Karelis explains the economics of poverty

Explaining the persistence of poverty has been one of the most enduring of socio-economic debates. Despite all this, there have been no satisfactory enough single explanation that captures all the reasons behind poverty and its persistence. And I am inclined towards the belief that complex challenges like poverty cannot be explained in a grand and all-encompassing narrative.

Conservatives and free-marketeers advocate the importance of getting incentives right in addressing the problem of poverty. They claim that once the required framework that provides everyone with equality of opportunities is put in place it becomes easy to eradicate poverty. These microeconomic foundations have been used to favor policies that emphasize good governance, institutions, rule of law, access to basic health care and education, and so on. They have also been invoked to oppose direct welfare measures that go beyond the most minimum of social safety nets and even multi-lateral aid. It is claimed that such support measures fail to achieve their poverty alleviation objectives and only end up distoring incentives by discouraging effort and promoting inefficiency and corruption.

Such simplifying narratives of a complex issue like poverty is audacious at best and plain ignorant at worst. Such explanations fail to appreciate the true complexity of poverty and deprivation and fails to acknowledge the importance of specific contextual factors (local community instiutions, weather, geography, politics etc) that keep people poor. Its underpinning rational economic man also ignores the bounded rationality of human beings that behavioural economists have exposed under a number of different circumstances with poor people. It is from this framework that I find Charles Karelis's work interesting and a welcome addition to the growing literature that helps us better understand the context in which poverty flourishes and the reasons why it is so impervious to change.

I have blogged earlier about Karelis's alternative explanation for the persistence of poverty, in which he claims that poverty introduces a diminishing marginal utility to putting in effort. He argues that classical microeconomic explanations of consumption and satisfaction that satisfactorily explains the economics of the well-off cannot explain that of the poor.

Karelis makes the distinction between pleasure goods and good that are relievers, and some goods can act as both, and claims that while there is diminishing marginal utility in pleasure goods, relievers have increasing marginal utility. As Karelis writes, "paying the first bill in a stack of overdue bills does little to relieve a guilty conscience".

Mike Konczal has this nice summary of Karelis' arguement

"Picture you are in a room with 10 people. Each of them has a slice of cake... You’d be willing to pay a $1 for the first slice of cake, but you’d only be will to pay 90 cents for the second slice. You’d only be willing to pay 10 cents for the 9th slice, and a penny for the 10th slice...

Now picture you are in a room with 10 people screaming. You hate it when people scream, and you can pay a person to get them to stop screaming... Getting one person to stop screaming would make very little difference in how much you dislike being in the room. Modern psychology tells us you might not even notice it. You’d probably only pay a penny to get that first guy to stop screaming. However getting the second guy to stop screaming might be worth 10 cents. And the last guy, the difference between some screaming and no screaming, might be worth the full dollar to you. The more quiet it got, the more a marginal difference in how quiet it is would be worth to you. There’s increasing returns to this good; the 10th guy not screaming is worth more than the first guy not screaming, which is the exact opposite dynamic of the 10th cake being less delicious than the first...

Let’s say that instead of money, you are given 20 tokens to be used over 4 days, and each token gets you one slice of cake in room #1, and one person to stop screaming in room #2. In the cake room, the optimal decision is to consumption smooth – eat five slices of cake each day, so you use the tokens {5,5,5,5}. In the screaming room, all the enjoyment is not in getting a room with half screaming but in getting a quiet room, and instead of consumption smoothing the optimal choice is to binge – pay 10 people to stop screaming the first two days, and deal with a loud room the last two days – {10,10,0,0}...

And most interesting, instead of tokens, let’s say you could work an hour for 1 token or take 65 cents in leisure over a 5 hour day. In the cake room, you’d probably work 3 hours, and relax 2 hours, as around that time you’d have the marginal return from cake equally the marginal return from relaxing. In the screaming room, you probably wouldn’t work at all – it’s impossible enough to make enough to stop the screaming to the point where it is worthwhile to try. Hence the persistence of poverty."

