VZCZCXRO3344
OO RUEHCN RUEHGH RUEHVC
DE RUEHBJ #3307/01 3450712
ZNR UUUUU ZZH
O 110712Z DEC 09
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC IMMEDIATE 7163
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
INFO RHEHNSC/NSC WASHDC PRIORITY
RUEHOO/CHINA POSTS COLLECTIVE

UNCLAS SECTION 01 OF 05 BEIJING 003307 
 
SIPDIS 
SENSITIVE 
 
STATE FOR E, EAP, EAP/CM 
TREASURY FOR OASIA/DOHNER/WINSHIP, LOEVINGER 
STATE PASS FEDERAL RESERVE BOARD OF GOVERNORS/WARSH 
STATE PASS FEDERAL RESERVE BANK OF SAN FRANCISCO 
NSC FOR LOI 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PREL CH
SUBJECT: U.S. Federal Reserve Nov. 18-20 Visit to Beijing: 
Recovery, Rebalancing, and Reform 
 
¶1. (SBU) Summary.  Chinese officials and local and 
foreign bankers and economists told visiting Federal 
Reserve Governor Warsh and San Francisco Fed President 
Yellen that China's GDP growth has been boosted by 
successful fiscal and monetary policies, largely focused 
on infrastructure investment, and should reach 8.3-8.4 
percent in 2010.  Massive new bank lending over the past 
year may lead to an increase of non-performing loans 
(NPLs) in 2011 and beyond, but the government has the 
fiscal capacity to intervene if necessary.  Discussion of 
stimulus exit strategy already is under way within the 
government, but is complicated by perceived needs to 
further consolidate economic recovery while avoiding any 
resurgence of inflation that could provoke social 
instability.  Some Chinese contacts are concerned about 
the U.S. recovery and revival of external demand for 
China's exports, while other observers view resumption of 
fiscal, social security, and financial sector reforms 
that would promote longer-term economic rebalancing as 
more important and urgent needs. 
 
¶2. (SBU) Summary, continued.  One government economist 
said China is taking a two-step approach toward managing 
the economy: first, arrest the downturn -- which has been 
done -- and then continue the rebalancing that began 
before the crises.  For that reason, the focus of 2010 
stimulus spending will shift from large-scale 
infrastructure projects to social sectors, including 
health and education, low-income housing, and training. 
Job creation, primarily in the services sectors, also 
will be a key concern.  While China has made some 
progress toward rebalancing, most economists urge further 
opening of the service sectors to private sector 
participation and measures to make urbanization "more 
permanent" by regularizing the status of migrants and 
their families, which would generate more labor-intensive 
service-sector urban growth.  While one official said the 
Chinese Government's fear of rising unemployment hinders 
significant near-term RMB appreciation, several 
economists said there is widespread recognition that the 
currency is undervalued and that broader price reform 
also is needed to sustain growth.  Several contacts 
raised concerns regarding the U.S. economic and fiscal 
situations, including the possibility of a "W-shaped" 
recovery, the danger of high inflation that would erode 
the value of China's USD-denominated investments, the 
rising U.S. fiscal deficit, the downward trend of the U.S. 
Dollar, and the current high unemployment level.  End 
Summary. 
 
¶3. (SBU) During their November 18-20 visit to Beijing, 
U.S. Federal Reserve Governor Kevin Warsh and Federal 
Reserve Bank of San Francisco President Janet Yellen 
discussed a broad range of U.S., China, and global 
economic and financial topics with senior Chinese 
officials and Chinese and foreign bankers and economists. 
The Federal Reserve delegation met with Executive Vice 
President Wang Yiming of the Academy of Macro-economic 
Research (AMR), National Development and Reform 
Commission (NDRC); Vice Chairman Gao Xiqing, China 
Investment Corporation (CIC); Vice Chairman Yao Gang, 
China Securities Regulatory Commission (CSRC); Vice 
Minister Liu He, Central Leading Group (CLG) on Financial 
and Economic Affairs; and other Chinese bankers and 
officials.  The Fed visitors also participated in a 
roundtable discussion with five Beijing-based economists: 
Senior IMF Resident Representative Vivek Arora, UBS Head 
of China Economic Research Wang Tao, Dragonomics Managing 
Director Arthur Kroeber, World Bank Senior Economist 
Louis Kuijs, and Guanghua School of Finance Associate 
Professor Michael Pettis. 
 
