Even if one doesn’t trust China’s data, there’s no doubt the economy has proved surprisingly resilient, despite the Trump 2.0 tariffs. And, the outcome of recent Sino-US trade negotiations indicate they enjoy considerable leverage in future talks, given America’s current dependence on Chinese rare earth materials.

As the Year of the Horse approaches, therefore, is China’s economy off to the races? Not quite. Behind the headlines, life is more complicated. Indeed, economic activity has become unsustainably imbalanced. On the one hand, the domestic sector still confronts powerful deflationary pressures. Meanwhile, the country is developing a dominant global position in key growth-industries of the future, e.g. EVs, AI, green technology, etc.

As a result, China limited the impact of US tariffs by increasing trade with other partners, especially other Asian nations. In part, however, this success has been achieved by implementing beggar-thy-neighbour trade policies. Indeed, China’s soaring foreign trade surplus poses serious potential risks to regional partners and global financial markets.

Overall, therefore, I expect deflationary forces will continue to dominate the outlook for the Chinese economy; with GDP growth slowing to less than 3% in 2026 and beyond. Indeed, whatever happened to the goal of rebalancing the economy towards domestic consumption and less reliance on exports and investment? As a result, I expect the PBOC will reduce interest rates up to another 100bp. Meanwhile, I anticipate the Chinese Yuan will appreciate another 5% this year. And, I continue to recommend overweight positions in Emerging Markets. Even China deserves reconsideration after a long period of underperformance, given the impressive innovation in the nation’s tech industries.

Domestic Economy: Deflation Still Dominates

The problems in China’s property market are well known. What’s perhaps less understood is that despite efforts to remedy the situation, the debt burden in the corporate sector continues to rise (Chart above). As a result, fixed asset investment is now contracting sharply (next Chart). Even more worrisome, the deleveraging in the corporate and property sectors is likely to remain an economic headwind for another few years.

In addition, government efforts to boost the economy have tripled the level of public sector debt during the past 15 years (earlier Chart). These programs have wrongly focused on subsidising State-Owned Enterprises rather than supporting the beleaguered consumer sector where confidence remains rock bottom. Reflecting this pessimism and tight household budgets, consumer spending continues to slump (next Chart).

To be sure, Chinese households are notoriously frugal, and have high savings rates relative to peer countries (next Chart). But, economic uncertainty is resulting in additional precationary savings. Indeed, the consumer sector is the only area not increasing its debt in recent years. Future efforts to stimulate the economy should focus on boosting household spending.

Innovation Economy Faring Much Better

Fortunately, not all is so gloomy. Government-led efforts are creating a thriving innovation-led technology sector. Indeed, China is building formidable global positions in electric vehicles, artificial intelligence, climate technologies, etc.: in addition to its dominant role in the processing of raw earth minerals.

Despite the rising tariffs and overall economic uncertainty, Chinese industrial production advanced nearly 6% in 2025. And, the key innovation-driven sectors led the way: with many industries enjoying double-digit growth (Chart above).

Risk of Beggar-thy-Neighbor Trade Policy

In large part, China’s economic resilience to US tariffs stems from their ability to find and expand alternative export markets. Indeed, this initiative commenced following the outbreak of the trade war in 2018. These efforts have been so successful China’s trade surplus has soared from $351 billion in 2018 to $1.2 trillion in 2025.

During this six-year period, Chinese exports advanced over 50%, despite a 12% decline in sales to the USA (Chart above). Sales to many parts of the world more than doubled during this interval, including Latin America, Africa, and Russia. Perhaps, the greatest achievement was the expansion of regional supply chains with Asian trading partners, especially ASEAN countries, Taiwan, and India.

However, there are less benign aspects to these trading patterns. First of all, a portion of the sales to ASEAN nations were simply re-exported to the USA. Recent bilateral trade deals with the USA, especially in Vietnam, Thailand, and Indonesia, sought to thwart China’s efforts to circumvent US tariffs.

More importantly, however, many heavily-subsidised Chinese industries are experiencing surplus capacity. A portion of the recent expansion in Chinese exports, therefore, reflects an effort to unload excess supply on trading partners.

Moreover, China’s surging trade surplus reveals the expansion in exports has not been mirrored by similar increases in purchases of foreign goods. Indeed, Chinese imports advanced only 3% annually since 2018. In fact, imports from the European Union, United Kingdom, Korea, Japan, and the USA all declined during this period. Even some ASEAN nations, e.g. Philippines and Thailand, as well as India and Africa experienced only relatively small increases in sales to China. There are exceptions: purchases from Indonesia, Taiwan, and Russia advanced strongly.

The Chart above illustrates China’s bilateral surpluses expanded with virtually all countries. In part, to be sure, weak Chinese imports reflect structural weakness in domestic spending. However, beggar-thy-neighbour policies — imposing trade barriers to imports and dumping excess production abroad — is unsustainable.

Most importantly, perhaps, unfair competition could impede the expansion of local industries, especially in developing Asian economies. If Asian partners object eventually, economic and political tensions could rise, and pose risks to both regional and global financial markets. In addition, developed nations (most recently Canada and the UK) need to evaluate carefully China’s trade strategy, as they seek more reliable trading partners than the USA.

Government Stimulus: Burden on PBOC

In an attempt to remedy deflationary domestic conditions, the government has implemented stimulative monetary and fiscal policies in recent years. However, the scope for additional budgetary measures is running its course, as large deficits are fueling an unsustainable rise in government debt (Chart above). (The situation is ever more dire after including the liabilities of local government financing vehicles). Future efforts, therefore, will require a re-prioritisation of spending priorities. In particular, rather than subsidising SOEs, the government should support Chinese households. For example, spending on social security and health care amounts to only 6% of GDP compared to 16% in the OECD and 11% in EM peer countries.

As a result, the responsibility for additional stimulus will fall increasingly on monetary policy. Therefore, I expect the PBOC to lower interest rates by up to another 100bp in 2026.

Strategic Considerations:

• China’s beggar-thy-neighbour policy and growing trade surplus reflects the advantages of a cheap Yuan (CNY). The Chart above, however, may overstate the degree of CNY undervaluation, if examined from a longer-term perspective. To be sure, part of China’s trade surplus reflects a structural excess in household savings.

• Nevertheless, the bloated external surplus has lifted international reserves to an all-time high (Chart above). As a result, I expect CNY to appreciate 5% in 2026. I anticipate the PBOC will offset the deflationary impact of a stronger currency with a 100bp interest rate cut. Bear in mind, if trade negotiations with the USA falter and tariffs rise further, China could threaten to recoup any competitiveness loss by allowing CNY to weaken.

• Despite the potential risks poses by China’s trade strategy, I have been advocating overweight positions in Emerging Markets, especially Asia, for some time. Relative to developed markets, EM are less expensive (Chart above), In addition, declining US interest rates and a weaker US dollar favour Emerging Market assets. I am focused especially on countries with large and strongly expanding domestic economies, which are more able to cope with the higher US tariffs, including China.

• China’s unbalanced economy and beggar-thy-neighbour trade policies could pose risks to global markets eventually; upsetting the current bullish, risk-on consensus.