eurasia group
Defining the Business of Politics.
US–China 1
Iran 2
E
uropean fiscal divergence 3
US financial regulation 4
Japan 5
Climate change 6
Brazil 7
India–Pakistan 8
Eastern Europe 9
Turkey 10
Red Herrings *
Top Risks of 2010
4 January 2010 1
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Eurasia Group’s Top Risks of 2010
W
e’ve just been through a year of enormous economic turbulence, and yet in
most ways 2009 was mercifully quiet. The financial crisis hit the previous
September and most things that could have gone wrong didn’t, allowing
the world to focus on the digging out. 2009 saw no big geopolitical crises, no tussles
with North Korea or Iran. The war on drugs in Mexico didn’t spill across the American
border in a big way. Iraq didn’t blow up. There were no massive terrorist attacks (though
Christmas saw a close call in the United States). No killer hurricanes, no huge earth-
quakes, and the H1N1 virus didn’t prove that threatening a pandemic after all. Govern-
ments around the world focused overwhelmingly on the domestic, putting tough policy
decisions on hold. (And when they didn’t, as with Obama’s Afghanistan and healthcare
plans, the results were seriously watered down, and actual policy risk was limited.)
This year, that’s going to be much harder to accomplish. If the 2009 top risks were first
and foremost about developed states having their wits sufficiently about them to get
through the financial crisis (with the US Congress leading the pack), as the world now
emerges from recession the risks begin to shift to the challenges created by the emer-
gence of a new global order—developed vs. developing states, the old unipolar system
vs. the emerging non-polar one, and the old dominant globalized system of regulated
free market capitalism vs. the growing strength of state capitalism.
The biggest risk for 2010 comes from the point at which these three trends converge:
US-China relations. Simply put, 10 (percent unemployment in the United States) plus
10 (percent growth in China) does not equal 20. There’s been an enormous effort by
the leadership of both governments to keep a functional US-Chinese relationship in
place, much like the international approach to the G20, so that everyone could see the
seriousness of the enterprise. But with the world’s principal actors under less immediate
strain, there’s less pressure to keep up appearances. This year, the gloves start coming off.
Next up is Iran, where a deteriorating domestic and international environment,
combined with toughening sanctions pressure, will create greater incentives for Tehran
to provoke conflict. Along with the continuing (though limited) risk of Israeli military
strikes on Iran’s nuclear sites, this is the year to watch for serious trouble emanating from
the Islamic Republic.
We’ll also still see significant concerns within developed states this year—weaker states
in Europe under massive fiscal pressure; financial regulatory reform in the United
States; and the impact of a political revolution in Japan. A few surprises from emerging
markets—Brazil’s a risk this year, as coming elections are more troubled than people
expect. India-Pakistan risk resurfaces after years of quiet engagement (while Afghanistan,
making headlines throughout the year, is effectively pushed as a top risk to 2011 by the
US troop surge). Unemployment, coupled with a spate of elections, merits a spot for
Eastern Europe in the top ten. And a host of domestic and international stresses puts
Turkey on the list too, though barely.
Terrorism doesn’t make the list. It’s a growing global concern, but as a specific risk, it’s a
fat tail. It can really upset markets when an attack hits, but short of that it’s principally
a growing drag on global growth. Yemen is emerging as a focus for al Qaeda, and no
doubt we’ll see significant fighting there...with direct American engagement. But short
 eurasia group
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of Yemen actually failing as a state (unlikely in the nearest term), it won’t have significant
impact globally—or even on neighboring Saudi Arabia. After many years, climate change
finally sees its place on the Top 10 list, mostly because of the growing policy and market
impacts of the continued absence of effective international coordination on responses, a trend
we’ll see more often in our increasingly non-polar world.

There are all sorts of country risks that don’t quite make the list—Colombia, Dubai, Malay-
sia, Mexico, Nigeria, and Thailand to name a few. Each is worthy of concern for those with
direct exposures in these economies, but none will grow to the level of global risk in 2010.

And then some interesting red herrings. These include US and British financial centers, the
death of which has been greatly exaggerated; Iraq, where investment and new oil will be a much
bigger story than security risks; the Persian Gulf, which we generally like quite a bit (Dubai’s
problems notwithstanding); and the dollar, where really slow and steady-ish still wins the race.

