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Cablegate: China Cautious On Derivatives, Shutting Out Foreign Banks

VZCZCXRO4785
RR RUEHCN RUEHGH
DE RUEHGH #0023/01 0220737
ZNR UUUUU ZZH
R 220737Z JAN 10
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 8496
INFO RUEHBJ/AMEMBASSY BEIJING 3263
RUEHCN/AMCONSUL CHENGDU 2356
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGZ/AMCONSUL GUANGZHOU 0813
RUEHHK/AMCONSUL HONG KONG 2528
RUEHLO/AMEMBASSY LONDON 0063
RUEHML/AMEMBASSY MANILA 0151
RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHFR/AMEMBASSY PARIS 0042
RUEHUL/AMEMBASSY SEOUL 0653
RUEHSH/AMCONSUL SHENYANG 2347
RUEHGP/AMEMBASSY SINGAPORE 0315
RUEHIN/AIT TAIPEI 2145
RUEHKO/AMEMBASSY TOKYO 0864
RUEHGH/AMCONSUL SHANGHAI 9163

UNCLAS SECTION 01 OF 04 SHANGHAI 000023

SENSITIVE
SIPDIS

DEPT FOR EAP/CM
NSC FOR MEDEIROS, LOI, SHRIER
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN
USDOC FOR ITA DAS KASOFF, MELCHER, SZYMANSKI, MAC/OCEA
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP
TREASURY FOR IMFP -- SOBEL/CUSHMAN
STATE PASS CEA FOR BLOCK
STATE PASS CFTC FOR OIA/GORLICK
MANILA FOR ADB USED
PARIS FOR US/OECD

E.O. 12958: N/A
TAGS: ECON EFIN EINV PGOV CH
SUBJECT: CHINA CAUTIOUS ON DERIVATIVES, SHUTTING OUT FOREIGN BANKS

REF: A. A) 09 SHANGHAI 401
B. B) 09 SHANGHAI 185

1. (SBU) Summary: Chinese government regulators remain
generally cautious of introducing new derivatives products in
China, and some continue to seek to restrict products previously
offered by foreign-invested banks. Foreign banks remain largely
shut out of the market for foreign exchange swaps and interest
rate swaps. Foreign banks are also disappointed with progress
so far on granting them permission to trade and underwrite
Chinese corporate bond offerings. End Summary.

==========
Background
==========

2. (SBU) Visiting Treasury Department International Economist
Benjamin Cushman met with several Shanghai-based contacts on
China's derivative markets December 15-16. These included Frank
Sirna, chief financial officer, and Paulus Mok, head of markets
and country treasurer, Citi China; Zhang Xiaogang, R&D head,
China Financial Future Exchange (CFFE); Chao Kejian, head of the
Offering & Listing Department, Shanghai Stock Exchange; David
Liao, managing director and head of global markets, HSBC China;
Racky Shum, executive director, credit & rates markets, China,
and head of rates trading, J.P.Morgan Chase China; and Raymond
Yin, executive director, Gaohua Securities (a joint venture with
Goldman Sachs).

3. (SBU) Chinese banks on September 16 began requiring
foreign-invested locally incorporated banks to supply guarantees
from their parent bank holding companies as a precondition to
signing a new version of a derivatives trading "master
agreement". (See ref A.) The new request from Chinese banks
came against a backdrop of increased caution on the part of both
Chinese regulators and Chinese banks regarding the riskiness of
counterparties and of derivative products. Few foreign banks
supplied a parent-company guarantee by the deadline for
concluding the new master agreements. Also in September,
China's State-Owned Assets Supervision and Administration
Commission (SASAC) announced that it would support Chinese
state-owned companies wishing to renege on what SASAC described
as improper derivatives contracts. Starting in spring 2009, many
foreign firms have expressed concern regulators are moving
slowly on opening the Chinese corporate bond market. (See ref
B.)

=========================================
Regulators Remain Cautious on Derivatives
=========================================

4. (SBU) Chinese government regulators remain generally
cautious about introducing new derivatives products in China,
and some continue to seek to restrict products previously
offered by foreign-invested banks. A Chinese financial official
noted that the Central Government is still focused on
implementing the economic stimulus package and assuring growth,
and has no time to develop derivatives markets. A manager in a
foreign-invested locally incorporated bank said that regulators
are pushing back timetables for new products in the aftermath of
the financial crisis. Several noted that Chinese retail
investors do not understand the risks of the market, and
regulators are taking time to build in protections for them.

