The central command system of government is notorious for its bureaucracy, and getting through all the departments to obtain approvals in Beijing alone is like getting a UN declaration. There are three emerging bond markets each jealously guarded by its own regulator, for example. When the fiefdoms in Beijing do come to an agreement, instruction is handed down as to a schoolboy. In the words of one Shanghai-based banking lawyer at an international firm: “Beijing can’t just sit there telling Shanghai what to do, how it should raise its game. It has got to help out and show some ingenuity in changing fundamentally some of its guidelines if it wants to attract international finance. What Shanghai can do is make the place conducive to setting up all sorts of businesses that come on the tails of a financial city, as well as making it a pleasant place to live.” 

 

Becoming an international financial centre like Hong Kong, or even London or New York, is a major task. For starters, it is not certain that Beijing really wants it. But representing a complete financial capability that matches the newly-earned global clout of China’s economy and its currency is an even greater challenge. Especially with the central government and the large state-owned enterprises taking back more power over the economy from the private sector in recent years which – rather ironically – has been engineered largely through the capital markets themselves.

 

 

In less than a decade since its accession to the World Trade Organisation (WTO) forced the opening up of its financial markets, China’s banks have become the largest in the world, and the most substantial issuers of equity in the world. And they are at it again this year – paying for the sterling effort in sparking China’s economic recovery. The Shanghai Stock Exchange (SSE) is about to host a flurry of massive fund raising by Chinese banks to recapitalize their balance sheets after their prodigious lending spree last year – at just the time when investors, led in the overseas media by the foreteller of doom, Jim Chanos, and more recently George Soros, are worrying about a crash in property prices or even a crisis in the banking sector. 

 

Agricultural Bank of China (ABC), the last and weakest of the Big Four Chinese banks, is the most ambitious prospect. It summoned 21 investment banks in April to pitch for a public listing on the SSE in the next few months. Combined with an offshore listing, probably in Hong Kong, the initial public offering (IPO) could raise US$30 billion, which would make it the largest ever. China’s other already-listed state banks are coming to the market again too: in March they announced stellar profits for 2009 and then laid out their plans for record amounts of follow-up equity issuance in the course of 2010. 

 

If it all goes according to plan, the SSE will break all its records and dominate global, let alone Asian, equity issuance tables for 2010, especially after the cancellation of the proposed US$10 billion to US$20 billion IPO by American International Assurance (AIA) that was slated to be launched in Hong Kong round about now.  

 

There is more. The Shanghai bourse is planning to soon announce the rules for its international board, with several of the world’s top banks and conglomerates vying for the privilege of being the first foreign issuer on the exchange. All this fund raising comes at a time when the Shanghai stock index has fallen this year – following a storming 80% recovery in 2009 from a similarly-sized slump in 2008. 

 

With 85% of trading on the SSE carried out by retail investors, according to Boston Consulting Group, volatility is never far away. Not surprisingly, a fair proportion prefers to invest in property: real estate prices have risen consistently over the last year despite the efforts of the government to dampen excessive speculation. But now the worries are that the banks loan books will suffer serious damage.

 

Could it come from their lending to local governments, or the lending to developers? Either or both: local governments want to build because they need to sell land to raise money; developers want to do the building; they both want loans from the bank, which in turn is happy to help out when it perceives encouragement from above. The increasingly gloomy sentiment doesn’t present a positive backdrop for the issuance of so many China bank shares in the next few months, which further undermines their capital strength. 

 

The connections between real estate, the banking sector and the stock exchange are thick – China’s financial sector almost in its entirety. 

 

Zhu Min, deputy governor at the People’s Bank of China, insists the fears about property lending are overblown, and that Chinese banks shares are undervalued. So much money has gone into property because the stockmarket has declined by 70% between 2007-2009, compared to its overall rise of 500% between 2003-2007. It is money that people can afford, he says: similarly the infrastructure spending in the coastal regions. In the middle and western regions it is the central government that spends on infrastructure, and we all know how vast its balance sheet is.

 

 

Analysts are not worried either about a financial crisis in China, but they do expect to see a major shake-up in the landscape of the financial sector – which might be no bad thing.

