China, it’s widely agreed, is the engine of world growth, today and for the foreseeable future. But it’s an engine that might need some tuning. As one industry after another – banking, telecoms, resources – gains new global champions from mainland China, it seems that some less esteemed names and practices are being pulled into the international spotlight along with them.

So far this year, three of the big four accountancy groups have either been caught up in controversy about their overseas-listed clients’ accounts, or have stepped away from a client out of growing concern about their books.

The biggest incident involved Sino-Forest, a Chinese timber company that listed on the Toronto Stock Exchange in the 1990s and grew to become one of the largest forestry groups listed in Canada. It appeared a success story, raising more than C$3 billion in debt and equity over the years and reaching a market capitalization of C$6 billion by March this year, reporting almost C$400 million in profit for 2010 from a 780,000 hectare forestry portfolio in China. But following a damningly negative research report from a hedge fund, triggering a share price plunge, it was suspended from trading by the Ontario Securities Commission in August for acts intended to “perpetuate a fraud” – specifically, that it didn’t have the assets it said it did, nor the profitability. Ernst & Young has been named in two class action lawsuits around Sino-Forest.

Elsewhere, big four accountants have started to become wary of their own clients. In May Deloitte stepped aside as auditor of Longtop Financial Technologies, a financial software provider from Xiamen, citing concerns about its accounts. In what is surely one of the most self-abrasing press releases ever assembled, Longtop itself said Deloitte had quit after identifying false financial records on cash and loan balances, the deliberate interference by Longtop management in Deloitte’s audit process, and the unlawful detention of Deloitte files. In late August Longtop said it could face legal action from the US Securities and Exchange Commission for violating disclosure rules.

And in January KPMG said it had found possible irregularities in the books of China Forestry, which is listed in Hong Kong; China Forestry’s shares were then suspended. Other problematic examples include Nasdaq-listed RINO International, which makes pollution control equipment, but admitted in March that two previously reported contracts didn’t exist (it has since been delisted); and Duoyuan Global Water, listed in the US, which has been suspended after it borrowed money from related parties and booked it as sales.

It’s hard to say how widespread this problem is, but some estimates are troubling. A Moody’s report in July assigned red flags to the corporate governance of 61 rated Chinese companies, including some big names like Hong Kong-listed Winsway Coking Coal. It spoke of “the inherent challenges in assessing these Chinese companies: their short history of operations, their diverse industries with limited peers for comparison, their concentrated family ownership structures, and their high-growth environments.”

But however widespread, it is causing a major challenge for the big four accounting firms who have worked long and hard to build businesses in China. Auditing Chinese firms who are readying themselves for international listing is a lucrative source of revenue. But at what risk?

At the very top level, there’s no obvious problem; corporate governance at some Chinese blue chips is in line with international best practice. The problem comes in smaller companies, often private sector seeking to float on the rising tide of investor interest in the China story. Here, auditors face a challenge: stick with the big names they are comfortable with, and forsake other revenue? Or spread the net wider and run the risk of it catching unscrupulous companies?

“My personal view is that the big four may step away from some high risk Chinese clients for the sake of their own reputation,” says Helen Yang, lecturer in accounting at Victoria University, who is working on a CPA Global Research Perspectives project on China’s convergence with IFRS international accounting standards. “If you look at those cross-listing companies controlled by the central Chinese government, a majority of them have the Big Four as auditors. To protect themselves, perhaps in the future they should have their own niche targeting these big Chinese companies rather than focusing on revenue accumulation only.”

But that would be to abandon a vast source of revenue: the private sector constitutes an ever greater part of the potential revenue pool for accountants in China – and the majority, it should be stressed, are legitimate businesses. It’s a debate that is troubling accountancy groups. All four of the big four names declined to comment on this story; however, before they all stopped talking, Paul Winkelmann, the partner in charge of risk and compliance for PWC in Greater China, was quoted as saying “costs have gone up, fees have gone down, as competition for fees is enormous. You can easily see there is a real risk of an audit firm failing.” Another big four auditor in China, asking not to be named, says: “I wouldn’t say we have changed our procedures exactly. But people are being careful.”

The generous interpretation of recent malfeasance is that it represents teething problems in Chinese corporate engagement with the world. “The way we read what’s going on in China among these smaller companies is that clearly many of them are relatively new to being listed, and aren’t entirely sure what they should be doing,” says Jamie Allen, founder and secretary-general of the Asian Corporate Governance Association. “We see some companies listing in Hong Kong, private Chinese companies that have only been in operation for a few years. If you look at governance, track record and continuity, it often raises lots of questions. If these are to be allowed to list on overseas exchanges, then it is absolutely to be expected that some are going to run into problems.”

Allen says this is not new – several years ago many companies listed on Nasdaq were sued for disclosure problems. “There has been a certain history of Chinese companies listing in the US then not fully disclosing material events and issues, then being sued through class action law suits.” But one of the things that is new is the scale of institutions that are being caught up, and that is turning it into a matter of concern for international regulators. Fidelity, for example, held 14.5% of Longtop’s stock as of its last filings on March 31, with major hedge funds also well represented. John Paulson, famous for spotting the problems in mortgage- backed securities early and making a fortune from them, was a Sino-Forest investor – selling out before suspension but at a heavy loss.

It has been sufficiently alarming for the US audit watchdog, the Public Company Accounting Oversight Board (PCAOB), to send a team to Beijing in July, for what has since been billed the “Sino-US symposium on audit oversight”. This pledged closer cooperation; beyond that, PCAOB spokeswoman Colleen Brennan told IntheBlack: “The PCAOB does not talk about any open enforcement investigations. Our recent trip to China was to talk about opening China to PCAOB inspections of auditors that are registered with us.” She also says Chinese officials have agreed to come to the US in October. Elsewhere, the Ontario Securities Commission is to review all companies listed in Canada with significant business operations in emerging markets, focusing on roles played by auditors and underwriters.

One common pattern in all of this has been that companies have often listed through reverse takeover, or back-door listing, which have less onerous standards than a whole new listing; this was the case with Sino-Forest, for example (although not Longtop, which raised US$210 million in an IPO in New York). PCAOB published a study in March which identified 159 Chinese companies that had listed on US capital markets alone through reverse mergers between January 2007 and March 31 2010 – and that’s without looking at Toronto, which has many more. That’s almost three times as many as the 56 Chinese companies that launched US IPOs during the same period. Between them, the 159 back-door listed companies had a market capitalization of $12.8 billion as of March 31 2010.

While the US and Canada allows this approach, Hong Kong has banned any attempt to get around listing requirements through a reverse takeover. “The US allows back door listings, which effectively means you do get much riskier companies,” says Allen. “In Hong Kong we started controlling these back in 2004. If you do a back door listing the exchange is not simply going to let that through; it treats it as an IPO and holds you to the same standards.”

“In the US there is a whole cottage industry of investment banks, accountants, auditors and law firms who specialise in these back door listings,” he adds. “Our problem with that is, they effectively undermine the IPO process and investor protection.”

The problems have come at a time of dramatic evolution in China’s domestic accounting industry. China is in the process of entering a new accounting regime, called Chinese Accounting Standards for Business Enterprises, which are largely in line with IFRS. CASBE was announced by the Ministry of Finance in 2006, began implementation for listed companies in 2007, and has since grown to cover local state-owned enterprises, commercial banks and insurers. A roadmap for further convergence with international practice was released in 2010.

Are challenges in Chinese disclosure related to this evolution? Professor Colin Clark, also at Victoria University and co-author of the CPA study, says that the varied quality of reporting is “a consequence of the stage of development of the profession. There are issues in the adoption of IFRS, issues around translation into a foreign language, and the shift from a more prescriptive basis of standard setting to a more principle-based system.” This inevitably gradual process of on-the-ground transition is a bigger problem than the regulatory infrastructure above it. “I don’t think the problems we’re referring to are problems of an absence of professional framework. The standards are in place. The problems are around implementation and enforcement.”

Naturally, no transition to international best practice takes place immediately. Yang says: “Because Chinese convergence with IFRS only started in 2007, it takes time for Chinese accounting professionals to catch up with international practice, and it is a steep learning curve for them to get used to IFRS.” And on top of that, there are clear issues around staffing. “The challenge is enormous,” says Clark. “The industrialization of the country has meant there has been enormous demand for accounting professionals, and a real challenge in producing sufficient graduates.” Other issues may be cultural – less willingness to speak out in a hierarchical structure, for example. (The Chinese Institute of Certified Public Accountants refused to answer IntheBlack’s detailed written questions on the profession and what is to be done about disclosure issues.)

There’s an issue here for the big four, because the near-monopoly they have held in being able to audit companies listing overseas appears to be ending. With convergence, it is understood that Chinese local accounting firms will also be allowed to do the auditing services for internationally listed companies. They will become direct competitors, and with much lower auditing fees. “The challenge for the big four is rising market competition in accounting services from local Chinese firms, and the need to localize their practices to be aware of the social and political context of China. Accounting reform in China goes hand in hand with economic reform.”

Even if big four groups are expected to have world-class standards in their accounting, there is some sympathy even at this level for those who have been duped by dishonest companies. “Even among state enterprises there have been significant frauds where bank statements or invoices are fraudulent, where a whole web of fraudulent deals has been set up with suppliers, customers and banks,” says Allen. “If you’re auditing that, it can be extremely difficult. On a typical audit you assume the documents companies are giving you are legitimate, so you’re cross-checking the trading and transactions the company is doing with the bank statement. Most are not forensic audits; that would cost a lot more money and effort.”

