Earlier this month, China’s Economic Information Daily published remarks by a senior Chinese official indicating that Dubai’s debt crisis could be a good opportunity for China to purchase gold and oil assets.

Ji Xiaonan (Chairman of the Supervisory Committee overseeing large state-owned enterprises) was quoted as saying that the Dubai debt crisis “could give China an opportunity to put some of its foreign exchange reserves into gold or oil.”

China is relatively well insulated from the Dubai crisis, as there are no reports of Chinese banks with debt exposure to Dubai. And while there are a few Chinese real estate and construction firms with limited exposure to projects in the Emirates, nothing seems to be grave. Yet Dubai’s issues portend the perception of a looming dollar crisis in the West.

What used to be less than US$ 2 trillion in Fx reserves (above) is now US$2.27 trillion. Much of this is parked in U.S. treasuries. Over the past year, Chinese officials have been pressing to move more of the country’s reserves into hard assets and commodities such as gold and oil.

Yesterday, we picked up the China Youth Daily newspaper in which Ji Xiaonan claimed that “China should increase the amount of gold it holds in reserves to reduce potential losses from a depreciating dollar. We recommend China increase its gold reserves to 6,000 metric tons within three-to-five years and possibly to 10,000 tons in eight to 10 years.”

For those readers that are unfamiliar with the gold market, it bears mentioning that China is the world’s largest gold producer. And according to the China Gold Association, the country may soon break records in supply and demand for gold. In 2007, China overtook South Africa to become the world’s largest producer. And this past July, the World Gold Council said China could surpass India as the world’s largest consumer as well.

Although China recently raised its national gold holdings, it has done so by buying domestically mined gold. China has not shown any interest (yet) in buying from international gold markets. Perhaps as a result of this, shares of Chinese gold mining companies have rocketed this year. Shanghai and Hong Kong-listed shares of companies like Zijin, Shandong Gold and others are up 3x-4x this year alone. But the main factor at play is fear of a U.S. dollar devaluation.

What are the major take-aways?

* People in China are seriously starting to take notice of the fragility of the U.S. dollar and are loading up on commodities.
* Chinese retail investors are also starting to take notice. As an example, there are “gold retail stores” popping up throughout major cities where individuals can buy mini gold bullion. There’s even a China Gold Store located in Beijing Airport’s new Terminal 3.
* Another example is that while it was illegal to buy gold two years ago, Chinese citizens can now go to the bank and purchase “paper gold” certificates. Paper gold is basically the Chinese equivalent of an ETF and is supposedly backed by bullion held at the banks.
* Chinese gold mining stocks are red hot and up 2-4x since last year.
* China has US$2 trillion and is going to start deploying it in overseas mining assets.

For investors, what is the play? Among others, we think there are good opportunities in Toronto listed mining companies, especially those with assets in Latin America (Peru, Chile, Mexico, etc). Why Latin America? Because since last November when the Chinese Central Government put out a Latin America Policy Paper, Chinese firms are tacitly encouraged to go to Latin America. Countries like Peru, Chile and Mexico have stable governments, ample supplies of gold, and favorable mining laws. And a good number of firms with assets in these countries trade in Toronto. We see many of them getting acquired by Chinese mining companies.

While many countries in the Gulf region slipped into recession this year, Qatar has not only avoided the financial crisis but moved straight past it at speed, gaining momentum.

Some eyebrows may have been raised when, at the beginning of the year, the government confidently predicted GDP would rise by around 9% in 2009. However, it appears the predictions were correct, with solid growth across much of the country’s economy being underpinned by a strong performance in the energy sector. The accuracy of this year’s forecast gives additional credence, if any were needed, to the projection that GDP will expand even faster in 2010, with HH The Emir, Sheikh Hamad bin Khalifa Al Thani, saying in November that the economy would grow by 16% in the coming year, having achieved its target for 2009.

This year’s figures make Qatar the fastest-growing economy in the region and indeed the world’s. Its projected rate of expansion for 2010 looks set to ensure this pole position is maintained.

Though GDP is still growing strongly, there is one bugbear for the Qatari economy – inflation. However, this has become less of a problem this year. Having peaked at 15% in 2008, falls in rental costs and of some commodities have seen consumer price rises ease, with year-end projections putting inflation at around 11%.

