CHINA CURRENCY AND MACRO POLICY: IMF'S

UNCLAS SECTION 01 OF 02 HONG KONG 001839

SIPDIS

SENSITIVE
SIPDIS

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

E.O. 12958: N/A
TAGS: EFIN ECON PGOV HK CH
SUBJECT: CHINA CURRENCY AND MACRO POLICY: IMF'S
PRESCRIPTIVE APPROACH OVERLOOKED BY MEDIA

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

INTRODUCTION/SUMMARY
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1. (SBU) Media coverage of the International Monetary Fund's
(IMF) May 2 unveiling in Hong Kong of its Asia-Pacific
regional outlook is based primarily on an advance press
release and does not capture the prescriptive approach put
forward at the event with regard to China's currency and
macroeconomic policies. The IMF used the event to call on
China to (a) exercise greater currency flexibility and (b) to
increase spending on education, health care, and retirement
as a way to reduce the need for "precautionary savings." END
INTRODUCTION/SUMMARY

PRESENTATION IN HONG KONG
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2. (SBU) On May 2 in Hong Kong, the IMF Deputy Director for
Asia, Wanda Tseng, presented the latest Regional Economic
Outlook (REO) for the Asia-Pacific region. A full copy of
the REO is available on www.imf.org. The purpose of this
message is not to summarize the full report but to highlight
a number of China- and Hong Kong-related comments made at the
event that are likely to be of interest to analysts and
policy makers.

CALL FOR RMB FLEXIBILITY
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3. (U) Tseng observed that despite the introduction of a new
currency regime in July 2005, the renminbi (RMB) has only
risen 1.25 percent since the initial 2.1 percent revaluation.
Though unwilling to provide a target for the RMB's vale
when asked, Tseng noted several times that Chia is not using
the full flexibility available toit under the new RMB
value-setting system. Ther is a hig cost and a loss of
policy flexibility ssociated with China's policy of
partially steriizing excess foreign exchange inflows. One
negaive result of this approach is the introducion of
excess liquidity into the mainland economy, which in turn is
fueling a resurgence of loans and investment that needs to be
reined in.

EMPHASIS ON CHINA AND U.S. IN EFFECTING ORDERLY ADJUSTMENTS
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4. (U) Tseng made repeated reference to the U.S. current
account deficit along with China's accumulation of foreign
exchange reserves. She suggested a role for both the U.S.
and China in managing global financial imbalances. At this
point, there is no apparent problem in managing the
situation, but there is likely medium-term risk considering
that there is a limit to how much of the U.S. current account
deficit foreigners are willing finance. When asked whether
the U.S. or Asia had a more important role to play in working
out imbalances, Tseng responded by referring exclusively to
the U.S., which she said must act "urgently"; a rise in U.S.
savings will be key. With regard to China's foreign exchange
reserves, Tseng would not name a figure that could be deemed
"adequate," but stated that China has "no need to go further"
in its accumulation.

REBALANCING CHINA'S ECONOMY
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5. (U) The REO report suggests "a very stark picture"
emerging from the fact that household consumption in China
only accounted for approximately 40 percent of GDP last year.
Although such consumption has grown at an average annual
rate of 8 percent since the early 1990's, this lags GDP
expansion. Savings now make up approximately 30 percent of
GDP. One factor in the high savings rate is "precautionary
savings motives," resulting in part from the decreasing role
of state-owned enterprises in the provision of pensions,
health care, and schooling -- and much of this responsibility
has now been transferred to central and local governments
that face budget crunches.


6. (U) Consequently, education spending is now only about
2.25 percent of GDP, the lowest among Asian economies, while

HONG KONG 00001839 002 OF 002


the proportion given to health care is 0.5 percent of GDP.
Making up for low expenditures in these two areas consumes an
increasing proportion of household consumption. Uncertainty
about such expenses in the future as well as anxieties about
funding old-age support -- which, in part, derives from the
effects of the one-child policy -- underpins the need for
precautionary savings. Tseng suggested that China reduce the
uncertainty facing households (and therefore promote their
propensity to consume) by boosting government spending on
education, health care and pensions. The need to save can
also be reduced through banking reform, which improves access
to credit, reducing the need to accumulate funds to finance
major purchases or small family businesses. Household
consumption might also be boosted through exchange rate
flexibility if RMB appreciation raises purchasing power.

HONG KONG STANDS TO GAIN
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7. (U) Tseng, joined by IMF Resident Representative Paul
Gruenwald, said that the demand from the mainland for Hong
Kong business services remains high. This is a huge
advantage for the city in the context of public anxiety
expressed here about the potential for "marginalization."
Recent steps to allow mainlanders to invest individually in
offshore financial instruments are welcome, but the impact on
Hong Kong is likely to be small in the near term. The peg of
the Hong Kong dollar to the U.S. dollar has worked well, but
its continuation is a local choice. The IMF forecasts that
Hong Kong's GDP will likely expand 5-5.5 percent this year,
down from 7.3 percent in 2006.
Cunningham