Public political drama in China, usually remarkable only in its banality, was downright Shakespearean this past week. It began with unsubstantiated reports of gunfire in the streets of the capital, followed by rumors that Chinese elites had tired of President Xi Jinping’s efforts to develop his Mao-like personality cult. The ceaseless lionization of the president in state-owned media ground suddenly to a halt, restarting only when he appeared in Africa for a series of state visits. News agency Xinhua released an eyebrow-raising article about the downfall of former Communist Party chairman Hua Guofeng in 1980, implying that no Chinese leader is bulletproof. Abruptly, Beijing announced the appointment of a new security chief as party boss of Guangdong province – the southeastern coastal manufacturing powerhouse where much of the pain from the trade war is likely to be felt. A tussle between the central bank and the Finance Ministry over fiscal stimulus spilled into the media. U.S. National Economic Adviser Larry Kudlow said Xi had killed attempts by his advisers to negotiate a truce on trade – suggesting the White House sees divisions in Beijing to exploit. A new scandal erupted over the weekend regarding the distribution of millions of faulty vaccines – just the latest in a string of corruption scandals in the pharmaceutical industry – once again calling into question the government’s ability to manage a crisis.
In short, a trade war is not the only war Xi is fighting.
Deleveraging vs. Stimulus
China expected 2018 to be a rough year even before U.S. President Donald Trump started with the tit-for-tat tariffs. Beijing is in the middle of a sweeping reform campaign meant to address systemic risks such as industrial bloat, unchecked pollution and soaring debt, the overriding goal of which is to make the country better able to withstand a prolonged period of slowed growth.
The reforms were always going to be painful. Indeed, even in the absence of a trade war, measures to cut back on industrial overcapacity, shut down highly pollutive factories, and wean the economy off its addiction to cheap credit would drag down the economy. In the first half of this year, for example, fixed-asset investment grew at its slowest pace since 1999. For the year, Beijing has set a GDP growth target of just 6.5 percent, after hitting 6.9 percent (officially, at least) in 2017.
Xi hopes that short-term pain will result in long-term gain. But in China, the risk is that short-term pain leads to long-term social unrest that destabilizes the whole system. This is why Xi has been able to amass so much power at the expense of party elites. By the time Xi began to purge his opponents and tame the bureaucracy, something of a consensus emerged among party royalty that China needed an authoritarian to see it through the coming crisis. And so, through his first term, Xi has had a mandate to reform, no matter how painful it may be, propelled by a sense of urgency while the Chinese economy still has the wind at its back.
The trade war with the U.S. has complicated Xi’s best-laid plans. Perhaps the most heated debate within Beijing right now appears to be focused on whether the government should be attempting to fight a two-front war – against the U.S. on trade, and against China’s internal dysfunction. In particular, there’s pressure on Beijing to ease off its deleveraging campaign and focus instead on stimulating growth as the trade war intensifies.
Staying the Course
All the while, Xi has refused to decelerate the drive toward reform. Beijing has hinted that some low-level fiscal monetary stimulus measures are in the works, including new local government bonds for infrastructure projects. But these plans, along with modest capital injections into state-run banks and new efforts to encourage purchases of low-rated corporate bonds, are meant merely to calm markets, channel liquidity to the corners of the economy that need it most, and decrease the likelihood of an overcorrection. They aren’t intended to signal an abandonment of the deleveraging campaign or to return to the high levels of stimulus exemplified by 2008, when China unleashed some 4 trillion yuan ($590 billion) in new spending to shield the country from the global financial crisis.
Beijing has, moreover, continued to roll out major new reforms, including in the past week alone, targeting wealth management products, new limits on SOE dabbling in the financial sector, and new property tax legislation. The government has notably declined to intervene amid a rising wave of private corporate defaults, and it has refused to bail out the nearly 60 online peer-to-peer lenders who’ve gone belly up since the beginning of the month. All this suggests that Beijing believes the reforms are doing what they were intended to do: weed out inefficiencies, give Beijing better control over where and how much liquidity is flowing, and put the economy in better position to handle shocks such as trade wars.
Beijing seems to think it’s well-positioned to ride out the trade storm – or at least to outlast the U.S. And there’s reason to be optimistic. Its trade vulnerabilities notwithstanding, China has some advantages in this regard. For example, the weakening yuan, combined with the strengthening dollar, will help keep Chinese exports competitive, even if it causes problems elsewhere in the economy (i.e. increased capital outflows). The sheer size of its labor pool, its superb manufacturing and export infrastructure, and its allure for foreign firms will limit the exodus of companies leaving the country in search of lower labor costs and greater access to the U.S. market.
And while China depends more on its exports to the U.S than the other way around, it’s worth noting that China relies less on exports now than it once did. Net exports (exports minus imports) now account for just around 2 percent of China’s GDP. A decade ago, they accounted for around 9 percent. (Exports to the U.S. make up just 19 percent of total exports.) Meanwhile, domestic consumption, including government expenditures, accounted for more than 78 percent of GDP growth in the first half of this year, compared to just more than 45 percent five years ago. Moreover, since most of the value of many goods exported from China comes from components manufactured elsewhere, only a fraction of the tariff hit will come out of China’s pocket.
Beijing believes time may be on its side. With U.S. midterms just around the corner, the mere possibility of losing control of Congress will dampen Trump’s biggest threats, or so the thinking goes. For Trump to make good on his promise to slap tariffs on another $200 billion-$500 billion of Chinese exports, he’d have no choice but to target finished consumer goods. It will be much more difficult to hide the sticker shock from voters than it has been with the intermediate Chinese goods targeted so far.
In other words, Xi’s trade war strategy is to try to make it politically problematic for Washington to continue the fight, manage the fallout at home and keep everyone from freaking out — and otherwise to stay focused on big-picture challenges facing the Chinese economy. The core message from state media in recent weeks has been: stay the course.
Nowhere to Hide
The trade war may actually help Xi. After all, if China is heading for an economic reckoning anyway – or, in the best case, painful reform in the face of slowed growth – then the trade war will make it easier for Beijing to pin the blame on the U.S. and to rally around the flag. Chinese state media has already framed the trade dispute as an inevitable byproduct of the country’s success. According to the CPC-crafted media narrative, the U.S. is a declining superpower, headed by an impulsive and vengeful president, eager to deny China its hard-earned place in the world. Its trade war is a tool of the insecure and embattled.
Still, the trade war will almost certainly put Xi’s model to the test. If the U.S. follows through with its 10 percent tariffs targeting $200 billion in Chinese exports, it would shave between 0.2 and 0.3 percentage points from China’s annual GDP growth, according to a study by Deutsche Bank. A smaller pie means less to go around, a status quo some factions will be less inclined to support. In choosing which sectors to shield from U.S. tariffs – and which to expose with countermeasures – Beijing will effectively be picking winners and alienating losers. China’s growing inequality is likely to be further exposed. Censorship, social controls and a cult of personality can help the government withstand the fallout of lost jobs, but they can only go so far.
Interestingly, Xi has been quiet about trade in recent weeks, letting Premier Li Keqiang stand in the spotlight instead. It might be wise to do so. No individual can bridge the structural disparities between China’s coasts and its interior, any more than he can reconcile the differences that are bound to be exposed over the coming months. If Xi’s two-front war becomes unmanageable, there won’t be anywhere for him to hide.