SHANGHAI STOCK EXCHANGE BREAKS THROUGH 5,000

UNCLAS SECTION 01 OF 03 SHANGHAI 000534

SIPDIS

SENSITIVE
SIPDIS

TREASURY FOR EXEC - TSMITH, OASIA/ISA
TREASURY FOR WRIGHT AND AMB HOLMER
USDOC FOR ITA/MAC DAS KASOFF, MELCHER AND MCQUEEN
STATE FOR EAP/CM
USDOC FOR 4420
NSC FOR MCCORMICK AND TONG
STATE PASS USTR FOR STRATFORD
STATE PASS CEA
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON; SAN FRANCISCO
FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK

E.O. 12958: N/A
TAGS: EFIN EINV ECON CH
SUBJECT: SHANGHAI STOCK EXCHANGE BREAKS THROUGH 5,000

REF: A. SHANGHAI 332

B. SHANGHAI 325

C. HONG KONG 2183

SHANGHAI 00000534 001.2 OF 003


(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: The Shanghai Stock Exchange's Composite Index
(SCI) rose above the "psychologically significant" 5,000 point
level for the first time on August 23, closing at 5,032. The
market has risen 80 percent since the beginning of 2007, adding
to the 130 percent gain in 2006. The SCI ended July 2007 at a
record 4441 points and gained 591 points -- 13 percent -- in the
past three and one-half weeks. Consulate contacts almost
uniformly remained bullish on the market and were confident that
market fundamentals support the 5,000 points level. Recent
regulations granting Chinese investors increasing freedom to
invest overseas, particularly in Hong Kong, would be more
significant in the long-term since expected RMB appreciation and
gains in Chinese markets makes keeping money at home more
attractive in the near-term. Market analysts did not anticipate
any moves by the central government aimed specifically at
reducing heating in the stock market, but noted that
macro-economic measures designed to address inflation and
sectoral overheating might affect the markets. End summary.

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Market Fundamentals Support 5,000
--------------


2. (SBU) Lombarda China Fund Manager Ian Midgely (Ref A) told
Econoff on August 24 that the 5,000 level was a "psychologically
significant barrier," but one that is clearly supported by the
underlying market fundamentals. The fundamentals are sound.
Efforts over the past few years to restructure the companies
that are listed on the exchange are now paying off with "quite
spectacular profit results." "This is also the first time I
have seen Chinese companies put the interests of its
shareholders first. They are starting to look more like Western
companies," he said.


3. (SBU) Midgely expected in the short term to see some
volatility, and even a temporary correction back to as low as
4,000 points. However, he would "be very surprised" if the
market did not close above 5,000 points at the end of this year.
Furthermore, he believed that the market would be up an
additional 50 percent in 2008. "Look," he said, "I know that
this sounds crazy if you think about the market starting out at
1,000 points last year. In China, it takes a long time to get
things started, but the companies have taken the hard steps to
restructure. This is what is driving investors. It takes
things a long time to get started in China, but once the process
gets up to speed it just keeps going. China has for years been
so far behind where they should have been that these gains just
make sense," he said.


4. (SBU) According to Midgley, policy makers are not concerned
by rising stock market levels. The stamp tax increase on May 29
(Ref B) reflected their concerns about the churning effect and
unpredictability caused by speculators "stir-frying" their
accounts. Raising the prices of trades was "exactly the right
thing to do" as it dampened the numbers of small trades and
encouraged investors to pour their money into mutual funds.
With fund managers accounting for more and more of the trading
volume, policy makers have increased confidence in the
rationality of the market. "It is better to let fund managers
drive the market," he said.


5. (SBU) Another reason Midgely did not expect policy makers to
issue any "massive or draconian" measures to cool the market was
the upcoming IPOs of such important companies as China Mobile,
China Petroleum and the China Construction Bank. (Note: In a
separate conversation on August 24, Shanghai Stock Exchange
(SSE) Deputy Director Chao Kejian said that the China Mobile IPO
on the SSE would be delayed due to resistance from Hong Kong
Stock Exchange's leaders who were concerned about maintaining
Hong Kong's special role. End note.)


SHANGHAI 00000534 002.2 OF 003



6. (SBU) The August 20 announcement by the State Administration
of Foreign Exchange that Chinese citizens would be allowed to
invest in overseas markets through a special trading account at
the Bank of China Tianjin Branch, meant that over the long term
the values of companies listed both in Shanghai and Hong Kong
would come together. (Note: There are some companies that are
traded both in Hong Kong and Shanghai. Given the
limited-convertibility of the RMB and other financial
restrictions, there have been wide P/E differences between
shares prices of the same company. End note.) In the short- to
medium-term, however, Midgely did not expect that arbitrage
would actually be as easy as reported since structural
impediments remain. He did not expect that P/E rations on the
Hong Kong exchange would rise to 30-40 and did not expect that
the P/E of these companies traded in Shanghai would fall to 20.
(Ref C)

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SSE: 5,000 -- Not a Big Event
--------------


7. (SBU) Shanghai Stock Exchange Deputy Director Chao Kejian
said, on August 24, that the SSE management was not viewing the
crossing of the 5,000 point line as a "big event." "We don't
think that this is very meaningful." Chao said that the
recently released mid-year corporate balance sheets showed
companies listed on the SSE averaged profits over 50 percent.


