SHANGHAI STOCK MARKET: UNCOMFORTABLY GOOD

UNCLAS SECTION 01 OF 03 SHANGHAI 000478

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM AND EEB
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN; NEW YORK FRB FOR CLARK/CRYSTAL/MOSELEY
CEA FOR BLOCK
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/ALTBACH/READE
USDOC FOR ITA/MAC DAS KASOFF, MELCHER AND MCQUEEN
TREASURY FOR ADAMS, AND OASIA - DOHNER/BAKER/CUSHMAN
TREASURY FOR WRIGHT AND AMB HOLMER
TREASURY FOR FDIC/BAIR, GRUENBERG, VILLARREAL AND CARNS
NSC FOR WILDER AND TONG

E.O. 12958: N/A
TAGS: ECON EFIN EINV CH
SUBJECT: SHANGHAI STOCK MARKET: UNCOMFORTABLY GOOD

REF: A. SHANGHAI 25


B. SHANGHAI 370

C. SHANGHAI 133

D. SHANGHAI 332

E. SHANGHAI 251

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


1. (SBU) Summary: According to Shanghai Stock Exchange (SSE)
Executive Vice President James Liu, Shanghai's stock market is
"on a rocket" with 60 percent gains so far in 2007. Huge
numbers of new retail investors who most likely lack an
understanding of the risks inherent in the market have been
overwhelming China's stock brokerage firms. Price to earnings
(P/E) ratios are high and profits for most listed companies have
been inflated by earnings the companies have made investing in
the market. This creates the possibility for an even heavier
crash should it come. Financial service sector companies
account for almost 80 percent of the SSE's market capitalization
while retail traders account for almost 90 percent of all
trades. Given the non-convertibility of the renminbi (RMB),
China's stock markets are insulated from other global stock
markets. When to launch the China Financial Futures Exchange's
first product (a stock market futures fund) has become a
political question that must be decided at the State Council
level. End Summary.


2. (SBU) Federal Deposit Insurance Corporation (FDIC) Chairman
Sheila Bair met with Shanghai Stock Exchange (SSE) Executive
Vice President James Liu during her July 26-27 visit to
Shanghai. Chairman Bair was joined by FDIC Vice Chairman Martin
Gruenberg, FDIC Director of International Affairs Fred Carns and
FDIC Chief of Staff Jesse Villarreal. Chairman Bair's other
meetings will be reported septel.

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"We Are On A Rocket"
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3. (SBU) SSE Liu told Chairman Bair that in the past 18 months
the SSE had been "on a rocket" with share values "skyrocketing"
up 61 percent since the beginning of 2007. Average daily
trading volume has been roughly 20 billion USD per day, he said.
(Note: The SSE Composite Index climbed 130 percent during the
last six months of 2006. Ref A).


4. (SBU) Liu said "business has been very good," and while the
SSE "felt very good about the enormous gains," the nature of
these gains was causing immense discomfort for both the stock
exchange's management and Chinese government officials. The
main cause of concern for the SSE was the market's very high
trading volume and the "unprecedented" numbers of new and
inexperienced retail traders jumping into the market. Liu was
concerned that China's brokerage firms did not have the
"capability to handle this type of trading and were not prepared
to deal with the numbers of new investors. (Note: More than
350,000 new trading accounts were opened in June 2007, alone.
There are more than 100 million open stock trading accounts.
Ref B.) According to Liu, there was no way that brokerage firms
could "know their customers" or educate them about the risks.

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Unsuitable Investors
--------------


5. (SBU) Liu noted that while China has regulations mandating
that brokerage firms question the "suitability" of customers
opening trading accounts, these were not being applied.

SHANGHAI 00000478 002 OF 003


Brokerage firms were hiring staff at unprecedented levels in an
attempt to keep up with demand. These new hires were
inexperienced, overwhelmed and unable to adequately judge a new
investor's suitability to sustain risk. Most of these new
investors were entering the market in order to make the same
gains they have heard about from friends and neighbors. "Only
in a country like China would we see such a phenomenon, and we
will see it for a long time to come since there are lots of
people left who have never traded," said Liu.


