Doubts About Dubai

Dubai's boom has long been fueled by the notion that the region's oil economy would one day betray the tiny emirate. With shrinking hydrocarbon revenues now a single-digit percentage of its GDP, diversification into tourism, finance and other services was a no-brainer. Even if oil prices slumped—as they have in recent weeks, to around $75-a-barrel—the city's rapidly multiplying hotels and resorts could still be counted on to attract sun-seekers from Europe and Asia. The result: a supercharged real-estate market that includes some $300 billion in recent projects.

Yet with stocks around the world tumbling and credit markets frozen, Dubai's heavily leveraged building binge is starting to raise concerns. A recent Moody's report found that Dubai's leverage now exceeds its GDP, and is likely to continue to outpace growth for another five years. That makes access to international credit markets particularly important. Unfortunately, loans are hard to come by these days. It doesn't help that Dubai's real-estate prices seem to be cooling somewhat (even if average returns are still in the double-digits). Finally, and perhaps most troubling, slumping world stock markets and rising unemployment are likely to keep non-Gulf tourists at home, just when those revenues are needed most.

Few believe that Dubai is really in danger of defaulting on its debt. It is, of course, only one of seven emirates in the U.A.E.; vastly wealthier Abu Dhabi or other Gulf countries would almost certainly rescue their neighbor in the event of a crisis. In a proactive move, the U.A.E. recently announced plans to guarantee domestic bank deposits for three years and inject some $30 billion into local banks. As for Dubai, any potential rescue would be relatively inexpensive, considering the hundreds of billions of dollars sloshing around in the region's sovereign wealth funds.

Still, with oil and natural gas prices falling, those funds are no longer unlimited. And any intervention close to home in the Gulf could make sovereign-wealth funds even more skittish about investing abroad in foundering U.S. banks, as they did late last year. That could remove an important prop for struggling Wall Street firms. "A lot of these funds invested [last year] and got burned," says David Rubenstein, managing director of The Carlyle Group, who spent much of last week in Dubai. "I don't think any part of the world is immune."

Gulf-watchers began raising eyebrows earlier this month, when two Dubai mortgage lenders, Amlak Finance and Tamweel, announced they were merging. Still, even if Dubai is likely to suffer from the lack of liquidity in the international credit markets, its fundamental problem is of a slightly different nature than the derivative-fueled bust of the American mortgage crisis. "There's virtually no securitization here," says one senior private-equity investor in the U.A.E., who asked not to be named so he could speak more frankly. "Markets are not very evolved here." The problem, instead, is that the speculative construction has been so feverish that banks have overextended themselves. "They just don't have the cash because they've been making these crazy loans," says the investor.

Dubai's building boom is so new that many of those loans are only beginning to be repaid. If tourism slows for any protracted period of time, it could leave developers vulnerable. Take, for example, the emirate's newly opened Atlantis resort, a massive pink structure complete with shark tank and palm-shaped man-made islands. For now it's packed—and not only with oil-rich Gulfies. "You walk around, and the voices you hear are all British and Russian," says Richard Rivlin, author of "Desert Capitalists." Yet "if the Brits are feeling pain in their pocketbooks, they're going to be more worried about making their mortgage payments than going on a weeklong holiday in Dubai."

There is, however, one category of visitor that is still making the cross-Atlantic trek to Dubai. As Wall Street firms have gone bust, "you're starting to see a lot of New York resumes floating around," says the private-equity investor, with more than a hint of schadenfreude. An influx of cash-strapped former masters-of-the-universe isn't exactly the kind of visitor the emirate's economic planners had in mind. But at least there are some people out there who still believe in Dubai's promise.