CHINA REBALANCING: HOW MUCH, HOW SOON, AND HOW?

C O N F I D E N T I A L SECTION 01 OF 05 BEIJING 003421

SIPDIS

STATE FOR E, EAP, EAP/CM
TREASURY FOR OASIA/DOHNER/WINSHIP AND LOEVINGER
NSC FOR LOI
STATE PASS USTR FOR STRATFORD

E.O. 12958: DECL: 12/22/2034
TAGS: ECON EFIN ETRD EINV PREL PGOV CH
SUBJECT: CHINA REBALANCING: HOW MUCH, HOW SOON, AND HOW?

REF: A. BEIJING 03307

B. BEIJING 03122

C. BEIJING 03191

D. HONG KONG 02178

Classified By: Economic Minister Counselor William Weinstein; Reasons 1
.4 (b, d)


1. (C) Summary. Recent senior leadership meetings in
Beijing indicate that with 2009 GDP growth in excess of eight
percent assured, the Chinese Government has turned its
attention to rebalancing the economy for more sustainable
development. Most observers believe the government is
serious about the need to rebalance, and is making
substantive efforts in many areas, although much more
understanding, funding and action are needed. For 2010,
while the "proactive fiscal" and "appropriately accommodative
monetary" policies of the past year will continue, both
"managing inflation expectation" and "adjusting economic
structure" have been grafted onto the overall GDP growth
target. Various economists forecast actual growth to reach
8.5-9.5 percent, but with a different composition. Public
expenditure on social security, education, health care,
low-income housing, agriculture, and environmental protection
will increase, certain new or strategic industries will be
targeted for support, and funding for infrastructure
investment projects already underway will continue. On the
monetary side, the government has begun to tighten, but not
so sharply as to risk a too-early exit. One significant
addition to economic policy is promotion of urbanization to
small and medium cities through relaxation of the household
registration system, which should contribute significantly to
household consumption and economic rebalancing.


2. (C) Summary, continued. Beyond the need for rebalancing,
key concerns for China's economic policy-makers in the coming
year include inflation, which for now remains very low, and
possible negative consequences of 2009's enormous flood of
new bank credit, including misallocation of credit,
non-performing loans (NPLs),asset price bubbles, and massive
local government debt. As much as twenty percent of 2009
lending might eventually become non-performing, but probably
not until overall economic growth slows in 2011-15. China's
financial regulators are aware of the problems and adopting
appropriate preventive measures, but certain aspects of the
problem are beyond their control, including continued
promotion of investment-led economic growth by powerful
ministries and local governments. Other economic issues not
yet addressed include asset price bubbles, price reforms,
exchange rates, and other financial sector reform needs.
China also needs to reform intergovernmental fiscal
relations, including the system for transfers from relatively
wealthy provinces to poorer areas, as well as the structure
of tax revenue, but the current leadership apparently has no
interest in doing so. End Summary.

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

3. (C) China's leadership understands the need for greater
economic rebalancing to promote sustainable growth and
development, although they have not reached consensus on how
and how rapidly to implement policy reforms to meet this
need. Issues of more direct relevance to the United States
and other trading partners, such as exchange rates and trade
balances, are closely linked to rebalancing and will be
impacted by policy adjustments. The internal debate on when
and how to withdraw fiscal and monetary stimulus measures
will continue, with various central and provincial
jurisdictions holding divergent views and agendas. In
Beijing, the pro-GDP growth through investment factions will
continue to cite social stability concerns and weak overseas
recoveries to justify continuation of the stimulus, while
financial regulators will continue to raise concerns about
misallocation of investment, asset bubbles, and future
non-performing loan problems. Beyond Beijing's ring roads,
however, provincial and local officials will continue to
promote infrastructure and industrial investment projects
that enhance their local economic statistics and personal
career prospects, unless and until they receive strong and
clear instruction from Beijing to do otherwise. End Comment.

