• Trump's proposed 60% tariffs on Chinese goods pose a significant risk to China's economy, already weakened by a downturn in the property market.
• China's total government sector debt is estimated at 147 trillion yuan ($20.7 trillion), with household and corporate debt pushing it to over 350 trillion yuan.
• The property crisis, debt overhang, and weak consumption have fueled deflationary pressures, which could worsen if tariffs shrink external demand.
• The yuan might have to fall 18% against the dollar to fully offset 60% U.S. tariffs, a level unseen since the 1990s Asian financial crisis.

The recent election of Donald Trump as the next U.S. president has sent shockwaves across the globe, particularly in China, the world's second-largest economy. Trump's threat to impose 60% tariffs on U.S. imports of Chinese goods poses significant growth risks for China.

The proposed tariff rates are much higher than the 7.5%-25% levied on China during his first term, and the Chinese economy is in a more vulnerable position than before.

In 2018, China's property market was robust, driving about a quarter of the country's economic activity. This strength in the property market meant that local government finances, heavily reliant on auctioning land for residential projects, were not questioned so forcefully. This situation helped China absorb the tariff shock. However, since 2021, the real estate sector has been in a severe downturn, and local government revenues have plunged.

The oversupply of housing means this sector may never return to the driving seat of Chinese economic growth.

The downturn in the property sector has saddled local governments with unsustainable debt. While Beijing is lining up fiscal help for them to curb their liabilities, the burden is huge, limiting China's ability to respond to any external growth shocks.

China's Economic Vulnerabilities

The International Monetary Fund calculates total government sector debt at 147 trillion yuan ($20.7 trillion) at the end of 2023. When household and corporate debt are added, that number surpasses 350 trillion yuan - roughly three times the size of the economy, according to the Bank for International Settlements.

China's household spending is below 40% of GDP, about 20 percentage points behind the global average, due to low wages and pensions, high youth unemployment, and a feeble social safety net. Boosting that requires either more debt or an overhaul of how national income is distributed, so that it benefits households at the expense of government and businesses.

This could be achieved by changing how companies and households are taxed and how government spends the money, raising retirement, health and unemployment benefits, and removing an internal passport system responsible for huge rural-urban inequalities, among other reforms.

The Impact of Tariffs and Deflation

However, authorities have so far focused on upgrading the export-reliant manufacturing sector instead, with remarkable success in electric vehicles, solar energy, and batteries. But this also prompted tariffs in the United States, Europe, Turkey, and elsewhere. China may be able to boost external sales in areas where its economy is extremely competitive, but has little control on external demand.

The property crisis, the debt overhang, and weak consumption have all fuelled deflationary pressures. China's policy of redirecting resources from the property market to the manufacturing sector, rather than consumers, has fuelled what Western governments describe as industrial overcapacity. This has led to factory gate deflation. Producer price inflation was 4.6% in July 2018 when Trump's first tariffs came into effect.

In September 2024, this stood at minus 2.8%. Consumer price inflation has ground to a paltry 0.4% from 2.1% over that period. Deflation, which hurts consumption, businesses, and growth, could get much worse if tariffs shrink external demand, exacerbating industrial overcapacity.

The yuan ended 2019 roughly 10% weaker against the dollar than in early 2018, when Washington flagged the tariffs plan and 4% weaker in trade-weighted terms against all currencies. The U.S. curbs increased the effective tariff rate on all Chinese exports by 2.4 percentage points, according to Capital Economics analysts, which means that the yuan's depreciation more than offset the tariff impact.

This time, the yuan might have to fall 18% against the dollar to fully offset 60% U.S. tariffs, implying a rate of 8.5 per dollar, the analysts calculated - levels unseen since the 1990s Asian financial crisis. Worried about capital outflows, authorities tried to prevent the yuan from weakening past 7.3 earlier this year. A full adjustment looks unlikely.