With the trade war now threatening to blow over into a full blown currency war, analysis on the potential impact and reaction from the U.S. side of the equation has been well-covered in mainstream press. What is, unfortunately, less focused on, is the Chinese, and how they might react. As I have argued in the past, the Chinese reaction function is key to navigating the current macro environment. I firmly believe this remains the case - perhaps even more so - at present.
The way I see it, the options available to Chinese policymakers to respond and counteract the new tariffs by the United States can be broadly split into two buckets -- an escalation of tariff retaliation or non-tariff retaliation.
The recent FX depreciation (dubbed "manipulation" by the U.S.) indicates Beijing may now be resorting to the latter.
At the moment, China is showing a great deal of restraint. The reluctance to resort to tit-for-tat retaliation indicates, to me, the next Chinese response will merely increase the potency of the policies that have already been put in place but not much more than that. In sum, we're nowhere near a currency war just yet.
Likely non-tariff measures we could see include a further currency depreciation or a targeted restriction on certain imports from the U.S. Potential tariff-related retaliation would be an escalation of measures which have already been used in the past, such as further tariffs on U.S. imports.
1) Restricting/Substituting U.S. Imports
The United States has been rather unyielding in its desire for China to purchase more goods from them rather than using alternative sources. President Trump believes that having a greater reliance on U.S. goods would make China a better partner for trade. In particular, the president has asked for China to buy more goods from the United States' agricultural sector.
There has been a sharp and steady drop in the amount of imports that China is receiving from the U.S., but China is looking to take further action. Specifically, the government has requested that state-owned businesses cease purchases and partnerships with U.S.-based agriculture and to move towards new suppliers. Not only is this substitution going to be a sore point for the U.S., but it could impact non-state-owned companies in China as well.
2) Currency Depreciation
One of the key options on Chinese policymakers' table would be to alter, or even allow the USD/CNY exchange rate to drift higher in an attempt to offset the impact that the tariffs are having on Chinese exports. This is a likely course that the Chinese policymakers could further pursue in the face of new tariffs even though it runs contrary to the government efforts to prevent depreciation from occurring in the last year.
It is important to recall that policies to limit the CNY depreciation were only put in place when there was hope of not facing tariff escalation.
Now, the CNY depreciation appears to be a beneficial, if not likely, course of action for the Chinese. Thus far, however, the Chinese have shown restraint -- fixing the CNY above 7.0 a day later.
While policymakers not want to risk a full-blown breakdown in trade negotiations, a moderate depreciation could be an effective tool in the ongoing trade war.
3) Increased Tariffs on U.S. Exports
Another potential response would be retaliatory tariffs on U.S. imports. This has been a long-standing policy for China, where they have countered tariffs from the U.S. with tariffs of their own.
Source: International Business Times
Additionally, China has restricted imports on various products and services coming from the U.S. At present, the tariffs appear as follows: 25% tariffs on $50 billion worth of U.S. goods. There is an additional variable 5-25% tariff rate on goods worth $60 billion from the U.S. When factored together, it appears that there is a total rate of 19% for 110 billion worth of products that are imported from the United States.
While China has often sought to respond proportionally to the U.S. tariffs, there are some areas in which they have not acted to place restrictions and additional costs. For example, there are roughly $50 billion worth of electronic and aeronautical products that are not currently being affected by tariffs. These could become targets in the future if China decides to ramp up tariffs against the U.S.
In this case, the Chinese still have several options on the table with regards to increased tariffs. For starters, they could increase the rates on the products that already being tariffed. That could have a more profound impact on many industries in the U.S. Additionally, China could seek to place additional tariffs on the sectors that are untouched, electronics, and aircraft parts.
Finally, China could begin putting constraints, formal or informal, on services, tourism, and students studying abroad in the United States. Again, this seems like a moderately likely course, but the degree is what matters most.
4) Placing Controls on Key Exports to the U.S.
The final option that China could pursue in order to respond to the ongoing trade war would be to place controls on the most important exports to the U.S. The reason this is the least likely option for China to take is that it would send the U.S. looking elsewhere for products and could do more harm than good in bringing policymakers to the table for future agreements.
The U.S. has already acted in this manner, to an extent. Specifically, the government has limited the types of products and technology that U.S. companies can provide for Huawei and their partners. This was somewhat of a punishment for supposed inappropriate behavior on the part of Huawei but also served a purpose in the trade disagreements.
China has several different areas in which they can act to disrupt companies in the United States by limiting exports. Specifically, there has been a lot of talks concerning limiting the export of rare minerals to the U.S. which are used in creating and developing technologies like computers, batteries, and as chemical catalysts. Presently, China provides more than two-thirds of these minerals, so they are certainly capable of halting the flow of them to the U.S.
Of course, this could be met with further actions and export restrictions from the U.S., which makes this a less likely but still effective action that China could take.
With new tariffs being put in place from the U.S. side, it is only a matter of time until China's position becomes clearer. Broadly speaking, Beijing's options fall into two key categories - tariff or non-tariff retaliation. With Beijing now resorting to the latter, we are slowly, but surely, seeing escalation from the Chinese side, though they are sill showing a great deal of restraint, e.g., fixing the Yuan below 7.0 a day after being labeled a currency manipulator.
As I've repeatedly stressed, understanding the Chinese reaction function is massively important -- the latest response by the Chinese indicates a slow escalation but not much more than that. In sum, I do not think we are anywhere close to a full-blown currency war - yet.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.