China's Successful 2009
--------------

4. (C) The Chinese Government took a two-stage approach to

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economic management during the global crisis, according to
National Development and Reform Commission (NDRC) Academy of
Macro-economic Research Vice President Wang Yiming (ref a):
first arrest the downturn, then resume the rebalancing that
began before the crisis. The most recent batch of
macroeconomic indicators, released in early December,
indicate the first goal has been met: 2009 GDP growth easily
should surpass the eight percent target, with some economists
predicting the year-end figure will reach 8.4-8.6 percent.
In a recovery strongly underpinned by effective fiscal and
monetary stimulus programs, China's GDP growth has
accelerated through the first three quarters of 2009,
primarily due to government-related fixed asset investment
and to a lesser extent consumption. While net exports remain
negative due to still-weak external demand, exports have
begun to improve and imports have surged from last year's low
level. Inflation has remained negative for most of this year.


5. (C) Despite this impressive performance, however, some
senior officials continue to believe China's economic
recovery remains fragile. China Securities Regulatory
Commission (CSRC) Vice Chairman Yao Gang, for example, told a
visiting Federal Reserve delegation in mid-November that
until private consumption, rather than government investment
and bank loans, becomes a primary driver of the economy, it
would be premature for the government to terminate its
stimulus measures (ref a). Other contacts worried that
external demand would remain weak until key overseas markets
fully recover, which they did not expect for another 2-3
years. For those reasons, IMF Senior Resident Representative
Vivek Arora said China would maintain fiscal stimulus
programs through 2010, while gradually unwinding monetary
measures.

Time to Calm Down and Rebalance
--------------

6. (C) The above concerns notwithstanding, as steady
improvements in most indicators have continued to accumulate,
and with the worst of the global crisis apparently over,
officials increasingly have turned their attention to
sustainable growth over the longer term, which includes
rebalancing. In the words of World Bank Senior Economist
Louis Kuijs, "the government now can calm down." He said
during the global crisis, China's "quest for growth" -- which
other contacts characterized as "panic" -- had over-ruled
structural reforms, which he now hoped would resume. The
"bright side" is that the government now is serious about the
need to rebalance and is making substantive efforts to
increase its presence in health care, education, and other
needed sectors. Dragonomics Managing Director Arthur Kroeber
believed the government already has "made a good start," with
significant improvements underway in education, health care,
and pensions, although much more funding is needed.

7. (C) IMF Resident Representative Tarhan Feyzioglu agreed
with this assessment, opining that the key government
agencies all understand China's need to increase consumption
and rebalance the economy; the problem is they do not know
how to do it. In particular, the NDRC -- which coordinates
economic policy recommendations to the State Council --
retains a "command economy reflex" rather than employing
market mechanisms to redirect growth. Also, while Feyzioglu
welcomed the new emphasis on service sector growth, he
cautioned that the "big money" continued to flow to large
industrial projects.

Internal Debate: When and How to Rebalance?
--------------

8. (C) The shift of economic policy focus has been under
discussion for some months: in late September, NDRC Director
General Xu Lin told visiting U.S. Treasury officials there
already was consensus that 2009 GDP growth would exceed eight
percent, so debate had shifted to how to sustain growth over
the next few years without strong external demand. He said
the NDRC favored extension of fiscal stimulus policies
through 2011 or even 2012, although he thought the more
fiscally conservative Ministry of Finance (MOF) and some
other agencies might disagree. Xu, observing that the NDRC
"always has these issues with MOF," said the State Council
would need to determine policy.


9. (C) After several months, that determination appears to be
a compromise: the stimulus is to continue, but with more
attention to rebalancing and to prevention or mitigation of
negative consequences. In mid-November, Vice Minister Liu He

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of the Central Leading Group for Finance and Economics
acknowledged China's need to rebalance toward greater
household consumption, and said both consumption and
urbanization would play greater roles in the 2010 policy
framework (ref b). Other policies, including education,
social safety net, low-income housing, and infrastructure
would flow from these rebalancing themes. The November 27
Politburo meeting confirmed these changes, which then were
discussed and disseminated at the annual Central Economic
Work Conference (CEWC) in early December (ref c). A December
9 State Council meeting provided more substance, including
extension and expansion of some consumption stimulus measures.

