In his first initiative, President Trump has implemented tariffs on a package of capital and industrial goods, which include semiconductor components, steel and aluminum that could amount to $34 billion. The White House has proposed an additional $200 billion in tariffs on Chinese imports, which will touch cell phones, electronics, appliances and clothing. The impact of this latest proposed round is that the U.S. consumer will end up paying more for Chinese goods as well as some U.S. manufactured goods. According to the U.S. Commerce Department, cell phones and computers are the two largest imports from China with $70.4 billion and $45.5 billion respectively imported annually to the United States.  

Tariffs act the same ways as taxes and will ultimately slow economic growth for both countries and raise prices for U.S. consumers as companies attempt to pass the tariff costs onto the consumer. However, we believe that China has more to lose in this trade spat than the United States.

The U.S. economy is on solid footing today growing at a rate near 2.7 percent annually with the unemployment rate at 3.8 percent and heading lower. The rate of inflation is nearing the 2 percent target and the Federal Reserve is in the process of reducing the simulative monetary policies that have supported economic growth since the financial crisis in 2008.  

According to the National Bureau of Statistics of China, the Chinese economy grew by 1.4 percent in the three months ended March of 2018. This compares to growth of 1.6 percent in the previous period, the weakest pace of expansion since the first quarter of 2016. We expect the Chinese economy is on pace to grow at a rate of 6.8 percent annually. This is its slowest pace of growth in the past 26 years.

China’s economy is fueled with huge levels of debt and as their economic growth slows, the debt burden increases. According to the International Monetary Fund, China’s debt as a share for Gross Domestic Product is near 240 percent, up from 125 percent in 2002. China is in a danger zone with its financial sector and debt burden. As an economy slows, the interest expense on the debt can create a chokehold on consumption further impeding growth.

Slowing Economic Growth In China

We expect there are three scenarios that China will experience through the Administration’s push to increase tariffs:

1. China may experience a severe recession as the tariffs effectively reduce exports to the United States resulting in a sharp decline in China’s manufacturing production. This would severely increase their nonperforming debt, which will result in higher level of nonperforming loans putting additional pressure on their financial system. The yuan will collapse and their banking sector will require large capital infusion.

2. We would posit that another scenario is that everything goes back to the way it used to be. However, the Administration has made a pretty strong argument for how unfair the trade practices have been over the past two decades and the impairment on the U.S. economy. We would place a low probability on this scenario happening. 

3. China and the United State come to an agreement that allows for fewer barriers for U.S. goods to be exported to China and address protections around U.S. intellectual property. We expect that this agreement would have a marginal impact on Chinese exports to the United States; however, the impact on the Chinese economy will result in slower growth. This will put pressure on the financial sector as the amount of bad debt increases albeit at a slower rate than the first scenario. The yuan weakens.