Market Talk

Dubai’s s debt crisis has been the topic du jour as a global selloff followed news that Dubai asked for a “standstill” on its debt payments. WSJ’s Heard on the Street columnist Simon Nixon says the reaction isn’t surprising, considering the Dubai government announced the news ahead of a four-day holiday weekend.

Still, he believes markets are severely over-reacting to the news as there’s Dubai’s problems aren’t large enough in scope to threaten the global financial system. From Nixon:

At this stage, however, the risk of contagion is small. Most at risk would be neighboring Middle Eastern markets where there has been no shortage of similarly reckless spending. Dubai’s neighbors are also among its biggest creditors. But unlike Dubai, the other Gulf states have vast oil wealth, making it unlikely they will lose access to funding.

But so long as central banks continue to pump extraordinary liquidity into the system, the markets should be able to accommodate local shocks. With interest rates low and signs of recovery around the world, that liquidity will continue to find its way into risky assets. The real risk will come in 2010, as the liquidity starts to be withdrawn and the full scale of government deficit problems become apparent. At that point, risk premia may start to rise, leading to higher interest rates and the dreaded “double dip,” forcing a new wave of losses. Dubai has provided a necessary wake-up call to frothy markets currently pricing in a robust recovery. But the greater systemic risks are likely to lie elsewhere.

Still, the cost of insuring Dubai’s debt continues to soar, although Bespoke Investment Group notes the cost hasn’t exceeded full-year highs achieved in February.

The news is getting more attention this time around because it’s an isolated event on the Friday after Thanksgiving, a day in which Wall Street trading is typically thin.

But back in February, “default risk was spiking for the majority of developed nations as well, so Dubai was the least of our problems,” Bespoke says. “Now that global markets have stabilized and exited crisis mode, an isolated event in Dubai where default risk doesn’t even spike to its 2009 highs has caused a global market selloff.”

Paul Krugman says there are three possibilities that exist for the next stage of the financial crisis in the aftermath of this Dubai debt crisis. Some believe this may be the beginning of many sovereign defaults, “and we’re now seeing the end of the ability of governments to use deficit spending to fight the slump,” Krugman notes. Others think this is just another commercial real estate bust, while some view it as merely a unique event.

“At the moment, I’m leaning to a combination of two and three,” he says. “We continue to live in interesting times.”

Dow industrials, which were down as much as 233 in earlier trading, closed down 154 at 10310, down about eight points on the week.