VZCZCXRO9373
RR RUEHCN RUEHGH RUEHVC
DE RUEHBJ #3311/01 2400558
ZNR UUUUU ZZH
R 270558Z AUG 08
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC 9560
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHINGTON DC

UNCLAS SECTION 01 OF 02 BEIJING 003311 
 
SENSITIVE 
SIPDIS 
 
STATE PASS USTR STRATFORD 
USDOC FOR MCQUEEN 
NSC FOR HERMANN/SHRIER/LOI 
TREASURY FOR OASIA/ISA/DOHNER/HOLMER/WRIGHT 
 
E.O. 12958: N/A 
TAGS: CH ECON EFIN
SUBJECT: CHINA ECONOMY: OBSERVERS SEE LIQUIDITY HURTING, 
DISAGREE ON EFFECT 
 
¶1. (SBU) Summary:  In recent meetings with visiting 
Treasury Deputy Assistant Secretary Mark Sobel and 
Financial Min-Couns, long-time China observers agreed on 
the basic condition of the Chinese economy, but disagreed 
dramatically on the likely outcomes.  They agreed China's 
ability to sterilize fully the liquidity generated by 
protracted and large-scale foreign currency interventions 
is limited and that this is fueling an unsustainable credit 
boom and unbalanced growth.  Further, although the Chinese 
economy continues to face inflationary pressures, the 
government has recently (and in their view prematurely) 
shifted emphasis slightly from controlling inflation to 
assisting exporters and businesses hurt by the decline in 
external demand, rising input and labor costs, the 
Renminbi's appreciation and credit limits.  The analysts 
diverged on their predictions for the future, with one 
professor envisioning the possibility of a sharp 
deterioration in banks' assets leading to a credit crunch, 
and another analyst calculating that the Chinese economic 
leadership will find a way to "muddle through" these 
troubles as they have in the past.  End summary. 
 
Reserves Grow 
------------- 
 
¶2. (SBU) Beijing University Professor Michael Pettis 
discussed the self reinforcing cycle that promotes larger 
macroeconomic imbalances and ultimately could lead to 
financial instability.   Excessively loose monetary 
policies--due to insufficient sterilization of protracted 
and large-scale foreign currency intervention--leads to 
more investment in production, which outpaces consumption 
and then has to be exported.  This increases net exports 
and leads to further foreign currency intervention (given 
China's rigid exchange rate), providing more money for 
increased investment in production. 
 
¶3. (SBU) Banking analyst Charlene Chu said the People Bank 
of China (PBOC) is requiring banks to meet their reserve 
requirements in U.S. dollars to limit the rise in reported 
international reserves and as an alternative to sterilized 
intervention (since PBOC would otherwise have to sterilize 
the liquidity injected by purchases of foreign exchange). 
Most banks still have excess reserves, though among the 
banks, there is considerable variation.  For the sector as 
a whole excess reserves are nearing four percent, while 
officials suggest a range of 1.5-2.0 percent is prudent, 
which leaves little room for further increases in required 
reserves.  As such, she expects the PBOC to place more 
emphasis on raising administered interest rates and/or 
allowing a faster rate of RMB appreciation to tighten 
monetary conditions further in the future. 
 
Hot Money 
--------- 
 
¶4. (SBU) Pettis said that in 2006, at least 89% of 
international reserve accumulation could be attributed to 
FDI, the trade surplus, and interest earnings, with the 
remainder attributable to speculative flows.  He said that 
by 2007 that number had dropped to 70%, and will be 39% 
this year - implying that over 60% of China's net balance 
of payments surplus is due to net short-term portfolio 
inflows. 
 
¶5. (SBU) Dragonomics analyst Arthur Kroeber agreed that a 
significant amount of the reserve growth is attributable to 
net portfolio inflows, dismissing valuation gains and the 
impact of any mark-to-market effects of the central bank's 
fixed income holdings as marginal. 
 
Policy Direction 
---------------- 
 
¶6. (SBU) Commenting on the recent Politburo meeting to 
discuss the direction of economic policies, Pettis thought 
that in-fighting between the monetarists, who believe the 
rise in inflation has been due to excessive growth of 
monetary aggregates, and the export and real estate 
interests, who have been hurt by a tightening of monetary 
conditions (including through a more appreciated exchange 
rate), had gotten so bad that it required top level 
intervention to quell the dispute.  He said the "growth 
guys are back in control." 
 
 
BEIJING 00003311  002 OF 002 
 
 
¶7. (SBU) Kroeber agreed that the exporter lobby had 
successfully argued they are "at their limits."  However, 
he characterized the increase in credit quotas and VAT 
rebates in certain sectors as "pretty cosmetic," and 
thought even with some minor adjustment, policymakers would 
not fundamentally veer from their efforts to rebalance the 
economic growth.  He noted that the reduction in China's 
savings-investment imbalances is made more difficult by the 
fact that it still doesn't have the mechanisms in place to 
increase social services significantly.  But he thought 
consumer spending would start to increase on its own now 
that years of pent up housing demand were satisfied. 
 
¶8. (SBU) Both Kroeber and Pettis noted that Hu Jintao now 
had his people in place throughout provincial governments, 
making rebalancing easier to implement. 
 
Inflation 
--------- 
 
¶9. (SBU) Kroeber said China is now facing higher 
inflationary pressures, with estimated real unit labor 
costs now rising after several years of decline.  Pettis 
thought the politically tolerable floor on inflation might 
now be in the 2-5% a year range.  Both agreed that Chinese 
inflation would be a significant issue in coming years, and 
they also both noted that the current government finds 
inflation a greater risk to social instability ("scarier" 
in Kroeber's words) than slower growth. 
 
Predictions 
----------- 
 
¶10. (SBU) Pettis was extremely pessimistic about China's 
ability to maintain macroeconomic and financial stability, 
stating he had a "front seat to see the whole thing 
unravel."  Pettis thought that weaker external demand will 
prevent China from being abl to dump its excess production 
abroad, leading to higher inventories, domestic dumping, 
lowe profits, higher NPLs and ultimately a credit crunch 
as impaired banks pulled back on lending.  He also thought 
high inflation was inevitable unless China broke the cycle 
leading to ever-higher reserve accumulation and liquidity 
growth.  Pettis acknowledged that one scenario was 
deflationary and one inflationary, but argued that they 
would both end in a sharp rise in NPLs, a credit crunch, 
and reduced growth. 
 
¶11. (SBU) Kroeber, on the other hand, said he thought China 
had significant "shock absorbers" in the economy, and 
policy makers have significant experience in "wiggling out" 
of economic challenges.  He thought the current downturn in 
growth was cyclical, although longer lasting than previous 
cycles. 
 
Comment 
------- 
 
¶12. (SBU) Both Pettis and Kroeber are known for their deep 
knowledge of China and their strong opinions on its 
future.  In truth, China does have some serious structural 
problems that it has to address, including the 
over-reliance on investment, and the excessive liquidity 
and credit growth fueled by a large balance of payments 
surplus and a rigid exchange rate.  Chinese economic 
advisers and policymakers are very aware of these issues, 
and are seeking to promote a slow reduction in imbalances 
that keeps economic adjustment at a politically acceptable 
pace.  Kroger and Pettis highlight how an slow and cautious 
approach increases the risks of more disorderly future 
adjustments.  However most observers, both inside and 
outside the Chinese government, agree with Korber that, 
short of a major unanticipated shock, the Chinese have the 
will and the resources to avoid systemic financial 
distress. 
 
RANDT