Pearls of financial wisdom

After a week in which global capitalism seemed on the brink of collapse, it may seem odd to begin with a look at the history of Dubai's pearl fishing industry, but bear with me. There are lessons in that story that the UAE should take to heart as it begins to assess what effects the world financial crisis will be for the Emirates and the wider Gulf region.

In 1929, the pearlers of Dubai were probably at their zenith. The world's aristocrats and millionaires (few billionaires in those days) desired the precious jewels taken from the sea in the Gulf, and were willing to pay top dollar, or more like rupee, to acquire them. Before the discovery of oil, and when income from aircraft landing rights in Dubai Creek and Sharjah was still comparatively small, pearling was the dynamo of the local economy, supporting a whole edifice of commerce and finance, from shipowners to merchants to bankers, that serviced it. Pearling brought in some $3 million (Dh11m) a year for Dubai, easily its biggest single source of revenue.

Two things happened round that time to change the picture irrevocably. The Japanese invented cultured pearls, and the Great Crash of 1929 sent the Western economies into depression from which it took 10 years to recover. The demand for Dubai pearls from wealthy foreign customers dried up virtually overnight, and the pearlers and local industries supporting them collapsed. Dubai entered a period of austerity that lasted until the arrival of oil in the 1960s.

Japanese ingenuity with cultured pearls tells us lots about the power of technological innovation to affect everyday lives; the experience of the Great Depression shows us that, even in the largely unglobalised world of the 1930s, the Gulf was at the mercy of gigantic world economic forces that it was powerless to resist. Its reliance on a single commodity, even one as aesthetically attractive and enduring as the pearl, was its undoing. The Gulf's bankers, financiers and policy-makers should remember the pearl today, as they evaluate their response to the financial convulsions that have emanated from the West, which is believed to be as serious as the cataclysm of 1929.

In the past week alone, the US – the home of free-market capitalism and by far the world's dominant economy – has gone through an unprecedented financial crisis. The bankruptcy of Lehman Brothers, the effective nationalisation of AIG, the forced sale of Merrill Lynch and the seizure of the global money markets have tipped the world towards the brink of financial chaos. This weekend, American financiers and politicians are gathering once again to find a way to pull their economy out of the nosedive, before it hits the ground in a catastrophic collapse.

When the American economy sneezes, the whole world gets influenza, goes the old saying. Well, this week the US had an economic cardiac arrest. It is no surprise that the rest of us are suffering badly. In Europe, Russia and Asia stock markets have plunged, money markets dried up, and governments have taken desperate measures to shore up their teetering economies. Just take the case of beleaguered British Prime Minister Gordon Brown forcing two of the country's biggest banks to merge before one of them went bust, or Russian President Dimitry Medvedev closing the Moscow stock exchange for two consecutive days to halt a firesale of Russian equities.

In these circumstances, it is entirely appropriate for the Gulf authorities to consider how to react to the maelstrom going on around it, and to offer reassurance. As the US showed, panic has its own inexorable momentum, and if the region's rulers can head off initial panic that is an important job done.

They have a convincing argument. Even as the rest of the world lurched towards the current collapse since the credit crisis of summer 2007, the accepted wisdom about the Gulf economies has held that different factors were at work here, which would make the region an oasis of growth and stability amidst the chaos. Fuelled by soaring oil revenues (it was not so long ago that crude was going for $147 a barrel), the region was in the middle of an economic boom, with forecast double-digit growth rates to make China and India envious.

The revenue from oil was not being squandered, but instead was to be spent on infrastructure development and economic diversification. Here, Dubai leads the way, with only around five per cent of economic activity in the emirate coming from oil revenue. The rest revolves around the huge property, leisure, transport and infrastructure developments that have propelled the city into the international imagination. Why should this huge and ambitious project be derailed because some bonus-fixated US bankers made some ill-judged plays on the property market?

In fact, the West's problems could be viewed as an opportunity for Gulf investors. As the value of American and European assets plummeted, Gulf investors could pick up some pretty good bargains, and there were a string of examples of such apparently shrewd deals – buying stakes in the likes of Citigroup, Merrill Lynch and Barclays; real estate and leisure deals in New York and Las Vegas; and industrial link-ups like the deal between Mubadala and GE could all be seen as examples of shrewd "bottom fishing".

Even when the oil price began to slip, the logic was still there. Now crude is below $100, and even Goldman Sachs – the long-term bull of oil markets with its forecasts of $200 a barrel by the end of next year – has pulled back its targets. But the cost of production of a barrel of oil is between $50 and $60, and Gulf governments have assumed a price of nearer $40 when drawing up their budgets. Nobody believes oil will fall to anywhere near that price, so profits from oil are still huge, if reduced.

But as the West's crisis wore on, there emerged worrying signs that the Gulf could not remain immune forever. Stock markets across the region have had a torrid summer, falling some 30 per cent in day after day of depressed trading. Noticeably, the exodus of foreign investors accelerated as Western institutions sought to shore up liquidity in their home markets, rather than leave cash tied up in the Gulf.

This coincided with, and was exacerbated by, some sobering realities about the condition of the real estate market, especially in Dubai. Property has taken the place of oil (and you might suggest, the old pearling industry) in the emirate's economy, accounting for as much as 40 per cent of economic activity. Prices have soared as much as 70 per cent over the past 18 months, and pessimistic forecasts began to flow. When Morgan Stanley suggested there might be a 10 per cent fall in the next 12 months, it further damaged stock markets. Official investigations into alleged abuses in the real estate sector also affected sentiment. With so much of the economic and financial infrastructure involved in property, there is bound to be a knock-on effect for the banking system.

Until last week, Gulf banks seemed to be weathering the storm pretty well. The big investment by sovereign wealth funds in American financial institutions were all "out of the money", but those were long-term investments anyway. Direct exposure to sub-prime or credit-crunch liabilities were small, and even the collapse of Lehman Brothers had little effect on Gulf balance sheets.

As the crisis accelerated in the past few days, this mood has changed for the worse, and many bankers in the region now predict a tightening of credit, both for the consumer and in the intra-bank market. The result will be a smaller mortgage pot to fund property purchases, tougher lease and hire-purchase agreements on consumers goods like cars and electronic goods, and a slowdown in personal consumption, especially in fast-growing Dubai and Abu Dhabi. With project finance tight, some of the UAE's grander developments could be put on hold. And if the bankers' meeting in Washington this weekend cannot do something to revive the world financial system, this slowdown will continue.

In the event of a global recession similar to the 1930s, the Gulf will of course feel the effects from declining world economic activity. Dubai, as a commercial hub and re-export centre, will inevitably face challenges.

But it is in a much better position than most of the rest of the world to meet those challenges. As in the golden days of the pearling trade, the region cannot be immune to world economic catastrophe; but now there are far more precious assets in the Gulf.

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