FEARS OF POLICY CHANGES DRIVE SHANGHAI STOCKS SLUMP

UNCLAS SECTION 01 OF 04 SHANGHAI 000369

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E.O. 12958: N/A
TAGS: ECON CH EFIN EINV PGOV
SUBJECT: FEARS OF POLICY CHANGES DRIVE SHANGHAI STOCKS SLUMP


1. (SBU) Summary: The Shanghai stock market's recent 18
percent decline stems from three main factors, say ConGen
Shanghai contacts: a more cautious Central Government stance
regarding potential asset bubbles; profit-taking by some leading
institutional investors; and an expected moderation to the flood
of new money into the economy. Most contacts indicated surprise
with the speed and extent of the drop since the market hit its
year-to-date high on August 4 -- one experienced observer called
it "shocking." Most see the market rebounding, with gains --
even if only small ones -- by the end of the year. End Summary.


============================
Background: The 2009 Rally
============================


2. (SBU) The Shanghai Composite Index this year gained roughly
90 percent through its peak of 3,471 on August 4. From that
point through mid-day August 20, the index fell to 2844, or over
18 percent. Price-earnings ratios soared to 30:1, compared to
an average of around 19:1 in the two years prior to the bubble
and 15:1 at the beginning of the year. (Comment: The large run
up can be attributed to (i) aggressive assumptions about a
potential economic recovery, supported by a 7.9 percent GDP
growth in the second quarter, (ii) the herd mentality of Chinese
investors entering the market on the rebound, and (iii)
expectations that the present loose monetary policy will
continue. End comment.)

============================================= =
Beijing Signals the Markets to Cool Down . . .
============================================= =


3. (SBU) Our contacts say that policymakers are becoming wary
of distortions in the Chinese economy as a result of the
economic stimulus measures introduced in fall 2008. These
include the interrelated problems of asset bubbles, which some
contacts see in the equities market as well as in the real
estate sector, market speculation, and the potential degrading
of loan performance. According to Chinese press, Chinese
regulators and state-owned banks became increasingly concerned
that companies were funneling funds allocated for stimulus
projects into the market. One contact at a European bank
estimated that up to RMB1 trillion of the RMB4 trillion
government stimulus spending may have made its way into the
market. According to press, the Central Government responded to
these potential issues with PBOC's second quarter monetary
policy report, released on August 5, which indicated that
tighter credit, increased scrutiny of loans, and a heightened
focus on mortgage lending standards could be expected in the
second half.

===================================
. . . And What Beijing Says Matters
===================================


4. (SBU) Many contacts have emphasized that the China market is
shallow and driven by political decisions and is not a
reflection of the macroeconomy. Over recent days, said two
contacts, the government had been telegraphing "sell" signals to
the market. One bank's chief economist for China said Chinese
policymakers probably welcome the market correction, with some
officials estimating a decline of around 20 percent could help

SHANGHAI 00000369 002 OF 004


ease concerns of an asset bubble. A Shanghai-based investment
advisor separately reinforced the notion that some parts of the
bureaucracy appear to be talking down the market, following a
typical playbook: first "water down" the shares in the market
through the sale of non-traded shares and small IPOs, then
through larger IPOs; if the market is still deemed too high,
expect to see imposition of higher transaction taxes on stock
trading, reversing tax cuts previously taken to support the
market.


5. (SBU) Our contacts are divided on the importance of stock
market performance to the Chinese leadership in advance of the
60th anniversary of the founding of the People's Republic of
China on October 1. The head of securities trading at a firm
affiliated with a Western bank emphasized the importance of the
upcoming National Day celebration, and said that a pullout by
insurance companies from the market appeared to be driven by a
calculation that the Central Government would start to tighten
monetary policy after the National Day anniversary, reinforcing
the need to lock in profits now. The contact said that October
was seen as being a definite "policy inflection point."
However, a Shanghai-based investment adviser discounted the
notion that the government would hold off changes until after
October 1. He noted that the market fell prior to the Olympics,
when some market players were hoping the government would prop
it up.


