CLSA Emerging Markets chief Gary Coull loves nothing more than to watch the Thoroughbred horses he breeds in England and Australia gallop around Hong Kong's Happy Valley and Sha Tin racetracks. Sometimes, though, the draining voyage and unfamiliar surroundings take their toll on his steeds: One 2001 import, Point Grey, recently had to be shipped back to England, having failed to win.
"He's not done well," sighs Coull. "The experts tell me he was very slow to acclimatize to local conditions."
Coull can only hope that CLSA finds its legs in China a lot faster. In December the Asian banking arm of French giant Crédit Lyonnais became the first foreign firm to burst from the gate and take advantage of new rules allowing it to create a joint venture investment bank with a mainland partner and underwrite so-called A-share companies. Until last year the coveted, yuan-denominated stocks of generally midsize Chinese companies listed on the Shanghai and Shenzhen exchanges were available only to domestic investors and could be underwritten only by domestic brokerage houses and one experimental joint venture.
Expected to be up and running this month, China Euro Securities is a partnership between CLSA and Shanghai's Xiangcai Securities made possible by liberalized foreign ownership rules laid down last year by the China Securities Regulatory Commission following the country's entry into the World Trade Organization. Foreign institutions can now take stakes of up to 33 percent in joint venture investment banks, a figure that will rise to 49 percent in three years. CLSA has put up $20 million of the $60 million seed funding for the venture, which started with about 60 staffers in Shanghai.
"Companies in China are now demanding more expertise and more integrated services, including advice on corporate governance and investor relations," says Coull. "An investment bank that can deliver most of these will probably win the better-quality deals."
Coull and CLSA aren't alone in taking advantage of the reforms. BNP Paribas Peregrine Securities received preliminary regulatory approval in March for a joint venture with Changjiang Securities Co. of Wuhan. And Core PacificYamaichi Securities, formed from the merger of the Hong Kong units of Taiwan's Core Pacific Group and Japan's Yamaichi Securities, has applied to set up a venture with with two Shenzhen brokerages, Hanteng Securities and Shenzhen Venture Capital Co. These new operations will vie with dozens of local firms, led by China International Capital Corp., the experimental venture created in 1995 by China Construction Bank and 35 percent partner Morgan Stanley that dominates A-share underwriting. They will soon be joined by massive commercial banks like Bank of China and Industrial and Commerce Bank of China, which are eagerly building their own Hong Kongbased investment banking units that, as foreign entities, are also now allowed to partner with local firms.
Though its vast markets are still daunting to outsiders, China is an increasingly powerful draw for the world's banks -- and for good reason. Last year, in the midst of a worldwide banking slump, Chinese companies accounted for more than $28 billion in IPOs globally, more than the $27.5 billion offered on the New York Stock Exchange. The biggest portion of these deals, $11.3 billion, came from big dollar-denominated offerings from large Chinese companies -- like the $343 million listing of Bank of China subsidiary Bank of China Hong Kong (Holdings) -- that were designed for foreign institutional investors and sold on the New York and Hong Kong exchanges. Local stock issuance accounted for the rest, with the A-share market accounting for $8.2 billion in new offerings. Chinese companies also offer B shares (which are denominated in U.S. or Hong Kong dollars, offered in Shanghai and Shenzhen and open to foreign buyers); H shares (central-government-owned companies incorporated in China and listed in Hong Kong) and so-called red chips (municipal and provincial companies incorporated and listed in Hong Kong).
The A-share market in particular holds great promise. The Shanghai and Shenzhen exchanges boast a combined market capitalization of nearly $500 billion, making their A-share bourses the second-largest equity market in Asia behind Japan's Nikkei. Some analysts believe that they could top $2 trillion by 2010 and surge ahead of the Nikkei.
A-share enthusiasts like Coull see the market as a foothold for what they expect to be big business coming in the future from China. "The challenge for investment banks in the next five years is to find the durable managers of good companies and to help those companies grow into regional and maybe, eventually, global leaders," says Coull.
Management consulting firm McKinsey & Co. predicts that within five years half of Asia's underwriting activity open to foreign firms will come from China, compared with less than one fifth now. Indeed, without a sizable China presence, banks are likely to find it difficult to justify their Asian businesses, says Emmanuel Pitsilis, head of McKinsey's investment banking practice in Asia. "There's a question about the ability to build a profitable Asia ex-Japan business without China," he says.
