The Royal Bank of Scotland (RBS) just invested US$1.6 billion in the Bank of China (BoC), becoming its major "strategic investor." The initial public offering (IPO) of China’s state banks on overseas stock markets has caught the attention of international economic circles.
Bank of China Finally Married to a Foreign Bank
In the eyes of foreign investors, in the past few years, China’s state banks have experienced both ups and downs, from "princesses" to "foundlings." In December of 2003, eleven international investment banks, including Citigroup, JP Morgan, Goldman Sachs, UBS-Warburg, and Morgan Stanley, all enthusiastically purchased China’s bad loans. The bidding war spurred the Chinese government’s unlimited imagination. Since investment banks found purchasing the state bank’s bad loans so attractive, they figured out that listing the state banks in an IPO would bring them even more interest and more money.
Although the government tried hard to raise capital in foreign markets, the results were unexpectedly disappointing. China’s Big Four state banks even became "foundlings." Not one investment bank, including those of China’s long-time partners, wanted to invest. It seems that, during the process of purchasing bad loans, the investment banks uncovered the reality of China’s banking system. Realizing it was a black hole that could never be filled, these banks backed off.
After extensive fishing, BoC finally managed to hook RBS, ending its two-year-long effort of seeking "strategic investors." Thus it was able to go public on the Hong Kong market in the first half of 2006. China’s propaganda organs quickly spread and even greatly exaggerated this piece of good news. The Xinhua News Agency, China’s popular state-owned media, reported the news on August 19 with the headline, "RBS spends US$3.1 billion to purchase a 10 percent ownership of Bank of China." Of course, examining the details reveals that it was not RBS alone that invested the US$3.1 billion. Led by RBS, the group included Merrill Lynch and Hong Kong tycoon Lee Kashing.
Here’s how the stock was allocated. RBS spent US$1.6 billion to purchase 5.16 percent of the ownership of BoC and to get one seat on the board of directors; Merrill Lynch and Lee Ka-shing, on the other hand, invested US$1.5 billion for the remaining 4.84 percent of ownership. What few people know is that the investment banking group only promised three years of stock ownership under an unprecedented bargaining condition that the Chinese government guarantee that their investments will not be affected by any sudden deterioration of BoC’s financial situation or other risks.
The official reports did not disclose Merrill Lynch’s ownership percentage. They purposely mingled Merrill’s ownership with that of the Chinese government’s "family member," Lee Kashing. Since Merrill Lynch was competing for the underwriting business for this transaction, it is unlikely that it would put up a lot of money. Most likely Merrill Lynch simply loaned its prestigious name to BoC to help the latter demonstrate to the rest of the world that BoC is hot. Regarding Lee Kashing’s involvement in the transaction, it would be too obvious to the public that the Chinese government used its own "relative" to decorate the transaction, which would not be a glorious thing for the government. No wonder Xinhua‘s headline shrewdly let RBS take the honor for all of the US$3.1 billion investment.
The Plans of China’s State Banks to List on the International Markets
The year 2005 is key to China’s reform of its financial industry. In the first half of this year, China’s banking industry tried its best to implement five strategic tasks: raising the overall competitiveness of its banks, pushing for IPOs on the overseas markets, seeking strategic investors, cleaning up major corruption in the banking system, and implementing a system of accountability and asset capitalization. Their main goal is to sew a few "beautiful new clothes" to cover up the gaping holes in order to raise much needed overseas money.
On June 23, having failed to recruit its "strategic investors," the Construction Bank of China was forced to go IPO on the Hong Kong Exchange. On the first day, the stock closed at HK$2.825, 13 percent higher than its IPO price of HK$2.5 per share. The value of the stock reached HK$5.158 billion, the highest of the day. According to the investment banking industry, however, this "great" news was widely circulated to be related to the anticipated appreciation of the Renminbi.
The rest of the four major state banks are also warming up to go public. In chronological order, they are:
The Bank of China
In the past few years, BoC has expanded its businesses in Hong Kong. In the meantime, it has implemented shareholder reform. On August 26, 2205, the Bank of China Ltd. was formally founded, setting the timetable for its IPO in the first half of 2006.
The China Construction Bank
The China Construction Bank Ltd. was formed on September 21, 2004. Its initial public offering time could be as early as this year.
The Industrial and Commercial Bank of China
Reform has been formally initiated, and the plan to raise capital is taking shape. It was reportedly to register the limited share corporation at the end of September. Currently, it is contacting American and European financial firms to negotiate how to introduce strategic foreign investments into the bank.
