By Luo Jun and Michele Batchelor
Bloomberg

HONG KONG—Chris Ruffle, a Shanghai-based fund manager, won’t buy Bank of China shares when the nation’s No. 2 lender goes public this month. As a Bank of China customer, he’s all too familiar with the bank’s failings.
       “I have my Bank of China checkbook in Shanghai, but it’s useless everywhere else,” says Ruffle, 47, who oversees about $1.8 billion of Chinese stocks at Martin Currie Investment Management Ltd. “Banks are the weakest part of the Chinese economic system, so buying into them doesn’t make sense to me.”
       Bank of China plans to raise $9.9 billion in the world’s biggest initial share sale since 2000, with the stock scheduled to begin trading June 1 in Hong Kong. Ruffle says he won’t invest, even though international companies such as Royal Bank of Scotland Group Plc, Merrill Lynch & Co. and Temasek Holdings Pte have bought stakes in the bank.
       Investor concerns about $13 billion of bad loans, repeated fraud investigations and antiquated computer systems are a reminder that China’s 10-percent economic growth masks fundamental weaknesses left by decades of state control over companies and markets.
       China’s banks have yet to overcome a legacy of unchecked lending to state companies and lax internal controls, even as they court international investors. The four biggest state-owned lenders still don’t adjust loan rates based on borrowers’ credit risk, the International Monetary Fund said in March. They remain burdened with a combined $137 billion of bad loans, according to government figures.
       Royal Bank of Scotland chief executive Fred Goodwin says potential growth in China’s banking market outweighs those risks. Britain’s second-biggest lender joined with Merrill Lynch, the No. 2 US securities firm, and the Li Ka-shing Foundation to buy 10 percent of Bank of China for $3.1 billion in July.
       “We believe Bank of China will grow and develop at quite a pace as part of the wider reforms that are taking place in the financial sector in China,” Goodwin said in a November interview.
       UBS AG, Europe’s largest bank by assets, and Temasek, the Singapore government’s investment arm, together own 6.6 percent of Bank of China. Twelve corporate investors, including Li’s Hutchison Whampoa Ltd. and Tokyo-based Mitsubishi UFJ Financial Group Inc., will buy $2.26 billion of shares in the IPO, according to a sale document released May 11.

New competition
China’s state banks face unprecedented competition as the government prepares to fully open the retail banking market in December, letting overseas lenders such as Citigroup Inc. and HSBC Holdings Plc open branches nationwide. Smaller domestic rivals such as Shenzhen-based China Merchants Bank Co., which plans a $1.7 billion IPO this year, also pose a growing threat.
       Bank of China, founded in 1912 by Sun Yat-sen, known as the father of modern China, held a monopoly on the nation’s foreign-exchange dealings and overseas banking from 1949 to 1994.
       The bank is China’s third state-owned lender to sell shares to the public as the government strives to shore up their capital and improve corporate governance. Industrial and Commercial Bank of China, the nation’s largest lender, plans a $10-billion IPO as soon as September.
       Other Chinese bank shares have surged since their IPOs, helped by falling bad-loan ratios, rising profits and China’s $1.9-trillion in household savings.
       Shares of Bank of Communications Ltd., China’s fifth-biggest lender, have climbed 81 percent to HK$5.10 since they debuted in Hong Kong last June. China Construction Bank, the No. 3 lender, has risen 48 percent to HK$3.48 since its $9.2-billion October share sale.
       The investment banks arranging Bank of China’s share sale—UBS, Goldman Sachs Group Inc. and BOC International (Holdings) Ltd., the lender’s investment banking arm—have already attracted enough demand to sell all the shares being offered, according to two people with direct knowledge of the IPO process.
       The banks began taking orders from institutional investors two weeks ago and started selling shares to individual Hong Kong investors on May 18.
       Bank of China is offering a 10.5-percent stake at HK$2.50 to HK$3 a share, or 1.9 to 2.2 times book value, the sale document says. Bank of Communications now trades at 2.9 times book value and China Construction Bank trades at 2.8 times, based on their book values—the market value of their assets minus their liabilities—at the end of 2005.

‘Much improvement’
‘This sector is attractive and shows high loan growth,” says Sebastiaan de Bont, who helps manage the equivalent of $4.2 billion at Robeco Group in Rotterdam. “Of course Chinese banks aren’t up to American or European standards, but what I look at are the improvements, and I see much improvement there.”
       De Bont owned shares of China Construction Bank as of February, according to Bloomberg data. He plans to buy Bank of China shares provided their price-to-book-value ratio remains lower than those of the other two banks that have gone public.
       While Bank of China reduced bad loans to 4.9 percent of lending at the end of 2005 from 22 percent two years earlier, that was still higher than Industrial & Commercial’s 4.4-percent ratio and Construction Bank’s 3.8 percent.
       The government supplied $22.5 billion of foreign reserves to Bank of China in 2003, allowing it to set aside more than 200 billion yuan ($25 billion) to cover delinquent loans. That was part of the $434 billion China has spent bailing out state-owned lenders since 1998, according to Moody’s Investors Service.
       “You can’t just throw government money at the banking sector and assume everything’s going to be OK,” says Rob Subbaraman, a senior economist at Lehman Brothers Holdings Inc. in Hong Kong. “Neither restructuring nor IPOs alone will improve business management or change lending behavior unless accompanied by real institutional change.”
       To pare bad loans, Bank of China chairman Xiao Gang, who took the post in March 2003, set up a risk-management system that forces loan approvals to be reviewed by a central oversight commission, according to the bank. Previously, individual branches approved loans without supervision from headquarters.
       Xiao, 48, who rarely appears in public or speaks to the press, previously spent 22 years at China’s central bank, where he was director of the research bureau and director of the planning and treasury department. He declined to be interviewed for this story.