Last year -- overall a poor one for fundraising in China -- 97 companies went public in the A-share market, generating roughly $145 million at the country's tight underwriting spreads. BNP's head of China research, Eva Chu, estimates the queue for listing in the A-share market at 1,000 companies.
"The opportunity is enormous: not in five to ten years' time, but now. You don't need a 20 percent market share in China to build a very big business in investment banking," says Guillaume Dry, deputy chief executive in Hong Kong of BNP, the leading underwriter in the H and red-chip markets.
Dry and Coull think that the joint ventures they've formed with local brokerages will enable them to get to know unlisted Chinese companies and their executives early on, distinguishing them from their foreign rivals. "I don't believe that in two years' time you will be considered a serious investment bank to advise on China if you don't have a local business in China," says Dry, who projects that Changjiang BNP Paribas Peregrine Securities will break even in just two years.
Yet for all Dry's confidence, most foreign banks have yet to succumb to the allure of the A market. Goldman Sachs (Asia) and J.P. Morgan Securities (Asia Pacific) have both said that they won't participate. And although other major firms, like Credit Suisse First Boston (Hong Kong), Merrill Lynch (Asia Pacific), Citigroup Global Markets Asia and UBS Capital Asia Pacific (HK), haven't dismissed entering into joint ventures with local partners, they aren't actively pursuing the idea either. ING Group and ABN Amro, which together with CLSA and BNP occupy a middle tier of foreign investment banks in China, also say that they're not interested now.
"I wouldn't hold my breath or have any energy spent on that part of the business," says Dennis Zhu, chairman of J.P. Morgan's Greater China Operating Committee.
Why the reluctance? The A-share market is volatile and murky, with most companies lacking Western-style transparency and accountability. Despite liberalized operating rules, foreign banks remain constrained by government-mandated restrictions; the new joint ventures can't broker shares. Also critical are issues of culture and control. Many foreign institutions see more-lucrative opportunities in other markets or even in other businesses, like M&A, that don't entail jeopardizing their brand names to bring in relatively small deals.
"There is nothing more valuable than an investment bank's reputation," says J.P. Morgan's Zhu. "What goes with that is control and how you actually do your day-to-day activities. If you have no control over how things are done, it is the No. 1 reputational risk."
CLSA and BNP are hardly racing down this track blindly. Both have solid experience in China. BNP built much of its business atop the equity operations of Peregrine Investment Holdings, which it bought in 1998 after the high-flying Asian investment bank collapsed following a disastrous bet on an Indonesian taxi company. Before that, Peregrine, which opened a Shanghai office in 1992, had successfully pioneered Hong Kong's red-chip market and launched the first batch of H shares. CLSA, which has underwritten more than 120 capital issues for mainland companies, was one of the first banks to place research staff on the mainland, back in 1989, and in 1992 it too opened an office in Shanghai. Last year it relocated its entire China research team to Shanghai.
The firms have received encouragement from the Chinese government. Coull, for example, first expressed interest in gaining an underwriting license at a private meeting with former premier Zhu Rongji in mid-2000; Zhu told him that China welcomed international expertise. When CLSA held its annual forum for institutional investors in Beijing two years ago, Zhu agreed to deliver the keynote address.
Both Coull and Dry see A shares as part of a comprehensive approach to banking in China. "If you know valuations and trends in the A-share market and the B-share market and all the various fractured constituencies of China shares, you can give an integrated service that is valuable," says Coull. And he's not just reaching out to local companies. Corporations from Hong Kong, Taiwan, South Korea and even Japan have operations in China and may want to float shares there at some point.
"Regional players like ourselves need to maintain an edge," says Dry. "It's only logical that we would be more innovative than the bulge-bracket firms."
OPERATING IN THE A-SHARE MARKETPLACE WON'T be a walkover. Shanghai and Shenzhen remain among the world's most notoriously opaque bourses. Few of the 1,200 listed companies adhere to Western accounting or corporate governance practices. (H shares and red chips have tighter accounting standards because they are available on the Hong Kong exchange.) In a 2000 investigation of 159 listed companies, the Ministry of Finance found that an astounding 157 had inflated their most recent earnings and 149 had falsified their asset values. A subsequent crackdown by the CSRC has helped somewhat, but such problems are still thought to be endemic.
