investment insights
Will trade tensions undermine China’s future?
Lombard Odier Private Bank
In this article, we look at the economic situation in China, the state of relations between the world’s two largest economies and the implications for investors exposed to the yuan and emerging currencies.
China posted year-on-year growth of 6.7% in June 2018, while the authorities’ full-year forecast stands at 6.5%. The latest consumer and producer price reports1 have confirmed this deceleration. The consumer price index (CPI) rose 2.5% from 2.3% in August, an increase mainly attributed to a rise in food prices. The producer price inflation, non-food inflation and core inflation, which strips out food and energy prices, all cooled in September, with the latter falling to a two-year low of 1.7%. These readings will not prevent monetary policy easing further in an effort to support the economy in coming months.
This slowdown in China’s growth is part of the country’s long-term economic transition from production to consumption and the political recognition of a need to cut overcapacity, lower inequality and strengthen social safety nets, while environmental issues become more prominent. China is also pursuing economic openness with the “One Belt, One Road” initiative, emphasising its challenge to the US as a global economic and political power.
That rivalry is now playing out over trade as the world’s two top economies square off over tariffs, highlighting the ideological differences separating the two. This trade war undermines the West’s working assumption that China’s growing economy would increasingly resemble its own standard economic policy prescriptions including property rights, privatisation of state firms or tax reform, collectively known as the ‘Washington Consensus.’
A solution demands some face-saving compromise on both sides, although it is hard to see how President Donald Trump can do so given that his tariffs cannot rectify the US trade balance. Still, there will be a face-to-face opportunity when Trump and Chinese President Xi Jinping meet at the Group of Twenty in Buenos Aires at the end of November.
Soft landing, bumpy flight?
We are working with three scenarios for the evolution of the US-China trade relationship (see chart 1). Our base case, to which we give a 70% probability, is for some further short-term escalation in tensions, with limited damage to the Chinese and US economies, before a compromise is reached sometime next year. This would exert some pressure on the Chinese economy, and we currently expect a growth rate of 6.3% in 2019, slightly less than this year’s 6.4%2.
This base case also considers that fundamentals should eventually prevail, and the Chinese authorities continue their economic transition. The country has successfully worked to balance its economy by shifting export-driven growth to a consumer-demand driven model through market incentive and state controls in a remarkably short time (see chart 2). The turnaround has combined state-driven infrastructure with high investment into sectors such as electric cars, medical equipment, aerospace and robots.
A sustainable debt burden?
There is of course a potential threat to this turnaround in the form of the sustainability of China’s debt. At around 260% of GDP, credit to the non-financial sector exceeds that of the US. Countering the effects of the US trade spat and supporting infrastructure projects may require even more borrowing at the local level. Will this exacerbate a deeper debt crisis in the future? That’s not out of the question in the medium-term, although a more likely scenario may be years of structurally low growth as debt weighs on investment while the population ages, similar to Japan. In the near-term the current account surplus, large pool of foreign exchange reserves and closed nature of the economy mean that a debt crisis is extremely unlikely.
Trade fireworks
A full-blown trade war therefore looks like the biggest short-term risk. Last month the US imposed a round of 10% tariffs on USD 200 billion of Chinese imports with the threat of increasing the rate to 25% by the end of the year. In retaliation, China has imposed tariffs valued at about USD 60 billion on more than 5,207 American products. The latest import duties are in addition to an existing round already in place on Chinese and US imports worth a combined USD 100 billion. In the very short run, the impact is expected to be limited to an annualised cut of only 0.1% to 0.2% of GDP from each of the two economies. However, longer term, the effects on disrupted supply chains and lower business confidence, while relevant, are harder to quantify.
The Trump administration has made cutting the US trade deficit with China a policy objective. That is unlikely to change as long as the trade imbalance keeps growing and in September, the US’s trade deficit with China rose to a record USD 34.1 billion. In purely political terms, the US mid-term elections on 6 November will, we estimate, most likely split Congress as the Democrats win a majority in the House and the Republicans hold onto the Senate. This won’t alter the politics of trade within the US as the Democrats, traditionally more protectionist than the Republicans, would not necessarily prove more lenient towards China than the current administration.
