What’s Behind BoA’s Bold Move into China?

For Sale: Ownership interest in a major bank with a legacy of corruption and mismanagement, too many employees, too many branches, and a mountain of bad loans on its books. But bank has a willingness to learn about free-market principles and mend its ways, and is situated in a fast-growing market with more consumers (1.3 billion) than anywhere else on earth.

This ad never actually appeared anywhere. But it could have because it summarizes both the risks and opportunities that await Bank of America now that it has announced it will pay $3 billion to own 9% of state-owned China Construction Bank, China’s second-largest commercial bank. Wharton faculty members and others who follow China say BoA’s high-profile move gives it a foothold in a country with a Wild West business culture — where the potential for both profitability and missteps is apportioned in equal measure. The deal gives CCB much-needed cash and a measure of respectability as it prepares for major changes in China’s competitive environment. But some observers say BoA executives may have bitten off more than they can chew if they think the company’s equity position will give it a significant amount of influence in reforming CCB.

The BoA announcement on June 17 was followed in quick succession by another announcement that focused more attention on China’s banking industry. On June 21, it was reported that UBS, the big Swiss bank, was in talks to purchase a stake in another financial institution owned by the Chinese government, Bank of China. These announcements about these overtures have come at the same time as news that Chinese firms are as interested in buying assets abroad as international firms are in Chinese assets. For example, the Haier Group, a major Chinese appliance manufacturer, and U.S. private equity firms Bain Capital and Blackstone Group bid $1.28 billion for Maytag, the venerable appliance maker based in Newton, Iowa. That bid topped a previous offer made by Ripplewood Holdings, another private equity firm.

Even more controversial was the action by CNOOC, a Chinese oil company, which has made an unsolicited, all-cash bid of $18.5 billion to acquire Unocal, based in El Segundo, Calif. The move by CNOOC was especially dramatic because Unocal had agreed on April 4 to be acquired by Chevron, of San Ramon, Calif., for $16.5 billion in cash and stock. CNOOC is a subsidiary of China National Offshore Oil Corporation, China’s third-largest oil company.

BoA’s move into China probably will not prove as controversial as CNOOC’s attempted move into the United States — which Knowledge at Wharton will analyze in a future issue — but is important in its own right to the future of China’s economy.

Wharton finance professor Yihong Xia says the purchase of the 9% stake in CCB — with the right to increase its stake in the future — gives BoA “a toehold to access the numerous branches, the large deposit market and the emerging but rapidly growing credit card business. Exactly because the banking system in China is in a difficult state, BoA has a lot to gain if it can successfully implement better management practices or leverage its know-how to the Chinese banking industry.”

The deal “positions BoA for a potentially lucrative share of consumer lending in the world’s fastest-growing large economy, at a time when it is eagerly looking to find new customers internationally,” says Chris Mark, Sr., chairman of The Signal Group, a consulting firm with offices in Princeton and Shanghai. “Non-U.S. business accounted for only about 5% of BoA’s revenue in 2004, but the bank has signaled its intention to increase this activity, given legal constraints on expanding its U.S. deposit base as well as its recent favorable experience in Mexico.”

Mark, a former senior economic analyst responsible for preparing assessments on China for the president of the United States and other senior decision makers, adds the deal “may give BoA a leg-up on its non-Chinese rivals by linking it with a recognized indigenous bank — one that is already China’s second-largest mortgage lender — allowing it to acquire knowledge and build relationships at a time when the competitive environment in the Chinese financial sector is about to undergo massive changes.” The fact that BoA is acquiring one seat on CCB’s board as part of the deal may signal some lessening of the governmental meddling that was at the root of many of CCB’s past problems, Mark notes.

Wharton finance professor Franklin Allen says the deal will give CCB the opportunity to put into place modern risk-management systems, which should go a long way to solving the problem CCB has with non-performing loans (NPLs), described by Allen as the bank’s most serious near-term problem. Allen says consumer lending holds greater potential for profitability for BoA than commercial lending. “The retail side is profitable. That’s where most of the money is to be made.”

Uncharted Territory

But BoA is assuming risks, too, in exchange for its presence in China. “BoA is making a high-profile move into a market that is rapidly changing but exceptionally opaque, with a regulatory environment in flux as China prepares to begin opening the financial sector to foreign competition in 2006 in line with its WTO commitments,” said Mark. “BoA has relatively little prior experience in consumer lending across East Asia, let alone in China, while CCB is saddled with a legacy of bad loans, poor management, massive overstaffing and corruption.”

Reports of employees embezzling money from Chinese banks are commonplace, but sometimes scandal reaches the top. In March, the president of CCB, Zhang Enzhao, resigned, it was said by the bank, for “personal reasons.” Published reports, however, indicated he had allegedly accepted bribes from an American company.

While China’s consumer lending business could offer major growth potential for BoA, it is still essentially uncharted territory, while BoA’s main Western rivals in the China market — Citigroup, HSBC, and Standard & Chartered — are already well ahead in the much larger corporate lending segment, according to Mark. Over the longer term, he predicts that BoA — along with all other banks operating in China — faces the potential risk of a banking crisis if Chinese authorities “mishandle the necessary but treacherous process of removing capital controls and introducing exchange-rate flexibility while liberalizing the financial sector in the coming years.”

Wharton’s Xia sees two main areas of concern for BoA. “The first one is similar to [the risks posed by] all joint ventures in terms of integration and influence, since a single seat on the board is not going to make a big difference unless BoA has a powerful and skillful director who understands the politics, culture and practices of Chinese business. I think that Chinese managers are very willing to learn, but BoA has to earn their respect and trust.”

