If trade frictions increase between the U.S. and China that could have significant fallout for China as it struggles with debt, and weigh on the global economy. President-elect Donald Trump has threatened to take a tougher stance — including imposing tariffs and labeling China a currency manipulator.

Meanwhile, with China's Communist Party congress set to meet this fall, the country's "leadership cannot afford to be perceived as weak," said David Cui, head of China equity strategy at Bank of America Merrill Lynch. "That's why the market has grossly underestimated trade frictions," Cui said, speaking on a call with reporters late Tuesday.



China was the biggest source of goods imported to the U.S. in 2015, according to the Office of the U.S. Trade Representative. If the U.S. trade deficit — $367 billion in 2015 — with China is cut by a third, Cui estimates the Asian giant's GDP growth could be hurt by 1 to 2 percent.

In the last decade, China's annual GDP growth fell from double digits to a 25-year low of 6.9 percent in 2015. Many China watchers say slower expansion is inevitable as China shifts from a debt-fueled manufacturing-driven economy to one driven by domestic consumption. But concerns about negative spillover from a sharp slowdown in China's economy have roiled global markets. China is scheduled to report fourth-quarter 2016 GDP on Friday.

Meanwhile, China's debt problems appear to be getting worse. Cui's analysis found that the country's debt-to-GDP ratio should increase in the near future, potentially at a faster rate. And in the mainland Class A share market, Cui estimates that leverage jumped from 15 percent of market capitalization in the middle of 2015 to 22 percent in the third quarter of last year. "If we look at top down the major drivers of bad debt, increasing overcapacity, leverage, all the major drivers seem to be far more than the last round," Cui said.

In July 2015, the Shanghai composite dropped more than 40 percent from a seven-year high as traders, who had borrowed heavily to buy stocks, rushed to sell to meet those loan obligations. That time, the Chinese government had to step in as a buyer to support the market, but the extreme volatility was followed by a sharp depreciation in the Chinese yuan versus the dollar, sending U.S. stocks down more than 10 percent that summer.



Potential economic pressure from a tougher U.S. stance on China could come soon. Trump takes office Friday and has already selected outspoken China critics for key positions on trade, including Peter Navarro, author of "Death by China," for the head of a newly formed National Trade Council. "I think there will be more trade frictions between the two countries," Cui said. Because of Trump's policymaker picks, "it's very difficult to see ... that the Trump administration doesn't do anything," Cui said. "Because of the political dynamic in China leading up to the 19th National Congress, [they will] not back down easily." The American Chamber of Commerce in the People's Republic of China found in its annual survey of about 500 of its member companies that one-third expect U.S-China relations to deteriorate this year, while half expect the relationship to remain the same. More than 40 percent said they would slow their investment in China due to factors such as market access barriers and uncertainty around business policy.

Adding further uncertainty to U.S.-China relations, Trump has challenged the "One China" policy in which the U.S. sees Taiwan as a province of China. "I think this is one of the red lines for the Chinese government," Cui said. They're "unwilling to compromise on that. It's possible in other areas." While Cui expects Beijing to take a tit-for-tat reaction to any U.S. policies, Chinese President Xi Jinping said in a high-profile speech Tuesday at the World Economic Forum in Davos, Switzerland, that "no one will emerge as a winner in a trade war."