aMF Working Paper The Rise of foreign Investment in Chinas Banks-Taking Stock Lamin Leigh and richard Podpiera INTERNATIONAL MONETARY FUND
WP/06/292 The Rise of Foreign Investment in China’s Banks—Taking Stock Lamin Leigh and Richard Podpiera
o 2006 International Monetary Fund WP/0629 IMF Working Paper Asia and Pacific Department The rise of foreign Investment in China's banks--Taking stock Prepared by Lamin Leigh and Richard Podpiera Authorized for distribution by Jahangir Aziz December 2006 Abstract This Working Paper should not be reported as representing the views of the Ime The views expressed in this Working Paper are those of the author(s)and do not necessarily represent those of the IMf or IMF policy. Working Papers describe research in progress by the author(s)and are ublished to elicit comments and to further debate The recent wave of foreign investment in China's banks and the prospects of further opening of the banking sector under the WTO agreement suggest that foreign banks are likely to play an increasingly important role in China. This paper takes stock of the involvement of foreign banks in the Chinese banking sector in the perspective of international experience. While in most other countries foreign bank entry took the form of direct takeover or majority shareholding, foreign investments in Chinas banks have been minority shareholdings with very limited management involvement. The paper concludes that China appears to be well positioned to benefit from further opening of the banking sector to foreign investors International experience suggests that greater competition from and participation of foreign banks can in general bring important benefits if appropriate incentives and sufficient opportunities are created JEL Classification Numbers: G21 G28 Keywords: Foreign investment, China, banks, WTO, banking reforms Authors'E-Mail Addresses: leigh @imf. org, rpodpiera@imf. org The authors would like to thank--without implicating-Jahangir Aziz, Brian Aitken, and Steven dunaway for their useful comments
© 2006 International Monetary Fund WP/06/292 IMF Working Paper Asia and Pacific Department The Rise of Foreign Investment in China’s Banks—Taking Stock Prepared by Lamin Leigh and Richard Podpiera1 Authorized for distribution by Jahangir Aziz December 2006 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The recent wave of foreign investment in China’s banks and the prospects of further opening of the banking sector under the WTO agreement suggest that foreign banks are likely to play an increasingly important role in China. This paper takes stock of the involvement of foreign banks in the Chinese banking sector in the perspective of international experience. While in most other countries foreign bank entry took the form of direct takeover or majority shareholding, foreign investments in China’s banks have been minority shareholdings with very limited management involvement. The paper concludes that China appears to be well positioned to benefit from further opening of the banking sector to foreign investors. International experience suggests that greater competition from and participation of foreign banks can in general bring important benefits if appropriate incentives and sufficient opportunities are created. JEL Classification Numbers: G21, G28 Keywords: Foreign investment, China, banks, WTO, banking reforms Authors’ E-Mail Addresses: lleigh@imf.org, rpodpiera@imf.org 1 The authors would like to thank—without implicating—Jahangir Aziz, Brian Aitken, and Steven Dunaway for their useful comments
Contents L. Introduction IL. Foreign banks in China 349 Lessons from International Experience V Conclusions References 1. Opening the Banking Sector to Foreign Investment in Late 2006 2. Foreign Investment in Domesstic Banks: Selected Country Experience Table 1. China: Foreign Investors in the Five Largest Banks 2. Foreign Investors in Smaller Banks
2 Contents Page I. Introduction ............................................................................................................................3 II. Foreign Banks in China.........................................................................................................4 III. Lessons from International Experience ...............................................................................9 IV. Conclusions........................................................................................................................11 References................................................................................................................................14 Boxes 1. Opening the Banking Sector to Foreign Investment in Late 2006........................................5 2. Foreign Investment in Domesstic Banks: Selected Country Experience............................10 Tables 1. China: Foreign Investors in the Five Largest Banks............................................................12 2. Foreign Investors in Smaller Banks.....................................................................................13
