By Aidan Yao and Shirley Shen, Research & Investment Strategy 16 August 2018

China: Quantifying the impact of trade war

Direct effects on exports will likely be overshadowed by complex and
uncertain indirect effects

Key points Exhibit 1

Worsening growth impact from escalating trade tensions
 China’s rapid advancement in technology
First and partial second round impact on GDP
and innovation has created a structural
conflict with the current leader, the US. 2.0% 1st round - trade

2nd round - investment

 The trade dispute is merely a disguise of
2nd round - consumption 1.5%
this structural conflict, making it much 1.5%
harder to resolve than those between
traditional US allies, including the
European Union, Canada and Mexico. 1.0% 0.9%

 With the situation still fluid, we outline

three scenarios of how the trade war may
evolve and consider their impacts on the 0.5%
Chinese economy. 0.2%

 Our results show that the first-round 0.0%

No escalation Limited escalation Full trade war
impacts on China’s exports are
50bn 250bn 500bn*
manageable, worth 0.1%, 0.5% and
Note: * 500bn from US perspective; Chinese own data suggests 433bn of total exports
0.8% of GDP in each of the three
scenarios. Source: CEIC and AXA IM R&IS calculations – As of August 2018

 The second-round impacts are more

complex, uncertain and potentially more
damaging. We estimate that the
subsequent shocks to domestic
investment and employment, disruptions
to the global supply-chain and tighter
financial conditions could amount to an
additional 0.1%, 0.4% and 0.7% of GDP.

