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RR RUEHCN RUEHGH
DE RUEHGH #0369/01 2320851
ZNR UUUUU ZZH
R 200851Z AUG 09
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 8232
INFO RUEHBK/AMEMBASSY BANGKOK 0215
RUEHBJ/AMEMBASSY BEIJING 3028
RUEHBS/USEU BRUSSELS 0013
RUEHBY/AMEMBASSY CANBERRA 0047
RUEHCN/AMCONSUL CHENGDU 2169
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGZ/AMCONSUL GUANGZHOU 0627
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RUEHHK/AMCONSUL HONG KONG 2335
RUEHJA/AMEMBASSY JAKARTA 0024
RUEHML/AMEMBASSY MANILA 0092
RUEHMO/AMEMBASSY MOSCOW 0060
RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHUL/AMEMBASSY SEOUL 0530
RUEHGH/AMCONSUL SHANGHAI 8883
RUEHSH/AMCONSUL SHENYANG 2160
RUEHIN/AIT TAIPEI 1964
RUEHKO/AMEMBASSY TOKYO 0741

UNCLAS SECTION 01 OF 04 SHANGHAI 000369 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EAP/CM 
NSC FOR LOI, SHRIER 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN 
USDOC FOR ITA DAS KASOFF, MELCHER, SZYMANSKI, MAC/OCEA 
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP 
TREASURY FOR IMFP -- SOBEL/CUSHMAN 
STATE PASS CEA FOR BLOCK 
STATE PASS CFTC FOR OIA/GORLICK 
MANILA FOR ADB USED 
 
E.O. 12958: N/A 
TAGS: ECON CH EFIN EINV PGOV
SUBJECT: FEARS OF POLICY CHANGES DRIVE SHANGHAI STOCKS SLUMP 
 
¶1.  (SBU) Summary:  The Shanghai stock market's recent 18 
percent decline stems from three main factors, say ConGen 
Shanghai contacts: a more cautious Central Government stance 
regarding potential asset bubbles; profit-taking by some leading 
institutional investors; and an expected moderation to the flood 
of new money into the economy.  Most contacts indicated surprise 
with the speed and extent of the drop since the market hit its 
year-to-date high on August 4 -- one experienced observer called 
it "shocking."  Most see the market rebounding, with gains -- 
even if only small ones -- by the end of the year.  End Summary. 
 
 
============================ 
Background:  The 2009 Rally 
============================ 
 
¶2.  (SBU) The Shanghai Composite Index this year gained roughly 
90 percent through its peak of 3,471 on August 4.  From that 
point through mid-day August 20, the index fell to 2844, or over 
18 percent.  Price-earnings ratios soared to 30:1, compared to 
an average of around 19:1 in the two years prior to the bubble 
and 15:1 at the beginning of the year. (Comment:  The large run 
up can be attributed to (i) aggressive assumptions about a 
potential economic recovery, supported by a 7.9 percent GDP 
growth in the second quarter, (ii) the herd mentality of Chinese 
investors entering the market on the rebound, and (iii) 
expectations that the present loose monetary policy will 
continue.  End comment.) 
 
============================================= = 
Beijing Signals the Markets to Cool Down . . . 
============================================= = 
 
¶3.  (SBU) Our contacts say that policymakers are becoming wary 
of distortions in the Chinese economy as a result of the 
economic stimulus measures introduced in fall 2008.  These 
include the interrelated problems of asset bubbles, which some 
contacts see in the equities market as well as in the real 
estate sector, market speculation, and the potential degrading 
of loan performance.  According to Chinese press, Chinese 
regulators and state-owned banks became increasingly concerned 
that companies were funneling funds allocated for stimulus 
projects into the market.  One contact at a European bank 
estimated that up to RMB1 trillion of the RMB4 trillion 
government stimulus spending may have made its way into the 
market.  According to press, the Central Government responded to 
these potential issues with PBOC's second quarter monetary 
policy report, released on August 5, which indicated that 
tighter credit, increased scrutiny of loans, and a heightened 
focus on mortgage lending standards could be expected in the 
second half. 
 
=================================== 
. . . And What Beijing Says Matters 
=================================== 
 
¶4.  (SBU) Many contacts have emphasized that the China market is 
shallow and driven by political decisions and is not a 
reflection of the macroeconomy.  Over recent days, said two 
contacts, the government had been telegraphing "sell" signals to 
the market.  One bank's chief economist for China said Chinese 
policymakers probably welcome the market correction, with some 
officials estimating a decline of around 20 percent could help 
 
SHANGHAI 00000369  002 OF 004 
 
 
ease concerns of an asset bubble.  A Shanghai-based investment 
advisor separately reinforced the notion that some parts of the 
bureaucracy appear to be talking down the market, following a 
typical playbook: first "water down" the shares in the market 
through the sale of non-traded shares and small IPOs, then 
through larger IPOs; if the market is still deemed too high, 
expect to see imposition of higher transaction taxes on stock 
trading, reversing tax cuts previously taken to support the 
market. 
 
