VZCZCXRO4718
RR RUEHCN RUEHGH
DE RUEHGH #0246/01 1790852
ZNR UUUUU ZZH
R 270852Z JUN 08
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6950
INFO RUEHBJ/AMEMBASSY BEIJING 1938
RUEHSH/AMCONSUL SHENYANG 1270
RUEHCN/AMCONSUL CHENGDU 1272
RUEHGZ/AMCONSUL GUANGZHOU 1243
RUEHHK/AMCONSUL HONG KONG 1411
RUEHIN/AIT TAIPEI 1081
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 7512

UNCLAS SECTION 01 OF 04 SHANGHAI 000246 
 
SENSITIVE 
SIPDIS 
 
TREASURY FOR OASIA/INA - DOHNER, HAARSAGER/CUSHMAN, WINSHIP 
TREASURY FOR IMFP SOBEL. MOGHTADER 
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA - MCQUEEN 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SF FRB 
FOR CURRAN/GLICK/LUNG; NY FRB FOR CLARK/CRYSTAL/MOSELY/DAGES/DAWSON 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PGOV SOCI CH
SUBJECT: SHANGHAI STOCK EXCHANGE:  RECENT VOLATILITY, PROSPECTS FOR 
 
REFORM 
 
REF: Shanghai 100; Shanghai 28 and previous 
 
¶1.  (SBU)  Summary.  Shanghai financial services industry 
participants identify last year's stock market bubble as the 
primary source of the Shanghai Stock Exchange's most recent 
volatility.  Poor economic performance in certain sectors has 
also fueled volatility, with inflation and softening real estate 
markets as well as export challenges emerging as key concerns 
for investors.  Government intervention to shore up the Shanghai 
Stock Exchange - the index is down almost 50 percent since 
January 1 - is seen as unlikely, with our interlocutors noting a 
lack of large-scale social unrest and regulator deadlock. 
 
¶2.  (SBU)  Summary cont'd.  Our interlocutors also note the 
Shanghai stock market may be approaching its bottom, making this 
an opportune time to continue non-tradable share reform and 
introduce new financial products and services.  They express 
skepticism about whether these reforms will be enacted, however. 
 Nevertheless, our interlocutors are generally positive about 
the stock market's future, noting that corporate non-financial 
earnings appear to be remaining strong.  They also note that the 
lack of investor protests in the stock market as well as the 
ability of firms to weather the market's recent downturn could 
be a sign that the Shanghai stock market is becoming more 
mature.  End summary. 
 
Introduction 
 
¶3.  (SBU)  In meetings from June 20-24, Congen Econoffs met with 
Shanghai financial industry participants to discuss recent 
volatility in the Shanghai Stock Exchange (SSE). Meeting 
participants included an American financial consultant based in 
Shanghai, the general manager of a U.S. joint venture securities 
firm, Haitong Securities Macro Economic Analyst Wu Yiping, 
Shanghai Municipal Government Financial Services Office 
Director-General Fang Xinghai, and SSE Global Business 
Development Deputy Chief Chao Kejian. 
 
Background 
 
¶4.  (U)  From June 10 through close of trading on June 27, the 
SSE has fallen 17.5%.  Trading during the shortened week of June 
10-13 (markets were closed on June 9 for a national holiday) was 
especially volatile, with the Shanghai Composite Index (SCI) 
falling 13.8% to 2869 points.  On June 27, the SCI fell to 2748 
points, its lowest level since the middle of March 2007.  The 
initial June 10 downturn was sparked by a 1% increase in 
required reserve rates (RRR), bringing that rate up from 16.5% 
to 17.5%.  That RRR increase was announced on Saturday, June 7, 
and on June 10 (first trading day thereafter) the SCI fell 7.73% 
to 3072 points.  Volatility has since continued, largely driven, 
according to these interlocutors, by rising fuel prices, 
softening real estate markets, inflation expectations and 
prosecution of former China Security Regulatory Commission 
(CSRC) Vice-Chairman Wang Yi. 
 
