Africa: Testing the theory of unstoppable momentum
Commodities matter, but other things matter more. Weak institutions do not prevent growth, but they increase susceptibility to crises. As the cycle turns, expect a greater focus on downside risks.

Middle East: GCC common market: common challenges
The GCC Common Market was established on 1 January 2008. There are great benefits, but also serious challenges. Fiscal prudence and monetary flexiblility are the key tests.

FX: Recoupling and the USD
US recession is not necessarily bad for the USD. We expect some USD upside by Q2-08 as bad news rotates elsewhere. The obsession with interest rate differential will persist in 2008. While we expect the GBP to underperform, at least in H1-08, Asia is far less vulnerable.

Commodities: USD weakness drives oil prices
Crude oil hits USD 100pb briefly as markets brush demand concerns aside. USD weakness, finely balanced market and geopolitics are key drivers. We are raising our forecast for WTI to average USD 82pb in 2008.

Kenya: The economic cost of turbulence

Korea: Myungbaknomics: small is big and beautiful

Malaysia: A challenging 2008

Pakistan: Resilience in the face of adversity

Singapore: Rough ride ahead

Thailand: Political uncertainty lingers

Forecasts and Sovereign risk tables

OVERVIEW

Gerard Lyons
Chief Economist and Group Head of Global Research, +44 20 7280 6988, Gerard.Lyons@standardchartered.com

• The big issue will be how the world copes with a US recession in 2008 and weakness in 2009
• Emerging economies are not immune but are in a better position to cope
• The current rise in gold suggests investors are searching for safe-havens

The year a stopped clock may be right

Singapore, Hong Kong and Malaysia all fell into recession during the last sharp US economic slowdown in 2001. That lesson should not be overlooked - despite much evidence of decoupling and a structural shift in the world economy the lesson of 2008 is likely to be that the business cycle still exits! Things now are different compared with 2001 but in offsetting ways. The US economy looks set to weaken far more than it did seven years ago, with the downturn driven by the consumer, not the corporate sector as it was then. In contrast, economies in Asia are a lot stronger now than they were at the turn of the century, when they were fragile, still recuperating after the devastating 1997-98 economic crisis, and of course China is much bigger and far more open now than it was then. At the millennium, emerging economies accounted for just over one-third of the global growth then being seen, in contrast last year they accounted for over half! Nonetheless, the lessons of 2001 should still be heeded - namely the importance of the US economy and the impact it can have on global trade and export growth if it slows.

The financial problems overhanging Western markets and the inevitable US downturn will dampen global growth, slow the pace of trade and take the heat out of commodity markets. This makes us cautious but not pessimistic about the year ahead. The likely downturn needs to be put in the context of what may well prove to be a pause - albeit a significant one - in a period of prolonged growth for the global economy. Furthermore, as important as the US is, it is not the only driver of the world economy. Already over the last twelve months we have seen evidence of the economic and financial shift that is already underway in the global economy: we saw economic decoupling (with the US slowing, whilst emerging markets remained strong in 2007) and also the increasing importance of sovereign wealth funds (SWFs).

Significant recent events
The last few weeks of 2007 and the early days of the new year have already held some significant developments: poor US jobs data (not such a surprise but suggesting economic weakness is spreading); oil hitting one hundred dollars per barrel (partly reflecting still buoyant demand across emerging markets and tight supply); a surge in gold prices (this is telling us something - it reflects a flight to quality given concerns about the dollar, the financial sector and about inflation); a welcome reduction in money market rates in Western markets (suggesting a return to more functional market conditions); further evidence of Western financial firms turning to SWFs in the Middle East and across Asia for an injection of liquidity and capital; a significant weakening in Singapore's GDP (but this was the first fall in seventeen quarters, and as we had previously warned, Singapore's recent period of above trend growth was not sustainable); and evidence of heightened political tensions in Pakistan, Kenya and Thailand, following the assassination of Mrs Bhutto in Pakistan, post-election social unrest in Kenya, and news that the Thai Supreme Court is considering dissolution of the People Party Power, victorious in the recent election. All are significant, and provided evidence, if it was needed, of the many different risks that overhang the global economy. There is no doubt that politics will, as always, be a key issue, not just in the countries mentioned but elsewhere, with Taiwan just one of many facing significant elections (in Taiwan, January's parliamentary election is followed by a March Presidential election which could lead to major changes in government and policies). What then are the key risks in 2008? There are many, but let me highlight three major ones.

