30 September 2006


The Globe and Mail, Sinclair Stewart & Geoffrey York, 30 September 2006

The world's largest IPO is still a month away, but Ding Qiang is already mapping out his strategy. It's not the money that's the problem -- the veteran Beijing stock investor has more than $300,000 (U.S.) of his own cash waiting at the ready -- but getting the opportunity to spend all of it.

China has been staging a series of progressively larger initial public offerings for its Big Four banks, and the attendant investor frenzy, some would say madness, is escalating in lockstep, conjuring images of the gold rush spawned by the Internet boom.

Hong Kong bank branches have resembled movie theatres on opening night, with lineups queuing out the door as hopeful investors jockey to buy shares. Such is the unabashed confidence in the prospects for these banks that one woman reportedly plowed three times her annual salary into Bank of China's $11.2-billion offering in June. China Merchants Bank, a smaller player, was so overwhelmed by the response to its $2.4-billion IPO this month that retail orders were oversubscribed by nearly 270 times.

Analysts are predicting this demand will reach even greater heights on Oct. 27, when Industrial & Commercial Bank of China launches what is expected to be a $19-billion IPO of its shares, beating the previous record set by Japan's NTT DoCoMo Inc. in 1998.

The febrile activity is easy enough to understand. The Chinese Economic Miracle is in full swing, and making a bet on the country's major banks is seen as one of the easiest ways to ride the wave. These are the institutions, after all, that are lending money to China's burgeoning industrial base, and that help to finance everything from new home purchases to the country's increasing need for foreign acquisitions. If you believe growth will continue at its double-digit clip, and that the country is serious about its privatization plans, the demand for Chinese banks stocks seems perfectly logical.

Lurking behind this infectious enthusiasm, however, is the bigger question of whether China's state-owned banks, riven as they have been by fraud, largesse, and hundreds of billions of dollars worth of bad loans, are stable enough to be foisted onto public shareholders. This is a country, despite its continuing reform efforts, where transparency remains dim, where ascertaining objective financial data can be an exercise in frustration, and where the state keeps a leaden hand even on the so-called "private" companies that have been spun off in the markets.

Few believe that these banks will collapse -- the popular view is that Beijing has too much at stake to let that happen -- or that the failure of one or two would incite an international financial crisis. Yet there are persistent concerns that the banks' well-rooted debt issues could rear their head during a recession and wreak some unanticipated havoc, not just with investors, but with China's increasingly important role in the global economy.

ICBC, because of its sheer size, looms as perhaps the biggest symbol of China's emerging promise.

China has traditionally favoured the Hong Kong stock exchange for IPOs of its state-run businesses, but now, for the first time, it will pursue a simultaneous listing on the Shanghai Stock Exchange, where it will sell about a quarter of ICBC's shares, providing mainland Chinese with a chance to get a piece of the action.

"We're all excited about the news," Mr. Ding said. "The Chinese economy has developed so fast, but until now the mainlanders had no way to enjoy the result of this fast development. But now China is trying to let us share in the economic results."

ICBC is the largest bank in the world's most populous country, with $815-billion in assets spread among about 18,000 branches. To give a sense of the sheer scale of the company, consider this: It has upwards of 150 million customers, or roughly five times the number of people who live in Canada. Analysts have crunched the numbers, and estimate that if demand is as heady as expected, ICBC will boast a market capitalization of around $180-billion. That's good enough for fourth-place worldwide, and about three times the size of Canada's biggest firm, Royal Bank of Canada.

In the eyes of investors, ICBC also comes with a guarantee of sorts, however implicit: That as the nerve centre of the Chinese financial system, its IPO-driven reformation is a "political task" the government cannot allow to fail.

"The main buyers in the mainland listing will be government-owned institutional investors, such as insurance companies and state investment companies," said Victor Shih, a political scientist at Northwestern University in Evanston, Ill., who specializes in the Chinese banking system.

"Under the current macroeconomic policies, those entities are under pressure to invest in 'safe' instruments, and ICBC shares would fall in this class. I have no reason to think that ICBC shares will not do well."

Zhiwu Chen, a professor of finance at the Yale School of Management, has seen the challenges of Chinese privatizations up close as an independent director of a handful of firms there. For him, China's decision to invite investors into its "Big Four" banks (ICBC, Bank of China, China Construction Bank, and, if it ever sorts out its problems, Agricultural Bank of China) is the only way to cure these institutions of their ills, and at the same time incite more profound political and economic change.

"The semi-privatizations have turned out to be the only way that the Chinese government can really shake things up and remove the entrenched interests in some of these state-owned banks," he said in a recent interview. "[The banks] will never be ready unless they are forced to take the challenge."

Not everyone is so certain. The chief issue dogging the sector is a residue of profligate, indiscriminate lending that left many banks saddled with staggering amounts of bad loans. For decades, banks functioned as thinly guised financing arms of the government, handing out money to all manner of state-owned enterprise.

"The big banks are junk," said Kent McCarthy, founder of U.S. hedge fund Jayhawk Capital Management LLC, which specializes in Asian securities. "They're less junky now than they were 10 years ago, but they'll still be junky 10 years from now."

