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RR RUEHCN RUEHGH
DE RUEHGH #0023/01 0220737
ZNR UUUUU ZZH
R 220737Z JAN 10
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 8496
INFO RUEHBJ/AMEMBASSY BEIJING 3263
RUEHCN/AMCONSUL CHENGDU 2356
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGZ/AMCONSUL GUANGZHOU 0813
RUEHHK/AMCONSUL HONG KONG 2528
RUEHLO/AMEMBASSY LONDON 0063
RUEHML/AMEMBASSY MANILA 0151
RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHFR/AMEMBASSY PARIS 0042
RUEHUL/AMEMBASSY SEOUL 0653
RUEHSH/AMCONSUL SHENYANG 2347
RUEHGP/AMEMBASSY SINGAPORE 0315
RUEHIN/AIT TAIPEI 2145
RUEHKO/AMEMBASSY TOKYO 0864
RUEHGH/AMCONSUL SHANGHAI 9163

UNCLAS SECTION 01 OF 04 SHANGHAI 000023 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EAP/CM 
NSC FOR MEDEIROS, 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 
PARIS FOR US/OECD 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV PGOV CH
SUBJECT: CHINA CAUTIOUS ON DERIVATIVES, SHUTTING OUT FOREIGN BANKS 
 
REF: A. A) 09 SHANGHAI 401 
     ¶B. B) 09 SHANGHAI 185 
 
¶1.  (SBU) Summary:  Chinese government regulators remain 
generally cautious of introducing new derivatives products in 
China, and some continue to seek to restrict products previously 
offered by foreign-invested banks.  Foreign banks remain largely 
shut out of the market for foreign exchange swaps and interest 
rate swaps.  Foreign banks are also disappointed with progress 
so far on granting them permission to trade and underwrite 
Chinese corporate bond offerings.  End Summary. 
 
========== 
Background 
========== 
 
¶2.  (SBU) Visiting Treasury Department International Economist 
Benjamin Cushman met with several Shanghai-based contacts on 
China's derivative markets December 15-16.  These included Frank 
Sirna, chief financial officer, and Paulus Mok, head of markets 
and country treasurer, Citi China; Zhang Xiaogang, R&D head, 
China Financial Future Exchange (CFFE); Chao Kejian, head of the 
Offering & Listing Department, Shanghai Stock Exchange; David 
Liao, managing director and head of global markets, HSBC China; 
Racky Shum, executive director, credit & rates markets, China, 
and head of rates trading, J.P.Morgan Chase China; and Raymond 
Yin, executive director, Gaohua Securities (a joint venture with 
Goldman Sachs). 
 
¶3.  (SBU) Chinese banks on September 16 began requiring 
foreign-invested locally incorporated banks to supply guarantees 
from their parent bank holding companies as a precondition to 
signing a new version of a derivatives trading "master 
agreement".  (See ref A.)  The new request from Chinese banks 
came against a backdrop of increased caution on the part of both 
Chinese regulators and Chinese banks regarding the riskiness of 
counterparties and of derivative products.  Few foreign banks 
supplied a parent-company guarantee by the deadline for 
concluding the new master agreements.  Also in September, 
China's State-Owned Assets Supervision and Administration 
Commission (SASAC) announced that it would support Chinese 
state-owned companies wishing to renege on what SASAC described 
as improper derivatives contracts. Starting in spring 2009, many 
foreign firms have expressed concern regulators are moving 
slowly on opening the Chinese corporate bond market.  (See ref 
B.) 
 
========================================= 
Regulators Remain Cautious on Derivatives 
========================================= 
 
¶4.  (SBU) Chinese government regulators remain generally 
cautious about introducing new derivatives products in China, 
and some continue to seek to restrict products previously 
offered by foreign-invested banks.  A Chinese financial official 
noted that the Central Government is still focused on 
implementing the economic stimulus package and assuring growth, 
and has no time to develop derivatives markets.  A manager in a 
foreign-invested locally incorporated bank said that regulators 
are pushing back timetables for new products in the aftermath of 
the financial crisis.  Several noted that Chinese retail 
investors do not understand the risks of the market, and 
regulators are taking time to build in protections for them. 
 
