The collapse of an economy that was built on sand

In the years of the boom, Dubai set about building with an ambition that would have made even Ozymandias blush. Artificial islands full of luxury villas, the world’s tallest tower, an underwater hotel, even a stone-by-stone recreation of the French city of Lyon – no project was too extravagant, some would say vulgar, for the construction magnates of the emirate.

But this was a project built on the shifting sands of credit. Foreign capital poured into Dubai as its ruler, Sheikh Mohammed Bin Rashid Al Maktoum, set about turning his nation into the financial, tourist and sporting hub of the Gulf. In less than a decade, Dubai managed to accumulate foreign liabilities of $80bn. Some estimates put it still higher.

But last year’s financial storm brought that party to an end. Since last autumn, Dubai property prices have fallen by more than half. Hundreds of building projects have been abandoned. Thousands of construction workers and other workers have been laid off. As in many nations that experienced intoxicating booms, the hangover has been especially painful.

And now the spectre of bankruptcy has appeared. Dubai World – a state-owned investment conglomerate which owes investors some $22bn – said this week that it will not be paying back any money to creditors for six months.

This announcement has also sent tremors through global financial markets. Nothing panics investors more that the revelation that what they thought was a safe bet is nothing of the sort. Dubai’s creditors had assumed that the kingdom’s oil-rich neighbouring states in the United Arab Emirates would never allow Dubai to renege on its liabilities.

They had believed the assurances of Sheikh Maktoum that Dubai’s debts would be repaid in full. Dubai’s receipt of a $10bn loan from the UAE central bank in February was seen as a sign that, despite the downturn, the rescue party would soon be on the way. But Dubai’s sovereign guarantee of investors’ money, it would seem, is not made of cast-iron after all.

In the end, it does seem likely that Dubai’s wealthy neighbours will finance its debts. It is not in the interests of any of the Gulf states to allow Dubai to default, since no other nation would invest in the region again after such a breach of trust. However, this week’s announcement might well be a prelude to Dubai’s creditors being forced to accept less back than they were originally promised.

This would constitute only a “technical” default, but its wider economic knock-on effects should not be underestimated. All of Britain’s major banks, from Barclays to the Royal Bank of Scotland, are rumoured to be exposed, to some extent, to Dubai debt. If they are forced to write down loan assets, that could have serious ramifications for our own economy. The weaker the banks, the less inclined they are to lend to domestic businesses.

Such write downs would be ominous for the global economy too. Confidence in credit markets, which has been creeping up since last autumn’s meltdown, is likely to take a fresh pummelling as investors ask themselves where might be next. Those animal spirits that have driven up stock markets this year could yet give way to fear.

Dubai’s boom was one of the gaudy symbols of the era of excess. The torments of the emirate’s creditors in the bust seem likely to determine how traumatic it will be for all of us as we retreat into a more modest age.