Is it (iron) curtains for Europe?

Today is the first day of the Abu Dhabi Economic Forum, but the focus should be on the giant catastrophe unfolding in Eastern Europe. The EU, in an emergency summit, has rejected a broad bailout of its beleaguered right flank despite concerns that the mess could put the Euro and even the very European Union in jeopardy. Instead, it hopes to handle the mess on a country-by-country basis, which is exactly the kind of piecemeal response that has kept policymakers behind the ball on this crisis since the first subprime US borrower went belly-up in the fall of 2007. The EU has a responsibility to help out its beleaguered new members, the Baltics, Bulgaria, the Czech Republic, Hungary, Poland,Romania, Slovenia, and Slovakia. Ukraine, where thousands are being laid off and the government appears on the verge of default, is apparently the IMF's continued problem. The bill for the others could be crippling, especially as older EU members such as Ireland and Greece are in no better shape. Banks in Italy and Austria are especially exposed to the rot from the East. So now the ECB is finally edging rates lower as Jean-Claude Trichet studies the Fed's playbook of unconventional measures. This should serve as a cautionary tale for the GCC as its members consider closer monetary and economic union. As the old saying go, any chain is only as strong as its weakest link. Would Saudi Arabia come to the rescue of, say, Oman or Bahrain, in such a time of crisis? Would Omanand Bahrain want that kind of rescue? Or would it prove as politically touchy as even efforts within the UAE to help out one of its own members? In the meantime, former OPEC Secretary General Dr Adnan Shihab Eldin is warning that the GCC could face a recession as the global economic crisis spreads. The problem for the UAE is that it more closely resembles Hungary and, in particular Russia, than Slovenia. While Slovenia bankrolled its economic development after the fall of the Iron Curtain with foreign direct investment, the UAE did so by borrowing against the perceived value of its principal natural resource export, oil. Had the UAE done the former instead of the latter, it might have been faced with overcapacity in manufacturing, a much more manageable problem than a collapsing property bubble. As the Economist points out this week, companies cannot easily dig up their high-tech manufacturing plants. The equipment, the investment and the knowhow that came with them tend to stay put. Loans, on the other hand, get called. Or they don't get refinanced. The lessons are the same: reform, reform, reform. Don't wait until the waters are around your neck to build a levee. More must be done to shore up banks in places like Ajman and Dubai. The guarantees on bank deposits are proving providential. And the peg makes a currency crisis unlikely; the addition of worker remittances to the outflow of investor capital could put pressure on the real exchange rate. We have no real-time sense of where Central Bank reserves stand after the purchase of Dubai's $10 billion in bonds. Presumably there is still plenty in the till. But as Malaysia, Thailand and now Russia have demonstrated, the only way to defend a fixed exchange rate in the face of massive capital outflows is to either waste billions of dollars in a vain attempt to strong-arm the market or to impose controls on the flow of capital. Were the peg scrapped, it would be devastating for those who have borrowed heavily offshore in dollars and Euros, such as Dubai, but good for the UAE overall, helping it better absorb the shock of falling oil prices, making its other exported services, such as hotel rooms and financial services, relatively cheap and attracting foreign investment. Inflation may be falling, it is true, but the real risk now is deflation. A devaluation would help stave off that possibility. Now that the federal government is backstopping Dubai's foreign debt with its own dollar reserves (that $10 billion bond issue was in US dollar, note, not in dirham) it may open the way for a devaluation of the dirham. With Dubai's debt safely insulated, a lower dirham would help resuscitate property investment and tourism. [e-mail]