5. (SBU) CFFE officials said that top Chinese leaders still
have not given the go-ahead for what is expected to be the
exchange's first product -- stock market index futures -- after

SHANGHAI 00000023 002 OF 004


three years of mock trading. (Note: On January 8, Chinese
media reported that the State Council has endorsed in principle
the launch of stock index futures, with regulators suggesting
final preparations could take three months. End note.) Since
the financial crisis broke out, CFFE has been developing
"investor suitability regimes" that weed out unsophisticated
retail investors and attract institutional investors. CFFE
officials were concerned that investors would be unable to
distinguish the differences between a futures contract and a
share. Investors will probably have to demonstrate a
significant net worth (at least RMB500,000 to invest), pass a
test on futures trading, and first participate in mock trading.
In addition, investors will most likely be required to put down
a 12 percent margin on trades, rather than the 10 percent
previously considered.

6. (SBU) Several contacts commented on a newly proposed
clearinghouse for spot currency trades and over-the-counter
(OTC) derivative deals, which regulators hope will provide
better information on exposures among market players. One
Chinese financial official said the clearinghouse is being
pushed by the People's Bank of China (PBOC), and shareholders
will include the China Foreign Exchange Trading System (CFETS --
a PBOC-sponsored platform for foreign exchange trading, RMB
lending and bond trading, and other financial transactions), the
Ministry of Finance (MOF), and China Government Securities
Depository Trust & Clearing Co., Ltd. (a clearinghouse for
bonds established by PBOC and MOF). However, details remain
sparse. Another noted the difficulty of posting OTC
transactions on CFETS, since the frequently one-off OTC deals
can't be quantified according to the usual standards; also,
public posting leads to copycatting that drives down profit
margins.

============================================= =====
Stand-Off on Derivatives Master Agreements Continues
============================================= =====

7. (SBU) Foreign-invested locally incorporated banks remain
largely shut out of the market for foreign exchange swaps and
interest rate swaps, say our contacts. Several point to Bank of
China (BOC) as the source of the difficulties, since BOC was
"burned" on several foreign exchange deals and has the largest
forex exposure of the major Chinese banks. For instance, BOC
held off signing any bilateral bank-to-bank agreements on the
terms of derivatives trades (known as a "master agreement")
until the deadline of September 16, 2009, and on that day signed
with several -- all Chinese banks. Some foreign bankers pointed
to a related, but more systemic, problem: Chinese banks,
including BOC, are not adept at handling collateral that
foreign-invested banks are willing to use to backup their
derivatives trades.

8. (SBU) While foreign-invested locally incorporated banks are
not able to carry on derivatives trades as before, our contacts
hold different perspectives on how this impacts their bottom
line. One foreign banker asserted derivatives trading is down
by 30 percent since the September 16 deadline passed. Another
said liquidity in the market is down, and hedging is more
expensive, but that since the renminbi exchange rate has
remained pegged to the U.S. dollar in recent months, part of the
drop off in transactions reflects less need for hedging. Two
contacts pointed out that transaction volume may actually be as
high or higher than previously because foreign banks are using
"bridge banks" -- smaller local banks with which they have
signed master agreements -- and therefore more transactions are

SHANGHAI 00000023 003 OF 004


recorded to complete each deal. A third foreign banker noted
that the onshore market in China is tiny compared to the
offshore market, where Chinese banks continue to deal
derivatives with foreign banks even without a master agreement.

9. (SBU) An executive at one foreign-invested locally
incorporated bank said that resolving the derivatives master
agreement issues is the "critical, number one issue to be
resolved in 2010." Several noted that discussion will be taken
up by the National Association of Financial Market Institutional
Investors (NAFMII), a nominally self-regulatory industry body
that is a spin-off from the PBOC. Two contacts said that the
China Banking Regulatory Commission (CBRC) has been very
supportive of a resolution. In the end, said one foreign
banker, market demand for hedging instruments may play the
crucial role.

