(SBU) SHANGHAI UNSURE OF NEXT STEPS IN THE WAKE OF THE

UNCLAS SECTION 01 OF 05 SHANGHAI 000120 SENSITIVE SIPDIS STATE FOR EAP/CM, DAS DAVIES TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP TREASURY FOR IMFP -- SOBEL/CUSHMAN USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA NSC FOR LOI STATE PASS CEA FOR BLOCK STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN STATE PASS CFTC FOR OIA/GORLICK E.O. 12958: N/A TAGS: CH ECON EFIN PGOV PREL SUBJECT: (SBU) SHANGHAI UNSURE OF NEXT STEPS IN THE WAKE OF THE FINANCIAL CRISIS REF: SHANGHAI 119 ¶1. (SBU) Summary. Foreign banks have largely been able to regain access to the renminbi interbank market after Chinese banks pulled credit lines this past fall in the wake of the Lehman Brothers collapse, Shanghai interlocutors told a Treasury delegation on February 19-20. The financial sector in East China is now working through follow-on impacts of the financial crisis: cross-border foreign exchange flows are being scrutinized; customers are reluctant to use derivative products; and officials are seeking new ways to regulate complex financial products. In the longer term, our interlocutors report that officials are reassessing the goals of financial reforms, given that the previously emulated U.S. model looks broken to them. One factor that may bolster the U.S. model in East China is the potential arrival of Wall Street refugees. End summary. ¶2. (U) This is the second of two reports based on Beijing Finatt's February 19-20 meetings in Shanghai. It covers financial service sector trends; the initial report covered macroeconomic issues. ============================ Short-Term Liquidity No Longer a Problem ============================ ¶3. (SBU) Foreign banks have largely overcome their difficulties in obtaining short-term renminbi funding from Chinese banks, our interlocutors told a Treasury delegation February 19-20. Citi China CEO Andrew Au and John Tan, a Shanghai-based managing director of Standard Chartered Bank, separately noted that overnight, 7-day, and 30-day borrowing is now possible, although not for longer terms. While People's Bank of China (PBOC) has now established an emergency liquidity facility, Tan believes that any bank using the facility will be put on a blacklist--he said that only Bank of East Asia has asked for such assistance. While Deutsche Bank Executive Director Gao Feng also said that liquidity is not currently a problem, he said some Chinese banks consider his firm "too small to lend to." ¶4. (SBU) Moving forward, critics of foreign investment in the Chinese financial sector have been strengthened as many Chinese have begun to doubt the trustworthiness of foreign partners. Royal Bank of Scotland's (RBS's) sale of its holdings in Bank of China after the shares were unlocked in January was "a big loss of face" for the Chinese, said Deutsche Bank's Gao. Ding Guorong, chairman of Shenyin & Wanguo Securities, one of China's largest securities firms, said Chinese see the recent sales of strategic stakes by foreign investors--including RBS, Temasek, and Bank of America--as irresponsible. ¶5. (SBU) The Chinese Government may be considering other relief for foreign banks. Standard Chartered's Tan said his bank in October made two suggestions to help alleviate foreign bank's funding shortfalls: 1) SAFE should temporarily increase foreign debt quotas. (Comment: This was subsequently agreed to in the December Strategic Economic Dialogue (SED),though foreign bankers report that SAFE remains reluctant to approve applications. End comment.) 2) Banks should be allowed to use other foreign assets as collateral. The assets could be posted overseas--for instance, with the Hong Kong Monetary Authority--and then the PBOC would issue renminbi to the company in China. (Comment: PBOC officials have noted that they are working on such a facility. End comment.) Citi's Au mentioned that the PBOC, along with the China Bank Regulatory Commission and the State Administration of Foreign Exchange (SAFE),at a meeting in late 2008 said that foreign financials firms would be allowed to issue renminbi-denominated bonds to avert liquidity problems, and that rules would be unveiled in January. However, there is still no action on this, said Au. SHANGHAI 00000120 002 OF 005 ============================ Customers Avoiding Derivatives ============================ ¶6. (SBU) Chinese insurance companies and state-owned companies do not want to be seen with derivatives on their books, said our interlocutors. Standard Chartered's Tan said that Chinese customers were turned off to derivatives by the case of Nansha Power, which bought hedges against oil price increases from Goldman Sachs, but is now disputing the contract after heavy losses. In addition, said Tan, regulators are looking into the books of state-owned enterprises to find out what derivatives they may hold. Shenyin & Wanguo's Ding agrees, saying Chinese regulators are slowing the approval of new financial products, particularly derivatives. Chinese securities firms will return to their core businesses--such as underwriting, corporate finance, and brokerage services--and will emphasize innovation less, said Ding. Gao Hao's Yin said that clients are cautious and want to buy only "plain vanilla" stocks or bonds. ¶7. (SBU) Several interlocutors mentioned the need to develop new ways to regulate and rate complex financial products. Luo Yang, People's Bank of China (PBOC) Shanghai Head Office International Department Director General, noted that some Chinese banks bought products rated AAA, but recently have seen these investments lose money. Luo commented that the United States needs to fix its regulatory system, and that credit rating agencies need to be better