Chinese banks, global ambitions

IN DECEMBER 2006, Industrial and Commercial Bank of China (ICBC), China’s largest lender, acquired a 90% interest in Bank Halim, a small Indonesian lender. The deal hit the headlines, not because of its size – the consideration of $56 million is not even a rounding error on a balance sheet of more than $1.1 trillion – but simply because it happened at all. Chinese banks are entering the market for overseas acquisitions and they have immense firepower.

That firepower was demonstrated in a more meaningful way in August when state-owned China Development Bank announced a deal to invest up to $11.6 billion in Barclays Bank to assist in the financing of the UK lender’s bid to buy ABN Amro.

"There’s a lot out there for these banks to look at," says the head of financial institutions at a major investment bank, "with the big three banks, [ICBC, China Construction Bank (CCB) and Bank of China (BOC)], all in the top five or 10 banks by market capitalization, they certainly have the currency."

Arguably, these banks have too much money to invest, a problem that looks likely to intensify. The main Chinese banks are accumulating enormous sums of surplus capital as China’s economic growth accelerates and restructured banks relieved of crippling bad loans learn how to become profitable. According to UBS, China’s banks are likely to generate total excess capital of $67 billion, based on 2008 earnings estimates, of which ICBC, CCB and BOC alone will account for $60 billion. Finding a profitable home for that money poses a major challenge for China’s lenders in the years ahead. Overseas investment is one obvious destination for surplus cash.

China outbound M&A .

By sector in 2005

Sources: Deutsche Bank/EIU

That cash is finding its way back into the economy through the banks in capital recycled into loans, rather than through capital markets. As a result, China’s equity market capitalization remains small despite a high ratio of loans to GDP. Capital markets are not taking enough of the strain of risk, says John Wadle, managing director and co-head of Asian banking research at UBS. "China needs to develop its capital markets to allow risk to be absorbed," he says. "It can’t allow its banks to be the shock absorber for every financial risk in the economy."

Unsustainable

Until that starts to happen, the country’s banks will continue to accumulate capital for as long as China’s economy continues to grow. Although the country is grossly over-banked, a closed capital account and interest rate caps mean that the government is able to manufacture profitability for its larger domestic banks, a situation that is not sustainable in the longer term.

"The regulators have really underpinned the system," says Wadle. "They used to manipulate the profitability of banks to make sure they didn’t make money. Now they’ve done the opposite: they’ve engineered banks to make a ROA [return on assets] of 1% through fixed interest rates."

But with interest rate deregulation inevitable, banks will no longer be able to rely on fat fixed net interest margins to generate returns. Non-interest and fee income will become increasingly important. That means greater product diversification and, of course, geographic diversification.

"Banks have good incentives to go out and find quality credits to gain yield," says Pogson. "Capital is becoming a much more important factor, and with most Chinese banks’ capital adequacy ratios way ahead of 8% [minimums] they need to find places to lend."

Despite compelling structural economic reasons for the banks to move abroad, the single biggest factors behind banks’ increasing appetite for foreign expansion are commercial.

Although senior management at China’s banks has improved following their successful restructuring, banking talent in depth is lacking. And China still lags western banks in product innovation and technology, attributes they need increasingly as China’s banking sector becomes more competitive. Acquiring the necessary banking talent and know-how is a very real proposition says Richard Yorke, president and chief executive officer of HSBC China.

"With the speed China is being opened up, the constraint on doing business here is neither business- nor regulator-driven," says Yorke. "The constraint is finding enough experienced people. One advantage of a Chinese bank acquiring a European or an American bank would be to acquire talent and products."

As China’s government promotes its Going Global strategy, large successful Chinese companies are moving aggressively in foreign markets, often by acquisition. Part of the government’s plans to create "global champions", banks are increasingly seeing the commercial benefit of moving with their biggest and best customers.

"It’s only natural that these banks look overseas," says Yorke. "Banks tend to follow their customers and many of the banks’ existing large customers are expanding internationally."

Sensitive

That may be so, but many of these companies are making acquisitions in regions that are not the obvious locations for Chinese banks, as a senior China banker points out. "It’ll be interesting to see how this evolves," he says. "A lot of Chinese foreign direct investment is commodities-driven and is going to Latin America, Australia, the Middle East and Africa. Are the banks going to acquire banks with networks in these places or will they make acquisitions for other, for example, product-driven reasons? That would point to deals in the US or Europe, but how politically sensitive will that be?"

"China needs to develop its capital markets to allow risk to be absorbed" John Wadle, UBS