Betting On China's Banks

The biggest IPO on earth may signal the start of a rich, new era in financial markets

Never accuse the Chinese of thinking small. The global public offering in late October of China Construction Bank, the mainland's third-largest bank, is set to raise a head-turning $8 billion on Oct. 27 -- the biggest IPO on the planet this year, and the biggest anywhere since Kraft Foods went public in 2001. The offer is vastly oversubscribed, as investors line up to buy a piece of a bank with $521.8 billion in assets, the first of China's Big Four state-owned banks to publicly list shares overseas. "We are well positioned to capitalize on the growth in China," says CCB Chairman Guo Shuqing. Guo just completed a road show in the U.S. to keep investor enthusiasm stoked.

The Buy China syndrome has long gripped global investors entranced by the country's hypergrowth story. Some 117 Chinese companies have raised $45.5 billion in global equity markets in the past decade. Just last August, Inc. (BIDU ), a Beijing search-engine outfit, blew away a five-year record on NASDAQ for best first-day trading performance as its share price jumped fivefold, to $154 per share.

Yet the China Construction deal is in a different realm. First, CCB already has the backing of Bank of America Corp. (BAC ), which has committed $3 billion for a minority stake. BofA is just one of several major banks, including Citigroup (C ), HSBC Securities (HSBC ), Goldman Sachs (GS ), and American Express, (AXP ) that have ponied up some $20 billion to buy into China's financial institutions, the biggest of which have plans to go public in the next year or so. Bank of America is probably already sitting on a hefty profit. Steven E. Wharton, portfolio manager of the Morgan Stanley Financial Services fund, which holds BofA shares, figures the U.S. bank bought its Construction Bank stake at 1.15 times book value. Smaller Chinese banks, he notes, have gone public at 1.6 times book -- implying a nearly 40% gain for BofA since it cut the deal in the summer. (Morgan is also an underwriter of the CCB offering.)

Not bad. But what has BofA, Goldman, HSBC and others excited is the prospect of winning a giant bet on China's next turn. The wager is that China's financial system, long one of the most dysfunctional anywhere, is finally getting fixed. It will blossom into one of the world's biggest profit machines as its banks make lucrative loans, the local bourses take off, a bond market develops, and consumers learn the joys of credit cards, mortgages, and personal finance. China, with more than $1.8 trillion in personal savings -- and a savings rate of close to 50% -- could become the financial market of the 21st century.

That's the idea, at least. At the moment, Beijing is in a titanic struggle to reinvent its financial system against considerable internal opposition. "The scale of what is happening has never been seen in the world," says U.S. Treasury Secretary John W. Snow.

Yet the great turnaround could still end up as the great flop, and global banks jumping into the fray could get hurt. A major economic slowdown could derail China's banks, some of which are hooked on real estate loans that sour easily. It will also be a struggle to escape the legacy of the past and forsake state-directed lending that almost brought the banks down. Ever since the Great Helmsman Mao Zedong nationalized China's banks more than 50 years ago, they have served as massive employment agencies, money pots for pet projects, and key props for the party apparatus. They've done everything except act as real banks -- institutions that gauge risk correctly, lend to the most promising businesses, and develop sophisticated services for consumers and companies alike. Instead China piled up half a trillion dollars in bad loans by the late '90s. Huge bailouts courtesy of Beijing have lessened that load, but some analysts say a fresh crisis may be developing as the banks back too many new real estate projects and too many new factories.

Beijing's grand plan is to fix the main banks, inject foreign capital and expertise into the system, clean up the local bourses -- and throw the financial markets virtually completely open to outside competition by Dec. 6, 2006. "It would be difficult to overstate the importance of this transformation," says Nicholas R. Lardy, a senior fellow and China watcher of the Institute for International Economics in Washington. "The financial sector is immense relative to China's GDP." Immense -- and wasteful. It takes about three times as much investment to generate $1 of gross domestic product in China as it does in the U.S., Japan, and Western Europe. That's largely because the banks have been ineptly run.


So a lot is riding on the successful transformation of CCB from a plaything of state planners into a viable business. Since the late 1990s the Chinese government has pumped $259 billion into CCB and the three other big state-owned banks -- Bank of China, Industrial & Commercial Bank of China, and Agricultural Bank of China. With good reason: These Fantastic Four account for 57% of all lending, control $1.8 trillion in deposits, and have bounced back from near insolvency in the late '90s.

The government's cash infusions have stabilized the banks, but the situation is still fragile. Neither China nor its banks have the managerial resources they need to build a better banking system. For that they are depending on investors like Bank of America. The Charlotte (N.C.) lender, the largest retail bank in the U.S., bought a 9% stake in CCB for $2.5 billion. It will spend an additional $500 million to buy equity during CCB's global offering of up to 30 million shares. Although it will get only one seat on the board, BofA plans to send in a SWAT team of some 50 managers to help implement best practices in a Chinese context. Bank officials declined to comment during a "quiet period" ahead of the Construction Bank listing, but if everything goes according to plan, Bank of America could exercise an option to raise its stake to 19.9% by March, 2011.

