HONG KONG ECONOMISTS HIGHLIGHT CHINA'S ECONOMIC

UNCLAS SECTION 01 OF 04 HONG KONG 000647

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM
TREASURY FOR OASIA -- DOHNER, HARSAAGER, CUSHMAN
USDOC FOR 4420

E.O. 12958: N/A
TAGS: ECON EFIN EINV HK CH
SUBJECT: HONG KONG ECONOMISTS HIGHLIGHT CHINA'S ECONOMIC
IMBALANCES, PRAISE NEW FINANCIAL LINKS WITH THE MAINLAND


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


1. (SBU) Comments from Hong Kong-based economists made in a
series of meetings with visiting Beijing Finance Attache
and Econoff suggest the following: Chinese economic policy
makers understand the negative byproducts of the current
macroeconomic policy mix: including overcapacity in some
industries, a structurally high trade surplus, excessive
foreign exchange reserves, excessive growth in monetary
aggregates, and asset price inflation. However, some parts
of the Chinese Government, e.g., the National Development
Reform Commission (NDRC),remain sensitive about slowing
investment growth and encouraging consumption in its place
because they fear any transitional slowdown could adversely
impact the rural and migrant populations, exacerbating
social tensions. A more rapid pace of renminbi (RMB)
appreciation is a powerful tool in reducing high levels of
liquidity and there are signs that several economic
ministries are growing more comfortable with this prospect.
China is likely to start investing its rapidly accumulating
foreign exchange reserves in higher-return assets,
particularly equities traded in large and liquid stock
exchanges, including the listed shares of companies based
in emerging markets.


2. (SBU) A recent announcement that mainland financial
institutions will be able to issue renminbi-denominated
bonds in Hong Kong breaks new ground: this is the first
time that renminbi-denominated financial instruments will
be issued outside of mainland's financial system. However,
the near-term prospects for issuing RMB bonds in Hong Kong
are modest, as the pool of RMB deposits remains small. The
Hong Kong Monetary Authority (HKMA) hopes that giving Hong
Kong-based banks higher yielding RMB fixed income assets
will allow them to offer higher deposit rates and thus
increase RMB deposits over time. HKMA also hopes the bonds
will be a source of financing for foreign bank subsidiaries
in China that may find it convenient to draw on renminbi
deposits in Hong Kong (since it will be initially difficult
for these entities to collect renminbi deposits on the
mainland itself). However, Beijing-based regulators say
they do not plan to allow foreign banks to issue RMB bonds
in Hong Kong in the near-term. END SUMMARY

MEETINGS IN HONG KONG
--------------


3. (U) Beijing-based Financial Attache and Econ Internal
Unit Chief joined Congen Hong Kong's Economic Unit Chief
for a series of meetings with Hong Kong-based economists
and the Hong Kong Monetary Authority. The meetings were
held in late January, 2007.

A NEED TO REBALANCE
--------------


4. (SBU) All of the Hong Kong-based economists said that
China's investment- and export-led growth model is
unsustainable, and several of them assessed that PRC
economic policy makers across all ministries now
increasingly understand this. However, Citibank Managing
Director Yiping Huang, for example, characterized the NDRC
as particularly anxious about slowing growth, given the
priority placed on job creation, but asserted that even
these officials increasingly understand that greater
consumption can offset over time any decline in growth due
to lower growth in investment and net exports. However,
the social welfare spending needed to achieve this (to fund
pensions, health care, and education) is less visible to
the population than tangible fixed asset investment
activity like building bridges and thus less politically
attractive to local government officials. Huang predicted
that government officials will remain hesitant to meddle in
an economy still experiencing high growth and manageable
inflation, and China will likely stay the current course
until forced into change by an economic shock.


