Regulators' Vague Signals and Inflation Policies Causing

UNCLAS SECTION 01 OF 02 GUANGZHOU 000378

SENSITIVE
SIPDIS

STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/LEE
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER
STATE PASS SAN FRANCISCO FRB FOR CURRAN
TREASURY FOR MOGHTADER


E.O. 12958: N/A
TAGS: ECON EFIN EINV CH
SUBJECT: Regulators' Vague Signals and Inflation Policies Causing
Uncertainty for South China's Foreign Banks

REF: A) 07 Guangzhou 850, B) 07 Shanghai 504

GUANGZHOU 00000378 001.2 OF 002


(U) This document is sensitive but unclassified. Please protect
accordingly. Not for release outside U.S. government channels. Not
for internet publication.


1. (SBU) Summary: To incorporate locally, or to remain a foreign
branch, that is the question for south China's international banks.
Bank of Montreal, Bank of America and other foreign banks are
concerned by what they see as unclear government signals that could
lead to future losses if banks fail to correctly interpret vague
instructions. Clearly one concern is whether unincorporated banks
will have their market access reduced at some time in the future.
Meanwhile, Citibank is clearly frustrated by the slow progress in
establishing full-service retail banking operations more than a year
after regulators approved the launch of local subsidiaries by
Citibank and British rival HSBC. The move by several small
international banks to comply with China's regulators and establish
onshore data processing is undermining the bargaining position of
larger international banks. Bank executives and academics agree
that inflation and hot money remain the primary concern of
regulators, who have increased monitoring efforts to track capital
inflows, particularly by scrutinizing joint venture investments and
prepayments made to exporting companies. End Summary.

To Incorporate, or Not to Incorporate?
--------------


2. (SBU) In a recent meeting with Congenoff, Brendan Wong, the
General Manager of Bank of Montreal's (BoM) Guangzhou Branch, said
the toughest decision facing his bank is whether to incorporate as a
local subsidiary. He explained that BoM has little internal
motivation to do this, as the bank is focused on treasury operations
and lending to multi-national companies, with no plans to establish
retail banking in China. Wong added that BoM would have difficulty
meeting the loan/deposit ratio requirements if it incorporated. At
the same time, Wong said he is very concerned about the future
direction of Chinese regulators; he complained that unincorporated
foreign banks could have their market access reduced at some point
in the future. Wong also said BoM would likely choose to
incorporate if doing so were necessary to protect the bank's niche
in this market. Unfortunately, his repeated requests that China's
regulators clarify what they want foreign banks to do have failed to
elicit a specific answer.


3. (SBU) According to Bank of America's (BoA) Guangzhou Branch
Manager, Andy Zhang, BoA views the issue of local incorporation
similarly to Bank of Montreal. Zhang told us at a separate meeting
that BoA has numerous reasons to remain unincorporated, including
the cost of creating a separate back-end system for its China
operations; the loan/deposit ratio requirements; and the likelihood
that a subsidiary would have a lower credit rating than the parent
bank. He asserted that operating as a foreign bank has no downsides
for wholesale banking, which is all BoA seeks to do in China. (Note:
BoA is contractually prohibited from retail banking as part of its
strategic investment in China Construction Bank. End note.) Echoing
Wong's concerns, Zhang acknowledged that failure to incorporate may
ultimately become a disadvantage for BoA, depending on the future
decisions of banking regulators.

Retail Banking Business Slow to Develop
--------------


4. (SBU) After successfully incorporating as a local subsidiary last
year, Citibank has started offering retail banking services. Peter
Qiu, the Guangzhou Branch Manager, expressed frustration, however,
that the bank has so far been limited to investment services, such
as deposits and QDII. Citibank currently cannot offer transactional
services, including debit and credit cards, because the bank has not
set up an onshore payments system as required by China's banking
regulators. Qiu told us that most foreign banks had anticipated a
grace period where they could offer card services while using
offshore systems, but this has not been forthcoming. He expressed
concern that several smaller international banks, including the Hong
Kong-based Bank of East Asia, are rushing to comply with the wishes
of the Chinese government, lessening the chance that a grace period

GUANGZHOU 00000378 002.2 OF 002


will ever be offered.

Inflation and Hot Money
--------------


5. (SBU) In separate meetings with bank executives, university
professors, and financial reporters, all agreed that inflation and
hot money remain the overriding concern of banking regulators.
Citibank's Qiu and BoM's Wong told us separately that in recent
months they have noticed much greater scrutiny by regulators of
joint venture investments and prepayments made to exporting
companies, a response to some of the most common tactics for
skirting the PRC's capital inflow restrictions. BoA's Zhang said
that he expects more and tighter restrictions to be implemented in
the coming months. Dr. Lu Jun, chair of Sun Yat-sen University's
Department of Finance, emphasized the historical significance of the
government's inflation policies by describing both the fall of the
Kuomintang (KMT, Nationalist Chinese) government in 1949 and the
student protests leading to the 1989 Tiananmen Square incident as
following periods of high domestic inflation.


6. (SBU) Despite the continued regulatory interest in hot money,
each of the bankers we spoke with expressed skepticism about the
actual volume of the inflows. Qiu questioned whether there are many
people with a strong enough incentive to smuggle capital into the
country, while Wong asserted that the central government is using
hot money as a scapegoat for the current high level of inflation.
Wong added that he doesn't trust official statistics; instead
expressing his belief that the true level of inflation is
considerably higher than figures reported by the government.


7. (SBU) In contrast, Luo Keguan, a journalist who covers the
banking sector for south China's Southern Metropolis Daily, told
Congenoff that hot money inflows are a serious problem and had
heavily distorted the Shenzhen real estate market in recent years.
He asserted that the ongoing slump in Shenzhen housing prices, which
have fallen 23% over the last year according to a recent article in
the Shenzhen Daily, is largely due to tightened regulations making
it more difficult to buy property using speculators' hot money.

Comment
--------------


8. (SBU) It was clear that Citibank and many other foreign banks are
unenthusiastic about China's requirements to establish onshore data
processing systems and had hoped that a grace period would allow the
banks to begin debit and credit operations that regulators would
later decline to shut down. Qiu seemed irritated at Bank of East
Asia for undercutting "Citi's and the other foreign banks'
bargaining position" with its apparent willingness to comply with
this regulation. This, combined with regulators' almost-obsessive
fixation on reducing inflation and real - or perceived - hot money
flows, is affecting how south China's foreign banks see their near-
and mid-term prospects.

GOLDBERG