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Future of Finance

WHEN LIN YONG CAME TO HONG KONG IN 2007 TO OPEN the first overseas operation for Haitong Securities Co., China’s second-largest brokerage by market value, he brought a draft check for HK$50 million ($6.5 million) and two assistants. It wasn’t nearly enough. Many of Haitong’s mainland clients ignored the offshore unit because it lacked the scale, experience and range of products and services of its international rivals.

Realizing that Haitong would have to make a bold move to gain an offshore foothold, Lin in 2009 led the firm’s $345 million takeover of Taifook Securities Group, then Hong Kong’s biggest locally owned brokerage. It was the largest-ever foreign acquisition by a Chinese securities firm and made Haitong the first Chinese institution to have a full-scale offshore trading platform capable of underwriting bond and equity offerings, and providing M&A advice to clients.

“The best way to grow is through mergers and acquisitions,” Lin, now CEO of the firm’s Hong Kong–listed subsidiary, Haitong International Securities Group, tells Institutional Investor. “To build Taifook’s operations in Hong Kong would have taken us ten years.” As it is, growth with Taifook has been less than spectacular. Haitong ranked a modest  No. 14 as an equity underwriter in Asia ex-Japan in the first half of this year, arranging seven initial public offerings worth a total of $509 million, according to data provider Dealogic. The Hong Kong subsidiary generated 5.8 percent of Haitong’s 9.3 billion yuan ($1.5 billion) in revenue last year and 2.8 percent of its 4.4 billion yuan of pretax profits. Lin is undaunted, though. He aims to make Haitong one of the ten largest global investment banks, a goal he figures will take a decade or two — and more acquisitions — to achieve. “We definitely will be looking at the global markets, and all possibilities remain,” he says.

China and its leading banks and brokerages are bound to play a bigger role in international finance in coming years, but as Haitong’s experience demonstrates, progress is likely to be much slower than the country’s economic clout suggests. China has the second-largest and fastest-growing economy in the world. It sits on an unprecedented $3.2 trillion of foreign currency reserves. Four of the top ten banks in the world by market capitalization are Chinese. But despite all those resources, China’s financial services giants have taken only the wariest of baby steps into the global marketplace. The Taifook deal was a rare foreign acquisition by a Chinese financial firm; most earn only a tiny fraction of their income overseas.

The caution of these institutions reflects the attitude of the Chinese government, which still owns majority stakes in the largest banks and brokerages. Sources say the Chinese Securities Regulatory Commission has made it clear to industry executives that it might reject sizable overseas acquisitions because of concern that they could entail systemic risk. Some early missteps have made Chinese officials leery of rapid foreign expansion. China International Corp., the country’s big sovereign wealth fund, made multibillion-dollar investments in Blackstone Group and Morgan Stanley in 2007, only to see the value of those stakes plunge when the financial crisis hit. Shenzhen-based Ping  An Insurance (Group) Co. of China bought a 5 percent stake in Fortis in 2007 and had to take a $2.3 billion write-off after the crisis devastated the Belgian-Dutch banking and insurance group.

As a result, Beijing is moving to its own timetable and is determined to control the financial sector’s development to make sure it meets the country’s domestic requirements. China needs a more dynamic financial sector to help its economy shift from an export-oriented model to one driven more by domestic consumer demand, and Beijing has taken several steps recently to accelerate financial liberalization. But officials, mindful of the excesses that sparked the global crisis, remain wary of an unbridled financial sector and are being careful to move step-by-step — “crossing the river by touching the stones,” as former leader Deng Xiaoping put it.

“China doesn’t have the ability to replace the U.S. and claim global financial hegemony,” says Gary Liu, executive deputy director of the Lujiazui Institute of International Finance at the China Europe International Business School, which advises the Shanghai government on financial reforms. “China has too many domestic issues and challenges to overcome, including necessary political and administrative reforms, before it can even lay claim to having a globally competitive financial domestic marketplace.”

