Cablegate: Shanghai Market Participants Discuss Hot Money: Market

DE RUEHGH #0264/01 1960840
R 140840Z JUL 08




E.O. 12958: N/A

1. (SBU) Summary. Shanghai market participants agree, hot
money presents a serious challenge for Chinese monetary policy.
With sterilization bills becoming increasingly costly to issue
and reserve requirement ratio (RRR) increases hurting the
profitability of an already constrained banking sector, there
are few good options for controlling liquidity. Instead of
tightening monetary policy, our interlocutors in Shanghai and
nearby suggest the Central Government will continue to try to
restrict hot money using administrative measures to control
inflows through the current and capital accounts. Our
interlocutors expressed confidence that capital and financial
account controls would be effective, though they were less
confident regarding current account controls. Some felt newly
adopted measures combining the monitoring capabilities of three
government agencies would be sufficient, though others expressed
skepticism. Our interlocutors also opined that hot money would
not affect RMB appreciation. They note structural changes in
the macro-economy, such as the shift from export-oriented growth
to growth driven by domestic consumption, necessitating a
market-determined RMB exchange rate. End Summary.


2. (SBU) Congen Econoff from June 19 to July 11 met with
Shanghai financial market participants and macroeconomic
analysts to discuss issues relating to hot money. Meeting
participants include Fudan University Professor Sun Lijian,
Shanghai Academy of Social Sciences (SASS) Economist Xu Mingqi,
PBOC Shanghai Head Office International Department Deputy
Director-General Shi Liya, Hong Kong Trade and Development
Council Regional Director for East China Brian Ng, Fortis
Haitong Investment Management Analyst Zhu Mingjie, Taiwan
Compatriot Investment Enterprises Association of Kunshan Deputy
Chairman Huang Jiangzhong, and a general manager of a U.S. joint
venture securities firm in Shanghai.


3. (U) Since China adopted its present exchange rate mechanism
in July 2005, the RMB has appreciated 21.1% against the U.S.
dollar (as of July 11, 2008). In the last 6 months, the RMB
appreciated 13.4%, with an average appreciation of .05% per day.
As of July 11, one year forwards imply an annual appreciation
of 5.6%. The large expected appreciation of the RMB versus the
dollar as well as a favorable interest rate spread with the U.S.
has caused a large amount of speculative capital, commonly
referred to as hot money, to flow into China. The exact amount
of hot money coming into China is difficult to discern, though
most analysts agree it has grown substantially since the
beginning of 2008. For example, analyst Logan Wright at Stone
and McCarthy estimates China's FX reserves grew by $393 billion
USD in the first five months of 2008, of which he estimates up
to $170 billion was hot money.

--------------------------------------------- --
Most hot money coming in through FDI,
Current account and bank deposits
--------------------------------------------- --

4. (SBU) According to a survey done by Deustche Bank analyst
Ma Jun, appearing May 28 on China financial website Caijing,
foreign direct investment (FDI) is the most popular means of
increasing RMB exposure by firms outside of officially
sanctioned foreign exchange markets. A Shanghai-based American
management consultant and investor told Econoff in late May,
foreign firms attempt to attain approval for investments larger
then the specified projects require, using the onshore surplus
funds derived thereby to make portfolio investments. Huang
Jianzhong, the Taiwan business association leader in Kunshan
(just west of Shanghai, across the border in Jiangsu Province)
readily admitted in a June meeting that Taiwan companies
frequently use this channel. Huang asserts that such investment
transactions are entirely legal, so long as investments are
approved by the appropriate mainland officials.

SHANGHAI 00000264 002 OF 004

5. (SBU) Huang in Kunshan and other interlocutors also note
companies use the current account, that is under-invoicing
imports or over-invoicing exports, as a means of acquiring and
retaining RMB. Huang notes the ubiquity of this practice among
firms engaged in trade. According to Deutsche Bank analyst Ma
Jun's above-referenced survey, trade invoice manipulation and
the FDI channel account for 73% of hot money transactions made
by firms. Fudan University Economics Professor Sun Lijian notes
that trade invoice manipulation is also a common means for
foreign companies to avoid mainland regulations meant to slow or
prevent profit repatriation.

