VZCZCXRO6862
OO RUEHCN RUEHGH RUEHVC
DE RUEHBJ #5562/01 2340950
ZNR UUUUU ZZH
O 220950Z AUG 07
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC IMMEDIATE 1187
RUEATRS/DEPT OF TREASURY WASHINGTON DC IMMEDIATE
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 03 BEIJING 005562 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
TREASURY FOR EXEC - TSMITH, OASIA/ISA 
STATE FOR EAP/CM 
USDOC FOR 4420 
NSC FOR MCCORMICK 
STATE PASS USTR FOR STRATFORD 
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: N/A 
TAGS: ECON EINV EFIN ETRD CH
SUBJECT: PBOC GOVERNOR AND SECRETARY PAULSON DISCUSS 
CURRENCY FLEXIBILITY, FINANCIAL SERVICES 
 
SUMMARY 
------- 
 
¶1. (SBU) SUMMARY: On July 31, People's Bank of China (PBOC) 
Governor Zhou Xiaochuan told United States Treasury Secretary 
Henry Paulson that he supports using dividend payments from 
state-owned enterprises (SOEs) to help rebalance China's 
growth and that only a relatively small share of payments 
will be used to finance new social expenditures.  Zhou favors 
greater currency flexibility for the sake of more autonomous 
monetary policy but is concerned there is no common ground 
between the somewhat more aggressive appreciation favored by 
some in the Chinese Government and the massive appreciation 
that the United States Congress appears to be demanding. 
Zhou suggested that the United States might make more 
progress in SED financial services discussions by 
highlighting evidence of financial sector openness in other 
emerging markets and by expediting the approval of Chinese 
banks' branch applications.  Finally, Zhou argued that the 
structural changes needed to address our trade imbalance will 
not occur overnight in either China or the United States, and 
the two sides should therefore consider additional options 
for managing political tensions.  END SUMMARY 
 
REDUCING IMBALANCES 
------------------- 
 
¶2. (SBU) Paulson asked about the prospects of having SOEs pay 
dividends that could be used to finance social services to 
reduce China's national savings rate (by reducing the need 
for household precautionary savings).  Zhou responded that 
the PBOC had long supported having SOEs pay dividends to the 
government and that this would start in the second half of 
¶2007.  However, despite PBOC support it appears that only 
10-20 percent of SOE dividends will go to the general 
treasury in MOF.  The rest will go the State Asset 
Supervisory and Administration Commission (SASAC).  (Comment: 
 SASAC will reportedly use the funds to subsidize loss making 
SOEs or to establish new SOEs.  End comment.) 
 
¶3. (SBU) Paulson asked about the scope for fiscal stimulus to 
reduce public and household savings rates.  Zhou said the 
while the PBOC believes there is some room for greater fiscal 
stimulus, the government needs to be cautious about 
increasing the government debt to GDP ratio.  While explicit 
government debt is not high (less than 30 percent of GDP 
compared to a sustainable rule of thumb level of 60 percent), 
implicit liabilities from unpaid pensions, non-performing 
loans, and rising public medical care costs are high. 
(Comment: Government assets, such as stakes in SOEs are also 
extensive, though the extent to which the government could or 
would be willing to sell these assets to finance liabilities 
is uncertain. End comment.) 
 
MAINTAINING OPEN TRADE POLICIES 
------------------------------- 
 
¶4. (SBU) Paulson said he would lead the fight against trade 
protectionism and would not support legislation that targets 
China.  Paulson stressed that for the Administration to do 
its part to keep markets open, it is important to show that 
engagement and dialogue are delivering results, particularly 
in food safety, currency, capital market liberalization, and 
investment.  To achieve this, the SED should focus on 
advancing reforms that China believes are in its interest as 
well.  One of Paulson's key concerns is that China will 
implement reforms but not until it is too late to constrain 
rising United States protectionism. 
 