It should be said, too, that big four accountants resigning from auditing their clients’ books is not really a bad reflection on the accountants themselves; indeed, it’s what they should do. But nevertheless they find themselves in a challenging position with some tough decisions to make around, expansion, revenue, reputational risk and strategy. The coming years will be interesting.

Sidebar: The muddy waters of disclosure

A central character in recent Chinese accounting issues is a man called Carson Block, who founded a research firm and investment manager called Muddy Waters. The name comes not from the blues singer but a Chinese expression: Muddy waters make it easy to catch fish. In other words, there are opportunities to make money when things are opaque.

Block’s strong sell recommendation on Sino-Forest on June 2 set in motion its share price collapse and subsequent investigations and law suits. He really doesn’t pull his punches: the report, at a time when the company’s stock was riding high, said:  the company “was aggressively committing fraud since its RTO [reverse takeover in 1995”, and was “a multi-million dollar ponzi scheme, accompanied by substantial theft.” More specifically, it claimed the company had dramatically overstated its forestry holdings and passed revenues through a host of intermediate companies in order to confuse auditors.

A look at the Muddy Waters research list shows only strong sell recommendations, in all cases on companies where fraud or at least mismanagement is alleged: Orient Paper, RINO, China MedicaExpress, Duoyuan Global Water. In Block’s view, fraud is widespread in China, and the big four firms face great challenges in detecting it. One of his central points is that a company can, in a sense, fake transparency, in that it provides a great deal of information but not the right sort. He argues that auditors might be looking for aggressive accounting, but not a situation where the underlying business doesn’t even exist.

There is another side to this coin though. Block is not just a good governance advocate in the mould of renowned Hong Kong gadfly David Webb, or Allen’s ACGA; he is there to make money, and in every instance has built a short position in the stocks he then hammers in his reports, profiting from their subsequent share decline. Block is open about this: whenever interviewed, he points out himself that he is conflicted.

But the power of raising a red flag can be very destructive. Raising doubts about accounts is all but guaranteed to knock a share price hard, providing gains to anyone shorting the stock. The latest name to appear is Silvercorp Metals, a Toronto-listed company, accused by an anonymous whistleblower in early September of a “potential accounting fraud” worth $1.3 billion. Silvercorp has strongly denied this, publishing many documents to support its accounts; it has retained analyst support, such as broker BMO, which maintains an outperform rating on the stock; and as yet the Ontario Securities Commission has taken no action. No matter, the share price fell 10% in a day anyway; its management said there had been a dramatic increase in short positions on its shares in the last two months.

And this is a central point: there’s actually nothing new in irregularity in accounts for overseas-listed stocks. What’s changed is scrutiny. “The difference is people like Muddy Waters and other hedge funds are realising there are problems, short selling, putting out reports and publicly criticising,” Allen says. “They are essentially taking advantage opportunistically of a problem that is real, but I don’t think you would necessarily find in every PRC company listed in the US.”

Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

As China grows, its institutions inevitably look further afield, and its remarkable domestic story starts to shape the rest of the world too. The headline deals are those that venture into the west or to Africa: Lenovo buying IBM’s PC division, Petrochina and CNOOC buying up chunks of Nigerian or Sudanese resource fields, China Investment Corporation taking stakes in Morgan Stanley and Blackrock. But what of its near neighbours? How is China Inc affecting Asia Inc?

When China buys overseas, it has gone local less frequently than it has ventured further afield. According to data from the Heritage Foundation, Chinese outbound investment into East Asia totalled $31.6 billion between 2005 and 2010, with Indonesia accounting for the biggest slice at $9.8 billion, followed by Singapore and Vietnam. But that’s actually one of the smallest blocs worldwide: it put $61.7 billion into the Americas minus the USA (a further $28.1 billion), $43.7 billion into Sub-Saharan Africa, $37.1 billion into the Arab world and $45.2 billion into what Heritage calls West Asia (chiefly Iran, Kazakhstan and the Russian Federation) over the same period. Australia on its own, with $34 billion, accounted for more than East Asia.

Why should this be? Chiefly, it’s a reflection of what Chinese companies have opted to buy. “The majority of M&A activity in China has been outbound and in the natural resources sector. That’s been the first wave,” says Mayooran Elalingam, who heads M&A execution for southeast Asia for Deutsche Bank. But with the exception of Indonesia, southeast Asia is not a huge market for resources compared to, say, Australia, Canada or Africa.

Consequently, outbound M&A into Asia has so far focused on the handful of places where the resources are found or processed. In 2009, for example, China Investment Corporation – China’s sovereign wealth fund – invested US$1.9 billion in the Indonesian mining group Bumi Resources through a debt instrument. Other key examples have included several deals in Singapore, most notably China Huaneng Power (and its Hong Kong-listed subsidiary Huaneng Power International) buying Tuas Power, and Petrochina buying Singapore Petroleum. And CIC is a big investor in Mongolia, notably with a $500 million investment in SouthGobi Energy Resources, which mines coal in Mongolia, in 2009.

While most southeast Asian nations do not offer big mining or oil operations, they do come with some other advantages. In the west foreign sensitivities have often nixed resources deals, most famously in the USA, with CNOOC’s attempt to buy Unocal. It’s particularly acute when state-owned companies involved – which includes most major Chinese resource companies. But politics have been less of an issue in Asia. National interest hardly came up in the Bumi Resources deal; Bumi’s President Director and CEO called CIC “the leading sovereign fund in the world,” and declared himself “honoured by this historic and transformational investment.”

In Singapore, too, the deals have attracted little dissent – partly because Singapore simply doesn’t do dissent, and partly because, in a nation built on free markets and with a chiefly Chinese population, big deals from China are considered welcome. “If assets are deemed to be sensitive nationally there is a suspicion in the west that wouldn’t exist so much in Asia,” says Malcolm Macdonald, partner at PricewaterhouseCoopers in Beijing.

Consequently more deals are likely to be struck in future. “There’s a lot of interest in Indonesia, not just in coal put plantations, both rubber and palm oil,” says Ronald Chao, national leader for China for corporate finance advisory at Deloitte in Beijing. “There’s a lot of people scouting for things, but there are just not that many major transactions being struck yet.”

And if resources are the first wave of Chinese overseas expansion, then what comes next? “The question is, will there by Chinese outbound M&A activity in sectors outside of natural resources?” asks Elalingam. “We think this is possible, but only if there is a strong strategic rationale and connection to the China growth story.” A Chinese company acquiring overseas for acquisition’s sake makes little sense: no acquisition is likely to offer a higher growth rate than is already available in China. There needs to be something else to be gained. “For example, can the consumer product or brand from the target be sold into the Chinese consumers?” says Elalingam. “If not, the target would be less attractive. Similarly, can the technology of the target be utilised to improve the technology of the Chinese operations?” Acquiring technology has tended to underpin industrial M&A from China – and it has tended to take place in places like Germany rather than in Asia. “With China outbound M&A, the question to ask is: ‘is there a connection back to the home market’?”

Nevertheless, there have been some interesting transactions that have hinted at further expansion into near neighbours. In financial services, Bank of China’s purchase of an aircraft leasing business in Singapore called SALE in 2006 was an interesting one-off deal, and more recently Industrial & Commercial Bank of China (ICBC)’s purchase of almost all of Thailand’s ACL Bank increased discussion that China’s vast banks might be looking to become more regional. “It is known quite publicly that ICBC has looked elsewhere in southeast Asia as well,” says Chao. “In Indonesia in particular, the overseas Chinese population there makes it attractive to Chinese banks.”

Macdonald adds: “Having a recognised financial services brand within Asia gives these [Chinese] banks an advantage. We might well see some transactions in financial services in future.” There’s certainly no shortage of capital: despite almost entirely domestic models, China’s banks are the largest in the world by market capitalization. But again, there has to be an obvious rationale for further expansion.

An interesting parallel here is the way that Japanese banks have expanded in the world: they have done so based on a model of serving Japanese corporates wherever they go, and then other businesses develop off that initial anchor. China is likely to behave in the same way. That said, Chinese banks are largely able to do that through establishing offices, rather than feeling the need to acquire in every country they do business in. ICBC, for example, has over 100 overseas subsidiaries, many of them in Asia. Bank of China said in May, when it set up a new Chinese desk in Dubai, that it had 711 overseas business branches and offices covering Hong Kong, Macau, Taiwan and a further 31 countries and regions; in Asia they include seven branches in Singapore alone, plus Malaysia, Japan, Kazakhstan, Korea, Thailand, Vietnam, Indonesia and the Philippines. ICBC’s ACL deal is discussed in the box but looks like something of a test case. “They don’t need to buy a DBS, they just need a presence here,” says one banker. “FIG is a highly regulated sector: it’s not easy to buy banks unless the relationship at a government level is very strong, and even then, buying 100% – which is always the preference for Chinese buyers – is very difficult.”

Political sensitivities aside, the other central challenge in Chinese M&A is talent: finding companies with good management teams that can help them to build. In this respect, Chinese companies tend to behave in perhaps unexpected ways after acquisitions: rather than imposing their own methods, they are very willing to learn. “The Chinese are fairly hands-off in terms of real integration,” says Macdonald. “They tend to trust the foreign management team and want them to stay in place to run the non-China business.” It is almost a reverse integration. “We’ve seen a number of clients want to learn the manufacturing processes, technology or internal systems” of the companies they acquire, Macdonald says. “They seek to learn a lot from the target they are acquiring, rather than assuming they know what to do and taking over. It’s a sensible approach, as they don’t have a surfeit of globally experienced managers.”

As one banker puts it: “It’s not the McDonald’s mentality of: my model should work here, so I will overlay it onto what I just bought.” At Singapore Petroleum, for example, the name has not been changed and the management is largely what it was before the acquisition.