5. (SBU) Deutsche Bank Managing Director Jun Ma expressed
concern that measures taken to date to slow down investment
are insufficient. He is already seeing data that suggests
that the growth rate in fixed asset investment, which has
cooled in recent months, is on the way back up, as local
governments simply delayed implementation of projects into
2007 to meet administrative targets. Large capital inflows

HONG KONG 00000647 002 OF 004


are inflating asset prices; there may already be a bubble
in the stock market and a continued need to take measures
to cool the property market. He envisaged the recent
downturn in the Chinese and Hong Kong stock markets and he
also said another small interest rate increase would help
signal that the government has assessed that asset
inflation has gone too far. John Anderson from UBS thought
that the sharp rise in the Chinese stock markets was not
in the Chinese government's interest. If valuations got
too high, regulators might need to reimpose the moratorium
on IPOs to reduce supply, which would undermine their
efforts to improve corporate governance through IPOs. From
the regulators' perspective a steadily, but not excessively,
rising stock market was ideal.

CURRENCY AND RESERVE POLICY
--------------


6. (SBU) Several economists to whom we spoke predicted that
China will soon put aside US$ 200-300 billion of its 1
trillion in foreign exchange reserves to invest in higher
yielding assets, particularly equities in large and liquid
financial markets. Most thought the PRC would take great
care not to destabilize markets. One economist thought
there would be a bias against U.S. stocks because of
concerns about dollar weakness. This economist expects
China to consider emerging market stocks that trade in
liquid markets (such as American Deposit Receipts of such
companies). The underlying fundamentals of these
securities reflect the home country economies, which should
outperform in the coming years, enough so to make up for
U.S. dollar weakness.


7. (SBU) An economist said his discussions with People's
Bank of China (PBOC) officials convinced him they are
looking for evidence to convince skeptics that currency
appreciation will help pressure Chinese companies to move
up the value-added chain, thus helping to support a key
Chinese government priority. He characterized the Ministry
of Commerce (MOFCOM) as relaxing its resistance to currency
appreciation, having observed that no significant harm has
come to exporters since China broke its U.S.-dollar peg in
July 2005. Another economist said that his PBOC contacts
recently told him that the case for RMB flexibility is
growing stronger but that arriving at broader government
political consensus will take time.

RENMINBI BONDS IN HONG KONG
--------------

8. (SBU) China recently announced approval for the sale of
renminbi-denominated bonds in Hong Kong by mainland
financial institutions. This will widen the channels for
renminbi deposits held by Hong Kong household and
enterprises to flow back to the Mainland. The move is the
latest step since the 2004 opening up of renminbi business
in Hong Kong, where 38 banks have already taken nearly US$
3 billion in RMB deposits and the use of mainland issued
bank cards for purchases in Hong Kong by tourists is now
widespread.


9. (SBU) Hong Kong Monetary Authority External Department
Executive Director Julia Leung observed that RMB bond
issuances will likely be limited as first, since only those
residents and businesses allowed to maintain RMB deposits
(earned though valid current account transactions) or banks
using those deposits will be allowed to purchase RMB
denominated bonds. However, since the bonds can be
expected to offer higher yields than RMB deposits at
the Bank of China, which is where Hong Kong based
banks must now place their RMB deposits (which are
subsequently deposited in the PBOC's Guangzhou branch),
their effect is likely to be an increase in the interest
rate on RMB-denominated bank deposits and a growth in such
deposits over time. Leung assessed that foreign banks and
corporations with a need for RMB in China may eventually be
able to issue RMB bonds. This could, for example, be
useful to foreign banks that seek a source of RMB to make
loans in China, given that due to limited retail networks,
it will take time for these banks to grow their RMB deposit
base. (Comment: In subsequent meetings, PBOC officials
said there is no plan to allow Chinese subsidiaries of
foreign banks to issue RMB bonds in Hong Kong in the near
term.)

CDR'S: A NEW CHANNEL FOR OUTFLOWS?

