VZCZCXRO2513
PP RUEHCN
DE RUEHHK #0335/01 0260620
ZNY CCCCC ZZH
P 260620Z JAN 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 4527
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 000335 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EAP/CM AND EB 
MANILA PASS AMBASSADOR PAUL SPELTZ 
TREASURY FOR U/S TADAMS, DAS DLOEVINGER, OASIA-GKOPEKE 
USDOC FOR 4420 
 
E.O. 12958: DECL: 01/26/2031 
TAGS: ECON EINV EFIN PREL HK CH
SUBJECT: TROUBLED MAINLAND FINANCIAL SYSTEM HELPS FUEL 
RECORD GROWTH FOR HONG KONG'S STOCK EXCHANGE 
 
 
Classified By: Acting DPO Simon Schuchat; Reasons: 1.4 (b/d) 
 
SUMMARY 
------- 
 
¶1. (C) China-related listings boomed again last year in Hong 
Kong, led by China Construction Bank's USD 9 billion IPO, the 
world's largest for 2005.  Hong Kong now ranks fourth in the 
world for raising equity capital.  This impressive 
performance, however, derives in part from dysfunction within 
China's own domestic financial system.  A prominent financial 
contact believes China has mismanaged the reform of its 
equity markets, creating a vicious cycle that will leave 
quality mainland companies permanently inclined to list in 
Hong Kong.  He described China as "flying on one engine" by 
failing to lay the proper groundwork for a reliable equity 
raising capacity, thus placing further strain on an already 
troubled banking system.  Other observers are less critical 
of China's reform efforts and believe the Shanghai exchange 
may see new initial public offerings (IPOs) as soon as the 
second quarter of this year.  They display more acceptance of 
what they term as the mainland's necessity to rely on 
financial intermediation outside of the mainland's domestic 
economy until issues involving state shares, capital 
controls, currency convertibility, and corporate governance 
can be overcome.  END SUMMARY 
 
OH, WHAT A YEAR IT WAS 
---------------------- 
 
¶2. (U) 2005 was a hugely successful year for Hong Kong's 
stock market, primarily because of the activities of mainland 
firms that have listed here.  Highlights of note: 
 
o Hong Kong hosted the world's largest initial public 
offering (IPO) in 2005, China Construction Bank.  The firm -- 
the first of China's "big four" banks to go public -- raised 
USD 9.2 billion in October.  More generally, 82 percent of 
IPO funds raised in Hong Kong last year were associated with 
mainland firms. 
 
o USD 38 billion of equity capital was raised in Hong Kong in 
2005, making it fourth in the world after New York, London, 
and Toronto.  Of that capital, USD 21 billion came from IPOs, 
likely placing Hong Kong second only to New York for new 
offerings, once final tabulations are in. 
 
o Hong Kong market capitalization rose 23 percent to USD 1.05 
trillion placing it eighth in the world.  Mainland firms 
account for 39 percent or USD 409 billion of this figure. 
 
o 1,135 companies are listed in Hong Kong of which 335 are 
mainland-related entities.  Specifically: 
 
     -- 120 firms are "H shares," enterprises incorporated on 
the mainland that usually, but not always, have significant 
affiliation with the PRC government; this is the vehicle by 
which state-owned enterprises in China normally sell pieces 
of themselves off on a foreign exchange (Market Cap = USD 165 
billion). 
 
     -- 89 firms are "red chips," enterprises incorporated 
outside of the mainland but that have significant affiliation 
with PRC government (Market Cap = 219 billion). 
 
     -- 126 firms are private enterprises, incorporated 
outside of the mainland but controlled by mainland 
individuals (Market Cap = 25 billion). 
 
o Although the Hang Seng Index rose only 4.54 percent in 
2005, turnover on Hong Kong's exchange increased by nearly 14 
percent, reaching a record USD 579 billion.  A major 
attraction of Hong Kong for portfolio investors has been the 
use of mainland-affiliated stocks as a way to buy into 
China's growth story.  Investors also buy China-related 
stocks here to speculate on the Chinese renminbi (RMB) 
because H-share values are calculated in RMB and then 
converted to Hong Kong dollars (HKD). 
 
