PRC PLANS FOR INDIVIDUAL INVESTMENT ABROAD

UNCLAS SECTION 01 OF 03 HONG KONG 001687

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM AND EB
TREASURY FOR DAS DLOEVINGER AND OASIA GKOEPKE
STATE PASS USTR
USDOC FOR 4420

E.O. 12958: N/A
TAGS: EFIN ECON PGOV HK CH
SUBJECT: PRC PLANS FOR INDIVIDUAL INVESTMENT ABROAD
ENERGIZE HONG KONG'S FINANCIAL SECTOR


(U) THIS DOCUMENT IS SENSITIVE BUT UNCLASSIFIED. PLEASE
PROTECT ACCORDINGLY. NOT FOR RELEASE OUTSIDE U.S. GOVERNMENT
CHANNELS. NOT FOR INTERNET PUBLICATION.

SUMMARY
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1. (SBU) SUMMARY: China's recent announcement of steps to
allow expanded individual access to foreign exchange as well
as the creation of new channels for investment abroad has
driven up Hong Kong's stock market, drawn out enthusiastic
prognostications from media, and even impressed our financial
strategist contacts, otherwise known for their tendency to
downplay the potential impact of economic policy changes from
the north. If only a small percentage of the USD 3-4
trillion of deposits in China's banking system flows out over
the next five years, the result could still be: a boost for
Hong Kong's stocks and role as a financial center; a
reduction of China's propensity to accumulate foreign
exchange reserves; and a structural environment far more
conducive to a renminbi (RMB) traded according to market
forces. Our contacts believe China's policy change at least
in part reflects internal alarm about the PRC's ability to
continue absorbing (sterilizing) large net inflows of foreign
exchange. END SUMMARY

MORE ACCESS TO FOREIGN CURRENCY FOR INVESTMENT...
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2. (U) A joint circular put out on April 14 by the People's
Bank of China (PBOC) and State Administration for Foreign
Exchange (SAFE) is the first step towards mainland residents
having expanded access to foreign exchange and, for the first
time, being able to invest some of their individual assets
abroad. The announcement included measures allowing:

o Companies that trade in goods and services to hold higher
foreign currency balances as well as an easing of
restrictions on services payments;

o Individuals to purchase up to USD 20,000 in foreign
exchange annually;

o Domestic banks to invest corporate and individual assets in
overseas fixed income securities;

o Domestic asset management companies to take corporate and
individual foreign exchange assets and invest them in
overseas markets, including equity markets;

o Insurance companies to have a wider scope to invest in
overseas fixed income markets.


3. (U) Detailed regulations are to be published by May 1,
with the changes taking place on that date.

SEEN AS SIGNIFICANT IN THE MEDIUM TERM
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4. (SBU) Drawing from our discussions with contacts as well
as a review of research reports and media analysis, we note
that the change in PBOC/SAFE policy offers individual
investors in China the ability to seek higher returns abroad
for the first time. There are an estimated USD 3-4 trillion
dollars of deposits in China, most of which is tied up in
low-yielding bank accounts (2.25 percent return) or domestic
stock markets, whose performance in recent years has been
poor and volatile. If even a small percentage of these funds
are eventually invested abroad, mainland wealth amounting to
hundreds of billions of dollars could eventually reach the
international financial system.


5. (SBU) Most observers expect the new PBOC/SAFE policy to be
implemented gradually, so a significant outflow of funds is
not likely to take place for years. An eventual and
significant transfer of assets abroad, however, could over
the next several years reduce the PBOC's propensity to
accumulate foreign exchange reserves. The more open capital
market resulting from the new provisions would also be a step
forward in creating an atmosphere where the RMB could trade
in greater accordance with market demand. A high outflow of
capital even has the potential to become a depreciating force
for the RMB.

