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The government’s China Development Bank is sinking billions of euros into Britain’s Barclays Bank in bid for ABN Amro, triggering debates over Beijing’s emerging role as a global market player with a lot of cash but limited experience.

Main facts

While investigating China Development Bank’s deal with Barclays, Caijing learned:

* An internal dicussion over the Barclays deal is raging within CDB’s ranks.
* CDB will not tap China’s foreign reserve investment agency for the nearly 10 billion euros that it    may invest in Barclays.  
* A Chinese, state-backed financial institution is in contact with an unidentified private equity heavyweight that is preparing an IPO. 
* Some senior investment bankers have questioned the timing of CDB’s decision and its risk-prevention measures. 

By staff reporters Yu Ning, Zhang Yuzhe and Ling Huawei 

Phones in Beijing government offices rang off the hook after word leaked on Wall Street that a mysterious Chinese investor would join Britain’s Barclays Bank PLC in its bidding war for the Dutch banking giant ABN Amro.

At first, the rumor mongers assumed China’s state foreign reserve investment agency was opening its wallet again, just weeks after leaping into the global finance game by investing US＄ 3 billion in the U.S. private equity fund Blackstone Group.

But the real story behind the July 23 rumor was that another arm of the Chinese government – the policymaking China Development Bank (CDB) — had upstaged the Beijing forex investment agency with a plan for a record overseas outlay.

CDB is still awaiting an injection of cash before finalizing its move into the commercial banking sphere. But Barclays said CDB has agreed to contribute an initial 2.2 billion euros toward the buyout offer. If the British bank outbids its competitor Royal Bank of Scotland (RBS) and wins ABN Amro, CDB would spend billions more euros to become Barclays’ largest shareholder.

CDB and the Singapore government’s Temasek Holdings would provide a combined 3.6 billion euros toward the bank buyout, Barclays said, and buy an additional 9.8 billion euros of Barclays’ stock if the bid succeeds.

Given CDB’s policy background and its cooperation with Temasek, market watchers speculated that the Beijing bank was acting unofficially for the newly formed forex investment agency, and that the Barclays funds would be drawn from China’s vast foreign reserves.

However, Caijing has learned that CDB’s investment in Barclays is not related to the foreign reserve investment agency and has no plans to borrow from the forex fund. CDB’s public statement said the investment was solely for its own strategic, commercial and financial considerations, was an important commercial decision driven by market behavior, and was a crucial step in its commercialization and reform process.

Meanwhile, a furor erupted in China after Blackstone’s stocks fell 20 percent shortly after the Chinese investment, causing a vast paper loss and leaving the fledgling investment agency abashed.

Some observers felt the act of a state-owned institution casting itself adrift into the murky waters of modern finance, and reaching independent commercial decisions, marked progress for China. Dissenters, however, argued that while government departments and state-owned enterprises were competing for the use of China’s foreign reserve funds, Beijing still needed a clear investment strategy.

The Beijing government’s ongoing outreach program, originally meant to drive Chinese foreign investment, has been criticized for meager guidance and reinforcing the view that state-owned institutions will experience a steep learning curve in the field of risk management.

Join the Battle 

Long before CDB’s announcement, directors for ABN Amro, one of Europe’s largest banks, recommended shareholders accept Barclays’ bid of 67 billion euros, with 67 percent in stock and the rest in cash. Two days after the April 23 announcement, RBS offered to pay 13 percent more, almost entirely in cash.

While battle lines formed over the single, largest bank buyout in European history, China’s financiers watched — and set the stage for the dragon’s roar. 

China’s foreign reserve investment company moved quickly to invest in Blackstone’s initial public offering less than a month later. The speed and size of the investment raised eyebrows internationally.

Another, Blackstone-like deal may be around the corner. Caijing learned that a Chinese, state-backed financial institution is in contact with an unidentified private equity heavyweight that is preparing an IPO.

