Till recently China's banks were described
in terms that made them global pariahs. They were not seen as banks that
mobilised savings for investment, but agencies for channelling State subsidies
(named loans) to sate-owned enterprises with soft budget constraints.
They were perceived as burdened with huge non-performing assets, which
were a legacy of their position as an instrument of the State rather than
commercial ventures. And they were considered to be corruption-ridden.
Unless they were restructured and recapitalised with substantial infusion
of funds, their closure was considered a serious possibility.
Such assessments were particularly disturbing because the 'big four' wholly
state-owned banks: Agricultural Bank of China, Bank of China, China Construction
Bank, and Industrial and Commercial Bank of China, dominated the banking
sector, accounting for an overwhelming share of assets. Failure of any
one of them could have devastating consequences for the financial sector
as a whole. But failure, most observers agreed, was a remote possibility,
given the strength and control exerted by the Chinese government. What
seemed more likely is that foreign players who were to be provided a greater
foothold in the Chinese banking market as part of China's WTO accession
conditions, which requires a complete opening up of the banking sector
to foreign firms by 2006, were seen as unlikely to be interested in acquiring
a stake in these banks even if offered a deal.
All that has changed considerably in recent months, but specially during
August which saw the completion or announcement of three major acquisitions
of equity in Chinese banks. On August 19, the Royal Bank of Scotland (RBS),
leading a consortium that included investment banker Merrill Lynch and
Hong Kong billionaire Li Ka-shing, acquired a 19.9 per cent stake in Bank
of China, the second largest in the country in terms of assets, with an
investment estimated at $2.5 billion. Soon thereafter, Temasek Holdings,
Singapore's state-owned investment company that is responsible for state
equity investment in the country, announced that it would acquire around
10 per cent of equity stake in Bank of China. If this is additional to
the acquisition by RBS, foreign ownership in Bank of China would amount
to an unprecedented proportion of nearly 30 per cent. However, full details
are still awaited.
As if this huge acquisition in China's second largest bank was not enough,
on August 30, a second consortium consisting of Goldman Sachs, American
Express and Allianz (of Germany), among others, signed a preliminary agreement
for acquisition of a 10 per cent stake in China's largest bank, the Industrial
and Commercial Bank of China for an estimated sum of more than $3 billion.
Add these to the acquisition by foreigners of two chunks of equity in
China Construction Bank in the second half of June, and the tendency towards
privatisation of the core of China's banking sector (except, of course,
for the Agricultural Bank of China, which is unlikely to find willing
buyers) is clearly established. On June 16, Bank of America invested a
9 per cent stake in China Construction Bank for $2.5 billion, with the
option to raise this stake to 19.9 per cent at a later date. Days later,
on July 1, Temasek announced the acquisition of an estimated 10 per cent
stake in China Construction Bank for $2.4 billion. This, together with
the more recent acquisition of equity in the Bank of China, makes Temasek
the biggest foreign player in China's banking sector.
Overall, the Wall Street Journal estimates that foreign investors have
pumped in more than $15 billion into the Chinese banking industry since
June. Why has there been such a sudden rush of interest in a sector that
was not considered a worthwhile investment till recently? Needless to
say, there have been a number of developments that have been occurring
in the background that warrant a change in mindset. First, partly in preparation
for the full opening up of local currency banking to foreign players by
2006, the Chinese government has been recapitalising its banks. The government
is estimated to have pumped as much as $60 billion into the three biggest
banks to write off loans that were unlikely to be repaid. As a result,
official figures show that the proportion of non-performing loans fell
to 13.2 per cent at the end of 2004, compared with 18 per cent the year
before. The Industrial and Commercial Bank of China, which received the
largest share of recaptalisation funds from the government, claims to
have slashed non-performing loans to 4.5 per cent of advances as compared
with 19 per cent last year. Though these figures are not accepted by many,
substantial recapitalisation has occurred.
Second, the governance structure of banks has been modified in keeping
with market requirements, with credit-risk assessment systems, audit committees
and boards of directors. Further, efforts are underway to substantially
reduce “overmanning”. And, third, penal actions against corrupt senior
bankers have been resorted to, in order to convey the message that such
corruption will not be tolerated, For example, the extreme penalty of
a death sentence (later suspended) was imposed on the head of Bank of
China's Hong Kong unit in August on grounds of embezzlement. Earlier in
March, the chairman of China Construction Bank was forced to resign because
of allegations of corruption. Bank of China has reportedly has “tried
and penalised” at least 50,000 workers for fraud.