See also Tyler Cowen on Karelis here.

Tagging-based taxation

One of the biggest challenges for public finance has been to design the most appropriate model for individual taxes. Any tax regime has to meet the twin requirement of fairness and efficiency, objectives which economists from the right and left view as conflicting. Left and liberal economists argue strongly in favor of progressive taxation that imposes the major share of the tax burden on the rich and thereby redistributes income. Conservative economists oppose higher taxes on the rich as inefficient since they dis-incentivize effort.

In the search for optimal tax policy design, Chris Dillow points to an old paper by George Akerlof that advocates the use of "tagging" - which tags (identifies) people and then makes specific transfers (or concessions) to them - in taxation. As Chris Dillow writes, "Given that taxes must be raised, therefore, it's best that they be imposed upon productive assets which won't be withdrawn from use if they are taxed". With their focus on inalienable and salient human characterisitics, tags also offer the additional advantage of controlling tax evasion.

Dillow proposes a tax design that would "tag" low-ability (or physically disadvantaged people, who can't work their way out of poverty and are therefore not likely to face incentive distortions with lower taxes or higher transfers) and high-ability (since high ability people would have to pay the same tax even if they work less, there is again no likelihood of incentive distortions) tax payers. Common tags include height, looks, gender or private education.

On the challenge with identifying appropriate tags for these characteristics, he turns to the large amount of recent reasearch on this area. In a famous paper, Greg Mankiw and Matthew Weinzierl had advocated an income tax system that includes "a tax credit for short taxpayers and a tax surcharge for tall ones".

Taxing women less than men, a proposal that even found support in last year's Spanish general elections, has been advocated by Alberto Alesina, Andrea Ichino, and Loukas Karabarbounis. They propose such gender-based taxation as a revenue netural policy by phasing out a variety of other policies already in place that favour women, like quotas, affirmative action, publicly supported child care facilities and care for the elderly.

Dillow also points to strong co-relation of private education with earnings, even controlling for university. And there is also the case for tax credits for the ugly, given evidence that "ugly people do less well at school and earn less than good looking ones - so much so that some turn to crime" and higher taxes on the beautiful given the co-relation between the beauty and intelligence.

And given evidence that ethnic minorities do badly in the labor market, there is also the case for tax credits for them. Is this also the economic rationale for taxation based on on other racial and communal characteristics (or "affirmative taxation" as in India!)?

While conventional progressive taxation does raise concerns about efficiency (in terms of incentive distortions), tagging-based taxation faces the same questions over fairness. In fact, the questions are even more relevant than those raised about regular taxation. For example, a tax on tall people as a tagged category, would unfairly impose a disproportionately larger burden on those tall people who are poor among them (compared to those poor among the short people). Even if have a mechanism to filter them out, the transaction costs associated with that process, would almost surely nullify any advantage with evasion and efficiency that tagging-based taxation enjoys. The only tag, I can think of, that would overcome this objection would be gender-based taxation.

Financial market liberalization

The aftermath of the sub-prime mortgage bubble has pitchforked cross-border capital controls into the centerstage of global economic debates.

For long, capital account convertibility (CAC) has been one of the most scared prescriptions of the Washington Consensus, despite many real world setbacks, the most famous being the East Asian currency devaluation crisis of 1997. Both the IMF and the World Bank have seen capital account convertibility as an important requirement for proper macro-economic management.

It is argued that in an increasingly integrated world, as economies get integrated by trade and cross-border Foreign Direct Investment (FDI), it becomes virtually impossible to control capital flows beyond a point. In this view, capital flows are a form of tax imposed on domestic private businesses who are prevented from accessing private capital at cheaper rates.

