Chinese Economy Slowing Down amid Intensifying U.S.-China Trade Dispute: Reform and opening-up should come before economic stimulus

The announcement on March 22, 2018, of the imposition of sanctions against China based on Section 301 of the U.S. Trade Act triggered the escalation of the U.S.-China trade dispute. In response to the tit-for-tat tariff hikes that are turning the dispute into a trade war, Chinese stock prices and the exchange rate of the yuan—the Chinese currency—have plunged, and the Chinese economy is starting to slow down. The impact of the trade dispute is expected not only to reduce Chinese exports to the United States but also to dampen investment and consumption in China. Under these circumstances, there are growing calls in China for the implementation of economic stimulus measures. However, the possibility that the government will meet such calls is expected to be small given the lesson China learned after the implementation of the four trillion-yuan economic package intended to stimulate domestic demand after the collapse of Lehman Brothers that triggered the global financial crisis: the economic package caused serious after-effects in the forms of the expansion of debt owed by local governments and excess production capacity at companies.

As part of its sanctions against China, the United States has imposed additional tariffs on some products imported from China and has been gradually expanding the scope of products subject to the sanctions. As the first tranche of the sanctions, on June 15, 2018, the United States announced a list of Chinese products subject to an additional tariff of 25%, which are worth a total of $50 billion. As the second tranche, on July 10, it announced a list of Chinese products subject to an additional tariff of 10%, which are worth a total of $200 billion. Regarding the first tranche of sanctions, the additional tariff was imposed on $34 billion worth of Chinese products on July 6. With respect to the remaining $16 billion worth of products, the additional tariff was imposed on August 23, after some items were deleted from the sanctions list. Regarding the first tranche of U.S. sanctions on $50 billion worth of Chinese products, China has announced plans to take a retaliatory measure against an equivalent worth of U.S. products, and regarding the second tranche, it has announced a plan to impose tariffs ranging from 5% to 25% on $60 billion worth of U.S. products.

The direct impact of the U.S. tariff hikes against Chinese products on the Chinese economy is expected to be limited. Let us calculate the impact of the tariff hikes based on the premise that China's price elasticity regarding exports to the United States is estimated at most at 1.5 (which means that a 1% price increase will lead to a 1.5% fall in export volume). If an additional tariff of 25% is applied to $50 billion worth of products, the value of Chinese exports to the United States is estimated to decline by $18.75 billion. If an additional tariff of 10% is applied to $200 billion worth of products, the value of exports is estimated to decline by $30 billion. The total estimated impact of these tariff hikes is an export decline of $48.75 billion. This figure is equivalent to only 0.4% of China's GDP in 2017 (approximately $12 trillion) (Table 1). Moreover, as China has been integrated into global supply chains, products exported from the country include a large amount of components imported from abroad. As a result, the value added in China (which is counted as part of China's GDP) is presumed to account for around only half of the export value (Note 1). In view of this point, even if exports decrease by a margin equivalent to 0.4% of GDP, the decline in the growth rate of GDP will be half of that rate, 0.2 percentage points.

However, the impact of the U.S.-China trade dispute on the Chinese economy extends beyond exports. As symbolized by the plunges of stock prices and the yuan, concerns over the prospects for the economy are growing. In this situation, investment and consumption are certain to slow down, increasing the possibility that the government's economic growth target of around 6.5% in 2018 will not be achieved.

Following the outbreak of the U.S.-China trade war, stock prices and the yuan have plunged in the Chinese financial market.

While the Shanghai Composite Index dropped by nearly 20% from March 22, when the imposition of the sanctions against China based on Section 301 of the U.S. trade act was announced, to mid-August, U.S. stock prices, as represented by New York's Dow average, rose (Figure 1).

Source: Compiled by the author based on the CEIC Database.

