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Asia-PacificDecember 5 2005

Mission accomplished

Sophie Roell in New York and Beijing explains the story of a seemingly mission impossible, the successful part-flotation of CCB, one of China’s huge state banks.
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By the time the management reached New York it was all over. China Construction Bank (CCB) – formerly People’s Construction Bank of China, set up to lend to large-scale government infrastructure projects – had successfully raised $8bn from selling just 10% of its shares in the largest initial public offering (IPO) in five years, the largest bank IPO since 1980 and the largest ever IPO out of China.

Over lunch at the Palace Hotel on Madison Avenue, Guo Shuqing, a high-ranking central bank official appointed chairman just seven months before, makes his final presentation to investors. It is largely a formality, as the IPO book has already closed.

Unusually for a Chinese official, the presentation is in English: learnt from a year Mr Guo spent at Oxford as a visiting scholar in the 1980s. Among the diners are some of the US’s top banking executives, tripping over each other to give the Chinese bank ‘face’. There is Brady Dougan, CEO of CSFB – the bank brought in just two months earlier to help underwrite the deal. And there is Ken Lewis, CEO of Bank of America, which in June gave the IPO a huge fillip by taking a strategic stake in the state-owned bank.

Lucrative work

For the investment banks in particular, Chinese IPOs spell huge business: Morgan Stanley, joint book-runner on the CCB IPO, will receive some $80m in fees for its work on the deal. CSFB, also a book-runner, but appointed 15 months later, will receive around $20m.

One hedge fund manager in the audience says he has bought shares. “It’s a hot IPO,” he says by telephone. “China’s a humungous market and the bank’s scale is just enormous.” With more than 14,000 branches, he is not exaggerating. But he also likes the improvements CCB has made to its cost to income ratio: the branches closed and employees laid off. “It’s impressive,” he says. “That’s always a concern when you invest in China – that the headcount tends to be enormous.” In the corridor, a member of the syndicate chats informally to an investor. “People are excited about the deal, almost too excited,” he says.

The lunch over, CCB’s management relax Chinese style, having a cigarette standing outside in the street. It has been a gruelling few weeks for them, explaining themselves to investors in Japan, Hong Kong (where the stock will be listed)and across Europe, as well as in the US.

German investors gave them a particularly hard time, while in Edinburgh, one sceptical fund manager asked Fan Yifei, the bank’s Columbia-educated deputy president, if he could put his hand on his heart and swear that the figures he had presented were true. Mr Fan replied “yes”.

They have done a good job: the IPO is 10 times over-subscribed. Three weeks later, after CCB shares have already started trading, a green-shoe is exercised to fulfil lingering investor demand and the size of the offering is increased to $9.2bn.

Investor zeal

The impossible has seemingly been achieved. One of China’ big four state banks – famous for their huge portfolios of non-performing loans (NPLs) and successive government bail-outs, for their lack of transparency and their habit of having senior executives arrested on corruption charges – had been snapped up by international investors.

“Even going back a year or two there were commentators who thought that the country’s large state banks were unlistable,” says Jonathan Zhu, China CEO for Morgan Stanley. “CCB’s IPO generated over $80bn in total global demand, was priced at nearly two times book and is trading well in the after market. In anybody’s book that’s a fantastic outcome and has helped to set the stage for the next wave of bank IPOs.”

“This is truly a landmark transaction for global capital markets,” says Paul Calello, CSFB chairman and CEO, Asia-Pacific. “It’s also a landmark transaction for China and its progress on financial market reform.”

Others are equally impressed. “Three years ago, two years ago, even one year ago, who would have thought the thing could have gone so smoothly?” says Huang Haizhou, head of Greater China research at Barclays Capital in Hong Kong.

The reality is that even eight months ago, the outlook for CCB’s IPO did not look so good.

Straddling state and market, CCB has, at times, reaped the benefits of its ambiguous position: though nimbler, more customer-friendly banks have sprung up in the big cities, China’s savers have remained loyal. CCB’s more bureaucratic, state-owned feel is amply compensated for by its huge branch network and one incontrovertible fact: it is unlikely the government would ever let it go bankrupt.

Double-edged sword

At other times, the bank has suffered all the disadvantages of its dual position, viewed by local governments as not just a bank, but also a social welfare agency. The bank’s staff were paid pitiful state salaries (according to figures provided in the prospectus, CCB’s top management earn, on average, less than $20,000 a year) while handling the large sums of money that inevitably pass through a major financial institution. The result has been NPLs and, at times, financial crime.

The run-up to the IPO had begun in earnest at the end of 2003. A previous transfer of the bank’s NPLs to Cinda – an asset management company specially set up for that purpose – though done on terms very favourable to CCB, had not proved enough to repair the bank’s balance sheet. CCB was, yet again, technically insolvent.

It was at that point that China’s central bank stepped in, injecting a massive $22.5bn from its foreign exchange reserves into the bank. In Hong Kong, investment bankers began to get excited: the Chinese government was serious about reforming the bank and getting it to market.