The lack of transparency in corporate accounts poses a special problem for investment bankers, who are charged with ensuring the accuracy of information provided to all investors. Because the IPOs in the A-share market average a relatively small $86 million and the due diligence process may prove lengthy, there's a concern about the payback for the bankers. John Seal, Hong Kongbased head of corporate finance at ABN Amro Asia, isn't convinced of the economics right now: "If you are looking to underwrite small IPOs, then maybe [it makes sense to create a joint venture], but we and most of the major investment banks are looking at larger issues."
The potential for regulatory problems extends to brokerage offices as well. Prominent mainland economist Wu Jinglian, a senior fellow at the Development Research Center of the State Council, has likened China's stock markets to a casino -- one with few rules and inconsistent oversight. The current policing system is, as one senior Western banker politely puts it, "not one that regulators in New York, London or Hong Kong would consider entirely satisfactory. These processes are a culture that doesn't yet exist in China."
Bankers also worry whether Chinese policymakers and regulators, who have a history of abrupt changes in direction, will make good on their promise to open the A-share market further. For instance, foreign underwriters are supposed to be allowed to own 49 percent of a joint venture in three years' time. "The big risk is on the evolution of regulations," concedes Dry. "The faster the pace, the better for us."
A lack of fundamental research and widespread rumormongering have made the A-share market volatile at times. Between the start of 2000 and the middle of 2001, it jumped 58 percent, only to drop 40 percent by early 2002. It has since rallied briefly a few times. Brokerage profits -- and investment banking opportunities -- are equally erratic: After two years of record profits in 1999 and 2000, the combined profits of China's 106 brokers slumped by 75 percent in 2001, the most recent year for which performance figures are available.
Any firm operating in China will face major uncertainties, but the government has placed strictures on what these joint ventures can do. They cannot broker shares, for example. That means CLSA and BNP will underwrite stock without being able to directly place it with investors; instead, they will have to rely on local brokers to sell the offerings and make a market in the shares afterward. This limitation, as much as the lack of control, has put off some foreign investment banks. "Distribution is as important as capital strength in underwriting," says ABN Amro's Seal. Adds CSFB Asia Pacific head Paul Calello: "It's certainly not an optimal model. We'll need the ability to secondary-trade. You need to support issues in the secondary market to provide clients with the liquidity they need."
Starting any investment bank in these circumstances would be tough; organizing one that must balance Eastern and Western cultural differences is a huge additional handicap. "Notwithstanding the best of intentions on the other side, there is very limited experience in China of what a Western financial model looks like," says Stuart Gulliver, co-head of corporate, investment banking and markets at HSBC Holdings in London. "If you took a bank from the U.K. and a bank from Germany and said, 'Let's form a joint venture,' both would have a fundamental idea of what the business model is. When you are doing it in the People's Republic of China, there is a very limited understanding of how a Western securities firm operates." HSBC, which reportedly considered a joint venture with leading brokerage Guotai Junan Securities Co. of Shanghai, remains open to the possibility of a partnership.
Trying to create a stable working relationship with senior managers at a local Chinese brokerage is further complicated by the government's practice of rotating staff at state-owned entities, which include brokerages. The trusted head of a joint venture partner could overnight become a government minister or a provincial representative. Worse, he could be named to run a major brokerage competitor. Since 1993 Bank of China chairman and president Liu Mingkang has been deputy governor of Fujian province, deputy governor of the State Development Bank of China, deputy governor of the People's Bank of China and chairman of financial conglomerate China Everbright Group. In March he was named head of the newly established China Banking Regulatory Commission.
Ultimately, if there are irreconcilable differences between the joint venture partners, the Chinese firm, as majority owner, can decide the venture's course. Most such agreements, however, allow for the Hong Kong International Arbitration Centre to settle disputes, which represents a foreign firm's best hope of legal redress. If the foreign partner wins in arbitration, it can then try to enforce the ruling in a Chinese court. Foreign firms have prevailed in such cases, but Thomas Jones, a lawyer in the Hong Kong office of Freshfields Bruckhaus Deringer, cautions that they have had a mixed record of success in sustaining favorable arbitration rulings in the local judicial system.
