VZCZCXRO7648
RR RUEHCN RUEHVC
DE RUEHGH #0654/01 2780929
ZNR UUUUU ZZH
R 050929Z OCT 07
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6333
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/WHITE HOUSE NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 6815

UNCLAS SECTION 01 OF 04 SHANGHAI 000654 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN 
FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR DAGES/CLARK 
STATE PASS CEA FOR BLOCK 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/LOI/READE 
USDOC FOR 4420 
USDOC FOR ITA/MAC DAS KASOFF, MELCHER AND MCQUEEN 
TREASURY FOR EXEC - TSMITH, OASIA/ISA -DOHNER/BAKER/CUSHMAN 
TREASURY FOR WRIGHT AND AMB HOLMER 
TREASURY FOR SOBEL AND MOGHTADER 
NSC FOR MCCORMICK AND TONG 
 
E.O. 12958: N/A 
TAGS: EFIN EINV PGOV CH
SUBJECT: SHANGHAI BANKERS ON RMB, PROTECTIONISM AND THE FUTURE 
 
REF: SHANGHAI 504 
 
SHANGHAI 00000654  001.2 OF 004 
 
 
(U) This cable is sensitive but unclassified and for official 
use only.  Not for distribution outside of USG channels or via 
the internet. 
 
¶1. (SBU) Summary:  China's weak and rigid exchange rate is 
increasing costs and inhibiting innovation in China's financial 
sector.  Shanghai officials and banking leaders told a visiting 
Treasury delegation that growing protectionism in the financial 
services sector would make increased foreign penetration 
difficult.  Foreign banks that had incorporated locally are 
facing increased regulatory interference and mixed results in 
opening new branches, while a bank that opted not to incorporate 
locally faces increased costs.  Foreign banks are also facing an 
increased cost in doing business due to recent reductions in 
their foreign debt quotas.  The ongoing need for China's central 
bank to sterilize its foreign exchange purchases is placing an 
increased burden on Chinese banks as they are forced to hold 
more and more central bank assets.  End summary. 
 
¶2. (SBU) Visiting Treasury DAS Mark Sobel and Embassy Finance 
Minister Counselor David Loevinger along with Shanghai ConGen 
Pol/Econ Chief met with financial service sector officials and 
banking leaders during a September 17-18 visit to Shanghai. 
They met with Wachovia Bank Shanghai Branch Managing 
Director/General Manager Ben Kinnas, JP Morgan Chase Bank Vice 
Chairman Andrew Zhang, Bank of Tokyo-Mitsubishi UFJ, (China) Ltd 
(MUFG) Senior Manager Ryan Hart, and Standard Chartered Senior 
Economist Stephen Green on September 17.  On September 18 they 
met with Citibank CEO Richard Stanley and Shanghai Metropolitan 
Financial Services Office (SMFSO) Deputy Director General Fang 
Xinghai.  Meetings with Chinese mutual fund companies' 
representatives will be reported septel. 
 
------------------------------------------- 
Foreign Investment in the Securities Sector 
------------------------------------------- 
 
¶3. (SBU) SMSFO's Fang said that protectionism in China's 
financial sectors is growing.  A major source of this 
protectionism is the feeling among some sectors of the Chinese 
populace that banks, as state assets, have been sold too 
cheaply.  This feeling has been reinforced by the massive 
profits generated by the recent IPOs of several state-owned 
commercial banks.  Wachovia's Kinnas separately agreed saying 
that the Chinese Banking Regulatory Commission (CBRC) has 
recently expressed concern at the purchase of stakes in city 
commercial banks by foreigners. 
 
¶4. (SBU) Fang said the increasing Chinese protectionism in the 
securities sector comes from two sources -- domestic firms fear 
increased competition and some public policy researchers believe 
that opening to foreign competition threatens national economic 
security.  To assuage concerns of the second group, the United 
States needs to show better how other countries have opened 
their securities sector without losing domestic players, such as 
in Taiwan, South Korea, Malaysia and Indonesia. 
 
¶5. (SBU) Fang suggested that one remedy for this protectionism 
could be new, post-WTO, framework agreement on financial 
services.  Making this agreement politically acceptable for the 
Chinese would necessitate a quid pro quo where both sides would 
make concessions.  Fang suggested that the United States could 
relax restrictions on high-tech exports in exchange for greater 
RMB appreciation. 
 
¶6. (SBU) Fang hoped that policies on equity caps in the banking 
and securities sectors would change after the upcoming Communist 
Party Congress that convenes in Beijing on October 15).  These 
caps, according to Fang, differ according to industry due to the 
different personalities of the regulators.  Upcoming personnel 
changes could affect policy. USG pressure can be of help in 
opening the sector, as long as it is "firm and consistent," he 
said. 
 