Three global risks
First, contagion from the financial sector to the real economy. Every financial crisis has its own dynamic, determined by the fundamentals, the policy response and confidence. The fundamentals are poor in the US and UK but good in most other major economies. The policy response has been helped by the recent coordination in the money markets but still more needs to be done. Meanwhile confidence is starting to suffer and has been shot to pieces in the banking sector in the West. All three factors are interlinked and all are important, but confidence is the hardest to predict. The reduction in money market rates in the West over the new year has been a welcome development, suggesting that the rise in rates seen in November and December was exaggerated by year-end fears, as banks held onto liquidity. Of course, the aggressive coordinated injection of liquidity by central banks was important in containing the situation. As the scale of the financial crisis deepens, the need for an aggressive policy response grows in order to prevent damage to the real economy. In recent months there has been financial decoupling: within the West (where equities have performed well despite problems in credit and banking markets) and between the West and the East. This financial decoupling is unlikely to continue in 2008. And we are also likely to see contagion from the financial sector into the real economy.

Second, a sizeable US recession. If it looks like a duck, walks like a duck and sounds like a duck, chances are it is a duck. That, I believe, is how the saying goes. Something similar may be appropriate for looking at the US economy this year. If it looks like a recession and feels like a recession chances are, it is a recession. This year, the US economy may technically avoid a recession (whether you want to define it in the current convention as two successive quarters of negative growth, or whether you prefer the old fashioned view of an outright year of negative growth). But to get caught up in the fine detail risks missing the key message - the US faces a prolonged period of weak growth. This began towards the end of 2006, when the housing market started to turn down, continued through last year, and in our view will persist in 2008 and 2009. Last year the loss of momentum was gradual. This year, because of the subprime crisis and credit crunch, the downturn may be more severe, with growth of only 0.5%, and next year only 1.2%. And this year's growth will not be driven by domestic demand, which will be flat, but will be explained by falling imports that reduce the current account deficit. These growth figures compare with trend growth around 2.7%. So it will look like a recession. It will feel like a recession. And chances are, it will be called a recession. This will justify significant fiscal and monetary easing. Expect the US Federal Reserve to respond aggressively, with large interest rate cuts, in our view down to 3% by mid-year and they could even fall further beyond that. Although all cycles are different, the present scale of economic and financial challenges means we should not overlook that the Fed got rates down to 1% in an environment that may well prove better than the one we are entering, whilst the Bank of Japan was forced to get rates down to 0% in their crisis. The downside for US rates should not be underestimated. As in Japan in the 90s, fiscal easing would be fully justified, but it may be too little, too late.

The third risk is a downturn in China. A US recession means increased attention on China, where the authorities are facing up to many different challenges. Financial markets are underestimating not only the speed and pace of change within China, but also the policy challenges ahead. As the private sector grows, and as the regions seek to develop their local economies, policymakers 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. Entering 2008 expect the Chinese authorities to focus more on the perceived inflation risk, raising rates, tightening reserve requirements, restricting lending, imposing investment controls and accepting the case for a stronger renminbi. As the year progresses, the Chinese economy will slow as a result of a double whammy: weaker exports to the US and the lagged response to policy tightening at home, as confidence wanes and investment plans are cut. The policy focus is likely to be on curbing inflation and maintaining financial stability. And whilst the pace of CNY appreciation is likely to be of secondary importance, a stronger currency is likely to support the authorities' overall aims. We expect a stronger pace of CNY appreciation during the year; at least 9%, possibly more.

First quarter focus
Attention in the first quarter is likely to be firmly on the US, as the authorities try to head off recession. One of the main themes of 2007 was decoupling, where despite a significant US slowdown, the rest of the world held up well. A year ago, we had some of the most optimistic growth forecasts for the emerging economies, particularly in Asia, Africa and the Middle East despite having a pessimistic US growth forecast. A view we held throughout the year, and indeed at the beginning of August we were in the minority of those expecting the Fed to cut rates before the end of 2007, at a time when the market anticipated rate hikes.

Recent economic data has been mixed, and the mood across the US varies significantly. There is a widely held view that problems in the financial sector are unlikely to be felt across the country. I hope that is right, but it would be wrong to plan on it. To repeat a message we have stressed for some time, US consumers need to spend less, and save more, and return their balance sheets to some sort of normality, much in the same way that the US corporate sector had to get its balance sheet into shape back in 2001. That points to a prolonged period of sluggish US growth.

