Dubai struggled to ease fears of debt default on Thursday after its move to delay repayments at two flagship firms shook confidence in the Middle East as a center for investment and a source of capital.
Dubai's debt problems, a hangover from a property boom that produced the world's tallest building, have shaken trust among Western investors who turned to the oil-exporting Gulf region for help during the global financial crisis.
The emirate shook the financial world on Wednesday when it said it would ask creditors of Dubai World, the conglomerate behind its rapid expansion, and Nakheel, builder of its palm-shaped islands, to agree to a standstill on billions of dollars of debt as a first step toward restructuring.
State-run Dubai World had $59 billion of liabilities as of August, a large proportion of Dubai's total debt of $80 billion.
Dubai tried to revive confidence by saying on Thursday its profitable DP World, which runs 49 ports around the world, would not be involved in the restructuring. DP World, which has $3.25 billion outstanding bonds, is majority owned by Dubai World but has shares listed on NASDAQDubai.
It might be a move to distinguish the solvent from less solvent companies in an attempt to shift the weight away from the less exposed entities, said John Sfakianakis, chief economist at Saudi Fransi bank.
But European bank shares, which had recovered in recent months on hopes that the worst of a global crisis was over, fell to lows not seen since May.
There was no immediate sign that U.S. banks were exposed, although checks were difficult to make given Thursday's Thanksgiving holiday.
The Dubai news sent a fresh shudder through emerging markets. Stock markets around the world sank, with weakness extending to Latin America, where the Mexican peso was knocked off a 1-year high and Brazilian assets sank.
If this eventually becomes an issue that affects the banks, once again it will put in doubt their capacity to start lending, which is a key factor in all the strategies to reactivate economies, said Carlos Ponce, head of equity strategy at brokerage IXE in Mexico City.
The U.S. dollar edged up from 14-year lows against the yen as renewed risk aversion prompted investors to shed riskier assets.
Spreads on a lot of fixed income products have gotten to very rich levels and the Dubai default will force risk to get repriced downward when U.S. markets reopen on Friday, said Andrew Brenner, at Guggenheim Securities. Either way, look for a flight to quality scenario tomorrow on a holiday-shortened day.
Exposure to Dubai World could be as high as $12 billion in syndicated and bilateral loans, including existing loans for Nakheel and Istithmar, an investment arm of Dubai's government, banking sources told Thomson Reuters LPC.
A senior Dubai financial official said he understood markets' worries.
However we have had to intervene because of the need to take decisive action to address (Dubai World's) particular debt burden, Sheikh Ahmed bin Saeed al-Maktoum, chairman of Dubai's Supreme Fiscal Committee, said in a statement.
In one of the first signs that Dubai's problems could hurt global fund-raising efforts for its neighbors, Saudi-backed Gulf International Bank pulled a bond sale due to price this week.
Dubai's move will likely lead to a reassessment of the riskiness of debt issued by the region's sovereign-linked firms.
Ratings agency Standard & Poor's said on Thursday it had placed the ratings of four Dubai-based banks on negative outlook due to their exposure to Dubai World.
S&P's and Moody's Investors Service had already severely downgraded several government-related entities on Wednesday.
Dubai World's announcement on Wednesday also sent the cost of insuring Dubai's debt against default soaring and bond prices tumbling.
Dubai World, whose slogan is The sun never sets on Dubai World, has $59 billion of liabilities.
Dubai's credit default swaps are being quoted as high as 500-550 basis points, some traders said, while the cost of insuring Qatari, Abu Dhabi and Bahrain debt also surged.
Analysts downplayed the fallout for the wider region, however, pointing out that Dubai funded its growth through loans, whereas its neighbors are mostly major oil and gas exporters.
I would not rush into talking about contagion. Anything from Abu Dhabi or Qatar is backed by serious money. Dubai is a lot more leveraged, said Youssef Affany, a relationship manager at Citi who specializes in the region.
There will be some level of solidarity from the emirates and the big neighbor, Saudi.
Analysts expect financial support from Abu Dhabi, a neighboring member of the United Arab Emirates and home to most of the country's oil. But Dubai might have to abandon an economic model that focused on heavy real estate investment and inflows of foreign money and labor.
OPTIONS FOR DUBAI?
If creditors reject proposals to postpone near-term debt obligations until May 2010, the Dubai government could be forced to hold a firesale of its international real estate.
International property advisers braced for a potential slew of instructions to sell trophy assets owned by Dubai World.
We do expect the Dubai government to step up efforts to raise capital via real estate sales, and sales of their UK assets in particular, said James Lewis, a member of the Gulf capital markets team at property consultant Knight Frank.
One fund manager said Dubai could not separate the debts of DP World from the Nakheel bond at the heart of Dubai's problems.
Trust is the basis of all credit. It can take decades to build up credit-worthiness and moments to destroy it. They have the money to pay the Nakheel bond, said the fund manager.
DP World can't be kept separate. If that's an asset of Dubai World, ownership of that can presumably be attached by Nakheel creditors.
(Writing by Alistair Bell, Additional reporting by Ulf Laessing in Saudi Arabia, Sebastian Tong, Steve Slater, Kristen Donovan, Natsuko Waki and Sujata Rao in London, Michael O'Boyle in Mexico City and Phil Wahba in New York; Editing by Dan Grebler)