1: US-China relations
The G2 was a stillborn idea, because Beijing didn’t want the responsibilities, even though the
United States pushed hard for this framework at the Obama-Hu Jintao summit in November.
That won’t last in 2010. In the future, we’ll look back at that summit as the peak of the relation-
ship, and we’ll see significant deterioration in US-Chinese relations in the coming year.

The problem isn’t Obama or Hu; both want to avoid ruffling feathers. But there are too
many structural pressures for it to last. The United States is looking for more (and more
responsible) international leadership from the Chinese—stakeholdership continues to be the
mantra in policy circles. But as clearly evidenced on climate change during the Copenhagen
summit, the Chinese have little national interest in taking a lead role. In 2010, we’ll see this
trend also play out on nuclear proliferation, reform of rules of the road for international trade
and commerce, cyber-security, and security in Afghanistan, Iraq, and beyond.

For Beijing, economic partnership with the United States looks

Partnership with a lot less attractive than it did just a couple of years ago. But
the US is China’s top leadership recognizes that it has little choice for the
near term, which is why they are taking their time in building
less attractive domestic demand and instead doing everything possible to main-
tain their share of global export markets. That means continuing
domestic stimulus for the economy and tight controls over the exchange rate of the yuan. It
also means a growing role for the state as lead actor and arbiter of the Chinese economy, and
growing support for “national champion” Chinese firms, both at home and abroad.

With the uptick in domestic protections against Chinese exports (steel, tire tariffs), we’re just
starting to see an American backlash to this Beijing response. The argument runs as follows: do-
mestic industry subsidies and the fixed yuan/dollar peg have allowed the Chinese government
to draw wealth away from the US economy by allowing its export-focused industries to sell to
the American consumer for artificially cheapened prices. By that logic, China hasn’t just been a
free rider in the international system...but more directly on the US economy. Therefore, China’s
plans for its immediate economic future are fundamentally incompatible with the vision of
“global rebalancing” as laid out by Larry Summers and other Obama administration officials.
This is the crux of the tension in the US-China relationship—by way of protectionist policies
and slower consumer spending, the United States is rejecting China’s development model.

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In 2010, a mid-term election year where unemployment is high, labor and even some industry
groups will lead the Obama administration to send the message that China’s economic policies
cannot persist and will lay down the gauntlet with more tariffs on Chinese exports. We’ll see more
intense politicizing of exchange rate policy (especially absent a significant rise in the yuan); invest-
ment policy tensions both in the United States (CFIUS) and in China (greater state preferences
for local firms); China–bashing when Obama pushes cap and trade in the Senate; growing trade
tensions (especially on steel); and issues involving cyber-security. And if any new “product safety”
scandal emerges involving Chinese manufactured goods in the middle of these tensions, we’ll also
see a populist American push against goods “made in China.”

A recent Pew-CFR survey reported that 44% of Americans believe China is now the “world’s
leading economic power.” Just 27% say it’s the United States. In 2008, we saw the last US
presidential election in which the overwhelming majority of voters didn’t know or care where
the candidates stand on China. The shift begins this year.

2: Iran
By far the biggest purely geopolitical risk in 2010 comes from Iran. Its government now faces
growing pressure on three fronts. At home, the regime has had a tough time since last June’s
presidential election; hardliners had initially consolidated, but are now under intensifying
pressure as domestic protests continue. Regionally, Tehran has lost considerable influence,
with elections in Lebanon turning against Hizbullah, rising Iraqi nationalism has made it
harder for Tehran to exert influence upon their principal historic competitors, and Iran’s
financial outpost in Dubai put at risk by the growing influence of Abu Dhabi.

Globally, Iran faces a considerably tougher sanctions regime over its nuclear program, a push
spearheaded by the United States, Europe, and Japan, with even Russia and China unhappy
over Tehran’s aggressive rhetoric. A Western push for negotiations
will continue, but divisive local politics and insufficient leader-
Iran faces ship coordination make it very unlikely that Iran’s leadership
growing pressure could reach a negotiated settlement even if it wanted one. And it
doesn’t. Even under considerable domestic pressure, the hardlin-
on three fronts ers in charge of the regime will continue to try to buy time to
achieve their nuclear ambitions.

