Systematic Relative Strength

Dubai is contending that it is not responsible for the debts of Dubai World, claiming that the Dubai World company is not part of the government.  Bondholders, in other words, are on their own.  Many buyers apparently felt that Dubai World was a safe bet since it is 100% owned by the government of Dubai.

This script is pretty much in line with what Ken Rogoff and Niall Ferguson suggested in an interview posted earlier to this blog.  When debt is denominated in your own currency and a lot of it is owned domestically, the government is more likely to inflate when they can no longer afford to pay the debt.  When debt is denominated in another currency and mostly owned by foreign investors, the government is more likely to default when they can’t pay it off comfortably.  Dubai World borrowed mostly in dollars and mostly from European banks.  They can get away with default because their domestic investors don’t own the paper. 

On the other hand, default always has consequences.  Although Dubai World may be resigned to letting the European banks yell at them right now, I suspect that those same banks won’t be extending any more credit to them—something that Dubai may find a little more troublesome down the road.

It’s a safe bet that most Americans could not locate Dubai on a map, yet our stock market sold off pretty hard the day after the Thanksgiving holiday because of worries about emerging market debt.  Welcome to globalization!  Financial markets are now global, money flows freely and electronically between them, and money will always go where it is treated best.  Investment survival in the new world will require a systematic way to allocate capital to the best global opportunities at any given time.  Global tactical asset allocation will become a necessity.