VZCZCXRO0241
RR RUEHCN RUEHGH
DE RUEHGH #0100/01 0801034
ZNR UUUUU ZZH
R 201034Z MAR 08
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6753
INFO RUEHBJ/AMEMBASSY BEIJING 1769
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHCN/AMCONSUL CHENGDU 1160
RUEHGZ/AMCONSUL GUANGZHOU 1131
RUEHSH/AMCONSUL SHENYANG 1158
RUEHHK/AMCONSUL HONG KONG 1292
RUEHIN/AIT TAIPEI 0970
RHEHAAA/NSC WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 7292

UNCLAS SECTION 01 OF 03 SHANGHAI 000100 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
FRANCISCO FRB FOR CURRAN/GLICK; NEW YORK FRB FOR 
CLARK/CRYSTAL/DAWSON 
STATE PASS CFTC FOR OIA/GORLICK 
CEA FOR BLOCK 
USDOC FOR ITA/MAC DAS KASOFF, MELCHER AND OCEA/MCQUEEN 
TREASURY FOR AMB.HOLMER, WRIGHT AND TSMITH 
TREASURY FOR OASIA - DOHNER/HAARSAGER/CUSHMAN 
TREASURY FOR IMFP - SOBEL/MOGHTADER 
NSC FOR KURT TONG 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PREL CH
SUBJECT: CHINA'S STOCK MARKETS:  EVOLVING "POLICY MARKETS" 
 
REF: SHANGHAI 97 
 
(U) This cable is sensitive but unclassified and for official 
use only.  Not for distribution outside of USG channels. 
 
¶1. (SBU) Summary: In a series of consultations with fund 
managers, securities firms and investor advisory firms from 
March 4-14, TDY Econ Officer solicited views on the drivers of 
China's equity markets.  An overarching theme is that China's 
stock markets should be viewed in the special context that the 
government is both the majority shareholder and the market 
regulator.  This fact, combined with China's relatively 
insulating capital control framework, means that market swings 
in China may in some cases demonstrate a certain degree of 
autonomy from global trends.  Interlocutors noted that as 
Chinese markets mature, economic trends and macroeconomic policy 
moves are having a greater impact on price trends.  Given the 
overall lack of transparency in economic policy making and the 
often poor quality of economic data in China, stock market 
trends may increasingly provide useful forward-looking signals 
on the direction of China's economy.  End Summary. 
 
-------------------------- 
China's Equity Markets are a Work-in-Progress 
-------------------------- 
 
¶2.  (SBU) As domestic stock investors, brokers, and advisors 
from both Chinese and joint-venture firms noted during meetings 
with TDY Econ Officer from March 4-14, despite high market 
capitalization and robust share-offering activity, China's 
emerging equity markets are still mid-stride in a decades-long 
reform process.  The Shanghai and Shenzhen stock markets are 
fundamentally different than most international markets and thus 
China-specific factors must be taken into account when tracking 
Chinese market movements against global trends.  The government 
has strong control over share supply as well as influence over 
share demand.  As both the largest shareholder and the market 
regulator, the Chinese Government oversees a "policy market" 
marked by high volatility.  Overall, the absence of tools to 
take short positions in the market means that profits come only 
from market gains. 
 
-------------------------- 
Non-Tradable Share Reform and the Supply of Shares 
-------------------------- 
 
¶3. (SBU) Central to China's equity market development is the 
non-tradable share reform, which phases in the proportion of a 
listed company's equity that is permitted to be traded.  The 
plan for share reform was introduced in 2005, allowing for 
increased tradability over a multi-year timeframe. 
Clarification on how the "share overhang" would be allowed to 
flow into the market helped to reassure investors and foster the 
2006-2007 boom.  (Note:  The Shanghai Stock Exchange Composite 
Index rose 130 percent in 2006 and 97 percent in 2007.) 
Similarly, shares issued in initial public offerings (IPOs) are 
bound by non-tradable lock-up periods.  Aggregating data on a 
firm-by-firm basis, one research team estimates that from 2007 
to 2010, the overall "free float ratio" will climb from near 10 
percent to 90 percent of total shares, with trillions of shares 
becoming tradable in that time frame.  Uncertainty about the 
proportion of those shares that will actually be unloaded on the 
market creates volatility and supports herd behavior in the 
market, which is exacerbated by information asymmetry. 
 
¶4. (SBU) Even as the non-tradable share reform phases in, 
authorities retain considerable control over the supply of new 
shares entering the market.  Authorities can control the 
availability of shares to guide investor expectations.  Though 
few interlocutors think the government will suspend the 
non-tradable share reform in the event of a soft market, they 
believe the authorities may lean on large firms to withhold 
sales of newly tradable shares.  In the event of excessively 
high valuations, authorities might encourage share selling by 
firms with newly tradable shares.  Further, approval for all 
 
SHANGHAI 00000100  002 OF 003 
 
 
IPOs and secondary share issuances is granted by the China 
Securities Regulatory Commission (CSRC), providing another check 
on share supply.  The CSRC modulates the pace of approval for 
share offerings depending on market conditions. 
 