¶7. (SBU) Several firms voiced frustration with their ability to 
enter the securities market.  JP Morgan's Zhang said the CBRC 
had turned down its petition to underwrite government bonds. 
 
SHANGHAI 00000654  002.2 OF 004 
 
 
Now that JP Morgan is locally incorporated, Zhang hopes that the 
CBRC will reconsider its decision.  However, he said, 
regulations on underwriting corporate bonds unclear.  While 
foreign banks cannot trade commercial paper or long-term listed 
corporate bonds, they can trade government bonds and bank debt. 
Wachovia's Kinnas also noted his bank's interest in being able 
to trade financial derivatives. 
 
¶8. (SBU) Citibank's Stanley said that foreign firms want 
securities licenses that allow for the provision of a full range 
of investment banking and brokerage services.  He noted rumors 
that China might lift equity caps on investment in securities 
firms, but expected this would only apply to joint ventures 
(JVs) with licenses limited to underwriting stocks.  He 
expressed concern that, using China Construction Bank, Bank of 
China and ICBC as models, the Chinese Securities Regulatory 
Commission (CSRC) may meet its Strategic Economic Dialogue 
commitment to allow foreign JVs to expand the scope of their 
business only by allowing them to take minority stakes in the 
largest Chinese brokerages.  This would limit the ability of 
foreign firms to gain management control of their JVs in China. 
 
¶9. (SBU) Stanley also pointed to regulatory fragmentation as a 
frequent obstacle to financial market development.  Though 
Citibank has received approval from the CBRC to issue debit and 
credit cards, the People's Bank of China (PBOC) is pressing Citi 
to move its payment processing system onshore, ostensibly due to 
privacy concerns about having data on Chinese households stored 
abroad. 
 
------------------------------------- 
Local Bank Incorporation: A Mixed Bag 
------------------------------------- 
 
¶10. (SBU) Both Citibank and MUFG have recently completed the 
process of incorporating as local Chinese banks.  Stanley 
repeated his concerns that the regulators are being far more 
intrusive than expected. (Reftel)  CBRC is imposing a local 
Chinese corporate structure on locally incorporated banks, 
including a geographic management approach that conflicts with 
Citibank's product line approach.  The Chinese approach 
increases the power of branch managers.  Though Citibank's 
application for a branch in Dalian was recently approved, 
approvals of other new branches are "a slog," and continue to be 
tied to the issue of Chinese banks' access to the United States 
market.  In an attempt to gain regulators' favor, Citibank will 
open a modified village bank (only lending) even though it 
expects it will lose money.  (Note: Rural finance reform was a 
primary focus of the National Financial Work Conference in 
January 2007.  Chinese banks, such as the Bank of Communications 
(BOCOM), have also been asked to consider opening branches in 
rural areas or to partner with one of the many failing rural 
cooperative banks.  A BOCOM official told Econoff in September 
that any such venture would lose money and that Chinese banks 
would be hesitant to pursue it.  End note.) 
 
¶11. (SBU) In contrast to Citibank, MUFG's Hart said that MUFG 
experience with local incorporation had largely been positive. 
It had benefited from an accelerated approval process for new 
bank branches.  MUFG, however, does not conduct retail RMB 
banking. 
 
¶12. (SBU) Wachovia, on the other hand, opted not to incorporate 
locally and, as a result, was required by the CBRC to increase 
its capital holdings.  Wachovia's Kinnas said that the capital 
requirement for non-locally incorporated banks "is far too high" 
and acts as a major impediment to United States regional banks 
who want to do non-retail banking business in China. 
 
--------------------------------------------- ---------- 
Shrinking Foreign Debt Quota Slows Growth, Raises Costs 
--------------------------------------------- ---------- 
 
¶13. (SBU) The State Administration of Foreign Exchange (SAFE) 
March 2007 decision to reduce banks' foreign debt quotas in 
order to clamp down on short-term foreign currency denominated 
borrowing has raised banking costs and constrained growth of 
their banks, said several interlocutors.  This policy took 
 
SHANGHAI 00000654  003.2 OF 004 
 
 
effect at a time of rising demand for foreign currency 
denominated debt and a shrinking supply of onshore foreign 
currency deposits as Chinese households and firms adjust the 
currency composition of their assets and liabilities to benefit 
from expected RMB appreciation.  The result, according to JP 
Morgan's Zhang, has been to create a "dollar liquidity crunch," 
one that the PBOC has done nothing to solve.  MUFG's Hart said 
that banks are paying a premium -- over 100 basis points over 
LIBOR -- to borrow U.S. dollars on shore. 
 
