China starting to batten down the hatches as Trump tariffs take effect

The impact of the first round of tariffs imposed by President Trump is starting to impact China’s economy. As reported Tuesday in the Wall Street Journal, China’s Purchasing Managers Index registered a decline.

This figure is closely watched as it measures indicators of production such as sales, inventory and business sentiment across a representative sample of companies. If the monthly PMI figure registers a decline, this suggests declining economic activity and an impending slowdown.

The magic number is 50. As the PMI drops to 50 or below, this is a clear signal of economic deceleration. China’s PMI registered 51.2 for the month of July declining from 51.5 in the month of June.

{mosads}The greatest fear that President Xi Jinping and his advisors have is the prospect of a “hard landing” that leads to financial crisis (bankruptcy and corporate failure) and consequential unemployment.

The past 30 years of China’s economic rise has been in large measure built on exports and the inflow of funds that have allowed China to enjoy some of the largest foreign currency reserves in the world. 

Other evidence indicates China’s economy is decelerating. China’s currency has lost 6 percent of its value against the U.S. dollar since June, signaling further weakness in the economy. China maintains tight reigns over the value of its currency.

It sets a daily trading range for the yuan and will intervene when necessary to support the value of its currency. China can control the value of the yuan by selling dollars and buying yuan.

China’s prodigious $3 trillion of dollar reserves has enabled it to engage in market interventions to sponge up excess yuan, thus decreasing its supply and elevating its price relative to the dollar.

It’s been noted that since the plunge in value in the summer of 2015, China has burned through $1 trillion dollars in defending the yuan. The recent dramatic devaluation of the yuan suggests China may be abandoning its previous policy of domestic currency defense.

A weakening yuan may be seen as a response to the trade war, enabling China’s exports to remain competitive in the face of rising tariffs. China’s change in sentiment may also signal that it is preparing for a rainy day.

In the face of storm clouds brewing on the horizon, China anticipates further shocks and thus wants to keep its “powder dry” as conditions continue to deteriorate.

Continued support of its currency by selling dollars and buying yuan is no longer an option. It will need all the dollar reserves it can get its hands on to shore up its economy if things get worse.

President Xi has announced two measures to shore things up as the economy continues to wobble. First, it will ramp up domestic spending and give the green light to a number of infrastructure projects. Second, it will open the spigots to credit and encourage banks to make more loans. Both measures will have stimulative impact but also carry potential harm.

Infrastructure cannot be built without debt. At present, China’s debt ratio is conservatively recorded at 250 percent of GDP. Some economists have stated that the debt-to-GDP figure may be as high as 270 percent. By any measure, this is a very high figure and one that can lead to a financial crisis if not managed.

Second, extending credit to loss-making companies is the equivalent of keeping a terminally ill patient on life support. Sooner or later, the underlying illness will win out and the patient will die. Rather than reigning-in runaway debt, China has reverted to its old playbook to juice the economy through the expansion of credit.

To confront a changing world and extend the runway for future growth, China has embarked on one of the world’s most ambitious infrastructure projects, the Belt and Road Initiative (BRI).

BRI is a part of China’s grand strategy to forge economic and geopolitical unity of the Eurasian continent. The plan envisions connecting the continent via rail links that stretch from China to Western Europe. A maritime linkage is also envisioned that stretches from the South China Sea all the way to the Mediterranean. 

To China, Eurasia represents the last frontier. Halford Mackinder, the father of modern geopolitics, described Eurasia as the “world’s island.”

The Eurasian landmass is the world’s single largest body of land. It contains the world’s largest populations, has an abundance of natural resources and energy resources and is endowed with high technology and some of the world’s best universities. 

BRI represents a complete re-imagination of the world order. China’s intention is to resurrect Marco Polo and reimpose a modern version of the Silk Road. Rather than rely on the United States, China envisions access to hundreds of millions new consumers in the landlocked regions of Central Asia and Africa who hitherto had limited access to trade or consumer products.

How the BRI initiative will play out is unclear, as it carries with it great uncertainties and risks. Converting some of the world’s poorest regions will be a tall order and it will not happen overnight.

Despite China’s bold ambitions to access new frontiers and open new markets one thing remains abundantly clear, there are few markets on the face of the earth that have the depth and breadth of the U.S. consumer market.

China was given a choice in the 1970s as to whether or not they wanted to trade with the United States or to trade with Soviet Russia. For Chairman Mao, the decision was a no-brainer and from that fateful decision one can say the rest is history.

Arthur Dong is a professor at Georgetown University’s McDonough School of Business. He specializes in legal and business engagements between China and the United States.