CODEL GRAHAM FOCUSES ON CURRENCY AND PORT SECURITY

C O N F I D E N T I A L SECTION 01 OF 04 HONG KONG 001285

SIPDIS

SIPDIS

STATE FOR EAP/CM AND EB
DEPARTMENT PASS H
STATE PASS USTR
USDOC FOR DAS LEVINE, ITA/OCEA MCQUEEN AND CELICO
TREASURY FOR LOEVINGER AND KOEPKE
NSC FOR WILDER, SHIRZAD

E.O. 12958: DECL: 03/27/2031
TAGS: PREL ETRD EFIN WTRO PGOV OREP HK CH
SUBJECT: CODEL GRAHAM FOCUSES ON CURRENCY AND PORT SECURITY

Classified By: EP Section Chief Simon Schuchat; Reasons 1.4 (b/d)


SUMMARY
--------------


1. (C) Renminbi (RMB) valuation, port security, and mainland
urban/rural disparity dominated the March 25-26 visit to Hong
Kong of Senators Lindsey Graham and Charles Schumer. Hong
Kong Monetary Authority Chief Executive Joseph Yam encouraged
the Senators to continue pressing the mainland to liberalize
currency policy but cautioned against seeking excessively
rapid changes that would destabilize China's financial system
and thereby harm the global economy. Hong Kong's former
Chief Executive C.H. Tung counseled patience concerning
financial liberalization, citing the rapid pace of China's
economic reforms in recent years and underscoring the
challenges posed to PRC leaders by growing income disparity
and continued high rates of bad loans in the banking system.
Seven financial strategists generally agreed that the
renminbi (RMB) is significantly undervalued but assessed that
the mechanics and political constraints faced by China rule
out a quick resolution of the currency question. A
demonstration of a pilot comprehensive container screening
system enabled Hutchison Port Holdings to highlight for the
Senators the degree to which global port operators are now 80
percent concentrated around firms from Hong Kong, Singapore,
Dubai, and Denmark -- with implications for U.S. policy
makers as they decide on how to engage the world on port
security issues; the demonstration was followed by a visit to
the Container Security Initiative (CSI) operations here.
Local business leaders expressed concerns about the potential
for instability on the mainland as resentment grows over
corruption, land seizures, and income disparities -- all
amidst increasingly free-flowing information, Internet
restrictions notwithstanding. The International Republican
Institute Resident Representative described the awkward
balance that IRI must strike as a foreign NGO operating in
China. END SUMMARY

VISIT DETAILS
--------------


2. (SBU) Senators Lindsey Graham (R-SC) and Charles Schumer
(D-NY) visited Hong Kong March 25-26 after traveling to
Beijing and Shanghai. Accompanying the Senators were:

o Matt Rimkunas, Legislative Assistant (Graham)
o Kevin Bishop, Communications Director (Graham)
o Jeff Haymond, Legislative Assistant (Schumer)
o Risa Heller, Press Secretary (Schumer)
o CDR Steve Vahsen, Military Escort

The Senators held the following substantive meetings (in
order of agenda):

o C.H. Tung, Former Chief Executive of Hong Kong
o Joseph Yam, Chief Executive, Hong Kong Monetary Authority
(HKMA)
o Visit to Integrated Container Inspection System (ICIS)
Pilot Demonstration
o Visit to Container Security Initiative (CSI) Operations
o Dinner hosted by the Better Hong Kong Foundation (BHKF)
o Amy Gadsden, Resident Representative, International
Republican Institute (IRI) (Graham Only)
o Gathering with Financial Strategists (Graham Only)

HKMA: KEEP PUSHING, BUT CAREFULLY
--------------


3. (C) HKMA's Yam assessed the mainland's movement towards a
more liberal financial system as understandably cautious. He
made clear that Hong Kong sees it in its own interest for
some elements of currency reform to move more quickly,
particularly those aspects that might allow the city to
benefit from expanded offshore RMB-related services. The HKG
has made known to Beijing its interest in such an accelerated
pace. Yam said the existing leadership is "unfortunately"
slow in moving forward, in part because Premier Wen Jiabao is
a consensus builder. People's Bank of China (PBOC) Governor
Zhou Xiaochuan understands that excess accumulation of
foreign exchange reserves implies that the time is now for
bolder steps forward on the RMB, but Premier Wen is not "100

HONG KONG 00001285 002 OF 004


percent there," and Zhou's bureaucratic influence is limited.
"If it was just Zhou, you'd be there," he said. Although
Vice Premier Wu Yi met with the Senators in China and clearly
impressed them, Yam commented that her responsibilities and
knowledge with regard to reform of the financial system are
limited.


