With the trade war escalating yet again, it is worth briefly updating our 3Q2019 outlook. Although the latest round of 10% tariffs will make Beijing’s economic management more difficult, we don’t believe it will fundamentally alter the current approach to handling the slowdown. In addition, despite the Chinese yuan falling nearly 2% on Monday, a disorderly depreciation similar to that in 2015-2016 is unlikely to be in the cards (I will have further thoughts on the currency in coming weeks).
Some adjustments will likely have to be made, however, since the 10% additional tariff will have a tangible impact on the Chinese economy in coming months. With the added pressure on the Chinese economy, we expect Beijing to double down on its current policy mix. So far, Beijing’s guiding principle in dealing with the impact of the trade war can be summarized as “spreading the costs to minimize the pain.”
For instance, if assuming the trade war will eventually reduce China’s national income by 2%, that cost can either be distributed equally among all Chinese or it could be concentrated—meaning 10% of Chinese will lose 20% of their income. Just as in inequality of wealth, inequality in suffering also begets similar problems of popular dissatisfaction because it is human nature to compare your own station with that of others. So the way to reduce broad-based complaints and quell discontent among specific interest groups over the trade war is to spread those costs more evenly so everyone suffers a little. And that’s exactly what Beijing has been trying to do in the past few months.
The main effort has been redistributing from the state sector to the private sector because trade war costs have fallen disproportionately on small and medium enterprises (SMEs). To spread the costs more broadly, Beijing is making the state sector share in some of SMEs’ pain by cutting taxes and subsidizing bank lending that once went exclusively to state firms. Such previously unthinkable actions are being taken because many SMEs, having struggled before the trade war, likely won’t survive the current environment. Because SMEs also provide the vast majority of urban jobs in China, alleviating their pain is important for preventing destabilizing forces from getting out of hand.
At the same time, amid the current slowdown, Beijing has shown much less enthusiasm for supporting headline growth. This is likely due to two factors: uncertainties surrounding the trade war outcome and Beijing’s limited policy room to stimulate. That unpredictability around the trade war has been reinforced yet again with the White House’s latest move. Since Beijing’s room to stimulate is limited, this only further validates policymakers’ strategy of conserving stimulus firepower until the economy really needs it—for instance, in the event that tariffs get raised again.
As such, Beijing will likely continue to implement the minimal level of stimulus necessary to prevent growth from falling through the floor and accept lower headline growth. The tools for supporting headline growth will largely comprise of fiscal spending and interest rate cuts. As detailed in the 3Q2019 Macro Outlook, fiscal support should be sufficient to offset downward growth pressures during the third quarter. But in coming months, Beijing may also allow local governments to issue more bonds by using the previous year’s leftover quotas to complement fiscal spending.
In the meantime, the latest Politburo meeting signaled further restraint on property sector growth, which reduces the People’s Bank of China’s (PBOC) concern that lower interest rates will re-inflate the property bubble. This means the PBOC now has even greater room to guide interest rates down, especially the bank lending rate, then what we expected in the latest outlook. In addition to lower interest rates, Beijing will likely boost subsidized lending to SMEs, while also expanding the postponement of struggling firms’ tax payments to more regions.
In sum, any new stimulus will be 1) modest and focus on redistribution; and 2) rely more on interest rate cuts rather than credit growth. Compared to previous rounds of pro-growth measures that tended to significantly accelerate credit growth, the new way that Beijing approaches stimulus should lessen pressures on capital outflows and currency values. This is one of the factors that makes currency volatility a la the 2015-2016 period less likely this time.
Even as the latest round of tariffs will take an additional toll on China’s growth through the end of the year, Beijing will likely succeed in lessening the pain by doubling down on its current approach.
Houze Song is our research fellow focusing on macroeconomics and financial markets. You can read his latest Macro Outlook for 3Q2019 here.
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