One thing that isn’t a challenge for Chinese state-backed companies is funding. State-backed companies, whether in listed form or through unlisted parents, have deep pockets; if they need more, bank liquidity has long been plentiful; and in recent years the domestic debt capital markets have opened up still another source. Instead, Chinese companies are much more concerned about deal certainty. “One of the clear distinguishing factors on a lot of these deals is that they want absolute certainty,” says one banker. “Announcing a deal and then failing to complete it is not an option.” In both the Singapore Petroleum and ACL deals, the buyers are understood to have required complete certainty that the deal would go through, without any danger of competing bids being considered, before going ahead.

Indeed, far from funding being a challenge, if anything the imperative is for deals to go ahead in the national good. “A lot of China’s huge foreign exchange reserves are locked up in fixed income investments, notably in the US, and with the RMB continuing to strengthen those assets are depreciating just through the exchange rates,” says Chao. “Rather than seeing it gradually deplete, finding more opportunities or assets with a higher long-run return is economical.” One trend that may have an impact is the increasingly international nature of the RMB itself, and another is the emergence of private equity businesses within China.

Beyond M&A, there is also potential for Chinese direct investment in neighbouring countries – setting up factories, for example, or outsourcing manufacturing. This is happening across Asean and sporadically in markets like Bangladesh, but for it to really take hold, the economic benefits of doing so have to outweigh the complexity. Chao says they don’t, yet. “If you are talking about manufacturing, that means dealing with local labour practices, unions, and all those things which can be very challenging for Chinese companies,” says Chao. “Labour costs are still relatively low here in China, and while land costs have been rising dramatically along the east coast, there’s still a vast supply of industrial land if you move further inland. As the economies of inland and western provinces improve, there is a need for Chinese manufacturers to service those markets. Before you see a massive outflow of manufacturing capacity overseas, a lot of Chinese companies would look further west in China first.” Macdonald, though, argues that this sort of direct investment is likely to become more widespread. “There is a tremendous amount of trade within the Asian region, with other territories supplying into China,” he says. And as China’s population enters the middle class, the cost of manufacturing locally is definitely rising; sooner or later the benefits of outsourcing bricks-and-mortar industry to cheaper markets are going to become compelling.

Any sense of Chinese buyers as wide-eyed ingénues going out into the world for the first time is wide of the mark. “Chinese institutions are increasingly getting more sophisticated in M&A situations,” says Elalingam. “With a multinational, the dialogue is relatively simple: where can I find growth opportunities and how much do I need to pay for that growth? Whereas the Chinese have plenty of growth already at home, so it is more important to justify the rationale for a transaction. It usually comes down to ideas with a specific connection back to China.”

One banker recalls meeting a Chinese client in Indonesia recently. “Most people would fall over themselves to enter Indonesia. But for them, it was relatively interesting, but no more. ‘Yes, it’s growing at 8% a year, but so what?’ That was the feedback.”

BOX: ICBC/ACL

ICBC’s acquisition of Thailand’s ACL Bank was the first major bank M&A transaction from China into Asia. It started in September 2009, when ICBC bought 19.3% of the bank from Bangkok Bank and announced a tender offer of the remaining shares; by the following April it had acquired 97.24% of the stock, including a 30% stake from the Thai finance ministry.

As is common in deals involving big Chinese acquirers, ICBC insisted on 100% ownership of the asset (or close enough) and had no interest in a minority stake. That was not straightforward. Thailand had allowed full foreign ownership of banks before, but only after the Asian financial crisis when the banks were in a distressed state; it had never allowed a 100% sale overseas of a healthy bank, as this was. Also, the norm for big asset sales in Thailand was to go through an auction process. Getting certainty on the sale required convincing Thai regulators that the deal was in Thailand’s best interests.

The deal, at $529 million according to Dealogic, was not material for a bank of ICBC’s size: ICBC recorded RMB166 billion (US$25.66 billion) of profit in 2010. But it was considered significant as a rare example of a Chinese bank expanding not through organic growth but an outright acquisition.

It was also closely watched to see what happened next. The name of the bank has changed, bringing it under the ICBC umbrella, but it is largely the same organisation as before. Under a new Chinese CEO, Youbin Chen, most of the executive vice presidents in charge of the various operating divisions are Thais who were there before the takeover. “At the end of the day, it’s a Thai bank,” says one analyst. “They added services to serve Chinese clients. But on its own, does the business work? Yes it does, so changing the management is not top of their agenda. Despite negative perceptions of China, they let the thing run as it is.”

BOX: Tencent/Sanook.com

People tend to get very excited about Tencent. It is one of broker CLSA’s top picks in China; Nomura has a buy recommendation on it, and its latest research report on the stock carries the title: “The X-Factor.”

It generates such excitement because it is China’s largest internet portal, with a leading position in instant messaging as well as internet software, gaming and online advertising. Based in Shenzhen, it listed on the Hong Kong stock exchange in 2004.

It is also one of the relatively rare examples of a private sector company buying cross-border in Asia. In 2010 it bought 49.92% of Sanook, a Thailand internet search and content provider, for $10.5 million. Sanook also provides internet content such as news, entertainment, games and social networking.

It was not, by any means, a huge deal, and tencent itself did not respond to repeated requests for comment to explain it. But analysts considered it significant. Billy Leung, an analyst at OSK Group in Hong Kong, called it “a positive step for Tencent, as their user base in China has reached a high level.” [Over 500 million users by that stage, and over 600 million now.] “While this is a small investment, we believe it shows that the company is embarking on its second phase of growth whereby it actively monetizes its large user base in China, and increases its geographical reach.” Overseas expansion, Leung said, was “a logical step.” It has made similar investments in Russia and, more recently, the US.

Tencent got two seats on the Sanook board as part of the deal and has the right to nominate candidates for executive president. But you wouldn’t know if from the web site, which remains much as it was: Thai, local and populist. As elsewhere, the approach appears to have been to buy something that works and, if it’s not broken, don’t fix it.

Singapore’s institutions were cagey about the prospect of a new Qantas-backed airline yesterday, while analysts raised questions both about the state’s willingness to approve such an airline and the logistics of making it work.

Singapore Airlines declined to comment, saying that it would be inappropriate to do so when Qantas itself had not confirmed the new venture. However, the airline is thought to be sanguine about the idea of increased access, feeling that it already faces intense competition from Asian or global airlines on almost every route it flies.

Changi Airport spokesman Ivan Tan said it would be “premature” to comment, saying that any application for an Air Operator Certificate would be handled by the Civil Aviation Authority of Singapore; the CAAS had not responded to phone and written inquiries by press time.

But Singapore state insiders said they did not expect any major hurdle to Qantas setting up provided that it followed the same ownership structure as applies to Jetstar Asia, in which 49% of the airline is held by Qantas and 51% by a Singaporean. It appears that the structure would be identical right down to the Singaporean partner: Jetstar’s major shareholder is Westbrook Investments Pte Ltd, which is wholly owned by Choo Teck Wong, widely known as Dennis Choo (see box), and it is understood the same vehicle would be used in the new full-service airline.

But analysts added that Singapore would likely expect something in return for an approval. “The Singapore government has said that its priority is to promote Singapore as an air hub,” said Siva Govindasamy, the Singapore-based Asia managing editor of Flightglobal Group. “A few years ago that marked a slight change in tack. While Singapore Airlines is still an important part of the strategy, it is not the main part – that is Changi [the airport].”

Consequently Singapore could be amenable to such a new airline, but approval “I think would lead to objections from airlines based here, chiefly Singapore Airlines,” Govindasamy said. “And that could lead to a quid pro quo where Singapore Airlines say: we allowed you guys to set up here, why can’t we do something in Australia?” In particular, Singapore Airlines has long coveted greater access to trans-Pacific routes.

CLSA aviation analyst Robert Bruce said “the Singapore government would be supportive of any new airlines that are going to be based out of Singapore.” He said the government’s support for new low-cost carriers over the last five years “have assisted in Singapore’s major strategic focus of growing as a tourism hub and making Changi one of the most successful airport hubs in the world.” He said Singapore is increasingly aware of the risk of losing its hub status to long-haul carriers in the Middle East, “which have developed an ability to overfly Singapore”, and that fear would fuel support of new Singapore-based airlines.

Others were less sure. “The only bit of it that’s surprising is that the Singaporeans would allow them to do it,” said Peter Harbison, chairman of the Asia Pacific Centre for Aviation, who described the method of getting in by staying under 50% ownership as “a side door”. “Allowing a flag carrier in would be quite a substantial step up in terms of the liberalisation process.” He added: “When that Qantas Asia, or whatever it’s called, aircraft is flying out of Singapore, it’s operating on Singapore bilateral rights and designated as a Singapore carrier – something that Singapore Airlines won’t like at all. The new airline will be up against Singapore Airlines in bidding for slots.”

One could also argue that the Australian government’s rejection of Singapore Exchange’s bid for the ASX could influence the Singapore state’s decision on a new airline, although the situations are different: Singapore Exchange proposed a takeover (subsequently re-aligned as a merger), while Qantas would simply be launching a business within which it is a minority shareholder. Additionally, the fact that Qantas is not state-owned removes a potential objection, as does the fact that Singapore has no equivalent to the Foreign Investment Review Board.

“They’re apples and oranges,” says someone who has worked closely in Singapore-Australia trade. “Frankly Singapore was very happy to entertain Jetstar, to get involved in it and to spin it off, because it was part of the strategy to develop Singapore as an aviation hub. And if this [new Qantas airline] is only planning on running 20 planes out of here, it’s not going to be anywhere close to competition for Singapore Airlines.” This person says the key to Singapore’s satisfaction will be “how much Singapore equity is in it. But they can always see where the long term interest is.”