4. (C) Yam said that slow liberalization of the currency
system deprives China of access to services that would help
channel funds in the most productive ways possible. Capital
controls prevent money from flowing out of China to places
like Hong Kong where talented intermediaries could put the
funds to their best use. Yam observed that mainland
investors are forced to invest domestically and are thus
unable to purchase the financial instruments (listed stocks,
bonds) of Chinese firms that obtain finance here. Beijing
fully appreciates the importance of the financial system for
growth and development but is very concerned about stability
and thus remains cautious about moving forward. The
leadership is now confronted by strains caused by rapid
development (e.g., rioting in villages where land has been
seized, mining accidents). While the U.S. should by all
means continue to put political pressure on China, it is
important to understand the downside risks should reform
trigger disorderly adjustments. Further, although the
Senators' proposed tariff legislation would not take effect
for two years, markets could "telescope" the impact by
reacting immediately.


5. (C) Yam said he was not sure whether the leadership in
Beijing looked to Hong Kong as a place for experimenting with
China's political direction. However, this is certainly the
case on the economic side as is already evidenced by existing
permissions granted for banks in Hong Kong to conduct limited
RMB business. (Note: This includes RMB conversions,
remittances, deposits, and transfers, but not loans or the
issuance of RMB-denominated financial instruments. End Note.)


6. (C) Senator Graham told Yam that he had drawn several
conclusions so far on his trip to China and Hong Kong: China
faces major challenges as it deals with growing income gaps
between rich and poor; the 3 percent RMB appreciation since
last July does not represent real reform but instead China's
desire to avoid political conflict; China needs to take
actions that will instill confidence that market disruptions
caused by currency policy will be addressed; and the currency
issue can be resolved in a win-win manner that can take us
all to the next level of globalization. Senator Schumer told
Yam that the currency question -- unlike intellectual
property rights protection -- is something that the PRC
central government has within its power to address now. He
contrasted China's high savings/low consumption rates with
the mirror image found in the U.S., concluding that changing
the patterns found in both countries will be ultimately be
part of the solution.

FORMER CHIEF EXECUTIVE: AVOID SHOCK THERAPY
--------------


7. (C) C.H. Tung said that China's greatest challenge is
managing urbanization as income disparity rises. This
includes dealing with environmental degradation, addressing
anger among the poor at issues such as land seizures, and
providing a social safety net. Such issues compel Beijing to
seek internal stability and a "peaceful globe" above all
else. He encouraged the Senators to look at how fast China
had changed in recent years and implored them not to judge
China by the standards of U.S. democratic and economic
development. Tung cited banking system reforms to date,
compliance with WTO obligations, and rapidly growing imports
as reasons to be more tolerant of China's pace of economic
liberalization. He warned of financial instability should
China move too quickly and asked that the Senators not try to
"force shock therapy" on the PRC. Tung also spent a few
minutes noting the importance to Beijing of the Taiwan
question -- their number one issue -- and assessed Taipei
Mayor Ma Ying-jeou -- a possible presidential candidate for
the Kuomintang in 2008 -- as someone who could bring a hope
of stability, unlike current President Chen Shui-bian who, in
Tung's words, is "trying to be relevant" by pushing towards
independence.


8. (C) Senator Schumer expressed concern that China is not

HONG KONG 00001285 003 OF 004


opening up its financial services sector quickly enough.
Noting barriers to market access for Visa-branded credit
cards, the Senator wondered aloud whether China is truly open
to obtaining the best services and technology relevant to its
development or whether it is trying to learn from the U.S.
and then create a situation where its firms copy American
practices but retain dominant access to the local market.
Tung answered that the mainland's focus is bringing in
investment and expertise from whatever source, and that this
can be seen through the listing, for example, of Chinese
banks in Hong Kong, a process that is occurring outside of
the domestic economy and involves a wide range of foreign
service providers and strategic investment partners.

INVESTMENT BANK ECONOMISTS: CURRENCY REFORM WILL TAKE TIME
-------------- --------------


9. (C) Seven investment bank economists, all of whom held
titles indicating a chief economist role involving China,
generally agreed with Senator Graham's assertion that the RMB
is undervalued, with four of them assessing that the currency
is priced at least 15 percent below its appropriate market
rate. Merrill Lynch's T.J. Bond cautioned that given the
technical challenges involved, the pace of currency reform in
China in unlikely to satisfy "any simple political argument."
Citibank's Yiping Huang echoed Bond, laying out the need to
coordinate broader capital account liberalization with
movement on the exchange rate. HSBC's Hongbin Qu said that
given these constraints, it is important to watch out for
excessive political pressure that sets back reform. BNP
Paribas' Andrew Freris encouraged Graham to always leave
China with flexibility by not making excessively detailed
demands that, for example, include both dates and percentage
targets with regard to RMB appreciation. Goldman Sachs' Hong
Liang said external pressure is a good thing but added that
the selling point should be China's own interests.