HONG KONG 00001687 002 OF 003



A BOOST FOR HONG KONG
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6. (SBU) Hong Kong Monetary Authority Chief Executive Joseph
Yam said he hoped the PBOC/SAFE policy change would lead to
Hong Kong serving as a conduit for new investments. Hong
Kong's Secretary for Financial Services and the Treasury
Frederick Ma was in Beijing during the announcement and
predicted that mainland institutions and individuals would
use Hong Kong as an investment platform to buy into the local
stock and debt markets, yielding benefits for local banks,
brokers, and fund managers. The news of the new investment
channels was credited with boosting the H-share index
(covering mainland firms listed in Hong Kong) to its highest
level since 1997. HSBC Senior China Economist Hongbin Qu
told us that much of the new investment outside of China will
actually go to fixed-income funds in the U.S. and Europe, but
he agreed that there will a measurable percentage of the
assets that will reach Hong Kong, probably going to
mainland-tied stocks listed here.

DRIVEN BY ECONOMIC PRESSURE
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7. (SBU) In a research note, UBS Managing Director Jonathan
Anderson suggested that economic pressure -- and, perhaps to
a lesser extent, President Hu's visit to the U.S. -- explains
the policy shift. First quarter 2006 trade data showing a
higher than expected surplus was almost certainly a big
disappointment to the PBOC, which is increasingly concerned
about keeping control of the domestic money supply in the
face of strong foreign exchange inflows. Overcapacity in
sectors like steel and cement, leading to a diminished need
for imports, as well as moderating trends in domestic demand
growth suggest a need for sustained intervention for the
foreseeable future to soak up excess foreign exchange by
taking the resulting excess funds out of the money supply
(i.e., sterilization). There is a risk over time that banks
will demand higher interest rates from the government for the
financial instruments used to do this. The PBOC is therefore
looking for structural solutions to reduce this net inflow.
Bear Stearns Managing Director Michael Kurtz and HSBC's Qu
echoed Anderson's view.

SIGNIFICANT OUTFLOWS FORESEEN
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8. (SBU) Although some of China's domestic banks,
corporations, and pension funds have been given limited
access to outward FDI and overseas portfolio investment in
recent years, the PBOC/SAFE policy change marks the first
time that households and average firms are going to be able
to invest in this way. It is also the first time that
domestic residents have been able to convert renminbi funds
for overseas portfolio investment purposes. Bear Stearns'
Kurtz contemplates up to 10 percent of existing deposits
moving offshore over the next five years to seek higher
returns, implying an outflow of at least USD 300 billion, or
USD 60 billion per year. In his view, this could ease
significantly the foreign exchange inflow pressures on the
PBOC. The improved rates of return on personal savings could
also lead a reduction in China's savings rate, since
consumers would need to save less in order to amass a given
amount of money to meet future welfare needs (e.g.,
education, health, retirement). (Comment: In reviewing this
message, Embassy Beijing noted that the magnitude of outflow
contemplated by Bear Stearns is significantly higher than the
approximately USD 10 billion quota anticipated by a SAFE
Deputy Administrator in a discussion about the policy change.
That said, the program has the potential to expand either
officially or as a larger informal outlet for funds flows.
End Comment.)


9. (SBU) Citibank Managing Director Yiping Huang picked up on
the personal savings issue. Huang emphasized the PRC
government's awareness of the "desperate need" for retirement
assets in China to attain higher returns. Consequently,
insurance companies, banks, and individuals are all looking
to Beijing to create new channels for investment. Huang also
noted the excessive liquidity now present in China's
financial system, with recent data showing high rates of new
loan creation. The new policy can therefore be seen as a
mechanism that offers potential for credit tightening to cool

HONG KONG 00001687 003 OF 003


the economy. In this vein, Bear Stearns' Kurtz observed that
improved returns on savings might also put pressure on banks
and corporations to think harder about how they lend and
invest capital; this could lead to better earnings and
governance for listed companies. HSBC's Qu focused on the
potential for a notable change in the composition of outflows
from China, with fewer purchases of foreign exchange by the
government. He assessed that this change will do much to
boost the development of a market-based system for setting
the value of the RMB.

THE LONG-AWAITED QDII?
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10. (U) China already has a Qualified Foreign Institutional
Investor (QFII) arrangement that allows foreign institutional
investors to invest foreign funds in stock and bond markets,
subject to limited quotas. There has been anticipation for
some time about a mirror program to enable domestic funds to
seek higher returns outside of China, and observers have
assumed this would be called a Qualified Domestic
Institutional Investor (QDII) arrangement. China has yet to
use the "QDII" terminology to describe the recent changes but
many observers and media outlets are already referring to it
in this manner.
Cunningham