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Cablegate: Shanghai Stock Exchange: Recent Volatility, Prospects For

VZCZCXRO4718
RR RUEHCN RUEHGH
DE RUEHGH #0246/01 1790852
ZNR UUUUU ZZH
R 270852Z JUN 08
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6950
INFO RUEHBJ/AMEMBASSY BEIJING 1938
RUEHSH/AMCONSUL SHENYANG 1270
RUEHCN/AMCONSUL CHENGDU 1272
RUEHGZ/AMCONSUL GUANGZHOU 1243
RUEHHK/AMCONSUL HONG KONG 1411
RUEHIN/AIT TAIPEI 1081
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 7512

UNCLAS SECTION 01 OF 04 SHANGHAI 000246

SENSITIVE
SIPDIS

TREASURY FOR OASIA/INA - DOHNER, HAARSAGER/CUSHMAN, WINSHIP
TREASURY FOR IMFP SOBEL. MOGHTADER
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA - MCQUEEN
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SF FRB
FOR CURRAN/GLICK/LUNG; NY FRB FOR CLARK/CRYSTAL/MOSELY/DAGES/DAWSON

E.O. 12958: N/A
TAGS: EFIN ECON PGOV SOCI CH
SUBJECT: SHANGHAI STOCK EXCHANGE: RECENT VOLATILITY, PROSPECTS FOR

REFORM

REF: Shanghai 100; Shanghai 28 and previous

1. (SBU) Summary. Shanghai financial services industry
participants identify last year's stock market bubble as the
primary source of the Shanghai Stock Exchange's most recent
volatility. Poor economic performance in certain sectors has
also fueled volatility, with inflation and softening real estate
markets as well as export challenges emerging as key concerns
for investors. Government intervention to shore up the Shanghai
Stock Exchange - the index is down almost 50 percent since
January 1 - is seen as unlikely, with our interlocutors noting a
lack of large-scale social unrest and regulator deadlock.

2. (SBU) Summary cont'd. Our interlocutors also note the
Shanghai stock market may be approaching its bottom, making this
an opportune time to continue non-tradable share reform and
introduce new financial products and services. They express
skepticism about whether these reforms will be enacted, however.
Nevertheless, our interlocutors are generally positive about
the stock market's future, noting that corporate non-financial
earnings appear to be remaining strong. They also note that the
lack of investor protests in the stock market as well as the
ability of firms to weather the market's recent downturn could
be a sign that the Shanghai stock market is becoming more
mature. End summary.

Introduction

3. (SBU) In meetings from June 20-24, Congen Econoffs met with
Shanghai financial industry participants to discuss recent
volatility in the Shanghai Stock Exchange (SSE). Meeting
participants included an American financial consultant based in
Shanghai, the general manager of a U.S. joint venture securities
firm, Haitong Securities Macro Economic Analyst Wu Yiping,
Shanghai Municipal Government Financial Services Office
Director-General Fang Xinghai, and SSE Global Business
Development Deputy Chief Chao Kejian.

Background

4. (U) From June 10 through close of trading on June 27, the
SSE has fallen 17.5%. Trading during the shortened week of June
10-13 (markets were closed on June 9 for a national holiday) was
especially volatile, with the Shanghai Composite Index (SCI)
falling 13.8% to 2869 points. On June 27, the SCI fell to 2748
points, its lowest level since the middle of March 2007. The
initial June 10 downturn was sparked by a 1% increase in
required reserve rates (RRR), bringing that rate up from 16.5%
to 17.5%. That RRR increase was announced on Saturday, June 7,
and on June 10 (first trading day thereafter) the SCI fell 7.73%
to 3072 points. Volatility has since continued, largely driven,
according to these interlocutors, by rising fuel prices,
softening real estate markets, inflation expectations and
prosecution of former China Security Regulatory Commission
(CSRC) Vice-Chairman Wang Yi.

Immediate and Long-Term Sources of the Markets Recent Downturn

5. (SBU) While June's downturn was set in motion by the PBOC's
RRR hike of June 7, the larger decline since the beginning of
the year has several sources. According to Fang and Chao, the
largest source was last year's speculation, which created a
bubble in the stock market. At its peak, P/E ratios reached
over 60, an unsustainable level according to many analysts.
Questions also remain over stock market corruption. Financial
news outlet Caijing reported on June 11 that former CSRC
Vice-Chairman Wang Yi had been detained while under
investigation for insider trading and violation of security
regulations. Chao and the JV manager noted this and rumors of
investigations into low and mid-level officials had been fueling
stock market volatility because retail investors see such
developments as introduction of additional uncertainties about
market operations. Fang on the other hand believes investors
have become sufficiently accustomed to the occasional regulatory
corruption case that such rumors no longer cause much concern.
All concurred that whatever the short-term impact on investor
outlook, investigation and prosecution of such cases in the
longer term will be good for investors' confidence and for the

SHANGHAI 00000246 002 OF 004


market.

