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THE WALL STREET JOURNAL: How Foreign Banks Scaled the Chinese Wall

Titans Acquire Minority Stakes
With Little Control of Their Own;
Will the Strategy Prove Wise?
By KATE LINEBAUGH
February 23, 2006

The world's banking titans, including Bank of America Corp., Royal Bank of Scotland PLC and Merrill Lynch & Co., have spent billions of dollars buying small stakes in China's biggest lenders. So far, they are looking pretty smart.
When Bank of America took a 9% stake in China Construction Bank Corp. last June, the North Carolina lender agreed to pay $3 billion. That stake is valued at about $9.2 billion, following a surge in the shares after the bank's initial public offering of stock in October. HSBC Holdings PLC's 19.9% interest in China's fifth-largest lender, Bank of Communications Co., is valued at more than $5 billion, more than double what the British bank invested. Shares in both Chinese banks have soared about 40% so far this year.
Those numbers help explain foreign investors' decision to put down a lot of money with not a lot of say in how their investments are managed. The investors have minimal influence over the operations of their Chinese partners, and so far they have received few of the benefits they anticipated, such as credit-card joint ventures. They are barred from holding more than 25% of a Chinese lender.
For a major Western bank, though, it remains an open question whether taking a minority stake with little control makes for a good China strategy. The returns can be huge, but there is no assurance that the investors' highflying stakes won't decline before their three-year lockup expires — or that China will succeed in turning its banks into institutions that the foreigners will be glad to be part of.
Low prices have increased the temptation for foreign bankers to buy into the financial system of one of the world's fastest-growing major economies. As a result, they will be well-positioned if China eases foreign-investment limits. “The growth potential is huge,” says Chi Lo, an economist in Hong Kong and author of several books on China. “That is why everyone is trying to get in and get a slice of it.”
As more of China's banks go public, their pre-IPO investors are hoping for gains. Bank of China, the country's second-largest bank by assets, is looking to raise about $6 billion in an initial public offering in the first half of the year, when the likes of RBS, Merrill Lynch and others may see the value of their investments increase. They say they are in China for the long haul.
The largest Chinese bank, Industrial & Commercial Bank of China Ltd., finalized a $3.8 billion pact last month for a consortium led by Goldman Sachs Group Inc. to buy a 10% stake. ICBC wants to go public by the end of the year.
The bank stakes give foreign investors broad exposure to all sectors of China's booming economy as the government is driving its lenders to overhaul. In the past two years, foreigners — including financial investors with no plans to do any banking in China, such as Singapore's state investing arm, Temasek Holdings Pte. Ltd. and New York hedge fund Och-Ziff — have sunk more than $20 billion into the banking sector. Meanwhile, the Chinese government has spent more than 10 times that to resuscitate its banks so they can help stimulate domestic spending and provide capital for its businesses.
The government aims to transform China's banks from de facto cashiers of the state into commercially driven enterprises. It hopes they will draw on the expertise of foreign financial institutions to improve their risk management, develop products and put in place stricter oversight.
What investors get, beyond the return on their investments, is access to China's biggest lenders and their client lists, and an inside view of banking in the world's fourth-biggest economy. In addition, the foreign banks can ingratiate themselves with Chinese authorities by helping to build confidence in a financial sector better known for poor management, corruption and lax lending policies.
“There is a level of enhanced access to the Chinese economy which isn't immediately obvious to the naked eye,” says Matthew Ginsburg, a managing director at Morgan Stanley, which advised on China Construction's listing.
Risks like China's chronic bad-loan problem have in part been mitigated through guarantees that the Chinese banks have made against future financial troubles. A recent Standard & Poor's Corp. report said the sector is high-risk in comparison with its global peers, but found that profitability, asset quality and the quality of information have improved. Asked if S&P expected China to change the 25% cap on foreign ownership in Chinese banks, Ping Chew, an analyst, said there won't be a “general liberalization,” but it could be done on a case-by-case basis.
Citigroup Inc. and Société Générale SA of France are fighting tooth and nail for the two companies and their partners to get an 85% stake in Guangdong Development Bank, a midsize lender in desperate need of capital to offset a balance sheet laden with bad loans. Citigroup is seeking an exemption to the foreign-ownership limit so it can hold between 40% and 45%, while Société Générale's eventual portion would be within current rules of 25% maximum foreign ownership.
China has frequently sold stakes to foreign companies in the same line of business before state-owned enterprises go public, to increase confidence in the share sale. Those arrangements have generally resulted in handsome profits for the investors, though not always in lasting partnerships. Royal Dutch Shell PLC and BP PLC, for instance, bought stakes in China's major oil companies before they went public and sold those stakes, for substantial gains, after the three-year lockup expired.
The situation is a bit different for the banks, because China is opening its vast retail-banking market to foreign institutions at the end of the year, under its World Trade Organization obligations. Foreign investors will then have a shot at China's $1.7 trillion in savings.
But foreign banks' true access to that money is limited by their tiny branch networks. HSBC has the biggest presence of any foreign bank in China, with its 20 banking outlets, compared with some 20,000 for ICBC, the country's biggest bank.
At present, one small local bank is effectively controlled by a foreign party. Private-equity firm Newbridge Capital has about an 18% stake in Shenzhen Development Bank, a lender with a broad base of shareholders with small stakes, that it purchased at the end of 2004.
The Chinese company's chairman, Frank Newman, a former Bankers Trust chief executive, says control has been essential to make the changes needed to bring the Chinese lender closer to modern banking. “Chinese banks historically have been very decentralized,” he says. “There are some functions, particularly credit and management functions, that need to be more coordinated across the entire bank.” Mr. Newman is a director of Dow Jones & Co., which publishes The Wall Street Journal. The lender has pulled back from marginal businesses with low returns, such as transactions between banks.
The investors that have cast their lot with China's biggest banks won't enjoy that kind of control. China isn't expected to allow foreigners to control any of its biggest four banks, which control more than 50% of banking assets.
Bank of America, for instance, has a seven-year strategic alliance with China Construction that involves committing the equivalent of 50 Bank of America employees' time to work at the bank, an institution with 14,000 branches and 300,000 employees. Bank of America has one seat on a 15-person board. The two sides have agreed to discuss a potential credit-card joint venture in China. As part of this, Bank of America agreed to withdraw from retail banking in China, though it retains its corporate and commercial-banking presence.
Investors “have these short-term windfalls and huge returns on their investments,” says Mei Yan, a banking analyst at Moody's Investors Service in Hong Kong. As to the chance they will find long-term partners, she says, “we have questions in our mind whether eventually that will work out or not.”
Write to Kate Linebaugh at [email protected]

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