Coull and Dry have heard all of the misgivings about their undertakings. Both contend that most of the cultural and management issues raised by rivals have been addressed through their painstaking selection process, which involved vetting China's top 20 brokerages. This due diligence assured them that their partners share a commitment to building a top investment bank. CLSA and BNP have teamed with relatively small firms that, they say, are eager to absorb Western practices. CLSA's partner, Xiangcai, was China's eighth-largest A-share underwriter last year, according to Thomson Financial. BNP's partner, Changjiang, ranked 13th.
Despite their minority positions, the foreign firms have placed executives in senior management slots. CLSA will provide China Euro's deputy chairman, deputy chief executive and CFO. The joint venture's most senior decision maker will be Anna Zhu, formerly Xiangcai's chief operating officer and a J.P. Morgan investment banker and salesperson for seven years in New York before returning to China in 1999. BNP will provide its venture's CEO, five bankers and two risk management specialists. It is investing $24 million and says the operation will have a staff of 80 to 100 people in Shanghai.
Coull and Dry don't see the lack of brokering licenses as a major impediment. They note that CICC, Morgan Stanley's joint venture, has operated without a license for eight years and has successfully placed stock through multiple local brokerages. China's underwriting system is very different from that in the West, Coull explains. In China investors subscribe for shares in IPOs electronically, using a system run by the stock exchanges. The lead manager and issuer have no control over where the shares go unless they are undersubscribed, and underwriters aren't required to have a dealing or brokering license. The only unanswered question, Coull says, is what happens if a deal is undersold and the underwriter needs to get rid of its shares in the secondary market. Given that China's IPOs are usually many times oversubscribed, Coull doesn't anticipate that this is a question likely to come up very often, if at all.
The small average size of A-share IPOs isn't a big concern either, say the executives. Both CLSA and BNP will be trying to secure deals on the upper tier of the market.
CLSA AND BNP PARIBAS MAY BE PART OF A SMALL group of foreign firms entering the A-share market, but they are hardly racing by themselves. As Neil Ge, who runs equity and fixed-income sales and trading at a local competitor, Bank of China International, says, "In every area we see stiff competition."
Prominent Chinese brokerages like GF Securities Co. and Citic Securities Co. lead a pack of local firms that also includes China Galaxy Securities Co., China Southern Securities Co., Guotai Junan Securities Co. and Shenyin Wanguo Securities Co. All compete vigorously for investment banking mandates. The arrival of foreign firms is expected to help drive consolidation among smaller and midsize Chinese brokerages.
The original pilot joint venture, CICC, has a seven-year head start on the newcomers. CICC was China's top A-share underwriter last year, when it helped raise $2.8 billion for three companies, mobile phone carrier China Unicom Group, China Merchants Bank and China Shipping Development Co., according to the state-published China Securities Journal. With $507.9 million of offerings, CICC rose to second place (not far behind Merrill Lynch's $673 million) from sixth a year earlier in the underwriter rankings for international issues done by Chinese companies, according to Thomson Financial.
The partnership benefits from some affiliations that the new joint ventures won't enjoy. China Construction Bank, the country's third-largest bank, with $308 billion in assets, is CICC's biggest shareholder, and its huge roster of corporate lending clients has been a major plus for the investment bank's deal makers. Holding smaller stakes are China National Investment and Guarantee Corp., an investment entity owned by China's Ministry of Finance and its State Economic Trade Commission; the hugely influential Government Investment Corp. of Singapore; and Hong Kong's Mingly Corp. (owned by real estate tycoon Payson Cha). Supplementing the efforts of these institutions is politically connected CICC banker Levin Zhu Yunlai, the son of former premier Zhu Rongji.
The venture gave Morgan Stanley access to top mainland companies, but it encountered the growing pains inherent in such partnerships. A key issue, says Gerard Kay, Morgan Stanley's Hong Kongbased Asia spokesman, was that the firm saw CICC as its sole China platform while China Construction Bank aimed to make it an independent, world-class domestic investment bank. This difference of opinion was resolved in 1998, says Kay, when the banks agreed that CICC should become independent. Morgan Stanley then built its own China investment banking platform and took a passive role in CICC's management. "Our investment banking strategy for China is two-track," notes Kay. "We have our own platform, and we happen to own 34 percent of CICC."
