A FUND MANAGER'S VIEW ON THE CHINA MARKET

UNCLAS SECTION 01 OF 03 SHANGHAI 000332

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E.O. 12958: N/A
TAGS: EFIN ECON PREL CH
SUBJECT: A FUND MANAGER'S VIEW ON THE CHINA MARKET

REF: SHANGHAI 251

(U) This cable is sensitive but unclassified and for official
use only. Not for distribution outside of USG channels.


1. (SBU) Summary: Lombarda China Fund Manager Ian Midgely told
visiting Embassy Finatt, on May 16, that the Chinese government
was attempting to rein in an overvalued stock market without an
overly heavy-handed approach that would undermine the market
reforms put in place to promote capital market development. The
real problem, said Midgely, was that there was simply too much
liquidity in China and not a broad enough array of financial
products, most importantly a vibrant government bond market.
Foreign joint venture fund management companies enjoy a de facto
level playing field with Chinese counterparts, unlike the
situation in securities and banking. Launching financial
futures derivatives products would be "suicidal" in the current
overheated and speculative environment, he said. End summary.


2. (SBU) Visiting Embassy Finatt met with Lombarda China Fund
Manager Ian Midgely, the only non-Chinese fund manager in China,
on May 16. Midgely said that there were currently 58 fund
companies in China; 32 of these were 100 percent Chinese-owned
and 26 were joint ventures between Chinese and foreign
investors. Chinese mutual funds were currently split 75 percent
to 25 percent between retail and institutional investors.
Midgely described most managers of funds in China as "traders,
not managers." Their turnover rate was over 500 percent.
Midgely said his own approach was much more conservative since
he tried to base investments on sound fundamentals.
Highlighting the competitive challenges of using traditional
stock selection techniques in China's raging bull market,
Midgely noted his returns were not as high as some of his
competitors. Nonetheless, he would be somewhat embarrassed to
show his investments to his peers in Hong Kong or London.

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Too Much Money, Not Enough Options
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3. (SBU) Midgely noted that the Chinese government was
attempting to let air out of the market without using an overly
heavy-handed approach that would run counter to the many
market-oriented reforms instituted in the last several years.
Part of the problem, he said, was that most people did not think
the problem was as bad as it actually was. He described the
disconnect between CSRC public statements that claimed to have
"warned" fund managers about risks and the actual circular that
fund managers received from CSRC. The memo actually commented
on how well things were going. The basic problem, Midgely said,
was that there was simply too much money in China's "massively
inefficient" banks and not enough in other financial assets.


4. (SBU) Midgely said that, in the short term, overheated
speculation in China's stock markets could be dampened by
raising the required reserve ratio by 1 percentage point and
raising the interest rate by 50 basis points. The fundamental
problem would remain, however. Chinese investors simply did not
have enough financial products to choose from. (Note: Two days
after the meeting, on Friday, May 18, China hiked the one-year
lending rate by 18 bps and the one year deposit rate by 27 bps.
China also raised the reserve requirement ratio by another 50
bps to 11.5%, effective 5 June. End note.)

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Launching Financial Futures Would Be Suicidal
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5. (SBU) Midgely said that since China did not have an effective
bond market and lacked a risk free yield curve, it was almost
impossible to accurately price riskier assets like equities. To
strengthen its financial system, China needed to develop both
its interbank and exchange-traded bond markets.


6. (SBU) It would be "suicidal" for China to launch its

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financial futures market, which would most likely start with a
stock index futures, in the current frothy and speculative
market environment, said Midgely (Ref A). Chinese investors
were not educated about the risks inherent in a futures market,
he added, with too many believing that futures trading only had
an upside and was without risk. (Note: In separate recent
conversations, Shanghai Financial Services Office Deputy
Director Fang Xinghai and JP Morgan Greater China General
Manager Andrew Zhang said they expected the China Financial
Futures Exchange to launch a stock index fund in late June or
early July. Both claimed that risk could be controlled by
limiting access for those eligible to trade in the product. End
note.)

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Fund Management is a Level Playing Field
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7. (SBU) In contrast to the situation in more developed markets,
fund management companies in China were more profitable than
full service securities firms. Midgely attributed this to the
fact that Chinese brokerages were hugely overstaffed, along the
lines of traditional state-owned enterprises, and full of people
who had no idea what they were supposed to be doing. This
inefficiency was further exacerbated by the relatively low
commissions they earned per trade, and by traders reluctant to
take aggressive positions. One exception, Midgely noted, was
Citic. Should a foreign company be allowed a minority stake in
a JV brokerage with a Chinese partner, Midgely was pessimistic
as to the possibility of that company's success. "Unless they
have real control of the company, they will have real problems,"
he said.


8. (SBU) Midgely speculated that the CSRC had allowed foreign
companies to own up to 49 percent of fund management companies,
rather than the more restrictive equity caps in securities,
since fund managers could only deal in products that already
existed, he said. Real power, he said, was in the hands of the
securities firms since they were able to create products and
influence which firms are able to come to market. For foreign
firms, "fund management is a level playing field," said Midgely.
"There is no reason why a foreigner shouldn't do well here."
The restrictions Lombarda faced were those requiring a certain
number of years of experience before offering new products, an
issue not unique to foreign firms.

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More Discretion is Coming
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9. (SBU) The CSRC would soon grant approval for fund managers to
set up individually tailored fund management products.
Currently, investors in funds - be they large investors or small
investors -- were only allowed to purchase shares in existing
funds. This meant that large investors, who would be able to
sustain more risk, were not given the types of products best
suited to their needs. Discretionary fund management products,
said Midgely, would be open to investors with a minimum of RMB
50 million (USD 6.5 million). These investors would be able to
work with fund managers to tailor a product that fit their
investing goals. CSRC would control the fees that the fund
managers could charge to at least 60 percent of what the fund
charged normal customers.


10. (SBU) According to Midgely, CSRC was implementing this
discretionary fund innovation to address the burgeoning problem
of unregulated "private funds." These illegal private funds (in
Chinese, ziwo jijin) now number in the thousands. Private funds
had staged a comeback, along with the rising stock market, since
they operated outside of CSRC's controls and thereby more
cheaply and with a more individually tailored investment
approach. Of course, being unregulated, these private funds
also represented a greater risk to their customers. Midgely
noted that lots of legal fund management firms had lost staff to

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these unregulated funds.

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Anatomy of a JV: The Lombarda China Fund
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11. (SBU) According to Midgely, the Lombarda China Fund was a
joint venture between Banca Lombarda e Piemontese (49 percent),
Guodu Securities (47 percent) and Pingdingshan Coal Group (4
percent). The JV fund was formed in May 2006 and received China
Securities Regulatory Commission (CSRC) permission in January
2007 to launch its first fund. Under the terms of the
partnership, Lombarda's Chairman and Chief Compliance Officer
were nominated by the local partners while the Chief Executive
Officer, who exercised operational and managerial control, was
nominated by Banca Lombarda. Midgely noted that resolving
management and cultural problems had been an ongoing process.
These disputes included such things as questions of
responsibility, the rate of fund enlargement, and employee
compensation.


12. (U) Embassy Finatt cleared this cable.
JARRETT