GOVERNANCE ISSUES MEET FEVERISH INVESTMENT

C O N F I D E N T I A L BEIJING 018541 SIPDIS SIPDIS STATE FOR EAP/CM AND EB USDOC FOR 4420 TREASURY FOR OASIA/ISA - DOHNER/KOEPKE NSC FOR MCCORMICK STATE PASS USTR FOR STRATFORD, WINTER, AND ALTBACH STATE PASS CEA FOR BLOCK STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK E.O. 12958: DECL: 09/01/2016 TAGS: ECON PGOV ETRD EFIN EINV CH SUBJECT: GOVERNANCE ISSUES MEET FEVERISH INVESTMENT REF: BEIJING 17937 CLASSIFIED BY: ECON ACTING MINCOUNS CHRIS BEEDE; REASONS: 1.4 (B/D) SUMMARY/COMMENT -------------- ¶1. (C) THE CHINESE GOVERNMENT IS WELL AWARE THAT EXCESSIVE INVESTMENT AND CREDIT GROWTH POSE A SIGNIFICANT RISK TO THE ECONOMY, BUT OUR CONTACTS SUGGEST THAT FOUR GOVERNANCE ISSUES STAND IN THE WAY OF A BOLD RESPONSE. FIRST, PREMIER WEN JIABAO'S EMPHASIS ON FORGING INTERNAL CONSENSUS, EVEN AMONG NARROWLY-FOCUSED REGULATORS, ON ALL MAJOR ECONOMIC ISSUES (EXCEPT FOR GRAIN PRODUCTION AND INFLATION CONTROL) YIELDS PIECEMEAL APPROACHES AND OFTEN LEADS TO POLITICAL GRIDLOCK. SECOND, FEARS OF SOCIAL INSTABILITY LEAD SOME TO FAVOR BOOSTING GROWTH TO CREATE JOBS. THIRD, TWO ECONOMISTS WE TALKED TO, WHO ADVISE THE GOVERNMENT, DOWNPLAY THE IDEA OF "OVERHEATING" AND BELIEVE THAT THE PRESENT AND EXTRAORDINARY 30 PERCENT GROWTH RATE IN FIXED ASSET INVESTMENT (FAI) CAN BE CHECKED WITH ADMINISTRATIVE MEASURES ALONE; THEY SAID THERE IS NO NEED TO EMPLOY RENMINBI APPRECIATION, WHICH WOULD INTRODUCE UNWANTED VOLATILITY, AND NO POINT IN RELYING ON INTEREST RATE HIKES, WHICH ARE INEFFECTIVE IN AN ENVIRONMENT WHERE LOCAL GOVERNMENTS AND STATE-OWNED ENTERPRISES ARE UNRESPONSIVE TO SUCH CHANGES WHILE OTHER INVESTORS BELIEVE HIGH RETURNS ARE STILL AVAILABLE ELSEWHERE, ESPECIALLY IN REAL ESTATE. FINALLY, THERE IS THE SELF-INTEREST OF PROVINCIAL LEADERS WHO PLAY TO CONSTITUENTS WITH VANITY PROJECTS OR, WITH AN EYE TOWARD NEXT YEAR'S PARTY CONGRESS, ARE PARTIAL TO INVESTMENT THAT GENERATES HIGH ECONOMIC GROWTH FIGURES. END SUMMARY/COMMENT LOTS OF MONEY SLOSHING AROUND... -------------- ¶2. (U) CHINA'S PRIMARY TACTICAL ECONOMIC CHALLENGE IS DIGESTING THE MASSIVE QUANTITY OF FUNDS ACCUMULATING IN THE FINANCIAL SYSTEM AS A RESULT OF THE TRADE SURPLUS, RENMINBI SPECULATION, FOREIGN DIRECT INVESTMENT, INCREASING PROFITS FOR MANY FIRMS, AND CAPITAL CONTROLS. LARGE QUANTITIES OF CHEAP MONEY HAVE CREATED A WIDE RANGE OF INCENTIVES FOR GOVERNMENT