So much for BMW’s run-flat tires. Believe it or not, I’m actually sitting on the side of the A3 motorway in central Germany, about halfway between Frankfurt and Munich, waiting for the tow-truck to arrive. 

Apparently you’re supposed to be able to drive on these tires even when they’re flat… and with such confidence in their country’s manufacturing capabilities, the German rental car company didn’t bother providing me with a spare.  Call me old-fashioned, but I’ll take a spare and a jack over run-flat tires any day.

Given what we put this car through, though, it has performed admirably– about 2,500 miles of hard driving in just 4 days at speeds usually exceeding 200 km/h.  You see a lot of interesting things when you spend that kind of time on the road, and one of my observations leads me to believe that we are in for a major shift world finance.

For starters, customs agents across Western Europe are visibly out in force, patrolling the highways and major travel hubs.  Their mission? Generate revenue, coercively if necessary.

In just a single 12-hour period, we were stopped twice in France by government thugs.  Similar to my treatment that I described last week at Helsinki airport, the encounter felt more like an inquisition– where were we driving from, what were we doing there, what do we do for a living, and most importantly, how much money were we carrying…?

They seemed disappointed and skeptical when we said “uh, about 250 euro…” as if two well-dressed gentlemen in a nice sports car were cosmically obliged to be carrying more than 10,000 euro.

They didn’t take our word for it and continued the snooping and inquisition.  If this had happened only one time, I would have written it off as an anomaly. But multiple times within a short period of time is suggestive of a broader agenda.

My business partner Matt had a similar experience before his flight from Chicago to Frankfurt just last week; as he was strolling down the jet bridge to board the plane from the business class entrance, he ran into a squad of customs agents waiting to randomly inspect passengers.

Once again, their chief concern was monetary instruments– How much cash was he carrying?

Customs officials are like feudal lords; they wield supreme power in their little border fiefdoms and have the authority to confiscate whatever they like, for any reason, and then stick you with the onus of proving your innocence.

This is exactly why the government has its people patrolling the airports and highways… low on ‘hope’ and short on ‘real change’, the government has tasked its border enforcement with grabbing as much cash as possible.  It’s sort of like setting up a speed trap in a small town with no economic prospects.

If customs officials believe the amount of money that you are carrying is for suspicious purposes, they have the authority to relieve you of your cash, Constitution be damned. The same standards apply in Europe. In a very literal sense, this amounts to highway robbery.

The standard generally applied is “presumed guilty until proven innocent,” and I think it’s safe to assume that these types of searches and seizures specific to monetary instruments will increase.  More importantly, though, these measures are likely an overture to the eventual implementation of capital controls.

Governments rely on capital controls to regulate the flow of capital through their borders.  In times of crisis begotten by political stupidity, they have an even greater need to keep money on shore to ensure that you’re paying your fair share of somebody else’s mortgage.

The first step in capital controls is to go after cash; it raises money through confiscation and makes people rely more on the banking system out of fear.  The next step is to re-regulate the banking system to make cash transactions more cumbersome and dealing with foreign financial institutions more controlled.

This is already in the works with the recently passed US House of Representatives bill H.R. 4213.

I discussed this trend towards capital controls three-months ago, but frankly I am surprised at how fast things are moving. The time to plant a financial flag overseas is now, and there are a couple of ways to do that.

First, foreign bank and brokerage accounts are a reasonable solution. I’ve mentioned this numerous times in the past, most recently with a discussion about Islamic Banking. I think that Panama, Singapore, Hong Kong, UAE, Malaysia, and Canada are all reasonable places to bank.  There are many more that I will be discussing in the future.

While there are some annual disclosures to file in some countries (like the US), it is completely legal to have a foreign bank account, and I doubt governments will ever change that… they’ll just make it next to impossible to move money.

That’s why the window of opportunity is now.

Second, buying foreign property makes a lot of sense. At present, there are no reporting requirements for foreign real estate, and as we have discussed in the past, you can even move individual retirement savings into foreign land.

More to follow on all of this. Stay tuned.

The ticking time bomb in Dubai finally exploded late last week.

On the eve of their most important Muslim holiday, which happened to coincide with the eve of Thanksgiving in the west, Dubai authorities made two statements spaced a few hours apart.

