KEY ECONOMIC ADVISORS ON FINANCIAL CHALLENGES

C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 003078 SIPDIS SIPDIS STATE FOR EAP/CM STATE ALSO FOR INR/B USDOC FOR 4420 TREASURY FOR OASIA/ISA - DOHNER/HAARSAGER/BAKER/CUSHMAN NSC FOR MCCORMICK/TONG STATE PASS USTR FOR STRATFORD, WINTER, AND ALTBACH STATE PASS CEA STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON; SAN FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK E.O. 12958: DECL: 05/09/2032 TAGS: ECON PGOV ETRD EFIN EINV CH SUBJECT: KEY ECONOMIC ADVISORS ON FINANCIAL CHALLENGES REF: 06 BEIJING 20974 Classified By: Minister-Counselor for Economic Affairs Robert Luke; Rea sons: 1.4 (B/D) SUMMARY -------------- ¶1. (C) The NDRC Director General for Fiscal and Financial Affairs said that Chinese monetary officials are &doing the best they can8 managing the increasingly difficult policy challenge of maintaining price and financial stability while facing a flood of liquidity in the financial system due to a rising balance of payments surplus. The People's Bank of China will continue to sterilize inflows and raise reserve requirements, perhaps another 3-4 percentage points but other near-term policy options are constrained. This assessment was largely echoed in a separate conversation with the Chairan of the Economic Leading Group. Despite rising inflation which has lowered real interest rates, China is hesitant to raise nominal interest rates to contain investment growth and the flow of bank deposits into equity markets because this would attract additional capital inflows, particularly since U.S. interest rates are expected by many to fall. Moreover, borrowing and investment by state-owned enterprises is unlikely to be sensitive to small hikes. ¶2. (C) Although the renminbi's (RMB,s) rate of appreciation has slowed, this does not signal a retrenchment from the decision to move towards greater currency flexibility. Rather, greater two-way risk in the RMB,s movement is needed to reduce investor expectations of the RMB,s appreciation, which has previously led to excessive speculative inflows. There is growing concern in the Chinese Government about the large and persistent trade surplus, and MofCom,s new emphasis on stressing the importance of reducing the trade surplus reflects this concern. There is a widespread search for mechanisms to slow export growth (e.g., eliminating VAT tax rebates, an export tax on sectors with excess capacity like steel). The government is working on plans to streamline corporate bond issuances and volumes should rise significantly this year. END SUMMARY LIQUIDITY -------------- ¶3. (C) During a recent meeting with Finatt and Econoff, NDRC Director General for Fiscal and Financial Affairs Xu Lin described a Chinese Government struggling with and at times divided over managing the increase in financial sector liquidity due to a large and rising balance of payments surplus. The People's Bank of China (PBOC) is in the short term trying to soak up excess liquidity from the system through interest rate hikes, reserve requirement (RRR) increases, and sterilization. The latter two tools, however, hurt bank profitability, since the interest paid on central bank assets does not cover the banks' cost of funds -- yet the PBOC has no other effective means to keep mounting bank deposits from turning into potentially unproductive loans and/or fueling inflationary pressures in goods and asset markets. ¶4. (C) Xu assessed room for another 300 to 400 basis point increase in the RRR. The bias toward RRR represents widespread concern in the Chinese Government that interest rate increases will only attract more capital inflows and liquidity, particularly given anticipation of a near-term decline in U.S. interest rates, he said. Besides, state-owned enterprises are not sensitive to small increases (interest rate hikes are usually 27 basis points at a time in China). ¶5. (C) Economic Leading Group Chairman Liu He made separate but similar comments about the challenges of liquidity. Liu underscored the government's preoccupation with short-term capital inflows and expressed frustration that higher interest rates would only bring more money into the system. He said the challenges of managing all of these inflows were BEIJING 00003078 002 OF 003 of sufficient concern that there would soon be a special meeting at the State Council to review options. RENMINBI FLEXIBILITY -------------- ¶6. (C) Xu stressed that a &straight line8 appreciation of the remnimbi would only attract further inflows. He explained that recent decline in the RMB,s rate of appreciation does not represent a reversal of the broader decision to pursue greater currency flexibility over time, adding, "We can't go back." ¶7. (C) Xu asserted that the direction of renminbi policy is now transparent and that it is important for China's companies to understand this and plan accordingly. Eliminating predictability in the RMB's movements is important in avoiding having investors perceive that money can be placed in China risk-free as a one-way bet on the currency. ¶8. (C) The currency basket in place is still heavily weighed towards the USD and will remain so given that approximately 65% of foreign exchange reserves are also held in USD (Xu's estimate, which he indicated might not be authoritative). Observing the RMB's depreciation against some Asian currencies, Xu