A Golden Age for China's Banks

Why are global players still buying up shares of mainland banks? It's a long-term wager on the country's financial system -- and overall growth potential

The global appetite for Chinese bank shares seems downright insatiable. On June 1, the Bank of China -- the mainland's second-biggest bank -- launched a $9.7 billion initial public offering in Hong Kong, and the shares shot up 15% in the first date of trading. This follows a similarly sized global offering by China Construction Bank last fall. And China's top bank, the Industrial and Commercial Bank of China (ICBC), is readying what analysts think will be a monster $12 billion IPO later this year.

Meanwhile, global players such as HSBC (HBC), Bank of America (BAC), UBS (UBS), Royal Bank of Scotland, Standard Chartered (SCBFF), and others have plowed more than $20 billion into strategic equity stakes in Chinese banks in recent years.

Those are huge sums. And they're even more remarkable given that just a few years ago China's biggest banks needed government bailouts to clean up their balance sheets. Their profitability is lackluster by international standards. Few would rank this trio among the leading pack of global banks when it comes to commercial and investment banking. And nobody is really sure whether they have a good grip on their non-performing loans -- though they are now lending like crazy to an overheated economy and creating tension in President Hu Jintao's government.


  Then there is China's world-class bank fraud. Bank of China has been home to some pretty outlandish scams relating to "forgery of loan and other documentation" and "embezzlement of customers' funds," according to its offering prospectus. At one branch in Guangdong province, bank employees managed to spirit away nearly $500 million in deposits over an eight-year period before getting nailed by Chinese and U.S. authorities.

But in an economy racing along at a 10% growth rate, the huge negatives don't really mean all that much. Global investors rushed to get a piece of the CCB and Bank of China offerings because they believe that China's rapid expansion of wealth guarantees secure times ahead for the big players. Thanks to the economy's white-hot growth and rising incomes, China's banking industry experienced more than 15% annualized growth in deposits from 2000 to 2005.

Another big plus: China's interest rates, which are still largely regulated. China's current one-year interest rate of 5.85% is more than three percentage points higher than what Chinese banks pay out to depositors. That is a very nice profit cushion.


  And if these big outfits do run into serious trouble with their loan books again, investors seem to feel that they're simply too big to fail. The Chinese government would have no choice but to bail them out. The big four banks (also including the Agricultural Bank of China) cast a mighty big shadow over the financial system. Since the late 1990s the Chinese government has pumped $259 billion into the quartet, and with good reason. They account for 57% of all lending, and have bounced back from near insolvency in the late '90s.

They lend into every industry that matters. And now that they have been restored to health and the economy is booming, they are coveted by investors looking for ways to buy into the mainland's growth story. These big banks "provide a pretty good proxy" for China's hyper-growth economy, notes May Yan, senior vice-president and a credit analyst with Moody's Investor Services in Hong Kong.

That helps explains why Bank of China's newly listed shares were 17 times oversubscribed, and its stock is likely to get bid up considerably from its initial offering price after it lists in the secondary market. China Construction Bank, for instance, has seen its shares jump more than 40% since its offering late last year.


  Big global investors like Bank of America, HSBC, and others that have invested billions into the banking sector have or will likely see robust returns. Bank of America purchased its 9% stake at roughly 1.2 times China Construction Bank's book value. The bank is now trading at well over twice its book value.

But this isn't just a short-term punt for foreign banks. They are collectively making a long-term 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 most lucrative financial market of the 21st century.

That's why foreign banks have been knocking each over to cement strategic relationships with big mainland banks. They have vast branch networks; BoC alone has some 11,000. And they're particularly strong along the prospering East Coast, which accounts for 64% of China's gross domestic product. That's something overseas banks simply can't match. There are about 67 foreign banks operating on the mainland, but they only control a puny 1.8% of China's banking assets.


  The big four offer an ideal platform to change that. They can reach mainland companies that need sophisticated lending and investment banking services and a rapidly emerging middle class in need of consumer finance. One big opportunity for just about every big foreign bank with retail expertise is credit cards, a relatively new market in China; There are only 32 million cards in circulation on the mainland, vs. 127 million in Japan and 654 million in the U.S., according to the Bank of China prospectus.

So is a bet on Chinese banks risk free? Anything but, if China's current boom were followed by a nasty bust. You can also probably count on more unpleasant cases of fraud and bad loan surprises from the big mainland banks even after they list. However, there is no denying these banks are far more transparent than they were a decade ago. "Mega banks are making good progress in classifying their assets and disclosing them, but some adjustments are still required," credit agency Standard & Poor's concluded in a banking industry survey in February.

Nor is it that difficult to buy into the idea of a promising future for the Chinese economy and the handful of mainland mega-banks that are destined to grow with it. China Construction Bank, Bank of China, and ICBC are scarcely brand names in global finance today, but they have a real shot at emerging as some of the largest financial institutions on the planet in the decades ahead. Add it all up, and the global love affair with China bank stocks starts to make sense.

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