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US, China Trade War: An Assessment

China’s huge domestic market is likely to act as a buffer and along with policy stimulus should be able to prevent a precipitous drop or plunge in growth over the coming quarters of 2019 and 2020.

Photo Credit : Reuters

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The specter of a full fledged trade war is hovering over the global economy and financial markets - with particularly worrying downside implications for business confidence and investment (especially in the US, China, Eurozone and Asia), and Asian exports - as trade related tensions between the US and China has been ratcheted up. Donald Trump has imposed tariffs on $200 billion worth of Chinese goods from 10 per cent to 25 per cent following the stringent line and assertive stance taken by China of refusing to make a commitment to change domestic laws pertaining to unresolved structural economic issues - ranging from intellectual property rights, forced technology transfers, state industrial policy, access to financial services, competition policy to currency manipulation. Further, Donald Trump has threatened to impose shortly new 25 per cent tariff on Chinese goods worth $325 billion.

China has warned of retaliatory action and has raised tariffs on $60 billion of US imports. Further, other retaliatory measures could possibly include renewed depreciation of the yuan, providing subsidies to Chinese firms, making the operating environment for US companies located in China more challenging and resorting to other non-tariff barriers.

The US-China trade war has rattled financial markets and will probably soon put more downward pressure on developed economies such as Eurozone, the UK and Japanese economies (who rely significantly on trade), along with undermining investor and business confidence and growth in Asia’s export reliant economies - given China’s substantial trade links with Asia (more than 50% of China’s imports are from Asia - consequently, a marked slowdown in Chinese domestic demand could hurt many Asian economies - and it accounts for around 35-36 per cent of China’s exports). Further, there is the possibility of devaluation of the yuan - which could seriously roil Asian currency markets (and, also lead to loss of export competitiveness for India, which in turn could increase the current account deficit and put more downward pressure on the INR). Moreover, Asia’s exports are potentially vulnerable, due to changes in global supply chains as a result of the escalation in US-China trade war.

China more vulnerable, yet a full-out trade war could prove costly for the US economy

Possibly, Donald Trump’s decision to escalate the trade war has been fueled by his belief that the US economy - which grew at 3.2 per cent annualized rate in 2019Q1 - is strong enough to weather the intensification of a trade war and any downside impact on it would be temporary. In my opinion, this could prove to be a costly mistake (for reasons stated later in this article). 

Next, it is widely believed that the Chinese economy will be more severely impacted by escalation of the US-China trade war. According to IMF estimates, a 25 per cent tariff on all trade (i.e. all-out trade war scenario) between the US and China would lower Chinese GDP by 0.5-1.5 per cent and reduce US GDP by 0.3-0.6 per cent (due to reasons stated later in this article, I don’t expect Chinese GDP growth to fall below 6 per cent in 2019 and by more than 1 per cent over the next 12 month period, and that US GDP growth might witnesses a reduction on the higher side of the aforesaid IMF estimate over the next 12 month period). 

Since China is growing at its slowest pace in almost three decades (as a result of decelerating domestic demand, slowing global economy and tariffs imposed by the US on Chinese goods over the past year) coupled with the fact that Chinese exports to the US (goods exports - $539.5 billion in 2018) account for around 4 per cent of its (Chinese) GDP, whereas US exports to China (goods exports - $120.3 billion in 2018) account for only around 0.5-0.6 per cent of its (US) GDP and that China is a far more trade reliant economy (its exports account for around 18-19 per cent of GDP, whereas for the US, exports account for only 12-13 per cent of GDP), the downside impact of escalating trade dispute on its economy will be greater in the short term, relative to the US economy. Further, the US is China’s largest export market (the US accounts for around 20-22 per cent of its total exports). 

Adding to the woes of China is European Union’s economic outlook (this economy is China’s second largest trading partner and accounts for around 16-17 per cent of its total exports), which is disconcerting. This economy is expected to witness decelerating growth over the coming quarters (principally due to US-China trade war, slowing global economy and undermining of business confidence translating into subdued business investment) - lowering demand for Chinese goods.

Having stated the above and before returning back to the Chinese economy, given below are reasons why I believe that the US economy will probably be more adversely impacted by a full-out trade war than is expected by many experts, economists and analysts. 

US Economy - not as strong as suggested by headline growth figure

I don’t think the US economy and domestic demand are strong enough to adequately withstand or absorb the downside impact of a full-scale trade war with China - even though it grew by stronger than expected 3.2 per cent annualized rate in 2019Q1, compared to 2.2 per cent in the previous quarter, and the US labour market is strong (with unemployment rate falling to 3.6 per cent in April and employers adding a solid 263,000 new jobs in the same month - according to official data).

