VZCZCXRO7488
PP RUEHCN
DE RUEHHK #0776/01 0550959
ZNY CCCCC ZZH
P 240959Z FEB 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 5093
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 000776 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EAP/CM AND EB 
MANILA PASS AMBASSADOR PAUL SPELTZ 
TREASURY FOR DAS DLOEVINGER AND OASIA-GKOPEKE 
USDOC FOR 4420 
 
E.O. 12958: DECL: 02/24/2031 
TAGS: ECON EFIN EINV HK CH
SUBJECT: CHANGING VIEWS OF CHINA'S ECONOMY HIGHLIGHTED BY 
HONG KONG SHARE RALLY 
 
 
Classified By: EP Section Chief Simon Schuchat; Reasons: 1.4 (b/d) 
 
SUMMARY AND COMMENT 
------------------- 
 
¶1. (C) SUMMARY: Prices of mainland corporate shares 
(H-shares) in Hong Kong, arguably a barometer of market views 
on prospects for mainland growth and currency appreciation, 
have increased dramatically in recent months, rising 26 
percent so far this year.  Financial strategists tell us that 
the rally signifies three things: greater investor confidence 
in balanced economic growth in the PRC; expectations of 
renminbi appreciation; and belief in the ability of 
higher-quality Chinese companies to manage economic shocks. 
Also fueling the rally has been a decision to include 
mainland corporate shares in Hong Kong's benchmark stock 
index later this year.  COMMENT: Placing H-shares in the Hang 
Seng Index will not only symbolize Hong Kong's ongoing 
economic integration with the mainland, but will also be yet 
another concrete step in the ongoing transformation of Hong 
Kong's exchange from a local market geared towards bank and 
property concerns to a global market with an emphasis on 
China plays.  END SUMMARY AND COMMENT 
 
UP, UP, AND AWAY 
---------------- 
 
¶2. (U) H-shares are the primary vehicle through which China's 
state-owned enterprises use stock issuances to sell pieces of 
themselves to foreign investors.  The 120 H-share companies 
that are listed in Hong Kong represent entities incorporated 
on the mainland, most of them state-affiliated.  China 
Construction Bank, the world's largest initial public 
offering last year (USD 9 billion), is an example of an 
H-share.  Such issuances are the primary source of new 
business for Hong Kong's exchange and already account for 16 
percent of market capitalization.  If other categories of 
mainland-affiliated firms are added in, then the market 
capitalization proportion rises to 39 percent. 
 
¶3. (U) The principal index for tracking H-shares (the Hang 
Seng Mainland Composite Index or HSMCI) has risen 26 percent 
this year, a significant rally by comparison with 6 percent 
rise for the benchmark Hang Seng (HSI), the index of 33 
stocks generally tracked by financial news services when 
reporting on Hong Kong; this index does not include H-shares. 
 
 
FACTORING IN RENMINBI APPRECIATION... 
------------------------------------- 
 
¶4. (SBU) JP Morgan Managing Director Grace Ng said that 
H-share investors increasingly anticipate significant 
appreciation this year of the Chinese renminbi (RMB); Ng 
herself predicts a 12 percent upward RMB movement against the 
USD.  H-share values are rising accordingly, since their 
fundamentals are to a great degree valued in RMB.  Ng noted a 
significant trade-weighted rise in the RMB last year (without 
providing a calculation, although another contact has 
concluded that there was an 8 percent trade-weighted 
appreciation).  China will be in a better position to let the 
RMB appreciate against the USD in 2006 because the USD is 
unlikely to continue its rise against the Euro and Yen.  In 
other words, Ng is suggesting that RMB-USD appreciation is 
easier for mainland policy makers to swallow now because it 
is unlikely to exacerbate an ongoing trade-weighted rise 
against other global currencies. 
 
... WHICH IS A VALUABLE POLICY TOOL 
----------------------------------- 
 
¶5. (C) Further, according to Ng, investors may appreciate 
that RMB-USD appreciation is suddenly a valuable policy tool 
for officials in Beijing for three reasons.  First, the 
National People's Congress will be held in early March and 
will formally approve the Eleventh Five-Year Plan.  This 
offers a roadmap towards domestic-focused growth and a more 
balanced economy less dependent on exports and investment. 
Currency appreciation coupled with maintaining low domestic 
interest rates fits in with promoting this scenario.  Second, 
Congressional pressure from the U.S. and the prospect of 
being named a "manipulator" in Treasury's currency report 
matters to the Chinese, who do not want the door opened to 
unilateral trade sanctions that could harm their economy and 
financial markets.  (Note: Ng stands out relative to other 
 
HONG KONG 00000776  002 OF 003 
 
 
contacts here, who believe U.S. pressure could backfire 
because the mainland would not want to be seen as bowing to 
American demands just as President Hu Jintao is about to 
visit the U.S.  End Note.)  Finally, recent positive growth 
figures (e.g., January's surprisingly strong export data) 
suggest that China has room to absorb the retarding effects 
of appreciation.  Confidence in prospects for appreciation 
has been only bolstered by faster upward movement of the RMB 
seen this month, since the end of the Chinese New Year, 
according to Ng. 
 
