(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
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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