China: A Bad Time For Trade Wars

The US-China trade war comes atop an economic slowdown and a potential debt crisis. Increasing consumption and innovation remain China’s key challenges.

For export-driven China, the ongoing trade war with the US appears to be accelerating an economic slowdown, not to mention dampening global trade growth.

Chinese exports to the US in the first four months of 2019 fell 9.7% year-on-year, dropping for five months in a row; and US exports to China have dropped for eight straight months, according to a white paper released at the end of May by the Chinese government. With the outlook for a resolution of the two countries’ trade dispute unclear, the World Trade Organization has lowered its forecast for global trade growth in 2019 from 3.7% to 2.6%.

Although China’s economy grew 6.4% in the first quarter—unchanged from the final three months of 2018—growth in industrial production and retail sales slowed sharply in April, the latter growing at their slowest pace in 16 years, according to official figures. China’s latest official Purchasing Managers’ Index seemed to underscore those fears, coming in at 50.2 in May and dropping to 49.4 in June, according to Trading Economics.

Reflecting the accumulation of bad news, the World Bank’s 6.2% economic growth forecast this year is well below China’s actual growth of 6.6% in 2018, which itself marked the slowest annual expansion in 28 years. The World Bank noted that the projection reflects weakening manufacturing activity and trade.

“The [US] trade conflict hits China at a very bad moment,” Michael Pettis, professor of finance at Peking University, tells Global Finance. “The Chinese economy is extremely vulnerable.” To boost lending and thereby the slowing economy, the People’s Bank of China has reduced the cash commercial lenders need to set aside as reserves six times since the beginning of last year. At the same time, Beijing is speeding infrastructure projects and passing trillions of renminbi in tax cuts to support business, especially manufacturers hurt by the intensifying trade war.

As a result, Beijing has little ammunition left to safely compensate for weakness on the trade front. Any stimulus should be “contained,” warns Kenneth Kang, deputy director of the Asia and Pacific Department at the International Monetary Fund, referring to concerns about rising debt and financial risks.

China’s economy has built up a hefty pile of debt in order to goose GDP growth, and the government has been trying unsuccessfully for years to bring it down. “You can’t allow your debt to grow at two to three times your debt servicing capacity year after year,” Pettis comments. “Most people realize that this is a ticking time bomb.”

A New Growth Model Needed

With that in mind, critics say Beijing cannot continue its present path to growth, boosting the economy through heavy investment on fixed assets funded by loans from state banks, even in the face of a punishing trade war.

Maximilian Rech, program director and assistant professor of international affairs at the Ecole Superieure des Sciences Commerciales d’Angers (ESSCA) in Shanghai, notes that in China, local governments tend to invest in infrastructure. Thanks to China’s state-owned banking system, local governments have the support of state lenders and base their investments on political utility rather than business profitability.

That has to end, says the World Bank in the June 2019 edition of its Global Economic Prospects report, regarding the Chinese economy: “In the longer term, the country’s key challenge is to continue its gradual shift to more balanced growth, while reducing the financial stability risks stemming from high levels of corporate debt.”

“Remember, in China, the GDP growth numbers tell us nothing about the economy,” Pettis says, since these numbers reflect only economic activity, not actual growth. “The real economic growth rate in China is already below 3%.” While he doesn’t expect China to suffer a financial crisis, Pettis argues that a long period of stagnation is “inevitable.”

GDP growth may slow to 5.8% in 2020 even in the best-case scenario, under which tariffs between China and the US would stay on the current level, says Tianshi Qu, senior economist at Bloomberg Economics in Hong Kong. Qu warns that any further escalation could trigger an even larger crisis, leading to further slowing of the economy.

“Nearly one-fifth [of US companies operating in China] have moved or are considering moving capacity outside China,” according to the 2019 China Business Climate Survey Report from the American Chamber of Commerce in China (AmCham China). The report cites “US tariffs, rising costs and slower growth [as] the top motivating factors.”

Moving up in the global value chain is the best choice for China, says Qu, adding that while China is kicking out its low-profit and labor-intensive sectors, such as the textile, chemical and heavy metal industries, development in the high-tech area is critical.

All the Right Moves

Cutting China off from western technology isn’t likely to reduce its capacity for innovation, Guo Shuqing, China’s top banking and insurance regulator, recently observed on China’s CCTV. He argued, rather, that its indigenous capacities would be forced to improve further.

China certainly ranks among global market leaders in 5G, automation and mobile-payment technology. If China manages to harness these modern technologies, it could shorten or temper the economic slowdown, says Rech. He foresees China as the global leader in cutting-edge technology in 10 years—if it can overcome a number of challenges, including massive debt, demographic change and of course the trade war with the US.

China still ranks as a first or top-three priority in the global plans of 62% of AmCham China members. Regardless of sector, companies continue to see growth in domestic consumption and a rising middle class in the world’s most populous country as a significant business opportunity. Eighty percent of consumer-sector respondents rank China as a top-three investment destination.

“I see a market of 1.4 billion consumers, all of whom will become better off in the coming years despite the trade war,” Rech says, pointing to opportunities for foreign investors in sectors where China is not the market leader yet, including new-energy vehicles, innovation and development projects in third- and fourth-tier cities.

The AmCham report states, “Confidence in China’s commitment to further open its markets is at the highest level since members were first asked about it in late 2016, with 50% optimistic.” And a majority believe Beijing’s enforcement of intellectual property rights—a major bone of contention with the US—has improved or at least held steady over the past five years.

Further boosting confidence, President Xi Jinping laid out a series of major reforms and market-opening measures in his keynote speech at the opening ceremony of the second Belt and Road Forum for International Cooperation in April, including expanding market access for foreigners and strengthening intellectual property rights. Earlier this year, the National People’s Congress passed the much-anticipated Foreign Investment Law, which will replace three separate laws regulating foreign-invested enterprises in China.

While the foreign business community in China welcomed the move, most companies are still taking a wait-and-see approach. AmCham reports that “65% of members said trade tensions are influencing their longer-term business strategies, and nearly a quarter are delaying additional China investments.”

Pettis stresses that if China wants to maintain long-term economic growth, it must boost domestic demand: household consumption now makes up only 68% of GDP, compared to 80% in the US. The solution, he says, is to focus on more-productive investment and share the wealth with ordinary Chinese households. Beijing understands the problem and is trying to resolve it, he says; but politically, finding a solution will be difficult.