Investors who kept faith in Asia as the world teetered on the brink of financial meltdown a year ago have been richly rewarded – the region’s markets rode out the storm in spectacular style and posted stunning gains.

The economic outlook for 2010 appears far sunnier. But with frothy markets betting on a smooth return to business as usual, the danger of a sudden correction hangs over Asia, unless the region can steer its way past some treacherous political risks.

The two most important issues for the world economy in the coming year are political — the pivotal relationship between the United States and China, and the timing and coordination of exit strategies from the stimulus measures that kept disaster at bay.

Investors in Asia also need to be wary of political shocks that could suddenly overturn the region’s risk profile.

Upheaval in North Korea, where there are persistent doubts about the health of leader Kim Jong-il and where the economy is going from bad to worse, could cause profound regional instability. And the risk of a confrontation between nuclear-armed India and Pakistan, perhaps sparked by another militant atrocity in India, is ticking upwards again.

“A multitude of political, security and operational risks converge in Asia,” said Michael Denison, research director at London-based Control Risks consultancy. “The causes of the global recession are now well understood. The contours of the recovery, by contrast, are far from clear.”

Relationship problems

The United States and China are already by far the two most important countries in terms of political clout. And in 2010 China is set to overtake Japan as the second-largest economy. The “G2” relationship is key to shaping our destiny not just in the coming year or coming decade, but through the 21st century.

Like most relationships, it is not easy.

Pressure on China to allow the yuan to appreciate will become ever more intense in 2010 as economic storm clouds evaporate, and one-year non-deliverable forwards suggest modest gains by the currency by the end of 2010.

But Beijing will not want to jeopardise economic growth by letting the currency rise too quickly, and does not appreciate being told what to do by Washington or anyone else. In the United States, meanwhile, yuan weakness is regarded as a protectionist policy that threatens the U.S. recovery.

Into this volatile mix add the ever-present threat of import restrictions, like the U.S imposition of tariffs on Chinese tyres in September, sparking a tit-for-tat trade war.

Plus the danger that Beijing’s backing of regimes that Washington finds unpalatable, from Pyongyang to Yangon to Tehran and Khartoum, explodes into a political confrontation.

Most analysts say Washington and Beijing are painfully aware of the risks and would step back from the brink before any dispute threatened the global economy. But the two countries have yet to find a way to communicate comfortably as partners. The risk of a misunderstanding or sudden chill in relations is real.

The second key political risk for Asia – and indeed the world – is dealing with the hangover from the stimulus measures that helped keep the global economy afloat over the past two years.

If governments withdraw the stimulus too soon, they jeopardise growth. But keep policy too loose for too long and they risk not just inflation but also catastrophic asset price
bubbles. Given China’s importance to the global recovery, signs of property and equity bubbles there are a particular concern.

Another risk for investors is if countries trying to prevent bubbles and curb inflows of “hot money” tighten capital controls. Analysts say this could be a key issue for India and Indonesia in 2010.

Disagreements could also erupt within countries, between governments focused on safeguarding growth and central banks fearful of inflation and bubbles. That could lead to bad decisions, and make policy hard to forecast. Policy friction is already an issue in Japan. India and South Korea could be next.

Known unknowns

As in any year, the best-laid plans in 2010 could be derailed by unexpected shocks. We have no idea about some of the lightning bolts that will hit Asia in 2010 — the surprises that author and fund manager Nassim Nicholas Taleb calls “black swans” and former U.S.
Defense Secretary Donald Rumsfeld called “unknown unknowns”.

But there are plenty of known unknowns to worry about.

Mass social unrest due to economic hardship was the dog that failed to bark in 2009. That could change in 2010.

“A structural rise in unemployment will represent a key macro, political and security risk in 2010, even in states like China where growth has remained relatively solid,” Denison said.

The decisive victory of the Congress party in India’s 2009 elections was another good-news story for markets that could be threatened if militants based in Pakistan provoke a confrontation again. Investors are already rattled that reforms in India are going slower than expected. The last thing they want is war risk.

“Another major attack would all but force India’s government to take a much more hostile approach to Pakistan … allowing Pakistan’s military leadership to set aside
attacks on local militants and turn their attention to an enemy they feel less reluctant to antagonise,” said Ian Bremmer, president of the U.S.-based Eurasia Group political risk consultancy.

And finally, two key Asian heads of state are ailing, with the question of who and what will come after them far from settled. Thailand’s 82-year-old King Bhumibol Adulyadej has been in hospital since September, another complication in the long-running political crisis that has riven the country.

Many analysts expect instability to get even worse after his reign ends — giving Thai markets another rough ride. But most say there is little risk of contagion in other
markets.

By contrast, when North Korean leader Kim Jong-il dies, the tremors will be felt in South Korea, Japan and beyond.

Many analysts say Kim’s death would herald the collapse of the regime in
Pyongyang, leading possibly to prolonged civil war in North Korea, aggressive moves against the South, or the sudden reunification of the Korean peninsula. In all of these cases, the likely market reaction would be the same – panic.