The news that Dubai has announced delays on the repayment of part of its debt caused panic in the global financial markets. On 26 November the UK’s FTSE100 index of leading company shares suffered the biggest daily loss for 8 months. Along with most other developed markets’ equity indices, it lost around 3% on that day, with developing markets suffering much sharper falls. However, soon the panic ended and most of the losses were reversed with the FTSE100 enjoying its biggest daily gain for 4 months on 1 December. So, what explains this volatility?

Dubai is one of seven semi-autonomous states of the United Arab Emirates. It is well known for the massive construction spree it has embarked on over the last several years. This led to a boom in real estate prices followed by a subsequent collapse in light of the global credit crunch. Unlike its neighbour, Abu Dhabi, Dubai was not rich in oil and therefore relied on borrowing to finance its projects. The objective was to make Dubai into a financial and tourist centre, thus building an economy that was not dependent on a depleting resource: oil.

It was no secret that Dubai was heavily indebted. However, the investors’ perception was that its debt was effectively underwritten by Abu Dhabi, where the elder brother of the ruler of Dubai was, it was believed, prepared to help finance the infrastructure spending in Dubai. This perception of risk changed dramatically when Dubai asked for a debt standstill at Dubai World, the government’s flagship construction company. The debt in question was US$3.5bn, which on its own should not be significant enough to affect global markets in this way. Dubai’s total outstanding debt, estimated at US$60bn, while very large, is still modest in the context of the vast sums that have been written off relating to the US housing market and commercial loans in various developed economies.

However, this change in perception of risk associated with semi-sovereign debt affected other countries that could possibly have similar problems. One only has to remember what happened to Iceland at the height of the current financial crisis to appreciate that the risks of default are real. Countries that have large financial liabilities, especially emerging economies, are regarded as especially vulnerable.

For the European Union it underlines the disparity between the financially prudent north, with Germany at the helm, and the profligate south, where Italy and Greece are seen as particularly risky. For some time investors believed that, rather like the UAE, the EU would underwrite the financing requirements of the heavily indebted nations such as Greece. But the situation in Dubai has concentrated their minds on the risks involved.

Another factor that affected the scale of the financial markets’ falls on 26 November was the fact that the US stock market was closed for Thanksgiving holiday, and most Middle Eastern markets were also closed for holiday until the end of the week. This, along with complete lack of communication by the Dubai authorities, added to the investors’ sense of uncertainty.

Having put things in perspective, this week the markets made up most of their earlier losses. The relief was triggered in part by assurances from Sheikh Mohammed, the ruler of Dubai and the prime minister of the United Arab Emirates (UAE). In his first statement since his Government refused to stand behind the debts of Dubai World, Sheikh Mohammed said that foreign markets had overreacted, and that the country's economy was strong.

Positive economic data from America also helped to lift sentiment, after new figures showed that the US manufacturing sector had grown for the fourth month in a row; that construction spending had increased for the first time is six months and that home sales had risen 3.7% between September and October.

This episode is another reminder, as if one was needed after the events of the past 2 years, that financial markets are not always right and, at least in the short-term, are subject to vast overreactions both on the way up and on the way down. It is also a good illustration of how interdependent global financial markets are, and how certain events can have significant unpredictable consequences on seemingly unrelated sectors. Finally, it shows that the recovery from the worst global recession since the Second World War, which is currently underway, is unlikely to be plain sailing.

If you would like to discuss these or any other market-related issues, please contact Michael Ageev on 020 8445 7886.