Meanwhile, Qatar’s financial markets underwent a facelift in June, with the launch of the Qatar Exchange (QE), the successor to the Doha Securities Market. The two shareholders in the new exchange, Qatar Holding and the New York Stock Exchange’s overseas arm Euronext, foresee the QE becoming a leading bourse not only in the Gulf region but internationally.

It is hard to say whether this change had any immediate impact on the exchange’s performance. By late 2009 the QE was moving upwards, clawing back some of the losses of the previous year. While in 2008 there had been a 28% decline in the market’s main index, which fell to its lowest level in four years by December to 6886 points, 2009 has seen a modest recovery, with the index rising to around 7200 points, some 6% up on the year.

This upward movement is more likely to have been a reflection of the overall stability of the Qatari economy, with the financial markets recovering confidence as the underlying strength of the country’s economic base became more apparent after the jitters prompted by the global recession.

At least some of this stability was provided by the government, which moved quickly to plug any gaps in the financial system. In February, the state announced it would acquire Qatari banks’ portfolio of local shares listed on the bourse at their book value in the banks’ accounts at the end of February, while in May it offered to buy the real estate assets of banks at a sale price equivalent to the net value of property loans and investments.

These measures, combined with others taken late in 2008, not only ensured that domestic banks maintained sufficient liquidity levels at crucial times, but that they were in a position to continue lending to the. Estimates put the total value of the government’s commitment to supporting the financial sector at around $5bn.

While some governments sought to mitigate the effects of the global recession by slashing spending to try and compensate for plunging state revenues, others pumped billions into their economy to try and revive them. Working from a position of strength, Qatar fundamentally did neither, maintaining high levels of project investments for the energy sector, along with transport and public services infrastructure as set out in various long-term development plans.

As 2009 draws to a close, the last stages of construction work are being carried out on the gas production facilities, or trains, that will allow Qatar to reach its targeted maximum output of 77m tonnes a year.

Qatar has also improved its ability to generate revenue from its energy industry long after the gas has left the wellhead. Throughout the year, Qatar took delivery of a stream of massive tankers; specially designed to carry locally produced liquid natural gas (LNG) to far-flung destinations. Qatar’s fleet, now the largest dedicated gas tanker operation in the world, with some of the biggest LNG carriers under its flag, means that the country keeps earning from its natural reserves right up to the point of delivery.

With most of the world’s economies expected to return to positive territory in the first half of 2010, and demand for gas draining off any excess of production, Qatar is well placed to ride the wave of its 2009 success into the new year and beyond.

Gold fell for the first time during last week, off 4% on Friday to $1,162.40 an ounce, the biggest drop since Dec. 1, 2008 after the new U.S. jobs data showed unexpected strength.

The Dollar rallied against rival currencies while traders reversed the “Sell Dollar/Buy Gold” strategy. (Fig. 1, click to enlarge)

The Dollar’s decline has been a key factor in the record rising gold price this year by boosting the metal’s appeal as an alternative investment along with other commodities and high-yielding currencies.

Though gold briefly touched a low of $1,136.80 during the Thanksgiving week on fears of a possible debt default in Dubai, the precious metal had otherwise continued its vertical ascent into uncharted territory advancing in 21 of the past 23 sessions.

While gold has some underlying support from central banks and investment funds, there are some indications suggesting gold is moving mostly on momentum, and that a deeper correction may be due.

India Leading the Gold Rush

Gold’s rally in the past couple weeks was largely on speculation that India’s central bank may buy more gold from the IMF adding to the 200 ton purchase it made last month.

This second purchase by India would be the fourth central bank sale this quarter of IMF bullion. The three prior sales were Sri Lanka’s $375 million purchase of 10 metric tons; India’s initial $6.7 billion purchase 200 metric tons, and Mauritius bought 2 tons for $71.7 million.

The three sales so far leave about 190 tons up for grabs from the 403.3 tons the IMF announced Sept. 18 it would divest to shore up its finances.