6. (SBU) Still, Beijing may not want the market to fall much
farther. The chief economist said the PBOC did not expect such
a strong market reaction to the central bank's rhetoric. The
head of an investment bank branch said that the Chinese
government still wants some growth in the equities market, so
the current Shanghai Composite Index level may be close to the
bottom. (Note: As of August 20, market players sensed a shift
back towards government support for a stable, if not growing,
market, with Chinese press reporting that the China Securities
Regulatory Commission has recently approved several
stock-oriented funds. Analysts anticipate that this will bring
more investors into the market. End note.)

========================================
Institutional Investors Cashing in Gains
========================================


7. (SBU) Several sources noted the movement by insurance
companies to trim the equities weight in their portfolios as a
trigger to the selloff. The head of a securities firm
explained that insurance companies look for absolute gains, so
that once they hit their annual target they decided to lock in
profits. Since half of insurance companies' investments in the
market are through fund managers, this in turn forced those
funds to sell off holdings, and led to a downward spiral. Ping
An Insurance started the selloff, said two contacts. The
securities firm head said that retail investors, on the other
hand, are generally loath to sell at a loss, and therefore many
are holding on to their stocks until a rebound. An investment
adviser made a similar call, saying that insurance companies and
fund managers looked at the healthy second quarter results, and
decided to liquidate their positions.


8. (SBU) The investment adviser pointed to an additional factor
impelling investors to close out their positions. He said that
since there is no way to short the market in China, the only way

SHANGHAI 00000369 003 OF 004


to hedge risk is to sell off a position. Another contact at a
U.S. bank echoed this sentiment. Mutual funds, hedge funds, and
social security funds are changing their portfolio allocation,
drawing down their equity holdings and moving into the bond
market, she said. Increased capital inflows to the bond market
reflect this trend, though it is uncertain how widespread and
fixed this movement will be. The securities firm head said
that--given the almost doubling of the market index this
year--it was no surprise that there was some pullback.


9. (SBU) The decision by the People's Bank of China (PBOC) to
begin "dynamic fine-tuning" was the perfect excuse for investors
who believed stocks were already overvalued to cash-in on the
equities market, according to the chief economist for China at a
major Western bank. (Comment: High valuations and doubts about
a timely recovery in the real economy, especially in light of
the consumer price index falling 1.8 percent year-over-year and
the producer price index down 8.2 percent, reinforce
expectations that the PBOC will begin to draw back liquidity.
End comment.)


10. (SBU) However, not all our contacts agreed that
institutional investors are now waiting out the stock market.
The head of China markets at a U.S. bank said institutional
investors are still bullish, by-and-large, and they will
probably re-enter the market again, in anticipation of a
rebound.

======================================
Liquidity Flood Seems to be Moderating
======================================


11. (SBU) Some contacts pointed to anticipation of an end to
monetary easing, or an impending start for monetary tightening,
as a reason for the stock market slump. Many contacts pointed
to concerns that sharp new lending growth in the first half had
led to over-liquidity. Some observers already see an impact
from the lower new bank lending in July. An investment adviser
said that this had forced some companies to withdraw funds
parked in the stock market in order to finance their investments
in the real economy. The head of an international investment
bank branch agreed, saying that there is a "zero sum liquidity
effect" in which July's lower lending has led corporations to
liquidate some stock holdings bought with the easy credit
available earlier this year. The lead China analyst for a major
bank said that the main driver of market fluctuations has been
liquidity. He noted that some are waiting to see the August and
September new lending figures to see if the PBOC has shifted
towards a tighter monetary policy.

=======
Comment
=======


12. (SBU) Our contacts in Shanghai largely confirm that market
insiders have been gaming the government's economic stimulus
plan and flood of new infrastructure lending to make short-term
profits on the stock market. With Beijing offering more money
to favored companies than they could profitably invest in the
real economy, chances were high that some of the funds would
find their way into the stock market. Savvy investors were able
to ride this wave up, but those ready to liquidate their
positions before the government slammed closed the credit door

SHANGHAI 00000369 004 OF 004


again would make the highest gains. That is why the July PBOC
report rang a sell signal for the market, even if true monetary
tightening does not begin for months -- everyone wanted to be
the first one to the exit. Looking forward, most market players
are now hoping for the Central Government to offer policy
support to keep the stock market from falling farther.
CAMP