OFFICIALS, BANKS, AND CORPORATIONS TO CONTINUE TO PUT THE FUNDS TO USE BY EXPANDING PRODUCTION CAPACITY TO THE POINT OF OVERCAPACITY AND BUILDING NEW INFRASTRUCTURE, MUCH OF IT DUPLICATIVE OR WASTEFUL (BUT IT OFTEN MAKES LOCAL OFFICIALS LOOK GOOD). THIS SITUATION IS EXACERBATED BY WEAK CORPORATE GOVERNANCE AND THE PRACTICE OF NOT PAYING DIVIDENDS. AS A RESULT, FAI CONTINUES TO GROW AT WHAT IS CONSIDERED AN UNSUSTAINABLE RATE: 30.5 PERCENT IN THE FIRST SIXTH MONTHS OF THIS YEAR COMPARED TO 2005. ¶3. (U) THE FAI RAMP-UP IS PARTICULARLY OBVIOUS AS URBANIZATION, LONG-TERM GROWTH, AND FOREIGN SPECULATION FUEL WIDESPREAD RESIDENTIAL CONSTRUCTION. THERE ARE ALSO LARGE AND ONGOING INFRASTRUCTURE PROJECTS SUCH AS THE THREE GORGES DAM AND FACILITIES FOR THE 2008 OLYMPICS. CHINA IS ADDITIONALLY POURING MONEY INTO EXPANDING PORTS, AIRPORTS, RAILWAYS, AND HIGHWAYS. SOME INVESTMENT IS FURTHER MOTIVATED BY CHINA BEING IN THE EARLY STAGE OF ITS ELEVENTH FIVE YEAR PLAN (FYP),IN PARTICULAR BECAUSE THE FYP HAS GIVEN A GREEN LIGHT TO MORE INVESTMENT IN RURAL AREAS. LESS VISIBLE, BUT OF GREATER ECONOMIC CONCERN, IS THE RESPONSE OF VARIOUS MATERIALS SECTORS TO ALL OF THIS INVESTMENT, YIELDING GROWING OVERCAPACITIES IN INDUSTRIES LIKE STEEL AND CEMENT. SLOWDOWN COMING TOO SLOWLY? -------------- ¶4. (C) NOBODY WE HAVE TALKED TO IS PREDICTING A CRASH IN THE SHORT-TERM, BUT ECONOMISTS LIKE CITIBANK'S VICE PRESIDENT FOR ASIA/PACIFIC RESEARCH SHEN MINGGAO, WHO RECENTLY JUMPED TO THE FIRM FROM A RESEARCH POSITION AT BEIJING UNIVERSITY, ARE CONCERNED THAT RECENT EFFORTS TO TIGHTEN ARE TOO LITTLE TOO LATE. SHEN LAMENTED THAT TWO INTEREST RATE HIKES THIS SUMMER AND A SLEW OF ADMINISTRATIVE MEASURES AIMED AT SLOWING THE BUILDUP OF OVERCAPACITY IN CONSTRUCTION-RELATED SECTORS ARE FAR TOO LIMITED. OVER THE COMING YEARS, THE CONSEQUENCE OF THE SLOW GOVERNMENT RESPONSE IS LIKELY TO BE DEFLATION IN SOME SECTORS AND AN OVERALL SURGE IN NON-PERFORMING LOANS. ¶5. (C) SHEN ALSO RAISED CONCERNS THAT CHINA IS MOVING TOO SLOWLY TO USE ITS MOST EFFECTIVE TOOL: CURRENCY FLEXIBILITY. HE AND NUMEROUS OTHER ECONOMISTS BELIEVE THAT WERE THE RENMINBI ALLOWED TO APPRECIATE SIGNIFICANTLY, FUNDS INFLOWS THAT FUEL INVESTMENT GROWTH WOULD SLOW MEASURABLY -- FIRST AS A RESULT OF SPECULATION DRYING UP, FOLLOWED BY AN EVENTUAL DECLINE IN THE TRADE SURPLUS RESULTING FROM CHEAPER IMPORTS AND A FALL-OFF IN EXPORTS