Dubai — After Dubai announced in late November that the state-controlled investment firm Dubai World was seeking to reschedule payments on some $26 billion of debt, global markets went into a tailspin. While foreign bourses quickly rebounded, local shares have taken a pounding, and the credibility of Dubai's leadership has suffered serious damage. Yet lost in all the drama is the fact that Dubai is an important economic experiment in a strategically vital region. The humiliating debt implosion aside, the emirate remains the most dynamic business hub in the Gulf and has become a model for its neighbors.
In a region of conservative, autocratic countries long chained to the boom-and-bust cycles of the oil industry, Dubai stands out for creating an open economy that has diversified well beyond energy. With nowhere near the oil and gas reserves of other Gulf countries such as Saudi Arabia and Kuwait, it had to. "Dubai shows that if you are part of the global economy, you do well; you don't have to have oil," says David Aaron, director of the RAND Center for Middle East Public Policy in Washington.
There's no denying that the emirate overreached and will pay a hefty price. Dubai led the region in allowing outsiders to own property, opening up its real estate market to foreign investment in 2003, and created a mortgage industry to finance their purchases. But lax rules ushered in wild speculation. With real estate prices rising at a double-digit annual clip, investors made a killing buying apartments with low deposits and quickly flipping them. Then when the credit crunch came, buyers fled and developers saw their cash flow dry up. Hardest hit was Nakheel, a subsidiary of Dubai World that created the iconic palm island real estate development off the coast. It has about $8 billion in debt and $13 billion in other liabilities such as bills from suppliers, Barclays Capital (BCS) reports.
Dubai's leadership has doubtless mishandled the recent turmoil. The emirate's debt problems have been looming for at least a year, but ruler Sheikh Mohammed bin Rashid Al Maktoum has made little progress in coming to grips with the challenge. As recently as October, Dubai raised nearly $2 billion in new money through an Islamic bond issue. Asked about the emirate's ability to pay its debts, Sheikh Mohammed told reporters: "I assure you, we are all right."
Part of the problem is that while Dubai is more open than its neighbors, it's no Jeffersonian democracy. It is dominated by a handful of people, and their decision-making and finances remain opaque. The debt crisis illustrates that. Until recently, no one knew how much debt Dubai had and which state-linked companies it might back in a crunch. Just as murky was the extent to which its wealthier neighbors, chiefly Abu Dhabi, were willing to bail it out. Investors who had assumed the best got spooked when it appeared Dubai couldn't meet its obligations. "To lower the perception of risk, Dubai must become more transparent quickly," says Matthew Vogel, head of emerging markets research at Barclays Capital in London.
Hassle-Free Business Climate Nonetheless, Dubai remains the region's nimblest competitor. It is a tolerant and comfortable base for anyone seeking a foothold in the Arab world, and today Americans, Europeans, Asians, and Middle Easterners work side-by-side in the senior ranks of its big companies. Salaries are high, and there's no personal income tax. Luxury apartment buildings abound, many of them weekend getaways for residents of neighboring states who flock to Dubai to enjoy lavish restaurants and bars often filled with available young women. Then there's all that famous froth such as the indoor ski slope, the sail-shaped Burj Al Arab hotel on the beachfront, and the world's tallest building, the soon-to-open Burj Dubai.
Beneath all the glitz, though, Dubai has become a place where serious business gets done. While the city-state has just 1.6 million residents and a gross domestic product of $80 billion, it is the business gateway for a region with a $1 trillion economy, millions of eager young consumers, and hundreds of billions of petrodollars to invest. Microsoft (MSFT), General Electric (GE), Cisco Systems (CSCO), and a host of other A-list multinationals have flocked to Dubai because of its open culture, top-notch infrastructure, and hassle-free business climate.
And virtually every leading investment bank is present in the Dubai International Financial Center, a lavish gray-granite complex with ornate fountains built on what was a desolate patch of sand just a few years ago. A big draw is the emerging market for Islamic financial services, which has become a $1 trillion business globally. "Dubai will continue to lay the foundations for sustainable growth," says Michael Geoghegan, group chief executive of HSBC, the leading lender in the United Arab Emirates with $611 million in loans out to Dubai World. "I am confident that Dubai and the U.A.E. will overcome any short-term issues they face."
Model Gulf State Dubai's homegrown companies have made their mark, too. At the core of debt-plagued Dubai World is a first-class ports operation, and the company has vast real estate holdings and a host of other businesses that span the globe. Emirates, the airline founded by the ruling Maktoum family in 1985 with $10 million in capital, is now among the world's top 10 carriers and a major customer for both Airbus and Boeing (BA). And Dubai-based Abraaj Capital, an independent group owned by local and Saudi investors, has grown into the leading private equity firm investing in the region.
