Risks policy Watch Asia 2011

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By Andrew Marshall and Daniel Magnowski

SINGAPORE (Reuters) – Asia's economies have been crucial engines of global growth as the world crawls out of economic crisis, but the 2011 outlook is clouded by China's growing clout, the volatile situation on the Korean peninsula and corruption scandals in India.

Following is a summary of key risks to watch in 2011:

HOW WILL CHINA USE ITS GEOPOLITICAL AND ECONOMIC CLOUT?

China's sharply strengthening geopolitical and economic influence brings a new set of global risks — how will it manage its growing clout, and its relations with the rest of Asia and the United States? China is the main engine of world economic growth, which means the question of whether its economy is overheating is a global concern.

What to watch:

Currency tension with the United States. Tension between Beijing and Washington over the value of the yuan appears to have receded. But the publication, delayed since October, of a U.S. Treasury report into whether China manipulates its currency may set the tone for relations between the world's biggest economies. Markets will also keep a close eye on President Hu Jintao's visit to the United States in January.How China uses its regional influence. Fallout from a territorial dispute with Japan in September was mainly political rather than economic, though China's apparent freeze on rare earth exports was a key factor in Tokyo's eventual capitulation. Other countries with maritime territorial disputes with Beijing viewed that confrontation with alarm, fearing China's hawkish stance heralds a higher risk of further standoffs that could damage trade and regional economies.Inflation and interest rates. China will set an inflation target in 2011 of 4 percent, higher than this year's 3 percent, an indication that the government will hold back from aggressive monetary tightening even as price pressures mount. But if inflation looks like it will significantly exceed the target, policymakers may raise interest rates sharply.

WILL NORTH KOREA UNLEASH WAR — OR IMPLODE?

Tensions on the Korean peninsula are at their highest in years following the sinking of a South Korean naval vessel in March with the loss of 46 lives and an exchange of artillery fire in November that killed four on a disputed island. With major powers at odds over how to handle the crisis, and secretive North Korea entering a potentially lengthy period of leadership transition, the risks of war on the peninsula or the sudden implosion of the Pyongyang regime are key uncertainties.

What to watch:

The small but serious risk of war. Analysts believe serious conflict to be unlikely. North Korea's ill-equipped armed forces face quick and near-certain defeat if they wage full-scale war, and Pyongyang is well aware of its limitations. But North Korea does have the ability to unleash thousands of artillery shells on Seoul in the early stages of any conflict, devastating South Korean industry, and any conflict would send regional markets into a nosedive. The biggest risk is that a mistake or miscalculation by the North or South during a game of brinkmanship results in an unintended escalation into a war that nobody wants.The leadership succession in the North. The appointment of Kim Jong-un, youngest son of the leader, to key positions confirms he is the chosen successor. Rising with him are Kim Jong-il's sister and her husband, forming a powerful triumvirate ready to take over the family dynasty that has ruled North Korea since its founding after World War Two. But given the parlous economic condition of the country, the ruling elites have an ever-shrinking share of the spoils to divide between them, and there is always the chance of an internal challenge to the regime, particularly from within the military.Signs the Pyongyang regime is imploding. Most analysts regard the chaotic collapse of the regime and the sudden reunification of the Korean peninsula as the most serious risk for markets. Unlike war, which is unlikely, regime change is inevitable sooner or later. The only question is when. Most estimates say it could cost Seoul more than $1 trillion to absorb its impoverished neighbour. Besides the enormous fiscal costs, South Korea would have to deal with the possible influx of millions of refugees and the social upheaval that this would cause. Tensions with China could spike as Beijing tries to protect its interests and influence the future of North Korea which it has used as a buffer against pro-Western states.

IS INDIAN ECONOMIC REFORM FURTHER AWAY THAN EVER?

A series of corruption scandals which broke in 2010, chief among them an alleged scam in the telecoms sector that a government auditor said may have cost India up to $39 billion, look set to dominate Indian business and politics in 2011. Corruption may be a fact of doing business in India, and one factored into investors' calculations, but its impact on government could become deeply damaging for Indian markets. Major risks for investors are twofold: that the corruption issue may continue to paralyse parliament with an emboldened opposition blocking proceedings, or that the scandals result in a less business-friendly policy environment.

What to watch:

Economic reforms stalled. The opposition has shown it can halt the progress of bills through parliament, shouting down debate and forcing the chamber to shut for weeks while it demanded a joint probe into the telecoms scandal. It has vowed to intensify its campaign against the Congress party-led coalition when parliament reopens in 2011, meaning large-scale financial reforms that investors want could well be delayed. Key changes that markets, and especially foreign businesses with an eye on expanding into India, are looking for include recasting the complex tax code to a more investor-friendly goods and services tax, and laws to liberalise the retail sector, keenly anticipated by firms such as Wal-Mart WMT.N .Confrontation between government and business. Prime Minister Manmohan Singh's credibility has taken a big blow from the allegations. In December he attacked corporate India for its "ethical deficit" and the worry is this could mark another step on a path towards confrontation between government and business. India's environment ministry has already shown itself unafraid of clashing with corporate interests as it takes an increasingly aggressive stance in trying to enforce green laws. Investments worth tens of billions of dollars, including a proposed $12 billion steel project by South Korea's POSCO 005490.KS , are up for review, and other firms who have either agreed deals to build factories and industrial plants, or are planning investments, will be wary of the ministry's scrutiny.

WILL POLITICAL RISK BEDEVIL ASIA'S DEVELOPED ECONOMIES?

