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Smart Cookies?

By Ian Fraser

Sunday Herald

August 21st, 2005

Bank of China branch

It’s the silly season but RBS executives are certain their plunge into eastern markets makes good business sense

IT was a great leap forward for Fred Goodwin. Talks with the Bank of China had been tortuous and on and off since February 2004. But the 47-year-old Paisley-born chief executive of the Royal Bank of Scotland finally lived up to his bank’s slogan and “made it happen” last Thursday morning.

In spite of the concerns of some investors about the merits of such empire-building, which has caused RBS shares to sink 9% since mid-July, the bank last week splashed out $1.6 billion (£900 million) for control of a 10% stake in the Bank of China.

Most nervous RBS investors, fearful about its lack of experience in China, the riskiness and lack of transparency of the market, and the length of time it might take for the bank to make any return, heaved a sigh of relief at the way the deal was structured.

Goodwin says: “There were some pretty lurid rumours going around, so the City was naturally wary. Now we have come out and talked about the facts, and they [investors] think it is a good thing.”

Effectively RBS has gained control of a 10% stake in the 93-year-old Bank of China, even though it is buying only 5% of its equity. After some hard bargaining with Xiao Gang, the Bank of China’s chairman, RBS will also benefit from an unprecedented “safety net” should the deal turn sour.

Investors who had been expecting a much bigger commitment from RBS were relieved at the relatively modest nature of the deal, as well as by the fact that its partners in the consortium deal, Merrill Lynch and Hong Kong-based tycoon Li Ka-shing, are shouldering half the cost.

The fact RBS secured unspecified “warranties and protections” to shield investors in the event of the deal turning sour was also widely welcomed.

David Cumming, head of UK equities at Standard Life Investments, says: “We are comfortable with the logic of the deal which should enhance earnings. It doesn’t require too much capital and the growth opportunities are good.”

The upbeat mood was reflected in the 2.4% rebound in the bank’s share price the morning of the announcement, the biggest gain in 18 months. They climbed 38p to £16.45 in lunchtime trading in London, valuing the bank at £52bn. But by Friday night they closed at £16.43.

In a neat twist – which indicated the shift of the Edinburgh-based bank’s ambitions away from old Europe and towards emerging Asia – the deal was wholly funded through a sale of the bank’s residual stake in its erstwhile Spanish partner, Banco Santander, further allaying shareholder fears.

So this is a defining moment for the Royal Bank, which currently derives just 1% of its profits from Asia, and a major stepping stone in its quest to become a truly global force alongside the likes of HSBC and Citigroup.

It has followed some hard bargaining from Goodwin and, according to China experts it would have been impossible for RBS to have secured the deal without its top executives sharing significant amounts of food and alcohol with prospective partners and government officials in Beijing and Shanghai. “You cannot do such deals in China without building up connections – or “Guanxi”, says China veteran and Martin Currie director Chris Ruffle.

With 238,000 employees, Bank of China (BoC) is the People’s Republic’s second-largest bank and is concentrated in the massive cities of eastern China. Through its stake, RBS gains access to a network of 11,307 branches in mainland China, where BoC bank has a 12% share of loans and 14% of deposits. Founded in Shanghai in 1912, BoC is the oldest bank in the country and opened its first overseas branch in London in 1929. Today it has 560 overseas offices in 25 countries and regions – giving scope for further co-operation between the new partners in other Asian markets.

Goodwin last week said the two banks intend to focus on co-operating in areas like credit cards, wealth management and corporate banking, where the Bank of China currently lacks products and expertise.

“I don’t know exactly how that will work out, but it opens opportunities to us,” says Goodwin. “How and when we take these forward remains to be seen.”

An early push will come in the area of wealth management, where RBS already has a Coutts operation in Hong Kong and a quiver full of suitable products ready to roll-out to China’s millions of nouveaux riches.

Goodwin says: “That is an area we feel we’ll be able to get moving pretty quickly, again probably through joint ventures.” Senior executives from Coutts’ Hong Kong branch will be relocating soon to major Chinese cities.

A second big push will come in credit cards, where RBS has long experience of credit scoring, marketing and systems. BoC launched the Renminbi Great Wall credit card in 1986, but despite being the first such card in China, it has failed to make a significant impression on the market.

The tantalising prospect of 1.3 billion more consumers is what has got Western bankers such as Goodwin salivating at the opportunities in China.

“All our figures show that there is still huge potential to be tapped in most personal finance products,” says Glen Murphy, managing director of AC Nielsen China. “With more money in their pockets, consumers tend to spend more and invest more.”

He says China is transforming itself from a cash to a credit society and that the potential for cards will accelerate once the Beijing government relaxes banking regulations for foreign players in 2007.

Management consultants McKinsey & Co predict total revenues from interest income and merchant fees on plastic will increase by more than 50% annually to reach $5bn by 2013. And Merrill Lynch analyst John-Paul Crutchley points out it would be impossible for a Western bank to make any inroads in China without working alongside a local institution.

Goodwin says that RBS’s priority was a strategic partnership rather than the hope of a dramatic return on its BoC stake. “The equity investment is, if you like, a ticket to the game.”

