VZCZCXYZ0000
PP RUEHWEB

DE RUEHBJA #8541 2441006
ZNY CCCCC ZZH ZUI RUEWCSE2559 2441330
P 011006Z SEP 06
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC 0000
INFO CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/NSC WASHDC

C O N F I D E N T I A L BEIJING 018541 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EAP/CM AND EB 
USDOC FOR 4420 
 
 
TREASURY FOR OASIA/ISA - DOHNER/KOEPKE 
NSC FOR MCCORMICK 
STATE PASS USTR FOR STRATFORD, WINTER, AND ALTBACH 
STATE PASS CEA FOR BLOCK 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN 
FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK 
 
E.O. 12958: DECL: 09/01/2016 
TAGS: ECON PGOV ETRD EFIN EINV CH
SUBJECT: GOVERNANCE ISSUES MEET FEVERISH INVESTMENT 
 
REF: BEIJING 17937 
 
CLASSIFIED BY: ECON ACTING MINCOUNS CHRIS BEEDE; REASONS: 1.4 (B/D) 
 
 
SUMMARY/COMMENT 
--------------- 
 
¶1. (C) THE CHINESE GOVERNMENT IS WELL AWARE THAT EXCESSIVE 
INVESTMENT AND CREDIT GROWTH POSE A SIGNIFICANT RISK TO THE 
ECONOMY, BUT OUR CONTACTS SUGGEST THAT FOUR GOVERNANCE ISSUES 
STAND IN THE WAY OF A BOLD RESPONSE.  FIRST, PREMIER WEN 
JIABAO'S EMPHASIS ON FORGING INTERNAL CONSENSUS, EVEN AMONG 
NARROWLY-FOCUSED REGULATORS, ON ALL MAJOR ECONOMIC ISSUES 
(EXCEPT FOR GRAIN PRODUCTION AND INFLATION CONTROL) YIELDS 
PIECEMEAL APPROACHES AND OFTEN LEADS TO POLITICAL GRIDLOCK. 
SECOND, FEARS OF SOCIAL INSTABILITY LEAD SOME TO FAVOR 
BOOSTING GROWTH TO CREATE JOBS.  THIRD, TWO ECONOMISTS WE 
TALKED TO, WHO ADVISE THE GOVERNMENT, DOWNPLAY THE IDEA OF 
"OVERHEATING" AND BELIEVE THAT THE PRESENT AND EXTRAORDINARY 
30 PERCENT GROWTH RATE IN FIXED ASSET INVESTMENT (FAI) CAN BE 
CHECKED WITH ADMINISTRATIVE MEASURES ALONE; THEY SAID THERE 
IS NO NEED TO EMPLOY RENMINBI APPRECIATION, WHICH WOULD 
INTRODUCE UNWANTED VOLATILITY, AND NO POINT IN RELYING ON 
INTEREST RATE HIKES, WHICH ARE INEFFECTIVE IN AN ENVIRONMENT 
WHERE LOCAL GOVERNMENTS AND STATE-OWNED ENTERPRISES ARE 
UNRESPONSIVE TO SUCH CHANGES WHILE OTHER INVESTORS BELIEVE 
HIGH RETURNS ARE STILL AVAILABLE ELSEWHERE, ESPECIALLY IN 
REAL ESTATE.  FINALLY, THERE IS THE SELF-INTEREST OF 
PROVINCIAL LEADERS WHO PLAY TO CONSTITUENTS WITH VANITY 
PROJECTS OR, WITH AN EYE TOWARD NEXT YEAR'S PARTY CONGRESS, 
ARE PARTIAL TO INVESTMENT THAT GENERATES HIGH ECONOMIC GROWTH 
FIGURES.  END SUMMARY/COMMENT 
 
