VZCZCXRO6102
RR RUEHCN RUEHGH
DE RUEHGH #0264/01 1960840
ZNR UUUUU ZZH
R 140840Z JUL 08
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6972
INFO RUEHBJ/AMEMBASSY BEIJING 1960
RUEHSH/AMCONSUL SHENYANG 1288
RUEHCN/AMCONSUL CHENGDU 1290
RUEHGZ/AMCONSUL GUANGZHOU 1261
RUEHHK/AMCONSUL HONG KONG 1430
RUEHIN/AIT TAIPEI 1099
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGH/AMCONSUL SHANGHAI 7539

UNCLAS SECTION 01 OF 04 SHANGHAI 000264 
 
SENSITIVE 
SIPDIS 
 
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SF FRB 
FOR CURRAN/GLICK/LUNG; NY FRB  FOR 
CLARK/CRYSTAL/MOSELY/DAGES/DAWSON 
TREASURY FOR OASIA/INA - DOHNER, HAARSAGER, CUSHMAN, WINSHIP 
TREASURY FOR IMFP/SOBEL, MOGHTADER 
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PGOV CH
SUBJECT: SHANGHAI MARKET PARTICIPANTS DISCUSS HOT MONEY:   MARKET 
MEASURES, ADMINISTRATIVE CONTROLS, IMPACT ON RMB 
 
¶1.  (SBU)  Summary.  Shanghai market participants agree, hot 
money presents a serious challenge for Chinese monetary policy. 
With sterilization bills becoming increasingly costly to issue 
and reserve requirement ratio (RRR) increases hurting the 
profitability of an already constrained banking sector, there 
are few good options for controlling liquidity.  Instead of 
tightening monetary policy, our interlocutors in Shanghai and 
nearby suggest the Central Government will continue to try to 
restrict hot money using administrative measures to control 
inflows through the current and capital accounts.  Our 
interlocutors expressed confidence that capital and financial 
account controls would be effective, though they were less 
confident regarding current account controls.  Some felt newly 
adopted measures combining the monitoring capabilities of three 
government agencies would be sufficient, though others expressed 
skepticism.  Our interlocutors also opined that hot money would 
not affect RMB appreciation.  They note structural changes in 
the macro-economy, such as the shift from export-oriented growth 
to growth driven by domestic consumption, necessitating a 
market-determined RMB exchange rate.  End Summary. 
 
------------ 
Introduction 
------------ 
 
¶2.  (SBU)  Congen Econoff from June 19 to July 11 met with 
Shanghai financial market participants and macroeconomic 
analysts to discuss issues relating to hot money.  Meeting 
participants include Fudan University Professor Sun Lijian, 
Shanghai Academy of Social Sciences (SASS) Economist Xu Mingqi, 
PBOC Shanghai Head Office International Department Deputy 
Director-General Shi Liya, Hong Kong Trade and Development 
Council Regional Director for East China Brian Ng, Fortis 
Haitong Investment Management Analyst Zhu Mingjie, Taiwan 
Compatriot Investment Enterprises Association of Kunshan Deputy 
Chairman Huang Jiangzhong, and a general manager of a U.S. joint 
venture securities firm in Shanghai. 
 
---------- 
Background 
---------- 
 
¶3.  (U)  Since China adopted its present exchange rate mechanism 
in July 2005, the RMB has appreciated 21.1% against the U.S. 
dollar (as of July 11, 2008).  In the last 6 months, the RMB 
appreciated 13.4%, with an average appreciation of .05% per day. 
 As of July 11, one year forwards imply an annual appreciation 
of 5.6%.  The large expected appreciation of the RMB versus the 
dollar as well as a favorable interest rate spread with the U.S. 
has caused a large amount of speculative capital, commonly 
referred to as hot money, to flow into China.  The exact amount 
of hot money coming into China is difficult to discern, though 
most analysts agree it has grown substantially since the 
beginning of 2008.  For example, analyst Logan Wright at Stone 
and McCarthy estimates China's FX reserves grew by $393 billion 
USD in the first five months of 2008, of which he estimates up 
to $170 billion was hot money. 
 
--------------------------------------------- -- 
Most hot money coming in through FDI, 
Current account and bank deposits 
--------------------------------------------- -- 
 
¶4.  (SBU)  According to a survey done by Deustche Bank analyst 
Ma Jun, appearing May 28 on China financial website Caijing, 
foreign direct investment (FDI) is the most popular means of 
increasing RMB exposure by firms outside of officially 
sanctioned foreign exchange markets.  A Shanghai-based American 
management consultant and investor told Econoff in late May, 
foreign firms attempt to attain approval for investments larger 
then the specified projects require, using the onshore surplus 
funds derived thereby to make portfolio investments.  Huang 
Jianzhong, the Taiwan business association leader in Kunshan 
(just west of Shanghai, across the border in Jiangsu Province) 
readily admitted in a June meeting that Taiwan companies 
frequently use this channel.  Huang asserts that such investment 
transactions are entirely legal, so long as investments are 
approved by the appropriate mainland officials. 
 
