VZCZCXRO6220
RR RUEHCN RUEHVC
DE RUEHGH #0026/01 0120212
ZNR UUUUU ZZH
R 120212Z JAN 07
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 5430
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 5771

UNCLAS SECTION 01 OF 05 SHANGHAI 000026 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE PASS FEDERAL RESERVE BOARD FRO JOHNSON/SCHINDLER; SF FRB 
FOR CURRAN/GLICK/LUNG; NY FRB FOR CLARK/CRYSTAL/MOSELY 
TREASURY FOR ADAMS, AND OASIA-DOHNER, BAKER, CUSHMAN 
USDOC FOR ITA A/DAS MELCHER, MCQUEEN 
NSC FOR HUBBARD AND TONG 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL PGOV CH
SUBJECT: FRB TOLD: NO OVERHEATING AND BUSINESS GOOD 
 
REF: A) 06 SHANGHAI 7112, B) 06 BEIJING 24442, C) 06 SHANGHAI 7129, D) SHANGHAI 25 
 
SHANGHAI 00000026  001.2 OF 005 
 
 
(U) This cable is Sensitive But Unclassified.  Not for 
transmission outside of USG channels. 
 
 
 
¶1. (SBU) Summary: A Federal Reserve Bank (FRB) delegation led by 
Governor Kevin Warsh met with economic analysts, U.S. business 
leaders, and equity market analysts during a December visit to 
Shanghai.  Economic analysts offered the contrarian view that 
China's economy was not overheated, and, in the short term, 
would continue to maintain its record growth.  In the long term, 
however, rich-poor gaps, failing educational and health 
services, environmental degradation, and a bankrupt pension 
system could lead to dramatic political and economic 
instability.  Business leaders were generally upbeat, noting 
that their biggest concern was finding and retaining qualified 
employees.  Equity analysts said China's stock market had 
regained much of the ground it lost during lengthy reforms and 
were bullish on continued gains.  They believed mergers and 
acquisitions (M&A) would play a major role in China's continued 
economic growth, but were concerned that foreign players could 
be left out.  End summary. 
 
 
 
¶2. (SBU) As part of a recent visit to China to assess 
macroeconomic and financial sector development, Federal Reserve 
System Governor Kevin Warsh, San Francisco FRB President Janet 
Yellen, and VPs Reuven Glick and Teresa Curran visited Shanghai 
December 1-2 to meet with analysts and business leaders, 
including Citibank CEO Richard Stanley (Ref A), accompanied by 
Pol/Econ Chief and Econoff.  The delegation met separately with 
People's Bank of China Deputy Governor Xiang Junbo. 
 
 
 
--------------------------------------------- ------- 
 
China's Macroeconomic Situation: Good Now, Bad Later 
 
--------------------------------------------- ------- 
 
 
 
¶3. (SBU) The delegation met with CLSA China Macro Strategist 
Andrew Rothman, BHP Billiton China Economist H. Robin Bordie, 
and Research Works President Hugh Peymann to discuss China's 
macroeconomic conditions.  Rothman and Bordie acknowledged that 
their view on China's economy differed from the consensus.  From 
their perspective, China did not have an overheating problem; 
rather, its biggest problem was "too slow growth" to balance out 
increasing social stability pressures.  The analysts forecasted 
that strong economic growth for the next seven years would 
further widen the rich-poor gap.  By 2013, this income-disparity 
could lead to widespread social instability. 
 
 
 
--------------------------------------------- ------ 
 
How Can It Be Overheated if We Can't Feel the Heat? 
 
--------------------------------------------- ------ 
 
 
 
¶4. (SBU) Rothman said that in recent years there had been "no 
real inflation in China," nor symptoms of overheating.  While 
fixed asset investment (FAI) had continued to grow, this had not 
led to overheating.  Rothman estimated China's year-on year FAI 
growth at 25 percent of GDP -- not excessive when compared to 
post-war Taiwan and South Korea.  China's problem had not been 
too much investment, but rather the poor quality of some 
investments.  Rothman attributed the quality problem primarily 
to the control  the Party still exerted on banks, as well as 
banks' inability to conduct adequate risk management. 
 
 
 
¶5. (SBU) According to Rothman, China's monetary policy had not 
been interest-rate sensitive.  China would need to increase its 
interest rates by 300 basis points to have any impact on the 
economy.  Therefore, Bordie said, the government used moral 
suasion with banks to reduce their lending rates.  She said this 
 
SHANGHAI 00000026  002.2 OF 005 
 
 
was done by "the Party calling bank managers to tell them what 
to do."  Typically, this moral suasion had been a three-step 
process.  The first step was the issuance of a White Paper 
identifying a problem.  The second step was issuance of a more 
"shrill" White Paper calling for drastic measures.  The third 
step was "arresting someone in Inner Mongolia."  It was only 
then that individual bank managers would take action, for 
example to reduce lending.  (Note:  Bordie's views were similar 
to those expressed by another contact in Ref C that actions 
taken against Party Secretary Chen Liangyu were in part an 
economic tool to persuade local governments to slow down, in 
lieu of effective macro policy.  End note.) 
 
