VZCZCXRO3564
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #4402/01 3370611
ZNR UUUUU ZZH
P 020611Z DEC 08
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 1169
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
INFO RUEHOO/CHINA POSTS COLLECTIVE
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 05 BEIJING 004402 
 
SIPDIS 
SENSITIVE 
 
STATE FOR EAP/CM AND E/YON 
TREASURY FOR OASIA/DOHNER/WINSHIP 
TREASURY ALSO FOR IMFP/SOBEL/MOGHTADER 
NSC FOR LOI 
 
E.O. 12958: N/A 
TAGS: ECON EFIN CH
SUBJECT: CHINA/ECONOMY: DETERIORATION WAS SURPISING, 
FISCAL SUPPORT FORTHCOMING; FED GOVERNOR KROSZNERQS 
NOVEMBER 17-18 MEETINGS IN BEIJING 
 
THIS CABLE IS SENSITIVE BUT UNCLASSIFIED.  NOT FOR 
INTERNET DISTRIBUTION. 
 
¶1. (SBU) Summary.  Chinese financial officials and 
foreign economists and bankers told Federal Reserve Board 
Governor Randall Kroszner that recent deterioration in 
ChinaQs real economy was much faster than they had 
expected.  However, most were confident that the 
government would inject sufficient stimulus to ensure 
ChinaQs real GDP growth rate would not fall below 7-8 
percent in 2009.  Several contacts said they are 
concerned the rush to implement policies to cushion the 
cyclical downturn would undermine progress made in 
market-oriented reforms and rebalancing growth.  While 
all interlocutors welcomed the recently announced fiscal 
stimulus, none offered consistent explanations of how 
much would come from the central government and how much 
represented additions to existing expenditures.  Several 
contacts noted concerns that high level political support 
for fiscal stimulus would undermine efforts to increase 
the effectiveness of public infrastructure investment, 
giving the green light to local government boondoggles 
that had been held back due to concerns about overheating. 
 
¶2. (SBU) Summary, continued.  Several officials said that 
after fleshing out further details on the fiscal stimulus, 
the government will turn its attention to how to make 
banking operations and financial regulation and 
supervision less pro-cyclical, as banks are becoming 
increasingly market-oriented.  Some officials noted that 
the government is considering explicit guarantees to 
encourage bank loans to targeted sectors, rather than 
relying on the moral suasion and implicit guarantees that 
occurred during previous cyclical downturns.  Foreign 
banks continue to experience liquidity problems due to 
difficulties in borrowing from Chinese banks.  While most 
interlocutors believed the U.S. had entered a prolonged 
recession, they were also concerned about inflationary 
pressures, in both the U.S. and abroad, that would be 
unleashed from the Federal ReserveQs large-scale 
liquidity injections.  Although one foreign banker said 
Chinese banks have become more cautious about buying 
overseas assets, both CCB and CIC raised concerns about 
openness to Chinese investment in the U.S. financial 
sector.  End Summary. 
 
¶3. (SBU) During a November 15-18 visit to Beijing, 
Federal Reserve Governor Randall Kroszner participated in 
a Bank for International Settlements conference on Qthe 
role of banking and banking supervision in financial 
stability,Q hosted by the PeopleQs Bank of China (PBOC). 
Kroszner held separate meetings with Central Leading 
Group (CLG) on Financial and Economic Affairs Vice 
Minister Liu He, China Banking Regulatory Commission 
(CBRC) Chairman Liu Mingkang, China Securities Regulatory 
Commission (CSRC) Chairman Shang Fulin, Bank of China 
(BOC) Vice Governor Zhu Min, China Construction Bank 
(CCB) CEO Guo Shuqing, China Investment Corporation (CIC) 
Chairman Lou Jiwei,  Vice Chair Wu Xiaoling of the 
Financial and Economic Committee of the National PeopleQs 
Congress (NPC), Director Yu Yongding of the Institute of 
World Economics and Politics at the Chinese Academy of 
Social Sciences (CASS), and several foreign bankers and 
economists. 
 
