Banking: What lies behind China’s opening door?
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Banking: What lies behind China’s opening door?

After a two-year hiatus, China’s regulators are allowing more foreign investment banks to enter the domestic capital markets. What are their strategies and is China’s potential as great as everyone assumes? Sudip Roy reports.

CICC powers on


NOW MIGHT NOT seem to be the most opportune time for a foreign investment bank to be doing business in China’s domestic equity market. After the heady heights of 2007, the country’s CSI 300 index is down 54% this year, with turnover in the Shanghai and Shenzhen A-share markets hitting 20-month lows in mid-August.

Still, that will not stop Credit Suisse from celebrating the fact that, after a two-year hiatus, Beijing has lifted its embargo on global investment banks entering into joint ventures with local securities firms and so allow it to underwrite domestic capital markets offerings.

The European firm is the first to benefit from this reopening of the door and has gained approval for a deal with Founder Securities, a mid-tier local broker. Other foreign investment banks could follow. Deutsche Bank has agreed to establish an investment banking joint venture with Shanxi Securities but is awaiting regulatory approval. Citi is thought to be sniffing around potential partners, among them Central China Securities. JPMorgan and Merrill Lynch have entered discussions with local firms in the past, which came to nothing, and continue to assess their opportunities.

Morgan Stanley is in the middle of resolving its relationship with China International Capital Corporation (CICC), and might enter into a partnership with China Fortune Securities, another mainland broker. It has signed a preliminary agreement with China Fortune but the authorities have told the US firm that it cannot be in two separate investment banking ventures. It has also bought a commercial bank, Nan Tung Bank, which Morgan Stanley might be able to turn into a securities firm one day, regulations permitting.

Which of these investment banks next gain the green light from the Chinese authorities remains to be seen, although Deutsche Bank and Morgan Stanley will hope to have their futures resolved soon. No one knows how long the opportunity to win a domestic capital markets underwriting licence will remain open before the regulator, the China Securities Regulatory Commission (CSRC), shuts the door again. In 2004–06, the government allowed Goldman Sachs and UBS to agree and establish partnerships, of differing natures, with locally licensed securities businesses before prohibiting any further such deals.

Why the authorities have done an about-turn this year remains a matter of conjecture, although some cynics say it is precisely because of the poor performance of the stock market. Goldman Sachs and UBS were both granted their licences when the A-share market was struggling, while nothing was forthcoming during the boom years of 2006–07.

Bankers, used to dealing with the political vagaries of the Beijing government, dismiss such talk as nothing more than coincidence. "When the regulator was first considering our licence the market was still strong," says Liping Zhang, head of China investment banking at Credit Suisse.

A rival investment banker in Beijing agrees that there’s little correlation. "I’m not convinced there is a link between the performance of the market and the approval of the licences. There’s clearly a measured approach to what the CSRC does," he says.

Another investment banker suggests that outside influences might have played their part. "You have to look at the decisions over a long time horizon," he says. "The securities regulator took the steps because of outside pressure from the US and Europe."

Talks between senior policymakers in the US and China, in particular, have become commonplace through the Sino-US Strategic Economic Dialogue. It is through this forum that US pressure on the Chinese to open the securities market further has become more intense, especially with the A-share market booming in recent years – until this year anyway.

At the same time, however, the Chinese authorities have always been reluctant to move too fast. "The regulator is wary of freeing the market too quickly," adds the investment banker. "The government realizes it’s a very fragile market."

In the back of the authorities’ mind is the fear that the local investment banks will get overpowered and swamped by the better-managed and more sophisticated foreign firms.

New guidelines

The new joint venture approval for Credit Suisse, which was announced in June, is the first since the revised Rules on the Establishment of Securities Companies with Foreign Equity Participation were issued at the end of last year.

These rules are supposed to ease restrictions on foreign investment in securities companies. Under the revised rules, the joint ventures can be structured in forms other than as a limited liability company. Another change is that foreign investors can buy shares of a publicly listed Chinese-invested securities company, although there are limits to the size of shareholding allowed.

Crucially, however, some restrictions remain, most notably that foreign investors are not permitted to own more than a passive one-third of the shares of the domestic securities ventures.

In addition, the new rules barely change the scope of business the joint venture is allowed to participate in, namely underwriting debt and equity offerings in China and trading in government bonds. The only addition is that now joint ventures will be allowed to sponsor equity and debt issuances too.

The licence does not, however, allow for the provision of asset management or private banking services, or for basic equity broking activities, such as sales, trading and distribution. One investment banker says the situation is "less than ideal".

He describes the process as follows: the rules allow a foreign investment bank to enter a deal with a local securities company, one that might have multiple licences. But when the two set up their joint venture, only the local firm’s underwriting licence gets transferred across. "The regulator is not increasing the number of licences but moving a particular licence from one entity to another," he says.

