Cablegate: U.S. Federal Reserve Nov. 18-20 Visit to Beijing:

DE RUEHBJ #3307/01 3450712
O 110712Z DEC 09




E.O. 12958: N/A
SUBJECT: U.S. Federal Reserve Nov. 18-20 Visit to Beijing:
Recovery, Rebalancing, and Reform

1. (SBU) Summary. Chinese officials and local and
foreign bankers and economists told visiting Federal
Reserve Governor Warsh and San Francisco Fed President
Yellen that China's GDP growth has been boosted by
successful fiscal and monetary policies, largely focused
on infrastructure investment, and should reach 8.3-8.4
percent in 2010. Massive new bank lending over the past
year may lead to an increase of non-performing loans
(NPLs) in 2011 and beyond, but the government has the
fiscal capacity to intervene if necessary. Discussion of
stimulus exit strategy already is under way within the
government, but is complicated by perceived needs to
further consolidate economic recovery while avoiding any
resurgence of inflation that could provoke social
instability. Some Chinese contacts are concerned about
the U.S. recovery and revival of external demand for
China's exports, while other observers view resumption of
fiscal, social security, and financial sector reforms
that would promote longer-term economic rebalancing as
more important and urgent needs.

2. (SBU) Summary, continued. One government economist
said China is taking a two-step approach toward managing
the economy: first, arrest the downturn -- which has been
done -- and then continue the rebalancing that began
before the crises. For that reason, the focus of 2010
stimulus spending will shift from large-scale
infrastructure projects to social sectors, including
health and education, low-income housing, and training.
Job creation, primarily in the services sectors, also
will be a key concern. While China has made some
progress toward rebalancing, most economists urge further
opening of the service sectors to private sector
participation and measures to make urbanization "more
permanent" by regularizing the status of migrants and
their families, which would generate more labor-intensive
service-sector urban growth. While one official said the
Chinese Government's fear of rising unemployment hinders
significant near-term RMB appreciation, several
economists said there is widespread recognition that the
currency is undervalued and that broader price reform
also is needed to sustain growth. Several contacts
raised concerns regarding the U.S. economic and fiscal
situations, including the possibility of a "W-shaped"
recovery, the danger of high inflation that would erode
the value of China's USD-denominated investments, the
rising U.S. fiscal deficit, the downward trend of the U.S.
Dollar, and the current high unemployment level. End

3. (SBU) During their November 18-20 visit to Beijing,
U.S. Federal Reserve Governor Kevin Warsh and Federal
Reserve Bank of San Francisco President Janet Yellen
discussed a broad range of U.S., China, and global
economic and financial topics with senior Chinese
officials and Chinese and foreign bankers and economists.
The Federal Reserve delegation met with Executive Vice
President Wang Yiming of the Academy of Macro-economic
Research (AMR), National Development and Reform
Commission (NDRC); Vice Chairman Gao Xiqing, China
Investment Corporation (CIC); Vice Chairman Yao Gang,
China Securities Regulatory Commission (CSRC); Vice
Minister Liu He, Central Leading Group (CLG) on Financial
and Economic Affairs; and other Chinese bankers and
officials. The Fed visitors also participated in a
roundtable discussion with five Beijing-based economists:
Senior IMF Resident Representative Vivek Arora, UBS Head
of China Economic Research Wang Tao, Dragonomics Managing
Director Arthur Kroeber, World Bank Senior Economist
Louis Kuijs, and Guanghua School of Finance Associate
Professor Michael Pettis.

China's Economy: Successful Stimulus Policies
4. (SBU) According to NDRC/AMR Vice President Wang,
domestic factors caused China's economic growth to slow
in the third quarter of 2007, a trend then accelerated by
the global crisis. Government stimulus programs reversed
this momentum in the second and third quarters of 2009,
bringing GDP growth for the first nine months of 2009 to
7.7 percent. Of this total, investment contributed 7.1
percent, consumption four percent, and net exports
negative 3.6 percent. Wang expected fourth quarter GDP

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growth to be higher due to the low base of fourth quarter
2008. He said the consensus estimate for 2009 GDP growth
was 8.3-8.4 percent. For 2010, Wang believes two key
growth engines, investment and consumption, might
moderate as investment in real estate slows and
government programs to promote consumption wind down.
Vice Minister Liu He said China's 2010 GDP growth should
reach eight percent or higher, based in part on
expectations of two percent U.S. GDP growth (three
percent globally).

