Asia: A year of growing monetary challenges
Rising inflation and slower growth will challenge Asia in 2008, more so given diverging trends in price and growth. This requires a better balance between monetary and exchange rate policies.

Africa: In search of safe havens - exploring Africa's resilience
African markets are likely to be resilient to any repricing of risk. Financial linkages are not yet deep enough to be a source of concern. However, weaker global growth and the commodity outlook do matter.

Middle East: Time to adjust the US dollar pegs
The GCC is booming and inflation is rising. The last thing the region needs is further monetary stimulus. However, because of the USD pegs, GCC countries are importing the Fed's policy.

FX: 2008 investment themes
USD remains in a multi-year downtrend, but may see a vicious rebound in H1-08. JPY has further upside near term, but EUR looks set to correct sharply. We believe commodity currencies will get hit, and the GCC currencies may revalue soon.

China: China slows in 2008

Ghana: Now or never to safeguard reforms

India: Slower and steady

Nigeria: Africa's most compelling currency play

Saudi Arabia: A future beyond oil

Taiwan: Higher base, lower growth

Thailand: Is inflation really a problem?

US: Mixed messages from the payroll data

Forecasts and Sovereign risk tables

OVERVIEW

• World economy faces a difficult 2008, as problems in the West spread East
• Emerging economies are not immune to the global business cycle, but are in a much better position to cope
• As the US slows sharply, more eyes will focus on how China manages its economic challenges
  

There is decoupling, but there is contagion as well

2008 will be a tough year for the global economy. After the boom of recent years, it would be no surprise if there was a slower pace of global growth. The outlook is compounded by the financial crisis in the West, and the challenges faced by policy makers across many emerging economies as they tighten policy now to ensure sustainable growth. A year ago, we took a pessimistic view of the US's prospects in 2007, expecting a slowdown and Fed rate cuts. Despite that, we were predicting strong growth across the emerging world, with high commodity prices. This is how things have turned out, but yet we are still reluctant to talk of economic decoupling. And the reason may become evident in 2008: the business cycle still exists! There are some profound, structural changes impacting emerging economies, yet, the emergence of China has not halted the business cycle. Furthermore, the US is still the world's biggest economy, and what happens there has global significance. In 2008 we expect to see some contagion into emerging markets from the current financial crisis and US downturn.

Three key themes
There are three key themes going into the New Year. First, how we see the West's financial crisis unfolding. Second, the policy changes impacting our regions, heavily impacted by the dollar. Third, the need not to lose sight of the profound structural changes impacting the world economy.

First, the financial crisis. The last few months have been characterised by financial decoupling. This has been evident primarily between the West and the East, with emerging markets being largely untouched. It has also been evident in the West, where the performance of equity markets has been in contrast to the difficulties in credit markets, the economic pessimism reflected in bond yields, and the general challenges overhanging the financial sector. Every financial crisis is different, heavily influenced by the economic fundamentals, the policy response and by confidence. Whilst all three are heavily interlinked, it is the last, namely confidence, that is hardest to call. Already the credit crunch, and high interbank rates, are a sign that there is a loss of confidence between banks; this could easily spread to the wider economy. The need to guard against such economic contagion is a big concern. Often within a crisis there is denial about how bad things are. The lack of transparency within the financial sector adds to the air of uncertainty about this crisis. Thus, one should take the downside financial risks seriously.

We are cautious about the US. At best the US faces a period of weak, below trend growth; at worst, a recession. Basically, US consumers need to spend less, save more, and return their balance sheets to normal. Whilst one could have said this at any time in recent years, the reality is that the background for US consumers was one of ample credit, a healthy jobs market and a solid housing and stock market. Now the credit environment is tightening, housing is fragile and there is more uncertainty about jobs. In such a scenario, one should expect US households to spend less, and if they do this gradually it will be a soft landing, if they cut back dramatically then it will be a recession. The mood in the US is mixed. Having visited there three times in the last two months there is no doubt sentiment has deteriorated because of the credit crunch, yet there are still many who are upbeat. One reason is the health of large US firms, who were forced in the last downturn to get their balance sheets back into shape and have since positioned themselves well overseas and have recently been buying back equity. But how deep into corporate America this healthy picture extends is hard to tell. Overall, there are mixed signals but we are expecting the problems in the financial and banking sector to spread. The liquidity challenges may soon become capital problems for banks, forcing a much tighter credit and lending environment. In such a situation the Fed should cut rates aggressively. We have factored in modest easing into our central scenario; aggressive cuts cannot be ruled out, to head off the downside from the credit crunch and also to help banks recapitalise themselves.

The last time the US experienced a downturn in 2001 the three most open economies in Asia suffered recession: Hong Kong, Singapore and Malaysia. We do not expect this in 2008, but it is a salient reminder of the importance of the US as an export market, then, and indeed now. Looking at exports to the US, as a proportion of GDP, those three economies still stand out, but there have been big changes in Asia over the last few years, highlighted by the fact that the latest financial crisis has left the region not only largely untouched, but, in fact, the source of much needed liquidity and capital for western financial firms in trouble! Asia, like other emerging regions, particularly the Middle East, is in a much better position to be able to cope with any US led downturn. Currency reserves are high, liquidity is ample, and macroeconomic policies are far more credible. Furthermore, China is now integral to the region, and indeed to the world, whereas previously it was a largely closed economy. Exports from China to the US are about 7% of GDP, significant, but relatively small. Of course, one should not overlook the financial contagion from the US if that could follow any stock market correction, spreading to India and China, where both domestic stock markets have led to recent concern.