. INTRODUCTION Banking reforms are at the core of Chinas strategy to improve the intermediation of its large private sector savings. As part of the financial liberalization program, reforms in the banking sector have been implemented over the last two decades, replacing the monobank system with a multilayered system that separates commercial lending and central banking functions Considerable progress has been made in restructuring three of the four major state-owned commercial banks(SCBs)and, by end-2005, all three banks announced the selection of major foreign financial institutions as strategic investors with minority ownership stakes. The three banks have also recently completed initial public offerings(IPOs). Opening the banking sector to foreign competition is part of that broader strategy by the Chinese authorities to enhance the efficiency of banking sector through various channels including greater financial innovation and improving corporate governance in banks Increasing foreign participation has been one of the key trends in the Chinese banking system in recent years. Foreign banks do business in China either directly through their own branches and subsidiaries or indirectly as minority investors in Chinese banks. The indirect participation has grown rapidly in recent years, particularly in 2005, as almost all major Chinese banks now have a foreign strategic investor. Since June 2004, foreign investors bought over US$ 17 billion worth of shares in Chinese bankS. This paper takes stock of the involvement of foreign investors in the Chinese banking sector, drawing on international experience with foreign banks in other emerging markets. Direct participation has remained elatively small, but it is likely to grow over time as remaining restrictions are eliminated effective December 11, 2006 under the WTO agreement(Box 1) Unlike many other emerging market or transition economies, China's domestic banks have well-established and extensive presence, thus direct market penetration by foreign banks may not be easy. While in most other countries, foreign investment took the form of direct takeover or majority shareholding, foreign investment in China's banks has taken the form of minority shareholding with very limited management involvement. Thus, how much nfluence foreign investment will have on the domestic banks' core business-and most importantly, risk management--is therefore debatable. Many of the strategic investors have also entered into separate arrangements with the domestic banks in noncore businesses such as credit cards. which brings both benefits and risks In these areas the foreign banks technological advantage and global networks can increase efficiency and help to expand these markets 2 Details of the progress made by China in banking sector reforms can be found in Podpiera(2006) This excludes the most recent agreement, finalized in late 2006, in which a consortium led by Citigroup(and including domestic participants as well) acquired an approximately 85 percent stake in the Guangdong Development Bank for about $3. 1 billion
3 I. INTRODUCTION Banking reforms are at the core of China’s strategy to improve the intermediation of its large private sector savings. As part of the financial liberalization program, reforms in the banking sector have been implemented over the last two decades, replacing the monobank system with a multilayered system that separates commercial lending and central banking functions. Considerable progress has been made in restructuring three of the four major state-owned commercial banks (SCBs) and, by end-2005, all three banks announced the selection of major foreign financial institutions as strategic investors with minority ownership stakes. The three banks have also recently completed initial public offerings (IPOs). Opening the banking sector to foreign competition is part of that broader strategy by the Chinese authorities to enhance the efficiency of banking sector through various channels including greater financial innovation and improving corporate governance in banks.2 Increasing foreign participation has been one of the key trends in the Chinese banking system in recent years. Foreign banks do business in China either directly through their own branches and subsidiaries or indirectly as minority investors in Chinese banks. The indirect participation has grown rapidly in recent years, particularly in 2005, as almost all major Chinese banks now have a foreign strategic investor. Since June 2004, foreign investors bought over US$17 billion worth of shares in Chinese banks.3 This paper takes stock of the involvement of foreign investors in the Chinese banking sector, drawing on international experience with foreign banks in other emerging markets. Direct participation has remained relatively small, but it is likely to grow over time as remaining restrictions are eliminated effective December 11, 2006 under the WTO agreement (Box 1). Unlike many other emerging market or transition economies, China’s domestic banks have well-established and extensive presence, thus direct market penetration by foreign banks may not be easy. While in most other countries, foreign investment took the form of direct takeover or majority shareholding, foreign investment in China’s banks has taken the form of minority shareholding with very limited management involvement. Thus, how much influence foreign investment will have on the domestic banks’ core business—and, most importantly, risk management—is therefore debatable. Many of the strategic investors have also entered into separate arrangements with the domestic banks in noncore businesses such as credit cards, which brings both benefits and risks. In these areas, the foreign banks’ technological advantage and global networks can increase efficiency and help to expand these markets. 