These developments are being used to justify why yesterday's pariahs have
become today's favourites. But they still do not explain why foreign players
are interested in acquiring minority stakes in the big banks rather than
set up operations on their own. As the WTO deadline of 2006 approaches
for providing foreign banks full national treatment in local banking,
what was expected was that there would be increased interest in increasing
their presence through their own subsidiaries and joint ventures. Rather
it appears that foreign interest in Chinese banking has gone through a
two-step process. To start with, foreign banks seemed to be interested
in establishing a Chinese presence through subsidiaries or joint ventures
with smaller banks. According to CBRC statistics, foreign banks had set
up 204 operational entities in China by the end of October 2004, with
total assets amounting to 553.4 billion yuan (US$66.7 billion). By that
time, sometimes ahead of WTO accession requirements, some 105 foreign
banks had won renminbi licenses, 61 of which have been allowed to provide
renminbi services to Chinese enterprises. But their overall presence is
indeed limited. They account for only 1.8 per cent of all banking assets
in China, though they have managed to secure 18 per cent share of the
foreign currency lending market.
Foreign banks also acquired stakes in smaller commercial banks. For example,
Shenzhen Development Bank announced in October 2002 that Newbridge Capital
Inc. had acquired a stake of 18.02 percent in the bank through an investment
of new capital and the acquisition of existing holdings from state shareholders.
Citigroup announced on January 2, 2003 that it would purchase a 5 percent
stake in Shanghai Pudong Development Bank. Ing Group acquired a 19.9 per
cent stake in Bank of Beijing in March 2005. And, Commonwealth Bank of
Australia bought a 19.9 per cent stake in Hangzhou City Commercial Bank
in April 2005. Instances of this kind have been proliferating.
However, what the current spate of acquisition suggests is that foreign
banks are graduating out of a complex process of growth involving building
a network based on making large investments, negotiating the regulatory
framework and competing with the big four banks. The Chinese government's
growing willingness to permit sale of minority equity blocs in the big
four banks as well as the promise of profit from the large network these
banks control in an economy that continues to boom, seems to have persuaded
the to settle for an initial minority stake. Competition between foreign
banks to acquire a share in the credit card, consumer credit and mortgage
loan business, which is expected to boom in the coming years, has obviously
changed their mindset.
But that is not all. These investments have a strong speculative component.
There are many who are speculating on the real possibility that the value
of bank shares would appreciate significantly in the run up to their being
listed on stock markets at different points of time over the next two
years. This clearly explains the interest of investment bankers like Merrill
Lynch and Goldman Sachs who are unlikely to be interested in contributing
to the management of large banking networks in a spiralling market. It
also possibly explains the interest of Temasek Holdings in making Chinese
bank equity a significant part of its $54 billion investment portfolio.
The recent decision of the Chinese government to begin the process of
unpegging the renminbi (RMB) from the dollar must be aggravating this
speculative tendency. China's massive foreign reserves, unprecedented
export success and attraction of foreign investors suggest that the RMB
would only rise if the government increased the band within which it can
fluctuate. A purchase of equity today not only promises to offer large
profits when these banks are listed, not only because of appreciation
of the RMB value of such equity, but also due to substantial gains from
currency appreciation.
Thus while foreign investor interest in the Chinese banking frontier is
understandable, what is unclear is the motivation for the Chinese government's
decision to divest large chunks of equity in the big four banks. Given
China's ambiguous guideline on foreign equity caps, the extent of such
divestment is clearly being decided on a case-by-case basis. And given
the most recent trends it appears that the aggregate 25 per cent ceiling
and limit of 20 per cent for ownership by a single investor may be reached.
However, having recapitalised banks with local resources and restructured
them, the government is unlikely to move to a situation where it loses
control.
It could be argued that a foreign presence could ensure managerial inputs
needed for new markets such as the credit card, automobile finance, consumer
credit and mortgage markets into which these banks are diversifying. But
even if such expertise is seen as not easily developed or hired, the focus
must be on acquiring appropriate partners. The indications are that speculative
motives, rather than purely long run interest, are involved in the current
spate of acquisitions suggest that this is not the emphasis. Given that,
the reason why the Chinese government is courting the dangers associated
with the entry of players with international private concerns that are
sharply at variance with national social concerns, which the banking system
must take account of, remains unclear. One would imagine that the Communist
Party would recognise these dangers and reverse the tendency, as it has
recently done regarding the inequalising effects of post-reform growth.