Across emerging markets, liquidity conditions are still good, particularly in Asia, reflecting positive economic fundamentals, large external surpluses, healthy fiscal positions, deleveraged household balance sheets, solid corporate earnings and strong output growth. The one region we are concerned about is Eastern Europe, which has attracted even more private sector flows than Asia, although much of this may be hot money, as Eastern Europe's trade imbalances leave it vulnerable. Meanwhile, the Middle East and Africa are clearly benefiting from the commodity boom. The previous cyclical nature of commodity cycles should not be overlooked, but the diversification and private sector growth in many Middle Eastern and African countries gives more reason for optimism on this occasion.

Policy challenges, especially in China and India
Second, the policy challenges for emerging economies in 2008 should not be underestimated. The Chinese leadership talked of harmonious society, prosperous society and scientific development over the last year. And, as we saw from the huge rises in education and health spending announced back in the spring, keeping the farmers happy and addressing the imbalances within their economy are key: urban-rural; coastal-inland; social; environmental; and international. The immediate challenge is to curb domestic inflation pressures, but to tighten in a way that is successful at home whilst not attracting speculative inflows from abroad. Hence we expect further policy tightening - both direct through higher rates and tighter reserve requirements, and also indirectly through moral suasion as they curb lending growth. Financial markets may still be underestimating both the speed and pace of change within China, and equally they may be underestimating the policy challenges ahead. As the private sector grows, and as the regions seek to develop their local economies, the policy makers in Beijing are likely to find it harder to control the economy, particularly with the limited policy tools that are available. This points to greater future volatility in the Chinese economy, albeit along an upward path. Since its opening up in1978-79, China has faced many domestic cycles; another may be due.

India, too, faces similar challenges. The immediate ones are the vulnerability of the stock market and the relentless rise of the rupee. I spoke on that last topic at the recent World Economic Forum (WEF) event in Delhi .Exporters are worried, as much at the pace of appreciation as its level. The mood at the Delhi event was upbeat, but at the same time realistic about the challenges facing India. India's economy is growing at a rapid pace, around 9%, but as in China, this disguises huge regional differences. The immediate issue is to keep inflation pressures in check, although in my view large fuel subsidies hinder, rather than help the process. Markets and investors will not only be focused on this in the year-ahead but also on how India faces up to its huge supply side challenges .For instance, in the WEF's annual competitiveness report over the last year India slipped from 42nd to 48th out of 131 countries, whilst China rose one place to 34th. The two big challenges for business are infrastructure and too much bureaucracy. Facing up to the challenge is the need for huge infrastructure spending, with a figure of $500 billion over the next five years sometimes cited. This, in turn, adds to the pressure for India to make rapid progress on its financial sector reforms. If not, the financing of its much needed infrastructure is likely to lag.

The other major policy challenge in 2008 concerns currency policy. Using the Fed's index, the dollar has fallen almost one-third since spring 2002. Whilst a huge fall, it is not unprecedented; the dollar fell 37.4% between March 1985 and May 1988, and that fall included a decline of one quarter between the Plaza and the Louvre Accords, when the major economies sought an orderly dollar decline. Currently we are witnessing a shortage of dollar liquidity around the world, as financial institutions and others hoard dollars, yet despite this the currency is weak. It would be wrong to view the dollar as a one-way bet; the euro and sterling both appear too strong when viewed domestically. And, as mentioned above, the rupee's strength is adding to concerns over exports in India. In contrast, the peg to the dollar is triggering inflation worries in the Gulf. One way this could play out is a shift in dollar policy, with more countries seeking to manage their currency not just against the dollar, but more against a basket of currencies with which they trade. This shift would allow increased flexibility in monetary policy and better reflect the changing world economy. But 2008 is as likely to be a renminbi as a dollar story. The need for greater monetary control in China should mean intervening less and accepting greater currency flexibility. The renminbi is undervalued, particularly when one thinks that on current trends China's current account surplus could reach $480 billion this year, with currency reserves rising to over $2.1 trillion by year-end.

Significant underlying change is happening
This leads onto the third key theme for 2008, that present developments have to be seen in the context of a structural shift in the world economy. That shift does not mean that the US is less important, instead it reflects that other regions are growing in importance, particularly in economic and financial terms. In recent weeks, the two hot topics have been sovereign wealth funds, and Gulf currency policy. Both are indicative of how the balance of power is moving from the West to the East. This shift is already seen in trade flows. New trade corridors show rising trade between Asia and the Middle East, Africa and Latin America. Already, Asian-European trade outstrips Asian-US trade. This will continue. Rapid urbanisation, huge infrastructure projects and private sector investment as firms reposition themselves for future growth markets all add to the shifting global picture. The growth of foreign exchange reserves, the rise of sovereign wealth funds and the increasing private flows into emerging markets suggest that a shift in the global financial architecture will be an ongoing story in 2008, added to by the pressure on many countries to deepen and broaden their financial markets. One lesson from the Asian financial crisis was the need to open up one's markets at a pace best suited to domestic needs. Another lesson of that crisis, a decade ago, was that it took a full year for its impact to be felt around the globe. The current financial crisis is still unfolding and it would be wrong to underestimate how it will play out. Thus caution, not pessimism is needed as we enter the New Year.

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