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CNBC Transcript: Li Daokui, Mansfield Freeman Chair Professor, Tsinghua University

Following is the transcript of a CNBC interview with Li Daokui, Mansfield Freeman Chair Professor, Tsinghua University. The interview was broadcast on CNBC on 20 March 2017.

All references must be sourced to a "CNBC Interview".

Interviewed by Eunice Yoon, Beijing Bureau Chief, CNBC at China Development Forum 2017.

Eunice Yoon: So how is China receiving the "America First" approach?

Li Daokui: Well, so far, China has been treating it very calmly, trying to watch what kind of policies President Trump can implement, rather than what he promised. This I think is very wise. Meanwhile, I think, the China side is trying very hard to communicate through informal and formal channels with the President's office. And that is also very smart.

EY: And how effective do you think those measures are?

LD: Well, judging from the outcome, the China and US communication channels have been working. Why? Because people used to worry a lot, two months ago, even one month ago about what Trump would do to the relationship. But so far, the Sino-US relationship has been the best, I think even better perhaps then the US-Australian relationship, let alone the US-Russian relationship right? So we're talking about a visit by President Xi to Florida, having an informal conversation, you know, between friends. That I think is a sign of effective communication.

EY: And how do you hope that the conversation is going to go between President Xi and President Trump?

LD: Well, I think, the most important, is the build-up of chemistry, because leaders they got to have chemistry, before taking decisions, before even communicating right? The most important objective is to build chemistry, is to meet the person, and to shake hands, to touch the person, to know what the person is really about, rather than going through the various kinds of channels, like tweets, like the internet, like the media, traditional media. So build up chemistry and know each other, shake hands, look eye to eye right, look at the expression of your face, that's most important.

EY: So it sounds like you're not very concerned about the anti-trade rhetoric that's been coming out of the White House?

LD: I am not too concerned. Look, in today's business communities on both sides, China and the US, it's hard to find a senior business executive who has not dealt with the other side. All US major companies in the US have dealt with China. All major Chinese companies vice versa have dealt with the US. So there are lots of underground, internal, informal channels of communication.

EY: How would China react if the Trump administration were to label it a currency manipulator?

LD: Well, China I think, openly, will make some protest, as a rule however China will not over-react, it will go through the procedures or public protest. However, most important is to have private communication with the state department, with the Treasury, with the White House, to try to work out what is it the US side want, and then what kind of things China could do for the US.

EY: At the National People's Congress, the Chinese Premier had made it clear that it's a priority that the yuan remains stable. So what does that tell you about the yuan policy for 2017?

LD: That means that first China will be very cautious, and pragmatic dealing with the yuan exchange rate, meaning that China will try to manage offshore exchange rate of RMB in Hong Kong, but slightly tightening up the supply of RMB in the Hong Kong market, therefore stabilizing the RMB exchange rate versus the US dollar in Hong Kong, and secondly, domestically, the focus will be on controlling capital outflow through trade channels, because lots of RMB got into US dollar through fake imports. That lead about US$300 billion going out of China. So that one will be tightened. And meanwhile, in the media and in policy statements, China will be very low profile, because RMB exchange rate, to me, is more noticeable, is more attention grabbing than sterling pound, or yen exchange rate. So my criteria is that, if RMB does not become a big topic of CNBC, that's the success of RMB policy.

EY: Why do you think that the yuan gets so much attention? Why would it be getting so much attention?

LD: Well, China is now the world's number one exporter, and the world's number one or number two, depending on year, importer, with US as number one or number two. So this is the biggest trading partner of most countries in the world, plus, China still has, in effect, capital controls. So RMB exchange rate, not only tells you the economic condition in China, but also tells you policy thinking in China. So lots of information is contained in the RMB exchange rate.

EY: So how long do you think China will have these restrictions on capital outflows in place?

LD: Well, I think it will be there for quite a long time. Of course, it is not black and white, there are many, many items, many, many details of the capital controls. But in principle, I think and also it's right, it's proper for China to do so, to remain, to keep capital controls for at least 10 years, because why? Because the Chinese domestic financial sector has to be healthy enough, has to be robust enough, and well-regulated enough to sustain a free capital flow. Because free capital flow can generate shocks to the domestic financial sector

EY: I was speaking more specifically about restrictions that we're seeing on capital outflows more recently. When you said that they're squeezing some of that flow of yuan and dollar exchange...

LD: Oh I see. I do expect that Chinese exchange rate policy and the capital control policy become more, more precise, that is to really cut down those fake imports. Because by faking imports, companies got cash, US dollar cash to bring out. Meanwhile the policy will be more relaxed about the genuine outflow of capital trying to acquire foreign companies. So I think the policy will become more targeted, more precise down the road, in the coming one year.

EY: So you don't think this is a temporary thing? You don't think that, just because I am wondering how long do you think the more recent restrictions that we had on capital outflows, how long do you think we have to see these restrictions?

LD: I think the restrictions will be relaxed in six months or eight months in the following sense, that is - genuine outward investment will be supported by the foreign exchange authority in China. Whereas those underground, illegal, crazy transactions using fake imports to get foreign currencies and then go out to buy foreign portfolio, that will be cut down.

EY: Recently we saw the Chinese central bank raising interest rates, so what kind of policy do you think we're going to see, in terms of monetary policy from China central bank?

LD: Yeah, the Chinese central bank has been trying to stabilize the Chinese money supply because in the background, the situation is that China has a lot of liquidity. The (money) which is consisting of cash in circulation and time deposit, or cash deposit in the bank account, amounts to US$22 trillion, the highest in the world. So the central bank has been trying to slow down the growth of what we call M2, or this cash plus bank deposits. So that's the background. So the central bank has been trying to tighten up the money supply, meanwhile periodically, in the end of June or end of December, periodically in China there's a wave of paying back debt. At that time, the central bank may have to reinject more liquidity in the system in order to have the system run more smoothly.

EY: With what we've seen with Fed policy, do you expect that China is going to have a tightening bias this year?

LD: Not this year. China's central bank will not try to tighten money supply purely for the sake of hiking interest rate in the Fed. Because the two markets, so far, are still relatively segmented, the US money market and the Chinese money market, the interest rates do not have to match.

EY: But we did see a tightening of interest rates in China, just recently...

LD: Yeah, that to me is a long term trend, for the central bank to slow down money supply in the economy, to drain out, to slow down the increase of liquidity.

EY: What kind of impact could that have on the overall economy, if any? Just because the economy, largely, has been driven by stimulus...

LD: Right, the impact is for the economy to slow down its wasteful investments, in certain sectors. Because when money is supplied, a lot of wasteful projects are invested.

EY: Chinese premier Li Keqiang also had said that stability is going to be very important this year for the economy. Do you think that's going to be good or bad?

LD: Well, this year is the year of the 19th Party Congress, so the government's top priority is to maintain stability, and with stability try to push reforms, specifically they want the GDP growth to be relatively stable, try to beat the 6.5 percent growth target this year, and meanwhile trying to avoid any liquidity volatility in the financial market, so these are the objectives of the economic policy.