Although the round of tariffs issued by the U.S. and by China on $50 billion of two-way trade imposed on July 6 will have only a muted overall economic impact on both countries, the tariffs signal that the risks of a full-blown trade war have increased markedly.
The latest news to impose 10% tariffs on a further $200 billion worth of goods imported from China to the U.S. demonstrates how keen the Trump administration is in getting some concessions from China, and which are likely to be focused on intellectual property protection. It is still unclear whether China will punch back aggressively given its potentially larger economic impact from a trade war loss, or whether it will seek to placate the U.S. by meeting its demands.
We tend to believe that cooler heads will prevail and negotiation is likely that will allow President Trump to declare some political victory. The recent Hong Kong and China stock market declines reflect investor concerns over the risk of escalation. While an all-out trade war would certainly diminish the long-term spending power and welfare of U.S. consumers, the economy’s stability would likely be left intact.
On the other hand, we think a trade war could be disastrous for China, given its dependence on its trade surplus as a source of economic aggregated demand. While in the past, most notably post-2008, China has been able to boost debt-fuelled investment expenditure to replace flagging trade as a source of demand, we think this option is now ruled out by China's swelling debt burden.
As such, a trade war could send China's economic growth into the low-single digits – likely a politically unpalatable option in a country accustomed to much higher levels. The recent reserve ratio requirement cut doesn't expand the amount of productive investments available in China, which would be required to offset any negative trade war impacts.
Without the trade war, we had already factored in slowing activity in China as the country rebalances with our forecast real GDP growth for China of 5.1% in 2018, which is below market consensus range of 6.5%-6.8%.
As it is, we forecast China's real GDP growth to average only 3.8% over the next 10 years and we remain comfortable with this estimate. We believe reinvestment in China remains on a slowing growth path and a trade war only reinforces this trend.
We do not expect China to spend its way out of a marked economic slowdown given heightened risk that limits capacity in the face of debt/GDP of 261%. Hence, should the trade war escalate and lead to a 50% drop in China's exports to the U.S., which would be our worse-case scenario, China's real GDP should slow by 1%.
In reality, we think a 50% drop is unlikely, as we assume that the tariffs are likely to be absorbed by either the exporting manufacturer, or by customers, or a mixture of both for a number of the goods. Assuming that half of the increased tariff is absorbed on the USD 250 billion in China imports and there is a 10% impact to volume, the impact to China's GDP would just be 0.4%.
Our forecast GDP growth for China assumes that net export growth will drop to just 0.1% in 2019 and 2020 from 0.6% in 2017. Real GDP growth is driven almost solely by consumption in our estimates with gross capital formation declining post 2020. We may see some short-term uptick in real estate-related investment that mitigates declining infrastructure construction growth but as this is largely related to inventory replenishment by property developers, we do not expect levels to be sustained.
