CHINESE OFFICIALS CONCERNED ABOUT FINANCIAL RISKS

C O N F I D E N T I A L SECTION 01 OF 02 BEIJING 004003

SIPDIS

TREASURY FOR OASIA/ISA/DOHNER
STATE FOR EAP/CM AND E/YON
NSC FOR SHRIER/LOI

E.O. 12958: DECL: 10/21/2028
TAGS: EFIN ECON ETRD PREL CH
SUBJECT: CHINESE OFFICIALS CONCERNED ABOUT FINANCIAL RISKS

Classified By: Economic Deputy Minister Counselor Robert Forden; Reason
s 1.4 (b, d)


1. (C) SUMMARY: People's Bank of China (PBOC) Director
General Zhang Tao told us October 16 that the State
Administration of Foreign Exchange (SAFE) had been criticized
internally by some senior Chinese leaders for its management
of foreign exchange holdings, and now needed to mitigate
risks to protect itself. He said the senior political
leadership also needed to be convinced that the next U.S.
administration will stand behind any commitments inherited
from the current administration. Zhang confirmed that any
reduction in credit availability for foreign banks in the
interbank lending market simply reflected risk aversion
decisions by individual Chinese banks, and was not driven by
government regulators. He believed the Chinese economy was
headed for a soft landing, with slower growth and acceptable
inflation. Zhang was optimistic that any recession in the
U.S. would be relatively short and not too harmful to China.
He appeared to agree to the need for further appreciation of
the RMB and thought China would continue to pursue this
course. Finally, Zhang said last weekend's telephone
discussions between U.S. Treasury Secretary Paulson and Vice
Premier Wang Qishan regarding the possible participation of
President Hu Jintao at a financial crisis summit had resulted
in misunderstandings and embarrassment within the Chinese
Government. END SUMMARY.


2. (C) In an October 16 meeting, Finatt briefed PBOC Director
General for Information and Statistics Zhang Tao on three
recent areas of U.S. concern in China related to the ongoing
financial crisis: first, that China's State Administration of
Foreign Exchange (SAFE) had pulled back from lending U.S.
treasuries in the repo market, due to concerns about
counterparty risk; second, that SAFE also had been shifting
its portfolio from long-term to shorter-term maturities; and
third, that U.S. and other foreign banks continue to
experience difficulty obtaining credit in the Chinese
interbank lending market.

Need to Avoid Risk
--------------


3. (C) In response, Zhang said SAFE had been criticized
internally by some senior Chinese leaders for its management
of foreign exchange holdings. As a result, SAFE officials
needed to mitigate risks to protect themselves. Zhang said
the senior political leadership, whose understanding of
financial issues was not deep, need to be convinced that the
next U.S. administration will stand behind any commitments
inherited from the current administration. If they are not
convinced, then they could do nothing to address these U.S.
concerns. Zhang offered a similar message on the shift to
shorter-term maturities for their holdings of U.S. agency
debt, noting that the SAFE portfolio managers and lower level
technocrats are constrained, unless concerns over the
long-term status and viability of Freddie Mac and Fannie Mae
of their State Council bosses are assuaged.


4. (C) On the interbank lending issue, Zhang confirmed what
we have heard consistently from other contacts: any reduction
in credit availability in the interbank lending market simply
reflected risk aversion decisions by individual Chinese
banks, and was not driven by government regulators.
Furthermore, he said the PBOC had not taken and would not
take a position that this was simply a foreign bank problem.
Rather, any foreign bank encountering severe difficulties in
its China operations would reflect badly on Chinese financial
regulators and senior leaders. He said he knew of one
instance where the PBOC had applied moral suasion to at least
one large Chinese bank to ensure the availability of
financing for a foreign bank.


5. (C) Zhang also said the PBOC was formulating various
contingency plans to deal with a bank facing serious
liquidity problems, but the first recourse would be to
convince Chinese banks to increase their lending, which he
believed would be preferable to offering any sort of PBOC
lending facility to foreign banks. Zhang said the PBOC would
be extremely cautious about making any public announcement in
this area, as that could raise concerns among depositors. He
also noted that any policy cannot be seen as providing
special treatment to foreign banks, even if they are more
dependent on interbank financing.

China's Soft Landing
--------------

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6. (C) Zhang agreed that the Chinese economy appeared headed
for a "soft landing," with slower growth and inflation that
would not be a problem "for now." He said the PBOC believed
it needed to be "flexible" to ensure adequate liquidity in
the domestic economy. Zhang also was fairly optimistic that
any recession in the U.S. would be relatively short, and that
a slowing U.S. economy - even a recession - would not hurt
China too much. He observed that even if U.S. households
reduced consumption, they would continue to purchase
inexpensive consumer staples where China has a comparative
advantage during their holiday season.

Kick the Habit
--------------


7. (C) Despite slower growth and rising political pressure
from exporters, Zhang appeared to agree to the need for
further appreciation of the RMB on a trade-weighted basis,
together with at least stability but preferably appreciation
against the USD, and thought China would continue to pursue
this course. He noted, however, that it was difficult for
some of China's policy makers to accept a rebalancing of
growth from net exports to consumption; in this regard China,
he said, was like a tobacco smoker who knew he had to quit
but kept postponing the change.

Summit Miscommunication
--------------


8. (C) Zhang told us that the previous weekend's (Oct. 11)
telephone discussions between U.S. Treasury Secretary Paulson
and Vice Premier Wang Qishan regarding the possible
participation of President Hu Jintao at a financial crisis
summit had resulted in misunderstandings and embarrassment
within the Chinese Government. In particular, at some point
the preliminary discussion of Hu's availability and interest
in attending had been misconstrued as a firm invitation from
the U.S., leading some ministries and senior State Council
officials to continue to work to prepare for the trip as late
as Tuesday night (October 14),24 hours after MOF and MFA
were informed that the summit would not take place on October
18, if at all. The result, according to Zhang, was that "the
next time it will be much more difficult" to arrange China's
participation in such a meeting.

RANDT