TROUBLED MAINLAND FINANCIAL SYSTEM HELPS FUEL

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 000335

SIPDIS

SIPDIS

STATE FOR EAP/CM AND EB
MANILA PASS AMBASSADOR PAUL SPELTZ
TREASURY FOR U/S TADAMS, DAS DLOEVINGER, OASIA-GKOPEKE
USDOC FOR 4420

E.O. 12958: DECL: 01/26/2031
TAGS: ECON EINV EFIN PREL HK CH
SUBJECT: TROUBLED MAINLAND FINANCIAL SYSTEM HELPS FUEL
RECORD GROWTH FOR HONG KONG'S STOCK EXCHANGE


Classified By: Acting DPO Simon Schuchat; Reasons: 1.4 (b/d)

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


1. (C) China-related listings boomed again last year in Hong
Kong, led by China Construction Bank's USD 9 billion IPO, the
world's largest for 2005. Hong Kong now ranks fourth in the
world for raising equity capital. This impressive
performance, however, derives in part from dysfunction within
China's own domestic financial system. A prominent financial
contact believes China has mismanaged the reform of its
equity markets, creating a vicious cycle that will leave
quality mainland companies permanently inclined to list in
Hong Kong. He described China as "flying on one engine" by
failing to lay the proper groundwork for a reliable equity
raising capacity, thus placing further strain on an already
troubled banking system. Other observers are less critical
of China's reform efforts and believe the Shanghai exchange
may see new initial public offerings (IPOs) as soon as the
second quarter of this year. They display more acceptance of
what they term as the mainland's necessity to rely on
financial intermediation outside of the mainland's domestic
economy until issues involving state shares, capital
controls, currency convertibility, and corporate governance
can be overcome. END SUMMARY

OH, WHAT A YEAR IT WAS
--------------


2. (U) 2005 was a hugely successful year for Hong Kong's
stock market, primarily because of the activities of mainland
firms that have listed here. Highlights of note:

o Hong Kong hosted the world's largest initial public
offering (IPO) in 2005, China Construction Bank. The firm --
the first of China's "big four" banks to go public -- raised
USD 9.2 billion in October. More generally, 82 percent of
IPO funds raised in Hong Kong last year were associated with
mainland firms.

o USD 38 billion of equity capital was raised in Hong Kong in
2005, making it fourth in the world after New York, London,
and Toronto. Of that capital, USD 21 billion came from IPOs,
likely placing Hong Kong second only to New York for new
offerings, once final tabulations are in.

o Hong Kong market capitalization rose 23 percent to USD 1.05
trillion placing it eighth in the world. Mainland firms
account for 39 percent or USD 409 billion of this figure.

o 1,135 companies are listed in Hong Kong of which 335 are
mainland-related entities. Specifically:

-- 120 firms are "H shares," enterprises incorporated on
the mainland that usually, but not always, have significant
affiliation with the PRC government; this is the vehicle by
which state-owned enterprises in China normally sell pieces
of themselves off on a foreign exchange (Market Cap = USD 165
billion).

-- 89 firms are "red chips," enterprises incorporated
outside of the mainland but that have significant affiliation
with PRC government (Market Cap = 219 billion).

-- 126 firms are private enterprises, incorporated
outside of the mainland but controlled by mainland
individuals (Market Cap = 25 billion).

o Although the Hang Seng Index rose only 4.54 percent in
2005, turnover on Hong Kong's exchange increased by nearly 14
percent, reaching a record USD 579 billion. A major
attraction of Hong Kong for portfolio investors has been the
use of mainland-affiliated stocks as a way to buy into
China's growth story. Investors also buy China-related
stocks here to speculate on the Chinese renminbi (RMB)
because H-share values are calculated in RMB and then
converted to Hong Kong dollars (HKD).