LOTS OF MONEY SLOSHING AROUND... 
-------------------------------- 
 
¶2. (U) CHINA'S PRIMARY TACTICAL ECONOMIC CHALLENGE IS 
DIGESTING THE MASSIVE QUANTITY OF FUNDS ACCUMULATING IN THE 
FINANCIAL SYSTEM AS A RESULT OF THE TRADE SURPLUS, RENMINBI 
SPECULATION, FOREIGN DIRECT INVESTMENT, INCREASING PROFITS 
FOR MANY FIRMS, AND CAPITAL CONTROLS.  LARGE QUANTITIES OF 
CHEAP MONEY HAVE CREATED A WIDE RANGE OF INCENTIVES FOR 
GOVERNMENT OFFICIALS, BANKS, AND CORPORATIONS TO CONTINUE TO 
PUT THE FUNDS TO USE BY EXPANDING PRODUCTION CAPACITY TO THE 
POINT OF OVERCAPACITY AND BUILDING NEW INFRASTRUCTURE, MUCH 
OF IT DUPLICATIVE OR WASTEFUL (BUT IT OFTEN MAKES LOCAL 
OFFICIALS LOOK GOOD).  THIS SITUATION IS EXACERBATED BY WEAK 
CORPORATE GOVERNANCE AND THE PRACTICE OF NOT PAYING 
DIVIDENDS.  AS A RESULT, FAI CONTINUES TO GROW AT WHAT IS 
CONSIDERED AN UNSUSTAINABLE RATE: 30.5 PERCENT IN THE FIRST 
SIXTH MONTHS OF THIS YEAR COMPARED TO 2005. 
 
¶3. (U) THE FAI RAMP-UP IS PARTICULARLY OBVIOUS AS 
URBANIZATION, LONG-TERM GROWTH, AND FOREIGN SPECULATION FUEL 
WIDESPREAD RESIDENTIAL CONSTRUCTION.  THERE ARE ALSO LARGE 
AND ONGOING INFRASTRUCTURE PROJECTS SUCH AS THE THREE GORGES 
DAM AND FACILITIES FOR THE 2008 OLYMPICS.  CHINA IS 
ADDITIONALLY POURING MONEY INTO EXPANDING PORTS, AIRPORTS, 
RAILWAYS, AND HIGHWAYS.  SOME INVESTMENT IS FURTHER MOTIVATED 
BY CHINA BEING IN THE EARLY STAGE OF ITS ELEVENTH FIVE YEAR 
PLAN (FYP), IN PARTICULAR BECAUSE THE FYP HAS GIVEN A GREEN 
LIGHT TO MORE INVESTMENT IN RURAL AREAS.  LESS VISIBLE, BUT 
OF GREATER ECONOMIC CONCERN, IS THE RESPONSE OF VARIOUS 
MATERIALS SECTORS TO ALL OF THIS INVESTMENT, YIELDING GROWING 
OVERCAPACITIES IN INDUSTRIES LIKE STEEL AND CEMENT. 
 
SLOWDOWN COMING TOO SLOWLY? 
--------------------------- 
 
¶4. (C) NOBODY WE HAVE TALKED TO IS PREDICTING A CRASH IN THE 
SHORT-TERM, BUT ECONOMISTS LIKE CITIBANK'S VICE PRESIDENT FOR 
ASIA/PACIFIC RESEARCH SHEN MINGGAO, WHO RECENTLY JUMPED TO 
THE FIRM FROM A RESEARCH POSITION AT BEIJING UNIVERSITY, ARE 
CONCERNED THAT RECENT EFFORTS TO TIGHTEN ARE TOO LITTLE TOO 
LATE.  SHEN LAMENTED THAT TWO INTEREST RATE HIKES THIS SUMMER 
AND A SLEW OF ADMINISTRATIVE MEASURES AIMED AT SLOWING THE 
BUILDUP OF OVERCAPACITY IN CONSTRUCTION-RELATED SECTORS ARE 
FAR TOO LIMITED.  OVER THE COMING YEARS, THE CONSEQUENCE OF 
THE SLOW GOVERNMENT RESPONSE IS LIKELY TO BE DEFLATION IN 
SOME SECTORS AND AN OVERALL SURGE IN NON-PERFORMING LOANS. 
 
