China Shifts Strategy to Attract Investment in the Banking Industry

In 2005, the Chinese communist regime changed its strategy to attract foreign investments. The most important change was to not list state-run banks on overseas stock markets, and to remove the 25% upper limit for foreign investment in Chinese banks. Once this decision became public knowledge, Chinese nationals were up in arms. They alleged that by cheaply "selling out" banks it would cause the government to lose control of the financing industry.

It comes to no surprise that responsible finance executives deny any intention of "selling out cheap." However, what they cannot say explicitly is that they have no other choice after their plan of absorbing money from Wall Street failed. They have to change the strategy to attract foreign bankers.

(They pointed to much that is troubling the Chinese banking sector. Opening up the Chinese financial industry to foreign banks only became reality after Wall Street investments in state-run banks did not materialize. )

Sarbanes-Oxley Act: Opportunists' Downfall

The Chinese banking industry is saddled with a mountain of problems, although the Chinese regime has pursued overseas investments opportunities over the past several years. To increase the ratio of shareholders equity to total assets [and close the holes in the capital base], the regime used foreign-exchange reserves to infuse money into state-owned banks. Since 1998, when the state-owned Central Huijin Investment Co. was created as an investment arm of China's central bank, the Chinese regime has infused approximately US$260 billion into the banks through cash infusion. The regime has also transferred non-performing loans [to the four Asset Management Companies (AMCs). The AMCs are similar to the Resolution and Trust Corporation (RTC) created by the U.S. government to deal with bad assets of failing Savings and Loan Associations.] The amount infused by the Chinese regime is twice the amount Korea infused to restructure its finance industry after the 1997-1998 Asian Financial Crisis, and equals what Latin American countries would require to bail out their banking industry.

China had to abandon their goal of state-owned banks listing in foreign financial markets, a goal that had been in the works for four to five years. An influential factor was that American investors had learned their lesson after many Chinese state-owned companies that had raised money through established financial systems in America ran into problems. The House Select Committee on US National Security and Military/Commercial Concerns with the People's Republic of China disclosed in its Commercial Concerns with the People's Republic of China 2005 report a number of fraudulent practices by Chinese companies that had received financial backing by American investors.

The most influential factor, however, was the Sarbanes-Oxley Act (SOX), a U.S. law passed by Congress in July 2002. This law requires strengthening corporate governance by corporations that wish to trade on American Stock Exchanges. The law was passed to prevent corporate and accounting scandals, such as those involving Enron and WorldCom [now MCI]. SOX is considered by some to be the most stringent law governing capital markets, marking a new era of market control.

Why is SOX More Stringent?

SOX instituted more severe penalties for fraudulent acts by publicly traded companies. It includes more stringent requirements concerning a company's information disclosure, financial accounting records, and corporate governance. For example, it requires that CEOs and Chief Financial Officers (CFO) accept responsibility for the accuracy and reliability of financial reports submitted to the Securities and Exchange Commission (SEC). The company officials must assume personal responsibility for the companies' financial reports. Corporate executive who are found to have deliberately and intentionally misstated financial statements may face large fines, criminal charges and long prison terms.

The intent is that stronger external monitoring precipitates better internal management of companies, especially when it comes to larger companies with many branches and departments. It forces the CEOs and CFOs to foster stronger internal controls, as they have to accept personal responsibility for any material misstatements due to error or fraud.

In an optimistic scenario, China's state-owned banks would take at least one year to meet the internal management requirements set by Article 404 of SOX. Experts stated that for a large company, there are thousands of risk points in a flow chart detailing the operation. It is much more complicated than a single management system, since there would be different internal controls, due to different regional cultures and tasks focusing on each section. Then the company officials must decide which components are crucial to the operation and perform further tests. For example, to complete a 404 analysis, a bank may first scrutinize the loan review and approval process and detail who will be handling what step in the process, such as the analysis steps in a loan report, departmental review authorities, credit committee evaluation, the weight assigned to each component in the process, signature authorities, and the screening process. Usually, a 404 analysis of a loan or credit approval would require a number of processes. The law does not indicate which processes, since even among banks there may be variations in their operations. The different companies would have different processes. Finally, there would be random tests to see if the operation at the employee level meets the requirements of internal controls. It is believed that completing this analysis would take at least one year.

Unsurpassable Obstacles for Chinese Banks and Companies

Faced with the requirements of the SOX Act, Bank of China and China Construction Bank, wanting to fill their coffers, have to take the following under consideration.

First, China's banks must consider possible litigation, especially since China Life Insurance Company Limited has been sued after listing on the New York Stock Exchange. This is a new kind of potential risk faced by foreign companies on Wall Street. China Life Insurance, China's largest life insurance company first listed on the New York Stock Exchange in 2003. Soon after being listed on the New York Stock Exchange and having sold stock valued at 3.5 billion U.S. dollars in Hong Kong and New York, China Life Insurance was sued and faced an investigation by the U.S. Securities and Exchange Commission for misstatements and falsehood in its prospectus prior to the stock listing. Market observers believe that the legal trouble of China Life Insurance serves as a clear warning to other companies.

