China needs to put its house in order as the trade war goes from bad to worse

In contrast with the progress seen in United States-European Union negotiations, there are no signs of trade talks resuming between the US and China since the breakdown of negotiations in June.

This underscores a fundamental difference between the US-EU and US-China disputes. The former is genuinely about trade between two allies, while the latter is a structural conflict – disguised as a trade spat – between two adversaries. That structural conflict is centred on China’s rapid catch-up in technology and innovation, which, in the eyes of the Trump administration, has been achieved via illegal technology transfer and lax protection of intellectual property.

Is the US trade war bent on prolonged conflict with China?

Hence, besides the trade war that is currently taking place – targeting China’s technology products, the US has also imposed restrictions on China’s investment in its hi-tech sectors, undertaken sanctions against Chinese tech companies (for instance, ZTE), and demanded that Beijing alter its industrial policies (Made in China 2025) designed to upgrade the Chinese economy via technology advancement.

Given the structural nature of the dispute, there is no easy fix. US President Donald Trump is very likely to implement additional tariffs before the midterm elections, countered by Beijing’s proposed retaliation.

As the trade war escalates, China needs to be prepared for the consequences.

Watch: The origins and impact of the US-China trade war

Below are three scenarios and how they may impact the Chinese economy.

First, no escalation, with only the currently or soon-to-be implemented US$50 billion tariffs; second, an escalation that includes 25 per cent tariffs on an additional US$200 billion of Chinese goods; and, third, an all-out trade war that hits all remaining Chinese exports with a blanket 10 per cent tax.

Estimates of the initial impact – on Chinese exports – show that the trade restrictions would reduce China’s GDP growth by 0.1 per cent, 0.5 per cent or 0.8 per cent respectively in the three scenarios, in the 12 months after the tariffs are implemented.

China can end the trade war by conceding defeat to Trump

In addition, China faces multiple second-round effects. These would include a reduction in investment and employment of exporters hit by the tariffs, the external impact from weaker global growth and supply-chain disruption and the feedback from financial market movements.

Estimates of the domestic second-round impacts – on investment and employment – point to an additional shock to GDP ranging from 0.13 per cent to 1.1 per cent. In other words, an all-out-trade war could subtract up to 2 percentage points off China’s GDP growth, when the first-round and domestic second-round effects are combined.

However, not all of the second-round impacts are negative for China. Take, for example, the effect on the global supply chain, which may actually mitigate the growth shock for China by spreading it across the entire global production process.

Our study shows that between 23 per cent and 33 per cent of the value-added in Chinese exports of electronics and machinery to the US are created outside the country.

Global technology leaders, such as Japan, South Korea, Germany and even the US are large contributors to this process.

All of them will share the pain from reduced Chinese exports to the US, as China will buy fewer components and inputs from them. Such burden-sharing could reduce the GDP shock to China by around 0.4 percentage points by our estimate.

Trumponomics is winning and global supply chains are hurting

Finally, financial markets have reacted strongly to the rising trade tensions, and their moves may also have a substantial economic impact. The falls in equity prices and the widening of credit spreads will tighten monetary conditions and subtract from economic growth.

However, yuan depreciation, if sustained, could provide an offset. Our study shows that the 5.4 per cent depreciation in the nominal effective exchange rate since mid-June could boost China’s export growth by 3.3 per cent in the ensuing 12 months.

With total export values at US$2.26 trillion in 2017, such a boost could be worth US$75 billion, more than offsetting the total tariffs (US$62.5 billion) Trump threatens to impose on China.

Granted, such a simplistic calculation ignores many complications associated with the distribution effect and uncertain behaviour of producers and buyers. But one cannot deny that yuan depreciation, provided it occurs in an orderly fashion, can help alleviate the impact of the trade war.

Despite the fluctuations, we’re not in a currency war yet

This is probably why the Chinese authorities have so far been fairly hands-off with the foreign exchange market, allowing the currency to serve as a buffer for the economy.

Overall, estimating the complete impact of the trade war is a challenging endeavour. While precise quantification is impossible, the direction of net impacts is clear. China needs to get its house in order and be prepared for the rough sailing ahead.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers