Eye on China: Bankers gambling for very high stakes

Banking and finance is generally not the most exciting part of your morning newspaper. Only rarely do you encounter an initial public offering, or IPO, where the outcome could either accelerate or severely damage a nation's superpower ambitions.

That was precisely the case last week with the pricing of the 12 per cent of its total shares that China Construction Bank is selling to the world.

Now, I'm not convinced that the "Rise of the Dragon" is automatic, and the IPO of China Construction Bank gives clear evidence of how the China juggernaut could be derailed by a series of human errors.

Let's take a look at what happened. It's a nail-biting story.

Generally, a company lists at 10 to 15 per cent discount to ensure the offer goes well, since investors will buy up the shares in order to sell them for a quick profit. So the company leaves some money on the table to ensure that the company's shares are well and truly got away.

The Chinese Government has traditionally made the partial privatisation of its state-owned assets attractive in this way. As it sold off stakes to the Hong Kong and US stockmarkets in its telecoms, steel, aluminium and petro-chemicals sectors, shares were priced at a generous discount to their fair value. That encouraged investors to apply for shares in the primary market which they could sell for easy money in the secondary market.

This sweetener was necessary because investors are very nervous about the Chinese Government's ability to run its companies efficiently and fairly for the benefit of public, minority shareholders. That's despite the much-trumpeted reforms these companies carry out before their listing.

Through the discount system, both parties were satisfied. The Chinese Government doesn't suffer any loss of face through a failed IPO, raises lots of capital, exposes its state-owned enterprises to market forces and prepares the ground for the next IPO. Investors make a tidy profit.

That was exactly the paradigm with Bank of Communications earlier this year, the first of China's state-owned banks to use the stock market to raise capital and force a rise in banking standards to international standards. The bank, the smallest, most modern and least significant of China's state-owned banks, listed so under-priced that it has since traded up almost 20 per cent. And we are talking here about a bank in which banking blue chip and China specialist HSBC has an almost 20 per cent stake, a position from which it can provide plenty of first class advice and capital. So it has plenty of good points.

Now take CCB. This is China's third biggest bank by assets (out of four giant state-owned banks which hold almost 70 per cent of the banking system's assets) and the country's largest mortgage lender. It's a bank whose chairman, Zhang Enzhao, was recently arrested in a million-dollar corruption case. It's a bank which even in the run-up to its listing was uncovering case after case of fraud and embezzlement.

Although staff have been cut by tens of thousands, there is a suspicion they have just been shuffled sideways.

Non-performing loans - the specialty of a non-accountable, decentralised and corrupt financial structure - have been slashed to a seemingly impressive 4 per cent. But investors know that's cosmetic. The Government poured money into these banks and simply transferred the dud loans to special asset management companies, which have the dirty work of trying to milk the loans for what value they have. The people who are responsible for the bad loans to their mates in the first place are still in place.

Banks are so important because China's stock and bond markets are so small. The banks fuel China's growth through loans. Traditionally they have done a very inefficient job, as you can see by the huge number of loans that turn out to be sour.

Yet CCB is the bank the underwriters decided to price as the most expensive bank in Asia, if not the developing world. Is this madness? Even if it isn't, it's a massive risk, because the performance of CCB in the after-market will help determine the IPO success of CCB's even larger and more chaotic siblings, Industrial and Commercial Bank of China, China Agricultural Bank and Bank of China.

What do I mean by expensive pricing? Well, a bank is normally valued at its book value, which refers not to its loan book but to its equity value, its net assets.

Most emerging market banks trade at well under twice book value. Only a couple of superbly run private Indian banks and a Brazilian bank price at that level or higher.

All the other Asian (not including Japan) banks trade at around less than 1.5 times book value - apart from CCB, that is, which has been priced at 1.96 times! BoComm, a better bank by far, priced at 1.6 times.

And the bankers chose to price CCB so high in an environment which is pretty grim: The US could be raising interest rates any time, the Hong Kong bourse has shed 1000 points since its August peak, and the global environment is volatile.

In China itself, third-quarter growth figures saw the authorities come out with their usual, frankly ludicrous clutch of numbers. Growth was supposedly 9.4 per cent for the quarter, year-on-year. According to one reading, non-export based growth has halved - now that's a slowdown scenario where you don't want to be holding bank shares. Yet according to another reading, domestic demand, as measured by fixed-asset investment, has surged, meaning everything is fine.

Given that level of ambiguity, one would imagine that very cautious pricing would be the order of the day.

So what were the bankers playing at? It seems that they may have taken a huge gamble. In the run-up to the pricing, as they were engaged in the bookbuilding, or the price exploration process, with institutional investors, they thought they could get away with actually hiking the price from its original, quite conservative level. Now this is where it gets interesting. It's not clear that when the bankers hiked the price five days into the price-setting process if demand really was that strong. It's possible that the bankers gambled that such a move would influence investors by providing a bullish signal that demand was so strong that a price hike was feasible.

That means that even if you paid the higher price for the IPO shares, you could make money selling the shares in the after-market. (The more demand there is which is not met in the primary allocation, the more demand is available for buying in the secondary market at a higher price. So the overall demand figure is very carefully watched by investors in the original IPO allocation.) So basically, you are trying to manufacture demand through clever marketing.

In the end, it seems that demand outstripped supply by around 10 times in total: Solid, but not stellar. In contrast, demand for BoComm outstripped supply by 25 times, one of the highest figures on record.

The demand for CCB could be enough to ensure the shares gain in the secondary market, everyone is satisfied, and the rest of China's banks can embark on a once-in-a-lifetime reform process.

If the demand is not enough to push the shares up, then the fallout for the reform of China's banking sector could be spectacular.

And the bankers responsible for the deal will be left ruing the day they tried to be too clever by half.

* The writer remains anonymous to protect his position in China.