By Lingling Wei 

BEIJING -- A bruising trade fight with the U.S. lands at a difficult time for China as its economy contends with rising headwinds, constraining Chinese President Xi Jinping's options.

While Chinese officials have been bracing for a trade war for months -- promising to match the Trump administration measure for measure -- signs are rising that China's recent economic expansion is ebbing, from weakening investment and household consumption to increasing corporate defaults, in part due to a key Xi initiative to contain debt and fend off financial risks.

That slowdown is triggering mounting calls from some corners of the government for Beijing to reopen the credit spigot and ease off on Mr. Xi's program before the trade conflict further dents growth.

"It's a testing moment for Beijing," said Larry Hu, China economist at Macquarie Group, a Sydney-based investment bank.

Soaring levels of corporate and local government debt are seen by economists as potentially dragging down the world's second largest economy. Getting a handle on debt has been a Xi priority.

The Trump administration's simultaneous fights with the European Union, Canada, Mexico, Japan and others on trade give Beijing some breathing room, making it less likely that those traditional U.S. allies will mount a broad front against Chinese trade practices widely seen as unfair. It also gives the Chinese leadership a chance to pick up potential partners against Washington.

The domestic back-and-forth over whether to press ahead or ease off on the campaign to reduce debt underscores the balancing act facing the Chinese leadership as it tries to fight a trade war with the U.S. while keeping China's economy from tanking. President Donald Trump has said that the U.S., with its economy steaming ahead, is in a strong position in a trade contest.

The latest volleys from Mr. Trump, who said Monday that he had directed aides to identify $200 billion in Chinese goods for new 10% tariffs, caught Beijing off guard. Officials scrambled to put together a strongly-worded response, pledging to fight back forcefully without giving any details.

By escalating the tariff threats to potentially $200 billion in Chinese goods, the Trump administration is in effect driving Beijing to look for penalties other than tariffs; the U.S. exports about $150 billion in goods to China.

Beijing could restrict access to China's market by American companies, tie up firms already in the China market in antitrust and other regulatory red tape and try to steer business to other foreign firms. The Trump administration already accuses Beijing of unfair practices so targeting American business would reinforce that perception, likely hardening the response.

Early Tuesday, hours after the Trump announcement on additional tariffs, the People's Bank of China pumped 200 billion yuan, or $31 billion, of one-year funds into the nation's banks.

Advisers to the central bank said the move didn't mean the bank was loosening its conservative monetary stance, but was aimed at calming jittery investors and containing any financial fallout from the trade fight.

Still, the unusually-large liquidity injection surprised market participants, helping drive down the yuan's value against the dollar to its weakest level in five months, at 6.4743 per dollar. The benchmark Shanghai Composite stock index plunged 3.8% Tuesday, dipping below 3,000, a psychologically-important level for investors and hitting its lowest mark in two years.

Meanwhile, news items containing "China-U.S. trade war" were temporarily deleted from searches on the popular Baidu Inc. search engine. The searches were restored late Tuesday. Baidu declined to comment.

To fend off an economic slowdown, some officials in the State Council, China's cabinet, are urging more aggressive loosening measures to boost lending and spur growth, such as reducing the portion of deposits banks are required to hold in reserve. Others, notably those at the central bank and other financial regulators, want to stay the course of debt control.

Yi Gang, China's newly appointed central-bank governor, told a closed-door meeting of prominent U.S. and Chinese economists in March that his "first task" was to keep a lid on credit growth, according to people present.

That effort has slashed borrowing between banks, crimping practices that enabled smaller lenders to ramp up risky borrowing and lending. The pain that has caused has started to show up in recent months, with more businesses having trouble getting financing.

Companies ranging from property developers, local-government financing vehicles to manufacturers recently have missed payments on either bank loans or bonds, even though overall default rates remain low.

"Financial deleveraging is now trickling down to the real economy," said Sheng Songcheng, a senior adviser at China's central bank. "All those efforts would go to waste if monetary policy gets loosened now."

In looking for options to deal with the Trump administration, Beijing has studied the U.S. trade fight against Japan in the 1980s and 1990s, according to Chinese officials. Back then, Tokyo accommodated Washington's demands by appreciating the yen and then subsequently unleashed fiscal stimulus to help the economy withstand the pressure from a stronger currency. Those actions led to a housing bubble that helped sink the Japanese economy.

"Every country now realizes when the U.S. launches punitive tariffs, you must retaliate," said Yukon Huang, senior fellow at the Carnegie Endowment in Washington. "You both lose. If you don't do that, only you lose."

How China adjusts its economic policy, officials and economists said, will depend on how much worse the trade fight with the U.S. becomes. Strong exports buoyed the Chinese economy last year, keeping expansion at 6.9% above the leadership's growth target of 6.5%.

Recent snapshots of economic activity show that investments in Chinese factories and other fixed assets have slowed to the lowest level in 18 years and China's household consumption, which has been steady in recent years, is starting to decelerate sharply.

With exports likely to take a hit too, policy makers have put in place tax cuts and other measures aimed at boosting consumption. If the conflict escalates to include $200 billion of Chinese exports, Deutsche Bank AG estimates that would shave between 0.2 and 0.3 percentage point from China's annual GDP growth.

"If the trade war gets worse from here, China's policy makers will be forced into easing," said Zhang Zhiwei, Deutsche Bank's chief China economist. "That will probably delay the current policy agenda of deleveraging and containing financial risks."

--Chao Deng contributed to this article.

Write to Lingling Wei at lingling.wei@wsj.com

(END) Dow Jones Newswires

June 19, 2018 11:12 ET (15:12 GMT)

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