FED HEARS HONG KONG VIEWS ON CHINA AND THE REGION

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 002178

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STATE FOR EAP/CM AND EEB/IFD/OMA, TREASURY FOR OASIA AND
S&ED

E.O. 12958: DECL: 11/24/2034
TAGS: EFIN ECON HK CH
SUBJECT: FED HEARS HONG KONG VIEWS ON CHINA AND THE REGION

REF: HONG KONG 2124

Classified By: Economic and Political Chief Martin Murphy, Reason 1.4 d


1. (C) Summary: Hong Kong economists, bankers and financial
observers for the most part painted a rosy picture about the
Chinese economy for U.S. Federal Reserve Board and San
Francisco Federal Reserve Bank officials. They said that
China would grow strongly in 2010, but that an economic
recovery in the West might, perversely, spark inflation that
could threaten China's continued economic growth. Many
argued that China was not really trying to rebalance, but was
just waiting until exports recovered. Real economic
rebalancing required painful RMB appreciation and a cultural
shift that could take decades. Although asset prices were
booming, China and the region were far from bubble territory,
as valuations and leverage remained well below danger levels.
Economists predicted Chinese interest rate hikes were
unlikely until there was clear evidence of inflation and
disagreed over whether interest rate increases were good, bad
or meaningless in the current environment. Asset price
increases were making bank balance sheets look healthy and
the inevitable non-performing loans were more of a nuisance
than a threat. Chinese government funds were making use of
U.S. hedge funds to invest in the U.S., according to one
senior banker. End Summary.


2. (U) San Francisco Federal Reserve Bank President Dr.
Janet Yellen and Federal Reserve Board Governor Kevin Warsh,
along with economists from both the San Francisco Fed and the
U.S. Fed in Washington, D.C., met with Hong Kong-based
economists, bankers and financial experts on November 16-17.
Dr. Yellen, along with former Bank of England Deputy Governor
Sir John Gieve, and President of the German Federal Financial
Supervisory Authority Jochen Sanio, also addressed an
audience of over 400 financial professionals at a private
dinner organized by the Institute for Regulation and Risk.

China's Bright Future?
======================


3. (C) Both Morgan Stanley Greater China Chief Economist
WANG Qing and CitiGroup Greater China Chief Economist SHEN
Minggao were optimistic about China's near term economic
prospects. Each predicted over 10 percent growth in 2010
with inflation at 2-3 percent. Wang insisted that Chinese
efforts to stimulate domestic demand would be sustained
through 2010 and that a weak recovery in the U.S., EU and
Japan would help to keep Chinese inflation low. In his
scenario, the biggest risk to China's economic performance
was that stronger than expected recoveries in the West would
lead to overheating and higher inflation. Shen agreed, but
added that the Chinese needed some inflation in 2010 to take
steam out of the system and avoid the possibility of
hyperinflation in 2011. He expected the People's Bank of
China (PBOC) would not raise interest rates, but would use
other tools to slow bank lendiQ56YGvQQ
in 2010 that would support increased Chinese exports in the
first half of the year, but predicted slowing Chinese growth
as the effects of the stimulus package wore off and were not
fully replaced by export growth. He dismissed the threat of
inflation in Cina, noting that the key components of
inflationwere commodity and asset prices, both of which
cold be controlled by Beijing regulators. Spencer ws
skeptical that domestic consumption in China would be helpful
in the near term and saw no evidence that a social safety net
would increase consumption. He did not think the Chinese
would implement additional stimulus packages.

Whither the RMB?
================


5. (C) Spencer expected a return to a slow RMB appreciation
in 2010 as a means of reducing the impact of commodity price
increases. Wang disagreed, suggesting that the PBOC would
not let the RMB appreciate because they did not want the
value of China's dollar reserves to fall. Only when the
dollar stabilized would the Chinese authorities consider
appreciation, said Wang. Shen agreed that China would wait
until the dollar stabilized before changing its monetary
policy. He noted that regional emerging market economies
were being constrained by the RMB. As long as China kept its

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dollar peg, regional emerging markets were losing
competitiveness, he said.


6. (C) The Chinese were not interested in rebalancing,
asserted Spencer, they cared about maximizing employment in
China. Promoting exports was a logical growth strategy while
global demand was high, but now the Chinese needed more
confidence in their own domestic demand. The only argument
Spencer felt might sway the Chinese to allow RMB appreciation
now was to convince Beijing that it would never have control
over its own economic performance until it reduced it
reliance on exports. Shenzhen Development Bank CEO Frank
Newman concurred. The Chinese were not taking steps to
promote rebalancing and the massive Chinese stimulus package
was just a stop-gap measure to fill in for exports until U.S.
and EU consumption returned to more normal levels, he said.
Chinese leaders might not fully believe exports would revert
to pre-crisis levels, said Newman, but making the changes
needed to shift the economy away from reliance on exports was
a difficult, long-term project.

