How bad will the Chinese economy get in 2009? And will there be a currency war with the US? The two critical questions are interlinked. Unless China's domestic stimulus starts to work soon, the leadership is likely to dig in its heels and resists pressure for further appreciation of the currency. In which case expect the tougher line indicated by new US Treasury Secretary Timothy Geithner, backed by a president still in a honeymoon phase and expected by the electorate to achieve a lot in a short time, to lead to tensions and possibly retaliation.

Long-bearish economic commentators in the west such as Nouriel Roubini of New York University and Albert Edwards of Societe Generale in London take China's claims of continuing growth and expectations of 7 percent gross domestic product growth in 2009 with a large dose of skepticism. For them, China is already in recession and may remain so through 2009.

On the other hand Hong Kong-based economists such as HSBC's Qu Hongbin and Tao Wang of UBS look for an early recovery and full year growth reaching 6.5-7.0 percent.

In the short run, the views are not as divergent as they may appear. China's report of 6.5 percent year-on-year growth for the fourth quarter of 2008 implies that quarter-on-quarter growth had fallen to about 2 percent and may have continued to fall as a collapse in imports suggested that a sharp fall in manufactured exports in early 2009 was imminent.

China's official growth numbers are of course politically tuned, tending to be massaged upwards when times are bad and downwards during excesses. But the trend is clear enough. Some data point to a much sharper slowdown. For example, electricity consumption for November/December was down 8 percent. This may have been attributable more to heavy users such as the massively over-supplied aluminum industry than to a wider decline in industrial activity. Nor are the woes of Pearl River delta export manufacturers mirrored in regions catering more to domestic demand.

Pessimists point to the fact that demand weakness has become a global phenomenon and thus after years of export-led growth China's difficulties will endure. At the same time, China itself will take a year or more to absorb excessive investment in various industries such as metals and autos and also apartments at the upper end of the real estate market where prices have still to come down to market-clearing levels. It will take time to re-focus construction on lower to middle income housing which can in turn drive cement, steel and consumer durable industries.

The optimists however believe that much of the slowdown has been due to inventory adjustments, at home as well as abroad, and that inventories will stabilize or even rebuild soon. They note that bank lending has already surged, that a variety of government measures will spur consumer demand and that hefty infrastructure spending will start to kick in by mid-year. They also note the positive impact on consumption of lower energy costs and stable food prices.

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If the optimists are right, China should for once have domestic-led growth, which would show the way to a significant narrowing of its trade surplus. Exports to the US in particular will be well down and imports will be up. It would be able to claim, and the US able to accept, that things are moving in the right direction so no retaliation will be needed.

However, it is not so simple. Unless China's recovery is strong enough to drive a recovery in commodity prices, its trade surplus may even increase. Indeed, UBS has its current account surplus rising to 9 percent of GDP in 2009 from an already massive 8 percent in 2008. At whose expense will this be? If most of the burden falls on the non-OECD world, the impact on the global economy will be extremely negative.

If China (and UBS) think a country of its size can get away with that level of surplus without inviting retribution, it is heading for a major shock. The already fragile international financial system cannot stand it. And anyway, why would China want to accumulate yet more foreign currency, perforce mostly dollars, which are likely to decline in value and make it hostage to a US which is capable of declaring a debt moratorium?

Whether or not China is manipulating its currency to help exports is debatable. For sure, exchange controls enable it to closely regulate the movement of the yuan. In recent weeks it has kept it stable against the dollar, partly to help exporters who had been complaining about loss of competitiveness. On the other hand, at the same time, when the dollar has been relatively strong, it has gained against European currencies and most Asian ones except for the yen. Indeed, this has for the time being taken the edge off European pressures for retaliation.

China's xenophobic reaction to foreign comments on its exchange rate policy is dangerous and may not only aggravate its relations with Washington but blind it to the necessity of bringing its current account surplus down to sustainable levels – maybe 2 percent of GDP.

Its surplus with the US may well fall sharply as US households shift from zero savings to 6 percent of GDP. But if at the same time China's surplus with the rest of the world, the commodity-exporting developing countries in particular, rises, its impact on global demand will be extremely negative. The US and Europe can fund external deficits with their own currency. The likes of Brazil, Indonesia, South Africa have to borrow in dollars, euros or yen – easier said than done.

As the US deficit shrinks while China's own surplus continues to rise, Beijing's argument that the problems of global imbalances are the result of American profligacy rather than its own excessive savings, will collapse.

The optimal outcome is that a pickup in China's domestic demand as 2009 progresses will also have a positive impact on raw material prices. This would reverse the sharp improvement in its terms of trade which China has been enjoying in recent months. Higher imports prices as well as volumes would thus sharply cut the trade surplus, reducing international pressure on China and improving the lot of most developing countries. But that outcome is neither in the forecasts of the China bulls nor the China bears.