Wednesday, September 14, 2005

China Construction Bank IPO Contends With Leery Investors

September 14, 2005

HONG KONG -- The big guns have had their shot at investing in China's banking story. Now it's everyone else's turn.

Next month brings the initial public offering of China Construction Bank, expected to be one of the biggest IPOs in the world this year. As the first stock offering in one of China's "Big Four" banks, it will serve as a sort of investor referendum on Beijing's vaunted changes in the industry.

The Chinese government has put US$22.5 billion into a bad-loan bailout of CCB, the nation's third-largest bank by assets, as part of an overhaul leading to the IPO expected to raise about $5 billion. Bank of America has made a $3 billion investment commitment, and the Singapore government's investment company, Temasek Holdings, has offered as much as $2.4 billion. All told, strategic investors such as these have committed some $15 billion to gain access to one of the world's fastest-growing financial-services markets.

In October, institutional and individual investors will at last get to vote with their own wallets. They must assess China's drive to transform its major banks from rubber stamps for state-endorsed lending to profit-minded institutions with professional management. With their shorter-term return horizons, they will want to take an especially hard look at the numbers and listen to some of the pros.

"We will not necessarily follow the strategic investors into the banks, since their objectives are different, in the sense that they need to get access to the market early," says Mark Mobius, manager of the $3.3 billion Templeton Developing Markets Trust. "If we look at the valuations of the Chinese banks, they are not necessarily cheaper than what we can find elsewhere."

According to a recent report by Fitch Ratings, Chinese banks' return on assets and return on equity are among the lowest in Asia, with China's banks clocking an average 0.43% return on net assets and 10.89% return on equity, vying with Taiwan for the worst marks in the region.

CCB says its return on net assets last year was 25.4%, a number Fitch says is "somewhat overstated" in light of an income-tax exemption. Most of the bank's profit was earmarked for dealing with nonperforming loans, the Fitch report says. Last year, CCB more than doubled its profit to 48.4 billion yuan, or $6 billion, and says without the tax break the return would have been 17.3%.

To lure investors leery of the risks -- notably, corruption, bad loans and poor accounting -- the banks have been sold at attractive prices. Bank of America paid about 1.2 times book value for its 9% stake in CCB. That compares with the 3.18 times book that a Standard Chartered-led consortium paid for Indonesia's Bank Permata last year. China's Bank of Communications, which sold shares in June at 1.6 times book, has seen its shares rally 40% from the IPO price.

But appearing to be cheaply priced isn't enough, Templeton's Mr. Mobius contends. CCB will also have to show that recent loan growth is strong enough to withstand a possible slowdown in the domestic economy, which has been growing at world-beating rates above 9%. Inflation slowed in August, and there are concerns that domestic demand is weakening. A slowdown would spell trouble for company profits and could lead to a resurgence in bad loans at the nation's banks. CCB says its nonperforming loan ratio is 3.9%, down from 19.2% in 2002.

Separately, another factor to consider is there is "an inherent contradiction in motivations for all these banks," says Andrew Rothman, China macroeconomic strategist for CLSA Asia-Pacific Markets in Shanghai. "On the one hand, they want to become more like real banks. On the other hand, every bank in China is still controlled by the Communist Party, and the party's interests are not always going to be in line with the shareholders' interest."

For its part, CCB is betting that changes it has made in recent years -- such as cutting branches by 30% in three years, reorganizing management and spending more than $1 billion in technology upgrades -- will be enough to make investors set aside concerns over the risks and wager that management can improve profitability.

For a start, the bank, with nearly 14,500 branches and about 310,000 employees, had its 2004 accounts signed by an international accounting firm, KPMG's Chinese affiliate -- a first for CCB. More important, the bank has reorganized its management, separating audit, lending and risk management into different reporting lines. In the past, auditors reported to branch managers; loan officers were also responsible for risk assessment; and loans could be approved by banking outlets in the hinterland.

"One of the big problems was that they were too decentralized, with the branches having too much authority. The same people who were marketing the loans were also approving the loans," says Peter Tebbutt, a ratings analyst at Fitch.

The bank has set up five board-level committees, including three that are headed by independent directors: a related-party-transactions committee, a risk-management panel and an audit group. The committees might help erode the influence the party has over the bank -- influence that the bank's chairman, Guo Shuqing, publicly criticized this year.

Mr. Guo came in from the nation's central bank after CCB's former chairman, Zhang Enzhao, resigned in March amid allegations of corruption. Since then, the bank has tried to show it is cracking down on corruption within its ranks. "The problem of Zhang Enzhao forces the senior management throughout the bank to pay greater attention to being honest and clean," the bank said in a June statement after implementing a new accountability system.

Investors can take heart from such changes but should remain clear-eyed when approaching China's biggest banks.

"Realistically, if you think about the sheer number of people that are involved here, it is going to take a while to change," says Matt Bekier, a partner at McKinsey & Co. "But once they make up their minds to do something, the execution of those projects is pretty good."


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