6. (SBU) Our interlocutors also noted larger then expected
inflation had cooled markets. Inflation has changed investors'
expectations in two ways: first, by compressing corporate
profit margins with rising costs; and second, by the credit
crunch resulting from the government's attempts to control
inflation. The JV manager notes the first was partially
mitigated using price controls, especially for energy, although
some fuel prices were significantly increased in mid-June.
Keeping prices artificially low, however, distorted the market
by encouraging over consumption and under production. This led
to fuel shortages throughout the country, which also compressed
corporate earnings, though through a combination of mandating
and subsidized production, near term costs were lower then they
would have been had the market been allowed to equilibrate,
according to the JV manager. Both he and Chao note that the
energy price increases announced in mid-June helped bring the
market closer to equilibrium, improving the long-term outlook,
but also increased costs for downstream firms in the near-term.

7. (SBU) Inflation also led to government attempts to contract
liquidity. The JV manager noted the current credit crunch has
made it difficult for real estate developers to find financing
in a time when the industry is already struggling due to falling
prices. Nevertheless, Fang, Chao and Wu believe the real estate
sector will be sufficiently buoyed by demand. The JV manager
and the financial consultant also believe that the government
will not allow real estate prices to fall too far, especially in
Beijing and Shanghai, because of large real estate exposure by
the major banks. Both Wu and the JV manager, however, suggest
that real estate in southern China may continue to cool, arguing
that the recent appreciation of residential prices had been most
significant there.

Prospects and Expectations for Policy Intervention in the
Shanghai Stock Exchange

8. (SBU) Prior to the market's fall since June 10, investors
and the media had predicted the government would not allow the
SCI to fall below 3,000. A previous reduction of the stamp tax
the last time markets fell below 3,000 reinforced this belief.
To date, however, no such intervention has occurred. Our
interlocutors were mixed on investor expectations of policy
intervention. Both Fang and Chao believed the government will
have to do something. This, they claim, is necessary to satisfy
retail investors who lost money in the market's most recent
downturn. The JV manager, however, does not believe investors
are expecting intervention. He notes a recent survey in which
only 20% of retail investors said they expected the government
to intervene. The financial consultant echoed this view, saying
he believed investor expectations of intervention have been
decreasing with each passing day since June 10's downturn.

9. (SBU) Our interlocutors also expressed uncertainty about
what form intervention would take, if indeed intervention is
undertaken. The financial consultant and JV manager expressed
skepticism regarding adjustment of the stamp tax or increasing
QFII quotas. The JV manager noted last time the government
increased QFII quotas to support stock prices they were
criticized for letting foreigners buy into a cheap market, and
now the market is even cheaper. Both also questioned the
efficacy of a tracker fund similar to the one used in Hong Kong
to help stabilize the market. The idea for using a tracker fund
in Shanghai has been discussed in the media as a means to help
stabilize the market's most recent volatility. The financial
consultant noted that the SSE is becoming more
institutionalized, with institutional investors helping to
stabilize the market. The JV manager also noted the market may
be near the end of its adjustment, thus eliminating the need for
such a fund in stabilizing recent volatility. Other policy
options the government may be considering include restricting
new IPOs, slowing non-tradable share reform, allowing margin
trading or launching stock index futures.

10. (SBU) Regardless of investor expectations, our
interlocutors expressed various opinions on what might spur or

SHANGHAI 00000246 003 OF 004


prevent government intervention. Financial Services Office DG
Fang admitted that only limited protests had occurred so far,
but felt the government is still under pressure by investors to
take action to support the stock market. SSE's Chao expressed
similar sentiments, noting that investor pressure would
eventually lead to intervention. The JV manager disagreed,
saying protests over the most recent downturn had not reached
the level they had when the government intervened last time.
Without more pressure from investors, he predicts the government
will not intervene. He notes Vice Premier Wang Qishan (in
charge of financial and economic issues) said this spring that
the government will not intervene unless there is social
disturbance. The financial consultant, however, believes
government intervention is unlikely because there is no one
willing to take charge of not only rescuing the stock market,
but the economy in general. He notes that any official who
takes charge will be held responsible if measures prove
ineffective in halting or reversing the recent downturn.

Investors Expectations of Market Performance

11. (SBU) Absent intervention, our interlocutors asserted that
retail investors are becoming increasingly pessimistic about the
stock investment climate. The financial consultant noted recent
natural disasters, inflation and the U.S. economic slowdown as
contributing to a general pessimism among investors. This view
was echoed by Fang at the Financial Services Office, who noted
that the stock market will follow the economy. He predicted
that as long as there is strong economic growth and inflation is
controlled, the stock market will recover and even do well.
SSE's Chao believes that investors are waiting for inflation to
decline before returning to the market with new purchases.