Over the same period, the yuan's exchange rate against the dollar fell by around 9%. When the yuan depreciated in the summer of 2015, the Chinese authorities conducted active dollar-selling, yuan-buying interventions in the foreign exchange market in order to support the yuan, and as a result, China's foreign currency reserves dwindled rapidly. However, this time around, China's foreign currency reserves have not decreased (Figure 2). This reflects the fact that instead of conducting exchange market interventions, China is using capital control as a means of supporting the yuan. The yuan would have dropped more steeply last time if market interventions had not been conducted. A steeper drop would also have occurred this time if capital outflow had not been prevented through capital control.

Source: Compiled by the author based on the CEIC Database (Original data from the State Administration of Foreign Exchange and the People's Bank of China).

Judging from the movements of stock prices in the Chinese and U.S. markets and the yuan, we may say that China has so far been at a disadvantage in the ongoing U.S.-China trade war.

Amid the growing concerns over the economic slowdown, there are growing calls in China for the government to implement economic stimulus measures, but the room for doing that is considered to be limited.

First, on the fiscal policy front, following the implementation of the four trillion-yuan economic package after the Lehman Brothers collapse, debt owed by local governments increased rapidly and excess production capacity emerged at many state-owned enterprises. Although the situation is starting to improve thanks to the implementation of supply-side structural reform measures since 2016, the efforts made so far would be wasted if infrastructure investments are made on a large scale once again.

On the monetary policy front, if a monetary easing measure such as lowering the benchmark interest rate or the reserve requirement ratio is implemented, the inflationary pressure due to the import tariff hikes imposed on U.S. products will further increase. Moreover, the interest rate spread between China and other countries will widen, leading to a vicious circle of capital outflow and the yuan's depreciation aggravating each other.

Although the economic growth rate has declined, the job offers-to-seekers ratio in urban areas has hit a record high of 1.23 this year (in the first and second quarters), in contrast to 0.85 immediately after the Lehman Brothers collapse (Figure 3). This suggests that full employment has been maintained. The current economic growth rate of 6.7% is certainly low compared with the growth rate of around 10% in the past. However, given that the potential growth rate has already declined below 7% because of constraints imposed by the labor shortage, it is inappropriate to judge that the Chinese economy has entered a recession. If we also take into consideration the fact that the Chinese economy has not yet fully recovered from the negative after-effects of the four trillion-yuan economic package, the government will have to be cautious about implementing economic stimulus measures (BOX).

Note: The job offers-to-seekers ratio shown above is calculated by dividing the number of job offers by that of job seekers registered in public employment services organizations in approximately 100 cities in China.

Source: Compiled by the author based on data provided by the National Bureau of Statistics of China and the Ministry of Human Resources and Social Security.

At a meeting on July 31, 2018 of the Central Committee of the Communist Party of China, it was decided to "continue to implement a proactive fiscal policy and prudent monetary policy" as a macroeconomic policy in the second half of this year (Table 2). Specifically, the statement issued after the meeting noted that fiscal policy should play a bigger role in expanding domestic demand and making structural adjustments and that money supply should be controlled so as to keep liquidity at an ample level. However, given that the growth in money supply (M2) and infrastructure investments has significantly slowed down because of the deleveraging initiative promoted by the government, the policy decided at this meeting merely represents a shift in the macroeconomic policy stance back to neutrality from austerity, rather than a plan to implement a large-scale economic package (Figure 4).

Note: The figures for infrastructure investments are based on the cumulative amount between the beginning of the year and the current month. For the months of January and February in each year, only the two-month total has been published. Therefore, the total was divided equally between the months of January and February in the above figure.

Source: Compiled by the author based on the CEIC Database (Original data from the National Bureau of Statistics of China).

If the U.S.-China trade dispute escalates further and continues for an extended period of time, both countries are certain to suffer considerable damage, so ultimately, they must explore points of compromise through negotiation. To calm down the situation, it is essential for China to give some ground in the following points: lowering the tariff rates; strengthening the protection of intellectual property rights; easing restrictions on foreign investments; and giving the market a greater role. However, implementing such measures will greatly benefit China itself by injecting more energy into the economy. There are precedents of China using pressure from the outside as a catalyst to accelerate its reform and opening-up initiatives, such as when the country acceded to the World Trade Organization in 2001. China should not miss this opportunity to do so again.