September 1, 2005    Volume 12, No. 16

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Growing Number Of Chinese IPOs
Are Bypassing U.S. Equity Markets:
Does China Pose A Financial Opportunity Or Threat?


There is a surge of initial public offerings from Chinese companies, but a large number of them are not listing on the New York Stock Exchange or NASDAQ. Many of the biggest IPOs are headed to the Hong Kong and London capital markets due in large part to less stringent disclosure requirements and the desire to avoid class action lawsuits in the United States, according to testimony received by the United States - China Economic and Security Review Commission (USCC).

"The level of interest among foreign companies listing in the United States has changed dramatically in recent years," said Robert DeLaMater, a partner with Sullivan & Cromwell, which has worked on dozens of Chinese IPOs. The sharp decline in listings "has implications for the position of the United States as the world's principal capital market."

Through IPOs, Chinese companies raised $8 billion in 2003, $14 billion last year and a projected $17 billion this year. Last year, Chinese firms raised $12 billion in the Hong Kong exchange, up from $7.5 billion in 2003.

Chinese IPOs "are now the second largest source of fee revenue for the investment banking community," said Howard Chao, head of the Asian practice for the firm of O'Melveny & Myers LLP. Chinese IPOs "were more important last year than European IPOs, and the pace of Chinese IPOs coming out is accelerating."

Some of the financial experts testifying before the commission said U.S. investors also could be losers, due to high risks associated with the lack of transparency among the newly public companies that were recently government-owned enterprises.

The size of Chinese offerings is also growing. Air China raised $1 billion in an IPO split between London and Hong Kong. Shanghai Electric Company raised $700 million in Hong Kong. Henhau Energy raised almost $3 billion in Hong Kong. The Chinese Bank of Communications raised $1.9 billion, also in Hong Kong. China's Industrial and Commercial Bank is said to be seeking to raise as much as $10 billion, according to Michael Geczi, managing director of The Torrenzano Group. Given that company's ties to the Chinese government and its portfolio of non-performing loans, it's unlikely it would expose itself to regulators at the Securities and Exchange Commission by listing in the United States. There is a growing frenzy among international investors who are frothing over China's explosive growth rates. Shares issued by Chinese startup Baidu soared by 350 percent in the first day of trading on August 5, and have now fallen by more than 50 percent.

"The Sarbanes-Oxley Act has irritated foreign issuers most because it goes beyond what has historically been the purview of U.S. financial securities regulation," DeLaMater said. "Historically, U.S. federal regulation was directed at disclosure...but what many of the provisions of the Sarbanes-Oxley Act do is go beyond disclosure to require certain types of governance arrangements," including the appointment of independent directors, and specific types of relationships with outside auditors. "Those are things that many foreign companies found difficult to comply with," DeLaMater told the congressional U.S.-China Commission's hearing on "China's Strategies and Objectives in Global Capital Markets."

Some foreign companies are in the process of de-listing from U.S. markets due to the "onerous hurdles" of Sarbanes-Oxley, added Geczi. "This is not a situation of Chinese companies trying to avoid [regulation]. It's a situation of foreign companies that are already listed thinking that the New York Stock Exchange is no longer in their best interests."

It took only about a year for the U.S. to start losing out to Hong Kong and London. "To the extent the New York Stock Exchange and NASDAQ do not get their fair share of that business, that will diminish the competitiveness of our capital markets," added Howard Chao, partner in charge of the Asia practice at O'Melveny & Myers, who has been stationed in Shanghai for the past seven years. "There is something to be said about being concerned about that as one of our most important industries in the United States -- the financial industry."

In the past 18 months there have been about 120 Chinese companies that have sold stock in initial public offerings in global markets. The average size of deals is up sharply. China Netcom was the fifth largest IPO in 2004. The second best performing IPO last year was the Chinese company 51job Inc. China Life Insurance Co. was the largest IPO of 2003, raising $3.4 billion.

Commissioners said it looks like many of the Chinese state-owned companies raising capital are shopping the globe for the weakest disclosure standards so they can fill their coffers with additional resources to attack U.S. companies.

But there is much more to it than that, said the speakers at the day-long hearing. Most Chinese companies would love to list in the United States, and doing so is viewed as reaching the "major leagues," they noted. Listing on the Hong Kong exchange -- described as the AAA league -- is not necessarily easy, either, since it has detailed disclosure rules and requires companies to have multi-year track records of profitability.

