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UNCLAS SECTION 01 OF 02 GUANGZHOU 000378 
 
SENSITIVE 
SIPDIS 
 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/LEE 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER 
STATE PASS SAN FRANCISCO FRB FOR CURRAN 
TREASURY FOR MOGHTADER 
 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV CH
SUBJECT: Regulators' Vague Signals and Inflation Policies Causing 
Uncertainty for South China's Foreign Banks 
 
REF: A) 07 Guangzhou 850, B) 07 Shanghai 504 
 
GUANGZHOU 00000378  001.2 OF 002 
 
 
(U) This document is sensitive but unclassified.  Please protect 
accordingly. Not for release outside U.S. government channels. Not 
for internet publication. 
 
¶1. (SBU) Summary: To incorporate locally, or to remain a foreign 
branch, that is the question for south China's international banks. 
Bank of Montreal, Bank of America and other foreign banks are 
concerned by what they see as unclear government signals that could 
lead to future losses if banks fail to correctly interpret vague 
instructions.  Clearly one concern is whether unincorporated banks 
will have their market access reduced at some time in the future. 
Meanwhile, Citibank is clearly frustrated by the slow progress in 
establishing full-service retail banking operations more than a year 
after regulators approved the launch of local subsidiaries by 
Citibank and British rival HSBC.  The move by several small 
international banks to comply with China's regulators and establish 
onshore data processing is undermining the bargaining position of 
larger international banks.  Bank executives and academics agree 
that inflation and hot money remain the primary concern of 
regulators, who have increased monitoring efforts to track capital 
inflows, particularly by scrutinizing joint venture investments and 
prepayments made to exporting companies.     End Summary. 
 
To Incorporate, or Not to Incorporate? 
-------------------------------------- 
 
¶2. (SBU) In a recent meeting with Congenoff, Brendan Wong, the 
General Manager of Bank of Montreal's (BoM) Guangzhou Branch, said 
the toughest decision facing his bank is whether to incorporate as a 
local subsidiary.  He explained that BoM has little internal 
motivation to do this, as the bank is focused on treasury operations 
and lending to multi-national companies, with no plans to establish 
retail banking in China.  Wong added that BoM would have difficulty 
meeting the loan/deposit ratio requirements if it incorporated.  At 
the same time, Wong said he is very concerned about the future 
direction of Chinese regulators; he complained that unincorporated 
foreign banks could have their market access reduced at some point 
in the future.  Wong also said BoM would likely choose to 
incorporate if doing so were necessary to protect the bank's niche 
in this market.  Unfortunately, his repeated requests that China's 
regulators clarify what they want foreign banks to do have failed to 
elicit a specific answer. 
 
¶3. (SBU) According to Bank of America's (BoA) Guangzhou Branch 
Manager, Andy Zhang, BoA views the issue of local incorporation 
similarly to Bank of Montreal.  Zhang told us at a separate meeting 
that BoA has numerous reasons to remain unincorporated, including 
the cost of creating a separate back-end system for its China 
operations; the loan/deposit ratio requirements; and the likelihood 
that a subsidiary would have a lower credit rating than the parent 
bank.  He asserted that operating as a foreign bank has no downsides 
for wholesale banking, which is all BoA seeks to do in China. (Note: 
BoA is contractually prohibited from retail banking as part of its 
strategic investment in China Construction Bank. End note.)  Echoing 
Wong's concerns, Zhang acknowledged that failure to incorporate may 
ultimately become a disadvantage for BoA, depending on the future 
decisions of banking regulators. 
 
Retail Banking Business Slow to Develop 
--------------------------------------- 
 
¶4. (SBU) After successfully incorporating as a local subsidiary last 
year, Citibank has started offering retail banking services.  Peter 
Qiu, the Guangzhou Branch Manager, expressed frustration, however, 
that the bank has so far been limited to investment services, such 
as deposits and QDII.  Citibank currently cannot offer transactional 
services, including debit and credit cards, because the bank has not 
set up an onshore payments system as required by China's banking 
regulators.  Qiu told us that most foreign banks had anticipated a 
grace period where they could offer card services while using 
offshore systems, but this has not been forthcoming.  He expressed 
concern that several smaller international banks, including the Hong 
Kong-based Bank of East Asia, are rushing to comply with the wishes 
of the Chinese government, lessening the chance that a grace period 
 
GUANGZHOU 00000378  002.2 OF 002 
 
 
will ever be offered. 
 
Inflation and Hot Money 
----------------------- 
 
¶5. (SBU) In separate meetings with bank executives, university 
professors, and financial reporters, all agreed that inflation and 
hot money remain the overriding concern of banking regulators. 
Citibank's Qiu and BoM's Wong told us separately that in recent 
months they have noticed much greater scrutiny by regulators of 
joint venture investments and prepayments made to exporting 
companies, a response to some of the most common tactics for 
skirting the PRC's capital inflow restrictions.  BoA's Zhang said 
that he expects more and tighter restrictions to be implemented in 
the coming months.  Dr. Lu Jun, chair of Sun Yat-sen University's 
Department of Finance, emphasized the historical significance of the 
government's inflation policies by describing both the fall of the 
Kuomintang (KMT, Nationalist Chinese) government in 1949 and the 
student protests leading to the 1989 Tiananmen Square incident as 
following periods of high domestic inflation. 
 
¶6. (SBU) Despite the continued regulatory interest in hot money, 
each of the bankers we spoke with expressed skepticism about the 
actual volume of the inflows.  Qiu questioned whether there are many 
people with a strong enough incentive to smuggle capital into the 
country, while Wong asserted that the central government is using 
hot money as a scapegoat for the current high level of inflation. 
Wong added that he doesn't trust official statistics; instead 
expressing his belief that the true level of inflation is 
considerably higher than figures reported by the government. 
 
¶7. (SBU) In contrast, Luo Keguan, a journalist who covers the 
banking sector for south China's Southern Metropolis Daily, told 
Congenoff that hot money inflows are a serious problem and had 
heavily distorted the Shenzhen real estate market in recent years. 
He asserted that the ongoing slump in Shenzhen housing prices, which 
have fallen 23% over the last year according to a recent article in 
the Shenzhen Daily, is largely due to tightened regulations making 
it more difficult to buy property using speculators' hot money. 
 
Comment 
------- 
 
¶8. (SBU) It was clear that Citibank and many other foreign banks are 
unenthusiastic about China's requirements to establish onshore data 
processing systems and had hoped that a grace period would allow the 
banks to begin debit and credit operations that regulators would 
later decline to shut down.  Qiu seemed irritated at Bank of East 
Asia for undercutting "Citi's and the other foreign banks' 
bargaining position" with its apparent willingness to comply with 
this regulation.  This, combined with regulators' almost-obsessive 
fixation on reducing inflation and real - or perceived - hot money 
flows, is affecting how south China's foreign banks see their near- 
and mid-term prospects. 
 
GOLDBERG