HK ECONOMISTS ADVISE CHINA AGAINST SOVEREIGN

UNCLAS SECTION 01 OF 02 HONG KONG 001931

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STATE FOR EAP/CM AMY NICODEMUS AND EB/IFD/OMA DAVID MOORE,
US TREASURY FOR HARSAAGER, WINSHIP, AND YANG

E.O. 12958: N/A
TAGS: ECON EFIN HK CH
SUBJECT: HK ECONOMISTS ADVISE CHINA AGAINST SOVEREIGN
WEALTH FUND TRANSPARENCY, PRAISE CEPA AMENDMENTS


1. (SBU) Summary: A senior Hong Kong private-sector
economist has been advising the Chinese government that a
high degree of transparency is not in the best interest of
China's State Foreign Exchange Investment Corporation (SIC),
as it will subject the fund to political pressure and media
second guessing. HKMA officials thought that Treasury
Assistant Secretary Lowery,s call for greater transparency
in sovereign wealth funds was overly critical as the U.S. has
long rebuffed Asian calls for greater transparency of large
institutional investors like hedge funds.


2. (SBU) Investment banking executives are grateful for the
market access commitments achieved in SED II. Lack of
regulatory transparency and predictability, along with equity
caps and the lack of a clear mandate to allow minority
shareholders management control of domestic firms remain
their primary market access concerns. HKMA officials noted
the benefits of collaboration through the SED-JCCT and CEPA
to gain greater access for foreign financial services firms
and described amendments in the most recent CEPA increasing
access in financial services, notably by: 1) reducing minimum
asset requirements for Hong Kong banks to purchase strategic
stakes in Chinese banks; 2) making it easier for foreign
banks to qualify as "Hong Kong banks" and benefit from CEPA
provisions; and 3) giving Hong Kong banks priority treatment
in applications to open branches in west central and
northeast China and in Guangdong Province. End Summary.


3. (SBU) Beijing-based Treasury Financial Minister Counselor
David Loevinger and Econoff Jim Mullinax met July 13 with
several Hong Kong-based senior economists and representatives
of international investment banks, fund managers, and the
Hong Kong Monetary Authority (HKMA).

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SIC: Transparency Makes Profitability Harder to Find
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4. (SBU) Hong Kong-based economists predicted that the SIC
would have difficulty reaching profitability in the near
term, given prospects for the RMB appreciating by up to 5%
vis--vis the U.S. dollar over the next several years and the
interest rate on Ministry of Finance bonds issued to finance
the SIC expected to be about 4.5%. (Comment: We noted that
there is not yet agreement in the Chinese government on
whether the government,s claim in the SIC will be RMB or
foreign currency denominated. End comment.) To finance the
SIC, Hong Kong economists we spoke to expect the Ministry of
Finance to issue bonds to either a special purpose vehicle or
a consortium of State-owned banks, which would then sell the
bonds to the People,s Bank of China (PBOC). To ensure
market pricing, a small quantity of bonds could be auctioned
publicly.


5. (SBU) One economist has advised the Chinese government
that a high degree of transparency in the SIC would not be in
China,s interest. Regular reporting on the composition and
performance of SIC investments would make it more difficult
for the SIC to focus on maximizing long-run returns,
subjecting it to greater political interference and media
second-guessing. In addition, a high degree of transparency
would allow market players to discern SIC,s investment
strategy and "front run" it. The economist advised SIC's
prospective management that Singapore,s Government
Investment Corporation (GIC) and most of the world,s central
banks do not make public the composition of investments or
returns, suggesting that this was a good model for the SIC to
follow. HKMA officials believe U.S. Treasury Assistant
Secretary Clay Lowery was too critical in his calls for

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greater transparency in sovereign wealth funds. They noted
the irony of the U.S. position advocating greater
transparency in sovereign funds after having repeatedly
rebuffed Asian calls for greater transparency in large
institutional investors like hedge funds.

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Export Misreporting Not a Factor in Trade Figures
============================================= ====


6. (SBU) The economists noted that expectations that RMB
appreciation would slow Chinese export growth had proven
unfounded thus far. Based on a recent survey of firms,
China,s State Administration for Foreign Exchange (SAFE)
believes that disguised capital account transactions in the
current account are relatively small, accounting for probably

HONG KONG 00001931 002 OF 002


less than 1% of the current account surplus. There are
incentives for both under-reporting (tax avoidance) and
over-reporting (access to foreign currency to speculate on
RMB appreciation) of export receipts. According to SAFE,
pre-payments for export receipts (another common tool used to
gain illicit access to foreign exchange) are down 40%.

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Equity Caps, Predictability, Control Top Securities Concerns
============================================= ===============


7. (SBU) The securities company executives we spoke with are
grateful for the market access commitments achieved in SED
II, particularly the removal on the moratorium on new
securities licenses and the ability for foreign securities
JVs to expand into brokerage and proprietary trading.
However, equity caps and the lack of regulatory transparency
and consistency remain their primary concerns. The lack of
regulatory predictability makes long-term planning difficult.
Firms cited as examples the moratorium and the ad-hoc nature
of foreign acquisitions of Chinese-invested securities firms
to date. To the bankers, a more restrictive but transparent
and predicable regulatory regime would be preferable to a
potentially less restrictive but opaque and volatile one.


8. (SBU) While the raising of equity caps in securities
remains a priority, and raising the caps even to 49% would be
helpful, the promulgation of regulations which clearly give
minority shareholders the right to managerial control would
be highly welcome, as this appeared to be a major stumbling
block in the UBS purchase of Beijing Securities.
Promulgating clear regulations on the ability of financial
services firms to provide private banking services is also a
key concern. Firms advised U.S. officials to point out to
Chinese counterparts that the current environment gives a
privileged market position to three foreign securities firms,
enhancing their ability to extract rents.

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CEPA Amendments Ease HK Firms' Entry into China
============================================= ==


9. (SBU) Senior officials of the HKMA described recent
amendments to the Mainland/Hong Kong CEPA on financial
services. First, while firms still need five years operating
experience in Hong Kong to qualify as a Hong Kong financial
services firm and gain the benefits of CEPA, they can now
count up to two years operating as a foreign affiliated
branch (with the rest as an incorporated subsidiary) to meet
the requirement. Under previous rules, a bank needed to have
been incorporated in Hong Kong for at least five years.
Second, the minimum asset requirement for Hong Kong banks to
acquire a strategic stake in a mainland bank has been reduced
from US$10 billion to US$6 billion. Finally, a new "Green
Lane" procedure will give Hong Kong banks priority treatment
in considering license applications to set up branches in the
central western and northeastern regions of China and, most
importantly, in Guangdong Province.
Marut