 

“A key point for us is that we do not think Beijing would – with rare exceptions to make a political point in corruption cases – allow local governments to default on bank loans for public infrastructure,” says Andy Rothman, economist at CLSA in Shanghai in March. “Remember that this is all one big Party. The Chinese Communist Party controls all of the nation’s banks, and all of the local governments. So any financial problems hurt the Party, which then has to decide which part of its balance sheet takes the hit.” He adds: “This is a significant long-term structural problem, but not a near-term threat to China’s banking system or fiscal health.”

 

Indeed the pressure could lead to financial reform, analysts believe, possibly in the development of a market in municipal bonds to give local authorities an alternative form of financing; similarly distressed loans could be worked out through securitization; farmers could be allowed to sell their land, encouraging the boost in consumption further into the countryside; selling bonds to foreign investors could help spread the internationalization of the renminbi. That is certainly a plus for Shanghai if it wants to call itself an international financial centre.

 

With the massive debt of local government entities, which could reach 12 trillion renminbi by the end of 2010, “some form of central government involvement would be required,” says Vincent Chan, equity analyst at Credit Suisse, “that will be shared between the central government, local governments and banks.” But the property lending may potentially be shakier, he thinks. “Property speculation had been condemned not only by the government, but by the increasingly vocal masses as well. Also, this involves more diverse groups of participants – local governments, property developers and speculators – over which the central government has much less influence in the course of events once the bubble bursts.”

 

That will be particularly apparent in Shanghai, where property prices for young professionals are already prohibitively high for a lot and where it is obvious that the too-little-too-late efforts of the central authorities are failing to dampen the speculative market. A good many people in Shanghai are ready to blame Beijing if the situation spirals out of control; a collapse ironically might be Shanghai’s best hope to dent the creeping centralization of financial power and reignite the trend towards the internationalization and disintermediation of the renminbi capital markets.

 

 

For a fair proportion of investors, Shanghai’s first experience of the internationality of China’s financial system was the qualified domestic institutional investors (QDII) scheme which, introduced in 2006, lost people most of their money, often in Western bank shares, as the financial crisis kicked off in late-2007. 

 

UBS was not only the Shanghai market leader in selling to QDII; as the Swiss bank with the strongest wealth management franchise in Asia, it was also the greatest casualty itself, and it was in its seemingly invincible shares that most of its clients invested. GIC, Singapore’s state investment fund, recorded its greatest loss on UBS, which, along with Goldman Sachs was one of the first investment banks allowed to underwrite domestic securities. As well as that, GIC inspired China’s own wealth fund, China Investment Corporation (CIC), to buy Western financials when it started in 2007. A bad move. 

 

With an allocated US$300 billion of the country’s reserves to play with, its first two investments were in Blackstone Group, the world’s leading private equity fund, and Morgan Stanley. The latter’s share price plunge in 2008 was a humiliation for CIC, although both share prices – and face for CIC – recovered in 2009. Still it was a nasty shock for CIC, which is now looking at almost everything on the planet with the possible exception of Western financial institutions.

 

Morgan Stanley’s joint venture with CICC, the leading domestic investment bank, was no success story either; its stake is being sold to major private equity firms, KKR and TPG, after the two parties clashed on management issues not long after the pioneering agreement was signed back in 1995. Morgan Stanley went from marching into China with the superior proselytising air of an American investment bank of the time, to coming within a whisker of going down with the last pieces of the US financial system in 2008 – China has had a lot to observe in the ways of international finance. The finest of European and American investment banking have not really performed for Chinese investors – becoming in the process substantially state-owned and seemingly devoid of ethical or social obligations (or at least, they haven’t been sentenced to be executed yet, unlike a former vice-chairman of CSRC and China Development Bank).

 

 

Banks still keep trying to get into China despite the restrictions, though. Beijing has promised to let international companies list on the Shanghai stock market via an international board. The regulatory framework for this is still being ironed out, but the way the plan is implemented carries enormous (symbolically at least) importance as a pointer to what the Chinese authorities are really looking for in internationalization. Three of the leading competitors to be the first company to go public in China are HSBC, a US stock exchange, and Wal-Mart.