If one sees through the headline growth figure, even though the US economy grew more rapidly than expected in 2019Q1, the large boost came from higher inventory investment and trade (with exports rising and imports falling) - which are temporary and volatile factors. But consumer spending (which accounts for around two-thirds of the US economy) slowed down and business investment growth cooled too - a reflection of weaker domestic demand. Residential real estate also turned out to be a drag on growth. All this suggests that the US economy is not as strong as suggested by the aforesaid growth figure. Further, though retail sales and consumer confidence rose more than expected in April, going forward, I expect these indicators of consumer demand to weaken over the coming quarters - with the escalation of US-China trade war (due to reasons stated below), which in turn will have downside implications for growth. 

Next, going forward, even though a strong labour market should continue to support consumer spending over the coming quarters of 2019 (and 2020), I expect growth rate of the same to steadily decelerate if a tariff hike of 25 per cent is imposed on all imports from China. If this happens, it will result in a rise in price of consumer goods - which will reduce consumers’ purchasing power at a time when prospects for higher wage growth do not seem to be promising (given that employers are bound to get more cautious about hiring due to lower consumer demand and business investment). This in turn will adversely affect consumer confidence and spending.

Further, the US consumer invests significantly in the stock markets and prolonged lower and volatile stock markets will possibly further adversely impact consumer confidence via the wealth effect over the coming quarters and restrain consumer demand. Moreover, the vast middle class segment of the population in the US has been witnessing tepid growth in their incomes and wealth at a time when housing, healthcare and education costs have been rising (and are expected to rise further). Going forward, this is likely to lead to lower consumer demand over the coming quarters. Also, rising consumer prices, as a result of imposition of tariffs, could make it harder for the Federal Reserve to stick to its dovish stance - which might restrain consumer spending.

Next, what is being underestimated by many experts is the possible indirect cost of tariffs on the US economy, which are likely to be significantly more than the direct cost of tariffs and will probably exert more downward pressure on growth over the coming quarters of 2019 and 2020. Some of the key indirect costs of tariffs are mentioned below.

Supply chain disruptions (due to the trade war), as companies accelerate restructuring of their supply chains and move production to other countries to obviate tariffs; strong possibility of significantly tighter financial conditions in the US; heightened economic and trade policy uncertainty; falling domestic and global stock markets; risks emanating from financial markets - which are likely to amplify trade shocks; lower corporate earning and large US Budget deficit (in a milieu of unresolved trade issues) undermining business confidence - which in turn might discourage corporate spending and consequently hold back business investment in the US  - resulting in lower productivity and wage growth and further deceleration of domestic demand.

Further, fading of tailwinds from fiscal stimulus will also slow the pace of growth over the coming quarters. Moreover, manufacturing that has been showing tentative signs of recovery and accounts for around 12-13 per cent of the US economy, is likely to languish again - the ISM Manufacturing Index has been trending lower for quite some time, even though it continues to be in expansion territory. Moreover, the temporary boost to growth from trade and inventories in 2019Q1 are likely to weigh on the US economy over the coming months. With reference to demand for US exports, slowing Chinese and European economies and the global economy, retaliatory tariff hikes by China on US goods along with loss of export competitiveness (as US manufacturers will have to pay more for imported components) will all lower demand for the same. Lastly, Chinese FDI in the US, which creates jobs and contributes to economic growth in the US, is likely to fall further, after plummeting in 2018, and adversely affect jobs and growth in the US.

Chinese economy - facing considerable downward pressure, but growth will not plunge

Turning to the Chinese economy (which has been witnessing domestic demand deceleration over the past year - amid growing downward external pressures on the economy), policy makers have been trying to avert a sharp economic slowdown and limit the damage from the ongoing trade  dispute by undertaking a spate of fiscal stimulus and credit easing measures since last year and in early 2019. Such stimulus measures include income and corporate tax cuts, reduction in VAT, ramping up of infrastructure investment by raising special bond issuance quota for local governments, unveiling of a 2 trillion yuan tax reduction package (March 2019) in annual tax and fee cuts for companies - which works to around 2% of GDP - easier monetary policy via reduction in required reserve ratio, more rapid new credit growth and looser lending standards to particularly support struggling small private companies via new bank loans. These firms find it rather difficult to obtain bank loans in China and tend to represent higher credit risk.

The stimulus-fed Chinese economy demonstrated tentative signs of stabilizing in the first three months of 2019 - growing by 6.4% year- on-year in 2019Q1 (same as in 2018Q4) - however this was the weakest growth rate since 2009. In April, the Chinese economy witnessed tentative recovery - as reflected in an unexpected rise in imports that suggest recovering domestic demand. However, in the same month, China’s manufacturing growth fell unexpectedly, car sales continued to slump and exports fell more than expected (reflecting tepid global demand for Chinese goods and downward pressure on the Chinese economy from the global economic slowdown). With the escalation of the trade conflict in early May, more stimulus measures are an imperative, considering the significant downward pressure on the Chinese economy.

