Oct 05, 2018 07:17 PM

Nick Marro: How Will the Trade War Affect Different Provinces?

The U.S.-China trade war shows little sign of slowing down. On Sept. 24, the U.S. and China moved forward with tariffs covering a total $260 billion-worth of bilateral merchandise goods trade. These trade measures will have negative repercussions for both China and the U.S. Although it will take time for the full effect to show up in the data, many businesses have already started to feel the impact of higher costs for inputs, and will ultimately raise higher prices of final goods for consumers by 2019, too.

The impact on provincial economic growth

Partly because of the trade war, we believe that China’s national gross domestic product (GDP) growth will slow to 6.2% in 2019, and that its current-account surplus will also narrow. The impact of the trade war at the local level in China may be even more pronounced. We expect to see disruption in a number of provinces that rely heavily on trade for economic growth, including Guangdong, Jiangsu, Shanghai and Zhejiang. These areas are China’s traditional export powerhouses, accounting for over half of China’s total export flows in 2017. In addition, although the external sector occupies a smaller role in these provincial economies when compared to a decade ago, trade growth remains an important pillar of economic activity: last year exports as a percentage of regional GDP stood at 50% in Guangdong, at almost 40% in Zhejiang and Shanghai and at roughly 30% in Jiangsu.

The U.S. is China’s largest trading partner, accounting for roughly 19% of total Chinese exports in 2017, according to Chinese customs statistics. In the key export centres of Guangdong and Jiangsu, shipments to the U.S. accounted for 17.4% and 23.5% of total exports respectively in 2017. For Guangdong specifically, the large amount of transhipments to the U.S. via Hong Kong means that trade vulnerability may be higher than official data suggests (Chinese customs authorities count these shipments as exports to Hong Kong, while U.S. customs may classify them as China-sourced imports, making them eligible for tariffs). Even in provinces where exports as a percentage of total GDP are relatively low, exposure to U.S. trade actions may be high: according to the official data available, the proportion of shipments to the U.S. as a percentage of total exports in 2016 stood at 19.3% and 24% in Shanxi and Chongqing, respectively.

Many of these provinces are uncomfortably vulnerable to the escalation of the U.S.-China trade war not just because of the volume of their exports, but also because of their make-up. In highly exposed provinces like Guangdong, Jiangsu and Zhejiang, a large proportion of exports are in the electronics and machinery industries — both of which sit squarely in the cross-hairs of U.S. trade actions, which have sought to target industries central to the Made in China 2025 agenda. The Economist Intelligence Unit has found a similar situation in terms of trade exposure and export composition across a number of largely coastal prefectures as well, including Dalian, Foshan, Fuzhou, Guangzhou, Shenzhen and Xiamen, among others. There is a chance as well that many of China’s inland provinces — such as Sichuan and Henan, which provide raw materials, inputs or manufacturing services in different parts of the supply chain — may also be affected by any slowdown in the manufacturing-for-export industry.

Slowing consumption, weaker business sentiment

The impact of the trade war on business sentiment will also be an important factor for companies operating in these regions, particularly in consumer-facing sectors. Already there has been much discussion over the “consumption downgrade” in China’s cities in the face of the slowing economy. Although such concerns have been overplayed, the data do indicate that urban consumption expenditure growth has slowed since the beginning 2018.

The cause of the slowdown in retail spending is tied more to the domestic financial “de-risking” campaign than to the building trade war. The data do suggest, however, that consumers — primarily in urban areas — are tightening their belts in the face of a cooling economy. While we believe that upgrading (not downgrading) remains the dominant theme in many consumer-facing industries, disruptions caused by the U.S.-China trade war will serve to constrain sentiment. Although we expect the drag on retail sales from higher import tariffs to be relatively modest — constrained by both the relatively small number of imported U.S. final consumer goods into China, as well as recent cuts to Chinese import tariffs on a wide range of imported consumer products more generally — we expect broader inflationary pressures linked to the U.S. tariffs, primarily in the food industry, to build in 2019. Consumer activity will also be disproportionately hit in coastal provinces and cities where jobs, incomes and wage growth are tied to export-oriented manufacturing industries.

Investment relocation and supply chain shifts

Against a background of rising labor costs in China, multinationals had already been looking to diversify production to more cost-competitive locations. We expect the trade war to accelerate this trend, which may in turn translate into weaker foreign investment at the local level. Samsung, which operates smartphone manufacturing plants in Tianjin and Huizhou, Guangdong province, has already begun expanding production in Vietnam, and in July opened the world’s largest smartphone factory in India. The company may dial down or withdraw some of these China-based operations, including its plant in Tianjin, with the U.S.-China trade war exacerbating the pressure from the recent collapse in Samsung’s smartphone market share in China. Foxconn and Pegatron, two large Taiwanese electronics manufacturers (and key suppliers for the iPhone), have already publicly mulled plans to rely on production in factories outside of the Chinese mainland, including in Taiwan, Europe and the U.S. This will divert resources away from their existing plants, such as in Shenzhen and Zhengzhou.

The shift of export-oriented manufacturing out of China, however, will take time, and the general structure of regional supply chains is unlikely to change in the short term. In Taiwan’s case, for instance, the Chinese mainland makes up such a large destination for investment that the trade war is unlikely to result in an immediate or dramatic shift in investment away from the mainland (although the Taiwan government remains keen to attract Taiwanese firms to bring back investment and production to the island). Multinational companies will need to spend time and money to find local partners, navigate local regulatory hurdles and negotiate the relevant contracts. It is also unlikely that foreign investors will exit en masse from the Chinese market: more and more companies are in China to access Chinese consumers. However, with U.S.-China trade frictions set to endure, companies will nevertheless need to start adjusting to the new reality — in terms of higher costs, weaker consumer confidence and other disruptions — sooner rather than later.

The risk remains that U.S.-China trade frictions could escalate even further. Donald Trump already seems eager to retaliate if China responds to the next round of tariffs. For its part, China increasingly views the trade tariffs as part of a wider U.S. effort to prevent its development. However the dispute escalates we expect the impact of the trade war to increasingly be apparent in a select number of export oriented regions, which will require careful scrutiny at the local level in the months ahead.

Nick Marro is an analyst with the Economist Intelligence Unit

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