The first– that the heavily indebted, government-owned flagship holding company Dubai World had successfully raised a few billion dollars.  Investors collectively exhaled, temporarily relieved that the company would be able to make good on its colossal debt payments.

The second statement came only hours later: Dubai World announced that it was asking creditors for a standstill on its outstanding debt… in other words, everything freezes– no more payments.

It’s a real life example of the adage, “If you owe the bank $100K and can’t pay, you have a problem. If you owe the bank $100 million and can’t pay, the bank has a problem.”

In Dubai’s case it’s around $80 billion.

Default and debt restructuring occur all the time, especially in the worst downturn of modern history.  The part that stings investors about Dubai, though, is the utter lack of transparency and potential subterfuge. For months, the emirate has been reassuring investors that it would be able to raise money and make its debt payments. 

Even Dubai’s ruler, Sheikh Mohammed gave worried investors the “talk to the hand” earlier this month, insisting that Dubai World (essentially his personal holding company) would be well capitalized and supported by Abu Dhabi, its rich neighbor.

Just a few weeks later, after months of tap-dancing, Dubai finally pulled back the curtain and confirmed investors’ fears– it had run out of cash. The nonchalant, innocuous way in which it was handled, however, will continue to infuriate investors for a very long time.

The reality is that lack of transparency defines the business culture in the Gulf region. I’ve been doing business and traveling there since 2001, and I can say unequivocally that this sort of behavior is typical. 

In an investment deal, for example, you never actually know where you stand until the moment they write the check. If they’re not interested, they will string you along for months and never actually say “no.”  In some parts of the Gulf, outright lying is considered to be the honorable thing to do.

Thus, it’s not surprising that while Dubai authorities were reassuring investors, local banks were busy raising money, preparing for what they knew was a certain outcome.

First Gulf Bank, for example, closed a $500 million issue for “general corporate purposes” less than a week before the Dubai news broke. Moreover, since September there has been a flurry of fund raising by banks and governments in the region, including the government of Qatar’s $7 billion debt issue this month.

Coincidence? Doubtful. Regional banks and governments likely seized the opportunity to raise cheap money while it was still available, probably with advanced knowledge of Dubai’s timeline. This is simply the way it’s done in the Gulf… and while it seems obtuse, there are some important things to keep in mind:

First, Abu Dhabi Islamic banking institutions are going to be just fine. The vast majority of Dubai exposure is with foreign banks, namely HSBC and RBS. Regardless, UAE’s central bank has indicated that it will support any bank that needs help, including the foreign banks.

Remember that the direct scope of the problem is ‘only’ $80 billion. This is equivalent to about a 2% drop in the Dow.

Abu Dhabi has already sustained losses of $125 billion so far in the financial crisis thanks to bad investments in western financial institutions like Citi. Yet with roughly $1 trillion in reserves and new oil revenue flowing in on a daily basis, this wealthy emirate is hardly breaking a sweat.
 
Dubai’s ruling Sheikh Mohammed, however, is going to have to dig deep to navigate his emirate through the downturn.

Foreign investors will certainly adopt a ‘fool me twice, shame on me’ attitude towards loaning any more money to the Sheikh. And with its credibility and creditworthiness in shambles, Dubai will likely cede its position as the region’s financial hub to Doha and Abu Dhabi.

I wrote about this just last month on October 27th:
—–
In a crunch, many of the companies under direct or indirect control of the ruling family had to go to the main office with hat in hand looking for funds. . . Dubai has become cash poor and its bills are piling up. . .

The price they are paying is great, but between this successful bond sale and the backing of big brother Abu Dhabi, Dubai’s cash flow issues should be solved for the next five years. . .

In the end, though, I think financial constraints prevent Dubai from winning– bruised and battered, it won’t make the final cut… always a contender, never again a champion.
—–

Now this outcome is even more certain. Dubai will recover financially with Abu Dhabi’s help, but investors won’t be able to wash out the sour taste.  Doha and Abu Dhabi will be there, cash in the bank, welcoming them with open arms.

** Lastly, a quick administrative reminder: if you signed up for the Panama Black Paper pre-notification, you will be receiving an email tomorrow with a purchase link.

