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Cablegate: China/Economy/Currency: Concerns About Economy,

DE RUEHBJ #4549/01 3510457
P 160457Z DEC 08




E.O. 12958: N/A


1. (SBU) Summary: In meetings with visiting Fed Governor
Warsh, Chinese researchers and bankers expressed concern
that the U.S. economic downturn would become a protracted
recession. They worried about the impact on ChinaQs
economy, and expected problems such as rent-seeking and
corruption to spring from ChinaQs plans to stimulate
growth through fiscal and monetary measures. Central
bank officials continue to affirm that Chinese financial
institutions are not experiencing liquidity problems, and
stressed that despite the recent depreciation of the RMB
there had been no fundamental change in exchange rate
policy. ICBC notified of its desire to buy a controlling
stake in a California-based bank. End Summary.

2. (SBU) On December 3, 2008, Federal Reserve Bank
Governor Kevin Warsh met with Development Research Center
(DRC) Director Xia Bin, China Securities Regulatory
Commission (CSRC) Vice Chairman Yao Gang, PeopleQs Bank
of China (PBOC) Vice Governor Yi Gang, Industrial and
Commercial Bank of China (ICBC) Chairman Jiang Jianqing,
China Banking Regulatory Commission (CBRC) Chairman Liu
Mingkang, and Bank of Beijing Executive Directors Bruno
Houdmont and Bashar Samra (representatives of ING
detailed to BoB). Discussions focused mainly on the
causes, impact, and policy responses to the current
global financial crisis, and related concerns including
bank liquidity, economic reform, and exchange rate

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Rising Concern about the Global Economy . . .

3. (SBU) Chinese banking and government officials
expressed concerns that the U.S. financial crisis would
lead to a protracted and severe U.S. recession. Most
interlocutors viewed the Chinese economyQs prospects as
closely tied to the U.S. economyQs and thus pressed Warsh
for his views on when the U.S. economy would recover.
CSRC Vice Chairman Yao expressed concern about the
impact of deteriorating U.S. consumer credit on financial
stability and household consumption. Yao was also
interested in the current debate on and prospects for
reform of the U.S. financial regulatory structure,
particularly in light of the Federal ReserveQs provision
of liquidity to non-bank financial institutions. DRCQs
Xia explained that while a housing bubble, compensation
systems and high leverage had all contributed to the U.S.
financial crisis, an important cause was global
macroeconomic imbalances. ICBC Chairman Jiang worried
about the loss of confidence in China and the global
economy. Even sound firms are afraid to invest due to
the uncertain outlook. Individuals are cutting back
their consumption - not because of insufficient income
but because of their deteriorating outlook. He stressed
it is therefore important for the Chinese government to
sustain confidence.

. . . and Rapidly Deteriorating Chinese Economy
--------------------------------------------- --

4. (SBU) Chinese officials generally agreed that economic
data in October had dropped more quickly than they
expected with power generation declining, something
unprecedented in many years. Most expect real GDP growth
for 2008 Q4 and early 2009 to be lower than the 9% real
growth (y/y) for the third quarter. The Chinese stimulus
package will help offset the decline in external demand
with domestic growth; for 2009, China could still achieve
9% GDP growth if the situation in the U.S. doesn't worsen.
DRCQs Xia Bin was confident that China can maintain at
least 8 percent real GDP growth in 2009. The rise of
government revenues as a percent of GDP, a roughly
balanced budget, and continued urbanization give China
ample room for fiscal stimulus. While Xia believes China
needs to pursue more consumption-led growth, he stressed
this will remain difficult in the short-term.

5. (SBU) PBOCQs Yi noted that the main channel for
contagion of the U.S. and European financial crises has

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been through trade, although ChinaQs diversification of
export markets away from the U.S. and Europe over the
past few years has helped cushion the impact. Yi also
believes that ChinaQs high household savings and banks
capital adequacy ratios give both households and
financial institutions a cushion to help absorb the
decline in external demand.

Supporting Growth Presents Challenges

6. (SBU) DRCQs Xia is concerned that the four trillion
RMB stimulus package could encourage corruption and rent-
seeking and would present an opening for supporters of
greater state-directed economic planning. With Premier
Wen Jiabao aware of these risks, the government is trying
to find appropriate ways to strengthen oversight of
additional spending. Xia predicted that the December 8-9
government economic work conference would focus on
measures to increase domestic demand and consumption,
including: raising the threshold for the personal income
tax; stimulating the housing market by cutting interest
rates further, and/or lowering the minimum down payment
for purchases of second homes; and increasing pensions
for retirees.

7. (SBU) Bank of Beijing executives said that while
regulators are encouraging banks to maintain lending
growth, they are not yet forcing banks to make loans that
the banks do not deem commercially viable. However if
the economic downturn worsens, they expect banks will
face more pressures to lend. Mr. Samra believed that
real estate is the major risk for banks, though BoBQs
exposure to real estate is relatively small at only 14%
of assets. While BoBQs borrowers had been sensitive to
interest rate hikes, they were less certain whether
interest rate cuts would spur increased borrowing given
the deteriorating outlook.