BREAKOUT

Who is Dennis Choo?

When a new shareholder structure was hammered out for Jetstar Asia in 2009, Australian investors and aviation commentators became acquainted with the name of Dennis Choo. Choo Teck Wong, to give him his full Chinese name, is the owner of a Singapore company called Westbrook Investments Pte Ltd, which in the 2009 restructuring became the 51% shareholder of Newstar Investment Holdings Pte Ltd, which in turn is a holding company for Jetstar Asia.

Though Choo became chairman of the Newstar holding company in 2009, he keeps a low profile. “He’s fairly unassuming, fairly low key,” says one who knows him.

Qantas, though, has known him for years through his travel agency, Tour East Group, which was formed in Singapore in the 1970s. It has a long relationship with Qantas in Singapore, one that got closer when Tour East Australia was launched in 2007 as a joint venture with Qantas. Choo is Group Managing Director of Tour East out of Singapore. “He has been a long-serving Qantas travel agent in Singapore, and has a good relationship with Qantas build over the very long term,” says CLSA analyst Robert Bruce.

Choo will now also be a 51% shareholder in the new Qantas full service airline in Singapore; Choo’s participation as the local partner is what allows Qantas to set up, just as it was with Jetstar. It’s not clear, though, if Singaporean parties are responsible for committing all the capital to these ventures, or if the bulk of it has originated from Australia.

The queue of foreign fund managers waiting to get in to Chinese domestic asset management has always been a long one. There are now 35 Sino-foreign joint ventures (JVs), with five more awaiting approval, and if ever a partner steps aside because of a regulatory compliance issue, there is another willing foreigner to take its place. But in February, something very significant happened: a step in the other direction. For the first time, a foreigner announced plans to sell out of its JV.

KBC Goldstate Fund Management combines a Chinese securities broker, Goldstate, with the Belgian bancassurance group KBC. And in February, it became clear that KBC was seeking buyers for its 49% holding in the company.

It should be made clear that this will not be the first exit of a foreigner from a JV, but in most other cases the circumstances have been forced upon them. So, for example, after the various mergers, acquisitions, collapses and disposals of the global financial crisis, BNP Paribas found itself with stakes in three separate ventures. Since firms are not permitted to hold more than stake in a Chinese investment management company, BNP Paribas sold out: first of all shifting its 49% stake in ABN Amro TEDA to Manulife in November 2009, and then its33% stake in SYWG BNP Paribas to Mitsubishi UFJ the following year. However, BNP Paribas remains committed to the Chinese market and still owns 49% of HFT Investment Management, which it acquired through the assets it bought from Fortis.

In contrast with other foreign firms in China, KBC has taken a decision that it’s no longer a good idea to be involved in a JV of its own volition, rather than because of any regulatory tap on the shoulder. So is this a turning point? Will we see more foreigners deciding the pressures of being in such a fiercely competitive industry no longer make sense?

In answering these questions, it’s important to look at the KBC situation in context. This is arguably still a hangover of the financial crisis. KBC is not the strongest institution in Europe, and received a total of Eu7 billion in bailout funds from its government during the crisis. Like many banks – RBS is another example – it reached a conclusion in 2009 that it should downscale and rebuild based on what it is good at. KBC from now on will be first and foremost a Belgian institution and its growth momentum will come from Central and Eastern Europe. Correspondingly, China has become non-core – reflected by the fact that KBC closed a Shanghai representative office in 2009.

On top of that – and this perhaps has broader relevance to others in the industry – the venture has not been particularly successful. KBC Goldstate’s assets under management fell 60% to RMB1.3 billion ($197 million) last year. That made it the second smallest fund manager in the country. It has been around for a little over four years but has never really developed traction or critical mass during that time. The firm has a bond fund, two balanced funds and three small equity funds, and industry analyst Z-Ben reckons that probably only one of those is large enough to be consistently profitable.

KBC Goldstate is one of the very rare examples of a manager in China with no money market fund. Plus, it’s not in segments of the market that are growing: exchange-traded funds, index funds, or (though this is a mixed blessing) the qualified domestic institutional investor (QDII) products that allow Chinese to invest overseas. Z-Ben puts it like this: “Knock three years off its operational history and we might consider KBC Goldstate to be a greenfield operation that has yet to enjoy any good luck. Add them back on and what remains is the stuff of cautionary tales: fail to take risk and this is how far you’ll be left behind.”

KBC’s experience in China has varying degrees of relevance to other foreigners.  KBC is not the only international business to have suffered and to need to refocus, although one would assume that most of that sort of news is already out there now and playing out in disposals. So there could be others who decide that a China stake is non-core and perhaps a chance to raise some capital.

More significantly, the group’s failure to grow in a competitive industry is a widespread occurence. Including the locals – there are 62 fund management companies in China – only two Sino-foreign JVs (Harvest Fund Management and Bank of Communications Schroder) rank in the top 10 in mutual fund assets under management. The top five – China Asset Management, Harvest Fund Management, E Fund Management, Bosera Fund Management and China Southern Fund management – have more assets between them than the bottom 42 funds combined. It is lop-sided and ferociously competitive.

According to data from June 30 2010 – the year-end for many China businesses – KBC Goldstate was far from being the only JV with less than RMB10 billion in assets, which many consider a basic foundation for critical mass. Others included Axa SPDB Investment Managers (the smallest at that point), Lord Abbett China Asset Management, Lombarda China Fund Management, First State Cinda Fund Management, GTJA-Allianz Fund Management, HSBC JinTrust Fund Management and Morgan Stanley Huaxin Fund Management . And while some smaller ventures, like Minsheng Royal, in which Royal Bank of Canada is a partner, are simply young and expect to grow, there are others (Franklin Templeton could be added to the list) that would surely have hoped for more traction by now and must be wondering where their investment is getting them. Institutions like this are generally considering their options: commit more capital in order to grow the business to a point of critical mass, or leave them without additional capital injection and hope they thrive on the back of broader market growth.

There is another consideration, though. KBC still has to find a buyer for its business, and that’s not necessarily going to be easy. Goldstate is not considered a five-star partner and it has not proven itself as a group that will take a foreigner to the right places, though clearly in any JV it takes two to tango. It’s true that there is still a queue of potential new entrants, but they may prefer to go in as a greenfield manager seeking to build from scratch rather than taking over something of a tarnished legacy – that might well be cheaper, too. It does have on its side the fact that most new opportunities that come up do not grant foreigners a 49% stake, as this one will, but it won’t be with a trophy partner.

So if KBC can’t find a buyer, or sells out at a loss, what’s the message that goes to others who may be wavering? Probably that there’s no point in selling. They have already made their investment. The growth of the Chinese investment industry is inevitable, and might be enough to help turn around these flagging businesses. And since many of the institutions involved are engaging with China on a variety of fronts – for example, Morgan Stanley, which is attempting to bed down a new securities joint venture which is vital to the investment bank – they may feel it would look bad to pull out of a China business.

In other words, KBC is a test case on two grounds: first, as an example of a foreigner willing to come out and say it’s time to get out; but secondly, because its success or otherwise in making a sale might inform a lot of other decisions from peers. At the time of writing, no foreign names were being mooted as potential buyers; market talk was that the stake might instead be bought locally, changing the business from being a joint venture to a wholly domestically owned asset manager.  Unless a buyer is found, it’s unlikely any of the other foreigners involved in disappointing businesses would try to sell.

Then again, the dynamics of the business are undeniably tempting. Z-Ben puts the total mutual fund assets in China at just over RMB2.5 trillion as of February 28, a huge and growing industry; on top of that the non-mutual fund sides of the business show enormous potential as well. There is an argument for sitting tight and hoping that the rising tide really does lift all boats.

The successful Sino-foreign JVs are illustrative. Harvest, the biggest, is something of a special case, since it was given a host of international funds from Deutsche’s fund management arm, DWS Asset Management. But below that, the ventures that have shone have largely done so by building a comprehensive range of products and getting into the right areas. Bank of Communications Schroders, for example, which started out with a medium risk equity fund in 2005, has since built a strong product range attuned to market needs, such as a successful money market fund and, more recently, an ETF mimicking the SSE 180 index. CITIC Prudential, which is gradually rising through the ranks with a range of 12 Fidelity funds, is also representative of the diversified approach: as of March it had five stock funds, a hybrid fund, three bond funds, a classification index fund, a QDII fund (one which allows it to invest in international stocks for local clients) and a money market fund; it had RMB18.3 billion in assets under management at the end of 2010. So successful JVs have to take the risk to build a diversified product range that will perform no matter how market sentiment is changing.

Smart JVs will also be getting ahead of longer-term trends like corporate annuities, representing the gradual growth of a corporate pension industry in China, and positioning themselves for mandates from key state institutions like the National Council for Social Security Fund.

This week the Australian Treasury did what most in the market had seen as inevitable for months: it nixed the Singapore Exchange’s bid for its Australian counterpart, the ASX. Today, in a somewhat forlorn statement, the SGX sad that “the parties have agreed to mutually terminate the merger implementation agreement entered into on 25 October 2010.” No revisions to the bid, then; it’s over.

The fact that the SGX won’t try again reflects the fact that the bid was rejected because of something it could do absolutely nothing about: Australian political sensitivity. Partly this was about the tricky question of the Australian national interest, which has always been a somewhat nebulous concept. But also it was the fact that there could never – literally never – have been a worse time to get a politically dicey development through an Australian parliament. The government has no majority; it is only in office at all because of the assistance of a couple of independent parliamentarians who must be kept happy. In such circumstances, nobody was ever going to expend the political capital required in order to change the law and allow the national stock exchange to be taken over by a foreigner. Who gets re-elected on a platform like that?

