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China must take care in countering trade war's economic blows

Fiscal stimulus best way to bolster short-term growth and support rebalancing

| China
Suitable policy measures, such as tax cuts for lower-income workers, would boost household consumption at a modest fiscal cost.   © Reuters

The U.S.-China trade war is at an impasse. The Trump administration has clearly signaled its intention to continue escalating tariffs until Beijing caves in, while the Chinese authorities have equally showed they have no intention of doing so. Hopes that the situation might improve after the U.S. congressional election on Nov. 6 seem wishful.

In this context, how policymakers in the two countries handle the domestic fallout from expanding trade tariffs could affect each of their economies for years to come. Both economies can withstand the trade war's repercussions for now. But hasty moves by China to offset the impact of U.S. tariffs risk worsening its myriad financial vulnerabilities and have implications for longer-term growth.

China's third-quarter gross domestic product growth, to be reported on Friday, is likely to be on par with the 6.7% year over year growth recorded in the second quarter. Most indicators of domestic demand, such as retail sales and industrial production, have held up well.

Even export growth has remained surprisingly strong so far. But a dip in investment growth, still a major contributor to gross domestic product growth despite the authorities' partial success in rebalancing toward consumption, does not portend well. Export expansion is still likely to taper down soon as U.S. tariffs begin to bite.

Currency depreciation, one tool to maintain export competitiveness, remains a double-edged sword for China. The weakening yuan will offset some of the detrimental effects of U.S. tariffs, mitigating the pain inflicted on both American consumers and Chinese exporters.

But faster currency depreciation would risk a capital outflow spiral. Chinese policymakers were scarred by the massive outflows that proved difficult to manage during the relatively small round of currency depreciation that they set off in August 2015.

Expansionary monetary policy could prop up short-run growth in China, just as it did during the global financial crisis a decade ago. The government appears somewhat inclined to take this route. In July, Beijing tweaked its monetary policy stance from "prudent and neutral" to just "prudent." The cut in the reserve requirement ratio for banks taking effect on Oct. 15 represents a significant easing step.

A surge in bank credit, however, risks worsening China's myriad financial vulnerabilities. The country's high level of corporate debt and its banks' large stock of potential bad loans make looser credit a less effective and increasingly risky channel to stimulate short-term growth.

Fiscal stimulus would be a better choice. Suitable policy measures could help bolster short-term growth and simultaneously help in rebalancing the economy away from an investment-led growth model -- at a lower cost and with fewer risks than monetary loosening. For instance, personal income tax cuts targeted at the lower end of the income distribution and higher expenditures to strengthen the social safety net would boost household consumption at a relatively modest fiscal cost.

Meanwhile, the U.S. does not appear vulnerable to a significant growth slowdown, at least in terms of a direct hit to its exports. Exports to China represent only a modest proportion of overall U.S. merchandise exports and an even smaller share of GDP.

American companies doing business in China's fast-growing markets -- or using China in their global supply chains -- are certainly facing some adverse impacts. But the U.S. economy's overall growth momentum remains strong enough to overcome this, with the effects of last November's fiscal stimulus still feeding into the economy.

Far worse than the tariffs themselves are some of the policies Trump has put in place to limit the economic and political pushback from domestic constituencies against the tariffs. Arbitrary tariff exemptions granted to politically powerful companies and industries, along with support mechanisms such as the package of support for farmers affected by retaliatory Chinese tariffs, amount to greater and unhealthy government intervention in the economy.

That America and China are in sturdy economic positions may be bad news. The longer the two can weather the trade war, the longer it will drag on.

China's capitulation to U.S. demands, which the Trump administration seems to view as the only viable end game, is an unlikely outcome given Beijing's domestic political imperative of not being seen as weak and unable to resist pressure from the U.S.

The trade war, and the way it has been executed, represent a missed opportunity for the U.S. President Donald Trump's aggressive posturing and martial rhetoric have eclipsed his legitimate complaints about China.

Its weak intellectual property protection regime, under-the-table subsidies, and discriminatory regulations fall short of its commitments under World Trade Organization rules and should be thwarted. But Trump's threat of withdrawing the U.S. from the WTO hardly helps in building a coalition to take on China.

The standoff, then, looks set to continue. While both economies can survive the short-run pain of the trade war, how Chinese and U.S. policymakers choose to alleviate this strain could, however, end up affecting the structure of their economies in subtle but more long-lasting ways.

Eswar Prasad is a professor of trade policy at Cornell University and a senior fellow at the Brookings Institution. Ethan Wu is a student at Cornell.

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