China's Economy: Successful Stimulus Policies 
--------------------------------------------- 
¶4. (SBU) According to NDRC/AMR Vice President Wang, 
domestic factors caused China's economic growth to slow 
in the third quarter of 2007, a trend then accelerated by 
the global crisis.  Government stimulus programs reversed 
this momentum in the second and third quarters of 2009, 
bringing GDP growth for the first nine months of 2009 to 
7.7 percent.  Of this total, investment contributed 7.1 
percent, consumption four percent, and net exports 
negative 3.6 percent.  Wang expected fourth quarter GDP 
 
BEIJING 00003307  002 OF 005 
 
 
growth to be higher due to the low base of fourth quarter 
¶2008.  He said the consensus estimate for 2009 GDP growth 
was 8.3-8.4 percent.  For 2010, Wang believes two key 
growth engines, investment and consumption, might 
moderate as investment in real estate slows and 
government programs to promote consumption wind down. 
Vice Minister Liu He said China's 2010 GDP growth should 
reach eight percent or higher, based in part on 
expectations of two percent U.S. GDP growth (three 
percent globally). 
 
¶5. (SBU) Although some observers questioned the stimulus 
focus on infrastructure construction, Dragonomics' 
Kroeber said China had huge infrastructure needs so this 
spending had not been wasted.  Several hundred million 
people needed relocation to the cities, requiring much 
more infrastructure, and some funded projects are 
anticipatory or addressed economic transformation, such 
as the high-speed railways.  At worst, he believed China 
had "borrowed" some future growth by front-loading 
infrastructure spending.  UBS' Wang agreed, observing 
that China was going through rapid industrialization for 
which it "cannot have too much" capital stock.  The 
primary concern was whether there was any misallocation 
of resources, not whether there was an overall excess. 
Kroeber also observed that China's use of bank credit 
rather than fiscal revenue to finance much of the fiscal 
stimulus enabled it to "postpone indefinitely" any 
repayment problems that arose.  If the stimulus program 
was extended for multiple years, however, the financial 
burden might cause problems. 
 
¶6. (SBU) Asked whether Chinese banks were encouraged to 
extend stimulus lending to preferred entities, one senior 
Chinese bank executive said his state-owned bank had 
"never been asked to lend to special projects."  He 
observed that China, unlike the United States and the 
European Union, still had a low overall debt ratio and 
considerable space to increase lending and domestic 
consumption.  The banker conceded, however, that new bank 
lending often flowed to industries with overcapacity, 
rather than Beijing's preferred recipients.  He also 
claimed the central government issued careful guidance on 
the types of business allowed to receive loans, as it 
wanted to support private consumption and investment 
through small and medium-sized Chinese enterprises. 
 
NPLs: Future Concern 
-------------------- 
¶7. (SBU) In part due to credit flowing to certain 
industries already burdened with overcapacity, the IMF 
was worried about a resurgence in non-performing loans 
(NPLs).  Arora said loans extended to households and 
infrastructure projects were not concerns, but 60-70 
percent of the stimulus-fueled credit expansion is "dark 
matter."  Nonetheless, he believed NPLs were a concern 
for 2011-12, if not 2009-10, but he did not expect the 
NPL ratio to reach double digits, as it has in the past. 
Also, the government had the fiscal capacity to intervene 
if necessary.  The IMF considered loan growth of 17 
percent in 2010 credible, but a more rapid increase would 
be worrisome.  Guanghua's Pettis echoed Arora's concern 
about this year's lending flood, opining that the massive 
increase was a step backward for China's banks.  He also 
believed there was considerable hidden debt at the 
provincial and local levels, while large amounts of old 
bad debts (from the banks previous quasi-fiscal role 
supporting state-owned entities) had not been fully 
resolved.  Kroeber agreed, noting that government and 
bank statistics did not reveal the entire debt, although 
he also said the government had hidden assets that could 
be "unlocked," as was done through housing reform in the 
late 1990s. 
 