China, The New King of Gold

Private Chinese gold buying, for both jewelry and investment, will overtake Indian demand this year, predicts metals consultancy Gold Fields Mineral Services (GFMS). China is now the world’s No.1 gold mining nation. The People’s Bank is widely thought to have grown its gold reserves by buying domestic production direct.

In addition, China has cut the import tax on jewelry and allowed select commercial banks to sell gold bars, and gold is now traded freely on the Shanghai Gold Exchange.

Russia & Vietnam Not Far Behind

On Nov. 23, Russia’s central bank announced it had bought 15.6 metric tons of gold in October and has said it aims to increase gold’s share in its reserves this year to keep its investments diverse. The Russian central bank had been steadily building its gold stocks this year, which has been up 17% since Jan. 1 to 606.5 tons.

The Vietnamese central bank has also granted quotas to import 10 tons of gold for use by its banking system and gold traders.

Low Interest Rate with Worthless Paper

Some analysts attribute the most recent rally to the reversal of a decades-long selling of gold by developed economy central banks to net buying by emerging market authorities.

Gold accounts for 9% of reserves held by central banks (valued at market prices). Therefore, it is logical for central banks stocking up on gold as it does bring the much needed diversity due to gold’s low correlation with key currencies and its strong inverse correlation with the US Dollar.

However, diversifying reserves primarily via gold rather than other currencies partly suggests the expectation of interest rates around the world to stay low for a long time. Moreover, it reflects central bankers’ growing distrust of all paper currencies, not just the Dollar.

Surging Derivative Trading

Some of the world’s most successful traders, including John Paulson, David Einhorn, and Paul Tudor Jones, have positions in gold or gold related investments. Pension funds allocate about 5% as protection against the weakening Dollar. Hedge funds and traders are piling into gold futures markets around the world, lured by the record-high prices in the precious metal.

Based on the Commitment of Trader (COT) report as of November 24 by the U.S. Commodity Futures Trading Commission (CFTC), the number of long positions in gold was around 370,000, up about 5,000 from just a week ago, mostly from non-commercial short-term speculative investors.

It is also interesting to note CFTC Nov. 2009 monthly report shows that while commercial participants held net short positions; non-commercial and other participants, who accounted for 51.4% of open interest, held net long positions,. Some traders already indicated there has been some good upside buying in March and April in the $1,300s and even $1,400s.

Overall, NYMEX Gold futures open interest increased 4.8% in November with longs outnumbering the shorts by 71% to 12%. This would have been the highest number of long speculators in the history of the New York gold market since 1975, except for last year when the gold hit $1,030. (Fig. 2, click to enlarge).

High number of speculative positions is the driving force of the commodities rally in general, but that also makes gold vulnerable to further corrections as well as high volatility.

Diminishing Physical Demand

Regardless of the gold fever this year, according to the third quarter 2009 Gold Demand Trends Report from the World Gold Council, demand reached 800.3 tons, representing a drop of 34% year-over-year. The report also found that average gold prices for the quarter were 10% higher than in the same quarter last year.

Diminishing physical demand coupled with higher price suggests it has been mostly speculators that are driving up the price. In addition to central banks using gold to rid Dollar dependency, fund managers and speculators also have been driving up the price of gold, partly seeking protection from potential inflation in a low interest rate environment.

Fear Factor

Gold is a commodity that perception plays a more significant role than other market factors. Almost all other commodities such as crude oil, natural gas, copper, prices often fluctuate on indications of inventory, supply, and demand; whereas gold moves primarily with investor’s fear or perception of inflation, U.S. Dollar and the economy.

But just as fast as the market perception can drive prices straight up, it could tank an asset class in a matter of minutes. As discussed here, investment/speculator demand is clearly a major factor in the current gold price rally, a decline could potentially take the gold price down quite significantly on indications such as rising interest rate, or the U. S. Dollar starts to strengthen.

If history is any indication, after gold rose sharply in 1979-1980 to $850, it was followed by a drop to near $500 in less than 2 months. It is conceivable that gold could take a similar loss in a short time.