6. (SBU) The most common means for individuals to increase
exposure to RMB appreciation is offshore transfers to RMB
accounts. Huang and HKTDC's Ng observe many Taiwan and Hong
Kong individuals use this tool to increase RMB exposure. China
permits only one bank account per person and limits transfers to
$50,000 USD per year, with holders of Hong Kong bank accounts
allowed to transfer up to 10,000 RMB per day, these
interlocutors explain. The JV manager points out several Hong
Kong banks with presences in the mainland now offer their
customers services in which daily transfers into the mainland
are automated. Our interlocutors note popular press accounts of
people from Taiwan and Hong Kong using the unused quotas of
friends and relatives to make even larger transfers. Ng
suspects that growing concern over inflation may lead the
government to eventually lower these quotas.

7. (SBU) Huang and Ng say both Taiwan and Hong Kong firms as
well as individuals also use underground banks to convert
currency. Ng suspects this channel is used more often than the
RMB account quotas. Fudan Professor Sun asserts Taiwan firms
are heavily involved in China's underground financial market.
He observes many have been in China for nearly two decades and
have had more time to build up liquidity than firms which have
entered more recently, such as those who did not venture into
China until after China's December 2001 accession to the World
Trade Organization. With exports losing competitiveness and
declining due to an appreciating currency, higher fuel and raw
material prices and increasing labor costs, (issues worriedly
mentioned by Huang, the Taiwan business association leader, and
HKTDC's Ng), these longer-established firm are using their
accumulated liquidity to provide loans to other firms, providing
an alternative source of income for China's cooling export
sector. Ng and Huang note many small and medium exporting firms
are also increasingly aiming their production and sales at
China's domestic market, again seeking payments in RMB and
foregoing immediate repatriation of profits.

--------------------------------------------- -
Most hot money sitting in bank accounts,
though substantial amounts may be entering
through underground capital markets
--------------------------------------------- -

8. (SBU) As previously noted, hot money is difficult to track,
with analysts not even sure how much hot money is actually
entering China. Determining where hot money is being invested
is even more difficult. Our interlocutors cite real estate as a
destination, though they add with softening markets and ever
higher hurdles placed on foreign investment, it is unlikely much
more is going there now. The most popular destination now, they
suggest, is normal liquid bank accounts. Ng notes that with
modest interest rates and expected appreciation of over 6%
annually, investors can earn a near risk-free 10% annual return
on their investments. PBOC Shanghai's Shi and the American JV
manager similarly suggest that most inbound hot money is
probably sitting in onshore bank accounts.

9. (SBU) Fudan's Sun also suggests another popular destination
for hot money is the informal banking sector, which has gained
new life in the current tight credit environment. A recent
published survey by Professor Li Jianjun at Beijing's Central
University of Finance and Economics estimates that 28% of all
bank loans in China come from the underground banking sector.
Our Shanghai interlocutors note that most underground banking
sector loans probably go to small and medium enterprises, which

SHANGHAI 00000264 003 OF 004

are not able to obtain loans from the larger state owned
commercial banks in the present credit environment.

--------------------------------------------- -
Left with few options, government is confident
administrative measures will work
--------------------------------------------- -

10. (SBU) China's "managed float" exchange rate regime forces
it to sterilize foreign currency inflows to prevent expansion of
the money supply. With the high volume of inflows lately,
sterilization has become increasingly difficult. PBOC
Shanghai's Shi admits the PBOC's main tool, sterilization bills,
are becoming increasingly costly to issue, with financial
markets already saturated with bills from previous
sterilizations. Fortis Haitong's Zhu and Fudan's Sun note that
increasing the reserve requirement ratio (RRR) is a much easier
means of sterilization. Zhu notes this is one of the few
effective means the PBOC has to contract liquidity, and expects
more RRR increases to come. Sun is quick to point out, however,
that current high or future higher RRRs could pose a serious
risk for the banking sector if faced with a sudden demand for
liquidity. He thus warns that the government must be careful
when using RRR as a tool for managing the money supply. While
PBOC Shanghai's Shi did not express the same level of concern as
Sun over the RRR, she did suggest the PBOC would use a
combination of tools to address over liquidity, possibly
including raising interest rates.

