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China dreams

As China's institutions begin to invest overseas, foreign banks are racing to enter its nascent global custody market.

For decades the vast potential of China's market has mesmerized the executives of Western consumer goods companies, who dreamed of the profits they would amass by selling just one of anything to a billion Chinese. Similar visions are appearing to Western global custodians, who hope to handle some of China's burgeoning financial assets.

"The banking deposits in China are the equivalent of about $2 trillion," says Hong Kong's K.K. Tse, executive vice president of investor services in the Asia-Pacific region for Boston-based State Street Corp. "China has 1.3 billion people and a 40 percent savings rate, so asset accumulation is very fast, even though GDP per capita is relatively low."

Global custodians have been handling Chinese securities held by foreign investors for years. But they are just beginning to provide safekeeping services to Chinese institutions investing outside the Middle Kingdom. Chinese authorities are taking the first steps toward liberalizing overseas investment for local institutions by allowing insurers and, perhaps eventually, banks to invest a portion of their foreign-currency assets in non-Chinese securities. In response, such Western banks as Brown Brothers Harriman & Co., HSBC Holdings, Northern Trust Corp. and State Street are vying to provide custody services for those investors by applying to open offices in China and competing for global custody mandates.

The Chinese government recently permitted several of the country's leading insurance companies to invest some of their foreign assets abroad. By the standards of global custodians, the initial sums aren't particularly impressive, but the potential is. "We're all chasing the same $5 billion," says Susan Livingston, vice president for Brown Brothers investor services in the Asia-Pacific region, estimating the sum the government will allow institutions to invest abroad. But she predicts the market will grow. "Some people are saying nothing will happen for seven to ten years, but things have already started to happen."

In January, China's State Administration of Foreign Exchange gave its approval for Ping An Insurance Co., the country's second-biggest life insurer, to invest $1.75 billion of the proceeds of its June 2004 IPO in U.S. and Hong Kong securities. Ping An has chosen London-based HSBC as its global custodian.

China Life Insurance Co., the country's biggest life insurer, has also received approval from SAFE and the China Insurance Regulatory Commission to begin investing abroad. In November 2004 it issued a request for proposals for two separate global custody mandates -- one to a foreign bank with a domestic presence and a second to one of five domestic banks, which would work with a global partner. The National Social Security Fund (NSSF), which has almost $21 billion in assets and receives 10 percent of each internationally launched IPO, and PICC Property and Casualty Co., the nation's biggest property insurer, with $10.7 billion in assets, are expected to follow Ping An and China Life in the drive to get permission to invest abroad.

Custodians see this initial liberalization of foreign investment restrictions on Chinese institutions as the first step toward the creation of what Beijing calls a Qualified Domestic Institutional Investor regime, a system of regulations that would allow other Chinese institutions to invest abroad, much as the Qualified Foreign Institutional Investor program has allowed non-Chinese investors to buy A shares in China. The government is expected to issue QDII regulations for banks in 2006.

"Insurance companies are the hot topic now," says James Wong, senior manager of custody and clearing for HSBC in Hong Kong. Regulations allow them to invest 80 percent of their foreign-currency assets, which come mainly from their IPO proceeds, abroad. "Not everyone has applied for permission to invest overseas yet, and we don't know how much they are planning to invest," says Wong. "Most are applying for the maximum, but in their actual investments they are taking a very cautious approach, given the turmoil in interest rates and the currency markets."

Bankers say that China needs to invest overseas to provide funds to pay for the retirement of an aging population, and that Chinese investors need to diversify their portfolios. "Now the local financial institutions have only one market to invest in -- China -- so they have all their eggs in one basket," says Wong. Overseas investment would also ease some of the upward pressure on the buoyant renminbi.

Custodians eagerly await the day when the NSSF announces that it will invest some of its assets abroad. Under contract with the World Bank's International Finance Corp. unit, and with funding from the Irish government, Northern Trust's Irish unit has been working with the NSSF's administrator, the National Council of Social Security Fund (Nacssef), for two years. It has provided Nacssef with technical advice on international risk-management controls, asset allocation, custody and information technology. Nacssef was created in 2000 to act as a backstop to meet pension liabilities of residents of China's cities as the nation adopts market economics. In a 2003 report the Asian Development Bank concluded that the NSSF would have to diversify its portfolio, which was then 98 percent invested in fixed-income instruments, into other asset classes, including overseas securities, to meet its liabilities.

Banks too may win the right to invest international IPO proceeds abroad. Two of the nation's top banks -- People's Bank of China and China Construction Bank -- are expected to go public this year, while offerings for two more, Industrial and Commercial Bank of China and Agricultural Bank of China, are tentatively scheduled for 2006.

Even if some of those bank deals are delayed, custodians are excited by the opportunity presented by the Chinese asset-servicing market. "China has the potential to establish one of the largest financial services industries in the world," said Stephen Potter, London-based group head of international business for Northern Trust, in a March statement announcing that the bank had received approval from the China Banking Regulatory Commission (CBRC) to open a representative office in Beijing.

Chinese regulations do not require foreign custodians to work in partnership with Chinese banks, but many of the interested Western institutions plan to do so. Chicago-based Northern Trust will partner with Chinese banks, which will handle the domestic side while the U.S bank focuses on the international custody work. Chinese institutions "need some help in understanding all the things that an investor has to consider when investing globally, such as risk and performance, and asset allocation," says Kathleen Dugan, the vice president and manager of Northern Trust's global institutional product group.

Brown Brothers may follow a similar model, Livingston says. Working initially from a base in Hong Kong, the New York firm envisions following its global practice of partnering with local banks.

"We are the custodian to the largest Japanese trust banks, but we didn't establish our own trust license there," says Livingston. "We would like to take a similar approach in China."

Some of the large commercial banks that also offer custody, by contrast, start as partners and then open their own offices and retail branches to compete with the local banks. State Street received its license from the CBRC to open a representative office in Beijing in July. HSBC has ten branches in China, plus three rep offices. Citigroup has five branches and two rep offices, as does Bank of Tokyo-Mitsubishi.

But most Western banks are proceeding slowly, in part because the Chinese government has been doling out banking licenses and permission to open representative offices sparingly.

How much will foreign custodian banks get out of China? Douglas Jaffe, Singapore-based senior research manager for Asia-Pacific banking at Financial Insights, of Framingham, Massachusetts, has his doubts.

"In China if you want to get something done, you need to have control," says Jaffe. "A lot of the partnerships that are happening with U.S. broker-dealers or investment banks will end in misery or go nowhere. The Chinese aren't stupid. They really want your expertise and know-how, but that doesn't mean they will give anything back in return."

Livingston is more optimistic. She believes the Chinese have learned lessons from financial collapses in other emerging markets, such as Russia in 1998, and are determined to move cautiously under government monitoring and control.

Despite the uncertainty, global custodians feel obligated to enter the Chinese market. "This could be the biggest market you've ever seen," explains one banker. "If you sit and wait until everything's clear, you'll be out of the picture. The Chinese believe in partnering. Go in carefully. You might lose your shirt, so make sure it's not an expensive shirt."