Foreign banks in China: lots of expenditure for little revenue?

In 2007 the Chinese banking market will be open to foreign competition. So why are foreign banks buying up local banks? Because despite WTO, penetrating the China market will not be easy and they are going to need all the help they can get.

On September 11, domestically listed Shenzhen Development Bank announced it was in talks with a foreign strategic investor. The candidates are fairly numerous these days, following the pick-up in activity involving foreign banks acquiring, or trying to acquire, stakes in Chinese banks this year.

US-based Newbridge Capital is rumoured to be interested in acquiring 15% of the Shenzhen Development Bank, majority owned by the Shenzhen municipal government. Citibank, which has one of the largest branch networks amongst the foreign banks in China, is said to be interested in buying an 8% -10% stake in Pudong Development Bank. Neither company has made any official comment.

The choice of SDB is interesting. Shenzhen is keen to rebuild itself as a financial center in the south of the country following Shanghai's victory gaining a commitment to host the country's unified stock market. Shenzhen has already been forbidden to permit further listings. The vaunted second board, which was meant to placate the city, still shows no sign of becoming a reality, despite years of talks.

A couple of days before the Pudong Development Bank rumours, the International Finance Corporation (IFC) and Canadian Bank of Nova Scotia announced that they were buying a 12.5% and 12.4% stake respectively in Xian City Commercial Bank.

Already the level of foreign ownership in the Chinese banking system has markedly exceeded the total of last year, marked by HSBC's and IFC's acquisition of minority stakes in Bank of Shanghai.

The People's Bank of China, the central bank, has announced its support for "appropriate" levels of investments by foreign investors and by domestic private investors to strengthen the capital and the management of the country's small and mediums sized banks. For the time, the big four state banks are still off-limits.

By the end of 2007 the Chinese government has promised to live up to its promises made under the WTO timetable. These restrictions now are pretty formidable, but in fact, surprisingly little will change under WTO rules. For example, after acquiring approval for opening one new branch, a foreign bank has to wait 12 months before applying for a new branch license. That will still be the case after 2007.

Nor can a branch engage in RMB business immediately, once it does set up a branch. Rather, it has to show two consecutive years of profit out of the previous three before it can hope to successfully apply for a RMB license. That will not change either. In effect, these regulations mean foreign banks will have trouble accumulating the low cost deposits domestic banks can rely on, and making the foreign banks more reliant on loans from the Chinese banks. Basically, while foreign banks will be theoretically able to set up shop anywhere in China, they will still have to wait for PBOC approval.

Other regulations also raise the cost of the capital for foreign banks, for example that each foreign branch should have RMB 600 million on hand ($72 million), or the hard currency equivalent, as operating capital to its hard currency and RMB activities. On top of that base amount, the PBOC stipulates the 8% capital adequacy ratios.

So it makes sense for the foreign banks to start acquiring their own branch network by looking at well-placed local banks. The basic aim is to supplement deposits and branch networks on the Chinese side with technology and skills in selling retail products such as mortgages and car loans.

Building up a banking operation in China can be costly. For example, HSBC has already invested $270 million in building up its China network and has spent another $65 million in acquiring the 8% in Bank of Shanghai. Profits in the first half of this year, estimate Chinese media sources, amounted to just $2 million. HSCB's China spokesperson refused to comment on the figures. Indeed, none of the foreign bank release figures specifically about their China operations, so estimating investments and profits is difficult.

HSBC is noteworthy since it is the only foreign commercial bank that has been able to buy a stake in a Chinese domestic bank. On the other hand, analyst say that may be because the price it paid for the stake was rather high, valuing the target at almost $1 billion.

IFC has been very successful at buying into local banks, since it is viewed by the government as politically uncontroversial source of funds and technology. It has minority stakes in the Bank of Shanghai, Nanjing City Commercial Bank and Xian City Commercial Bank.

The stakes are all under 25% since that prevents the target bank from turned into a joint venture. Joint venture banks are ringed about with restrictions, as well as benefiting from certain tax privileges, so it is not always in the interest of either partner for the company to be classified as such.

There often a conflict between the local partner wanting to maintain as much control as possible, and the foreign partner wants to grab more. As the banking environment in China becomes more competitive, it is clear that the foreign partners are able to acquire larger stakes, certainly based on the evidence of the past couple of years.

The targets for foreigner investors are local banks with potential, a good location and close to the foreign banks' core markets.

One of the pre-conditions of any such deal is that the target bank has to draw up its financials usually international accounting standards. Still, there is usually a lot of haggling about how to settle the difference between the Chinese evaluation and that of the foreign bank.

For example, Nanjing City Commercial Bank's audit calculated the net asset value per share at RMB 1.37, while the IFC calculations put it at a RMB 1.07. The two parties eventually agreed on 1.21 says Zhou Xiaoqi, vice chairman of the bank. He adds that many difficulties came over the issue of how to value the bank's investments in government bonds, which are highly illiquid and difficult to mark to market, fixed asset depreciation and the whole issue of goodwill.

China's lax accounting regulations when it comes to making provisions for bad loans means that local banks will have to get used to having the value of their assets downplayed by foreign investors, he says.

It can also be important that the target bank be owned by the local government, such as Bank of Shanghai and the shareholding city commercial banks of Xian and Nanjing, since such official muscle can provide an important fast track to the deal being authorized by PBOC in Beijing. Bank of Shanghai is 40% owned by the city government and affiliated organs.

On the other hand, the size of the local government stake means that it will be difficult for foreign shareholders to increase their stakes beyond a certain size. And even if the local government does cede ownership in return for cash, no uniform regulations are in place as to the validity of such a move. It is still very much on a case-by-case basis. That is to say, the PBOC is keen to maintain the freedom to arrange the difficult balancing act of benefiting from foreign capital and technology while maintainng sovereignty over the banking system.

The shareholding banks are a relatively new, and hence devoid of the legacy of government directed loans, and the shareholding structure means profitability was part of their mission from the start, although some, like BoS, they are not devoid of bad loans, accumulated from their days as credit cooperatives.

What is clear, is that penetration of the domestic banking system by foreign banks is still very low. It is going to be a while yet before China figures large in the revenues of the foreign banks. At the moment, the country figures mainly on the expenditure side.

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