In The Days

• Source: Morgan Stanley
• News Date: 2/23/07
• Author: Stephen S. Roach

It has been almost three weeks since I returned from my latest trip to the Middle East, but I am still haunted by the sight of the cranes of Dubai. According to construction trade sources, somewhere between 15% to 25% of the 125,000 construction cranes currently operating in the world today are located in Dubai. As a macro person, I am struck by two possible interpretations of this astonishing development: It could be a property bubble of epic proportions or it may be emblematic of a new Middle East that challenges its long-standing role as a financial recycling machine. Either outcome could have profound consequences for world financial markets and the global economy.

Iniquity Abounding

“For the mystery of iniquity doth already work: only he who now letteth will let, until he be taken out of the way.”
—2Thessalonians 2:7

Root Of All Evil

“For the love of money is the root of all evi:…..”
—1 Timothy 6:10a

The comparison with Shanghai Pudong — China’s massive urban development project of the 1990s — is unavoidable. I saw Pudong rise from the rice fields and never thought anything could surpass it. I was wrong. Based on industry sources, 26.8 million square feet of office space is expected to come on line in Dubai in 2007, alone — more than six times the peak rate of completions in Pudong in 1999 and nearly equal to the total stock of 30 million square feet of office space in downtown Minneapolis. Based on current projections, another 42 million square feet should come on line in Dubai in 2008 — the equivalent of adding the office space of a downtown San Francisco. There is one obvious and critically important difference between these two urban development projects: Pudong has an indigenous support base of 1.3 billion Chinese citizens. Dubai’s current population is 1.3 million. Throw in the entire native population of the UAE and the support base is still only around 4 million domestic citizens. That’s right, a region with less than 0.5% the population of China is out-building the biggest construction boom in modern Chinese history.

That doesn’t necessarily spell trouble. After all, construction and economic development go hand in hand. The problems arise when building cycles go to extremes — fueled by speculation or funded by the easy money of state-directed lending. The jury is out on Dubai, although it’s hard not to take note of the obvious excesses — ski-domes in the desert, offshore cities in the shape of palm trees and the “world,” a massive 8-runway second airport under construction, the Tiger- and now Sergio-led golf-course bonanza, Venetian-like canals for the urban cruise, a world record 160-story skyscraper, and on and on. Dubai aspires to be the premier financial center and destination tourist resort for the Middle East. It may well get there. The problem is that other urban centers in the region are vying for the same title. Take a look at Doha, Bahrain, Riyadh, and even nearby Abu Dhabi. Far too many are in the same chase.

Bubble or not, the Dubai-led Gulf building boom is not an isolated development. Throughout the region, it has been accompanied by expanded infrastructure efforts, rapidly growing commitments to education and medicine, increased industrialization, and the growth of domestic capital market activity. These trends are emblematic of a new and important development in the Middle East that distinguishes the current period of elevated oil prices from the oil shocks of the past — a massive push toward internal development. The “Dubai factor” simply was not present in the two oil shocks of the 1970s or in the brief surge of oil prices in 1990. Lacking in domestic spending commitments, the inflow of elevated oil revenues spun quickly through a revolving door — reinvested in world financial markets, especially dollar-based assets. Such petro-dollar recycling quickly became synonymous for the oil shock.

This shock is different. As noted above, internal absorption is now very much in focus for oil-producing countries in the Middle East. As oil prices have surged in recent years, imports of goods and services of the world’s major oil producers more than doubled from around $170 billion in 1999 to $355 billion in 2005. At the same time, according to IMF estimates, primary government expenditures — a good proxy for publicly sponsored infrastructure and social spending initiatives — accounted for fully 15% of GDP growth in 2005 in the GCC (Gulf Cooperation Council, which includes Saudi Arabia, Kuwait, the UAE, Bahrain, Qatar, and Oman); by contrast, this share was basically “zero” in 2002. Moreover, the region’s fiscal authorities are mindful of the policy mistakes of the past, when mean-reverting oil prices led to substantial government budget deficits for those who had been too aggressive in opening up the spending spigot. For the developing economies of the Middle East, the IMF is estimating central government surpluses of a little more than 8% of GDP in 2007 — about the same as in 2006 but a swing of around 11 percentage points of GDP from the 3% average deficits of 2002-03. This more prudent fiscal response is a very encouraging development that could avoid the boom-bust cycles of the 1980s and thereby set the stage for more sustainable state-led spending initiatives in the years ahead.

Notwithstanding the push toward internal absorption, Middle East oil-producing states have not turned their backs on dollar-denominated assets. Due largely to dollar-pegged currencies, GCC monetary authorities still need to invest a large portion of their outsize portfolio of official foreign exchange reserves in dollar-based assets. But the combination of new domestic spending programs and reserve diversification strategies challenges the time-honored conclusion that petro-dollar recycling is an automatic outgrowth of rising oil prices. There is an added and important twist in the current climate: America’s post-9/11 Patriot Act now makes it much more difficult for Middle East portfolio investors to transfer funds into the US. At the same time, the recent controversy over the purchase of US assets by Dubai Ports World, together with congressional efforts currently underway to tighten up restrictions on foreign direct investment into the US — the so-called CFIUS approval process — also discourages dollar-centric buying of Middle East investors. An offset comes from the sharp corrections in local stock markets since late 2005 — underscoring the risks of the domestic capital markets option for non-dollar diversifications strategies. But should these markets start to recover, I suspect local buying will intensify rather quickly — diverting assets away from lower-return alternatives in the US and elsewhere in the developed world. In short, there are many reasons to believe that in the current period of sharply elevated oil prices, the petro-dollar recycling story may be far less compelling than it used to be.

This conclusion has important implications for world financial markets. Most importantly, it challenges consensus views that high oil prices create a natural bid for dollar-denominated assets. In a climate where dollar risk remains an ongoing concern, that could be an especially important point for the currency debate. In light of recent dollar-diversification concerns expressed by reserve managers in the Middle East — especially those in the UAE, Qatar, Iran, and Syria — that possibility should not be taken lightly.

The cranes of Dubai are emblematic of a much deeper point: We need to update our thinking about the Gulf economy — especially insofar as its internal development efforts are concerned, but also with respect to its role in world financial markets. It was only a little over 33 years ago when rising oil prices first came into play. Since then, the economic development of Middle East oil producers has been nothing short of extraordinary. Dubai underscores a critical difference between then and now. Even if it ends up being a bubble, I suspect there will be no turning back for the new Middle East. In a world where the globalization debate is dominated by China, it is high time to broaden our horizons.