Sheikh Makhtoum won't go to debtor's prison, but short of that, Dubai's
all-but-sovereign default is an epochal event in its story. I wrote a
column in Financial Express titled Dubai's great crash
where I draw on this episode to think more clearly about (a)
International financial centres and (b) Puffery. On this subject, also
see Reality catches up with the Gulf's model global city by Roula Khalaf in the Financial Times, and 'The Sheikh's New Clothes?' Dubai's Desert Dream Ends by Stanley Reed in Business Week.

One hears talk about Dubai giving up crown jewels, like the airline, in
exchange for a bailout. I think the time for that bailout was six
months ago. Today, with a funding gap of $80 billion, the crown jewels
are not big enough. But six months ago, it was possible to think of a
deal where ADIA bought up the crown jewels for (say) $40 billion and
Dubai would have tided over the storm. Or maybe this is big, and runs
beyond just the crown jewels: see Enough glitzy debt: time for regime change by Jo Tatchell in The Times.

This episode is an opportunity to think about exchange rate regimes.
What if Dubai had used a floating rate instead of a fixed rate? This
would have worked in two ways. First, it would have been a stabiliser.
When bad times came, capital would have started leaving Dubai, the
exchange rate would have depreciated, thus making real estate or hotel
rooms in Dubai cheaper in the eyes of foreign customers. (Conversely,
in good times, the exchange rate would have appreciated, thus reducing
the attraction of going to Dubai). The key intuition (RBI speechwriters
please note) is that exchange rate fluctuations stabilise the economy.
Without a flexible exchange rate, adjustment in Dubai was forced on to
the labour market, the real estate market, etc., which are all places
where adjustment is more disruptive and is resisted more.

The second interesting feature of this thought experiment is linked to
borrowing. A fixed exchange rate encourages and even subsidises dollar
denominated borrowing. For society, the low cost of borrowing (the USD
interest rate) is paid for by the loss of monetary policy autonomy. If
a flexible exchange rate were used. Mr. Makhtoum would have been more
careful and would have borrowed less.

Source : http://ajayshahblog.blogspot.com/