The odd thing is that everybody seemed to know all this from the start. SGX CEO Magnus Bocker – who has completed more exchange mergers than anyone – built his pitch from the outset on efficiencies, logic, technology, liquidity; the nuts and bolts of an exchange merger in a new world of capital flows. And he was right on all of that, as the ASX could clearly see, hence the fact it backed the bid from the outset. But that was never the point on which the deal would thrive or fail. Bocker thought the force of this logical argument would be enough to get it through Australian politics and public opinion, and in that he miscalculated.

In the short term, the only people to have benefited are the banks who made a great deal of money in M&A advisory fees on a deal that they must have suspected from the outset could not go through. But what has it done to Bocker and the SGX?

It may not all be bad. It has certainly raised the profile of the SGX at a time when global exchange mergers are once again the flavour of the month. If Bocker has successfully represented Singapore as the best possible hub through which to bring Asian liquidity – current and future – into an international alliance, then it may be well placed to tie up either with Bocker’s old employer, Nasdaq OMX, or a mooted suitor like the Chicago Mercantile Exchange. If so, then everything will depend on the terms through which SGX enters such a deal. SGX being bought outright by a US institution would be politically difficult in Singapore. And if Bocker is right in thinking Asia will make up half of the world’s financial markets within a decade, then its role in any merged global group ought to reflect that. But some sort of partnership, or a stakeholding allowing Singapore access to a global network while retaining some autonomy, might work well. Market chat is about CME, but our money’s on Nasdaq.

If none of that comes to bear, though, Bocker’s reputation will unquestionably have been dented. The ASX bid was the signature flourish of a new CEO in his first year. If all it did was cost a ton of money in advisory fees, that’s not such a great way to start.

So what now for Magnus Bocker and the SGX?

The first thing the exchange did on Tuesday was to work out whether the coded language from the Treasurer’s office was a flat no or an invitation to revise the terms of the deal to turn it into a yes. SGX insiders say there will be no further move until a more detailed final decision is made by the Treasurer and communicated officially to the SGX. But it doesn’t look good: Bocker noted on Tuesday evening that the objections did not appear to be structural, and if that’s the case, it moves the problem into territory he can’t do anything about. Tweaking the deal with board seats and governance structures is fine, but it’s not going to make a difference when the substance of the problem is political expediency and the national interest.

Some who have worked with him believe that, from day one, Bocker will have pitched up in Singapore with a list of potential deals for SGX upon which the ASX just happened to be number one. They feel that he’ll simply turn to another target to bring about the exchange consolidation he sees as inevitable in Asia.

But it’s not really that simple. There are not obvious combinations among Asian exchanges in the way that there were in single-currency Europe. Tie-ups and alliances, yes – why not cement ties between Singapore and India, in order to make Singapore a safe and steady entrepot for capital into that vast market in the same way Hong Kong has done with China? But in terms of full mergers, the candidates are not so compelling. Hong Kong is a competitor. Tokyo and Seoul are too far away, physically and culturally, to have much relevance as a combined entity. And any sense of Singapore taking over a southeast Asian peer such as Kuala Lumpur or Jakarta would be politically nightmarish, as Singapore’s sovereign fund Temasek found out some years ago when buying a majority stake in Thailand’s Shin Corporation (the resulting political fallout was a large part of the reason the Thai government fell). If anything, dark pool liquidity providers like Chi-X, seen as competitors to exchanges, would be an easier route of combination.

Instead, Bocker is likely to look on a different scale altogether: integrating Asia into global capital flows, and making Singapore the hub through which that happens. And the most obvious way to do that is to go back to his old employer, Nasdaq OMX, where he was president before moving to SGX.

Bocker has seen first-hand the benefits that can come from binding a smaller partner in with a global network of capital infrastructure, because that’s exactly the deal he secured for the sundry Scandinavian and Baltic exchanges that were folded into OMX under his watch.

Singapore is no Finland or Latvia, though, and would expect a central seat in any global exchange alliance: as Bocker has consistently pointed out, Asia could account for half of all global financial markets within a decade, so simply being eaten by a global exchange will not be an option. So if this is the way that Bocker wants to pilot the SGX, the first thing he will have to do is see how the dust settles on the Nasdaq OMX, NYSE Euronext and Deutsche Borse farrago; and then to work out the best possible deal that could be struck in this new world of global exchanges. In this respect, he is in somewhat more familiar territory: helping a smaller exchange to punch above its weight within an international alliance.

In the meantime, he will wait for the Treasury to spell out formally just what its problem is with the SGX bid, in the unlikely event that the situation can be retrieved. But Plan B will already be gathering pace.

Euromoney, April 2011

Records are made to be broken, but you normally have a fair idea of the candidates for breaking them. Had you laid bets a year ago on what would replace Malaysia’s Petronas Chemicals as southeast Asia’s largest ever IPO, you might have plumped for an Indonesian resources play, or a Singaporean sovereign wealth fund spin-off, or even another arm of Petronas. You’d have had a lot of guesses before you came up with a port operator that isn’t based in southeast Asia, doesn’t have a single asset there, is owned by Hong Kong’s ultimate tycoon and has opted not to list as a company at all, but a trust.

But this is the curious case of HPH Trust, the owner of about 60% of Hong Kong’s Kwai Tsing container port, Shenzhen’s Yantian container port, and a few auxiliary assets. HPH Trust is sponsored by Hutchison Ports Holdings, by some measures the world’s top port operator; that, in turn, is owned by Hutchison Whampoa, the conglomerate controlled by Li Ka-Shing – the tycoon’s tycoon, as central and iconic to Hong Kong as the Bank of China building. Yet this two-port trust of Pearl River assets raised US$5.5 billion in a listing on the Singapore Exchange in March, breaking the southeast Asian IPO record by over US$1 billion.

So what was this jewel of Hong Kong doing seeking a listing in Singapore? For the Singaporeans, this is a coup to beat all coups. Attracting foreign listings has been a mainstay of the SGX’s approach to business for years: it calls it the Asian Gateway strategy, and by the end of 2010 it had resulted in 321 non-Singaporean companies accounting for 47% of the market’s overall capitalization. In a country – no more than a city state – too small to grow much further on homegrown listings, attracting foreigners is the future. But many of them have been Chinese private sector mid-caps of variable quality; few heavyweights, beyond Jardine Matheson and Noble Group, tend to opt for Singapore. Bringing in a multi-billion dollar IPO from a foreigner, and a Hong Kong conglomerate spin-off to boot, is more than they could have hoped for.

But there is really only one reason this prized Hutch asset has made its way to a Singapore listing rather than Hong Kong, and it has nothing much to do with the rivalry between the two Asian cities, or getting out of the way of Chinese state-owned listings in Hong Kong, or even valuations. It is all about a structure called the business trust.

The business trust structure was launched in Singapore in 2006 with the world’s first shipping trusts, Pacific Shipping Trust and Rickmers Maritime. It’s sort of a cross between a company and a real estate investment trust (REIT) – and Singapore is unarguably the ex-Japan Asia leader in REITs (it has 22 of them, worth US$27 billion). The idea of it is that it allows assets such as property or infrastructure to be monetised so that they pay their income distributions out of cash flows instead of accounting profits. For a business with stable cashflows and high initial capex, like a utility or an infrastructure business, a business trust structure gives it greater freedom in how it pays dividends.

It is, from the investor perspective, a yield play. “Our market participants and investors are familiar with such yield instruments,” says Lawrence Wong, head of listings at SGX. “The tax incentives and business friendly regulations have made Singapore the choice venue for the listing of such structures.”

When business trusts first came along, they were touted as an important new line of business alongside the REITs, but the truth is that until now they have been nothing like as impressive. Wong says SGX has nine business trusts with a combined market cap of US$11.9 billion, but US$8.8 billion of that is the post-IPO market capitalization of HPH Trust itself.

Instead, several businesses have struggled under the structure, including one of the first, Rickmers, which in 2010 received a report from its parent group’s independent auditor, PricewaterhouseCoopers, questioning its ability to survive owing to its debt load. Rickmers did stay afloat, but it – and, to a lesser extent, fellow shipping trusts First Ship Lease Trust and Pacific Shipping Trust – has struggled within the business trust model precisely because of being positioned as a dividend play. On one hand they are obliged to pay out as much of their operating cash flows as possible as dividends; but that doesn’t leave much margin for debt repayment or capital management, particularly when the shipping industry itself is under pressure. Even those trusts that have not struggled have been somewhat illiquid.

So why take this structure? After all, Hutch had considered a lot of alternatives for a listing venue. Those close to the deal say that it undertook feasibility studies for a listing in Hong Kong, the US, Australia and Europe besides Singapore, declining on first choice Hong Kong precisely because it lacked this seemingly underwhelming business trust structure.

It’s true that ports are the sort of operations that business trusts are pitched at: infrastructure with steady and reasonably predictable inflows. And Canning Fok, group managing director of Hutchison Whampoa, pointed this out when asked at a pre-listing press conference in Singapore about why he had chosen this route. “Why are we listing in Singapore instead of Hong Kong? If you look at the characteristics of our assets, most of the capex has been spent in the past, and in the next five to six years there is no significant capex that needs to be spent,” he said. “The business trust is welcomed by the investment community on this aspect, because then the cash flow generated by this business can be distributed.”

But then he added something else: “These two ports are important parts of our portfolio going forward. With our business trust structure, we can aim to avoid potential hostile situations with regards to our shareholders.”

And that, more than anything, is the point.