Second, they must consider the cost of compliance with U.S. accounting standards. U.S. accounting standards are different from international or UK standards. To meet U.S. standards, foreign companies and banks must expend much manpower. For example, some European banks are the result of acquisitions or mergers. U.S. accounting practices require consolidation of the accounting information of the two banks. Such consolidation may require analysis of information from four or five years ago. Therefore, many banks must examine historical data, certificates and documents. Generally, companies that list on stock exchanges must provide three years of year-end financial information. However, some banks are required to provide five years of such information. Many banks did not retain such historical data. According to knowledgeable source, U.S. banking supervision authorities have rejected many banks because of financial information issues, and banks' applications for exception were not granted.

Bank Officials Shy Away at Having to Accept Personal Risk

Third, the SOX Act requires that CEOs and CFOs accept legal responsibility. This requirement forces Chinese bank officials to consider the personal risk they have to accept if their stock is listed in the U.S. China's state-owned banks are large and spread out, and the work styles of different branches vary greatly. Corruption is not infrequent in China's banks. According to Li Jinhua, the head of China's General Auditing Bureau, corruption in the banking and financing sectors are the highest among the 15,000 cases registered at various levels of the General Auditing Bureau, since 1998. In over 1,000 cases recorded by the General Auditing Bureau, more than half involve state-owned banks. High-ranking bank officials clearly understand the chaotic situation of China's banks. Even if they would have American investment banks and accounting agencies assist in producing acceptable financial material for stock listing, they could face litigation at any time. For those Chinese banks that plan to sell stock on the New York Stock Exchange, the directors have put in great effort to achieve their high ranks. Some have even become Chinese Communist Party Central Committee members or alternate members. If their banks would face the problems of China Life Insurance after a stock listing, those who hold positions of power might suffer imprisonment because of violations of U.S. SEC requirements. At present, some have proposed to hire foreign CEOs and CFOs. For this, certain qualifications and experience is needed by the individual who accepts such a position. The questions remains, "Who among the qualified would be willing to take such a risk?"

The Chinese Communist regime and Chinese companies have spent quite a bit of effort studying the SOX Act, and have also criticized, through various channels, the severity of the act. Many American companies and investment banks that have close economic ties with China have also complained. It has been difficult for New York to attract Asian companies to list their stocks, a difficult arising from the pressure of banking supervision, as well as the strict regulations, especially the SOX act. The reasons are the requirements of banking supervision and legal authorities, especially the SOX act. Christopher Cox, the newly appointed Chairman of the Securities and Exchange Commission, does not hold a positive opinion of the Chinese Communist regime. Last November, he stated in Beijing before many bank supervisors, managers and politicians that China's capitalism might be "facing the same destiny as the Qing (Dynasty)." From this comment we can see clearly that neither pressure or criticism has affected his standing on the subject. Unless the U.S. authorities change the people in charge, Wall Street will not open its doors widely to Chinese banks and companies.

China Construction Bank Collects Money in Hong Kong and Dries up Hong Kong's Stock Market

Getting China's banks and companies listed on the American stock exchanges at this time has become an unrealistic goal. Therefore, the CCP controlled regime changed strategy. Listing China Construction Bank in the Hong Kong Stock Market is the choice the CCP has made. The rating adjustments made by the Standard & Poor's Rating Services (S&P) have greatly helped China's banking system.

On November 26, 2003, S&P gave a poor rating to China's banking system. The CCP regime was embarrassed by two of the conclusions. One is that the credit ratings for 12 commercial banks, including the four major state-owned banks in China were below BBB. The second is that S&P estimated the ratio of non-performing assets for China's banking system to be around 44 to 45 percent. This is far from the official figure of 22.9 percent, released by the CCP regime. According to the CCP regime's custom, if such a "poor rating" came from other governments or non-government organizations, it would definitely speak harshly and protest loudly to have such ratings changed. However to get a better S&P rating, and because "complaining" would not solve the problem, the CCP regime remained silent on the subject matter. It turned out to have been "worth the sacrifice." S&P adjusted its ratings for China's banking system this year.

One month before China Construction Bank was listed, S&P, who always regarded China's banking system as one of the most risky systems in the world, raised its rating for seven Chinese banks. Its long-term foreign currency rating for the three state-owned commercial banks, the Bank of China, the China Construction Bank and the Industrial and Commercial Bank of China, was raised from "BBB-" to "BBB+", and the short-term rating was raised from "A-3" to "A-2". The long-term rating outlook for these three banks is "stable". At the same time, for the Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Bank of Communications, the banks' financial strength has been raised from "D+" to "C". The reason for this adjustment is not due to any improvement in the banks' management or financial position, but because "the banks in China are state-owned and the government will not allow them to go under."