Regardless, the flurry of financial deal-making has certainly trained a spotlight on China’s deep pockets. CDB President Chen Yuan called the Barclays investment “a unique opportunity that would hold the world’s attention,” and was based on a successful history of cooperation between the two banks.

According to foreign media reports, Chen met Barclays CEO John Varley in Beijing at the behest of Barclays Capital Chairman David Wright five weeks before the deal was announced at 5 a.m. London time, when Barclays’ top managers gathered at their London headquarters to congratulate their new partners at CDB in Beijing.

Chen said the strategic and financial cooperation indicated the direction of CDB’s transition to becoming a commercial bank. Furthermore, he said, CDB would help Barclay’s management build a world class bank with business networks that bolstered its global strategy. 

Barclays’ motivation for partnering with CDB was obvious. As a profitable bank, with diversified equity ownership, the move was designed to attract new shareholders and drive up its share price. 

Currently, Barclays’ offer for the Dutch bank still trails far behind that of the consortium led by RBS. But if Barclays share price rises to 7.94 pounds, its bid would suddenly soar to rival the competition. 

This does not mark the first attempt by a European bank to levy foreign capital as a method to raise share prices. Last year, Dubai International Capital and Saudi Arabia’s Maan Al-Sana bought a 5 percent stake in Britain’s bank HSBC.

Under the agreement, CDB will initially put up 2.2 billion euros by August 14 to buy ownership shares at 7.2 pounds per share, securing a 3.1 percent stake in ABN Amro.

If Barclays wins the Dutch bank, CDB would provide another 7.6 billion euros and increase its stake at 7.4 pounds per share. To ensure fair treatment for Barclays’ existing shareholders, 1.8 billion euros worth of shares would form part of a compensatory agreement that Barclays’ shareholders outside the United States could repurchase at 7.4 pounds per share. Barclays and Temasek have already promised to buy any unwanted shares.

Currently, the reaction to the deal among existing shareholders has been lukewarm. Should the ABN Amro acquisition proceed, CDB Temasek could wind up owning 7.6 and 2.5 percent of Barclays, respectively.

Moreover, CDB has another card to play: A further option to buy another 67 million shares of Barclays’ stock at 7.8 pounds per share, to be exercised within two years and adding another half-percent to CDB’s stake. Even if the ABN Amro deal fails, CDB can still purchase Barclays’ shares on the secondary market for three years, although it would be limited to a maximum stake of 10 percent stake. Also, CDB and Temasek would each hold a spot on Barclays’ 17-member board.

Where is the Money 

Beijing observers are actively debating whether CDB can raise the nearly 10 billion euros Barclays expects from the Chinese if it wins the Dutch bank, not to mention the 2.2 billion euros CDB must pay whether or not the bidding succeeds.

CDB’s plan for commercialization and market-oriented reform are unclear, and its capital-replacement mechanism is not fully developed. Moreover, the huge investment would challenge CDB’s capital adequacy ratio.

But CDB can only hope to raise money from the market for the Barclays deal, since it has no plans to borrow from the foreign reserves investment agency. 

Currently, CDB operates with a policy bank mission and is charged with implementing China’s strategic policies. Controlled by the Ministry of Finance (MOF), at the end of 2006, the bank’s net profit was 28 billion yuan. It had 2.2 trillion yuan in outstanding loans, 3.1 trillion yuan assets in management on and off the book, and a capital adequacy ratio of 8.05 percent.

Capital input to the CDB can come via direct input from MOF or Central Huijin Investment Co. — an investment arm the MOF and also a major shareholder of the Bank of China — or by raising funds through bonds. Thus, CDB and the foreign reserves investment company are viewed as sovereign funds. 

But there’s another wrinkle. One of the major share holders of Bank of China is RBS, Barclays’ rival for ABN Amro. Thus, CDB is not likely to receive support from Huijin.