2010: Continuity, with Adjustments
--------------

10. (C) China intends to maintain the broad direction of
economic policy for the coming year. The "proactive fiscal"
and "appropriately accommodative" monetary policies of the
past year will continue, but with greater attention to the
quality of growth. "Managing inflation expectation" and
"adjusting economic structure" have been grafted onto the
overall GDP growth target. Various Chinese and foreign
economists now forecast 2010 GDP growth to accelerate
slightly to 8.5-9.5 percent, but with a different
composition. Kuijs of the World Bank said China's domestic
economy has enough momentum to fuel strong domestic demand
growth, even with much less expansionary support from
government-influenced spending. Officials also hope modest
recovery in overseas markets will bring single-digit growth
to net exports. At the same time, continuing growth in
property investment and construction, together with some
acceleration of household consumption growth, should enable
the economy to meet the overall GDP growth target.


11. (C) For fiscal policy, public expenditure on social
security, education, health care, low-income housing,
agriculture, and environmental protection will increase. UBS
economist Wang Tao told us the government also intends to use
industrial policy to facilitate restructuring toward
designated new or strategic industries, as Japan and South
Korea have done in the past. Funding for infrastructure
investment projects already underway will continue, but any
new proposals will receive closer scrutiny. On the monetary
side, the IMF's Feyzioglu said the government needed -- and
has begun -- to start tightening monetary policy, but not so
sharply as to risk a too-early exit. In 2009, China wanted
to "push money out quickly," but that is no longer the case.
Wang Tao of UBS said the government has not set a formal
lending quota for 2010, but instead has given the banks a
"target" of 17-18 percent credit growth, which would mean RMB
7-7.5 trillion new lending. Also, more credit support may be
directed to small and medium enterprises and sectors with
greater job creation potential.

New Focus on Urbanization
--------------

12. (C) Both Chinese and foreign economists characterized the
CEWC's decision to promote urbanization as an important and
encouraging policy change that will contribute significantly
to expansion of household consumption, thereby promoting
economic rebalancing. More specifically, the CEWC announced
relaxation of the household registration system, which for
decades has impeded labor mobility, to allow rural residents
and their families to move permanently to medium and small
cities. The new policy should boost private demand for
lower-cost urban housing, while improved access to social
services for the migrants also may reduce precautionary
saving and increase consumption. CICC economist Ha Jiming
estimates the policy change will allow approximately 25
million additional rural residents to move to the cities over
the next five years.


13. (C) These new urbanites should boost China's real estate
and construction sectors, which already in recent months have
been major factors in economic growth. November's monthly
property sales and construction figures set new records, as
low interest rates, low taxation, discounted mortgage rates,
and abundant liquidity in the market all encouraged buyers.
According to China Construction Bank Vice President Hwa
Erh-cheng, investors seeking a hedge against future inflation
also have become "a force in the market," and he expects
overly exuberant housing price expectations to generate
future bubbles. With more lower-income buyers, Kuijs also
noted that further "rebalancing" within the real estate

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sector -- from construction of luxury developments toward
more affordable housing -- will be needed.

Key Concern Number 1: Inflation
--------------

14. (C) Inflation remains a worry for Chinese leaders, as
they believe significant consumer price rises could spark
social instability among low and fixed-income groups. After
recording negative inflation rates for the past nine months
before turning slightly positive in November, however, most
economists do not see significant inflation as a short-term
problem. The IMF's Feyzioglu said he was not concerned about
any imminent inflation resurgence, as recent food price rises
were "normal," but asset prices remain an area to monitor.
He believed the government would watch price data closely and
act quickly if inflationary pressures appear to build.
Dragonomics Managing Director Arthur Kroeber was more
concerned, expecting inflationary pressures by mid-2010 to
become greater than the government could tolerate, especially
in the real estate sector.

Key Concerns Number 2: Credit Boomerang
--------------

15. (C) China's year-long, unprecedented bank lending flood
(RMB 9.2 trillion from January through November, 122 percent
higher than the same period of 2008) apparently has ended, as
monthly credit figures have returned to near-normal levels.
According to Kuijs of the World Bank, the lending spree may
have produced or sown seeds for several future problems,
including misallocation of credit, a possible large increase
in non-performing loans (NPLs),and asset price bubbles. One
particular, relatively unnoticed concern is massive local
government debt, incurred as city, county, and district
jurisdictions established local investment platforms to raise
the matching funds needed for central government financing of
stimulus projects.


