You can look, but you can’t touch.
Despite China’s recent financial liberalisation, that description continues to sum up the situation for foreign investment banks seeking to enter the country’s secondary capital markets.
Eager to get a foothold in the finances of the world’s second-largest economy, almost all major international brokerages and banks are rushing to pair up with local Chinese brokerages to form securities joint ventures (JVs).
Last month it was the turn of Morgan Stanley (which teamed up with Huaxin Securities), Citi (which tied the knot with China Orient), and Royal Bank of Scotland (RBS) (it joined hands with Guolian Securities).
US bank J.P. Morgan was on June 28 also given the go-ahead to establish its mainland China securities JV with First Capital Securities.
These institutions follow several others with existing Chinese JVs, including Goldman Sachs, UBS and Deutsche.
The temptation for the new entrants is the same as for their predecessors: access to Chinese companies in their home market.
Yet the end results of these JVs have so far proven modest. Market shares in primary markets are small, and the JV contributions to the bottom line of international banks is miniscule, with little prospect of imminent improvement.
It will take years for these banks to build a meaningful presence in the world’s most populous nation. In the meantime, most JVs look likely to cost them more than they offer.
Meanwhile, their local partners will be drinking in world-class financial market knowledge, understanding, and technology – to the point that the international banks could risk making themselves redundant.
For all the breathless fervour with which investment banks are announcing approved tie-ups, it’s unlikely that all will succeed.
A joint-venture journey
So far eight foreign banks have formed securities JVs in China: Credit Suisse, Deutsche Bank, Goldman Sachs, UBS, Morgan Stanley, Citi, RBS, and J.P. Morgan.
In addition, Bank of America-Merrill Lynch, Barclays Capital, HSBC, and Nomura are reportedly seeking Chinese partners.
It’s easy to understand why these investment banks are so eager to move into China, particularly when the economic growth of most developed countries is slow or has stalled.
China has, of late, dominated the global initial public offer (IPO) market, accounting for about 27% of global volumes last year. Its bond market is also expanding fast, with outstanding volumes rising threefold since 2008 to US$449 billion in 2010, according to data from Thomson Reuters. That growth could accelerate as the government seeks to expand its bond markets to make up for tighter bank lending at home.
Economists at Goldman Sachs believe that China’s stock-market capitalisation will rise to US$41 trillion by 2030 from US$5 trillion now, making it comfortably the world’s biggest. Over that period, the US’s market cap is expected to grow from US$14 trillion to US$34 trillion.
It’s not all good news. China’s stock market has performed poorly of late, with the Shanghai Composite Index falling 13% over the past two months after declining for almost a year.
But there are signs of stronger times ahead. China’s inflation rate, responsible for much of the market uncertainty, looks likely to even out in the latter half. And the Shanghai Stock Exchange is preparing to launch its long-awaited international board. Once it does, several Hong Kong-listed red chips and international companies want to list in the city.
Add to that the rising interest of Chinese companies in doing business offshore and it’s easy to see the appeal of having a shop on the mainland.
But not all China JVs are created equal.
While all securities JVs can underwrite local-currency A-share listings in China, early entrants Goldman Sachs and UBS are the only global banks to have been awarded full-service JVs.
Goldman Sachs established its Beijing-based JV Goldman Sachs Gaohua Securities in 2004, whereas Swiss bank UBS set up in 2007, creating a JV from the restructuring of Beijing Securities, in which it owns a 20% stake.
But by the time Deutsche and Credit Suisse received approval in 2009, Beijing’s terms were less liberal. The two JVs were only permitted to do debt and equity underwriting and M&A advisory, not participate in areas such as trading and brokerage (believed to be where Goldman makes its big bucks) or private banking.
The same goes for other recently approved JVs, such as those of J.P. Morgan and RBS. For the next five years, they will only be able to underwrite but not trade securities.
“The capital markets are becoming more and more market-driven, and IPOs require distribution. The separation between primary and secondary markets cannot be sustained,” says David Chin, UBS’s head of investment banking for Asia.