HONG KONG 00000647 003 OF 004


--------------


10. (SBU) One economist told us that China's State
Administration for Foreign Exchange (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 local investors
would have a vehicle, in addition to the Qualified Domestic
Institutional Investor (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) to trade their shares in mainland
China; these entities cannot list on mainland China's
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."

REACTION TO NEW FINANCIAL INSTRUMENTS
--------------


11. (SBU) Hang Seng Bank Deputy General Manager Andrew Fung
underscored the importance of new links with the mainland's
financial system for Hong Kong's status as a financial
center. He sees particular benefit to Hong Kong in CDRs,
which he assessed to be "a done deal." Fung said that RMB
bonds are a helpful pilot effort but observed that they
will only be marketed through a limited channel - Hong Kong
residents and banks that have RMB deposits. He noted that
Hong Kong would also like to see RMB-denominated listings
on its exchange, but to be liquid this would require a
significant capital account opening that mainland China is
not ready for. In the meantime, HKD-denominated H-share
IPOs end up discounted because of anticipated depreciation
relative to the RMB that takes place during the lengthy
time required to convert Hong Kong dollar initial public
offering proceeds to RMB.


12. (SBU) HKMA's Leung said that although the RMB bonds
create new inflows into China, they are a key step forward
in expanding Hong Kong's role as a financial center that
can serve the mainland's financial system. If mainland
China goes forward with CDRs, this will also be an
opportunity for Hong Kong's financial sector while at the
same time creating a new channel for capital outflows.
Leung expressed interest in seeing an expansion of the
QDII program noting that this would create fee income for
financial institutions based in Hong Kong.


13. Leung noted that a high level advisory group had
recently issued a series of recommendations for reforms of
the mainland financial sector to promote Mainland/Hong Kong
integration. She encouraged the USG to review these
recommendations (which received considerable support,
though not an explicit endorsement from the HK government)
and considering incorporating them into SED deliverables so
that mainland officials would hear a unified message on
financial services liberalization.

SHENZHEN DEVELOPMENT BANK
--------------


14. FINATT met with Shenzhen Development Bank (SDB)
President Frank Newman. Newman stressed the important and
supportive role of Shenzhen city officials, who are
appreciative that Newbridge had turned SDB from a large
contingent liability into an income-earning asset. He
viewed the arrest of the bank's former Party Secretary as a
sign that the government and party are increasingly serious
about reducing directed lending.


15. Newman expressed concern that despite numerous
attempts, China's Securities Regulatory Commission (CSRC)
would not approve Newbridge's proposal to compensate
tradable shareholders, by allowing it to issue stock to
meet capitalization requirements. He noted that large
institutional holders of tradable shares understood
Newbridge's prudential constraints on giving away financial
assets to tradable shareholders. He thought it was unfair
for CSRC to press Newbridge to provide the same amount of

HONG KONG 00000647 004 OF 004


compensation as non-tradable shareholders in other listed
companies because typically those non-tradable shareholders
(most often the government) owned a 70 percent stake, while
tradable shareholders in SDB only owned an 18 percent stake.
However, he thought CSRC was reluctant to approve any deals
too different from others out of concern they would be
criticized for approving a more favorable arrangements for
foreign shareholders.


16. Newman said China's Banking Regulatory Commission
(CBRC) and PBOC moral suasion and administrative controls
tend to be implemented "pragmatically." He noted that
though SDB was initially on the list of banks that were
prohibited from providing new loans last summer, once they
explained the progress SDB had made in improving their
operations and how important new loans were to their
reforms, regulators allowed them to go ahead.


17. Newman thought CBRC was comfortable maintaining the
current foreign direct investment (FDI) limits in Chinese-
invested banks (20% for a single investor and 25% for all
foreign investors). It was large enough to allow for
strategic investments, bringing capital and know-how, but
still allowed the majority of financial benefits to accrue
to domestic investors.


18. (SBU) This message was jointly drafted by Congen Hong
Kong and Embassy Beijing.