IN PRICE-SENSITIVE SECTORS SUCH AS APPAREL AND LOWER-END ELECTRONICS. HE ADDED THAT GIVEN PROSPECTS OF WEAKER U.S. DEMAND, THE WINDOW MAY BE CLOSING ON THE ABILITY TO ALLOW GREATER RENMINBI APPRECIATION. FURTHER, BECAUSE EFFORTS TO TIGHTEN INVESTMENT WILL MOST OFTEN IMPACT INDUSTRIES GEARED TO PRODUCTION FOR INTERNAL CONSUMPTION, ONE RESULT WOULD BE A FALL OFF IN IMPORTS, EXACERBATING CHINA'S GLOBAL TRADE SURPLUS. GOVERNANCE CHALLENGES -------------- ¶6. (C) SHEN FURTHER DESCRIBED TO US A LOWEST COMMON DENOMINATOR APPROACH TO KEY ECONOMIC DECISIONS UNDER THE DIRECTION OF PREMIER WEN JIABAO. IN SHEN'S VIEW, WEN WILL ONLY PROVIDE CLEAR AND DECISIVE DIRECTION ON TWO ISSUES: MAINTAINING GRAIN PRODUCTION TARGETS AND CONTROLLING INFLATION. EVERYTHING ELSE IS HELD HOSTAGE TO A LENGTHY PROCESS OF DIFFERENT GOVERNMENT PLAYERS -- INCLUDING REGULATORS WITH NARROWLY DEFINED CHARTERS -- PRESSING THEIR PAROCHIAL AGENDAS UNTIL "CONSENSUS" IS REACHED. ¶7. (C) CHINA ACADEMY OF SOCIAL SCIENCES (CASS) SENIOR RESEARCH FELLOW DR. WANG TONGSHAN SAID THAT ALTHOUGH THE ELEVENTH FIVE-YEAR PLAN AIMS TO INJECT BALANCE INTO THE ECONOMY, CHINA IS ACTUALLY MOVING AWAY FROM SUCH A GOAL, WITH FIXED ASSET INVESTMENT PRESENTLY RISING AT TWICE THE RATE OF CONSUMER SPENDING. FURTHER, ECONOMIC POLICY MAKERS ARE VERY FOCUSED ON JOB CREATION, THE GROWING RICH-POOR DIVIDE, AND OVERALL SOCIAL STABILITY, SO THEY ARE RELUCTANT TO ALLOW FOR APPRECIATION OF THE RENMINBI. THE BEST COURSE, IN HIS VIEW, IS STRONGER ADMINISTRATIVE CONTROLS ON CREDIT AND RESTRICTIONS ON LAND USE. NDRC: NEED CONTROL BUT EXISTING PPROACH SUFFICIENT -------------- -------------- ¶8. (SBU) DR. WANG XAOGUANG, WHO DIRECTS THE MACROECONOMICS DIVISION AT THE NATIONAL DEVELOPMENT REFORM COMMISSION (NDRC) INSTITUTE OF ECONOMIC RESEARCH ECHOED OUR CASS CONTACT CONCERNING THE NEED FOR ADMINISTRATIVE CONTROLS RELATED TO PROJECTS, CAPITAL, AND LAND. HE WENT A STEP FURTHER IN EXPRESSING CONFIDENCE IN SUCH MEASURES, ASSERTINGTHAT RECENT MOVES TO SLOW OR HALT NEW PROJECTS WILL BE SUFFICIENT TO ARREST SPIRALING FAI GROWTH RATES. WANG PREDICTED THAT IN SIX MONTHS, THE FAI GROWTH RATE WILL FALL FIVE PERCENTAGE POINTS TO 25 PERCENT (COMMENT: THIS IS STILL A VERY HIGH RATE OF INCREASE). HE SAID THERE WOULD SOON BE MORE FOCUS BY THE GOVERNMENT ON ISSUES SUCH AS PROJECT QUALITY AND ENVIRONMENTAL IMPACT. LIKE CASS'S DR. WANG, NDRC'S DR. WANG RULED