Mr. McCarthy, a former Goldman Sachs banker in Hong Kong, described the valuations some of these banks enjoy as "ridiculous," and likened reading the prospectuses for their offerings to a "comedy show." While he acknowledged public shareholders should accelerate the pace of banking reform, he predicts there will be two or three painful blowups in the sector before it gets its house in order. "It's going to end badly," he promised. "We're in the 'nuts' stage -- we're not at 'super-nuts.' This could be one of those things where they shoot up another 20 per cent or 30 per cent first."

In the mid-1990s, the soured loan problem was so crushing that China injected more than $60-billion into its main banks to keep them solvent. It also created asset management companies whose function was to siphon off more than $150-billion worth of bad loans from the Big Four's balance sheets.

The result, Chinese authorities say, is that non-performing loans at the Big Four have been winnowed down to just $133-billion. Yet there are more than a few skeptics who believe Beijing is radically understating the problem. Several analysts have estimated problem loans at between $400-billion and $600-billion. (Ernst & Young, which put the figure at $358-billion, retracted its projection after a sternly worded rebuke from Chinese authorities, and sanctioned the official estimates.)

"You can't blow up your balance sheet at 20 to 25 per cent a year and not incur a very substantial portion of bad loans," said Gordon Chang, an outspoken critic of China's debt problems and author of The Coming Collapse of China. "You can't do that with a well-managed bank in a well-regulated society. How the devil can you do it China? This is just ludicrous."

The U.S. investment banks advising on the IPOs stand to make a healthy profit. The fees themselves are very lucrative: a 2.5-per-cent cut on the ICBC offering alone will yield nearly half-a-billion dollars in commissions. The far bigger payoff could accrue to firms like Goldman Sachs, which in May injected $2.6-billion for a stake in ICBC. Analysts say that investment could easily double. China Construction Bank has gained 45 per cent since going public with a $9.2-billion offering last October, and China Commercial Bank rocketed 25 per cent on the first day of trading in Hong Kong last month.

"People are going to make money in the short term, but long term, these have got to be bad investments because the banks are not as solid as the government says they are," Mr. Chang insisted. "They've got better systems, they've got better computers, their offices look nice, all sorts of things. But these banks are essentially weaker than they were before. China is just piling up more and more non-performing loans, and eventually it's going to come crashing down, because economically this doesn't make any sense."

Last year, bank lending in China increased 9.7 per cent, and was up another 10.4 per cent in the first half of 2006 alone. At that pace, insist investors like Mr. McCarthy, China must be inhaling vast amounts of additional bad loans.

The government has said it is fully committed to reforming the sector on the eve of a massive deregulation set for the end of the year. That's when foreign banks can open branches across the country and offer local currency services.

But a cleanup of these banks will take more than commitment, analysts say. Beijing still faces the huge and time-consuming challenge of transforming the banking culture, re-educating staff, centralizing lending decisions, and learning how to market new products.

"There's definitely a 'China hype' story that's behind a lot of this," said Michael Pettis, a finance professor at Peking University and a director of the New York hedge fund Galileo. "It's linked to the excess of global liquidity, the huge amount of risk appetite and a tendency to focus on the positive, rather than the negative. China is one of the hottest areas of international interest, and there's perhaps an overexcitement about China investments."

Don't tell that to Mr. Ding. He's less worried by the pitfalls than by the ability to get his hands on $300,000 worth of ICBC shares. "I don't worry about the risks of investing in ICBC," he says. "Every bank has bad loans, but ICBC is the most powerful bank in China, with the biggest market share, and it is reforming continuously. Unlike other big Chinese banks, no big scandal has ever been reported at ICBC. Every rich person in the world would like to buy shares in Chinese banks."

China's Big Four

• Industrial and Commercial Bank of China

ICBC, the country's largest bank by assets, is preparing for a record-setting $19-billion IPO on Oct. 27. It is the third of the Big Four to tap the public markets with an offering, and the first to do it simultaneously in Shanghai and Hong Kong.

Assets: $815-billion
Branches: 18,764
Ratio of non-performing loans: 4.7 per cent
Date founded: 1984

• Bank of China

The country's most international lender traces its roots back almost a century and was once the official bank for all foreign exchange. It unveiled an $11.2-billion IPO in June, and the stock has since climbed 14 per cent.

Assets: $661-billion
Branches: More than 11,000
Ratio of NPLs: 4.4 per cent
Date founded: 1912

• China Construction Bank

CCB was the first of the Big Four to list its shares in Hong Kong with a highly successful $9.2-billion offer one year ago. The bank's shares are up roughly 45 per cent since that time.

Assets: $534-billion
Branches: 14,250
Ratio of NPLs: 3.9 per cent
Date founded: 1954

• Agricultural Bank of China

The last of the Big Four, while one of the biggest by assets, is viewed as the weakest because of its issues with bad loans and surfeit of branches. The bank has been restructuring its operations, and market watchers say it will eventually follow its peers into the public markets.

Assets: $603-billion
Branches: 31,000
Ratio of NPLs: 26.2 per cent
Date founded: 1949