SHANGHAI 00000264  002 OF 004 
 
 
 
¶5.  (SBU)  Huang in Kunshan and other interlocutors  also note 
companies use the current account, that is under-invoicing 
imports or over-invoicing exports, as a means of acquiring and 
retaining RMB.  Huang notes the ubiquity of this practice among 
firms engaged in trade.  According to Deutsche Bank analyst Ma 
Jun's above-referenced survey, trade invoice manipulation and 
the FDI channel account for 73% of hot money transactions made 
by firms.  Fudan University Economics Professor Sun Lijian notes 
that trade invoice manipulation is also a common means for 
foreign companies to avoid mainland regulations meant to slow or 
prevent profit repatriation. 
 
¶6.  (SBU)  The most common means for individuals to increase 
exposure to RMB appreciation is offshore transfers to RMB 
accounts.  Huang and HKTDC's Ng observe many Taiwan and Hong 
Kong individuals use this tool to increase RMB exposure.  China 
permits only one bank account per person and limits transfers to 
$50,000 USD per year, with holders of Hong Kong bank accounts 
allowed to transfer up to 10,000 RMB per day, these 
interlocutors explain.  The JV manager points out several Hong 
Kong banks with presences in the mainland now offer their 
customers services in which daily transfers into the mainland 
are automated.  Our interlocutors note popular press accounts of 
people from Taiwan and Hong Kong using the unused quotas of 
friends and relatives to make even larger transfers.  Ng 
suspects that growing concern over inflation may lead the 
government to eventually lower these quotas. 
 
¶7.  (SBU) Huang and Ng say both Taiwan and Hong Kong firms as 
well as individuals also use underground banks to convert 
currency.  Ng suspects this channel is used more often than the 
RMB account quotas.  Fudan Professor Sun asserts Taiwan firms 
are heavily involved in China's underground financial market. 
He observes many have been in China for nearly two decades and 
have had more time to build up liquidity than firms which have 
entered more recently, such as those who did not venture into 
China until after China's December 2001 accession to the World 
Trade Organization.  With exports losing competitiveness and 
declining due to an appreciating currency, higher fuel and raw 
material prices and increasing labor costs, (issues worriedly 
mentioned by Huang, the Taiwan business association leader, and 
HKTDC's Ng), these longer-established firm are using their 
accumulated liquidity to provide loans to other firms, providing 
an alternative source of income for China's cooling export 
sector.  Ng and Huang note many small and medium exporting firms 
are also increasingly aiming their production and sales at 
China's domestic market, again seeking payments in RMB and 
foregoing immediate repatriation of profits. 
 
--------------------------------------------- - 
Most hot money sitting in bank accounts, 
though substantial amounts may be entering 
through underground capital markets 
--------------------------------------------- - 
 
¶8.  (SBU)  As previously noted, hot money is difficult to track, 
with analysts not even sure how much hot money is actually 
entering China.  Determining where hot money is being invested 
is even more difficult.  Our interlocutors cite real estate as a 
destination, though they add with softening markets and ever 
higher hurdles placed on foreign investment, it is unlikely much 
more is going there now.  The most popular destination now, they 
suggest, is normal liquid bank accounts.  Ng notes that with 
modest interest rates and expected appreciation of over 6% 
annually, investors can earn a near risk-free 10% annual return 
on their investments.  PBOC Shanghai's Shi and the American JV 
manager similarly suggest that most inbound hot money is 
probably sitting in onshore bank accounts. 
 
¶9.  (SBU)  Fudan's Sun also suggests another popular destination 
for hot money is the informal banking sector, which has gained 
new life in the current tight credit environment.  A recent 
published survey by Professor Li Jianjun at Beijing's Central 
University of Finance and Economics estimates that 28% of all 
bank loans in China come from the underground banking sector. 
Our Shanghai interlocutors note that most underground banking 
sector loans probably go to small and medium enterprises, which 
 
SHANGHAI 00000264  003 OF 004 
 
 
are not able to obtain loans from the larger state owned 
commercial banks in the present credit environment. 
 
--------------------------------------------- - 
Left with few options, government is confident 
administrative measures will work 
--------------------------------------------- - 
 
¶10.  (SBU)  China's "managed float" exchange rate regime forces 
it to sterilize foreign currency inflows to prevent expansion of 
the money supply.  With the high volume of inflows lately, 
sterilization has become increasingly difficult.  PBOC 
Shanghai's Shi admits the PBOC's main tool, sterilization bills, 
are becoming increasingly costly to issue, with financial 
markets already saturated with bills from previous 
sterilizations.  Fortis Haitong's Zhu and Fudan's Sun note that 
increasing the reserve requirement ratio (RRR) is a much easier 
means of sterilization.  Zhu notes this is one of the few 
effective means the PBOC has to contract liquidity, and expects 
more RRR increases to come.  Sun is quick to point out, however, 
that current high or future higher RRRs could pose a serious 
risk for the banking sector if faced with a sudden demand for 
liquidity. He thus warns that the government must be careful 
when using RRR as a tool for managing the money supply.  While 
PBOC Shanghai's Shi did not express the same level of concern as 
Sun over the RRR, she did suggest the PBOC would use a 
combination of tools to address over liquidity, possibly 
including raising interest rates. 
 
