What Can China Do About U.S. Protectionism?

China is experiencing the full force of U.S. protectionism. Several Chinese goods entering the U.S. have been hit with tariffs since the beginning of the year, and more are likely to come. In retaliation, China has slapped several tariffs of its own on U.S. imports. China, however, cannot possibly retaliate to the same degree, given the asymmetrical nature of trade between the two countries. Nevertheless, China is not lacking in ways to deal with the situation.

Devalue the Yuan?

Devaluing its currency would be one way for China to remain competitive in the export market, although that could be risky, especially if the devaluation is large. For example, all of China’s trading partners would be penalized, and several countries might become more protectionist against China.

Another possibility is that foreign investors could heavily withdraw their assets from China should they anticipate highly volatile exchange rates. More liquid investments, such as portfolio investments, are usually quicker to transfer from one country to the next. China’s residents may also seek to massively withdraw their assets from the country. They may have to contend with strict rules limiting capital outflows, however.

A capital flight would be a threat to China’s economic growth, making it far more difficult to finance business investment as well as consumer and government loans. However, China has huge reserves of foreign assets, which could meet its capital needs. That said, dipping too heavily into these reserves could make China more vulnerable to other potential shocks.

Finding Other Markets

Instead of strongly devaluing its currency, China could bank on new markets for its exports, about 20% of which are currently destined for the U.S. market (Chart 1). That goal seems achievable, especially since the United States would have to continue importing a certain quantity of Chinese goods in spite of the customs tariffs. For example, the United States imports a lot of electronics manufactured in China. This includes computers, televisions and smartphones—consumer goods that are rarely built on U.S. soil and are thus difficult to substitute.

The United States could always turn to importing some of these products from countries other than China, however. In fact, several Asian countries would be well positioned to take advantage of the situation. That said, ramping up investments and exports would stimulate economic growth in these countries, and have positive effects on the entire region, including China. Chinese exports to the rest of Asia could well go up. China could also increase its market share in other world regions, such as Africa and Latin America.

Why Not Domestic Consumption?

China has another option to offset a potential drop in exports to the United States. It could bank on greater domestic demand, especially in terms of household consumption. While domestic consumption often exceeds 50% or 60% of the gross domestic product in many countries, in China it represents just under 40% (Chart 2).

To encourage domestic consumption, however, China would have to change the economic development model it has leaned on these past decades. China’s success resulted from policies that spurred investment, often to the detriment of consumption. Supporting high investment takes a lot of money, and this money can either be borrowed from abroad or from China’s households. China has depended on the population’s deep-rooted propensity to save. But increasing consumption would reduce savings and make it harder for businesses to support themselves financially.

Increase Income by Going Upmarket

Income growth would be another way to stimulate consumption. Wages in China are clearly increasing, but this does not seem to be enough to push households to allocate a bigger share of their income to consumption.

The challenge with wage growth is that it stems from labour productivity. China has positioned itself well on the international markets by producing low-cost and labour-intensive goods. It has made significant productivity gains mostly by reallocating its labour force from low-productivity agriculture to higher-productivity manufacturing. This mechanism cannot last indefinitely, however. Even without U.S. tariffs, China’s competitiveness would eventually decline due to its shrinking rural, under-used labour pool.

The trade tariffs introduced by the United States are therefore an incentive to speed up the transformation that will need to take place sooner or later. China must increase its productivity in ways that do not involve labour movements, and this could be achieved by accelerating the development of an economy that focuses on producing higher value-added goods.

In the End, China Still has Several Cards to Play

In short, while the rise in U.S. protectionism is a significant issue for China’s economy, we should not necessarily expect Chinese growth to plummet in the next few years.

The truth is, China can still play several cards to mitigate the effects of U.S. trade tariffs. The first one is to let its currency settle without undue pressure. Next, China could offset potential losses of U.S. market share by making gains in other countries. China’s trade composition could also be reviewed over time. This would be consistent with a gradual economic shift toward higher value-added products. The potential for increasing consumption spending is also high. However, there is a good deal of uncertainty in this scenario, and not everything will evolve rapidly. It will also hinge on Chinese authorities’ willingness to implement the required reforms.