Foreign banks and other investors have poured about $20bn into more than 18 Chinese banks and plenty more deals are still in the pipeline. Clearly, many are keen to stake out claims in the $1700bn industry before China fully opens the industry to foreign competition by the end of this year, in keeping with its market-opening commitments to the World Trade Organization.
“It’s the fashion right now. If you are not doing it, you are out of the loop,” says Lawrence Brahm, chairman of NAGA Group, an investment consulting company in Beijing. HSBC, Citigroup, Bank of America and Royal Bank of Scotland are just a few of the many banks that have made multi-billion dollar commitments as they jostle for global dominance.
Everyone is betting on the China high growth story, but who will be the winners and losers in the next five to 10 years? The consensus among banking analysts and bankers is that HSBC and Citigroup, with their historical ties to China and regional experience, lead the pack of potential winners, while Bank of America and Royal Bank of Scotland could end up among the also-rans.
A September 2005 poll of 35 major foreign banks in China by PricewaterhouseCoopers ranked HSBC in first place and Citigroup in second. Both giants have taken a dual approach to entering the Chinese market, expanding their own branch networks while also investing in major local banks to get to know the Chinese market faster, launching joint venture businesses such as credit cards. Both have a strategy of targeting high net worth, affluent clients in their own branch operations while gaining access and indirect exposure to the mass retail market through their invested banks. Both are setting up joint venture fund management companies or investing in insurance companies so that they can provide a full range of financial products once the China market fully opens to outside competition. Teaming up with local lenders, HSBC and Citigroup have steered clear of making major commitments to the ‘Big Four’ state-owned banks, Bank of China, China Construction Bank (CCB), Industrial and Commercial Bank of China and the Agricultural Bank of China.
By contrast, Bank of America put up $3bn for a 9% stake in CCB ahead of its $9.2bn initial public offering (IPO) in October and Royal Bank of Scotland has committed $1.6bn to Bank of China, joining with Merrill Lynch and Hong Kong billionaire Li Ka-shing to share a 10% stake worth a total $3.1bn. Although having the well-connected Mr Li on board is a plus, analysts question what Royal Bank of Scotland expects to gain. They regard teaming up with a large state-owned bank as a high-risk strategy.
Blueprint for success
Speaking from the sleek HSBC Tower in Shanghai’s Liujiazui financial district, Richard Yorke, CEO of HSBC China, is forthright about the UK bank’s strategy, and is confident of success. “In terms of our overall China strategy, it is two-pronged. We have our own organic business of HSBC as the largest foreign commercial bank in China. Then, we have our strategic investment partners,” he says. HSBC has invested more than $4bn in the Shanghai-based Bank of Communications, Bank of Shanghai, Industrial Bank of China, Ping An Bank and Ping An Insurance Co of China, grooming its corporate banking business. Although its corporate headquarters is in London, HSBC was founded in Hong Kong and Shanghai in 1865 and its local roots are key to its marketing strategy. “We’ve had a continuous presence in China for 140 years,” Mr Yorke says, stressing that the bank’s historical ties allowed it to take opportunities as they arose. “It is a reflection of our commitment to the market.”
That long-term commitment is already paying off. Local tie-ups accounted for more than 70% of HSBC’s China pre-tax profit in 2005, which rose 944% over the previous year to $334m. Regarding its own brand business, HSBC has the largest branch network of the foreign banks –12 branches and nine sub-branches, scattered from the north-eastern city of Dalian to the far western city of Chengdu and the southern city of Shenzhen, which borders Hong Kong. There are plans for further expansion this year, with an increase of bank staff inside China from 2000 to 3000 by year end.
“You have to be very focused on your customer segment and focused geographically in personal banking,” says Mr Yorke. HSBC focuses on high networth customers in the four richest and most developed cities in China: Shanghai, Beijing, Guangzhou and Shenzhen. When China lifts its last restrictions on foreign banks by the end of December this year and allows foreign banks to do local currency business for Chinese customers, HSBC will be well positioned to serve premier clients. It plans to open two or three sub-branches a year in each of the four major cities to serve affluent Chinese. And HSBC subsidiary Hang Seng Bank has six branches and four sub-branches as well as a stake in the mid-sized Fuzhou based Industrial Bank of China.
HSBC was the first foreign bank to invest in a local city bank, when it took a $62.6m, 8% stake in the small Bank of Shanghai in 2001, a deal that many questioned at the time. But a report from rating agency Moody’s on Chinese city banks issued in February rated it as one of the most profitable commercial banks in 2004.
HSBC was also the first foreign bank to take a stake in the Bank of Communications, China’s fifth largest state-owned bank, with an estimated 4% market share, when it invested $1.75bn in April 2004. Though smaller than the Big Four, Bank of Communications has 2700 branches in 137 cities and listed shares on the Hong Kong Stock Exchange in June 2005. “Given the different scale of organisation and level of our investment, Bank of Communications is our primary focus for business cooperation as a strategic investment partner in the commercial banking side,” says Mr Yorke.