On page 71 of the vast, 600-page-plus prospectus, one finds this. “Under the Trust Deed and the Business Trusts Act, the Trustee-Manager may only be removed by Unitholders by way of an extraordinary resolution (that is, by the approval of not less than 75% of the voting rights of all Unitholders who vote on such resolution). Accordingly, a Unitholder who owns or controls more than 50% but less than 75% of the Units and has statutory control of HPH Trust may not be able to remove the Trustee-Manager.”

In other words, you could become a majority shareholder of this thing and still not have the right to change the trustee-manager, which in this case is Hutchison Port Holdings Management, and by extension Hutchison Whampoa. And there’s no special treatment been given to Hutch here to attract this listing: this is what Singapore’s business trust rules say for anyone who uses this structure.

Approached by Euromoney, Fok confirms that this was a key consideration. “It is an integral part of our strategy,” he says. “We don’t want somebody to end up in our door asking me to step aside. It is a central part of the strategy.”

People close to the deal confirm this was the clincher. “From an issuer perspective, if you own 25% of the company there’s no hostile takeover scenario that can happen,” says one. “For an issuer who’s not looking at a straight disposal but an extension of their business, which they want to keep running, it makes a lot of sense.”

While that’s great for the issuer, it has caused some consternation among corporate governance activists. David Webb, the Hong Kong-based independent analyst and thorn in the side of many a company and regulator, came out strongly – and uncharacteristically – in Hong Kong’s corner when the listing was announced. “There’s been much hand-wringing amongst legislators and media in Hong Kong about losing out to Singapore as a choice of listing,” he says. “We don’t think Hong Kong is losing out at all, and it would be a loss if Hong Kong were to lower its standards to attract such business.”He points out that Hutch plans to retain only 25% of the listed trust – a key number given the business trust rules (the precise number it ends up with will depend on the greenshoe, and it was not clear as Euromoney went to press if this would be exercised). “If HPH retains 25% plus one unit, then HPH Trust will be bid-proof. Even if HPH is prohibited from voting, it would be an uphill struggle to get the required majority,” he says.

“Short of that, unitholders will have very little say, except on connected transactions, because they will not be able to elect directors of HPH Management, unlike a listed company. In short, the only way to change the directors of a trustee-manager is to own the trustee-manager.” He also points out that under the structure of the deal, although Hutch’s interest in HPH will be reduced to 25%, it will still retain 100% of its operations and receive fee income for doing so. “Nice work if you can get it.”

“We can see no good reason for Hong Kong to emulate Singapore business trusts,” concludes Webb. “There’s no tax reason for doing so, and there are governance reasons why we shouldn’t. We should not race to the bottom just to win business from tycoons who are not willing to work with existing corporate governance standards.”

Hutch and its bookrunners take a different stance: that HPH works best with Hutch involved, so anything that blocks a potential takeover is good for investors rather than bad. “The company needs good management,” Fok tells Euromoney. “To raise this kind of money around the world, it can only be delivered, the business plan, with the support of HPH. That is very important. With the kind of shareholdings we have, 25%, we can deliver the result to the shareholders and the management is a crucial part of it.”

Bookrunners also say this didn’t turn up as much of an issue on the roadshow. “Investors are not concerned,” says Eng-Kwok Seat Moey, managing director and head of asset-backed structured products at DBS Bank. “In fact, investors view it as a sign of the sponsor’s commitment and see it as an alignment of interests. They would like the sponsor to provide continuity through managing the assets. For REITs , the sponsors’ stake is on the average about 30%.”

If Webb’s concerns were shared by institutional investors, it wasn’t immediately apparent as the three bookrunners – DBS, Deutsche Bank and Goldman Sachs – hit the road pre-marketing in pursuit of cornerstone investors. By the time the deal launched, they were able to announce eight cornerstones taking up US$1.62 billion of the deal. That would prove a vital anchor and vote of confidence in getting the rest of the deal away in record time.

The eight – Ally Holding, Aranda Investments, Capital Research and Management, Cathay Life Insurance, Lone Pine Capital, Metropolitan Financial Services, Paulson & Co and Seacrest FIR – make for a curious combination. On one hand there is some suitably steady or Singapore-linked money: Aranda, in for US$100 million, is owned by Temasek, the Singapore sovereign wealth fund; Cathay Life, from Taiwan and up for US$100 million too, is a natural holder of a yield-producing infrastructure asset. Capital Research, the biggest buyer with US$634 million, is also a natural holder. But Paulson & Co is John Paulson’s vehicle: a multi-strategy event arbitrage investor (a hedge fund manager, in other words). And at US$350 million, he made the second-biggest commitment of all the cornerstones. Lone Pine Capital, too, is not an obvious candidate; founded by Steven Mandel, it is also seen as a hedge fund group (it put in US$186 million). Ally and Seacrest are BVI companies, in Seacrest’s case representing Jenkin Hui, a Jardine Matheson director who runs Pointpiper Investments; and Metropolitan represents “various reputable individuals from the South-East Asia region” with “substantial stakes in both private and public companies in the natural resources sector,” according to the prospectus.

Those close to the deal say the diversity was intentional. “We were very selective in our cornerstones,” one says. “We wanted a wide range: long funds, hedge funds to provide liquidity, and also the family, high net worth investors.”

This eclectic gathering would represent 30% of the total deal. The rest of the deal was structured in four parts: a global offering, a public offering without listing (POWL) in Japan led by Daiwa and Mizuho Securities (the global offering plus the POWL eventually made up 88% of the base offer, cornerstones excepted), a Singapore public offering (just 3.4% of the deal) and a preferential offering to Hutchison Whampoa shareholders (8.6%). There were two roadshow teams, one led by Fok and the other by long-standing Hutchison Whampoa CFO Frank Sixt, in both cases alongside members of the Hutch Ports team.

The strength of the anchor book meant that when the roadshows started, they were able to get what they needed and stop pitching a day earlier than expected; this would prove crucial when the POWL in Japan ended on the morning of Friday, March 11, just hours before the earthquake and tsunami wrecked the country’s northeast.

Those who saw the roadshows say that governance issues rarely came up: questions focused much more on the growth profile of the ports, the ability to sustain cashflows, and on gearing. Fok says the global offer part, including the institutional book bar the cornerstones, was three times covered. Still, some institutions stayed away, fearing an operator as canny is Li Ka-Shing was selling his assets for top dollar at the top of emerging market buoyancy. “We let that one go through to the keeper,” says one fund manager. “A bit expensive, with other listed options more attractive.” In the end the deal priced in the middle of a US$0.91 to US$1.08 range, settling at US$1.01 per unit.

Business trust structures aside, there were some other reasons for the Singapore listing too. Hutchison Ports Holdings (the company not the trust) features PSA International, the Singapore state-owned port operator, as a 20% shareholder; PSA has bought assets from Hutch before.  Also, Singapore offers a tax break for trustee managers in offshore infrastructure: 10% for the first 10 years, assuming HPH Trust is deemed to qualify.

And there’s no denying that these are good and well-positioned businesses. Yantian is a play on Chinese export strength; Hong Kong, while clearly more mature, has become a regional transhipment hub. “Despite the global financial crisis, both assets achieved record throughput in 2010, both exceeding 10 million TEU each,” says Ivor Chow, CFO of the trustee-manager. He says growth over the last 10 to 15 years has been 10 to 15%, and that in future it is realistic to expect 8-10% throughput growth, driven not just by Chinese export growth but imports too, for which the trust owns the longest berths and largest yards with deepwater access in the region. “We have very long-term relationships with our customers with some spanning over 30 years,” Chow adds. Investors will go into the deal with an expected yield of 5.9%.

But it’s hard to shake the sense that HPH represented a great deal for Singapore, and a great deal for Hutch, without quite the same certainty that it will be a great deal for investors. Singapore gets a landmark upon which to base a whole new push for overseas infrastructure assets. Hutch gets a lot of money to pay down debt and invest in more ports. Investors get a play on Chinese exports, decent yield – and an unproven structure from which its managers could not be removed with gelignite. Time will tell if that’s a smart call.

Box: The big moment

Having won such a trophy, Singapore paraded it with pride. On the day HPH Trust began trading, March 18, newspapers – international as well as local – carried two full pages of ads apiece using the listing to promote Singapore as the “home of infrastructure companies tapping into Asian liquidity.” And the moment of listing was set at 2pm, the start of the afternoon session, rather than the morning bell in order to accommodate maximum participation at the listing ceremony.

These ceremonies come and go regularly at SGX on the second-floor foyer of the exchange’s Shenton Way building, but this attracted a particularly senior crowd. Ho Ching, chief executive of sovereign wealth fund Temasek, was there to greet the great and the good of the Hutch empire including Canning Fok, Frank Sixt and a host of executives from the port business and the new trust. Singapore Exchange had its top brass out: chairman Chew Choon Seng, president Gan Seow Ann, listings head Lawrence Wong – in fact everyone bar CEO Magnus Bocker, no doubt embroiled in SGX’s continuing tilt for the Australian Securities Exchange.

A screen had been erected behind the stage showing the bid and ask prices ahead of commencement of trading; in front of it, as the big moment approached, Chew and Fok made speeches. An SGX spokeswoman announced there would be a 10-second countdown to the start of trading. Then she started counting down to the countdown. It began to feel like a Space Shuttle Launch.

The crowd – and it was quite a crowd – obediently counted down to 1.59pm whereupon Fok, Chew and HPH group managing director John Meredith started hammering at a gong with mallets, a swirl of gold confetti filled the air and two dragons commenced a lion dance to a clash of cymbals. It was a perfect moment: except for the fact that, at that moment, on the big screens behind this exuberant melee, the stock opened 4% down on its listing price.