¶11.  (SBU)  Our interlocutors offered different opinions 
regarding their expectation of government policies for dealing 
with inflation from over liquidity. SASS economist Xu believes 
that the government will use price controls in the near term to 
lower the CPI, removing some of the inflationary pressure from 
over liquidity.  He suggests China's central planning legacy 
makes Chinese officials more comfortable with price controls 
then other measures.  Fudan's Professor Sun however, believes 
the government will utilize quantitative restrictions as a means 
of controlling over liquidity.  He notes that the Central 
Government has stepped up monitoring of current and capital 
accounts, integrating the networks of SAFE, the Ministry of 
Commerce and General Administration of Customs.  By valuing the 
goods in customs transactions and comparing those values to 
payment amounts, PBOC could effectively control hot money 
entering or leaving through the current account, and help hedge 
against the possibility of capital flight were a financial 
crisis to occur.  Shanghai PBOC's Shi echoed this point, though 
she admitted implementation at the local level would be 
difficult.  Ng was less confident that such an approach would 
prove to be effective.  He notes trade in services continues to 
increase.  Services transactions are much more difficult to 
value then goods transactions, lacking a tangible good for SAFE 
to value. Services trade could thus become a prominent loophole 
for avoiding SAFE controls on hot money. 
 
------------------- 
Hot - and sticky? 
------------------- 
 
¶12.  (SBU)  The American JV manager suggests the government may 
have more flexibility in managing hot money than many expect. 
He believes that since most hot money is probably coming from 
Taiwan, Hong Kong and overseas Chinese elsewhere (a point echoed 
by our other interlocutors), hot money is less likely to rapidly 
flow out of China as it did in SE Asia during the 1997 Asian 
financial crisis, as these people will still require liquidity 
to support business operations in China.  This, in his words, 
makes the hot money inflows into China "sticky."  Though 
stickiness may lower the risk of capital flight, it will not 
help contain liquidity growth which poses risks for persistently 
high inflation. 
 
--------------------------------------------- - 
Interlocutors suggest hot money will not 
slow RMB appreciation 
--------------------------------------------- - 
 
¶13.  (SBU)  Fudan's Professor Sun does not believe the hot money 
 
SHANGHAI 00000264  004 OF 004 
 
 
issue will have any significant effect on the RMB exchange rate. 
 Instead he expects administrative measures will be sufficient 
to control hot money, while other tools can be used to combat 
over liquidity.  Shi and Zhu similarly argued that over 
liquidity and capital flight could be targeted using policies 
other than RMB appreciation.  HKTDC's Ng agrees, noting that in 
order for Shanghai to attain its goal of becoming an 
international financial center, China must first have a freely 
floating exchange rate.  SASS's Xu, however, believes the 
current level of hot money inflows is unsustainable, 
necessitating a slowdown of the RMB's appreciation until 
inflation comes down. 
 
¶14.  (SBU)  Despite acknowledging risks of gradual RMB 
appreciation, our interlocutors were skeptical of a one-off 
appreciation, even though such an action might immediately stem 
inflows.  Xu notes the damage a one-off appreciation would 
inflict on many exporters, who keep many urban workers employed. 
 Sun echoes this point, adding most export firms are not 
financially hedged against appreciation.  Sun notes that onshore 
RMB forwards exist, but they remain prohibitively expensive for 
most firms and relatively underdeveloped.  He adds that because 
many firms have known only a fixed exchange rate for so long, 
they do not know how or realize the need to hedge against 
appreciation. 
 
-------- 
Comment 
-------- 
 
¶15.  (SBU)  These Shanghai market participants and analysts 
expect the PBOC will continue to follow a gradual RMB 
appreciation policy, despite concerns over hot money and over 
liquidity.  PBOC Shanghai's Shi and Fudan Professor Sun framed 
this as part of a broader structural change national policy 
makers are trying to promote, namely the transition from 
export-driven growth to growth driven by domestic consumption, 
hence the importance of continuing RMB appreciation despite 
other monetary challenges.  RMB appreciation, ignoring the hot 
money aspect, is also consistent with PBOC's effort to fight 
inflation, they averred.  In sum, these interlocutors expect 
that for now, the PBOC is likely to continue to rely on RRR 
hikes and sterilization to remove liquidity, even though the 
cost of sterilization continues to rise. 
 
¶16.  (SBU)  Administrative measures also figure prominently in 
these interlocutors' expectations about government policy, 
particularly as a means of controlling inflows.  Professor Sun 
was the most confident administrative measures would be an 
effective method of controlling liquidity growth.  Other 
analysts, however, have expressed strong skepticism that with 
such large volumes of trade, China will be able to control the 
current account, and as Ng notes, services will likely remain a 
large loophole.  Though administrative measures would likely 
slow liquidity growth to a degree, they come with the 
externality of further empowering an unregulated and inefficient 
underground capital market, which may ultimately render such 
measures ineffective. 
JARRETT