In fact, most of the Chinese high-tech companies that are going public -- those without close ties to the Chinese government -- are doing so in the United States because NASDAQ does not require a company to show profits. Many of these Chinese tech firms also have tapped into U.S. venture capital, and are run by U.S.-trained executives. "They may be the Microsofts and Googles of the future for China," said Chao.

Those testifying agreed that many Chinese companies going public do not need the money, given that there is so much capital flowing into China. "Part of the reason for seeking the substantial investments from foreign financial institutions is to assist in the transition to a modern commercial [business] culture with risk management, checks and balances and proper documentation," says DeLaMater.

Chinese companies want to be accepted as part of the global marketplace. "They want to aspire to best practices," added Geczi. "They want to have Western advisors come in and help teach them and teach their people and learn because they know they have a long way to go on the learning curve."

Frank Gaffney, president of the Center for Security Policy and formerly Assistant Secretary of Defense for International Security, didn't see it that way. "The question before us today is what are the financial and strategic implications of such transactions? I think they are, in short, not good for the investors and not good for this country, especially since it appears that in doing such underwriting of these state-owned enterprises, we are likely to be underwriting such things as the manufacture of intercontinental range ballistic missiles, space-based and other weapons designed to blind our satellites, the proliferation of weapons of mass destruction, and suppression," he told the committee.

Solomon Tadesse, assistant professor of international finance at the Moore School of Business at the University of South Carolina, was equally skeptical of China's intentions when it comes to its state-owned enterprises, particularly its banks, raising money in the global equity markets. "The Chinese government owns about 99 percent of the 10 largest commercial banks in China," he said. The state-dominated financial system, which he described as "financially repressed," pays little in way of interest to the tens of millions of people who place their savings into accounts with the banks. That money is then directed into state-owned enterprises at interest rates well below the market rate, providing these companies with a direct subsidy.

This system "poses serious risks to the security and economic interests of other countries, particularly the U.S." said Tadesse. "In essence, China could be thought of as using financial repression as a strategic tool to build competitive advantage in its [industrial] sectors at the expense of others, including the U.S." He recommends that the U.S. government recognize this form of unfair subsidy and make it a "national foreign trade policy priority" to have it eliminated.

China's financial system remains frail and "primitive," added Donald Straszheim, president of Straszheim Global Advisors and formerly chief economist for Merrill Lynch. Its four major banks "aren't banks," he told the commission. "They're lending arms of the government. That has been their role. That is their role. They dominate about two-thirds of all commercial banking and they have an enormous lack of talent and technology."

These banks have little transparency, said Tadesse. They suffer from "pervasive corruption -- even by developing country standards" and have little legal oversight, given the fact that there are only 150,000 lawyers in the entire country.

The big Chinese banks, added Straszheim, have "no chance, no chance" to compete with global competitors like Citibank and Deutsche Bank starting Dec. 11, 2006, when the World Trade Organization has required the China banking system be open to international participation.

Others testifying before the commission said the large state-owned banks are undergoing an internal revolution, and that the bank reform process is in high gear. "The risk of a serious banking crisis in China today is much lower than it has been for a long time," said Pieter Bottelier, professor at Johns Hopkins School of Advanced International Studies. The quality of management of these banks has vastly improved. With China holding $700 billion in foreign reserves any crisis caused by $300 billion worth of non-performing loans can be addressed.

"China has no choice but to reform its banks," added Marshall Meyer, professor of management and sociology at the University of Pennsylvania's Wharton School of Business. "The alternative is nearly unimaginable. The reform of state-owned enterprises has been more rapid and more successful than most people predicted. As one senior banker puts it: 'This is a revolution.' "

A lot will change in China when the banking system is reformed. The Communist government has no option but to let capitalism run its course and provide it with an annual GDP growth rate of 8 to 9 percent. "The reform of the financial sector is the last straw" in China's shift to being a benign world power, said Tadesse. The IMF and World Bank have learned that in trying to force countries to reform their economy, the banking and financial sector is the last hurdle they're willing to jump.

"Basically, government comes to believe that the banking sector is an extension of their treasury and they don't easily give it up," said Tadesse. "So our last push in terms of pressuring China to open up and come to the arrangements we want would be to pressure it on financial reform. By that I mean privatization, change of ownership and competition, particularly foreign bank competition. The government's power basically is from the control it has on financial resources through the banking system. You take that away, then I think we'll be on the right track [politically]."

To view a transcript from the hearing, go to

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