12. (SBU) The market's fall has also shaped investor
expectations regarding where the market's bottom might be. As
previously noted, many thought the SCI bottom would be around
3,000 due to expected government intervention at that level.
Our interlocutors noted the difficulty of predicting where the
new bottom might be, but 2,500 came up repeatedly as a best
guess. Both Haitong Securities' Wu and the JV manager noted
that at the SCI 2500 level, the P/E ratio would be near 17,
about the same level as for markets in developed countries.
SSE's Chao also noted he had spoken with foreign institutional
investors who had signaled they would begin investing again when
the market reached 2,500.

13. (SBU) Despite the downturn and poor performance in some
sectors, Chao, Fang and the financial consultant remain
optimistic about the market's performance. Chao and the
financial consultant noted that while a substantial portion of
the earnings of several companies came from financial
investments last year, earnings for many companies did not.
Chao notes that for many listed companies, performance is
actually better this year than it was last. The financial
consultant notes that in such an environment, speculators are
taking the greatest losses while fund managers are doing
considerably better. The U.S. JV manager is not so optimistic,
however. He notes that corporate profit margins are still being
squeezed by rising costs. He notes that even upstream
industries such as coal and aluminum are suffering, mostly due
to higher energy prices.

Stock Market Downturn Presents Opportunity for Reform though
Regulators Remain Reticent

14. (SBU) Several of our interlocutors noted the market's
recent downturn may present an opportunity for equity market
reform. The JV manager, the financial consultant, Fang, Wu and
Chao noted that the markets current level may make it easier for
non-tradable share reform to proceed by making it easier to
absorb additional shares. They agreed that because most holders
of non-tradable shares acquired them at negligible prices, they
will immediately sell when given the chance, driving down
prices. Given that many investors now see the market as
relatively cheap, and the relative paucity of good investments
in China's increasingly bearish markets, they believe the market
is now more ready to absorb newly tradable shares without

SHANGHAI 00000246 004 OF 004


significantly affecting current share prices. Fang, Wu and Chao
made similar arguments regarding the supply of new shares from
IPOs, noting that the China Securities Regulatory Commission
could delay the dates of IPOs.

15. (SBU) In addition to share reforms, the recent downturn
may point to the need for additional financial products. Fang
and Chao noted that introducing index futures and short selling
would allow investors to better hedge against risk, making the
markets less volatile. Chao, Fang, the JV manager and the
financial consultant emphasized the need for broader margin
trading as well, though they acknowledged the systemic risk this
may introduce and its role in the stock market's fall in 2001.
Fang noted that the absence of leverage this time may have
contributed to the lack of protests over this market downturn,
since individual retail investors' downside risks were smaller
in the absence of leverage.

16. (SBU) Prospects for these reforms are mixed. The
financial consultant said index futures are ready for launch,
but government regulators are reluctant to launch new financial
products for fear that they could be held responsible by the
investing public if introduction coincides with a further
decline in the market. DG Fang similarly opined that China's
financial services regulators are risk averse. Fang and the
SSE's Chao also noted a current SSE controversy over warrants,
the trading conditions for which some retail investors have
claimed were biased against small investors. They both believe
warrants will no longer be allowed at the SSE, and that the
controversy may only reinforce regulators' caution about
introduction of new financial products. Still, the JV manager
speculated the CSRC is probably under pressure from the SSE and
the Shanghai Municipal Government to introduce new products in
pursuit of the city's goal of becoming an international
financial services center. Chao and Fang, our interlocutors
from the SSE and the Shanghai Government respectively, are
indeed enthusiastic about the launch of new financial products.

Real Economic Impact of Shanghai Stock Market Downturn Remains
Limited

17. (SBU) Though the SSE market downturn has been substantial,
our interlocutors are quick to emphasize that the impact on the
real economy has been and will be limited. China remains a
magnet for foreign direct investment (and hot money) and China's
trade surplus remains large. The SCI decline's impact may be
most apparent in lowering demand for luxury goods, DG Fang
allowed. The JV manager echoed this view, saying he expected
auto sales in particular to decline. He predicts that Shanghai
auto dealership sales in May and June may decline 30 percent
from the April volume. SSE Research Department's Fu Hao, with
whom we met in late May, highlighted that most companies in
China still rely on bank loans and retained earnings rather than
the stock market to raise capital. Fu also noted that most
investment in the stock market is surplus savings, income earned
beyond what one had initially planned to consume and to save.
The market downturn, by our interlocutors' analyses, will
therefore not significantly affect consumer confidence outside
of luxury goods.

Investor's Reaction to Market Downturn Could Signal a More
Mature Market

18. (SBU) Despite the market's recent downturn and volatility,
our interlocutors remain optimistic about the market's future.
DG Fang noted that in the recent downturn, fewer firms went
under, a sign that listed companies have stronger fundamentals
then they had in previous downturns. He also notes that fewer
protests could be a sign that investors, especially retail
investors, are beginning to better understand the risks
associated with the stock market. The financial consultant and
JV manager expressed similar optimism that the SSE is showing
signs of becoming a more mature market through the travails it
is now enduring.
JARRETT

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