Uncertainties in two of Asia's two developed economies, Japan and Australia, share a similar root: policy is complicated by their governments' precarious grip on power.

Japanese Prime Minister Naoto Kan's approval rating is around 20 percent and opposition parties can block the passage of laws through parliament. In Australia, Prime Minister Julia Gillard's minority government relies on the support of Green and independent MPs to pass legislation.

In both countries, the chief risk for markets is that administrations become so bogged down in trying to garner day-to-day support, and their leaders preoccupied fighting off internal and external attacks, that they lack the authority or political capital to effectively conduct the business of government, including passing sometimes-unpopular laws.

What to watch:

Next year's budget in Japan. Government action is needed to deal with deep-rooted problems, most pressingly the burden of huge public debt twice the size of the $5 trillion economy. The ruling Democratic Party of Japan (DPJ) has for months been firefighting rather than taking the tough steps economists say are needed to boost growth. A key test will be passing the budget for the fiscal year 2011/2012, which starts in April.Snap election in Japan. If the government, which has already had to reach out to a smaller party in order to get laws through parliament, finds deadlock so great that it cannot pass the budget, Kan may feel compelled to call a snap election. In any case, voters will get the chance to express discontent with the DPJ in April municipal elections. Even if the party performs worse than expected, Kan is unlikely to resign, not least because there are few if any obvious replacements, and yet another new leader — Kan is the country's fifth since 2006 — would not solve its problems.Can Japan enact economic reforms? Experts say raising the 5 percent sales tax is key — a radical idea in a country where the tax has not been increased for years, but one the DPJ has openly broached. Still, with his popularity low and parliamentary power sapped, Kan is unlikely to try to force the issue. In December, the government ordered a 5 percentage point cut in the corporate tax rate starting from April 2011, but analysts doubt the move will boost either Japanese corporate spending or the popularity of the DPJ. Australia's mining tax. The government's centrepiece policy is a proposed new tax regime for the resources firms that have long been the backbone of the Australian economy. After taking office in August, Gillard made a deal with miners Rio Tinto RIO.AX RIO.L , BHP Billiton BHP.AX BLT.L and Xstrata XTA.L to cut the headline rate of the new tax to 30 percent from 40 percent, but the matter is far from settled. Final details of the tax are under discussion between the government and mining firms. Smaller miners are unhappy with the plan, and a dispute over royalty payments could scuttle the deal. The government is expected to present the tax law to parliament in May, and it will be voted upon after June, when it will depend on Green support in both houses of parliament.Resistance to Singapore's $7.9 billion takeover bid for the Australian bourse (ASX), a deal which cannot go through without Australian political backing. No single owner is allowed to hold more than 15 percent of ASX, a rule which would have to be lifted by parliament. Indications are that the independents and Greens oppose the takeover, and may block it. If the buyout does go ahead, firms will be concerned that it may mean changes to listing rules and higher compliance costs.

WILL SOUTHEAST ASIA'S SURGING MARKETS RUN OUT OF STEAM?

Southeast Asia's financial markets were among the world's best performers in 2010. Indonesia led the pack on growing expectations that it will be awarded an investment grade sovereign rating, but the Philippines and Malaysia also posted impressive gains, and even Thailand staged spectacular stock market and currency rallies despite the worst political violence in its modern history in April and May.

The risk is that these gains unravel in 2011 and that the plug is pulled on the flood of hot money that has buoyed the region's markets. Monetary authorities will probably have to play catch up with other Asian central banks that are further into a tightening cycle, food prices could easily get out of hand, foreign participation in the region's markets is already relatively high and rising U.S. Treasury yields could pull money out of places like Indonesia and the Philippines.

Foreign investors have largely turned a blind eye to Southeast Asian political risk in their hunt for high-yield assets. If enthusiasm begins to wane, a more glass-half-empty view of regional politics could spark a significant reversal.

What to watch:

The biggest political risks are in Thailand, where an intractable political conflict remains far from resolution. New general elections must be held by the end of 2011, and given the country's divisions there is a significant risk of unrest during campaigning. If the Puea Thai party backed by fugitive former Prime Minister Thaksin Shinawatra wins enough electoral support to form a government, a coup or judicial intervention to overturn the result is almost inevitable — Thailand's elites remain bitterly opposed to Thaksin and terrified of political reprisals if a party loyal to him wins power. If the Democrat Party of the current prime minister, Abhisit Vejjajiva, manages to win enough seats to form another coalition, the "red shirt" movement demanding change may resort once more to mass street protests. The risks are heightened by the poor health of 83-year-old King Bhumibol Adulyadej. Secret U.S. embassy cables released by WikiLeaks have underlined concerns the succession to Crown Prince Maha Vajiralongkorn will be a tense time with high potential for unrest and upheaval. In Indonesia, President Susilo Bambang Yudhoyono has disappointed many with his failure to decisively promote economic reforms and crack down firmly on corruption. For now, investors see Indonesia's bullish domestic growth story as too good to miss despite the political risk. But a change in sentiment could hit Jakarta markets hard. In Malaysia, the opposition is losing ground and that may embolden Prime Minister Najib Razak to hold early elections in 2011. But a verdict in the sodomy trial of opposition leader Anwar Ibrahim may widen divisions.Early optimism sparked by the election of Philippine President Benigno Aquino is fading. He has yet to show he can challenge entrenched vested interests and crack down on corruption to tackle the fiscal deficit.

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