VZCZCXRO6618
RR RUEHCHI RUEHCN RUEHDT RUEHGH RUEHHM RUEHVC
DE RUEHHK #2598/01 2841041
ZNR UUUUU ZZH
R 111041Z OCT 07
FM AMCONSUL HONG KONG
TO RUEATRS/DEPT OF TREASURY WASHDC
RUEHC/SECSTATE WASHDC 3166
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUEHOO/CHINA POSTS COLLECTIVE
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 02 HONG KONG 002598 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM AND EEB/OMA, 
TREASURY FOR DOHNER, HARSAAGER, YANG, WINSHIP, AND CUSHMAN, 
NSC FOR TONG AND WILDER 
 
E.O. 12958: N/A 
TAGS: ECON EFIN HK CH
SUBJECT: INFLATION, OVER-INVESTMENT KEY CHINESE RISKS HK 
ECONOMISTS TELL TREASURY DAS DOHNER 
 
¶1.  (U) Summary: Hong Kong-based China analysts warned U.S. 
Treasury representatives that unproductive investment was a 
disturbing trend that threatened to derail Chinese economic 
growth and stability, but that the risk to the Chinese 
economy from a U.S. slowdown was minimal.  Analysts differed 
in their assessment of Chinese inflation, with some 
dismissing current price increases as a one-off food supply 
shock and others seeing long-term wage and price increases as 
a potential threat to growth.  Renminbi appreciation thus far 
has had no discernible effect on U.S./China trade flows and, 
barring a significant U.S. economic slowdown, analysts expect 
even a large appreciation would simply shift U.S. demand for 
imports to other suppliers.  A sharp drop in Chinese exports 
is unlikely to hurt the Chinese economy and could even 
benefit China by encouraging the development of domestic 
consumption, but could harm regional suppliers tied to 
Chinese export-processing industries.  End Summary. 
 
¶2.  (U) Treasury Deputy Assistant Secretary for East Asia, 
Robert Dohner, accompanied by Treasury East Asia Office 
Director Mathew Harsaager, and Treasury economists T.T. Yang 
and Ben Cushman, met with Hong Kong-based economists and 
analysts September 24-5 to discuss Chinese macroeconomic 
performance, currency policy and risks to the Chinese 
economy.  Dohner's party met separately with Michael Spencer, 
Chief Economist, Asia and Jun Ma, Chief Economist, Greater 
China at Deutsche Bank; Robert McCauley, Chief Representative 
at the Bank for International Settlements (BIS); Yiping 
Huang, Managing Director at Citigroup; and Morgan Stanley's 
Managing Director and Chief Economist, Stephen Roach. 
 
====================================== 
Inflation is not a threat... or is it? 
====================================== 
 
¶3.  (SBU) Views about the seriousness of inflationary 
pressures in China were mixed.  Some, including Stephen Roach 
of Morgan Stanley and Jun Ma and Michael Spencer of Deutsche 
Bank, dismissed rising Chinese inflation as a food-based 
supply shock that would correct itself.  While acknowledging 
that increasing food prices threaten those at the lower end 
of the income scale and are a short-term risk to stability, 
they believe prospects for the fall harvest are good and 
expected the price of pork to fall dramatically by next year. 
 Ma and Spencer predicted that inflation would fall from 
current levels of over 6% to just 3% by early 2008.  In the 
near term, they suggested the Chinese authorities would use 
price controls and other mechanisms to force manufacturers to 
keep prices down. 
 
¶4.  (SBU) Others, including Citigroup's Huang Yiping and 
BIS's Robert McCauley, told DAS Dohner that one-off supply 
shocks were part of the problem, but they were less sanguine 
about the prospects for Chinese prices.  Huang noted that 
prices have been steadily trending up for some time and would 
continue to do so, barring agricultural trade liberalization. 
 McCauley added that, with over 45% of the Chinese CPI 
measurement comprised of "core" elements like food, official 
inflation statistics did not do a good job of capturing price 
movements.  With current inflation in China pushing interest 
rates into negative territory, Chinese are increasingly 
moving money out of traditional savings and into goods, 
property and stocks, said Huang, feeding bubbles in land and 
equity prices. 
 