CURRENCY 
-------- 
 
¶5. (SBU) On exchange rate policy, Paulson stressed that he 
would not support any policy changes that would hurt the 
Chinese economy, because this would not be good for the 
United States economy.  While a few companies might have been 
hurt by the RMB's rise against the USD, Paulson sees no 
evidence that the RMB's appreciation is adversely affecting 
the broader Chinese economy.  Rather, in Paulson's view, a 
 
BEIJING 00005562  002 OF 003 
 
 
stronger and more flexible currency would enhance China's 
financial security by giving it more policy tools to avoid 
asset bubbles and maintain financial stability, as well as 
rebalance its economy towards more consumption-led growth. 
Paulson stressed that international pressure on China to 
change its exchange rate policy was likely to increase, 
including through the IMF.  While noting that the RMB had 
appreciated by 9.5 percent in two years, Paulson did not 
understand why the appreciation had not been 15-16 percent. 
 
¶6. (SBU) Zhou responded that the PBOC had long supported 
greater exchange rate flexibility, first and foremost because 
it gives the PBOC greater room to adjust monetary policy. 
While China's leadership could support appreciation at a 
slightly faster rate, they believe this will be insufficient 
to placate the United States Congress and what would placate 
Congress ) a 20-40 percent revaluation, is not politically 
viable in China.  Thus, China's leadership believes there is 
little scope for finding common ground on this issue.  Zhou 
said it would be helpful if Treasury could give the PBOC a 
better sense of how much appreciation is needed to placate 
Congress.  While a new Chinese Government might revisit 
exchange rate policy next year, until then there is unlikely 
to be a major change in policy. 
 
¶7. (SBU) Zhou added that, while United States policy makers 
believe that market prices will promote needed economic 
adjustments, and are advised by economists who rely on 
empirical data, China's older generation of political leaders 
still prefers administrative controls and fiscal changes 
(such as higher taxes or subsidies) targeted on sectors of 
concern over market-based policies such as interest and 
exchange rates that have a broader impact.  This preference 
is based on their experience, even if not supported by data. 
As a result, Zhou expects Chinese leaders will wait to assess 
the impact of fiscal policy changes annouced in the last 
several months (which raised ffective taxation on certain 
export sectors that are resource intensive or highly 
polluting) before making any changes to exchange rate policy. 
 
¶8. (SBU) Zhou said Paulson could more effectively promote his 
agenda if he addressed Chinese leaders' concerns that: 1) 
greater market access for foreign firms in financial services 
would adversely impact China's financial security, 
particularly the ability of Chinese firms to compete with 
foreign firms (Comment: Embassy interlocutors say this is a 
particular concern in the securities sector.  End comment.); 
and 2) the United States protects its companies from 
competition through prudential supervision (such as bank 
licensing) and national security reviews (CFIUS) and thus 
China should as well.  Zhou noted that if the Fed could 
accelerate its approval of Chinese banks' branch 
applications, this would remove an excuse for maintaining 
market access barriers in China,s financial sector and would 
not threaten the safety and soundness of the Unites States 
financial sector.  Zhou also suggested that Paulson stress to 
China's leaders that most other emerging markets do not limit 
FDI in financial services, and note how open the United 
States is in the financial sectors, since China's leaders 
believe their own policies are the norm.  Finally, he 
recommended not pressing China's leaders on currency policy 
unless the United States could reduce its demands to an 
amount that is viewed as more politically realistic in China. 
 
¶9. (SBU) Zhou said it would be difficult to reduce trade 
imbalances in the near term since they are caused mainly by 
high savings in China and low savings in the United States, 
and it is difficult for policy changes to affect short-term 
savings rates.  Given this, Zhou suggested it is likely that 
China will continue to accumulate large official assets and 
proposed that China and the United States consider how these 
investments could be made in a way that reduces bilateral 
trade tensions.  In addition to investing in the United 
States, Zhou suggested that China could invest its official 
assets in NAFTA or CAFTA companies whose products have a high 
American content.  Furthermore, Chinese companies do not 
understand the regulatory and political investment climate in 
the United State and other countries and could use advice 
from United States officials. 
 
BEIJING 00005562  003 OF 003 
 
 
 
¶10. (SBU) Finally, Zhou commented that the United States SED 
proposal to reduce tariffs on environmental goods is worth 
pursuing.  He also thanked the United States for its support 
of China's membership in the Inter-American Development Bank 
(IDB) and the Financial Action Task Force (FATF). 
 
 
¶11. (U) Secretary Paulson's delegation cleared this cable. 
Piccuta