BANKING SECTOR FAILURES

THE single most crucial issue - on which the world recovery hinges - is the restoration of stability to the crippled banking sectors of the United States and Europe.

Banks in the US have been repeatedly brought back from the brink over the last few months. The three largest surviving institutions - Citigroup, Bank of America and JP Morgan Chase - have finally reported a return to profitability. And the infusion of fresh bailout funds into AIG has also gone into paying off the company's debts to European banks, lifting banking stocks in the US and Europe last week.

But the banks are not on safe ground yet, with US$1 trillion (S$1.5 trillion) or so of toxic assets still hobbling their balance sheets, and creditors and investors still unsure about how the US government is going to help them.

So far, Asian banks are holding steady, but a surge of bad loans resulting from the economic meltdown could spell an end to that. Until banks around the world see a return to business as usual, a sustainable economic recovery is difficult to envision.

DEFLATION, HIGH INFLATION OR STAGFLATION?

THE world is on the verge of serious concern about prices - but no one knows whether the problem will turn out to be deflation or inflation.

As demand for goods and services plummets around the world and people start to lose their jobs, countries including the United Kingdom, China and India are starting to see inflation fall to multi-year lows and deflation loom on the horizon.

But the sheer amount of money being pumped into the financial system to encourage banks to lend means that inflationary pressures will not be too far behind. If the easy money clears the blockages and starts to flow faster than economies improve, we could face the dreadful phenomenon of stagflation: high inflation coupled with low or no growth.

What will be needed then are central bankers with a sharp eye and a quick touch, to lower the money supply as soon as liquidity appears to be flowing again.

PROTECTIONISM

IN ANY economic crisis, nationalism is quick to come to the fore. This time around, the protectionist instinct was not slow to rear its head: Witness US President Barack Obama's knee-jerk 'buy America' proposals, Indonesia's 'buy local' plans, and bailouts and subsidies given to automakers in the US, Canada, France, Germany, the UK, China, Argentina, Brazil, Sweden and Italy.

World Bank economists monitoring trade measures have noted that 47 trade-restricting steps have been implemented since the beginning of the financial crisis - despite a pledge made by the G-20 countries last November to maintain open trade.

Most of these steps have had negligible effects individually, but the emergence of a trend is worrying. A protectionist spiral would eliminate any hope for global economic cooperation and stunt recovery.

DEVALUATION RACE

A TRIED-AND-TESTED way that a country can boost its economy at the expense of others is to devalue its currency. This makes its exports more competitive and its inward investment opportunities more attractive to those overseas.

Switzerland, faced with bankruptcy over its exposure to Eastern Europe, recently became the first major Western economy to devalue its currency to support the economy, setting off speculation that other countries would follow suit.

In Asia, economists noted that the Thai and Taiwanese are also actively weakening their currencies. Like protectionism, this policy works only if there is no retaliation from other economies - an extremely unlikely scenario.

Indeed, Russian Finance Minister Alexei Kudrin declared last weekend that a 'global devaluation contest' had started. 'Devaluation in one country leads to inevitable devaluations in other countries and creates problems,' he said.

COLLAPSE OF EASTERN EUROPE

A DANGEROUS debt crisis is looming in Eastern Europe. With growth built largely on borrowed foreign capital, countries such as Hungary and Poland are finding themselves deep in debt at a time when previously generous inflows of funds are drying up and reversing direction.

It has been estimated that Eastern Europe's borrowings amount to US$1.7 trillion, of which US$400 billion must be repaid or rolled over this year - equal to a third of the region's gross domestic product (GDP).

The region's exports to its main Western Europe market have collapsed, pitching its companies and banks into a downward spiral. With much of Eastern Europe's debt denominated in foreign currency, demand for foreign exchange has rocketed and local currencies have plunged.

The International Monetary Fund has already stepped in to bail out Hungary, Ukraine, Latvia and Belarus, but its own reserves are being fast depleted. If a nation does default, the consequences - for Europe and the world - could be devastating.

This article was first published in The Straits Times.