Long ago, physical commodities were used as a mediums of exchange… gold and silver were quite popular because they were scarce, divisible, durable, and hard to replicate.

If you had a few extra ounces laying around and wanted to store it securely, you would seek out the people who dealt with precious metals all the time and had the right equipment and staff to keep it safe.  At the time, those were goldsmiths.

In exchange for keeping your wealth safe, goldsmiths would charge a fee… and for that fee, you could drop by any time and withdraw some of your gold on demand.

In other cases, if you wouldn’t be needing your gold for a while, you could leave it with him for a fixed period, say 1-year. In this case, the goldsmith would pay you interest on the deposit, knowing that he could loan out the gold to someone in need of capital at a higher rate for the same duration.

It was a simple, admirable system. When you wanted your money, it was there; if you didn’t need it, you could earn a return.

Over time, the system changed. Goldsmiths (turned bankers) began issuing paper notes which were redeemable for the gold that was secured in their vaults. The paper notes circulating around town were ‘as good as gold,’ depending on the bank’s reputation.

Occasionally, a greedy banker would circulate too many notes around town– $100,000 worth of gold in the vault, $110,000 worth of notes circulating around town. The banker got rich, and no one really noticed… until $110,000 became $150,000 became $200,000.

Then suddenly, noticing the spike in money supply, the townspeople would lose confidence in the note and descend on the bank to demand their gold. The banks collapsed and depositors took it on the chin.

Naturally, governments eventually became involved.  They standardized a single paper currency for the country and took charge of securing the nation’s gold reserves.  In the United States, perhaps the greatest change took place in 1913.

After intense Congressional deliberation, Woodrow Wilson signed the Federal Reserve Act into law in December of that year. Aside from creating the United States Federal Reserve, the Act created a regulatory structure for a nationwide fractional reserve banking system.  And from that day forward, every bank in the country became effectively insolvent.

Fractional reserve banking is the practice of loaning out more money than is on deposit. Someone deposits $10 in a bank; the banker keeps $1 in the vault and loans out the other $9. That $9 makes its way through the economy and is eventually deposited in the bank. The banker keeps $0.90 and loans out the other $8.10.

This scheme is repeated over and over again until there is $100 floating around the economy based on a single deposit of $10.  An additional $90 was conjured out of thin air by the bank.

Suppose you went to a storage facility and paid them to secure your furniture… if the facility owners went behind your back and loaned out your kitchen table, this would constitute fraud.  Yet in banking, this is standard practice thanks to the Federal Reserve Act.

The Fed governs the ‘reserve ratio,’ which is the amount of deposits that banks actually have to keep on hand. Depending on the type of deposit, it ranges from 0% to 10%.

The system works when everyone has confidence. When they don’t, banks go under– and that is exactly what is happening right now.  Between balance sheet deterioration and loss of depositor confidence, banks are dropping like flies… but hey, don’t worry, the taxpayers have you covered.

Personally, I want to put my money in a place where the bank will actually hang on to it and no one has to rely on a taxpayer bailout.

One solution that you won’t hear too many people talk about is Islamic Banking.  Based on the ‘Shariah’ principles of Islamic law, Islamic banks in theory must hold 100% of their demand deposits in reserve.

In practice, thanks to creative deals and a bit of leniency from Muslim scholars, the reserve ratio is a bit less than 100% for Islamic banks… but as a whole, their reserves and financial strength are extraordinarily higher than western banks that are on the fractional reserve system.

If you are concerned about what another financial meltdown will do to your bank account, consider opening an account at an Islamic bank. Abu Dhabi Islamic Bank in the UAE is one example– they work with US citizens and even have safety deposit boxes for rent.  ADIB has branches across the country, including in Dubai.

Outside of the Gulf region, Singapore and Malaysia are two up-and-coming Islamic Banking centers that have interesting tax advantages. Malaysia is particularly interesting because of its tax-free Labuan region.  I’ll be discussing this in future letters.

As a final note this afternoon– I know Turkey day is tomorrow in the United States even though it will just be Thursday here in Asia, but I will likely refrain from email for the next two days and talk with you again on Monday.

