Rolling the dice on China's banks

(Fortune Magazine) -- By the time it was all said and done, an astonishing $22 billion had been vacuumed up in a matter of hours. So frenzied was the desire for this initial public offering - the largest in history - that institutional investors placed $350 billion in orders only to find that few could squeeze their way into the euphoric buying.

The subject of this hysteria? It wasn't Google. It was a bank. And not some sort of newfangled, Internet-enabled, you've-never-seen-anything-like-it confection that claims it will transform the way money is managed. No, it was the Industrial & Commercial Bank of China, a sprawling state-owned lender run by political appointees chosen by China's Communist Party. It's an institution better known - like all Chinese banks - for a legacy of bloated payrolls and bad debts than for its commercial prowess.

Circular logic: Investors have flocked to buy Chinese bank shares on the Hong Kong exchange (pictured here), in part because everyone else seems to be doing it.

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SO FAR, SO GOOD China's three giant banks have trounced the S&P from their IPOs through Dec. 4. Bank IPO date Total return U.S.$ S&P 500 China Construction Bank 10/26/05 72.2% 20.9% Bank of China 5/30/06 26.9% 13.0% Industrial & Commercial Bank of China 10/26/06 26.8% 1.7% Source:Bloomberg

This mania didn't take place on Wall Street - it occurred in Hong Kong. And what happened in late October was only the latest hot Chinese-bank IPO for that stock market.

Bank of China, the mainland's second-largest lender, enticed global investors to the tune of $11 billion in May. China Construction Bank, ranked No. 3, pulled in $9 billion in October 2005.

The success of the three banks' debuts is eye-opening - but what, exactly, does it portend? Can individual investors get rich on these stocks? Will it be savvy U.S. investment houses that clean up? Or is the Chinese government the true beneficiary?

For anyone seeking to understand the state of financial opportunities in China - and for the record, we've never recommended putting more than a tiny portion of your portfolio into such a volatile arena - the recent bank IPOs provide a telling prism. Certainly, the country's markets continue to improve. But China, including its banks, also remains incredibly risky, as some U.S. financial institutions may discover (or in a few cases, rediscover) before too long.

There's no denying that the Middle Kingdom is emerging as a new force in global stock markets. Banks, brokers and money managers all over the globe have shelled out tens of billions to purchase stakes in Chinese companies in recent years. All told, China's state-owned firms have raised more than $91 billion from overseas investors in public offerings since 2000, according to Dealogic, and dozens more wait in the IPO pipeline for 2007.

Mainland companies now account for more than half the daily volume on Hong Kong's stock exchange. No wonder U.S. firms like Goldman Sachs (Charts), Morgan Stanley (Charts) and Merrill Lynch (Charts) are looking to invest in Chinese companies or wooing them as clients, while large institutional investors are dispatching fund managers to Hong Kong to be closer to the market action.

China's behemoth banks might seem unlikely investments. Despite a flurry of recent reforms, their loan books and earnings prospects remain as hazy as the smog-choked Beijing skyline. And yet, at least in the very early going, nearly everyone to bet on them has hit the jackpot.

The biggest winners have been the handful of blue-chip foreign investors invited to take strategic stakes in Chinese lenders before they floated shares on overseas exchanges. The Royal Bank of Scotland's $1.6 billion piece of Bank of China is now worth $10 billion. Goldman Sachs, which spent $2.6 billion for 5 percent of ICBC, has tripled its money. Bank of America's $2.5 billion investment in CCB has swelled to nearly $10 billion.

All told, foreign listings of China's banks have raised more than $40 billion since 2005, vaulting the mainland's big three lenders into the ranks of the world's ten largest banks by market capitalization.

Foreign investors have battled fiercely for stakes in even the most beleaguered Chinese financial institutions. Consider Citigroup's November announcement that it will team with IBM (Charts) and four large Chinese companies to acquire an 85 percent stake in Guangdong Development Bank, an all-but-insolvent regional lender, narrowly fending off a rival bid from a consortium led by France's Société Generale.

With so many big players putting so much money into Chinese bank shares - and apparently doing so well - regular folks may be forgiven for itching to join the party. As has happened frequently in the history of hot IPOs, those who managed to get in on the action early have made a mint so far.

But if you ante up now, you're hardly getting a bargain. Indeed, you'll be buying in at prices many times higher than those offered to the investment banks (which would also not qualify as a new phenomenon in the annals of investing). As of early December, shares of the three big Chinese banks were trading at price/earnings ratios of 21 to 27, about twice the P/Es of elite Western banks.

