Dubai's near-default on $36 billion in debt in December 2009 shook the capital markets. The situation grew from an ambitious capital development program that got caught in the global financial crisis. It is a story of exposure and opportunity, the contrasting sides of risk management. Let us examine the original strategy and its outcome.

Position of Dubai

Dubai, United Arab Emirates, is not Abu Dhabi, an emirate with large oil and gas reserves that essentially insulate it from dramatic negative changes in global economics. Three million barrels a day of crude oil allow Abu Dhabi to finance a diversification of the economy that will reduce future reliance on the energy sector. It has the world's largest sovereign wealth fund, estimated at more than $800 billion, and invests money outside the U.A.E. Although Abu Dhabi experienced a decline in real estate values and some adjustments to projects since 2008, the emirate continues substantial spending to build its economy and infrastructure.

Dubai is a different story. It started to diversify earlier. A milestone occurred in Dubai in 1833 with the arrival of the Al Maktoum tribe. It welcomed foreigners and encouraged trade. A big help was the Dubai Creek, a saltwater channel that was one of the few resting places for fishing vessels and dhow sailing ships carrying goods in the region.

In the 20th century, Dubai faced the reality that it should diversify. In the 1960s, the government dredged Dubai Creek and built wharfs to handle cargo ships. In the 1970s, it built Port Rashid, capable of handling the largest container ships in the world. In the 1980s, it built dry docks to maintain or construct large oceangoing vessels. Even today, it is the only such facility in the Arabian Gulf.

The modern vision for Dubai starts in 2002. An aggressive plan was developed based on risky debt financing to change its economy. Leveraged to the hilt, the government adopted a grand vision built upon five pillars—port operations, real estate, tourism, transportation and financial services.

Port operations

Dubai has taken advantage of its location to expand port services to vessels in the region. Jebel Ali is the world's largest man-made port. Established as a free zone, the port houses 5,000 companies from 120 countries, contains 70 berths and is one of the world's 10 largest transshipment ports. Companies and vessels operate free of bureaucratic red tape tying up goods, labor and money. The free zone offers business centers, ready-to-occupy offices, warehouses, factories and a modern infrastructure. One-stop shopping simplifies operations licensing and work permit approval.

Dubai set up Dubai Port World in 2005 to oversee port operations and it quickly became more than a local port operator. It acquired large port operators CSX World Terminals and the Peninsular and Oriental Steam Navigation Co. Today, Dubai Port World operates more than 50 terminals employing 30,000 workers in more than 30 countries and is developing new projects elsewhere.

Real estate

In the real estate sector, the government and private developers financed massive projects, including the world's tallest building, the Burj Khalifa, which opened in January and was renamed from the Burj Dubai to honor the emir of Abu Dhabi who has been supportive amid Dubai's liquidity problems.

Dubai has the tallest hotel, biggest shopping mall, luxury resorts and residences, and entire areas called “cities.” Some projects were over the top. They include offshore islands in the shape of palm trees, 50 islands with luxury villas in an artificial lake and plans for an underwater five-star hotel.

Tourism

The tourism plan was equally bold. It started with shopping and the Dubai Mall, a $20 billion project with 1,200 stores. It includes a three-story aquarium, an ice skating rink that can accommodate 2,000, an indoor amusement park and even an indoor ski slope.

On the future tourism horizon is Dubailand, a project that will create the largest collection of theme parks in the world. When it opens sometime after 2012 and reaches full size, it will be twice as big as Disney World.

The most famous visitor event is the Dubai Shopping Festival, a monthlong event that attracts 3 million shoppers annually. Jazz, film and other festivals are found throughout the year. Sporting highlights include Barclays Dubai Tennis Championship, Dubai Desert Golf Classic and the Dubai 24 Hour Sports Car race. A $4 billion Dubai Sporting City is being built with a 60,000 seat multipurpose outdoor stadium to host world-class sporting venues.

Transportation

You cannot attract tourists without transportation. Dubai solved that problem on two fronts. The first occurred when Gulf Air reduced service to Dubai in the 1980s. Dubai responded by creating Emirates Airlines, which now operates 2,000 flights every week to 90 destinations in 55 countries. The second occurred with the construction of a new airline terminal at Dubai International Airport. It is a modern marvel, handling more than 41 million passengers a year. For passenger traffic, Dubai has the 17th busiest airport in the world. For cargo traffic, it ranks even higher.

Finance

The Dubai International Financial Center completes the vision. As with all of Dubai's free zones, benefits include no taxation on income and profits, 100% foreign ownership of operations, and no restrictions on exchanging currency and repatriating profits. The excellent infrastructure allows Dubai to compete with New York, London and Hong Kong in banking services, placement of equity and debt, trading derivatives, managing financial assets, and even reinsurance and Islamic risk transfer.

Conclusion

The failure to take a risk is a risk itself. For Dubai, the exposure was running out of oil and having no other natural resources. The opportunity was to grasp a near-term window of plentiful, low-cost financing that would develop projects to allow it to become a world-class player in the region. Dubai seized the opportunity and, as often happens when risk is accepted, got caught in a liquidity trap that hurt many organizations and investors.

It is fortunate that the emirs of Abu Dhabi and Dubai are cousins. Abu Dhabi has helped Dubai in the past and stepped up with some $25 billion to rescue its sister state in the current crisis.

We will never know what would have happened without the intervention. The emirate clearly went too far and too fast. Being forced to stop most construction since 2008, accompanied by other serious financial consequences, was costly and unfortunate. But ERM is a two-edged sword. To pursue great opportunity is also to accept significant risk. The emirate borrowed to create assets that would eventually repay the debt, even with a default. Dubai took risks and has a valuable industrial, real estate, tourism, transportation and financial infrastructure. Aside from the pain and lessons learned, this may be the real enterprise risk management story.