The slowdown in Chinese and US growth plus their tariffs have implications for global economic growth next year. The International Monetary Fund pointed last week to rising trade tensions as a threat to the world economy, and trimmed its global growth forecasts for next year from 3.9% to 3.7%.
‘Not manipulating’
The other target of President Trump’s ire is the Chinese currency, which has depreciated against the US dollar this year. At the time of writing, the yuan was trading at around 6.93 to the USD3, its lowest level since January 2017. It has fallen to 6% year-to-date and its value against the CFETS (China Foreign Exchange System), a diversified basket of currencies and China’s official inter-bank market trading platform, has declined by 2.6% in the same period (chart 3).
A weakening yuan can affect the wider emerging markets universe. A combination of higher dollar funding costs, global trade frictions and a sustainable rise in the USD above 7.00 CNY would trigger broad capital outflows from emerging economies, putting their currencies under pressure to depreciate to remain competitive. Negative growth shocks to China’s economy could then derail sentiment and result in broad sales of emerging market currencies. Based on our analysis, if the USDCNY moves closer to 7.50, externally imbalanced currencies, such as TRY and ZAR, would suffer the most. However, this is not our central scenario, and we do not believe that China is actively countering US tariffs by devaluing the yuan as fiscal support is currently mitigating their impact.
Chinese Premier Li Keqiang said on 19 September that there is no intervention behind the renminbi’s weakening. “One-way devaluation will do more harm than good to China’s economy,” he said. “China will by no means stimulate exports by devaluing the yuan.”4
The US Treasury department declined to label China a currency manipulator in a report published on 17 October, despite pressure from the US President to do so. Treasury Secretary Steven Mnuchin noted that there remain concerns over the yuan’s weakness and lack of currency transparency. This could, however, potentially ease tensions ahead of the probable G20 meeting between the US and Chinese presidents in November.
The ‘Beijing Consensus’
Fundamentally, the White House is still acting as if it expects China to adopt a western growth model. Yet Beijing does not intend to follow the western world’s economic prescriptions. That has been clear at the very least since last year’s Chinese Communist Party congress when President Xi invited other economies to adopt China’s policies. China’s ‘One Belt One Road’ multi-lateral trade and investment initiative ranging across Asia to Europe, the Middle East and Africa, sometimes called the Silk Road of the 21st century, is a clear example of its ambitions.
“There is a good chance that China’s economy will continue to grow toward middle- and then high-income levels, driven by a mixed market- and state-driven development model,” Adair Turner, former Chairman of the UK’s Financial Services Authority wrote last year5. “If China had more comprehensively embraced the policy prescriptions implied by the Washington Consensus over the last ten or 20 years, its economic growth would have been considerably slower.”
Despite rising US and Chinese import tariffs, we remain convinced that sooner rather than later, economic sense will prevail. As a result, our outlook is for a slightly stronger yuan and limited immediate impact on GDP. In the meantime, as with most wars, we will undoubtedly once again learn that trade disputes are easier to start than finish.
Key takeaways
- We expect China’s GDP to expand 6.3% in 2019, slightly less than this year’s 6.4% pace2.
- We forecast the yuan appreciating to 6.65 against the dollar in 12 months, mostly thanks to a weaker dollar
- The US and China should reach a trade compromise next year before too much economic damage is done.
1 15 October 2018, the National Bureau of Statistics
2 Lombard Odier projections
3 As of 16 October 2018
4 https://www.bloomberg.com/news/articles/2018-09-19/china-won-t-devalue-yuan-to-stimulate-exports-premier-li-says
5 https://www.project-syndicate.org/commentary/china-versus-washington-consensus-by-adair-turner-2017-10?barrier=accesspaylog
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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