 

But it is the banks that are keenest: Standard Chartered and Bank of East Asia are vying to list first but HSBC has long wished to return to one of the cities of its origin; it wants to become the first company on the international board and issuer in the domestic bond market. It has also been discussing a joint venture with a brokerage house – like every investment bank has for years – to tap into the lucrative underwriting of debt and equity issues. But HSBC too has let down investors: its investment in Household Inter­national lost retail investors huge sums and the bank was fortunate to retain the loyalty of Hong Kong investors for its rights issue last year. 

 

When HSBC bought Midland Bank and de-listed from Hong Kong in 1991, most British shareholders in Midland demanded assurances that the bank would not be liable for indirect investments in communist China that could lose them millions. Google ‘HSBC’ and ‘international board’, and meet the unfriendly netizens: one suggests that Shanghai should not accept the deceitful HSBC that still has a lot of subprime exposure which might entail Beijing or Hong Kong having to bail it out.

 

In contrast, Western banks have done well in their China investments. Some that had only just made large cornerstone investments in the Chinese bank IPOs watched them soar in value, which – to compound the injustice in the view of many in China – most of them sold off at the first opportunity as their most profitable, available asset.

 

 

Can Shanghai achieve the goal of being a hub for international finance? Two years ago you would have said that Shanghai didn’t have a hope, especially with the restrictions placed upon any attempted liberalization of the markets. But after the US and European credit crisis, the fallibility of financial markets is plain to see and the planned economy folks are looking pretty comfortable at global financial bashes. 

 

One thing we can be sure of: Shanghai will not soon do a New York – co-opting and compromising Wash-ington DC. Or a City of London – thinking itself bigger than not just London but the whole UK economy. Nor even a Hong Kong, a cocoon of laissez-faire finance that has more or less run itself and whose banks have never been regulated by the UK Treasury or Beijing, and where the role of the regulator, central bank, mortgage lender, note issuing commercial bank has never been clearly defined, a bit like the British constitution within the People’s Republic of China.

 

There are no such shades of grey in the relationship between Shanghai and Beijing about who is the boss. The State Council decision, coming at the end of the annual National People’s Consul­tative Conference (NPCC) in March 2009, urged Shanghai to improve cooperation with other major cities in the Yangtze River Delta areas and strengthen strategic cooperation with Hong Kong. Quite. The latter suggestion concealed the intrinsic importance of the latest Communist Party of China financial super-plan: Hong Kong’s unparalleled status as China’s financing outlet to the world is under threat.

 

The Hong Kong authorities, and many bankers in its Central business district too, have been slow to act or even recognize the prize of their status as an international financing centre for China fading away. Remember China’s “through train” of 2007? The trial programme, that allowed an investor with a Bank of China account in Tianjin to buy Hong Kong stocks, was meant to help rein in all the excess cash sloshing around China’s bubbling economy, and was widely interpreted as a long-awaited sign that Beijing was moving to open the capital account. The Hang Seng Index soared 55% to a record high in the three months after the preliminary proposal was announced. But as each month went by, the momentum got lost within the turf wars up north – crucially because of the opposition of the State Administration of Foreign Exchange (SAFE) – before being put out of its misery by Premier Wen Jiabao, who warned that too much money pouring in too soon would destabilize Hong Kong’s market. 

 

That was the end of Tianjin’s attempt to become a financial centre blown as well. It disappeared along with its mayor, Dai Xianglong, a former central bank governor who was re-posted to head up the National Social Security Fund of China, the national pensions fund. It has just become the only cornerstone investor in the ABC IPO – the first from a bank that has not called upon a foreign strategic shareholder. 

 

To add to the overlap in reporting lines, the central authorities allowed Beijing city itself to start building a posh financial area in the central-western part of town around a main road named Financial Street.

 

“Over the last few years, we have seen different cities coming into the limelight when particular mayors or officials push for things to happen, but many such efforts had not been sustained when there is a change in officials,” says Maurice Hoo, attorney at law (California) at Paul, Hastings, Janofsky & Walker. He cites two factors affecting success: “Firstly, the ability of that city government to convince the central government to allow certain ‘experiments’ to occur there first, and to convince the central government it can do so without disturbing stability. Secondly the depth of bench strength of financial, legal, accounting and other professionals in that city to facilitate development of an industry which is, in my view, necessary for experiments to occur without chaos or crisis.” 