acknowledged that the RMB has not moved much on trade-weighted basis, and this is clearly a factor fueling China's trade surplus. Xu said MofCom has softened its position on the currency and trade surplus issues, now recognizing the need to balance promotion of exports and foreign direct investment with the need to reduce broader macroeconomic imbalances. IMBALANCES -------------- ¶9. (C) Xu said the government is determined over the longer term to reduce China,s external imbalances by encouraging domestic consumption. In the mean time, China is reducing VAT rebates for exports and identifying other measures that the State Administration for Taxation and MofCom can deploy to slow the rise in China's current account surplus. Even zeroing out VAT rebates, however, will still leave some products highly competitive, so there may the need for export taxes on products like steel and that consume a lot of energy or pollute heavily. Such an arrangement would only be needed for 1-2 years, he suggested. CORPORATE BONDS -------------- ¶10. (C) Developing a corporate bond market is a priority, according to Xu. Institutional reforms are underway and there will soon be a dramatic increase in issuance volume. Contrary to press reports, Xu said that transferring approval authority from NDRC to CSRC is still under debate. NDRC is not adamant about hanging on to its existing authority, but the outcome of any changes must be a market-oriented issuance process with clear and simple procedures for obtaining approval. Xu mentioned there may soon be pilot projects for foreign companies to issue RMB bonds here. Wal Mart has shown interest in participating; this would allow the company to obtain RMB for local operations without increasing foreign exchange inflows into the country. (Comment: It would also facilitate diversification of Chinese investors, financial assets by giving them access to debt instruments of blue chip foreign companies. End Comment.) STATE FOREIGN EXCHANGE INVESTMENT CORPORATION -------------- ¶11. (C) Our government contacts have suggested the new State Foreign Investment Exchange Corporation (SFEIC) will focus primarily on portfolio investments. Xu, expressing a personal view, said he would like SFEIC to explore more direct investment opportunities, perhaps working with other partners to invest in infrastructure and energy in Asia. Whatever the case, SFEIC will have limited fund management talents at first, so it will take time to ramp up assets BEIJING 00003078 003 OF 003 under its management. NDRC's role will be informal and suggestive, although the NDRC may ultimately hold a seat on any board set up to advise SFEIC. ¶12. (C) The SFEIC might also be a catalyst for bond market development. The Ministry of Finance could issue Treasury bonds with a duration greater than the PBOC,s sterilization bonds, extending China,s domestic yield curve said Xu. (Note: SFEIC Chairmen Lou Jiwei later confirmed to Ambassador Randt that the most likely financing scheme will be for MOF to issue RMB denominated bonds, buy foreign currency from SAFE, and then invest the foreign currency in SFEIC. End Comment) STOCKS AND IPO'S -------------- ¶13. (C) Xu explained that the NDRC does not itself approve which Chinese companies go public, but that he holds a vote on the approval committee. NDRC does, however, review projects that IPO proceeds will fund and then send comments to the CSRC stating whether investment plans are in line with government policies. FISCAL POLICIES -------------- ¶14. (C) Xu called for greater coordination between monetary and fiscal policies. The government should stand ready to help workers and companies dislocated by an appreciating RMB. Tax revenues are rising rapidly, so the government is in a good position to offset any contractionary impact of currency appreciation through fiscal stimulus, which would also improve the social security system, and pursue initiatives that would narrow the growing income gap. However, the Ministry of Finance resists this. It is focusing too narrowly on containing the growth of government debt, explained Xu, and limits too strictly, for example, NDRC,s budgetary allocations for rural infrastructure investment. As a means to provide fiscal stimulus, tax cuts are undesirable because they would widen income disparities. "PEACEFUL RISE" AND THE STRATEGIC ECONOMIC DIALOGUE -------------- -------------- ¶15. (C) Liu He referred to China's desire to have a "peaceful rise" on the world stage. China will pursue policies that bring stability around the world so that it can raise the living standards of its own population. In this regard, the Strategic Economic Dialogue is highly valued by Chinese officials as a means to advance issues that will allow China and the U.S. to pursue growth on mutually beneficial terms. To this end, there is a need for SED outcomes that demonstrate the dialogue's short-term value while laying the groundwork for productive longer-term collaboration. Liu predicted that it would be relatively easy for both sides to achieve energy and environment related deliverables, much more so than attaining finance-related outcomes. COMMENT -------------- ¶16. (C) Xu and Liu both saw China's monetary policy options as frustratingly limited. Liu, however, commented that Xu is particularly reform-minded and stands out among his colleagues at the NDRC. RANDT