That’s why the government is likely to overreact to sanctions when they hit. 2010 carries the
highest risk to date of Iranian provocation in the region, in the form of shipping harassment of
in and around the Strait of Hormuz, support for radical organizations in neighboring countries,
and instigation of trouble for Iraq and other neighbors as demonstrations of muscle. The Iranian
regime looks increasingly like a cornered, wounded animal. In 2010, it’s likely to act like one.

Israeli military strikes have actually become less likely—certainly for the first half of the year
as sanctions are put in place. Faced with strong opposition from the Obama administration
(even as it uses the threat of strikes to gain support for sanctions and to pressure Tehran),
mounting intelligence challenges on the location of key Iranian targets, and recognition of
the military limitations of Israeli strikes, some Israeli government officials now privately are
beginning to discuss how to cope with an eventual nuclear Iran as much as the nature of its
“existential threat.” Still, the perceived Israeli national security issue is enormous. Looking
toward the final months of the year, the Israelis remain an important question mark.

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Over time, if the regime in Tehran remains in power, the Iranian danger will become more
diffuse and start to look more like North Korea. It’s clearly a significant long-term negative
for global stability. Though for Iran itself, by 2011, we’ll probably see a bunch of countries
begin thinking about how they’d like to start investing there, even as the Western powers seek
to prolong sanctions.

3: European fiscal divergence

Political risk returns to the Eurozone in an important way this year, with the consequent
blurring of the distinction between “mature” and “emerging” markets. Fiscal policy coordina-
tion has been eroding for some time, and member state political processes are highly uneven.

Greece, Ireland, Spain, Portugal, and Italy face the most complex fiscal challenges, and while
Ireland appears ready to make aggressive budget cuts, the others are reluctant. Defaults
remain possible, since EU support should not be considered automatic. But policy changes
will have far-reaching implications even without a default, with a new set of risks arising
from fundamentally new political drivers at play in the Eurozone—and a consequent grow-
ing importance of political factors in healthier European economies. We’ll see this arise as tax
structures are revisited, governments continue to use fiscal tools to support specific firms and
sectors, and as policymakers struggle to adapt domestic politics to the more pressing public
financing challenges elsewhere in the Eurozone.

There are related risks in Eastern Europe, particularly if European Central Bank (ECB)
liquidity measures are curtailed. This has long been, and still is, a major concern for Austria,
given its bank exposure. This is compounded by overlapping exposure in economies where
Greek banks are systemically important. In this vein, if one of the big Western European
banks active in Eastern Europe gets in to trouble, a rescue effort would be extremely messy.

4: US financial regulation
On balance, 2010 is looking like a tougher year for President Obama than 2009 proved to be.
Going into the new year, he has succeeded in kicking Afghanistan and climate change down the
road, but pulling off a real policy success on either still looks unlikely. Unemployment remains
high as the country pulls weakly out of recession and mid-term elections appear on the horizon.
While Obama’s popularity may take a beating, the coming year will see considerably less actual
domestic policy risk in the United States than in 2009. But the exception is in the process of
financial regulatory reform. That’s likely to be a tougher issue than people expect.

The reform package that passed the House of Representatives is comprehensive, though it will be
moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being
undertaken. Either way, substantial change is afoot—more far-reaching than anything we’ve seen
since the Great Depression. The result will be a structure put in place to monitor and address
systemic risk, largely self-financed by the financial community, as well as changes on many other
issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank.

Unlike cap-and-trade or immigration reform, there’s a very high likelihood that comprehen-
sive financial regulatory reform will pass. But with mid-term elections approaching, it’s likely
to turn populist and lose a considerable amount of its bipartisan flavor. Congress as a whole
is likely to imitate what’s already come to pass in the United Kingdom, where an unpopular
Gordon Brown government is going after the financial sector to try to lift its poll numbers

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from the morass. Congress doesn’t want to be tarred by Treasury Secretary Tim Geithner,
bailouts, or billionaire bankers. The best way to avoid that fate is to include some visibly
populist elements in the new legislation, especially on consumer protection and executive
compensation. Members of Congress will look to score points by taking aim at the Fed, but
actual policy change there is a step too far—the administration will likely ensure that nothing
in the ultimate bill will undermine the Fed’s political independence.

But while President Obama’s economic team will be wary of populist measures, Democrats in
Congress and the president’s own political advisors will see such measures as a necessary piece
of “mobilizing the base” before mid-term elections. Big banks are an easy target, especially in
the context of high profits and a strong recovery for the financial markets, but a weak overall
economic rebound. The legislation should pass by late spring.