Short-term Outlook

The general expectation is that the Federal Reserve will not act in favor of the Dollar until later next year. Gold and Dollar correlation is still highly negative, but one should expect a fair amount of volatility given the uncertainty of global economic direction intensified by the Dubai crisis. In that sense, gold could certainly challenge the $1,225 levels again, with $1080, $1050 and $1025 each represents significant support level.

Technically Overbought

Friday’s pullback has moved gold’s MACD to the downside and the 14-day Relative Strength Index (RSI) back in the neutral territory (Fig. 1), which could spur more selling if Dollar retains its strength.

Though gold’s longest rally (nine days) since 1982 ended last Wednesday, the precious metal is racking up a near 35% gain on the year, and moved up almost 17% this month alone, heading for the sharpest annual increase in two decades.

So, at this level, gold has also run into profit-taking, as well as year-end fund manager’s portfolio repositioning. Closes below the 20-day moving average crossing would likely confirm that a short-term top has been posted.

Long Term Bullish Intact

Sporadic green shoots of economic data could obscure the harsh reality, and lead to gold weakness in the short term. Nevertheless, there’s enough momentum around for gold to make new highs as long as the Dollar stays weak spurring further safe haven demand on concerns about a double dip recession.

Therefore, the potential exists for a large rise in the longer term. However, if this rally extends into uncharted water on momentum without a healthy enough correction, upside targets will be hard to project with the eventual correction equally difficult to predict, just as they say, “The higher you climb, the harder you fall.”

As doubts grow that in the post Dubai word Russia’s central bank will be able to sustain a great deal of momentum in its ongoing programme of interest rate reductions, we learn this week that the pace of expansion in Russia’s economy slowed back in November, following two months of steady advance in September and October.

This time services activity also weakened its advance while manufacturing activity registered its second month of contraction. Yet the central bank may well show increasing restraint in lowering interest rates, even as the economy slows, the ruble rises, and bank retail lending continues to fall, having declined for nine consecutive months up to and including October, while corporate lending dropped for a second month in a row and hasn’t risen for six months (for more on the particular topic see my recent post – Are Russia’s Consumers Getting “Carried Away” With Themselves?).

While the seasonally adjusted VTB Capital Total Activity Index remained in positive territory for the fourth month running in November, the latest figure of 52.8 indicated the weakest rate of growth in three months.

The VTB Capital Monthly GDP Indicator, based on the PMI surveys for both the manufacturing and service sectors, continued to show an annual economic contraction in November, even if the the rate of decline eased for yet another month. At an annual minus 2.5%, down from a revised minus 4.0% in October, the indicator stood at its highest level since December 2008. Over the third quarter as a whole, the GDP Indicator suggested that the economy contracted by a revised 8.7% year-on-year, a better outcome than the record 9.9% fall posted during Q2. Data for the first two months of the final quarter show an average contraction of 3.3%.

The outcome is not surprising when we take into account that November saw an overall deterioration in business conditions in Russian manufacturing for the second month running. Output rose only marginally, while incoming new orders fell for the first time since June. Growth of purchasing activity was maintained, but at a slow pace, while employment continued to fall. Thus the headline seasonally-adjusted Russian Manufacturing PMI remained below the no-change mark of 50.0 for the second month running, and although the November figure of 49.1 indicated only a marginal rate of deterioration, it was still slightly worse one than the 49.6 posted in October. The fall in the PMI primarily reflected slower output growth and falling new orders.

Business conditions in the Russian service sector, on the other hand, continued to improve during the month, albeit at a weaker pace than previously. The easing primarily reflected slower rates of growth in business activity and new business, which both remained well below pre-crisis levels. Meanwhile, inflationary pressures remained subdued, with input prices rising at a relatively weak rate and charges falling slightly for the second month running.

The headline seasonally adjusted Russian Services PMI came in at 53.3, down on the 54.3 registered in October, and well below the historic average of 56.9, highlighting the fragility of the Russian recovery. Restricted credit continued to be a theme in this months survey responses, although sector data pointed to a stronger rise in financial intermediation activity.

The rate at which incoming new business increased slowed during the month and contributed to additional spare capacity at service providers and a faster decline in outstanding business. Backlogs of work have contracted every month since September 2008, and the latest rate of decline was at the most rapid rate since July.

