VZCZCXRO7826
PP RUEHCN RUEHGH RUEHVC
DE RUEHHK #0647/01 0660612
ZNR UUUUU ZZH
P 070612Z MAR 07
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 0816
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC

UNCLAS SECTION 01 OF 04 HONG KONG 000647 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM 
TREASURY FOR OASIA -- DOHNER, HARSAAGER, CUSHMAN 
USDOC FOR 4420 
 
E.O. 12958:  N/A 
TAGS: ECON EFIN EINV HK CH
SUBJECT: HONG KONG ECONOMISTS HIGHLIGHT CHINA'S ECONOMIC 
IMBALANCES, PRAISE NEW FINANCIAL LINKS WITH THE MAINLAND 
 
 
SUMMARY 
------- 
 
¶1. (SBU) Comments from Hong Kong-based economists made in a 
series of meetings with visiting Beijing Finance Attache 
and Econoff suggest the following: Chinese economic policy 
makers understand the negative byproducts of the current 
macroeconomic policy mix: including overcapacity in some 
industries, a structurally high trade surplus, excessive 
foreign exchange reserves, excessive growth in monetary 
aggregates, and asset price inflation.  However, some parts 
of the Chinese Government, e.g., the National Development 
Reform Commission (NDRC), remain sensitive about slowing 
investment growth and encouraging consumption in its place 
because they fear any transitional slowdown could adversely 
impact the rural and migrant populations, exacerbating 
social tensions.  A more rapid pace of renminbi (RMB) 
appreciation is a powerful tool in reducing high levels of 
liquidity and there are signs that several economic 
ministries are growing more comfortable with this prospect. 
China is likely to start investing its rapidly accumulating 
foreign exchange reserves in higher-return assets, 
particularly equities traded in large and liquid stock 
exchanges, including the listed shares of companies based 
in emerging markets. 
 
¶2.  (SBU) A recent announcement that mainland financial 
institutions will be able to issue renminbi-denominated 
bonds in Hong Kong breaks new ground: this is the first 
time that renminbi-denominated financial instruments will 
be issued outside of mainland's financial system.  However, 
the near-term prospects for issuing RMB bonds in Hong Kong 
are modest, as the pool of RMB deposits remains small. The 
Hong Kong Monetary Authority (HKMA) hopes that giving Hong 
Kong-based banks higher yielding RMB fixed income assets 
will allow them to offer higher deposit rates and thus 
increase RMB deposits over time.  HKMA also hopes the bonds 
will be a source of financing for foreign bank subsidiaries 
in China that may find it convenient to draw on renminbi 
deposits in Hong Kong (since it will be initially difficult 
for these entities to collect renminbi deposits on the 
mainland itself).  However, Beijing-based regulators say 
they do not plan to allow foreign banks to issue RMB bonds 
in Hong Kong in the near-term.  END SUMMARY 
 
MEETINGS IN HONG KONG 
--------------------- 
 
¶3. (U) Beijing-based Financial Attache and Econ Internal 
Unit Chief joined Congen Hong Kong's Economic Unit Chief 
for a series of meetings with Hong Kong-based economists 
and the Hong Kong Monetary Authority.  The meetings were 
held in late January, 2007. 
 
A NEED TO REBALANCE 
------------------- 
 
¶4. (SBU) All of the Hong Kong-based economists said that 
China's investment- and export-led growth model is 
unsustainable, and several of them assessed that PRC 
economic policy makers across all ministries now 
increasingly understand this.  However, Citibank Managing 
Director Yiping Huang, for example, characterized the NDRC 
as particularly anxious about slowing growth, given the 
priority placed on job creation, but asserted that even 
these officials increasingly understand that greater 
consumption can offset over time any decline in growth due 
to lower growth in investment and net exports.  However, 
the social welfare spending needed to achieve this (to fund 
pensions, health care, and education) is less visible to 
the population than tangible fixed asset investment 
activity like building bridges and thus less politically 
attractive to local government officials.  Huang predicted 
that government officials will remain hesitant to meddle in 
an economy still experiencing high growth and manageable 
inflation, and China will likely stay the current course 
until forced into change by an economic shock. 
 