The Agricultural Bank of China
The Agricultural Bank of China has the highest rate of bad loans and the lowest capital adequacy ratio of all four major state banks of China. Therefore it is facing the most difficult challenge of reform in preparation for an IPO. Currently it is reorganizing its financial structure.
Although it is a relatively small bank, the Construction Bank of China will probably have no problem selling its ~US$700 million worth of shares on the Hong Kong stock market. However, expecting Hong Kong’s stock market to bring in as much as US$15 billion for shares of both the China Construction Bank (CCB) and BoC is most likely too optimistic. Instead these two banks may have to look for capital outside of Hong Kong.
The Road to Finding Strategic Investors Is Not Smooth
Because of the current condition of China’s state banks, it would be nearly impossible to go public overseas without the involvement and assistance of foreign banks. Therefore, the most important step for them to go public overseas is is to invite overseas "strategic investors." An official from China’s financial administration pointed out three things that foreign strategic investors will provide: strong capital, advanced corporate structures and management experience to run the companies, and help with elevating the quality of financial services in China’s banking industry. The last two are companions of the first, since any single foreign bank is officially prohibited from owning over 20 percent of the total shares. With such a low involvement, it would be difficult for foreign investors to be effective in the bank’s management.
Early in July of 2005, BoC tried to get underwriting for its overseas IPO by interviewing seven investment banks that are qualified to bid for the business. These investment banks include Citigroup, the Bank of Germany, Goldman Sachs, Morgan Stanley, Solomon Brothers, Merrill Lynch, and the Bank of Switzerland. It has been estimated that the IPO of BoC will raise as much as US$5 billion, which means 3 percent, or US$150 million of underwriting fees to the three or four underwriters. Experts in the investment banking industry believe that Bank of China International, Bank of Switzerland, and Goldman Sachs will likely earn most of the US$150 million of underwriting fees. As a close partner with Bank of China International, Merrill Lynch will also likely be able to share the profit.
As the second largest bank in China, BoC has over 11,000 subsidiaries and branches. Together they own 12 percent of China’s credit market, and 14 percent of residential savings. To support BoC’s reform, the Chinese government injected US$22.5 billion into it at the end of 2003 to clean up its bad loans and to prepare it for its IPO in the first quarter of 2006. Despite their competition for the underwriting rights for BoC’s IPO, none of the 11 investment banks showed any interest in becoming its "strategic investors." They even failed to keep their promise of purchasing shares prior to the IPO of China Construction Bank. Citigroup was crossed off the list of underwriters and lost about US$87 million as a result.
As a "strategic investor" this time, however, Merrill Lynch is reluctant to make public its actual investment amount. Given the rumor that Merrill Lynch will become the underwriter, one has to suspect that the intention of Merrill’s investment is to establish a good relationship for further cooperation.
From the process of RBS’s investment, it is clear how important it is for China to find this "strategic investor." Right after it made public its intention to buy shares of BoC at the end of July, RBS’s stock price dropped 5 percent. The Wall Street Journal reported that, according to people familiar with the bank, due to the resulting pressure, the management of RBS would, at its next board meeting, propose reducing the amount of its stock ownership in BoC. Based on the final investment ratio, this news seems to have proved true.
Which Banks Are Willing to Become the "Strategic Investors" in China’s State Banks?
There are two reasons that foreign investors do not want to be the shareholders of China’s state banks. One is that investors are cautious because of the lack of transparency about these banks’ financial information and various rumors about the bad loans and corruption in China’s banking industry. The other is that foreign banks can’t obtain sufficient shares for them to own the decision-making power in running the businesses.
So far there are three foreign banks that have become the "strategic investors" in China’s state banks. The most prominent among them is Bank of America, which is often interpreted in China’s reports as "United States Bank," or even mistakenly quoted as "Citigroup."
On June 17, 2005, in Beijing, CCB and Bank of America signed the final agreement of the latter’s strategic investment and collaboration with the former. Investing in CCB in multiple steps, Bank of America will eventually own 19.9 percent of the shares of CCB, which is close to the 20 percent limit that the Chinese government imposes on foreign investors in owning China’s banks. This transaction becomes the largest single investment of foreign companies in Chinese firms, which makes CCB the first of the Big Four state banks in reaching agreements with foreign strategic investors. On July 4, Singapore’s Temasek Holdings also signed a final agreement with CCB to become CCB’s second foreign strategic investor. By spending US$1 billion, Temasek bought one seat on CCB’s board of directors.
Like RBS, Bank of America does not have a lot of businesses in China. Both companies’ investment in China’s state banks is apparently an investment in relationship. Their purpose is to use their capital to gain advantage in expanding their businesses in China’s vast market, to take advantage of CCB’s existing sales channels in China in the name of collaboration, to sell various retail banking services, and to elevate their global status.
