## Saturday, November 28, 2009

### Dubai's great crash

Sheikh Makhtoum won't go to debtor's prison, but short of that, Dubai's all-but-sovereign default is an epochal event in its story. I wrote a column in Financial Express titled Dubai's great crash where I draw on this episode to think more clearly about (a) International financial centres and (b) Puffery. On this subject, also see Reality catches up with the Gulf's model global city by Roula Khalaf in the Financial Times, and 'The Sheikh's New Clothes?' Dubai's Desert Dream Ends by Stanley Reed in Business Week.

One hears talk about Dubai giving up crown jewels, like the airline, in exchange for a bailout. I think the time for that bailout was six months ago. Today, with a funding gap of $80 billion, the crown jewels are not big enough. But six months ago, it was possible to think of a deal where ADIA bought up the crown jewels for (say)$40 billion and Dubai would have tided over the storm. Or maybe this is big, and runs beyond just the crown jewels: see Enough glitzy debt: time for regime change by Jo Tatchell in The Times.

This episode is an opportunity to think about exchange rate regimes. What if Dubai had used a floating rate instead of a fixed rate? This would have worked in two ways. First, it would have been a stabiliser. When bad times came, capital would have started leaving Dubai, the exchange rate would have depreciated, thus making real estate or hotel rooms in Dubai cheaper in the eyes of foreign customers. (Conversely, in good times, the exchange rate would have appreciated, thus reducing the attraction of going to Dubai). The key intuition (RBI speechwriters please note) is that exchange rate fluctuations stabilise the economy. Without a flexible exchange rate, adjustment in Dubai was forced on to the labour market, the real estate market, etc., which are all places where adjustment is more disruptive and is resisted more.

The second interesting feature of this thought experiment is linked to borrowing. A fixed exchange rate encourages and even subsidises dollar denominated borrowing. For society, the low cost of borrowing (the USD interest rate) is paid for by the loss of monetary policy autonomy. If a flexible exchange rate were used. Mr. Makhtoum would have been more careful and would have borrowed less.

1. i cannot but help comparing this with the south east Asian crisis of 97 ... i think the premise is the same ... exchange rate and convertibility ... the underlying is the same .. real estate ... maybe the difference is that UAE was expecting to get some money from oil that didnt come .. in addition to external demand ... probably the exchange rate was fixed so as to sustain oil exports ... would really appreciate your views on this

2. I think Dubai is like East Asia in :

* Too much leverage
* Encouraged by a fixed exchange rate
* Loss of the automatic stabilisation that happens when the exchange rate moves. So the thing is more brittle.

It is unlike East Asia in that:

* The UAE is a `hard peg' - like Argentina. They are a currency board. They are not mere central banks trying to do market manipulation of the currency market. E.g. nobody is thinking theUAE peg will now break, while in the Asian Crisis there was a lot of fear about the exchange rate doing a big devaluation (which in turn encouraged people to leave, which in turn increased the chances of the exchange rate breaking).

* I think East Asia had better fundamentals; their basic business model worked. Dubai more explicitly used the tools of media-led hype-building (with resources invested into this by the government) than East Asia ever did.

Dubai was more like the dubious end of Indian entrepreneurship: bribing media, pulling off a glowing image makeover, rushing to cashin with an
IPO. East Asia was mainly a classic currency crisis of an unsustainable pegged exchange rate.

3. I believe reference to RBI in the third paragraph was not too much in context, more so reference to "RBI speech writers".
It looks like you people (including Ila Patnaik and Surjit Bhalla) with same philosophical mind set (accepting there is no vested interests) are searching one pretext or another to campaign against RBI. One would have thought these recurring financial crises had some sobering effects on the typical free market rants.

4. Ashish:

The basic intuition -- that flexible exchange rates are a shock absorber -- is not widely understood in India, and is certainly not known amongst the people who write speeches at RBI.

E.g. a few weeks ago, a senior RBI person (name supressed so as to not embarass the guilty party) said that the right thing to do is to buy reserves in good times and sell reserves in bad times. This is wrong! :-) A little macroeconomic intuition will go a long way.

The fact that we've just been through a great global financial crisis has not changed the 1st principles.

5. Ajay:
Let us discuss the first principles for a moment.

It must be accepted that the most of the finance, especially concepts based on the efficient markets, are not theoretically incontrovertible because it does not derive from the general equilibrium proofs of the existence, stability or optimality since such proofs generally apply in the context of competitive market economies without the modern financial markets. The economic case for free capital mobility relies on a strong macro version of the efficient market hypothesis.

In the absence of these general proofs most of the arguments depend on our theoretical/philosophical underpinnings. There are undeniably several benefits due to liberalization process but we should not every time slip into a euphoric frame of mind and jump to conclude all forms of official interventions/regulations in the financial markets as financial repression.

6. Ashish: I am focused on one point. Exchange rate flexibility is a big source of business cycle stabilisation.

7. Ajay:

I humbly submit that the hypothesis "Exchange rate flexibility is a big source of business cycle stabilization" is academically inconclusive and highly debatable.

But it was a nice conversation.

Thanks and bye,
Ashish

8. I'm not an economist but I'm curious to know if it makes sense to frame the exchange rate stabilization role in terms of money supply management - ie; is it correct to say that a free exchange rate would reduce money supply during good times and hence would reduce asset inflation/bubbles?

9. JB, These days we are all "Wicksellian" and don't like to focus so much on money supply. The focus is on interest rates as the measure of what monetary policy is doing, and the short-term interest rate as the instrument of monetary policy.

However, the links between exchange rate pegging and money supply are more clear than the links between exchange rate pegging and the short-term interest rate. The steps run like this:

* For emerging markets, capital inflows are procyclical (i.e. in good times, more money comes in, and vice versa)

* Suppose the central bank tries to stabilise the exchange rate. Then in good times, it buys dollars, paying for these in rupees. So money supply goes up. Conversely, in bad times, capital leaves the country. If the central bank tries to stabilise the exchange rate, then in bad times, it sells reserves. This reduces money supply.

For a clean presentation of this way of thinking as applied to Indian data, see: this.

If you're optimistic about financial globalisation, then you would dispute the 1st proposition -- that capital flows to emerging markets are procyclical. In the narrow Indian experience, one does see evidence that more money comes into India in good times and vice versa.

10. Hi Ajay,
I found your article pretty interesting, however there are few aspects that I am unclear about. You have mentioned about exchange rate regimes. Can you explain in laymen terms how fixed exchange rate could have created this problem for Dubai and how floating rate could have been the deterrent for this problem.

TIA

- Sandeep

11. i think recession is every where in Dubai also.

12. Dubai is also in the major downfall due to recession.

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