6. (SBU) Liu said that this wave of new investors into China's
stock market boom differed from those in the United States who
began investing during the Dot.Com boom. U.S. investors at
least had access to some information about companies from
"reading the Wall Street Journal" or watching business shows on
television. Chinese investors, especially these new ones, were
not doing any research at all. According to Liu, they were
basing their stock picks based on which companies their friends
were buying.

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P/E Ratios Also Problematic
--------------


7. (SBU) Price/Earning (P/E) ratios were also a major concern.
Liu estimated that companies listed on the SSE currently
averaged P/E ratio between 35 and 45, though this was lower than
previous highs of 75. Most problematic for Liu was the fact
that "the majority of listed companies are themselves investing
in the stock market." This meant that their profits were tied
to the overall health of their investments in the market and
created a "double-jeopardy" situation. If the market continued
to rise, their P/E ratios would continue to look healthy; if the
market "tumbled, then this would further cause the market to go
down," he said.

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"The Shanghai Financial Stock Exchange"
--------------


8. (SBU) In terms of market capitalization, the SSE has become
increasingly dominated by financial service sector companies.
With the listings of the Bank of China, China Construction Bank,
the Industrial and Commercial Bank of China (ICBC),insurance
companies and brokerage companies, over the past year, 80
percent of SSE was now made up of financial services sector
companies. "We are now the Shanghai Financial Stock Exchange
and dependent on the performance of the financial sector," said
Liu. "This is bad," he said, "ICBC alone represents almost 15
percent of the entire market."


9. (SBU) Liu speculated that over time the dynamics of the
market would even out and become more balanced. He noted that
the future listing of China Mobile, a telecommunication company,
would be a good thing for the market.

-------------- ---
China's Markets: "Not Affected By Outside World"
-------------- ---


10. (SBU) Liu did not believe that China's stock markets would
be impacted by gains or losses in the U.S. equities markets.
While there was "some correlation" with the Hong Kong stock
exchange, Chinese investors were largely unable to move money
out of China and therefore forced to keep their money in Chinese
stocks. He "did not believe for one single minute" that the
February 2007 correction (Ref C) was related to declines on
other international stock markets. Given the non-convertibility
of the Chinese Yuan, "though we might affect the outside world,

SHANGHAI 00000478 003 OF 003


the outside world does not affect us."

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Retail Trades: 90 Percent of Total
--------------


11. According to Liu, retail traders account for 90 percent of
all trades on the Shanghai exchange. (Note: This figure
measures mutual funds as "retail traders." End note.) At their
peak, institutional traders such as insurance and pension funds
accounted for as much as 30 percent of market share and 40
percent of trade volume. With the entry of so many new retail
investors, however, institutional influence on the market has
declined markedly. Recently, 97 percent of USD 30 billion in a
single day's trade was done by retail investors, said Liu. This
has had the effect that institutional investors and fund
managers no longer looked at a company's fundamentals; they now
followed what the retail investors were doing. This was "a
tremendously bad situation," he added. Ref D.

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Financial Futures: Waiting for the Trigger to Be Pulled
-------------- --------------


12. (SBU) In response to a question about the long-expected
launch of the stock index futures product by the China Financial
Futures Exchange (CFFEX) (Ref E),Liu expressed some
exasperation at the delays. According to Liu, CFFEX had been
ready to launch its first product for some time, and, from a
business point of view the stock index futures product should
have been launched "a long time ago." But the timing of the
launch had become a political issue. "The head of CFFEX can't
pull the trigger, the China Securities Regulatory Commission
(CSRC) can't pull the trigger, no one can pull the trigger.
Only the top can pull the trigger, he said." From his
perspective, since the decision to launch had become entangled
with politics, it would be "some time" before it would take
place.


13. (U) This report has been cleared by the FDIC delegation.
SCHUCHAT