Identifier
Created
Classification
Origin
07BEIJING770
2007-02-01 08:41:00
CONFIDENTIAL
Embassy Beijing
Cable title:  

FOREIGN EXCHANGE RESERVES: PROBABLE INVESTMENT IN

Tags:  ECON EFIN EINV CH HK 
pdf how-to read a cable
VZCZCXRO4572
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #0770/01 0320841
ZNY CCCCC ZZH
P 010841Z FEB 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 4396
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC
C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 000770 

SIPDIS

SIPDIS

STATE FOR EAP/CM
USDOC FOR 4420
TREASURY FOR OASIA/ISA - DOHNER/HAARSAGER/CUSHMAN
NSC FOR MCCORMICK/TONG
STATE PASS USTR FOR STRATFORD 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: 02/01/2017
TAGS: ECON EFIN EINV CH HK
SUBJECT: FOREIGN EXCHANGE RESERVES: PROBABLE INVESTMENT IN
NEW ASSETS WITH ATTENTION TO MARKET STABILITY


Classified By: A/ECON MINCOUNS CHRIS BEEDE; REASONS: 1.4 (B/D)


SUMMARY
-------

C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 000770

SIPDIS

SIPDIS

STATE FOR EAP/CM
USDOC FOR 4420
TREASURY FOR OASIA/ISA - DOHNER/HAARSAGER/CUSHMAN
NSC FOR MCCORMICK/TONG
STATE PASS USTR FOR STRATFORD 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: 02/01/2017
TAGS: ECON EFIN EINV CH HK
SUBJECT: FOREIGN EXCHANGE RESERVES: PROBABLE INVESTMENT IN
NEW ASSETS WITH ATTENTION TO MARKET STABILITY


Classified By: A/ECON MINCOUNS CHRIS BEEDE; REASONS: 1.4 (B/D)


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


1. (C) Top officials from the State Administration of Foreign
Exchange (SAFE) said in a January 25 meeting with Treasury
Department Deputy Assistant Secretary for International
Monetary Affairs Mark Sobel, Finatt Loevinger, and Econoffs,
as well as a January 23 meeting that took place before
Sobel's arrival, that SAFE will place a higher emphasis on
long-term returns and a lesser emphasis on liquidity in its
management of foreign exchange reserves. They stressed,
however, that any change would be gradual and done in a way
that minimizes market volatility, particularly with regard to
United States Treasury bonds. They noted that SAFE has
already extended the maturity of its fixed income holdings
beyond the consensus expectations of market analysts. SAFE
officials agreed that developing and sticking to a public
mantra on the management of reserves could help minimize
market uncertainty. They said that quotas for the qualified
foreign institutional investor program (QFII, an inbound
investment channel enabling foreigners to buy Chinese stocks)
and the QDII program (an outbound channel enabling domestic
investors to purchase foreign stocks) should be expanded at
an opportune time. Separately, a Deutsche Bank economist in
Hong Kong told us on January 18 that he believes China is
considering investing some foreign exchange reserves in
shares of companies based in emerging markets but traded in
large and liquid stock exchanges (such as American Depository
Receipts). END SUMMARY

MEETINGS WITH SAFE
--------------


2. (C) On January 25, Treasury Department Deputy Assistant
Secretary for International Monetary Affairs Mark Sobel,


SIPDIS
Finatt Loevinger, and Econoffs met with SAFE Deputy
Administrator Wei Benhua and Deputy Director General for
Reserve Management Yin Yong, following up on a January 23
meeting between Finatt, Econoffs, and SAFE DG for General
Affairs Liu Guangxi.

CARE WITH PUBLIC COMMENTS
--------------


3. (C) In both meetings, Sobel and Loevinger stressed that
management of China's foreign exchange reserves is a
sovereign decision, though the United States Government has
an interest that public statements not contribute to market
uncertainty and a rise in risk premiums. Wei agreed that,
just as in foreign exchange policy, developing and sticking
to a public mantra on the management of reserves could help
minimize market uncertainty. Yin asserted that China had not
officially even stated a reserve management policy. He
admitted, however, that some government officials in China
have made public comments that have impacted markets.

DIVERSIFICATION WITH MARKET STABILITY
--------------


4. (C) SAFE's Wei, Liu, and Yin said that China's reserves
are adequate to meet short-term liquidity needs, such as
terms of trade shocks or shifts in market sentiment. As a
result, SAFE can now place less emphasis on safety and
liquidity and more emphasis on achieving higher long-term
returns. However, any movement into new assets will be done
in a way to minimize volatility in financial markets. Yin
noted that in determining the foreign currency composition of
its investments, SAFE considers: (1) the composition of its
current and capital account transactions as well as its
foreign liabilities; (2) the liquidity of foreign currency
markets; and (3) the expected return on foreign currencies.


