If the US-China trade war escalates, how will the Chinese economy respond? Here are the numbers
Lawrence J. Lau says China can weather the effects of a trade war with the US, even if imports of the products the US is targeting with its tariffs halt completely. The result would mean only a marginal drop in annual economic growth, and China is unlikely to take the drastic step of severely devaluing its currency
What are the impacts of the trade war on the Chinese economy? While the immediate direct impacts on the Chinese economy are certainly negative, they are small, affecting less than 0.5 per cent of gross domestic product, and quite manageable.
However, the trade war itself may do damage to the longer-term relations between the two countries. For example, it may affect the future rate of growth of the trade in services between the two countries, which consists mostly of education and tourism, and in which the United States has a large and growing surplus, estimated at US$54 billion by China and US$40 billion by the US in 2017.
The immediate impact of the current trade war is psychological. Uncertainty will rise. Stock markets, which abhor uncertainty, will decline. Many of the Chinese stock markets have already taken a hit. Both the Shanghai and Shenzhen exchanges have seen their average stock prices decline by more than 15 per cent since the beginning of 2018. Hong Kong overall has declined 5 per cent, but mainland enterprises listed there have declined by almost 10 per cent. By comparison, the S&P 500 has gained 5 per cent during the same period.
But the performance of the Shanghai and Shenzhen stock exchanges is not a reliable barometer of the state of the Chinese economy. This is because most of the investors on the mainland Chinese stock exchanges are individuals looking for a quick profit through frequent trading. The average holding period of individual Chinese stock investors is less than 20 trading days and that of institutional investors is between 30 and 40 trading days. Since the trade war looks like it will last much longer, most mainland Chinese investors have elected to bail out and stay on the sidelines.
Similarly, the yuan exchange rate has also been negatively affected. The yuan central parity rate has devalued 2 per cent with respect to the US dollar since the beginning of 2018 and more than 3 per cent since the start of the trade war. By comparison, during the same period, the US dollar has appreciated close to 3 per cent relative to an index of a basket of currencies of its trading partners.
However, since the end of June, the yuan central parity rate has stabilised and once again has been moving in tandem with the China Foreign Exchange Trade System (CFETS) Index, an index of a trade-weighted basket of currencies. A significant devaluation of the yuan with respect to the US dollar is unlikely as China still has an overall trade balance in goods and services, and it is in the interests of China to maintain a relatively stable yuan exchange rate.
The actual US users of the targeted imported Chinese products, consumers as well as producers, will be affected immediately because they have to bear the burden of the new tariffs. However, it has also been announced by the Office of the US Trade Representative that exemptions from the new tariffs for a year may be granted to US importers upon application on a product-by-product basis.
The new tariffs, if fully implemented, will make the imports of the targeted products from China prohibitively expensive, and effectively lead to a complete halt of Chinese exports of such products to the US. As a result, there will be a potential reduction of Chinese exports to the US of up to US$250 billion, or around US$225 billion in FOB (free on board) terms.
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What will be the real impact on the Chinese economy?
First of all, China, as a large economy like the US, has always been relatively immune to external disturbances. During the past four decades, while the rates of growth of Chinese exports and imports fluctuate like those of other economies, the rate of growth of Chinese real GDP has remained relatively stable, and in fact has always stayed positive.
Moreover, Chinese dependence on exports has continued to decline over the past decade. The share of exports of goods in Chinese GDP has fallen from a peak of 35.3 per cent in 2006 to 18.1 per cent in 2017. The share of goods exports to the US in Chinese GDP has also fallen from a peak of 7.2 per cent in 2006 to 3.4 per cent in 2017. The growth of Chinese exports to the world has slowed from an average annual rate of 22.6 per cent in the decade 1998-2007 to only 7.9 per cent in 2008-2017. Similarly, exports to the US grew at 22 per cent during 1998-2007, but slowed to less than 7 per cent in the most recent decade. Exports are no longer the principal engine of Chinese economic growth.
In addition, the direct domestic value-added content of Chinese exports is around 25.5 per cent in the aggregate, and slightly lower for exports to the US, 24.8 per cent, in 2015. This means every US$1 of Chinese exports to the US generates less than US$0.25 of Chinese GDP. In contrast, the direct domestic value-added content of US exports to China may be estimated to be slightly more than 50 per cent in 2015.
Total Chinese exports of goods to the US in 2017, on an FOB basis, is US$430 billion, according to the National Bureau of Statistics of China, or 3.4 per cent of Chinese GDP. Current and pending new tariffs are supposed to cover US$225 billion of US imports from China, on an FOB basis, or around half of the total Chinese exports of goods to the US.
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Assuming a complete halt of all Chinese exports of targeted products to the US, total Chinese exports of goods to the world will fall by 9.4 per cent. As a comparison, in the aftermath of the global financial crisis of 2008, total Chinese exports of goods declined by 16 per cent in 2009. However, the Chinese economy still managed to grow 8.7 per cent that year.
What would be the impact of the decline in Chinese exports on GDP? The fall in Chinese exports may be estimated at 1.7 per cent (3.4 per cent x 0.5) of GDP. However, since the direct domestic value-added content of Chinese exports to the US is less than 25 per cent, the actual direct loss in Chinese GDP may be estimated at only 0.43 per cent (1.7 per cent x 0.25). A reduction of this magnitude is material, but quite manageable in the aggregate, especially for an economy growing at an average annual real rate of 6.5 per cent and with a per capita GDP of US$9,137.
Thus, the decline in Chinese GDP in the first instance will not exceed 0.5 per cent. In the intermediate run, indirect, that is, second-, third- and higher-round effects of the reduction of exports may kick in, increasing the total effect on domestic value-added to 66 per cent. This implies ultimately a total loss in Chinese GDP of 1.12 per cent (1.7 per cent x 0.66). A reduction of 1.1 per cent from an expected annual growth rate of 6.5 per cent leaves 5.4 per cent, still a very respectable rate compared to 3.9 per cent for the world, as projected by the International Monetary Fund for 2018.
In the longer run, assuming that the tariffs continue, the US importers will begin to replace Chinese imports with imports from other Asian countries such as Vietnam and Bangladesh, and eventually perhaps even North Korea. This is similar to the shift of the sources of US imports of apparel from Hong Kong, South Korea and Taiwan to mainland China that began in the mid-1990s. The new tariffs will accelerate this process. However, it is unlikely that the tariffs will stimulate new domestic production of the targeted products in the US
Second, it is actually quite unlikely that the yuan will be devalued significantly in response to the trade war, despite widespread expectations. The new tariffs are prohibitive and a moderate devaluation of the yuan accomplishes nothing except to make the yuan less desirable domestically and internationally as a store of value. For an economy as large as China, devaluation is never a useful strategy.
It is also not necessary for the yuan to devalue. The Chinese trade surplus in goods and services in 2017 was 1.71 per cent of its GDP, almost exactly the same as the expected fall in its exports of goods as a result of the new tariffs. So China will still be able to maintain a current account balance and there should not be any pressure to devalue from balance of payments considerations. In fact, it is in the best interests of China to maintain a relatively stable yuan exchange rate.
Lawrence J. Lau is Ralph and Claire Landau Professor of Economics at the Chinese University of Hong Kong