Each year for some time now there have always been forecasters who have predicted doom and gloom for the US. Those forecasts reminded me of a stopped clock - saying the same regardless of what was happening. Of course, such pessimism has been misplaced in recent years, as the US economy has grown strongly, the US corporate sector is in good shape and the world has boomed. But even a stopped clock is right at some point and this is likely to be the year when it is correct to be pessimistic about the US. Whilst one could have said for some time that US consumers needed to save more, the reality is that in recent years the housing market was rising, the jobs market was strong and credit was readily available. Now, things are different. Housing has been weakening for some time. The jobs market is deteriorating, and problems in the financial sector will spill over into tougher lending conditions. Consumers will be forced to save more.

Attention will then turn to global linkages
Although 2007 provided evidence of decoupling between emerging markets and the West, we have continued to stress that this is a multi-year story and that it does not prevent the impact of the business cycle being seen in the near-term. Although the US has been slowing for over a year, the downturn has been largely driven by a weakening housing market, and thus the spillover to other countries has been relatively limited. But with signs of slowdown spreading, to consumption and investment, the cross-border spillover will be larger, but will also be manageable if countries impacted react quickly with pro-growth policies.

Eastern Europe, where many countries have large current account deficits, and a region that has seen private sector inflows even higher than Asia, is the region most at risk to a shift in global risk aversion. Mexico and Canada are more exposed to a US downturn. The rest of Latin America should be seen more as a commodity region, and much in the same way that Africa and the Middle East are benefiting from the longer-term commodity cycle, all three regions could see some cyclical adjustment as the recent easing in metals prices is extended to other commodities. Even oil prices could ease towards, say, seventy dollars per barrel by year-end. But the softness in commodity prices this year, may well be followed by a further upward trend, driven by renewed strength across the emerging world.

For Asia, the impact of a US downturn will be seen in two ways: a slowdown in export growth and via a financial market impact, particularly a correction in stock markets. Typically, a US recession sees US import growth turn sharply negative (indeed that itself may account for all of this year's 0.5% US growth, and in the process reduce the current account deficit). The pro-cyclicality of US imports is particularly relevant for Asia, and will lead to slower but still steady growth across the region. Last spring the International Monetary Fund provided a good analysis of the global impact of previous US slowdowns and recessions. The table here reproduces some of the relevant aspects with respect to US recessions and emerging Asia. Perhaps just as important from last spring's IMF analysis was that disturbances to US growth also have a significant but, again, short-lived effect.

The importance of exports for Asia leaves the region vulnerable early in 2008. Yet, recent data shows that exports from Asia are performing relatively well, despite weak electronic export demand. In dollar terms, east Asian exports rose 19.9% year on year in October, and November is likely to see a slightly slower pace of growth. Also, the financial spillover effects are also not yet evident, in part because global equity markets have held up well, but also because there is still ample liquidity across Asia and many emerging markets, as was evident at the end of last year. We expect the 12 economies in East Asia ex Japan to grow at an aggregate 6.4% in 2008, down from 7.8% in 2007 with no one expected to be in recession. This contrasts sharply with the previous downturn in 2001 when four of the 12 Asian economies were in recession and aggregate growth rate dropped by 3 percentage points to 4.2%.

Although emerging economies - and not just those in Asia - are more integrated into the global economy and thus more exposed, the reality is that emerging economies are much better able to cope. Indeed, the credit crunch at the end of last year saw a significant contrast between liquidity conditions in the West and those across the bulk of the emerging world. In addition, the policy tools now available, helped by the huge accumulation of foreign exchange reserves, provide better ability for countries to absorb shocks.

As the world economy moved into a low inflation environment during the 90s, it became common for local factors and not global factors to drive overall economic growth. This was highlighted most by the decoupling seen between the world's major two economies, the US and Japan, but indeed was evident for many others. Similarly now, one should not overlook the domestic factors that could drive growth in a number of countries in the years ahead.

