China Outlook: Can China make it in 2025?

Author: Asia Investment Strategy Team
 

Two concurrent developments are impacting China in opposite ways. A policy shift is underway in Beijing that is driving fiscal support to the economy in an effort to stem the downturn and prevent deflation. From the other direction, a newly elected President Trump has vowed to dramatically increase tariffs on China and engage in a new trade war. In this note, we assess the potential paths of both developments and how their intersection could impact China’s outlook for 2025. 

Stimulus plans: what was announced and what do we expect next?

The recent National People’s Congress (NPC) Standing Committee meeting announced a comprehensive debt restructuring plan that we think could have a modestly positive impact on growth. The Committee’s forward guidance for 2025 was also pretty consistent, reiterating that there is room for more fiscal expansion. Our expectation is for more policies to stabilize the property market, increase investment, and perhaps some measures to boost consumption. 

A comprehensive debt restructuring plan was put forward to resolve RMB 14.3tn of local government hidden debt. The plan consists of a RMB 6tn one-off resolution, RMB 4tn to be accounted for by future-year budgets, and a RMB 2tn deferred payment – with only RMB 2.3tn left for local governments themselves to resolve. The headline amount (RMB 14.3tn) is at the top end of market expectations, signaling a serious effort to resolve the debt issue.

Some investors have asked whether a debt restructuring means anything more than a large series of accounting changes. The reality is that not all debt is created equal. Off balance sheet debt is like private sector debt – it needs to be repaid fully at a point. Sovereign debt, on the other hand, is almost always refinanced. The duration extension and interest cost savings are additional benefits. Local governments were previously struggling to repay maturing debt, leading to salary cuts for civil servants, deferred payments for corporate suppliers and draconian tax collection measures. These were a significant drag on business sentiment. The restructuring takes this problem off the table. Local government bond issuance quotas will likely see a further increase as part of the upcoming 2025 budget, which means the green-lighting of more investment spending. The debt restructuring is the first step to reverse deflation, and to allow local governments to play a bigger role in counter-cyclical fiscal policies.      

As we wrote in earlier reports, since September, China’s policy focus has shifted back to the economy with the goal of ending deflation and turning around economic sentiment. The message from the NPC is still consistent with this direction. There is contention as to why the MoF couldn’t provide further details on the 2025 fiscal plan beyond the broad direction. In short, we don’t know. But given that the guidance hasn’t changed, we don’t view the lack of details as a dealbreaker. Our expectation is that policymakers will likely follow through on the announced state bank recapitalization plan and raise local government debt quotas further to support the housing market. The latter could see quotas being raised to around RMB 5tn for 2025. The official budget deficit will likely expand to around 4%, with expanded urbanization investments and targeted consumption support. There are opportunities for further policies during the year if and when tariffs go up. While tariffs are likely, the major uncertainty is over the magnitude of the growth challenges posed by tariffs, and the full policy response may only follow the specific tariff announcements.

Assuming 60% tariffs, how will that impact China’s economy?

The known unknowns

As Trump builds out his cabinet and coterie of advisers, investors are turning their attention to the prospect of tariffs and a “Trade War 2.0”. There are currently a wide range of estimates on the impact of tariffs and the growth outlook. This highlights both the fluidity and the uncertainty of the situation especially around the magnitude, timing and format of the tariffs -- Will they go to 30% or 60%? Will that happen in 2025 or 2026? Will it be in phases or in one go, and do they start with certain categories of goods? Will there be tariffs on other economies?

Analysts are also split on the degree of total impact on GDP growth, for a few reasons. One is the global trade environment. During the first trade war, despite Chinese exports to the U.S. falling, they rose elsewhere, keeping overall Chinese exports relatively unimpacted (see chart below). The U.S. is only 15% of China’s overall exports, making the remaining 85% important for determining the trade outlook. Second, how much impact will there be on business and household sentiment? This is partly a function of policy calibration – will policymakers act to prevent a de-anchoring of business expectations or will a delay cause weak sentiment to become entrenched? Third, what will policymakers do to offset the tariff impact – and by how much? Lastly, the actual implementation and path of retaliation creates a slew of unknowns – for example: how much could currency depreciation offset the tariff rate; will there be retaliation and escalation; how much will be trans-shipped through other jurisdictions; and will tariffs be applied broadly to prevent transshipments?