2 Details of the progress made by China in banking sector reforms can be found in Podpiera (2006). 3 This excludes the most recent agreement, finalized in late 2006, in which a consortium led by Citigroup (and including domestic participants as well) acquired an approximately 85 percent stake in the Guangdong Development Bank for about $3.1 billion
Overall, the main lesson of international experience is that foreign banks can bring important benefits if appropriate incentives and sufficient opportunities are created. In any event, with or without foreign participation, China's banking system needs to continue to forge ahead with fundamental reforms in internal control, risk management, and corporate governance, to improve the intermediation of China's large pool of domestic say IL. FOREIGN BANKS IN CHINA So far, foreign banks' direct activities have remained restricted. As of end-September 2006, foreign-funded banks accounted for 1.8 percent of total banking assets. Similar to other types of banking institutions, foreign-invested commercial banks are supervised and regulated by on their RMB-denominated operations, mainly in providing banking services to uma the China Bank Regulatory Commission( CBRC), and there have been important restriction in domestic banks. There have been three rather distinct phases in this entry into Chinese ors More recently, foreign banks are starting to play a more substantial role as minority invest 1996-2001: isolated transactions China: Ownershp Structure ofthe Frve largest Commercal Bunk with niche players like the Bank oo of Shanghai and Nanjing Commercial Bank Foreign somoN portfolio investors were mainly multilateral financial institutions who had no active operational role 2001-2004 with the conclusion of Chinas WTO negotiations, foreign banks' entry increased Entry was limited to joint-stock commercial banks and city banks Share ef Bank Assets Hed by Far in in major cities. The large state owned banks were in poor financial situation and foreign investors were mostly interested potentially the most profitable geographical areas. Smaller banks also required smaller investments Late 2004-present: foreign Arsem Mere investors' interest intensified Soures: CGFS CONK ECB; eatDmalcentnalbanks; BS. further, as reforms in the large
4 S ha re o f B a nk As s e ts He ld by F o re ig n B a nks 0 20 40 60 80 100 Bulgaria Hungary China Ho ng Kong SAR India Ko rea Argentina Mexico 1990 2004 So urces : CGFS (2004); ECB; natio nal central banks ; BIS. Overall, the main lesson of international experience is that foreign banks can bring important benefits if appropriate incentives and sufficient opportunities are created. In any event, with or without foreign participation, China’s banking system needs to continue to forge ahead with fundamental reforms in internal control, risk management, and corporate governance, to improve the intermediation of China’s large pool of domestic savings. II. FOREIGN BANKS IN CHINA So far, foreign banks’ direct activities have remained restricted. As of end-September 2006, foreign-funded banks accounted for 1.8 percent of total banking assets. Similar to other types of banking institutions, foreign-invested commercial banks are supervised and regulated by the China Bank Regulatory Commission (CBRC), and there have been important restrictions on their RMB-denominated operations, mainly in providing banking services to individuals. More recently, foreign banks are starting to play a more substantial role as minority investors in domestic banks. There have been three rather distinct phases in this entry into Chinese banks. • 1996–2001: isolated transactions with niche players like the Bank of Shanghai and Nanjing Commercial Bank. Foreign portfolio investors were mainly multilateral financial institutions who had no active operational role. • 2001–2004: with the conclusion of China’s WTO negotiations, foreign banks’ entry increased. Entry was limited to joint-stock commercial banks and city banks in major cities. The large stateowned banks were in poor financial situation and foreign investors were mostly interested in potentially the most profitable geographical areas. Smaller banks also required smaller investments. • Late 2004-present: foreign investors’ interest intensified further, as reforms in the large 0.0 200.0 400.0 600.0 800.0 1000.0 ICBC ABC BOC CCB BCOMM Strategic investors Financial investors (incl. IPO) Government agencies and companies China: Ownership Structure of the Five largest Commercial Banks (Total assets in billions of US$)