Far from the earthquake unleashed on international markets by Dubai’s request to defer payment of its multi-million dollar debt, the two major stock exchanges in Latin America, Mexico City and Sao Paulo finished November with significant gains in what was the first month world economies began to show signs of recovery after the onset of the global financial crisis.

Mexico and Sao Paulo, ended November with gains of 8.07 % and 8.93 % respectively. Next came Colombia, with a 5.22 % gain, Caracas (5.04%), Montevideo’s IMEBO (1.63%) and Buenos Aires’s MERVAL (1.49%). The only two regional markets without increases were Lima (-0.59%) and Santiago (-1.78%).

On Nov. 26, noted Reuters, global markets tumbled on worries about Dubai’s debt problems and fears that a renewed financial crisis could put an end to the burgeoning recovery.

Regional markets showed a mixed performance during the last week of November. The highest gain, according to EFE, was registered in Colombia with 1.58 % and the greatest loss came in Santiago with a 2.05 percent drop.

A study by Compass Group consultants for La Tercera revealed that shares of several large companies listed on regional stock markets were returning to pre-crisis values.

The market value of 104 companies, linked to 40 of the largest economic groups (in Argentina, Brazil, Chile, Colombia, Mexico and Peru), was only 1.2% below the prices recorded in late 2007, representing a market value approaching US$803 billion. The driving forces of recovery, the report said, were the consumer goods and financial services sectors.

Asked whether the crisis in Dubai could lead investors to reconsider markets such as Latin America, Jaime Sabal, professor of corporate finance in emerging markets at Barcelona’s ESADE business school, told BBC Mundo that it “should have no impact whatsoever.” Sabal continued, “What happens in Dubai is a particular case, related to the real estate sector and should have no impact on other markets.”

Most markets moved higher in the last week but still lost some upward momentum. The big news, of course, was the request by state-owned Dubai World to renegotiate some of its debt payments.

Coming as it did during a thin holiday market – which may not have been a coincidence – the story sparked a brief sell-off in emerging markets equity and debt. Losses were reversed once traders decided this was not the beginning of yet another credit crisis. Anyone who has seen the glittering new construction in Dubai knows it must be highly leveraged, so we are not convinced the story will end happily. For now, however, the worst-case scenarios seem to have been avoided.

The S&P 500 Index continues to flirt with both sides of the 1100 level. The Dow Jones Industrial Average has held above 10,000 for about four weeks now, but there is no guarantee it won’t dip below again. In fact, there is a high probability it will drop back into four-digit territory at some point. As noted above, momentum is slipping in the major benchmarks. Year-end window dressing is well underway for many portfolio managers. Those fortunate enough to be ahead of their benchmarks are not eager to let that edge slip away. For “absolute return” managers this means raising cash, for “relative return” managers it means making your portfolio look more like the S&P 500. We suspect another big move is coming after some consolidation, but we could see more weakness first.

Economic reports still mostly fall into the “not as bad as it was” category. The Federal Reserve’s beige book, released today, suggests the economy is stabilizing and may be improving slightly by some measures. Of course this is the same Fed that created the housing bubble and then failed to see the recession coming, so we are not sure why anyone pays attention to what they think. Reports from the Black Friday/Cyber Monday retail sales frenzy were generally less than impressive. Consumers snapped up the deeply-discounted promotional items but were not enticed into buying higher-margin goods. More ominously, the proportion of sales paid by credit card fell sharply from prior years. Frugality appears to be foremost on consumer minds this year, and that’s not good news for retailers.

The Dubai scare, brief though it was, caused a pop in the U.S. dollar and a dip in Treasury yields, along with a spike in equity volatility. Interest rates headed back up as the new week opened, with the ten-year Treasury ending today just above its 200-day moving average at 3.323%. Banks and institutions that want to go into year-end with “safe” assets on their books are probably behind some of the Treasury purchases. A similar pattern was seen at the end of 2008 but is not quite as pronounced this year. Spot gold prices crossed above $1,200 this week to yet another all-time high. There is no doubt the gold market is frothy, but as yet there is no sign of a breakdown.

