ABC's IPO Underscores the ABCs of Banking in ChinaPublished: July 21, 2010 in Knowledge@Wharton
The wait is finally over. After several years of will-it-or-won't-it guessing, Agricultural Bank of China (ABC) made its stock market debut -- first in Shanghai on July 15, then in Hong Kong the following day -- with much fanfare. Raising $19.3 billion with an anticipated option to issue an additional $2.7 billion over the following weeks, ABC has now set the world record for the largest initial public offering (IPO), nudging out the $21.9 billion IPO from Industrial & Commercial Bank of China (ICBC) in 2006. As the last of the country's big state-owned banks to launch a public offering, ABC's shares -- whose early performance has been somewhat subdued -- attracted big global investors, from Qatar Investment Authority and Singapore's Temasek Holdings to Standard Chartered Bank of the U.K., and Dutch banking group Rabobank.
But this hasn't been an easy ride for ABC. Perhaps more so than with the 10 other banks the government has brought to market since 2003, it was a struggle to get ABC (or AgBank, as it is increasingly known) ready for its market debut. On more than one occasion in recent years, the banking behemoth -- China's third-largest lender, with 320 million retail customers, 440,000 employees and 23,000 branches -- has needed government cash injections and other help to clear an enormous pile of nonperforming loans (NPLs) off its books and rescue it from the brink of bankruptcy.
The hope is that being publicly listed will do for ABC what it is said to have done for many of the country's other banks -- mark a new era of greater management discipline and transparency in which the bank is focused on return on assets and profits, rather than fulfilling state policies for spending. In other words, says Gary Liu, deputy director of Shanghai-based CEIBS Lujiazui International Finance Research Center, an IPO "is the best way to change ABC from an ugly duckling to a white swan."
Hurry Up and Wait?
Up until April of this year, it was increasingly assumed that ABC, which had $8.5 trillion in assets as of the end of 2009, would be taken public later in the year, or even in 2011. But according to a July 16 Reuters article, Chinese authorities rushed through the IPO's road show and other preparations in a breathtaking three months. Why the hurry? "If it didn't do an IPO soon, it would just fall further and further behind, and underperform in comparison to the other banks in terms of governance and risk control," states Huining (Henry) Cao, a finance professor at Cheung Kong Graduate School of Business in Beijing.
Yet experts note there is much more behind the government's decision to sell a 15% stake in ABC. After 2009's unprecedented amount of lending -- RMB 9.6 trillion ($1.4 trillion) -- by all of China's banks as part of the country's massive RMB 4 trillion stimulus package, ABC's largest rivals are heading to the market this year to shore up their wobbly balance sheets, including the recently announced $8.8 billion rights issue from Bank of China, the country's fourth-largest lender.
"The official line is that [the government is] encouraging these banks to raise capital just as a precautionary measure," suggests Patrick Chovanec, a professor at Tsinghua University's School of Economics and Management in Beijing. "But a lot of people are legitimately concerned that these banks have problems, which haven't yet manifested themselves in their financial statements."
Until recently, he notes, such problems weren't a concern for policy makers, who believed that the sector's reform -- which began around the time of the country's entry into the World Trade Organization in 2001 -- was going according to plan. But as last year's government-dictated bank lending spree is coming under heavy scrutiny both inside and outside the country, many experts question the strength of China's banking reform.
"Everyone is riveted by [ABC's big IPO] instead of putting it in the overall context of banking reform in China, which is moving in the right direction but extremely slowly," says Wendy Dobson, an economics professor and director of the Institute for International Business at the University of Toronto's Rotman School of Management. "In this broader context, is there more competition? A bit more. Is there more market-based decision-making in the banks? A bit more.... But the regulatory environment is one where the government still sets interest rates and all the banks have access to low-risk-spread income so they have very little incentive to manage risk."
Old Habits Die Hard
According to Liu of CEIBS, that small incentive is diminished further if the banks assume that, as in the past, the government, not them, will pick up the bill for any of their rash high-risk, no- or low-reward lending. After all, financial institutions like ABC carry the legacy of the enterprise reforms of the 1980s, when they were set up as so-called "policy banks," with the primary aim of providing funding to state ventures, regardless of their commercial viability.
That legacy has created numerous problems for the sector. "At the beginning of this century, China's banks were close to being bankrupt -- nonperforming loans were as high as 30%, some even say 40%, [of total loans]," Liu recalls. "The government spent a lot of energy trying to save China's banking system. It tried to recapitalize the banks, using a lot of foreign exchange and issuing bonds. Second, asset management companies (AMCs) were set up to take over the bad loans so [the country] could have some clean banks. The final step was to list the big banks and introduce foreign investors, like HSBC, Morgan Stanley and Bank of America."