Within CCB, something of a transformation was also under way. Cutting costs was a massive operation: by the time of the IPO some 100,000 people (around 25% of CCB’s workforce) had been laid off. Many of them were older employees, used to the old way of doing things and deemed unsuitable for the new, commercial bank that CCB wants to be.

The number of branches, meanwhile, was cut from more than 21,000 in 2002 to around 14,000, with an emphasis on keeping a strong presence along China’s prosperous coast, not its less profitable interior.

By far the most important process, however, was that of getting the bank’s lending under control. What was the point, after all, of injecting new capital if the bank built up a new stash of NPLs? That effort would involve a major restructuring of the bank to reduce the power of the branch managers, as well as a revamp of its IT systems.

In spring 2004, the underwriting mandate for the IPO was awarded. The task of putting together the international financial reporting standards financials for the offering was already well under way, with hundreds of auditors from KPMG scouring the bank’s massive loan books – essentially rebuilding the accounts from scratch – in preparation for the IPO.

Chinese partner

It was decided there would be three joint book-runners: Morgan Stanley, Citigroup, and CICC. The choice of CICC was straightforward – as China’s only domestic investment bank, it participates in almost every Chinese IPO. It probably also helped that at that time CICC was still partly owned by CCB (it is a joint venture with Morgan Stanley).

CCB’s ownership would later, as part of the setting-up of a special purpose company for the IPO, be transferred from the CCB to the government, much to the chagrin of CCB management, who say they would have liked to have kept it. (Technically, China is still a Glass-Steagall kind of place where commercial and investment banking are strictly separated, though exceptions are made).

The choice of Citigroup, was, however, more complicated. According to CCB, Citi’s underwriting mandate would be linked to a concurrent strategic investment by its commercial banking arm into CCB. Having a western commercial bank offering technical assistance and know-how to Chinese banks by way of a strategic investment was, by 2004, viewed as critical by the government for turning CCB and the other state-owned banks into genuine commercial entities.

The man heading CCB was Zhang Enzhao. The bank had previously suffered from being led by chairmen who were not real bankers. For them, leadership of CCB was just another step on their way up the Communist nomenklatura system. Zhou Xiaochuan, who led the bank in the late 1990s, is now governor of the central bank. Wang Qishan, who built CCB’s shiny black headquarters in western Beijing is now mayor of Beijing.

Party hack

Mr Zhang was different; he spoke no English, which was a drawback in terms of marketing the IPO. He also had a tendency to rely on Communist Party committees (of which he, as chairman of CCB, was the chief representative) to help with the day-to-day running of the bank, not an ideal way to run a supposedly commercial entity. But he was definitely a bank veteran: he had been with CCB 40 years.

Up to that point, there had been a number of ups and downs that could well have derailed any Western bank preparing for an IPO but in China’s semi-reformed economy were just par for the course. For example, one of CCB’s selling points is that it has nearly 25% of the mortgage market. But in January 2005, China’s Supreme Court ruled that banks would not be allowed to foreclose on a home if it was a person’s primary residence. The ruling highlighted the abysmal status of creditor rights in China, particularly when the government thinks they may interfere with social stability.

But worse was to come. In March 2005, after the IPO process had begun in earnest, Mr Zhang suddenly resigned. It was said to be for “personal reasons” but rumours immediately swirled about what the real cause might be. It was a blow to the bank’s reputation, which had already seen a previous chairman, Wang Xuebing, end up in prison. By June, Mr Zhang was under arrest on charges of alleged bribery.

Enter Guo Shuqing, appointed chairman of the bank in March. A vice-governor of the central bank (up to that moment he had been involved in the preparations for the loosening of the yuan peg against the dollar), he did not hold back on speaking his mind about what was going wrong at the scandal-tainted bank.

In a series of astonishingly outspoken statements, Mr Guo criticised not only Communist Party control over daily decision-making at the bank, but he also raised questions about the competence of 90% of the bank’s staff.

Having followed him to Beijing, I ask him about the latter comment. A man of disarming candour, he replies: “I have to be careful, I received some criticism from within the bank after that.”

The figure was taken slightly out of context (it referred only to the performance of some of his consumer finance managers in an exam) and yet: “The truth is that we have to be aware that our employees or associates are not very familiar with modern commercial banking, and when I say that I am including myself. All of us have to learn the skills of modern commercial banking, that’s just a fact.”

But as Mr Guo was breathing new life into the bank, his straight talking a breath of fresh air that would end up going down exceptionally well with international investors, talks with Citigroup on its strategic investment had hit an impasse. Citi’s very commitment to China was proving a disadvantage. With its own branch network and an investment in a Shanghai-based bank, it could not agree to the kind of exclusive agreements and non-compete clauses that CCB wanted.

Another strategic investor was now urgently needed. In April, Mr Fan flew to Zurich to talk to Credit Suisse about a possible investment. Given its limited commercial lending business, co-operation with CS would be more on the private wealth management side. The Swiss bank was amenable.

Fortunately, however, a US retail commercial bank was about to come into the picture. Bank of America, based in Charlotte, North Carolina, and with more limited operations in China, could agree to everything Citi had not. It would shut down part of its existing network and take an 8.7% stake in CCB, with an option to increase that to 19.9% in the future.

