FRB TOLD: NO OVERHEATING AND BUSINESS GOOD

UNCLAS SECTION 01 OF 05 SHANGHAI 000026

SIPDIS

SENSITIVE
SIPDIS

STATE PASS FEDERAL RESERVE BOARD FRO JOHNSON/SCHINDLER; SF FRB
FOR CURRAN/GLICK/LUNG; NY FRB FOR CLARK/CRYSTAL/MOSELY
TREASURY FOR ADAMS, AND OASIA-DOHNER, BAKER, CUSHMAN
USDOC FOR ITA A/DAS MELCHER, MCQUEEN
NSC FOR HUBBARD AND TONG

E.O. 12958: N/A
TAGS: ECON EFIN PREL PGOV CH
SUBJECT: FRB TOLD: NO OVERHEATING AND BUSINESS GOOD

REF: A) 06 SHANGHAI 7112, B) 06 BEIJING 24442, C) 06 SHANGHAI 7129, D) SHANGHAI 25

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(U) This cable is Sensitive But Unclassified. Not for
transmission outside of USG channels.




1. (SBU) Summary: A Federal Reserve Bank (FRB) delegation led by
Governor Kevin Warsh met with economic analysts, U.S. business
leaders, and equity market analysts during a December visit to
Shanghai. Economic analysts offered the contrarian view that
China's economy was not overheated, and, in the short term,
would continue to maintain its record growth. In the long term,
however, rich-poor gaps, failing educational and health
services, environmental degradation, and a bankrupt pension
system could lead to dramatic political and economic
instability. Business leaders were generally upbeat, noting
that their biggest concern was finding and retaining qualified
employees. Equity analysts said China's stock market had
regained much of the ground it lost during lengthy reforms and
were bullish on continued gains. They believed mergers and
acquisitions (M&A) would play a major role in China's continued
economic growth, but were concerned that foreign players could
be left out. End summary.




2. (SBU) As part of a recent visit to China to assess
macroeconomic and financial sector development, Federal Reserve
System Governor Kevin Warsh, San Francisco FRB President Janet
Yellen, and VPs Reuven Glick and Teresa Curran visited Shanghai
December 1-2 to meet with analysts and business leaders,
including Citibank CEO Richard Stanley (Ref A),accompanied by
Pol/Econ Chief and Econoff. The delegation met separately with
People's Bank of China Deputy Governor Xiang Junbo.



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China's Macroeconomic Situation: Good Now, Bad Later

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3. (SBU) The delegation met with CLSA China Macro Strategist
Andrew Rothman, BHP Billiton China Economist H. Robin Bordie,
and Research Works President Hugh Peymann to discuss China's
macroeconomic conditions. Rothman and Bordie acknowledged that
their view on China's economy differed from the consensus. From
their perspective, China did not have an overheating problem;
rather, its biggest problem was "too slow growth" to balance out
increasing social stability pressures. The analysts forecasted
that strong economic growth for the next seven years would
further widen the rich-poor gap. By 2013, this income-disparity
could lead to widespread social instability.



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How Can It Be Overheated if We Can't Feel the Heat?

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4. (SBU) Rothman said that in recent years there had been "no
real inflation in China," nor symptoms of overheating. While
fixed asset investment (FAI) had continued to grow, this had not
led to overheating. Rothman estimated China's year-on year FAI
growth at 25 percent of GDP -- not excessive when compared to
post-war Taiwan and South Korea. China's problem had not been
too much investment, but rather the poor quality of some
investments. Rothman attributed the quality problem primarily
to the control the Party still exerted on banks, as well as
banks' inability to conduct adequate risk management.




5. (SBU) According to Rothman, China's monetary policy had not
been interest-rate sensitive. China would need to increase its
interest rates by 300 basis points to have any impact on the
economy. Therefore, Bordie said, the government used moral
suasion with banks to reduce their lending rates. She said this

SHANGHAI 00000026 002.2 OF 005


was done by "the Party calling bank managers to tell them what
to do." Typically, this moral suasion had been a three-step
process. The first step was the issuance of a White Paper
identifying a problem. The second step was issuance of a more
"shrill" White Paper calling for drastic measures. The third
step was "arresting someone in Inner Mongolia." It was only
then that individual bank managers would take action, for
example to reduce lending. (Note: Bordie's views were similar
to those expressed by another contact in Ref C that actions
taken against Party Secretary Chen Liangyu were in part an
economic tool to persuade local governments to slow down, in
lieu of effective macro policy. End note.)