Going forward, with the ratcheting up of the trade conflict with the US, investor sentiment will increasingly be rattled, as China is likely to witness growing external pressures, further loss of momentum in manufacturing, softer construction growth, export growth slowdown (that will lower the incentive to invest, adversely impact industrial profits and make employers more cautious about hiring), further softening of domestic demand, rising unemployment in small and medium size enterprises that export to the US, slower wage and income growth, more uncertain trade and business environment along with lower business confidence, accelerating pace of relocation of production capacity from China to other Asian economies and lower exports (as a result of the trade war and a slowing global economy) - which will adversely affect employment and wage growth - and, lower investment demand (due to further weakening of the manufacturing sector and slower pace of real estate investment)  in 2019 and 2020.

Having stated the above, even while there is a tangible risk that growth could plunge or plummet, yet, I don’t think that will happen. First, the policy stimulus given to the Chinese  economy in early 2019 will provide some support to growth over the coming quarters of 2019 and 2020; second, Chinese policy makers are likely to go in for more policy stimulus - mainly in the form of more tax cuts (corporate and income tax cuts) and further reduction in VAT, rather than infrastructure spending (to curb an unsustainable rise in local government debt); third, expectations of fairly resilient consumption spending (which accounted for more than three-fourths of growth in 2018 and is the main driver of growth in China. Retail sales, a key gauge of consumer demand, grew by more than 8% year-on-year in the first quarter of 2019 - reflecting slowing, yet fairly strong rate of growth) and services sector growth (the services sector accounts for more than half of the Chinese economy and expanded at its fastest pace in 15 years in April 2019 - as reflected in Caixin Services PMI) - even though slower growth is expected in both - should prevent growth from plunging in the coming quarters of 2019 and 2020. Fourth, PBOC has already reduced banks’ reserve requirement ratio five times over the past one year and is widely expected to further reduce this ratio for lenders - in order to spur lending to small and medium scale enterprises - which should also provide some support to growth. Having stated this, China will have to lean more on fiscal policy, than monetary policy, to support growth ( however, fiscal policy stimulus in China has its constraints (i.e. a massive stimulus is not expected), due to overhang of debt and concerns of long term economic and financial stability). 

Fifth, depreciation of the yuan is a possibility and is likely to mitigate the negative impact of tariffs on the Chinese economy. Sixth, China may ease restrictions on real estate sales in small cities. Seventh, since consumption accounts for slightly more than a third of Chinese GDP and China has a massive middle class that is highly aspirational, there is ample scope for consumer spending to rise as a percentage of GDP and for consumption to continue its healthy, albeit slower, rate of growth in the coming quarters of 2019 and 2020. Eighth, China’s long-standing goal to ramp up consumption and lower reliance on trade has made it undertake policy stimulus (example, tax cuts) to support the consumer - amid slow income rise, rising living costs and  moderating wage growth in 2018 and in early 2019 - and possibly more policy support via incentivizing car sales and sales of big-ticket items and lowering borrowing costs for households could be expected in the near future. All this should aid in the continuation of healthy, albeit slower, rate of consumer spending over the following quarters of 2019 and 2020 and I expect consumption to account for a higher percentage of growth in 2019 and 2020, than in 2018. 

Ninth, while concerns of rising unemployment are mounting, labor market conditions are likely to be less benign coupled with the fact that wage growth (which has been pushed up by a shrinking labour force) is likely to slow further (amid rising household debt (estimated at 51% of GDP as of 2018Q3 by IIF) and higher inflation) in the near future - as a result of the US-China trade war - which in turn will somewhat undermine consumer confidence and result in lower growth of consumer spending, yet it should not be forgotten that China has a vast consumer base, it is the world’s largest market for consumer durables i.e. big-ticket items, has a highly aspirational middle class, incomes have gone up higher in urban areas and household savings are fairly healthy - which in turn is likely to lead to fairly resilient consumer spending over the coming quarters of 2019 and 2020 and provide some support to growth. 

To conclude, despite the escalation of US-China trade war, gargantuan debt to GDP ratio - estimated at $300 billion last year - according to IIF, marked rise of defaults in China’s corporate bond market in 2018 and early 2019 and slowing domestic demand, China’s huge domestic market is likely to act as a buffer and along with policy stimulus (that will provide support to the economy in 2019 and 2020) should be able to prevent a precipitous drop or plunge in growth over the coming quarters of 2019 and 2020. 

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Sher Mehta

The author is Director of Macroeconomic Research and Econometrics, Virtuoso Economics

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