October 19, 2005

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Investing in China's banks

The China Economic Quarterly, always a good read, has several interesting articles in its latest edition. Over the next few days I'll post some excerpts of some of the more interesting pieces. One makes some telling points on the recent strategic investments in some of the big state owned banks:

The three biggest Chinese banks now all have their foreign dance partners. Herewith a few random thoughts inspired by this orgy of risk-taking:
• It is noteworthy that the banks with the widest experience of and exposure to China – HSBC, Citibank, Standard Chartered, and the French banks – are nowhere to be found on the list of investors.
• The government of Singapore (via its vehicle Temasek Holdings) is now the biggest overseas investor in the Chinese financial sector, with commitments of US$4.6bn.
• HSBC’s acquisition last year of 19.9 percent of the Bank of Communications is looking better and better. HSBC paid a lower price (US$1.7bn) for a bigger take in a better bank. Bocom is a smaller institution with a more commercial management and a heavy concentration of assets in the most dynamic part of China (the east coast). HSBC got two seats on the Bocom board, compared to the one that the new set of strategic investors will get in their respective institutions.
• The three deals effectively assign the same value to all three Chinese banks – about US$30bn. Perversely, this means that the worst bank – Industrial and Commercial Bank of China (ICBC) – is valued at the biggest premium, 50 percent above end-2004 book value of US$20bn.
• In ICBC’s case, the implicit value of US$30bn exactly equals the amount of new capital it received from the government this year. In the case of Bank of China (BOC) and China Construction Bank (CCB), the price tag is only slightly more than the total value of government assistance received in the past two years.
• Large investments by Merrill Lynch, Goldman Sachs and Allianz are predicated on those institutions offloading most of the risk on to private equity and hedge fund investors who will be expected to buy into China bank funds. This should produce some interesting road shows between now and the BoC and ICBC IPOs.

Clearly, none of these investments makes sense in a plain commercial way. What are the ways in which they do make sense? First of all, the investments are in essence capital-guaranteed. All three banks are linchpins of China’s financial system, and thus “too big to fail” and beneficiaries of an implicit sovereign guarantee. Even this was not enough, however, and Royal Bank of Scotland received warranties that would effectively prevent the value of its position falling below the purchase price even if Bank of China’s net asset position deteriorates. Bank of America is believed to received something similar for its CCB stake.

Second, it is just conceivable that plunking down a fat wad for a stake in a big stateowned bank will prove a more cost-effective way to enter China’s banking market than laboriously building up a branch network. Each new branch requires minimum capital of Rmb400m (US$49m). With the number of branches effectively limited by this high capital requirement and the slow rate of new-branch approval, foreign banks find it almost impossible to raise enough renminbi funds. They must therefore buy funds from Chinese banks (on a bilateral basis, since the interbank market is in its infancy). This means that foreign banks face an effective cost of funds of over 4 percent, about two percentage points higher than Chinese banks’ cost. A strategic investor, however, might be able to source funds at a lower rate from its partner, and try to run its China business from two or three branches in major markets.

As far as I'm aware, retail investors in CCB's IPO don't qualify for these puts.

Update (10/20)

Victor Shih says perhaps these investors don't have puts, rather a guarantee re book values.

posted by Simon on 10.19.05 at 06:50 PM in the China economy category.


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Very simple. Remember during the internet boom when pre-IPO internet companies signed on "prestigious" names to sit on their boards, in return for options? Looks like the same deal to me. Western banks prostitute their reputations in return for a piece of the IPO proceeds, and bolster investor confidence in Chinese banking institutions that have done nothing to deserve investor confidence. Some saps in these Western banks may actually believe they'll access some sort of long term benefit and guarantee their guanxi status forever by shacking up with all the key princelings, etc. In any case, somebody will be left holding the bag - Chinese depositors, taxpayers, and probably foreign investors too. Real estate agents in America/Canda/Australia probably can't wait to sell mansions to the soon-to-be Chinese Bank IPO millionaires looking for a safe place to stash their cash.

posted by: A.West on 10.19.05 at 09:18 PM [permalink]

Gordon Chang is wrong.

In the Coming Collapse of China, he argued that WTO regulations would cause money to flow out of the Chinese banking system into Western banks. The money is clearly flowing in the opposite direction.

Also, it's not "guanxi" or "princelings" that the Western banks are after. Western companies are perfectly able to develop guanxi on their own. Also, the princelings were pretty much wiped out in the late-1990's.

It's the branch network that Western banks are after. A western bank can conceivably create its own branch in the really big cities, but try opening up a branch in a small town in the middle of nowhere where there are more chickens than people. $49 million to start a branch there????

posted by: Joseph Wang on 10.19.05 at 10:43 PM [permalink]

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