Exit Strategies: When and How? 
------------------------------ 
¶8. (SBU) CSRC Vice Chairman Yao said discussion of 
stimulus exit strategy had begun, since China's proactive 
policy measures enabled it to recover earlier than other 
countries.  He was not certain this year's eight percent 
GDP growth rate was sustainable; if not, then exit from 
the stimulus would be premature.  Yao believed China 
faces a dilemma: with real economic recovery not yet 
 
BEIJING 00003307  003 OF 005 
 
 
assured and consumer price inflation still negative, 
China was likely to continue the stimulus package; at the 
same time, however, Beijing already had injected enormous 
liquidity into the markets, so asset price bubbles might 
arise.  Noting that China's equity market had risen 
almost 100 percent since its lowest point, and that the 
current price-to-earnings ratio was almost thirty, Yao 
believed China's recovery had been too fast.  It had been 
fueled by government investment and bank loans, which 
needed to be replaced as primary drivers by private 
consumption.  Until that happened, Beijing was adjusting 
policies slightly rather than moving to an exit.  Vice 
Minister Liu also worried about potential "bubbles" 
developing in Hong Kong, Shanghai, and Beijing real 
estate markets. 
 
¶9. (SBU) Several of the roundtable economists broadly 
confirmed Yao's assessment.  The IMF's Arora said the 
government was not convinced the recovery was here to 
stay, so it probably would continue fiscal stimulus 
through 2010 while gradually unwinding monetary measures. 
Wang of UBS observed that China was concerned about the 
U.S. recovery and also debating how serious the crisis 
really was, given the quick recovery of many indicators, 
and the outcome of this assessment would affect both exit 
timing and measures to address structural imbalances. 
She believed Premier Wen Jiabao was worried about the 
"doomsday scenario" and was reluctant to "take the foot 
off the pedal" too soon, so the concern was that China 
would tighten too late rather than too early.  Wang also 
said the central government was opposed to a sharp credit 
curtailment, so for 2010 there was risk that prolonged 
loose credit would bring a "boom and bust" scenario. 
 
Other Concerns 
-------------- 
¶10. (SBU) Various interlocutors listed other concerns for 
the short term.  According to Wang of the NDRC/AMR, two 
major uncertainties were recovery of external demand and 
rising inflationary pressure, which would have serious 
implications for macro-economic decision-making in 2010. 
He said China needed both to stabilize economic growth 
and to stem inflation next year, which would be difficult. 
For external demand, the United States was a key factor: 
for every one percent decline in U.S. GDP, China's 
exports fell five percent.  Kuijs said the World Bank was 
not concerned about inflation, as the supply side was 
responsive, but fiscal, social security, and financial 
sector reforms -- all of which faced political obstacles 
-- were important and/or urgent. 
 
Rebalancing 
----------- 
¶11. (SBU) NDRC/AMR Vice President Wang said the 
government was taking a two-step approach toward managing 
the economy: first, arrest the downturn -- which had been 
done -- and then continue the rebalancing that began 
before the crises.  For that, China needed to boost 
consumption by increasing the role of the domestic 
economy, rather than exports, in economic growth.  More 
investment in social welfare, including health care, 
rural, education, and pension programs also was needed. 
In that regard, CLG Vice Minister Liu said China's 2010 
stimulus spending would approach 2009 levels, but the 
focus would shift from large-scale infrastructure to 
health, education, low-income housing, and training.  He 
noted China's needed to address production overcapacity, 
while cautioning that a premature U.S. economic recovery 
might soften China's efforts to enact deeper, more 
painful rebalancing reforms.  Liu said China's foremost 
challenge would remain job creation, with a particular 
focus on services. 
 
