China's trade is slowing down and its central bank needs to be careful

It looks like the tide is turning in China.

China's trade data was weak in July, with lower-than-expected export and import growth at -4.4% and -12.5%, respectively.

The country's reduced appetite for commodities drove down imports growth, while labor-intensive goods (i.e. industries such as agriculture and electronics) were a main drag on exports, according to a note by a team led by Morgan Stanley economist Robin Xing.

The bigger drop in imports than in exports helped widen China's trade surplus by $4.4 billion to $52.3 billion in July.

Meanwhile, foreign-exchange reserves declined by $4.1 billion to $3.2 trillion in the month, The People's Bank of China said on Sunday, better than analysts had expected. The reserves jumped $13.4 billion in June, after hitting a 5-year low in May.

"We believe the better-than-expected reading was mainly supported by still positive valuation effect due to weaker US dollar as well as the wider trade surplus (the trade surplus in July is US$4.4bn larger than in June)," Xing wrote. "This suggests that underlying capital outflows may have intensified in the month."

The economists aren't counting on things to get better. They expect export growth to remain slow, thanks to Brexit's potential drag and tepid global trade growth in the third quarter.

Chinese officials have repeatedly said they're sticking to a "prudent and relatively accommodative" monetary policy. Credit conditions are the loosest they've been in over five years, while private investment is not growing at all.

China needs to slash benchmark interest rates further in order to shore up growth, according to the Morgan Stanley economists, who have estimated that the country could see 50 basis points more in interest rate cuts by the first quarter of next year.

However, policymakers will need to be cautious and make sure rate cuts don't lead to a further drawdown of foreign capital. Here is Morgan Stanley again (emphasis ours):

"We believe policymakers have been trying to strike a balance to manage the trilemma challenge - flexibility of exchange rate, openness of capital account and control over domestic interest rates. Namely, the central bank will need to allow some USDCNY depreciation in a general environment of USD strength to maintain monetary policy independence of rate cuts. But the pace of rate cuts will need to be carefully measured to avoid sharp USDCNY depreciation, which would un-anchor expectations and accelerate outflows, resulting in an undesired tightening in domestic liquidity conditions. Indeed, the PBOC's 2Q16 Monetary Policy Report released over the weekend warned that too frequent cuts in RRR could add too much liquidity to the financial system and lead to yuan depreciation expectations. This suggests that policymakers may have turned more cautious and will likely slow down the pace of monetary easing in the near term to keep capital outflow pressures at bay."