5. (SBU) Although some observers questioned the stimulus
focus on infrastructure construction, Dragonomics'
Kroeber said China had huge infrastructure needs so this
spending had not been wasted. Several hundred million
people needed relocation to the cities, requiring much
more infrastructure, and some funded projects are
anticipatory or addressed economic transformation, such
as the high-speed railways. At worst, he believed China
had "borrowed" some future growth by front-loading
infrastructure spending. UBS' Wang agreed, observing
that China was going through rapid industrialization for
which it "cannot have too much" capital stock. The
primary concern was whether there was any misallocation
of resources, not whether there was an overall excess.
Kroeber also observed that China's use of bank credit
rather than fiscal revenue to finance much of the fiscal
stimulus enabled it to "postpone indefinitely" any
repayment problems that arose. If the stimulus program
was extended for multiple years, however, the financial
burden might cause problems.

6. (SBU) Asked whether Chinese banks were encouraged to
extend stimulus lending to preferred entities, one senior
Chinese bank executive said his state-owned bank had
"never been asked to lend to special projects." He
observed that China, unlike the United States and the
European Union, still had a low overall debt ratio and
considerable space to increase lending and domestic
consumption. The banker conceded, however, that new bank
lending often flowed to industries with overcapacity,
rather than Beijing's preferred recipients. He also
claimed the central government issued careful guidance on
the types of business allowed to receive loans, as it
wanted to support private consumption and investment
through small and medium-sized Chinese enterprises.

NPLs: Future Concern
7. (SBU) In part due to credit flowing to certain
industries already burdened with overcapacity, the IMF
was worried about a resurgence in non-performing loans
(NPLs). Arora said loans extended to households and
infrastructure projects were not concerns, but 60-70
percent of the stimulus-fueled credit expansion is "dark
matter." Nonetheless, he believed NPLs were a concern
for 2011-12, if not 2009-10, but he did not expect the
NPL ratio to reach double digits, as it has in the past.
Also, the government had the fiscal capacity to intervene
if necessary. The IMF considered loan growth of 17
percent in 2010 credible, but a more rapid increase would
be worrisome. Guanghua's Pettis echoed Arora's concern
about this year's lending flood, opining that the massive
increase was a step backward for China's banks. He also
believed there was considerable hidden debt at the
provincial and local levels, while large amounts of old
bad debts (from the banks previous quasi-fiscal role
supporting state-owned entities) had not been fully
resolved. Kroeber agreed, noting that government and
bank statistics did not reveal the entire debt, although
he also said the government had hidden assets that could
be "unlocked," as was done through housing reform in the
late 1990s.

Exit Strategies: When and How?
8. (SBU) CSRC Vice Chairman Yao said discussion of
stimulus exit strategy had begun, since China's proactive
policy measures enabled it to recover earlier than other
countries. He was not certain this year's eight percent
GDP growth rate was sustainable; if not, then exit from
the stimulus would be premature. Yao believed China
faces a dilemma: with real economic recovery not yet

BEIJING 00003307 003 OF 005

assured and consumer price inflation still negative,
China was likely to continue the stimulus package; at the
same time, however, Beijing already had injected enormous
liquidity into the markets, so asset price bubbles might
arise. Noting that China's equity market had risen
almost 100 percent since its lowest point, and that the
current price-to-earnings ratio was almost thirty, Yao
believed China's recovery had been too fast. It had been
fueled by government investment and bank loans, which
needed to be replaced as primary drivers by private
consumption. Until that happened, Beijing was adjusting
policies slightly rather than moving to an exit. Vice
Minister Liu also worried about potential "bubbles"
developing in Hong Kong, Shanghai, and Beijing real
estate markets.

9. (SBU) Several of the roundtable economists broadly
confirmed Yao's assessment. The IMF's Arora said the
government was not convinced the recovery was here to
stay, so it probably would continue fiscal stimulus
through 2010 while gradually unwinding monetary measures.
Wang of UBS observed that China was concerned about the
U.S. recovery and also debating how serious the crisis
really was, given the quick recovery of many indicators,
and the outcome of this assessment would affect both exit
timing and measures to address structural imbalances.
She believed Premier Wen Jiabao was worried about the
"doomsday scenario" and was reluctant to "take the foot
off the pedal" too soon, so the concern was that China
would tighten too late rather than too early. Wang also
said the central government was opposed to a sharp credit
curtailment, so for 2010 there was risk that prolonged
loose credit would bring a "boom and bust" scenario.