 
¶5. (C) SHEN ALSO RAISED CONCERNS THAT CHINA IS MOVING TOO 
SLOWLY TO USE ITS MOST EFFECTIVE TOOL: CURRENCY FLEXIBILITY. 
HE AND NUMEROUS OTHER ECONOMISTS BELIEVE THAT WERE THE 
RENMINBI ALLOWED TO APPRECIATE SIGNIFICANTLY, FUNDS INFLOWS 
THAT FUEL INVESTMENT GROWTH WOULD SLOW MEASURABLY -- FIRST AS 
A RESULT OF SPECULATION DRYING UP, FOLLOWED BY AN EVENTUAL 
DECLINE IN THE TRADE SURPLUS RESULTING FROM CHEAPER IMPORTS 
AND A FALL-OFF IN EXPORTS IN PRICE-SENSITIVE SECTORS SUCH AS 
APPAREL AND LOWER-END ELECTRONICS.  HE ADDED THAT GIVEN 
PROSPECTS OF WEAKER U.S. DEMAND, THE WINDOW MAY BE CLOSING ON 
THE ABILITY TO ALLOW GREATER RENMINBI APPRECIATION.  FURTHER, 
BECAUSE EFFORTS TO TIGHTEN INVESTMENT WILL MOST OFTEN IMPACT 
INDUSTRIES GEARED TO PRODUCTION FOR INTERNAL CONSUMPTION, ONE 
RESULT WOULD BE A FALL OFF IN IMPORTS, EXACERBATING CHINA'S 
GLOBAL TRADE SURPLUS. 
 
GOVERNANCE CHALLENGES 
--------------------- 
 
¶6. (C) SHEN FURTHER DESCRIBED TO US A LOWEST COMMON 
DENOMINATOR APPROACH TO KEY ECONOMIC DECISIONS UNDER THE 
DIRECTION OF PREMIER WEN JIABAO.  IN SHEN'S VIEW, WEN WILL 
ONLY PROVIDE CLEAR AND DECISIVE DIRECTION ON TWO ISSUES: 
MAINTAINING GRAIN PRODUCTION TARGETS AND CONTROLLING 
INFLATION.  EVERYTHING ELSE IS HELD HOSTAGE TO A LENGTHY 
PROCESS OF DIFFERENT GOVERNMENT PLAYERS -- INCLUDING 
REGULATORS WITH NARROWLY DEFINED CHARTERS -- PRESSING THEIR 
PAROCHIAL AGENDAS UNTIL "CONSENSUS" IS REACHED. 
 
¶7. (C) CHINA ACADEMY OF SOCIAL SCIENCES (CASS) SENIOR 
RESEARCH FELLOW DR. WANG TONGSHAN SAID THAT ALTHOUGH THE 
ELEVENTH FIVE-YEAR PLAN AIMS TO INJECT BALANCE INTO THE 
ECONOMY, CHINA IS ACTUALLY MOVING AWAY FROM SUCH A GOAL, WITH 
FIXED ASSET INVESTMENT PRESENTLY RISING AT TWICE THE RATE OF 
CONSUMER SPENDING.  FURTHER, ECONOMIC POLICY MAKERS ARE VERY 
FOCUSED ON JOB CREATION, THE GROWING RICH-POOR DIVIDE, AND 
OVERALL SOCIAL STABILITY, SO THEY ARE RELUCTANT TO ALLOW FOR 
APPRECIATION OF THE RENMINBI.  THE BEST COURSE, IN HIS VIEW, 
IS STRONGER ADMINISTRATIVE CONTROLS ON CREDIT AND 
RESTRICTIONS ON LAND USE. 
 
NDRC: NEED CONTROL BUT EXISTING PPROACH SUFFICIENT 
--------------------------------------------- ----- 
 
¶8. (SBU) DR. WANG XAOGUANG, WHO DIRECTS THE MACROECONOMICS 
DIVISION AT THE NATIONAL DEVELOPMENT REFORM COMMISSION (NDRC) 
INSTITUTE OF ECONOMIC RESEARCH ECHOED OUR CASS CONTACT 
CONCERNING THE NEED FOR ADMINISTRATIVE CONTROLS RELATED TO 
PROJECTS, CAPITAL, AND LAND.  HE WENT A STEP FURTHER IN 
EXPRESSING CONFIDENCE IN SUCH MEASURES, ASSERTINGTHAT RECENT 
MOVES TO SLOW OR HALT NEW PROJECTS WILL BE SUFFICIENT TO 
ARREST SPIRALING FAI GROWTH RATES.  WANG PREDICTED THAT IN 
SIX MONTHS, THE FAI GROWTH RATE WILL FALL FIVE PERCENTAGE 
POINTS TO 25 PERCENT (COMMENT: THIS IS STILL A VERY HIGH RATE 
OF INCREASE).  HE SAID THERE WOULD SOON BE MORE FOCUS BY THE 
GOVERNMENT ON ISSUES SUCH AS PROJECT QUALITY AND 
ENVIRONMENTAL IMPACT.  LIKE CASS'S DR. WANG, NDRC'S DR. WANG 
RULED OUT USING RENMINBI APPRECIATION AS A TOOL FOR 
MACROECONOMIC COOLING. 
 