¶12. (SBU) Arora (IMF) observed that if the global crisis 
resulted in increased household income and consumption as 
well as good infrastructure investments in China, then it 
would be seen as good for China; if, however, China 
responds as it has in the past -- with more investment in 
manufacturing -- then the crisis would be a negative 
influence.  For now, the IMF saw more of the former than 
the latter, and China also had made progress on boosting 
pensions and other social security programs to encourage 
household consumption.  China also had taken measures to 
 
BEIJING 00003307  004 OF 005 
 
 
improve availability of financing for small firms, and to 
reform corporate dividends.  Arora said the country's 
primary goal was employment, for which service sector 
growth was more beneficial than manufacturing. 
 
¶13. (SBU) The World Bank's Kuijs said China had begun to 
address its neglect of social safety net, environment and 
energy problems with its eleventh five-year plan (2006- 
10).  This plan was a good vision with advances in some 
areas (e.g. pricing and environment), but overall 
progress had been insufficient to alter the course of the 
"very heavy ship" of China's growth pattern.  Kuijs said 
most economists offered similar policy recommendations: 
open the service sectors to private sector participation 
and make urbanization "more permanent" by regularizing 
the status of migrants and their families, which would 
generate more labor-intensive service-sector urban growth. 
At present, migrant workers were not really involved in 
the urban economy. 
 
¶14. (SBU) UBS' Wang agreed with Kuijs' analysis, 
observing that China essentially had a system of "dual 
citizenship" based on place of birth (urban verses rural). 
A more important factor for rebalancing, however, was 
that local officials were judged by their GDP growth 
rates, and capital-intensive growth tended to be faster, 
so the government needed to change the incentive system 
for these officials.  There also was a bias in the tax 
system, as services were taxed as revenue and this type 
of tax was difficult to collect, so local officials were 
not eager to encourage further development of the service 
sector.  Finally, there were many state-owned monopolies 
in the services sector that did not welcome competition; 
the government often cited "strategic" or "national 
security" justifications for these monopolies. 
 
¶15. (SBU) Pettis (Guanghua School) argued that 
expectations of a coming surge in private consumption 
were overblown, primarily due to constraints on household 
income and channeling of capital from households to 
industrial sectors.  Traditionally low interest rates 
also were a part of this problem that was not likely to 
improve in the near future, as state-owned enterprise 
(SOE) profitability depended on low interest rates. 
Pettis said policies to remove subsidies enjoyed by SOEs 
and to reverse flows away from household sector were 
needed, but the transition to a more consumption-based 
economy would be gradual.  He believed rechanneling 
capital to small and medium-sized companies and the 
service sectors would produce a large growth burst, but 
required a political decision.  Pettis estimated, however, 
that even without major economic restructuring, and 
assuming no unexpected major problems, China should 
average 5-7 percent GDP growth over the next 5-10 years. 
If the U.S. no longer absorbed China's exports, then the 
nature of the problem changed and China's development 
model no longer worked. 
 
¶16. (SBU) Kroeber (Dragonomics) offered two general 
observations: first, although the nature of China's 
challenge now was qualitatively different than in the 
past, China's policy mechanism had earned the "benefit of 
the doubt" due to past success; and second, for any self- 
sustaining growth mechanism, whenever the state retreats 
there is an automatic productivity increase.  China had 
serious structural issues to address, and after thirty 
years of using capital accumulation to increase labor 
productivity, now the "demographics were turning negative 
forever."  Kroeber believed, however, that China had 
sufficient "breathing space" to keep growth going while 
making structural adjustments.  The key was to ensure 
capital pricing was correct; if not, then China would 
"hit a wall" in the 2020s when demographics were most 
negative. 
 