Taking advantage of BoComms’ huge networks, HSBC has launched a joint credit card operation, and has seconded 17 HSBC specialists to BoComms’ credit card unit. The venture is 100% owned by BoComms but the card centre is headed by Ron Logan, a HSBC-nominated Australian banker. Mr Yorke says HSBC hopes the credit card operation will turn into a 50-50 joint venture once regulations permit.
One of the explicit goals of China’s opening to foreign bank investments is the acquisition of advanced banking expertise and technology, especially in the area of risk controls, a notorious weak spot for Chinese banks. HSBC has seconded six mid to high-level executives to help BoComms improve its risk management, human resources and internal controls. Mr Yorke’s predecessor, Dicky Ip, was named BoComm’s executive vice-president, with the retail banking and credit card businesses as part of his remit.
As a bank with a conservative reputation, HSBC is aware of the risks attached to doing business in China, says Mr Yorke. So far, BoComm’s performance has borne that out. The bank’s shares are trading at HK$4.525 as of March 14, almost double its IPO price of HK$2.5 last June. Overall, signs are promising, says Mr Brahm, who in 20 years of advising multinationals in China has seen many investments founder. “HSBC is going to do the best in the next five or 10 years because it has most experience in this market and its strategy is clearly well thought-through. It understands the psychology of this retail banking market.”
Risky investment
Like HSBC, Citibank has approached the China market from two angles – retail banking for wealthy customers and corporate banking. Its future, however, may hinge on the outcome of a deal that Citigroup has been working on for months. Citibank hopes to become the first foreign bank to take a majority stake in a Chinese state bank with its bid for 85% of troubled Guangdong Development Bank, which has 500 branches in the wealthy Guangdong region. Under current rules, China only allows foreign banks to hold a maximum total of 25% in any Chinese bank, with the investment by a single foreign entity capped at 20%.
A decision by Guangdong Development Bank’s controlling shareholder, the local government, was originally expected before March, but has been delayed for unknown reasons. A decision in Citigroup’s favour could be a milestone for the industry. Since it is still in negotiations, Citibank declined to talk to The Banker for this story.
However, there is a potential downside. The reason regulators are willing to consider selling off the bank is that it is a mess, analysts say. “Guangdong Development Bank’s asset quality is very poor but the government does not want to spend a lot of money to bail out small banks. They’ll let foreigners in and let them take over 50%,” said Doris Chen, China financial sector analyst at BNP Paribas Peregrine in Shanghai.
Guangdong Development Bank says its non-performing loan (NPL) ratio was 22.84% at the end of 2003 and has not even released its 2004 financial results. Analysts believe the actual amount of bad debt is much higher. Moreover, by taking over Guangdong Development Bank, Citigroup ends up diluting the bank’s image and marketing appeal as a Chinese bank, says Ms Chen. Like HSBC, Citibank has a long history in China, having set up the first US banking operation in Shanghai in 1902. It was the second major foreign bank to invest in a local lender, when in 2002 it paid $70m for a 4.62% stake in Shanghai Pudong Development Bank, a local lender with 350 branches in 30 cities. The two banks set up a joint credit card operation in February and now issue more than 200,000 cards.
The terms of its arrangement with SPDB prevent Citigroup from joining rival local lenders in credit card operations before 2007. But SPDB recently agreed to waive an exclusivity agreement preventing investments in other Chinese lenders, allowing Citigroup to pursue the Guangdong deal. Citigroup also agreed to raise its stake in the Shanghai bank to 19.9%, the legal maximum. While it is casting its sights elsewhere, Citigroup remains committed to its first local partner, says its China CEO Richard Stanley, who described the tie-up as “highly successful”.
Though Citibank only has a minority share in SPDB, the Shanghai bank is a relatively healthy and well-run bank. Its annual net profit was up 29% to Yn2.49bn ($310m) in 2005 and its NPL ratio of only 1.97% is one of the lowest in China. Like HSBC, Citibank has developed its own branch networks, setting up six branches and 10 sub-branches in mainland China. Its retail business is aimed at high net worth Chinese. Its bid for Guangdong Development Bank may be a risky foray into new territory, but like HSBC, at least it has a long-term focus and knows the landscape. Not so Bank of America and Royal Bank of Scotland, which have paid billions for minority stakes in China’s mega banks. Both lack experience and a prior presence in China, and both have made investments that carry high risks and daunting limitations. They must overcome those obstacles if they are to end up among the winners.
Potential losers?
China, with its restrictions and Communist Party red tape, is one of the most difficult banking markets to operate in. But Wendy Tan, Bank of America’s spokeswoman in Asia, says she believes the bank’s long experience in the US market will give it an edge in China as it develops its tie-up with China Construction Bank (CCB). “Bank of America is the leading consumer bank in the US. We can provide the benefits of that experience to China Construction Bank,” Ms Tan says in a written response to questions (the bank refused to allow interviews of its senior executives).
Bank of America clearly is expecting CCB, China’s main property lender and third largest bank by assets, to lead any further expansion into the local market. The terms of the New York-based bank’s investment agreement with CCB call for it to close its sole own retail outlet by the end of March. Bank of America’s Beijing, Shanghai and Guangzhou branches will only provide wholesale and investment banking services, Ms Tan says in her statement. “As the best-positioned bank in China, CCB is poised to benefit from the rapid growth of the Chinese economy.”