In addition, Huijin’s input would first require a CDB overhaul to transform it into a commercial entity. Such a drastic change would dwarf the scope of a one-time investment into Barclays.

“The state (foreign reserve) investment company is still not officially established, nor is it a member of the interbank market,” said a well-placed source. “If CDB wants to issue U.S dollar-denominated bonds to the forex investment company, it must first receive permission from the State Council,” China’s cabinet.

It was announced that the source for the Barclays funds was still under discussion, with CDB seeking to raise the money in a market-oriented manner without relying solely on the market for revenue. According to the source, CDB has diversified financial resources and its own positions in the market.

Other concerns are the vast amount of debt that would surely impact CDB’s capital adequacy ratio. Even if it successfully issues bonds, CDB’s next step would be planning how to fill the capital gap. 

It has been learned that, in addition putting up its own funds, CDB would seek to raise funds by issuing U.S. dollar-denominated bonds or organizing loans from a banking consortium. The bank has been steadily gaining fund-raising experience in this area.

In September 2003, CDB successfully issued US＄ 500 million worth of bonds through the interbank bond market, marking the first foreign-denominated bonds issued by a Chinese financial institution.

To date, CDB has issued US＄ 3.73 billion in bonds, comfortably making it the largest issuer of foreign-denominated debt within China. It has additionally succeeded in organizing a US＄ 700 million in syndicated loans with 21 participating banks, 19 of which were foreign.

As of May, CDB had issued US＄ 700 million in five-year, floating interest bonds. CDB also secured the rights to a combined, US＄ 1.5 billion in dollar-denominated debt in 2007. But the central bank must sign off on any CDB plan to further raise the debt cap.

Nevertheless, the situation remains uncertain. Pessimistic analysts have asked, “If CDB issues U.S. dollar-denominated debt on the interbank market, and the yuan appreciates rapidly, what knock-down effect would this have on bond sales?”

It has been reported that the CDB has set about researching the supply and demand situation for U.S.-denominated debt in the Chinese market and is floating the idea of issuing bonds over several phases.

Market analysts report that should the CDB issues U.S.-denominated bonds or obtain syndicated loans, its cost of capital would likely top a 5 percent yearly interest rate.

Mutual Benefits?

CDB’s turmoil follows a good 2006 for Barclays. The bank saw a 25 percent return on equity, revenue growth of 25 percent, pre-tax profit growth of 35 percent as well as a 17 percent increase in dividends. Barclays also sees half of its pre-tax income coming from overseas.  

Barclays’ Varley is maintaining an active stance toward international growth. For example, the bank began due diligence toward buying a 19.9 percent stake in China’s Xinhua Trust and Investments Co. Ltd. Varley aims to see the bank’s overseas profits rise to 75 percent of the total, with Asia providing a quarter of company revenue.  

For Barclays, CDB’s involvement is picture-perfect. Not only has it found a prime partner to join its bidding war with RBS but, according to the agreement, Barclays would gain priority access to managing CDB’s assets.

However, should the Barclays bid fail, the British bank might see a wholesale change in its fortunes and become a buyout target itself. Yet the capital influx from CDB and Temasek, as well the subsequent rise in Barclays’ share price, create a shield warding off that possibility.

CDB, which recently launched the US＄ 5 billion China-Africa Development Fund, stressed its cooperation with Barclays in Africa and praised the British bank’s commodity trading experience. The Chinese are also looking forward to gaining valuable management experience, technology and personnel training.

Barclays is currently the biggest international bank in African, with more than 1,000 branches, making it an invaluable resource for CDB in advancing China’s strategy for Africa. In the past two years, as part of China’s outreach program, CDB has provided more than US＄ 1 billion in traditional loans in Africa and has collaborated on 50 development projects worth more than US＄ 2 billion. 

Barclays and CDB insist their joint investment is a strategic move that would lead to synergy. 

