Cablegate: China/Economy: Deterioration Was Surpising,

Published: Tue 2 Dec 2008 06:11 AM
DE RUEHBJ #4402/01 3370611
P 020611Z DEC 08
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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
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
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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
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?
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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
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
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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.
19. (SBU) Officials appeared caught off guard by
OctoberQs deceleration in growth and hinted that the
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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.
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