8. (SBU) Chao said that if profits continued to be strong, SSE
price to earnings (P/E) ratios would fall from the 50s range to
33 by the end of the year. The key issue for continued growth
was that China's economic environment continues to be conducive
to economic growth and expansion. These macro-economic
questions were dependent on whether or not the central
government would tighten economic controls or fiscal policy.
The overheated real estate market and heavy industry sector had
policy makers "worried" he said. They might take steps to cool
off those sectors and this could lead to declines on the stock
market. Interest rate increases by the People's Bank of China
were aimed at inflation and not at the market, he said.


9. (SBU) SSE internal forecasts were for the market to rise to
5,500 or 6,000 by the end of the year. Chao was optimistic
about market sentiment given the expected IPOs of such quality
companies as China Petroleum, the China Construction Bank, the
Bank of Beijing and other big companies. Given the political
sensitivity of the next couple of months as China holds the 17th
Party Congress, Chao did not expect any major policy changes
that would affect market stability.

-------------- --------------
Will Access to Overseas Markets Trigger a Crash in China?
-------------- --------------


10. (SBU) Industrial Securities Research Analyst Shi Hong told
Econ Assistant on August 24, that since China's macroeconomic
situation remained unchanged with continued excess liquidity and
ongoing RMB appreciation, the current stock market "bubble"
appeared to be "very sustainable." Shi expected that the market
would reach 6,000 points by the end of the year. He expected
that the central government would continue to tighten monetary
policy by raising interest rates and bank required reserve
ratios, but it was "highly unlikely" that it would take any
steps directly aimed at the market such as the May 30th stamp
duty increase. It was the central government's aim to maintain
a "Harmonious Society" among the retail investors. This meant
that the government wanted to avoid getting blamed for any
negative outcomes from its policy, he said.


11. (SBU) In the long-term, Shi said, allowing Chinese investors
to purchase stocks freely overseas might trigger a crash in the
Chinese markets. "Maybe when we look back ten years from now,
the trigger to an A-share market crash will be fully tradable
H-shares by regular residents," he said. Shi asserted that the
SSE is a "policy market," controlled by the central government
and subject to political tinkering. In contrast, Hong Kong's
stock market and other markets around the world are free from
political control. Once investors are free to invest in

SHANGHAI 00000534 003.2 OF 003


whatever markets they want to, should the central government
take any "harsh" steps to rein in China's markets, investors
will flee overseas (or to Hong Kong). Investors have confidence
that Hong Kong's exchange is free and driven by market forces
rather than politics. Nevertheless, given the current
environment of RMB appreciation and massive gains, investors
found the SSE a more attractive market at this current time.

--------------
The Bulls are Running in Shanghai
--------------


12. (U) Other consulate contacts expressed the following views
on August 24:


13. (SBU) CITIC Fund Management Company Senior Vice President
for Business Development Peng Yan said that the market will
continue to advance due to investor confidence. In the
short-term, she expected that both individual and institutional
investors will pour new money into the market. New mutual fund
launches will also cause market advances since they are forced
to purchase stocks despite their high prices. Should the
government issue policies aimed at contracting the market, she
anticipated that the market would respond with a drop as sharp
as the recent gains.


14. (SBU) Deutsche Bank Research Associate Hong Tianfeng Hong
noted that while 5,000 points sounded like a high number, over
60 percent of stocks were still below their May 30 level,
pre-stamp tax increase, level. Hong believed that this left
"limited room for a market correction."


15. (SBU) Haitong Securities Company Director Wu Bing said that
"there was too much money in the market." This excess
liquidity, combined with recent company profit statements, was
what had pushed the markets up. Like other analysts, he
expected that the SSE's high P/E ratios would decline as these
profits continued to grow. For example, while the banking
sector, the SSE's largest sector (REF Shanghai 478),has a high
P/E ratio, the growth rate of banks' profits has been at least
30 percent. Since this growth rate was expected to continue for
the next two to three years, its current high P/E ratio was not
actually representative of reality and "quite acceptable."


16. (SBU) Shenyin & Wanguo Securities Company Li Qinghai said
that over-liquidity in the market would continue pushing up the
market. High returns from the equity market were attracting
more capital into the stock market. She noted that August 23's
gains came after yet another PBOC interest rate hike. While
there might be some adjustments, Li was extremely bullish on
future market performance.


17. (SBU) Guotai Junan Research Analyst Kevin Luo said that the
market was unlikely to experience a significant dip despite the
"stretched valuation" at 5000 points. Luo said that that the
market was being sustained by the increasing number of new
investors bringing new money. "On the other hand, as a primary
research brokerage house, we no longer see any more under-valued
stock picks," he said. It was Guotai Junan's house view that
the A-share and H-share price difference would narrow from the
current 60 percent to 20 percent in the next two years.
JARRETT