THE CHALLENGE FROM LOCAL GOVERNMENTS 
------------------------------------ 
 
¶9. (C) HU ANGANG, DIRECTOR OF THE CENTER FOR CHINA STUDY AT 
TSINGHUA UNIVERSITY'S SCHOOL OF PUBLIC POLICY AND MANAGEMENT, 
 
SIPDIS 
SAID THAT THE CHINESE GOVERNMENT HAS FOR YEARS EMPHASIZED 
RAPID ECONOMIC GROWTH, AND LOCAL GOVERNMENTS STILL HAVE MANY 
INCENTIVES TO SEEK HIGHER GDP FIGURES.  WITH MANY LOCAL 
OFFICIALS ACTUALLY EVALUATED AGAINST GROWTH RATES AND SOME 
LOOKING AHEAD TO NEXT YEAR'S PARTY CONGRESS, IT IS NATURALLY 
DIFFICULT TO RESTRAIN LOCAL GOVERNMENT INVESTMENT.  HU 
EXPLAINED THAT THE ISSUE IS FURTHER COMPLICATED BY LOCAL 
AUTHORITIES HAVING A LARGE SAY IN THE LOAN DECISIONS OF LOCAL 
BANK BRANCHES.  WHEN PROJECTS FAIL, IT IS THE BANK, WHOSE 
LOCAL BRANCH HAD LENT THE MONEY UNDER LOCAL GOVERNMENT 
PRESSURE, WHICH MUST CLEAN UP THE LOAN, AND LOCAL OFFICIALS 
INVOLVED AT THE INCEPTION MAY BE LONG GONE. 
 
¶10. (C) BEIJING HAS RECENTLY BECOME MORE FORCEFUL IN ITS 
EFFORTS TO CONTROL INVESTMENT AT THE PROVINCIAL LEVEL AND 
 
RECENTLY WENT SO FAR AS TO PUBLICLY REPRIMAND OFFICIALS IN 
INNER MONGOLIA FOR PURSUING UNAUTHORIZED POWER PROJECTS.  THE 
CENTRAL GOVERNMENT SEPARATELY ANNOUNCED IN EARLY AUGUST THAT 
IT WOULD DISPATCH ECONOMIC INSPECTION TEAMS TO KEY PROVINCES 
TO COMPEL THEM TO MORE CLOSELY FOLLOW BEIJINGS DIRECTION. 
LOCAL OFFICIALS IN INNER MONGOLIA AS WELL AS HUNAN APPEARED 
DISMISSIVE WHEN DISCUSSING THE CENTRAL GOVERNMENT'S PUSH WITH 
US, PERHAPS REFLECTING HOW CAREER INCENTIVES AND LOCAL 
CONDITIONS MOTIVATE THE CONTINUED PURSUIT OF HIGH RATES OF 
INVESTMENT, EVEN WHEN OFFICIALS ARE VERBALLY ENCOURAGED BY 
THE CENTRAL GOVERNMENT TO DO OTHERWISE.  (SEE REFTEL) 
 
DOUBTS ABOUT INTEREST RATES 
--------------------------- 
 
¶11. (C) BEIJING UNIVERSITY CENTER FOR ECONOMIC RESEARCH 
DIRECTOR LIN YIFU TOLD US THAT WITH CHINA'S ECONOMY STILL IN 
TRANSITION, MONETARY POLICY IS LESS EFFECTIVE AS A TOOL THAN 
ADMINISTRATIVE CONTROLS.  HE EMPHASIZED THE PROBLEM OF 
GROWING OVERCAPACITY, BUT NOTED THAT MOST INVESTMENT COMES 
FROM RETAINED EARNINGS, SO INVESTORS ARE ULTIMATELY 
INSENSITIVE TO INTEREST RATE CHANGES.  MANY PEOPLE BELIEVE 
RETURNS OF 20 PERCENT ARE AVAILABLE IN SECTORS LIKE REAL 
ESTATE, AND THIS MAKES A 2.25 PERCENT INTEREST RATE FOR 
DEPOSITS PALE BY COMPARISON.  EVEN DEPOSIT RATES OF 5 PERCENT 
-- MORE THAN DOUBLE CURRENT RATES, WOULD MAKE NO DIFFERENCE, 
IN LIN'S VIEW. 
 
SEDNEY