The CCB-Bank of America alliance, announced in June, would turn out to be vital to the success of the IPO. It was not only the fact that the US bank would make available 50 staff for advice and technical assistance to CCB and Gregory Curl, its director of corporate strategy, would join CCB’s board – though these helped. It was also the $3bn of its own money that it was putting into CCB (presumably not without checking CCB’s books carefully first).

“That was a big benefit,” says Peter Tebbutt, senior director for financial institutions at Fitch Ratings in Hong Kong. “The fact that Bank of America did fairly rigorous due diligence gave investors confidence that the numbers were probably OK.”

Exit Citibank

For Citi, however, the end of its possible investment in CCB also spelt the end of its underwriting hopes, and not even a visit by Chuck Prince, CEO of Citibank, to Beijing in mid-May could save the day. Some 15 months into the IPO process, Citi lost its underwriting mandate, and with it, tens of millions of dollars in fees.

It is not an issue Mr Guo is comfortable talking about, and he is keen to mend fences with the financial services giant. “We cooperated with Citigroup for a long time. They gave us a lot of help and we look forward to working with them in future,” he says.

Two months later, the mandate to be the third book-runner on the deal would be awarded to CSFB. Parent company CS had never withdrawn its offer of an investment, and its loyalty would be rewarded.

“Credit Suisse never lost confidence in us, even in March when our former chairman resigned,” says Mr Fan. “As the saying goes, ‘a friend in need is a friend indeed’. Credit Suisse was a friend in need and we’ll never forget it.”

Momentum for the deal was now building up. Over the summer, Bank of Communications, a smaller, Shanghai-based bank, and the first Chinese bank to be listed overseas, had sold well, and by October was trading at around 2.3 times book value. Despite its historic problems, there was clearly appetite for the sector.

Even a negative comment by Securities and Exchange Commission chairman Christopher Cox (who managed to incur the eternal wrath of CCB’s management by saying the bank had only listed in Hong Kong because “it couldn’t meet the New York Stock Exchange requirements” – a claim CCB denies) was not enough to prevent the deal from being a success.

While just before pricing underwriters had pressed the bank to set a lower indicative price range to increase demand, CCB stuck to its guns. Five days into the roadshow, strong demand would lead the price range to move upwards, and each share finally sold for HK$2.35 ($0.30) – or nearly two times book value.

Old risks, new risks

Back in Beijing, Mr Guo is visibly pleased by how it has gone (“so far so good,” he says) but there is little time to relax.

The day before I meet him, some 50 laid-off employees from Hebei province have come to the bank’s headquarters. They believe that now CCB has listed it has got a ton of money and can give them their jobs back. Unfortunately, says Mr Guo, if anything, more people will need to be laid off to make way for younger people capable of handling public relations, IT, risk management and other things that used not to exist in Chinese banks.

“We had to lay off some people, to turn this into a commercial bank, we had no choice,” he says.

Following in the footsteps of foreign banks, this year CCB also started doing something unheard of for a Chinese state bank – charging fees on low balance accounts. Mr Guo says he received a letter from one customer complaining that the bank should be for everyone, including the poor, and that the charging of fees was criminal.

But it is particularly on the lending side that the IPO is supposed to help CCB change from a bank serving society as a whole, to a commercial institution serving only its shareholders. Though the bank will remain 72% state-owned, its status as an internationally listed company and the presence of foreign investors on the board, will, it is hoped, actually help CCB to just say “no” to local state-owned enterprise demands for subsidies.

CCB staff are also having to adjust to a whole new set of risks as the country moves towards a market economy. Though the cap on corporate lending has been removed, other rates – such as the interest paid on mortgages – remain controlled by the government. Also, as Mr Fan points out, government restrictions make fee transactions – where western banks make a lot of their money – hard to implement and product innovation difficult. Non-interest income accounts for only about 10% of CCB’s income, he says.

“We have to persuade the government to loosen their control on pricing and allow increased product innovation in the banking industry,” he argues.

Internal conflicts

Across the bank’s operations contradictions abound. For example, after the IPO, management will, in principle, be incentivised by share options. But some observers wonder how the bank’s leaders will, in practice, be able to collect on these, given they are, in principle, government employees on a graded salary scale. Mr Guo says his salary and stock options are still “under discussion”.

As a state-owned bank trying to become fully commercial in a semi-reformed economy, it is not always easy being CCB.

Still, the bank itself is doing what it can to get itself into shape. Assistance from Bank of America and employee training is regarded as key. “We need to learn,” says Mr Guo, who during the Cultural Revolution herded cattle in the Gobi Desert, was self-taught and yet managed to get a place at one of China’s top universities.

“That is why we have strategic investors, to try to get experience, and knowledge, and foreign expertise.”

Mr Fan is equally committed. “We have made the first step in the long march, but we still have a lot of work to do in the future.”

On the Hong Kong Stock Exchange, a share price will track CCB’s every move and, for the first time in the history of a Chinese state-owned bank, provide a very precise indicator of its progress, and – by extension – that of China’s financial sector reform.

“Every member of the management feels the pressure of the IPO,” says Mr Fan.

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