Additionally all the recent Sino-foreign JVs are subject to a mandatory ownership cap of 33%. This stands in contrast to UBS, which only has a minority stake in its JV but managed to secure full management control in addition to its primary and secondary licences.
Even the success of the most promising two JVs of UBS and Goldman Sachs is relative. Seven and four years respectively after being established, both continue to lag their homegrown Chinese rivals such as CICC and Citic, or the investment banking arms of domestic banks such as Bank of China and Industrial & Commercial Bank of China (ICBC).
“Most of these investment banks’ operations in China are not very prominent because they are late-comers in a tightly controlled market; it will take years for them to grow,” says Alex Lee, a banking analyst at DBS Vickers.
Beijing seems intent on hobbling the onshore capabilities of international banks to keep them from dominating the local capital markets. And so far it’s working.
Studying the statistics
A quick look at the onshore China primary equity capital markets (ECM) and debt capital markets (DCM) capabilities of these JVs underlines this point.
UBS was the strongest bookrunner of A shares among all Sino-foreign securities JVs in 2010, according to data provider Dealogic. Yet the eight deals it completed, worth a combined US$4.24 billion, left it only ninth in the overall bookrunner rankings.
Goldman Sachs and Deutsche Bank ranked at 23rd and 24th respectively.
In contrast market leader Citic Securities enjoyed a market share of 12.1% and was the bookrunner for US$12.67 billion from 17 deals. Other chart-topping Chinese local brokerages included Bank of China, Guosen, Guotai Junan and Haitong Securities.
In domestic DCM, UBS was once again the highest of the financial JVs, ranking 14th in China’s local-currency domestic bond bookrunner league table. The Swiss bank lost out to local banks such as Bank of China, Agricultural Bank of China and ICBC. Goldman Sachs, Deutsche Bank and Credit Suisse were ranked at 20th, 27th and 29th respectively.
But UBS is ambitious. It aims to steal the top spot in both equity and debt bookrunner league tables from domestic rivals in two years.
“We are not benchmarking ourselves against the likes of Morgan Stanley, J.P. Morgan or Goldman Sachs. We are benchmarking ourselves against Citic and CICC,” says Chin.
International bank JVs are not only frustrated by limited business licences; cultural issues can also play a role.
On paper, both parties look complementary. Foreign banks usually have a pool of experienced talent, a global footprint and international deal-making supremacy, whereas their budding Chinese counterparts enjoy local knowledge, connections and branch networks.
But foreign banks also tend to hold western values that can contradict Chinese beliefs. For example, western lenders are accustomed to appraisal systems that reward staff based on performance while their Chinese partners are often rewarded according to seniority or length of service.
“Although many Chinese workers are gradually adopting the western practices, they do still find the foreigners being too blunt sometimes,” says Edmond So, a general manager at Besteam Personnel Consultancy.
“When it comes to evaluating staff, foreigners tend to be more direct and critical; they might not understand the sensitivities in pointing out a co-worker’s shortcomings, and they could offend Chinese colleagues by causing them to lose face.”
Western bankers also like to call the shots in the board room because of their international experience. However they frequently cannot, due to their status as minority shareholders.
“Being in a partnership means you cannot do it on your own, therefore you need to listen to those people who know the unique way of doing business in their own country,” says a retired Chinese banker who worked in a Sino-foreign JV.
Local partners may offer unique market insight and contact, but their staff also tends to have different standards and goals. Getting everybody on message can be a long and tiresome process, particularly without management control. “You don’t press a button and have everything start at once; it takes time and training to get local staff in line,” notes the head of investment banking at a major international bank with an onshore JV.
In addition, the very nature of limited JVs means that the business priorities of the two participants can clash. While the local partner might want to arrange a local A-share listing, for example, the international bank might well press for an H-share listing in Hong Kong, as that enables them to trade the shares too.