Sectors

Materials kept the top sector spot but lost some of its bullish momentum. Health Care moved up to #2, not because of a strong improvement but because other sectors pulled back. Technology slipped from second place to fifth but still looks quite healthy. Energy slid further down the list while Financials displaced Utilities on the bottom

Styles

Our relative Style rankings were mostly unchanged in the last week. A bias toward Large Cap remains in effect, with Mid Cap in the middle of the curve and Small Cap toward the bottom. Micro Caps, still in last place, slipped back into a negative intermediate-term trend.

International

Japan had a huge week, gaining +5.1%, mostly due to a surging Yen. The Yen exchange rate climbed 2.6% in the last five days and has gained more than 6% against the dollar in the last five weeks. Japan has been lagging badly for most of the year but seems to be resuscitating itself lately. Time will tell if the surge is sustainable. On an intermediate-term basis, Latin America is still the strongest region and Japan is still in last place. The U.K. dropped from #2 to #4. Canada made a strong move back into the top half of the chart and could move higher soon.

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

In recent years Emirati investors have played a key role in the development of Algeria’s economy. Encouraged by the country’s increasingly welcoming attitude towards foreign investment, UAE-based companies have channeled investment and resources into a variety of economic sectors.

The visit to Algeria in May of this year by Sultan bin Saeed Al Mansouri, the UAE’s minister of economy, was largely aimed at putting the once-profitable bilateral relationship back in gear. During the event, it was remarked that despite the reduction of capital inflows following the financial crisis, investments from the UAE in Algeria had reached a total of €27.2bn, positioning the UAE as the largest Arab investor in the country. He continued by highlighting industry, agriculture and tourism as sectors with the most potential for joint investments and cooperation in the coming years.

The arrival of the financial crisis dampened the UAE’s involvement in Algeria, with tightening financing conditions in the home country causing various Emirati investment funds to scale down, and in some cases withdraw entirely. Dubai-based developer Emaar Properties, for example, cancelled four major projects, including the construction of a new city in Sidi Abdallah, as well as a health care complex on the western periphery of the capital.

Up until mid-2008, the property sector had been a primary focus of investment for UAE companies, with announcements of multibillion-dollar projects made by various real estate firms, including Emaar, Al Qudra and Emirates International Investment Company (EIIC). This was followed by new investments in the industrial sector by companies such as Dubai-based Emirates Aluminium International, which announced plans to construct of a €5.1bn aluminium plant at Beni Saf in western Algeria, and EIIC, which announced investments in electrical cabling, agriculture and banking.

Emirati investors – in a bid to better buffer themselves against sectoral volatility – are also beginning to diversify their operations in Algeria, expanding their investments into sectors outside of real estate. National Holding (NH), the private Abu-Dhabi holding company that owns EIIC, is one example.

In May this year, the company, which has exclusive investments in Algeria, announced its plans to redesign its global portfolio along five main business lines – EIIC (investments), Bloom (properties), Exeed (industry), Rise (trading) and Petromal (energy).

NH’s activities in the property sector are dominated by two large-scale projects. The most prominent among them is Dounya Park; set to become one of the world’s biggest urban parks measuring up to 800 ha. In addition to almost 630 ha of green space, the project will include high-end commercial and residential complexes, a shopping centre, an international school and a hospital. Works are expected to start before the end of the year in anticipation of the green light from the investment authorities.

The company’s second property investment is Oran Waterfront, a major tourist development in Algeria’s second-largest city. It will include a marina, an aquarium and a sea museum, as well as two five-star hotels, office space and high-end residential units. After officially presenting the project to the regional authorities this month, the company is expecting to submit it to the National Investment Council later this year.

The newly reorganised Exeed has recently broken ground on a cable production facility called Cablet El Djazaïr, which aims to produce an annual total of 45,000 tonnes of copper and 7000 tonnes of aluminium cables for the country’s rapidly expanding electricity network. The plant is expected to be complete over the following 18 to 24 months.

Also, the company is currently in negotiations for the purchase of land to build a large-scale milk farm, Mahassil. The farm, which is the first example of Emirati investment in the agricultural sector, will produce an annual total of 100m litres of milk as well as 3000 tonnes of meat.