 Against mounting downside risks, Beijing

has started to adjust domestic policy to
safeguard the economy. However, it has
refrained from using renminbi (RMB)
devaluation to fight the trade war, as this
would run the risk of reigniting capital
outflows and provoking more hostility
from the US.
Trade war: What is the end-game?
The dramatic escalation of Sino-US trade tension has
come as a major shock to global financial markets. From
initial tariffs targeting solar panels, washing machines,
steel and aluminium, to a more broad-based tax on
1
$50bn of technology products , the Trump administration
has significantly ramped up its protectionist measures
against China over the past six months. With ongoing
threats of more tariffs to come, fears of an all-out trade
war have weighed on Chinese markets and clouded the
economic outlook.
Contrary to the apparent progress in negotiations
between the US and the EU, trade talks between the US
and China have stalled since the first batch of the $50bn
tariffs came into effect. This underscores a fundamental
difference between the US-EU and US-China disputes.
The former is genuinely about trade imbalances between
2
two allies , while the latter is a structural conflict –
disguised as a trade spat – between two adversaries.
That structural conflict is centred on China’s rapid
3
convergence in technology and innovation , which, in the
eyes of the Trump administration, has been partly
achieved via illegal technology transfer and lax protection
of intellectual property. Hence, besides the trade war that
is currently taking place – targeting China’s technology
products, the US has also imposed restrictions on
China’s investment in its high-tech sectors, undertaken
sanctions against Chinese tech companies (e.g. ZTE),
and demanded that Beijing alters its industrial policies
(e.g. Manufacturing 2025) designed to upgrade the
economy via technology advancement.
China has, so far, not wavered in its response to US
trade policies. After retaliating in-kind to the $50bn tariffs,
Beijing put an additional $60bn of US goods on the
watch-list for a 5%~25% tax. Given the structural nature
of the dispute, we think there is no easy fix to the current
trade spat, with the US likely to implement the additional
tariffs before the Mid-Term elections, countered by
4
Beijing’s proposed retaliations .
This forecast is subject to considerable uncertainties,
with a full-on trade war and resumed negotiation leading
5
to a de-escalation of tension both still on the table . To
cover all bases, we examine three scenarios in this
paper and asses their respective impacts on the Chinese
economy:
1. a no-escalation scenario that takes account of only
the $50bn in currently-implemented tariffs;
1
These tariffs were implemented after the breakdown of a few
rounds of Sino-US negotiation, where the US refused to accept a
number of concessions Beijing offered to close the trade gap –
including buying more US products, opening its market and
strengthening the protection of intellectual property.
2 Source: US Trade Representative and AXA IM R&IS calculations –
The average tariffs rates are visually the same, at around 2%,
between the US and EU, while trade practices and standards are
also very similar.
3
Yao, A and Shen, S., “Innovation: Made in China”, Research and
Strategy Insights, 24 July 2018
4
Page, D., “Trade wars: an old hope ” Research and Strategy
Insights, 9 August 2018
5
Leonard, J., Martin, P., Mohsin, S. and Jacobs, J., “U.S., China Aim
to Restart Talks to Defuse Trade War, Sources Say”, Bloomberg.com 21
July 2018
2  AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS
2. a limited escalation scenario that includes 25% tariffs
on an additional $200bn of Chinese goods; and
3. an all-out trade war that hits all remaining Chinese
exports to the US with a blanket 10% tax.
First-round impact manageable
Our estimate of the first-round impacts from the trade
tension focuses on only the direct shock to China’s
exports. These calculations are simplistic in nature and
are subject to many assumptions. For example, we
assume Chinese exporters will fully pass on the tariff
increases and US end-buyers will reduce the quantity of
their purchases proportionally to the price hikes. Our
calculation shows this would reduce China’s GDP growth
by 0.1%, 0.5%, 0.8% across the three scenarios in the
twelve months after the tariffs are implemented.
These estimates are subject to change under different
assumptions of export price pass-through (e.g. exporters
decide to absorb some tax increases using margins) and
the price elasticity of demand (e.g. consumers buy
more/less quantity proportional to the price hikes). At the
macro-level, these variations are unlikely to materially
alter the overall magnitudes estimated. But at the micro
level, different sectors facing different supply and
demand dynamics, varying degrees of market
substitutability, and margin compression, could see their
impacts vary substantially.
Second-round shocks more damaging but
highly uncertain
Besides the direct impact on trade, China will also face
multiple second-round shocks if the trade war is long-
lasting. These would include the reduction in investment
and employment of exporters hit by the tariffs, the
external impact from weaker global growth and supply-
chain disruption, and feedback from financial markets.
Exhibit 2
Electronics and machinery make up the bulk of tariff list
China - Key products subject to US tariff
500 US$ bn
450 Machinery
400 Electronics
350
Others
300
250
200
150
100 53%
50 52%
86%
0
50bn 250bn 433bn
As of August 2018
To keep the calculation manageable, our estimates of
the domestic second-round impacts – on investment and
employment – focus on the two sectors that are heavily
targeted by the US policy. Electronics and machinery, as
shown in Exhibit 2, make up almost 90% of the $50bn
tariffs, and account for over half of the $250bn and full- Japan, Korea and Taiwan, are large contributors to the
6
trade-war baskets . value embedded in Chinese exports to the US. Some
European countries (e.g. Germany and UK), and even
Our analysis shows that these two sectors together
the US itself, are also beneficiaries of this global
account for about a quarter of China’s industrial
production process.
production, manufacturing investment, and industrial
employment (Exhibit 3). By applying the first-round Exhibit 4
impact, estimated above, to industrial production, we A significant portion of the added value in Chinese
calibrate a proportional shock to investment and exports is created offshore
employment, feeding through to consumption. Our China exports in electronics and machinery value added
results, summarised in Exhibit 1, show that the second- domestic vs foreign
800 USD bn China's own value added
round impacts of the $50bn tariffs would likely subtract
700 43.2%
another 0.1 percentage points (ppt) off GDP growth, Foreign value added
taking the total impact to 0.2%. For the escalation and 600

full-trade-war scenarios, the second-round shocks could 500

amount to 0.4ppt and 0.7ppt of GDP, raising the full 400
7
impacts to 0.9% and 1.5% respectively . 300
Exhibit 3 200
Tariff-targeted sectors make up a large share of the 26.6%
100
economy
0
China - Machinery and electronics share of total, by sectors Electronics Machinery
20% Tariff targetted ($50bn) Exports to US Domestic
Source: OECD TiVA, CEIC and AXA IM R&IS calculations – As of
18% % Industrial % Manufacturing % Industrial
employment
August 2018
Production FAI
16%
14% Exhibit 5
12% Trump’s tariffs will hit the global supply chain
10% Value added embedded in Chinese exports to the US
8% 12%
6% 10%
4% Electronics Machinery
8%
2%
0% 6%
Machinery Electronics Machinery Electronics Machinery Electronics 4%
Source: CEIC and AXA IM R&IS calculations – As of August 2018
2%

