CHINA ECONOMY: OBSERVERS SEE LIQUIDITY HURTING,

UNCLAS SECTION 01 OF 02 BEIJING 003311 SENSITIVE SIPDIS STATE PASS USTR STRATFORD USDOC FOR MCQUEEN NSC FOR HERMANN/SHRIER/LOI TREASURY FOR OASIA/ISA/DOHNER/HOLMER/WRIGHT E.O. 12958: N/A TAGS: CH ECON EFIN SUBJECT: CHINA ECONOMY: OBSERVERS SEE LIQUIDITY HURTING, DISAGREE ON EFFECT ¶1. (SBU) Summary: In recent meetings with visiting Treasury Deputy Assistant Secretary Mark Sobel and Financial Min-Couns, long-time China observers agreed on the basic condition of the Chinese economy, but disagreed dramatically on the likely outcomes. They agreed China's ability to sterilize fully the liquidity generated by protracted and large-scale foreign currency interventions is limited and that this is fueling an unsustainable credit boom and unbalanced growth. Further, although the Chinese economy continues to face inflationary pressures, the government has recently (and in their view prematurely) shifted emphasis slightly from controlling inflation to assisting exporters and businesses hurt by the decline in external demand, rising input and labor costs, the Renminbi's appreciation and credit limits. The analysts diverged on their predictions for the future, with one professor envisioning the possibility of a sharp deterioration in banks' assets leading to a credit crunch, and another analyst calculating that the Chinese economic leadership will find a way to "muddle through" these troubles as they have in the past. End summary. Reserves Grow -------------- ¶2. (SBU) Beijing University Professor Michael Pettis discussed the self reinforcing cycle that promotes larger macroeconomic imbalances and ultimately could lead to financial instability. Excessively loose monetary policies--due to insufficient sterilization of protracted and large-scale foreign currency intervention--leads to more investment in production, which outpaces consumption and then has to be exported. This increases net exports and leads to further foreign currency intervention (given China's rigid exchange rate),providing more money for increased investment in production. ¶3. (SBU) Banking analyst Charlene Chu said the People Bank of China (PBOC) is requiring banks to meet their reserve requirements in U.S. dollars to limit the rise in reported international reserves and as an alternative to sterilized intervention (since PBOC would otherwise have to sterilize the liquidity injected by purchases of foreign exchange). Most banks still have excess reserves, though among the banks, there is considerable variation. For the sector as a whole excess reserves are nearing four percent, while officials suggest a range of 1.5-2.0 percent is prudent, which leaves little room for further increases in required reserves. As such, she expects the PBOC to place more emphasis on raising administered interest rates and/or allowing a faster rate of RMB appreciation to tighten monetary conditions further in the future. Hot Money -------------- ¶4. (SBU) Pettis said that in 2006, at least 89% of international reserve accumulation could be attributed to FDI, the trade surplus, and interest earnings, with the remainder attributable to speculative flows. He said that by 2007 that number had dropped to 70%, and will be 39% this year - implying that over 60% of China's net balance of payments surplus is due to net short-term portfolio inflows. ¶5. (SBU) Dragonomics analyst Arthur Kroeber agreed that a significant amount of the reserve growth is attributable to net portfolio inflows, dismissing valuation gains and the impact of any mark-to-market effects of the central bank's fixed income holdings as marginal. Policy Direction -------------- ¶6. (SBU) Commenting on the recent Politburo meeting to discuss the direction of economic policies, Pettis thought that in-fighting between the monetarists, who believe the rise in inflation has been due to excessive growth of monetary aggregates, and the export and real estate interests, who have been hurt by a tightening of monetary conditions (including through a more appreciated exchange rate),had gotten so bad that it required top level intervention to quell the dispute. He said the "growth guys are back in control." BEIJING 00003311 002 OF 002 ¶7. (SBU) Kroeber agreed that the exporter lobby had successfully argued they are "at their limits." However, he characterized the increase in credit quotas and VAT rebates in certain sectors as "pretty cosmetic," and thought even with some minor adjustment, policymakers would not fundamentally veer from their efforts to rebalance the economic growth. He noted that the reduction in China's savings-investment imbalances is made more difficult by the fact that it still doesn't have the mechanisms in place to increase social services significantly. But he thought consumer spending would start to increase on its own now that years of pent up housing demand were satisfied. ¶8. (SBU) Both Kroeber and Pettis noted that Hu Jintao now had his people in place throughout provincial governments, making rebalancing easier to implement. Inflation -------------- ¶9. (SBU) Kroeber said China is now facing higher inflationary pressures, with estimated real unit labor costs now rising after several years of decline. Pettis thought the politically tolerable floor on inflation might now be in the 2-5% a year range. Both agreed that Chinese inflation would be a significant issue in coming years, and they also both noted that the current government finds inflation a greater risk to social instability ("scarier" in Kroeber's words) than slower growth. Predictions -------------- ¶10. (SBU) Pettis was extremely pessimistic about China's ability to maintain macroeconomic and financial stability, stating he had a "front seat to see the whole thing unravel." Pettis thought that weaker external demand will prevent China from being abl to dump its excess production abroad, leading to higher inventories, domestic dumping, lowe profits, higher NPLs and ultimately a credit crunch as impaired banks pulled back on lending. He also thought high inflation was inevitable unless China broke the cycle leading to ever-higher reserve accumulation and liquidity growth. Pettis acknowledged that one scenario was deflationary and one inflationary, but argued that they would both end in a sharp rise in NPLs, a credit crunch, and reduced growth. ¶11. (SBU) Kroeber, on the other hand, said he thought China had significant "shock absorbers" in the economy, and policy makers have significant experience in "wiggling out" of economic challenges. He thought the current downturn in growth was cyclical, although longer lasting than previous cycles. Comment -------------- ¶12. (SBU) Both Pettis and Kroeber are known for their deep knowledge of China and their strong opinions on its future. In truth, China does have some serious structural problems that it has to address, including the over-reliance on investment, and the excessive liquidity and credit growth fueled by a large balance of payments surplus and a rigid exchange rate. Chinese economic advisers and policymakers are very aware of these issues, and are seeking to promote a slow reduction in imbalances that keeps economic adjustment at a politically acceptable pace. Kroger and Pettis highlight how an slow and cautious approach increases the risks of more disorderly future adjustments. However most observers, both inside and outside the Chinese government, agree with Korber that, short of a major unanticipated shock, the Chinese have the will and the resources to avoid systemic financial distress. RANDT