¶5.  (SBU) Our contacts are divided on the importance of stock 
market performance to the Chinese leadership in advance of the 
60th anniversary of the founding of the People's Republic of 
China on October 1.  The head of securities trading at a firm 
affiliated with a Western bank emphasized the importance of the 
upcoming National Day celebration, and said that a pullout by 
insurance companies from the market appeared to be driven by a 
calculation that the Central Government would start to tighten 
monetary policy after the National Day anniversary, reinforcing 
the need to lock in profits now.  The contact said that October 
was seen as being a definite "policy inflection point." 
However, a Shanghai-based investment adviser discounted the 
notion that the government would hold off changes until after 
October 1. He noted that the market fell prior to the Olympics, 
when some market players were hoping the government would prop 
it up. 
 
¶6.  (SBU) Still, Beijing may not want the market to fall much 
farther.  The chief economist said the PBOC did not expect such 
a strong market reaction to the central bank's rhetoric.  The 
head of an investment bank branch said that the Chinese 
government still wants some growth in the equities market, so 
the current Shanghai Composite Index level may be close to the 
bottom.  (Note:  As of August 20, market players sensed a shift 
back towards government support for a stable, if not growing, 
market, with Chinese press reporting that the China Securities 
Regulatory Commission has recently approved several 
stock-oriented funds.  Analysts anticipate that this will bring 
more investors into the market.  End note.) 
 
======================================== 
Institutional Investors Cashing in Gains 
======================================== 
 
¶7.  (SBU) Several sources noted the movement by insurance 
companies to trim the equities weight in their portfolios as a 
trigger to the selloff.   The head of a securities firm 
explained that insurance companies look for absolute gains, so 
that once they hit their annual target they decided to lock in 
profits.  Since half of insurance companies' investments in the 
market are through fund managers, this in turn forced those 
funds to sell off holdings, and led to a downward spiral.  Ping 
An Insurance started the selloff, said two contacts.  The 
securities firm head said that retail investors, on the other 
hand, are generally loath to sell at a loss, and therefore many 
are holding on to their stocks until a rebound.  An investment 
adviser made a similar call, saying that insurance companies and 
fund managers looked at the healthy second quarter results, and 
decided to liquidate their positions. 
 
¶8.  (SBU) The investment adviser pointed to an additional factor 
impelling investors to close out their positions.  He said that 
since there is no way to short the market in China, the only way 
 
SHANGHAI 00000369  003 OF 004 
 
 
to hedge risk is to sell off a position.  Another contact at a 
U.S. bank echoed this sentiment.  Mutual funds, hedge funds, and 
social security funds are changing their portfolio allocation, 
drawing down their equity holdings and moving into the bond 
market, she said.  Increased capital inflows to the bond market 
reflect this trend, though it is uncertain how widespread and 
fixed this movement will be.  The securities firm head said 
that--given the almost doubling of the market index this 
year--it was no surprise that there was some pullback. 
 
¶9.  (SBU) The decision by the People's Bank of China (PBOC) to 
begin "dynamic fine-tuning" was the perfect excuse for investors 
who believed stocks were already overvalued to cash-in on the 
equities market, according to the chief economist for China at a 
major Western bank.  (Comment:  High valuations and doubts about 
a timely recovery in the real economy, especially in light of 
the consumer price index falling 1.8 percent year-over-year and 
the producer price index down 8.2 percent, reinforce 
expectations that the PBOC will begin to draw back liquidity. 
End comment.) 
 
¶10.  (SBU) However, not all our contacts agreed that 
institutional investors are now waiting out the stock market. 
The head of China markets at a U.S. bank said institutional 
investors are still bullish, by-and-large, and they will 
probably re-enter the market again, in anticipation of a 
rebound. 
 
====================================== 
Liquidity Flood Seems to be Moderating 
====================================== 
 
¶11.  (SBU) Some contacts pointed to anticipation of an end to 
monetary easing, or an impending start for monetary tightening, 
as a reason for the stock market slump.  Many contacts pointed 
to concerns that sharp new lending growth in the first half had 
led to over-liquidity.  Some observers already see an impact 
from the lower new bank lending in July.  An investment adviser 
said that this had forced some companies to withdraw funds 
parked in the stock market in order to finance their investments 
in the real economy.  The head of an international investment 
bank branch agreed, saying that there is a "zero sum liquidity 
effect" in which July's lower lending has led corporations to 
liquidate some stock holdings bought with the easy credit 
available earlier this year.  The lead China analyst for a major 
bank said that the main driver of market fluctuations has been 
liquidity.  He noted that some are waiting to see the August and 
September new lending figures to see if the PBOC has shifted 
towards a tighter monetary policy. 
 
======= 
Comment 
======= 
 
¶12.  (SBU) Our contacts in Shanghai largely confirm that market 
insiders have been gaming the government's economic stimulus 
plan and flood of new infrastructure lending to make short-term 
profits on the stock market.  With Beijing offering more money 
to favored companies than they could profitably invest in the 
real economy, chances were high that some of the funds would 
find their way into the stock market.  Savvy investors were able 
to ride this wave up, but those ready to liquidate their 
positions before the government slammed closed the credit door 
 
SHANGHAI 00000369  004 OF 004 
 
 
again would make the highest gains.  That is why the July PBOC 
report rang a sell signal for the market, even if true monetary 
tightening does not begin for months -- everyone wanted to be 
the first one to the exit.  Looking forward, most market players 
are now hoping for the Central Government to offer policy 
support to keep the stock market from falling farther. 
CAMP