¶5.  (SBU) CFFE officials said that top Chinese leaders still 
have not given the go-ahead for what is expected to be the 
exchange's first product -- stock market index futures -- after 
 
SHANGHAI 00000023  002 OF 004 
 
 
three years of mock trading.  (Note:  On January 8, Chinese 
media reported that the State Council has endorsed in principle 
the launch of stock index futures, with regulators suggesting 
final preparations could take three months.  End note.)  Since 
the financial crisis broke out, CFFE has been developing 
"investor suitability regimes" that weed out unsophisticated 
retail investors and attract institutional investors. CFFE 
officials were concerned that investors would be unable to 
distinguish the differences between a futures contract and a 
share.  Investors will probably have to demonstrate a 
significant net worth (at least RMB500,000 to invest), pass a 
test on futures trading, and first participate in mock trading. 
In addition, investors will most likely be required to put down 
a 12 percent margin on trades, rather than the 10 percent 
previously considered. 
 
¶6.  (SBU) Several contacts commented on a newly proposed 
clearinghouse for spot currency trades and over-the-counter 
(OTC) derivative deals, which regulators hope will provide 
better information on exposures among market players.  One 
Chinese financial official said the clearinghouse is being 
pushed by the People's Bank of China (PBOC), and shareholders 
will include the China Foreign Exchange Trading System (CFETS -- 
a PBOC-sponsored platform for foreign exchange trading, RMB 
lending and bond trading, and other financial transactions), the 
Ministry of Finance (MOF), and China Government Securities 
Depository Trust & Clearing Co., Ltd.  (a clearinghouse for 
bonds established by PBOC and MOF).  However, details remain 
sparse.  Another noted the difficulty of posting OTC 
transactions on CFETS, since the frequently one-off OTC deals 
can't be quantified according to the usual standards; also, 
public posting leads to copycatting that drives down profit 
margins. 
 
============================================= ===== 
Stand-Off on Derivatives Master Agreements Continues 
============================================= ===== 
 
¶7.  (SBU) Foreign-invested locally incorporated banks remain 
largely shut out of the market for foreign exchange swaps and 
interest rate swaps, say our contacts.  Several point to Bank of 
China (BOC) as the source of the difficulties, since BOC was 
"burned" on several foreign exchange deals and has the largest 
forex exposure of the major Chinese banks.  For instance, BOC 
held off signing any bilateral bank-to-bank agreements on the 
terms of derivatives trades (known as a "master agreement") 
until the deadline of September 16, 2009, and on that day signed 
with several -- all Chinese banks.  Some foreign bankers pointed 
to a related, but more systemic, problem:  Chinese banks, 
including BOC, are not adept at handling collateral that 
foreign-invested banks are willing to use to backup their 
derivatives trades. 
 
¶8.  (SBU) While foreign-invested locally incorporated banks are 
not able to carry on derivatives trades as before, our contacts 
hold different perspectives on how this impacts their bottom 
line.  One foreign banker asserted derivatives trading is down 
by 30 percent since the September 16 deadline passed.  Another 
said liquidity in the market is down, and hedging is more 
expensive, but that since the renminbi exchange rate has 
remained pegged to the U.S. dollar in recent months, part of the 
drop off in transactions reflects less need for hedging.  Two 
contacts pointed out that transaction volume may actually be as 
high or higher than previously because foreign banks are using 
"bridge banks" -- smaller local banks with which they have 
signed master agreements -- and therefore more transactions are 
 
SHANGHAI 00000023  003 OF 004 
 
 
recorded to complete each deal.  A third foreign banker noted 
that the onshore market in China is tiny compared to the 
offshore market, where Chinese banks continue to deal 
derivatives with foreign banks even without a master agreement. 
 
¶9.  (SBU) An executive at one foreign-invested locally 
incorporated bank said that resolving the derivatives master 
agreement issues is the "critical, number one issue to be 
resolved in 2010."  Several noted that discussion will be taken 
up by the National Association of Financial Market Institutional 
Investors (NAFMII), a nominally self-regulatory industry body 
that is a spin-off from the PBOC.  Two contacts said that the 
China Banking Regulatory Commission (CBRC) has been very 
supportive of a resolution.  In the end, said one foreign 
banker, market demand for hedging instruments may play the 
crucial role. 
 
