How much will higher tariffs affect China?

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The writer is chief Asia economist at Morgan Stanley

Investors hoping volatility will ease for the rest of the year may not like what they see on the calendar. As attention turns to the U.S. election in November, investors in Asia are trying to understand how the U.S.-China trade relationship might evolve.

The experience of the 2018-2019 round of US tariffs on China may be instructive. What we learned was that the indirect effect of tariffs on corporate confidence, global capital spending, and thus trade, exerts more pressure on China’s growth than the direct effects on export and import flows.

Although only China faced tariffs, these spillovers weighed equally on the rest of the world, and the force on China was not disproportionate. China’s GDP growth slowed by 1 percentage point in 2018-19, but its contribution to global growth over that period remained broadly stable.

This time, the extent of the damage to growth from corporate confidence will depend on whether, if re-elected as president, Donald Trump follows through on ideas he has floated to impose 50 percent tariffs on imports from China alone, and also , 10 percent tax in the rest of the world. It will be better for the cyclical growth outlook in China if the US does not raise tariffs on the rest of the world.

I would argue that companies around the world have been alert to possible rate increases and efforts to diversify supply are underway. But tariffs for the rest of the world would pose a bigger challenge, as they could compromise supply chain diversification efforts of the past few years.

What about the direct effects of the tariffs and their implications for China’s exports? Last time, China took several steps to ensure that it did not lose market share in global exports, and these measures may provide compensation.

First, currency movements played a key role in mitigating the effect of tariffs. In 2018-19, the depreciation of the renminbi offset up to 65% of the weighted average increase in tariffs. On the other hand, appreciation in the trade-weighted US dollar index more than offset the impact of tariffs on total imports and mitigated potential US inflationary pressures.

Second, what started as a diversion has evolved into a much deeper integration into global supply chains. Mexico and Vietnam have seen their trade surpluses with the US grow significantly since trade tensions emerged in early 2018, but we estimate that only 30% of this increase can be explained by an increase in net imports from China. This means that the domestic value added of their exports has increased. China has made several inroads into global supply chains by supplying components and investing in these economies.

Third, China has created new products to export and new geographies to export, moving from the US to emerging markets. While China’s share of US imports fell to 13.5% today from 21.6% in December 2017, its global market share in global goods exports rose from 12.8% to 14.4% in the same period.

China will certainly find it challenging to sustain the 15-20% export growth needed to use its excess capacity. External conditions are changing, as the US is not alone in imposing tariffs. The EU and several emerging markets are planning, if not already, to apply selective tariffs on imports from China. Tariffs, when imposed, will hurt trade and corporate confidence and put pressure on global growth and China.

Moreover, China’s supply-driven growth model has made exports more important in managing deflation. To maintain its export market share, it has to squeeze profit margins.

This means that China’s deflation challenge will persist. Domestic demand remains weak and China will not be able to export its way out of the debt deflation loop. We estimate that nominal GDP growth will remain low at 4.3% and 4.8% in 2024 and 2025, respectively, and that debt-to-GDP ratios will continue to rise.

As it is, we project China’s debt-to-GDP ratio to reach 312% by the end of 2024, a level that is higher than that of the US and about 30 percentage points higher than it was at the end of 2021.

We believe that its current policy stance of targeting real GDP growth with heavy investment will create more excess capacity and is unlikely to solve China’s economic problems anytime soon. The solution is to boost domestic consumption by increasing spending on social security, such as health care, education and housing, and thereby reducing household precautionary savings. Small steps in this direction are unlikely to be enough.