The same cautious approach extends to Beijing’s international financial policy and the management of its prodigious reserves. China is the biggest holder of  U.S. Treasuries, with some $1.2 trillion, and should have a keen interest in diversifying its portfolio, but its leaders know they have a lot to lose if their actions destabilize markets. They also don’t want to see China’s economy whipsawed by a rapid rise in the renminbi, after watching a strong yen damage Japan over the past two decades.

So Beijing has moved creatively to increase the international use of the renminbi while maintaining strong control over the exchange rate. China has promoted the renminbi as a trade settlement currency in deals with mostly Asian trade partners and encouraged the rise of an offshore renminbi bond market in Hong Kong. Beijing is also eager to foster South-South capital flows with Brazil, Russia, India and South Africa, and has suggested that the so-called BRICS nations set up their own development bank to lend to emerging markets, in competition with the World Bank. At a China-Africa summit meeting in Beijing in July, Chinese officials offered some $20 billion worth of soft loans for various infrastructure projects in Africa over the coming three years, double the amount extended at the previous summit, in 2009.

China’s long-term ambition is to promote a sort of Beijing Consensus: a multipolar world in which new political and financial powers, including the Chinese, help set the rules, says Laurence Brahm, an American lawyer and entrepreneur based in Beijing who advises China’s State Council on international affairs. Unlike the so-called Washington Consensus, the U.S.-driven agenda that offered developing nations support from the World Bank and International Monetary Fund in return for market-oriented policy reforms, China’s model provides loans to and massive infrastructure investments in emerging markets in exchange for resource extraction rights.

“In the past the U.S. ruled the world through the Washington Consensus, where all major global decisions, political and financial, were either made in Washington or had to have tacit approval in Washington,” says Brahm. “Those days are over.”

DESPITE ITS DRAMATIC SUCCESS OVER THE PAST TWO decades, when growth averaged 10 percent a year, China’s investment-­driven economic model is showing signs of strain. In the aftermath of the global financial crisis, the government and state banks pumped more than 12 trillion yuan into the system to sustain rapid growth. Much of the money went into investments in infrastructure and real estate, causing urban property prices to quadruple between 2009 and 2011. Investment now accounts for 48 percent of China’s economic output, while domestic consumption, the main driver of advanced economies, has fallen to just 40 percent.

“The Beijing Consensus simply doesn’t exist if we cannot build an economically sustainable growth model,” says Liu Mingle, an independent analyst and former executive of the People’s Daily group, the flagship publisher of the Communist Party.

With growth slowing amid global economic uncertainty, China must accelerate financial market reforms so that more credit goes to private sector investments than to white-elephant public sector projects, says Guan Anping, a Beijing-based securities lawyer and a former aide to Wu Yi, who was vice premier from 2003 to 2008.

“China needs a financially competitive landscape and sustainable capital market system before it can even think about challenging the U.S. in global finance,” says Guan.

The government has announced nearly a dozen liberalization moves since December, shortly after Premier Wen Jiabao appointed Guo Shuqing, a reformer and a longtime chairman of China Construction Bank, to head the CSRC. These measures include:

• Authorizing private lenders to operate in Wenzhou, a coastal city known for its entrepreneurial culture and informal lending networks. Before this experiment only government-approved banks could legally make loans, most of which have gone to big state-owned enterprises rather than small and medium-size businesses.

• Allowing banks to raise deposit rates to 110 percent of the benchmark for one-year deposits and to lower lending rates to 70 percent of the one-year benchmark. This is a first step toward interest rate liberalization, which officials hope will lead banks to allocate capital to the areas of the economy that need it most.

• Creating a high-yield bond market to allow small, unlisted companies to raise funds through private placements.

• Doubling the permitted daily trading band for the renminbi–U.S. dollar exchange rate, to plus or minus 1 percent — the first time since 2007 that Beijing has increased currency flexibility.

• Expanding the quota for qualified foreign institutional investors, the main vehicle by which foreigners can buy Chinese stocks, from $30 billion to $80 billion.

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