However, in the wake of the current crisis, Dani Rodrik had made the point that the four Asian countries with the least open financial markets - China, India, South Korea and Thailand - are the least affected by the ongoing financial turmoil. Asian-style resistance to financial globalization has taken the form of limiting the role of foreign banks in the domestic banking system and of restricting cross-border arbitrage in foreign currency, money, bond and equity markets. Evidence from prices and quantities shows the most limited globalization in China, followed at a distance by India, followed in turn by Thailand and then Korea.

Menzie Chinn and Hiro Ito, using the KAOPEN index which measures the degree of a country's capital account openness, has the following graphic.



The graphic shows that the East European and Latin American economies, which have been the worst affected by the current crisis among the emerging economies, are also the most open. Further, their financial market liberalization has been dramatic over the last decade. In contrast, the East Asian economies pulled back after the bitter experience of the late nineties and were saved off much of the troubles. Interestingly, South Asia has been amongst the most consistent of reformers, with a gradual and phased liberalization over the last three decades. The LDCs are also among the most liberalized of all developing economies, laying to rest some of the claims that attribute their backwardness to their failure to pursue open market policies.

The idea that greater exchange rate flexibility leads to more rapid current account adjustment has been a central tenet of the Washington Consensus and the policies of IMF. However, Menzie D Chinn and Shang-Jin Wei find that contrary to conventional wisdom, the benefits of exchange rate flexibility for current account adjustment are greatly exaggerated and by some measures, a fixed exchange rate facilitates faster adjustment.

They studied the performance of the financial markets of countries having freely floating currency, a dirty float, a crawling peg, or a fixed rate with respect to their current account balances for 170 countries over the 1971-2005 period. They find some evidence that for non-oil developing countries, the most rigid fixed regimes have the fastest current account adjustment, followed by pure floaters, whereas countries with a dirty-float exchange rate regime exhibit the slowest current account adjustment.

In a recent NBER working paper, Maurice Obstfeld writes that "there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries" and also "that there is little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies". He also agrees that opening the financial account does appear to raise the frequency and severity of economic crises.

Despite all this, developing countries have moved over time in the direction of further financial openness, because "financial development is a concomitant of economic growth, and a growing financial sector in an economy open to trade cannot long be insulated from cross-border financial flows". He also finds that domestic financial market development - which promotes growth, can enhance welfare more generally, allows easier government borrowing, and eases the conduct of a domestically oriented monetary policy - also makes capital controls costlier to enforce.

The development of the domestic financial markets, which also helps correct the domestic financial market imperfections and institutional weaknesses, makes external financial liberalization easier to live with. He is in favour with the standard World Bank prescription for external financial policy making which has "three core components – membership in a credible currency union (like euro zone), or an exchange rate that reflects market forces; gradual opening of the capital account; and a monetary policy framework that favors price stability". The benefits of financial market liberalization are most likely to be realized when implemented in a phased manner, when external balances and reserve positions are strong, and when complementing a range of domestic policies and reforms to enhance stability and growth.

In another NBER working paper, Raghuram Rajan and Easwar Prasad, too argue in favour of a gradual movement towards capital account liberalization by emerging economies. They claim that the main benefits of capital account liberalization for these economies are indirect, more related to their role in building other institutions than to the increased financing provided by capital inflows. This line of thought places more emphasis on the efficiency improvement function of CAC.

Growing global public debt ratios

The Dubai government's decision to postpone the repayment of the debt obligations of its investment arm, Dubai World, has set off intense speculation about similar prospects elsewhere. Going beyond private sector debt defaults, there is mounting concern about the prospect of sovereign defaults among economies.

In the wake of the Dubai crisis, William Buiter has argued that the contraction of credit "makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral".

After decades of living beyond its means, the leading economy of the world faces payback time. The Times points to a trifecta of headaches being faced by the US government - a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

With 36% of the $12 trillion and growing national debt due for repayment within a year, there is a real danger of the US government facing the same payment shock that sent homeowners to default on their mortgages. As the Times reports, the White House estimates that the government will have to borrow about $3.5 trillion more over the next three years, besides refinance, or roll over, the huge amount of short-term debt that was issued during the financial crisis.



