Citigroup Storms China: The GDB Purchase and What It Means for the Future 

At the close of 2005, which has been labeled “the year of strategic investors in Chinese banking” by local media, a Citigroup-led consortium bought 85% of Guangdong Development Bank (GDB) for $3.2 billion, striking a resounding note for the theme. Strictly speaking, Citigroup, which is to acquire a 50% stake in GDB, is not just a strategic investor, but the biggest and controlling shareholder, one that can now call the shots at GDB. Other investors in the consortium, including a few state-owned as well as foreign firms -- such as China National Cereals, Oils & Foodstuffs Corp and allegedly the Carlyle Group based in New York which would take the remaining 35% stake in GDP -- are not strategic investors either, since none of them is a commercial bank. According to the GDB restructuring plan disclosed by the media, GDB plans a Hong Kong listing by the end of 2006.

Big deals never lack dramatic elements, especially for public relations firms and the media. GDB’s restructuring plan kicked off at the end of 2003 and was nothing if not a draining marathon. It took KPMG six months to investigate GDB’s assets and produce the auditor’s report. There had been difficult negotiations with the Guangdong government, GDB’s biggest shareholder, over such issues as investor compensation over more non-performing loans found after the deal. ABN AMRO teamed up with Ping An Insurance to participate in the bidding, but quit in the middle over unspecified disagreements. Apart from all these factors, the biggest buzz about the deal is this: Should the State Council approve it, Citigroup will “historically” break the 20% cap imposed by the government on ownership in a Chinese bank by a single foreign company.

Banking Reform: A Recurrent Theme

Will the State Council approve the deal? The guess by the media is probably, since it is the Guangdong government that initiated the bidding to sell shares in GDB. Also, the group that made the final decision to award the bid included six officials from the China Banking Regulatory Commission (CBRC), the People’s Bank of China and the Guangdong government. The consortium is paying more than twice the book value of GDB, vs. 1.15 times the book value when Bank of American (BoA) bought shares in the China Construction Bank (CCB).

Since September 1999, when IFC acquired 5% of Shanghai Bank, opening up the floodgate of foreign ownership in the Chinese banking industry, overseas investors have paid about $20 billion for shares in various Chinese banks. 2005 was simply the peak of this trend. According to China’s agreement with the World Trade Organization, restrictions on foreign banks will be fully removed starting in 2007. Although the market will be opened, the most important platform for a commercial bank – branch offices and client lists -- cannot be built in a short time. The costs of replicating this system will make it meaningless for any foreign bank to come to China, says the Economist, acquiring a local bank, however, gives a foreign bank access to the most important resources, including bank branches, overnight. Liu Mingkang, chairman of the CBRC said foreign banks were showing strong interest in acquisitions.

In fact, looking back over six years of opening up of the Chinese banking industry, there has been no shortage of deals that were described as “historic breakthroughs” and “milestones” by the media.

In September 2002, New Bridge, a U.S. private equity firm, paid RMB 1.234 billion ($153 million) and acquired a 17.89% stake in Shenzhen Development Bank (SDB), becoming the number one shareholder of the bank. It was the first time that a foreign owner had become the biggest shareholder of a Chinese bank. In August 2004, HSBC spent RMB 14.461 billion ($1.8 billion) to buy 19.9% of the shares in Bank of Communications. It was the biggest single deal in the Chinese banking industry involving a foreign investor up to then. In June 2005, Bank of America bought 9% of the shares in the CCB. It was the first time one of the big four state-owned banks had attracted an overseas strategic investor.

If one compares the opening up of the Chinese banking industry to a grand symphony, equity deals of various sizes are the recurrence and development of the same theme. “Ever deepening banking reforms, competition and discipline drive local banks to improve efficiency, to promote integration of international and local capital, to alleviate the pressure on the government to fix non-performing loans, and to transfer some potential financial risks in China to international financial institutions”, says Pan Xilong, a professor at the Southwest Finance and Economy University, when interviewed by Knowledge@Wharton China version. “At the same time, after foreign investors have taken equity in domestic commercial banks, administrative interference from government in the operations of Chinese banks can be effectively prevented, allowing local banks to establish an effective incentive system, as well as checks and balances, helping them to establish good corporate governance,” adds Zhou Kai, a professor from the same university, when interviewed by Knowledge@Wharton China version.

Exercises in attracting foreign capital have been following a very clear strategy and sequence, starting with small city commercial banks as a testing ground. So far, 17 city commercial banks have sold equity to foreign investors, with the total deal size estimated at about RMB 4 billion ($496 million). The next step has been pushing joint-stock commercial banks into international capital markets. The cooperation between Bank of Communications and HSBC was the first “breakthrough” deal. By now, 12 joint-stock banks have partnered with overseas strategic investors. Among them, SDB is controlled by a foreign company, as mentioned earlier.

The final and most ambitious movement in the symphony is tackling the big four state-owned banks, all following a model of asset restructuring -- attracting overseas strategic investors and finally overseas listing. The CCB had a successful IPO on October 27, 2005, on the Hong Kong Stock Exchange, floating 12% of its shares and raising $8 billion in capital. This is the largest global IPO in four years.

Li Liming, senior finance reporter of the Economic Observer expected that almost all Chinese banks will sell some equity to foreign investors in the next few years. Jeffery R. Williams, president of SDB, the first ever foreign president of a Chinese bank, says that there is a “no-turning-back mindset” on the part of the Chinese government on banking reform. Xu Xiaonian, an economist and the professor of the China European International Business School (CEIBS), notes that the Chinese government takes the initiative in reforming its banks, not waiting for crises to strike, as they have in other Asian countries.