Potentially, the joint ventures' biggest rivals are ICEA Finance Holdings and Bank of China International, the Hong Kongbased investment banking units of China's two biggest banks. (China Industrial and Commerce Bank, ICEA's parent, has $427 billion in assets, and BOCI parent Bank of China has $351 billion.) ICEA is awaiting approval on its license application to underwrite and trade A shares, and BOCI has taken a stake in a joint venture with China Petrochemical Corp. and State Development Investment Corp., a unit of one of China's biggest policy, or government project, banks, to underwrite stocks. Both firms will try to turn the banks' corporate relationships and financial clout into underwriting business.
The BOCI venture holds two significant advantages over the foreign affiliates. Although its Hong Kong headquarters technically makes it a foreign entity, BOCI was permitted to buy a 49 percent equity stake in its joint venture. It was also granted a stockbrokering license. "BOCI will eventually be a tough competitor because it has overseas offices and good research, and it's starting to run a competitive international banking operation," says a banking analyst with a European investment bank.
For now, most of the bulge-bracket firms seem content to watch this race from the stands. They will instead continue to build their local contacts and generate fees by underwriting larger international issues and picking up M&A advisory assignments. If need be, these behemoths with their international distribution and strong global brands can fashion their own partnerships later or make acquisitions, if the government ever allows them to.
Smaller investment banking units like CLSA and BNP don't necessarily have that luxury. "If you are not entrenched by the time all the others come in, it's going to be very difficult," says McKinsey's Pitsilis, who predicts that the global investment banks will eventually position themselves in the A-share market. "It makes sense for a midtier firm to go in early because that's the only chance to be well positioned compared to the bulge bracket."
Another foreign influence on A shares
When underwriters like China Euro Securities and Chiangjiang BNP Paribas Peregrine Securities take fledgling Chinese companies public on the A-share market, another newly empowered group of foreign financial firms will be reviewing the deals to see if they merit investment.
On November 5, 2002, the Chinese government decreed that, for the first time, selected foreign institutions would be permitted to invest in these famously volatile local-currency shares. The new statute, crafted by the People's Bank of China and the China Securities Regulatory Commission, took effect in December, but the application process to become a so-called qualified foreign institutional investor, or QFII, was still going on last month; before petitions could be considered, certain administrative matters, including the approval of custodian banks, had to be resolved.
The initiative was the latest in a carefully orchestrated series of market liberalizations that to date have allowed foreigners to buy minority positions in Chinese fund management and securities firms and, in certain circumstances, to take controlling stakes in local companies. The government has also said it will permit state-owned shares to be sold to foreigners.
Once the government completes its review, the approved asset managers will gain access to Asia's second-largest equity market behind Japan's Nikkei. Among the attractions: They will be able to buy and sell a broad array of stocks (about 1,200 in all) in sectors like autos, petrochemicals and consumer goods that are underrepresented on the other bourses where Chinese shares trade. Then there's liquidity. Turnover in the A-share market is $300 billion annually, versus just $10 billion in so-called B shares (the 111 Chinese stocks traded locally but denominated in foreign currency and freely available to foreign investors). Another plus: exposure to China's currency, the yuan, which is thought to hold upside potential as the world's fastest-growing economy expands.
"We made a draft application with the authorities in China at the earliest available opportunity in December last year," says John Holland, head of Asian equities at UBS Warburg. "We are very keen to be in the vanguard of the QFII opening, which is clearly a key point in the liberalization of China's financial markets."
In addition to UBS, brokerages Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley, Nomura Securities and Salomon Smith Barney have all submitted applications to offer funds. Others, such as Credit Suisse First Boston, say that they are still considering whether to apply.
Hesitation is understandable given the long list of criteria the firms have to meet. Chinese authorities set very clear parameters to ensure that the foreign firms provide liquidity to the market without unduly controlling it. These QFIIs (referred to as "q-fees") will be required to purchase at least $50 million in A shares but can hold no more than $800 million at any one time. A QFII cannot buy more than a 10 percent stake in any single company, and, in combination, QFIIs can't hold more than 20 percent of a company's shares.
More controversial are lockup restrictions. Closed-end funds must keep their principal in China for three years, while open-end funds face a one-year commitment. Afterward they can repatriate money on a set schedule. Some asset managers say that these constraints may prevent them from participating because they don't want to be stuck in a volatile market with limited means to redeem investors' shares.