The biggest worry is not so much immediate, but prospects for the future, given the inevitability of continuing and growing deficits (and resultant debts) and higher debt servicing rates. In an indication of the ultra-low levels of interest rates prevailing, the US government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt. The government’s average interest rate on new borrowing last year fell below 1% and for short-term IOUs like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent. The Times refers to Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits, who summed it up most appropriately,

"The government is on teaser rates. We’re taking out a huge mortgage right now, but we won’t feel the pain until later."

Exacerbating this is the massive anticipated explosion in spending on benefits under Medicare and Social Security as the nations babyboomers arrive to collect their old age benefits. Further, as the foreign lenders diversify away to other investment avenues and domestic investors return to their regular invesmtents as the economy and credit markets return to normal, there will be an upward pressure on interest rates to keep investors interested. And this in turn will drive the debts further up.

Echoing these concerns, Bill Gross, MD of Pimco bond management firm had this to say about America's burgeoning deficits and debts, "What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it’s eating the ones left over from the last winter."

The White House itself estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. The Times writes,

"Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode."

The fiscal strains imposed by the financial market bailouts and fiscal stimuluses coupled with the continuing economic weakness (with its attendant drop in tax and other revenues), has dramatically raised the debt burdens of all major economies. Germany's government debt outstanding is expected to increase to the equivalent of 77% of GDP in 2010, up from 60% in 2002, and in Britain that figure is expected to more than double over the same period, to more than 80%.

Eastern Europe is the worst affected by the burgeoning debt disease as its governments gorged on domestic and, more damagingly, foreign debt. Public debt in Ireland is expected to soar to 83% of GDP next year, from just 25% in 2007. Latvia's borrowings are set to reach the equivalent of nearly half the economy next year, up from 9% a mere two years ago. The debt situation is worse with the two other Baltic states of Lithuania and Estonia, and others like Bulgaria and Hungary, all of whom carry foreign debt that exceeds 100% of their GDPs.

Encouragingly, India has been among the few countries which have managed to keep their debt shares stabilized, despite the fiscal stimulus spending. Interesingly, it is among the few major countries expected to show a slight decline in debt share over the next year. Further, unlike the vulnerable East European and Latin American economies, external liabilities form a very small share of the debt burden. Short-term debt coming due is also a small share. However, of great concern is the fact that India's debt burden as a share of GDP is the highest among all the major emerging economies, almost double that of their average.



In this context, Catherine Rampell has an interesting post in Economix, which seeks to put in perspective the burgeoning public debt burdens across the world and find out what level of public debt marks the Rubicon. It compares the trends and projections of government debt across countries from Moody's Investors Service and feels that the debt thresholds vary across nations.

Though many emerging economies, especially from East Europe have debt levels much lower (as share of their GDP's) than Japan and the US, they face greater threats and are more vulnerable to economic shocks. Japan and Italy ahve been sustaining more than 100% debt burdens for more than a decade without much trouble, whereas similar figures for any developing economy would have spelt certain disaster. The Moody's estimates predict debt ratios of 223.4% of GDP for Japan, 99.3% for US, 79.5% for India, and just 15.7% for China for 2010.

In their magisterial examination of 800 years of financial crises, Carmen Reinhart and Kenneth Rogoff had found evidence that the thresholds for default are much lower for many emerging markets. They also argue that developing countries have lower market credibility of their institutions and governments and therefore have low levels of debt intolerance, especially those who have had a history of debt defaults. Further, since they have large share of foreign borrowings, they cannot use inflation to deflate away their debts.

Ban OTC trades in electricity markets

Though exchange based trading of power has been in vogue in India for slightly more than a year, they constitute just 0.3% of the total consumed power in the country. Two power trading exchanges - Indian Energy Exchange (IEX) and Power Exchange of India (PXI) - are presently operational. Further, of the total short term power trade, exchanges (which trade only day-ahead contracts) form just 9%, while bilateral forward contracts (upto one year) form 50% and Unscheduled Interchange (UI) (spot market with frequency-based pricing to settle real time inter-state unscheduled imbalances) forms 41% (figures from April, 2009).

