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E.O. 12958: N/A 
TAGS: ECON EFIN PREL EINV CH
SUBJECT: China:  PBOC Research Bureau Deputy Director General 
discusses Chinese economy 
 
SUMMARY 
------- 
 
¶1. (SBU) On February 28, Minister Counselor for Financial Affairs 
and econoff exchanged views on China's macroeconomic and monetary 
policy with Dr. Jiao Jinpu, Acting Director General of the People's 
Bank of China (PBOC) Research Bureau.  Jiao stressed that, despite 
the potential deflationary risks of high investment growth and a 
drop in external demand, he believes the balance of risks in the 
Chinese economy remain overheating and inflation.  As a result, 
monetary policy will maintain a tightening bias.  He believes that 
high and rising agricultural and commodity prices will keep headline 
inflation high for the near term, exacerbating already rising 
inflationary expectations that will lead to wage pressures.  Jiao 
said the PBOC's efforts to constrain the growth of lending will hurt 
small and medium-sized financial institutions more than large 
institutions.  Jiao expressed concern that expectations of continued 
RMB appreciation will induce additional capital inflows. Although 
the rising spread between U.S. and Chinese interest rates could also 
further induce inflows, Jiao believes capital flows are more 
sensitive to relative changes in investor expectations about asset 
prices in China and overseas markets.  On renminbi (RMB) 
appreciation, Jiao reported that gradual appreciation has not had a 
widespread negative affect on exporters.  While a gradual 
appreciation risks inducing greater inflows than a sudden and large 
discrete appreciation, the consequences of the latter are less 
certain, making this a less attractive option to Chinese leaders. 
End summary. 
 
Balance of risks remain tilted towards inflation 
---------------------------------------- 
 
¶2. (SBU) Jiao noted that the Chinese economy is likely to have 
reached a cyclical peak and could be headed for a period of slower 
growth.  While he noted the potential deflationary risks of 
continued high investment growth and a drop in external demand, he 
believes the balance of risks facing monetary authorities remain 
overheating and inflation. Jiao underscored that some of the recent 
increase in the inflation rate is due to temporary agricultural 
supply shocks that are unlikely to be repeated.  (Comment:  As a 
result, even if agricultural prices stay high (but don't rise 
further) this will not necessarily contribute to continued high 
inflation. End Comment.)  However, Jiao expressed concern that high 
and rising agricultural and commodity prices, due both to global and 
domestic factors, will keep headline inflation high for the near 
term, exacerbating already rising inflationary expectations that 
could lead to wage pressures.  These factors increase the risk of 
keeping inflation high and rising even as the impact of temporary 
supply shocks wane. 
 
¶3. (SBU) Financial MinCouns pointed out that some economists have 
argued that China has targeted too low an inflation rate and, like 
other developing countries with high rates of productivity in the 
goods sector and a fixed exchange rate, China might be able to 
tolerate a higher rate of inflation to achieve a real appreciation 
of its currency to rebalance economic growth, and in particular 
promote investment in services. Jiao agreed that China could 
tolerate a slightly higher rate of inflation, but he did not specify 
what higher threshold would be tolerable, He also stressed that even 
moderate inflation would have a negative effect on China's economic 
growth.  In Jiao's view, Chinese policy makers must now decide 
between keeping inflation in check or maintaining rapid short-term 
economic growth at the expense of longer-term economic stability. 
"If we seek economic growth without controlling inflation, we will 
face a long adjustment period in the future," he added. 
 
Monetary policy to retain a tightening bias 
--------------------------------- 
 
¶4. (SBU) Jiao explained that the PBOC plans to maintain a tight 
monetary policy in reduce inflation. Partly in response to shortages 
resulting from recent snowstorms, the central government has imposed 
provisional price controls on specific products.  Jiao underscored 
that the government plans to lift price controls soon, and agreed 
with Financial MinCouns that price controls would limit incentives 
to expand production in sectors where prices are controlled. 
 
