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Global Financial Deleveraging Crisis Will Cost Western Banks Future China Profits

Companies / China Stocks Jan 18, 2009 - 02:25 PM GMT

By: Money_Morning

Companies Best Financial Markets Analysis ArticleWilliam Patalon III writes: In mid November, Bank of American Corp. ( BAC ) ponied up more than $7 billion to nearly double its already existing investment in the state-owned China Construction Bank Corp ., a move that gave the biggest U.S. bank a 19% stake in China's second-largest lender.


Less than two months later, however, BofA sold $2.8 billion of its shares in the Beijing-based China Construction Bank, a jarring about face made necessary by the U.S. bank's need to raise cash.

And Bank of America isn't the only Western lender making such a move.

Just this week, the Royal Bank of Scotland Group PLC (ADR: RBS ), Great Britain's biggest government-controlled bank, sold its $2.3 billion stake in the Bank of China Ltd. (Pink: BACHF ), the No. 3 Chinese lender - also because RBS needed to replenish its capital position. That stake represented 4.3% of the Bank of China's outstanding shares.

RBS, BofA and UBS AG ( UBS ) - all early “strategic investors” in China's biggest banks - have now each trimmed their investments in those banks, thanks to the expiration of restrictive “lockup periods.” UBS said last month that it had sold its entire 1.33% stake in the Bank of China.
More divestitures are expected.

“Undoubtedly, foreign banks will continue to expand their footprints in China ,” Zhao Xijun, deputy director of the School of Finance at Renmin University of China, told The Wall Street Journal . “But they will be more focused on developing their own businesses, rather than buying a Chinese lender.”

Cash-strapped Western banks - desperate to raise money in the face of the worst financial crisis since the Great Depression - are paring their stakes in top China banks. That will bring in needed capital today but at the cost of lost future profits tomorrow in an economy that's the world's fastest-growing, and a market in which a burgeoning middle class figures to create all sorts of lucrative businesses for players with the ability to stay in the game.

On China's end, the divestitures are forcing Beijing to reassess its strategy of using foreign know-how to assemble a world-class banking system.

Since 2005, foreign financial institutions such as Bank of America and the RBS have pumped more than $25 billion into Chinese banks as part of a high-dollar game of quid pro quo engineered by the Red Dragon's regulators: Foreign investors would gain access to China's banking market, and in return would show China's banks how to make money in a free-market environment.

As these developments demonstrate, the global financial crisis continues to worsen, meaning the bailout strategies used so far haven't had the desired benefit. BofA received a $15 billion infusion from the U.S. Treasury Department's $250 billion “recapitalization” effort. The Edinburgh-based RBS received $29 billion in bailout money of its own after taking $10.2 billion in write-downs in 2008.

As a Money Morning investigation has demonstrated, many U.S. banks used bailout money to go on a global shopping spree , instead of retiring bad debts or boosting lending to businesses and consumers. The payback has been rather quick in some cases.

As the divestments have now demonstrated, the worsening financial crisis is forcing financial institutions to sell promising assets, and to do so at a point when the value of those holdings is probably at or near their nadir.

“For RBS, they don't really have much choice,” Samuel Chen, a Hong Kong-based analyst at JPMorgan Chase & Co. ( JPM ), told Bloomberg News . “They would probably rather hold it.”

Indeed, as one analyst said, Western banks are selling out at prices where they should actually be buying.

“Although the selling by foreign strategic investors may put some short-term pressure on prices, bank stocks are undervalued given their long-term growth prospects ,” Zhang Xi , a Beijing-based analyst at China Galaxy Securities Co., told Bloomberg News. . “Now is a good time to buy Bank of China and other big lenders.”

Goldman Sachs Group Inc. ( GS ) still owns 16.5 billion shares in Industrial & Commercial Bank of China, the world's largest bank by market value, and has agreed not to sell the shares until after April 28, according to published reports. American Express Co. ( AXP ) and Allianz SE (ADR: AZ ) are among the Commercial Bank of China's other U.S. and European shareholders.

Frustrations Abound

When it comes to China's banking sector, the so-called “Big Four” consist of:

  • China Construction Bank Corp .
  • Industrial and Commercial Bank of China .
  • Bank of China Ltd .
  • Agricultural Bank of China (PINK: ABGEF , ABGEY ).

