Cablegate: Frb Senior Economist Ahmed's Visit to Shanghai

DE RUEHGH #0370/01 1690439
R 180439Z JUN 07





E.O. 12958: N/A

This message is UNCLASSIFIED as defined by E.O. 12958

(U) This cable is sensitive but unclassified and for official
use only. Not for distribution outside of USG channels.

1. (SBU) Summary: During his June 6-7 visit to Shanghai,
visiting Federal Reserve Board (FRB) Division of International
Finance Emerging Market Economies Section Senior Economist
Shaghil Ahmed met with a cross-section of Shanghai economic
experts and officials in the banking, securities, and real
estate sectors. He attended a speech by Shanghai Municipal
Government Financial Services Office Deputy DG Fang Xinghai on
prospects for financial deregulation in China. He discussed
Shanghai's stock market and related issues with Shanghai Stock
Exchange (SSE) Executive Manager of Global Business Development
Department Chao Kejian (aka George). Research Works consulting
head Hugh Peymann discussed the growing influence of Chinese
consumerism. McKinsey and Company China Principal Wang Yi
outlined the general health of China's banking system. Jones
Lang LaSalle Senior Manager Kenny Ho and Cushman Wakefield
Managing Director Kim Clarkson briefed Ahmed on developments in
China's real estate sector. End Summary.

--------------------------------------------- -----
China Needs Foreign and Private Help to Deregulate
--------------------------------------------- -----

2. (U) At a June 6 luncheon for about 150 participants organized
by AmCham Shanghai's Financial Services Committee, Shanghai
Financial Services Office DDG Fang Xinghai said that the Chinese
government needed to take three steps to reform its financial
services sector: (1) open the financial services sector for
private domestic firms; (2) open the market for foreign
financial firms; and (3) relax regulatory controls.

3. (SBU) Fang said that the reason there were so few private
domestic financial service firms was that Chinese regulators
lacked the capacity to effectively regulate. Regulations were
either overly restrictive or inadequate, creating a difficult
environment for private enterprise. Chinese politicians also
had ideological antipathy towards the financial sector. He
quoted Deng Xiaoping's remarks that the financial sector was the
heart of a modern economy. The government was reluctant to open
up the sector too fast for fear that it would get too strong.

4. (U) Fang said that under China's WTO and SED commitments,
foreign financial firms were "making good progress." The
banking sector, which had benefited from strong WTO commitments,
should be a model for reforming other financial services. Local
incorporatization of foreign banks was a very good step in
increasing competition for Chinese banks. And foreign banks
were doing well. In the first four months of 2007, loan
portfolios of foreign banks in Shanghai had increased 32
percent, compared to an 11 percent increase for domestic banks.
Foreign banks in Shanghai now accounted for 15 percent of the
total loan portfolio, although they represented only about two
percent nationwide.

5. (SBU) The insurance sector was relatively well-regulated and
the SED appeared to have broken the logjam in approvals by the
China Insurance Regulatory Commission (CIRC) for wholly-owned
subsidiaries in the property sector. The securities sector was
not well-regulated or open, in part because there had been few
WTO commitments. Although the Chinese government knew it needed
to open up its market, it would do so slowly so that its
domestic players would have time to adapt and adopt foreign
techniques. The purpose of foreign competition was not to
benefit the foreign firms; it was to strengthen the Chinese

6. (U) Fang stressed that bilateral or multilateral negotiations
were the best means to effect financial sector reforms. He said

SHANGHAI 00000370 002 OF 005

"innovative back-door" approaches might benefit a firm
initially, but could lead to unforeseen consequences down the
road. The Strategic Economic Dialogue (SED) provided an
excellent forum for both the United States and China to advance
their own agendas but it would be important for both sides to
make commitments.

7. (SBU) Fang said the progress made in the SED was
"encouraging," but not enough - and was too one-sided with the
Chinese side seemingly making all the concessions. For
political reasons, it was important that both sides make
concessions - even if China's reforms would benefit China as
well as the United States. China ultimately was concerned with
securing access for its manufactured products. "China needs a
trade surplus to grow, he said. "China needs open markets in
other countries. Other countries have a right, as well, to
demand that China open up its services sector." "China's
underdeveloped service sector is already hurting its own
growth," he said. Along these lines, Fang thought that opening
up the SED to include Japan and the European Union might be a
good idea since those economies' firms would benefit from
concessions made to the United States.

8. (SBU) Fang said that there were three reasons for tight
regulations in China:

- Regulators were rarely responsible for the effects of
regulations that they enforced. Regulations also were a form of
power, and many often gave in to the temptation to abuse it.

