Merrill Lynch bullish on investment banking fees in China

Recent report paints rosy picture, but could be a case of wishful thinking.

A snortingly bullish report from investment bank and brokerage Merrill Lynch suggests that China's stock markets, dwarfed by the country's banking sector and foreign stock markets, could be a major component of global investment banking profits in the next five to ten years. Given the dismal performance of China's A-shares, (Yuan-denominated and traded only on the mainland) recently touching six-year lows, the report is sure to raise some eyebrows.

Chinese stocks listed outside China, at Rmb 2200 billion, have almost twice the market cap of those tradable shares listed within China (Rmb 1200 billion), while the corporate debt market in China is tiny and rigidly controlled. Only around one third of the shares of mainland-listed companies can be traded, with the rest in government hands.

According to the report, China's economy accounts for 4% of world GDP, but its equity market cap is just 2% of global equity market cap, and its debt market cap is just 1% of global debt markets.

In contrast, the US's 27% contribution to global GDP is much smaller than the 43% and 48% contribution of its equity and debt market to global totals.

The relatively sluggish development of investment banking in mainland Europe and Japan, together with the mature and competitive nature of the US markets, means that investment bankers are looking around for new earnings drivers.

Driven by its role as the 'key engine of the region's GDP and capital markets growth' Merrills views China as the 'primary catalyst of economic/capital markets growth' in Asia.

The report suggests China's capital market fees from investment banking and brokerage could rise threefold to $12 billion, based on 20%-plus annual fee growth through 2009, with leading firms such as Goldman Sachs and Morgan Stanley Dean Witter generating revenue of above $1 billion within five years.

The report says that China could propel broader Asian investment banking revenue. Asia currently accounts for around 10% of global capital markets revenue, but that could rise to 15% to 20% in ten years.

Merrills states that market development and foreign access go hand in hand. Foreign investment banks are currently only allowed to operate in minority JV positions, but once regulations are relaxed foreign banks will play a powerful role in stimulating the markets. The report suggests that ultimately it will be China's need for investment banking and financial services expertise which will give international investment banks their opportunity.

That need for foreign help is based on the urgent need to clean up non-performing loans, estimated to be equivalent to 25% to 50% of GDP, fund the $300 billion pension shortfall and provide a platform for the privatization of government state shares.

The report suggests that US bulge bracket firms Goldman Sachs and Morgan Stanley will be the main beneficiaries of any liberalization moves, thanks both to their expertise and to commitment to China.

MS was the first player to set up an investment banking joint venture with China Construction Bank in 1995, while Goldman acquired effective control of a Chinese securities house last year. Second tier players Citigroup, CSFB, Deutsche Bank, UBS and JPMorgan would also benefit to a lesser extent.

The domestic securities market is not covered by any World Trade Organization time table. That means that opening up the market is dependent on government whim.

Given the dynamic that exists between deep-pocketed foreign players and the gatekeeper mentality of the mainland bureaucracy, the report is probably right to predict a step-by-step opening of the market biased towards the biggest global players.

The report suggests that it will be Citigroup, with its full range of financing services, which will capture the most revenue in China. JPMorgan and HSBC would also likely benefit from their non-IB businesses.

In terms of which business lines will contribute what to revenue, the report suggests that in five years time sales and trading will contribute the most, followed by asset management, equity underwriting, private client brokerage and debt underwriting. M&A would be in bottom place. The steepest growth could be seen by the debt market, given its low base and the need for capital by China's growing manufacturers.

However, the most intractable problem faced by China stock markets, the overhand of state shares, is not addressed by the report.

The government has been trying to convert its non-tradable shares to tradable shares for four years. But every move has been met by a steep drop in the equity markets on the back of investor concerns of massive dilution.

China's listed stocks are generally not the country's best, and are plagued by corporate governance problems. Rights issues, for example, were historically excessive, severely diluting minority shareholders.

In addition, the government seems on fixing its insolvent banks through foreign listings this year, rather than tinkering with the stock market.

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