¶5. (SBU) In the course of discussions, interlocutors noted that 
Chinese authorities take measures to influence share demand as 
well as share supply.  To stoke share buying, the CSRC approves 
quotas for new asset management funds.  Expanding access to the 
domestic market for foreign investors by raising quotas for 
Qualified Foreign Institutional Investors (QFIIs) is another 
option for policymakers to increase share demand.  In addition, 
authorities may increase the proportion of assets that pension 
funds and insurance companies can invest in equities.  Several 
interlocutors noted that the CSRC has in the past resorted to 
use moral suasion to encourage asset management funds to buy 
shares, either during meetings with fund managers or through 
phones calls.  One director at a joint venture securities firm 
saw this approach as decreasingly effective, as fund managers 
are more concerned about their professional reputations and 
performance than doing favors for the CSRC.  In his observation, 
efforts in the past two years by the CSRC to encourage buying by 
funds had no discernable impact on the market.  He noted that 
even if the CSRC pressed large, cash-flush state-owned 
enterprises (SOEs) to buy shares, SOEs are now bound by 
performance targets and increased managerial accountability, 
which would limit their cooperation.  The director commented 
that if a fund manager or SOE were to ultimately lose money from 
such share purchasing, the CSRC would not bail them out. 
 
-------------------------- 
Structural Changes and Market Reform 
-------------------------- 
 
¶6. (SBU) In several conversations, interlocutors noted that 
fast-moving economic development and reform measures impact the 
composition of investors, company valuations, and investor 
expectations.  Investor composition has fluctuated in recent 
years.  The plan for non-tradable share reform boosted investor 
confidence and drew droves of retail investors to a booming 
market.  However, market swings since May 2007 have led retail 
investors to move substantial assets to accounts overseen by 
professional fund managers. 
 
¶7. (SBU) But fund managers indicate that share valuation is 
complicated by weak accounting practices, changes in accounting 
rules in 2006-2007, and the large amount of corporate 
restructuring and mergers and acquisition activity.  An 
individual firm's price-to-earnings (P/E) ratio may reflect 
hidden value or may overstate underlying value.  For these 
reasons, the usefulness of index-wide P/E ratios is limited. 
The fact that investors can only take long positions on shares 
creates an upward bias to P/E ratios in China. 
 
¶8.  (SBU) Both the announcement and implementation of reform 
measures can have a notable impact on China's stock markets. 
For example, in May 2007, the Ministry of Finance raised the 
stamp duty on share trades from 0.1 percent to 0.3 percent, 
precipitating a large drop in the market. (Note: The Shanghai 
Composite Index fell 15 percent from May 30 to June 4.) 
Authorities have delayed the launch of equity index futures for 
fear of a dramatic impact on the market (cf. reftel).  (Note: 
Interlocutors generally thought that introduction of stock index 
futures and other means to short the market will be an important 
step for the maturation of China's stock markets, especially as 
a means to facilitate price discovery.)  In February 2008, 
authorities mentioned consideration of a pilot stock margin 
buying framework, an announcement seen by investors as an 
attempt to boost the market.  Investors may also react to the 
government's periodic measures to liberalize the capital 
account, given the resulting change in perception of demand for 
shares. 
 
¶9. (SBU) The reform process in China's stock markets lends to 
 
SHANGHAI 00000100  003 OF 003 
 
 
uncertainties and price volatility.  At the same time China's 
stock prices are increasingly reflecting domestic macroeconomic 
developments and global events.  China's stock markets are 
becoming more sensitive to economic data releases and statements 
by senior policy makers on macroeconomic policy measures.  While 
China's controls on portfolio investment flows insulate domestic 
stock markets, the Qualified Domestic Institutional Investor 
(QDII) and QFII programs provide a channel for portfolio inflows 
and outflows, though quotas are carefully governed. 
Interlocutors noted that movements in China's domestic "A-Share" 
market are becoming more correlated with the Hong Kong market, 
which itself tracks trends in the United States.  Stronger 
correlation with overseas markets is especially apparent for 
firms that are cross-listed in overseas markets. 
 
¶10. (SBU) Interlocutors highlighted a perception among 
investors, particularly among less-experienced retail investors, 
that the government would use the measures outlined above to 
ensure that markets continue to rise.  Previous government 
interventions support this notion, creating expectations for 
future interventions and moral hazard.  During past market 
downturns, reports circulated of disgruntled investors 
protesting at government offices and of an investor phoning in a 
bomb threat to the local Ministry of Finance building.  One 
securities firm director professed that the CSRC's ability to 
control the market is weakening, and he noted that if stock 
index futures are launched, the CSRC may lose control completely. 
JARRETT