Morgan Stanley: What Great Wall?

In a joint venture, the big U.S. bank breaks into China's financial sector

It was a first-ever for China's financial sector and a major step forward in banking reform. In a July 8 ceremony on the top floor of the 22-story China Construction Bank (CCB) headquarters in Beijing, financiers drank champagne toasts to a deal that paired Morgan Stanley with CCB, one of China's big four commercial banks, giving Morgan Stanley bragging rights as the first foreign bank to sign a direct joint venture to dispose of the mainland's nonperforming loans.

For China, it's just the latest opportunity to leverage Western banking expertise to clean up a bad loan problem that Standard & Poor's says will cost $500 billion to clean up. That's a major drag on still largely state-run China Inc. as the country slowly moves toward a free market economy. "Through this cooperation, China Construction Bank will import and use Morgan Stanley's advanced techniques and experience," says Yang Xiaoyang, general manager of the special asset resolution department at CCB.

For Morgan Stanley, the accord represents something more. It keeps the New York firm ahead of the competition as foreign investment banks pour into China looking for a piece of the action. "This is part of a step-by-step development in the opening of China's marketplace," says Stephan F. Newhouse, chairman of Morgan Stanley International. "The direction forward is clear."

Morgan Stanley already had a leg up. The Wall Street bank is part of a nearly nine-year-old experiment in an investment banking joint venture: China International Capital Corp. (CICC). That partnership with CCB made Morgan Stanley the only Western bank privileged to do deals in China until another got permission in April. Over the years, Morgan Stanley has helped market a slew of acquisitions and initial public offerings. In November it advised on a $1.5 billion offering of China Telecom (CHA ) Corp. shares. And in January it helped with Anheuser-Busch (BUD ) Cos.' $182 million purchase of a larger stake in Tsingtao Beer. It has big plans for investments in stocks and real estate, and wants to do more business in private equity and foreign exchange. "They've got guts," says a rival investment banker in Beijing. "It's a great vision they have for their China business."

But Morgan Stanley's lead in China is by no means assured -- and neither are the profits it clearly is hoping for. Over the past 19 months, China has been opening its financial markets to comply with World Trade Organization commitments, and Morgan Stanley's rivals are forging deep links with local partners and pioneering new businesses. CICC is likely to face stiff competition from French investment bank CLSA's recently formed China Euro Securities Ltd., as well as from Hong Kong-based Bank of China International. On July 9, Switzerland's UBS (UBS ) got the first chance of any foreign bank to invest in China's domestic "A" share stock markets. It promptly poured in well over $50 million of client funds. (Morgan Stanley plans to sink as much as $300 million of client funds into A shares.) And Goldman, Sachs & Co., Morgan Stanley's strongest competitor in China, is angling for more IPOs and mergers and acquisitions. "China still holds all the promise," says Richard J. Gnodde, president and managing director of Goldman Sachs (GS ) (Asia) LLC. "Every six months we are able to do a deeper and broader range of business."

Beijing's goal in this opening is to create a commercially sound industry that begins to efficiently allocate capital. That is crucial as China undergoes a wrenching restructuring of its state sector and relies more and more on cash-hungry private enterprises to create jobs. But the communist bureaucracy isn't known for its quickness in instituting ground-breaking reforms. For instance, Morgan Stanley's new bad loan deal has yet to be cleared by the bureaucrats at the People's Bank of China, the China Banking Regulatory Commission, or the Ministry of Finance. A chief sticking point is what value will be put on the loans, most of them to state-run companies. "You are still not supposed to sell below book value," says one Western investment banker in China. "How do they get around that?"

Good point. The China Construction Bank is asking the government for "trial permission" to sell the debt at less than par value, says John Langlois, president of Morgan Stanley Properties (China). Assuming that problem is worked out, the venture will be set up as a 70%-30% joint operation, with Morgan Stanley holding the majority stake. It will take on a portfolio of 700 troubled loans to companies with a total book value of $519 million. Instead of liquidating borrowers' assets, the venture plans to help them remake themselves through a combination of debt restructuring, debt forgiveness, and refinancing. But if that doesn't work, it may have to rely on China's untested courts to lay claim to the debtors' assets. "The legal process will be a final option," says Langlois.

With the memory of SARS quickly fading and China's economy roaring back to life, Morgan Stanley is pushing other deals aggressively. Over the next year, it aims to carry out IPOs for People's Insurance Co. of China and China Ping An Insurance Co. Each is expected to try to raise at least $1 billion. That's just a small taste of what the firm predicts could be a $150 billion IPO market for listings in China and abroad over the next five years. Morgan Stanley is also aiming to broker more M&A deals, and is branching into new business lines such as real estate. Its local property unit and Shanghai's Yong Ye Group have announced plans for a $90 million luxury residential complex in a swank district of downtown Shanghai. "Expansion of the capital and financial markets is a high priority for the Chinese government," says Newhouse. "We want to be a part of that."

To be sure, Morgan Stanley isn't waltzing off with all of the best deals. Goldman Sachs is fighting it tooth-and-nail for M&A business and has scored some big wins such as Nissan (NSANY ) Motor's $1 billion purchase of a 50% share of Dongfeng Motor Corp. last year. Goldman also is pushing for its own joint venture to dispose of bad debt with the Industrial & Commercial Bank of China. Neither Morgan nor any other foreign bank discloses revenue and profit figures for their business on the mainland.

So will the foreign investment banks flooding into China make any money? There are a lot of doubters, at least for the near term. But waiting is not a problem for Morgan Stanley's Newhouse. "China is one of the great opportunities anywhere in the world," he says. "It's a place to put one's bets for the next 25 years." He and others are determined to cash in on the vast China financial market, however long it takes.

By Dexter Roberts in Beijing and Mark L. Clifford in Hong Kong

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