Deciphering the financial links between the Emirates

Abu Dhabi has achieved its financial rating through a cautious outlook towards intervention in the fiscal affairs of other Emirates. It will probably continue to do so.

A Dubai construction site is seen behind the flag of the UAE, the emirate has seen rapid development in recent years.

Abu Dhabi's considered and, so far, indirect financial support for Dubai is in line with a Fitch Ratings understanding of the emirate's attitude towards support. A conservative attitude helps underpin Abu Dhabi's foreign currency long-term rating of "AA/Stable". Fitch expects the emirate to preserve its own balance sheet strength and avoid actions that could jeopardise its creditworthiness, while at the same time intervening selectively to preserve the stability of the UAE if needed.

The Abu Dhabi rating could come under pressure only if the problems of Dubai spread to the UAE as a whole and triggered a systemic banking crisis, including major capital flight. That would require heavy support from the Federal Government and Abu Dhabi authorities. Fitch considers such a scenario as very unlikely. Abu Dhabi has stated that although it has no legal obligation to do so, it might provide financial support to other emirates if they were faced with difficulties that threatened the reputation or economic health of Abu Dhabi, or the UAE.

Abu Dhabi is under no legal obligation to support other emirates and if support were requested, it would be provided on a case-by-case basis. Given the close links between Abu Dhabi and the Federal Government, Fitch regards federal debt as a contingent liability, while the debt of emirates including Dubai is a potential liability. Fitch's understanding of Abu Dhabi's attitude to support within the federation has so far been borne out by events. To the agency's knowledge, Abu Dhabi has made no direct bilateral transfer to Dubai. Support has so far been indirect, confined to the US$5 billion (Dh18.36bn) subscribed by two Abu Dhabi Government-owned banks to the Dubai bond offer on November 25, immediately before the Dubai World debt standstill announcement.

The Central Bank subscribed to the initial $10bn Dubai bond issue last March, the proceeds of which went to the Dubai Financial Support Fund. Fitch believes the first clarification of Dubai's direct sovereign obligations in October may have made it easier for Abu Dhabi to contemplate direct support for those obligations. Dubai's direct sovereign obligations now amount to $20.3bn equivalent, none of which come due until 2011. By contrast, direct unconditional support for the much larger and more uncertain liabilities of Dubai-owned entities has clearly been ruled out.

Abu Dhabi's economic development, like Dubai's, is being carried forward by state-owned companies. International Petroleum Investment Corp (IPIC) is charged with investing in energy distribution and refining. The Tourism Development and Investment Corp (TDIC) is responsible for developing tourism projects integral to Abu Dhabi's development strategy. Mubadala Development is investing at home and abroad to develop partnerships that will help diversify the local economy.

Those companies have been prolific borrowers on international markets, especially this year, when they raised $9bn in bonds and loans. Even so, Abu Dhabi's total public sector debt is estimated by Fitch at just $24.1bn. Only $4bn is directly sovereign and the rest is the debt of 100 per cent government-owned entities. That is equivalent to 17 per cent of GDP compared with sovereign external assets of more than 200 per cent of GDP.

Fitch has rated each of those companies at the same level as the sovereign. While Abu Dhabi has not issued guarantees to any of them, it has delineated much more clearly than Dubai which entities it considers as "core". Mubadala, IPIC and TDIC receive direct and ongoing transfers and capital infusions from the Abu Dhabi Government. The Dubai World restructuring is a major about-face relative to the implicit support that had previously been assumed for government-related entities. Although Dubai may have been willing to support its state-owned enterprises at the outset of its debt problems, in practice it was unable to do so given its limited budgetary resources, even after supplementation by the Dubai Financial Support Fund. By contrast, Abu Dhabi has one of the strongest balance sheets of any sovereign rated by Fitch.

When Abu Dhabi's rating was first assigned in 2007, its balance sheet was subject to a combined stress of low oil prices and investment losses very similar to what occurred at the end of last year and early this year. The scale of investment losses on the 2008 portfolio of its main sovereign wealth fund, the Abu Dhabi Investment Authority (ADIA), about 20 per cent of its holdings (since reduced by the subsequent recovery in global stock markets), is much larger than the costs of most conceivable UAE financial crisis scenarios.

The Abu Dhabi Government confirmed to Fitch that ADIA held external assets equivalent to at least 200 per cent of last year's GDP. At an average oil price of $60 a barrel this year, Fitch expects Abu Dhabi to run a fiscal surplus of $16bn, or 15 per cent of GDP. That excludes the dividend of the state-owned oil company ADNOC, which if included would boost the budget surplus substantially. The banking system is relatively large, with private credit equivalent to 83 per cent of GDP at the end of 2008. External liabilities, which have been declining, were $71bn last June. Net external liabilities have also fallen and are now just $15.4bn.

Non-performing loans (NPLs) are rising and may be understated, but currently average just more than 2 per cent for the banks that Fitch rates, with a range of between 1 to 4 per cent. The Dubai World restructuring will probably lead to additional loan impairments. However, the direct exposures of most banks rated by Fitch to Dubai World are relatively limited and the problem, if confined to Dubai World and related entities, should be manageable for the system as a whole.

Fitch calculates that UAE system-wide NPLs would have to reach about 10 per cent before banks in aggregate would breach the 12 per cent minimum Tier 1 capital ratio set by the Ministry of Finance as a condition for access to its Dh70bn liquidity support facility. The regulatory core Tier 1 ratio is a less demanding 8 per cent. In practice, some banks would breach the minimum capital threshold before the general level of NPLs reached 10 per cent.

Fitch placed the individual ratings of four Dubai-based banks on "rating watch negative" on Thursday December 3 due to the agency's belief that they have significant exposure to Dubai World and other Dubai Government-related entities. A major loss of confidence in the banking system, an event which could prove costly for Abu Dhabi, appears very unlikely at this stage. Foreigners remain willing to lend to UAE banks, and investor and depositor confidence in the banks is underpinned by a three-year Federal Government deposit guarantee put in place in October last year. The Central Bank has recently stepped in to expand its offer of short-term lending.

Were UAE banks to incur large losses, some would need extra capital to meet the regulatory minimum. However, current capitalisation levels provide a large cushion for the system as a whole, before widespread capital infusions from the Government or Emirates authorities are required. Richard Fox is the head of Middle East and Africa sovereign ratings for Fitch Ratings