Montreal, Canada

Over the last several months I’ve been warning about a sovereign nation defaulting on its foreign debt. I’ve also forecast some sort of market dislocation occurring in the emerging markets sphere where “bubbles” in credit, equities and some currencies might trigger a panic.

The weight of loans prior to the peak in this credit cycle in late 2007 was bound to spillover across from the industrialized countries and ultimately had to challenge debt-financing in the emerging markets where Western banks hold significant loan exposure. Western Europe is a major creditor to Central Europe, the Balkans and the Baltic Republics; Spain and to a lesser extent, Portugal, are among the largest creditors to Latin America. At some level, almost every nation is intertwined in the super debt-cycle.

The United Kingdom is the largest creditor to Dubai in the West. As a result, more pressure is likely to afflict some of England’s banks – already mired in a severe capital shortage and for the weakest institutions like RBS, still reliant on the Bank of England for support.

Last Wednesday Dubai surprised the world announcing it would seek to delay payment on billions of dollars of debt issued by conglomerate Dubai World and its main property subsidiary, Nakheel. Estimates peg loans on the verge of default at roughly $80 billion dollars – an amount the Federal Reserve can print before lunch on any given day but a sizable sum for the Arabian emirate and its mostly regional creditors.

Global markets plunged on Thursday while U.S. markets were closed for Thanksgiving. Though stocks and riskier assets declined on Friday when the U.S. reopened, the sell-off was tempered as fears of spillover receded. Dubai is not the Black Swan threatening to unravel recovering credit markets.

Dubai’s debt crisis marks the inflection point for emerging markets where its seemingly miraculous growth story has hit a brick wall following years of massive credit growth to finance a bull market in property.

Ecuador was the last emerging market to default a few years ago but its size was virtually a non-event as it pertained to threatening the financial system; Dubai is a far larger creditor. Argentina was the last significant sovereign issuer to default in 2001. Prior to Argentina, Russia defaulted on its foreign-issued GKO bonds in the summer of 1998 along with a crash in the rouble currency. And in 1997, Thailand triggered a wave of currency devaluations across Asia resulting in a depression for regional markets until 1999.

Dubai’s prospective debt default is another in a long series of blunders in fast-growing emerging markets whereby surging debt levels ultimately resulted in a panic by creditors. The same phenomenon is happening in the West as banks cling to government life support while the populace depends on government fiscal spending to keep the financial system as we know it afloat.

Indeed, the entire gamut of the post-WW II super debt cycle has been unraveling since late 2007 and Dubai’s crisis reminds us that we’re still very much vulnerable to other shocks in the financial system. The greatest credit overshoot in history is far from over.

The price of a $3.5 billion dollar sukuk, or Islamic bond, issued by a subsidiary of Dubai World, tanked to $0.57 cents on the dollar last Friday compared $1.10 on Wednesday. That’s one heck of a haircut for creditors.

Dubai’s troubles are not a shock – entirely. The emirate has been the hottest property “bubble” this decade with well documented real estate construction sprouting across the Arabian enclave as far as the eye can see. Dubai has enjoyed a full-fledged boom in trade, finance and tourism. But the party is over. At the end of the 3rd quarter prices for office space were down 58% from a year earlier. And more office space is set to hit a glutted market by 2011 as surviving projects are completed.

Credit default swaps or CDS’s that measure the cost of protecting against a credit default surged last week for most emerging market countries, including not only the United Arab Emirates but also Hungary, Greece and Turkey among others.

Dubai will survive. Luckily, nearby creditors in the region include oil-rich nations sitting on vast cash surpluses amid a bull market in crude oil this decade. That should help to mitigate any collateral damage across the region. Still, we are left with a feeling of uncertainty that this post-March 9 rally is increasingly vulnerable to other shocks that don’t justify current asset values.

Apparently, the great post-2007 credit unwinding has yet to pass as we shortly conclude 2009.