Get Ready for the World's Biggest IPO

The World Expo that kicked off in Shanghai on May 1 is the kind of spectacle Beijing officialdom loves, a grand showcase for China's economic ascendancy. Another fanfare event, this time in the realm of global finance, is the initial public offering expected this summer by the Agricultural Bank of China, which may prove to be the world's biggest ever. The state-owned lender hopes to raise $20 billion to $30 billion, a top Chinese official told the Beijing Times last month. A successful offering by AgBank would be another step in the evolution of Chinese lenders from government-controlled playthings to globally competitive banks.

Everything about this deal is big, even the $200 million in bank underwriting fees up for grabs for global investment banks. AgBank has hired 10 banks, including Deutsche Bank (DB) and Goldman Sachs (GS), to manage the dual offering in Shanghai and Hong Kong expected by July. AgBank, like other big mainland banks, is in the midst of a makeover. Beijing has spent about a decade (and $650 billion) pushing banks to clean up their balance sheets, upgrade lending practices, and invest in better technology. China's banks "are no longer cashiers for the government," says David Wu, a partner in Beijing with PricewaterhouseCoopers. "They are commercial banks."

That's a stretch, since AgBank is only selling up to an 18 percent stake, say two sources with knowledge of the matter, and will remain majority-owned by the government after it lists. Beijing also kept a controlling interest in other big banks, such as the Industrial & Commercial Bank of China (ICBC) and China Construction Bank, that went public last decade. While U.S. and European banks were laid low by the recent credit crisis, Chinese banks, powered by a robust economy, have grown stronger. ICBC's market capitalization is $227 billion, the biggest of the world's banks, and China Construction Bank is right behind at $190 billion. Bank of America, by contrast, is valued at $176 billion.

AgBank does boast some impressive strengths, including a customer base of more than 350 million people, a figure that exceeds the population of the U.S. In a year when other banks around the world lost piles of money, AgBank's earnings expanded by 26.3 percent in 2009, to $9.52 billion, according to a Mar. 11 report in the state-owned China Daily. AgBank Chairman Xiang Junbo is a Peking University-trained lawyer and former deputy governor of the People's Bank of China, the nation's central bank. Both he and AgBank President Zhang Yun, who holds a PhD in economics from Wuhan University, are respected players in Chinese finance.

Still, pitching AgBank to investors may be a challenge. The bank lacks the big-name Chinese corporate clients, with the notable exception of agricultural sector players, that other mainland banks enjoy. The majority of its depositors are in far-from-wealthy, though fast-growing, middle-of-nowhere cities, plus the quality of AgBank's loan book remains suspect; the government transferred dud loans off AgBank's books, lowering its nonperforming ratio from 20 percent in 2007 to 2.9 percent now. Yet on Apr. 30, China's National Audit Office revealed the bank violated rules on $1.6 billion in loans it made in 2008, with some of the money ending up in the stock market and unqualified projects. AgBank's balance sheet problems are "massive," says Liu Ming, portfolio manager at Shenzhen-based investment firm Dacheng Fund Management.

The AgBank offering will also come at a time of market skittishness. Stock markets in Hong Kong and Shanghai are off 7 percent and 12.8 percent, respectively, in 2010. Investors are worried that property bubbles, generous lending, and rapid monetary growth will derail China's white-hot economy. Nor is AgBank the only lender trying to get its hands on big sums of cash this year. Listed banks, including ICBC, Bank of China, and China Construction, hope to raise a combined $26 billion though share and bond sales.

Credit conditions are also tightening: On May 2, China's central bank announced that the country's biggest lenders would have to increase their capital reserves by 50 basis points to 17 percent, the third such hike this year. "There are headwinds for the sector," says Wendy Liu, head of China research at Royal Bank of Scotland in Hong Kong. Chinese banks "lent too much last year" and so need to replenish their capital now.

In spite of such concerns, market pros like Patrick Ho, an analyst with UBS (UBS) in Hong Kong, say there will be plenty of big financial institutions willing to take a chance on AgBank, given China's robust overall economy. Right now, listed Chinese banks are trading at modest price-to-earnings ratios of around 10. If AgBank prices its shares in line with that level, "there should be institutional demand" and "enough liquidity in the market to lap up those shares," says Ho.

The longer-term challenge for AgBank is learning how to operate in a less regulated environment. With the government controlling banks' lending and deposit rates, and keeping the yuan fixed against the dollar, the banks "have lived in a controlled environment," says John Wadle, head of Asian banks research at Mirae Asset Securities in Hong Kong. Liu Mingkang, chairman of the China Banking Regulatory Commission, on Apr. 16 warned Chinese lenders that this situation would not last forever and called on them to restructure. "Banks are going to have to adjust to lower margins," says Wadle.

After AgBank, analysts expect more banks to list their shares. China has more than 130 smaller banks owned by city governments that it hopes to dress up for the big dance in the global capital markets. "This whole cycle of bringing the banks to the international stage is only maybe a third over," says James Antos, an analyst in Hong Kong with Mizuho Securities. "We are only at the beginning."

The bottom line: If successful, AgBank's mega-stock offering may mean more IPOs of smaller banks controlled by local governments in China.

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