HK ECONOMISTS DISMISS DOWNSIDE RISKS TO CHINESE

C O N F I D E N T I A L SECTION 01 OF 02 HONG KONG 000182

SIPDIS

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

E.O. 12958: DECL: 01/28/2025
TAGS: EFIN ECON HK CH
SUBJECT: HK ECONOMISTS DISMISS DOWNSIDE RISKS TO CHINESE
ECONOMY

Classified By: Acting Consul General Christopher Marut, Reason 1.4 b


1. (SBU) Summary: China macroeconomists in Hong Kong predict
inflation and Renminbi (RMB) appreciation for 2010 but are
not overly worried about asset bubbles or non-performing
loans. The recent small interest rate increase and hike in
reserve requirements were intended to show the market that
Chinese economic policymakers are watching closely and will
step in to tighten if needed. But with growth still
dependent on loose monetary policy, officials will be
reluctant to do too much, too soon. Overheating, caused by
stronger-than-expected global demand, was the biggest risk
they saw to Chinese economic growth. Loose monetary fiscal
policies are already spurring high growth. Add resurgent
exports and the Chinese government may be forced to rapidly
tighten, with unforeseen consequences. But several months of
export growth could also provide helpful cover for RMB
appreciation. Economists warned that foreign pressure to
allow the currency to strengthen would not be helpful.
Observers agreed that China needed to rebalance its economy
away from exports towards more domestic consumption, but this
was a long-term goal likely to be delayed until the new
Chinese leadership team was installed in 2012. End Summary.


2. (C) Hong Kong Economic Unit Chief and Beijing Deputy
Financial Attach met with China economists Shen Minggao
(Citibank),Helen Qiao (Goldman Sachs),Qu Hongbin (HSBC) and
Ben Simpfendorfer (RBS) in Hong Kong January 22 to discuss
the risk of inflation in China, asset bubbles, exchange rate
policy, economic rebalancing and risks of non-performing
loans in China's banking system.

Inflation Accelerating, China Wary of the Brake Pedal
============================================= ========


3. (C) Shen predicted that China's 2010 economy would face
many of the same problems last seen in 2007, namely, loose
money and global commodity price increases leading to asset
bubbles and concerns about inflation, which he said might
reach five percent by year's end. He noted that while China
planned to restrict lending to just RMB 7.5 trillion in 2010,
that was still over 50 percent above pre-2009 peak lending.
Simpfendorfer noted that food and energy prices were
increasing, in part due to bad weather in China, and that
could spur inflationary expectations. Qiao and Qu also
agreed that the risk of increased inflation this year was
significant. The People's Bank of China's early January
decision to raise its base rate 27 basis points was a signal
to markets that the PBOC would not hesitate to tighten if
necessary, said Qu. Qiao predicted that Chinese authorities
would rely on administrative measures to cool the economy.
Loan quotas and price controls could be in the cards, she
said. But all agreed that with liquidity-driven growth,
China would be cautious about tightening too much, too soon.

NPL = No Problem Loans
======================


4. (C) Rapid loan growth has raised the specter of
non-performing loans (NPLs),but none of our interlocutors
were overly concerned. Qiao believed only an economic "hard
landing" or double-dip recession -- which she did not expect
to occur -- could generate serious NPL problems, and in any
case the government would not slow the flow of funding to
ongoing projects. Shen acknowledged that an increase in NPLs
stemming from China's unprecedented loan growth in 2009 was
certain but argued that they wouldn't be a concern for
several more years; if the amount of new NPLs grew too large,
however, Shen believed they could worsen China's fiscal
situation and undermine public confidnce in the Government.
Continued rapid nominal growth would resolve the issue, said
Qu. In the meantime, "evergreening" (rolling over debt with
new loans) would prevent bad loans from showing up on bank
books. Simpfendorfer agreed, noting that much of the
short-term debt had been replaced by longer term borrowing.
In any event, NPLs in infrastructure loans had historically
been low, he said.


5. (C) Senior Chinese officials worried more about asset
bubbles than NPLs, said Qiao, but she downplayed concerns
that housing or equity prices were in bubble territory. She
drew a distinction between the low and high end of the
housing market, noting that prices for luxury properties were
rising rapidly while lower-end property prices were more
stable. Given that investors and speculators in the high-end
often paid in full and in cash, Qiao questioned the
effectiveness of government controls on lending, down
payments, and higher interest rates. The government should
focus on ensuring there was a sufficient stock of lower end

HONG KONG 00000182 002 OF 002


properties at reasonable prices and let the top of the market
go where it would, she said. Shanghai equity prices, after
leading the world in late-2008 and early-2009, now were
lagging other regional markets and were not a worry.

Biggest Risk to China? U.S. Recovery
=====================================


6. (C) Ironically, many of our interlocutors identified a
stronger-than-expected recovery in developed markets as the
most serious risk to the Chinese economy. China's December
export figures surprised the market, said Qiao. Some
recovery in the U.S. and other developed country markets,
combined with low numbers from early 2009, would make Chinese
export growth look strong in the first half of 2010. If
export growth remained at about 20% beyond the first quarter,
China risked overheating and the government would be forced
to tighten monetary policy and slow spending, said Qu. Only
Citibank's Shen disagreed, arguing that with China's share of
G3 (U.S., EU, and Japan) imports hovering around 20 percent,
these economies don't have capacity to absorb much more from
China. Significantly higher-than-expected growth in both
developed and emerging market economies was the only thing
that could support a meaningful increase in Chinese exports,
he said.

Bet on a Strengthening RMB in 2010, But When?
=============================================


7. (C) All agreed that RMB exchange rate appreciation was
likely this year, but our interlocutors disagreed on the
timing. Shen predicted a return to gradual appreciation
during the first half of 2010, driven by concerns about
inflation and sterilization costs. He noted that large firms
would welcome a stronger RMB for its impact on smaller
rivals. With many exporting firms operating on thin margins,
a three percent appreciation could force the smallest and
weakest into the arms of larger competitors or out of
business entirely. Chinese firms would benefit from
consolidation, but the government worried about increased
unemployment, said Shen. Qu agreed that appreciation was
overdue, but suggested that Chinese policymakers needed to
see several months of strong export growth to provide them
with political cover to allow a return to a gradual
appreciation. He added that foreign pressure, particularly
from the developed economies, wasn't helpful.


8. (C) Qiao also advised against pressuring China on
currency issues. Senior leaders knew it had to happen and
would allow the RMB to appreciate this year but were
extremely sensitive to accusations that they were responding
to foreign demands, she said. The "unfavorable political
calendar," including U.S. Treasury's foreign currency report
in April, the G20 meeting in June, and the Strategic and
Economic Dialogue in mid-year, would prevent Chinese
officials from taking action until the second half of 2010
when she predicted a relatively large and sudden appreciation
of up to five percent.


9. (C) A stronger currency could contribute to weaker
external demand for Chinese exports in the second half of the
year and force leaders to start the process of rebalancing
toward domestic consumption, said Shen, although he did not
expect significant structural adjustment until 2012 or
beyond. Chinese statistics suggesting domestic consumption
was already increasing were not credible, said RBS's
Simpfendorfer, and merely reflected temporary subsidies
rather than real rebalancing. Without income growth or
increased access to consumer credit, Chinese consumers were
in no position to spend more, he said, so any real increase
in private consumption would be a "slow-burning story." Qiao
agreed, noting that household income had grown more slowly
than GDP since 2000. She and Shen argued that real change
was unlikely before the new leadership took charge in 2012
and would require at least five to ten years to achieve.
MARUT