VZCZCXRO4572
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #0770/01 0320841
ZNY CCCCC ZZH
P 010841Z FEB 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 4396
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC

C O N F I D E N T I A L SECTION 01 OF 03 BEIJING 000770 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EAP/CM 
USDOC FOR 4420 
TREASURY FOR OASIA/ISA - DOHNER/HAARSAGER/CUSHMAN 
NSC FOR MCCORMICK/TONG 
STATE PASS USTR FOR STRATFORD AND ALTBACH 
STATE PASS CEA 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON; SAN FRANCISCO 
FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK 
 
E.O. 12958: DECL: 02/01/2017 
TAGS: ECON EFIN EINV CH HK
SUBJECT: FOREIGN EXCHANGE RESERVES: PROBABLE INVESTMENT IN 
NEW ASSETS WITH ATTENTION TO MARKET STABILITY 
 
 
Classified By: A/ECON MINCOUNS CHRIS BEEDE; REASONS: 1.4 (B/D) 
 
 
SUMMARY 
------- 
 
¶1. (C) Top officials from the State Administration of Foreign 
Exchange (SAFE) said in a January 25 meeting with Treasury 
Department Deputy Assistant Secretary for International 
Monetary Affairs Mark Sobel, Finatt Loevinger, and Econoffs, 
as well as a January 23 meeting that took place before 
Sobel's arrival, that SAFE will place a higher emphasis on 
long-term returns and a lesser emphasis on liquidity in its 
management of foreign exchange reserves.  They stressed, 
however, that any change would be gradual and done in a way 
that minimizes market volatility, particularly with regard to 
United States Treasury bonds.  They noted that SAFE has 
already extended the maturity of its fixed income holdings 
beyond the consensus expectations of market analysts.  SAFE 
officials agreed that developing and sticking to a public 
mantra on the management of reserves could help minimize 
market uncertainty.  They said that quotas for the qualified 
foreign institutional investor program (QFII, an inbound 
investment channel enabling foreigners to buy Chinese stocks) 
and the QDII program (an outbound channel enabling domestic 
investors to purchase foreign stocks) should be expanded at 
an opportune time.  Separately, a Deutsche Bank economist in 
Hong Kong told us on January 18 that he believes China is 
considering investing some foreign exchange reserves in 
shares of companies based in emerging markets but traded in 
large and liquid stock exchanges (such as American Depository 
Receipts).  END SUMMARY 
 
MEETINGS WITH SAFE 
------------------ 
 
¶2. (C) On January 25, Treasury Department Deputy Assistant 
Secretary for International Monetary Affairs Mark Sobel, 
 
SIPDIS 
Finatt Loevinger, and Econoffs met with SAFE Deputy 
Administrator Wei Benhua and Deputy Director General for 
Reserve Management Yin Yong, following up on a January 23 
meeting between Finatt, Econoffs, and SAFE DG for General 
Affairs Liu Guangxi. 
 
CARE WITH PUBLIC COMMENTS 
------------------------- 
 
¶3. (C) In both meetings, Sobel and Loevinger stressed that 
management of China's foreign exchange reserves is a 
sovereign decision, though the United States Government has 
an interest that public statements not contribute to market 
uncertainty and a rise in risk premiums.  Wei agreed that, 
just as in foreign exchange policy, developing and sticking 
to a public mantra on the management of reserves could help 
minimize market uncertainty.  Yin asserted that China had not 
officially even stated a reserve management policy.  He 
admitted, however, that some government officials in China 
have made public comments that have impacted markets. 
 
DIVERSIFICATION WITH MARKET STABILITY 
------------------------------------- 
 
¶4. (C) SAFE's Wei, Liu, and Yin said that China's reserves 
are adequate to meet short-term liquidity needs, such as 
terms of trade shocks or shifts in market sentiment.  As a 
result, SAFE can now place less emphasis on safety and 
liquidity and more emphasis on achieving higher long-term 
returns.  However, any movement into new assets will be done 
in a way to minimize volatility in financial markets.  Yin 
noted that in determining the foreign currency composition of 
its investments, SAFE considers: (1) the composition of its 
current and capital account transactions as well as its 
foreign liabilities; (2) the liquidity of foreign currency 
markets; and (3) the expected return on foreign currencies. 
 
¶5. (C) DG Liu separately told Finatt and Econoffs that he had 
a "message": China has a stake in the stability of foreign 
financial markets and has no interest in doing anything that 
would increase the volatility of, or erode, the value of 
United States dollar (USD) denominated assets, particularly 
United States Treasury bonds.  As China contemplates changes 
 
BEIJING 00000770  002 OF 003 
 
 
in its management of foreign exchange reserves, it will act 
in accordance with these principles, said Liu. 
 