state-owned banks gathered speed and as the government began to permit higher foreign ownership Since 2004, foreign strategic investors have entered in four of the largest five banks. The 2004 purchase by Hong Kong and Shanghai Banking Corporation(HSBC)of a stake in the Bank of Communications(BoCom), Chinas fifth largest bank, was the first major transaction. Since June 2005, foreign investors have invested or committed to invest over USS14 billion in the three large state-owned commercial banks, and all three have acquired strategic investors: the Bank of America(BOA)in China Construction Bank(CCB),a consortium led by Royal Bank of Scotland(rBS)in the Bank of China(BOC), and Goldman Sachs led investor group in the Industrial and Commercial Bank of China (ICBC). Table 1 provides an overview of these investments Box 1. Opening the Banking Sector to Foreign Investment in Late 2006 In its WTO accession agreement, China has committed to a phased-in liberalization of foreign bank access to its banking market, with the aim to fully open its banking sector to foreign bank participation, without geographic or client restrictions, effective December 11. 2006 Foreign banks and branches would be permitted to engage in a similar range of financial services as Chinese banks, and they would be treated and regulated in the same way as domestic banks. Specifically, for conducting local currency business, geographic restrictions were to be lifted as of December 11. 2006. With regard to commercial presence, there would be no geographic restrictions for conducting foreign currency business. In addition, foreign financial institutions licensed to provide local currency services in one region would be able to do so in any other region that has been opened for such business. As of December 11, 2006 all non-prudential market access constraints on foreign banks which restrict ownership, operation, and juridical form of foreign financial institutions, including on internal branching and licenses were also be lifted In November 2006, the authorities issued Regulations for the administration of foreign Funded Banks, which should implement the WTO commitments. As a result of these new regulations, access to Chinese banking market will be easier, but building a larger presence could take some time as foreign banks must satisfy certain requirements before they can granted approval for offering full domestic currency services to Chinese individuals. To fulfill these requirements, foreign banks must establish an incorporated affiliate in China with minimum capital of RMb 1 billion and each branch must have a minimum capital of RMB 100 million. Furthermore, foreign financial institutions plying to engage in local currency business must have three years of business operation experience in China and have been profitable for two consecutive years prior to applying Ownership by a single foreign investor is limited to 20 percent, while the combined share of all foreign investors in one bank is limited to 25 percent
5 state-owned banks gathered speed and as the government began to permit higher foreign ownership.4 Since 2004, foreign strategic investors have entered in four of the largest five banks. The 2004 purchase by Hong Kong and Shanghai Banking Corporation (HSBC) of a stake in the Bank of Communications (BoCom), China’s fifth largest bank, was the first major transaction. Since June 2005, foreign investors have invested or committed to invest over US$14 billion in the three large state-owned commercial banks, and all three have acquired strategic investors: the Bank of America (BOA) in China Construction Bank (CCB), a consortium led by Royal Bank of Scotland (RBS) in the Bank of China (BOC), and Goldman Sachs led investor group in the Industrial and Commercial Bank of China (ICBC). Table 1 provides an overview of these investments. 4 Ownership by a single foreign investor is limited to 20 percent, while the combined share of all foreign investors in one bank is limited to 25 percent. Box 1. Opening the Banking Sector to Foreign Investment in Late 2006 In its WTO accession agreement, China has committed to a phased-in liberalization of foreign bank access to its banking market, with the aim to fully open its banking sector to foreign bank participation, without geographic or client restrictions, effective December 11, 2006. Foreign banks and branches would be permitted to engage in a similar range of financial services as Chinese banks, and they would be treated and regulated in the same way as domestic banks. Specifically, for conducting local currency business, geographic restrictions were to be lifted as of December 11, 2006. With regard to commercial presence, there would be no geographic restrictions for conducting foreign currency business. In addition, foreign financial institutions licensed to provide local currency services in one region would be able to do so in any other region that has been opened for such business. As of December 11, 2006 all non-prudential market access constraints on foreign banks which restrict ownership, operation, and juridical form of foreign financial institutions, including on internal branching and licenses were also be lifted. In November 2006, the authorities issued Regulations for the Administration of ForeignFunded Banks, which should implement the WTO commitments. As a result of these new regulations, access to Chinese banking market will be easier, but building a larger presence could take some time as foreign banks must satisfy certain requirements before they can granted approval for offering full domestic currency services to Chinese individuals. To fulfill these requirements, foreign banks must establish an incorporated affiliate in China with minimum capital of RMB 1 billion and each branch must have a minimum capital of RMB 100 million. Furthermore, foreign financial institutions applying to engage in local currency business must have three years of business operation experience in China and have been profitable for two consecutive years prior to applying