ECONOMIC CENSUS ALSO HELPS H-SHARES... 
-------------------------------------- 
 
¶6. (C) Ng referred to China's recent economic census that led 
to a 17 percent upward revision of the size of its economy. 
The change was primarily a result of recognizing the larger 
role played by services than previously thought, suggesting 
that the economic forces underpinning the growth of 
consumption in wealthier, more urban markets are stronger 
than investors had believed.  This strengthens the outlook 
for at least some of the H-share companies, Ng told us. 
Further, signs of sustainability in consumer growth are 
suggestive of more stable profit margins.  Confidence in the 
resilience of these profits coupled with increasing 
recognition that the mainland firms listed in Hong Kong are 
among the best in terms of corporate governance is another 
factor bolstering H-shares, in Ng's view. 
 
... AND GREATER ECONOMIC BALANCE AS WELL 
---------------------------------------- 
 
¶7. (C) Goldman Sachs Managing Director Hong Liang old us 
that the rally represents growing investo confidence in the 
ability of China's economy tosustain high rates ofeconomic 
growth, but she dew a contrast between market sentiment and 
her ow views, which are more pessimistic.  Investors, sh 
said, are positively reassessing China's macroeonomic 
health, and they see an economy tending towards greater 
balance with regard to continued expansion generated by 
exports, investment, and domestic consumption.  There is also 
increasing confidence, perhaps misplaced, in Beijing's 
ability to manage China's economy in the coming years, 
especially given its perceived bias towards stimulating 
domestic demand.  Investors additionally believe that as the 
sustainability of high levels of growth becomes evident to 
policy makers, they will grow more comfortable in letting the 
RMB appreciate.  Liang predicted a 3-5 percent RMB 
appreciation this year. 
 
A CAUTIONARY NOTE 
----------------- 
 
¶8. (C) Liang said that mainland policy makers might fail to 
manage the current economic cycle properly by reacting too 
slowly.  She thinks that economic activity is understated and 
that policy makers are likely to wait until after first 
quarter data are finalized to see that this is the case and 
then respond.  Liang termed China's slow response to the need 
for RMB appreciation a "worst case approach" towards 
macroeconomic management and asserted that continuing in this 
way will lead to inflationary pressures amidst rising 
commodity prices.  The result will inevitably be "bubbly 
stuff somewhere."  But by reacting too late, authorities will 
find themselves hesitant to prick the bubbles with higher 
interest rates out of fears of hurting other sectors of the 
economy that need to keep growing.  Consequently, they may 
once again resort to administrative approaches; such 
arbitrary non-market measures could quickly change investor 
sentiment. 
 
H-SHARES TO JOIN HONG KONG'S BENCHMARK INDEX 
-------------------------------------------- 
 
¶9. (SBU) H-shares account for a significant proportion of 
foreign investor interest in the Hong Kong exchange, yet they 
are not represented on the benchmark HSI.  They are barred 
from the index because the ownership held by state-affiliated 
parent firms is often in the form of "non-tradable" shares 
that cannot be bought or sold.  To reform the Shanghai stock 
market, China is presently converting non-tradable shares of 
companies listed there (A-shares) to tradable shares.  This 
will open the way for H-share firms in Hong Kong to join the 
HSI for two reasons.  First, some H-share firms are also 
listed as A-share firms in Shanghai, so the 
 
HONG KONG 00000776  003 OF 003 
 
 
Shanghai-initiated conversion to tradables affects some 
companies listed here and will make them eligible to join the 
HSI.  Second, Chinese firms that have not yet listed as 
H-shares or A-shares will be more inclined to list as fully 
tradable the first time around, thus qualifying them up front 
for HSI constituent status. 
 
INTEGRATION AND TRANSFORMATION 
------------------------------ 
 
¶10. (C) We note that loading the HSI up with PRC firms 
symbolizes Hong Kong's further integration into the 
mainland's economy.  It will also draw those who invest in 
Hong Kong's market away from traditional property and banking 
concerns located here and into companies based in the PRC. 
This is because fund managers often allocate investments 
against a basket of shares like the HSI.  Therefore, if the 
HSI is weighted less towards companies like HSBC (bank) and 
Sun Hung Kai (property) and more towards H-shares like China 
Construction Bank and Angang Steel, then foreign funds will 
flow accordingly. 
 
Sakaue