HELPED BY AILING CHINA EXCHANGES
--------------


2. (SBU) Newbridge Capital Managing Partner Weijian Shan
described the success of Hong Kong's stock exchange as both a
symptom and future cause of structural economic problems in

HONG KONG 00000335 002 OF 003


China. Speaking at an off-the-record event, Shan offered a
scathing review of China's efforts to reform the country's
domestic (A-share) market. Until recently, approximately
two-thirds of A-shares were held as non-tradable shares,
primarily by government-related entities. In 2005, China
began converting these shares to make them tradable.
Anticipation of these shares flooding the market has created
an environment where it is difficult to list new companies,
and IPO's have been at a trickle for two years. The
"overhang problem" has also depressed share prices, with
eight-year lows reached on the Shanghai and Shenzhen
exchanges last July.


3. (SBU) Shan said that converting the shares is necessary.
However, China is forcing holders of non-tradable shares to
compensate holders of existing tradable shares for the losses
associated with more shares hitting the market. In his view,
this amounts to stock manipulation and disrespect for
property rights. The state injecting itself into the
value-setting process is corrosive to the markets themselves
establishing a reputation for finding fair prices. This in
turn will create a vicious cycle whereby China's best
companies continue to seek listings outside of the mainland.


4. (SBU) According to Shan, the lack of a reliable means to
raise equity capital is like forcing the domestic financial
system to fly on one engine. Financial intermediation is
reduced to the government taking savings from the public and
channeling them through banks to build excess production
capacity. This squelches profitability and keeps the rate of
return for existing stocks below the rate of economic growth.
Hong Kong, by contrast, has a strong reputation for rule of
law. Nobody in Hong Kong worries about government
shareholders selling their H-shares here because all players
know that stock values in this well-functioning market are
determined by fundamentals.


5. (C) Shan's negative outlook is illuminating, but it stands
out against the conventional wisdom found in media coverage
of China's stock market reforms. Numerous analysts have
pointed to the impressive pace of non-tradable conversions --
70 percent of market capitalization is likely to be converted
by late this year, according to estimates. There has also
been a recent positive trend in mainland domestic share
prices, attributed in part to confidence about the reforms.
Consulate Shanghai notes that foreign security advisors there
see the conversion process as positive, though confusing, and
some expect new IPOs as early as the second quarter of this
year. That said, Shanghai Stock Exchange Executive Vice
President James Liu recently told Consulate Shanghai that the
Hong Kong Exchange's focus on the mainland is "eating our
lunch." Liu's comment about the stock exchange's focus is
consistent with what we have heard here: Hong Kong Exchanges
and Clearing Chairman Paul Chow recently told us that the
exchange's current strategic plan focuses exclusively on
attracting new business based in Greater China.


6. (C) HSBC Senior Economist Hongbin Qu told us that he
disagrees with Newbridge's Shan, asserting that ongoing share
reform efforts are the only way to go forward. In the mean
time, China must "outsource" financial intermediation until
it can get its own house in order, and so will rely heavily
on the Hong Kong stock exchange for years to come. Qu
observed that beyond the question of working off non-tradable
shares, China must also address capital controls, the
convertibility of its currency, and corporate governance
before its domestic stock markets will begin to function as
Hong Kong's does. It will thus be a long time before
Shanghai is ready to compete with Hong Kong for prized
listings. After non-tradable share reform is complete,
however, the Chinese government may start directing some
companies to Shanghai, and this could take business from Hong
Kong.


7. (SBU) Bank of China Hong Kong Senior Economist Michael Dai
authored a research paper that he shared with us, taking a
line similar to that of HSBC's Qu. Dai noted that "China
simply cannot afford... (to halt) its own growth to buy time
for its stock market reform. It is at this juncture that
Hong Kong steps in and takes on the important financial
intermediation role.... China's financial security also has
to be considered. The mainland stock and bond markets have
yet to be well established, resulting in banks shouldering
most of the financing burden for economic as well as
corporate developments... the concentration of risks in the

HONG KONG 00000335 003 OF 003


banking sector carries huge destabilizing potentials itself.
Hong Kong in this case does its part to help diversify some
of the risks by helping Chinese companies to raise funds."


8. (U) This message was coordinated with Consulate Shanghai.
Cunningham