists, or capitalists. It's a law of nature, a mechanism many governments can't seem to understand or trust to make things right." Jim Rogers, Investment Biker, (Chichester, John Wiley & Sons, 2008), p. 26.
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