As recently as five years ago, most of China's lenders were technically insolvent. After a cleanup and bailout that cost the Chinese government an estimated $500 billion, foreign investors entered the scene. Three of the Big Four - China Construction, ICBC and Bank of China - ultimately went public on exchanges outside China.

RBS, Bank of America, and Goldman Sachs Group Inc. ( GS ) are among overseas financial firms that bought stakes in Chinese banks even before they went public in 2005 and 2006. RBS paid $1.6 billion for its stake in August 2005, investing alongside the Li Ka-shing Foundation and Merrill Lynch & Co., which is now owned by Bank of America.

Bank of China went public in 2006.

Western lenders boasted of the growth potential and “strategic” value of their stakes in China's lenders. Since then, however, the $738 billion of write-downs and credit losses banks and brokers have recorded worldwide since 2007 added urgency to stake sales.

Bank of China's Hong Kong-traded shares have fallen 46% in the past year, paring the value of the RBS stake, as the Red Dragon bank rolled up $3.7 billion worth of losses from securities linked to U.S. home loans. That's the biggest loss related to the U.S. housing meltdown of any China-based lender - most of which steered clear of subprime mortgages, and the U.S. housing bubble.

And - as we noted - RBS wasn't the only seller. On Jan. 7, Hong Kong billionaire Li Ka-shing raised $511 million selling shares in Bank of China, Separately, Bank of America sold the afore-mentioned $2.8 billion of shares in China Construction Bank, while Zurich-based UBS sold about $900 million of Bank of China shares last week.

The moves underscore how desperate Western banks are to raise capital and to bolster their balance sheets: By divesting these stakes, U.S. and European banks are either reducing or eliminating altogether ownership positions in what figures to be the world's fastest-growing economy for decades to come.

Even if China's economy gets tripped up by the global financial crisis in the short run, its lower cost structure, rising incomes and demand, and massive currency reserves promise to make the Red Dragon a big long-term winner. And any Western countries that make the commitment to go along for the ride - maintaining the all-important long-term connections, or guanxi , in the Chinese market - stand to benefit handsomely.

And these Western banks had it made - at least as far as China goes. The billions invested in China's financial system by foreign firms was a key in helping some of China's banks to list their shares on U.S. and other overseas exchanges in 2005 and 2006, The Journal reported.

China's leaders were extremely upbeat over the prospects of working so closely with “successful” foreign financial institutions. Those foreign firms were expected to imbue their Chinese partners with the most-current management methods, to transfer over the latest banking technologies, and to help their China-focused counterparts develop revenue streams by helping to create fee-generating businesses.

But there have been problems. On both sides.

Foreign investors have become increasingly incensed at their inability to gain controlling ownership interests in China-based banks and in not being able to exert much influence on the daily operations of those institutions. Foreign investors had long expected that the 20% cap on foreign ownership would have been lifted.
That hasn't happened.

China bankers have been frustrated - if not mystified - by foreign bank advisors who have long histories of high-level international experience, but repeatedly stub their strategic toes because they don't understand the wants and needs of the local Chinese markets they are serving, meaning these foreign advisors too often can't solve the problems they come across. That's shattered the perceptions of China bankers that foreign marketers are experts who are able to address any situation, or capitalize on any opportunity, experts say.

As can be expected, there have also been some misunderstandings. For instance, when the Bank of China announced an “exclusive partnership” with the Royal Bank of Scotland's private-banking unit. But the Bank of China subsequently went off and created its own wealth-management unit, creating a competition between banks that were supposed to be partners, The Journal reported.

Desperate Straits

When BofA announced it was boosting its stake in China Construction Bank, also known as CCB, the news actually ended months of speculation that the Charlotte, N.C.-based lender would dump part of its three-year-old investment in the Beijing-based bank to offset the effects of the global financial crisis. In fact, Money Morning tracked the deal's progress and the rumors, ultimately reporting in early November that the deal was close, though noting that the actual timing was unknown.

When the deal was announced a week later, Bank of America said it planned to be “a long-term and significant strategic investor in CCB.” It also noted that the new shares it was acquiring carried a restriction: BofA wasn't permitted to sell the shares before Aug. 29, 2011, unless the China bank provided special permission. However, the three-year lockup period on its initial share purchase expired in October.

