The U.S.-China trade war has dragged China’s GDP by around 0.5 percentage points, from start to May 2019. In our new baseline scenario where a 10% tariff on $200 billion of Chinese goods is raised to 25% indefinitely, we estimate the additional drag on China’s GDP growth would be 0.4 percentage points in 2019-20,” said Zhu.

However, if the U.S. were to impose tariffs on all Chinese imports in a more severe scenario, the economic impact would be far greater. The additional drag on China’s growth in 2019-20 will increase from 0.4 percentage points in the current baseline scenario to 1.2 percentage points.

On the domestic front, the message has been quite mixed. Infrastructure and real estate investment have held up well, but manufacturing investment has continued to decelerate, posting negative growth this year. In the consumer sector, the positive impact of a significant individual income tax cut (especially for middle-income families) seems to be offset by concerns on the health of the labor market. Although official survey-based unemployment rate is coming down, the unemployment component in National Bureau of Statistics of China manufacturing PMI continued to deteriorate. On the upside, auto sales appeared to have passed the worse and are expected to return to positive growth in the second half of this year.

Externally, uncertainty surrounding bilateral negotiations between the U.S. and China and their long-term relationship could hit export growth and reduce the incentive to invest. J.P. Morgan Research has revised down China’s exports growth to -2.9% in 2019 and expects growth in imports to also fall -2.7%, when compared to the previous year.

“The biggest downside risk comes from the trade side, as reflected in the big decline in new exports order component. The unexpected turnaround in U.S.-China bilateral trade talks in May, followed by the announcement of a new round of tariff wars and the USTR plan to impose tariff on the remaining $300 billion Chinese imports, will hit the bilateral trade activity,” added Zhu.

In an effort to combat the slowing economy, Chinese authorities made a flurry of policy announcements in early 2019 including tax cuts, monetary policy loosening and plans to support public spending. In May, the People’s Bank of China (PBOC) reiterated their “prudent” monetary policy stance.

“The PBOC wants to avoid large fluctuations in monetary policy and instead prefers policy fine-tuning. PBOC policy operations are more likely to be data dependent and reactive, rather than pre-emptive,” said Zhu.

Will tax cuts provide a necessary boost?

Tax cuts in China is at the center of Beijing’s fight against its slowing economy. The government announced a total package of 2 trillion yuan ($300 billion) reduction in tax and fee burden in 2019, or 2% of GDP this year. While the Chinese government previously favored spending on infrastructure as a fiscal stimulus, that led to a sharp rise in local government and state-owned enterprise debt—which Beijing has been trying to keep under control.

“The major fiscal effort will be tax cuts this year, instead of the infrastructure spending it relied on in the past. The government has grasped the problem and is adopting a different style of fiscal stimulus: tax cuts, for both households and corporations,” said Zhu.

Earlier this year, the government adopted the new individual income tax code that significantly reduced the tax burden for middle-income families. In April, the government lowered the VAT rate by 3 percentage points in the manufacturing sector and 1 percentage point in a number of service sectors.

But the impact on growth could still be modest, adding 0.46 percentage points to GDP growth according to J.P. Morgan Research. This is for two main reasons: first, the actual size of the tax cuts may be smaller than headline numbers due to more vigorous tax collection or to problems in policy implementation. Second, tax cuts have an indirect impact on the economy by increasing the capacity for households to spend and corporates to invest. During a business downturn, consumers tend to spend less and investment appetite eases, so a meaningful boost to growth takes longer.

Can China count on the consumer?

Retail sales in China slowed in the second half of last year, creating perceptions of a broad-based slowing in China's consumption. But this disappointing data was driven largely by weaker auto sales and the expiration of a tax break, confusing the picture according to J.P. Morgan Research. After dismal performance in the past several quarters, auto sales appear to have bottomed out and look set to recover to positive growth in the second half of the year.

“Excluding auto sales, nominal retail sales growth largely held steady, rising 10.6% in 2018, compared to 11.7% in 2017. The message is similar for retail sales volume: the slowdown is mainly attributable to the decline in auto sales,” said Zhu.

Apart from the weaker than expected data, long-term structural factors support China’s growing consumption, as its share in GDP is still much lower in China than the world average. China’s demographic trends and government policies also support the consumption story and with trade frictions likely to remain in place for the foreseeable future, the domestic market is becoming more important for China’s production. Recent policy measures such as tax cuts for individuals and corporations, as well as import tariff reductions will benefit consumers, but the outlook for the consumer is not without its challenges.

“Consumption is susceptible to labor market conditions. A tariff war could squeeze industrial profits and deter investment and hiring, not to mention possibly further drive the relocation of the global supply chain as uncertainty lingers,” said Zhu.