Dubai's success hasn't gone unnoticed in the neighborhood, and nearby states are following its lead. Gas-rich Qatar is promoting its own financial center. Abu Dhabi has announced an $8 billion financial-services joint venture with GE. And it's working hard to transform itself into a higher-end version of Dubai with even fancier hotels and branches of the Louvre and Guggenheim museums. Even hyperconservative Saudi Arabia has taken a leaf from Dubai's book by liberalizing its financial system to draw in Western investment banks such as Morgan Stanley (MS) and Deutsche Bank (DB).
What these countries see in Dubai is a chance to move beyond the petro-economy that has provided their wealth but does little to create jobs. The Gulf region has millions of young, underemployed people who want a better life—and who risk being drawn toward Islamist extremism if they don't get it. Some of the most talented of these have made their way to Dubai, where they find a more meritocratic culture that offers seemingly endless opportunities. "They look at this place as somewhere that allows them to do things that they can't do [at home]," says Tarik Yousef, dean of the Dubai School of Government. "It has been built out of nothing."
Hard Choices While Dubai's neighbors want to emulate its success, that doesn't mean they won't exact a serious political toll for the recent turmoil. The U.A.E., a federation of seven city-states ruled by hereditary clans, is largely bankrolled by Abu Dhabi, but Dubai is its business center. Sheikh Mo, as Dubai's leader is popularly known, is vice-president and prime minister. Abu Dhabi's ruler, Sheikh Khalifa bin Zayed Al Nahyan, serves as president, and he's unlikely to simply write a check to bail out Dubai. Instead, he will probably force Sheikh Mo to make hard choices about developer Nakheel and other troubled enterprises. Some in Abu Dhabi will even want to see Dubai pay for its profligacy by turning over stakes in major assets. The two sides "will sit down and say this is sustainable, this isn't," says Hashem Montasser, Dubai-based managing director of EFG-Hermes, the leading regional investment bank. "I am sure there will be differences."
Until Dubai cleans up its act, it will be much harder to find the money needed to keep building the new highways, the public transit system, and other big infrastructure projects that have helped give it its edge. Already businesses in the emirate say it's tough to line up bank credit, and that won't ease anytime soon. "We are expecting it to be very difficult for Dubai-based entities to raise money," says Farouk Soussa, a Standard & Poor's (MHP) analyst in Dubai.
Given Sheikh Mo's missteps in the current crisis, he may find himself increasingly under the thumb of his neighbors in Abu Dhabi. It hasn't gone unnoticed that solo portraits of him on billboards in prominent locations across Dubai have been replaced by signs showing both the Dubai leader and Sheikh Khalifa.
Dubai may no longer be allowed to run an independent foreign policy. Sheikh Mo has long kept the city-state close to Iran—and tapped into its capital—while most other Gulf states see the Islamic Republic as one of their greatest enemies. And Abu Dhabi, which worries that the U.A.E. is losing its character due to excessive immigration, may push to tighten up on visas for visitors from Iran, Russia, and elsewhere. "The entire U.A.E. will gravitate toward Abu Dhabi," says Ian Bremmer, president of New York-based risk consultancy Eurasia Group. "That means Dubai will become more conservative socially and politically. Dubai's branding will be toned down."
"Don't Count Dubai Out" That toned-down branding means the emirate will surely rein in some of its excesses. Although the skyline and palm islands won't disappear, further over-the-top development will likely be put on hold. The city-state has "realized it's no longer about building the world's tallest tower," says Saud Masud, research chief for Swiss bank UBS (UBS). "Now it's about Dubai's legacy and its long-term future." And the crisis could help spur greater transparency—admittedly the weakest part of Dubai's economic model, says David Kirsch, an analyst at Washington-based consultancy PFC Energy. "This will put more pressure on Dubai to tighten up on regulations and improve governance," Kirsch says.
It is also hard to see Dubai losing its role as the region's leading business hub. It's true that Qatar's Doha, Abu Dhabi, and even the Saudi capital, Riyadh, are scoring some successes in attracting banking and other businesses. And with greater access to capital, they'll be able to close the infrastructure gap with Dubai. But few expatriates are going to want to settle in those places, which don't really want lots of foreigners and their unfamiliar ways anyhow.
While Dubai's current problems may be severe, the viability of its economic model remains sound. Demand for business services is down now, but it will surely bounce back once the credit crunch eases. "Don't count Dubai out," says Carlyle Group co-founder David Rubenstein. "It has world-class infrastructure, a high-quality talent pool, and will continue to be an important financial center for decades to come." Singapore, which has served as an inspiration for Dubai, learned from the crash of 1997-1998 and emerged much stronger from it. Dubai, too, now has the opportunity to take lessons from its mistakes and thrive once again.