And don’t forget that next Tuesday will be the 2nd release of the Panama Black Paper– only 25 copies will be sold, so if you want a copy, make sure you sign up to be on our pre-notification list. 12/1/2009 update: We received a lot of feedback from subscribers around the world in ‘inconvenient’ time zones that would be unavailable for the pre-notification launch… I understand this more than most people– 12pm on the east coast is the middle of the night in Sydney. Consequently, we are sending out a public notification on December 1st will keep it open for 24-hours.

Dubai is looking something like Rocky Balboa late in his first fight with Apollo…bruised, battered, struggling to his feet– but still fighting. Of course, if you remember the movie, Rocky didn’t win that fight. He was all heart, no belt. I think the analogy fits.

To be clear, I think Dubai is great… I have done a lot of business there and I enjoy it; it’s fun, safe, diverse, historic, and cosmopolitan. For the right expat, namely internationalists and expeditioners, it is a worthy location… as long as you don’t mind abiding by a few cultural guidelines.

Dubai is one of seven emirates that collectively make up the United Arab Emirates. Each is semi-autonomous– the UAE federal government handles things like the postal system, air traffic control, national immigration issues, foreign affairs, national defense, etc.

All other powers not expressly granted to the federal government are reserved for the individual emirates. Come to think of it, I think I read a similar clause to this once in the US Constitution. Oh well, at least someone is getting some use from it.

Out of the seven emirates, the two that count are Dubai, for its glitzy showmanship, and Abu Dhabi for being the money man.

As for the other ones… well, Sharjah is a fairly important port location, Ajman is where they tried to sell overpriced real estate using Stephen Baldwin as their celebrity poster boy, and the other three emirates don’t even try to get noticed.

The reason for the inequality is a matter of resource rights; Abu Dhabi has the most productive real estate, therefore it gets the majority of the resource wealth. And for most of the last several decades, Abu Dhabi has been patiently saving its money and waiting.

Dubai, on the other hand, took the relative chump change from its own resource wealth and began investing heavily around the turn of the century. The goal was to attract foreign businesses and professionals to create sustainable industries in technology, finance, media, health care, education, and just about everything else you can think of.

Each of these industries became subsidized by the government in some capacity in order to provide foreign companies with a strong incentive. Zero taxes and lax labor laws certainly helped.

Then the government, through quasi-state owned construction companies, started ‘master planning’ by building huge, self-contained mini-cities specifically for each industry– “Internet City”, “Media City”, “Academic City.” Each was designed to have a full suite of commercial, residential, retail, and recreational space.

Initial demand was strong, and for the first few years it looked like the plan was working. By 2006, Dubai was the IT place, and people from all over the world were flocking there to live, work, and invest. It was during this time that the world bubble economy was starting to peak, and Dubai would not be immune.

When the bubble burst, much of Dubai’s financial industry dried up instantly, as did trade. Real estate and retail buckled shortly after. The city turned into a ghost town– even Sheikh Zayed Road, the main ‘thoroughfare’ that was typically a parking lot in the middle of the day looked more like a lonely rural highway.

In a crunch, many of the companies under direct or indirect control of the ruling family had to go to the main office with hat in hand looking for funds.

Needless to say, with a relatively small capital base to start with and an enormous outlay of cash to make the infrastructure investments, Dubai has become cash poor and its bills are piling up. The emirate is now planning on selling 5-year bonds as part of a plan to raise $6.5 billion in order to repay outstanding debt obligations.

Ironically, the bonds are being priced to yield the same as other bonds just a cut above junk status, according to a Bloomberg report. The bond yield’s premium over the mid-swap rate is seven times greater than before the slump, no doubt indicative of the market’s risk appetite, investors’ available cash, and Dubai’s desperation to get the deal done.

The price they are paying is great, but between this successful bond sale and the backing of big brother Abu Dhabi, Dubai’s cash flow issues should be solved for the next five years. This is plenty of time for it to get back on its feet again.

I don’t expect Dubai to rise back to its former, short-lived greatness as the region’s undisputed financial and cultural champion… Abu Dhabi and Doha, Qatar, having both taken copious notes of all the mistakes to avoid, are executing their own ambitious growth plans which trump Dubai.

The three of them will duke it out for regional supremacy, like Hong Kong and Singapore.  In the end, though, I think financial constraints prevent Dubai from winning– bruised and battered, it won’t make the final cut… always a contender, never again a champion.