While global stock markets plunged (and the dollar rose) in the wake of Dubai World’s effort to reach a standstill agreement with its creditors, one has to keep the most important fact in mind. Technically, at least at this time, there is no default nor is there likely to be one. And although there could be some restructuring of the $80 billion stockpile of debt accrued, the impact will likely be but a short term, a knee-jerk reaction that will soon be forgotten by investors.

Dubai World, which is controlled by the government of Dubai, did however have something that was very important to investors; an implicit guarantee from other United Arab Emigrate nations (especially from oil-rich Abu Dhabi) that the debt would be repaid.

Background

Abu Dhabi and Dubai are two members of the United Arab Emirates (UAE), a federation of seven small states that was formed in 1971. Abu Dhabi is by far the richest of the seven because it has the bulk of oil reserves and is the federation’s capital. Since the 1980s Dubai has been intent on diversifying its economy because it has little or no oil. The states of Dubai and Abu Dhabi are ruled by royalty and there are long-established merchant family relationships between them.

Dubai, which embarked on a huge plan to become a world financial center, has experienced cash flow problems since the collapse of Lehman last year. It decided to do what many governments do when cash appears to be running short-issue more debt. In February, the UAE central bank subscribed $10B out of a proposed $20bn bond program issued by Dubai. On Wednesday, two Abu Dhabi banks subscribed a further $5B to the program, leaving another $5B yet to be issued. Then something strange happened.

On Wednesday, the Dubai department of finance made two statements, saying first it had raised the remaining $5B and then two hours later asking for a standstill until the end of May on payments due from Dubai World.

The Reaction

As is typical with any debt crisis, the credit default swaps protecting the bonds rose dramatically in price. Investors in Asia and Europe (U.S. markets were closed Thursday for the Thanksgiving holiday) fled risky assets (stocks and any currencies other than the dollar and the yen). S&P futures declined as much as 3% in overnight trading but by Friday morning had pared the loss to around 2.5%.

The (Likely) Result

Investors in the region (primarily banks like RBS and Barclay’s) will need to reassess their risk premiums in future transactions, since the formerly implicit sovereign guarantees seem to be less so. But by global standards the amounts are relatively small and in any event, much (if not all) is likely to be repaid. What this sets up then, in my opinion, is a chance to once again “buy low,” or to partake in what Warren Buffett refers to as being greedy when others are fearful.

Now, doing this of course involves a bit of risk in that it’s extremely difficult to time the best entry correctly. Even Buffett himself failed miserably at this when he made his famous Goldman Sachs investment (announced on September 23, 2008) which came months before an actual bottom was seen in the stock although at this point, he’s billions of dollars ahead of the game.

Of course, if the data next week should surprise to the downside, Dubai will be viewed as a tipping point. There are a number of important reports such as Chinese, European and American PMI numbers due for release next Monday and Tuesday. I’m looking for those reports to continue the trend of improvement as the global economy continues is modest rebound from the worst financial crisis since the Great Depression and if all works out as planned, the Dubai effect will recede to the backrooms of the banks involved.