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RUEHGP/AMEMBASSY SINGAPORE 0327
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RUEHGH/AMCONSUL SHANGHAI 9189

UNCLAS SECTION 01 OF 04 SHANGHAI 000034 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EAP/CM 
NSC FOR MEDEIROS, LOI, SHRIER 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN 
USDOC FOR ITA DAS KASOFF, MELCHER, SZYMANSKI, MAC/OCEA 
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP 
TREASURY FOR IMFP -- SOBEL/CUSHMAN 
STATE PASS CEA FOR BLOCK 
STATE PASS CFTC FOR OIA/GORLICK 
MANILA FOR ADB USED 
PARIS FOR US/OECD 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV PGOV CH
SUBJECT: FINANCIAL SECTOR BUBBLES STILL CONTAINED, SAY EAST CHINA 
CONTACTS 
 
¶1.  (SBU) Summary:  Chinese policymakers are taking only 
moderate steps to dial back the financial system and deflate any 
incipient asset bubbles, according to East China financial 
sector contacts.  There is a good chance that the pace of 
financial sector liberalization will pick up this year, starting 
with the launch of stock market index futures and other simple 
derivates in the first quarter.  However, problems could emerge 
over the medium term, as China's financial system is 
misallocating capital to the state sector.  End Summary. 
 
¶2.  (SBU) Visiting Economic Minister Counselor William Weinstein 
met with Shanghai-based contacts on China's stock market and 
securities industry on January 19-20.  These included Peter 
Alexander, Principal of Z-Ben Advisors, Steve Lee, Chief 
Executive Officer, HSBC Jintrust Fund Management Company, and 
Gao Feng, Executive Director, Deutsche Bank (China). 
 
=========================================== 
Asset Bubbles Forming, But Not Overwhelming 
 
=========================================== 
 
¶3.  (SBU) Chinese policymakers and market players are debating 
the extent to which bubbles exist in China's financial sector as 
a result of economic stimulus funds being siphoned off into the 
stock market and real estate sector, said Gao.  Nonetheless, he 
said, the bubble in the residential property market, for 
instance, is not that worrisome, since Chinese households are 
not as leveraged as U.S. households were.  Alexander was 
dismissive of the recent claim by short-seller Jim Chanos of the 
hedge fund Kynikos Associates that "China is Dubai times 1,000." 
 Naysayers like Chanos cannot understand the Chinese 
government's ability to channel resources into economic growth, 
said Alexander. 
 
¶4.  (SBU) Both Gao and Alexander, though, said inefficient 
financial market operations could lead to future problems. 
China's recently inaugurated small-cap, high-growth stock 
market, Chinext, is "an accident waiting to happen," said 
Alexander, because getting listed is all about the company's 
relationship with the stock underwriters.  Gao pointed to 
misallocation of resources to local government development 
agencies, where debts have reached RMB6-7 trillion 
(approximately US$880 million to US$1 trillion), although he 
noted this is still only around 10 percent of deposits in the 
banking system. 
 
¶5.  (SBU) More worrying for Gao, China appears to be financing 
itself into a form of "state capitalism."  Thus, even though 
household consumption is up, it is state-owned enterprises that 
monopolize earnings and have "hijacked policy," said Gao.  Lee 
offered a more hopeful outlook, predicting that China's equity 
markets, with a current market capitalization of US$3.5 
trillion, would double within the next five to ten years as 
foreigners gain greater access, Chinese household move their 
savings into the market, and Chinese companies are privatized 
through market listings.  Alexander was also hopeful that 
domestic consumption will take off, noting that young people's 
consumption is very high once they are assured of steady income. 
 
================================== 
Government Response Limited So Far 
================================== 
 
¶6.  (SBU) The Chinese Government response to the potential 
 
SHANGHAI 00000034  002 OF 004 
 
 
financial system bubbles has been moderate so far, our contacts 
agreed.  In the stock market, authorities are more concerned to 
reduce the volatility of trading, rather than targeting a lower 
overall market valuation, said Alexander.  Similarly in real 
estate, said Gao, government policy is to allow speculation on 
the high end of the market, while keeping price rises down on 
the middle and low end by increasing the supply of affordable 
housing -- even though at present the local authorities have 
fallen far behind their affordable housing construction targets. 
 Gao suggested that the government would be slow to introduce a 
property tax, since it would be difficult to implement and 
therefore would not reduce speculation. 
 
¶7.  (SBU) The government is reducing its maneuvering room by 
approaching the potential asset bubbles from a political angle 
rather than an economic one, said Gao.  For example, the 
renminbi exchange rate has "definitely created an imbalance," 
said Gao, but Chinese authorities do not want to be seen as 
caving into international pressure by removing the peg. 
Therefore, China has lost control of its monetary policy and 
officials are not able to raise interest rates without 
attracting hot money, especially given low rates around the 
globe, said Gao.  Alexander said that this has forced Chinese 
authorities to wait for the U.S. Federal Reserve Bank to first 
raise interest rates, even though inflation trumps unemployment 
as a concern. 
 
