Since April 2, escalating trade tensions between the U.S. and China have led to successive rounds of reciprocal tariff hikes. The tit-for-tat actions peaked with the U.S. imposing 145% broad tariffs on Chinese goods, prompting China to retaliate with 125% tariffs on U.S. goods. However, late last week, the U.S. announced reciprocal tariff exemptions for some key product categories, including smartphones, computers, semiconductors, electronic circuits, and televisions.

We examine the potential impact of tariffs on China’s economic growth, explore policy measures China could use to cushion the downside risks, and evaluate how Chinese equities may perform from here.

The economic impact and workarounds

Economists are busy revising their growth forecasts for the Chinese economy. With effective tariffs above 100%, the bilateral trade framework that has existed for many years between the world’s two biggest economies has been severely impaired, and direct trade volumes are projected to shrink significantly.

Analysis of available data suggests that 145% tariffs on many products could reduce Chinese exports to the U.S. by more than half, potentially shaving one to two percentage points off China’s GDP growth in 2025.

While the potential drag on China’s growth could be significant, we argue that the actual impact may be less severe than worst-case scenarios suggest, for two major reasons:

1) Substitution challenges: The U.S. remains heavily reliant on Chinese manufacturing for key consumer and industrial goods. For example, the overwhelming proportion of U.S. imports for products such as smartphones, laptops, lithium-ion batteries, toys, and video game consoles are from China.

This dependency and the fact that the U.S. exempted many of these items from very high tariffs (at least for the time being), indicate to us the lack of viable short-term alternatives, therefore undermining the sustainability of 145% tariffs on all products over the long term.

Major U.S. imports from China in 2024

2) Trade rerouting potential: The wide differential between the U.S. tariffs on China (145%) and tariff rates on most other nations (10%) leaves channels for Chinese exporters to reroute their goods through a third country, such as Vietnam, Canada, Mexico, or many others. By repackaging or lightly processing goods in these jurisdictions, exporters can reclassify products’ country-of-origin, thereby qualifying for lower tariff rates.

Furthermore, the de minimis exemption—which allows parcels valued under US$800 to enter the U.S. duty-free—remains available for all major U.S. trading partners except China. That means Chinese sellers could still leverage logistics hubs in other countries to bypass the tariffs, although this would likely lengthen logistics times.

China’s potential policy response

One potential response to offset tariff headwinds could involve currency depreciation, the most direct way to mitigate the impact of tariffs on exports. However, we think the People’s Bank of China may prefer a gradual depreciation of the yuan, possibly to around CNY7.4 or CNY7.5 against the U.S. dollar. A rapid depreciation could trigger severe capital outflows which could lead to a potential loss of domestic economic confidence, a similar episode seen during 2015–2016.

We believe boosting domestic consumption is another logical step to cushion the economic downturn. In President Xi Jinping’s December speech to the Central Economic Work Conference—a meeting that sets the annual economic agenda—he emphasized that “expanding domestic demand relates not only to economic stability but also to economic security.”

An effective approach to step up consumption stimulus would be to expand funding and broaden the existing consumer trade-in program, potentially by including services such as airline tickets and hotel bookings. Additionally, the government could introduce nationwide childcare subsidies to support families with young children. Over the longer term, we think efforts should focus on increasing household incomes and strengthening social welfare systems.

We have long argued that stabilizing the property market would be the most effective way to boost customer confidence, given that a large part of Chinese household assets is tied to housing. Policymakers may take decisive actions to support the property market, such as ramping up purchases of housing inventories and offering more funding support to developers.

Beyond government efforts, Chinese enterprises have already taken steps to help exporters expand domestic sales. E-commerce giant JD.com (JD US/9618 HK) and Alibaba’s (BABA US/9988 HK) supermarket chain Freshippo have launched initiatives to provide domestic sales channels for products that usually would have been exported.

Implications for China’s equity market

The MSCI China Index fell around 13% on April 7, reflecting market concerns over tariffs escalation. We think the move has largely priced in the immediate tariff risks.

Drawing parallels to the 2018 trade dispute in Trump’s first term, equity market declines were mainly driven by valuation compression instead of earnings deterioration.

With the MSCI China Index trading at a price-to-earnings ratio of 10.5x the 12-month forward consensus earnings forecast, the index hasn’t yet touched the lowest valuation of 9.7x seen in 2018, suggesting to us that there could be more downside if the tariff situation deteriorates further.

Recently, however, earnings beats for MSCI China companies have turned positive for the first time in 3.5 years, a critical divergence from prior rallies. Unlike the sentiment-driven rally during the post-pandemic reopening in late 2022 and the rally that occurred during the government policy pivot in September 2024, the market is now underpinned by fundamental improvement, particularly in the Technology and high-end manufacturing sectors. While tariff uncertainties may challenge the sustainability of this earnings recovery, early signs of profit margin stabilization and tech-driven productivity gains offer cautious optimism, in our view.

We recommend investors in China equities take advantage of the market rebound by trimming exposure to tariff-vulnerable sectors such as textiles and exporters that mainly focus on the United States. We prefer Technology stocks that we believe will benefit from artificial intelligence adoption and domestic substitution trends, along with high-dividend yielding stocks that offer stable dividends and insulation from tariff volatility.

With the contribution of Leo Shao.