Immediate and Long-Term Sources of the Markets Recent Downturn 
 
¶5.  (SBU)  While June's downturn was set in motion by the PBOC's 
RRR hike of June 7, the larger decline since the beginning of 
the year has several sources.  According to Fang and Chao, the 
largest source was last year's speculation, which created a 
bubble in the stock market.  At its peak, P/E ratios reached 
over 60, an unsustainable level according to many analysts. 
Questions also remain over stock market corruption.  Financial 
news outlet Caijing reported on June 11 that former CSRC 
Vice-Chairman Wang Yi had been detained while under 
investigation for insider trading and violation of security 
regulations.  Chao and the JV manager noted this and rumors of 
investigations into low and mid-level officials had been fueling 
stock market volatility because retail investors see such 
developments as introduction of additional uncertainties about 
market operations.  Fang on the other hand believes investors 
have become sufficiently accustomed to the occasional regulatory 
corruption case that such rumors no longer cause much concern. 
All concurred that whatever the short-term impact on investor 
outlook, investigation and prosecution of such cases in the 
longer term will be good for investors' confidence and for the 
 
SHANGHAI 00000246  002 OF 004 
 
 
market. 
 
¶6.  (SBU)  Our interlocutors also noted larger then expected 
inflation had cooled markets.  Inflation has changed investors' 
expectations in two ways:  first, by compressing corporate 
profit margins with rising costs; and second, by the credit 
crunch resulting from the government's attempts to control 
inflation.  The JV manager notes the first was partially 
mitigated using price controls, especially for energy, although 
some fuel prices were significantly increased in mid-June. 
Keeping prices artificially low, however, distorted the market 
by encouraging over consumption and under production.  This led 
to fuel shortages throughout the country, which also compressed 
corporate earnings, though through a combination of mandating 
and subsidized production, near term costs were lower then they 
would have been had the market been allowed to equilibrate, 
according to the JV manager.  Both he and Chao note that the 
energy price increases announced in mid-June helped bring the 
market closer to equilibrium, improving the long-term outlook, 
but also increased costs for downstream firms in the near-term. 
 
¶7.  (SBU)  Inflation also led to government attempts to contract 
liquidity.  The JV manager noted the current credit crunch has 
made it difficult for real estate developers to find financing 
in a time when the industry is already struggling due to falling 
prices.  Nevertheless, Fang, Chao and Wu believe the real estate 
sector will be sufficiently buoyed by demand.  The JV manager 
and the financial consultant also believe that the government 
will not allow real estate prices to fall too far, especially in 
Beijing and Shanghai, because of large real estate exposure by 
the major banks.  Both Wu and the JV manager, however, suggest 
that real estate in southern China may continue to cool, arguing 
that the recent appreciation of residential prices had been most 
significant there. 
 
Prospects and Expectations for Policy Intervention in the 
Shanghai Stock Exchange 
 
¶8.  (SBU)  Prior to the market's fall since June 10, investors 
and the media had predicted the government would not allow the 
SCI to fall below 3,000.  A previous reduction of the stamp tax 
the last time markets fell below 3,000 reinforced this belief. 
To date, however, no such intervention has occurred.  Our 
interlocutors were mixed on investor expectations of policy 
intervention.  Both Fang and Chao believed the government will 
have to do something.  This, they claim, is necessary to satisfy 
retail investors who lost money in the market's most recent 
downturn.  The JV manager, however, does not believe investors 
are expecting intervention.  He notes a recent survey in which 
only 20% of retail investors said they expected the government 
to intervene.  The financial consultant echoed this view, saying 
he believed investor expectations of intervention have been 
decreasing with each passing day since June 10's downturn. 
 