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What Keeps China's Leaders Up at Night?

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6. (SBU) According to Rothman, the issue that "keeps China's
leaders up at night," was the poor--both urban unemployed and
those living in extreme poverty in rural areas. According to
Rothman's research, the urban unemployment rate, while
officially only 4 percent, was probably closer to 8 percent and
possibly as high as 16 percent. These unemployed were mainly
unskilled rural migrants. Rothman added that, despite China's
best efforts to reduce rural poverty, there were still more than
150 million people living at less than $1/day. Bordie said that
poverty in China had been essentially a rural issue, with few
real urban slums. However, this had started to change with the
massive migration from rural to urban areas underway in China.




7. (SBU) According to Bordie, China's leaders had made a
"Faustian bargain" to remain in control. The terms of this
agreement were that they "had to keep everyone happy," with
happiness defined in economic terms so they would not question
their inability to participate politically. She said that the
next five years would see huge investments in China's social
infrastructure -- education, healthcare, and pension systems --
as well as continued attempts to rein in corruption. In the
short term, these steps would prove effective. By 2013-2015,
however, a massive and obvious rich-poor gap, a generation of
wealthy individuals not beholden to the Communist Party for
their success, and a substantial decline in the working-age
population would create an environment for significant social
instability and challenges to the Communist Party's monopoly on
power.




8. (SBU) Rothman added that the government had realized that it
now had less control over its people than it had prior to a
decade of market-based reforms. The market-based economy had
"forced the development of personal freedoms." These freedoms
were, in turn, creating a sense of individual entitlement.
Peymann agreed that, unless the government was able to fix
China's healthcare and pension systems and improve its
environment, by 2013, political instability would result from
urban "rich" who would feel entitled to a better life than they
would be able to attain.



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Doing Business in China

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9. (SBU) Starbucks China President Wang Jinglong, American
Express Vice President for Business Services Mary Crawford, UPS
Director Tan Sockhwee, Dell (China) General Manager Yvonne Pei
and U.S. China Business Council's Godfrey Firth briefed the
delegation on experiences of U.S. companies in China. While
generally upbeat on their respective companies' prospects in
China, business leaders noted some policy trends that were
intended to favor Chinese over international companies. The

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high cost of training and retaining staff able to work in an
international environment was also a common theme, with several
noting difficulty finding staff with competent English skills.



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Starbucks: Symbol of Success

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10. (SBU) Starbuck's Wang Jinglong said he believed the Chinese
government was still one of the most pro-business governments in
the world, but noted that its "Fourth Generation Leadership" had
subtly, but dramatically, shifted direction from the previous
profit-driven model to an economic model that emphasized the
need to respect China's "land, culture, and people."




11. (SBU) According to Wang, having a Starbucks had become seen
by China's local political leaders as a sign of progress, that a
town or city "had made it." He said that wherever he went in
China, "the mayor always has time to meet with me." Starbucks
China had also carried out active corporate social
responsibility programs to build goodwill, with over $5 million
USD in donations to educational institutions. As a result,
Starbucks had been able to cut through bureaucratic obstacles in
places such as Xian, where recently it only took three days to
"resolve six months of issues." There were already 200
Starbucks in China and Wang anticipated continued strong growth.




12. (SBU) Wang noted that 80-90 percent of its baristas in China
were college graduates and that while China's labor market was
very big, its pool of experienced, trained workers was quite
small, leading to intense competition. He said that in a market
like Shanghai's, individuals under 30 changed jobs on average
every 17.5 months.



