The trade war with the U.S. couldn’t have come at a worse timing for China , which had just begun focusing "in earnest" on fixing problems with its economy, J.P. Morgan analysts said.
Many analysts have suggested that the impact of the Washington-Beijing trade skirmish will be relatively muted on the Chinese economy, noting that exports to the U.S. do not hold a commanding presence in China's economic portfolio. But that line of thinking does not take into account how tariffs will affect business sentiment, investment and growth in China, the J.P. Morgan analysts wrote in a note.
Those indirect effects could lead to “large” collateral damage, they said.
On July 6, U.S. President Donald Trump's administration officially instituted 25 percent duties on $34 billion worth of Chinese goods. China, for its part, responded by implementing retaliatory tariffs on the U.S. shortly afterward. The following week, the U.S. released a list of Chinese goods with an annual trade value of about $200 billion that may be subjected to 10 percent tariffs .
“All this puts China in a very difficult position. Not only because much of the tariff and non-tariff measures are directed towards it, but the timing couldn’t have been worse,” the note said.
“After years of handwringing and navel gazing, China finally began to focus in earnest on curbing credit growth — its Achilles’s heel — from around mid-2017.”
China’s banks extended a record 12.65 trillion yuan ($1.88 trillion) in loans in 2016 as the government encouraged credit-fueled stimulus to meet its economic growth target. The credit explosion stoked worries about financial risks from a rapid build-up in debt, which authorities in 2017 pledged to contain.
Both China's monetary and fiscal policies have been kept on a tight leash so far this year, and deleveraging — the process of reducing debt — has been hastened through tighter regulations, the analysts noted.
However, this stance has run into headwinds in recent months, the analysts said.
“The rise in US-China trade tensions have raised concerns about the strength of external and domestic demand in (the second half of 2018) via direct and indirect effects on services such as logistics, wholesale trade, and trade finance, as well as on business sentiment and investment,” the analysts wrote.
With business demand being potentially hit, the right way for China to respond to the trade war is for it to ease its monetary policy or to enact fiscal measures, they suggested.
“Under the circumstances, easing monetary conditions to support demand and allowing the currency to absorb the shock of the trade war are the right policy choices.”
The depreciation of the yuan would offset the loss in export competitiveness for Chinese exporters due to higher tariffs, meaning that Chinese goods will essentially be cheaper to Americans.
However, the analysts warned that easing monetary policy too aggressively could also “raise doubts about the commitment of the authorities" to reduce debt.
China's dilemma: Beijing is seeking to implement relatively tight monetary policy to force financial deleveraging, but it also needs easier monetary conditions to support growth.
“Over the last 15 years, whenever credit growth has risen more than warranted it has fueled concerns over financial stability and that has seeped into depreciation pressures on the currency,” the note said. “Consequently, the current monetary policy stance will need to be carefully balanced.”
Given the limits to using monetary policy, fiscal measures to support exporters or boost domestic demand could also be used, the note suggested.
That could include increasing tax rebates — known as the value-added tax credit rate — to exporters in China which would raise their income by between 3.5 percent and 4 percent.
“Relying more on fiscal policy to support domestic demand and defray the costs of the trade war is the wiser choice ... Lessening the burden on monetary policy will also lighten the pressures on the currency,” the analysts said. They added, however, that the government could be held back by fears that easing caps on government spending could again build up debt.
— Reuters and CNBC's Huileng Tan contributed to this report.