Cablegate: Shenzhen Stock Market Laments Lack of Autonomy

DE RUEHGZ #0052/01 0300801
R 300801Z JAN 08





E.O. 12958: N/A

REF: A) GUANGZHOU 0001, B) 2007 GUANGZHOU 1267

(U) This document is sensitive but unclassified. Please protect
accordingly. Not for release outside U.S. government channels. Not
for internet publication.

1. (SBU) Summary: Managers at the Shenzhen Stock Exchange (SSE) are
frustrated that excessive regulation and limited market access for
foreign investment banks stymie financial innovation, SSE officials
told Embassy Beijing's Financial Attache and Congenoffs. As a large
institutional investor, Shenzhen fund management executives also
support greater competition in China's brokerage sector, including
from foreign investment. Executives at China's only two domestic
banks with substantial foreign managerial influence hope the
successes they've achieved in financial restructuring will allay
concerns of regulators and open opportunities for more foreign
investment in the banking sector. They also noted that high reserve
requirements have a larger impact in restraining credit growth in
small and medium-sized banks with fewer deposits. The appreciation
of the renminbi against the U.S. dollar (albeit a modest one in
trade-weighted terms) is nevertheless adding to rising cost
pressures on exporters and thus beginning to promote a rebalancing
of China's economy. End summary.

Shenzhen Stock Exchange Wants More Autonomy

2. (SBU) SSE Officials expressed frustration that excessive
regulation stymies financial innovation. Vice Director for Strategy
and International Relations Jane Wu complained that all new listings
must be approved by the Chinese Securities Regulatory Commission
(CSRC), which has frozen initial public offerings (IPOs) for
companies that meet the SSE's listing requirements. In addition, Wu
lamented the long delay in the CSRC's approval of trading in stock
index futures on the Shanghai Financial Futures Exchange. Approval
would increase market liquidity by allowing investors to take both
short and long positions. Similarly, the Shenzhen Stock Exchange
has been waiting more than six months for approval of a new board
that would focus on start-up and other young companies. New product
development also suffers from the lack of access for international
investment banks, according to Wu.

Investors Need Financial Product Diversification
--------------------------------------------- ---

3. (SBU) Top management at Shenzhen's Bosera Asset Management
Company also wants to see greater opening of China's financial
products market. While the firm has grown significantly, with 13
different fund products, with over USD 18 billion under management,
company president Xiao Feng said foreign assets were still too small
a share of Chinese investors' portfolios, preventing effective
diversification. Xiao supports further expansion of the Qualified
Domestic Institutional Investor (QDII) program, which allows
domestic investors to invest overseas, and the Qualified Foreign
Institutional Investors (QFII) program, which allows foreign
investors to invest in China, stating that both programs benefit his
firm and other local fund managers. As a large institutional
investor, Xiao noted the benefits of increased foreign investment in
the securities sector as it uses Gaohua Securities as its broker
(Note: Goldman Sachs effectively controls Gaohua) and would welcome
more foreign firms providing research and brokerage services.

4. (SBU) Investor education is a major priority at Bosera,
especially as the firm's customer base has ballooned from 1 million
investors to 10 million in 2007 alone. Bosera officials admitted
that many of these customers are new to stocks and may not
understand the risks. In addition to establishing a customer
information hotline and distributing a pamphlet of frequently asked
questions to customers, the company published a best-selling
investment book and hosted 200 investor information sessions at
hotels and other venues throughout China.

5. (SBU) Nevertheless, the meeting with Xiao raised doubts about how
customers would react to a sudden downturn in the market and whether
Chinese mutual fund companies have adequate contingency plans to
handle large-scale redemptions. Xiao pointed out that Bosera's
website had been able to handle up to 70,000 inquiries at a time
(Comment: Inquiries could be in the millions during periods of
market stress. End comment). When asked how Bosera would respond
to a surge in redemptions, Xiao said the firm had the authority to
delay filling redemption orders of more than 10 per cent of a
shareholder's investment. He expressed confidence that most clients
are aware of this policy, but admitted that few customers actually
have read the details in the prospectus. (Comment: Xiao notably did
not mention efforts to establish bank lines of credit to meet

GUANGZHOU 00000052 002 OF 003

redemptions. End comment).

Foreign Control Does Not Break the Bank

6. (SBU) Executives at Shenzhen Development Bank (SDB) and Guangdong
Development Bank (GDB) described dramatic turnarounds at both banks
within one year of assuming control over day-to-day operations.
Shenzhen Development Bank has run a substantial profit for over half
of the 28-month period since American investors took over in 2005.
Guangdong Development Bank will soon announce profits exceeding
internal targets by more than 100 per cent for the second half of
2007 -- only 16 months after taking control. In both cases,
officials stressed that the large spread between deposit and lending
rates (resulting from a ceiling on the former and floor on the
latter) makes Chinese banking highly profitable with even modest
efforts to rationalize costs and improve the quality of lending.
These include holding branch managers accountable for collection of
non-performing loans (NPLs) and improving customer service through
increased bank tellers and ATMs. GDB's Zink noted the long-term
importance of cutting costs and developing non-interest sources of
revenue as interest rate controls would eventually be phased out and
NPLs will follow a cyclical downturn.

7. (SBU) Executives at both banks are cautiously optimistic that the
results of a survey conducted by the Chinese Banking Regulatory
Commission (CBRC) on market conditions for foreign banks in the
country will lead to further opening. Survey results are expected
in the spring and will likely form the basis of CBRC recommendations
to the State Council on future banking reform. As the only two
domestic joint-venture banks in China with substantial foreign
managerial control, SDB and GDB hope their success will help allay
concerns among regulators and open opportunities for more foreign
investors to take control of Chinese banks.