“As the world’s largest banks all seek to devour small shares in Chinese banks and develop strategic partnerships, can we not do the same thing?” said a senior source at Central Huijin. “If Barclays is able to acquire ABN Amro, this might be a good move by CDB.”

Many investment bankers, however, think that even though the CDB would have a seat on the Barclays’ board and hold 10 percent of the bank’s shares, it would still wield minimal influence on the behemoth’s management decisions. The present agreement signed by the two sides is simple and not sufficiently binding, seemingly relegating CDB to the role of a basic financial investor.

Indeed, Caijing has learned an internal discussion over the deal is raging within CDB’s ranks. And one Central Huijin insider said the time is not ripe for China’s banks to seek large expansions abroad.  

China’s publicly listed banks, such as the Industrial and Commercial Bank of China and China Construction Bank, might have balked at the Barclays investment. At the very least, the boards of these publicly traded banks would have taken a slower approach, aiming to raise the level of management control, and feel restrained by a shortage of experienced talent and expertise. 

“We require that foreign investments have a rate of return that is not less than the rate of return on capital operations. It’s best if equity yields and growth prospects are similar to our own, so that we don’t dilute our earnings per share,” said an investor at a listed, state-owned bank. “This sort of acquisition target is hard to come by, though, as mature international banks don’t have very high growth rates. More importantly, we have to consider whether we will have management control after our acquisition and whether the target’s strategic goals agree with our own.”

In addition to these general concerns, CDB may be vulnerable to the losses wracked by a Barclays unit that invested in two, Bear Stearns sub-prime mortgage hedge funds that recently collapsed in the United States.

Barclays is a successful trader of financial derivatives, but current market risks are troubling even the market’s best and brightest. For the relatively inexperienced CDB, the risks are potentially even greater.

Nevertheless, as news broke that CDB was becoming a Barclays shareholder, the move was applauded by political and industry heavyweights. British Prime Minister Gordon Brown expressed support for the deal, and British Chancellor of the Exchequer Alistair Darling lashed against protectionism that would hinder any deal.

Former Bank of England Gov. Lord George, currently a member of the CDB’s International Advisory Board, also gave the CDB a vote of confidence.

“Like China’s other banking institutions, the China Development Bank is sparing no effort to commercialize itself,” George told the British media. “This means not only a versatility in funding all sorts of projects, but also investments that are developing in such a way as to allow the bank to recover its investments and profits.”

Good Timing or Bad?

Back in Beijing, a senior investment banker told Caijing that CDB’s timing may be wrong. “It’s necessary for Chinese companies to move out into the world, but their methods and timing are equally important,” the banker said. “Frankly, now is not the time.”

The banker thinks it may be tricky for CDB to be dragged into today’s white-hot buyout market. As a policy bank, CDB may be giving conflicting signals to international markets.

From a financial perspective, if Barclays’ bid succeeds, it will be at a premium price leading to high costs and risks during the acquisition.  If the bid fails, CDB’s investment will be purely financial. “Such opportunities abound,” the banker said. “There is no reason to rush into it.”

In pricing terms alone, CDB is entering Barclays at a rate 2.4 times the price-to-book ratio, and the bid for ABN Amro is 2.8 times the P/B ratio (as of end 2006). The average European bank was trading at only 1.88 times book last spring, with the Bank of Ireland topping the list at 2.69. Chinese banks have an average price/book ratio of 3.37.

Recent buyout fever has pushed bank stock prices to new highs. But CDB is not a publicly traded bank and does not enjoy the benefits of available equity, relying instead on mass fund-raising to secure investments.  

“Overseas investment should be cautious in order to avoid the problems Japan encountered when it first began to invest abroad,” said an investment banker at China International Capital Corp. Ltd. “The economic cycle and the cycle for bank stocks are both already at historic highs. It wouldn’t be unprecedented to experience a worldwide adjustment, possibly of 20 percent or higher. That only increases the uncertainty of these deals.”

