ONWARD WITH THE PARTY?
Yes, and ongoing reforms will bring stability and efficiency in capital allocation.
By Abe De Ramos

That muffled chatter and clinking of champagne glasses that you hear from mainland China is the sound of subsiding euphoria surrounding its banking sector, following the successful listing last October of the third largest of the Big Four state-owned banks, China Construction Bank (CCB). But it will only take a while before the cheering grows again. The second largest, Bank of China, is expected to launch its initial public offering in the first quarter of 2006, likely to be followed by the largest, Industrial and Commercial Bank of China (ICBC), later in the year.

The height of the noise will most likely come when ICBC opens itself up to foreign stakeholders before it goes public, as the two others have done. Deals with smaller banks will add to the din. Anytime soon, international banks Citigroup, ABN Amro, Deutsche Bank, Société Générale, and DBS Bank are expected to make a bid for Guangdong Development Bank, a southern China player. No one doubts the potential that these deals offer their foreign buyers. With an urban market of 540m people and an economic growth rate in excess of 9% a year, China is attracting and creating capital like never before.

But the acquisitions sweeping Chinese banks are good not just for the parties involved; they could change the way China knows banking. Even now, most of the banks behave as expected of a socialist financial institution. The entry of foreign banks and their eventual privatization should bring capitalism where the capital is. At least, the structural changes should overhaul the primitive credit culture in China that, in any other country, would have already brought its banks to the ground. This will have two long-term benefits: a more stable financial sector, and a banking system that allocates capital more efficiently. The beneficiaries are not just the state, but multinationals and domestic private enterprises that compete for capital as well.

Prior to the current wave of banking reforms, state banks and virtually all of their autonomous branches wrote blank checks for pet projects of local governments regardless of returns or viability. Such aggressive growth created not only some of China’s best and largest enterprises, but also thousands of struggling ones – along with high-level corruption and massive amounts of bad debt. As of last year, even after small amounts of recapitalization, non-performing loans represented 25% of GDP. With $711 bn in foreign reserves, the Chinese government has spent $60 bn to recapitalize the banks as a first step to bringing them to international standards.

Ultimately, China’s goal is to make its banks more competitive by the time it further opens up its financial-services sector to foreign players by the end of 2006, as part of its commitments to the WTO. Pressured for reform, Beijing acknowledged that party bureaucracy should distance itself from commercial banking activities. “For the large state banks, it’s almost like a pre-requisite for them to have strategic partners,” says May Yan, vice president of Moody's Investor Service in Hong Kong. “Local banks can catch up quickly in terms of product knowledge and get the most advanced software in the world, but for them to control risk, they need to change their credit culture and commercialize their operations.”

Such drastic change could only come from outside. As such, last June, Beijing sold 9% of CCB to Bank of America for US$2.5 bn, and a further 5% to Temasek Holdings of Singapore for US$1.5 bn. A month later, it ceded 10% of Bank of China to a consortium consisting of the Royal Bank of Scotland, Merrill Lynch and the Li Ka Shing Foundation for US$3.1 bn. But more than the cash it generated, China wanted and expects the foreigners to share their knowledge and help improve the state banks’ risk-management and internal control systems, to finally end the cycle of ballooning bad loans and state-sponsored recapitalization.

To be sure, the Chinese banks had been centralizing their operations to rein in lending activities. CCB, for example, had reduced its loan-authorizing branches to about 200 out of 14,500 prior to its stake sale. Greater expertise is needed in a wider range of issues – from credit-risk assessment to transparency in reporting to better corporate governance. Bank of America, for one, has sent 50 senior staff to train head-office staff at CCB in these areas. “Having foreigners who have access to the accounts and representation on the board means the banks will be managed to make a profit for the shareholders, not to do as the government tells them and to just help line the pockets of some of the senior management,” says Peter Tebbutt, director at Fitch Ratings. Going forward, as China eases its interest-rate and foreign-exchange policies in response to international pressure, local banks would also need to learn from foreign partners about how to manage market risk.

In the end, the commercialization of Chinese banks will depend on how well the two cultures work together. Analysts choose to be optimistic. Ryan Tsang, credit analyst at Standard & Poor’s in Hong Kong, gives Bank of China a stable outlook with the “expected improvement of the bank’s financial profile, corporate culture, and risk-management capability over the near term.” Of CCB, Tsang says the IPO is likely to strengthen the bank’s internal reform program “by subjecting the bank to a high degree of market discipline.” Analysts expect Chinese banks’ risk management to be in line with international standards in five to seven years. “If they didn’t have the foreigners in there, it might take local banks seven years to get up to international standards, and even then they’ll probably fall short,” says Tebbutt.

In the meantime, what the foreign banks expect to gain from their investments is first-mover advantage as China opens up the rest of its financial-services sector. “What the foreigners would like to get into are joint ventures in things like credit cards, bank assurance, wealth management and investment banking,” says Tebbutt. These are nascent services in the mainland and like commercial banking, the mostly state-owned players could also use some help in international best practices. These services also touch the heart of the population – the Chinese still save 40% of their earnings. Perhaps with shared expertise from foreign players, the ordinary wage-earner could be better served as well.