¶5. (SBU) Deutsche Bank Managing Director Jun Ma expressed 
concern that measures taken to date to slow down investment 
are insufficient.  He is already seeing data that suggests 
that the growth rate in fixed asset investment, which has 
cooled in recent months, is on the way back up, as local 
governments simply delayed implementation of projects into 
2007 to meet administrative targets.  Large capital inflows 
 
HONG KONG 00000647  002 OF 004 
 
 
are inflating asset prices; there may already be a bubble 
in the stock market and a continued need to take measures 
to cool the property market.  He envisaged the recent 
downturn in the Chinese and Hong Kong stock markets and he 
also said another small interest rate increase would help 
signal that the government has assessed that asset 
inflation has gone too far.  John Anderson from UBS thought 
that the sharp rise in the Chinese stock markets was not 
in the Chinese government's interest.  If valuations got 
too high, regulators might need to reimpose the moratorium 
on IPOs to reduce supply, which would undermine their 
efforts to improve corporate governance through IPOs.  From 
the regulators' perspective a steadily, but not excessively, 
rising stock market was ideal. 
 
CURRENCY AND RESERVE POLICY 
--------------------------- 
 
¶6. (SBU) Several economists to whom we spoke predicted that 
China will soon put aside US$ 200-300 billion of its 1 
trillion in foreign exchange reserves to invest in higher 
yielding assets, particularly equities in large and liquid 
financial markets.  Most thought the PRC would take great 
care not to destabilize markets.  One economist thought 
there would be a bias against U.S. stocks because of 
concerns about dollar weakness.  This economist expects 
China to consider emerging market stocks that trade in 
liquid markets (such as American Deposit Receipts of such 
companies).  The underlying fundamentals of these 
securities reflect the home country economies, which should 
outperform in the coming years, enough so to make up for 
U.S. dollar weakness. 
 
¶7. (SBU) An economist said his discussions with People's 
Bank of China (PBOC) officials convinced him they are 
looking for evidence to convince skeptics that currency 
appreciation will help pressure Chinese companies to move 
up the value-added chain, thus helping to support a key 
Chinese government priority.  He characterized the Ministry 
of Commerce (MOFCOM) as relaxing its resistance to currency 
appreciation, having observed that no significant harm has 
come to exporters since China broke its U.S.-dollar peg in 
July 2005.  Another economist said that his PBOC contacts 
recently told him that the case for RMB flexibility is 
growing stronger but that arriving at broader government 
political consensus will take time. 
 
RENMINBI BONDS IN HONG KONG 
--------------------------- 
¶8. (SBU) China recently announced approval for the sale of 
renminbi-denominated bonds in Hong Kong by mainland 
financial institutions.  This will widen the channels for 
renminbi deposits held by Hong Kong household and 
enterprises to flow back to the Mainland.  The move is the 
latest step since the 2004 opening up of renminbi business 
in Hong Kong, where 38 banks have already taken nearly US$ 
3 billion in RMB deposits and the use of mainland issued 
bank cards for purchases in Hong Kong by tourists is now 
widespread. 
 
¶9. (SBU) Hong Kong Monetary Authority External Department 
Executive Director Julia Leung observed that RMB bond 
issuances will likely be limited as first, since only those 
residents and businesses allowed to maintain RMB deposits 
(earned though valid current account transactions) or banks 
using those deposits will be allowed to purchase RMB 
denominated bonds.  However, since the bonds can be 
expected to offer higher yields than RMB deposits at 
the Bank of China, which is where Hong Kong based 
banks must now place their RMB deposits (which are 
subsequently deposited in the PBOC's Guangzhou branch), 
their effect is likely to be an increase in the interest 
rate on RMB-denominated bank deposits and a growth in such 
deposits over time.  Leung assessed that foreign banks and 
corporations with a need for RMB in China may eventually be 
able to issue RMB bonds.  This could, for example, be 
useful to foreign banks that seek a source of RMB to make 
loans in China, given that due to limited retail networks, 
it will take time for these banks to grow their RMB deposit 
base.  (Comment: In subsequent meetings, PBOC officials 
said there is no plan to allow Chinese subsidiaries of 
foreign banks to issue RMB bonds in Hong Kong in the near 
term.) 
 
CDR'S: A NEW CHANNEL FOR OUTFLOWS? 
 