¶6. (C) Separately, Deutsche Bank Managing Director Jun Ma 
told Finatt and Econoff in Hong Kong on January 18 that, 
based on talking with his Chinese Government finance 
contacts, he expects an entity to be created along the lines 
of Singapore's Government Investment Corporation (GIC).  As 
Ma sees it, China is likely to focus on acquiring stocks with 
high growth potential, especially those that offer underlying 
exposure to emerging market economies.  Given SAFE's size, it 
will need to operate in large and liquid markets and thus is 
likely to focus on instruments like American Depository 
Receipts (ADRs) of corporations based in non-OECD countries. 
(Note: ADRs currently trade in the United States and are a 
means for United States investors to buy into foreign 
corporations not actually listed on United States exchanges. 
End Note.) 
 
CHINESE FOREIGN ASSETS NOT LARGE, BUT GOVERNMENT OWNED 
--------------------------------------------- --------- 
 
¶7. (SBU) Liu acknowledged that China's officially-held stock 
of foreign exchange reserves is the world's highest (USD 
1.066 trillion as of 12/31/06), but noted that China's 
overall foreign assets, considering both private and public 
holdings, are not exceptionally large, totaling USD 1.3 
trillion, as compared to 11 trillion for the United States, 
4.8 trillion for Japan, and 3.5 trillion for Germany.  As Liu 
sees it, there is much room for expansion of non-official 
foreign currency denominated assets, which the government is 
trying to encourage. 
 
CREATION OF CHINESE DEPOSITORY RECEIPTS 
--------------------------------------- 
 
¶8. (SBU) Liu noted that SAFE is undertaking research on 
creating Chinese Depository Receipts (CDRs).  (Note: A CDR 
would be a locally issued and traded financial instrument 
with the underlying foreign stock shares held by mainland 
banks; the net effect would be that local investors would 
have a vehicle, in addition to the QDII, for investing in 
foreign stocks.  End Note)  State-controlled media has 
speculated that CDRs would enable Hong Kong-based Red Chips 
(subsidiaries of Chinese state-owned enterprises that are 
listed in Hong Kong, e.g., CNOOC Ltd and Bank of China Hong 
Kong) to trade their shares in Mainland China; these entities 
cannot list on domestic stock exchanges because they are 
technically "foreign."  The Hong Kong Government recently 
published recommendations from its in-house think tank, the 
Central Policy Unit, calling for the introduction of 
"depository certificates of financial instruments issued in 
the HKSAR for trading on stock exchanges, interbank markets, 
or over the counter on the Mainland," i.e., CDRs. 
 
STOCK MARKET BUBBLE? 
-------------------- 
 
¶9. (SBU) Liu acknowledged the widespread focus on the rapid 
rise of China's stock markets (which rose 130% in 2006). 
Given this concern about excessive market valuations, now is 
not the right time to expand foreign access to Chinese 
domestic shares through the QFII program.  That said, Liu 
agreed that expanding QFII -- whose volume is presently very 
small relative to overall market capitalization -- is a 
laudable goal. 
 
COMMENT: IMPACT OF MOVE TO RISKIER ASSETS 
----------------------------------------- 
 
¶10. (SBU) Recent conversations with government officials, 
Chinese think tanks, and Hong Kong-based bankers and analysts 
suggest that Chinese foreign currency reserves will be 
increasingly invested in financial assets beyond fixed 
income, whether or not a new entity is created to manage 
them.  These discussions indicate that changes are likely to 
be gradual, and that SAFE may have already been investing in 
longer-maturity and riskier fixed income assets for some 
time.  As Chinese foreign exchange reserves grow beyond what 
is needed as a short-term liquidity cushion, SAFE officials 
appear to be grappling with two conflicting challenges: (1) 
 
BEIJING 00000770  003 OF 003 
 
 
there is greater scope to diversify into riskier and 
higher-yielding assets; yet (2) SAFE is increasingly limited 
to markets where it can take meaningfully sized positions 
without causing disruption.  As a result, the bulk of SAFE's 
investments outside of fixed income are likely to be in large 
and liquid financial assets and markets, most likely equities 
in the United States, Europe, Hong Kong (including Red Chips 
and H-shares), and Japan. 
 
¶11. (SBU) Moreover, a shift towards more risky financial 
assets will not necessarily lead to major changes in the 
currency composition of reserves, given the emphasis 
officials place on matching the currency denomination of 
foreign exchange assets with the currency composition of 
China's current and capital flows and its foreign liabilities. 
RANDT