Since Q2 2018, Beijing has let the yuan depreciate against the dollar each time the US has raised its tariffs on imported goods from China. Yet, exchange rate policy as an instrument to support economic activity is expected to be used moderately in the short term. There is also little room to stimulate credit given the excessively high debt levels of the economy and the authorities’ priority on pursuing efforts to clean up the financial system, the public sector and the housing market. Torn between stimulating economic growth and deleveraging, the authorities’ dilemma could get worse if recent fiscal stimulus measures do not have the intended impact on domestic demand, or if the external environment were to deteriorate further.

Real GDP growth slowed to 6.2% year-on-year (y/y) in Q2 2019, down from 6.4% in the previous quarter and 6.6% in full-year 2018. Growth should continue to slow in the short term since the support provided by policy stimulus measures will only partially offset the impact of the slump in external demand. The authorities’ room for manoeuvre to stimulate growth has narrowed sharply in recent years due to the erosion of external surpluses and rising internal imbalances (excessive debt, need to clean up the public and financial sectors).

Yuan depreciation should continue to be moderate

In the first eight months of 2019, export revenues stagnated compared to the same period in 2018 (-0.05%) because of higher US tariffs and the decline in world trade growth. Thanks to a 4.5% fall in imports, the trade surplus increased by 30% y/y to USD 262 billion over the same period. The export sector’s troubles are expected to get worse in the months ahead, and the outlook for 2020 is still very uncertain since it hinges on the outcome of trade talks between Washington and Beijing.

Since Q2 2018, the weighted average tariff imposed by the United States on imported Chinese goods has increased from 6.5% to about 20% at the end of September 2019 (tariffs have so far been raised on more than two thirds of these imports). The weighted average tariff could exceed 25% by the end of the year if the recently renewed trade talks were to collapse and the new tariffs announced by the Trump administration last summer were effectively introduced. It threatened to apply tariffs to all US imports of Chinese goods (totalling USD 550bn). Between the end of March 2018 and the end of August 2019, the yuan lost nearly 13% against the dollar (including 3% in July-August). This decline more than offset the increase in the yuan reported in the previous fifteen months. With each new increase in US tariffs (announced or effective), the Chinese authorities have responded by letting the yuan depreciate to partially offset the impact on exporting companies (chart 2). In September, despite the introduction of new tariffs, the yuan levelled off against the dollar because Beijing and Washington had agreed to restart trade talks.

The authorities are expected to resort to the exchange rate policy moderately to stimulate economic activity in the short term. They fear the anticipation of currency depreciation could trigger a vicious circle of new capital outflows and yuan weakening. Yet this risk is limited given the existing controls on resident capital outflows (which have been reinforced since 2016, and then adjusted depending on balance-of-payment pressures). Moreover, the slight improvement in the current account surplus (it stood at 1.3% of GDP in H1 2019 and is projected 1.7% in full-year 2019, compared to 0.4% in 2018) and the expected increase in foreign portfolio investment inflows into China’s financial markets (following recent market opening measures) might also help stabilise the exchange rate in the short term.

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