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How China is preparing for a potential trade war with the U.S.

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WATCH ABOVE: War of words amid escalating trade tensions between China and the U.S., the world's two largest economies – Jun 22, 2018

China is stocking up its war chest for a potential trade war with the United States.

China’s central bank said on Sunday it would cut the amount of cash that some banks must hold as reserves by 50 basis points (bps), releasing US$108 billion in liquidity, to accelerate the pace of debt-for-equity swaps and spur lending to smaller firms.

The reserve reduction, the third by the central bank this year, had been widely anticipated by investors amid concerns over market liquidity and a potential economic drag from a trade dispute with the United States.

READ MORE: China responds to Trump tariffs, hikes import duties on American goods

Tensions have been mounting amid a steady stream of tough talk from U.S. President Donald Trump, who has refused to back down on a series of threats issued in recent months.

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Trump has ordered 25 per cent tariffs on $50 billion in Chinese goods in response to Beijing’s forced transfer of U.S. technology and alleged intellectual property theft, and threatened to impose duties on $400 billion more in Chinese products.

“We have the great brain power in Silicon Valley, and China and others steal those secrets,” Trump said on Fox & Friends earlier this month.

″We’re going to protect those secrets. Those are crown jewels for this country.”

All told, the scope of the tariffs would be equivalent to 90 per cent of the goods that China shipped to the United States last year.

Trump’s order of 25 per cent tariffs, which are set to take effect July 6, was quickly matched by Beijing on U.S. goods exported to China.

READ MORE: Here’s why Donald Trump is taking aim at Canada’s dairy industry

Trump has also touched off separate trade disputes with Canada and the European Union over tariffs on steel and aluminum.

Impact of China’s move

The 700 billion yuan ($107.65 billion) in liquidity that the Chinese central bank said will result from the reduction in reserves was bigger than expected.

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Expectations of a cut had risen after the State Council, or cabinet, said last week monetary policy tools including targeted cuts in banks’ reserve requirement ratios will be deployed to strengthen credit flows to small firms and keep economic growth in a reasonable range.

Economists are not ruling out further reserve requirement reductions for the rest of the year as borrowing costs rise due to Beijing’s clamp-down on leverage in the financial system, a campaign now in its third year, while uncertainty over Sino-U.S. trade ties persists.

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The People’s Bank of China (PBOC) said on Sunday that the latest targeted cut in some banks’ reserve requirement ratios (RRRs) – currently 16 per cent for large banks and 14 per cent for smaller banks – will take effect on July 5.

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The PBOC said the cut will release about 500 billion yuan ($77 billion) for the country’s five large state banks and 12 national joint-stock commercial banks. Lenders are encouraged to use the money to conduct debt-for-equity swaps.

READ MORE: Donald Trump threatens new tariffs on $200B in Chinese imports

China’s policymakers have been pushing for debt-for-equity swaps since late 2016 to ease pressure on firms struggling with their debts.

The country’s top banks, controlled by the government, have rushed to sign deals with state-owned enterprises to ease their debt burden and give them time to turn around their business and improve their creditworthiness.

READ MORE: China threatens to pull U.S. trade deal if Trump’s tariffs continue

The latest RRR cuts will also release about 200 billion yuan in funding for mid-sized and small banks to increase lending to credit-strapped small businesses, the PBOC said.

The combined 700 billion yuan liquidity injection exceeded market expectations of 400 billion yuan. In the PBOC’s last targeted RRR cut in April, 400 billion yuan of net liquidity was released.

“The intensity of the move exceeded market expectations,” said Wang Jun, Beijing-based chief economist at Zhongyuan Bank.

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“This move will help support the real economy and stabilize financial markets. We’ve seen rising debt defaults and funding strains on small firms, as well as a sharp adjustment in the capital market.”

But the latest reserve cut signals a “policy fine-tuning,” not a policy reversal, Wang said.

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The central bank said on Sunday it will keep monetary policy prudent and neutral.

Sunday’s announcement followed the worst weekly loss in the Chinese stock market since early February as fears of a full-blown trade war with the United States weighed.

The Chinese yuan on Friday also fell to its lowest versus the dollar in more than five months, though it has remained firm against a basket of trading partners’ currencies, and a sharp depreciation is not in the cards.