 
 
--------------------------------------- 
 
What Keeps China's Leaders Up at Night? 
 
--------------------------------------- 
 
 
 
¶6. (SBU) According to Rothman, the issue that "keeps China's 
leaders up at night," was the poor--both urban unemployed and 
those living in extreme poverty in rural areas.  According to 
Rothman's research, the urban unemployment rate, while 
officially only 4 percent, was probably closer to 8 percent and 
possibly as high as 16 percent.  These unemployed were mainly 
unskilled rural migrants.  Rothman added that, despite China's 
best efforts to reduce rural poverty, there were still more than 
150 million people living at less than $1/day.  Bordie said that 
poverty in China had been essentially a rural issue, with few 
real urban slums.  However, this had started to change with the 
massive migration from rural to urban areas underway in China. 
 
 
 
¶7. (SBU) According to Bordie, China's leaders had made a 
"Faustian bargain" to remain in control.  The terms of this 
agreement were that they "had to keep everyone happy," with 
happiness defined in economic terms so they would not question 
their inability to participate politically.  She said that the 
next five years would see huge investments in China's social 
infrastructure -- education, healthcare, and pension systems -- 
as well as continued attempts to rein in corruption.  In the 
short term, these steps would prove effective.  By 2013-2015, 
however, a massive and obvious rich-poor gap, a generation of 
wealthy individuals not beholden to the Communist Party for 
their success, and a substantial decline in the working-age 
population would create an environment for significant social 
instability and challenges to the Communist Party's monopoly on 
power. 
 
 
 
¶8. (SBU) Rothman added that the government had realized that it 
now had less control over its people than it had prior to a 
decade of market-based reforms.  The market-based economy had 
"forced the development of personal freedoms."  These freedoms 
were, in turn, creating a sense of individual entitlement. 
Peymann agreed that, unless the government was able to fix 
China's healthcare and pension systems and improve its 
environment, by 2013, political instability would result from 
urban "rich" who would feel entitled to a better life than they 
would be able to attain. 
 
 
 
----------------------- 
 
Doing Business in China 
 
----------------------- 
 
 
 
¶9. (SBU) Starbucks China President Wang Jinglong, American 
Express Vice President for Business Services Mary Crawford, UPS 
Director Tan Sockhwee, Dell (China) General Manager Yvonne Pei 
and U.S. China Business Council's Godfrey Firth briefed the 
delegation on experiences of U.S. companies in China.  While 
generally upbeat on their respective companies' prospects in 
China, business leaders noted some policy trends that were 
intended to favor Chinese over international companies.  The 
 
SHANGHAI 00000026  003.2 OF 005 
 
 
high cost of training and retaining staff able to work in an 
international environment was also a common theme, with several 
noting difficulty finding staff with competent English skills. 
 
 
 
---------------------------- 
 
Starbucks: Symbol of Success 
 
---------------------------- 
 
 
 
¶10. (SBU) Starbuck's Wang Jinglong said he believed the Chinese 
government was still one of the most pro-business governments in 
the world, but noted that its "Fourth Generation Leadership" had 
subtly, but dramatically, shifted direction from the previous 
profit-driven model to an economic model that emphasized the 
need to respect China's "land, culture, and people." 
 
 
 
¶11. (SBU) According to Wang, having a Starbucks had become seen 
by China's local political leaders as a sign of progress, that a 
town or city "had made it."  He said that wherever he went in 
China, "the mayor always has time to meet with me." Starbucks 
China had also carried out active corporate social 
responsibility programs to build goodwill, with over $5 million 
USD in donations to educational institutions.  As a result, 
Starbucks had been able to cut through bureaucratic obstacles in 
places such as Xian, where recently it only took three days to 
"resolve six months of issues."  There were already 200 
Starbucks in China and Wang anticipated continued strong growth. 
 
 
 
¶12. (SBU) Wang noted that 80-90 percent of its baristas in China 
were college graduates and that while China's labor market was 
very big, its pool of experienced, trained workers was quite 
small, leading to intense competition.  He said that in a market 
like Shanghai's, individuals under 30 changed jobs on average 
every 17.5 months. 
 
 
 
--------------------------------------------- -- 
 
Dell: Impacted by China's Self-Innovation Drive 
 
--------------------------------------------- -- 
 
 
 
¶13. (SBU) While Dell had 7,000 employees in China and purchased 
$20 billion USD worth of computers, it had recently been 
negatively impacted by China's recent push to support Chinese 
"self-innovation" companies (ref B) according to Yvonne Pei. 
Pei said that in Dell's eight years in China, 80 percent of its 
computer sales had been to institutions, such as Chinese 
government offices.  She said that recent changes to the bidding 
process meant that Chinese computer companies were awarded extra 
points for being "Chinese self-innovation" companies.  These 
extra points meant that Dell's bids were no longer competitive, 
despite the fact that Dell offered lower prices and had an 
research and development center in Shanghai that employed 
approximately 1,000 people in addition to a manufacturing plant 
located in Xian. 
 