It's also worth considering that if global financial giants like Goldman, Bank of America (Charts) and Citi seem unusually keen to roll the dice on Chinese bank shares, it's because they're playing a different game than you are: They're angling for relationships and entry into China's burgeoning financial services market.

Goldman, for example, hopes to leverage its partnership with ICBC into new investment-banking opportunities within China and with fast-growing Chinese enterprises venturing overseas. Citi has its eye on Guangdong Development Bank's network of 500 branches and its roster of corporate clients in China's richest province.

For financial services firms like Citi, HSBC and American Express, the lure of China's market - with 1.3 billion people and $2 trillion in household savings but so far no more than 20 million credit card holders - is irresistible. Given the stakes, why should they quibble over risking a few billion dollars here or there?

For individual investors, the perils of investing in Chinese bank shares loom larger. As recently as a decade ago, nonperforming loan ratios at China's largest banks were more than 40 percent, according to analyst estimates.

Since 1998, Beijing has spent more than $400 billion on a series of ambitious capital injections and bad-loan removal schemes to put the banks on solid footing. As a result, nonperforming-loan percentages have dropped to low single digits, a level generally considered manageable in a growing economy.

But skeptics fear that hundreds of billions' worth of risky loans have merely been shuffled into a new category known as "special mention." Others warn that the drop in bad-loan ratios may only reflect an increase in new loans - many of them related to real estate - about to sour.

Chinese banks are spending billions on state-of-the-art IT systems, and executives at ICBC, BoC and CCB claim that foreign partners have been given broad sway to review their books and establish modern credit-control procedures.

But the challenge is monumental. ICBC, for example, has 18,000 branches and 335,000 employees. Senior executives acknowledge that at most branches, loan officers wouldn't necessarily be aware of a potential borrower's credit history even if he had an account across town at another branch of the same bank. Is that the sort of enterprise you want to invest in?

Among the more compelling arguments for buying China's bank stocks is that their biggest shareholder is the Chinese government. A collapse in bank shares would be a political embarrassment for Beijing, and with China's central bank sitting on $1 trillion in foreign reserves, regulators have means as well as motive to finance a bailout or three.

In the long run, however, pumping more money into banks to prop up share prices would defeat the purpose of issuing bank shares in the first place. In the 1990s, reform-minded technocrats hatched the idea of selling stock to foreigners partly as a means of attracting capital and management know-how, but mainly as a counterweight to mismanagement and rampant corruption. In theory, domestic banks would clean up their act as they felt the pressure of foreign scrutiny and competition.

Not coincidentally, that argument was floated as China negotiated to enter the World Trade Organization. Indeed, when it joined the WTO five years ago, China agreed to throw open its banking market on Dec. 11, 2006, and grant foreign banks the right to operate under the same rules as domestic banks.

But during the past year Chinese regulators have lost their zeal for bank reform. In a speech in March, Premier Wen Jiabao made clear that though Beijing is willing to offer minority interest in the nation's major banks to outsiders, "the state must have absolute controlling stakes."

Non-Chinese banks aren't permitted to offer regular banking services to ordinary Chinese citizens at the retail level. Foreign firms like Citigroup (Charts) and HSBC aren't allowed to accept deposits or make loans in China's currency, the yuan. Citigroup has 13 branches in China, but they mainly serve non-Chinese customers and overseas corporate clients with operations there.

Beijing was anything but accommodating with Citi's bid for Guangdong Development Bank. Rejecting the U.S. lender's initial offer of $3 billion for an 85 percent stake, regulators instead held fast to rules limiting total non-Chinese ownership in domestic banks to 25 percent, with ownership by any single non-Chinese investor not to exceed 20 percent.

The result is a consortium dominated by Chinese firms, all of them - surprise! - owned by the state. Citi executives hope the deal has left it implicit authority to manage the bank day-to-day. But there are no guarantees.

China's reluctance to open its financial markets to foreign competition means investors should think twice about another strategy: playing the China growth story by investing in well-managed Western banks seeking to expand operations in China.

For now Beijing has managed to have it both ways. It has attracted just enough outside capital and expertise to prod its banks to become more competitive without sacrificing much in operational control. And somehow it has managed the implausible feat of turning a drab Communist-run bank into a hot stock.

It may even - in the long run - succeed in fostering well-run banks that are sound investments. But for most investors, that outcome still falls in the realm of speculation. As the ancient proverb says, Let the buyer beware.

Research associate Joan L. Levinstein contributed to this article.

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