As a result, China's banking sector -- and financial services generally -- "have come a long, long way in the past 10 years," says Wolfram Hedrich, a Shanghai-based partner at consulting firm Oliver Wyman. That includes setting up the China Banking Regulatory Commission (CBRC) in 2003, launching a futures market in Shanghai, and "investing heavily in people, processes and systems" within the banks.
Today, China boasts the world's two largest banks by market capitalization -- ICBC and China Construction Bank -- and the prospects for its banking sector look far more promising than elsewhere, including in the United States and Europe. According to a study prepared for Oliver Wyman's most recent annual "State of the Financial Services Industry" report, China's sector is expected to grow some 10% annually between 2009 and 2014, among the most of any other G20 country.
"However, we must realize this is only the end of the first round of China's banking reform," notes Liu. "There must be a second round. Why? China's banks are looking good, but because of the stimulus plan, we've seen a huge amount of new loans -- nearly RMB 10 trillion, which is almost 30% of China's GDP. It's an amazing proportion."
Back to Square One
Much of that stimulus plan leaned on the banks to provide an enormous amount of funds for new infrastructure projects and the like. "The purpose of the lending was to juice up the economy and keep employment up, rather than to earn a return," says Chovanec. "It was unfortunate that the decision was reached last year to make the banks -- because they were so readily available -- the main conduit for stimulus lending. In the process, [the banks] reverted to their old role [and] loans weren't being extended on a commercial basis, but [based] on policy goals."
That's been bad news for many balance sheets. "With so much money being dispersed over such a short period of time, it's raised a lot of questions about the quality of the lending," Chovanec notes. "Around this time last year, the CBRC didn't seem too concerned about it because they said, 'Look, it's all going to infrastructure projects and for government-sponsored purposes.' Those very loans are now the ones that have been called most seriously into question."
Beyond the stimulus package, local governments and state-owned enterprises (SOEs) continue to turn to their trusty banks to help them spend far beyond their means, something that Beijing has struggled to control. Nowhere is this more evident than in the country's bubbling property sector. A new working paper for the National Bureau of Economic Research in the U.S., co-written by Wharton real estate professor Joseph Gyourko, notes that land auction data collected in Beijing shows that "real, constant quality land values have increased by nearly 800% since the first quarter of 2003, with half that rise occurring over the past two years." Fueling the increase are the SOEs, which the authors found "paid 27% more than other bidders for an otherwise equivalent land parcel." It's highly likely that the country's banks -- directly or indirectly -- are providing the loans for those purchases, which might never be paid back. But it's unclear how many loans the SOEs and local governments have been taking out.
It's a cause for concern at Fitch, the ratings agency. In a report published in mid-July, Fitch analysts said they identified a form of securitization being used by China's banks in order to keep their aggressive lending for real estate and other deals off their balance sheets and out of sight. In addition, an article about the report in The New York Times draws attention to Fitch's assertion that Chinese regulators understated loan growth in the first half of the year by 28%, or about $190 billion, and that many banks secretly shifted loans off the books, creating a "pervasive understatement of credit growth and credit exposure."
Could the lending spree take the country's banking sector back to where it was in the 1990s? Yes and no, says Marshall Meyer, a Wharton management professor. The shift from being policy banks -- making loans to keep the pet projects of local ministries running without any commercial basis -- to market-oriented institutions isn't done yet. When it comes to the country's banking sector these days, he notes, "governance can be somewhat oxymoronic," and bankers know this. He recalls one bank manager he met with during a recent visit to China lamenting that he had to choose between "being a responsible banker and keeping my job."
Meyer, like other China observers, says the new players on the scene -- the state-run AMCs -- add another layer of complexity and murkiness. According to Andrew Peaple, a Beijing-based Wall Street Journal columnist, the AMCs -- set up in the 1990s to buy the losses incurred by the banks -- "bought about $200 billion of bad debts in 1999, at face value, and issued [10-year] bonds to the banks as payment. On their balance sheets, the banks swapped $200 billion of loans for $200 billion of bonds. The AMCs, whose only assets were the bad debts, would repay the bonds, plus interest, by disposing of these bad debts."
But as Tsinghua University's Chovanec pointed out in a recent blog post, the banks "should admit that the bad debts they sold the AMCs were worth nothing close to the $200 billion they are still keeping on their books. The reason the banks have been able to avoid doing this so far -- and presumably the reason their auditors have allowed them to -- is that the AMC bonds are ostensibly guaranteed by the Chinese government. If the AMCs default, as they must, the government has promised to pay up."
