Cablegate: China Economy: Observers See Liquidity Hurting,

DE RUEHBJ #3311/01 2400558
R 270558Z AUG 08




E.O. 12958: N/A

1. (SBU) Summary: In recent meetings with visiting
Treasury Deputy Assistant Secretary Mark Sobel and
Financial Min-Couns, long-time China observers agreed on
the basic condition of the Chinese economy, but disagreed
dramatically on the likely outcomes. They agreed China's
ability to sterilize fully the liquidity generated by
protracted and large-scale foreign currency interventions
is limited and that this is fueling an unsustainable credit
boom and unbalanced growth. Further, although the Chinese
economy continues to face inflationary pressures, the
government has recently (and in their view prematurely)
shifted emphasis slightly from controlling inflation to
assisting exporters and businesses hurt by the decline in
external demand, rising input and labor costs, the
Renminbi's appreciation and credit limits. The analysts
diverged on their predictions for the future, with one
professor envisioning the possibility of a sharp
deterioration in banks' assets leading to a credit crunch,
and another analyst calculating that the Chinese economic
leadership will find a way to "muddle through" these
troubles as they have in the past. End summary.

Reserves Grow

2. (SBU) Beijing University Professor Michael Pettis
discussed the self reinforcing cycle that promotes larger
macroeconomic imbalances and ultimately could lead to
financial instability. Excessively loose monetary
policies--due to insufficient sterilization of protracted
and large-scale foreign currency intervention--leads to
more investment in production, which outpaces consumption
and then has to be exported. This increases net exports
and leads to further foreign currency intervention (given
China's rigid exchange rate), providing more money for
increased investment in production.

3. (SBU) Banking analyst Charlene Chu said the People Bank
of China (PBOC) is requiring banks to meet their reserve
requirements in U.S. dollars to limit the rise in reported
international reserves and as an alternative to sterilized
intervention (since PBOC would otherwise have to sterilize
the liquidity injected by purchases of foreign exchange).
Most banks still have excess reserves, though among the
banks, there is considerable variation. For the sector as
a whole excess reserves are nearing four percent, while
officials suggest a range of 1.5-2.0 percent is prudent,
which leaves little room for further increases in required
reserves. As such, she expects the PBOC to place more
emphasis on raising administered interest rates and/or
allowing a faster rate of RMB appreciation to tighten
monetary conditions further in the future.

Hot Money

4. (SBU) Pettis said that in 2006, at least 89% of
international reserve accumulation could be attributed to
FDI, the trade surplus, and interest earnings, with the
remainder attributable to speculative flows. He said that
by 2007 that number had dropped to 70%, and will be 39%
this year - implying that over 60% of China's net balance
of payments surplus is due to net short-term portfolio

5. (SBU) Dragonomics analyst Arthur Kroeber agreed that a
significant amount of the reserve growth is attributable to
net portfolio inflows, dismissing valuation gains and the
impact of any mark-to-market effects of the central bank's
fixed income holdings as marginal.

Policy Direction

6. (SBU) Commenting on the recent Politburo meeting to
discuss the direction of economic policies, Pettis thought
that in-fighting between the monetarists, who believe the
rise in inflation has been due to excessive growth of
monetary aggregates, and the export and real estate
interests, who have been hurt by a tightening of monetary
conditions (including through a more appreciated exchange
rate), had gotten so bad that it required top level
intervention to quell the dispute. He said the "growth
guys are back in control."

BEIJING 00003311 002 OF 002

7. (SBU) Kroeber agreed that the exporter lobby had
successfully argued they are "at their limits." However,
he characterized the increase in credit quotas and VAT
rebates in certain sectors as "pretty cosmetic," and
thought even with some minor adjustment, policymakers would
not fundamentally veer from their efforts to rebalance the
economic growth. He noted that the reduction in China's
savings-investment imbalances is made more difficult by the
fact that it still doesn't have the mechanisms in place to
increase social services significantly. But he thought
consumer spending would start to increase on its own now
that years of pent up housing demand were satisfied.

8. (SBU) Both Kroeber and Pettis noted that Hu Jintao now
had his people in place throughout provincial governments,
making rebalancing easier to implement.


9. (SBU) Kroeber said China is now facing higher
inflationary pressures, with estimated real unit labor
costs now rising after several years of decline. Pettis
thought the politically tolerable floor on inflation might
now be in the 2-5% a year range. Both agreed that Chinese
inflation would be a significant issue in coming years, and
they also both noted that the current government finds
inflation a greater risk to social instability ("scarier"
in Kroeber's words) than slower growth.


10. (SBU) Pettis was extremely pessimistic about China's
ability to maintain macroeconomic and financial stability,
stating he had a "front seat to see the whole thing
unravel." Pettis thought that weaker external demand will
prevent China from being abl to dump its excess production
abroad, leading to higher inventories, domestic dumping,
lowe profits, higher NPLs and ultimately a credit crunch
as impaired banks pulled back on lending. He also thought
high inflation was inevitable unless China broke the cycle
leading to ever-higher reserve accumulation and liquidity
growth. Pettis acknowledged that one scenario was
deflationary and one inflationary, but argued that they
would both end in a sharp rise in NPLs, a credit crunch,
and reduced growth.

11. (SBU) Kroeber, on the other hand, said he thought China
had significant "shock absorbers" in the economy, and
policy makers have significant experience in "wiggling out"
of economic challenges. He thought the current downturn in
growth was cyclical, although longer lasting than previous


12. (SBU) Both Pettis and Kroeber are known for their deep
knowledge of China and their strong opinions on its
future. In truth, China does have some serious structural
problems that it has to address, including the
over-reliance on investment, and the excessive liquidity
and credit growth fueled by a large balance of payments
surplus and a rigid exchange rate. Chinese economic
advisers and policymakers are very aware of these issues,
and are seeking to promote a slow reduction in imbalances
that keeps economic adjustment at a politically acceptable
pace. Kroger and Pettis highlight how an slow and cautious
approach increases the risks of more disorderly future
adjustments. However most observers, both inside and
outside the Chinese government, agree with Korber that,
short of a major unanticipated shock, the Chinese have the
will and the resources to avoid systemic financial


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