Other Concerns
10. (SBU) Various interlocutors listed other concerns for
the short term. According to Wang of the NDRC/AMR, two
major uncertainties were recovery of external demand and
rising inflationary pressure, which would have serious
implications for macro-economic decision-making in 2010.
He said China needed both to stabilize economic growth
and to stem inflation next year, which would be difficult.
For external demand, the United States was a key factor:
for every one percent decline in U.S. GDP, China's
exports fell five percent. Kuijs said the World Bank was
not concerned about inflation, as the supply side was
responsive, but fiscal, social security, and financial
sector reforms -- all of which faced political obstacles
-- were important and/or urgent.

11. (SBU) NDRC/AMR Vice President Wang said the
government was taking a two-step approach toward managing
the economy: first, arrest the downturn -- which had been
done -- and then continue the rebalancing that began
before the crises. For that, China needed to boost
consumption by increasing the role of the domestic
economy, rather than exports, in economic growth. More
investment in social welfare, including health care,
rural, education, and pension programs also was needed.
In that regard, CLG Vice Minister Liu said China's 2010
stimulus spending would approach 2009 levels, but the
focus would shift from large-scale infrastructure to
health, education, low-income housing, and training. He
noted China's needed to address production overcapacity,
while cautioning that a premature U.S. economic recovery
might soften China's efforts to enact deeper, more
painful rebalancing reforms. Liu said China's foremost
challenge would remain job creation, with a particular
focus on services.

12. (SBU) Arora (IMF) observed that if the global crisis
resulted in increased household income and consumption as
well as good infrastructure investments in China, then it
would be seen as good for China; if, however, China
responds as it has in the past -- with more investment in
manufacturing -- then the crisis would be a negative
influence. For now, the IMF saw more of the former than
the latter, and China also had made progress on boosting
pensions and other social security programs to encourage
household consumption. China also had taken measures to

BEIJING 00003307 004 OF 005

improve availability of financing for small firms, and to
reform corporate dividends. Arora said the country's
primary goal was employment, for which service sector
growth was more beneficial than manufacturing.

13. (SBU) The World Bank's Kuijs said China had begun to
address its neglect of social safety net, environment and
energy problems with its eleventh five-year plan (2006-
10). This plan was a good vision with advances in some
areas (e.g. pricing and environment), but overall
progress had been insufficient to alter the course of the
"very heavy ship" of China's growth pattern. Kuijs said
most economists offered similar policy recommendations:
open the service sectors to private sector participation
and make urbanization "more permanent" by regularizing
the status of migrants and their families, which would
generate more labor-intensive service-sector urban growth.
At present, migrant workers were not really involved in
the urban economy.

14. (SBU) UBS' Wang agreed with Kuijs' analysis,
observing that China essentially had a system of "dual
citizenship" based on place of birth (urban verses rural).
A more important factor for rebalancing, however, was
that local officials were judged by their GDP growth
rates, and capital-intensive growth tended to be faster,
so the government needed to change the incentive system
for these officials. There also was a bias in the tax
system, as services were taxed as revenue and this type
of tax was difficult to collect, so local officials were
not eager to encourage further development of the service
sector. Finally, there were many state-owned monopolies
in the services sector that did not welcome competition;
the government often cited "strategic" or "national
security" justifications for these monopolies.

15. (SBU) Pettis (Guanghua School) argued that
expectations of a coming surge in private consumption
were overblown, primarily due to constraints on household
income and channeling of capital from households to
industrial sectors. Traditionally low interest rates
also were a part of this problem that was not likely to
improve in the near future, as state-owned enterprise
(SOE) profitability depended on low interest rates.
Pettis said policies to remove subsidies enjoyed by SOEs
and to reverse flows away from household sector were
needed, but the transition to a more consumption-based
economy would be gradual. He believed rechanneling
capital to small and medium-sized companies and the
service sectors would produce a large growth burst, but
required a political decision. Pettis estimated, however,
that even without major economic restructuring, and
assuming no unexpected major problems, China should
average 5-7 percent GDP growth over the next 5-10 years.
If the U.S. no longer absorbed China's exports, then the
nature of the problem changed and China's development
model no longer worked.