“These shops cannot offer agnostic advice, because they can’t offer everything. Added to that you have fee issues, where international banks probably don’t want to equally reimburse local securities companies when their clients decide to do offshore business,” says the investment banking head. “It’s hard enough getting everyone to pull in the same direction in a business you’re in control of, let alone when you put fee differences into the mix.”
The challenges of coordinating a securities JV with a local partner have already proven too much for some. Morgan Stanley famously set up CICC in 1995, effectively the first securities JV, yet it fell to a backseat role and eventually pulled out of the venture last year (see box).
Equally, BNP Paribas decided to shutter its JV with Changjiang Securities in 2007 due to irresolvable management disagreements.
Yet for all these challenges, many international banks evidently believe that the restrictions – and the growing cost of decent staff – is worth it.
“The partnership might be flimsy, but the whole point [for these foreign banks] is to go there, to be in the middle of the action and learn about what’s happening in China,” says a Beijing-based business consultant. “More importantly, these banks want to cultivate ‘guanxi’.”
The Mandarin word guanxi literally means relationships, referring to a network of connections arising from party, family and work that may go back several generations.
The local brokers already have it, but the foreign ones will need to spend years acquiring it if they are to build their business streams from China.
“Homegrown Chinese brokerages enjoy good relationships with different company executives, regulators or government officials, so they will be able to smell out a company’s upcoming fund-raising plan or any policy changes; that will give them first-mover advantage,” says the consultant.
“Obviously, the foreign bankers want to close the gap, so they are relying on the Chinese partners to make introductions.”
Global banks certainly seem convinced that forging relationships in China is worth any friction with local partners and the initially limited money-making opportunities.
“This is just the first step. We’d like to grow [our JV] as far as we can under the existing framework. If, and whenever, regulation changes, we’ll review our options – one of these would obviously be to take a larger stake in the business,” UBS’s Chin says.
Chin declined to comment on how profitable UBS’s JV is now but he emphasises that the Swiss bank intends to invest in and grow the business.
His enthusiasm is understandable, particularly given UBS’s relatively unfettered onshore business. But for others the allure of a local partner could prove less tangible.
By teaming up with Chinese partners, western investment banks have to train Chinese personnel, import advanced technologies, and bring in western practices. They are also helping to link Chinese companies raising funds offshore since the Chinese counterparts have not yet built up their international distribution networks.
That’s great news for the local brokers, who gain technology, skills and international contacts. And they stand to keep on getting it – potentially until the point where they feel that their foreign partners are unnecessary.
“That risk [of being sidelined by local partner] always exists, particularly for those who have a strong Chinese party that ultimately may think they do not need, or do not see the value of, their foreign partner,” admits Chin.
Anybody who considers that unlikely need only look at what happened between CICC and Morgan Stanley. Additionally CICC’s local rival Citic Securities is spreading its wings internationally, having just agreed to purchase a 19.9% stake in Hong Kong-based broker CLSA and French sister company Cheuvreux on June.
Many of China’s local securities companies want to grow, and eventually go offshore. For now they need international players to help them. But in a few years they might not feel quite so reliant.
Meanwhile, most international partners cannot conduct onshore trading, limiting their investment banking capabilities, and there’s no sign of liberalisation soon. Their punt on developing better business relationships looks set to be long and costly.
Some knowledgeable rivals are cynical about the prospects of securities JVs.
“The foreign JVs are very limited which means that their focus is different to that of their partner and they cannot take full advantage of the relationships they have,” says a senior manager at a local Chinese securities company. “With the possible exception of UBS I don’t think any of these securities JVs will work out unless they’re allowed into more of the local market.”
For all the understandable enthusiasm with which international banks align themselves with Chinese partners, profitability is the ultimate objective. Some will no doubt achieve it. Yet it will elude others, especially if they remain mere spectators to the mainland’s secondary capital market activity.
Some of today’s eager entrants may yet end up reweighing the costs of these onshore ventures.