INFLATION, OVER-INVESTMENT KEY CHINESE RISKS HK

UNCLAS SECTION 01 OF 02 HONG KONG 002598

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM AND EEB/OMA,
TREASURY FOR DOHNER, HARSAAGER, YANG, WINSHIP, AND CUSHMAN,
NSC FOR TONG AND WILDER

E.O. 12958: N/A
TAGS: ECON EFIN HK CH
SUBJECT: INFLATION, OVER-INVESTMENT KEY CHINESE RISKS HK
ECONOMISTS TELL TREASURY DAS DOHNER


1. (U) Summary: Hong Kong-based China analysts warned U.S.
Treasury representatives that unproductive investment was a
disturbing trend that threatened to derail Chinese economic
growth and stability, but that the risk to the Chinese
economy from a U.S. slowdown was minimal. Analysts differed
in their assessment of Chinese inflation, with some
dismissing current price increases as a one-off food supply
shock and others seeing long-term wage and price increases as
a potential threat to growth. Renminbi appreciation thus far
has had no discernible effect on U.S./China trade flows and,
barring a significant U.S. economic slowdown, analysts expect
even a large appreciation would simply shift U.S. demand for
imports to other suppliers. A sharp drop in Chinese exports
is unlikely to hurt the Chinese economy and could even
benefit China by encouraging the development of domestic
consumption, but could harm regional suppliers tied to
Chinese export-processing industries. End Summary.


2. (U) Treasury Deputy Assistant Secretary for East Asia,
Robert Dohner, accompanied by Treasury East Asia Office
Director Mathew Harsaager, and Treasury economists T.T. Yang
and Ben Cushman, met with Hong Kong-based economists and
analysts September 24-5 to discuss Chinese macroeconomic
performance, currency policy and risks to the Chinese
economy. Dohner's party met separately with Michael Spencer,
Chief Economist, Asia and Jun Ma, Chief Economist, Greater
China at Deutsche Bank; Robert McCauley, Chief Representative
at the Bank for International Settlements (BIS); Yiping
Huang, Managing Director at Citigroup; and Morgan Stanley's
Managing Director and Chief Economist, Stephen Roach.

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Inflation is not a threat... or is it?
======================================


3. (SBU) Views about the seriousness of inflationary
pressures in China were mixed. Some, including Stephen Roach
of Morgan Stanley and Jun Ma and Michael Spencer of Deutsche
Bank, dismissed rising Chinese inflation as a food-based
supply shock that would correct itself. While acknowledging
that increasing food prices threaten those at the lower end
of the income scale and are a short-term risk to stability,
they believe prospects for the fall harvest are good and
expected the price of pork to fall dramatically by next year.
Ma and Spencer predicted that inflation would fall from
current levels of over 6% to just 3% by early 2008. In the
near term, they suggested the Chinese authorities would use
price controls and other mechanisms to force manufacturers to
keep prices down.


4. (SBU) Others, including Citigroup's Huang Yiping and
BIS's Robert McCauley, told DAS Dohner that one-off supply
shocks were part of the problem, but they were less sanguine
about the prospects for Chinese prices. Huang noted that
prices have been steadily trending up for some time and would
continue to do so, barring agricultural trade liberalization.
McCauley added that, with over 45% of the Chinese CPI
measurement comprised of "core" elements like food, official
inflation statistics did not do a good job of capturing price
movements. With current inflation in China pushing interest
rates into negative territory, Chinese are increasingly
moving money out of traditional savings and into goods,
property and stocks, said Huang, feeding bubbles in land and
equity prices.


5. (U) Analysts acknowledged reports that labor was becoming
scarce in the manufacturing centers of the Pearl River Delta
and Shanghai, and that formal wages in these areas are
increasing, but agreed that rising wages are more than offset
by increases in productivity. Labor costs should not drive
inflation in the near term, they said.

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China Immune from U.S. Recession?
=================================


6. (SBU) Analysts agreed that the subprime loan-generated
liquidity crunch did not appear to be a problem for Asian
banks. Of greater concern is that a U.S. economic slowdown
could hurt Asian exports and slow growth in Asia outside of
China. Ma and Spencer worried that a U.S. recession or
protectionist trade legislation directed at China could have
disastrous effects on Asian economies. The current trade
paradigm has regional economies increasingly exporting raw

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materials and intermediate components to China for processing
and eventual export. Spencer argued that a sharp slowdown of
Chinese exports to the U.S. would catch other regional
producers, reducing their exports, and undercutting
confidence in the "still fragile" economic growth in the
region. The Deutsche Bank economists warned that falling
Chinese exports could lead to competitive devaluations in
Southeast Asia, slowing investment and further eroding
industrial capacity, potentially fostering another regional
economic crisis. A U.S. recession might even benefit China
by reducing the red-hot growth rate to just 10% and
encouraging the development of domestic consumption, said Ma.

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Too Much Investment Choking the Chinese Economy
============================================= ==


7. (SBU) Domestic consumption is the key to continued
Chinese economic development, according to Morgan Stanley's
Stephen Roach. Total consumption accounts for only 50% of
China's economic activity and just 35% is private sector
consumption. China needs pro-consumption policies and
accelerated capital reforms to create sustainable growth.
The current Chinese leadership is more risk-averse than their
predecessors, said Roach, and less willing to embrace bold
measures. Re-orienting the economy and controlling
investment rates are crucial to keeping China on a
sustainable growth path, but incentives at the provincial
level still reward rapid growth over sustainability. Barring
a large increase in interest rates, the central government's
only near-term option for controlling investment growth is
administrative controls, including strict management by the
National Development and Reform Commission (NDRC),said
Roach.


8. (SBU) Huang agreed that economically inefficient
investment is becoming a problem for China. Subsidized land,
artificially low labor costs, administered energy prices, and
lax environmental regulatory enforcement reduce the cost of
investment and encourage projects that would be rejected if
the true costs were born by investors. Ma and Spencer agreed
that most Chinese investment is still directed toward
infrastructure, heavy industry, and real estate. The
Deutsche Bank economists predicted real estate investment
would grow by more than 20% per year over the next several
years. Roach noted concerns about a property bubble, but
argued that the Chinese leadership views this as a natural
result of shifting investment patterns.

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RMB Appreciation Won't Solve U.S. Trade Deficit
============================================= ==


9. (SBU) Dohner asked analysts whether RMB appreciation
would significantly affect the U.S. current account deficit.
Roach responded that RMB strengthening over the past three
years had done nothing to reduce Chinese export growth and
suggested that a large and sudden appreciation of at least
15% is the only way to impact Chinese exports to the U.S. He
predicted that such a shock would have repercussions in the
Chinese domestic financial sector, noting that many banks
have indirect exposure to U.S. dollars; mid-size banks in
particular are unsophisticated managers of currency risk, he
said. Morgan Stanley believes the U.S. savings rate is the
key to addressing the current account deficit. Even if the
RMB appreciated dramatically, Roach predicted, the U.S.
appetite for imports would just shift elsewhere.


10. (U) Treasury Deputy Assistant Secretary Dohner did not
have the opportunity to clear this message.
Marut