Blingtastic

This week Dubai, the glitzy debt-fuelled emirate that makes Paris Hilton look short on bling, announced that it is seeking a standstill on repayment of part of the debt of Dubai World, a state holding company. Short on detail, as you might expect, nobody is yet clear what this means or what the details of this postponement will look like. A Machiavellian pot pourri of Madoff-Enron-AIG-subprime conspirators all rolled up into one secretive national entity - that's Dubai's way. Intriguingly the announcement came on the eve of Eid-al-Adha, a national holiday, which marks the end of the Hajj (the annual pilgrimmage to Mecca), so public faces to answer the substantial queries as to when you'll get your money back were thin on the ground. Regardless of whether this was deliberate or not, the news managed to scare the hell out of global markets at the back end of the week.

The scale of the market's response surprised many. Dubai was a big borrower during the boom times, running up debts of at least $80bn - which is a lot of money for a country who's biggest natural resource is sand - but in the global context, however, this is not huge. The nervous reaction of the world's markets shows the continuing fragility of the financial system, and heightened the awareness that sovereign debts can go unpaid just like any other form of debt, especially if the assets backing those debts are as valueless as the ones knocked together in Dubai over the past 15 years.

As I've blogged about before, the financial system remains massively over-leveraged and undercapitalised. Token green shoots are pointed to by the optimists, but the clear picture is that the unprecedented increase in sovereign and sub-sovereign debt over the past 18 months is the new "elephant in the room".

On Thursday the world's financial institutions with exposure to Dubai World were forced, for the first time, to put some real thought into what their level of competence would be in trying to make a creditor claim in the UAE.

Not a lot, was the instant response followed by nervy panic, and a quick acknowledgement that for all their other loans in other jurisdictions the world over, if those over-leveraged bodies decide that they don't want to pay, what would I be able to do about it. Suing a government entity, wherever it happens to be, is always going to be more tricky than suing a private sector institution. Time intensive, costly, and typically futile.

In Dubai's case, thinking through the logistics of making a creditor claim exposes a clear minefield. This emirate doesn't function in any way that is comparable to the economic and legal frameworks in the countries that have lent most of the $80bn. Sheikh Mohammed bin Rashid al-Maktoum, Dubai's autocratic leader has been on a mission to usher in nothing short of an Arab renaissance - albeit one that Liberace rather than Michaelangelo would be proud of. His decisions on any specific matter will easily outrank the decision of whatever legal body a creditor might make a claim through. Ironically, 40% of the inmates at Dubai's main jail are there because it is a prisonable offence to fail to pay back a debt. I suspect that such harsh terms don't apply evenly across the hierarchy that rules Dubai and the rest of the UAE.

Those who have lent to Dubai World, or any of its subsidiaries, seem to have made the assumption - unwritten but widely accepted - that Abu Dhabi would be on hand to pick up the tab if things went amiss. While the UAE is a one country, "united" just like the USA, it appears to be two sets of people in a form of cohabitation. Locally, I'm sure there has been significant resentment from the "big brother" that Dubai has grabbed all international headlines while bringing the worst of western excesses to the region. Dubai is the badly behaved younger brother, and Abu Dhabi like the good older brother wants to get some commitments to change before he steps in to help solve the youngster's troubles.

The question many have raised is what price would Abu Dhabi put on its support? Would it require equity stakes in the better-run Dubai entities? Would it use its financial clout to rein in Dubai to ensure the excesses were not repeated? All of these should be causes for concern for the international bondholders in Dubai World, who have quickly realised that their negotiating position in this particular part of the world is likely to be quite weak.

The reaction of the markets to the situation was probably a symptom of a wider sense that there is a limit to where federal support begins and ends around the world. If California defaults on its debts, will the US government step in to support it, particularly when the federal deficit is so large. In Eastern Europe, where $1.7trillion has been borrowed abroad ($400bn due this year, much of it to eurozone banks), will stronger European nations step-in to help in the event of default? The situation in Dubai has served to highlight that there are no guarantees.