Monetary policy instruments hurting small and medium financial 
institutions 
---------------------------------------- 
¶5. (SBU) According to Jiao, China's large financial institutions 
have a larger deposit base, and thus more excess liquidity.  As a 
result, they will be less affected by PBOC's policies to reduce the 
growth of monetary aggregates, such as higher reserve requirements. 
 
The longer the PBOC maintains a tight monetary policy, the more 
important it is to target policies in a way that forces larger 
institutions to shoulder more of the burden, Jiao explained. 
 
Capital flows more sensitive to asset prices than interest rate 
differentials 
------------------------------------------ 
¶6. (SBU) Jiao expressed concern that expectations of continued RMB 
appreciation will continue to induce additional capital inflows.  In 
Jiao's view, an extended gradual appreciation of the RMB risks 
inducing greater inflows than a sudden and large discrete 
appreciation (Comment: provided it is large enough to convince 
investors there is two-way risk in the exchange rate's movement. 
End comment.) However, the economic impact of a large discrete 
change is less certain, and thus carries greater risks, making it a 
less attractive option to Chinese leaders.  Although the rising 
spread between U.S. and Chinese interest rates could also further 
induce inflows, Jiao believes investors' relative expectations about 
asset prices (in particular real estate) in China and overseas 
appear to play a more influential role in affecting capital flows 
than relative interest rates. He explained that foreign investors 
still view housing prices in Beijing and Shanghai as cheaper than in 
major U.S. cities, and that investors expect real estate values in 
China to continue to rise. 
 
Limited adverse impact of renminbi appreciation 
-------------------------------------- 
¶7. (SBU) Jiao said he believes China should move toward a more 
market-based exchange rate, but too few participants in the foreign 
exchange market and capital controls prevent the RMB exchange rate 
from being freely market-determined.  Once these obstacles are 
removed, he said, we won't need to argue over the exact exchange 
rate. 
 
¶8. (SBU) Jiao noted that the impact of the RMB's appreciation 
against the U.S. dollar on exporters has been relatively small. 
Jiao pointed out, however, that many companies have increasingly 
complained to PBOC about the RMB's appreciation.  In a recent 
conversation with Huawei's CFO, for example, he learned that Huawei, 
China's largest networking and telecom equipment supplier, has 
experienced major losses due to its dollar-denominated transactions 
and holdings. Financial Mincouns noted that the faster rate of RMB 
appreciation and its greater flexibility since last October was both 
noted and welcome by the USG and encouraged the PBOC to maintain the 
recent high rate of appreciation. 
 
China should strengthen domestic demand 
--------------------------------------- 
¶9. (SBU) In Jiao's view, China should strengthen its efforts to 
expand domestic demand in preparation for a potential downturn in 
the U.S. economy.  Increasing farmers' income and improving 
financial services in rural areas will play an important role in 
this effort.  Jiao said he expects these issues to be addressed in 
policy announcements during the National People's Congress, which 
will convene March 5-18. 
 
Comment 
------- 
¶10. (SBU) Despite the rising risk that weak external demand and 
growing productive capacity could be deflationary, Jiao's comments 
indicate that monetary policy officials continue to believe 
inflation represents a greater risk, particularly as new central, 
provincial, and municipal government leaders have traditionally 
tended to start their terms with large increases in public and 
publicly-supported investment.   Although Jiao stressed the 
importance of maintaining a tight monetary policy, the monetary 
policy stance remains less tight than PBOC rhetoric would suggest. 
In fact, real interest rates remain low (and in some cases 
negative), broad monetary aggregates continue to exceed nominal GDP, 
and the RMB has appreciated only modestly on a trade-weighted basis. 
 Jiao's comments that relative expectations on asset price changes 
are a more important determinant of capital flows than interest rate 
differentials indicate that despite the Federal Reserve's easing, 
PBOC officials believe they still have some room to adjust interest 
rates.