There's another big difference between now and the 1990s: It's not just the government's money that today's publicly listed banks are frittering away. As Rotman's Dobson says, the dilemma for China's government is whether it "is just going to inject capital again into the banks or is it going to say to the banks, 'You're on your own.' There's no way it can say that.... It's just not a message that's heard in China."
In the absence of that, what would Dobson like to see now? Along with a loosening of the country's interest rate policy, she recommends China set up "some kind of deposit insurance corporation, like the FDIC in the U.S., where only a certain share of deposits is guaranteed [by the government]. That then puts some liability on depositors to monitor what they do."
What about the sector's new wave of foreign investors? Can they help change the ingrained habits in China's banking sector? Dobson has her doubts. "For a [foreign] strategic investor -- which is allowed to own up to 19.9% of a bank -- its directors have some voice. But the boards are still stacked with people from the [government]."
Indeed, says Liu of CEIBS, "these executives are not really managers, but government officials." What he wants to see in the next round of reform is the state to reduce its shareholdings in the banks, while also "establishing really independent boards of directors, which should at least have the power to be able to appoint the CEO and decide the CEO's pay. Otherwise, there's no way we can get rid of the hidden dangers in the system."
Cao of Cheung Kong also wonders whether the salaries of board members and other senior executives at China's banks need to be addressed alongside these other issues. He says the low salaries of China's top bankers "would be unheard of in the Western world." A recent Wall Street Journal article in which Cao discussed the issue pointed out that despite driving their banks to enviable levels of profitability in 2008, the heads of ICBC and China Construction Bank earned $263,000 and $230,000, respectively, before a government-mandated pay cut of 10% for the most-senior executives of the country's biggest financial institutions. Cao reckons that adjusting the pay scales to reflect the ability of individual bank executives to create value could reduce corruption and make working at these companies more attractive.
But Liu maintains that despite all the noise about reform, "in terms of corporate governance, I'm afraid the banks haven't made much progress." The problem is that there is little incentive to change, he says. "Reform is not easy because [the banks] are profitable; they don't have the pressure they had during the first round of reforms, when they had no choice because they were about to go bankrupt." Riding on the country's economic boom, "they are very strong now and have strong relationships with local governments and large SOEs." They also face very little external competition -- he points out that the market share of all foreign banks in China at the end of last year was less than 3%. "The banks are getting better -- not because of corporate governance, but because of the golden opportunity in China's markets."
It's for that golden opportunity that the IPO of an "ugly duckling" like ABC is able to attract relatively robust investor attention. The IPO might have been met with a much different reception were it in a tougher environment. After all, over the years, ABC seems to have been plagued with one problem after another. Following a government bailout, auditors in 2006 said they found fraudulent deals at the bank totaling RMB 60 billion. Despite the government having brought in a bevy of heavyweight executives -- including a former vice governor of China's central bank, Xiang Junbo, to be chairman, and Pan Gongsheng, who was in charge of ICBC's IPO, as vice president -- ABC has stumbled along.
At the end of 2007, the bank's NPLs were 24% of its total loan portfolio, before it removed RMB 816 billion of NPLs from its balance sheet a year later. At the end of 2009, NPLs were 3% of total loans. "The key issue will be how its asset quality evolves," noted Yvonne Zhang, a vice president and senior analyst at Moody's, in a recent report for the ratings agency, which upgraded ABC's "Bank Financial Strength Rating" prior to the IPO to D- from E+ and gave its foreign currency deposits an A1/Prime-1 rating, citing improving financial metrics along with expectations of "very strong" government support. But the report also points to ABC's "weak" corporate governance, risk management and internal controls. "In preparing for its IPO, ABC only established its board of directors in early 2009," the report stated. "The effectiveness of these efforts has yet to be tested."
Others are skeptical about how much the government is willing to let go of its control over ABC and allow the bank to become more commercial. "It looks like there are efforts [at ABC] to be more commercial and make loans on a more commercial basis rather than just than handing out working capital," says Rotman's Dobson. "But [it's] a huge institution, and I would suspect that it doesn't have the IT systems -- let alone the trained skills and manpower -- to improve its ability to make decisions on loans that will be repaid, given how long it has taken the other banks that have far, far less of a challenge in modernizing themselves."
Chovanec says it's now time for ABC and others to move on. "In terms of the loans that have been made, that horse is out of the barn. There can be a renewed recognition of the [concept] that in order for China to get to where it needs to be, it needs a financial system that allocates capital on an efficient basis. In many circles, there is that recognition, and in some circles, there is a little bit of regret about using the banking system as such a ready conduit for stimulus spending." Like others, Chovanec says there is still a long way for China's banks to go, "not just in terms of their balance sheets, but also the corporate culture they were trying to build. It will take some serious dedication of policy makers in China to do that."