Following the second purchase, Bank of America owned 44.7 billion of the Class “H” shares of CCB, Reuters reported.

The initial investment turned out to be a major financial success for BofA. The U.S. bank first invested in CCB back in June 2005, taking a $3 billion stake months before the lender was taken public. Additional purchases brought the cost of BofA's earlier CCB stake to $4.9 billion. The value of that holding had almost tripled, to $14.5 billion, as of Sept. 30, a regulatory filing showed. Indeed, shares of CCB rose 75% from the bank's October 2005 initial public offering (IPO) to November, when BofA's second purchase was made - even though the shares were down by more than half from their October 2007 peak , Reuters said.

But then came the about-face. Earlier this month, Bank of America sold 5.6 billion shares, or 2.5% of China Construction Bank, to institutional investors. Its costly purchases of both Merrill Lynch and failed mortgage firm Countrywide Financial Corp. likely were key reasons the capital was needed, said Li Qing, a Shanghai-based analyst for CSC Securities - who noted that additional share sales may be required.

Bank of America still holds 16.6% of China Construction Bank.

Bank of America likely went ahead with the sale after getting some assurance that the move wouldn't significantly damage relations with Beijing or China's state banks, said Warren Blight, Hong Kong-based analyst for Fox-Pitt Kelton Cochran Caronia .

“They're working closely and explaining the situation to China Construction Bank,” Blight said. “I'm sure the Chinese authorities are understanding of the position that the foreign banks are in.”

Indeed, CCB said in a statement that BofA's share sale constituted “normal market activity” and reaffirmed the two banks' strategic cooperation in the future.

“China Construction Bank is tightly tied to the government and they are a preferred bank,” Richard Wottrich, managing director of Dresner Partners, a Chicago-based investment-banking firm, told Bloomberg .

Unfortunately for Bank of America - at least from a near-term financial standpoint - BofA Chief Executive Officer Kenneth D. Lewis had canceled the sale of the CCB shares at the very last minute back in the last minute in December, missing the chance to book the gains in the San Francisco-based lender's 2008 results. That last-minute reversal sparked speculation that Beijing was unhappy with the prospect of a sale by Bank of America - or by any other major institution that holds shares that have come out of lockup - fearing that such transactions could undermine authorities' efforts to prop up the country's depressed stock market.

“It's a real shame that Western banks have engineered themselves into this situation,” says Keith Fitz-Gerald, the investment director for Money Morning and a longtime expert on China's financial markets . “These guys had been given the keys to the castle in terms of having a direct [and endorsed] access to the China market. On the other hand, it's a great situation for the leadership of China, and for its financial sector. They accomplished all their goals,” getting Western capital, technology and know-how - and now can proceed without the constraints the foreign banks might want to impose.

No Fallout

Although foreign investors are slashing their stakes in China's banks, the sales will have only a limited financial impact and won't affect the sector's stability, the state-run Xinhua News Agency said Monday.

Xinhua issued the commentary after a series of reports about banks selling their stakes in Chinese lenders sparked come as fears that additional sales might damage China's financial sector, if not its economy , the AFP news service reported.

“The impact is limited and controllable and will not affect the capital adequacy ratio … of China's state-controlled financial institutions or the stability of the overall financial sector,” Xinhua said in a statement.

The liquidity in China's banking system is “ample,” Xinhua added. Chinese households have placed about $3 trillion in China-based banks, according to earlier news reports.

[ Editor's Note : Money Morning Investment Director Keith Fitz-Gerald will be personally leading our 7th annual Chinese investment tour this April and invites anybody who wants to sample hairy crabs to join him. It's a great way to see firsthand how and why China is critical to the global economic recovery and to our individual investing futures - not to mention that it's also a great opportunity to sample some truly spectacular food . Please click here to learn more.

Fitz-Gerald is also the editor of the new "Geiger Index" trading service. As the whipsaw trading patterns investors have endured this year have shown, the ongoing global financial crisis has changed the investment game forever. Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this " New Reality " will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive - they will thrive. With the Geiger Index, Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as " The Golden Age of Wealth Creation ." The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it's particularly well suited to the kind of market we're all facing right now. Check out our latest report on these new rules, and on this new market environment . ]

By William Patalon III
Executive Editor

Money Morning/The Money Map Report

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