16. (C) Regarding NPLs, Wang Tao of UBS estimated that up to
thirty percent of stimulus-related lending was directed to
local governments for infrastructure projects with no real
expectation of repayment. Overall, she thought about twenty
percent of 2009 bank lending eventually would "go bad,"
probably when overall economic growth slows in 2011-15. The
IMF's Arora believes NPLs could rise significantly as early
as 2011-12, although he also thinks the government has the
fiscal capacity to intervene if needed. Feyzioglu said the
China Banking Regulatory Commission (CBRC) would need to
maintain strong macro control over the banks, which thus far
it has done, although internal bank governance remained a
fundamental problem. He said China's large commercial banks,
which received the "best part" (centrally-led investment
projects) of the stimulus, generally had sound capital
structures, but some of the smaller city commercial banks
that were closely linked to local governments were worrisome;
there is a dangerous "triangle" at local levels that includes
enterprises, government, and bank branches, from which the
banks should be extricated.


17. (C) UBS economist Wang told us the People's Bank of China
(PBOC),the financial regulators (CBRC and CSRC),and
possibly MOF understand these current and future risks, and
are attempting to prevent and mitigate problems stemming from
the lending binge. In early December, for example, the CBRC
raised required capital adequacy ratios (CAR) to eleven
percent for large commercial banks and ten percent for medium
and small banks. More recently, on December 9 the State
Council approved a CBRC proposal instructing commercial banks
to assess and prevent six types of lending risks; the agency
is requiring the banks to perform these risk assessments
retroactively on loans issued since November 2008. Wang said
these financial conservatives are to some degree opposed,
however, by the powerful pro-GDP growth camp, which includes
the economic ministries and provincial and local governments,
the leaders of which are evaluated and promoted in part on
their ability to deliver economic growth and tax revenue.
(Note: A December 6 report by the Bank for International
Settlements in Basel, Switzerland warned that China's rapid
credit expansion of the past year had increased risks to the
banking sector. The report specifically noted that any
future tightening of lending policies might leave some
projects short of funds before they are completed. End
note.)

Key Concerns Not Addressed

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--------------

18. (C) Published reports of the recent Politburo, CEWC, and
State Council meetings largely omitted detailed discussion of
monetary policies, asset price bubbles, or price reforms,
including utility prices, interest rates, and exchange rates.
As noted above, continuing abundant liquidity raises the
possibility of asset bubbles, but the central bank and
financial regulators will want to avoid the need for a sharp
tightening of credit. The IMF's Feyzioglu said whether or
not bubbles form in the equity and/or property markets next
year will depend on policy measures; one way to avoid them
would be for banks to raise deposit rates, but "that's not
going to happen." Inflation was mentioned in the reports,
but generally only in the context of "managing inflation
expectations." These issues undoubtedly figured prominently
in preparations for the policy meetings, and will be closely
monitored in the coming year; as conditions warrant,
officials will be prepared to adjust policies.


19. (C) Both the IMF (Feyzioglu) and the World Bank (Kuijs)
emphasized China's need to deepen reform in the capital,
bond, and equity markets; liberalize interest rates; and
relax exchange rate controls. For various reasons, the
government is reluctant to address these issues at this time;
on interest rates, for example, officials worry that
elimination of the deposit rate ceiling would provoke "excess
competition." Regarding exchange rates, with export recovery
still weak, most analysts expect the RMB-USD exchange rate to
be held steady until mid-2010, when gradual appreciation
might resume.


20. (C) Several contacts noted a strong need for China to
reform intergovernmental fiscal relations, including the
system for transfers from relatively wealthy provinces to
poorer areas. Kroeber of Dragonomics said the current
leadership, however, has no interest in pursuing this topic,
or in significant financial sector reform, preferring to
"kick the problems down the road" to its successors in 2012.
He said many Chinese economists believe fiscal reform is more
important and urgent than financial reform. Those economists
emphasize the need to alter the structure of revenue at the
local level, which now is based on value-added tax and land
sales.
GOLDBERG