China has already excluded smaller money managers. The foreign firms must have at least $10 billion under management and meet other industry-specific benchmarks. For instance, insurance companies must have been in business for at least 30 years and have a minimum of $1 billion of paid-in capital. Banks and asset management firms have to clear similar sorts of hurdles.
Passing this stiff entrance exam is just the first obstacle. China's domestic stocks have long been driven by manipulation, rumor and occasionally outlandish corporate and government decisions. Accounting standards are weak. As a result, stock prices have tended to be volatile. Between the beginning of 2000 and mid-2001, for instance, the Shanghai Stock Exchange A-share index (A shares are also available on the Shenzhen exchange) rocketed 58 percent before plummeting 40 percent in the following seven months. Since then it has staged a few short rallies, only to fall back each time.
Even the rumored arrival of the new foreign contingent sent the skittish market off in an unimagined direction. In the second half of 2002, as speculation about the regulatory change took hold, Shanghai-traded local shares fell about 20 percent. "Everyone expected the market to go up" because a substantial new source of buying power was coming, says Lan Xue, managing director and China strategist at Salomon Smith Barney, "but it went down."
Why? Because the foreign firms, with their emphasis on fundamental analysis and transparency, are expected to remove some of the market's speculative excesses.
China's A-share market is expensive -- the problem is, no one's quite sure just how expensive. Shanghai A shares, for example, traded at an average price-earnings ratio of 38.20 in March, while Hong Kong's broad all ordinaries index traded at 12.53. But because corporate reporting is so unreliable and accounting so weak, metrics like P/Es are highly suspect.
In their discussions with foreign firms, bureaucrats in Beijing have professed to be more interested in addressing these issues than in enriching local investors. "China is not just trying to raise stock prices, but rather it is trying to introduce international investors into the A-share market," says Tai Hui, an economist at Standard Chartered Bank. (Standard Chartered Bank's Shanghai branch, along with Citibank Shanghai and the Hongkong and Shanghai Banking Corp., won approval as a QFII custodian in mid-March.) "It wants improvements on the qualitative side rather than just boosting the market." Adds his colleague Paul Hedges, head of the bank's securities services sales and relationship management, "The message from the Shanghai Stock Exchange is that they are looking for behavioral changes and behavioral transfers of best practices from international institutional investors."
Of course, bad behavior doesn't change overnight. "Most money here has been made through insider information, and people still believe that is the way to make money," says Gareth Lennon, director of Value Investor, a new magazine designed to offer Western-style research to local investors. "That is changing gradually. There are people with knowledge, but no one is willing to part with it. They believe knowledge is power."
The overseas firms will step very deliberately into this situation. As Salomon's Xue puts it, "At first you don't invest, you study." There are roughly 50 A-share companies with market capitalizations greater than $1 billion. Most receive scant research attention (the smaller B-share market has gotten much more thorough monitoring). "The major concern is for coverage to pick up," says Kenneth Ho, head of China research at J.P. Morgan in Hong Kong. "Until then people are too cynical; no one will care about the market."
As a result of the regulatory limitations and wariness about the market, no one is expecting an immediate tidal wave of funds. "From the Salomon Smith Barney point of view we are very interested in the market even though most of our clients won't put money in" for quite a while, says Xue. Stuart Leckie, an expert on Chinese investment and author of the book Investment Funds in China, says, "Aside from having the kudos of being the first in, I don't see a reason to rush."
Some observers even think the approval criteria may have to be loosened to attract sufficient money. Because of the high minimum investment and capital levels, for example, many eager hedge funds and China or Asia specialists won't be able to participate.
Some of the bigger firms are already looking at ways to mitigate their risk. Lawyers say it may be possible for qualifying asset managers to set up subaccount structures that would allow them to, in effect, rent out their QFII status to others more interested in using it. The CSRC, say the lawyers, hasn't nixed the creation of some sort of offshore structure that would allow the subaccounts.
In the end, China itself is expected to be a sufficiently strong investment magnet to overcome all of the obstacles. However flawed, greater liberalization will only increase the desire to participate in Asia's dominant economy. "A few years ago it was a risk to invest in China," says author Leckie. "Soon it will be a risk not to." -- Richard Meyer