Speaking to OBG, Camille Nassar, the CEO of NH Algeria, stated that for Emirati investors the outlook in the Algerian economy is a favourable one. “The opportunities abound, even more so considering the excellent job Algeria has done in the development of its road and maritime infrastructure, social housing as well as its energy sector.” According to Nassar, Algeria will figure as a centre for the company’s expanding North African operations.

Recent changes to the country’s investment laws have put question marks around foreign investors’ confidence in Algeria. However, with the precedent being set by the likes of National Holding, Emirati enthusiasm for investment in the country is hoped to be brought back to pre-crisis levels. Persistence and commitment on the part of foreign investors is likely to be rewarded with a diversified portfolio of high-potential development opportunities.

Bank of America’s tail-risk warning may indeed be precisely the impetus needed for another Abu Dhabi (the emirate of last resort?) -financed bailout.

Though there is some question as to whether the technical defaults of two state-owned firms–Dubai World, an investment firm, and Nakheel, a real-estate subsidiary of Dubai World–necessarily imply the defacto default of the sovereign emirate as a whole in the first place. In fact, argues Gavan Nolan, a research analyst at Markit Group, a financial information services company:

“It should be made clear that the Dubai sovereign is not in any immediate danger of a default. The standstill, if it is mandatory, may constitute a technical default on Nakheel and Dubai World. However, the Dubai government did not make an explicit guarantee on the companies’ debt, and are under no legal obligation to honour the debt. This is clearly the position Dubai’s wealthy sister emirate Abu Dhabi favors. Its actions this week seem to indicate that, while it will support the sovereign, its backing is conditional. The funds are available – Abu Dhabi has immense oil resources and the world’s largest sovereign wealth fund. Indeed, Dubai has already been advanced funds by Abu Dhabi. But it was quite clear that Nakheel and the rest of Dubai World will not be allowed to benefit from the largesse.”

The exact point was trumpeted by Saud Masud, a Dubai-based real estate analyst, in a comment made to Bloomberg:

“Abu Dhabi and Dubai have decided to seek to bolster long-term confidence in the market by forcing weaker parts of government businesses to take responsibility for bad decisions and could involve defaults at some Dubai firms, Masud said.”

Less debatable, however, is the absurdity of the hitherto resulting regional contagion, which immediately drove up the cost of protecting emerging-market sovereign debt against default. Default swap contracts on Abu Dhabi rose 23 basis points to 183, Qatar climbed 17 to 131, Malaysia was up 11 at 104, Saudi Arabia climbed 18 to 108, while Bahrain rose 22.5 to 217. Having said that, one could buy the theory that the Dubai announcement is merely the requisite impetus whereby the ‘risk rally’–which having essentially been on since March seemed destined to eventually taper–unwinds. If the rally does unwind, moreover, frontier and emerging markets, which represent the tail end of the risk curve, would be the first to feel it. Templeton Asset Management Ltd.’s Mark Mobius, for example, said on Friday that Dubai’s attempt to reschedule debt could indeed cause a “correction” in emerging markets.

Yet even a market correction per se should not correlate with a higher sovereign default risk–this is where the current, broad brushstroke of contagion should be arbitraged. Abu Dhabi and Qatar, for instance, remain as resource and reserve rich as ever, objectively speaking. But fund managers clamoring to keep in tact whatever YTD returns they have may be hesitant to brashly step in front of the bus so quickly–suggesting the sudden and drastic point spike may even have some more legs to it. Nevertheless, ultimately, as Silk Invest’s Baldwin Berges reminded investors on Friday, “the major driving forces for the GCC region’s economy are still intact: high reserves, low taxes (competitive advantage) and geographic location. It’s all about perspective, investor sentiment and above all valuation. The medium term investor could be looking at a great opportunity here.” Nolan concurs:

“The sovereign CDS market sometimes has a habit of conflating geographical proximity with economic similarity (eastern Europe earlier this year springs to mind). Unlike Dubai, the countries mentioned above have significant natural resources and their public finances are in better shape. To an extent this has been reflected in CDS spreads for some time (see chart above). It seems that Dubai is something of a special case and its problems are not necessarily found elsewhere.”

