BANKING
Riding the Chinese Banking Dragon
August 9, 2007
Keith Pogson, Ernst & Young & Fergus Duncan, Ernst & Young

As the countdown clock to the Beijing Olympics ticks past the two-year mark, officials are rushing to prepare for China's grand entrance onto the world stage. Simultaneously, China has worked hard on readying its financial services sector to meet WTO demands requiring further liberalization of the industry to foreign competition in 2007.

These reforms reached a striking new climax with October's world record-setting US$21.9bn listing of the Industrial and Commercial Bank of China (ICBC), China's biggest lender.

While globalization has sparked a buying spree in emerging markets generally, China has been the front-runner in raising new capital in the banking sector. Its leadership status is best reflected by the fact that 98% of bank IPO funds raised in Asia in the past 20 or so months have been secured for Chinese banks.

Historical Challenges

China's record-breaking performance in raising more than US$46bn is all the more stunning given that, just two years ago, the challenge of cleaning up balance sheets and non-performing loan portfolios was deemed next to impossible by the international investment community.

China's financial institutions have historically suffered the disadvantage of having dual operating roles. The authorities viewed them not simply as banks, but also a major vehicle for providing capital to state-run companies. This historical bank role required a shift to a different operating model, and the Chinese government determined that public ownership was the best way to improve the performance and international reputation of its state-owned commercial banks.

Bank Restructuring

China's banks kicked off their structural reforms ahead of receiving capital injections from the central government. During the past five years, they have streamlined their organizations through closure of less efficient branches and scaling back their workforces through attrition and early retirement, among other factors.

For example, China Construction Bank (CCB) and ICBC closed more than 11,500 and 12,900 branches respectively, and each reduced its workforce by over 100,000 employees. They then converted into joint-stock companies with improved corporate governance and enhanced risk management systems.

The financial restructuring of these banks was unprecedented in China's banking history. The initial recapitalization from 2003-2005 amounted to at least RMB608bn (US$78.2bn), consisting of an injection of capital through State Administration of Foreign Exchange (SAFE) investment, new shares subscribed to by the National Social Security Fund, and accumulated losses replenished by the Ministry of Finance.

In addition to capital injections by the Chinese government, restructuring was accomplished in a two-stage carve-out of non-performing loans. Initially, approximately RMB420bn of Loss-Classified NPLs were written off from the four banks' accounts. Subsequently, nearly RMB796bn of doubtful NPLs were sold off to asset management companies created specifically for this purpose. Carve-outs of the four banks' NPLs during 2003-2005 resulted in the total disposal of RMB1.216bn of NPLs, and NPL ratios dropped from the mid-teens to mid-single digits by the end of 2005.

Strategic Investors Appear

The hugely successful listing run began in the summer of 2004 when HSBC invested US$1.8bn in the Shanghai-based Bank of Communications (BOC), China's largest non state-owned bank and fifth-largest lender. The next milestone occurred when Bank of America announced its US$2.5bn investment in state-controlled CCB (the country's fourth-largest lender) in June 2005. Later, ICBC also took on strategic investors when Goldman Sachs, American Express, and Germany's Allianz agreed to invest US$3.78bn.

The Chinese government viewed the participation of strategic investors as a crucial step forward in improving corporate governance and management of the nation's banks. Alliances with foreign banks turned out to be a vital ingredient in the success of the IPOs, as they provided Chinese banks with technical assistance and, most importantly, equity stakes that offered additional credibility and reassurance to other investors when the banks came to market.

The rapid intensification of global investment in Chinese banks is particularly remarkable when contrasted with the slow pace of foreign participation during the preceding two decades, when the 200 or more foreign commercial banks operating in China accounted for a mere 1% of total loans and deposits. From a negligible combined outlay of estimated US$500m at the end of 2003, foreign investors have now committed as much as US$18bn to the Chinese banking sector in the past 12 months alone.

Giant Banks Come to Market

BOC became the first Chinese lender to sell shares 'overseas', as the Hong Kong bourse is termed, with a stock offering that raised US$2.2bn. Another landmark transaction for global capital markets came in October 2005 when CCB successfully raised US$9.2bn, making it the largest global IPO in five years and, at that time, the largest bank IPO worldwide since 1980. The IPO generated a whopping US$80bn in total global demand, of which US$60bn came from institutional orders.