The second risk, according to Xia, is unique to doing business in China — the strong hand of political leaders in the banking sector. “I am worried that the interests of BoA may not be well aligned with the managers of the bank,” she says. “For a state-owned Chinese bank, carrying out government policies and maximizing the political gain are more important than maximizing shareholder returns. Therefore, how well BoA can do also depends on how independent the bank can be from the interference of the government.” She adds, however, that CCB’s government affiliation may mean that BoA will benefit from “some special treatment” from Beijing.

Observers say CCB and other state banks are mandated by the central government to beat economic growth targets. A reliable — if uninspired — way to do that in the short term is to loan money for fixed-asset investments, like buildings and other construction projects. Buildings are erected, jobs are generated and the nation’s gross domestic product gets a nice bump. But if the projects turn out to be boondoggles, as they often do, the loans do not get repaid and the level of NPLs rises. Reforms at CCB and other banks would involve reducing the role of government and that will not be easy.

Wharton management professor Marshall Meyer says that management control of China’s banks remains a serious issue. “The big problem is internal control. Control over local branches is exerted as much by local governments as it is by the bank’s headquarters in Beijing. But banks don’t have bottom-line responsibility. As a result, many loans are given by political command.”

Meyer says BoA executives may be mistaken in thinking that holding a 9% stake in CCB will allow them to “exercise influence” on CCB and its business practices. “With so many branches and employees and little accountability, do you think anything the top says or does will influence what anybody does at the bottom?”

From Mao to Now

In buying a piece of CCB, BoA is allying itself with a bank with a history unlike those of financial institutions in developed countries. After the People’s Republic of China was founded in 1949 under Mao Zedong, all capitalist institutions and companies were nationalized. From 1950 to 1978, China had just one bank — the People’s Bank of China, which served as the nation’s central bank (comparable to the U.S. Federal Reserve or the Bank of England), as well as a commercial bank that took deposits and made loans. It controlled more than 90% of the country’s assets. When Chinese leader Deng Xiaoping opened China up to the world in the late 1970s and 1980s, the government made the People’s Bank of China a proper central bank and, over time, split its commercial operations into four banks — the Bank of China, the People’s Construction Bank of China (the present CCB), the Agriculture Bank of China, and the Industrial and Commercial Bank of China.

Today CCB has $472 billion in assets and 14,500 branches. BoA operates a bank in Hong Kong and has corporate offices in Beijing, Shanghai and Guangzhou.

Over the years, China’s Big Four, as the banks are called, made most of their loans to state-owned enterprises, typically at the direction of Communist Party officials. Creditworthiness of the borrowers was not much of an issue in a command economy where the state determined which companies and projects would get loans. Before long, the Big Four became saddled with NPLs.

“At one point, China’s NPL problem was potentially much larger than that of Japan, Indonesia or South Korea,” says Wharton’s Allen. “So in 2004, the government took $45 billion from its foreign exchange reserves and made loans to CCB and other banks. That helped them clean up their balance sheets and went a long way to solving the historical part of the problem. Now the question is whether CCB and the other banks will change their lending practices.”

Mark agrees that, as a result of its deal with BoA, CCB will be under more pressure than ever to reform itself, especially since it plans to sell shares to the public in an initial public offering expected later this year. As the first of the Big Four banks to enter a high-profile, stake-holding agreement with a foreign investor in the run-up to a planned public offering, CCB will be in the limelight more than ever, raising expectations that could be dashed by any further scandals or any revelations that the bank’s progress in reducing its nonperforming loans has been less than advertised.

“While touted as a benefit, the BoA deal promises a major transformation in CCB management, which will be extremely difficult to implement in a bank that is highly over-branched and, even after major downsizing in recent years, still has over 310,000 employees,” Mark explains. He notes that part ownership by a foreign bank proved to be a strong selling point for the IPO of Shanghai-based Bank of Communications, China’s fifth-largest lender, in which HSBC, a major international bank, owns a 19.9% stake. Shares of Bank of Communications made a strong debut when they began trading on June 23, rising 14% from the IPO price.

Wharton’s Xia says BoA’s move may provide an impetus to U.S. banks that have yet to take the plunge into China. Foreign banks investing in China usually have two options: Set up a local branch or invest in Chinese banks. The second option is typically better since the foreign bank and the local bank have complementary skills. The problem is that mixing different cultures and practices can be difficult. Says Xia: “A lot of foreign banks now face a dilemma: They probably would like to wait and see how well such a partnership works and what lessons can be learned from the BoA deal, but they cannot really wait for too long since the first-mover advantage is tremendous in China.”

Financial Market Challenges

Much attention has been paid in recent years to the emergence and growth of China’s stock market as a source of capital and as a bellwether of China’s move toward a market economy. But so far the stock market has played only a limited role in supporting economic growth, according to Allen. Over the long run, the financial markets will come to play an increasingly important role in the economy. But in the short and near term, banks may prove more critical. “People talk a lot about the financial markets,” he notes, “but most of the action is with the banks.”

In a chapter to appear in a forthcoming book titled China’s Economic Transition: Origins, Mechanisms and Consequences, Allen and two colleagues at Boston College — Jun Qian and Meijun Qian -– examine China’s financial institutions at length. They say a stable financial system will help strengthen China’s economy in years to come. Reducing the number of NPLs will be crucial in avoiding a banking crisis, while the effort to improve the regulatory environment surrounding the financial markets, including governance and accounting standards, can help stave off a market crash.

“The entrance of China to the WTO introduces cheap foreign capital and technology, but free capital inflow and foreign competition and speculation also bring the risk of a twin crisis (foreign exchange and banking/stock market crisis), which severely damaged emerging economies in Asia in 1997,” the authors write. “In order to prevent such a crisis, policies [aimed at] improving the financial system must be made along with supportive fiscal and trade policies.”