ChinaQs Slowing Economy 
----------------------- 
 
¶4. (SBU) All of Governor KrosznerQs interlocutors agreed 
that the direct impact of the global financial crisis on 
ChinaQs financial sector was limited, but it now is 
negatively affecting ChinaQs real economy, especially the 
export sectors.  CIC Chairman Lou said the Qfinancial 
tsunamiQ had not hit China hard, but the global recession 
has a great impact on ChinaQs real economy.  CASS 
Professor Yu and CLG Vice Minister Liu said the recent 
slowdown has caught many officials by surprise but growth 
would not fall below 8%, an assessment generally shared 
by the other contacts.  Since October, industrial output 
has plummeted.  (Comment: NDRC officials told FINATT that 
November economic data is likely to show growth 
decelerating as fast, or even faster, than October data). 
Liu believed there will be no growth in 2009 in some 
 
BEIJING 00004402  002 OF 005 
 
 
sectors, such as heavy industry and textiles. 
 
¶5. (SBU) BOC Vice Governor Zhu noted that power and 
transport figures were down on a year-on-year basis for 
the first time in this growth cycle.  From the second to 
the third quarter, GDP grew only 4.6% on an annualized 
basis.  Exports were slow and there is serious 
overcapacity in steel and manufacturing.  The global 
financial crisis hit at a particularly bad time, because 
it impacted Christmas shipping and letters of credit at 
the time when exportersQ shipments usually peak.  Zhu 
said 70,000 companies have closed in the Guangdong area. 
However, consumption is still strong and is 
underestimated in official data (Comment:  Purchases of 
some motor vehicles and existing homes are included in 
fixed asset investment rather than consumption.).  Zhu 
estimated that the final real GDP growth figure for 2008 
would be 9%, and the economy would rebound quickly by the 
first or second quarter of next year, with 2009 growth 
reaching 7-8%. 
 
¶6. (SBU) CLG VM Liu said BeijingQs top priority now is to 
promote growth.  Inflation is no longer a concern as it 
will decline to 4% year-on-year for November, and next 
year there will be deflationary pressures due to excess 
capacity, weak demand and declining input prices. 
Unemployment is the biggest concern related to slowing 
growth, as the government is uncertain whether unemployed 
migrants will return home to the countryside or stay in 
the city and spark social instability.  Liu said the 
government needs to Qbreak the market principle to keep 
the market viable. 
 
Opportunities for Restructuring? 
-------------------------------- 
 
¶7. (SBU) Madame Wu of the NPC, who previously served as 
PBOC Deputy Governor, said China had Qtaken the long 
roadQ to reform, but the decline in the export growth 
rate due to the international financial crisis now was 
generating pressure to accelerate reform and structural 
adjustment.  This, she said, was Qnot a bad development, 
although the fall in export growth was not being 
compensated fast enough by domestic demand growth.  One 
western economist agreed, noting that the current 
situation presents an opportunity for China to reform: 
for example, he said it would be a good time for China to 
allow its agricultural prices to adjust to meet 
international prices.  Also, he believes the trade 
surplus will now need to come down more gradually, as 
there are millions of workers unable to find employment. 
He said some Chinese officials blame the United States 
for the global financial crisis, but China itself bears 
some responsibility due to its persistent trade surpluses 
and over-dependence on export-led growth.  He also 
believes China should have begun to appreciate the RMB 
much earlier, so that there would have been less 
investment in the export and import-competing sectors, 
leaving China less vulnerable to a slowdown in external 
demand. 
 
¶8. (SBU) Professor Yu of CASS said the GovernmentQs 
recently-announced stimulus plan had been prepared as a 
contingency earlier in the year.  He expressed concern 
that focus on slowing growth and the stimulus would 
undermine support for continued structural adjustment. 
Exports and investment have been the two engines of 
growth, but are too volatile and have led to excess 
capacity; for example, China has 600 million tons of 
steel productive capacity but only 300 million tons of 
sustainable domestic demand.  They have to decide whether 
to close the excess capacity or use fiscal policy to 
support it.  Yu argued that China having a more flexible 
exchange rate is not in the United StatesQ interest, as 
foreign exchange intervention helps support demand for 
U.S. financial assets.  Financial MinCouns Loevinger 
countered that since Chinese monetary authorities most 
likely hold more creditworthy assets than Chinese 
commercial investors, continued large scale foreign 
currency intervention exacerbates the retrenchment away 
from riskier financial assets. 
 
Fiscal Stimulus: Enough? 
 
