Where China's Top IPOs List: Offshore

Bank of China is the latest major offering to shun the mainland's dodgy bourses in favor of better-regulated foreign exchanges

Pity the poor mainland investor. The only two viable options for stock investing in China are the notoriously dodgy bourses in Shanghai and Shenzhen. And those are trading at multiyear lows, despite China's white-hot, $2 trillion domestic economy, which is a primary engine of global growth. The reason: Both are chock full of smallish local players that often cut corners and are less than fastidious in reporting their numbers. "The market has been plagued by corruption and fraud," notes Fred Hu, managing director of Asia Investment Research with Goldman Sachs (Asia). "It's really ugly out there."

What makes things even uglier -- for investors, at least -- is the fact that the best companies in China don't even bother offering their shares in the mainland. Instead, the country's most promising financial institutions and tech companies are blowing off the local exchanges entirely and opting for overseas listings in Hong Kong, New York, or London.

The latest slap in the face is the Bank of China. The No. 2 lender in China has just won approval from Beijing to go forward with an initial public offering valued at $6 billion to $8 billion, probably sometime in the spring. The deal will be underwritten by Goldman Sachs (GS ) and UBS (UBS ) and likely will be the second-biggest IPO ever out of China. The biggest was the $9 billion-plus that China Construction Bank raised when it sold off a 13.5% stake in a Hong Kong listing last October.

EARLY ACCESS. That deal set off a national firestorm among government officials and mainland investors. They were miffed that they were cut out, since they can't invest in Hong Kong or overseas markets. Worse, some say, is the 9% stake in CCB that Bank of America (BAC ) bought before the listing. The price tag of $2.5 billion represented about 1.2 times book value for the bank, compared with about two times book value for other Chinese banking shares trading in Hong Kong. Since the IPO, CCB's shares have jumped about 25%.

Whether the Bank of China's offering will be as successful is hard to tell. The bank has made some strides cleaning up its nonperforming loans, and it enjoys a 12% share of the mainland's loan market. Andrew Chan, an analyst with Pacific Sun Investment Management in Hong Kong, thinks Bank of China will set its share price at about twice book value.

But again, foreigners are getting in early. A consortium of investors led by Royal Bank of Scotland is paying about $3 billion for a 10% stake ahead of the offering -- substantially less than two times book value. There are also reports out of Tokyo that newly merged Bank of Tokyo-Mitsubishi UFJ is interested in a piece of the action before Bank of China lists.

BAFFLED BANKERS. This has led some to charge that Beijing is being played for a sucker. Western banks, these critics say, are getting into what's sure to be one of the biggest financial markets of the 21st century on the cheap. And it's not like there's a capital shortage on the mainland. The Chinese collectively control about $1.8 trillion in household savings but either have to stuff that dough into low-yielding bank deposits or invest in real estate at inflated prices in overheated property markets such as Shanghai and Beijing. Given that stocks have been headed south for years, precious few Chinese even bother with equity markets.

One vocal critic has been Xia Bin, director of the Financial Research Institute at the Development Research Center run by the all-powerful State Council of the Chinese government. "Why can't banks raise funds at home?" he asked shortly after the CCB offering. Even foreign bankers are baffled by this facet of Chinese capitalism. "Chinese residents aren't getting a chance to invest in their own best businesses," says Malcolm Wood, an Asia-Pacific strategist with Morgan Stanley.

It would help if Beijing were to sanction more dual listings of blue-chip mainland companies in, say, Hong Kong and Shanghai or New York and Shenzhen. To get there, though, the government has to gradually unwind its massive equity holdings in the 1,400 or so companies now listed on the two mainland exchanges.

FIXES NEEDED. That must be done in baby steps because if the government departments and state-linked companies that hold these shares were to dump all those shares too abruptly, the markets would really tank. And the exchanges have to clean up their act. Financial reporting and regulatory oversight at the Shenzhen and Shanghai exchanges lag behind those in Hong Kong and in the West, and until that gets fixed, the smart money will stay away.

It's unlikely that the mainland will create much of an investor culture until its best companies stop departing for foreign exchanges.

READER COMMENTS

Bremner is BusinessWeek's Hong Kong bureau chief

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