Exchange Rate to Remain QBasically Stable

8. (SBU) PBOCQs Yi said the U.S. government Qshould not
worryQ as there has been no change in exchange rate
policy. He noted that in the second half of 2008, the
RMB-USD rate has been Qbasically stable,Q but in the
context of a strong USD that had caused the RMB to
appreciate significantly on a nominal and real-trade
weighted basis. Yi added that in the near term the RMB
was likely to remain Qbasically stableQ against the US
dollar, and in this context fluctuations in either
direction were Qperfectly normal.Q Over the long-term
China is still committed to the goal of a convertible

PBOC Taking Steps to Maintain Bank Liquidity

9. (SBU) PBOCQs Yi said liquidity remains ample in China;
in fact just three months ago there were concerns about
excessive liquidity. November data will show very large
increases in bank lending. According to Jiang, the solid
growth in the real economy allowed Chinese banks to grow
rapidly while paying less attention to QfakeQ financial
derivatives than their western counterparts. Only
foreign banks, which are a tiny portion of ChinaQs
banking sector, have experienced liquidity problems.
Through moral suasion, PBOC and CBRC encouraged Chinese
commercial banks to resume normal lending to the foreign
banks. Also, the PBOC has established a facility to
provide liquidity similar to the Federal ReserveQs TAF
(term auction facility). Foreign banks can use Qwhatever
they haveQ as collateral for this facility, including
foreign assets. This will allow foreign banks who need
RMB liquidity to borrow foreign currency from their
parent banks, and use the borrowed funds as collateral
for an RMB loan from the PBOC, without requiring approval
from the State Administration of Foreign Exchange to
bring the foreign currency into China.

Macro Stimulus Consistent with Structural Reform?
--------------------------------------------- ----

10. (SBU) PBOCQs Yi said the economic downturn is an

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opportunity for further structural adjustment of the
economy. China can speed the transfer of resources out
of some sectors and enterprises, although certain
ministries, SOEs, and local governments will resist this.
To promote this, China needs to accelerate its efforts to
strengthen its social safety net, as it is much more
efficient to support directly household incomes than prop
up inefficient enterprises.

11. (SBU) Yi also stressed the importance of maintaining
progress on reforming Chinese banks into more
commercially-oriented entities, particularly by
emphasizing good corporate governance and risk management;
the former was gradually improving, the latter was much
better. The Qgood newsQ is that ChinaQs banks are closer
to international standards; the Qbad newsQ is that this
is making them more pro-cyclical. However, despite the
priority on sustaining growth it will not be possible for
the Chinese government to press banks to lend to
particular borrowers.

Committed to Reform, but Pace Will Slow

12. (SBU) CSRCQs Yao stressed that, while the U.S.
financial crisis has raised doubts among some people
about whether to continue financial opening and reform,
Chinese leadership are committed to continuing but first
need to analyze the reasons for and implications of the
U.S. financial crisis.
DRCQs Xia said current problems might lead to Qfine-
tuningQ of the pace of financial reform and opening, but
the policy and overall trend would not change. As ICBC
Chairman Jiang noted, Qit is lucky that Chinese banking
reform over the past few years occurred in such a good

ICBC Seeks Controlling Stake in California Bank
--------------------------------------------- --

13. (SBU) ICBC, the largest bank in China, believes that
now is a good time to pursue foreign investment through
mergers and acquisitions (M&A). ICBC is interested in
acquiring small U.S. banks to expand its network and
learn more about the US market. Mr. Jiang mentioned
interest in a controlling share of East-West Bank in
California, and asked Governor Warsh whether the Federal
Reserve would have regulatory concerns. Warsh responded
that while foreign investors would have to comply with
U.S. banking regulations, the Federal Reserve has an
Qopen mindQ towards foreign investment, and recommended
that ICBC discuss any specific proposal with the
appropriate Federal Reserve staff.

COMMENT: Balancing Rebalancing

14. (SBU) Chinese economic policy makers continue to
grapple with how to cushion the macroeconomic downturn in
an efficient manner without undermining progress made in
modernizing the financial sector and rebalancing the
economy. They appear well aware that more market-oriented
banking and banking supervision practices tend to be more
pro-cylical and appear intent not to repeat the heavy
handed moral suasion on banks to prop up state
enterprises which occurred in prior cyclical downturns.
They also appear committed to continue to resist pressure
rising from vested interests to use the U.S. financial
crisis as a pretext for backsliding on financial and
exchange rate reforms, though the pace of financial
liberalization and RMB appreciation will certainly slow.
ICBCQs proposed investment in East-West Bank could be the
second test, after China MinshengQs request to increase
its stake in San Francisco-based bank UCBH Holdings, of
whether the Federal Reserve will allow Chinese banks to
take more than a 5-10 percent equity stake in U.S. banks.


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