VZCZCXRO0588
PP RUEHCN RUEHGH
DE RUEHHK #2094/01 1391039
ZNY CCCCC ZZH
P 191039Z MAY 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 6784
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

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