China's Vulnerability to a Potential Trade War 2.0

China's domestic economic landscape has significantly changed since the initial US-China trade war in 2018. Now, as another US presidential election approaches, China faces the prospect of a renewed trade war. Former president Donald Trump has proposed 60% tariffs on the country if he wins. China’s economy has been slowing thanks to a combination of rising global trade protectionism, domestic economic pressures and persistent deflationary trends. Despite recent stimulus measures from the People’s Bank of China (PBoC), we think China is much more vulnerable to high tariffs than it was six years ago. Here, we’ll look at some of the key factors shaping its economy and the potential impact of additional tariffs.

Trade tensions and export sector risks

First, let’s consider the historical context of the 2018 trade war. From early 2018 to 2020, the Trump administration sharply raised US tariffs on Chinese goods from 3% to 21%.[i] At the time, strong domestic consumption, a robust housing market, healthy local government finances and an absence of persistent deflationary pressures helped China weather the initial storm of trade tensions with less severe economic repercussions than many had anticipated.

Today, the economic landscape in China is markedly different. The export sector is now the only bright spot in the Chinese economy, and even that is at risk. Recent US and EU tariff hikes and the threat of more to come cloud the future. Many companies have begun shifting production away from China to avoid tariffs, and some Chinese firms have invested overseas to secure supply chains and diversify manufacturing. Even if the tariff threat eases, some economic damage seems inevitable, in our view.

Housing market slump

China’s prolonged housing market slump, which began with property developer Evergrande’s default in July 2021, is perhaps the biggest change to the economy since 2018. This slump represents the first sustained period of significant price declines since China established its private housing market in the late 1990s. With property developers’ cash flow and profits badly squeezed, companies are aggressively pulling back on construction to reduce costs. New housing construction starts are running at just a third of 2019 levels.[ii] Given that housing accounts for roughly 60% of urban household assets, the decline in China’s housing market has led to a significant erosion of household wealth, with far-reaching implications for consumer confidence and spending.

Consumption and labor market challenges

Housing market weakness has cascaded through China’s economy, contributing to challenges in consumption and the labor market. Unlike in 2018, when consumer confidence was high, China now faces weak labor market conditions and slow household income growth. The PBoC’s quarterly survey of urban depositors shows that expectations for employment have hit record lows.[iii] Persistently low retail sales growth, which has remained below 4% for seven consecutive months, reflects the lack of consumer confidence.[iv] Direct policy stimulation of household consumption has been limited, and ideological barriers appear to prevent massive debt-fueled transfers to households.

Local government finances and business confidence

Local government finances, which were relatively healthy in 2018, are now under severe strain. Revenue shortfalls from slumping land sales, which have plunged 56% from their peak,[v] have led to aggressive back-tax collection efforts. These measures, along with a surge in non-tax revenue such as fines and confiscations, are undermining business confidence at a time when the economy can ill afford it.

Deflationary pressures

Perhaps most concerning to us is the emergence of persistent deflationary pressures, which were not present in 2018. China has experienced six consecutive quarters of negative GDP deflation.[vi] We believe domestic producer prices could potentially remain in contraction through 2025 and core CPI inflation could stay below 1%. This deflationary environment makes it more challenging for businesses and consumers to service existing debts and reduces the effectiveness of traditional monetary policy tools.

Policy easing a welcome development

In September, China rolled out an extensive monetary policy package to address these economic challenges. In our view, the most significant element of the package is the repricing of existing mortgages, which could save households an estimated RMB 150 billion in interest costs annually. Given the low confidence levels among Chinese households and businesses, the sustainability of this support depends on whether policymakers can reverse the trend of decelerating nominal growth. However, the package lacks sizable fiscal policy, which we believe is essential for a sustained impact on sentiment and growth.

We believe tariffs would add significant strain to the economy

While we see the recent policy easing as a positive for China’s growth outlook, we believe the potential impact of new tariffs in the current economic landscape could be severe. We estimate that a 60% tariff could reduce China's GDP growth by 1.5 percentage points over the first 12 months. About half of this would likely stem from lower exports, with the remainder from indirect effects on domestic consumption and investment. In our view, the ongoing impact of weaker employment and capital expenditure would further strain the domestic economy. Such a shock would likely intensify deflationary pressures, further dampen the already weak labor market and potentially accelerate the relocation of manufacturing out of China. In our view, the outcome of the US election in November and potential policy shifts will be crucial in determining China's economic trajectory in the near future.

[i] Source: https://www.piie.com/research/piie-charts/2019/us-china-trade-war-tariffs-date-chart

[ii] Source: National Bureau of Statistics.

[iii] Source: PBoC, Quarterly Survey of Urban Depositors, August 2024.

[iv] Source: National Bureau of Statistics.

[v] Source: National Bureau of Statistics.

[vi] Source: National Bureau of Statistics.

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