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Cablegate: Hk Economists Discuss China's Economy, Banking in China,

DE RUEHHK #4265/01 3050037
P 010037Z NOV 06





E.O. 12958: N/A

SUBJECT: HK Economists discuss China's Economy, Banking in China,
and the Strategic Economic Dialogue


1. (SBU) Summary: Hong Kong economists, bankers, and Hong Kong
Monetary Authority (HKMA) officials told Embassy Beijing
Minister-Counselor for Financial Affairs David Loevinger (Finatt)
that the rate of renminbi (RMB) appreciation would not sustain the
rate it achieved following the September visit of Treasury Secretary
Paulson and the withdrawal of the Graham-Schumer Bill, but would
remain at a modest 3-5 percent a year. Given a steady, moderate
appreciation, most of the economists thought China's external
competitiveness would continue to improve, with a large current
account surplus and speculative inflows. The People's Bank of China
(PBOC) thus will continue its large-scale sterilized intervention
for the foreseeable future. Chinese authorities should tighten
monetary conditions further (through both interest rate hikes and a
more liberalized exchange rate) said the economists, though they
noted the political constraints caused by urban/rural income gaps.
Foreign bankers reaffirmed that the China Banking Regulatory
Commission's (CBRC) requirement for foreign banks to incorporate in
order to provide RMB denominated services would not be a major
barrier to entry. On the Strategic Economic Dialogue, one economist
thought Vice Premier Wu Yi was an "interesting choice" to head the
Chinese side as she has no responsibilities for financial or
macroeconomic issues. End Summary.

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RMB Valuation, Trade Imbalances

2. (SBU) Embassy Beijing Minister-Counselor for Financial Affairs
David Loevinger, Economic Officers Patrick Chow and Byron Tsao, and
Economic Specialist Kevin Harper met with Hong Kong-based China
economists, investment bank representatives, and Hong Kong Monetary
Authority (HKMA) officials on October 5-6 to discuss China's
economy, financial sector, and the U.S.-China Strategic Economic
Dialogue (SED).

3. (SBU) Deutsche Bank economist Jun Ma thought that although China
is grateful to Treasury Secretary Paulson for his role in the
withdrawal of the Graham-Schumer legislation, China feels it has now
"given enough face" to Paulson and is unlikely to let the RMB
appreciate beyond a modest 3-4 percent per year. As a result, given
continued substantial differences in labor productivity growth
between China and the U.S. (7-8 percent for China versus 2-3 percent
for the U.S.), maintaining such a modest rate of RMB appreciation
means that export competitiveness will continue rise. As a result,
Ma predicted that Chinese export growth will continue to outpace GDP
growth, leading to rising external imbalances. Another factor
limiting the Chinese Government's willingness to allow for greater
RMB appreciation is the need to protect unskilled workers, who are
not experiencing significant productivity gains, particularly
vis-`-vis increasingly competitive and cheaper labor in Southeast
Asia. The key to reducing the current account surplus, which is 7%
of GDP, concluded Ma, is to increase import growth by cutting
Chinese import tariffs beyond World Trade Organization (WTO)

4. (SBU) Bank of International Settlements Senior Economist Ma
Guonan said he believed that the People's Bank of China (PBOC) is
holding back RMB appreciation until after the Industrial and
Commercial Bank of China's (ICBC) IPO. ICBC, like the other large
state banks, maintains a long dollar position to enhance its balance
sheet. Ma predicted that the current account surplus would shrink
noticeably next year once people finish repositioning their
portfolios in anticipation of a stronger RMB. Ma then argued that
the current account surplus may not be as large as it appears
because capital inflows, which account for an important part of the
surplus, are taking place through both over and under-invoicing of
current transactions. Furthermore, large and growing amounts of
personal remittances should actually be accounted for as investments
and not gifts. Multinational corporations also appear to be
hoarding RMB as the growth of the stock of foreign direct investment
(FDI) continues to outpace the growth of profit remittances.

5. (SBU) Julia Leung, Executive Director, External Department of the
Hong Kong Monetary Authority (HKMA), told Finatt that PBOC Governor
Zhou's comments in the Chinese finance magazine "Caijing" were an
important signal that the PBOC would soon allow for greater RMB
volatility. In the article, Zhou comments that the RMB would be
based "more on supply and demand," also signaled greater RMB

6. (SBU) Hong Kong University (HKU) Professor Geng Xiao, who will be
moving to Beijing to direct a new Qinghua University-Brookings think
tank, felt that the RMB should appreciate between 3-4 percent per

HONG KONG 00004265 002 OF 003

year to account for relative productivity differentials, and to
appreciate by even more by the extent to which U.S. inflation
exceeds Chinese inflation. Geng agreed with Jun Ma that the unequal
distribution of labor productivity growth means that rapid RMB
appreciation would hurt unskilled workers, which the government
politically must protect. Geng urged the U.S. to press for greater
liberalization of China's service sector. This would increase
productivity and lower the price of services in China, thus freeing
money that could spur an increase in imports. Unfortunately, he
concluded, Chinese ministries tend to focus on the health of firms
in the sectors they oversee and thus fail to grasp how increased
competition in protected sectors can benefit the broader economy.

Is China Overheating?

7. (SBU) Geng Xiao told Finatt that he did not see overheating as a
significant risk, as China can "grow through" asset bubbles. He also
did not think that overall investment was too high, given still-high
returns on public infrastructure investment. However, he did see
significant scope to improve the efficiency of investment,
particularly by having the National Development and Reform
Commission (NDRC) decentralize more decisions on finance to local
and provincial governments.

