* Shanghai Composite is world’s worst-performing index in 2018
* Deleveraging campaign, outflow fears limit responses
* Authorities keen to avoid policy missteps made in past
By Andrew Galbraith and Kevin Yao
SHANGHAI/BEIJING, June 27 (Reuters) - Amid fears over a full-blown trade war between the United States and China, Beijing has a more immediate worry - jitters in Chinese markets that could fuel anger at government policy.
Market sentiment has already been dulled by Beijing’s multi-year financial deleveraging campaign, which has driven up borrowing costs for businesses and slowed the economy.
An uncontrolled slide in Chinese stocks and a prolonged decline in the country’s currency could undermine Beijing as it mounts its defences in the trade battle with Washington.
But policy insiders, investors and economists say Beijing has a limited toolbox to combat a deeper market sell-off, constrained by its deleveraging pledge and by fears that easing monetary policy could prompt capital outflows.
Authorities are keen to avoid the policy missteps of 2015, when a botched attempt to support stocks, including a suspension of new listings and aggressive easing, failed to calm investor fears. Shanghai shares plunged more than 40 percent that summer, propelled by a devaluation of the yuan.
China will try to avoid resorting to currency depreciation or selling its U.S. Treasury holdings, which could extend the trade conflict into financial markets, the policy insiders say.
That leaves targeted measures to support the economy, such as cuts to the amount of cash some banks must hold as reserves.
But such moves have done little to halt the slide so far.
On Tuesday, two days after the People’s Bank of China (PBOC) cut banks’ reserve requirement ratios for the third time this year, the Shanghai Composite index entered bear-market territory.
Down more than 20 percent since late January, the gauge is the world’s worst-performing major index this year.
The net amount of cash released from the reserve ratio cut was larger than expected. But it hewed closely to a statement by the cabinet last week highlighting the use of such targeted cuts as part of a strategy to support the economy by strengthening credit availability to smaller firms.
In further signs of caution, the central bank has also refrained from following a recent Federal Reserve interest rate hike, and has directly injected liquidity into the interbank market.
The central bank’s governor, Yi Gang, has urged China’s investors to remain calm.
Yi is showing that the central bank “is trying to actively manage expectations,” said Wang Jun, chief economist at Zhongyuan Bank.
Economists say further targeted loosening is likely, particularly if a trade war presents headwinds in the second half of the year. The central bank could also choose to release more liquidity into the banking system through its regular open market operations.
The question remains whether such targeted policy support will effectively shore up market sentiment, when broader loosening remains an unpalatable choice.
“A trade war may bring pressure on Chinese exports, triggering yuan depreciation. Thus the PBOC cannot cut rates,” said Yun Xiong, partner at Leiton Capital in Shanghai.
To prop up trade and soothe market worries, Beijing could also unveil incentives to spur domestic demand to compensate for weaker exports, including expanding its annual budget deficit target, policy insiders said.
Beijing could also use fiscal levers such as tax cuts to boost household income, promote domestic consumption and investment, they said.
In April, the Politburo, a top decision-making body of the ruling Communist Party, added “expanding domestic demand” back to a policy statement after dropping it in December.
China could also provide credit support for firms making the switch from overseas markets to the domestic market.
“We should develop other markets to substitute for the U.S. market,” said a policy insider. But he cautioned that any attempt to boost domestic demand would not be successful overnight.
“We need time to switch markets,” he said.
Another insider said China could use yuan depreciation, which may support exporters, but runs the risk of fuelling capital outflows, as a last resort.
But he cautioned, “this may not affect others but we could shoot ourselves in the foot. We cannot easily use it.” (Reporting by Andrew Galbraith and Kevin Yao; Editing by Philip McClellan)