So investors in quasi-sovereigns are likely to demand a higher risk premium. Analysts at the Royal Bank of Scotland suggest rating agencies may review assumptions on sovereign support, potentially bringing a wave of downgrades. In that case, the effects could be felt far and wide, from Russia’s “Kremlin Inc” companies such as Gazprom and Russian Railways, to South African or Israeli utilities. Borrowing costs will rise, at an awkward time for quasi-sovereign borrowers. For investors, Dubai is a reminder of the need for careful homework. And that if bonds offer a higher yield than sovereign debt, there is good reason.
Another issue is the way that uncertainty over backing for the debt encourages over-investment. This can also be seen in the case of Fannie Mae and Freddie Mac. If investors are able to convince themselves that there is state backing, the return looks very attractive and money flows into, encouraging additional bond issuance. The small risk premium remains due to the uncertainty, but this is not sufficient to compensate for the real risk. These developments, as has been the case in the US housing market and is now likely to be the case in Dubai, will lead to reduced investment in the likes of those entities that have been identified by the FT column.