HELPED BY AILING CHINA EXCHANGES 
-------------------------------- 
 
¶2. (SBU) Newbridge Capital Managing Partner Weijian Shan 
described the success of Hong Kong's stock exchange as both a 
symptom and future cause of structural economic problems in 
 
HONG KONG 00000335  002 OF 003 
 
 
China.  Speaking at an off-the-record event, Shan offered a 
scathing review of China's efforts to reform the country's 
domestic (A-share) market.  Until recently, approximately 
two-thirds of A-shares were held as non-tradable shares, 
primarily by government-related entities.  In 2005, China 
began converting these shares to make them tradable. 
Anticipation of these shares flooding the market has created 
an environment where it is difficult to list new companies, 
and IPO's have been at a trickle for two years.  The 
"overhang problem" has also depressed share prices, with 
eight-year lows reached on the Shanghai and Shenzhen 
exchanges last July. 
 
¶3. (SBU) Shan said that converting the shares is necessary. 
However, China is forcing holders of non-tradable shares to 
compensate holders of existing tradable shares for the losses 
associated with more shares hitting the market.  In his view, 
this amounts to stock manipulation and disrespect for 
property rights.  The state injecting itself into the 
value-setting process is corrosive to the markets themselves 
establishing a reputation for finding fair prices.  This in 
turn will create a vicious cycle whereby China's best 
companies continue to seek listings outside of the mainland. 
 
¶4. (SBU) According to Shan, the lack of a reliable means to 
raise equity capital is like forcing the domestic financial 
system to fly on one engine.  Financial intermediation is 
reduced to the government taking savings from the public and 
channeling them through banks to build excess production 
capacity.  This squelches profitability and keeps the rate of 
return for existing stocks below the rate of economic growth. 
 Hong Kong, by contrast, has a strong reputation for rule of 
law.  Nobody in Hong Kong worries about government 
shareholders selling their H-shares here because all players 
know that stock values in this well-functioning market are 
determined by fundamentals. 
 
¶5. (C) Shan's negative outlook is illuminating, but it stands 
out against the conventional wisdom found in media coverage 
of China's stock market reforms.  Numerous analysts have 
pointed to the impressive pace of non-tradable conversions -- 
70 percent of market capitalization is likely to be converted 
by late this year, according to estimates.  There has also 
been a recent positive trend in mainland domestic share 
prices, attributed in part to confidence about the reforms. 
Consulate Shanghai notes that foreign security advisors there 
see the conversion process as positive, though confusing, and 
some expect new IPOs as early as the second quarter of this 
year.  That said, Shanghai Stock Exchange Executive Vice 
President James Liu recently told Consulate Shanghai that the 
Hong Kong Exchange's focus on the mainland is "eating our 
lunch."  Liu's comment about the stock exchange's focus is 
consistent with what we have heard here: Hong Kong Exchanges 
and Clearing Chairman Paul Chow recently told us that the 
exchange's current strategic plan focuses exclusively on 
attracting new business based in Greater China. 
 
¶6. (C) HSBC Senior Economist Hongbin Qu told us that he 
disagrees with Newbridge's Shan, asserting that ongoing share 
reform efforts are the only way to go forward.  In the mean 
time, China must "outsource" financial intermediation until 
it can get its own house in order, and so will rely heavily 
on the Hong Kong stock exchange for years to come.  Qu 
observed that beyond the question of working off non-tradable 
shares, China must also address capital controls, the 
convertibility of its currency, and corporate governance 
before its domestic stock markets will begin to function as 
Hong Kong's does.  It will thus be a long time before 
Shanghai is ready to compete with Hong Kong for prized 
listings.  After non-tradable share reform is complete, 
however, the Chinese government may start directing some 
companies to Shanghai, and this could take business from Hong 
Kong. 
 
¶7. (SBU) Bank of China Hong Kong Senior Economist Michael Dai 
authored a research paper that he shared with us, taking a 
line similar to that of HSBC's Qu.  Dai noted that "China 
simply cannot afford... (to halt) its own growth to buy time 
for its stock market reform.  It is at this juncture that 
Hong Kong steps in and takes on the important financial 
intermediation role.... China's financial security also has 
to be considered.  The mainland stock and bond markets have 
yet to be well established, resulting in banks shouldering 
most of the financing burden for economic as well as 
corporate developments... the concentration of risks in the 
 
HONG KONG 00000335  003 OF 003 
 
 
banking sector carries huge destabilizing potentials itself. 
Hong Kong in this case does its part to help diversify some 
of the risks by helping Chinese companies to raise funds." 
 
¶8. (U) This message was coordinated with Consulate Shanghai. 
Cunningham