SHANGHAI STOCK EXCHANGE UP 300 PERCENT IN TWO YEARS

UNCLAS SECTION 01 OF 03 SHANGHAI 000679

SIPDIS

SENSITIVE
SIPDIS

STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK
STATE PASS CEA FOR BLOCK
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/LOI/READE
USDOC FOR 4420
USDOC FOR ITA/MAC DAS KASOFF, MELCHER AND MCQUEEN
TREASURY FOR EXEC - TSMITH, OASIA/ISA -DOHNER/BAKER/CUSHMAN
TREASURY FOR WRIGHT AND AMB HOLMER
TREASURY FOR SOBEL AND MOGHTADER
NSC FOR MCCORMICK AND TONG

E.O. 12958: N/A
TAGS: EFIN EINV PGOV CH
SUBJECT: SHANGHAI STOCK EXCHANGE UP 300 PERCENT IN TWO YEARS

REF: A. SHANGHAI 534


B. SHANGHAI 133

C. SHANGHAI 325

D. SHANGHAI 251

SHANGHAI 00000679 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 Composite Index
topped 6,000 points on October 15 bringing gains over the past
two years up to 300 percent. This growth is "good" according to
a Shanghai Stock Exchange (SSE) official and the government
should not attempt to set limits on where the index should be.
Instead, the government should promote new products, laws and
regulatory oversight that protect the interests of investors.
Legal protections for investors are weak. Concerns about how to
protect retail investors from losses mean that the Tianjin-Hong
Kong "Fast Train" investment plan is on hold, but short selling,
margin trading, and a stock index futures product will be
introduced soon. The SSE will not be interested in swapping
equity with the Hong Kong exchange until it is privatized, but
it is also being courted by other international exchanges.
Non-Chinese companies that might want to issue a primary or
secondary listing on the SSE will need to wait until competing
Chinese agencies agree on a legal framework and China's foreign
exchange controls are lifted. End summary.


2. (SBU) Shanghai Stock Exchange (SSE) Assistant to the
President Dr. Que Bo, noting that the Shanghai Composite Index
closed over 6,000 points for the first time on October 15, told
Econoff on October 19 that the SSE's management has been
"surprised" at the 300 percent increase in the market over the
last two years (ref A). "Over the past two years many things
have been unexpected. We expect more unexpected things to
happen in the future," he said. According to Que, all this
growth is "good" and the government should be happy to see the
markets going up. While there have been official government
media stories talking down the markets, as happened in February
and June (refs B & C),the SSE thinks that the government should
not interfere with the market to maintain a certain index level.
Instead, the government should focus on promoting better legal
and regulatory infrastructure and encourage new products such as
futures, short selling and margin trading in order to better
protect investors.

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A Share-H Share Swap?
--------------


3. (SBU) Que said that China Security Regulatory Commission
(CSRC) Vice Chairman Tu Guangshao's widely-reported October 17
remarks that CSRC was considering permitting the exchange of
mainland-listed A shares and Hong Kong-listed H shares had been
"completely misunderstood" by reporters. Que clarified that
CSRC's Tu had been referring to a swap of equity between the
Hong Kong and Shanghai Stock Exchanges. This swap of equity was
an "unilateral wish" on behalf of the Hong Kong stock exchange
since the SSE has neither the ability nor the desire to swap
equity with any stock exchange at this point. The Hong Kong
government is afraid that with international exchanges buying
each other up, the same thing might happen to their exchange.
As a result, they are trying to "pre-empt" this from happening
by buying up enough of the Hong Kong exchange so that "the
Japanese Stock Exchange couldn't own it."

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SSE's Dance Card is Full
--------------


4. (SBU) While the SSE was ignored by the world's exchanges for
its first 15 years, in the past year it has been heavily courted
by stock exchanges from around the world, including NYSE,
NASDAQ, London, Nikkei. They are all interested in partnering
with and acquiring some of the SSE. The SSE, however, is still
government-owned. While most SSE staff would like to see it
privatized, it will be "5-15 years" before the regulators feel
comfortable enough to let this happen. The SSE needs to improve
its own management capabilities, human resources, and bring

SHANGHAI 00000679 002.2 OF 003


itself up to international standards before this will take place.

-------------- --------------
Tianjin-Hong Kong 'Fast Train' -- Off the Tracks?
-------------- --------------


5. (SBU) Que said that the much-ballyhooed Tianjin Bank of China
- Hong Kong "Fast Train" proposal to allow Mainland investors to
purchase stocks on their own accounts on the Hong Kong stock
exchange is not likely to happen anytime soon. Recent success
of new Qualified Domestic Institutional Investor (QDII)
products that invest in Hong Kong and elsewhere have
accomplished the goal of starting to move money out of China in
a way that looks safer to the regulators than letting retail
investors make their own decisions about stocks in Hong Kong.
Que expects more delays and backtracking on this issue before it
is finally derailed over regulatory discomfort with the risks
involved to individual investors.

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Short selling -- In Place Soon
--------------


6. (SBU) Regulatory approval to allow Chinese investors to
engage in short selling of stocks "will definitely be in place
soon, possibly by the end of this year." Que said that both the
SSE and stock brokerages are "technically ready" to handle short
selling. The decision on timing will be made by the CSRC who
are apparently concerned that they do not understand the effects
that short selling will have on the market. The CSRC hopes to
time their decision so that it would "not destabilize the
markets." Que added that margin selling is another innovation
that will be introduced after the markets have adjusted to the
expected launch of the stock index futures product.

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The Futures Is Also "Soon"
--------------


7. (SBU) Que dismissed rumors that the stock index futures
product could be launched as early as November, saying State
Council approval is necessary and they are not ready to give it.
He said that while the China Financial Futures Exchange (CFFEX)
is ready to launch its first product -- a stock index future --
it is not likely to happen until the beginning of next year (Ref
D). (Note: Mutual fund managers tell Econoff that not having
this index fund hurts their ability to hedge risks and keep up
with the market. The Chinese government is concerned that a
stock index future product would destabilize the markets
further. End note. )

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Regulatory & Legal Framework: Implementation is Weak
-------------- --------------


8. (SBU) Protecting investors continues to be one of the SSE's
major goals. Que said that the SSE's Surveillance Department is
"incredibly busy" with daily reports about insider trading and
other irregularities. While all of these tips and complaints
are sent to the CSRC for further investigation, most are not
investigated since the CSRC lacks the staff to follow through.
China has lots of laws and regulations designed to protect
investors, but its implementation of these laws is weak.
China's legal structure contributes to this weakness since it
does not depend on case law for precedents. Each case is
decided by the courts based on their own interpretation of the
law. The markets have grown and changed too rapidly for judges
to keep up with those changes, said Que. Last year some
investors tried to sue a company for violating their rights --
the case was not accepted by a judge on the basis that investors
had never sued a company in China before.

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Overseas Companies Listing in China
--------------


9. (SBU) There is currently only one non-Chinese company listed
on the SSE -- a Japanese company. The SSE would be very pleased

SHANGHAI 00000679 003.2 OF 003


to have other non-Chinese companies list and in fact has been
talking with Mercedes-Benz about listing since 1993. Que said
that recently both HSBC and Siemens have expressed interest in a
secondary-listing on the SSE. However there are significant
regulatory and legal hurdles that need to be overcome by the
CSRC, the Ministry of Commerce, and the State Administration of
Foreign Exchange. Que did not think it likely that these
problems could be overcome in the near future -- especially
given the context of China's capital controls.
JARRETT