Cablegate: China: Pboc Research Bureau Deputy Director General


DE RUEHBJ #0800/01 0650617
O 050617Z MAR 08





E.O. 12958: N/A
SUBJECT: China: PBOC Research Bureau Deputy Director General
discusses Chinese economy


1. (SBU) On February 28, Minister Counselor for Financial Affairs
and econoff exchanged views on China's macroeconomic and monetary
policy with Dr. Jiao Jinpu, Acting Director General of the People's
Bank of China (PBOC) Research Bureau. Jiao stressed that, despite
the potential deflationary risks of high investment growth and a
drop in external demand, he believes the balance of risks in the
Chinese economy remain overheating and inflation. As a result,
monetary policy will maintain a tightening bias. He believes that
high and rising agricultural and commodity prices will keep headline
inflation high for the near term, exacerbating already rising
inflationary expectations that will lead to wage pressures. Jiao
said the PBOC's efforts to constrain the growth of lending will hurt
small and medium-sized financial institutions more than large
institutions. Jiao expressed concern that expectations of continued
RMB appreciation will induce additional capital inflows. Although
the rising spread between U.S. and Chinese interest rates could also
further induce inflows, Jiao believes capital flows are more
sensitive to relative changes in investor expectations about asset
prices in China and overseas markets. On renminbi (RMB)
appreciation, Jiao reported that gradual appreciation has not had a
widespread negative affect on exporters. While a gradual
appreciation risks inducing greater inflows than a sudden and large
discrete appreciation, the consequences of the latter are less
certain, making this a less attractive option to Chinese leaders.
End summary.

Balance of risks remain tilted towards inflation

2. (SBU) Jiao noted that the Chinese economy is likely to have
reached a cyclical peak and could be headed for a period of slower
growth. While he noted the potential deflationary risks of
continued high investment growth and a drop in external demand, he
believes the balance of risks facing monetary authorities remain
overheating and inflation. Jiao underscored that some of the recent
increase in the inflation rate is due to temporary agricultural
supply shocks that are unlikely to be repeated. (Comment: As a
result, even if agricultural prices stay high (but don't rise
further) this will not necessarily contribute to continued high
inflation. End Comment.) However, Jiao expressed concern that high
and rising agricultural and commodity prices, due both to global and
domestic factors, will keep headline inflation high for the near
term, exacerbating already rising inflationary expectations that
could lead to wage pressures. These factors increase the risk of
keeping inflation high and rising even as the impact of temporary
supply shocks wane.

3. (SBU) Financial MinCouns pointed out that some economists have
argued that China has targeted too low an inflation rate and, like
other developing countries with high rates of productivity in the
goods sector and a fixed exchange rate, China might be able to
tolerate a higher rate of inflation to achieve a real appreciation
of its currency to rebalance economic growth, and in particular
promote investment in services. Jiao agreed that China could
tolerate a slightly higher rate of inflation, but he did not specify
what higher threshold would be tolerable, He also stressed that even
moderate inflation would have a negative effect on China's economic
growth. In Jiao's view, Chinese policy makers must now decide
between keeping inflation in check or maintaining rapid short-term
economic growth at the expense of longer-term economic stability.
"If we seek economic growth without controlling inflation, we will
face a long adjustment period in the future," he added.

Monetary policy to retain a tightening bias

4. (SBU) Jiao explained that the PBOC plans to maintain a tight
monetary policy in reduce inflation. Partly in response to shortages
resulting from recent snowstorms, the central government has imposed
provisional price controls on specific products. Jiao underscored
that the government plans to lift price controls soon, and agreed
with Financial MinCouns that price controls would limit incentives
to expand production in sectors where prices are controlled.

Monetary policy instruments hurting small and medium financial
5. (SBU) According to Jiao, China's large financial institutions
have a larger deposit base, and thus more excess liquidity. As a
result, they will be less affected by PBOC's policies to reduce the
growth of monetary aggregates, such as higher reserve requirements.

The longer the PBOC maintains a tight monetary policy, the more
important it is to target policies in a way that forces larger
institutions to shoulder more of the burden, Jiao explained.

Capital flows more sensitive to asset prices than interest rate
6. (SBU) Jiao expressed concern that expectations of continued RMB
appreciation will continue to induce additional capital inflows. In
Jiao's view, an extended gradual appreciation of the RMB risks
inducing greater inflows than a sudden and large discrete
appreciation (Comment: provided it is large enough to convince
investors there is two-way risk in the exchange rate's movement.
End comment.) However, the economic impact of a large discrete
change is less certain, and thus carries greater risks, making it a
less attractive option to Chinese leaders. Although the rising
spread between U.S. and Chinese interest rates could also further
induce inflows, Jiao believes investors' relative expectations about
asset prices (in particular real estate) in China and overseas
appear to play a more influential role in affecting capital flows
than relative interest rates. He explained that foreign investors
still view housing prices in Beijing and Shanghai as cheaper than in
major U.S. cities, and that investors expect real estate values in
China to continue to rise.

Limited adverse impact of renminbi appreciation
7. (SBU) Jiao said he believes China should move toward a more
market-based exchange rate, but too few participants in the foreign
exchange market and capital controls prevent the RMB exchange rate
from being freely market-determined. Once these obstacles are
removed, he said, we won't need to argue over the exact exchange

8. (SBU) Jiao noted that the impact of the RMB's appreciation
against the U.S. dollar on exporters has been relatively small.
Jiao pointed out, however, that many companies have increasingly
complained to PBOC about the RMB's appreciation. In a recent
conversation with Huawei's CFO, for example, he learned that Huawei,
China's largest networking and telecom equipment supplier, has
experienced major losses due to its dollar-denominated transactions
and holdings. Financial Mincouns noted that the faster rate of RMB
appreciation and its greater flexibility since last October was both
noted and welcome by the USG and encouraged the PBOC to maintain the
recent high rate of appreciation.

China should strengthen domestic demand
9. (SBU) In Jiao's view, China should strengthen its efforts to
expand domestic demand in preparation for a potential downturn in
the U.S. economy. Increasing farmers' income and improving
financial services in rural areas will play an important role in
this effort. Jiao said he expects these issues to be addressed in
policy announcements during the National People's Congress, which
will convene March 5-18.

10. (SBU) Despite the rising risk that weak external demand and
growing productive capacity could be deflationary, Jiao's comments
indicate that monetary policy officials continue to believe
inflation represents a greater risk, particularly as new central,
provincial, and municipal government leaders have traditionally
tended to start their terms with large increases in public and
publicly-supported investment. Although Jiao stressed the
importance of maintaining a tight monetary policy, the monetary
policy stance remains less tight than PBOC rhetoric would suggest.
In fact, real interest rates remain low (and in some cases
negative), broad monetary aggregates continue to exceed nominal GDP,
and the RMB has appreciated only modestly on a trade-weighted basis.
Jiao's comments that relative expectations on asset price changes
are a more important determinant of capital flows than interest rate
differentials indicate that despite the Federal Reserve's easing,
PBOC officials believe they still have some room to adjust interest

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