Besides the domestic shocks, some second-round 0%

impacts are likely to come from offshore. For example,

weaker global growth, as a result of the US-China trade
war, will weigh on Chinese exports, over and above the
direct hit from tariffs. However, given that over 90% of
China’s GDP growth now comes from domestic demand
and its export sensitivity to global growth has declined
over time, we think the impact from this channel will be
limited.
Another source of external shocks is from the disruption
to global supply-chains. This is particularly important for
goods, such as electronics and machinery, which rely on
the collective contribution of many producers on the
global production process. China may be the final
assembler of many products shipped to the US, but it is
far from the sole profit earner. Exhibit 4 shows that over
40% of the value-added in electronics, and nearly 30% of
that in machinery, is created outside China. A
reallocation of these values back to their originators
(Exhibit 5) shows that Asia’s technology leaders, such as
6
China’s total exports to the US amounted to $433bn in 2017,
according to China custom data. This is smaller than the $505bn
reported by the US Census Bureau, with the difference due to
measurement differences.
7
We apply a less than proportional adjustment to derive the full
impacts based on the share of electronics and machinery in the
tariff baskets. This is because other industries tend to have much
smaller FAI and employment than electronics and machinery.
Source: OECD TiVA and AXA IM R&IS calculations – As of August
2018
The implication for China is not as straightforward as it
seems. On the one hand, as China’s exports to the US
decline on the back of trade tensions, its imports of
components and inputs from others will also decrease,
effectively spreading the negative shock across the
supply chain. Even for production that occurs in China,
many top exporting firms are in fact foreign-owned
(Exhibit 6), meaning that their profits will ultimately flow
outside the country. These analyses suggest that the
overall growth shock for China may not be as large as
8
estimated in Exhibit 1 on a value-added basis .
On the flipside, a long-lasting trade war would weaken
China’s position in the global supply-chain. With its
products restricted by the world’s largest market, China’s
competitiveness in global manufacturing, particularly in
8
Our calculation shows that the foreign value-added contents in
China’s exports to the US are 33% in electronics and 23% in
machinery – both are slightly lower than those in total exports as
shown by Exhibit 4. If these are used to calculate the tariff impact
on a value-added basis, and assume the second-round shocks
adjust accordingly, the GDP impact will be reduced to 0.2%, 0.7%
and 1.1% in the near-term.

AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS  3

high-value-added and sophisticated technology products,
would decline, leading to lower foreign direct investment
and employment further down the road. This would put
China’s economic growth under pressure and hinder its
technology convergence over the medium-term.
Exhibit 6
70% of top exporting firms to the US are foreign-owned
Top 100 Chinese exporters to the US by original
ownership
SG JP
% share, 2016 data 3% 2%
CA
KR EU1%
HK 6% 2%
7%
TW
37%
US
12%
CN
30%
Source: China Customs and AXA IM R&IS calculations
However, quantifying these global effects is not easy, not
least because of the uncertainty associated with the
evolution of the trade conflict, but also because the
behaviours of global producers are difficult to predict ex
ante. Our analysis here merely tries to sketch the
contours of these second-round shocks and highlight
9
their complexity.
Policy supports coming to the rescue
With potentially large impacts from the trade war
weighing on the economy, Beijing has started adjusting
policies to support economic growth. We summarise
these policy responses on three dimensions:
1. Trade policy for retaliation: China has so far not
shied away from retaliation, while making it clear that
it does not want to escalate tensions. However,
without responding in-kind to Trump’s latest stake-
raising (i.e. $60bn vs. $200bn), Beijing has shown
10
restraint to avoid aggravating its opponent . Should
Trump go ahead with the new measures, we expect
Beijing to respond, although its retaliation may fall
short of pure tit-for-tat.
2. Domestic policy for risk management: Over the
past month, monetary, fiscal and financial regulatory
policies have all been relaxed to support the economy
against mounting downside risks. With the lion’s
share of China’s economic growth now generated by
9
On inflation, the negative growth impact of the trade war will be
deflationary. But China’s retaliation – 25% tariffs on the US
agricultural and auto products – will lift domestic prices. We think
the impact on overall inflation is manageable, given China’s ability
to substitute many products from other suppliers. The NBS
estimates that China’s counter measures executed so far would lift
CPI inflation by 0.1% over the coming 12 months.
10
The less-than-proportional response is also a result of US
exports to the China being smaller than the reverse. That said, the
fact that China’s retaliation has four tariff rates from 5% to 25%, as
opposed to a flat 25% matching the US, is also a demonstration of
restraint.
4  AXA INVESTMENT MANAGERS – RESEARCH & INVESTMENT INSIGHTS
domestic demand, we think this combined policy
response will be effective to cushion the economy
from the trade shock 11. The challenge, however, is to
manage such stimulus so that it does not undo the
progress on deleveraging and supply-side reforms. In
this regard, Beijing’s commitment to keeping
monetary policy neutral, and to continue putting
pressure on shadow banking and property markets, is
encouraging at face value.
3. Accelerating reforms to address structural
weakness: finally, the trade war has revealed
China’s Achilles heel in many areas, such as
innovation (e.g. its reliance on foreign technology),
export diversification (e.g. still dependent on the US
and EU demand) and its communication of policies
(e.g. how China’s “peaceful rise” is being seen as a
threat by many). These shortcomings each call for
faster reforms and liberalisation to shore up China’s
own competitiveness. Beijing has started to deliver
these by cutting trade tariffs (except those vis-a-vis
the US), opening up financial markets, strengthening
intellectual-property protection, lowering taxes, and
accelerating debt-to-equity swaps and financial-
system reforms. If there is a silver lining in the Sino-
US trade conflict, it could be that Beijing is pressured
to spearhead faster and more substantial reforms
than it would have done otherwise, leading China to
benefit from this debacle in the long run.
Will RMB be used to fight the trade war?
With the recent sharp depreciation in the RMB exchange
rate, renewed talks of competitive devaluation have led
to an eerie feeling of déjà vu to the summer of 2015.
From a growth perspective, a weaker currency could
help China to weather the trade turmoil. Our analysis
shows that the recent depreciation in the yuan nominal
effective exchange rate (NEER), to the tune of 5.5%
since mid-June, can boost export growth by 3.3% with a
12
quarter lag . On paper, this could more than offset the
$250bn trade tariffs from the US, although in reality such
13 14
an offset may not be perfect , .
However, this depreciation has not been a deliberate
policy aim, but a result of market forces. Our analysis
11
We are keeping our 2018 growth forecast at 6.5% but see
downside risks to our 2019 forecast of 6.3%.
12
We regress China’s annual export growth on annual percentage
of RMB NEER, while taking into account of US and EU demand,
proxied by GDP growth. All three values are statistically significant,
with a model R^2 of 0.68. The coefficient on the NEER is 0.6 with a
three-month lag, suggesting that 1ppt depreciation in the RMB will
boost China’s export growth by 0.6% after a quarter.
13
The 3.3% NEER depreciation will boost China’s total exports by
$75.2bn (3.3%* 2,280bn = 75.2bn). This will more than offset the
impact of US tariffs, at $62.5bn (25%*250bn = 62.5bn). However,
this calculation is simplistic, which does not account for the multiple
distribution effects (e.g. exports to the US will still suffer, as the FX
changes are smaller than the tariffs rates, while those to other
regions will not. Also, the tariff-hit sectors will still suffer, while the
non-tariff-targeted industries will enjoy the full FX gains. These
variations in the distribution of impacts mean that the FX gains may
not completely offset the tariff losses on the micro level.
14
This positive growth impact from FX depreciation also needs to
be weighed against the negative impacts from selloffs in equity and
credit markets.
shows that the People’s Bank of China (PBoC) has been destabilizing the capital account and provoking more
rather hands-off with its FX operations, refraining from hostility from the US.
manipulating the rate-setting process or intervening
Exhibit 7
directly in the market. The latter has resulted in broadly Little evidence of PBoC direct intervention
stable FX reserves since 2017 (Exhibit 7). Overall, we
CNYUSD and monthly change in FX assets
see little evidence that Beijing has used any of its USD bn CNY/USD
10 7.0
conventional tools to deliberately force down the
6.9
exchange rate. -10
6.8
If anything, the authorities have tried to slow the pace of -30
6.7
depreciation by recently raising the costs of FX 6.6
15
speculation and putting more emphasis on fiscal policy, -50 6.5
rather than monetary policy, to support the economy. 6.4
-70
This reflects the official desire to balance the gains from 6.3
FX depreciation against the costs of potentially large mom change in PBC FX assets [Lhs] 6.2
-90
CNYUSD [Rhs]
capital outflows. With the scar from the 2015-16 capital 6.1
exodus still fresh, we think the authorities are managing -110 6.0
Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18
this double-edged sword carefully. Overall, we do not
Source: Bloomberg, CEIC and AXA IM R&IS calculations
think Beijing has any intention to fight the trade war with
currency devaluation, as it would run the risk of

15
The recent re-introduction of a 20% reserve requirement on CNY
forward trading reflects the PBoC’s desire to curb FX speculation
and ease the pressure off the RMB.

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