Exchange Rates 
-------------- 
¶17. (SBU) Vice Minister Liu said the Chinese Government's 
fear of rising unemployment prevented near-term currency 
appreciation, but added that "some market-oriented 
reforms" would continue.  Wang of UBS said the People's 
Bank of China wanted to "untie at least one hand" (for 
monetary policy) by allowing more exchange rate 
 
BEIJING 00003307  005 OF 005 
 
 
flexibility, as noted in its latest monetary policy 
report, but did not have the deciding voice on this issue. 
She dismissed the negative coverage of the exchange rate 
issue in the  foreign media during President Obama's 
visit to China, observing that references to adjusting 
"relative prices" in the joint communiqu essentially 
referred to exchange rates.  Wang said "everyone agrees" 
the RMB was undervalued; since land and energy also are 
under-priced, fixing those imbalances would be equivalent 
to a real exchange rate shift.  She expected to see an 
exchange rate adjustment in 2010.  Similarly, the IMF's 
Arora said the exchange rate issue did not stand alone 
and was part of a broader problem of relative prices and 
reorienting investment away from the tradeable sectors. 
China's moves on prices, social safety net, etc., had 
been in the right direction, but the exchange rate had 
moved in the wrong direction, so the world's largest 
surplus country had a depreciating currency.  Arora also 
believed European governments should be complaining about 
RMB depreciation.  CIC Chairman Gao said his company must 
be RMB-neutral, but the PRCG was under pressure to 
appreciate its currency, which he thought Beijing 
eventually would do. 
 
¶18. (SBU) Kroeber of Dragonomics said there was a clear 
inflationary risk for asset prices in 2010, closely 
related to the exchange rate issue.  China had deferred 
exchange rate appreciation for several years, but next 
year it would need to choose between appreciation and a 
rise in inflation.  China no longer could "fudge" the 
issue through sterilization.  It was difficult, however, 
because the government "hates" both exchange rate 
appreciation and inflation, the latter because it was 
socially destabilizing (he believes this "paranoia" is 
exaggerated).  China tried gradual appreciation from 2005 
to 2008, with bad consequences: the rest of the world 
"threw capital" into China. 
 
U.S. Economy 
------------ 
¶19. (SBU) Several contacts raised various concerns 
regarding the U.S. economic recovery.  AMR Vice President 
Wang said the NDRC closely followed U.S. economic 
developments, including the prospects for a "W-shaped" 
recovery.  CLG Vice Minister Liu worried that the U.S. 
might revert to old patterns if deep reforms did not take 
hold, possibly resulting in high inflation that would 
erode the value of China's USD-denominated investments. 
He also questioned whether U.S. stock indexes and global 
commodity prices were climbing too rapidly, and suggested 
capital flight from the U.S. may be to blame for current 
Asian asset "bubbles."  Similarly, CSRC Vice Chairman Yao 
opined that interest rates in the United States were 
driving capital flows into emerging markets, such as Hong 
Kong.  He also said China was concerned about future U.S. 
fiscal and monetary policies as well as the rising U.S. 
fiscal deficit and the downward trend of the U.S. Dollar. 
 
¶20. (SBU) CIC Vice Chairman Gao said the United States 
was unique due to the size of its economy; with eighty 
percent of its valuation in U.S. dollars, CIC's view of 
the United States and the USD also was rather unique.  At 
the same time, however, CIC has liabilities in RMB.  Gao 
said CIC "becomes nervous" when it looked at how much 
money the United States had been printing, and they 
believed a U.S. policy mistake could induce a double-dip 
recession or a major fall in the market.  CIC's head of 
strategic research said he agreed the U.S. economy and 
U.S. companies were dynamic, noting that the United 
States was more flexible in restructuring but the 
European Union could more easily accommodate unemployment 
due to its social system.  He believed it was difficult 
for the United States to have unemployment above ten 
percent, as that would induce problems in the social 
security network. 
 
¶21. (U) The Federal Reserve delegation has cleared this 
report. 
 
HUNTSMAN