 

 

Gone are the days when the PRC representatives got excited about pulling off an offshore bond issue: these days the only bond issues bond bankers outside China see are private sector property companies or commodities outfits in borrowings, however structured with covenants and triggers in high-yield terminology that they don’t really have to pay back. Or they go offshore because there is a liquidity squeeze in mainland China. 

 

“The Chinese don’t want their industry to be dominated by Blackstone or Morgan Stanley, and they certainly don’t need the capital, but they want major players who can help them gain the institutional know-how to do it on their own,” says one private equity banker in Shanghai.

 

Beijing has given Shanghai special privileges in luring private equity players to the city to boost its international ambitions: they have just been allowed to set up renminbi funds, and already they are joining up with well-connected Chinese groups, including Blackstone with Shanghai’s Pudong government. 

 

But private equity outfits prefer to be based around Beijing. Forget the greater potential pool of fast growth companies to be found near Shanghai: they want to be nearer the China Securities Regulatory Commission, and also the state funds that dispense most of the investment money. “China’s central government has become the most significant large new source of PE capital,” says Peter Fuhrman chief executive officer at China First Capital in Shanghai. “Second, the locus of IPO activity is also shifting from international stockmarkets, principally Hong Kong and New York, to China’s domestic exchanges. This has elevated the importance of the Beijing-based Chinese Securities Regu­latory Commission (CSRC).”

 

“Staging an IPO in China is a complex, time-consuming and not terribly transparent process,” continues Fuhrman. “The CSRC is at the apex of this bureaucratic pyramid...[with] the final say on which companies can IPO and when. For a PE firm, building good relations with the CSRC is almost as important as choosing good companies to invest in.” Beijing firms are usually best at working these and other levers of Chinese power, he concludes. “This skill trumps any advantage Shanghai may have as China’s official “financial capital”.

 

 

So in the end Beijing can’t boss everybody around, always. And it may find it easier not to – to let the participants in the market make and meet their own valuations. Just holding all China’s foreign reserves in Beijing and having most of its banks incorporated in the capital is making it hard enough for Shanghai as it is. Providing world-class channels to facilitate savings and investment within the Middle Kingdom is an onerous enough task, but integrating an economy (however vast and liquid) with a still-closed capital account and non-convertible renminbi completely into the international financial markets is nigh on impossible. It would be a juggling act supreme if it was accomplished. But perhaps China doesn’t need Shanghai to be an international financial centre as we know it – one that is dependent on a credit-enhanced single currency. 

 

China could grow large enough to have a self-sufficient economy that only needs to use the renminbi, just like the US did with the dollar once the railways had created a united national economy in the late-19th century. But the US taxation of offshore dollars in the 1960s let London in to create the Eurobond market. China could do all its financing onshore and use Hong Kong perhaps as a sort of offshore haven for trading securities with other parties requiring legal work not related to the People’s Republic.

 

Hong Kong has all the advantages over Shanghai, as it has a stronger legal system, is already integrated in the international market and has a fully-convertible currency, as well as much more banking and other financial services expertise, in addition to – important right now for international bankers – lower taxes. 

 

Shanghai has the contacts with government and the corporate clients. Shanghai could represent China Inc in the international financial markets, with Hong Kong operating more as a trading exchange with the world.

 

Few think Beijing will ever give up control of the means of exchange if it is still the People’s Republic. If that has changed then Shanghai will surely have succeeded in becoming an international financial centre. But that might mean China owning the world. Maybe it would be preferable for all to accept a stand-off between the international currency and renminbi –  the same dream, different beds – because there may be more important issues to deal with.

 

“We all know that years of growth will have to slow, but the rate of deceleration will hinge on how well policymakers resolve existing economic distortions to improve the efficiency of Chinese investments, and combat recurrent risks of asset bubbles, industrial overcapacity, etc,” notes Kim Eng Tan, Standard & Poor’s credit analyst. 

 

“China’s economy is rapidly growing in size and complexity. Policy­makers are likely to find it increasingly difficult to make the right decisions on a timely manner for the economy,” he says. “At some point in the next ten years, their preference for directly managing the economy may be a binding constraint on further economic development. Without a significant increase in reliance on indirect market-based policy tools, the economic growth rate could fall sharply from the current lofty levels.”