10. (C) CSFB's Dong Tao suggested that one possible way to
begin closing the trade deficit would be to ease up on visa
restrictions. He noted that many other countries are now
benefiting from growing Chinese tourism, not to mention the
extensive purchases that these travelers make while
traveling. Goldman Sachs' Liang seconded this view,
commenting that the Chinese elites who wish to travel to the
U.S. are not an immigration threat. (Note: Neither analyst
acknowledged DHS Secretary Chertoff's recent comments to
media that China is refusing to take back an estimated 39,000
citizens that have been found ineligible and deportable. End
Note)

REVIEW OF PORT SCREENING TECHNOLOGY
--------------


11. (SBU) The Senators visited Hong Kong International
Terminals (HIT, part of the Hutchison Conglomerate) to see a
demonstration of the Integrated Container Inspection System
(ICIS),which has been set up as a pilot test here in Hong
Kong by the U.S. firm Science Application International
Corporation (SAIC). SAIC is awaiting a decision from the HKG
on whether to buy ICIS. The U.S. Department of Energy has
been working with the HKG on identifying options for
extending the Megaports radiological screening program to
Hong Kong by leveraging the capabilities of ICIS.


12. (SBU) Hutchison Port Holdings Senior Vice President Gary
Gilbert showed the Senators how the ICIS system generates an
"electronic folder" for each container as it enters the
terminal yard. Trucks drive by scanning equipment that
creates both an image of the container's interior and a
radiation profile. Were the system fully deployed, the
electronic folder could be made available to USG personnel at
the destination port of entry, allowing the to prioritize
issues involving ship arrivals and follow-on inspections.


13. (SBU) Gilbert emphasized the need for rapid scanning
systems like ICIS, commenting that more goods are actually on
the high seas at any given time than in transit at ports
themselves. Consequently, any disruption -- from instituting
screening procedures that slow down the movement of goods
through ports to work stoppages - very quickly causes
bottlenecks. 80 percent ofthe world's cargo volume is now
handled at some oint by firms from Hong Kong, Singapore,
Dubai, r Denmark as a result of consolidation in the port

HONG KONG 00001285 004 OF 004


operator industry. Any U.S. port security strategy must
therefore take into account the need to work with firms from
these locations, said Gilbert. Hutchison facilities alone
handle 45 percent of all U.S. cargo at some point before
entry into the U.S.


14. (SBU) The Senators were then briefed by the ConGen's
Container Security Initiative (CSI) Team Leader. CSI has
been in operation in Hong Kong since May 2003. The 11
American personnel assigned here for CSI review all shipping
manifests. They work with Hong Kong Customs inspectors
dedicated to supporting the screening of containers for
weapons of mass destruction. No WMD have been found to date
but there has been the seizure of several million dollars
worth of counterfeit merchandise as a result of CSI
operations here.

BUSINESS LEADERS: ANXIOUS ABOUT INSTABILITY
--------------


15. (C) Participants used a dinner hosted by the BHKF to
express anxiety about the potential for serious instability
in China that could block the momentum of reform should
economic and political liberalization move too quickly. Hang
Lung Group Chairman Ronnie Chan said that a rapid currency
appreciation could cause unrest given that China now is a
place where "voices are loud" but that still lacks rule of
law to address complaints. BHKF Executive Director George
Yuen spoke of "priorities and varieties," explaining that the
leadership in Beijing must constantly juggle what it wants to
accomplish through reform with the variety of constituencies
that are affected (e.g., different geographical areas,
sectors, income rates, ethnic backgrounds). Commerce,
Industry, and Technology Bureau Deputy Secretary Philip Yung
observed that Hong Kong developed economically before it
liberalized politically. Esquel Group CEO Marjorie Yang,
noting corruption in China, questioned the capacity and
sincerity of local government officials in deploying funds
from Beijing aimed at improving the welfare of rural
residents. Yang also asserted that Internet controls
notwithstanding, the surge effect of chatter created by
blogging means that word spreads quickly when events such as
land seizures or disturbances occur.

IRI: IT'S NOT EASY TO BE AN NGO IN CHINA
--------------


16. (C) IRI Resident Representative Amy Gadsden told Senator
Graham that all NGOs receive extensive scrutiny in China; she
couldn't even pull her down her own email during her trip
there last week. That said, IRI has a good record on the
mainland; its proposals on extending land tenure rights were
actually adopted by the government. While the Internet may
offer some outlet for debate, there remains widespread fear
that anything posted might someday lead to a "knock on the
door." Gadsden said it is distressing to see President Hu
Jintao be so hesitant about political reform. She noted
instances where lawyers have been detained or harassed for
taking on sensitive cases, especially those involving Falun
Gong.


17. (U) Codel Graham provided a substantive clearance for
this message.
Cunningham