The big questions emerging from the escalating U.S.-China trade war are about both the Chinese economy and the longer-term impact on the status of Xi Jinping.
The immediate economic impact of spiraling friction between the two powers is not large but is likely to grow over time, and accentuate other significant domestic economic challenges for China's President Xi. This could add to doubts about his leadership style and tactics -- something that would have been unthinkable a year ago when the 19th Congress of the Communist Party almost deified him.
U.S. President Donald Trump's decision to increase punitive tariffs on imports from China from $50 billion to $250 billion now covers about 1.8% of China's gross domestic product. The 10% tariff on the latest $200 billion of goods is more or less neutralized by the almost 7% depreciation of the yuan against the dollar since June. Yet, Trump is proposing to lift the tariff to 25% from January. China has retaliated with Its own new tariffs of 5% and 10% on $60 billion of imports from the U.S. The White House has said that if China did this, it might extend its tariffs to the entire volume of goods shipped to the U.S. by China, which amounts to just over $500 billion.
The damage inflicted by the trade war on China's economy so far has been limited, perhaps between 0.2%-0.5% of gross domestic product. This impact is easily absorbed in China's $14 trillion economy and is more than likely offset by monetary policy easing that has been going on for much of this year to combat the economic effects of tighter financial policies. But the prospect of U.S. tariffs on all Chinese imports, and the unknown ways in which China might retaliate, threaten to raise the economic costs considerably.
China cannot match U.S. tariffs because it imports only a quarter of the goods it sends to the U.S. It is unlikely to risk the wrath of the U.S. and other countries for the time being by aggressively devaluing the yuan. Its preferred option, confirming to past behavior when it has engaged in political spats with Japan, South Korea and the Philippines, is to target its adversaries' companies.
It is already applying more red tape and greater licensing and regulatory scrutiny to American companies. There are suggestions that it could restrict or ban the export of products that are important and integral to the supply chains of U.S. companies. This would have repercussions on China's domestic economy. Apple, for example, might be a prime target due to the company's presence in and dependence on China. It employs about 10,000 people directly in China, and nearly 3 million people indirectly through its supply chain networks. If U.S. companies were targeted and forced to reconsider their supply chain relationships, the economic, employment and business confidence consequences for China would become far more serious.
The trade war is not occurring at a propitious time for Beijing. China's stock market, the yuan and the economy have all been under pressure. The Shanghai Composite index, now at its lowest level since November 2014 when it was rising in a strong bull market, has fallen 25% since the start of the year. The yuan has fallen more or less in line with the broad trade-weighted U.S. dollar. But the People's Bank of China has had to exercise tighter control over the currency to keep it stable. Meanwhile, the economy still grew at 6.7% in the year to June, according to official sources. But investment growth in manufacturing, real estate and infrastructure has fallen to the lowest levels since 1998. While household consumption and some property indicators remain buoyant, restraints loom in the forms of a surge in the ratio of household debt to disposable income (now higher than in the U.S.), a significant fall in the debt service capacity of Chinese companies, and the continuing clampdown on financial activity, borrowing and lending.
It is no surprise then that the Chinese authorities have been "softening" their macroeconomic policy stance by boosting liquidity, allowing interest rates to fall, approving increased local government bond issuance and expenditure, lowering collateral requirements for lending, boosting infrastructure spending, and promoting "pilot free trade zones." Whether these measures gain traction and raise economic growth rates is a moot point. So far, they have only prevented a sharper economic slowdown from occurring.
If Beijing wants to meet its pledge to double per capita income between 2010 and 2020, though, further policy easing will be required this year and next to keep the growth rate at or above 6.5%. Yet, this would negate other pledges to reduce debt levels and lower the economy's dependence on credit-fueled lending that results in the misallocation of resources. If the government retreats from these latter goals, it could buy some time. But it cannot evade a protracted period of slow economic growth -- perhaps around 3%-4% -- over the coming decade. The major question is not so much the outcome, but rather the pattern as it unfolds.
In any event, slower growth will undermine the government's attempts to overcome other medium-term challenges that loom ever larger. Foremost among these is an aging demographic and the middle income trap. As the working age population falls relentlessly in coming decades, China needs new productivity-led growth to sustain economic dynamism and look after the surging number of people aged 65 and over. By 2050, China will have barely 2.5 workers per senior citizen, compared with over 7.5 today. The recent abandonment of the one-child policy is unlikely to have much effect in boosting fertility. While health and pension benefit coverage is broad, the benefits themselves are not great and half that as a share of GDP as Western economies. China has about 20 years to create a more robust social security system.
The appearance of a middle income trap, or the tendency for the rapid growth rates of emerging countries to stall, is evident in the absence of new productivity-led growth. Advanced technologies, including robotics and artificial intelligence, are seen as answers. China is making strides in some scientific and technological areas, but also lags behind the U.S. and other Western nations in many others. The key to unleashing technological enterprise and initiatives related to the AI revolution is widely understood to lie in institutional arrangements, such as the rule of law and regulatory and competition policies. But China does not rank highly in this regard. Xi's governance system is largely about control, restraint, and the primacy of state companies and government-set targets, which usually militate against beneficial institutional arrangements.
Xi does not look to be under any immediate threat. But he seems to have been wrong-footed recently by Trump's resolve in prosecuting the trade war. Criticism by intellectuals about Xi's leadership has emerged in widely circulated essays. Xi has publicly defended the government's record since he came to power in 2012 and has supported ideological and propaganda chiefs whose status had been questioned. Opinion pieces have appeared in nongovernment media outlets discussing the slowdown in market reforms and the excessive emphasis given to the state sector. Meanwhile, the pressures on the economy, stock market and yuan continue.
Although Xi's status will likely remain secure, these developments serve notice that the risk of policy instability in China is something to which we should pay attention. If anything does go wrong in China, there is really only one person who will have to shoulder the blame.
George Magnus is a research associate at Oxford University's China Centre; his new book, "Red Flags: Why Xi's China is in Jeopardy" has just been published by Yale University Press.