The structure of the four partnership arrangements has been similar The strategic investor is a major international commercial bank with substantial commercial banking expertise. The only exception is Goldman Sachs, the main investor in ICBC, which is a leading investment bank without major commercial banking operations. ICBC explains this investment as intended to aid it in developing wealth management business and its strategy to keep consumer finance in-house With ownership shares between 9 and 20 percent, the strategic investors have no management responsibility, but have the right to nominate one or two members of the Board of Directors, which has more than 15 members, on average Direct investment safeguards are relatively limited. Bank of America is covered only book value below end-2004 and end-2005 book value; respective/nst a decline of for the restatement of 2004 financials, rbs and Goldman Sachs ag Strategic investors have started or plan to start cooperation in one or more non-core banking business Credit card business is one popular area, and HSBC's agreement with the bank of Communications can serve as an example The credit card business unit is managed as a joint venture and the existing agreement is to give hsbc a 50 percent share once regulations permit spinning off the unit from the bank. RBS has a similar arrangement with the BOC, and Bank of America is negotiating credit card cooperation with the CCB. similar agreements may be developed in investment banking, wealth management, or information technology Foreign ownership participation in smaller Chinese banks has increased substantially as well In 2004, five Chinese bankS, including BoCom, Shenzhen Development Bank, and Xian City Commercial Bank, brought in foreign strategic investors, doubling the number of Chinese banks with foreign equity participation. In 2005 and early 2006, a number of further arrangements with strategic investors were announced, including China Minsheng Banking Corporation, Huaxia Bank, Bohai Bank, Bank of Beijing, and Hangzhou City Commercial Bank(table 2) There are several reasons that may have motivated the interest of foreign strategic investors the smaller banks while there are substantial risks in entering the chinese banking sector as a strategic investor, (including in corporate governance, legal system, reliability of financial information, and regulatory treatment), foreign interest may have been influenced by: (i) strong growth of the Chinese economy, which creates profitable opportunities; (ii a large banking sector, relative to the economy, allows considerable space to expand market share; (iii) recent progress in reforming the banking sector, improving regulation and supervision, and the Wto commitment to open the banking sector to foreign competition as of December 11, 2006; and (iv)theglobal balance sheet argument--because of the global
6 The structure of the four partnership arrangements has been similar: • The strategic investor is a major international commercial bank with substantial commercial banking expertise. The only exception is Goldman Sachs, the main investor in ICBC, which is a leading investment bank without major commercial banking operations. ICBC explains this investment as intended to aid it in developing wealth management business and its strategy to keep consumer finance in-house. • With ownership shares between 9 and 20 percent, the strategic investors have no management responsibility, but have the right to nominate one or two members of the Board of Directors, which has more than 15 members, on average. • Direct investment safeguards are relatively limited. Bank of America is covered only for the restatement of 2004 financials, RBS and Goldman Sachs against a decline of book value below end-2004 and end-2005 book value; respectively. • Strategic investors have started or plan to start cooperation in one or more non-core banking business. Credit card business is one popular area, and HSBC’s agreement with the Bank of Communications can serve as an example. The credit card business unit is managed as a joint venture and the existing agreement is to give HSBC a 50 percent share once regulations permit spinning off the unit from the bank. RBS has a similar arrangement with the BOC, and Bank of America is negotiating credit card cooperation with the CCB. Similar agreements may be developed in investment banking, wealth management, or information technology. Foreign ownership participation in smaller Chinese banks has increased substantially as well. In 2004, five Chinese banks, including BoCom, Shenzhen Development