The debt woes of Dubai World have rattled equity, bond, derivative and bullion markets. Traders who have breezed through the rally since March have once again found reason to stop and think. The Chicago Board Options Exchange Volatility Index, or VIX, which measures the extent of fears in the financial markets, jumped on Friday. The cost of buying protection with credit default swaps, or CDS, against a Dubai debt default has climbed to 500 basis points, meaning it now costs $500,000 a year to insure every $10 million of Dubai bonds in a portfolio against a debt default.
Illustration: Jayachandran / Mint
Indian authorities, companies and banks quickly moved into damage control mode, assuaging the worst market fears. To be sure, there will be some tremors in India, especially from lower remittances. One-third of the money sent home by overseas Indians comes from West Asia and is an important source of capital to fund India’s current account deficit. Finance minister Pranab Mukherjee on Saturday admitted that remittances could be affected even as he explained that the implosion in Dubai may not have a serious impact on the Indian economy as a whole. Meanwhile, the Kerala government has asked the Centre to offer financial aid to workers returning from West Asia to Kerala, a ridiculous idea but one that does highlight the state government’s fears.
The government’s confidence is realistic. The Indian economy has absorbed far bigger global shocks in the past two years and thus it is very likely that a debt default by Dubai will not directly send the economy reeling.
Yet, the events in Dubai offer us some important lessons about the changing nature of systemic risks in the world economy. The spectre of sovereign debt defaults has grown even as the global banking system has pulled back from the brink and shows signs of fragile stability.
The two are related. Huge amounts of public money —around $3 trillion by some estimates—was used over the past two years to rebuild bombed-out banks and support faltering economies. Growing fiscal deficits have led to an increase in the indebtedness of most governments.
Economists have stayed focused on the long-term risks of higher public debt: either higher inflation or higher taxes a few years down the line.
The Dubai debt crisis points to more immediate risks. Traders have bid up CDS spreads of countries such as Greece, Hungary, Ireland and Malaysia. Dubai’s near-default could embolden bond vigilantes and add further urgency to the raging debate on when countries should exit loose fiscal policies.
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