A key factor that needs to be taken into account in considering the policy response is the inflation outlook across countries. Oil has replaced the financial sector as the big theme entering 2008. This is not a surprise, with oil touching USD100 per barrel. The immediate issue is what is this telling us? In recent years high oil prices have largely reflected buoyant global demand. But as we have seen from other commodities, even with buoyant demand prices can fall, depending on the supply situation. Metals prices, for instance, eased significantly last year despite having previously been boosted by demand. In previous cycles, high oil prices were largely a reflection of tight supply. In this cycle, the world has found it easy to cope with high oil prices driven largely by strong demand. That strong demand also contributed to buoyant global growth, boosting trade and sales volumes and allowing the cost of higher oil to be absorbed.

For some time now there has been talk of a 'permanent oil shock', as strong demand from emerging economies such as China looked set to keep oil prices stubbornly high. And so it has proved. And it is not just the demand, it is also the energy inefficiency of countries such as China and India that has much to do with it. Meanwhile, whilst there is now huge supply from many non-OPEC members, it is the response of the big OPEC members that plays a key role in the price. OPEC has memories of raising supply in previous cycles, just at the time that global growth was slowing, and the combination of both factors could drive oil prices down sharply, leading to a boom-bust situation. Keen to avoid a repetition now, we have a situation where the oil price appears to have a firm floor and a soft ceiling.

The combination of high energy, and high food prices, will lead to inflation worries in some countries, although it would be wrong to believe that inflation will be a global problem this year. Take, for instance, those countries across the Asia Pacific region with formal inflation targets. In 2008, we expect five of these six to achieve their target, and one, Korea, to undershoot. For instance, we expect Australia's inflation to be 2.7% versus a 2.0% to 3.0% medium-term target; Indonesia's to be 6%, versus 4.0% to 6.0%; New Zealand 1.8% versus a 1.0% to 3.0% target; Philippines 3.5% versus 3.0% to 5.0%; South Korea 2.0% versus 2.5% to 3.5%; Thailand 3.2% core inflation versus a 0% to 3.5% target. Despite this, in some countries, inflation will be a problem, particularly where domestic demand is strong. China, India and Malaysia face inflation pressures. The implication is that one needs to judge the inflation and interest rate outlook in each country on its own merits. China, and India, for instance, need further policy tightening, even allowing for currency appreciation.

Overall
In such an environment, a flight to quality is one of the key issues. Yet, in saying this, an important factor that has to be taken into account is what has already been discounted by markets on both the economic and the policy outlook. Thus markets that look very attractive in the longer-term, such as in Asia, could even suffer some short-term setback, as the downside risks to growth that could occur during this phase of the business cycle are factored in. There could even be a temporary bounce in the dollar, before it resumes a weaker profile. When one looks at currencies, the shock absorbers may well be appreciations for those currencies backed by large current account surpluses - and this will inevitably put pressures on pegs. In the Middle East, for instance, currency appreciation is a strong possibility, despite political resistance. In contrast, the deficit currencies, not just those in Eastern Europe, but sterling too, look vulnerable. Gold is a safe-haven, benefiting from longer-term worries over the dollar and financial and inflation concerns. The prospect of significant policy easing, particularly from the Fed, will give fixed income markets and even equities near-term support. Yet the equity markets most at risk include those in some of the strongest growing economies, namely China and India, where even though growth may slow it will still be rapid enough to lead to worries about inflation and further policy tightening. Sovereign wealth funds are likely to grow in importance and, over time, we expect them to allocate more of their funds to emerging markets as well as to alternative investments. A year ago it was widely felt that markets were not pricing sufficiently for risk, and the reaction to that is still feeding through across credit and fixed income markets. Every financial market crisis is different, influenced by the fundamentals, policy response and confidence. It is confidence that is hardest to predict, and that gives the present market outlook a hard to call feel to it. But what is clear is that caution, not pessimism, is called for.

Despite justifiable near-term worries about the credit crunch and slower global growth, it is also important not to lose sight of the fundamental shift taking place in the world economy. Once the impact of this credit crunch has worked its way through the system, the economic prospects for the world economy look very good. The recent sight of Asian and Middle Eastern sovereign wealth funds providing liquidity and capital to western financial institutions is just another example of the shift in the global balance of economic and financial power. 2007 provided some evidence of decoupling, as emerging markets boomed despite a US slowdown. 2008 will show that whilst there is decoupling there is contagion as well. The business cycle still exists! Emerging economies are not immune to a US recession, but they are in a much better position to be able to cope, with huge reserves, ample liquidity and credible macroeconomic policies. Whether one is bullish or bearish about the world economy, the better prospects are in the emerging markets. But even this will not prevent some contagion from the US in 2008.

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