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Cablegate: South China Financiers Prepare for China's First Real

VZCZCXYZ0000
RR RUEHWEB

DE RUEHGZ #0685/01 3260931
ZNR UUUUU ZZH
R 210931Z NOV 08
FM AMCONSUL GUANGZHOU
TO RUEHC/SECSTATE WASHDC 0013
INFO RUEHGZ/CHINA POSTS COLLECTIVE 0005
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC 0003
RUEATRS/DEPT OF TREASURY WASHINGTON DC 0003
RUEAIIA/CIA WASHDC 0005
RUEKJCS/DIA WASHDC 0005

UNCLAS GUANGZHOU 000685

SENSITIVE
SIPDIS

STATE PASS USTR CHINA OFFICE


E.O. 12958: N/A
TAGS: EFIN SENV ECON PGOV CH
SUBJECT: South China Financiers Prepare for China's First Real
Financial Crisis in Thirty Years

REF: A) GUANGZHOU 214, B) GUANGZHOU 398

(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: The withdrawal of inter-bank credit lines to
foreign banks following Lehman's collapse was largely due to
bankers' concerns about increased counter party risks, according to
south China bankers. They told Financial Minister Counselor
Loevinger that regulators did not explicitly instruct Chinese banks
to reduce exposure, but implicitly signaled concern by asking for
daily reports of exposure. Financiers are preparing for an extended
economic downturn, described by one contact as the first "real
financial crisis" since China adopted its reform and opening policy
30 years ago. Given excess production capacity among many borrowers
and the worsening outlook for borrowers' sales and profitability,
bankers expect lenders to be increasingly reluctant to lend and
borrowers to be increasingly reluctant to incur additional debt.
The recent lifting of credit controls and reduction in reserve
requirements and interest rates won't be effective in overcoming
this reluctance. They expect non-performing assets to rise
(particularly to small and medium-sized private exporters) and bank
profits to fall next year. While they expect local officials to
pressure banks to support enterprises in isolated cases, they do not
anticipate systemic moral suasion to prop up unviable enterprises.
End summary.

Stability is Key
----------------

2. (SBU) In a recent meeting with Financial Minister Counselor David
Loevinger, China Merchant's Bank (CMB) Executive Vice President
Zhang Guanghua said inter-bank lending in recent weeks had "mostly"
returned to normal for the first time since they were suspended
immediately after Lehman's collapse. (Comment: Some foreign banks
report that they still have difficult getting RMB credit from
Chinese banks.) He said that the withdrawal of inter-bank credit
lines to foreign banks had been largely due to bankers' concerns
about increased counter party risks. Regulators did not instruct
Chinese banks to reduce exposure, but instead signaled concern by
asking for daily reports on such exposure, according to Zhang.

3. (SBU) Zhang said his bank had suffered direct Lehman bond losses
of approximately USD 70 million and losses of 20 percent on its
approximately USD 1 billion in holdings of fixed income and equity
of U.S. financial institutions. However, he emphasized that CMB was
less exposed to U.S. assets than China's biggest banks. He praised
U.S. government efforts to stabilize financial markets.

4. (SBU) Before Lehman's collapse, Zhang had expected the financial
crisis to be over in one to two years, but he now expects a longer
period of weak growth. He said the "panic" in financial markets
appeared less threatening now, however, his bank was preparing for
difficult conditions in the near and medium term, citing the
slowdown in China's export growth and real economy. China's top
banks (China Merchant's is the sixth largest) have set aside a total
of RMB 15 billion (approximately USD 2.2 billion) for possible
write-downs, according to Zhang.

5. (SBU) Guangdong Development Bank (GDB) President Michael Zink
described a recent meeting he had with local officials in
Guangdong's coastal city of Zhanjiang where Communist Party leaders,
sugar factory owners and representatives of local sugar cane farmers
pressed GDB to provide interim financing to pay for harvesting and
processing of the current crop. They pressed him arguing that such
financing would prevent disgruntled sugar cane farmers from "burning
down government offices." Zink speculated that few such meetings
end as this one did because, in this case, the bank was represented
by a non-Party member. GDB agreed to provide financing only after
the government identified buyers for this year's crop, but without
committing to incur losses to support the area's largest sugar
company or sacrificing the bank's fiduciary duty to shareholders.

