Solomon Macro: A Static Analysis of Tariff War 2.0’s Impact on China (5 April 2024)

Following on from our macro observations the last couple of days, we wish to take a stab at making a quick and dirty analysis on the impact of the latest draconian tariffs on China.

The tariff war in 2018-19 provides a starting point for the analysis of the potential impact of tariff war 2.0 on China’s economic growth, as well as China’s possible policy reactions.

The drag on China’s GDP growth by around 2% in the next 4-6 quarters and could arise from three scenarios:

1. Negative impact on exports hence negative to GDP growth, which accounts for around one third of the 2% drag. Assuming a coefficient of 1 for the tariff impact, China’s exports to the US would fall 40%. This would reduce China’s total exports by about 6%. Meanwhile, weaker exports would also lower processed imports. On a net basis, we estimate net exports (or merchandise trade balance) would fall by around US$180bn, dragging GDP growth by 0.7%.

   
   

2. Weaker investment and consumption, especially in export-related sectors. Exports are equivalent to around 20% of GDP, with roughly similar share in employment and economic activity. We estimate that the drag on growth via the income channel would be around 0.6% of GDP.

   
   

3. Business confidence, i.e. broader spillover to other economic sectors as uncertainty arises from heightened trade tension and the US-China relationship. This also accounts for one third of the overall economic impact (0.6%).

Possible policy responses from China

Using the 2018-19 episode as a benchmark, China’s possible policy reactions could involve the following aspects:

First is retaliation to the tariff hike, e.g. tit-for-tat tariff hike on US imports as happened in 2018-19. In addition, China may impose export controls on critical minerals where China has a dominant role in global production (e.g. rare earth), and MNCs may face increasing headwinds in their business operations in China, e.g. tightened rules on profit repatriation and deterioration in doing-business environment, though the probability is lower if China wants to maintain its opening-up policy stance.

Second is currency devaluation strategy to partially offset the tariff shock. This was the most important offsetting measure in 2018-19, when CNY depreciated against USD by 12-13% as average US effective tariff on China imports rose to 20% in multiple phases. The currency

depreciation largely offset the tariff impact, with the rest of the cost split between exporters, importers and US consumers hence the macro impact was modest. If the same coefficient applies, USD/CNY may spike to above 9-threshold.

But such a large depreciation seems unlikely to us this time. From an economic perspective, the tariff hike from 20% to 54% is very different from the tariff increase from 3% to 20% (in 2018-19). We are almost certain that China will observe a large fall in market share in US imports, and the purpose of currency devaluation is more to expand China’s export share in non-US markets. Hence depreciation in trade-weighted terms is more important than in bilateral terms against the USD. Moreover, the PBOC has seemed more reluctant to tolerate large deprecation since July 2023, as manifested in the change in CNY daily fixing mechanism (i.e. daily fixing can deviate from daily spot, an effective way to defend the exchange rate). Hence, we think a 10% depreciation against USD (USD/CNY to 7.75) is a reasonable policy response after the tariff hike to 54%.

Third, what is likely to be different this time is that China will more actively use countercyclical fiscal and monetary policies to address the economic shock. The Ministry of Finance has indicated that there is room to lift the budgetary fiscal deficit, increase the size of ultra-long Treasury bond and special local government bond as counter-cyclical policy instruments. We also expect the PBOC will cut policy rates by 30bps in 2025. In addition, the export pressure may force Chinese policymakers to increase efforts to support consumption and boost domestic demand, a desirable policy re-direction to drive economic rebalancing.

Lastly, Chinese companies will also accelerate the pace of export diversification (by destination and by product), and increase outbound FDI to relocate production lines to other countries to mitigate the tariff impact. The trend has been obvious in recent years, and will likely accelerate when facing a larger tariff shock from the US.