BANK OF CHINA GOING PUBLIC IN A VOLATILE MARKET

C O N F I D E N T I A L SECTION 01 OF 04 HONG KONG 002094

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM AND EB
TREASURY FOR DAS DOHNER/KOEPKE
USDOC FOR 4420
USDOC FOR DAS LEVINE AND ITA/MAC/AP/MCQUEEN
MANILA FOR ADB/USED AMBASSADOR SPELTZ
STATE PASS USTR
STATE PASS CEA FOR BLOCK
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN/LUNG; NEW YORK FRB FOR
DAGES/CLARK/MOSELEY
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN

E.O. 12958: DECL: 05/19/2031
TAGS: EFIN ECON HK CH
SUBJECT: BANK OF CHINA GOING PUBLIC IN A VOLATILE MARKET

REF: 05 HONG KONG 4858

Classified By: EP Chief Simon Schuchat; Reasons: 1.4 (b/d)


SUMMARY
--------------


1. (C) SUMMARY: In a financial history milestone for both
Hong Kong and the mainland, the Bank of China (BOC) is going
public. The USD 10 billion initial public offering (IPO) now
underway will almost certainly be the world's biggest this
year and the largest ever for Hong Kong. The high degree of
enthusiasm for the IPO -- carefully cultivated with sales of
strategic stakes to foreign investors and culminating now
with thousands of Hong Kongers lining up to get a piece of
the action -- appears immune to what is otherwise the
sharpest short-term downturn in recent memory for Hong Kong's
stock market. Last year, two of China's five largest banks,
China Construction Bank and Bank of Communications, went
public in Hong Kong, and another of China's large lenders,
the International Commercial Bank of China (ICBC),is
expected to list here shortly, perhaps this fall. The
listing process has served as a catalyst for all of these
banks to clean up balance sheets, upgrade internal controls,
and modernize operations, all while helping Hong Kong rise to
the position of the world's fourth-ranked capital raising
center. BOC will also issue stock in Shanghai, but the
number of shares in that market will be far less than what is
placed in Hong Kong. The motive for even selling shares at
all in Shanghai appears to be political, in the view of head
of Hong Kong's Securities and Futures Commission (SFC).
Although China appears to have found a successful formula for
selling state banking assets through strategic sales that
then give credibility to follow-on IPOs, there are critical
voices in this regard: some who suggest that foreigners will
be disappointed when the true scope of China's banking
problems emerges and others who believe the Chinese
government is selling off valuable and strategic assets at
unacceptably low prices. END SUMMARY

HUGE LISTING
--------------


2. (U) BOC's stock will start trading in Hong Kong on June

1. By that time, between 10.5 and 12 percent of the bank
will be in the public's hands, and in return BOC will have
raised USD 10-12 billion in what will be almost certainly be
the top IPO in the world this year, the biggest ever
conducted in Hong Kong, and perhaps the fourth largest in
global financial history. Although Hong Kong's stock market
has fallen by more than 6 percent since its recent May 8
peak, the success of BOC's IPO does not appear in question,
as is evidenced by the thousands of people lining up all over
Hong Kong to get a piece of the action. These investors are
motivated in part by the very high post-IPO returns enjoyed
by investors in two mainland banks that went public here last
year -- China Construction Bank (48 percent appreciation) and
Bank of Communications (81 percent appreciation).

A LONG TIME IN COMING
--------------


3. (U) BOC is China's oldest bank, dating to 1912, and has
historically played the role of the PRC's state-directed
international finance arm, holding a monopoly on foreign
exchange dealings and international banking from 1949 to

1994. Like China's other large state-run banks, BOC evolved
into a channel for funneling the public's savings into
inefficient state-owned enterprises, ultimately resulting in
very high non-performing loan (NPL) levels. The bank has
also been slow to develop internal credit risk assessment
capabilities and has suffered from a string of malfeasance
cases including the jailing of Wang Xuebing, its president
from 1994 to 2000, for taking bribes.