16. (SBU) Kroeber (Dragonomics) offered two general
observations: first, although the nature of China's
challenge now was qualitatively different than in the
past, China's policy mechanism had earned the "benefit of
the doubt" due to past success; and second, for any self-
sustaining growth mechanism, whenever the state retreats
there is an automatic productivity increase. China had
serious structural issues to address, and after thirty
years of using capital accumulation to increase labor
productivity, now the "demographics were turning negative
forever." Kroeber believed, however, that China had
sufficient "breathing space" to keep growth going while
making structural adjustments. The key was to ensure
capital pricing was correct; if not, then China would
"hit a wall" in the 2020s when demographics were most

Exchange Rates
17. (SBU) Vice Minister Liu said the Chinese Government's
fear of rising unemployment prevented near-term currency
appreciation, but added that "some market-oriented
reforms" would continue. Wang of UBS said the People's
Bank of China wanted to "untie at least one hand" (for
monetary policy) by allowing more exchange rate

BEIJING 00003307 005 OF 005

flexibility, as noted in its latest monetary policy
report, but did not have the deciding voice on this issue.
She dismissed the negative coverage of the exchange rate
issue in the foreign media during President Obama's
visit to China, observing that references to adjusting
"relative prices" in the joint communiqu essentially
referred to exchange rates. Wang said "everyone agrees"
the RMB was undervalued; since land and energy also are
under-priced, fixing those imbalances would be equivalent
to a real exchange rate shift. She expected to see an
exchange rate adjustment in 2010. Similarly, the IMF's
Arora said the exchange rate issue did not stand alone
and was part of a broader problem of relative prices and
reorienting investment away from the tradeable sectors.
China's moves on prices, social safety net, etc., had
been in the right direction, but the exchange rate had
moved in the wrong direction, so the world's largest
surplus country had a depreciating currency. Arora also
believed European governments should be complaining about
RMB depreciation. CIC Chairman Gao said his company must
be RMB-neutral, but the PRCG was under pressure to
appreciate its currency, which he thought Beijing
eventually would do.

18. (SBU) Kroeber of Dragonomics said there was a clear
inflationary risk for asset prices in 2010, closely
related to the exchange rate issue. China had deferred
exchange rate appreciation for several years, but next
year it would need to choose between appreciation and a
rise in inflation. China no longer could "fudge" the
issue through sterilization. It was difficult, however,
because the government "hates" both exchange rate
appreciation and inflation, the latter because it was
socially destabilizing (he believes this "paranoia" is
exaggerated). China tried gradual appreciation from 2005
to 2008, with bad consequences: the rest of the world
"threw capital" into China.

U.S. Economy
19. (SBU) Several contacts raised various concerns
regarding the U.S. economic recovery. AMR Vice President
Wang said the NDRC closely followed U.S. economic
developments, including the prospects for a "W-shaped"
recovery. CLG Vice Minister Liu worried that the U.S.
might revert to old patterns if deep reforms did not take
hold, possibly resulting in high inflation that would
erode the value of China's USD-denominated investments.
He also questioned whether U.S. stock indexes and global
commodity prices were climbing too rapidly, and suggested
capital flight from the U.S. may be to blame for current
Asian asset "bubbles." Similarly, CSRC Vice Chairman Yao
opined that interest rates in the United States were
driving capital flows into emerging markets, such as Hong
Kong. He also said China was concerned about future U.S.
fiscal and monetary policies as well as the rising U.S.
fiscal deficit and the downward trend of the U.S. Dollar.

20. (SBU) CIC Vice Chairman Gao said the United States
was unique due to the size of its economy; with eighty
percent of its valuation in U.S. dollars, CIC's view of
the United States and the USD also was rather unique. At
the same time, however, CIC has liabilities in RMB. Gao
said CIC "becomes nervous" when it looked at how much
money the United States had been printing, and they
believed a U.S. policy mistake could induce a double-dip
recession or a major fall in the market. CIC's head of
strategic research said he agreed the U.S. economy and
U.S. companies were dynamic, noting that the United
States was more flexible in restructuring but the
European Union could more easily accommodate unemployment
due to its social system. He believed it was difficult
for the United States to have unemployment above ten
percent, as that would induce problems in the social
security network.

21. (U) The Federal Reserve delegation has cleared this


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