The known knowns

Despite the many unknowns, a certainty is that a trade war with the U.S. would have a considerably negative impact on China’s economy, for a few reasons. First, except for a spike during Covid, China is currently more reliant on exports to drive its economy than at any point since the 2000s. Given the weakness in domestic consumption and investment, exports have become a key driver of growth. This is evident in both GDP and trade data, where a surging gap between imports and exports highlights how extreme this imbalance has become. Second, despite the U.S. only accounting for 15% of China’s exports, it is still the single largest trading partner and over 3x larger than the next largest export destination. Exports to the U.S. account for approximately 4% of China’s GDP. If the U.S. dramatically reduces demand for China-produced goods, and cuts off paths for transshipment, it would undeniably have a meaningful impact. A key reason Chinese exports stayed resilient during the first trade war was that transshipments were occurring through other countries, with the U.S. as a final destination, and not because rest-of-world demand dramatically increased and offset the U.S. For this reason, the potential for transshipment will be a key factor to watch.

To illustrate the impact, let’s start with the assumption that the tariff rate goes up to 60% on all goods in the first half of 2025. Based on the experience of the last trade war, this could significantly reduce bilateral trade between the U.S. and China. We estimate there will likely be a negative shock to economic growth, through exports, investment, employment, and broader confidence. Putting aside the possibility for transshipment for now, we estimate a 60% tariff could lead to a 1-1.5ppt drag on economic growth over a twelve-month period. 

How do we get to this number? Every 1ppt increase in the tariff rate roughly translates into a -0.9ppt drag on China’s exports to the United States. So assuming an increase to 60%, that’s around a 40ppt drag on exports to the U.S. This should translate into a 6ppt hit to overall exports, and about 1ppt hit to real GDP growth, purely through the trade channel. Because the export sector is a big employer and source of investment, there are knock-on effects throughout the economy.

We think the impact could be near the lower end of the range if transshipments are strong, but at the high end or possibly above the range if transshipment routes are shut off. Transshipments offset most of the tariff impact in the last trade war. Since then, overall exports have grown despite a slowdown in bilateral trade with the United States. We think it’s prudent to bake in some degree of impact to sentiment, as uncertainty is likely to be high. That said, our assumption is that policymakers will likely act to arrest a meaningful decline in business confidence. We also assume they will likely launch more stimulus to offset the growth impact. All policy tools are on the table, but the exact split between fiscal, monetary and FX will likely depend on the situation at that point in time. For this reason, our overall growth outlook is not as bearish as some of the estimates on the street.

The next big question: Deal or no deal? Are tariffs just a negotiating tool?

Another question is whether the incoming U.S. administration will follow through with tariffs or if they will be used as a negotiating tool to achieve a deal. This is currently an open debate, but market pricing (and sentiment across Asia) appears to lean towards a belief that tariffs are merely a negotiating tool, given that many tariff-sensitive assets have yet to fully “price in” the potential impact. While it’s impossible to know exactly what the next administration will do, it can be helpful to analyze their goals and constraints, and walk back the policy options that can achieve those goals within their constraints.

Why tariffs? What’s the point?

What are the U.S. intentions around trade policy? What are they trying to achieve? This is important to analyze with regards to the U.S.-China trade relationship as it could point to very different outcomes. If the goal is to reduce the trade deficit with China, redirect trade to other countries, or simply provide less foreign currency revenue to China, then tariffs to block trade would be the desired tool. If the goal is to further open China’s markets to U.S. firms, have China buy more U.S. exports and become a larger market for U.S. producers, or to drive structural reforms, then using tariffs as a negotiating tool could help achieve these outcomes. In short – if the goal is decoupling, then tariffs could be used to block trade. If the goal is further integration of the U.S. and Chinese economies through a deal, then tariffs could be used to achieve some grand bargain.

Most indications from Washington are that a deal is not achievable, nor politically palatable. There is a belief in Washington that the structural reforms proposed in the first trade deal (but ultimately rejected)  are unachievable, and a further deepening of the U.S.-China relationship – thereby making U.S. producers even more reliant on Chinese demand – is not the desired outcome. While trying to understand the path of future policy, investors have to ask if U.S. policymakers want a deal that deepens the economic relationship and makes the U.S. more reliant on China, or do they simply want to buy less goods from China?

What could stop the U.S.? Is it too risky to reignite inflation?

If the path is tariffs and no deal, would the U.S. economy be too constrained by inflation to raise tariffs? It is important to understand what constraints could limit the use of tariffs as trade policy. Starting with inflation: core goods inflation accounts for 20% of core PCE, and 35% of core goods are imported. In the scenario where tariffs are increased on imports from China, the headline tariff rate could increase by around 35-40% points. Given that imports from China account for 13.5% of all imports, in a rough estimation this would all translate to 33bps upside for core PCE inflation (20% x 35% x 13.5% x 35pp = 33bps) – not zero, but not a meaningful increase. Using elasticities from the first trade war, the estimated increase would be 40bps. It’s important to make a distinction between tariffs on just China and a blanket 10-20% tariffs on all imports. By the same calculation, a 10% tariff on all core goods could result in an initial upside of 70bps for core inflation (20% x 35% x 10pp). Ten percent on everything would be much more impactful than tariffs just on China, from an inflation perspective.

