ICBC's IPO: Reckless Spending in China?

The bank's monster public offering Oct. 27 seems set to symbolize China's hyper-growth. But will an overheating economy kill the stock frenzy?

Call it the Buy China syndrome. All year there has been a virtual feeding frenzy for Chinese stocks. Mainland companies have raised nearly $50 billion in share offerings on domestic exchanges in Shanghai and Shenzhen and overseas bourses in 2006.

That includes the $20 billion that Chinese mega-lender, Industrial and Commercial Bank of China (ICBC), is expected to rake in with the biggest initial public offering in history. It's selling 15% of its shares to the public and its stock will start trading on Oct. 27 (see, 9/27/06, "China's ICBC: The World's Biggest IPO Ever").

One reason is that China's hyper-growth wave shows no signs of abating. This $2.6 trillion economy grew at a torrid 10.6% pace during the first half, and third-quarter gross domestic product data due out on Oct. 19 are expected to show 10%-plus year-on-year.

Bad Memories

The Hong Kong Hang Seng Index is up 20% in 2006, while key stock indices in Shanghai and Shenzhen (largely off limits to foreign investors) have delivered returns of more than 50%. And any day now, China's stockpile of foreign currency holdings—already the biggest on the planet—is expected to top $1 trillion, thanks to record export levels. The scent of fast money is everywhere.

Beijing officialdom views the ICBC offering as symbol for the China's new economic prowess. But this monster IPO may be remembered more as a symptom of a financial mania that has overwhelmed common sense. It's worth recalling that only a decade ago big state lenders such as ICBC, China Construction Bank, and Bank of China were up to their eyeballs in dud loans thanks to a boom and bust economic cycle driven by reckless lending. Beijing spent $300 billion-plus on capital injections on government purchases of non-performing loans to mop up that mess.

China optimists insist a reprise of that unhappy business is quite unlikely. Now that ICBC, China Construction, and Bank of China are globally listed banks with strategic investors such as Goldman Sachs (GS), Bank of America (BAC), and American Express (AXP) at their side, they will be shrewder about lending.

No Stopping Them

Chinese Premier Wen Jiabao vowed this summer that Beijing will "take forceful measures" to "prevent the economy's rapid growth from turning into overheating." To that end, the government has raised interest rates and reserve requirements imposed on banks, placed tighter rules on real estate development, and warned big-spending local governments to cool it.

Yet even if the banks somehow manage to restrain their lending, there is little stopping Chinese companies now awash in cash from revving up investment to unsustainable levels.

Jing Ulrich, managing director and chairman of China equities at JP Morgan, points out that banks are only funding about 20% of the current wave of fixed-asset investment that is driving the mainland's white hot economy. The lion's share (about 56%) of China's investment spending spree is being bankrolled out of the retained earnings of the mainland's cash-rich enterprises, many of which are state-owned.

Giving Nothing Back

Big state-owned companies in China aren't required to pay dividends to the government, despite the fact that Beijing is a major shareholder. A company listed in the U.S. or even Hong Kong has to divert cash to deliver decent returns to private shareholders. In the case of Chinese companies, they are effectively getting a huge subsidy from Beijing and a big incentive to spend. "Without a dividend policy, state-owned enterprises can freely invest funds" for new plants and equipment, Ulrich says.

A no-dividend policy for government-owned companies—which generate more than 40% of total corporate profits in China—may have made sense a decade ago. In the mid-1990s, Beijing forced these giant enterprises to lay off workers, restructure, and become more efficient. Yet the World Bank, Asia Development Bank, and even some Chinese officials contend that's no longer the case now that most state-owned companies are hauling in sizable profits in a booming economy.

These government-controlled companies generated profits of $61 billion in the first seven months of 2006, up 15% over last year, and some $113 billion for all of 2005, according to World Bank officials who have analyzed Chinese government data. The worry is that unless Beijing addresses this issue, its other measures to engineer an economic soft landing will be for naught.

Money For Social Services

Already the government concedes there is excess capacity in sectors such as steel, alumina, coking, and autos. Fixed asset investment is expected to have grown 28% or so through the first nine months of 2006 when third-quarter GDP data are released. That would be a slight improvement over the pace of investment seen earlier this year, but still way too high.

The World Bank estimates that if the government demanded a reasonable dividend the move would not only cool off investment spending but give Beijing the resources to spend more on social services such as health care and affordable housing in major cities (see, 8/9/06, "China's Housing Headache").

Precautionary Savings

China's savings rate is 50%, which is viewed admiringly by some in the West, but is really precautionary and driven by families' fears of not being able to finance medical emergencies, educate their children, or live comfortably in retirement.

Right now, enamored investors discount such risks, given China's dazzling growth rates, gargantuan corporate profits, and high-flying stock markets. If the recent trading history of other newly-listed banks such as China Construction and Bank of China are any measure, ICBC shares should do extremely well in the coming months. Yet if Beijing hasn't wrestled down the economy to more sustainable levels in the next year or so, there might be another stampede—this time right out of Chinese stocks.

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