In sharp contrast to the "satisfying" days for China Construction Bank when it was listed in Hong Kong (it collected 62.2 billion Hong Kong dollars; approximately U.S. $8.02 billion), after the stocks of the Construction Bank were listed again, the market's reaction has been lukewarm. In the eyes of the senior officials of China's banking system who direct China's financial reform, as long as the Construction Bank gets listed, it signifies a staged success for the reform on state-owned commercial banks. However, due to the large amount of market capitalization obtained by Construction bank, the small stock market in Hong Kong is not capable of collecting such huge amounts of capital for other Chinese banks. Therefore, opening mainland China's financial sector and attracting foreign investment have become the only practical choice.

U.S. $13 Billion Foreign Investment Has Entered China, but China Still Needs US$220 Billion More

According to Chinese media reports, banks from various regions of the world, such as Asia, Europe and America have been busy laying their foundations in China. The investments from these foreign banks have one or more of the following three goals: 1. To hold a controlling percentage of stocks, so they can affect the running of the bank and have a seat on the board. The U.S. New Bridge Capital's Investment in the Shenzhen Development Bank is an example. 2. To have a controlling seat with speaking rights on the board. An example is HSBC Bank of the United Kingdom (UK), which spent U.S. $62.6 million to purchase 8 percent of the Bank of Shanghai's stock. They became the second largest shareholder only next to the Shanghai State-owned Asset Operations Co., Ltd. 3. To be involved in and control a certain kind of business in the day-to-day running of the bank. For instance, Citi-Bank became a shareholder of the Shanghai Pudong Development Bank. Furthermore, two banks signed a contract to establish an exclusive and strategic partnership

But all-in-all, the majority of foreign banks have only been laying foundations. Not many have been truly investing in Chinese banks. According to the latest statistics released by the China Banking Regulatory Commission, a total of eighteen foreign financial firms have become shareholders of sixteen Chinese banks, as of date. The overall investment is approaching U.S. $13 billion, less than the target of U.S. $18 billion set by the China Construction Bank for its fund raising activities on Wall Street. .

In addition, high-level Chinese officials have not reached an agreement on the issue of how Chinese banks bring in foreign investment. Liu Mingkang, chairman of the China Banking Regulatory Commission, stated that the upper limit for foreign investment into China's banks was no longer capped at 25 percent of the overall bank capital. Meanwhile, the vice chairman of the China Banking Regulatory Commission, Tang Shuangning, presented an arrogant image at the "2005 China Forum." He announced that "the major purpose of bringing in strategic investors is not to bring in capital, instead it is to bring in the advanced management experience and technology, to facilitate [the reform of] Chinese banks, to perfect their management structure and to improve their management." He also claimed that in the process of bringing in strategic investors, China should firmly hold on to its principles. The investors should be big financial firms and be highly experienced in the banking business. The following five standards must be adhered to strictly: 1. They must hold not less than five percent of the stocks. 2. They have to hold the stocks for more than three years. 3. Board members should live in China. 4. They cannot invest into more than two similar Chinese banks. 5. They should provide support in technology and the Internet area.

While the executives of Chinese banks are busy responding to the critics at home for selling their banks at low prices, foreign strategic investors also have to put out fires in their own backyard. The shareholders of the Royal Bank of Scotland, after finding out that the bank had reached an agreement to hold shares in a Chinese bank, loudly objected that the bank had invested too much capital with too much risk in exchange for stocks of a state-owned bank. They complained that the deal was too expensive.

The question remains, how much money can truly fill this gigantic hole in the Chinese financial system?

ABN Amro, a bank in Holland that has been looking for investment opportunities in China, estimated this number. The board vice-director, Cen Yongxian, who is in charge of the organization, once said to the "Global Financial Observer": ABN Amro has noticed that recently a few Chinese banks have been actively preparing for an IPO, but if all the Chinese banks are to reach the standard of a more than eight percent Core Capital Adequacy Ratio and an over 80 percent non-performance preparation level, the Chinese banking system still needs an additional U.S. $220 billion.

So far, foreign banks have only invested US$13 billion into various Chinese banks. In other words, China still needs to absorb over ten times the current investment to clean up this mess. Then this leads to one question:

Will there be that many foreign banks that are interested in China's state-owned banks?

He Qinglian is perhaps the most famous Chinese economic commentator. In August 1996 she completed a book on the social and economic ills of China after two decades of reform policies. It first appeared in Hong Kong in 1997 under the title China's Pitfall, and an edited version was published in Beijing as Modernization's Pitfall in January 1998, with a preface by Liu Ji, Vice-President of the Chinese Academy of Social Sciences, then an adviser to Jiang Zemin. The book was an immediate success, selling 200,000 legal copies and vastly more pirated ones. Her more recent writings have more blatantly found fault with the government, and have led to her exile to the United States.