============================================= ======
Threats to Renege on Derivatives Contracts Receding
============================================= ======

10. (SBU) SASAC in September 2009 stirred up concerns that it
was encouraging state-owned enterprises (SOEs) to refuse to pay
when derivatives contracts turned against them, but our contacts
now see little chance that this will happen. Several contacts
pointed to a November 30 speech by SASAC Vice Chairman Li Wei as
helping to calm the waters. That said, SOEs are clearly
becoming more cautious about taking on risky derivatives, with
one banker with a major foreign-invested derivatives player
saying his bank had not written a structured deal in six months.
Another foreign banker said that he would not be surprised,
however, if one or two SOEs reneged on a derivatives contract
because the contract was entered into irregularly. (Note:
According to Chinese regulations, a person signing a derivatives
contract on behalf of a corporation must have proper authority
from the company's board of directors, the derivative must fit
into the company's overall risk-management strategy, and the
hedge must be used in a real transaction. End note.)

11. (SBU) Our contacts pinned blame on both the banks and the
firms involved in the derivatives contracts for some unadvisable
deals. Chinese companies were taking on more risk because they
saw only profits for several years, said several contacts. In
some cases, firms were doubling or tripling down on their bets,
hoping to make even greater gains. When the market turned, the
profits evaporated and firms were in over their heads because
some unscrupulous deals allowed for unlimited losses by the
firms. "There were a lot of inappropriate trades," said a
banker with one major foreign player. At the same time, another
foreign banker noted that now some of the problem contracts
turned profitable again for the SOEs in December, and they have
since stopped complaining. (Note: One foreign banker said that
if the yen falls below 88 to the U.S. dollar, many SOEs who have
signed derivatives contracts betting it would stay above 88
would begin to lose large amounts of money. End note.)

============================================= ===
Foreign-Invested Banks Blocked from Bond Trading
============================================= ===

12. (SBU) Foreign-invested locally incorporated banks are
disappointed with progress so far on granting them permission to
underwrite Chinese corporate bond offerings on the interbank
market. Blame is placed on NAFMII, which has been sitting on
the implementing rules for underwriting corporate bonds since
early this year. One foreign banker says NAFMII -- which is

SHANGHAI 00000023 004 OF 004


composed of industry players -- is seeking to limit competition.
While two foreign-invested banks are represented in NAFMII,
representatives of these banks say they are outvoted by the
domestic NAFMII members when it comes to expanding the number of
competitors allowed into the bond underwriting market. Several
of our foreign banking contacts affirm they are eager to get
into this potentially lucrative segment.

13. (SBU) Meanwhile, approval for foreign-invested banks to
underwrite financial bonds is required from the PBOC Financial
Markets Division, said one foreign banker, and the criteria for
such approval remains unclear. HSBC has participated in a
financial bond offering, but the circumstances may not be
applicable as a precedent. Our HSBC contact says HSBC was a
sub-underwriter on the bond issue of Bank of Shanghai, in which
HSBC has investments; given this close corporate tie, HSBC
applied to the lead underwriter, Industrial and Commercial Bank
of China (ICBC), and ICBC accepted. Thus, the regulatory issue
still has not been fully resolved at PBOC. CBRC, on the other
hand, has recently taken a more open stance, according to our
contacts, in particular Li Fuan, head of the banking innovation
supervision department.

=======
Comment
=======

14. (SBU) The go-slow approach Chinese financial regulators are
taking on derivative products is a predictable, and in some ways
understandable, reaction to the turmoil in Western financial
markets. For Chinese regulators, the connection is clear -- in
his November 30 speech, SASAC vice chairman Li Wei states
categorically that "The high leveraging of financial derivatives
is a direct cause of the U.S. subprime loan crisis developing
into a global financial crisis." However, both Chinese and
foreign-invested financial institutions point out that hedging
to facilitate business transactions is useful, while speculative
hedging is more like gambling. In order to help advance the
national goal of building Shanghai into an international
financial center by 2020, the Shanghai Stock Exchange, for
instance, needs to offer foreign investors a simple stock index
future. At present, the CBRC appears to be on the side of
further market opening, while NAFMII and to a lesser extent
PBOC, are slowing progress.

15. (SBU) The Department of Treasury has cleared on this cable.
CAMP

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