supervised. Shenyin & Wanguo's Ding said that securities firms will emphasize strengthening internal risk controls. ============================ Regulators Concerned About Foreign Exchange Flows ============================ ¶8. (SBU) Most of our interlocutors said that SAFE appears to be slowing the flows of foreign currency into and out of China. Citi's Au said that SAFE has been scrutinizing Citi's forex activities, and recently SAFE director general-level officials--a much higher rank than previously-- have questioned transactions. Citi Country Treasurer Paulus Mok said a SAFE official recently for the first time called him before the bank hit its forex trading limit. ¶9. (SBU) SAFE has stopped approving new quotas for companies under the Qualified Domestic Institutional Investor (QDII--a mechanism for Chinese investors to invest in overseas capital markets) program since the third quarter of last year, said Steve Lee, CEO of HSBC Jintrust Fund Management Co. As for overseas companies seeking to invest in China's stock market through the Qualified Foreign Institutional Investor (QFII) program, the China Securities Regulatory Commission has been active in approving new licenses--a total value of US$2.8 billion in 2008--but SAFE has left some twenty licensees with no quotas, said Lee. In the latter case, SAFE is not moved by the logic that expanding the QFII program would support the Chinese stock market, said Lee. Gao Hua's Yin had a different take, saying that QFIIs are being quietly approved, including quotas, and that his firm is helping clients to start investing in China. China has committed to raise the QFII quota to US$30 billion, noted Yin. (Comment: This was an SED commitment. End comment.) ¶10. (SBU) Regarding the depreciation of the RMB in early December 2008, Standard Chartered's Tan speculated that PBOC tested the dollar-yuan exchange market to see if it would remain stable without PBOC intervention, and determined that it would not. On December 1, the PBOC stopped selling dollars, said Tan, and since no other market participants wanted to sell, the yuan ended at the bottom of the +/- .5 percent daily trading band. SHANGHAI 00000120 003 OF 005 The PBOC concluded that it needed to continue to intervene heavily to avoid a sharp depreciation of the renminbi, said Tan. Lian Ping, chief economist of Shanghai-based Bank of Communications, one of China's top five banks, said that, in his view, the renminbi exchange rate will remain stable--this is the responsible thing to do, and it is good for China's medium and long-term growth. ============================ Chinese Officials Reassessing Financial Reforms . . . ============================ ¶11. (SBU) Several interlocutors noted that the model of the U.S. financial system now looks broken. Shenyin & Wanguo's Ding said that China's financial sector reforms over the past few years were patterned after the U.S. model, but that unfortunately the pace of reforms in the financial sector has stalled in the wake of the U.S. financial crisis. Ding said that Chinese officials and financial firms are now also unsure how to proceed on improving corporate governance, internal risk controls, transparency, and disclosure. Nonetheless, Ding said he was sure that the U.S. model would rise again after this "lesson." "No one has said to reject the U.S. system," said Ding. ¶12. (SBU) As a result, some reforms are being put on hold. For instance, said Gao Hua's Yin, stock market index futures will not be rolled out this year, since officials are concerned about the problems Chinese companies had speculating with derivatives in 2008. In addition, the government wants to protect the welfare of retail investors with limited financial literacy, who would be large users of stock futures trading, said Yin. Regarding the eventual futures trading system, Chinese officials are putting a "ring fence" between securities and futures brokers, said Yin, even though this leads to highly inefficient duplication of back offices. On a separate issue, Shanghai Financial Services Office Director General Fang Xinghai said emphatically that the Central Government had rejected decentralization of regulatory approval to the Shanghai offices of CBRC, CSRC, and other regulators--a measure bolstering financial innovation in Shanghai that Fang had expected to be approved last September. ============================ . . . While Unveiling Some Innovations, and Considering Others ============================ ¶13. (SBU) Our interlocutors cited several welcome measures recently introduced: -- Permitting foreign-invested banks to trade and underwrite corporate bonds on the interbank market--begun in December. (Comment: Allowing foreign banks to trade bonds was an SED V commitment. End comment.) -- Allowing the Shanghai Interbank Offered Rate (SHIBOR) to better reflect market conditions. According to Standard Chartered's Tan, the PBOC--upon Standard Charter's prodding in mid 2008--has stepped away from moral suasion on SHIBOR participants to limit their quotes from what PBOC views as excessively low or high interest rates. -- Allowing securities firms to handle block trades--started in late 2008. Gao Hua's Yin said that firms are allowed to control pricing and allocation, making the process similar to a secondary offering. No licensing is required. However, Gao Hua has not carried out a trade, since the market is too volatile. ¶14. (SBU) Interlocutors cited other measures that could be unveiled this year, including: -- Licensing commodities brokers to trade on overseas markets, to allow arbitrage with the London Metal Exchange. -- Allowing foreign trade to be settled in renminbi. Fang said SHANGHAI 00000120 004 OF 005 that China needs to be cautious, but