Regulators will be given significant new discretionary powers, including some authority for
breaking up institutions deemed a systemic risk. A key risk is that, depending on the political
environment, the newly empowered regulators could use their capabilities to issue strict
rulings that go well beyond what is specifically included in the legislation. Regulators will
also likely issue proposals for revising capital requirements upward next year.

Another key risk to watch will be efforts to impose further fees

and taxes on the financial system. With the US government
Obama’s team running record deficits in the wake of the financial crisis, trying
will be wary of to recoup these costs from the financial services industry will be
seen as a relatively low-cost political option. Executive compensa-
populist measures tion is one likely possibility; taxes on carried interest for hedge
funds are another.

Both the Americans and Europeans are aware of the risk of driving the financial industry into
the ground with too much (or too drastic) regulation or taxation. But as reform becomes an
election-year domestic battleground, the need to serve political interests will be increasingly
at odds with the need to create an efficient framework for regulatory reform.

5: Japan
What happens when the ruling party loses power in a one-party state? You get a zero-party
state. That has effectively happened in Japan, and it’s hard to overstate the importance of the
sweeping political change—indeed it’s unprecedented for a major industrial democracy. The
new Democratic Party of Japan’s (DPJ) efforts to limit the influence of bureaucrats and indus-
trialists are creating higher policy risk, especially after upper house elections in the summer.

Currently Prime Minister Yukio Hatoyama is holding back on that agenda, given coalition
and electoral constraints. But indications are that the DPJ would stick with its electoral
mandate and not continue its present more cautious policy positions if it gains control of the
upper house. Given Japan’s extraordinary fiscal constraints, that’s going to be tough to pull
off, particularly since the sidelining of senior technocrats makes it much more difficult to put
flesh on the bones of DPJ policy goals.

The real power in the DPJ regime is long-time party boss Ichiro Ozawa, who, himself tainted
by scandal, remains outside the cabinet and so behind the formal policy scene. It’s quite
possible that Hatoyama won’t last the year. He’s not a skillful campaigner nor an effective

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decision-maker, and has a scandal of his own around his neck. Insiders are already looking to
someone like Deputy Prime Minister Naoto Kan or even to the more youthful and policy-
savvy Kazuhiro Haraguchi to take Hatoyama’s place—even before the upper house elections.

If so, regardless of the merits of the actual successor, the DPJ will appear to be simply a
continuation of the post-Koizumi era succession of weak governments, but this time without
the benefit of a strong unified bureaucracy to guide policy and with a much more worri-
some economic situation. Meanwhile, uncertainty over how 2010 will play out for the DPJ
and the party’s less favorable disposition toward the business community is likely to harm
financial confidence, deepening economic woes.

Some pundits worry that the United States will replicate Japan’s lost decade. For 2010, the
greater risk is that Japan might be starting another one.

6: Climate change
Before Copenhagen, the prevailing presumption was that 2010 would be the year when a
global treaty, including the United States, China and India, really got done. (Though even
a year ago, we were far less optimistic.) After Copenhagen, we look years away from such a
treaty, and there is a growing likelihood that it will never happen.

From a market and industry perspective, the failure to establish clear timetables and goals at
Copenhagen complicates investment decision-making for everything from renewable energy
investments to forest product management to commodity price
forecasting. On the latter, natural gas markets emerge as a loser
Copenhagen from the climate change gridlock. While the overall trend is
toward greater use of natural gas-fired generation for electricity
complicates in North America, the implementation of an actual carbon
decision-making price is crucial to unleashing new investment and encouraging
fuel-switching. The absence of this catalyst (outside of the EU)
increases the likelihood that the current weak price environment for natural gas is likely to
continue, creating problems for gas exporters from Russia to Bolivia.

The Copenhagen outcome makes it even less likely that the United States Congress will
pass cap-and-trade legislation in 2010. Though Obama’s political advisors see a big push for
cap-and-trade as a way to energize the base and sharpen distinctions with Republicans ahead
of November’s mid-term elections, they don’t have an international treaty to use as a pressure
tactic to move votes forward in the Senate. Opponents of the legislation will use the absence
of a substantive agreement with China as further reason to balk at American commitments.
Moderate Democratic senators in poor and energy-intensive states strongly oppose the
climate change measure and will not provide the votes that Obama needs.

