There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s 
ongoing quest to develop advanced nuclear technologies.

These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).

Political risks have historically mattered much more in emerging markets, but political risk in the developed, industrial democracies is rising more quickly than anyone would have predicted a year ago.

Europe

Political-market risk in emerging Europe is significantly higher now than any time in the past decade. Russia and Ukraine, and even recent star “emerging Europe” performers such as Turkey, Hungary, and Romania face serious vulnerabilities in the coming 
year. In addition, western financial institutions based in countries
 like Germany, Italy and Austria are particularly vulnerable to a credit 
crisis in Eastern Europe, where they have large loan exposures. Russia’s growing anti-westernism, its state intervention in strategic
 economic sectors, and its assertive posture regarding Georgia have been widely discussed, and will remain concerns in
 2009.

This also plays into one of the most problematic country risk 
stories right now: Ukraine. Its steel-centric economy is in free
 fall due to dramatically reduced global demand, many of its companies
 have large foreign debt financing needs that they will struggle to meet, 
 and its domestic politics are gridlocked and bordering on 
dysfunctional.

Add serious ongoing tensions with Russia to the list, and 
the situation looks bad from almost every angle. The year has
 already started badly, with Gazprom cutting gas supplies 
to Ukraine, and the
 standoff highlights the growing animosity between Moscow and Kiev.

The global financial and credit crises, combined with recession in
 Western Europe, have exposed several other countries in emerging Europe 
to serious financial market risks. In Hungary, the IMF and the 
EU needed to step in with a dramatic aid package in order to head off a potential currency and bond market collapse. And in Romania, there are
 growing concerns about a real estate bubble, rapidly declining economic
 growth, and the evaporation of repatriation cash flows from Romanians 
living in Italy and Spain.

Both the Hungary and Romania stories highlight the increasing 
interconnectedness of political and market risk in the EU. The newer
 member states can no longer be considered in relative isolation from the
 core, Western European countries.

The most notable example is the 
exposure of Western banks to credit risk in Eastern Europe. In recent
 years western banks have made substantial home mortgage, consumer, and
 business loans to eastern Europeans that were denominated in western 
currencies. The borrowers were
 exposed to local currency risks that the often did not fully understand
.

Italy, 
 Austria, and Germany had the largest exposures. Now these western
 governments may need to step in to assist with the solution. In fact, if
 the EU and European Central Bank had not intervened in dramatic fashion 
in Hungary, a number of western-European banks and pension funds would
 have been in very serious trouble. The problem is that this may only be 
the beginning of a crisis that could involve dozens of countries in both 
the East and the West.

The U.S. and Multilateralism

In the past several years the dynamics of “multilateralism” have evolved 
fairly dramatically. Two central developments this year:

1.  A number of
 additional players such as India, China, and Brazil are actively
 seeking to play a larger role in multilateral negotiations and 
institutions.

2.  The U.S. is in the process of a presidential 
leadership transition, with an expectation that the new administration
 will address these issues differently than its predecessor.

This new environment presents both challenges and opportunities. A 
larger number of “key” players at the table means that policy 
coordination could be much more difficult - a classic collective action
 problem. At the same time, engaging newer, emerging-market countries may 
make sustainable “breakthrough” outcomes more plausible, as these 
countries will be central to tackling complex issues such as climate 
change and global trade.

Prior to September of 2008, the central challenges of 
multilateral cooperation were in areas such as energy/climate change, 
 trade, and security. Then the global financial and credit crisis offered 
an almost perfect experiment. How would the world’s leading 
countries, along with those who aspired to positions of greater 
leadership (e.g. China, India, Brazil) manage this systemic crisis?

When it comes to a new financial regulatory architecture, the U.S. is 
likely to find support for its agenda in the UK and China, who will
 share the its general aversion to giving meaningful regulatory authority 
to multilateral institutions such as the IMF. As long as these three key
 players can agree on general principles for market regulation, power 
will remain in the hands of national governments rather than any
 multilateral organization.

But this 
is where a key, lurking political risk comes into play - can the U.S.
 actually take the lead in developing a coherent approach to new 
regulation of capital markets?

Congress will probably feel that it needs to act in a dramatic
 fashion and enact new legislation. The Treasury and the Federal Reserve 
will also have serious, and potentially conflicting agendas. So even if
 the multilateral dimension looks manageable, the domestic and
 bureaucratic politics of new regulation present a substantial new risk.