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Trade war

The latest RRR cut is set to take effect a day before the United States and China are expected to begin collecting increased tariffs on respective lists of goods.

READ MORE: How the U.S.-China trade dispute could impact fruit prices in Canada

Fears of a full-scale trade war with Washington have magnified concerns about the outlook for the world’s second-largest economy, following weaker-than-expected Chinese growth data for May and as Beijing’s financial regulatory crackdown starts to weigh on business activity.

Net exports overall were already a drag on growth in the first quarter after giving an added boost to the Chinese economy last year, highlighting the need for sustained strength in domestic demand if significant new U.S. tariffs are imposed.

READ MORE: China accuses U.S. of ‘blackmailing’ as Trump targets $200B in tariffs

Beijing is also likely to backtrack on efforts to reduce its reliance on debt if the dispute escalates into an all-out trade war, some economists say.

Beijing’s financial risk clamp-down has already slowly pushed up borrowing costs, and is restricting alternative, murkier funding sources for companies such as shadow banking.

Strained liquidity conditions have caused a growing number of credit defaults with private companies facing mounting refinancing risks. Latest official surveys also showed tight funding has hit smaller manufacturers.

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The weighted average lending rate for non-financial firms, a key indicator reflecting corporate funding costs, rose 22 basis points in the first quarter to 5.96 per cent, PBOC data showed. That compared with a total of 47 basis points in 2017.

Policymakers have been trying to strike a delicate balance between the need for tougher supervision and reforms and ensuring the stability of the financial system, while keeping economic growth on track.

READ MORE: In angering his closest allies, Trump is ‘probably strengthening China’s hand’: U.S. trade rep

ANZ Research said on Sunday that it still expects another 50 bps RRR cut in October.

Economists still expect China’s economic growth to slow to 6.5 per cent this year from 6.9 per cent in 2017, citing rising borrowing costs, tougher limits on industrial pollution and an ongoing crackdown on local governments’ spending to keep their debt levels in check.

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Unfair trade tactics

China accused the United States last week of using bullying tactics and blackmail in threatening to impose tariffs on hundreds of billions of dollars of Chinese imports, ramping up criticism that the measures levied in the name of balancing trade would harm both countries’ companies and the world economy.

Commerce Ministry spokesman Gao Feng said the U.S. was damaging the global trading order and that its methods would harm its own business interests as well as those of trading partners.

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“We oppose the act of extreme pressure and blackmail by swinging the big stick of trade protectionism,” Gao told reporters at a news conference.

“The U.S. is abusing the tariff methods and starting trade wars all around the world.”

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Gao said accusations of forced technology transfer and intellectual property theft “seriously distorted the history and reality.”

READ MORE: U.S.-China trade dispute could have ‘domino effect’ on global economy: WTO

U.S., European and other governments have repeatedly complained their firms operating in China are being compelled to surrender technology as part of Beijing’s bid to create world-leading companies in fields such as robotics and electric cars under a program it calls “Made in China 2025.”

Economists note the U.S. global trade deficit started to balloon several years before China’s surplus started to surge. They say that suggests the reason behind the imbalance lies somewhere other than China.

Trump’s thinking on trade is largely misguided, said Yukon Huang, senior fellow in the Asia program at the Carnegie Endowment for International Peace.

“The reason why we have a trade war is the fundamental assumptions which triggered this, in my view from a White House perspective, is totally wrong,” Huang said.

Such assumptions, he said, included the idea that the trade deficit is a problem and that there’s too much American investment in China — when in fact there’s too little.

READ MORE: Here are the winners and losers in the China-U.S. trade war

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Economists say the bulk of China’s trade surplus with the United States stems from the country’s role as the final assembly point for components imported from South Korea, Taiwan and other economies. Meanwhile, China’s imports of food, clothes, cosmetics and other consumer goods from United States are growing, but with Chinese incomes at about one-tenth of U.S. levels, spending power is limited.

“If you begin with faulty assumptions, you’re going to come (up) with faulty policies,” Huang said.

“And that’s why we’re having a very difficult time trying to figure out what is the solution.”

— With files from Reuters and Global News reporter Josh K. Elliott

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