Bank, and Xi’an City Commercial Bank, brought in foreign strategic investors, doubling the number of Chinese banks with foreign equity participation. In 2005 and early 2006, a number of further arrangements with strategic investors were announced, including China Minsheng Banking Corporation, Huaxia Bank, Bohai Bank, Bank of Beijing, and Hangzhou City Commercial Bank (Table 2). There are several reasons that may have motivated the interest of foreign strategic investors in the smaller banks. While there are substantial risks in entering the Chinese banking sector as a strategic investor, (including in corporate governance, legal system, reliability of financial information, and regulatory treatment), foreign interest may have been influenced by: (i) strong growth of the Chinese economy, which creates profitable opportunities; (ii) a large banking sector, relative to the economy, allows considerable space to expand market share; (iii) recent progress in reforming the banking sector, improving regulation and supervision, and the WTO commitment to open the banking sector to foreign competition as of December 11, 2006; and (iv) the “global balance sheet” argument—because of the global
scale of operations of major foreign banks, the reater and once the technological platform has been installed, the marginal cost of extending the platform and integrating the processing of transactions to a regional center is very low Nonbank investments into Chinas banking system have increased as well (Table 2). In many cases, they are the leading strategic investor in the investment consortia(for example American Express and Allianz in the ICBC). Large financial investors have entered as well- Temasek, the investment arm of Singapore's government, has invested approximately US$4.5 billion in the CCB and boC(directly and in IPOs), and China's National Social Security Fund has invested over $1 billion in BOC shares. In addition, public listing of shares in overseas markets increases transparency of the banks and provides a mechanism for investors to evaluate their performance The pricing of foreign investments into Chinas banking system has varied. For instance relative to BoComm's pre-IPO price paid by foreign strategic investors, BoComm shares are currently trading at about 300 percent higher, suggesting that strategic investors made significant paper profits. Similarly, CCB's and BOC's IPO price is currently at about 170 percent and 160 percent relative to pre-IPO prices paid by foreign investors, respectively However, several factors can influence the pricing for foreign investors. First, the entry of the strategic investor itself may have increased the potential market value by raising investor confidence. Second, the cooperation with strategic investors may signal potentially larger uture profits for both sides. Third, strategic investors are locked-in for a period of time, mos stly for 3 years, so the implied profit cannot be realized So far the involvement of foreign investors in improving China's banks has be to SAFE Investments as foreign investors partly bought existing shares; (i)provideo t went Foreign investors have: (i) increased bank capital, even though part of their investment went credibility needed to launch IPOs of relatively large size; (iii) induced improvements in corporate governance and management, with some board seats being occupied by candidates nominated by the foreign investors; and (iv)provided limited technical assistance Overall. it remains unclear whether foreign strategic investors have sufficient incentives and foreign strategic investors are relatively small and their management involvement is minimal While the entry of foreign investors will undoubtedly bring some benefits, including greater transparency and some knowledge transfer, the structures of the strategic agreements so far do not give strong assurances that the investors will improve credit risk management, which is at the core of recent and potential future problems of Chinese banks. Operations in non- core areas by strategic partners can be lucrative irrespective of the banks overall Investors bought pre-IPO interests in CCB at about 1.15 to 1. 19 times book value, but the CCB went public at about 2.5 times book value. BOC's recent IPO delivered a pricing of about 2. 1 times book value, pre-IPO prices
7 scale of operations of major foreign banks, the return on investment in technology is greater and once the technological platform has been installed, the marginal cost of extending the platform and integrating the processing of transactions to a regional center is very low. Nonbank investments into China’s banking system have increased as well (Table 2). In many cases, they are the leading strategic investor in the investment consortia (for example, American Express and Allianz in the ICBC). Large financial investors have entered as well— Temasek, the investment arm of Singapore’s government, has invested approximately US$4.5 billion in the CCB and BOC (directly and in IPOs), and China’s National Social Security Fund has invested over $1 billion in BOC shares. In addition, public listing of shares in overseas markets increases transparency of the banks and provides a mechanism for investors to evaluate their performance. The pricing of foreign investments into China’s banking system has varied. For instance, relative to BoComm’s pre-IPO price paid by foreign strategic investors, BoComm shares are currently trading at about 300 percent higher, suggesting that strategic investors made significant paper profits. Similarly, CCB’s and BOC’s IPO price is currently at about 170 percent and 160 percent relative to pre-IPO prices paid by foreign investors, respectively. 