Predictions of an Extended Economic Downturn
--------------------------------------------

6. (SBU) Vice CEO of Shenzhen Stock Exchange (SSE) Dai Wenhua
predicted an extended downturn, amplified by slowing export growth
and declining real estate values in south China. Dai said this was
the first "real financial crisis" to seriously impact China since
the country adopted its reform and opening policies 30 years ago.
New initial public offerings ceased in October as central government
regulators stopped authorizing new listings, and the

long-anticipated launch of a new SSE board for small companies now
appears indefinitely postponed until market conditions improve (ref
A). In addition, Dai said Chinese qualified domestic institutional
investors (QDII - those who bought foreign securities via licensed
mainland dealers) had seen their investments drop by an average of
40 percent, spurring many calls from upset investors, and a possible
area of concern for government authorities concerned about broader
social stability. Dai also expects a slowdown in the development of
Chinese derivative markets.

Inherent Contradictions in PRC Responses
----------------------------------------

7. (SBU) Shenzhen Development Bank (SDB) President Frank Newman said
south China's current economic difficulties, and the options
available to prevent greater damage, were hampered by structural
weaknesses in the domestic financial system. Weak and
over-regulated equity markets, as well as under-developed bond
markets, mean that bank loans are the only real source of financing
for struggling companies, especially small and medium sized
enterprises (SMEs) (ref B). Although the government has eliminated
lending caps and encouraged banks to step up lending, neither the
government nor banks are willing to accept additional risk given
concerns about excess production capacity among many borrowers and a
deteriorating outlook for demand for manufacturers' products. As a
result, China's recent interest rate cuts are unlikely to spur
lending, according to Newman. He also expressed concern that the
government had cut lending rates more than deposit rates, thus
squeezing banks' intermediation margins at a time when
non-performing assets were expected to rise and put downward
pressure on profitability.

Continuing Risks for Banks
--------------------------

8. (SBU) Each of the three bankers expects a rise in non-performing
loan ratios as growth slows, particularly among private SME
exporters. The biggest banks will also face lower fee-based
earnings as local investors trade fewer mutual funds and other
equity-related financial products due to the weak stock market.
Less systemic threats include property-related lending schemes that
some property developers and wealth management firms used to
circumvent lending quotas. In one scheme, property developers would
threaten their banks with default unless the bank agreed to extend
favorable mortgage terms to home buyers. In other cases, funds of
banks' wealth management clients were channeled to trust companies
who then made an "equity investment" in property developers with "a
guaranteed return" (thus allowing banks to circumvent loan limits).
Even though these assets and liabilities are off balance sheet,
reputational risks could force banks to make their best customers
whole in case of losses. Thus, as a result of these and other
possible schemes, banks' actual exposure to the property sector was
higher than senior management had thought.

Unrealized Opportunities?
-------------------------

9. (SBU) SDB's Newman suggested that the lack of exotic and
sophisticated financial products insulated many of China's banks
from the worst problems seen in U.S. and E.U. institutions. At the
same time, the role of these products in the crisis may make it more
difficult to convince China's regulators that continued innovation
in financial products like derivatives is in the country's best
interests.

10. (SBU) One banker told us that the lack of merger and acquisition
activity between medium and small Chinese banks is an unrealized
opportunity. He said several of the strongest city banks would be
excellent takeover candidates for strong regional banks like SDB and
GDB. He theorized that the absence of these transactions might
indicate a prevailing aversion to such deals by local officials,
especially when viewed in comparison to the recent pace of PRC banks
taking over competitors in Hong Kong and Macau.

Comment: Hard Times, But Not Impossible
---------------------------------------

11. (SBU) With high exposure to the export sector, bankers in south
China are generally more concerned than their colleagues in other
regions about the short and medium-term outlook. This exposure
primarily takes the form of loans to small and medium-sized private
exporters, which are less likely to gain direct government support
than home mortgages or loans to real estate developers. However,
each contact expressed optimism that his institution would weather

the downturn and continue to remain profitable, albeit with greatly
reduced profits. Interlocutors were cautiously optimistic that
although local government officials would press banks to help
struggling businesses to maintain employment and ensure social
stability in isolated cases (particularly as these local governments
have been forced to compensate workers of bankrupt firms for unpaid
wages), regulators would not force banks to prop up unviable
enterprises to a systemic extent, as during previous severe cyclical
downturns. Such an approach would undermine the longstanding
efforts of both senior bank management and regulators to turn
China's banks into more commercially oriented enterprises.

JACOBSEN

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