 
 
----------------------------- 
 
UPS: All Deliveries Are Local 
 
----------------------------- 
 
 
 
¶14. (SBU) Tan Sockwhee noted that UPS opened its first 
China-based UPS Express retail store in Shanghai in August 2006 
and was now focused on trying to instill the "UPS culture" in 
its rapidly growing workforce which had increased from 400 
employees in 4,000 the past year.  Tan said that one of UPS's 
biggest challenges was retaining qualified employees due to the 
 
SHANGHAI 00000026  004.2 OF 005 
 
 
high demands for trained employees.  Tan described some of the 
complications UPS had experienced in entering the Chinese 
domestic postal market, saying that "China is not an open 
field."  Other issues UPS faced were securing landing rights for 
the flights it needed to support its volume, and inter-city 
transportation problems where, for instance, a UPS truck with a 
Shanghai license plate was not permitted to enter another 
municipal area such as the nearby city of Suzhou. 
 
 
 
------------------------------------- 
 
AMEX: Focused on Outsourcing Services 
 
------------------------------------- 
 
 
 
¶15. (SBU) American Express's Mary Crawford said Amex's bank card 
sector was "very undeveloped in China."  (Note: Amex has been 
classified by the Chinese government as a travel services 
company and thus is limited in its ability to issue bank cards. 
End note.)  Amex's proposed plan to open a business process 
outsourcing services operating center here, however, had been 
warmly welcomed.  Amex had been encouraged to open the operating 
center in the western city of Chengdu, Sichuan Province, but had 
not yet settled on a location due to the necessity of finding a 
critical mass of potential employees with adequate English 
language skills. 
 
 
 
--------------------- 
 
Equity Market Meeting 
 
--------------------- 
 
 
 
¶16. (SBU) The delegation was briefed on equity market 
developments by: Peter Alexander, Principal of Z-Ben Advisors, a 
privately-run information clearing house for China equities 
information; Ian Midgley, Chief Investment Officer of Lombarda 
China Fund Management, a fund management joint venture company 
with Italy's Banca Lombarda holding a controlling stake of 49 
percent with two Chinese partners, Guodu Securities Company and 
Pingding Shan Coal Company; and Robert Theleen, Chairman of 
ChinaVest, a Shanghai-based venture capital firm that had been 
in China since 1981 with assets of 30-40 billion USD. 
 
 
 
--------------------------------------------- - 
 
Stock Markets: Rising Up on a Sea of Liquidity 
 
--------------------------------------------- - 
 
 
 
¶17. (SBU) According to Alexander, China's recent stock market 
gains had been largely driven by excess liquidity, with two 
trillion U.S. dollars worth of money "sitting idly in banks." 
Midgley agreed, but added that the Chinese Security Regulatory 
Committee (CSRC) had also recently resolved major structural 
issues that had contributed to several years of historic lows 
(See Ref D). 
 
 
 
----------------------------------- 
 
China's Improving Regulatory System 
 
----------------------------------- 
 
 
 
¶18. (SBU) Theleen said that China's regulators were "young -- in 
their 30's to 50's", many with post-graduate degrees from 
universities outside China.  He said the regulatory process in 
China had been in the process of shifting from the state as 
owner-operator-regulator under a Ministry to a more independent 
 
SHANGHAI 00000026  005.2 OF 005 
 
 
regulatory system.  He added that now, thanks in large part to 
WTO requirements, when a task-force was formed by the Chinese 
government to design a new law or regulation, these 
newly-empowered regulatory bodies would join in policy-level 
discussions. 
 
 
 
---------------------------- 
 
Market To Be Driven by M&A's 
 
---------------------------- 
 
 
 
¶19. (SBU) Midgley said that for the foreseeable future, the 
market would be driven by mergers and acquisitions (M&A).  He 
noted that there was enormous scope for M&A's, pointing out, for 
example, that China's top steel producer, Bao Steel, only 
represented five percent of China's steel production capability. 
 The underlying political question, however, was whether foreign 
companies would be permitted to participate.  According to 
Theleen, there were 40 multinational firms with more than one 
billion USD each who were ready to invest in China, but who were 
hesitant about current policies that seemed to be trending away 
from China's recent open-door policy.  Midgley added that, in 
addition, provincial and city-level governments often owned 
companies and thus had enormous power and interest in 
maintaining their own brand-names.  This might also be a factor 
in slowing down the pace of China's M&A activity. 
 
 
 
¶20. (U) The delegation did not have the opportunity to clear on 
this cable. 
JARRETT