In the Chinese calendar, the lunar year which started on Jan 23, 2012 is a Dragon Year. In China, the dragon stands for power, superiority and success. But 2012 looks like being a year of difficulty and change. The three big motors of the world economy - Europe, the US and China - all have their own particular challenges to face and overcome. In today's globalized world, all are interlinked. The successful outcome of one depends on the others. Do China's roles as a potential source of finance for troubled Europe, and as a global engine of economic growth mean that, in 2012, the Chinese dragon will move to the center of the world economy?

In Europe, will Europe's population accept the need for consolidation, harsh cutbacks in spending, and the loss of their precious social entitlements? If the euro does disappear, how will the world manage the failure of a major reserve currency?

In the US, will the markets demand a solution to the US debt problem before the presidential election in November 2012? Will we see a dollar crisis early in 2012?

Can the Chinese economy, now the world's second-largest, complete its switch from an export-driven to a domestically-driven economic model without collapsing in the face of a recession in Europe?

Together, these separate, but related developments make 2012 the year when the much-discussed new world order starts to take shape - a turning-point. Since 2008, we've known that the world was changing fundamentally. By the end of 2012, we'll have a much better idea what those changes will look like.

Let's start in Europe. Recently, under enormous financial pressure, 26 European countries took a step toward cutting future debt by agreeing to balance their budgets, with automatic penalties if annual deficits exceed 3 percent. Only 18 of the 27 countries in the European Union actually use the euro, but the German/French leadership considered they needed a Europe-wide agreement to change the euro rules.

Apart from promising to cut future debt, the main purpose of the European agreement was to put in place the conditions which would allow China and other countries to support Europe financially. Under the agreement, the EU will provide up to 200 billion euros to finance the International Monetary Fund (IMF) in Washington. These funds will provide a core for additional financing by the IMF for Europe's governments and banks from non-euro countries like China, who refused to become involved earlier in helping Europe financially because there was no restructuring plan and the Europeans themselves were not prepared to put their hands in their pockets to help themselves. But now the IMF can turn to surplus countries in the Middle East and Asia to ask for large additional funds to support Europe, by saying that the Europeans have contributed, and there is a plan to place Europe's finances on a stronger basis.

The euro agreement is important not just to gain the market's support for the euro economies in trouble (Greece, Spain, Italy, Ireland, Portugal, even France) but also because the European banking system is coming under acute stress as banks refuse to lend to each other, and start to run out of assets they can sell to raise liquidity. President Nicholas Sarkozy has an election coming up in May. The last thing he wants is for one or more of the major French banks to collapse while he is campaigning for re-election. Angela Merkel, Germany's chancellor, would also suffer if a German bank, like Commerzbank, went under as well. Behind the recent euro agreement lies a good measure of political self-preservation on the part of the two architects, Sarkozy and Merkel.

Meanwhile, Germany's continued refusal to allow money-printing to put a safety net under the euro means that, as the tide of liquidity retreats, the rocks start to show - in this case, the problems of uncompetitiveness inside Europe's economy. The European agreement reached recently in Brussels will force Europe's political leaders to examine how to reform their economies to reduce unemployment and increase growth, because European governments will be forced into huge spending cuts which, in the short term, will weigh heavily on economic growth.

There will be some kind of economic recession in Europe in 2012-13. Without the capacity to depreciate their currencies to boost exports and encourage capital inflows, the 18 members of the euro will need to take strong measures to boost economic growth, by encouraging more flexibility in labor markets, raising retirement ages and by encouraging innovation and the establishment of new businesses.

If these measures are successful, then Europe will emerge much stronger than before. But the immediate risk is that European populations, unable to tolerate such big cuts to their living standards, will revolt and overturn their governments. In this case the euro system will fail, and Europe, unable to carry out the reforms necessary to maintain its position as the world's largest economic grouping, will sink into a long depression marked by social unrest and increasing poverty.

It's just possible that the euro region could stay together in 2012. But the likeliest outcome is still that Greece, and probably other countries like Portugal, Ireland and even Spain, will have to leave the euro and return to using their own currencies - causing huge losses for banks and enormous disruption. The IMF looks set to ask for a Chinese contribution to support Europe. The interesting question is what China will get in return for providing financial assistance to the IMF. China may find it more advantageous to invest its savings directly into European banks and other European institutions which need new capital, giving China the benefit of direct ownership in return for committing major financial resources.

Across the Atlantic Ocean from Europe, 2012 is starting to look, for some people, like the year when the US economy will start recovering from the huge impact of 2008's credit crisis. There are even signs that the US private housing market may have bottomed out, after five years of weakness. But can the US really recover economically with such a large debt overhang? It seems certain that US public spending, including defense spending, will have to be cut hard, and US taxes will have to rise. Both these measures will cut growth. Such, though, is the reluctance of the US politicians in Congress to compromise on their deeply-held beliefs that it seems entirely possible that the financial markets, fresh from their destructive and profitable forays into Europe, will start in 2012 to test the will and capacity of the US to balance its books.

Meanwhile, on the other side of the world, the Asian world motor, China, is slowing. But at last Chinese inflation has started to moderate. This gives the authorities more room to stimulate growth. Other Chinese problems remain: the housing market, the export sector and local government finances are three of them. But the mood in Beijing is one of confidence - and given China's strong record of economic management, who can argue with that?

If China manages to stabilize its economy while Chinese demand shifts toward domestic spending, then China will be confirmed as the world's principal engine of economic growth over the next few years. The other major East Asian economies which border China - Japan and South Korea - all run large trade surpluses with China, and rely heavily on China for their own growth. These three East Asian economies account for about one-fifth of world economic output - about the same as the US. Add to this China's role as an export market for US and European products, and the key economic role that China now plays in the world will become very clear.

Is China - still emerging, and with a huge population of poor people - ready for the leadership responsibilities that accompany such a role? Probably not. But does China, or the world, have a choice?

The author is visiting professor at the Guanghua School of Business, Peking University. The views do not necessarily reflect those of China Daily.

(China Daily 02/10/2012 page8)