If, over at least five years, the joint venture performs well, management may apply for further licences. For example, CLSA Asia-Pacific Markets, which had set up an investment banking joint venture in 2003 to underwrite A-shares and renminbi bonds, announced in June that it had now won a licence to start an institutional research, sales and broking business in the Yangtze River Delta area. It is the first joint venture between a foreign and local firm to win a broking licence since the introduction of the new rules.

"The single licence is a starting point," says the investment banker.

He adds: "This is very consistent with China’s banking reforms in that the authorities have created a schedule that they can control."

Credit Suisse venture

So the approved deal between Credit Suisse and Founder Securities allows for only primary markets underwriting activities in China. "If the joint venture goes well then we hope to get an equity trading licence in the next few years," says Zhang.

Under the agreement with Founder, Credit Suisse will own 33.3% of the joint venture; its Chinese partner will own the rest. The venture is expected to be fully operational later this year.

Liping Zhang, Credit Suisse

"When the regulator was first considering our licence the market was still strong"
Liping Zhang, Credit Suisse

Founder is a top-20-ranked brokerage in China, whose roots are in information technology, healthcare and pharmaceuticals. In 2002, the Founder Group branched out into the world of finance when it bought Founder Securities, which was previously called Zhejiang Securities. Zhang says the deal has taken about 12 months to strike from starting negotiations to gaining the CSRC’s approval. "In the past year, we’ve formed a friendly relationship with the senior management at Founder with the view to getting a joint venture done," he says.

"Our private banking division first introduced the firm to the investment bank," he adds.

Lie Jie, chairman of Founder Securities, will take on the same role at the new entity, while Neil Ge, a managing director of Credit Suisse’s investment banking business in Shanghai, will be the chief executive. The crucial issue for Credit Suisse will be how much control it has over the joint venture, something that remains to be seen.

Zhang says it is important to make a distinction between the shareholders and the management. "The management will be independent from the shareholders. We will recruit the management from the market," he says, adding that the Swiss bank would want majority ownership eventually, if the regulators allow.

Goldman’s unique structure

The structure of the new Sino-foreign investment banks will differ from those joint ventures already established by Goldman Sachs and UBS.

These two firms were able to bypass the regulations in place and, with the authorities’ blessing, establish ventures over which they have true management control.

One investment banker at a rival firm admits: "The most admired models are those achieved by Goldman Sachs and UBS. Both stepped out of the boundary of what the Chinese government initially wanted to allow."

Goldman Sachs’s deal is a complicated structure and comprises two separate entities. The first, Beijing Gao Hua Securities (GH), holds a domestic securities licence to broke and trade domestic shares and convertible bonds. The second, Goldman Sachs Gao Hua Securities (GSGH), is a domestic investment bank that can underwrite domestic shares, bonds and convertible bonds, as well as provide domestic financial advisory services.

GSGH is owned 67% by GH and 33% by Goldman Sachs. GH is owned 75% by veteran banker Fang Fenglei and partners and 25% by Legend Holdings, a big shareholder in Chinese PC-maker Lenovo. Goldman therefore owns no equity in GH, meaning it is a wholly Chinese-owned company. Goldman, though, has considerable indirect influence over GH, thanks to a $97.5 million loan made to Fang to help establish the entity.

Relations between Goldman and Fang have become even more complicated since last year when Fang set up a private equity firm, Hopu Investment, with backing from Singapore’s Temasek, while remaining chairman of GSGH. Goldman has invested in the fund as a limited partner.

Still, it shows how important Fang is to Goldman’s fortunes that he is able to set up a new and potentially rival business, at least for non-mainland transactions, while remaining in charge of the investment bank’s China venture.

UBS control

UBS also has a unique structure. In 2006, it invested a hefty $210 million for a 20% stake in Beijing Securities, a mid-tier broker. Like Goldman, UBS has management control over the new entity, despite owning just one-fifth. Five other shareholders, mostly Chinese institutions, own the rest. The biggest individual shareholder is Guoxiang, a special investment body set up by Beijing’s municipal office, with a 33% stake.

Nevertheless, UBS personnel dominate the board. Perhaps the most compelling evidence demonstrating UBS’s influence over its China venture is that Beijing Securities no longer exists and instead the remnants of that business have been restructured and renamed as UBS Securities (UBSS). "UBS has control of the management and of the company," says Joseph Chee, deputy head of investment banking at UBSS.

To achieve what UBS has was not easy. The bank first began to consider a partner in 2002 before deciding on Beijing Securities in 2005. Its nationwide franchise was particularly appealing. Even then it took another 18 months before UBSS formally opened for business in May 2007. Although Beijing Securities had the relevant licences, it lacked the infrastructure, management and bankers to be competitive at the top level. "We provided most of that," says Chee.