The Copenhagen failure also makes it more likely that individual countries will move to
“nationally appropriate” mitigation measures. Countries like China, India, Canada, Brazil,
and eventually even the United States will move toward an increasingly heterogeneous set
of policy responses, including intensity-based goals, renewable energy mandates, and even
carbon taxes, creating a greater challenge for international coordination.

The lack of an international framework will complicate compliance efforts by multinational

corporations with carbon footprints in dozens of countries at once. More significantly for

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global politics, technical disputes over implementing and verifying actual emissions from
these uncoordinated systems will create diplomatic tensions, particularly between the United
States and China. And a multilateral stalemate is likely to intensify the existing rift between
industrialized and G77 countries. Lastly, the risk of trade disputes over carbon will rise as
disparate policy responses heighten concerns over firms relocating to countries with more lax
carbon policies, and border adjustment measures gain traction as a result.

7: Brazil
After years of being wildly bullish on Brazil, we’re in for a bump. The country stands to gain
from a strong rebound in growth over the course of 2010, but Brazil’s newfound economic
abundance will lead to a drop in the quality of economic policymaking—both on macroeco-
nomic policy and, to a much greater extent, through leaning more heavily on state-owned
enterprises. As a result, 2010 will be marked by growing investor concern on both macro and
sectoral policy as the October presidential election draws near.

Brazil’s challenge of abundance looms greatest in the oil sector. The government wants
more control over resources, and has very little desire to allow the international community
to profit unduly (or, in some cases, even duly) from the exploitation of the country’s vast
new oil frontier. With Lula’s political capital running high, he should be able to approve
legislation creating a new exploration and production framework which relies heavily on
state-owned Petrobras. What’s happening in the oil sector, while
more extreme, should be seen as part of broader trend whereby
Brazil’s challenges state enterprises grow in relevance and industrial policy becomes
loom greatest in more inwardly focused. That’s a negative for Brazilian markets.
A rosy economic outlook is also likely to impact the discipline
the oil sector of macroeconomic policymaking. The Lula administration isn’t
about to abandon a macroeconomic framework that has proved
wildly successful, but lowered fiscal vulnerabilities will tempt the administration to keep
fiscal policy expansive for longer than markets would like. That will put additional pressure
on the central bank precisely when the membership of its board may be in flux...as Central
Bank President Henrique Meirelles considers a run for elected office.

Markets will thus become jittery as the elections draw near, particularly given that some of
the concerns will be overblown when investors awaken to these risks more explicitly. Lula’s
hand-picked candidate Dilma Rousseff enters 2010 favored to win the election, and she will
undoubtedly deepen the government’s turn toward a bigger state. Sectoral policy won’t be
evenly problematic—in the telecom sector, these drivers exist, but are weaker; while in transport
infrastructure, the political push actually goes the other way (more foreign investment is needed
given the scope of projects to complete before the World Cup in 2014 and the Olympics in
2016). If opposition candidate Jose Serra wins the sectoral upside will be larger given the lack of
a bias toward state-owned enterprises, and fiscal policy will be tighter. But markets will surely be
concerned over his long standing criticisms of both exchange and monetary policy.

The situation is a little like post-Mandela South Africa (though from a more attractive
economic trajectory), where people and markets expected continuity until Thabo Mbeki
disappointed. Leaders like Mandela and Lula are impossible acts to follow. Post-Lula Brazil
will not have the capable policymaking of the past several years and Brazil will be in for a
bumpier transition as a new administration seeks to put its stamp on managing the country’s

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newfound economic wealth. Still, the long-term outlook for the country remains strong. By
2011, Brazil should be set for a bounce.

8: India-Pakistan (no, not Afghanistan)

South Asia is still a morass in 2010. But the US troop surge has given Obama some time.
Afghanistan will produce bigger and bigger domestic headlines, but not much will actually
change until the United States reaches (or, more likely, is forced to reach) a decision point.
For now, that’s 2011 at the earliest.

Having said that, there’s a broader south Asia risk developing this year. The decision by Paki-
stan to go after terrorists domestically provides Islamic extremists with powerful reasons to
expand asymmetric attacks on Pakistan’s urban centers and to try to reignite Indian-Pakistani
conflict. That’s easy enough to do. Pakistan’s extremist groups have increased in sophistication
and consolidated their capacity, both by joining together and by forging closer links to al
Qaeda in the region. In Pakistan, a significant proportion of the population continues to
believe that terrorist attacks against the population originate in India. Pakistani networks
operating in India haven’t gotten much attention, however, and represent a weak link on the
counterterrorist front.