11. (SBU) Our interlocutors offered different opinions
regarding their expectation of government policies for dealing
with inflation from over liquidity. SASS economist Xu believes
that the government will use price controls in the near term to
lower the CPI, removing some of the inflationary pressure from
over liquidity. He suggests China's central planning legacy
makes Chinese officials more comfortable with price controls
then other measures. Fudan's Professor Sun however, believes
the government will utilize quantitative restrictions as a means
of controlling over liquidity. He notes that the Central
Government has stepped up monitoring of current and capital
accounts, integrating the networks of SAFE, the Ministry of
Commerce and General Administration of Customs. By valuing the
goods in customs transactions and comparing those values to
payment amounts, PBOC could effectively control hot money
entering or leaving through the current account, and help hedge
against the possibility of capital flight were a financial
crisis to occur. Shanghai PBOC's Shi echoed this point, though
she admitted implementation at the local level would be
difficult. Ng was less confident that such an approach would
prove to be effective. He notes trade in services continues to
increase. Services transactions are much more difficult to
value then goods transactions, lacking a tangible good for SAFE
to value. Services trade could thus become a prominent loophole
for avoiding SAFE controls on hot money.

Hot - and sticky?

12. (SBU) The American JV manager suggests the government may
have more flexibility in managing hot money than many expect.
He believes that since most hot money is probably coming from
Taiwan, Hong Kong and overseas Chinese elsewhere (a point echoed
by our other interlocutors), hot money is less likely to rapidly
flow out of China as it did in SE Asia during the 1997 Asian
financial crisis, as these people will still require liquidity
to support business operations in China. This, in his words,
makes the hot money inflows into China "sticky." Though
stickiness may lower the risk of capital flight, it will not
help contain liquidity growth which poses risks for persistently
high inflation.

--------------------------------------------- -
Interlocutors suggest hot money will not
slow RMB appreciation
--------------------------------------------- -

13. (SBU) Fudan's Professor Sun does not believe the hot money

SHANGHAI 00000264 004 OF 004

issue will have any significant effect on the RMB exchange rate.
Instead he expects administrative measures will be sufficient
to control hot money, while other tools can be used to combat
over liquidity. Shi and Zhu similarly argued that over
liquidity and capital flight could be targeted using policies
other than RMB appreciation. HKTDC's Ng agrees, noting that in
order for Shanghai to attain its goal of becoming an
international financial center, China must first have a freely
floating exchange rate. SASS's Xu, however, believes the
current level of hot money inflows is unsustainable,
necessitating a slowdown of the RMB's appreciation until
inflation comes down.

14. (SBU) Despite acknowledging risks of gradual RMB
appreciation, our interlocutors were skeptical of a one-off
appreciation, even though such an action might immediately stem
inflows. Xu notes the damage a one-off appreciation would
inflict on many exporters, who keep many urban workers employed.
Sun echoes this point, adding most export firms are not
financially hedged against appreciation. Sun notes that onshore
RMB forwards exist, but they remain prohibitively expensive for
most firms and relatively underdeveloped. He adds that because
many firms have known only a fixed exchange rate for so long,
they do not know how or realize the need to hedge against


15. (SBU) These Shanghai market participants and analysts
expect the PBOC will continue to follow a gradual RMB
appreciation policy, despite concerns over hot money and over
liquidity. PBOC Shanghai's Shi and Fudan Professor Sun framed
this as part of a broader structural change national policy
makers are trying to promote, namely the transition from
export-driven growth to growth driven by domestic consumption,
hence the importance of continuing RMB appreciation despite
other monetary challenges. RMB appreciation, ignoring the hot
money aspect, is also consistent with PBOC's effort to fight
inflation, they averred. In sum, these interlocutors expect
that for now, the PBOC is likely to continue to rely on RRR
hikes and sterilization to remove liquidity, even though the
cost of sterilization continues to rise.

16. (SBU) Administrative measures also figure prominently in
these interlocutors' expectations about government policy,
particularly as a means of controlling inflows. Professor Sun
was the most confident administrative measures would be an
effective method of controlling liquidity growth. Other
analysts, however, have expressed strong skepticism that with
such large volumes of trade, China will be able to control the
current account, and as Ng notes, services will likely remain a
large loophole. Though administrative measures would likely
slow liquidity growth to a degree, they come with the
externality of further empowering an unregulated and inefficient
underground capital market, which may ultimately render such
measures ineffective.

© Scoop Media

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