REASONS BEHIND THE LIMITED RESPONSE TO FEVERISH

C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 020796

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E.O. 12958: DECL: 09/28/2016
TAGS: ECON PGOV ETRD EFIN EINV CH
SUBJECT: REASONS BEHIND THE LIMITED RESPONSE TO FEVERISH
INVESTMENT

REF: BEIJING 17937

Classified By: Charge d'Affaires, a.i., David S. Sedney. Reasons 1.4 (
b/d).

SUMMARY
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1. (C) SUMMARY: Several contacts have pointed out reasons
they believe that China will not or should not pursue bold
action in the near term to deal with high rates of investment
and credit growth. A private sector economist emphasized
Premier Wen Jiabao's desire for officials -- including
regulators with narrowly defined charters --to reach
"consensus" on major economic issues, a process that slows
down decision making. A researcher who advises the
government said that significant renminbi appreciation is not
an attractive option for economic policy makers focused on
job creation, the growing rich-poor divide, and overall
social stability. A government macroeconomist downplayed the
idea of "overheating" and asserted that the 30 percent growth
rate in fixed asset investment (FAI) can be checked with
administrative measures alone. An academic observed that
many local officials are still evaluated against growth
rates, making it difficult to restrain investment supported
by local governments. END SUMMARY.

LOTS OF MONEY SLOSHING AROUND...
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2. (C) FAI continues to grow at a feverish pace: 30.5 percent
in the first sixth months of this year compared to 2005.
Among the sources of funds for all this investment are large
inflows from abroad, including: China's global trade
surplus, which was over USD 14 billion per month in June and
July; "hot money" associated with speculation on the
renminbi, impossible to accurately quantify but very roughly
estimated by the National Bureau of Statistics to have
averaged nearly USD 6 billion per month between February and
May; foreign direct investment, which so far this year has
averaged above USD 4 billion per month; and increasing
profits for many firms, up 29 percent so far this year among
major industrial enterprises.


3. (C) With capital controls limiting outward investment,
accumulating funds are often either lent out by banks or
spent by corporations on new industrial capacity or
residential construction. This spending is in addition to
large government projects already under way, including
housing projects, facilities for the 2008 Olympics, and the
expansion of transportation infrastructure in the form of
ports, airports, railways, and highways. Concern among
government and private sector economists about overcapacities
in industries like steel and cement results in part from the
enlargement of these sectors in response to government-funded
infrastructure expansion.

SLOWDOWN COMING TOO SLOWLY?
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4. (C) Citibank's Vice President for Asia/Pacific Research,
Shen Minggao, who recently jumped to the firm from a research
position at Beijing University, is concerned that recent
efforts to slow down FAI growth 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, said Shen.


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

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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
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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, he said.


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 APPROACH SUFFICIENT
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8. (C) Dr. Wang Xiaoguang, 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, asserting that 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
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9. (C) Hu Angang, Director of the Center for China Study at
Tsinghua University's School of Public Policy and Management,

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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 Beijing's direction.
Local officials in Inner Mongolia as well as Hunan appeared
dismissive when discussing the Central Government's push with
us (further details in reftel).


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DOUBTS ABOUT INTEREST RATES
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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, make no difference, in
Lin's view.
SEDNEY