EFFECTS OF DUBAI DEFAULTS ON ISLAMIC FINANCE INDUSTRY

The financial tsunami has finally struck the coast of the Arab Gulf, after it managed to avoid this for more than one year, to the point that many believed that the region had emerged from the crisis without suffering any losses. However the world, and the Gulf States, woke up last Wednesday following the closure of the Dubai markets to the news that Dubai World had requested a six-month halt to debt payments that amount to around $3.5 billion, and this is in the framework of restructuring the company's debts that total around $59 billion.

Dubai was poised to become the financial centre for the Islamic banking industry, and a gateway for Islamic banking in the Middle East, as due to Dubai's position, the Gulf region was able for the first time in 2007 to surpass Malaysia in the issuance of Sukuk. Dubai also sought to make the Dubai International Financial Centre [DIFC] the centre for Islamic finance as well, and last year DIFC sought to make Dubai Gold Securities compatible with the provisions of Shariah, which was through cooperation between the World Gold Council, and Dubai Multi Commodities Centre.

It seems that the endeavour to turn Dubai into a centre for Islamic banking will be strongly affected by the results of the financial crisis that Dubai is suffering from today, and which is due to Dubai World and Nakheel Properties’ inability to pay their debts. This news shook Dubai's financial credibility, and raised many questions over Dubai's financial transparency, as many investors and creditors had received assurances over the past month from officials that Dubai would be able to meet its financial obligations.

Let us see the issues at hand :

a) There could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World. Most of those are either UAE-related or European banks

b) Secondary aftershocks too would be entities similar to Dubai — other places in the world that have borrowed a lot Thus many emerging markets are getting hit in this mini-crisis by rising borrowing costs.

c) More borrowing to solve the Dubai crisis makes another one more likely.

d) Risk that an isolated default can spread then rises, as an increasingly leveraged financial system comes more and more to resemble a massive arrangement of dominoes. The more leverage on any entity, the taller that domino. The more leverage in the system, the more tightly the dominoes are spaced. That arrangement collapses when someone knocks over a key domino.

One fact remains - A default by Dubai will put the world of Islamic finance to the test at a time when hard questions are being asked by bankers and lawyers about the protection afforded by financial instruments based on Shariah.