The Scots go a-hunting

Aug 22nd 2005
From The Economist Global Agenda

Royal Bank of Scotland is leading a $3.1 billion investment to take a minority stake in Bank of China. The deal is risky given the parlous state of the country’s banking system. But the pitfalls may be exaggerated

ONCE again, China’s booming economy, personal savings of $1.5 trillion and ever-strengthening consumerism have proved tempting enough for another big bank to take the plunge. On Thursday August 18th, Royal Bank of Scotland (RBS) said that it would take the lead in an investment of $3.1 billion for a 10% stake in Bank of China (BoC), the country’s second-biggest lender. RBS will put up just over half the cash; America’s Merrill Lynch and Li Ka-Shing, one of Hong Kong’s wiliest and richest investors, will stump up the rest.

RBS’s foray into China comes on the heels of Bank of America’s announcement in June that it would pay $3 billion for a 9% stake in China Construction Bank (CCB), another of the country’s biggest lenders. And last year HSBC, a British bank with its roots in Hong Kong, paid $1.8 billion for 19.9% of Bank of Communications, China’s fifth-biggest bank. Further deals are likely: Germany's Deutsche Bank, for instance, is in talks to buy nearly 5% of Huaxia Bank, a publicly listed commercial lender, for some $110m. At present, no more than 25% of a Chinese bank may fall into foreign hands, and no single investor can own more than 20%. China’s government, while keen to attract foreign capital and expertise, is not yet ready to cede control of its banks to outsiders.

Some think that is no bad thing. Indeed, RBS’s shares had languished this year, falling by 8%, precisely because of concerns about its desire to expand in China. The small bounce in its share price immediately after the deal was announced reflected relief that it had not invested more. Earlier rumours had put RBS’s planned investment in BoC at up to $5 billion. That had investors worried because, for all China’s potential, its banks are in a bad state.

Chinese banks have never been shy of giving very cheap loans to foundering state-owned companies. They now claim that they have gone some way towards tackling the problem: official figures show that the proportion of non-performing loans on banks’ books fell to 13.2% at the end of 2004, compared with 18% the year before. (In March, after receiving tens of billions of dollars from the government to clean up its books, BoC said that its own bad-loan ratio was just 4.7%.) But China’s official statistics are notoriously dodgy. Standard and Poor’s, a rating agency, reckons that 35% of loans are unlikely to be repaid.

As the government tries to bring the bad-loan problem under control, China has embarked on a new credit boom. Consumers, buoyed by the country’s hyperactive economy—GDP growth hit 9.5% in 2004—have embraced credit cards, mortgages and car loans like never before. The fear is that when the economy finally slows down, defaults will increase, possibly leading investors like RBS and Bank of America to regret their earlier enthusiasm. In a report last week, the World Bank said it expects Chinese growth to slow to 8% next year.

Fraud is another ill that besets China’s banks. In March, Zhang Enzhao was removed from his post as chairman of CCB for allegedly taking bribes. Shortly beforehand, some 50 members of staff at the same bank were accused of embezzling over $85m. Earlier this year a BoC branch manager fled the country with up to $120m of the bank’s money. And this month a deputy chairman of BoC received a lengthy prison term for bribe-taking and embezzlement. Sentences have become much harsher recently, in an effort to deter wrongdoing as the end-2006 deadline approaches for China’s financial market to open fully to foreign competition under its commitments to the World Trade Organisation. But it is too early to say if bank fraud is on the wane.

Where else to spend it?

China’s banks doubtless hope that overseas investors will bring skills that can help them to tackle these problems. But some observers are sceptical that RBS has the right background to succeed in China. They point out that the bank, unlike HSBC, has little experience in Asia despite its aggressive international expansion in recent years.

Once a lowly British lender, RBS has built itself into Europe’s third-largest bank by market capitalisation. Bumper profits in its home market have fuelled its expansion, with RBS spending over $60 billion on assets worldwide in the past five years. In 2000 it took over and successfully absorbed NatWest, a rival British bank that was twice its size. And in 2004 it paid $10.5 billion for Charter One, then combined it with Citizens Bank, which RBS had bought in 1988, to form one of America’s top-ten banks.

In Europe, however, RBS’s quest for growth has hit obstacles. Britain’s banking market is already highly concentrated. In more fragmented markets, regulatory nationalism has stood in the way of cross-border deals. Witness the criticism lately heaped on Antonio Fazio, the governor of Italy’s central bank, for his efforts to block the purchase of Padua-based Antonveneta by ABN AMRO of the Netherlands.

In light of this, it is perhaps unsurprising that RBS is unwinding a European alliance to pay for its Chinese deal: it will sell its holding in Spain’s Santander Central Hispano for $1.6 billion. Hopes of a closer relationship with Santander were dashed after the Spanish bank bought Abbey, one of RBS’s main British rivals, in 2004.

So, with ever fewer opportunities closer to home, RBS may be right to discount the problems of China’s banking system in order to put down a marker in a country with such promise. And some observers think the risks of its Chinese investment are overstated. An initial public offering of BoC’s shares, set for 2006, could guarantee an early return on RBS’s investment.
Furthermore, China’s government is reliant on the banking system to keep the economy on track. Having already dipped into state coffers to prop up BoC and other banks, it is likely to do so again should balance-sheet woes threaten their future. But if the government does discover a black hole in BoC's accounts, it will surely ask RBS to contribute its share of any bail-out. That, after all, is why foreign investors are being courted in the first place.

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