BEIJING 00004402  003 OF 005 
 
 
------------------------ 
 
¶9. (SBU) Liu said the RMB four trillion (USD 586 billion) 
stimulus package includes RMB 600 billion each year (to 
2010) in central government money.  The central spending 
will result in a deficit of 0.6% of GDP this year and 
1.5% next year.  Both Liu and CIC Chairman Lou agreed 
this is not enough, and the number likely will have to 
increase.  Wu Xiaoling of the NPC said stimulus efforts 
should focus more on increasing consumption.  One western 
banker observed that the fiscal stimulus package would 
not help the SMEs that have been one of ChinaQs growth 
engines. 
 
¶10. (SBU) BOC Vice Chair Zhu said some observers are 
worried the stimulus package, by focusing on 
infrastructure investment, will exacerbate ChinaQs 
already capital-intensive growth, but most argue that 
China needs to Qsave the patient firstQ and then worry 
about structural problems.  He estimated the stimulus 
would add 3% to GDP in the next two years.  Much of the 
spending can come online within nine months.  Targeted 
projects include railways, nuclear power plants, and 
ports, but there also will be RMB 1.5 trillion for health, 
rural, and education spending.  He claimed a fiscal 
stimulus aimed at helping SOEs may not diminish ChinaQs 
productivity, as there is no evidence that the private 
sector is more profitable or efficient than SOEs.  China 
would have no problem funding the stimulus, as inflation 
and corporate debt are low, household debt is just 19.6% 
of GDP, and government debt is around 20%. 
 
¶11. (SBU) One western economist with close government 
contacts said the stimulus is more consumption oriented 
than it appears, since much of the investment will go 
into areas such as construction of passenger rail lines 
that will stimulate consumption.  He believes China will 
be able to implement the package fairly quickly, since 
most of the projects were already in the pipeline but on 
hold while the government was trying to cool the 
overheating economy.  He also thought China would be open 
to imported components when implementing the stimulus, in 
order to access better technology. 
 
ChinaQs Banks: Too Cautious? 
---------------------------- 
 
¶12. (SBU) CBRC Chairman Liu downplayed concerns about 
banking sector health, claiming it would remain solid 
even in the face of a two-year slowdown (with real GDP 
growth falling to 8% and some deflation).  According to 
BOC Vice Chair Zhu, the exposure of Chinese banks to the 
global financial crisis is limited.  In the subsequent 
economic downturn, however, he predicted non-performing 
loan (NPL) levels will rise and profitability will fall, 
but not to unmanageable levels.  He agreed with CBRCQs 
Liu that China has greatly improved its risk management 
and asset quality. 
 
¶13. (SBU) CLG Vice Minister Liu agreed the banking system 
is Qsound,Q but banks now are unwilling to extend credit 
to SMEs.  While the central government is currently 
focused on fleshing out details of the recently announced 
fiscal stimulus, its next task will be how to promote 
bank lending in a prudent manner.  One option being 
considered is for the central government to provide 
explicit guarantees to banks and specific interest 
subsidies to borrowers for loans to firms in targeted 
sectors, such as SMEs.  This would allow increasingly 
market-oriented banks to be compensated for taking credit 
risks.  The government is also trying to encourage 
lending through collective bonds, where banks borrow on 
behalf of a group of debtors; Qeverything is under 
discussion,Q he said.  Several foreign bankers and 
economists confirmed the central government is urging 
Chinese banks to lend, and the banks have extended more 
credit than is apparent.  Banks also appear to be 
shifting loans to larger borrowers at the expense of job- 
creating SMEs.  The same banker believes that as a result 
of increased lending, banks likely will face rising NPLs 
Q and the government will bail them out Q in the future. 
 
¶14. (SBU) Liu acknowledged that foreign banks continue to 
 
BEIJING 00004402  004 OF 005 
 
 
have liquidity problems due to the reluctance of Chinese 
banks to lend them RMB.  One western banker reported that 
despite PBOCQs agreement to allow foreign banks to 
increase their borrowing from foreign affiliates, SAFE 
would not allow the foreign banks to bring in funds.  CIC 
Chair Lou confirmed that banks were wary of extending 
credit, noting that despite government encouragement, 
banks would seek any excuse if they did not want to 
extend credit. 
 