================================== 
2009 an Off Year for Fund Managers 
================================== 
 
¶8.  (SBU) Managed funds experienced a net outflow of investors 
in 2009 as they cashed out of funds that had regained their 
breakeven value, buoyed by the stock market rise, said Lee. 
While the market surge in the first nine months meant that the 
total assets under management of the funds industry reached 
US$2.6 trillion by year end, up from US$2 trillion at the 
beginning of the year, nonetheless the number of fund units held 
by investors declined, he said.  For the most part, said Lee, 
retail investors still remain on the sidelines.  However, HSBC 
Jintrust did not see a net outflow in 2009, because it had taken 
a hit from investors the previous year: HSBC Jintrust products 
were doing well in 2008 when other funds fell below their 
breakeven point, so investors redeemed their HSBC Jintrust 
products to provide liquidity as they waited for the underwater 
funds to rise again. 
 
¶9.  (SBU) Despite their difficulties holding onto investors in 
2009, Alexander said fund management in China is a lucrative 
business because the government has mandated a 1.5 percent 
management fee.  The government did not do this only to assure 
profits, but also because if the firms were allowed to set their 
own fees they would compete for customers by lowering the 
management fees and "half the managers would disappear," 
creating disruption for retail investors, said Alexander. 
 
============================================= ===== 
CIC Continues to Emphasize Passive Fund Management 
============================================= ===== 
 
¶10.  (SBU) China Investment Corporation (CIC) -- China's 
sovereign wealth fund established in 2007 -- has been "working 
as hard as it can not to buy U.S. bonds," said Alexander.  Of 
the total US$300 billion CIC manages, an additional US$60 
billion has been allocated to a variety of fund managers since 
 
SHANGHAI 00000034  003 OF 004 
 
 
June, with half of this going into passive investments, such as 
funds that track the S&P 500, he said.  Alexander has heard that 
CIC could get an additional US$200 billion from China's foreign 
exchange reserves this year, making it one of the world's 
largest sovereign wealth funds, but he believes that CIC's 
portfolio will not exceed 15 percent in direct equity. 
 
¶11.  (SBU) CIC President Gao Xiqing leads the process for 
choosing fund managers, said Alexander, as compared with CIC 
Chairman Lou Jiwei, who focuses on CIC's direct investments in 
companies.  Alexander said that CIC's Gao had been hoping to 
retire as vice chairman of the National Social Security Fund, 
where he had built a reputation as preferring conservative, 
transparent management of the assets through outside fund 
managers.  This reputation was why Gao was selected for the CIC 
position, but Gao's strategy had led to disagreements with Lou, 
said Alexander, until the present split of duties was arranged. 
Gao's advocacy of openness also appears to be diluted -- on the 
one hand Alexander says CIC "wants to be like the Norwegians," 
but on the other he admits the first annual report (for 2008) 
was "a joke" and that he is hoping for increased disclosure in 
the 2009 report. 
 
============================================= ======== 
Expecting Progress on Financial Market Liberalization 
 
============================================= ======== 
 
¶12.  (SBU) The year 2010 will see many new steps to liberalize 
the financial services sector, said Alexander, because officials 
pushing for changes want to launch them before 2011, when 
politics in advance of the 2012 leadership change will stifle 
any further moves.  Both Alexander and Gao pointed to the launch 
of stock market index futures trading, which Gao said should 
start by the end of the first quarter; even before that, said 
Gao, he expects trials for short selling and margin trading, 
which are stepping stones for trading of stock index futures. 
(Note:  On January 8, Chinese media reported that the State 
Council has endorsed in principle the launch of stock index 
futures, with regulators suggesting final preparations could 
take three months.  End note.)  Hu Jintao's January 15 visit to 
Shanghai was significant in demonstrating support for the 
development of Shanghai as an international financial center, 
said Lee, since one of Hu's stops was the offices of China 
UnionPay -- which holds a monopoly in the domestic credit card 
business -- where he urged the company to increase its 
international presence. 
 
¶13.  (SBU) Trusts will probably remain on the forefront of 
financial product innovation this year, said Alexander.  A great 
deal of money is flowing into trusts, he said, and trusts are 
"filling in the gaps" of the financial system, creating real 
estate investment trust (REIT) vehicles, investing in 
infrastructure, and more riskier financing, such as mezzanine 
financing, which offers holders less rights in case of a 
bankruptcy. 
 
======= 
Comment 
======= 
 
¶14.  (SBU) Shanghai financial sector players remain sanguine 
that financial markets are not overshooting in the wake of 
2009's record surge in bank lending, and that Beijing will 
therefore not be tempted to take blunt administrative measures 
 
SHANGHAI 00000034  004 OF 004 
 
 
to shut down speculation.  There is some support for this theory 
in both the stock market, which has remained mostly flat since 
its selloff in August 2009, and the real estate market, in which 
trading volume has dropped off following the end of favorable 
tax and mortgage policies at the end of last year.  However, 
Chinese media is widely reporting strong lending growth by banks 
in the first two weeks of January, along with rumors that 
Chinese regulators have shut down lending by some banks -- or 
even required them to retract loans already extended -- for the 
rest of the month.  If the financial system continues to pump 
credit into the economy, Chinese authorities are more likely to 
put increasingly strict administrative controls in place than 
they are to raise interest rates, which would just encourage 
further hot money inflows.  Even this may not be soon enough, 
though, should a further stock market slump or a drop in housing 
prices cause consumers to pull back in a "double dip" economic 
slowdown. 
 
¶15.  (SBU) EconMinCoun has cleared on this cable. 
CAMP