Nine months after it signed the investment deal with CCB, Bank of America is still in talks over setting up a credit card joint venture. The US bank has sent a team of 50 specialists on short assignments to help CCB improve its risk management, corporate governance, retail banking and human resources policies. But analysts are sceptical about how much Bank of America, with only a 9% share, can do. “I am not positive or putting much hope into how much Bank of America can help. It is more a question of how much CCB is willing to be influenced or accept help. It is up to CCB senior management,” says BNP Paribas’ Ms Chen.
Outsiders can have a tough time in any country but China’s state-owned financial institutions are particularly harsh. “When the positions or benefits of Chinese employees at the bank are affected, the Chinese get together and fight against the foreigners,” said Wei Yen, banking analyst and managing director of financial institutions at Moody’s.
Viewed from the point of view of sheer numbers, it is hard to see how 50 Bank of America staff can influence CCB, a giant with 14,500 branches that claims a 12% share of total lending and 13% of total deposits in China. The same applies to Royal Bank of Scotland’s influence over Bank of China, which has 11,307 branches, a 12% share of lending and 14% of deposits.
Royal Bank of Scotland (which refused to respond to The Banker’s enquiries), has an even smaller presence in China, with one branch in Shanghai, which opened in 2003 and does only wholesale banking. According to a Bank of China executive, the Scottish bank has sent some staff to help beef up the Beijing-based bank’s risk controls and is in talks on other cooperations.
Although corporate culture at headquarters may be adapting to international standards, the far-flung branch networks – the foundation of the Chinese banks’ operations – are a different story, says Stephen Green, senior economist at Standard Chartered Bank in Shanghai. “Walking into one of the state-owned banks’ headquarters in Beijing is a very different experience from walking into a local branch in Shenyang or a village,” he says. “You can roll out risk management systems, you can train credit officers and you can establish corporate governance practices at the centre, but rolling those out at the local level is extremely hard. These are vast bureaucracies.”
The Big Four’s average NPL ratio was 10.5% by year end, a big improvement on the estimated 40%-plus in 2002, but in February, CBRC chairman Liu Mingkang and other top officials warned that the banks could be heading for more problems due to a financial fallout in the real estate and construction industries.
“Default rates on mortgage loans to individuals and to developers are going up but we have not seen a rise of NPLs yet because banks do not want to report them. They hide them,” says Mr Yen of Moody’s. Analysts estimate that about 25% of CCB’s loans are tied up in the overheated real estate market. Bank of America could get a big surprise as those loans surface over the next several years. Other problem areas include loans to steel and cement companies that are now the subject of a government crackdown due to overexpansion. Until Chinese banks began disclosing the standard five categories of NPLs a few years ago, analysts and economists were guessing at the extent of China’s problem. Yet they still have to guess, says Mr Yen. “No one knows how much of the new loans are becoming NPLs.”
Hard questions
Ultimately, foreign banks can only expect a good return on their investments – either in financial gains or in expanding their own Chinese operations – if local lenders manage to improve their poor risk management and bad loan problems. “What percentage of necessary reforms have actually happened to turn them into truly commercially run banks? Are we 20% there, or 50%, or 80%? That is very hard to answer,” says Mr Green of Standard Chartered.
What would Bank of America do if CCB’s NPL level rose sharply? How about the Royal Bank of Scotland? As a condition of their investments, both banks were required to lock up their shares for three years, preventing a near-term exit if new problems are discovered. Bank of China has promised to buy back its $3.1bn stake from Royal Bank of Scotland if the Chinese bank fails to go public within three years. Even the price Royal Bank of Scotland paid for the stake could be adjusted lower if audits turn up any problems before the IPO, which is expected within the next few months. In a statement, Royal Bank of Scotland said that appropriate guarantees and protections have been received but it declined to elaborate. Several top foreign bank executives in China and Hong Kong have questioned those guarantees.
Bank of China is busy preparing for its planned $8bn IPO in Hong Kong in the first half of this year, despite continued problems with dubious loans and other financial abuses. But corruption cases are not limited to Bank of China. All of the Big Four have disclosed scandals involving managers at all levels. The China banking watchdog said in February that it discovered irregularities involving Yn767bn at mainland banks in 2005, resulting in 1272 criminal cases.
China watchers and economists agree that corruption remains perhaps the biggest risk for foreign investors. “It is a huge problem. No one can give you an accurate answer to the question of what scale of losses we are talking about due to corruption,” says Mr Green.
HSBC and Citibank appear to have hedged their risks by opting for smaller commitments to better managed institutions. They also have a good head start, with strong earnings already from their own business in China. The jury is out over how the latecomers will do, but Peter Alexander, principal of Shanghai-based financial consultancy Z-Ben Advisors, and a 15-year veteran of the country’s financial markets, is among those who are doubtful. “The odds are against all of these banks being successful,” he says.