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

Dell: Impacted by China's Self-Innovation Drive

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




13. (SBU) While Dell had 7,000 employees in China and purchased
$20 billion USD worth of computers, it had recently been
negatively impacted by China's recent push to support Chinese
"self-innovation" companies (ref B) according to Yvonne Pei.
Pei said that in Dell's eight years in China, 80 percent of its
computer sales had been to institutions, such as Chinese
government offices. She said that recent changes to the bidding
process meant that Chinese computer companies were awarded extra
points for being "Chinese self-innovation" companies. These
extra points meant that Dell's bids were no longer competitive,
despite the fact that Dell offered lower prices and had an
research and development center in Shanghai that employed
approximately 1,000 people in addition to a manufacturing plant
located in Xian.



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UPS: All Deliveries Are Local

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14. (SBU) Tan Sockwhee noted that UPS opened its first
China-based UPS Express retail store in Shanghai in August 2006
and was now focused on trying to instill the "UPS culture" in
its rapidly growing workforce which had increased from 400
employees in 4,000 the past year. Tan said that one of UPS's
biggest challenges was retaining qualified employees due to the

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high demands for trained employees. Tan described some of the
complications UPS had experienced in entering the Chinese
domestic postal market, saying that "China is not an open
field." Other issues UPS faced were securing landing rights for
the flights it needed to support its volume, and inter-city
transportation problems where, for instance, a UPS truck with a
Shanghai license plate was not permitted to enter another
municipal area such as the nearby city of Suzhou.



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AMEX: Focused on Outsourcing Services

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15. (SBU) American Express's Mary Crawford said Amex's bank card
sector was "very undeveloped in China." (Note: Amex has been
classified by the Chinese government as a travel services
company and thus is limited in its ability to issue bank cards.
End note.) Amex's proposed plan to open a business process
outsourcing services operating center here, however, had been
warmly welcomed. Amex had been encouraged to open the operating
center in the western city of Chengdu, Sichuan Province, but had
not yet settled on a location due to the necessity of finding a
critical mass of potential employees with adequate English
language skills.



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Equity Market Meeting

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16. (SBU) The delegation was briefed on equity market
developments by: Peter Alexander, Principal of Z-Ben Advisors, a
privately-run information clearing house for China equities
information; Ian Midgley, Chief Investment Officer of Lombarda
China Fund Management, a fund management joint venture company
with Italy's Banca Lombarda holding a controlling stake of 49
percent with two Chinese partners, Guodu Securities Company and
Pingding Shan Coal Company; and Robert Theleen, Chairman of
ChinaVest, a Shanghai-based venture capital firm that had been
in China since 1981 with assets of 30-40 billion USD.



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

Stock Markets: Rising Up on a Sea of Liquidity

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




17. (SBU) According to Alexander, China's recent stock market
gains had been largely driven by excess liquidity, with two
trillion U.S. dollars worth of money "sitting idly in banks."
Midgley agreed, but added that the Chinese Security Regulatory
Committee (CSRC) had also recently resolved major structural
issues that had contributed to several years of historic lows
(See Ref D).



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China's Improving Regulatory System

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18. (SBU) Theleen said that China's regulators were "young -- in
their 30's to 50's", many with post-graduate degrees from
universities outside China. He said the regulatory process in
China had been in the process of shifting from the state as
owner-operator-regulator under a Ministry to a more independent

SHANGHAI 00000026 005.2 OF 005


regulatory system. He added that now, thanks in large part to
WTO requirements, when a task-force was formed by the Chinese
government to design a new law or regulation, these
newly-empowered regulatory bodies would join in policy-level
discussions.



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Market To Be Driven by M&A's

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19. (SBU) Midgley said that for the foreseeable future, the
market would be driven by mergers and acquisitions (M&A). He
noted that there was enormous scope for M&A's, pointing out, for
example, that China's top steel producer, Bao Steel, only
represented five percent of China's steel production capability.
The underlying political question, however, was whether foreign
companies would be permitted to participate. According to
Theleen, there were 40 multinational firms with more than one
billion USD each who were ready to invest in China, but who were
hesitant about current policies that seemed to be trending away
from China's recent open-door policy. Midgley added that, in
addition, provincial and city-level governments often owned
companies and thus had enormous power and interest in
maintaining their own brand-names. This might also be a factor
in slowing down the pace of China's M&A activity.




20. (U) The delegation did not have the opportunity to clear on
this cable.
JARRETT