According to The Economist, Beijing has poured more than $260 billion into Chinese banks through direct handouts and by allowing the big four state-owned banks to shed non-performing loans to state-backed asset companies since 1998. This is equivalent to what the American government spent to bail out the savings and loans industry, and about twice the sum South Korea spent to restructure its banks after the 1997-1998 Asian financial crisis. However, old habits die hard and new, risky loans are still being offered by Chinese banks with alarming speed. To overhaul its banks, observers say, the government has started the strategy of pushing local banks to seek foreign capital and expertise.

There have been some successful cases of foreign capital having its intended effects on Chinese banks, making it easier for subsequent equity deals involving foreign partners to proceed. After Williams became the president of SDB, he curtailed the autonomy of branch managers in granting loans by establishing a direct line of reporting from headquarters to loan officers at branches. A week later, Chinese regulators issued a notice asking other banks to follow suit, according to Williams.

He has also strengthened internal auditing and established a new code of conduct for banking and information systems. In addition, GE Capital invested $100 million in SDB, helping it to develop new consumer banking products. The capital adequacy ratio of SDB has been raised from 2.3% to 3.3%, which is set to rise further when the bank is able to issue subordinated debt (which it can when its capital adequacy ratio reaches 4%.) As another example of progress, Bank of America reportedly contributed to the successful listing of the CCB, five months after the bank’s chairman was arrested for alleged bribery.

Turnaround No Big Deal for Citigroup

Meanwhile, there are some clues to Citigroup’s overall strategy in China.

Citigroup’s two acquisition targets in China are GDB and Pudong Development Bank (PDB), located in the Pearl and Yangtze River Deltas, which have booming economies and the most affluent populations in China. While making its move in Guangdong, Citigroup has also announced its intent to increase its stake in PDB to 24.9%, as planned in the original agreement with PDB. Although GDB is one of China’s most destitute banks, Citigroup, according to observers, feels that without the meddling of the local government to force GDB to lend to favored clients, the loan portfolio can easily be improved. And as long as Citigroup gains access to the branch office networks and client lists of GDB (and PDB), and given Citigroup’s sophisticated system, process, experience and highly-acclaimed innovation in consumer banking, it is well-positioned to sort out GDB, observers say.

For a starter, Citigroup can replicate its top-of-the-grade online banking in China to reduce operating costs and lock in high-quality customers, who tend to be affluent, young and technology savvy. Lending in the housing, car and education sectors, foreign-currency trading and wealth management are all booming, lucrative segments. Citigroup can also embrace the entrepreneurs in the Yangtze and Pearl River Deltas and beyond, who are underserved by Chinese banks. With Citigroup’s risk management system, it can develop this market profitably, observers say.

There is also the credit card market, which is still a virgin land in the eyes of foreign banks. Of the 880 million bankcards in China, only 12 million are genuine credit cards. Citigroup has been focusing on credit cards since it acquired a 4.62% stake in PDB at the end of 2002. It was the first foreign bank to put its name on a Chinese credit card, laying a solid foundation in branding for any other businesses it might launch in the future. The PDB credit center is under PDB only in name; it is actually a semi-independent operation center, whose CEO and directors of four key departments all come from Citigroup. The CEO reports to a credit center management committee comprised of three people each from Citigroup and PDB. Citigroup supplies the latest-version business system while data processing is integrated into its data processing center in Singapore. Once the market is further liberated, the credit center can immediately transform into a joint venture without a transitional period, says Ba Shusong, associate director-general of the Research Institute of Finance under the State Council, in an article published on Daily Economic News.

For banks issuing credit cards, the revenues are three-fold: annual fees payable by cardholders, a cut of the Merchant Discount Rate (MDR) (the remaining goes to payment networks such as Visa and MasterCard, and acquirers), and finally high interest rates charged to cardholders who don’t pay back credit allowance on time. The last revenue stream is the most lucrative and yet the hardest to predict in China. Most Chinese are prudent spenders and have the habit of paying back loans monthly. Investing in Chinese banking is a huge gamble, says the Economist.

On an optimistic note, McKinsey forecasts exponential growth in credit cards in China, with profits reaching $1.6 billion in 2013. On the other hand, competition has driven up marketing costs in acquiring new cardholders. Jacques Santini from BNP Paribas, which just bought 20% of Nanjing City Bank, expects losses for any foreign investors in credit card business for the first three or four years.

If all barriers to, and restrictions on, foreign banks are truly and fully removed after 2007, observers expect long-established foreign banks (to the point of being boring) to show their Chinese counterparts how to properly run a commercial bank. Recently, there has been much opposition to, and concerns, about foreign ownership in the banking industry. As Tong Meng, a PhD student with the Southwest Finance and Economy University, puts it, when interviewed by Konwledge@Wharton Chinese version: “The Chinese banks might not necessarily be sold on the cheap to foreigners. But we might not achieve the objective of obtaining advanced management and technology, at the expense of handing over the core secrets, branding and national credit for free.”

Other high-profile economists disagree with this view. Yi Xianrong, an economist in Beijing, said at the seventh Enterprise/Bank Forum: “It is China which sets up the casino, and the government can see all the cards in the hands of all the players.” He is quite convinced that Chinese banks will still dominate the banking industry in 10 or 20 years time. Fred Hu, managing director and economist of Goldman Sachs, also notes that the most developed and efficient financial systems reside in countries and regions with the most open financial markets, such as Hong Kong, Singapore, Britain, Switzerland and Luxemburg.

From Knowledge at Wharton