¶14. (SBU) Stanley said Citibank's foreign debt quota will be 
fully obligated by March 2008.  He had also heard that SAFE was 
considering a further reduction of foreign debt quotas.  Stanley 
said this would not necessarily be a disaster for the larger 
foreign banks that are well-established in China, like Citibank, 
since they have a proportionally larger RMB deposit base, but 
smaller banks would be hurt. 
 
¶15. (SBU) Wachovia's Kinnas noted that while SAFE's intent is to 
limit speculation on the RMB and reduce capital inflows, the 
reduction of foreign borrowing is adversely impacting financial 
services, such as the financing of imports or re-lending to 
offshore customers that have no net balance of payments impact. 
 
¶16. (SBU) Zhang said that in terms of banks' financing RMB 
denominated lending, RMB deposits are the cheapest means, 
followed by the swapping of offshore dollar borrowing for RMB, 
with inter-bank RMB borrowing being the most expensive.  Thus, 
restricting foreign borrowing raises the costs of RMB financing 
and benefits Chinese banks who are the main suppliers of RMB to 
the inter-bank market.   Moreover, limits on foreign currency 
borrowing, along with foreign banks' limited deposit base, 
restriction on inter-bank borrowing (not more than twice their 
capital) and inability to issue RMB bonds all serve to further 
constrain the ability of foreign banks to grow. 
 
-------------------- 
Exchange Rate Policy 
-------------------- 
 
¶17. (SBU) Standard Chartered's Stephen Green said that he is 
seeing a growing acceptance among Chinese decision makers, even 
among the more conservative officials of the National 
Development and Reform Commission (NDRC), that faster pace of 
RMB appreciation is needed.  However, the economy is not 
slowing, and Green said he saw no consensus among high-level 
leaders that there is a need to slow the economy, or that they 
considered the current upsurge in inflation to be a major 
problem.  Continued large-scale sterilized intervention is 
adversely impacting banks' income, with Citibank's Stanley 
noting that PBOC assets (including sterilization bonds and 
reserves) now account for 25 percent of Citibank's financial 
assets in China. 
 
¶18. (SBU) According to JP Morgan's Zhang, the lack of foreign 
currency hedging instruments contributes to the Chinese 
authorities' reluctance to allow a faster rate of RMB 
appreciation.  However, he noted, banks' inability to short 
foreign currencies, except to offset the long position of a 
customer with an approved underlying current account 
transaction, limited the development of a liquid foreign 
currency derivatives market. 
 
---------------------------------------- 
The Future of Chinese Financial Services 
---------------------------------------- 
 
¶19. (SBU) SMFSO's Fang said that a working group that includes 
the Shanghai mayor, Shanghai's Financial Services Office, and 
local regulators had recently formulated a three-part strategy 
to turn Shanghai into a global financial center.  The plan is 
to: (1) Grow Shanghai's financial markets, making Shanghai the 
place where prices of Chinese financial assets are determined; 
(2) Attract more financial firms, especially large state-owned 
enterprises currently located in Beijing; and (3) Create a 
financial sector arbitration body.  In Fang's vision, there 
would be a division of labor between Hong Kong and Shanghai, 
with Hong Kong being China's center of foreign-exchange-based 
 
SHANGHAI 00000654  004.2 OF 004 
 
 
financial services, and Shanghai acting as a hub for RMB 
services. 
 
-------------------------------------- 
Comment: The High Price of a Rigid RMB 
-------------------------------------- 
 
¶20. (SBU) Conversations with financial sector firms in Shanghai 
highlight how China's rigid exchange rate is increasing costs 
and inhibiting innovation in China's financial sector.  China's 
large and rising balance of payments surplus and its rigid 
exchange rate require the monetary authorities to maintain large 
scale foreign currency intervention.  This keeps the growth of 
monetary aggregates high and its cost of capital low, resulting 
in continued high rates of investment, particularly in the 
tradable sector.  This high rate of fixed asset investment 
contributes to higher export growth, perpetuating the liquidity 
induced investment cycle.  To contain investment growth and the 
rise in asset prices, monetary authorities are raising interest 
rates.  But to keep higher Chinese interest rates (and lower 
U.S. interest rates) from inducing even more capital inflows, 
SAFE is tightening restrictions on capital inflows and continues 
to prohibit banks from taking short foreign currency positions, 
constraining liquidity in the foreign exchange market. 
 
¶21. (U) Embassy Finatt cleared this cable. 
JARRETT