It’s also worth noting that the final effect on inflation will likely depend on a number of factors, and some of these can play a bigger role in influencing inflation than just the direct effects of tariffs. For example, over the 2018-19 trade war period, core goods PCE inflation actually remained in negative territory and in a range between -0.9% and -0.1%.

The other factors to watch are:

1) How much of an offset could there be from USD appreciation? In 2018-19, CNH depreciated by 11.6%, which offset 65% of the increase in the effective tariff rate.

2) Whether the U.S. will be able to divert and secure alternative sources to replace imports from China and at what price. Much of the textiles, apparel, and toys can be sourced elsewhere. Some electronics and other goods are more challenging.

3) Global goods demand. It’s important to focus on the growth implications and not just the inflationary implications. The rise of trade tensions in 2018-19 slowed global demand as financial conditions tightened and corporate confidence suffered. The weaker demand outlook led to lower global goods prices and even weighed on commodity and intermediate product prices.

In other words, there are many factors that could influence the final inflationary impact that makes modeling it extremely difficult.

Could retaliation blunt the U.S.’s ability to levy tariffs on China?

Looking first at trade, it’s important to understand just how unbalanced the U.S.-China trade relationship is – it is the U.S.’s largest deficit and China’s largest surplus by a large margin. When counting both goods and services, U.S. trade is fairly balanced, with the major exception of China. When looking at it from China’s perspective, China’s trade is fairly balanced, with the large exception of the U.S. With such a large surplus, it limits China’s ability to retaliate through the trade channel. Put another way, China’s exports to the U.S. are about 3-4% of China’s GDP, while U.S. exports to China are 0.5% of GDP.

How about retaliation against U.S. companies doing business in China?

Here it’s a mixed bag, and it’s the one area where retaliation could potentially limit the scope of tariffs. On the one hand, U.S. corporate exposure to China is quite limited. On the whole, U.S. multinationals derive about 1% of profits from China, however when looking at the S&P 500, the number increases to about 7.5%. At the macro level, any retaliation through market access by limiting American corporate sales in China is unlikely to have an impact, but at the listed level it could have an impact and feed through to the market. If stock market downside is something policymakers wish to avoid then any retaliation against large listed corporates with significant business exposure to China could potentially constrain the application of tariffs. This doesn’t come without costs to China, but this is the key area to watch in terms of equity market impact.

Market implications: FX could be the most exposed

A Trump presidency presents asymmetric risks to the Chinese yuan. Potential trade disputes could lead to a depreciation in the yuan's fair value, driven by a deterioration in the current account and adverse effects on capital flows. Conversely, the U.S. dollar may experience further strengthening over the next 6 to 12 months, supported by U.S. economic growth and interest rate exceptionalism.

Reflecting on historical precedents, during the 2018-2020 trade war between the U.S. and China, the offshore yuan (CNH) weakened against the dollar by as much as 15%. This depreciation coincided with an approximate 15% increase in effective tariff rates imposed by the U.S. on Chinese goods during that period, with a highly correlated path. This correlation may be attributed to the PBOC’s stance on foreign exchange, as currency devaluation could serve to mitigate the impact of tariffs. Given the fact that the yuan is heavily managed by the central bank, the PBOC's tolerance for currency weakness is critical to its outlook. Notably, the yuan’s current exchange rate against a basket of currencies remains significantly stronger than the levels observed during 2018-2020.

As previously mentioned, further policy easing will likely be a  response to increased U.S. tariffs or more aggressive anti-China policies. While such measures could help improve risk sentiment and cushion economic growth in China, we anticipate mixed implications for the yuan, as additional monetary easing would increase currency supply and exacerbate the carry disadvantage.

Therefore, we anticipate a weaker CNH outlook with heightened volatility. Geopolitical risk premiums are expected to dominate over the next 6 to 12 months, with considerable uncertainty surrounding the levels and scope of tariffs that may be implemented. We encourage investors with long CNH exposure to consider hedging strategies. Additionally, the yuan could be utilized as a funding currency to capitalize on opportunities in other markets.

How does this impact Chinese equities?

So far, Chinese equities have broadly responded as expected. Tariff concerns and a stronger dollar are headwinds for offshore China, and broader Asia Emerging Markets. We see limited upside for these markets. A more forceful-than-expected fiscal response from Chinese authorities remains a possibility to offset potential economic headwinds from a renewed trade war, but we await more clarity and details before factoring this in. Overall, this backdrop is more supportive for onshore China relative to offshore China, but we retain a neutral view on both markets in 2025 for now. We see trading the range-bound market and utilizing structures as preferred ways to participate.

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