THE INTERVENTION by Abu Dhabi earlier this week to rescue Dubai, its fellow emirate state, by providing a $10 billion (€6.85 billion) bailout for state-owned Dubai World, has bought time for Dubai and provided Dubai World with the financial means to restructure its debt.
The move has averted also a deepening crisis in the United Arab Emirates which has badly damaged the reputation of the Gulf region as a financial centre. Abu Dhabi – the largest and wealthiest state in the seven-member federation – belatedly threw its financial lifeline after Dubai’s debt difficulties raised borrowing costs for all Gulf states, including Abu Dhabi. One consequence is that the contagion effect evident within the region has extended beyond it, notably affecting Greece.
Dubai’s debt problems revived concerns among international investors about sovereign debt risk, namely that a country might default on its debt obligations. Default risk can be seen in a higher cost of borrowing - the premium that lenders secure from borrowers as compensation for extra risk. Bond market investors now consider Greece and, to a lesser extent, Ireland as more likely to default, given the weak state of their public finances. The risk premium is measured in the interest rate differential, the increased yield spread on 10-year Irish bonds over equivalent-maturity German bunds. Once again that gap has widened in recent weeks, with Irish bonds at one stage close to two percentage points higher.
Credit rating agency Fitch downgraded Greece’s sovereign debt rating last week, following the Greek government’s surprise revelation that its budget deficit in 2009 would be 12.7 per cent of GDP, or more than double its original forecast. These developments, when allied to the failure of the new Greek government credibly to tackle the fiscal crisis, have meant diminishing investor confidence. Greece’s difficulties have created problems for Ireland and for the euro zone. Because Greece and Ireland are the two weakest economies in the euro area, they are linked in the minds of international investors. The increased risk of Greece defaulting on its debt has been damaging to Ireland, even though the Government demonstrated in the Budget that, unlike its Greek counterpart, it has a credible plan to stabilise the deficit and to achieve a balanced budget by 2014.
The efforts of Ireland and Greece to tackle their fiscal difficulties offer a striking contrast which bond markets are beginning to recognise. Where the Government here has cut spending, including public sector wage cuts, the Greek prime minister, George Papandreou, this week said he would fight to avoid similar pay cuts, having already announced a partial wage freeze for public employees. Despite Greece having the largest budget deficit in the EU, Mr Papandreou aims to achieve budget balance by 2013 – a year ahead of Ireland. But until his government can provide clearer evidence of a willingness and determination to tackle its fiscal crisis, Greece’s credibility deficit will remain – with worrying implications both for Ireland and the euro.