Japan's Foreign Minister Seiji Maehara (L) meets with China's Foreign Minister Yang Jiechi in Hanoi
Japan's Foreign Minister Seiji Maehara (L) meets with China's Foreign Minister Yang Jiechi in Hanoi October 29, 2010. REUTERS

The Asia-Pacific region will continue to be the fastest-growing region of the world in 2011, according to a forecast by IHS Global Insight.

After posting a strong economic rebound in 2010, the Asia-Pacific economies' surge next year will be ably supported by a U.S. recovery, continued growth in China and firm domestic demand in many Asian economies, the report written by Rajiv Biswas, Asia-Pacific Chief Economist at IHS, said on Wednesday.

However, the report says the region faces significant risks in the backdrop of the fragile state of some of the largest economies in the world, the raging sovereign debt crisis in the European Union and 'deep-seated structural problems facing Japan.

It spells out ten chief political and economic risks facing the region in 2011:

1. Volatile Capital Flows

With interest rates expected to remain on hold in the G-7 and the Fed’s QE2 plan for quantitative easing injecting liquidity into financial markets, there is a significant risk that further significant capital flows will enter emerging Asian capital markets in 2011 given their positive medium-term growth outlook and expected rising interest rate differentials as many Asian central banks continue to tighten monetary policy. Given considerable concern amongst Asian central banks about the impact of such volatile capital inflows on their own domestic asset markets, as well as the recent decision by G-20 leaders to give the green light for limited capital controls to help to control destabilizing capital inflows, it is likely that some Asian governments will implement further limited capital control measures in 2011.

2. Asset Bubbles in Asian Economies

A risk related to volatile international capital flows is that of asset bubbles building in some Asian economies due to loose monetary policy and abundant liquidity. There are already concerns that some property markets in China, Taiwan, Hong Kong and Singapore are overheated due to the very low cost of borrowing, and that continued strong economic growth in 2011 will fuel further property price rises, increasing risks of property bubbles developing that could burst later if significant monetary policy tightening occurs. The Australian property market is also vulnerable due to the significant monetary tightening that has already occurred in 2010 and the risk that further tightening will be needed in 2011 due to the strength of domestic economic conditions and inflation already running close to the upper limit of the Reserve Bank of Australia’s target range.

3. Double Dip Recession in World Economy

While IHS expects that the global recovery will pick up steam in the second half of 2011 after some moderation in growth momentum in the first half of 2011, there is still a risk of a double dip recession in the global economy in 2011 given the fragility of recovery in the G-7. IHS currently assigns a 20 per cent probability to such a double-dip scenario. Should such a double dip recession occur, this would result in a significant impact on the Asia-Pacific economies as a result of a drop in exports to the key US and EU markets given the importance of exports as a share of GDP for many East Asian economies. Furthermore, global financial markets would decline in such a scenario, resulting in a rise in risk aversion amongst international investors and likely triggering capital outflows out of emerging Asian equity and bond markets. Commodity prices would also decline, hurting the economies of commodity exporters such as Indonesia, Australia and Malaysia.

4. Military Tensions in Korean Peninsula

The escalation of military tensions on the Korean Peninsula is one of the key geopolitical risks for the Asia-Pacific in 2011. The unprovoked attacks on South Korea in 2010 by the North Korean regime with the sinking of the Cheonan and the recent artillery shelling of Yeonpyeong Island highlight the unpredictable behavior of the Kim Jong Il regime and have heightened the risks that further such incidents could result in escalating confrontation in 2011.

5. Thailand - Parliamentary Elections in 2011

While the political situation in Thailand has stabilized since the violent clashes between opposition protestors and the Thai military in April and May 2010, Thai society remains deeply divided politically. With national parliamentary elections due to be held in 2011, there are significant risks of renewed political turmoil during 2011 over the process and outcome of the elections. The frail health of the ageing monarch adds to the political uncertainty, since he has played a unifying role in the Thai political landscape for decades. Unless the new government that emerges after the elections is willing to pursue governance based on reconciliation and inclusiveness, the dangerous political rifts that divide Thailand are likely to remain a key risk to the Thai political outlook.

6. Political Risks on Indian Subcontinent

Tensions between India and Pakistan remain a significant geopolitical risk for the Asian region given both are nuclear powers. A key trigger for escalation in tensions remains the threat of major terrorist attacks on Indian soil by terrorists originating from Pakistan similar to the Mumbai terrorist attacks in 2008, and that this could provoke some form of military response by the Indian government.

7. Rising Inflation in Asian Emerging Economies

While inflationary pressures were generally low throughout much of emerging Asia in 2010, there are signs of increasing inflation in some economies as global commodity prices rise and stronger domestic demand conditions support higher wage rises, resulting in rising unit labour costs. Rising inflation in China is of particular concern, given the importance of the Chinese economy as a global and regional growth engine and the risks that if significant tightening in Chinese monetary policy and credit conditions is required, that this could result in a growth slowdown that would have transmission effects throughout the Asia-Pacific region.

8. China Hard Landing

While some moderation in the pace of Chinese economic growth is forecast for 2011, the risk of a hard landing remains a low probability scenario. Nevertheless, due to the rising importance of China for the Asia-Pacific region as a key trade partner, such a scenario would have a high impact on the rest of the Asia-Pacific region, with China already the largest export market for a number of Asia-Pacific economies, including South Korea, Australia and Hong Kong. Key areas of concern including rising inflationary pressures as well as the likelihood of significantly higher non-performing loans in the Chinese banking system in coming years due to the very rapid expansion in credit in 2009-10 and the related problem of significant poor quality lending to local governments.

9. Early Australian Elections

With the current government having been formed only with the support of several independents, the political balance of power is delicate. Furthermore, the opposition has seen a resurgence of support at the state level, reflected in the Victorian state elections in late November 2010, with a Liberal-National coalition government winning power. The New South Wales state election due by March 2011 will also be another key test, with the opposition Liberals also expected to perform strongly. While the risk of another Federal election in 2011 remains low, it would have major economic policy implications for the future of the controversial mineral resource rent tax being pursued by the current government, as this would be scrapped by an incoming Liberal government.

10. Rising Asian Currencies

While rising interest rates will support some appreciation of Asian emerging markets currencies, there is a risk that such appreciation pressures could become very significant for some countries during 2011, as some Asian central banks tighten monetary policy to manage inflationary pressures. Such a scenario of rapid appreciation of some Asian currencies vis-a-vis the USD and Euro could result in a significant deterioration in export competitiveness, hurting their export sectors while also increasing the risks of volatile capital inflows chasing higher interest rates and benefiting from currency appreciation.