This means that the likelihood of attacks in India and against Indian targets in the region is
increasing, a particular worry given the nature of the potential targets (government facilities
and densely populated urban areas). The Indian government is aware of the threat and has
sought to improve its counterterrorist response—including via increased ground-level coordi-
nation in Delhi and Mumbai with American and British counterterrorist organizations. But
progress has been slow, and India’s counterterrorism capacity remains underdeveloped, badly
coordinated, and vulnerable.

Meanwhile, any new attacks would put serious pressure on India to take a tougher line
on Pakistan. India’s Congress Party leadership is loath to escalate military tensions with
Pakistan. But following a quieter line after the Mumbai attacks in late 2008, it made strong
demands on Pakistan to take decisive steps against extremist networks with ties to India.
Successful large-scale attacks would undermine the Congress Party’s credibility on the issue,
leading the Indian government to take outsized steps in raising the military posture toward
Pakistan. That, in turn, means Pakistan shifting its focus away from the tribal areas and, as
importantly, changing its strategic view on taking on further operations—a shift that would
sit comfortably with much of Pakistan’s senior military command, who still see rising India as
Pakistan’s main strategic challenge.

Indian-Pakistani relations, which had been quietly improving during the final years of the
Musharraf regime, have already deteriorated somewhat under President Asif Ali Zardari,
and it will prove harder for both sides to back away from any high-level military alert.
Meanwhile, in both Delhi and Islamabad, Obama’s pledge during his Afghan speech to
begin US troop withdrawals in 2011 is being read as a signal that the US is minimizing its
long-term commitment to the region. This feeds the already powerful views in both capitals
that they should plan for continuation of their long-term strategic rivalry. Worst case, should
there be a series of terror attacks in India, we could see Indian efforts to secure international
sanctions against Pakistan—and potentially surgical strikes by India against military training

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camps inside Pakistan. In short, for the first time in nearly a decade, there are serious factors
pushing the Indian and Pakistani governments back toward confrontation.

9: Eastern Europe
Coming out of global recession, historically high levels of unemployment are a critical factor
in a solid majority of the world’s economies. But as a political risk, it’s perhaps most worri-
some in Eastern Europe—where upcoming elections in a number of key countries materially
increase the likelihood of instability.

High unemployment weakens the popularity and limits the flexibility of incumbent govern-
ments, making political leaders especially sensitive to domestic economic and social constituen-
cies, and increasingly tempted by protectionist, nativist, and populist policy options. That’s
particularly true where elections are on the horizon, as candidates look to channel the frustra-
tion and anger of the unemployed. Governments will increasingly
come into conflict with monetary authorities and international
Employment is of lenders such as the IMF, which in turn may send very negative
signals to capital markets investors...introducing yet another set of
greatest concern in risks to financial stability. In Eastern Europe, Ukraine, Hungary
eastern Europe and Latvia look the most vulnerable, but even solid regional
performers like Poland may face stresses in the coming year.

Ukraine’s economic contraction and related jump in unemployment has been dramatic.
With two rounds of presidential elections likely in the first quarter of 2010, then perhaps
fresh parliamentary elections as well, politicians are under enormous pressure to boost public
spending and assist debt-burdened enterprises. But this is all in a context of a crucial IMF
agreement and framework that puts serious constraints on public spending in return for loan
support and guarantees. Whoever emerges as the president and parliamentary leaders will
find it incredibly difficult to balance these two sets of competing demands this year.

Hungary’s current government has succeeded in staving off a full blown financial crisis by
implementing a series of IMF– and EU–mandated fiscal reforms in the past year. But the
economic fundamentals remain weak, unemployment has shot up dramatically, and national
parliamentary elections are due in the spring of 2010. The leading opposition party, Fidesz,
will almost certainly win those elections, but they are already signaling that they want to
re-negotiate IMF-EU mandated budget deficit and spending targets for 2010. We also expect a
surge of populist and anti-foreigner rhetoric from Fidesz ahead of the elections. Even if the new
government responds to market and IMF constraints after it is elected, the election build- up
will worry investors-—a dangerous scenario given Hungary’s fragile standing in markets.

