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Massive credit risks building in emerging markets

SANTA MONICA, Calif. (MarketWatch) -- The emerging markets are usually last in line. When times are good in developed economies, this means prosperity is on its way. In bad times, it means doom and gloom are coming.

Forecasts are for massive credit risks in the emerging markets to be exposed with damaging consequences.

In a Financial Times editorial about developing countries and the perils of a debt hangover, the newspaper reported last weekend, "In Turkey, Brazil and Russia, private-sector credit grew by more than 20% over the 12 months to April. In China it rose by roughly 15%. Between 2007 and 2011, Poland's ratio of private credit to gross domestic product climbed from 32% to 49%."

To be sure, fast credit growth in emerging economies is expected; normal even. The problem as I see it and as the FT points out is how credit is extended: to whom and for what.

"In Brazil, for example, much of it has been used for consumption rather than for building roads and bridges. In China, money has too often flowed to wasteful projects by politically well-connected firms, rather than financing the credit-starved small and medium-sized enterprises," the FT said.

This is the crux of the problem, and solving it would not only prevent a massive credit meltdown -- a la Europe -- from occurring in the emerging markets, it will also foster sustainability. The call to exact reform and to invest in social enterprises in the developing world has never been stronger.

Not only should developing countries take it upon themselves to redirect credit and bring capital to growing businesses that create jobs and strengthen infrastructure, investors in the developed world should be investing in these areas of social impact. Why? A snap back of credit defaults from the emerging markets and ensuing economic calamity could further harm the global economic environment and hamper recovery efforts in the developed world.

Therefore reform must accompany a careful response to the emerging market credit crisis on the horizon.

For many developed countries it's too late to fix credit woes. The emerging markets are different. There is time to redirect capital and support continued growth.

By many accounts November will bring a flood of capital to the markets after the U.S. presidential election is decided. Corporations and individuals are sitting on the sidelines poised to invest, reports say, once America's political direction becomes apparent.

While much of this capital will and should go toward patching up the holes left by the European debt crisis, a big tranche should be put toward small and medium enterprises in the developing world before the halt in credit growth cycle there comes back to haunt us here -- and drags the world economy down again.

Red tape and political considerations, as the FT editorializes, need to be cut in the emerging markets for reform efforts to take hold. As well, corporate governance needs to be embraced.

From the Libor scandal to the credit default bottoming out, the developed world holds many lessons for emerging economies to learn from. The test for them is coming. And there's no room for failure.