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai.

Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe.

So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government’s expressed intention of supporting only viable companies.

More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region – will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World’s $4 billion Nakheel bond was seen by investors as a key test for the emirate’s ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai’s growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan “highlights the government’s intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound on the fear that the Dubai government could be forced into a rapid sale of its international real estate, and since the emirate has extensive UK property holdings which might go under the hammer any such move would clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently such comparisons constitute a fairly bitter blow to Greek pride, but there is a much bigger issue here, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Today financial markets all over the world dropped by 2-3 percent. That is quite a big, taking into account that major financial and economic news during the past few weeks has been quite good. All major investors, economists and decision takers seemed to agree that we were leaving the recession caused by the Global Credit Crisis behind us.

But just as much as the Global Crisis was according to us at LMG a nice example of Overreaction, we’re seeing a new example here! People will never learn! Time after time behavioral tendencies seem to lead markets into some kind of overreaction. Or like that famous German saying: ”Zum Himmelhoch Jauchzend, zum Tode getruebt” (free after Goethe).

Financial journalists explained the 2-3 percent losses in all major Asian and European markets (the US couldn’t give guidance due to the fact that it was also Thanksgiving) by the news that Dubai World had announced that it was incapable of paying off its debts of USD 60 billion. After some quick calculations analysts found out that European banks were holding some USD 40 billion of this debt. But in and of itself it was not ‘new’ news that Dubai was struggling.

A couple of weeks ago it already became clear that new loans from Abu Dhabi were actually necessary to help Dubai pay off older debt and interest. This is such a different story when comparing it with the fantastic news stories seen a couple of years ago in all major magazines and news papers about a new world miracle taking place in the Arab desert. Dubai was a modern Babylon and the construction of the Burj Dubai tower, the highest building in the world, added to this.

The idea that Dubai would be capable in a few years to establish itself as the next major financial center in the world, doing in a few years what had cost countries like Hong Kong and Singapore decades, was the beginning of the overreaction (i.e. the positive side of it). Loads of investors, banks, governments etcetera seemed to forget that trees don’t grow into heaven without paying some kind of price and/or without doing the necessary preparatory work. Trendy Europeans, Americans, movie stars, sports heros all of them tried to get a place under the sun (literally in this case) by buying one of the islands in the extravagant off-coast Palm Island project.

But this type of overreaction was oh so similar to what already had been described by scientists Werner De Bondt and Richard Thaler back in 1985. Exaggeration leads people to pay too much to be part of an allegedly ‘hot market’. That hot market in what in and of itself is a fantastic region in the world – the Middle East – was then caught by the Global Crisis and panicky investors. Property prices in Dubai dropped as much as 60 percent. The city, in the meantime transformed into a mega construction site, switched from being one of the world’s busiest and most entrepreneurial places to one characterized by paralysis. New projects were cancelled and work on existing ones was stopped and postponed.

But OK, this was all already taking place. So let us now – after a good period for Emerging Markets since March of this year – analyze what was going on today. The total debt of Dubai World is $ 60 billion. World markets (ex USA) dropped 2-3 percent. Let’s say 2.5 percent on average. That 2.5 percent is about the size of a market like the Netherlands or Switzerland when looking at global market sizes.

In other words: if Dubai World would go bankrupt completely without its government helping it out one way or another (directly or indirectly through the support of other United Arab Emirate partners like Abu Dhabi, Bahrein, Qatar etc) and this 2.5 percent drop would be ‘correct’ it would have to be similar in size to loosing markets of the size of the Netherlands or Switzerland. However, both are far bigger than the $ 60 billion that is at stake. True, Western banks that are just about to recover from the Global Crisis (helped by their governments) will have to face a new big problem and that could have far-reaching consequences.

But the bottom-line is that the sizes of the Dutch and Swiss economies are about 10-15 times larger than what is at stake here in Dubai. Therefore, by all means markets are overreacting once again.

And don’t forget: the US markets were closed due to Thanksgiving. When observing how European markets move before mid-afternoon vis-a-vis the end of the day we all know that when the US markets don’t provide investors across the globe with their guidance, paralysis and fear are more likely to strike.