Nevertheless, experts in the industry do not expect good results from such strategic investment. Cameron Fagan, director of research at Straszheim Global Advisors in the United States, called RBS’s investment "not a strategic investment, but a relationship investment." With only 10 percent of stock ownership, RBS will hardly have any material impact on the management and reform of BoC. "To many foreign banks such as RBS, their Chinese partners remain structurally large, very inefficient, and heavily bureaucratic government branches that carry a lot of risks. With these risks, it is hard to expect normal investment returns. These are not strategic investments based on profit returns, but relationship investments to establish good connections with the Chinese government to facilitate their long-term development."
United States’ Concerns: The Wave of China’s Capital-Raising Effort May Negatively Affect the Security of the U.S. Economy
The United States, which China regards as the "heaven of capital raising," is cautious of China’s activities in the U.S. capital market. A number of China’s state-owned companies want to enter the U.S. capital market. BoC and CCB alone are planning to raise $15 billion in the U.S. capital market. To address the trend of China’s fundraising in the United States, the U.S.-China Economic and Security Review Commission (USCC) of the U.S. Congress held a hearing on August 11 to evaluate how this wave of Chinese fundraising will affect U.S. national security.
Two of the experts the committee invited have a business relationship with China. They believed that those reviewing China’s companies should not be too strict. Donald H. Straszheim, the former Chief Economist of Merrill Lynch, suggested that U.S. lawmakers should trust the ability of the market to distinguish winners and they should not create any obstacles to the IPOs of China’s state-owned firms. Having processed many IPO businesses of Chinese companies, Robert G. DeLaMater, a partner of Sullivan & Cromwell LLP, was concerned that if the United States starts to impose too high a requirement for the IPOs of foreign firms, the American capital market might lose its attractiveness.
The voice for strict review was much higher. Frank J. Gaffney Jr., the director of the Center for Security Policy in Washington, insisted that the massive IPOs of China’s state-owned institutions in the U.S. capital market would affect the national security of the United States. "I believe that it is neither in the interest of American investors nor of the country as a whole to be underwriting Communist China’s state-owned enterprises engaged in such activities as: the manufacture of intercontinental-range ballistic missiles and space-based weapons designed to blind our satellites; the proliferation of weapons of mass destruction; the suppression, in conjunction with police units and regional and national level governments, of human rights; the despoiling of the environment; the crushing of Tibetan freedom; and various business dealings with terrorist-sponsoring states," said Mr. Gaffney.
Richard D’Amato, Chairman of USCC, thinks that even from the perspective of economic interest, American investors should be cautious of the IPOs of China’s state-owned firms, "because we have just experienced the bubble burst of our stock market when millions of Americans incurred losses as a result of the bubbles of the technology shares. I don’t want to see millions of American investors trapped once again by the stock bubbles of Chinese companies." D’Amato expressed his special concern over the extent of China’s state banks’ bad loans and the opacity of its banking system. He cautioned investors to be alert for the risks of investing in Chinese companies. "As Chinese financial institutions prepare for an estimated combined US$15 billion in listings, questions need to be raised regarding the loan portfolios of these institutions. I am concerned that U.S. investors may not have sufficient information to make informed decisions about the risk of these investments. Furthermore, the possible links between listed state-run firms and banks and China’s military industrial complex has here-to-for lacked comprehensive examination."
Hearing Co-Chair Michael R. Wessel stressed concerns to the USCC about the lack of transparency of the Chinese firms.
Despite the big differences between the USCC leaders and their invited testimony experts with regard to whether to restrict Chinese firms’ listings in the U.S. equity market, the United States has at least been alerted about China’s listing strategies, as is demonstrated in the concerns raised by USCC. The swearing-in of Conservative Rep. Christopher Cox as the new chairman of the Securities and Exchange Commission (SEC) makes the Chinese government particularly uneasy. Back in 1999, Cox authored the "Cox Report" in which he accused China of stealing U.S. nuclear secrets in a planned way. He is therefore regarded in China as a "representative of the Anti-China and Anti-Communist force." As the U.S.-Sino relationship tends to be more and more distant, the nomination of Cox for the critical position on the SEC certainly has subtle implications. With Cox guarding the door of the U.S. equity market, the IPOs of the Chinese state-owned firms that have routinely deceived and robbed the Chinese equity market and are full of bad loans will surely face stricter examinations.
He Qinglian is an renowned Chinese economist currently residing in the United States as a guest researcher.