4. (U) China has in recent years injected significant funds
into cleaning up bank balance sheets with an eye towards

HONG KONG 00002094 002 OF 004


making its banks capable of competing when the domestic
retail banking market opens up at year-end, in accordance
with WTO membership commitments. In BOC's case, the Chinese
government supplied USD 22.5 billion of foreign reserves in
2003 to help it cover delinquent loans. Media reports that
BOC's NPL ratio declined from 22 percent in 2003 to 4.9
percent in 2005. (Note: Earlier this month, Ernst & Young
estimated that the Chinese financial system might have up to
USD 900 billion in bad bank loans compared with a recent
official estimate of USD 164 billion. Ernst & Young
retracted the report after it drew a sharp rebuke from the
Chinese government. End Note)


5. (SBU) In 2002, BOC's Hong Kong operations -- now a
subsidiary and separate entity known as BOCHK -- were
consolidated and the company was taken public. BOCHK, with
USD 22 billion in market capitalization, ranks third among
mainland enterprises incorporated and listed here ("Red
Chips"). The bank has had its share of transition pains,
malfeasance cases, and organizational reshuffles and now,
according to our contacts there, sees itself as a
multinational bank with a culture much more focused on
cultivating a reputation for international grade internal
controls.


6. (U) After the dust settled from the BOCHK launch, BOC
began selling single-digit strategic stakes of itself to
large foreign investors, with RBS, Temasek, UBS, the Li
Ka-shing Foundation, Merrill Lynch, and the Asian Development
Bank all buying in. This was an important step in generating
confidence in BOC's future in advance of the IPO. An
additional twelve corporate investors then made advance
commitments to buying actual portions of the IPO, laying the
groundwork for what is apparently going to be a very
successful listing.

SHANGHAI NEXT -- BUT IS IT POLITICAL?
--------------


7. (C) Because of the PRC's capital controls, mainland firms
that go public either come to Hong Kong to market themselves
to foreign investors and raise foreign exchange or go to
Shanghai/Shenzhen to tap domestic investors and get renminbi.
Hong Kong shares trade freely, are denominated in a
convertible currency, and are placed on the market in
accordance with strict listing standards, applied thoroughly
yet efficiently. Shanghai has over time demonstrated a less
rigorous and less efficient listing process, and the exchange
has faced difficulties because of corporate governance issues
and as a result of the overhang created by a high proportion
of government holdings in listed shares. Reforms now
underway, including efforts to address the government
holdings issue, have gained traction, and the exchange has
just recently signaled its willingness to host new listings.


8. (C) SFC Chairman Martin Wheatley told us on May 18 that
there is growing sensitivity among the mainland public about
the inability to access good investment opportunities
involving quality mainland companies, which often list only
in Hong Kong. He observed that after Hong Kong, BOC will
have a smaller listing in Shanghai. In the view of Wheatley
and one of his subordinates elaborating on the issue, listing
in Shanghai is a political necessity in the context of that
exchange's reform process rather than reflective of a need to
raise renminbi. BOC's Chairman Xiao Gang recently announced
that the combined listings in Hong Kong and Shanghai will
amount to 15 percent of shares, implying that the Shanghai
tranche will be 3 to 4.5 percent of BOC's ownership,
depending on whether high demand in Hong Kong triggers an
enlargement of the listing here from 10.5 to 12 percent,
considered likely.