that Hong Kong already holds adequate renminbi to start trade settlement. It will subsequently be expanded to other nearby countries, such as Thailand. -- Approving a forex options market. Standard Chartered's Tan and Citi's Au agreed that SAFE has made all necessary preparations, but had held off for fear it would add to appreciation pressure; now that depreciation is also a concern, it is a good time to renew lobbying for this. -- Permitting exchange traded funds (ETFs) on the Shanghai stock exchange. Fang and HSBC Jintrust's Lee both said that the first ETF would be based on the Hong Kong Heng Seng index. ============================ New Blood Arriving from Wall Street? ============================ ¶15. (SBU) Financial sector professionals laid off in developed countries are eager to work in Shanghai, said our interlocutors. Standard Chartered is receiving "loads" of resumes from prospective candidates willing to take 30-40 percent pay cuts, said Tan. Shanghai in December sent a delegation to the West to recruit professionals, said Fang, and about 10 percent were non-overseas Chinese. Fang said that these non-Chinese view a few years in China as an addition to their careers. (Note: One draw for these applicants may be that, according to Citi's Au, China has overtaken Japan as East Asia's biggest banking market. End note.) ¶16. (SBU) However, interlocutors also pointed out that Shanghai's financial sector is not at its most robust. Multinationals are pulling back and remitting profits out of China, said Standard Chartered's Tan. He added that the work atmosphere in Beijing is much better than in Shanghai--in Shanghai "you can feel the pain," but in Beijing there are "no salary cuts, no bonus cuts." ============================ Leadership Notes ============================ ¶17. (SBU) Regarding financial sector leaders, our interlocutors had the following observations: -- Liu Mingkang is "on the rise," said Citi's Au. Au said that Premier Wen Jiabao is happy with Liu's performance during the financial crisis, including the high-profile efforts Liu made to clamp down on mortgage lending a year-and-a-half ago. Liu now accompanies Wen on the Premier's trips, said Au. -- Wang Qishan, who has now been in office for more than a year, has assembled a team that he is ready to move into place in the financial regulatory bureaucracy, said HSBC Jintrust's Lee, citing some vice ministerial level vacancies that will soon be filled in the CSRC. -- Shanghai Stock Exchange President Zhang Yujun, former president of the Shenzhen exchange, in recent years has given quotas to each of his direct reports to attract business, including new companies and product innovations, said Lee. -- Fang Xinghai said that, after the financial system was rattled in mid September, leaders began a lengthy internal reassessment. He has tried to convince them China is at a different stage of development than the United States, and that China has an "undersupply" of financial services. Fang has argued that this is an unprecedented opportunity for financial reforms--developing the bond market, for instance, since it is the best source of long-term finance for infrastructure. ============================ Comment ============================ SHANGHAI 00000120 005 OF 005 ¶18. (SBU) Our Shanghai-based interlocutors generally mark the end of the previous financial era as September 15, 2008, when they awoke to find that two seemingly unshakable pillars of the U.S. financial system had failed: Lehman Brothers was bankrupt and AIG was essentially nationalized. Their first reaction was to shed without discrimination possible counterparty risk with foreign financial institutions, thereby subjecting foreign banks, insurance companies, and securities companies with solid operations in East China--many locally incorporated, and having met high capitalization requirements--to the equivalent of bank runs. While the PBOC created several avenues for foreign banks to obtain renminbi financing, it has been reluctant to allow banks to use them, out of apparent fear that it could signal that the global financial crisis was spilling into China's financial sector. In the end, Chinese regulators relied on the tool they know best, moral suasion on the large state banks to provide financing to foreign banks. Some foreign bankers feel bitter after this experience; after years of developing relationships with Chinese regulators and financial institutions, they were left feeling abandoned in a crisis. Many wholesale foreign banks are now rethinking their business model of relying on short-term loans from their Chinese competitors to finance their renminbi lending. In addition, AIG's problems and foreign banks' sales of strategic stakes in Chinese banks has strengthened the position of vested interests who now argue that foreign investment in the financial sector is a source of systemic risk rather than strength. As a result, foreign financial services firms believe it has become increasingly difficult to get regulatory approval to expand their operations. ¶19. That said, reform and opening up of the financial sector has not stopped. The need for macroeconomic stimulus appears to have catalyzed reform of the bond market, including allowing foreign banks to underwrite and trade corporate bonds. In addition, the PBOC's efforts to promote trade settlement in renminbi have accelerated, even if part of this is to capture in the formal sector transactions that were occurring in the black market. In terms of staffing, financial professionals arriving from overseas to give new impetus to financial sector reforms is another potential bright spot. ¶20. (U) Beijing Financial Attache David Loevinger has cleared on this cable. CAMP