VZCZCXRO5710
PP RUEHCN RUEHGH RUEHVC
DE RUEHHK #4265/01 3050037
ZNR UUUUU ZZH
P 010037Z NOV 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 9253
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE

UNCLAS SECTION 01 OF 03 HONG KONG 004265 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM 
BEIJING FOR DLOEVINGER, PCHOW, KHARPER 
TREASURY FOR DOHNER/HAARSAGER/BAKER/CUSHMAN 
 
E.O. 12958: N/A 
TAGS: EFIN ETRD HK CH
 
SUBJECT:  HK Economists discuss China's Economy, Banking in China, 
and the Strategic Economic Dialogue 
 
Summary 
-------- 
 
¶1. (SBU) Summary:  Hong Kong economists, bankers, and Hong Kong 
Monetary Authority (HKMA) officials told Embassy Beijing 
Minister-Counselor for Financial Affairs David Loevinger (Finatt) 
that the rate of renminbi (RMB) appreciation would not sustain the 
rate it achieved following the September visit of Treasury Secretary 
Paulson and the withdrawal of the Graham-Schumer Bill, but would 
remain at a modest 3-5 percent a year.  Given a steady, moderate 
appreciation, most of the economists thought China's external 
competitiveness would continue to improve, with a large current 
account surplus and speculative inflows.  The People's Bank of China 
(PBOC) thus will continue its large-scale sterilized intervention 
for the foreseeable future.  Chinese authorities should tighten 
monetary conditions further (through both interest rate hikes and a 
more liberalized exchange rate) said the economists, though they 
noted the political constraints caused by urban/rural income gaps. 
Foreign bankers reaffirmed that the China Banking Regulatory 
Commission's (CBRC) requirement for foreign banks to incorporate in 
order to provide RMB denominated services would not be a major 
barrier to entry. On the Strategic Economic Dialogue, one economist 
thought Vice Premier Wu Yi was an "interesting choice" to head the 
Chinese side as she has no responsibilities for financial or 
macroeconomic issues.  End Summary. 
 
RMB Valuation, Trade Imbalances 
-------------------------------- 
 
¶2. (SBU) Embassy Beijing Minister-Counselor for Financial Affairs 
David Loevinger, Economic Officers Patrick Chow and Byron Tsao, and 
Economic Specialist Kevin Harper met with Hong Kong-based China 
economists, investment bank representatives, and Hong Kong Monetary 
Authority (HKMA) officials on October 5-6 to discuss China's 
economy, financial sector, and the U.S.-China Strategic Economic 
Dialogue (SED). 
 
¶3. (SBU) Deutsche Bank economist Jun Ma thought that although China 
is grateful to Treasury Secretary Paulson for his role in the 
withdrawal of the Graham-Schumer legislation, China feels it has now 
"given enough face" to Paulson and is unlikely to let the RMB 
appreciate beyond a modest 3-4 percent per year.  As a result, given 
continued substantial differences in labor productivity growth 
between China and the U.S. (7-8 percent for China versus 2-3 percent 
for the U.S.), maintaining such a modest rate of RMB appreciation 
means that export competitiveness will continue rise.  As a result, 
Ma predicted that Chinese export growth will continue to outpace GDP 
growth, leading to rising external imbalances.  Another factor 
limiting the Chinese Government's willingness to allow for greater 
RMB appreciation is the need to protect unskilled workers, who are 
not experiencing significant productivity gains, particularly 
vis-`-vis increasingly competitive and cheaper labor in Southeast 
Asia.  The key to reducing the current account surplus, which is 7% 
of GDP, concluded Ma, is to increase import growth by cutting 
Chinese import tariffs beyond World Trade Organization (WTO) 
commitments. 
 
¶4. (SBU) Bank of International Settlements Senior Economist Ma 
Guonan said he believed that the People's Bank of China (PBOC) is 
holding back RMB appreciation until after the Industrial and 
Commercial Bank of China's (ICBC) IPO. ICBC, like the other large 
state banks, maintains a long dollar position to enhance its balance 
sheet.  Ma predicted that the current account surplus would shrink 
noticeably next year once people finish repositioning their 
portfolios in anticipation of a stronger RMB.  Ma then argued that 
the current account surplus may not be as large as it appears 
because capital inflows, which account for an important part of the 
surplus, are taking place through both over and under-invoicing of 
current transactions.  Furthermore, large and growing amounts of 
personal remittances should actually be accounted for as investments 
and not gifts.  Multinational corporations also appear to be 
hoarding RMB as the growth of the stock of foreign direct investment 
(FDI) continues to outpace the growth of profit remittances. 
 
