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.

(Photo: Obama image in Jakarta, 25 Oct 2008/Dadang Tri)

Two French academics, Islam expert Olivier Roy and political scientist Justin Vaisse argued in a New York Times op-ed piece on Sunday that Obama's premise of trying to reconcile the West and Islam is flawed:

Such an initiative would reinforce the all-too-accepted but false notion that “Islam” and “the West” are distinct entities with utterly different values. Those who want to promote dialogue and peace between “civilizations” or “cultures” concede at least one crucial point to those who, like Osama bin Laden, promote a clash of civilizations: that separate civilizations do exist. They seek to reverse the polarity, replacing hostility with sympathy, but they are still following Osama bin Laden’s narrative.

Instead, Mr. Obama, the first “post-racial” president, can do better. He can use his power to transform perceptions to the long-term advantage of the United States and become a “post-civilizational” president. The page he should try to turn is not that of a supposed war between America and Islam, but the misconception of a monolithic Islam being the source of the main problems on the planet: terrorism, wars, nuclear proliferation, insurgencies and the like.

Also on Sunday, the Istanbul newspaper Sunday's Zaman ran a piece by sociologist Dogu Ergil who spelled out what he thought "moderate Muslims" expected of Obama.

(Photo: Blue Mosque in Istanbul, 9 Dec 2008/Tan Shung Sin)

Moderate or non-ideological Muslims expect Mr. Obama to support democratic trends in their countries, but not to push them from above using ruling elites that will never adopt a democratic agenda but rather will simply play for time, making only cosmetic changes. This will, in turn, further reinforce the power of autocratic regimes that are threatened by genuine democracy.

Muslim moderates look at religion as a cultural affair, wanting to render it autonomous of politics so that it will be protected from political power and in the same way, preventing it from seeking political power. So they want the Obama administration to press their governments to enact reforms that will pave the way to democratic politics and legal changes that will allow for more individual freedoms. They do not want a hypocritical stance from an America which advocates democracy but supports the most authoritarian regimes in the Arab world for the sake of oil deals and other strategic ends. The Bush administration set a very bad example of paying lip service to democracy, which, in fact, worked as a vehicle to blackmail Arab regimes and served America's strategic interests.

Michael Fullilove at the Brookings Institution made a pitch for an Obama speech in Indonesia in the New York Times while several Moroccan blogs have been running a campaign (including a petition with a long list of reasons) to have him speak there. Saad Eddin Ibrahim, an exiled Egyptian sociologist and human rights who is a visiting professor at Harvard and Indiana universities, made the case for Indonesia or Turkey in the Washington Post.

Maleeha Lodhi, a former Pakistani ambassador in the United States and Britain, has a long list of suggestions for a reformed U.S. policy towards the Muslim world in the Harvard International Review.  The list is fairly extensive, although it would have been even more informative if it had included suggestions for what should change in the Muslim world.

(Photo: Badshahi Mosque in Lahore, Pakistan, 21 Dec 2007/Mohsin Raza)

How Obama manages issues in the Muslim world will determine the success or failure of his foreign policy...

In the Muslim world ... perceptions have been shaped by decades of uneven handed policies and by US double standards that placed the security of Israel and the need for cheap oil above considerations of international law and justice for the Palestinians. In essence, Muslims regard US policies as responsible for the trust gap between the United States and the Islamic world. In the West, opinions concerning the cause for the gap with the Muslim world are more mixed. The most common view attributes this rift in relations not only to US policies but also to factors internal to the Muslim world-- to the weakness and contradictions in those societies and particularly to the democratic deficit, which allows radicals to build support for their cause. This, in fact, inspires the idea that the United States should lead efforts to restructure the Muslim world. Irrespective of the reality, both perspectives urge the need to review and recast US foreign policy.

My vote for the most interesting argument goes to Roy and Vaisse, who ask the basic question of what role religion actually plays in the big issues facing Obama.

The truth is, Islam explains very little. There are as many bloody conflicts outside of regions where Islam has a role as inside them. There are more Muslims living under democracies than autocracies. There is no less or no more economic development in Muslim countries than in their equivalent non-Muslim neighbors. And, more important, there exist as many varieties of Muslims as there are adherents of other religions. This is why Mr. Obama should not give credence to the existence of an Islam that could supposedly be represented by its “leaders”.

(Photo: Olivier Roy, 4 Dec 2007/Charles Platiau)

Who are these leaders that President Obama would convene anyway? If he picks heads of state, he will effectively concede Osama bin Laden’s point that Islam is a political reality. If he picks clerics, he will put himself in the awkward position of implicitly representing Christianity — or maybe secularism. In any case, he would meet only self-appointed representatives, most of them probably coming from the Arab world, where a minority of Muslims live.

Do you think Obama should launch a special initiative aimed at the Muslim world, or, as Roy and Vaisse argue, assert that "American values are universal and do not suffer any kind of double standard, and that they could be shared by atheists, Christians, Muslims and others"?