Open Season for Chinese Banks

China puts out the welcome mat for foreign investors

Once a month, Li Guan queues as long as 30 minutes to withdraw cash from her Bank of China branch in Shanghai, then makes separate trips to deposit the yuan in other banks to pay for her phone, utilities, and apartment. To make mortgage payments on a home in Beijing, the stockbroker asks friends there to take cash from a separate BoC account and deposit it into yet another account at the same bank. "It's a headache," Li says wearily.

Multiply Li's headache by a few hundred million and you get the dismal picture of China's banking industry: Customer service is pitiful, back-office systems are decades behind Western standards, and sophisticated financial products are as scarce as a smog-free day in Beijing.

A remedy for those ills may be around the corner. Chinese authorities are encouraging a flurry of deals that could see foreign financial institutions buy stakes in mainland banks, brokerages, and insurance companies. That would give local partners access to the knowhow they need to upgrade their service in a hurry. Good thing, because competition is coming. As part of China's membership in the World Trade Organization, Chinese authorities have agreed to phase in regulations that should allow foreign banks to do everything that domestic banks can--from mortgages to Internet banking--by the end of 2006. That would make the $620 billion in deposits held by Chinese companies and savers such as Li fair game for the world's best banks. "We see a great growth story in China," says Hongkong & Shanghai Banking Corp. CEO Aman Mehta.

Today, though, regulations and red tape still keep foreign banks from opening more than a branch or two yearly--which is fueling a dealmaking frenzy. Pudong Development Bank in Shanghai confirms it is negotiating with Citigroup, although Citi won't comment on the talks. HSBC last December bought a piece of the Bank of Shanghai. J.P. Morgan Chase, HSBC, and others have talked with Shenzhen Development Bank about taking a stake. And Chase has a joint venture with asset manager Huaan Fund Management, which last year launched the country's first open-end mutual fund. "Everybody's talking about everything," says R. Ralph Parks, Asia chairman for J.P. Morgan Chase.

Underlying China's opening is the realization that the country's financial sector badly needs a lift out of the 19th century. Half-hour waits at teller windows are commonplace. Personal checks and automatic debits for monthly bills are a novelty. And loan officers might as well gamble their banks' capital at the casino: Standard & Poor's estimates that China's dud loans represent at least 50% of the total, or as much as $600 billion.

Granted, Chinese banks have started offering ATMs and other modern services. But change has been slow. So Beijing is throwing down the welcome mat and allowing foreigners to buy stakes in Chinese banks to help a few smaller banks quickly modernize ahead of a full market opening in 2006. That in turn would force change as the rest of the industry scrambles to compete. "China wants to use foreign banks to change the sector," says one buyer who is negotiating for a stake in a Chinese bank.

Improving troubled banks isn't the only motivation for the policy shift. Chinese authorities need to raise some $600 billion to $800 billion for the bankrupt pension system. One possible source of cash: shares in banks. Indeed, people familiar with talks say that officials may even allow the foreigners to take management control. China's four biggest banks--which control two-thirds of the banking sector--have so many problem loans that authorities would be loath to sell them to foreigners even if they could find anyone interested in buying. But smaller banks, including the Pudong and Shenzhen development banks and China Merchants Bank, are said to be looking for partners.

The changes go far beyond retail banking. CLSA Emerging Markets in July inked a joint-venture investment banking agreement with a local securities firm, Xiangcai Securities. The reason: to capture some of the estimated $8 billion in deals expected this year. CLSA's joint venture makes it the country's second such tie-up, following a Morgan Stanley venture--China International Capital Corp.--set up nearly a decade ago with the China Construction Bank. UBS, Invesco, Société Générale, and Fortis have signed joint-venture fund-management agreements in the past year. And HSBC is negotiating to buy a stake in Pingan Insurance Co., China's second largest insurer.

To date, HSBC has led the charge. It invested $270 million in its own branch network, and plunked down $65 million for its 8% stake in the Bank of Shanghai. It's also providing technical assistance to help the Shanghai bank with everything from fraud prevention to e-procurement. The eventual payoff: the ability to sell services such as credit cards and mortgages to the holders of Bank of Shanghai's 6 million accounts as the market liberalizes.

So far, the profits are tiny. Pretax earnings at HSBC's China operations grew 30% in the first half, but reached just $2 million--out of total operating profits of more than $5 billion for the London-based banking group. "The real returns lie in the future," says Mehta. His big hope: Chinese authorities will allow banks in Hong Kong to accept deposits in yuan, which the banks can then lend to other customers throughout China. The governor of the People's Bank of China, Dai Xianglong, told a Hong Kong audience earlier this year that the change was on the way, although no timetable has been set. "If we were allowed to take [yuan] deposits here we would have explosive, limitless growth in China," says Mehta.

That's just what worries many Chinese. Foreign financial firms are "a big crocodile," warns Liu Ji, executive president of the China Europe International Business School in Shanghai. Liu cautions that foreign financial capital could swamp China so local banks need to shape up fast. Foreign bankers insist they'll never supplant China's biggest banks. That's probably true. But if the foreigners can cut the line at the teller's window, they may get more customers than they ever dreamed of.

For a BusinessWeek editorial on this topic, see "Foreign Banks Will Give China a Boost"

By Mark L. Clifford and Frederik Balfour in Hong Kong with Alysha Webb in Shanghai

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