¶5. (SBU) Julia Leung, Executive Director, External Department of the 
Hong Kong Monetary Authority (HKMA), told Finatt that PBOC Governor 
Zhou's comments in the Chinese finance magazine "Caijing" were an 
important signal that the PBOC would soon allow for greater RMB 
volatility.  In the article, Zhou comments that the RMB would be 
based "more on supply and demand," also signaled greater RMB 
appreciation. 
 
¶6. (SBU) Hong Kong University (HKU) Professor Geng Xiao, who will be 
moving to Beijing to direct a new Qinghua University-Brookings think 
tank, felt that the RMB should appreciate between 3-4 percent per 
 
HONG KONG 00004265  002 OF 003 
 
 
year to account for relative productivity differentials, and to 
appreciate by even more by the extent to which U.S. inflation 
exceeds Chinese inflation. Geng agreed with Jun Ma that the unequal 
distribution of labor productivity growth means that rapid RMB 
appreciation would hurt unskilled workers, which the government 
politically must protect.  Geng urged the U.S. to press for greater 
liberalization of China's service sector.  This would increase 
productivity and lower the price of services in China, thus freeing 
money that could spur an increase in imports. Unfortunately, he 
concluded, Chinese ministries tend to focus on the health of firms 
in the sectors they oversee and thus fail to grasp how increased 
competition in protected sectors can benefit the broader economy. 
 
Is China Overheating? 
---------------------- 
 
¶7. (SBU) Geng Xiao told Finatt that he did not see overheating as a 
significant risk, as China can "grow through" asset bubbles. He also 
did not think that overall investment was too high, given still-high 
returns on public infrastructure investment. However, he did see 
significant scope to improve the efficiency of investment, 
particularly by having the National Development and Reform 
Commission (NDRC) decentralize more decisions on finance to local 
and provincial governments. 
 
¶8. (SBU) Jun Ma cited three factors accounting for the growth in 
Chinese monetary aggregates that continue to fuel the growth in 
investment. In addition to foreign currency intervention due to 
large balance-of-payment (BOP) surpluses, large PBOC loans to 
non-bank financial firms, which Ma thought were most likely 
securities firms, had been an important factor for the increase in 
base money. Ma thought up to 50 percent of the loans are not likely 
to be paid back. In addition, an increase in the money multiplier 
was causing the growth of broad money (M2) to exceed the growth of 
base money, which increased Chinese banks' loanable resources 
despite PBOC's sterilization efforts.  Ma continued that this 
increase was driven by improvements in Chinese payment systems that 
reduced the time needed to settle payments, thus reducing the need 
to hold large excess reserves with the central bank. 
 
¶9. (SBU) Ma expressed concern over the lack of cooperation between 
the Ministry of Finance (MOF) and PBOC.  The MOF tends to set the 
term structure of its Treasury bills and bonds mainly to minimize 
its cost of financing.  As a result, it issues insufficient 
short-term treasury bills, forcing the PBOC to issue its own 
short-term bonds for sterilization.  The PBOC is increasingly 
concerned that the interest cost of sterilization bonds will lead to 
net income losses and ultimately even the possibility of insolvency. 
Ma continued that the strength of PBOC's balance sheet in RMB terms 
is exaggerated as it does not mark to market its foreign exchange 
reserves, but rather values its foreign securities at the cost 
incurred at the time of purchase, including the exchange rate 
prevailing at that time. [Comment: Despite statements by PBOC 
officials, including from Governor Zhou to Al Hubbard on September 
21, that PBOC can comfortably sterilize foreign exchange 
intervention for several more years, other analysts have noted that 
fiscal concerns may be limiting the extent to which the PBOC is 
willing to sterilize such interventions.] 
 
New Opportunities in Chinese Finance 
------------------------------------- 
 
¶10. (SBU) Several economists and financial company officials 
commented on recent moves by their firms to enter the Chinese 
financial services market.  Standard Chartered Economist Tai Hui 
said that one reason Standard Chartered established Bohai Bank as a 
greenfield investment, despite their plans to expand Standard 
Chartered branches in China, is that they expected that banks 
classified as domestic institutions would still receive more 
favorable regulatory treatment even after the implementation of 
China's WTO commitments. 
 
