Bank of America’s tail-risk warning may indeed be precisely the impetus needed for another Abu Dhabi (the emirate of last resort?) -financed bailout, though there is some question as to whether the technical defaults of two state-owned firms–Dubai World, an investment firm, and Nakheel, a real-estate subsidiary of Dubai World–necessarily imply the defacto default of the sovereign emirate as a whole in the first place. In fact, argues Gavan Nolan, a research analyst at Markit Group, a financial information services company:

“It should be made clear that the Dubai sovereign is not in any immediate danger of a default. The standstill, if it is mandatory, may constitute a technical default on Nakheel and Dubai World. However, the Dubai government did not make an explicit guarantee on the companies’ debt, and are under no legal obligation to honour the debt. This is clearly the position Dubai’s wealthy sister emirate Abu Dhabi favors. Its actions this week seem to indicate that, while it will support the sovereign, its backing is conditional. The funds are available – Abu Dhabi has immense oil resources and the world’s largest sovereign wealth fund. Indeed, Dubai has already been advanced funds by Abu Dhabi. But it was quite clear that Nakheel and the rest of Dubai World will not be allowed to benefit from the largesse.”

The exact point was trumpeted by Saud Masud, a Dubai-based real estate analyst, in a comment made to Bloomberg:

“Abu Dhabi and Dubai have decided to seek to bolster long-term confidence in the market by forcing weaker parts of government businesses to take responsibility for bad decisions and could involve defaults at some Dubai firms, Masud said.”

Less debatable, however, is the absurdity of the hitherto resulting regional contagion, which immediately drove up the cost of protecting emerging-market sovereign debt against default. Default swap contracts on Abu Dhabi rose 23 basis points to 183, Qatar climbed 17 to 131, Malaysia was up 11 at 104, Saudi Arabia climbed 18 to 108, while Bahrain rose 22.5 to 217. Having said that, one could buy the theory that the Dubai announcement is merely the requisite impetus whereby the ‘risk rally’–which having essentially been on since March seemed destined to eventually taper–unwinds. If the rally does unwind, moreover, frontier and emerging markets, which represent the tail end of the risk curve, would be the first to feel it. Templeton Asset Management Ltd.’s Mark Mobius, for example, said on Friday that Dubai’s attempt to reschedule debt could indeed cause a “correction” in emerging markets.

Yet even a market correction per se should not correlate with a higher sovereign default risk–this is where the current, broad brushstroke of contagion should be arbitraged. Abu Dhabi and Qatar, for instance, remain as resource and reserve rich as ever, objectively speaking. But fund managers clamoring to keep in tact whatever YTD returns they have may be hesitant to brashly step in front of the bus so quickly–suggesting the sudden and drastic point spike may even have some more legs to it. Nevertheless, ultimately, as Silk Invest’s Baldwin Berges reminded investors on Friday, “the major driving forces for the GCC region’s economy are still intact: high reserves, low taxes (competitive advantage) and geographic location. It’s all about perspective, investor sentiment and above all valuation. The medium term investor could be looking at a great opportunity here.” Nolan concurs:

“The sovereign CDS market sometimes has a habit of conflating geographical proximity with economic similarity (eastern Europe earlier this year springs to mind). Unlike Dubai, the countries mentioned above have significant natural resources and their public finances are in better shape. To an extent this has been reflected in CDS spreads for some time (see chart above). It seems that Dubai is something of a special case and its problems are not necessarily found elsewhere.”

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