HONG KONG 00000647  003 OF 004 
 
 
---------------------------------- 
 
¶10. (SBU) One economist told us that China's State 
Administration for Foreign Exchange (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 local investors 
would have a vehicle, in addition to the Qualified Domestic 
Institutional Investor (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) to trade their shares in mainland 
China; these entities cannot list on mainland China's 
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." 
 
REACTION TO NEW FINANCIAL INSTRUMENTS 
------------------------------------ 
 
¶11. (SBU) Hang Seng Bank Deputy General Manager Andrew Fung 
underscored the importance of new links with the mainland's 
financial system for Hong Kong's status as a financial 
center.  He sees particular benefit to Hong Kong in CDRs, 
which he assessed to be "a done deal."  Fung said that RMB 
bonds are a helpful pilot effort but observed that they 
will only be marketed through a limited channel - Hong Kong 
residents and banks that have RMB deposits.  He noted that 
Hong Kong would also like to see RMB-denominated listings 
on its exchange, but to be liquid this would require a 
significant capital account opening that mainland China is 
not ready for.  In the meantime, HKD-denominated H-share 
IPOs end up discounted because of anticipated depreciation 
relative to the RMB that takes place during the lengthy 
time required to convert Hong Kong dollar initial public 
offering proceeds to RMB. 
 
¶12. (SBU) HKMA's Leung said that although the RMB bonds 
create new inflows into China, they are a key step forward 
in expanding Hong Kong's role as a financial center that 
can serve the mainland's financial system.  If mainland 
China goes forward with CDRs, this will also be an 
opportunity for Hong Kong's financial sector while at the 
same time creating a new channel for capital outflows. 
Leung expressed interest in seeing an expansion of the 
QDII program noting that this would create fee income for 
financial institutions based in Hong Kong. 
 
¶13.  Leung noted that a high level advisory group had 
recently issued a series of recommendations for reforms of 
the mainland financial sector to promote Mainland/Hong Kong 
integration.  She encouraged the USG to review these 
recommendations (which received considerable support, 
though not an explicit endorsement from the HK government) 
and considering incorporating them into SED deliverables so 
that mainland officials would hear a unified message on 
financial services liberalization. 
 
SHENZHEN DEVELOPMENT BANK 
------------------------- 
 
¶14.  FINATT met with Shenzhen Development Bank (SDB) 
President Frank Newman.  Newman stressed the important and 
supportive role of Shenzhen city officials, who are 
appreciative that Newbridge had turned SDB from a large 
contingent liability into an income-earning asset.  He 
viewed the arrest of the bank's former Party Secretary as a 
sign that the government and party are increasingly serious 
about reducing directed lending. 
 
¶15.  Newman expressed concern that despite numerous 
attempts, China's Securities Regulatory Commission (CSRC) 
would not approve Newbridge's proposal to compensate 
tradable shareholders, by allowing it to issue stock to 
meet capitalization requirements.  He noted that large 
institutional holders of tradable shares understood 
Newbridge's prudential constraints on giving away financial 
assets to tradable shareholders.  He thought it was unfair 
for CSRC to press Newbridge to provide the same amount of 
 
HONG KONG 00000647  004 OF 004 
 
 
compensation as non-tradable shareholders in other listed 
companies because typically those non-tradable shareholders 
(most often the government) owned a 70 percent stake, while 
tradable shareholders in SDB only owned an 18 percent stake. 
However, he thought CSRC was reluctant to approve any deals 
too different from others out of concern they would be 
criticized for approving a more favorable arrangements for 
foreign shareholders. 
 
¶16.  Newman said China's Banking Regulatory Commission 
(CBRC) and PBOC moral suasion and administrative controls 
tend to be implemented "pragmatically."  He noted that 
though SDB was initially on the list of banks that were 
prohibited from providing new loans last summer, once they 
explained the progress SDB had made in improving their 
operations and how important new loans were to their 
reforms, regulators allowed them to go ahead. 
 
¶17.  Newman thought CBRC was comfortable maintaining the 
current foreign direct investment (FDI) limits in Chinese- 
invested banks (20% for a single investor and 25% for all 
foreign investors).  It was large enough to allow for 
strategic investments, bringing capital and know-how, but 
still allowed the majority of financial benefits to accrue 
to domestic investors. 
 
¶18. (SBU) This message was jointly drafted by Congen Hong 
Kong and Embassy Beijing.