¶9.  (SBU)  Our interlocutors also expressed uncertainty about 
what form intervention would take, if indeed intervention is 
undertaken.  The financial consultant and JV manager expressed 
skepticism regarding adjustment of the stamp tax or increasing 
QFII quotas.  The JV manager noted last time the government 
increased QFII quotas to support stock prices they were 
criticized for letting foreigners buy into a cheap market, and 
now the market is even cheaper.  Both also questioned the 
efficacy of a tracker fund similar to the one used in Hong Kong 
to help stabilize the market.  The idea for using a tracker fund 
in Shanghai has been discussed in the media as a means to help 
stabilize the market's most recent volatility.  The financial 
consultant noted that the SSE is becoming more 
institutionalized, with institutional investors helping to 
stabilize the market.  The JV manager also noted the market may 
be near the end of its adjustment, thus eliminating the need for 
such a fund in stabilizing recent volatility.  Other policy 
options the government may be considering include restricting 
new IPOs, slowing non-tradable share reform, allowing margin 
trading or launching stock index futures. 
 
¶10.  (SBU)  Regardless of investor expectations, our 
interlocutors expressed various opinions on what might spur or 
 
SHANGHAI 00000246  003 OF 004 
 
 
prevent government intervention.  Financial Services Office DG 
Fang admitted that only limited protests had occurred so far, 
but felt the government is still under pressure by investors to 
take action to support the stock market.  SSE's Chao expressed 
similar sentiments, noting that investor pressure would 
eventually lead to intervention.  The JV manager disagreed, 
saying protests over the most recent downturn had not reached 
the level they had when the government intervened last time. 
Without more pressure from investors, he predicts the government 
will not intervene.  He notes Vice Premier Wang Qishan (in 
charge of financial and economic issues) said this spring that 
the government will not intervene unless there is social 
disturbance.  The financial consultant, however, believes 
government intervention is unlikely because there is no one 
willing to take charge of not only rescuing the stock market, 
but the economy in general.  He notes that any official who 
takes charge will be held responsible if measures prove 
ineffective in halting or reversing the recent downturn. 
 
Investors Expectations of Market Performance 
 
¶11.  (SBU)  Absent intervention, our interlocutors asserted that 
retail investors are becoming increasingly pessimistic about the 
stock investment climate.  The financial consultant noted recent 
natural disasters, inflation and the U.S. economic slowdown as 
contributing to a general pessimism among investors.  This view 
was echoed by Fang at the Financial Services Office, who noted 
that the stock market will follow the economy.  He predicted 
that as long as there is strong economic growth and inflation is 
controlled, the stock market will recover and even do well. 
SSE's Chao believes that investors are waiting for inflation to 
decline before returning to the market with new purchases. 
 
¶12.  (SBU)  The market's fall has also shaped investor 
expectations regarding where the market's bottom might be.  As 
previously noted, many thought the SCI bottom would be around 
3,000 due to expected government intervention at that level. 
Our interlocutors noted the difficulty of predicting where the 
new bottom might be, but 2,500 came up repeatedly as a best 
guess.  Both Haitong Securities' Wu and the JV manager noted 
that at the SCI 2500 level, the P/E ratio would be near 17, 
about the same level as for markets in developed countries. 
SSE's Chao also noted he had spoken with foreign institutional 
investors who had signaled they would begin investing again when 
the market reached 2,500. 
 
¶13.  (SBU)  Despite the downturn and poor performance in some 
sectors, Chao, Fang and the financial consultant remain 
optimistic about the market's performance.  Chao and the 
financial consultant noted that while a substantial portion of 
the earnings of several companies came from financial 
investments last year, earnings for many companies did not. 
Chao notes that for many listed companies, performance is 
actually better this year than it was last.  The financial 
consultant notes that in such an environment, speculators are 
taking the greatest losses while fund managers are doing 
considerably better.  The U.S. JV manager is not so optimistic, 
however.  He notes that corporate profit margins are still being 
squeezed by rising costs.  He notes that even upstream 
industries such as coal and aluminum are suffering, mostly due 
to higher energy prices. 
 