Currently, of the total power traded, exchanges form just 9%, while bilateral trades form 50% and Unscheduled Interchanges (UI) forms 41% (figures from April, 2009). This multiplicity of platforms for traded power has resulted in the fragmentation of the nascent power trading market, and rendered all of them inefficient and distorted. The bilateral trades are conducted Over the Counter (OTC) by registered traders who sell day-ahead and longer term contracts to mainly state utilities at negotiated prices. Sensing the importance of increasing liquidity in the exchanges, the Government have also taken several steps including obligating all new generators to sell a part of their produce through the exchanges, and a proposal to slowly shift UI trades into the power exchanges.

Markets in electricity trading are qualitatively different from those in other products, including commodities. Since electricity is not storable and transportation a major constraint, the markets trading in electricity contracts are inherently inefficient, liquidity strapped and have limited fungibility. The constraints in transmission capacity means that prices for delivery at one place at any time will have no relation to that for delivery at another place at the same time. This limits the forward market for each time and place to only a few buyers and sellers. In other words, the absence of a country-wide market in forward contracts seriously limits the market liquidity and efficiency. It is therefore important to have markets that trade the full spectrum of products - spot, forwards and futures; have considerable liquidity; and have enough transmission capacity to increase the fungibility of contracts.

In the context of a market with substantial power deficit, limited number of sellers, and relatively inelastic demand (buyers cannot afford not to meet the demand due to political compulsions), sellers will always be the market makers. All the aforementioned conditions are likely to persist for some time to come. This market power of the seller's gets amplified in inverse proportion to the volumes traded in the exchange. In the circumstances, it is imperative to take all possible measures to increase trading liquidity in the exchanges so as to mitigate market conditions favoring the sellers.

In the circumstances, it would appear natural for the government to encourage the shifting of OTC trades into the transparent of platform of power exchanges. It will do more than any other intervention to considerably enhance the market liquidity and promote efficient price discovery in exchange transactions. This assumes importance especially in view of the proposal by both IEX and PXI to introduce term ahead contracts in its portfolio of offerings. Contracts not covered by the exchanges can continue through OTC route, while those offered by the exchanges can be immediately brought under the exchanges.

The presence of OTC traders inhibits the development of efficient power exchanges in the country. The non-transparent nature of its price discovery and the demand-supply imbalances makes OTC trades attractive for traders who enjoy a superior bargaining power. These bilateral contracts "crowds in" all types of trades and drains liquidity from the exchanges. Despite its high prices, desperate state utilities too prefer the longer term bilateral contracts which lowers the uncertainty associated with procuring power in an illiquid and deficit market. In the final analysis, the day-ahead and term-ahead markets should converge towards the same efficiency and transparency that has been the mark of the CERC managed UI market.

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The State and Regional Load Despatch Centers consolidate the requirements of each utility on a day-ahead basis and then schedules the transmission corridors to match the generating station and the purchasing utility or open access customer. Any demand by a utility, over and above that scheduled is called unscheduled inerchange (UI) demand. The UI rates are fixed based on the marginal cost of production of the costliest scheduled generator supplying at that point in time and is capped by a ceiling rate. Since the UI rate are known in advance, these trades are done without any contracts and involve real time balancing and settlement.

Chinese power equipment makers and India's capacity addition program

The Government of India is concerned with the increasing market share of Chinese equipment makers in the new Indian power projects. It may even be contemplating taking anti-dumping action or invoking safeguards clause of the WTO to restrict these imports which now form a quarter of the power equipment market, especially among the upcoming private projects. However, such concerns fuelled by national security fears and a threat to BHEL's market position in India, may be more a case of fighting shadows.