In 2006, the Chinese authorities gave their blessing to UBS to restructure Beijing Securities. Twenty-one out of the firm’s 27 retail brokerage branches were sold – these branches had negative assets and cumulative losses. UBS also set about moving on the majority of staff from the branches. At the same time, it kept about 180 staff from the legacy Beijing Securities business and incorporated them into UBSS.

Through UBSS, the Swiss bank is allowed to undertake domestic debt and equity underwriting and trading. It is also permitted to conduct onshore wealth management through its six retained brokerage branches.

The Goldman Sachs and UBS models were very much part of a strategy of the Chinese government to see how foreign investment banks and domestic securities firms might work together. "The regulators like the fact that they have different models and it gives them an opportunity to see what’s the best path," says one investment banker. "It’s like a science experiment."

The success or otherwise of these experiments, though, will ultimately depend on control. Morgan Stanley, for example, owns one-third of CICC but it has never had management control over the investment bank, which is run by Levin Zhu, son of former prime minister Zhu Rongji (see box). In addition, the regulators are wary about ceding too much power to foreign partners too quickly.

"The authorities are much more sensitive on the broking side than on the banking and on who is moving shares across the exchanges," adds the investment banker. "That’s where they will focus more on the control issue."

With the government sensitive about the performance of the A-share market, the chances are that the brokerage business will only be opened in a piecemeal fashion, as the CLSA announcement shows.

Onshore equity

Still, irrespective of whether any of the foreign investment banks entering China have their ideal model or not, none will pass up the opportunity to participate in an increasingly lucrative market.

Although China is a difficult and competitive market, plenty of money can be generated from both underwriting and broking for the leading firms. Annual revenues of more than $100 million are possible within investment banking, while total broking commissions in China’s A-share market exceeded $20 billion, according to CG Wu, CLSA’s China chairman.

Xie Zhichun, China Everbright Bank

"The IPO is very important to us to ensure that our operations are transparent"
Xie Zhichun, China Everbright Bank

The foreign investment banks have already made their presence felt. Last year, UBS ranked third in the league tables for underwriting A-share issues, lead managing more than $8 billion of deals. Its big-ticket transactions included the $8.9 billion Shanghai IPO for PetroChina and an $814 million IPO for Western Mining, a gold miner whose stock sale was originally destined to go ahead in Hong Kong. Goldman Sachs also ranked among the top 10 leading bookrunners in 2007, including a $5 billion Shanghai IPO for Ping An Insurance. This year is proving tougher, with neither ranked among the 10 leading underwriters. The best Chinese brokers, CICC and Citic, are very much ahead of the pack. Not only do they have the necessary relationships with the government and potential clients, but also understand the nuances of the market.

Even so, the early successes for UBS and Goldman Sachs underline the importance of a domestic equity markets business for the big European and US firms. As the data reveal, China equity capital raising is increasingly moving onshore.

Even this year, despite the A-share market’s traumas, in terms of both volume and number of deals listed, the mainland’s stock markets in Shanghai and Shenzhen massively outstrip Hong Kong.

Mainland is outstripping Hong Kong
IPO and follow-ons of Chinese A-shares
Pricing date Value ($mln) Number
2006 20,937 92
2007 78,100 174
2008 YTD 23,074 108
IPO and follow-ons of Hong Kong H-shares
Pricing date Value ($mln) Number
2006 39,001 33
2007 15,414 32
2008 YTD 5,245 14
Source: Dealogic

Up to mid-August, Chinese companies have raised $23.1 billion through A-share IPOs and follow-on transactions, according to Dealogic, compared with $5.2 billion in Hong Kong. In China, there have been 108 deals in total, compared with just 14 by mainland companies in Hong Kong. This move towards greater capital raising onshore is relatively new. In 2006, for example, Chinese companies raised $39 billion in Hong Kong – indeed about one-third of the $826 billion market capitalization of the Hang Seng index is attached to Chinese companies that have listed in Hong Kong. That same year, the A-share market saw $20.9 billion of transactions. The turnaround began last year when a whopping $78.1 billion was raised in the A-share market compared with just $15.4 billion in Hong Kong.

Much of the volume in Hong Kong in 2006 was driven by big IPOs by the state-owned banks, such as Bank of China and Industrial and Commercial Bank of China, and other enterprises. Now the government is much keener to push transactions domestically, market conditions notwithstanding.

"The government is increasing the supply of stocks and is encouraging more red chips, though it doesn’t want the listing to crap out," says an investment banker.

The pipeline of deals is impressive. Several state-owned financial services, power and transport companies are expected to list once the government feels comfortable about the direction of the market. Technology, media and telecoms companies are hoping to raise money too.