- Chinese financial firms had no effective internal risk
controls. Regulators, who must approve all new products and
innovations before they can be implemented, had thus been very
conservative. If a regulator approved a new product, and there
were problems, he would be blamed. Thus, there was no incentive
to approve innovation.

- The rapid growth over the economy for a long period of time
had concealed lots of structural problems. When everything was
going well, these problems were not visible. When the economy
slowed down, they would become more painfully obvious. Tight
regulations inhibited innovation and the economy needed
innovation to grow. But so far, no one had complained.

9. (U) Fang said that the government should encourage private
financial service firms -- both foreign and domestic -- to
expand in China. These firms had a strong incentive to make
money and thus were required to be innovative. They also tended
to have better internal risk controls, which should give
regulators more confidence and lead to better and more effective

10. (U) Fang noted that during Premier Wen Jiabao's recent visit
to Shanghai, he had held a meeting with government agencies
responsible for financial services. Wen emphasized that China's
central government continued to support Shanghai's development
into an international financial center and explicitly instructed
Shanghai's municipal leaders to speed up the process. He also
told them to contact him directly to solve any policy roadblocks
that stood in the way of accomplishing this goal.

--------------------------------------------- -
Shanghai's Stock Market Is Not China's Economy
--------------------------------------------- -

11. (SBU) SSE's Chao, also on June 6, acknowledged that the
SSE's Composite Index was not representative of China's economy.
He did note, however, that the equity market over time had
become increasingly more representative of the economy. Chao
said the market capitalization of the SSE had increased from 18
percent of China's GDP in 2003 to about 80 percent of China's
GDP in 2006. Total market value of Chinese equity market,

SHANGHAI 00000370 003 OF 005

recently, was RMB 15 trillion (USD 1.97 trillion).

12. (SBU) Despite this high market cap, however, Chao pointed
out that only about 1/3 of the total shares on the SSE were in
the "tradable" category. Although the non-tradable share reform
process was basically complete, these shares had largely not
entered the market due to required holding periods. Chao also
noted that the majority of Chinese blue chip companies
(sometimes referred to as "red chips") were not listed on the
SSE. Some were listed on the Hong Kong or New York stock
exchanges; some were not listed at all.

13. (SBU) Chao said that there were four factors driving the
recent gains in the stock market: 1) the success of the
non-tradable share reform; 2) the expectation of continued
strong RMB appreciation; 3) high inflation risks that depressed
bank savings; and 4) the lack of any other investment channels
besides property. Furthermore, Chao laughed, "Chinese people
love to gamble" and this had caused a great deal of speculative
investing in the equity market.

14. (SBU) Chao said that the best way to cool the market was to
increase the numbers of listed companies. The SSE had lobbied
the China Securities Regulatory Commission (CSRC) to allow more
blue chips listed in overseas market to be listed in the A share
market. But, increasing supply took time since companies needed
to jump through so many regulatory hoops to list.

More Shareholders Than Party Members

15. (SBU) Chao said that there were over 100 million individual
share accounts and less than 1,000 institutional share accounts
in China. The peak record for the daily new account opened was
350,000, set this month. He noted that there were more trading
account holders than Communist Party members, which he estimated
at about 70 million, although he noted that many Party members
were stock owners as well. Currently, retail investors owned
about 80 percent of market value while institutional investors
owned about 20 percent. Chao speculated that mutual funds
companies controlled about RMB 500 billion of the total market
capitalization. Of the 100 million open trading accounts, only
one third were active; with active defined as at least one trade
per week.

16. (SBU) Chao said that a great number of investors were very
angry with the SSE, since SSE had changed its circuit breaker
trading rules on June 4 and 5 without any notice. According to
these rules, trading of shares that had declined or advanced by
the maximum 10 percent per day over two days (down total of 20
percent) would be halted during the first four hours of trading
on the third day. Also, any share that increased or decreased
by 10 percent from its closing price the day before would be
closed for trading on that day. Chao said that, under CSRC
pressure, the SSE did not enforce this rule on June 4 since this
would have meant that more than one third of its shares wouldn't
trade. Some share owners had been caught off guard by this
change in policy and SSE's legal office had been getting phone
calls from investors planning to sue. This sort of problem, he
commented, was caused by the fact that few high-level government
officials understood the equity market and its rules.

--------------------------------------------- -------------
Chinese Now Confident Enough in Future to Become Consumers
--------------------------------------------- -------------

17. (SBU) In a separate meeting on June 6, Research Work's
Peymann observed that China's consumers were increasingly
confident about their future. He said that in the 1980s and
1990s as the cradle-to-grave social contract with the government
and state-owned enterprises had fallen apart, people began to

SHANGHAI 00000370 004 OF 005

pour their earnings into precautionary savings. They were
afraid of the future and the uncertainty it then held. The
success of China's economic transition to a more market-oriented
economy and its continued year-on-year growth had reduced
Chinese people's uncertainty about the future. With time,
people would feel the need to save less and ultimately would
consume more. Chinese people now wanted to enjoy the benefits
of the booming economy.

