The panic associated with the financial difficulties of Dubai’s government-controlled Dubai World is having ripple effects into commodities, developing countries, and other markets.  Such contagion seems to have become commonplace now, as the short-run interests of traders in worldwide markets are matched against the interests of long-run investors.  Predictably, the call is going out from Dubai for support from the United Arab Emirates.  Most likely that support will be supplied once the internal politics have been worked out.  Reputation risk, especially when solvency is at issue, is even more important when it comes to government sponsored firms than for subsidiaries and affiliates of private companies.

Will the spillover effects require action in the U.S. by the Federal Reserve?  The answer is, not likely.  US financial institutions are not exposed to Dubai to the significant extent that European institutions are.  Furthermore, discount-window and other borrowing facilities are already in place, should liquidity be needed.  Since the dollar is benefiting temporarily from this crisis, reversing its recent declines, there is no likelihood of or need for a currency intervention by US authorities.

Short-term, there is a movement away from the Middle East, but that is not likely to carry with it negative spillovers to Asian markets whose fundamentals haven’t changed.  Developing-market contagion is not the problem it was during the Asian crisis.  Markets now have a much better idea about the relative strengths and weaknesses of developing countries and don’t treat them as a group, as was the case in the past.  Given the extremely large credit exposures of UK and European banks to Dubai, their stocks are likely to take a hit until more progress is made on credit-risk transparency and loss recognition.  An interesting commodity-currency play suggests itself, since oil sales will likely be the source of funds to support credit losses in Middle East institutions, combined with an appreciation of the dollar relative to the euro.

Longer-term, US fundamentals haven’t changed, and the dollar is likely to continue to drift downward relative to other currencies.  Asian economies haven’t changed either.  The big effects will be on fund flows to investments in those Middle Eastern countries where excessive spending, combined with unfavorable demographics and government policies, imply a substantial increase in risk.