In the last couple of years, the Chinese state power equipment makers - Harbin, SEC, Dongfang, Sepco etc - have captured nearly a quarter of the market share, especially among the independent power producers (IPPs). Thanks to favorable Chinese government policies like standardization of equipment sizes and bulk procurements, these state owned firms have emerged as the largest and lowest cost manufacturers of BTG equipments required for thermal power generating plants across the world, ahead of even established global players like Alstom, Siemens, and Hitachi.

The Government's fears may not only be unfounded but the Chinese imports ought to be positively welcomed for many reasons

1. The Chinese equipments are good for Indian power generators and for consumers. They are 10-15% cheaper than equipments sourced from elsewhere, including BHEL, and have therefore lowered the cost of capacity addition from about Rs 4.5 Cr per MW to Rs 3.5 Cr. The generators would have to pass on the resultant benefits to the consumers by way of lower tariffs.

2. The concerns about BHEL may be a classic case of an incumbent wanting to protect its turf. As any one with knowledge of Indian power sector would acknowledge, the BHEL is struggling to meet its commitments on already available delivery schedules. Its order books are overflowing and in the absence of substantial capacity addition on making these equipments, its inability to meet its commitments would adversely affect the capacity addition program in Indian power sector. And the state owned utilities who have a larger exposure to BHEL will be the biggest sufferers. In the circumstances, the Chinese imports may actually end up expediting the capacity addition program.

3. The surge in Chinese imports provide an excellent opportunity for policy makers to promote an industrial policy that encourages these equipment suppliers to provide upfront commitment for progressive indigenisation of technology or a phased manufacturing programme (PMP). This would not only reduce costs even further, but also facilitate the development of a vibrant heavy and capital equipment industry in the country.

4. Finally, to the extent that the Chinese equipments are cheaper due to the numerous implicit subsidies (like cheaper capital, tax concessions etc), the imports are a form of Chinese subsidization of Indian power generation program! And we would be extremely foolish to reject this.

Instead of fighting shadows, we should be leveraging the buyer's power to fortify ourselves, something the Chinese have perfected in many industries, most notably the aircraft industry during their massive fleet expansion programs. This would require not only strategic use of industrial policy to encourage local manufacturing and technology transfer, but also addressing concerns about the post-delivery servicing and visa regulations for Chinese engineers working in the commissioning of these projects. We should also use the opportunity to get the Chinese to immediately resolve all lingering concerns about the suitability of Chinese equipments to the high-ash content Indian coal, besides sharing all required information about equipment standards and designs and permitting more intensive inspections of the manufacturing facilities by the Central Electricity Authority (CEA) as mandated by the Electricity Act 2003.

Further, taking a leaf out of China's own diplomatic handbook (in its dealings with the US), we could selectively use such leverage as part of our foreign policy to wring out concessions from the Chinese.

Update 1
An estimated 21,519 MW of generation capacity during the Eleventh Plan period is being implemented during using Chinese equipment while orders for another 14,000 MW have been placed for projects coming up in the Twelfth Plan (April 2012-March 2017).

Update 2 (9/5/2011)

Businessline reports that Chinese companies - Dongfang Electric Corporation, Shanghai Electric, Sichuan Machinery and Equipment and Shandong Electric Power Construction Corporation - have edged out state-owned Bharat Heavy Electricals Ltd (BHEL) as the top equipment suppliers to thermal power projects slated to come up in the next five years. According to the latest equipment ordering status for the 79,000 MW of fresh capacity slated to come up in the Twelfth Plan (2012-17), Chinese vendors have bagged contracts for supplying electro mechanical equipment adding up to 28,740 MW. This is against the 27,746 MW to come from BHEL during the five-year period. Of the Twelfth Plan orders booked by Chinese firms, 96% or 27,540 MW, are from private project developers.