Nobody seemed to be looking in that direction.

Singapore Exchange (SGX) is about to find out if its audacious bid to take over its counterpart in Australia will go through. Getting there will require it to win over a hostile and suspicious Australian public who don’t like the idea of losing a national icon to a foreign buyer.

But whether it succeeds or not, chief executive Magnus Bocker’s bid has cemented the sense that Singapore’s exchange, having grown as much as is practical at home, must strike out overseas in order to move forward.

In that respect, it mirrors the country itself: no natural assets to exploit, and too small to thrive on home-grown business, so built on the back of other people by servicing their trade and being a go-between, riding on the back of domestic growth in far bigger countries by making life easier for their merchants.

To see the article as it ran, click here: http://www.storm.sg/Issue07/07_Pg18.html

And so it is with Singapore Exchange. Actually, the SGX bid is only the natural conclusion of a trend that has been underway for a decade or more. Singapore has, over the years, built some outstanding national champions in its corporate and banking world. But, barring the Port of Singapore Authority, they are pretty much all now listed already. Many years ago the exchange’s executives realised that in order to grow any further, they would have to become a regional hub and attract companies from overseas to list there too, because Singapore was just too small to grow indefinitely off its own domestic growth. This became known as the Asian Gateway strategy, and it is going from strength to strength.

By the end of 2010, 40% of Singapore’s companies by number, and 47% by market capitalization, were foreign – and that’s just the start. Lawrence Wong, the head of listings, says he hopes that within a few years the percentage will top 50%. It’s already on its way: of the five new listings that closed their offers in January, only two were for Singaporean companies; the others were a Chinese property developer from Xiamen, a Thai natural rubber processor and a Malaysian tin smelting operation. And by far the most eagerly awaited listing of the year so far is Hutchison Ports – from Hong Kong. That might well prove to be the biggest listing in Singapore all year.

And so, like the country it represents, the exchange is growing by going regional. “We are a microscopic version of Singapore,” Wong says. “If you look at Singapore per se, we can never produce the kind of GDP [on our own], so we keep reaching out. The exchange is doing the same.”

When the exchange hired Magnus Bocker as CEO last year, it did so knowing that he came with a particular reputation and strength. Bocker had started out with a company called OM Technology in Sweden which operated the Stockholm stock exchange. In 2003, when he was deputy CEO, OM merged with a company called HEX Integrated Markets, which ran the exchanges of Finland, Estonia and Latvia. It was to be the start of a breakneck series of mergers that Bocker, who swiftly became CEO, would pilot: exchanges in Denmark, Lithuania, Iceland, Norway and Armenia, before he sold the whole consolidated business to Nasdaq in 2008 and became its president. By his own count, the Australia bid is the 10^th attempted merger he’s been involved in.

When you talk to Bocker, his language is that of process, efficiency, operations. While he understands the emotional connection to exchanges – they do, after all, tend to be housed in historic buildings and represent a certain national standing – he is unemotional about them himself, thinking of them purely as servants to the markets and its participants. Europe, which at one stage had 40 exchanges even as most of the countries themselves were consolidating to a single currency, clearly needed consolidation, and Bocker sees the same trends coming together in Asia. “Asian financial markets a decade from now will be more than half of the world’s financial markets,” he says. And he believes Singapore has the market, regulation, infrastructure and willingness to adapt to be the senior financial centre.

If his ASX bid goes through, the combined company will have pro forma revenues of US$1.1 billion before tax, be the second largest listing venue in Asia Pacific, have 2,700 listed companies, the largest sectors for real estate investment trusts and exchange traded funds in the region, the widest range of Asia Pacific derivatives, and technology that stands up to any competitor worldwide.

That heft is becoming increasingly important: in the months since the bid was first announced, the London Stock Exchange has agreed to merge with its counterpart in Toronto, while Deutsche Borse and NYSE Euronext are likely to join forces to form the largest exchange platform worldwide. The world’s exchanges are increasingly grouping into a handful of aligned and merged blocs, pooling liquidity, serving an inter-connected planet. This wave of M&A has much further to run and Bocker wants to be at the forefront of it.

But is something lost along the way in all this?

Few countries are more of a brand than Singapore is. That might not be obvious on the ground, but from a distance, it’s true: the Singapore Inc label makes a lot of sense. Its business acumen and open-market policy is a brand. Its cleanliness and civil obedience is a brand. The peerless functionality of the MRT is a brand. Singapore stands for certain things, particularly in the international business world: ease of process; strength of infrastructure; accommodation of regulation; and, to be frank, no likelihood of democracy effecting political change.

SGX, too, is a brand, and it has built a world-standard position as a top-notch exchange from the perspective of technology, infrastructure and regulatory environment. But there is a risk that as more and more non-Singaporean companies become part of the SGX family, that brand is cheapened.

This is nowhere more true than in the S-chip world. S-chips were born out of a perceptive observation: that there was a whole world of emerging mainland Chinese private sector companies, built by entrepreneurs, that could not get access to capital in Hong Kong because that market was swamped with state-owned behemoths like the mainland banks, energy and telecommunications companies, who would raise billions of dollars at a time and suck not only the money but the attention of investors from the market. Singapore stepped in and served a need: and by now, over 150 Chinese companies in that bracket have come to list in Singapore.

Some have done very well. China Fisheries is a current market darling; Cosco and China Merchants have performed well for investors too. Some people really do get in on the ground floor of a rapidly rising elevator, and do very well. But the roll call of companies that not only do not do well, but outright fail through incompetence, bad governance or even fraud, has become embarrassing.

FerroChina. FibreChem Technologies. Oriental Century. Zhonghui Holdings. Sino-Environment. China Sun Bio-Chem. Beauty China. Celestial. China Milk. All have been suspended or delisted for one reason or another, some for accounting irregularities, some for defaults. And in very few situations have Singapore investors got any money back. Take China Milk: loved by institutional investors when it listed in 2006, this upstream dairy producer – that is, bull semen and cow embryos – won over names like DBS Asset Management, JF Asset management and Dubai Investment Group with its bold plan to revolutionise the Chinese dairy herd with Canadian cows and bulls. Yet in January 2010, faced with calls on a convertible bond, it said it was experiencing a brief delay remitting funds from the mainland; the following month it was suspended. Its last announcement was in October, since when its web site has been shut down, and there is no indication of it ever coming back. Yet who can the shareholders complain to? A closer look at the company reveals that it has no office and no assets in Singapore to pursue, just two independent directors who have no real power. It is domiciled in the Cayman Islands and its assets – a load of cows – are all in China.

SGX takes great pride in the level of vetting it does before letting companies list, and in the monitoring it conducts while companies are on its market. And, in fairness, six or seven Chinese delistings clearly do not represent a majority in a market of 150. But they do represent a reputational problem, and they demonstrate loud and clear the flip side of seeking listings from far and wide.

The Australia bid doesn’t fit into this category, for several reasons. For a start, the ASX has world-class standards of supervision as well as technology: it is, in many respects, quite similar to the SGX. Also, what’s been proposed so far is a merger at the holding company level, not a merger of the actual exchanges, which will remain separate, just with greater links between them (such as a so-called passport scheme for the biggest companies, making it easy for investors on one exchange to buy the big stocks on another). SGX-ASX is a bid played out on an altogether different field: one of global alliances, combined liquidity, and technological efficiency.

But the ASX situation does raise an interesting point of difference which speaks to the issue of whether Singapore is cheapened by its regional ambitions.

To some, it seems odd that a stock exchange can be listed on itself. In fact, these days, it’s increasingly commonplace, and has been done all over the world. But it creates one difficult situation. Stock exchanges are supposed to regulate the companies that list on them, and to make sure they impose high standards in terms of who they allow to list. But as a listed company, a stock exchange exists to make profits for its shareholders – and to do that, it’s in its interests that it allow as many companies to list as possible.

“It is a conflict of interest to be a for-profit regulator in any field,” says David Webb, the Hong Kong-based commentator and governance advocate, speaking about exchanges generally. “There is a short-term incentive to lower standards to attract listings, and to cut regulatory costs to boost profits.”

Different exchanges have dealt with this in different ways. When the London Stock Exchange listed, its regulatory functions were moved out and put into the Financial Services Authority. In Australia, regulatory functions were moved out in two stages after demutualisation, so that while the ASX remains the front-line regulator, it then also has various functions supervised by the Australian Securities and Investments Commission. But at SGX, as in Hong Kong, the exchange is also the regulator.

SGX says its policies internally prevent a conflict: that nobody on the listings side could compel someone on the regulatory side to allow a listing through. But perhaps if Singapore is going to continue to embrace the rest of the world’s companies in order to build market size and listing fees, it would look better – even if it doesn’t make much difference in practice – to move regulation out completely to the MAS.

SGX is the perfect sort of institution to thrive in this new global world, just as Singapore itself is the perfect nation to capitalise on a globalised planet with ever-growing flows of people and trade. It is smart, sophisticated, and crucially willing to change. Its policies have put it among the drivers in a period of consolidation that could, in time, reshape the region just as it has reshaped Europe. But nothing comes for free. Just as Singapore itself fears the changes to its identity that come with increased foreign immigration, its exchange’s character and brand are going to be changed too as it becomes a regional rather than a local place.

China’s telecommunications industry is reaching a stage of maturity: three established operators, national 3G coverage, and widespread mobile phone usage. Yet the staggering rates of growth in the country show no sign of tailing off as they do in most mature markets. Instead, operators are now being propelled by a new trend: the shift to data, content and apps.

China continues to add nine to ten million new subscribers per month – far more than the entire population of Hong Kong. Numbers like this have been commonplace in China for years. But such is China’s extraordinary scale, penetration is still only 60%, leaving considerable opportunity for growth.

