Financial markets are still on shaky ground. The debt-default crisis in Dubai has made that obvious. After the collapse of Bear Stearns, the fall of Lehman Brothers, the swindles of Bernard Madoff and other similar episodes, investors are terrified of any asset that has even the slightest hint of being problematic. From now on, sovereign debt, which was until recently considered to be safer than other types of investments, will put some investors on red alert amid concerns that the problems in Dubai, one of the seven emirates of the United Arab Emirates (UAE), will spread to other countries.

What happened "shows that even the biggest ones (investors) fall if they invest carelessly. Dubai has been the King Midas of markets in recent years, and investors have to pay careful attention to both reliability and profitability when it is time to deposit their money”, says Manuel Romera, professor of financial management at IE Business School.

For Mauro F. Guillén director of the Lauder Institute at Wharton, “The problem is that this [crisis] could have a domino effect if markets begin to suspect that other countries can have the same problems. I believe that so long as interest rates are low, not much is going to happen. But when they rise, there are going to be several sovereign [debt] crises.”

Dubai’s financial misfortune came to the fore on Wednesday, November 25. Nakheel, which is the largest property developer in Dubai and a flagship company of Dubai World, the state holding company, sent a letter to its bondholders announcing a moratorium on its payment of $3.5 billion of debt scheduled for May 2010. Panic spread in the market because of fear that a company owned by the government might not be able to pay its investors.

Dubai’s problem is rooted in the piles of debt incurred to finance its growth. The emirate has aimed to become an Arab Monaco, aggressively trying over the past decade to transform itself into a hub for finance and tourism. Lacking the natural resources of its richer neighbor, Abu Dhabi, Dubai borrowed more than $80 billion amid the frenetic construction of its skyscrapers, resorts and shopping centers, which competed with each other in terms of size and luxury.

Lots of Doubts

What effect will the crisis have on the rest of the world? Will it lead to the collapse of a financial system, just like the bankruptcy of Lehman Brothers did in September 2008? Has Dubai burst the public debt bubble that originated in 2008? These were some of the questions that investors posed in the days after the Dubai crisis came to a head.

The first general area of agreement among financial experts is that the crisis should cause relatively little, if any, long-lasting damage beyond the Gulf region. Dubai’s limited financial influence on an international level makes its possible inability to pay its debt less significant. In fact, Dubai World has an estimated debt of $80 billion (and Dubai itself $26 billion), compared with the $619 billion that Lehman Brothers owed when it went bankrupt, leading to the greatest financial crisis since the stock market crash of 1929 in the U.S.

“Dubai is too small an economic player to provoke a catastrophe in the markets for now. Sure, this news is having an impact but it makes no sense [to say] that this is going to set off a real catastrophe,” commented strategists at Saxo Bank, a Danish investment bank, in a research note.

There is another reason Dubai is far from being another Lehman: The emirate of Abu Dhabi – Dubai’s much wealthier neighbor – will most likely step in and help it meet its financial commitments and thus avoid the crisis in confidence that a default (or bankruptcy) would generate. And in a worse-case scenario, international political pressure could be a powerful tool to cajole UAE authorities into dealing with its financial commitments.

Even so, investors continue to have the jitters ever since the Dubai government said it was under no obligations to help investors holding Dubai World’s debt, and insisted that the company’s creditors should take responsibility for their investments. “The company received funds in conjunction with its project schedule, not from government guarantees,” said Abdulrahman al-Saleh, director-general of Dubai’s Department of Finance, on November 30. “Creditors must assume part of the responsibility for their decisions to lend to companies….They deemed Dubai World to be part of the government and this is not true.”

In a new research note, analysts at Exane BNP Paribas, the research division of the French bank, describe two scenarios about the impact the Dubai crisis could have on markets. The first is that it remains a local problem, like the crisis in Iceland in 2008, when that country had to nationalize its biggest banks. “In this case, the damage done to markets would be limited,” write the analysts. But the consequences would be worse if the problems of Dubai spread to the rest of the region. “If that were the case, stock markets would spiral down a long road.”

From Dubai to Dublin?

Beyond the headaches that the financial crisis could create in the Middle East, the real danger for financial markets lies in the public debt that the UAE governments tried to alleviate. On the one hand, experts fear the impact following a rise in interest rates on those portfolios of bonds issued by government-owned banks.

On the other hand, investors are suspicious of withdrawals of assistance to the financial sector that already have an expiration date, given that these entities might be incapable of lending money without the backing of central banks. Greek banks are an example: In recent weeks, their share prices plunged because of their potential fragility if they had to return funds they had received earlier [from] the European Central Bank.

What’s more, the Dubai crisis makes investors consider the possibility that other countries will experience the same problems as the emirate. For example, consider credit default swaps (CDSs), used by investors to both insure against and bet on their debtors – companies or countries – defaulting on loans. Within two days after the Dubai crisis began, the notional value covered by CDSs shout up worldwide.

“This demonstrates that the public debt is not as secure as people believe,” notes Romera. “Vast public sector deficits financed with debt issues cannot go on forever. It is okay if the government comes to the defense of the private sector but not to such an outrageous extent as in the past year.”

The U.K., Japan, France and Switzerland are among the countries that investors are showing the least confidence in. But taking the lead in that respect are Greece and Ireland, where the investor community believe the risks of non-payment of sovereign debt are similar to those in Dubai. “Some emerging countries have a high level of indebtedness, and other developed countries, such as Greece, Italy and even the United Kingdom, could be affected by problems such as those in Dubai,” says Guillén.

The Dubai crisis could have another effect if the emirate is incapable of making its debt payments. In such a case, it would affect the financial sector, which has remained depressed since the subprime mortgage crisis erupted in mid-2007. A report by Credit Suisse calculates that European financial institutions could lose $7.5 billion because of their exposure to Dubai, something that would mean raising provisions for 2010 by 5%. Credit Suisse analysts also estimate that the country most affected by the debt crisis would be the United Kingdom, which has $50 billion of outstanding loans to the region.

Anxiety in the City

British institutions have been catapulted to the top of the list of the UAE’s biggest lenders. HSBC has lent the most money to the region ($17 billion), according to a report by the Emirates Banks Association.

Nevertheless, Lloyd’s is the bank getting battered the most on the stock market because of its exposure to Dubai. Although that bank has granted fewer loans than HSBC has to the UAE, most of the $1.6 billion that Lloyd’s has committed there is concentrated in Dubai.

Other banks with loans to the region include Britain’s Standard Chartered, with $7.7 billion, and Barclays, with $3.5 billion; the Netherlands’ ABN Amro, with $2.2 billion; and France’s BNP Paribas and Calyon, which have jointly lent the UAE $1.9 billion.

Thus, everything indicates that the crisis in Dubai will just be a shock to markets, and therefore will not transcend beyond what this emirate represents for the global economy. "We don’t expect that the events in Dubai (will) have a significant impact on the course of the global economic recovery and the behaviour in emerging economies," says the experts from Oxford Economics in its weekly report on emerging markets.

Still, the events that have occurred in recent weeks have led to mistrust even sovereign states. Now the question in everyone’s mind is who will be next.