============================================= ====== 
Threats to Renege on Derivatives Contracts Receding 
============================================= ====== 
 
¶10.  (SBU) SASAC in September 2009 stirred up concerns that it 
was encouraging state-owned enterprises (SOEs) to refuse to pay 
when derivatives contracts turned against them, but our contacts 
now see little chance that this will happen.  Several contacts 
pointed to a November 30 speech by SASAC Vice Chairman Li Wei as 
helping to calm the waters.  That said, SOEs are clearly 
becoming more cautious about taking on risky derivatives, with 
one banker with a major foreign-invested derivatives player 
saying his bank had not written a structured deal in six months. 
 Another foreign banker said that he would not be surprised, 
however, if one or two SOEs reneged on a derivatives contract 
because the contract was entered into irregularly.  (Note: 
According to Chinese regulations, a person signing a derivatives 
contract on behalf of a corporation must have proper authority 
from the company's board of directors, the derivative must fit 
into the company's overall risk-management strategy, and the 
hedge must be used in a real transaction.  End note.) 
 
¶11.  (SBU) Our contacts pinned blame on both the banks and the 
firms involved in the derivatives contracts for some unadvisable 
deals.   Chinese companies were taking on more risk because they 
saw only profits for several years, said several contacts.  In 
some cases, firms were doubling or tripling down on their bets, 
hoping to make even greater gains.  When the market turned, the 
profits evaporated and firms were in over their heads because 
some unscrupulous deals allowed for unlimited losses by the 
firms.  "There were a lot of inappropriate trades," said a 
banker with one major foreign player.  At the same time, another 
foreign banker noted that now some of the problem contracts 
turned profitable again for the SOEs in December, and they have 
since stopped complaining.  (Note:  One foreign banker said that 
if the yen falls below 88 to the U.S. dollar, many SOEs who have 
signed derivatives contracts betting it would stay above 88 
would begin to lose large amounts of money.  End note.) 
 
============================================= === 
Foreign-Invested Banks Blocked from Bond Trading 
============================================= === 
 
¶12.  (SBU) Foreign-invested locally incorporated banks are 
disappointed with progress so far on granting them permission to 
underwrite Chinese corporate bond offerings on the interbank 
market.  Blame is placed on NAFMII, which has been sitting on 
the implementing rules for underwriting corporate bonds since 
early this year.  One foreign banker says NAFMII -- which is 
 
SHANGHAI 00000023  004 OF 004 
 
 
composed of industry players -- is seeking to limit competition. 
 While two foreign-invested banks are represented in NAFMII, 
representatives of these banks say they are outvoted by the 
domestic NAFMII members when it comes to expanding the number of 
competitors allowed into the bond underwriting market.  Several 
of our foreign banking contacts affirm they are eager to get 
into this potentially lucrative segment. 
 
¶13.  (SBU) Meanwhile, approval for foreign-invested banks to 
underwrite financial bonds is required from the PBOC Financial 
Markets Division, said one foreign banker, and the criteria for 
such approval remains unclear.  HSBC has participated in a 
financial bond offering, but the circumstances may not be 
applicable as a precedent.  Our HSBC contact says HSBC was a 
sub-underwriter on the bond issue of Bank of Shanghai, in which 
HSBC has investments; given this close corporate tie, HSBC 
applied to the lead underwriter, Industrial and Commercial Bank 
of China (ICBC), and ICBC accepted.  Thus, the regulatory issue 
still has not been fully resolved at PBOC.  CBRC, on the other 
hand, has recently taken a more open stance, according to our 
contacts, in particular Li Fuan, head of the banking innovation 
supervision department. 
 
======= 
Comment 
======= 
 
¶14.  (SBU) The go-slow approach Chinese financial regulators are 
taking on derivative products is a predictable, and in some ways 
understandable, reaction to the turmoil in Western financial 
markets.  For Chinese regulators, the connection is clear -- in 
his November 30 speech, SASAC vice chairman Li Wei states 
categorically that "The high leveraging of financial derivatives 
is a direct cause of the U.S. subprime loan crisis developing 
into a global financial crisis."  However, both Chinese and 
foreign-invested financial institutions point out that hedging 
to facilitate business transactions is useful, while speculative 
hedging is more like gambling.  In order to help advance the 
national goal of building Shanghai into an international 
financial center by 2020, the Shanghai Stock Exchange, for 
instance, needs to offer foreign investors a simple stock index 
future.  At present, the CBRC appears to be on the side of 
further market opening, while NAFMII and to a lesser extent 
PBOC, are slowing progress. 
 
¶15.  (SBU) The Department of Treasury has cleared on this cable. 
CAMP