18. (SBU) Household expectations were now what controlled the
economy; not the government. Chinese individuals now had more
choices and more money than they had ever had in China's
history. He expected that China's individual savings rate would
decline as people spent money and took on more debt to finance
their purchases of "luxuries."

19. (SBU) While this was good for the economy, Peymann said, he
was less sanguine about what this meant for China's ability to
increase its energy efficiency and decrease its environmental
degradation. The polluting and energy intensive industries,
such as steel, cement, plastics, automobile, textiles, were the
same ones that needed to keep producing to make the things that
Chinese consumers wanted to buy, like houses, cars, clothes,
televisions. The government could, by fiat, rein in these
polluting, energy intensive industries, but then would face a
strong backlash.

--------------------------------------------- ----
China Uses Foreign Banks to Improve Chinese Banks
--------------------------------------------- ----

20. (SBU) McKinsey's Wang told Ahmed on June 7 that based on
McKinsey's experience, the published data and statistics on
China's banks were a fairly accurate reflection of reality and
China's banking system was currently healthy. Chinese banks had
not, however, been able to change their business model from one
of taking in deposits from individuals and lending to large
state-owned enterprises. They were dependent on the fixed
interest rate spread and not ready for competition or interest
rate deregulation - or a downturn in the economy or collapse of
the stock market.

21. (SBU) All of China's banks appeared to operate under the
underlying assumption that economic growth would continue as it
has for the past several years. They had not factored in any
risk to their loan portfolios. So while current non-performing
loans (NPLs) were low, an economic downturn would quickly
reverse this trend. Chinese bankers lacked the experience and
know-how to conduct proper risk analysis of companies and so
were unable to evaluate loans to small- and medium-sized
enterprises. Fundamental to these bank's calculations was the
implicit understanding that the government would never allow
banks to fail, said Wang.

22. (SBU) Wang said that China has allowed foreign banks into
China not to benefit foreign companies, but to strengthen their
own banks. Central Government policymakers aimed to introduce
just enough competition so that Chinese banks would be spurred
to improve without being overwhelmed. Foreign competition
educated Chinese bankers and helped them to adapt. Wang said
that the Chinese government generally believed that "foreign
investors have been positive agents for change." Nevertheless,
China would not fully open up to foreign banks until Chinese
banks could compete.

Real Estate: Building for the Rich

23. (SBU) According to Jones Lang LaSalle's Ho and Cushman &
Wakefield's Clarkson, China's real estate market was healthy and
booming despite the government's best efforts to rein it in.

SHANGHAI 00000370 005 OF 005

One major issue the government faced in understanding the market
was determining what constituted "affordable housing."
Government statistics on income did not include any of the
wealth effect caused by capital gains in the real estate or
equity markets. Furthermore, private enterprises underreported
salaries in order to avoid taxes. This led to the market
appearing to have been priced out of average people's reach, and
yet continuing to grow.

24. (SBU) While industrial, commercial, and residential property
prices had risen in Shanghai and Beijing, Ho said, there was a
great deal of development taking place in China's secondary
cities. China was on track to urbanize 250 million people over
the next 10 years. The government hoped to stimulate the
development of other cities. The ideal size for Shanghai was no
more than 25 million people. Clarkson said that there was
incredible demand for commercial space in Shanghai and that
rents were rising. Vacancy was 5 percent, below the ideal
level. While there was a lot of building going on now that
would be opening in two to three years, this was desperately
needed as Shanghai developed as China's services capital.

25. (SBU) Ho said that the government's policy restricting 70
percent of all new housing units to 90 square meters or less was
not being enforced at the local level anywhere in China. While
most developers were continuing to mainly build high-end units
in Shanghai, there were still not enough luxury apartments to
meet demand. Sales prices in Shanghai for high-end apartments
were roughly RMB 80,000/square meter (USD 978/square foot) while
low-end units sold for about RMB 15,000/square meter (USD
183/square foot). There was also insufficient low-income
housing, but developers were not generally building this.

26. (SBU) Foreign real estate service companies, in contrast to
financial service companies, had no special government
restrictions on their operation in China. Clarkson noted that
both Cushman & Wakefield and Jones Lang LaSalle were
wholly-owned foreign enterprises that had operated in China for
more than 10 years. Capital account controls had not been a
problem for Cushman & Wakefield, said Clarkson, since due to its
growth his company had been plowing all of its earnings into
development in China.

27. FRB Senior Economist Ahmed cleared on this cable.

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