One potential IPO will be by China Everbright Bank, part of state-owned financial conglomerate the Everbright Group. "All the documents have been finalized and there is no obstacle in terms of the application, until now," says Xie Zhichun, executive vice-president of the bank. "We are now just waiting for final approval from the CSRC to go ahead with the listing."

Xie says the IPO is more than just a capital-raising exercise. "A more important reason is to improve our corporate governance and to be regulated by the market. The IPO is very important to us to ensure that our operations are transparent."

The comment is typical of many IPOs and their motive. "To improve transparency and governance standards more than to raise cash has always been a reason why state-owned assets have been privatized," says one investment banker.

Debt openings

Opportunities for investment banks will also become more apparent in China’s debt market. This year, issuance volumes in the domestic debt market have already reached $38.2 billion, according to Dealogic – not far off the $41.9 billion raised in 2007. In 2006, only $20.2 billion was raised.

"We are seeing more debt issuance than before," says Wei Ding, executive chairman of CICC’s corporate finance committee and head of investment banking. "That’s partly because of the difficulties in the equity market and to improve companies’ debt-to-equity ratios. Companies are considering debt issuance more to leverage their balance sheets."

Another reason why the bond market has begun to gain greater credibility is because of government reform. More than 90% of all financial capital is provided by the banking system, which is neither healthy nor sustainable for an economy still growing at more than 10% despite a slowdown.

Aware of this, the government has tried to lower the administrative hurdles for issuers by streamlining application processes and relaxing requirements for certain borrowers, such as for project financings. In another helpful development, corporate bonds no longer require bank guarantees. Moreover, listed companies can now issue debt too.

The government has also tried to simplify regulatory oversight by releasing the stranglehold that the National Development and Reform Commission (NDRC) used to have on all debt-related products. Now the CSRC has authority over the corporate bond market, while the People’s Bank of China runs the commercial paper market. The NDRC has jurisdiction for all enterprise bonds undertaken by the state-owned companies.

These changes have shaken up the debt market. One of the first things the central bank did on taking over the commercial paper market was to end the quota system, which the NDRC employed to limit how many bonds could be issued each year. The CSRC too has lifted the quota system after gaining regulatory control of listed firms’ bonds. The NDRC has done the same for the non-listed firms’ bonds that it oversees.

Another plus is product development. The government is keen to develop a domestic foreign-currency bond market, for example. Although the first such bond was issued in 2003, there are only nine in total, worth $4.3 billion. Given the growing demand in China for foreign currency, the bonds make sense. To that end, the NDRC, the ministry of commerce, the central bank and the China Banking Regulatory Commission have been charged with the task of developing the market.

Regulatory brakes

In spite of these pushes to develop the debt market, there are still plenty of obstacles. The market can be dysfunctional and lacks liquidity.

One problem is that institutional investor interest is low. The paucity of longer-dated bonds means that portfolios are difficult to build and yields are often unappealing. Instead, the banks dominate the market. They tend to hold the bonds to maturity, so stunting the development of a secondary market.

Debt trading takes place through two mechanisms: the inter-bank market and the exchanges. The first, the bigger inter-bank market, is regulated by the central bank and is the trading platform for sovereign and enterprise bonds, as well as medium-term notes issued by state-owned companies. Corporate bonds are traded on the exchanges, which fall under the jurisdiction of the more reformist CSRC.

Although the regulatory oversight is improving, transparency and governance standards still fall short. In the inter-bank market, for example, the government has the power to set interest rates for new issues, rendering price discovery a meaningless exercise. And although the interest rate for corporate bonds is determined by the market, there are other problems for investors, such as getting basic credit information. "The corporate debt market is pretty much a Wild West," says an investment banker.

An even bigger problem facing China’s debt market is that the government has the capacity to change tack at whim, closing a market if it so wishes. Earlier this year, for example, the authorities put the brakes on the MTN market.

In June, the market’s regulator, the National Association of Financial Market Institutional Investors, which falls under the supervision of the central bank, announced that it was no longer reviewing applications for MTN issuances by companies, just two months after the market was launched. In that time, 20 companies had issued notes, mainly three-year to five-year bonds, raising $10.7 billion, according to Bloomberg. The regulators had already given approval for more than twice that amount, although no one knows when the market might reopen.

According to local reports, the opening of the MTN market had begun to affect the issuance of enterprise bonds and other securities that fall under the watchful eye of the NDRC and the CSRC. Officials from those two bodies say, however, that the MTN market, which waived government approval for issuances, contravened the law. This states that government approval is a necessary step before issuing a bond.

The MTN debacle shows that foreign investment banks hoping to make their way in China will need to tread carefully, whatever the product. Understanding the delicate relations between the various regulators and direction of the political wind are as essential as basic banking skills. For nothing is ever straightforward in China’s financial markets.

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