May 17th 2007From The Economist print edition
In Asia, banks have to try harder
“IN THIS part of the world relationship is everything,” says a seasoned British banker in Hong Kong. UBS, a Swiss bank, has learned that lesson too. In 2002 it helped the Chinese government with a landmark initial public offering for Bank of China in Hong Kong. At about the same time it worked with China to design a quota system allowing foreign banks limited rights to trade Chinese shares (and won the first quota). And it employs Leon Brittan, the former European Union commissioner who negotiated China's entry into the World Trade Organisation, to take tea with the country's leaders in Beijing.
These attentions paid off earlier this year when UBS won permission to take control of its joint-venture partner, Beijing Securities. If everything goes as planned, that will make it the only foreign bank besides Goldman Sachs to manage underwriting in the local market. Morgan Stanley has a 34% stake in China International Capital Corp, which was the top share underwriter last year, but it is a passive one. Other banks keen to establish joint ventures in China's brokerage industry will have to wait, because China has stopped issuing new licences.
Goldman, too, has practised the art of courtship. Hank Paulson, now America's treasury secretary, is said to have visited China at least 70 times when he was the firm's chief executive. There is a lot at stake. A senior UBS manager acknowledges that his firm could be called upon to help bail out other brokers if something went wrong. But both UBS and Goldman are undoubtedly delighted to be firmly ensconced in China as their rivals watch in envy. For China is arguably the most important prize as investment banks scramble back into Asia, putting the mishaps of the late 1990s behind them.
According to Freeman & Co, investment banking fees from Asia grew at 18% a year between 2001 and 2006, faster than in Europe and three times as fast as in America. Growth was strongest in India, rising by 47% a year from a low base, but the fee pool in China and its region was almost the size of Japan's, which has a much larger domestic market (see chart 9). Most firms predict that double-digit revenue growth will continue across the region in the next few years.
A strategy for Asia is more complex to design than for Europe or America. The financial systems across the region are at vastly different stages of maturity and there is a bewildering array of regulations, legal systems and compliance requirements. In Hong Kong and Singapore, for example, investment banks trade everything from foreign-exchange futures to credit derivatives and structured products. South Korea has become one of the world's biggest markets for warrants in the few years since it started trading in equity derivatives. India has a vibrant local stockmarket and sophisticated retail investors, but currency and other controls make it a frustrating place for international brokers.
China, as ever, blows hot and cold. Curiously, at present more investment-banking revenues come from Taiwan than from the mainland, though China's are growing faster, says Lehman Brothers. The value of the Chinese stockmarket tops $1 trillion, but after a huge run-up at the start of this year the market fell when officials sought to calm down overexcited retail investors. The regulatory environment in Beijing is hard to gauge and enforcement of securities law is haphazard. Bankers say local brokers have often misused clients' funds.
Watch it grow
But there are plenty of reasons for risk-takers to salivate over the region. Australia provides the second-largest source of fees in the region after Japan, according to Lehman Brothers. It is also replete with private-equity money (much of it on the rebound after a rebuff from China). Hong Kong and Singapore compete to attract hedge funds. Some banks have made fortunes from pouring private-equity-style capital into the region. Goldman earned $5.2 billion from a small stake in the Industrial and Commercial Bank of China, which issued a record-breaking $22 billion-worth of new shares last year; Merrill Lynch and the Royal Bank of Scotland tripled their money from investing in Bank of China. Liquidity is abundant because the region saves so much. Yet no bank has established a fully integrated investment-banking model in Asia, which means all comers have a chance to make their mark.
Merrill Lynch believes India may be the land of greatest opportunity in the near term, judging China more of an IPO prospect (the bank was lead bookrunner for the ICBC flotation, which paid it handsomely). Last year it paid $500m to raise its stake in DSP, a leading Indian broker, to 90%. Goldman and Morgan Stanley have abandoned their Indian joint ventures because regulations have eased, believing they can do better on their own there. Citigroup and UBS, among others, have successfully entered alone. All want to book a bigger share of investment-banking revenues that have risen tenfold since 2002. The spoils have not been divided evenly, however: local brokers have dropped down the league tables. None of them advised on Tata Steel's takeover last year of Corus, an Anglo-Dutch steel company.
China is likely to keep a careful eye on the experience of India's domestic brokers. As the head of a top global investment bank in China puts it, the authorities are prepared to see a securities market that is less than fully Chinese, “just not a predominantly foreign one”. They want to retain control to stop markets becoming too volatile and threatening domestic stability. A compliant domestic brokerage base is easier to steer than the thundering herd from Wall Street and Europe.
Many instruments still cannot be traded in China. Currency controls impede all manner of things that could be useful to Chinese firms. Hedging is extremely difficult. For banks such as Morgan Stanley, which has acquired a local licence by buying a small bank, each new product it hopes to sell requires a separate stamp of approval, which can take months. And because local banks still account for almost all domestic lending, there is no securitisation of bank loans.
Yet even with such constraints, there are plenty of ways for banks to make money in China. IPOs are the biggest, and even if the giant listings of recent years are close to exhausted, there are still mid-market firms needing to raise capital. China's vast corporate underbelly contains lots of growing companies that are not yet ready for public markets but are prepared to offer bold investors long-term stakes through private placements. Such issues are handled quietly, but a banker says hedge funds in Hong Kong are mopping them up.
Some bankers believe that the keenest foreign firms may have got a little ahead of themselves. “It's like kids going to the sweet shop for the first time,” says a long-time Hong Kong banker. Others are playing a waiting game. JPMorgan Chase, for example, appears to believe that at a weaker point in the economic cycle it will find opportunities to make a decisive move into China. Not all are wholly sympathetic to Mr Paulson who, in response to mounting congressional pressure against China's trade surplus, is urging the country to free up the capital markets. Some, such as Robert Morrice, chief executive of Barclays Capital in Asia, note a lack of reciprocity in the West in granting access to emerging-market banks.
Clearly there will be setbacks in Asia. Last year Merrill led the underwriting of a bond issue for a government-owned Thai bank launched hours before the military coup. After a debate about whether to exercise the bond's force majeure clause, the issue was repriced and relaunched.
Getting the risk management right is one of the reasons why banks like UBS prefer to have full control of operations in the region. But Peter Wuffli, the bank's chief executive, argues that diversification matters most and can improve stability over time. When regulators express concern about the bank's growing exposure to far-flung places, he has the perfect riposte. What business has lost UBS the most money in recent history? Not emerging markets, he says, but lending on property in Switzerland in the late 1980s.