China is about to stress test the world

The Trump administration is about to grapple with the “Pottery Barn rule” as China’s economy hits a wall. The “you break it, you bought it” principle applies in spades as United States President Donald Trump’s trade war slams mainland industrial production, exports and retail sales.

Both consumer and producer prices fell in November from a month earlier – by 0.3% and 2%, respectively.

Officials in Beijing are already in damage-control mode. In recent weeks, Xi’s team rolled out tax cuts, new business loans and ordered up new infrastructure projects to keep growth from plunging below 6%.

“[But] it will take a while for those policy changes to deliver a stabilization in growth,” Chen Long, an analyst at Gavekal Research, said. “That means there will likely be more bad economic news through early 2019.”

That’s “bad news” for a global financial system on edge. US expansion that began in 2009 is losing momentum, even after Trump’s giant US$1.5 trillion tax cut. Wall Street’s previously hefty gains for 2018 have long since been wiped out. And credit market dislocations are filtering through the real economy.

As Trump mulls what he’s breaking in China, Xi is running into the diminishing returns rule about which John Maynard Keynes warned. At some point, every nation reaches a point when new roads, dams, bridges and huge white-elephant projects cease to generate notable economic returns.

This strategy, one that’s worked so well since the 2008 global crisis, now appears to be falling flat. As Cindy Huang, an analyst at S&P Global Ratings pointed out, supportive measures didn’t reverse the rising default trend in November, “meaning such easing policies may only benefit publicly traded companies or industrial champions.”

Not the broader real economy or the weakest of corporate links, though.

Bankruptcy risks are rising apace. In the coming year, for example, more than $500 billion of bonds are maturing among non-financial companies, many in the manufacturing realm.

If put options are exercised, that burden would grow more than one-third, adding to cash-flow woes. The more stimulus Xi’s men shovel into the economy, the more incentive companies have to lever up again.

Slowdown hitting Asia

Another wild card is how downshifts in China and the US influence each other, creating fresh strains within the so-called Group of Two. Already, China’s slowdown is reverberating around Asia.

Japan’s automakers, South Korea’s shipbuilders, Taiwan’s chipmakers, Singapore’s electrical machinery, Indonesia’s timber, Philippine inbound tourism and  Australia’s natural resources are all becoming collateral damage as China loses altitude.

Yet Trump’s tariffs are colliding with Xi’s efforts to curb bubbles in credit, debt and property. As the Institute for International Finance points out in a recent report, a variety of “nontradable sectors affected by the deleveraging campaign are slowing.”

In another report, Fitch notes that “shadow-banking activity has weakened over 2018, which suggests that the deleveraging campaign has not yet been abandoned.” The inertia from such efforts is creating domestic headwinds working in concert with intensifying gusts from abroad.

To Chen, the first few months of 2019 will turn on the fallout from regulatory tweaks, “which have been aggravated by financial markets spooked by the trade war.” Chen estimated that total credit – to both the private sector and government – slowed markedly to 9.9% in November, the first time it’s been below 10% in 15 years.

“The slowing momentum does make the growth outlook for 2019 very challenging, especially in the first half,” Chen said. “It is clear that Beijing will come up with more easing policies, but the question is the speed and scale of these measures.”

It would be easier to devise a growth-stabilizing plan if Beijing knew what Trump had up his sleeve. The supposed tariff ceasefire Trump claimed he and Xi agreed on in Buenos Aires on December 1 has since unraveled. The recent arrest of Huawei chief financial officer Meng Wanzhou in Canada on vague allegations of flouting US sanctions on Iran hardly smacks of détente.

Trump’s White House is considering 25% taxes on all imports of cars and auto parts. China is already ailing from $250 billion of goods the US is targeting with tariffs. Upping the ante to savage the Asian supply chains on which China relies could add to Xi’s woes in the year ahead.

Trump, too, has problems as global growth takes a hit. That gets us back to the Pottery Barn dynamic boomeranging Washington’s way. As Trump looks in the mirror wondering where that amazing stock rally he likes to tout has gone, his trade war is staring back at him.