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The Sovereign Earning Power and The Economy Layers

This time I will talk about Dubai’s debt case, its development strategy and what lessons we have to learn about sovereign earning power and economy layers to commit smart investments. I will start from the economic development part of the Dubai Strategic Plan (2015), available here, and then will proceed with other aforementioned topics to come up with the logical conclusion.

The very first point to note in the Dubai Strategic Plan is a rapid real GDP growth – Dubai outperformed even such oil-reach countries as Saudi Arabia and Qatar. It seems like a good stuff, but the picture becomes clear when we take a look at the sectoral performance and changes in GDP sector shares. The strategy states: “The service sector has been key driver of economic growth with an annual rate of 21% since 2000, constituting 74% of Dubai’s current GDP in 2005″. The shares of trade, construction and real estate sectors increased 6.7%, 4.1% and 2.3%, respectively, whereas the shares of oil & gas, manufacturing and agriculture sectors decreased 5.3%, 3.0% and 0.3%, respectively.

Dubai is not rich in oil & gas and its future development path comes through the capital-intensive construction sector leveraged by different services: tourism, which heavily depends on successful development of the construction sector; trade, transportation and storage services, which require developed infrastructure and communications system; financial and professional services, which are very distress-eligible, in particular financial services, and I would better designate them as a sort of utilities being used to facilitate cash and capital flows in other sectors of the economy (I rationalized this point in my last articles).

Knowing that, we can scrutinize the sovereign earning power. Obviously, it is mainly driven by the capital-intensive construction sector. The bunch of services supposed to ignite the economy growth engine depends on successful development of the construction sector, infrastructure and communications system. The reliable infrastructure and communications system, as well as attractive, bright and mind-teasing leisure and tourism facilities must be built in order to provide better services: tourism, leisure, transportation and storage.

The construction sector requires a lot of greenbacks, terrain and property development projects are capital-intensive by their very nature and payback period is years and even decades for very specific projects, which Dubai has in abundance. The earning power of services cannot stand against the capital requirements of the construction sector alone. Other capital inflows are required to satisfy its needs and they have come to Dubai as debt. What we have got is the highly leveraged enterprise with distress-eligible earning power, whose cash flows are mainly generated by different services. It might be so-so for a single business. The ground of this sovereign enterprise is very shaky and can become a morass during rainy days, because it does not have the firm bedrock.

The bedrock of the real economy is created by basic materials, industrials, manufacturing and agriculture sectors, where the capital value is created. Different services, utilities and other industries form upper layers, thus securing the economy diversification. As a matter of course, not every economy possesses required resources and territory to form its economic bedrock. But that is why we have invented different financial instruments and foreign direct investments, leave alone different political games.

So, what lessons we have to learn from Dubai’s debt case to commit smart investments in the country of interest. First it is that any economy must have the firm bedrock where the capital value is created. If the economy does not have such bedrock, it is a risky and distress-eligible economy and can be considered as a subordinated or servicing economy, which heavily depends on other firm economies, where the capital value is created.

But the economy development strategy must not be focused on successful development of the bedrock only. It must create the upper layers too – different services, utilities and technological stuff. If the economy is focused on development of its bedrock only, it risks becoming the bedrock for other economies – raw materials economy, where other economies have their equity stake, thus creating their own bedrocks. The balance is a must; the economic landscape must be diversified.

So, the sovereign earning power must be diversified. As smart investors, we must comprehend where the sovereign earning power is generated, before committing any investments in equity or loading the sovereign ship with debt and loans. With regard to the debt, we must understand that if the sovereign earning power is not diversified and it is used to guarantee the corporate debt of companies, whose earning power is limited to the same sources, then such guarantee is not worth a scrap. The same is true when the sovereign ship is overloaded with debt, which is a case for the developed economies.

Thus, to commit smart investments we must pay attention to three key factors: sovereign earning power, sovereign debt level and what layers the economy has – sovereign diversification. Finally, as smart investors, we have to watch for shock events in the system and in different economies. We have to learn to benefit by any event, no matter good or bad. That is where we have to learn to turn any bad event into a good one with our knowledge and common sense. That is what means to be the smart investor.