¶15. (SBU) CEO Guo of the CCB said his bank focuses on 
infrastructure and long-term loans in the highway, energy, 
railroad, and housing sectors, so the government stimulus 
program would be very beneficial.  Bank profit growth is 
slowing, from 40% this year to an expected less than 10% 
next year, and many non-financial companies in China are 
losing money: 30% of steelmakers are posting losses and 
many exporters are closing, although CCB is not very 
exposed to that sector.  Guo said CCB would begin to 
suffer asset quality problems (NPLs are currently 2.2%) 
if GDP growth dropped below eight percent. 
 
U.S. Economy: Present and Future Worries 
---------------------------------------- 
 
¶16. (SBU) While all of Governor KrosznerQs contacts were 
concerned that the U.S. has entered a prolonged Japan- 
like recession of several years, they also expressed 
concern about the global inflationary impact of the 
Federal ReserveQs large injections of liquidity.  CSRC 
Chairman Shang said he believes the U.S. downturn would 
last a year or so, but also noted many Chinese experts 
are forecasting a 2-3 year recession.  CSRC Director 
General Tong Daochi was concerned that recent moves by 
the Federal Reserve to lower interest rates and increase 
liquidity would only lead to more asset bubbles.  The 
NPCQs Wu was concerned that the Federal ReserveQs 
excessively loose monetary bias was keeping the US dollar 
too low, with excess liquidity flowing to China, 
maintaining upward pressure on the RMB and downward 
pressure on ChinaQs interest rates, and promoting 
excessive investment. 
 
Investment in the U.S. 
---------------------- 
 
¶17. (SBU) Although one foreign banker said Chinese banks 
have become more cautious about buying overseas assets in 
light of domestic criticism of high-profile losses to 
date, both CCB and CIC raised questions about possible 
investments in the U.S.  CCB CEO Guo said his bank 
currently is considering overseas investments.  He said 
ChinaQs enormous reserves will decline in value in the 
long-term if they are kept in debt, so they should be 
diversified into equity.  More specifically, Guo asked 
about U.S. banking regulations limiting Chinese 
investment of 10% or more in a U.S. bank, and also CFIUS 
regulations triggering reviews if foreign investments 
exceed 10% of equity; the expected U.S. reaction to 
investing Chinese foreign reserves in large U.S. 
companies; and, the reaction to Chinese investment in 
non-bank and high-tech companies.  CCB also inquired 
about the status of its pending application to open a U.S. 
branch, and asked for approval to increase its equity 
stake in a U.S. bank from 5 to 10%. 
 
¶18. (SBU) Asked about his corporationQs interest in 
investment in U.S. banks, Chairman Lou said CIC had held 
QintenseQ negotiations with Morgan Stanley.  CIC 
eventually decided not to proceed Qfor many reasons,Q the 
most significant of which was its failure to receive from 
the U.S. Federal Reserve a written exemption from U.S. 
regulations and investment Qbarriers,Q including the Bank 
Holding Company Act.  Lou lamented that CICQs inability 
to increase its stake in Morgan Stanley had become viewed 
as a symbol of the United StatesQ lack of openness to 
Chinese investment. 
 
Comment 
------- 
 
¶19. (SBU) Officials appeared caught off guard by 
OctoberQs deceleration in growth and hinted that the 
 
BEIJING 00004402  005 OF 005 
 
 
economy may stall or even decline on a sequential basis 
in the fourth quarter.  Interlocutors stressed that the 
government had set a floor of eight percent real GDP 
growth.  However, it was apparent that reformers are also 
concerned that political issues related to slowing growth 
will strengthen the hand of vested interests, which want 
to slow or roll back efforts to continue market-oriented 
reforms and economic rebalancing.  In addition, the lack 
of consistent and coherent explanations from senior 
economic officials of the size and content of the fiscal 
stimulus supports the view that the RMB four trillion 
headline number was rushed out in advance of the G-20 
summit and the release of October economic data, with 
little consensus about its underlying content.  Few 
interlocutors saw the conflict in their concerns about a 
protracted and deep U.S. recession and future 
inflationary risks.  And, few agreed that the best way to 
address concerns about U.S. monetary policy is to pursue 
greater monetary policy independence through a more 
flexible exchange rate. 
 
¶20. (SBU) Governor Kroszner did not have an opportunity 
to review this cable. 
 
RANDT