For the Twelfth Plan, apart from BHEL, domestic manufacturers, including the L&T-Mitsubishi Heavy Electric combine, Bharat Forge-Alstom and Toshiba-JSW have cumulatively clocked orders worth 10,182 MW. Foreign suppliers other than the Chinese, including Korean firm Doosan and Russian firm Power Machines, have got orders for over 7,000 MW. However, central sector firms, led by NTPC Ltd and Neyveli Lignite Corporation, are yet to place a single order on Chinese equipment suppliers.

Update 3 (20/2/2012)

The Finance Ministry favours the imposition of 5 per cent basic Customs duty, 4 per cent additional import duty and 10 per cent countervailing duty (imposed in lieu of excise duty for domestic producer) making a total of 19 per cent on all power generation equipment for projects above 1,000 MW. Businessline reports that the Cabinet Committee on Economic Affairs (CCEA) is expected to take a call on the issue in the next 15 days.

Lessons from Dubai crisis

The not-so-unexpected decision by the Dubai Government to request its banks for a six-month stay (atleast till May 30, 2010) on the $59 bn worth debt repayment obligations of Dubai World, the corporate arm of Dubai and which has led many of its most ambitious real estate projects (and which also operates Dubai's world class port, including the Jebel Ali free trade zone), and the markets reaction to the announcement raises a few interesting issues.

1. Abu Dhabi, the oil rich governing emirate of the United Arab Emirates, for maybe political reasons, initially showed remarkable resolve to not to jump in with an unconditional bailout of the investment arm of one of its own states or even purchases of Dubai's debt. It forced the Dubai government formally announce its distress and thereby bring its (often greedy and irresponsible) creditors to the negotiating table for a genuine debt restructuring deal and share in the pain inflicted by the losses.

This stand-off attitude (by both governments), instead of the more direct and immediate bailouts (atleast some of the more dubious ones like the infamous AIG payouts) that chacterized much of the US government response during the height of the sub-prime crisis, deserves commendation. The decision to refrain from a blanket support for creditors of Dubai World was aimed at forcing out concessions from the irresponsible creditors who deserve an equal share of the blame for the mess.

Interestingly, Dubai World had already raised $5 billion from Abu Dhabi banks on Wednesday, making it possible to pay the $3.5 billion to the holders of its Islamic bond by Dec. 14. However, it decided not to go ahead with payment and sought a moratorium on debt repayment for six more months so that they could work together or risk not being paid at all. As the Times writes, for the bankers, not to be paid would raise the prospect of more write-downs at a time when the industry has absorbed more than a trillion dollars in losses related to bad mortgages and is still recovering.

Abu Dhabi which sits on 9% of the world’s oil and manages the largest sovereign wealth fund, has on other occasions too shown a healthy restraint in refusing to unconditionally cover for the losses of its emirates and write blank cheques to cover all their debts.

2. The subsequent decision by the UAE Central Bank to pledge to lend money to banks operating in Dubai, after a week of turmoil that ravaged the stocks of these banks and those with exposure to them, was aimed at pre-empting the kind of crisis of confidence that froze credit markets last year in the aftermath of the Lehman failure in September 2008. Then the markets got back to some ssemblance of sanity only after the US Government announced a massive $700 bn banking bailout plan and guaranteed a variety of borrowings. This latest decision is only the latest example of the moral hazard that has been unleashed in the financial markets by the risk of system-wide contagion of banking failures.

The Abu Dhabi government's decision is not a blanket guarantee of all of Dubai's debt, but is obviously a dilution of its hardline stance from last week, and is a reflection of the dilemma and pressures faced by governments during such crises.

3. The steep increase in spreads on even Dubai government debt and cost of capital for Dubai government, in the face of what is essentially a private debt crisis, is a clear indication that the distinction in debt ownership may have disappeared. With governments forced into mounting massive bailouts and guarantees for its private "too-big-to-fail" financial institutions, their deficits threaten to spiral out of control.