Even SEC Chairman Christopher Cox's comment that CCB failed to meet the New York Stock Exchange requirements did not prevent the IPO from being a roaring success. By electing to go to market in Hong Kong rather than New York, CCB challenged the assumption that large companies need to list on a US exchange to raise significant capital, and this has potentially changed the rules of engagement for capital markets forever. Previously, Hong Kong had been a steady pipeline of large-scale Chinese IPOs for more than a decade. It has now become the prime fundraising center for China (with Shanghai set to play an increasingly important support role) for a variety of reasons: the more onerous reporting Sarbanes-Oxley requirements of New York, its proximity and easier cultural fit, and an increasing ability to compete with New York in terms of liquidity.

In June this year, China's second-largest bank by assets, the Bank of China (BoC), successfully braved volatile global stock markets to pull off what was, at that time, the world's fourth-largest IPO, with its US$11.2bn Hong Kong listing. BoC floated 10.5% of its enlarged share capital after attracting a staggering volume of orders worth more than US$150bn. The float of a 10.5% slice, conservative even by Asian standards, at least partly explains the huge demand, which reached 50 times subscription levels by institutions and almost 80 times for retail.

To further improve its capital adequacy, BoC followed up on its Hong Kong float with a secondary issue of domestic A-shares on the Shanghai Stock Exchange, raising nearly RMB20bn (US$2.5bn) in what was the biggest-ever IPO on China's stock exchanges.

After BoC's offerings, ICBC's mega-listing further demonstrated the capacity of China's stock market to channel massive market liquidity into the first-ever dual Hong Kong-Shanghai stock offering. The timing of the offering was favorable, capitalizing on a recently reinvigorated Shanghai market. ICBC picked up orders of US$400bn for the Hong Kong offering and US$100bn in Shanghai, triggering a green shoe option, marking the full emergence of China's banking system onto the world stage.

To take advantage of the sustained growth in China's economy, ICBC promised to pay out 45% of its earnings as dividends to further whet investor interest. After its float, ICBC was catapulted to the position of the world's fifth-largest bank based on market cap. Its share price on its debut surged to a premium of almost 15% to its offer price on the Hong Kong Exchange and a more modest 5% in Shanghai. By December the share price had reached parity; both classes advanced over 25% over the issue price.

Deal Pipeline Continues

CCB's turnaround was rewarded this August when it was afforded Hang Seng Index status and made history as the first Chinese entity to be elevated to blue chip status on the Hong Kong bourse. BoC was also selected to join the elite on the Hong Kong bourse in December, reflecting the growing profile of the Chinese banking sector.

In the wake of these mega-floats, a number of smaller Chinese banks are also planning to list. China Minsheng Banking Corporation and China Industrial Bank are seeking listings worth over US$1bn each, the latter scheduled for early in 2007. In the meantime, some leading city commercial banks, including Ningbo City Commercial Bank, Nanjing City Commercial Bank, Bank of Shanghai, and Bank of Beijing, are preparing to sell shares to fund network expansion. These banks represent the next wave of financial institutions coming to market.

Chinese banks with newly listed status are now subject to the reporting and transparency discipline of the marketplace for the first time in the country's history of state-owned financial institutions. Their performance under such scrutiny will provide a real indicator not only of their own progress, but also of China's financial sector reform and the health of the PRC economy.

The successful completion of the IPO process and establishment of a bank as a public company is an ongoing process that will continue for years to come. While it remains to be seen whether China's large state-owned banks, now with strategic investors on board, can adapt in a truly competitive landscape, the early signs are positive.

ICBC's historic listing may only be the first step in achieving their ambitions. The bank has already professed its aspirations to become a first-rate international enterprise. With a huge supply of funds now at hand, it will undoubtedly seek to follow in the footsteps of other Chinese companies that are making their mark on the world stage. CCB has declared its intention to make overseas expansion its top priority, having already bought Bank of America's Hong Kong and Macau assets in August. The gauntlet has been thrown down for other banks to follow CCB's expanding presence outside of mainland China.

The future performance of ICBC and BoC will be seen as a barometer by which the financial community will judge the health of China's banking system as a whole. But more exciting will be watching global banks respond to the growing presence of China's institutions in their home markets.

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