Executives at BofA will train their local partners in such basics as due diligence on potential borrowers and fine-tuning loans to reflect borrowing costs and client risk. Construction Bank also desperately needs help in corporate governance and information technology. Of course, CCB officials may not be such quick studies. "There's a lot of work to be done when it comes to straightening up the bank sector in China," says banking analyst Andrew Collins at Piper Jaffray & Co. (PJC ) in New York. "You don't know how long this change in culture is going to take."

Yet as the new era of IPOs begins, the banks are in better shape than they have been in decades. Not only are the Big Four profitable, but thanks to the economy's white-hot growth and rising incomes, they saw 18% annualized growth in deposits from 2000 through 2004. China Construction Bank is raking in profits. It says nonperforming loans are now 4% of its portfolio, down from 17% in 2002, although it has a much higher percentage of loans that need careful watching. Chairman Guo, a fluent English speaker, is a well-regarded former deputy governor of the country's central bank, the People's Bank of China. Better yet, CCB is earning a fat spread thanks to China's heavily regulated interest rate regime. Banks can charge a 5.76% rate on one-year loans, but only need to pay out 2.23% on 12-month deposits.


True, former bank Chairman Zhang Enzhao was arrested last June for allegedly taking bribes, and the banks and authorities have disclosed precious little about who got the money. Also, the offering prospectus reveals more than 100 cases of theft and embezzlement at the bank between 2002 and 2004. But CCB earned $6.07 billion in net income in 2004 -- and $3.5 billion during the first half, according to accounts audited by KPMG in Hong Kong. The bank has also acted to cut costs by trimming its branches from 21,391 in 2002 to 14,458 today. Head count has been pruned 20%, to 311,000, over the same period. "CCB management is extremely focused on cost controls," says bank President Chang Zhenming.

What's in it for BofA? It's buying into a bank with a huge footprint and millions of potential customers for Bank of America products and services. China Construction already controls loans valued at about $293 billion, or 12% of the industry total. The bank enjoys dominant market positions in home loans (23.1%) and even credit cards (18.7%). Guo says CCB has a huge edge with blue-chip companies in growth industries such as power and telecoms.

With the Bank of China and Industrial & Commercial Bank of China expected to list in 2006 and investors already chomping at the bit to buy shares, it's clear that China will get all the Western help it wants to help it with bank reform. The question is whether that help will be enough. Beijing still insists the government retain a majority stake in its Big Four state banks. (Post-IPO, CCB will be 62.5% owned by the state.) China has refused, despite pressure from Washington, to lift its 25% cap on total equity held by outsiders and 20% for any single investor.

And while foreign investors may land a board seat or two at the banks, they won't be calling the shots on bank strategy or structure. If BofA CEO Kenneth D. Lewis or other foreign investors want to cut back on some of the banking industry's 1 million employees -- CCB alone has 300,000-plus -- they will have no leverage to do so. The American bank has also agreed to abandon any solo efforts on the mainland and any tie-ups with other Chinese lenders. These rules don't appeal to some of its global competitors. Citigroup, for example, plans to expand its existing mainland retail network -- although it has hedged that by taking a 4.6% stake in Shanghai Pudong Development Bank. Analysts say Citi officials are actively scouting for branch locations in urban areas throughout China.

Beijing, meanwhile, is still keeping as tight a grip on bank reform as it has on its broader economic opening -- despite a weeklong visit by U.S. Treasury Secretary Snow and Securities & Exchange Commission Chairman Christopher Cox. In meetings with PBOC Governor Zhou Xiaochuan and China Securities Regulatory Commission Chairman Shang Fulin, Cox says he heard a lot of talk about gradual steps, not quick leaps. As Cox puts it: "If you take nothing but half-steps to reach the wall, will you ever reach it?"

Given all the hoopla, it could prove embarrassing for Chinese leaders if CCB flops as a listed bank. For starters, about 25% of its loan portfolio is tied to the highly volatile residential mortgage and property-development markets at a time when many worry about a possible housing bust in big cities such as Shanghai. "Its exposure to China's red-hot property sector is higher than many of its peers, but the asset quality of CCB's property portfolio is slightly better," says May Yan, vice-president and a senior analyst with Moody's Investors Service (MCO ) in Hong Kong.

The other issue with CCB is the quality of its numbers. Although the books have been examined by Western auditors, the possibility of unpleasant surprises is still there. Moody's notes the disturbing existence of "special mention" loans on CCB books that represent almost 17% of borrowing activity. Moody's is monitoring them closely, since a portion of these credits could eventually tip into the bad loan column.

Chinese officials urge the critics to be patient. After all, they say, just a few years ago there was no financial system to speak of that a Western banker would recognize. "China's capital markets were created out of nothing," says securities regulator Shang. Now they have to grow up.

By Brian Bremner, with Frederik Balfour in Shanghai and Chester Dawson in New York

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