¶5.  (U) Analysts acknowledged reports that labor was becoming 
scarce in the manufacturing centers of the Pearl River Delta 
and Shanghai, and that formal wages in these areas are 
increasing, but agreed that rising wages are more than offset 
by increases in productivity.  Labor costs should not drive 
inflation in the near term, they said. 
 
================================= 
China Immune from U.S. Recession? 
================================= 
 
¶6.  (SBU) Analysts agreed that the subprime loan-generated 
liquidity crunch did not appear to be a problem for Asian 
banks.  Of greater concern is that a U.S. economic slowdown 
could hurt Asian exports and slow growth in Asia outside of 
China.  Ma and Spencer worried that a U.S. recession or 
protectionist trade legislation directed at China could have 
disastrous effects on Asian economies.  The current trade 
paradigm has regional economies increasingly exporting raw 
 
HONG KONG 00002598  002 OF 002 
 
 
materials and intermediate components to China for processing 
and eventual export.  Spencer argued that a sharp slowdown of 
Chinese exports to the U.S. would catch other regional 
producers, reducing their exports, and undercutting 
confidence in the "still fragile" economic growth in the 
region.  The Deutsche Bank economists warned that falling 
Chinese exports could lead to competitive devaluations in 
Southeast Asia, slowing investment and further eroding 
industrial capacity, potentially fostering another regional 
economic crisis.  A U.S. recession might even benefit China 
by reducing the red-hot growth rate to just 10% and 
encouraging the development of domestic consumption, said Ma. 
 
============================================= == 
Too Much Investment Choking the Chinese Economy 
============================================= == 
 
¶7.  (SBU) Domestic consumption is the key to continued 
Chinese economic development, according to Morgan Stanley's 
Stephen Roach.  Total consumption accounts for only 50% of 
China's economic activity and just 35% is private sector 
consumption.  China needs pro-consumption policies and 
accelerated capital reforms to create sustainable growth. 
The current Chinese leadership is more risk-averse than their 
predecessors, said Roach, and less willing to embrace bold 
measures.  Re-orienting the economy and controlling 
investment rates are crucial to keeping China on a 
sustainable growth path, but incentives at the provincial 
level still reward rapid growth over sustainability.  Barring 
a large increase in interest rates, the central government's 
only near-term option for controlling investment growth is 
administrative controls, including strict management by the 
National Development and Reform Commission (NDRC), said 
Roach. 
 
¶8.  (SBU) Huang agreed that economically inefficient 
investment is becoming a problem for China.  Subsidized land, 
artificially low labor costs, administered energy prices, and 
lax environmental regulatory enforcement reduce the cost of 
investment and encourage projects that would be rejected if 
the true costs were born by investors.  Ma and Spencer agreed 
that most Chinese investment is still directed toward 
infrastructure, heavy industry, and real estate.  The 
Deutsche Bank economists predicted real estate investment 
would grow by more than 20% per year over the next several 
years.  Roach noted concerns about a property bubble, but 
argued that the Chinese leadership views this as a natural 
result of shifting investment patterns. 
 
============================================= == 
RMB Appreciation Won't Solve U.S. Trade Deficit 
============================================= == 
 
¶9.  (SBU) Dohner asked analysts whether RMB appreciation 
would significantly affect the U.S. current account deficit. 
Roach responded that RMB strengthening over the past three 
years had done nothing to reduce Chinese export growth and 
suggested that a large and sudden appreciation of at least 
15% is the only way to impact Chinese exports to the U.S.  He 
predicted that such a shock would have repercussions in the 
Chinese domestic financial sector, noting that many banks 
have indirect exposure to U.S. dollars; mid-size banks in 
particular are unsophisticated managers of currency risk, he 
said.  Morgan Stanley believes the U.S. savings rate is the 
key to addressing the current account deficit.  Even if the 
RMB appreciated dramatically, Roach predicted, the U.S. 
appetite for imports would just shift elsewhere. 
 
¶10. (U) Treasury Deputy Assistant Secretary Dohner did not 
have the opportunity to clear this message. 
Marut