5 However, several factors can influence the pricing for foreign investors. First, the entry of the strategic investor itself may have increased the potential market value by raising investor confidence. Second, the cooperation with strategic investors may signal potentially larger future profits for both sides. Third, strategic investors are locked-in for a period of time, mostly for 3 years, so the implied profit cannot be realized. So far the involvement of foreign investors in improving China’s banks has been limited. Foreign investors have: (i) increased bank capital, even though part of their investment went to SAFE Investments as foreign investors partly bought existing shares; (ii) provided credibility needed to launch IPOs of relatively large size; (iii) induced improvements in corporate governance and management, with some board seats being occupied by candidates nominated by the foreign investors; and (iv) provided limited technical assistance. Overall, it remains unclear whether foreign strategic investors have sufficient incentives and opportunities to improve the core operations of Chinese banks. The ownership shares of foreign strategic investors are relatively small and their management involvement is minimal. While the entry of foreign investors will undoubtedly bring some benefits, including greater transparency and some knowledge transfer, the structures of the strategic agreements so far do not give strong assurances that the investors will improve credit risk management, which is at the core of recent and potential future problems of Chinese banks. Operations in noncore areas by strategic partners can be lucrative irrespective of the bank’s overall 5 Investors bought pre-IPO interests in CCB at about 1.15 to 1.19 times book value, but the CCB went public at about 2.5 times book value. BOC’s recent IPO delivered a pricing of about 2.1 times book value, pre-IPO prices paid by strategic investors were lower at about 1.17 times book value
erformance. Almost all strategic investors have started joint operations in one or more non- core areas, with potentially larger involvement. Importantly, the return on such investment is not fully dependent on the bank's overall performance, which will hedge some of the risks mentioned above and also weaken incentives for the investors to push hard for changes in the core commercial banking business. The authorities need to ensure that: (i) no value is lost in the side cooperation agreements, because the banks will all be listed and there could be major legal and reputation issues; and(ii) foreign investors have strong incentives to fully engage in improving core banking business Price developments of large Chinese Banks IPOs (Bocomm, BOc and CCB) 18.0004 18,000 BoComm's Share P CCB's Sha 17,000 16.5003 Pre-lPO price paid by 15,0002 strategic investors 15.000 Pre-lPO price paid by 14.000 strategIc Investors 13,5001 14.000 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Hang Seng Index(RHs) 4.0 18.0005 BOC's Share prices BOC's Share prices 1750 17.000 3.0 16,5003 1,650 16.000 ipo price paid by trategic Investors 150001 1,500 ndex(rHs) Shanghai Composite Index(RHS) Sources: Bloomberg CEIC
8 performance. Almost all strategic investors have started joint operations in one or more noncore areas, with potentially larger involvement. Importantly, the return on such investment is not fully dependent on the bank’s overall performance, which will hedge some of the risks mentioned above and also weaken incentives for the investors to push hard for changes in the core commercial banking business. The authorities need to ensure that: (i) no value is lost in the side cooperation agreements, because the banks will all be listed and there could be major legal and reputation issues; and (ii) foreign investors have strong incentives to fully engage in improving core banking business. Price developments of large Chinese Banks IPOs ( BoComm, BOC and CCB) Sources: Bloomberg, CEIC. BoComm's Share Prices 1 2 3 4 5 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 13,500 14,000 14,500 15,000 15,500 16,000 16,500 17,000 17,500 18,000 BoComm Hang Seng Index (RHS) Pre-IPO price paid by strategic investors CCB's Share Prices 1 2 3 4 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 14,000 15,000 16,000 17,000 18,000 CCB Hang Seng Index (RHS) Pre-IPO price paid by strategic investors BOC's Share Prices 2.0 2.5 3.0 3.5 4.0 May-06 Jun-06 Jul-06 Aug-06 Sep-06 15,000 15,500 16,000 16,500 17,000 17,500 18,000 BOC Hang Seng Index (RHS) Pre-IPO price paid by strategic investors BOC's Share Prices 1 2 3 4 5 3-Jul-06 21-Jul-06 10-Aug-06 30-Aug-06 19-Sep-06 1,500 1,550 1,600 1,650 1,700 1,750 1,800 BOC Shanghai Composite Index (RHS)