NOT THE FIRST ONE
--------------


9. (C) The Bank of Communications (BoCom),China's fifth
largest bank, went public in June 2005 and was the first
Chinese domestic bank to list here, raising approximately USD

HONG KONG 00002094 003 OF 004


2 billion in a highly successful IPO. HSBC had purchased a
19.9 percent stake in the bank the previous year. China
Construction Bank (CCB),China's third largest bank by
assets, raised USD 9.2 billion in October 2005 by selling off
12 percent of itself in Hong Kong. CCB was the first of the
"big four" Chinese banks to go public. The strong reception
for the IPO was viewed by analysts here as a vote of
confidence not only in prospects for China's economy to
maintain feverish growth without a hard landing but also in
the ability of state-run Chinese banks to clean up their
balance sheets, reform their lending practices, and manage
themselves in a manner that will create value for foreign
investors. CCB's IPO was bolstered by strategic investments
already made in the bank by Bank of America (USD 3 billion,
9.9 percent stake) and Singapore's state-affiliated Temasek
Holdings (USD 2.4 billion, 5.1 percent stake).

WIN-WIN, WIN-LOSE, OR LOSE-LOSE?
--------------


10. (C) Taken together, the experiences of BOCHK, BoCom, CCB,
and BOC, suggest that the mainland has found a formula for
drawing foreign ownership into its large banks at a rewarding
price. But there are some observers who feel otherwise.
CLSA Managing Director Jim Walker recently told us that with
the exception of the HSBC-BoCom deal, all other strategic
stakes taken by foreign commercial banks are likely to turn
out disappointing, given internal management and loan quality
problems that have yet to become apparent. BOCHK Senior
China Economist Michael Dai commented to us that recent high
rates of lending by the big mainland banks lower their
apparent NPL rates and make them look more attractive to
investors -- yet these new loans are often in sectors like
property and construction where there is much risk ahead, so
a new batch of balance sheet problems may lie down the road.
(Note: Dai very explicitly said that he was unable to comment
specifically on the BOC IPO given his employment with a
subsidiary; his comment should be read as general in nature.
End Note) Others feel that valuable state assets are being
sold too cheaply to foreigners. After all, strategic stake
sales and IPOs are giving people outside the mainland a
chance to buy into a rapidly growing market of USD 4 trillion
of assets held by a population with fast-growing incomes and
which is increasingly interested in borrowing money and using
a broad array of banking services. Such skepticism about
under-pricing of assets in transactions with foreigners
emerged at the National People's Congress meeting in March.

HONG KONG AS A LISTING CENTER
--------------


11. (U) "Going public" for mainland firms in Hong Kong
involves issuing two kinds of shares here, both well known to
China-oriented investors: "H-shares" are stocks of
Chinese-incorporated firms that trade in Hong Kong, such as
PetroChina, China Life Insurance, and Air China; Red Chips
are stocks of Hong Kong-based corporations that are
substantially owned by entities affiliated with the Chinese
government, including Lenovo and China Mobile. BOC will be
an H-share; BOCHK is a Red Chip.


12. (U) The issuance of shares by Red Chip and H-share
companies has, since 1993, raised over USD 140 billion in
funds and created over USD 450 billion of market
capitalization, 40 percent of the Hong Kong stock market's
total, representing a range of key sectors. This in turn has
provided significant volumes of cash to refine or expand the
business operations of major Chinese corporations (whose
activities, depending on the firm, are both domestic and
foreign) by attracting portfolio investment from foreign
shareholders via Hong Kong. The Hong Kong stock market
ranked fourth in the world last year for equity fund-raising
(after New York, Toronto, and the Spanish Exchanges) and
eighth overall for market capitalization.

PLATEAU COMING?
--------------


HONG KONG 00002094 004 OF 004



13. (C) BOCHK's Dai said that once ICBC lists, the era of
large mainland IPOs in Hong Kong may start to wane. SFC's
Wheatley echoed Dai, adding that there is some tension and
heightened competition now between Hong Kong and Shanghai
because the latter is increasingly interested in attracting
blue chip firms. That said, Beijing wants to keep Hong Kong
a strong financial center to take advantage of the high
degree of confidence in the city's legal system and
reputation for relatively strong corporate governance.
Wheatley predicted that while there may be fewer blockbuster
IPOs coming down the pike, the Hong Kong exchange is unlikely
to look beyond Hong Kong and the mainland for a new source of
listings business any time in the near future.

Cunningham