- Medley Global Advisors China research head speaks in interview
- Polk encouraged by increasing rhetoric, energy around reforms
Andrew Polk has told clients for years that China’s growth is slower than they think and its problems more deeply entrenched than they realize. So he’s feeling a tad uneasy about turning more optimistic these days.
"I hate to seem too sanguine, but in the short-term time horizon things look pretty good," says Polk, Beijing-based head of China research at Medley Global Advisors, which advises hedge funds and other institutional investors. "It’s hard for me to see the blowup that people are expecting."
His shift is prompted by increased confidence that policy makers will avoid a repeat of January or August, when steps to weaken the yuan freaked out global markets. A sharp reduction in corporate external debt is reducing pressure on capital outflows while increased "rhetoric and energy" around plans to slash excess industrial capacity in industries from steel to coal have encouraged him.
Still, Polk is far from turning bullish: he sees economic growth grinding down to about 3.5 percent in four to five years, and is concerned that there’s no long-term plan to rein in rising debt. The possibility the Federal Reserve will hike interest rates this month is a big risk for emerging markets generally, and China in particular, said Polk, who joined Medley in February and previously worked for the Conference Board and the U.S. Treasury.
Polk, 34, said in an interview this week that the central bank should navigate its way through any Fed-induced volatility with greater finesse this time around. Here are excerpts of the conversation:
Question: What’s your outlook for the economy?
Answer: Growth is probably at 4 percent now or slightly below, but they are growing below trend so maybe in the medium term there’s room for some short-lived economic improvement. We can’t stay at 1 percent growth of investment in real estate like we had in 2015. I’m still a bit cautious on the current real estate recovery because I believe it’s very liquidity driven. If the government is serious like it says about reducing overcapacity in the real estate sectors and they do get through some level of that then it would be appropriate to start building again.
That would be a short-term positive for growth. The long-term trajectory is still downward and we’ll ultimately end up somewhere at around 3.5 percent growth. But that’s not necessarily a lot lower than where we are now.
Question: How do you see the prospects for reform, particularly plans to cut excess industrial capacity?
Answer: I’m encouraged by at least the increased rhetoric and energy around the capacity cuts. They have actually committed the 100 billion yuan ($15 billion) for worker retraining. It’s not enough but it’s there now, it’s a concrete move. From the companies that I’ve talked to in upstream sectors, it seems that more is happening.
Question: Aren’t you underwhelmed by the scale of the capacity cuts?
Answer: Underwhelmed, but it does seem like things are happening. My understanding is there was a lot of push back in Heilongjiang province specifically to the capacity cuts and Xi going there himself is an important marker to try to get the local leadership on board. We know these implementation issues are the perennial sticking point. In so far as he goes out there and makes sure people are on board could go a long way to removing that road block.
Question: Where’s the currency headed?
Answer: I expect mild weakness throughout the rest of the year. The People’s Bank of China seems to have learned a lesson from January where they went on auto pilot, too far too fast. The market got freaked out and thought they are losing control, a lot of big bearish bets piled on and everybody thought "Oh my God, the thing we’ve been waiting for in China is happening."
This time around they are being much more cautious in the pace of devaluation. They are devaluing more slowly than the dollar is gaining against other currencies. As long as that remains the case the market doesn’t have too much to freak out about. Yes, there’s yuan weakness, but it’s less than other major currencies.
Question: What about the trajectory for capital outflows?
Answer: One of the major channels for outflows, Chinese corporates paying down external debt, seems to have largely run its course. They’ve cut down a significant amount of U.S. dollar external debt and on top of that Chinese corporates are much better hedged. They were essentially not hedged at all pre-2016 and now they’re buying forward rates and engaging in swaps with the PBOC, so they are better hedged. So if there’s yuan weakness this likely won’t have the same push effect that it had in the past.
Higher-frequency data like the spreads between onshore and offshore yuan have been pretty tight. The fact that they’re well behaved says the outflow might be there, but it’s not too intense. It seems that a lot of the measures that were put in place to potentially crack down on capital flows are still basically there so they’ve sort of gummed up the works.
Question: What are you worried about?
Answer: The name of the game now is understanding on a more granular level where the vulnerabilities in China’s banking system are. The simple answer is city level banks. City level banks concern me the most in terms of their asset growth. The question is how connected is the banking system. A lot of this debt at the city level seems to be relatively contained, so then you get into the question of the big banks’ exposure to the small banks via the interbank market. Obviously the interbank market has been growing massively for a while, but specifically over the past year and a half. Can you have localized financial crises in China? My expectation would be that maybe you can. But maybe the banking system is more connected than I expect and that’s why I’m worried about the interbank market.
— With assistance by Kevin Hamlin