Chinese Consumption Increasing... in 20 Years
=============================================


7. (C) UBS Chief Asia Economist Duncan Wooldridge speculated
that Chinese domestic demand would increase gradually over
time, but that economic fundamentals, rather than government
policy, would drive the process. Wang agreed, and predicted
that demographic shifts would boost domestic consumption, but
asserted that it would be a slow, steady process that could
take 20 years. In the near term, the Chinese would seek to
delay the inevitable appreciation of the renminbi (RMB) for
as long as possible, said Wooldridge. HSBC Senior Economist
Fred Neumann noted that HSBC analysis suggested that the
Chinese household savings rate was just 22 percent, a bit low
by Asian standards. The Chinese savings rate was boosted by
massive corporate savings. Neumann said Chinese corporate
profits were not trickling down to boost household income,
but were held by companies and reinvested. A lesson other
economies took from the U.S. experience was that having
strong productivity growth was not enough, asserted
Wooldridge. If an economy does not generate income growth,
it is necessary to fuel consumption with credit. In the
U.S., median wages had not grown despite high productivity
growth. The U.S. therefore incentivized borrowing to prop up
domestic demand, a cycle that eventually led to the current
crisis. Improving social safety nets in China was unlikely
to release much pent up consumer demand until incomes
increased dramatically, he said.


8. (C) Analysts at Fitch agreed that Chinese rebalancing was
not happening yet. Managing Director for Sovereign Ratings
James McCormack noted that Chinese domestic consumption had
been growing steadily for many years, but had fallen as a
percentage of GDP as investment and exports increased even
faster. Shifting away from China's investment and export
driven growth model would require RMB appreciation, but
Chinese policymakers were clearly reluctant to allow that.
McCormack discounted prospects for inflation in China, noting
that food prices, typically the key inflation driver, had not
been an issue. China's problem was excess supply of both
goods and labor, said McCormick. Deflation was more of a
risk in that environment.

No Bubbles for Now, NPLs Just a Nuisance
========================================


9. (C) Although asset valuations have been increasing
rapidly around Asia, the region was "nowhere near bubble
territory now" based on the relatively low degree of leverage
in markets in the region, according to HSBC's Neumann. Asian
investors were flush with cash, he said. It is unlikely that
marginal interest rate hikes by the Fed would have a
significant impact on Asian asset prices. Standard Chartered
CEO Ben Hung concurred, noting that in Hong Kong, a sharp
jump in home sales had been accompanied by a much smaller
increase in mortgage lending, suggesting that many of the
buyers were paying in cash. Wooldridge believed that U.S.
interest rate increases would not stop the flow of capital to
the region. Investors were betting on Asia's long term
growth, he said. Asian central banks would use every tool at
their disposal to avoid tightening monetary policy until
consumer price inflation became a problem. In the medium
term, high levels of liquidity would almost certainly lead to
asset bubbles, but we are not there yet, said Neumann.


10. (C) Bank of America Merrill Lynch Head of Asia Financial
Institutions Research Allistair Scarff noted that Asian banks

HONG KONG 00002178 003 OF 003


balance sheets had benefited from the rapid increase in asset
prices. Chinese bank lending was growing rapidly, but other
parts of Asia had not experienced similar increases, he said.
Regional banks were desperate to lend, but they were finding
that qualified borrowers were not eager to take their money.
At the moment, mortgage lending was one of the only outlets
for banks, feeding exceptionally high prices for luxury
properties. But it "doesn't look like a bubble," as
mass-market properties were still priced well below previous
records, he said.


11. (C) Standard & Poor analysts were more optimistic about
the impact of Chinese economic policy on the rest of the
region. Around Asia, the focus has shifted from crisis
management to recovery, said S&P's Chief Asia Economist Subir
Gokarn. Momentum from China's stimulus package was driving
growth rates in the whole region, he said. Head of Asia Tom
Schiller agreed but noted that structural issues remained a
problem. Many believed that lending to State-owned
enterprises (SOEs) was implicitly guaranteed by government,
but it remained unclear whether municipal governments would
really be able to service all of the debt. The lack of
experience with bankruptcy proceedings also was a concern.
With such a rapid pace of lending, non-performing loans
(NPLs) were a certainty, but municipal and provincial
governments had strong political incentives to avoid letting
the problem get so big that Beijing had to intervene, said
Schiller. SDB's Newman noted that the China Banking
Regulatory Commission (CBRC) had begun to shut off lending at
some banks after concerns about credit quality, but he
discounted worries about NPLs as more a nuisance than a
crisis.


12. (C) The Chinese government was interested in investing
in the U.S. but was wary of perceived discrimination, said
Newman. Beijing was attempting to avoid scrutiny by using
U.S. hedge funds as cutouts. Several U.S. hedge fund
managers had already received funds from the Chinese in
recent months for investment abroad, he alleged.
MARUT