"This is huge - really pleased", was the delighted response of one banker close to China Construction Bank's (CCB)IPO in the aftermath of Friday morning's announcement that Bank of America (BOA) is to buy a 9% stake in the banking giant for $3 billion.
He had reason to be thrilled. The investment is the largest-ever single investment by a foreign entity in China.
BOA has announced it is buying $2.5 billion worth of existing shares held in CCB by the holding company, central Huijin, and has committed another $500 million to acquiring shares in the IPO, scheduled for the end of the year.
However observers say it is not yet clear how much of this money will go to the bank itself. It currently looks as if the $2.5 billion will go straight to CCB's state-owned holding company, Central Huijin, and hence the government.
"It's rather disappointing," comments Peter Tebbutt, senior director at Fitch Ratings, Hong Kong. " The bank could do with the money more than the government."
Under the terms of the deal, BOA will have the right to increase its stake to 19.9% within five years, the maximum amount permitted for a single foreign company. That means that means other strategic investors could still acquire up to 5%, since the total limit for multiple foreign owners is 25%.
But Guo Shuqing, chairman of CCB, has also been at pains to point out that the 25% rule only applies to the bank pre-IPO, and that it has always declared an interest in up to three strategic investors. Observers conclude this would seem to leave the door open for further large stakes by foreign strategic investors at the IPO stage.
Both parties refused to comment on the fate of Citigroup, which apparently refused to buy a strategic stake in the bank in return for the underwriting slot it had earlier obtained on condition it took a strategic stake. Instead, BOA is now believed to have secured a joint bookrunner's slot alongside Morgan Stanley and CICC.
In a dig at his US rivals, BOA chairman Kenneth D. Lewis said the bank had entered into the strategic alliance with CCB based on its faith in the management and a desire to share in China's strong economic performance, not because they expected an investment banking mandate.
Lewis said that BOA would have one board seat, but did not mention who would take it up.
He expressed his confidence in the systems CCB has put in place for overseeing credit growth and improving corporate governance.
"It's not the number of people you have on the board which will make a success of the acquisition," he said.
The deal puts a more favourable spin on an IPO, which is regarded as one of the most challenging to ever come out of the Mainland.
China's country risk is being hit by several factors: trade and currency valuation conflicts with the US and the EU; the prospect of a domestic slowdown; a margin squeezes in the corporate sector, and last but not the least, the house arrest of CCB's own chairman for bribery.
All this adds up to a tough sell, though potentially a very lucrative one given that investment banking fees should top the $170 million mark.
CCB's supporters point out that the capital markets are a fine benchmark for pricing risk. If the risk is high you can lower the price.
But some say CCB's bookrunners are the proverbial nut sandwiched between a hammer and anvil. This is because it is not yet certain whether CCB can be pitched low enough to attract international investors given that the Chinese government does not permit a sale of state assets below book value.
One side effect of the BOA acquisition should have been an increase in CCB's book value. But with no money going to the bank itself, this looks unfeasible.
"If the money does not go to the bank itself, there will no favourable impact on its book value," says Fitch's Tebbutt.
According to Fitch, CCB reported a 2004 ROA of 1.3%, ROE of 25%, and non-performing loans a fraction over 3%.
Despite these impressive figures, Fitch only gives the bank a stand-alone financial strength ratio of D/E (The stand-alone aspect refers to the bank's ability to operate without government capital injections), up from E before the 2003 $22.5 billion capital injection.
Fitch MD David Marshall says this is because the agency believes CCB's profitability ratios are inflated.
"CCB's net income looks good in 2004 because its tax charge was unusually low, as the government cut its taxes as a way of assisting the bank," he says. "It also appears as if most the net income was earmarked for dealing with what appear to be legacy NPL issues."
Low profitability is problem common to all Chinese banks. Even on the A-share market and taking into account its inflated valuation, Minsheng Bank is trading at only 1.4 times book. Internationally, a healthy bank would trade at around two times book, according to Fitch.
Marshall adds, "Chinese banks receive almost all their income from interest income, and strikingly little from fees, but their interest income is limited by low rates on the back of massive liquidity."
Chinese banks need to expand their fee income, control costs and start making high-interest loans to the private sector in order to accelerate profitability, he says.
Most international banks boost profitability through treasury and forex operations, but given the capital restrictions in China, that avenue is not open to them. Nor are the government bonds Chinese banks invest in especially high yielding.
Marshall adds that, in his experience, no other bank has attempted an IPO with a Fitch rating of D/E, as CCB is attempting.
This all paints a very gloomy picture. On the plus side, Morgan Stanley has plenty of experience dealing with difficult China IPOs.
Most notably, investors baulked at paying more than one times book for China Telecom in autumn 2002. The $1.4 billion IPO had to be re-launched at half its orginal size and just scraped home at 1.007 times book value.
Yet some observers comment that no-one should underestimate the desperation of the Chinese government to get the deal done.
CCB's loan book has grown explosively in recent years and analysts say it is this that has caused NPL ratios to drop. They argue that many of these loans may go sour and the most cynical suggest the government is racing to get an IPO done before these dud loans appear.
On the plus size, bankers say the deal's size will play to its advantage. Index buyers will prefer to buy cheap at the IPO, rather than months later when the counter joins the major indices.
Others point out that Hong Kong tycoons will also help out the effort and buy into the deal.
It is to be hoped that they are right. There is far more riding on this IPO than just recapping a state bank - success or failure could have huge repercussions on China's real economy and its political system.
Only Russia's Gorbachev has managed to peacefully reform a totalitarian system by giving up power in the same way the Chinese government is doing by commercializing its piggy banks.