China and the US have reached a preliminary agreement on a trade negotiation framework that looks more likely to be a tactical de-escalation of tensions than a long-term resolution of the differences resulting from a deep distrust between the world’s largest two economies.
Mutual incentives to tackle trade war
Both sides appear to want to ease tensions over tariffs. June’s agreement helps address pressing needs amid competition for technological dominance.
- China still needs to import high-end semiconductor chips and is eager for a relaxation of US tech export restrictions.
- The US needs imports of rare earth minerals – resources in which China dominates, controlling some 70% of global production and supplying about 90% of the world’s refined rare earth products.
China and the US have been trying to reduce their economic inter-dependence, but with limited success, as can be seen in the recent agreement. The deal involves the US backing off from a full decoupling of trade relations with China and China softening its non-trade retaliation measures towards the US.
In short, both sides have incentives to de-escalate tensions.
China has room to manoeuvre
Beijing’s incentive for de-escalation is as strong as that of the US:
- China’s exports have suffered in the trade war (see Exhibit 1). This has intensified its labour market woes (see Exhibit 2), especially in labour-intensive manufacturing.
- Beijing is concerned about the possibility of the US administration rallying its overseas allies to stand against China to impose coordinated barriers to Chinese exports and foreign investment.
China has room to meet many of the US demands, including better market access, lower tariffs and stronger intellectual property protection. The fact that these demands are broadly aligned with China’s structural reform agenda suggests there are reasonable prospects for progress.
The crucial task is to actually implement the changes needed to achieve balance in the two countries’ trade relations.
What it means for growth and financial markets
It is unclear how China’s macroeconomic situation will evolve in the coming months. On top of the battle with the US over import tariffs and weak domestic demand, the country’s property market woes and deflationary pressures remain major concerns.
From a policy perspective, Beijing is determined to achieve its 5% growth target this year despite investor scepticism, trade tensions, and increasing geopolitical risks.
Beijing likely has little tolerance for any further decline in growth given the deflationary pressures – there were eight quarters of deflation, as measured by the GDP deflator, between the second quarter of 2023 and the first quarter of this year (see Exhibit 3). Further weakness in the economy would add pressure on an already softening labour market.
In its monetary policy statement for Q1 2025, the People’s Bank of China shifted its price stability stance from curbing inflation to addressing deflationary risks. The central bank is calling for coordinated policy efforts across the fiscal, monetary, employment and social security domains to revive pricing power.
Keeping Chinese growth on track
Politically, Beijing needs to keep growth steady to demonstrate its capacity to counter the trade war and compete with the US. Steady growth would help solidify its bargaining position in bilateral negotiations.
Despite market doubts over China hitting its 5% growth target this year, recent developments suggest the goal may still be achievable if Beijing continues the more assertive policy easing started in September 2024.
Firstly, the stronger reflation effort since September appears to be delivering initial improvements in the credit impulse (see Exhibit 4), a leading indicator for growth. However, more is needed as private credit growth is still lacking.
So far, public borrowing has been the key driver of aggregate credit growth (see Exhibit 5). In our view, more easing will be needed until the economy shows signs of stabilisation.
Secondly, China’s property market downturn – the biggest drag on public confidence and growth – appears to have run its course. A sustained rebound in housing market activity has yet to materialise, but the rate of contraction has slowed steadily (see Exhibit 6 and 7). Recent monetary easing has focused on cutting mortgage rates to stimulate housing demand.
Lastly, subdued growth and weak consumer confidence since the Covid pandemic have pushed household savings to record levels (see Exhibit 8). Any improvement in public confidence could unleash pent-up demand for consumption and housing.
In our view, Beijing needs to sustain its policy stimulus to:
- Limit the fall-out from the tariff war
- Encourage the green shoots of consumption
- Stabilise the economy
- Boost China’s stock market performance
US – Implications for growth and inflation
The limited impact of the agreement with China leaves the US administration with the prospects of weaker growth and higher inflation in 2025. The new import tariff regime is in essence a tax on consumption and capital that is set to boost inflation in the short term. Higher inflation will make it harder for the US Federal Reserve to ease policy pre-emptively to counter weakening growth.
The relatively poorer outlook for the US will likely keep downward pressure on the US dollar and Treasury bond yields. Tariffs create greater uncertainty about the path of inflation, which could not only lower Treasury yields, but also cause the yield curve to steepen. The long end of the curve is likely to reflect this uncertainty, on top of the worries over the prospect of larger fiscal deficits under President Trump’s ‘One Big Beautiful Bill Act’.