Fueled largely by concerns over America’s mortgage and real estate markets, worldwide markets saw a relatively large adjustment in late July. Barclays’ share price fell to 6.81 pounds, 7 percent below the level when the deal with CDB and Temasek was announced a week earlier. 

CDB’s hopes of playing Atlas to Barclays’ share price seemed to be fading. But during Barclays’ second quarter earnings call in early August, Varley said that to judge the CDB’s future success based on Barclays’ current stock price was premature.

Despite the torpor engulfing Barclays’ shares, CDB remained calm. “This is simply the nature of the global stock market,” said a CDB source. “Our goal is to be a strategic investor and to enter into a cooperative partnership. We are not seeking short-term gains, and believe Barclays’ growth prospects to be very promising.”

There are also optimists who believe the deal will succeed in helping Barclays move up to become the world’s fifth largest bank. As Barclays’ client base grows, European business will expand, they argue, and as the bank itself expands, the current investment will look like a wise choice.

Sovergien Wealth Funds

The CDB-Barclays relationship comes at a time when international financiers are discussing the future of “sovereign wealth funds.” These funds are government-owned and managed, originating in Middle East, Singapore, and China in recent years.

Before and after the CDB-Barclays announcement, European analysts said funds backed by governments would forever change the morphology of international mergers and acquisitions, since decisions would no longer be exclusively driven by profit margins. Others said they could even interfere with market rules.

’The so called State Sovereign Fund is the investment vehicle a government uses, it is ususally dominated by a certain government. Investors associate it with government institutions,” said Steven Davis, chairman of the law firm Leboeuf Lamb. “ …people’s perceptions toward SWF are different…unlike private sector, in which all decisions are motivated by pure economic concerns, there are more uncertainties surrounding the decision making of the SWF led by government institutions..’

Another issue is how best to manage large foreign reserves. One common thought is that sovereign wealth funds are just a weapon in the monetary management arsenals at the disposal of governments, a view that also holds that governments are more cautious on investment decisions than hedge funds or private equity firms.

Rong Enlin, a former International Finance Corp. executive, said more than 60 percent of China’s foreign reserves are dollar assets, mainly in the form of traditionally safe investments like government bonds. However, the recent collapse of America’s sub-prime mortgage market has brought the dangers of undiversified portfolios into sharp focus. Should the dollar’s current slump become more permanent, storm clouds could gather over China’s foreign reserves. 

“From the day it entered into the family of nations with large foreign reserves, China has been strapped to the global capital train,” Rong said. “There is only one road ahead, and that is to run with the pack.”

Chen Zhiwu, a Yale University finance professor who recently joined the State Investment Council’s Committee of Experts, said the current goal of China’s state-owned enterprises in investing abroad remains unclear. The enterprises invest and handle foreign exchanges through different channels, but still see their risks underwritten by the government.

Wu Qianli, fund manager at America’s Rydex Funds, thinks that from a historical perspective, government investments are mirror the rise and fall of markets, but are always a step behind. Governments generally make a massive entrance into markets when investment is hot, but this often proves unwise.  

The best historical example, Wu stated, is when gold was selling for more than US＄ 800 per ounce. Every central bank rushed to buy as the ounce value fell to just over US＄ 200.

“Continuing the conservative path of only holding U.S. government bonds would certainly be hard to sustain,” one source said. “There must be a mechanism to stabilize risk, but history has proven that direct investment control by governments is extremely unproductive.

“Having state-owned financial institutions explore the situation is a real possibility, but are there few guarantees of risk-prevention measures, operating efficiency, and standard levels of professionalism?” the source asked. “At present, this is a key question.”

Another analyst broached the possibility of building a more diverse and extensive investment portfolio, saying the main issue is not the fate of Blackstone or Barclays shares, but whether the Chinese government clearly grasps the levels of risk and reward in foreign exchange investments, and whether it can build an investment portfolio that accurately represents Chinese interests.