Back in business

The long wait finally ended on June 14. Following an unofficial embargo dating back to the end of 2005, foreign banks had finally made their way back into China’s capital markets. e

The embargo was lifted at the end of 2007, prompting a flood of speculation about potential Sino-foreign securities joint ventures. But the first applications spent six months being digested by China’s regulatory machine before Credit Suisse announced it had received approval to take a 33% stake in an underwriting joint venture with Founder Securities.

Shortly afterward, CLSA said that China Euro Securities – a joint venture established in 2003 with Hunan-based Fortune Securities – had been granted an A-share broking license in addition to the underwriting license it already holds.

“This is very important for us,” C.G. Wu, chairman of CLSA China, told CHINA ECONOMIC REVIEW. “Broking revenue is much higher than underwriting revenue. Last year China saw US$21.4 billion in A-share commissions and US$1.3 billion in underwriting fees.”

Incremental progress
These new approvals do not represent an opening of the floodgates so much as a staged entry into the market. Given the frailty of the securities industry – characterized by the way in which it swings precariously between profit and loss – this guarded approach is understandable.

The trading commissions and underwriting fees that Wu refers to came on the back of a 97% gain in the Shanghai Composite Index (SCI). As a result, brokerage industry profits came to US$18.66 billion, according to the Securities Association of China (SAC). In 2005, when the SCI hit a six-year low, the industry posted a loss of US$1.12 billion.

“Chinese securities companies have made a lot of money from proprietary trading. In a bearish market proprietary trading drops and so we see huge losses,” said Alex Guo, head of research at Tebon Securities in Shanghai.

Poor risk management is exacerbated by the fact that Chinese brokerages can only make money when the market is rising. There is no hedging mechanism, which means trading commissions fall as the market falls. Unable to cover their proprietary trading losses, some brokers have turned to fraud as the only way out.

In 2004, the CSRC tried to clean up the sector, closing or restructuring 31 underperforming securities houses. The SAC had 106 brokerages under its supervision by the end of 2007, down from 128 in 2004. The brokerages that remained were subject to stricter rules and had to meet registered capital requirements to participate in certain kinds of business.

The next step was enlarging the brokerages’ business scope. Last year, CICC, China Merchants Securities and CITIC Securities received permission to invest in overseas securities through the Qualified Domestic Institutional Investor (QDII) program. CICC and CITIC Securities also got the green light to make private equity investments.

Another significant presence in the product pipeline is stock index futures, which should go some way toward providing investors and brokers with a means of hedging their risk. It is hoped that this will bring some stability to the market.

Despite strong performance in 2006 and 2007, the sector is not yet in the clear. With the SCI down more than 45% so far in 2008, industry watchers warn that problems of old may reemerge.

“In a booming market, even a fool can make money; it is a bear market that can test the survival skills of securities companies,” said Qiu Yanying, chief strategist at TX Investment Consulting. “The market has turned bad in 2008 and the firms with the weakest risk control will end up in the red. If the bad market continues, securities firms may go back to the difficult situation of several years ago.”

Access for expertise
Foreign investment banks are undoubtedly in China for a slice of the profits but, in return, they are expected to help the industry get over these growing pains. In this way, the latest approvals represent the continuation of a project that began in 1995 when Morgan Stanley pledged technology, expertise and US$35 million in cash to help set up CICC, China’s first investment bank. The three other foreign players with access to A-share trading licenses – Goldman Sachs, UBS and now CLSA – have all had to deal with China’s broken brokerages in one way or another.

Xiangcai Securities was CLSA’s original partner in China Euro Securities until the local player ran into difficulty in 2005. The Hunan government, which controlled Xiangcai, was forced to step in and transfer the 67% domestic stake in the joint venture to Hunan Valin Iron & Steel, and then on to Fortune Securities.

Swiss bank UBS only got its opportunity to invest in and then restructure Beijing Securities because the brokerage was in such dire financial straits. UBS ended up paying US$37 million for 20% of Beijing Securities and a further US$173 million to cover the brokerage’s debts.

Goldman Sachs, meanwhile, wasn’t willing to risk exposing itself to the legacy problems of an existing market player and decided to build a brokerage from scratch. Goldman provided the technology and US$190 million in capital, and leading banker Fang Fenglei took care of the registration. Fang and his fellow shareholders are holding Beijing Gao Hua Securities in trust until the rules allow Goldman to assume direct control.

Solid returns
Despite this exposure to the industry’s growing pains, the joint ventures have prospered. According to Thomson Reuters, Goldman earned US$1.67 billion in underwriting fees last year, trailing CITIC Securities, CICC, Galaxy Securities and Bank of China. UBS ranked seventh with US$817 million in fees.

But it is A-share broking fees generated by China’s institutional investors that they prize above all else.

“Although at this stage most of the revenue is probably generated by the retail broking business, we believe that the institutional side is going to grow rapidly,” said CLSA’s Wu.

“More and more professional money managers will buy A-shares than retail investors. We want to plan ahead of the curve and position ourselves to use our research capabilities to attract institutional business.”