8. (SBU) Jun Ma cited three factors accounting for the growth in
Chinese monetary aggregates that continue to fuel the growth in
investment. In addition to foreign currency intervention due to
large balance-of-payment (BOP) surpluses, large PBOC loans to
non-bank financial firms, which Ma thought were most likely
securities firms, had been an important factor for the increase in
base money. Ma thought up to 50 percent of the loans are not likely
to be paid back. In addition, an increase in the money multiplier
was causing the growth of broad money (M2) to exceed the growth of
base money, which increased Chinese banks' loanable resources
despite PBOC's sterilization efforts. Ma continued that this
increase was driven by improvements in Chinese payment systems that
reduced the time needed to settle payments, thus reducing the need
to hold large excess reserves with the central bank.

9. (SBU) Ma expressed concern over the lack of cooperation between
the Ministry of Finance (MOF) and PBOC. The MOF tends to set the
term structure of its Treasury bills and bonds mainly to minimize
its cost of financing. As a result, it issues insufficient
short-term treasury bills, forcing the PBOC to issue its own
short-term bonds for sterilization. The PBOC is increasingly
concerned that the interest cost of sterilization bonds will lead to
net income losses and ultimately even the possibility of insolvency.
Ma continued that the strength of PBOC's balance sheet in RMB terms
is exaggerated as it does not mark to market its foreign exchange
reserves, but rather values its foreign securities at the cost
incurred at the time of purchase, including the exchange rate
prevailing at that time. [Comment: Despite statements by PBOC
officials, including from Governor Zhou to Al Hubbard on September
21, that PBOC can comfortably sterilize foreign exchange
intervention for several more years, other analysts have noted that
fiscal concerns may be limiting the extent to which the PBOC is
willing to sterilize such interventions.]

New Opportunities in Chinese Finance

10. (SBU) Several economists and financial company officials
commented on recent moves by their firms to enter the Chinese
financial services market. Standard Chartered Economist Tai Hui
said that one reason Standard Chartered established Bohai Bank as a
greenfield investment, despite their plans to expand Standard
Chartered branches in China, is that they expected that banks
classified as domestic institutions would still receive more
favorable regulatory treatment even after the implementation of
China's WTO commitments.

11. (SBU) Morgan Stanley Managing Director and COO Asia Greg Terry
told Finatt that contrary to press reports, their recent acquisition
of Nantong Bank from Bank of China Macau did not gain them a lead
over other foreign banks in obtaining a license to provide RMB
denominated services. Nantong currently has licenses to provide
foreign exchange denominated services to retail and corporate
clients. Morgan Stanley has no interest in retail RMB business;
they are seeking licenses to provide RMB services to corporate
clients and to offer derivatives. Neither the PBOC nor the CBRC
have suggested they incorporate to conduct RMB business, but Morgan
Stanley will do so if necessary, given that they do not view the
minimum capital requirements as overly onerous.

HONG KONG 00004265 003 OF 003

12. (SBU) Terry told Loevinger that CSRC Chairman Shang Fulin's
political ambitions are currently an obstacle to the opening of the
securities sector. The Chinese government has allowed three foreign
firms into the securities sector. Terry said only the UBS/Beijing
Securities model is viable; Goldman Sach's arrangement, which
involved an unsecured loan to the major Chinese shareholder, is not
replicable. Morgan Stanley's stake in CICC is purely passive; it
plays no role in running the business. He also voiced his
appreciation for Treasury's efforts to engage CSRC on this issue.

13. (SBU) Commenting on UBS' recent acquisition of Beijing
Securities, UBS Chairman and CEO for Asia Pacific Rory Tapner told
Finatt that Beijing Securities will be renamed UBS Securities
(China)and will have a comprehensive license to trade, distribute,
and underwrite A shares. For UBS, the ability to trade A shares is
key, as it is critical to their ability to distribute underwritten
shares to customers. UBS was nicely surprised to discover that
Beijing Securities had licenses to engage in wealth management,
which no other foreign banks have. Tapner said finding employment
for Beijing Securities staff was an important, and politically
sensitive, issue. UBS will keep six of Beijing Securities' 27
branches, selling 21 to China Merchants Bank. They will also retain
180 of Beijing Securities' 600 employees, with 400 moving to China
Merchants Bank. As in the other two securities sector deals
involving foreign investment banks (Morgan Stanley/CICC and Goldman
Sachs/Gao Hua), current Beijing Mayor Wang Qishan played a prominent
and critical role.

14. (SBU) On other mainland financial issues, HKMA's Leung said the
Chinese government's upcoming high-level financial meeting would
most likely take place in late October. One issue that might be
discussed is the extent of FDI in the financial sector, and in
particular, a review of allowable FDI in Chinese banks. Leung
discussed ASEAN+3 efforts to promote China's bond markets. To create
an exchange traded China bond index fund as part of the second Asian
Bond Fund (ABF2), it will be necessary to shift some of the
underlying bonds from the inter-bank bond market, regulated by the
PBOC, to the stock market, regulated by the CSRC. This will spur
greater cooperation among the regulators.

SED: Why Wu Yi??

15. (SBU) Jun Ma questioned China's choice of Vice-Premier Wu Yi to
head the recently announced U.S./China Strategic Economic Dialogue.
Ma noted that although Wu Yi covers trade issues, she has no
financial portfolio and is thus an "interesting" choice to head the
Chinese side of the dialogue. Any discussion of financial matters
would have to be passed to Premier Wen Jiabao.

16. (SBU) HKMA's Julia Leung, commenting on Wu Yi as China's
counterpart for Secretary Paulson for the SED, noted however, that
Wu Yi "can deliver." During Hong Kong's interaction with Vice
Premier Wu Yi during the Closer Economic Partnership Agreement
(CEPA), Wu shepherded various Chinese ministries to reach agreement.

17. (U) Embassy Beijing Minister-Counselor for Financial Affairs
David Loevinger cleared this report.

© Scoop Media

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