¶11. (SBU) Morgan Stanley Managing Director and COO Asia Greg Terry 
told Finatt that contrary to press reports, their recent acquisition 
of Nantong Bank from Bank of China Macau did not gain them a lead 
over other foreign banks in obtaining a license to provide RMB 
denominated services.  Nantong currently has licenses to provide 
foreign exchange denominated services to retail and corporate 
clients.  Morgan Stanley has no interest in retail RMB business; 
they are seeking licenses to provide RMB services to corporate 
clients and to offer derivatives.  Neither the PBOC nor the CBRC 
have suggested they incorporate to conduct RMB business, but Morgan 
Stanley will do so if necessary, given that they do not view the 
minimum capital requirements as overly onerous. 
 
 
HONG KONG 00004265  003 OF 003 
 
 
¶12. (SBU) Terry told Loevinger that CSRC Chairman Shang Fulin's 
political ambitions are currently an obstacle to the opening of the 
securities sector.  The Chinese government has allowed three foreign 
firms into the securities sector.  Terry said only the UBS/Beijing 
Securities model is viable; Goldman Sach's arrangement, which 
involved an unsecured loan to the major Chinese shareholder, is not 
replicable.  Morgan Stanley's stake in CICC is purely passive; it 
plays no role in running the business. He also voiced his 
appreciation for Treasury's efforts to engage CSRC on this issue. 
 
¶13. (SBU) Commenting on UBS' recent acquisition of Beijing 
Securities, UBS Chairman and CEO for Asia Pacific Rory Tapner told 
Finatt that Beijing Securities will be renamed UBS Securities 
(China)and will have a comprehensive license to trade, distribute, 
and underwrite A shares. For UBS, the ability to trade A shares is 
key, as it is critical to their ability to distribute underwritten 
shares to customers. UBS was nicely surprised to discover that 
Beijing Securities had licenses to engage in wealth management, 
which no other foreign banks have.  Tapner said finding employment 
for Beijing Securities staff was an important, and politically 
sensitive, issue. UBS will keep six of Beijing Securities' 27 
branches, selling 21 to China Merchants Bank. They will also retain 
180 of Beijing Securities' 600 employees, with 400 moving to China 
Merchants Bank. As in the other two securities sector deals 
involving foreign investment banks (Morgan Stanley/CICC and Goldman 
Sachs/Gao Hua), current Beijing Mayor Wang Qishan played a prominent 
and critical role. 
 
¶14. (SBU) On other mainland financial issues, HKMA's Leung said the 
Chinese government's upcoming high-level financial meeting would 
most likely take place in late October.  One issue that might be 
discussed is the extent of FDI in the financial sector, and in 
particular, a review of allowable FDI in Chinese banks.  Leung 
discussed ASEAN+3 efforts to promote China's bond markets. To create 
an exchange traded China bond index fund as part of the second Asian 
Bond Fund (ABF2), it will be necessary to shift some of the 
underlying bonds from the inter-bank bond market, regulated by the 
PBOC, to the stock market, regulated by the CSRC.  This will spur 
greater cooperation among the regulators. 
 
SED: Why Wu Yi?? 
---------------- 
 
¶15. (SBU) Jun Ma questioned China's choice of Vice-Premier Wu Yi to 
head the recently announced U.S./China Strategic Economic Dialogue. 
Ma noted that although Wu Yi covers trade issues, she has no 
financial portfolio and is thus an "interesting" choice to head the 
Chinese side of the dialogue.  Any discussion of financial matters 
would have to be passed to Premier Wen Jiabao. 
 
¶16. (SBU) HKMA's Julia Leung, commenting on Wu Yi as China's 
counterpart for Secretary Paulson for the SED, noted however, that 
Wu Yi "can deliver."  During Hong Kong's interaction with Vice 
Premier Wu Yi during the Closer Economic Partnership Agreement 
(CEPA), Wu shepherded various Chinese ministries to reach agreement. 
 
 
¶17. (U) Embassy Beijing Minister-Counselor for Financial Affairs 
David Loevinger cleared this report.