There has been a significant improvement in sentiment toward the global economy in the first few months of this year, but even though this improvement can easily be explained it needs to be kept in context, as there are still considerable challenges ahead.

When considering the economic outlook, we must not lose sight of two key influences. The first is the shift in the balance of economic and financial power, highlighted by the emergence of China, India and Brazil - not to mention a host of other economies across Asia, Africa and the Middle East. This shift is a strong, positive driving force.

The second factor's influence is shorter-term, but negative. This is the overhang of debt that continues to weigh on the recovery in Europe and the United States. The need to deleverage - as people, firms and governments pay off debt - points to a steady but unspectacular recovery in the US, and signals further problems in the eurozone.

It is against this backdrop that one needs to view the recent improvement in financial-market sentiment across the globe.

At the end of last year, a number of factors were weighing on the global economy. Lest we forget, the markets feared a double-dip recession in the US, a hard landing in China and a collapse of the euro. Thankfully, none of these fears materialised. I did not share the markets' views about the US or China, but I was pessimistic about the euro, expecting a muddle-through. The fact that economic data from both the US and China was better than expected helped sentiment, but the key factor was the actions of the European Central Bank (ECB).

The ECB did a great job pulling the euro area back from the brink by providing cheap three-year money in both December and February, which averted a bank collapse and a credit crunch. But as profound and necessary as the ECB's actions were, the short-term relief it has provided should not be seen as a longer-term cure for Europe's problems.

This year, the world economy still faces significant challenges. Let me highlight the main ones.

The first is the euro. The eurozone is in recession. With the exception of France, most major euro economies contracted in the last three months of 2011. This included the peripheral euro-area countries of Ireland, Italy, Spain, Portugal and Greece. There is every likelihood that this contraction will have continued in the first quarter, and perhaps even through the first half of this year. In short, the periphery is seeing a double-dip recession. The ECB's actions may have averted a credit crunch, but they will not prevent a credit squeeze where funds are still hard to come by.

Moreover, the eurozone is focusing on the wrong problem. Although debt levels are high, the biggest challenge is the lack of growth. Europe needs a growth strategy. It does not have one. Instead, it is cutting public spending and raising taxes to reduce debt. This is a long and painful process. Unless private spending picks up, economies will be weak. The trouble is, with demand sluggish, many firms are thinking twice about increasing their spending, which has resulted in a continuation of the difficulties that have engulfed the eurozone in recent years. This means further problems for Greece, and future worries for Spain, Portugal and Italy, as they will be in recession, probably this year and next.

Another challenge is the US. If there is to be a pleasant surprise this year, with US growth being much higher, it will be because big companies whose balance sheets are in good shape decided to go out and invest. Yet they seem reluctant, either because they fear demand will be weak or because they are worried about the regulatory outlook following this year's presidential election in November.

Confidence, of course, is an impossible thing to predict. It would be pleasing if a rebound in confidence did allow corporate America to go on a spending spree. Yet, if it does not, then the backdrop for the average American will be one of only modest employment growth, a small rise in wages and a still-weak housing market. Americans will still need to save more and spend less.

This leads to the issue of energy and food prices. A year ago, rising food and energy prices added to inflation pressures across the globe, justifying higher interest rates in many growing economies. Now, rising oil prices appear more like a tax on global growth, eating into spending power in the US and Europe, and hitting many Asian economies at a time when they are slowing.

The impact of oil prices on the global economy can never be underestimated. Rising oil prices are usually the biggest threat to continued global growth.

There can often be a big difference between oil prices being driven higher by strong demand and by supply shocks. If strong demand is driving prices, then at least when oil prices rise, there is also increased spending and trade. In the past, demand-driven spikes in oil prices would come late in an economic cycle. Now, it is demand from Asia and the Middle East that is driving oil prices up, and thus Western economies may not be in a strong position to cope. The more oil prices rise this year, the weaker the economic outlook will be in the West.

This vulnerability is worse now, as supply-side worries surrounding Iran have led to a large risk premium, pushing oil prices up. Oil prices appear to have a firm floor because of strong demand, and a soft ceiling because of geopolitics.

It is not just the West that watches oil prices closely. So, too, does China. Over the past year, China's authorities have tightened policy in order to squeeze inflation. Their main focus appears to have been on property prices, yet they have also been keen not to see a wage-price spiral develop.

As has so often been the case in recent years, the Chinese authorities have handled things well. But the challenges are not getting any easier. China's economy is cooling, not collapsing, and it is having a soft, not a hard, landing. At this year's National People's Congress, Premier Wen Jiabao sensibly cut the growth projection to 7.5 percent from 8 percent. Although I remain positive about China's long-term prospects, it is important to stress that, at some stage, China will have a setback. This should be seen as a feature of China's likely development. As the economy grows bigger, it becomes harder to manage than in the past. Moreover, the need to switch from investment to consumption-led growth poses many challenges.

Thankfully, China has enough policy room in which to manoeuvre in to cope with any setback, and that a setback seems unlikely to occur this year. As the Chinese economy cools, one should expect further gradual policy easing that allows for a rebound later this year.

Over all, this should prove to be another challenging and interesting year for the world economy. In the immediate aftermath of the financial crisis, for the first time since World War II, the world economy contracted in 2009.

In 2010, there was a strong rebound, with the world economy growing 4.4 percent, led by policy stimulus in the West, and by the strength of China and the emerging economies. But in 2011, the pace of growth slowed as the policy stimulus in the West started to wear off and as more economies in Asia and Latin America raised interest rates to curb inflation.

This year, the good news is there will be growth, but it will be difficult for it to be any more than it was in 2011, because Europe faces further challenges, the US still has a debt mountain to climb, and many emerging economies have been slowing in the early months of the year. The economic story is one of a fragile West and a resilient East.

The author is chief economist at Standard Chartered Bank.

(China Daily 03/20/2012 page9)