Stock Market Downturn Presents Opportunity for Reform though 
Regulators Remain Reticent 
 
¶14.  (SBU)  Several of our interlocutors noted the market's 
recent downturn may present an opportunity for equity market 
reform.  The JV manager, the financial consultant, Fang, Wu and 
Chao noted that the markets current level may make it easier for 
non-tradable share reform to proceed by making it easier to 
absorb additional shares.  They agreed that because most holders 
of non-tradable shares acquired them at negligible prices, they 
will immediately sell when given the chance, driving down 
prices.  Given that many investors now see the market as 
relatively cheap, and the relative paucity of good investments 
in China's increasingly bearish markets, they believe the market 
is now more ready to absorb newly tradable shares without 
 
SHANGHAI 00000246  004 OF 004 
 
 
significantly affecting current share prices.  Fang, Wu and Chao 
made similar arguments regarding the supply of new shares from 
IPOs, noting that the China Securities Regulatory Commission 
could delay the dates of IPOs. 
 
¶15.  (SBU)  In addition to share reforms, the recent downturn 
may point to the need for additional financial products.  Fang 
and Chao noted that introducing index futures and short selling 
would allow investors to better hedge against risk, making the 
markets less volatile.  Chao, Fang, the JV manager and the 
financial consultant emphasized the need for broader margin 
trading as well, though they acknowledged the systemic risk this 
may introduce and its role in the stock market's fall in 2001. 
Fang noted that the absence of leverage this time may have 
contributed to the lack of protests over this market downturn, 
since individual retail investors' downside risks were smaller 
in the absence of leverage. 
 
¶16.  (SBU)  Prospects for these reforms are mixed.  The 
financial consultant said index futures are ready for launch, 
but government regulators  are reluctant to launch new financial 
products for fear that they could be held responsible by the 
investing public if introduction coincides with a further 
decline in the market.  DG Fang similarly opined that China's 
financial services regulators are risk averse.  Fang and the 
SSE's Chao also noted a current SSE controversy over warrants, 
the trading conditions for which some retail investors have 
claimed were biased against small investors.  They both believe 
warrants will no longer be allowed at the SSE, and that the 
controversy may only reinforce regulators' caution about 
introduction of new financial products.  Still, the JV manager 
speculated the CSRC is probably under pressure from the SSE and 
the Shanghai Municipal Government to introduce new products in 
pursuit of the city's goal of becoming an international 
financial services center.  Chao and Fang, our interlocutors 
from the SSE and the Shanghai Government respectively, are 
indeed enthusiastic about the launch of new financial products. 
 
Real Economic Impact of Shanghai Stock Market Downturn Remains 
Limited 
 
¶17.  (SBU)  Though the SSE market downturn has been substantial, 
our interlocutors are quick to emphasize that the impact on the 
real economy has been and will be limited.  China remains a 
magnet for foreign direct investment (and hot money) and China's 
trade surplus remains large.    The SCI decline's impact may be 
most apparent in lowering demand for luxury goods, DG Fang 
allowed.  The JV manager echoed this view, saying he expected 
auto sales in particular to decline.  He predicts that Shanghai 
auto dealership sales in May and June may decline 30 percent 
from the April volume.  SSE Research Department's Fu Hao, with 
whom we met in late May, highlighted that most companies in 
China still rely on bank loans and retained earnings rather than 
the stock market to raise capital.  Fu also noted that most 
investment in the stock market is surplus savings, income earned 
beyond what one had initially planned to consume and to save. 
The market downturn, by our interlocutors' analyses, will 
therefore not significantly affect consumer confidence outside 
of luxury goods. 
 
Investor's Reaction to Market Downturn Could Signal a More 
Mature Market 
 
¶18.  (SBU)  Despite the market's recent downturn and volatility, 
our interlocutors remain optimistic about the market's future. 
DG Fang noted that in the recent downturn, fewer firms went 
under, a sign that listed companies have stronger fundamentals 
then they had in previous downturns.  He also notes that fewer 
protests could be a sign that investors, especially retail 
investors, are beginning to better understand the risks 
associated with the stock market.  The financial consultant and 
JV manager expressed similar optimism that the SSE is showing 
signs of becoming a more mature market through the travails it 
is now enduring. 
JARRETT