The US-China Trade War continues to shape the dynamic global trade market. The trade war with the U.S. couldn’t have come at a worse timing for China, which had just begun focusing in earnest on fixing problems with its economy.

Many analysts have suggested that the impact of the Washington-Beijing trade skirmish will be relatively muted on the Chinese economy, noting that exports to the U.S. do not hold a commanding presence in China’s economic portfolio. But that line of thinking does not take into account how tariffs will affect business sentiment, investment and growth in China.

On July 6, U.S. President Donald Trump’s administration officially instituted 25 percent duties on $34 billion worth of Chinese goods. China, for its part, responded by implementing retaliatory tariffs on the U.S. shortly afterward. The following week, the U.S. released a list of Chinese goods with an annual trade value of about $200 billion that may be subjected to 10 percent tariffs.

All this puts China in a very difficult position. Not only because much of the tariff and non-tariff measures are directed towards it, but the timing couldn’t have been worse.

China’s banks extended a record 12.65 trillion yuan ($1.88 trillion) in loans in 2016 as the government encouraged credit-fueled stimulus to meet its economic growth target. The credit explosion stoked worries about financial risks from a rapid build-up in debt, which authorities in 2017 pledged to contain.

Both China’s monetary and fiscal policies have been kept on a tight leash so far this year, and deleveraging — the process of reducing debt — has been hastened through tighter regulations, the analysts noted.

The resent resurgence in US-China trade war has raised concerns about the strength of external and domestic demand in (the second half of 2018) via direct and indirect effects on services such as logistics, wholesale trade, and trade finance, as well as on business sentiment and investment.

With business demand being potentially hit, the right way for China to respond to the US-China trade war is for it to ease its monetary policy or to enact fiscal measures, they suggested.

Under the circumstances, easing monetary conditions to support demand and allowing the currency to absorb the shock of the trade war are the right policy choices.

The depreciation of the yuan would offset the loss in export competitiveness for Chinese exporters due to higher tariffs, meaning that Chinese goods will essentially be cheaper to Americans.

China’s dilemma: Beijing is seeking to implement relatively tight monetary policy to force financial deleveraging, but it also needs easier monetary conditions to support growth.

Over the last 15 years, whenever credit growth has risen more than warranted it has fueled concerns over financial stability and that has seeped into depreciation pressures on the currency. Consequently, the current monetary policy stance will need to be carefully balanced.

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