Non-Performing Loans Falling Rapidly

8. (SBU) Non-performing loans at Shenzhen Development Bank peaked at
11.3 per cent in mid 2005, not long after Newbridge Capital
purchased its controlling stake in the struggling bank. Chief
Credit Officer Li Wenhuo said the NPL ratio dropped by almost half
in two and a half years (ref A) as lending expanded under more sound
risk management policies. However, the decline in the ratio was due
mainly to an expansion in loans. The absolute value of NPLs did not
substantially decline until the second half of 2007 when the bank's
collection efforts began to yield positive results. SDB formed
teams with legal, prosecution, and police experience to press
borrowers in arrears to turn over assets. Li hopes that continued
collections on legacy loans combined with SDB's continued track
record of only 0.2 percent of new loans becoming non-performing will
lead to a double decline in both ratio and absolute total of NPLs in

9. (SBU) Michael Zink, President of Guangdong Development Bank,
described a similar decline in NPLs by holding branch managers and
loan officers accountable for the collection of bad loans. Only one
case required a court judgment to assist in resolution. Zink said
Communist Party officials within the bank occasionally warned of
potentially sensitive loans. In those cases, management allowed
Party officials to lead collection efforts.

10. (SBU) Both SDB and GDB officials explained how monetary
authorities' efforts to limit credit expansion through
sterilization, increased reserve requirements, and asymmetric
increases in administered interest rates (with deposit rates rising
more than lending rates) had impacted their income. SDB officials
noted that the PBOC's most recent rate hike, which raised deposit
rates more than lending rates (to limit the transfer of assets to
equity markets) but lowered the interest rates on demand deposits,
would in fact increase the bank's net interest income, given that 40
percent of SDB's deposits were demand deposits. Officials of both
banks told how the increase in reserve requirements constrained
their lending more than the big state-banks given that their retail
deposits, and thus excess reserve holdings with the central bank,
are smaller. Neither SDB nor GDB officials were excessively
concerned about efforts to limit credit growth through enhanced and
quarterly enforcement of tighter lending quotas as both institutions
intended to increase income by improving the profitability of their
loan portfolio, not just by loan growth. SDB had sold off some NPLs
and GDB is reducing its participation in lending syndicates to large
credit-worthy SOEs to make rooms for more profitable lending (such
as commercial real estate) under existing quotas.

11. (SBU) According to Zink, relations among shareholders and

GUANGZHOU 00000052 003 OF 003

stakeholders remain the biggest managerial challenge at GDB (ref B).
Both China Life and Citibank hold an equal share of equity (20
percent) and, given GDB's profitable outlook, both want to assume
control. Moreover, the Communist Party continues to play a major
role in the appointments of senior management, which makes it
difficult to hold senior management accountable to meeting financial
targets. This differed significantly from the Party's much less
operational role in Citibank (China).

RMB Appreciation helping to shift China economy
--------------------------------------------- --

12. (SBU) Executives at Nike and Guoguang Electric (audio speakers)
highlighted the challenges caused by the recent appreciation of the
renminbi against the U.S. dollar (USD) for China-based
manufacturers. Nike does not bear currency risk because all of its
purchasing contracts with factories in China are USD-denominated.
Instead, Nike works closely with its contracted factories to help
them find ways to cope with currency appreciation, mainly by cutting
costs. While the recent tight market for skilled workers may ease
in the short term given the closure of several neighboring low-end
assembly operations, worker retention continues to be the area of
highest cost for Nike's contract factories. While Nike continues
procurement from Chinese firms in apparel and footwear, it has
shifted orders for equipment towards Vietnamese suppliers. At the
same time, Nike China is looking to expand its sales to China's
domestic market.

13. (SBU) Guoguang produces audio speaker components. Less than
five percent of its product is sold in China, and currency-related
losses were 10 per cent of total revenue in 2007. Guoguang's export
prices are all USD-denominated in inflexible one-year agreements.
Given the cost of long term foreign currency hedging in China,
Guoguang tries to roll out new products at a faster rate to replace
old export contracts with new ones at current exchange rates. Mr.
Zheng Yamin estimated that his company will become unprofitable at
RMB/USD 6.5, at which point Guoguang will have to either move
operations to a cheaper location (they have begun to look in China's
west) or invest heavily to increase labor productivity. The
reduction of the value-added tax (VAT) refund also raised costs, and
Zheng complained about the lack of advance warning on reductions in
VAT rebates. He pointed out that Guoguang primarily competes
against other manufactures in Taiwan and Korea, so RMB appreciation
tilts the advantage to his overseas competitors. (Comment: Though
to date most other Asian currencies have appreciated more against
the USD than the RMB. End comment).

14. (SBU) In response to higher wages, taxes and a more appreciated
exchange rate Nike, Guoguang, and South China AmCham have all
observed a shift of manufacturing toward China's center and west.
Guangzhou AmCham cited estimates of some 5-6000 factory closings in
the Pearl River Delta (PRD).

15. (SBU) Comment: The discussions with SSE and Bosera highlighted
the importance of stressing to Chinese officials and the Chinese
public how barriers to foreign investment erected by regulators to
protect some Chinese firms (i.e. underwriters and brokerages) can
harm other constituents of the same regulators. The Communist
Party's continued influential role in Chinese financial
institutions, and the tension it creates with foreign investors
trying to import commercially-oriented managerial practices, may
account for some of the political opposition to foreign acquisitions
of large Chinese companies. End comment.


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