And Dubai is not alone in this - the cost of insuring debt issued by Greece, a member of the euro bloc, is now as much as insuring Turkey’s debt, an investment that was once considered much riskier. Greece, whose short-term debt burden has risen from $14.5 billion at the end of 2007 to $24 billion in the second quarter of 2009, has many others in Eastern Europe for company. Hungary, Bulgaria and the Baltic states of Latvia, Lithuania and Estonia carry foreign debt that exceeds 100 percent of their gross domestic products. In fact, Eastern Europe is precipitously perched in much the same situation as the East Asian economies in the late nineties.





All these economies face the problem of massive private sector debts, with a substantial portion being short-term, All this raises the importance of a trans-national mechanism, that goes beyond the limited mandates of multilateral institutions like the IMF, to address such crises.

4. The decision by the Dubai government, which was not a default but only a postponement or a rescheduling of the repayment obligations of one of its government backed agencies, was seen by the markets as equivalent of a sovereign bankruptcy. Legally neither Dubai nor Abu Dhabi are bound to guarantee the debt of Dubai World. The prospectus for Nakheel that lays out numerous warnings, including that Nakheel has relied "upon capital contributions from the government of Dubai" and "there can be no assurance that these contributions will continue".

Questions are being asked about whether Dubai government will default on its other repayments, and the cost of capital for Dubai itself has risen steeply. However, the real and spectacular achievements of Dubai in building up its remarkable success story from a barren desert cannot be compared to the illusory gains from paper transactions of modern financial engineering that kept much of Wall Street pumped up in recent years. The markets have also overlooked the fact that the parent government, Abu Dhabi has more oil than Dubai, has no cash problems, and could easily wipe out Dubai World’s $59 billion of debt.

Faced with similar implicit government guarantees, the global financial markets did clearly give the benefit of doubt to the stumbling Wall Street firms, most notably the Citigroup, at the peak of the sub-prime crisis. But in case of Dubai World, with a debt burden built on arguably less shaky foundations, the reaction of the global financial markets appear similar to that with the East Asian economies in late nineties. In the circumstances, the market reaction casting doubts on Dubai government itself may be a reiteration of the fact that emerging economy governments face much greater risks with global financial market shocks.

5. The news battered the stocks of these banks (like Barclays, Standard Chartered and HSBC) and Dubai World's entities and those with Dubai exposure. The debt rescheduling is the latest blow to Dubai World diffuse portfolio, which has plunged in value due to the global financial market and economic distress that has battered the real estate market. The bonds of Dubai World’s property developer, Nakheel, the developer of Dubai’s signature palm-shaped islands, dropped sharply and the cost of insuring against a Dubai government default soared.



6. FE has this nice graphic on India's exposure to Dubai. Dubai's woes could also but breakers on the flood of capital into the financial markets of emerging economies. Ironically this could be a positive development for these overheated markets.



See also this superb post by Ed Glaeser on Dubai's spectacular government driven growth story which sought to create a world class business environment in a barren desert, and which in the process may have over-reached with the consequences that we see now. However, the real achievements, which will surely endure the crisis cannot be overlooked.

See also this article from Andrew Ross Sorkin which draws attention to how Shariah compliant investment products helped channelized the massive savings of wealthy, oil-rich Muslim investors and finance a substantial share of Dubai World's investments. With the Koran prohibiting investments that pay interest, the natural investment alternative was real estate, one which also suited the ambitions of Dubai World's promoters.



Update 1

See also this on the Duabi debt crisis



Update 2
Abu Dhabi government finally stepped in with a $10 bn short-term loan to embattled Dubai, which comes with more closer scrutiny of the so-far free-wheeling Duabi government's investment decisions.

Update 3 (25/3/2010)

The government of Dubai has announced putting up to $9.5 billion into Dubai World and its subsidiary Nakheel PJSC to help them restructure debt. The Nakheel bonds falling due this year and next will be paid by Dubai World, which is the chief investment vehicle for Dubai. Nakheel, the company’s real estate development unit, will receive about $8 billion in the new government funds.