Latvia, the other particularly high-risk country in the region, also has elections due this year,
and politicians there will feel similar social pressures. Relative safe havens such as Poland and
the Czech Republic will also have noisy (presidential and parliamentary) elections this year.
While the political and economic outlook for Poland remains solid, it’s not smooth sailing.
If the Polish government’s leading presidential candidate (Donald Tusk) is underwhelming,
populist/nationalist opposition politicians will pounce, highlighting the growing unemploy-
ment in the region’s largest economy, which may look more vulnerable as a result.

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10: Turkey
There’s very little “country risk” in the Top 10 this year, but trends in Turkey are sufficiently
worrisome that it deserves a slot. Domestically, an increasingly unpopular Justice and
Development Party (AKP), facing popular fallout from the economic downturn, is embroiled
in intractable and increasingly interlinked fights with the judiciary, industrialists, and the
military. The party’s experiment with trying to buy some support from Turkey’s Kurdish
population failed, which not only loses them the Kurds but many Turks if there’s further
social instability as a consequence—as seems likely. Meanwhile, there’s growing political
pressure within the AKP to keep would-be splinter Islamist forces onside and to formulate
policies that appeal to more emotive calls from that base.

Turkey’s international orientation is moving away from Europe and closer to Iran and Syria—
driving further domestic wedges between Turkey’s Islamists and secularists. And while Turkey’s
EU candidate membership status isn’t going to shift in 2010, the threat of confrontation looms
larger, especially as Cyprus negotiations, which seemed on a strong track, now look like they
might leap off the rails. Prime Minister Recep Erdogan’s principal diplomatic success is with
Armenia. That’s important historically, but not for the country’s relationship with creditors at
the IMF. And though Iraq looks better (more on that in a moment), if there’s a worry, it’s the
unsettled status of Iraq’s Kurdish north—just across the border from Turkey.

In short, country risk is hitting Turkey from just about every side. By year’s end, the fight for
the coming year’s elections will heat up. Unlike in Brazil, 2011 doesn’t look like a bounce.

Red herrings
Iraq
Elections in March will spark violence as al Qaeda makes a bid to undermine the transition
to Iraqi national sovereignty. A US troop withdrawal beginning right after the elections will
invite more violence. But compared to what we’ve seen before, and what might have happened,
the overall story is remarkably positive. For the markets, Iraq is suddenly an opportunity. The
institutions are becoming legitimate (even with the unresolved Kurdish issue), the army is starting
to work, and most importantly, political leaders from all communities are beginning to recognize
the value of Iraq’s tremendous natural resource base from which all can benefit if they make the
compromises to maintain stability in the country. For all their basic governance problems, there’s
very little chance of Iraq actually becoming a failed state at this point—a meaningful risk even a
year ago. It’s not a place we’re ready to vacation in, but we’re bullish on Iraq.

Iraq is also moving in a positive geopolitical direction. Ties with Turkey have grown particu-
larly quickly—not just in the Kurdish region in the north, but in Baghdad. That’s one of the
few positive stories for Ankara this year. Arab states in the region are still hesitant to build ties
with Iraq as they wait for clarity on its next government. Maliki hasn’t been a popular figure
with neighboring Gulf Arabs, but they recognize that Iraq’s economic consolidation won’t
wait for another four years, and they’ll start making political overtures to Baghdad if Maliki’s
mandate is extended. And if the Iraqi prime minister isn’t returned (which is certainly plau-
sible), we’ll see a stream of head of state visits to place relations with a new leader on a more
solid footing. So whatever the electoral outcome in March, we’re likely to see Iraq on a faster
path to integration with regional political and economic infrastructure next year. Meanwhile,
Iran’s role in Iraq has quietly receded. Iran’s controversial presidential election and subsequent

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state violence did nothing to improve Tehran’s influence among Iraq’s Shia population, where
Iraqi nationalism has been steadily growing.

The headlines for Iraq next year will undoubtedly be the timing/delays/pace of the US troop
withdrawal. But the real story is going to be a moderate government, growing geopolitical
influence, and the most exciting new investment opportunities the region has seen in a decade.