OUT USING RENMINBI APPRECIATION AS A TOOL FOR MACROECONOMIC COOLING. THE CHALLENGE FROM LOCAL GOVERNMENTS -------------- ¶9. (C) HU ANGANG, DIRECTOR OF THE CENTER FOR CHINA STUDY AT TSINGHUA UNIVERSITY'S SCHOOL OF PUBLIC POLICY AND MANAGEMENT, SIPDIS SAID THAT THE CHINESE GOVERNMENT HAS FOR YEARS EMPHASIZED RAPID ECONOMIC GROWTH, AND LOCAL GOVERNMENTS STILL HAVE MANY INCENTIVES TO SEEK HIGHER GDP FIGURES. WITH MANY LOCAL OFFICIALS ACTUALLY EVALUATED AGAINST GROWTH RATES AND SOME LOOKING AHEAD TO NEXT YEAR'S PARTY CONGRESS, IT IS NATURALLY DIFFICULT TO RESTRAIN LOCAL GOVERNMENT INVESTMENT. HU EXPLAINED THAT THE ISSUE IS FURTHER COMPLICATED BY LOCAL AUTHORITIES HAVING A LARGE SAY IN THE LOAN DECISIONS OF LOCAL BANK BRANCHES. WHEN PROJECTS FAIL, IT IS THE BANK, WHOSE LOCAL BRANCH HAD LENT THE MONEY UNDER LOCAL GOVERNMENT PRESSURE, WHICH MUST CLEAN UP THE LOAN, AND LOCAL OFFICIALS INVOLVED AT THE INCEPTION MAY BE LONG GONE. ¶10. (C) BEIJING HAS RECENTLY BECOME MORE FORCEFUL IN ITS EFFORTS TO CONTROL INVESTMENT AT THE PROVINCIAL LEVEL AND RECENTLY WENT SO FAR AS TO PUBLICLY REPRIMAND OFFICIALS IN INNER MONGOLIA FOR PURSUING UNAUTHORIZED POWER PROJECTS. THE CENTRAL GOVERNMENT SEPARATELY ANNOUNCED IN EARLY AUGUST THAT IT WOULD DISPATCH ECONOMIC INSPECTION TEAMS TO KEY PROVINCES TO COMPEL THEM TO MORE CLOSELY FOLLOW BEIJINGS DIRECTION. LOCAL OFFICIALS IN INNER MONGOLIA AS WELL AS HUNAN APPEARED DISMISSIVE WHEN DISCUSSING THE CENTRAL GOVERNMENT'S PUSH WITH US, PERHAPS REFLECTING HOW CAREER INCENTIVES AND LOCAL CONDITIONS MOTIVATE THE CONTINUED PURSUIT OF HIGH RATES OF INVESTMENT, EVEN WHEN OFFICIALS ARE VERBALLY ENCOURAGED BY THE CENTRAL GOVERNMENT TO DO OTHERWISE. (SEE REFTEL) DOUBTS ABOUT INTEREST RATES -------------- ¶11. (C) BEIJING UNIVERSITY CENTER FOR ECONOMIC RESEARCH DIRECTOR LIN YIFU TOLD US THAT WITH CHINA'S ECONOMY STILL IN TRANSITION, MONETARY POLICY IS LESS EFFECTIVE AS A TOOL THAN ADMINISTRATIVE CONTROLS. HE EMPHASIZED THE PROBLEM OF GROWING OVERCAPACITY, BUT NOTED THAT MOST INVESTMENT COMES FROM RETAINED EARNINGS, SO INVESTORS ARE ULTIMATELY INSENSITIVE TO INTEREST RATE CHANGES. MANY PEOPLE BELIEVE RETURNS OF 20 PERCENT ARE AVAILABLE IN SECTORS LIKE REAL ESTATE, AND THIS MAKES A 2.25 PERCENT INTEREST RATE FOR DEPOSITS PALE BY COMPARISON. EVEN DEPOSIT RATES OF 5 PERCENT -- MORE THAN DOUBLE CURRENT RATES, WOULD MAKE NO DIFFERENCE, IN LIN'S VIEW. SEDNEY