SHANGHAI STOCK EXCHANGE EVP ON CAPITAL MARKET REFORMS

UNCLAS SECTION 01 OF 02 SHANGHAI 000174

SIPDIS

SENSITIVE
SIPDIS

STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN/GLICK/LUNG; NEW YORK FRB FOR
CLARK/CRYSTAL/MOSELEY
STATE PASS CFTC FOR OIA/GORLICK
CEA FOR BLOCK
USDOC FOR ITA DAS LEVINE AND OCEA/MCQUEEN
TREASURY FOR OASIA - DOHNER/CUSHMAN
TREASURY FOR IMFP - SOBEL/MOGHTADER
NSC FOR KURT TONG

E.O. 12958: N/A
TAGS: EFIN EINV ECON CH
SUBJECT: SHANGHAI STOCK EXCHANGE EVP ON CAPITAL MARKET REFORMS

REF: A. Shanghai 159


B. Shanghai 133

This cable is Sensitive But Unclassified. For official use
only, not for transmission outside USG channels.




1. (SBU) Summary: In a March 8 meeting with Beijing Financial
Attache David Loevinger, Treasury DAS Robert Dohner, Asia
Office Director Mathew Haarsager and Congenoffs, Shanghai Stock
Exchange (SSE) Executive Vice President Liu Xiaodong (aka James
Liu) shared his views on necessary reforms to China's capital
markets. Liu said the major current challenge for China's
capital markets was how to manage the excess liquidity. Other
challenges included: the lack of risk management and technical
skills of China's broker dealers, the lack of investment options
beyond fixed income available for Qualified Domestic
Institutional Investor (QDII) quota, and the difficulties that
many Chinese companies had in getting their financial statements
clean enough to apply for a public listing. Liu agreed with
Treasury Secretary Paulson's views (Ref A) that foreign JV
security companies had not been successful in China, but reached
a different conclusion - that approvals of further
foreign-invested securities JVs should be slowed. Liu was
particularly disappointed that the Goldman/Gaohua JV hadn't been
more active in promoting China listings of foreign-invested
enterprises in China, particularly U.S. companies. The China
Securities Regulatory Commission (CSRC) and SSE were actively
pursuing discussions with the U.S. Securities and Exchange
Committee (SEC) and the New York Stock Exchange (NYSE) on the
possibility of approving China Depository Receipts (CDRs) to
allow companies listed on foreign exchanges to be traded in
China as a possible compliment to QDIIs as a way for Chinese
households and firms to invest in foreign companies. Liu hoped
the idea of CDRs could be discussed in the upcoming Strategic
Economic Dialogue meetings in May. End Summary.

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Managing China's Excess Liquidity
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2. (SBU) Liu said excess liquidity was the major challenge for
China's capital markets, particularly as most Chinese broker
dealers and bankers have sub-standard risk management practices.
Even though SSE was perhaps the best stock market in the world
in terms of its technology, many of China's broker dealers were
so far behind technologically that they couldn't even accept new
accounts. The best way to manage excess liquidity was to allow
dollars to flow out to diversify risk and go international.
China was moving slowly on QDII. Liu acknowledged that CSRC
might be moving slowly on QDII in part to avoid a negative
impact on SSE. He said the Shanghai Municipal Government also
had "lots to say" on this issue. Shanghai was not happy with
the current situation where many PRC nationals took cash to Hong
Kong and deposited it there. Liu wasn't happy, either; it was
illegal, unsafe and inefficient. It was clear CSRC was not yet
comfortable with the ability of Chinese financial institutions
to invest overseas since it awarded the contracts for overseas
fund management of China's social security fund to exclusively
to foreigners, a politically sensitive decision. Liu agreed
that it probably made sense to expand the Qualified Foreign
Institutional Investor (QFII) quota. Even if China doubled or
tripled the quota, it "wouldn't be a big deal."




3. (SBU) Liu said another problem was that many Chinese
companies were unable to get their financial statement clean
enough to list. Many had problems with their land titles,
unpaid taxes or even lacked the requisite three to five years of
records.

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SHANGHAI 00000174 002 OF 002


Why Haven't Foreign Security JVs Worked Out as Hoped?
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4. (SBU) Liu, like Paulson, was disappointed with the track
record of foreign securities JVs in China. He said it was
easier for foreign asset management JVs to be successful in
China. First, their business model was simpler since they just
dealt in secondary market listings. Second, asset management
companies were new, most about 2-3 years old and the oldest with
only about a five-year history; thus they had stronger balance
sheets. Third, they were under strong supervision. Finally,
all had performed well in the 18 month-long bull market; 99
percent had made money, no matter what they had done.


5. (SBU) China's broker dealers were a different story. Ninety
percent were old companies and had been financially weakened by
the long stock market drop and weak corporate governance. No
new securities companies had been formed in the last 6-7 years.
Securities firms were also more complicated to manage since they
were involved in a broader range of financial services. The
last 18 months had been an anomaly; all had done well because
the market was skyrocketing.


6. (SBU) Liu was particularly disappointed with Goldman's JV
with Gaohua. China's leaders had been watching it closely.
They recognized that it would have higher operating costs than
Chinese securities firms, but had expected it to be more
successful in increasing the number of share listings in Chinese
markets by persuading foreign-invested enterprises in China to
list in China. For example, Microsoft China was interested in
listing in China, but he hadn't seen Goldman/Gaohua making a
sales pitch. There had been a few foreign listings, including a
Japanese company two years ago and a Taiwan company this year.
However, it appeared that Gaohua was more interested in chasing
the listings of large Chinese companies, carving up slices of
the existing pie, rather than expanding the market. Liu
wondered whether there was some regulatory reason Goldman wasn't
pushing such deals, perhaps related to Sarbanes-Oxley
provisions. Given the unclear benefits of securities JVs, Liu
thought the Chinese regulators should be cautious before
approving any further JVs.

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Interest in CDRs or Similar Instruments
--------------


7. (SBU) Liu said he had accompanied the CSRC to meet with SEC
Chairman Christopher Cox to discuss the possibility of China
Depository Receipts (CDRs) allowing Chinese investors to
purchase U.S. dollar-denominated stocks on China markets. They
agreed to set up a dialogue to discuss the issue. At the time,
CDR was not on the top of China's agenda, now it was. SSE had
also talked to NYSE CEO John Thain two or three months ago about
the possibility of trading NYSE-listed companies in China and
they had set up a task force to explore. Liu thought it was a
good approach. If U.S. blue chips were listed in China, it
would help China's fund management companies and would be good
for promoting corporate governance. Liu hoped China would have
a CDR or similar concept operational in 12 months and hoped the
upcoming SED could take the issue up to speed progress.
JARRETT