He adds that the deal kicks off straight away, even though it awaits regulatory approval from UK and Chinese authorities. He also stresses that regulatory approval for any formal joint ventures between the two banks is not a prerequisite to them doing business together.

He says: “The announcement gives us material opportunity to develop in Asia in a controlled way. Today is a start and it’s a start we’re very excited about.

“We’ve talked about the technology transfer from us to Bank of China. But don’t overlook the knowledge transfers from Bank of China to us in terms of how to do business in China.”

Asked whether the relatively modest size of the financial commitment signalled a lack of confidence in the deal, Goodwin says: “We’re very confident about this investment. We have a finite appetite for holding minority equity investments in other banks.”

However, doing business in China has been fraught with dangers and buying into its banking system is seen by some as a very risky business indeed.

The legal and corporate governance backdrop is quite different in China, a neo-capitalist one-party state that remains firmly in the grip of a party that professes to be communist.

This state of affairs has given rise to a banking system that is widely described as “dysfunctional”. Many of China’s banks are technically insolvent and burdened with a history of bad loan crises requiring costly state bailouts. Bank of China itself benefited from a $22.5bn government bailout in December 2003.

Traditionally, the banks did not issue loans on the basis of a company’s health, but on a mix of centrally determined quotas and party allegiances. Borrowers, often poorly managed state-owned enterprises, tended to treat the money they received more as working capital than as loans which had to be repaid.

The idea of commercially-driven loans and tight reporting lines, prerequisites of successful banks in the West, only recently came onto the agenda.

Now the People’s Republic – which still owns all four of China’s largest banks – is determinedly seeking to spruce them up, and make them more presentable to investors, in advance of initial public offerings planned for later this year and 2006. Bank of China is itself planning a listing on the Hong Kong stock exchange in the first quarter of 2006.

The goal? To meet World Trade Organisation requirements that the country opens up its financial services markets by 2007. Understandably Beijing also wants to ensure its state-owned banking dinosaurs are not swiftly overtaken by fleeter-footed international players.

As part of the process China’s banks have been striving to improve their internal controls and clamp down on corruption. The proportion of non-performing loans on the state-owned banks’ books have been falling, largely through debt transfers to state-owned asset management corporations as well as massive infusions of public funds such as the $45bn pumped into BoC and China Construction Bank in late 2003.

The latest report from the China Banking Regulatory Commission said bad debts across the Chinese banking sector stood at 8.71% at the end of June 2005. The report said the non-performing loan ratio at the the Big Four state fell to 10.12% in the six-month period. However, there may be an element of smoke and mirrors to this. Independent experts believe 35% is a more accurate figure.

But the efforts to improve internal controls and balance sheets has also thrown up a series of scandals involving embezzlement and loans-for-favours. Earlier this month Liu Jinbao, former boss of BoC’s Hong Kong division was sentenced to death after being found guilty of corruption. The sentence was suspended for two years in a move that usually means it will be commuted to life imprisonment.

Dismissed by BoC in May 2003, Liu had been convicted of embezzling 14.3m yuan (£970,000) along with several others, plus another 7.5m yuan for himself. Liu was also convicted of taking 1.4m yuan in bribes.

Wang Xuebing, former president of China Construction Bank, was jailed for 12 years for corruption in 2003 for offences committed while he ran the Bank of China.

“There can only be two reasons for RBS to do this,” says Chris Ruffle, a Shanghai-based director of Martin Currie who manages the investment firm’s $1.5bn Greater China funds.

“It could be they want to show willing to the authorities in order to get to the front of the queue when it comes to getting a standalone licence once deregulation kicks in. Maybe the authorities quietly mentioned that, if they want to secure a licence after 2007, then they had better show willing by taking a minority stake in the Bank of China now.

“Anther reason could be they are simply having a bit of a punt – the current valuation of Bank of China is cheap enough and they may be hoping to “flip” it after the IPO.”

Ruffle, a Yorkshireman who has lived in China most of the time since 1983 adds: “But if RBS really believes they are entering a long-term strategic partnership, with a view to a full merger further down the road, they are deluding themselves and being hopelessly optimistic.

“I mean talk about the Augean Stables! It would swallow up so much management time and effort to turn the Bank of China around it would make your hair curl.

“I am a customer of the Bank of China in Shanghai and visit my branch regularly. The most extraordinary things go on there. For example the cheque book I have is only usable in Shanghai. And yet it’s supposed to be the Bank of China. The whole thing is pretty medieval.”

But Peter So, of Macquarie Securities, believes that in light of the recent corruption scandals and the limited control bank head offices appear to exert over their branch networks, investors should be “quite cautious” about the quality of assets of the banks that are trying to list.

There are also wider concerns that Chinese companies entering partnerships with Western firms often have a hidden agenda. This can involve learning their methods, and milking them for all their worth, before effectively stealing their intellectual property.

But Goodwin told the Sunday Herald: “We feel that we are dealing with a highly reputable partner here. I mean this is the eponymous bank, and it is a bank which is in the lead up to IPO so, I am not concerned that our partners would do that [attempt to steal our intellectual property].”

© 2005 SMG Sunday Newspapers Ltd

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