5. (C) DG Liu separately told Finatt and Econoffs that he had
a "message": China has a stake in the stability of foreign
financial markets and has no interest in doing anything that
would increase the volatility of, or erode, the value of
United States dollar (USD) denominated assets, particularly
United States Treasury bonds. As China contemplates changes

BEIJING 00000770 002 OF 003


in its management of foreign exchange reserves, it will act
in accordance with these principles, said Liu.


6. (C) Separately, Deutsche Bank Managing Director Jun Ma
told Finatt and Econoff in Hong Kong on January 18 that,
based on talking with his Chinese Government finance
contacts, he expects an entity to be created along the lines
of Singapore's Government Investment Corporation (GIC). As
Ma sees it, China is likely to focus on acquiring stocks with
high growth potential, especially those that offer underlying
exposure to emerging market economies. Given SAFE's size, it
will need to operate in large and liquid markets and thus is
likely to focus on instruments like American Depository
Receipts (ADRs) of corporations based in non-OECD countries.
(Note: ADRs currently trade in the United States and are a
means for United States investors to buy into foreign
corporations not actually listed on United States exchanges.
End Note.)

CHINESE FOREIGN ASSETS NOT LARGE, BUT GOVERNMENT OWNED
-------------- --------------


7. (SBU) Liu acknowledged that China's officially-held stock
of foreign exchange reserves is the world's highest (USD
1.066 trillion as of 12/31/06),but noted that China's
overall foreign assets, considering both private and public
holdings, are not exceptionally large, totaling USD 1.3
trillion, as compared to 11 trillion for the United States,
4.8 trillion for Japan, and 3.5 trillion for Germany. As Liu
sees it, there is much room for expansion of non-official
foreign currency denominated assets, which the government is
trying to encourage.

CREATION OF CHINESE DEPOSITORY RECEIPTS
--------------


8. (SBU) Liu noted that SAFE is undertaking research on
creating Chinese Depository Receipts (CDRs). (Note: A CDR
would be a locally issued and traded financial instrument
with the underlying foreign stock shares held by mainland
banks; the net effect would be that local investors would
have a vehicle, in addition to the QDII, for investing in
foreign stocks. End Note) State-controlled media has
speculated that CDRs would enable Hong Kong-based Red Chips
(subsidiaries of Chinese state-owned enterprises that are
listed in Hong Kong, e.g., CNOOC Ltd and Bank of China Hong
Kong) to trade their shares in Mainland China; these entities
cannot list on domestic stock exchanges because they are
technically "foreign." The Hong Kong Government recently
published recommendations from its in-house think tank, the
Central Policy Unit, calling for the introduction of
"depository certificates of financial instruments issued in
the HKSAR for trading on stock exchanges, interbank markets,
or over the counter on the Mainland," i.e., CDRs.

STOCK MARKET BUBBLE?
--------------


9. (SBU) Liu acknowledged the widespread focus on the rapid
rise of China's stock markets (which rose 130% in 2006).
Given this concern about excessive market valuations, now is
not the right time to expand foreign access to Chinese
domestic shares through the QFII program. That said, Liu
agreed that expanding QFII -- whose volume is presently very
small relative to overall market capitalization -- is a
laudable goal.

COMMENT: IMPACT OF MOVE TO RISKIER ASSETS
--------------


10. (SBU) Recent conversations with government officials,
Chinese think tanks, and Hong Kong-based bankers and analysts
suggest that Chinese foreign currency reserves will be
increasingly invested in financial assets beyond fixed
income, whether or not a new entity is created to manage
them. These discussions indicate that changes are likely to
be gradual, and that SAFE may have already been investing in
longer-maturity and riskier fixed income assets for some
time. As Chinese foreign exchange reserves grow beyond what
is needed as a short-term liquidity cushion, SAFE officials
appear to be grappling with two conflicting challenges: (1)

BEIJING 00000770 003 OF 003


there is greater scope to diversify into riskier and
higher-yielding assets; yet (2) SAFE is increasingly limited
to markets where it can take meaningfully sized positions
without causing disruption. As a result, the bulk of SAFE's
investments outside of fixed income are likely to be in large
and liquid financial assets and markets, most likely equities
in the United States, Europe, Hong Kong (including Red Chips
and H-shares),and Japan.


11. (SBU) Moreover, a shift towards more risky financial
assets will not necessarily lead to major changes in the
currency composition of reserves, given the emphasis
officials place on matching the currency denomination of
foreign exchange assets with the currency composition of
China's current and capital flows and its foreign liabilities.
RANDT