Big country, big business, big risk
Some of the world's richest IPOs are happening in China, but investors who jump in may regret it.
By Clay Chandler, FORTUNE senior writer

HONG KONG (FORTUNE) - China, a country that didn't recognize the right of businesses to sell shares to the public until 1984, seems now to be barreling down the capitalist road but will global investors scrambling to hitch a ride wind up as roadkill instead?

The nominally communist nation is spawning many of the world's richest IPOs. China Life's $3 billion offering to overseas investors was the biggest of 2003. China Construction Bank's $9.2 billion debut was the top deal in 2005.

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This year brings two more blockbuster listings: the $9.9 billion IPO of the Bank of China, slated for early June; and the $12 billion debut of Industrial and Commercial Bank of China, expected before year-end.

(For more about the multibillion-dollar battle U.S. investment banks are waging for a piece of the action in China, click here or go to www.fortune.com.)

All told, Chinese firms are hoping to raise about $30 billion from global investors in 2006. Dozens more plan foreign listings before 2008.

China's IPO boom is ringing up hefty fees for Wall Street firms like Goldman Sachs (Research), Merrill Lynch (Research) and Morgan Stanley (Research).

But global financial giants are pouring in their own cash, too. Goldman, American Express (Research) and Germany's Allianz have invested $3.8 billion for 9 percent of ICBC. Bank of America (Research) paid $3 billion for 9 percent of CCB. A consortium led by the Royal Bank of Scotland has taken a $5 billion stake in the Bank of China.

For now, these look like shrewd investments. CCB's shares have risen more than 50 percent since the bank's debut. Shares of Bank of Communications, a smaller Chinese lender offered to foreign investors last year, have doubled. The Bank of China appears heavily oversubscribed.

A risky bet

But over the long run, will betting on China's debutantes pay? China's big banks, in particular, have a long history of mismanagement and fraud.

Indeed, the reason China's communist leaders are shoving the banks onto foreign exchanges is that, several years ago, they recognized that corruption and bad loans were spinning out of control. State-led efforts to reform the banks were falling short.

With China's domestic stock markets - rife with fraud and inside trading - little better than casinos, selling bank shares to Chinese investors offered little prospect of imposing meaningful market discipline. The hope was that foreign IPOs might help bring China's state-owned dinosaurs to heel.

To bring their Chinese clients to market, Wall Street advisors would have to goad executives to adopt global accounting practices. Strategic partners would have an incentive to lend manpower, share technology and help develop systems for credit analysis and risk management. Prospective foreign investors would grill Chinese executives on global roadshows.

It sounds great in theory. But the hitch is that Beijing was never willing to relinquish real control. Foreign ownership of the nation's banks has been capped at 25 percent.

At China's largest banks and manufacturers, senior executives are predominantly Communist Party appointees in little danger of getting tossed out should the stock price languish - and who stand little to gain if it soars.

In recent months, the government of Hu Jintao has grown increasingly wary of criticism that it has been too willing to surrender state assets to outsiders. The most dismaying sign of Beijing's ambivalence came earlier this month as bank regulators made clear that they would not bend foreign ownership restrictions to allow a consortium led by Citigroup (Research) to gain control of Guangdong Development Bank, a money-losing lender in the booming province bordering Hong Kong.

In recent months, Beijing has also hit the brakes on appeals by foreign investment banks for permission to purchase shares in the nation's troubled securities brokerages, and delayed the Carlyle Group's bid for control of China's largest construction group.

Dissent isn't welcome

Moreover, regulators show scant tolerance for the sort of freewheeling debate about economic policy matters that is taken for granted in Western markets.

Last week, China's central bank lashed out at a report by Jack Rodman, Ernst & Young's Beijing-based expert on distressed debt. The report estimated China's total liabilities for non-performing loans to be more than $900 billion, far exceeding official estimates. Although the report's conclusions didn't differ radically from those of many other private analysts, the central bank decried the Ernst & Young report as "ridiculous" and inconsistent with the firm's own assessments of individual banks.

E&Y, which serves as auditor for ICBC and is battling other foreign accounting firms for market share in China, promptly retracted the document. In a flourish of self-criticism worthy of China's cultural revolution, the global accounting giant renounced the report's conclusions as "factually erroneous."

Ernst & Young says it will reissue the report within the next few days once it has a chance to correct its errors. But the truth is neither Rodman, nor Chinese regulators, nor the banks' new foreign partners can know the full extent of China's bad loan woes.

The only thing that seems certain is that as China continues on this capitalist road trip, fellow travellers should be prepared for some nasty bumps. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.