The Persian Gulf

Iraq’s gain trumps Dubai’s loss in the Persian Gulf, and the rest of the region is doing just fine.
There is strong political stability, increasingly coherent policy approaches, and lots of reasons for
broader, more sensible investment trends diversifying away from over-reliance on oil.

The outlook is particularly promising for Saudi Arabia, where there’s strong reason to believe
that political succession will ultimately be handled well. And they’re slowly but surely un-
locking the economic potential of larger and larger pieces of their country—geographically,
sectorally, and most important, demographically. Neighboring (and far more socially
liberal) Bahrain will also benefit significantly from that trend. Abu Dhabi is taking over
more coordinated direction of economic (and regional political) policy for the United Arab
Emirates, a far more sensible model for national development. Smaller countries like Oman
and Qatar have the economic and political stability to benefit from the region’s rise.

Russia
This year, Russia gets through the downturn and starts to look stable again. Prime Minister
Vladimir Putin will feel more confident, and anybody who doesn’t agree with him can leave
or face the consequences. The country doesn’t really deserve to be a BRIC, because its longer-
term trajectory is more ominous (with a tough geopolitical neighborhood, a precipitously
declining population, and negative trends in governance). But for this year, especially with
energy prices having doubled off their lows, Russia will go back to being uninteresting.

The dollar
The United States will continue to run a massive deficit with crisis-reduced tax revenues,
high levels of spending and few near-term moves to raise revenue in the cards for 2010. And
while the Obama administration has big plans for fiscal responsibility, much of it is hard to
get through Congress, while other pieces of the plan are typical/political accounting sleight
of hand. With the Chinese saying the world needs a new reserve currency and the Indians
buying gold, does anyone believe in the dollar any more?

Well, yes. But it’s important to start with recognition that the dollar’s relative value and
reserve currency status are related, but separable. A weaker dollar can still be the primary
reserve currency—that’s been a long running story over the past six decades.

The status of the dollar as the world’s reserve currency is much stronger than the hyped
commentary. To paraphrase Churchill, the dollar’s outlook is the worst of the developed
currencies out there...except for all the others. For now, if there’s dollar weakness, it’s at least
in part that the United States wants a weak dollar to boost exports (since domestic consump-
tion is going to stay weak for a while). Longer term, US demographic growth, the pull from
higher education, a strong penchant for innovation, a continuing military lead (which will

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increasingly matter for commodities), underlying political stability and sheer size will keep
the dollar going as the world’s preeminent reserve currency.

That’s not to say there’s no structural weakness. Over time, should China manage its chal-
lenges successfully, the yuan will rise in both value and utilization. But for the foreseeable
future, even if the dollar’s relative value falls, its reserve currency role is not going anywhere
in the next decade and probably well beyond. Similarly...

New York and London

All this fear about “finance” running away from New York and London—because of regulatory
burdens or growth outside the developed world—is misplaced. Bankers like to complain about
regulations and to threaten to move elsewhere. It’s far harder to execute. The slow pace of
change is particularly true for the physical location of the top financial markets, and the fact
that Singapore does more bond issuances in one particular year than does London doesn’t mean
it will overtake the city anytime soon. Since the year 1600, there have been three top financial
centers: Amsterdam, London and NYC (well, Paris too, which made a run at it in the 18th–
19th centuries). Rapid and massive shifts in the way money is intermediated are unrealistic.

Capital can be generated anywhere (Chinese factories, Middle Eastern oil, etc), but capital
intermediation (most finance) needs a set of special political, economic, and social conditions
in which to thrive. Structurally, successful capitals of finance require stable legal systems,
stable political systems, effective/apolitical policing of corruption, low levels of social unrest
and violent conflict, large and highly literate work forces, a large economic base to sustain
financial activities, and a liberal policy orientation that welcomes cross-border flows of
people, goods, and capital. Except for the United States and the EU/Switzerland, only Tokyo
meets all these requirements. But Japan has elements of a closed economy, lacking as much of
an international orientation, as reflected in a relatively low level of English proficiency.

If the United Kingdom truly cracks down on its financial industry (a possibility), some of
it will disperse...with New York standing to gain the most. If the United States decides to
impose tough regulations while Europe doesn’t (much less likely), we’ll see more dispersion,
with smaller jurisdictions picking up some of the more risky/profitable activities (hedge
funds). But for the most part, large financial institutions will stay put, grumble, and try to
reverse whatever regulations the United States and the United Kingdom burden them with.
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