On top of that, as penetration grows, so too does the use of newer technology. China is aspirational and tech-savvy, and more and more phone users are no longer happy with 2G capability. The shift towards 3G is going to be the most important driver for Chinese telco operators in the coming years.

Last year 3G was something of a headwind for operators. They had to commit large amounts to capital and operational expenditure, and had to invest heavily in handset subsidies, discussed in more detail below. But the industry is at a tipping point. Today, 3G coverage is truly national – which means, strictly speaking, that the 335 population centres considered as cities in China have coverage. It is becoming more affordable, as smart phones drop in price, and the growth numbers here are already becoming impressive. Roughly 46 million new 3G users were signed up in 2010, compared to 10 million in 2009, according to CLSA; the figure is growing at around four million per month. “China 3G users will likely double next year to 94 million,” says Elinor Leung, analyst at CLSA.

Remarkably, despite this rapid growth, 3G take-up in China is a long way back from where the government expected it to be by now. Nomura analyst Leping Huang says the Ministry of Industry and Information Technology, which regulates the telecoms sector in China, had set a target of 150 million 3G subscribers by the end of 2011. Nevertheless, he thinks that growth is coming: he expects 100 million by the end of 2011, and that the 150 million target will be hit within 2012. Huang’s colleague Danny Chu, a China telecoms analyst at Nomura, adds: “In most Asian countries, it’s the second or third year after 3G launch that you see massive numbers of 2G subscribers migrating to it. This year in China will be the second year since the operators launched their services. If China goes through the same cycle, I expect this year we are going to see a whole lot more people migrating to 3G.”

Huang and Chu take the view that handsets are going to be instrumental in this growth. “When I have travelled inside China and talked to consumers, quite often the price of a 3G handset being relatively high was the main reason 2G subscribers were choosing not to migrate,” says Chu. “In very few cases it’s the monthly fee, but in most cases it’s the handset price.” Huang calls handsets “one major bottleneck to 3G growth,” and adds: “In 2011, we believe 3G subscriber growth will be a key theme for China’s telecom industry, and entry-level smartphones could be an important accelerant of it.”

Indeed, in a landmark January report, Nomura heralded “the RMB1,000 revolution” in Chinese telecoms – by which it means entry-level smartphones available at or below that price (roughly US$150). In fact, once operators apply their customary subsidies to bring subscribers in, the actual cost could be as low as RMB600. “We are seeing a boom in smartphone development among Chinese handset OEMs [original equipment manufacturers],” Huang says. “Most companies are aiming to capitalise on the growth opportunities presented by 3G in China and want to penetrate the mid-range segment of the global handset market.” This increased affordability, coupled with efficient distribution networks and attainable pricing for voice and data services, ought then to drive 3G usage. Huang’s report calls for the 3G handset market to grow from 37 million in 2010 to 151 million in 2012, boosting penetration from 6% to 17% as it does so, and overtaking the UK to become the world’s second largest smartphone market by 2012 alone the way.

Nomura is not alone in this view. Navin Killa at Morgan Stanley says in a January report that “the rapid development of mid-range smartphones in the RMB1,000 price range will lead to accelerated take-up of 3G services in 2011.” Killa points to a new scheme from China Unicom to offer RMB46 per month 3G plans, in addition to its existing RMB66 per month plan, in order to target the low-end market.

And James Sullivan, an analyst at JP Morgan, also believes this is a key theme for 2011. “The iphone gets a tremendous amount of press in China,” he says. “But the bigger story is the introduction of smart phones with full Android functionality [the free operating system for smartphones] coming in at around the US$100 price point. This serves to considerably increase the addressable market for data services in China and it will be a real driver of subscriber growth and data usage in 2011 and beyond. When you get lower priced, but still reasonably full-functioning, phones and put them into the hands of consumers, that really allows the next stage of revenue growth.”

There are several knock-on effects of these trends. One relates to the handsets themselves. The handset industry is intensely competitive and will remain so as operators compete for 3G users. The market research firm iSuppli says there are more than 400 handset design houses and more than 3,000 handset assembly vendors in China. Most are known as white box, meaning they do not have their own brands; many are not even legal, registered companies. “The initial wave of handset assembles make reasonably good money,” says Sullivan. “The danger is it goes down the path – as it did with 2G – of five guys making money to 150 all losing money. And I think that’s very likely. But, from an operator perspective, it’s positive because it drives down handset costs.”

Generally the big telecom operators subsidise handsets in order to improve business, and this trend isn’t going to go away. “Competition will remain intense next year as operators compete for 3G users,” says Leung. “China Mobile and China Telecom will likely step up their 3G promotions to attract high end users with better smartphones.” CLSA estimates that China Mobile will spend about RMB16 billion in subsidies in 2011 – it spent RMB15.5 billion in 2010 – and thinks China Telecom will spend RMB12 billion, and China Unicom RMB7-8 billion. There are contradicting pressures at work here: on one hand, handset prices are falling generally, meaning subsidies don’t need to be so high, but at the same time the growth of 3G services and users mean that subsidies then have to be applied to better and more expensive phones in order to win that business. There are some ways around it – China Telecom has renewed many CDMA contracts with offers of free minutes and tariff discounts rather than handset subsidies – but it will remain a big issue for operators.

Partly for this reason, average revenue per user (APRU, in industry terms) has been declining for some time and is likely to continue to do so. China Mobile’s ARPU fell 7.2% in 2009 and 5.6% in 2010, for example, and is still falling, although China Unicom’s is expected to rise as 3G becomes a larger proportion of its subscriber mix.

At the same time, these trends mean that data generally is going to become much more important to phone companies. This, too, presents enormous opportunity for growth. Internet penetration is only 30% in China, compared to 80% in the developed world, but it’s already clear that Chinese are keen to embrace internet access through their phones. Half of China Mobile’s revenue growth in the first half of 2010 came from non-messaging data usage, or ‘real data’.

“Real data growth should accelerate in 2010 with increasing supply of affordable smartphones and smart devices like tablets,” Leung says. “China is well positioned for mobile data growth given the strong demand for both wireless broadband services and mobile apps. China also has a large internet market and strong internet culture.” It’s worth remembering that 30% penetration might not sound much, but in a nation of over a billion people, it’s an extraordinary volume. CLSA says there are 294 million users using instant messaging – close to the population of the USA – and 200 million using social networking services alone, and 150 million digital books. “These internet content and users can be easily transferred to the mobile platform.”

All three Chinese telcos have launched their own apps stores to help capture the growth, such as China Mobile’s Mobile Market store, as well as its mobile payment and eReader services. Noting that it is starting from a small base – Mobile Market has just under 10,000 software apps compared to 300,000 on Apple’s iTunes and 100,000 on Google’s Android Market – China Mobile has launched a marketing campaign to encourage university students and other young people to develop apps for them, with the developers getting 70% of the revenue. Additionally, since smartphones are tending to use the Android platform – which is open to anyone – that encourages entrepreneurial content creation, unlike Apple, which exerts more centralised control.

But while there’s a clear market, there’s also a question of how it affects the bottom line. “The big question is the impact of wireless data on margins,” Sullivan says. “China is a reasonably good market in that network capex is done at a parent company level by most of the operators, so the additional burden won’t be felt on the listed companies.” But that’s only half the story, he says. “There is also the operating expense impact of wireless data, and there are a couple of ways that plays out.

“It’s good in that it will mainly be local language on Chinese servers, unlike Singapore, Malaysia or the Philippines, where content is English-language and incurs linkage costs. China avoids that because o the local level of content and the lower media presence.

“But on the other hand, one of the biggest drivers of operational expense is the number of base stations you are running. A lot of cost line items – site rentals, power, maintenance – are inextricably linked to the number of base stations you are running, and as data usage starts to explode, you have more base stations to service.” New technologies with greater efficiency help, but Sullivan says it can’t keep pace: if a new technology is 50% more efficient than an old one, that doesn’t help with a 300% increase in data usage. “It is critical that investors understand the cost characteristics of wireless data. Opex drives free cashflows and the ability to service reinvestment requirements.”

Chu agrees that the shift to data is a mixed blessing. “You would expect that as more subscribers use mobile data services, over time it should help operators to generate additional earnings,” he says. “But at the same time, there is the additional capex they may have to invest in the network. Back in 2009 I’m pretty sure no operators in Chian would have imagined the surge in data traffic in the network they are experiencing now.”

Despite these pressures, analysts are broadly positive about earnings in the industry. It has been one of the best sectors in the country to be exposed to: in 2010 the sector outperformed both the MSCI China Index and Hong Kong’s Hang Seng Index, by 6.8% and 3.5% respectively. Notably, that outperformance was most pronounced – around 15% – in the first half of 2010 when the Chinese government began macroeconomic tightening. The tightening dynamic is underway again in 2001: interest rates are rising and inflation is a challenge, all of which supports continued outperformance.

Chinese telecoms “will continue to do well in the uncertain market environment in the first half of 2011,” notes Leung at CLSA. “2011 should be a better year with accelerating 3G user and data growth.” She expects 11% growth in industry mobile revenue in 2011; in China Unicom’s case, she expects earnings to double (despite which, the broker does not recommend holding it, seeing it as too expensive, instead recommending China Telecom and China Mobile, based on earning recovery and valuations respectively). Elsewhere, Credit Suisse prefers China Mobile, then China Unicom, with China Telecom least preferred because of its heavier exposure to fixed line. Morgan Stanley prefers China Unicom as “the bet 3G play in China”. And JP Morgan is overweight Unicom and China Telecom, and neutral on China Mobile.

While these operators are the names that attract most attention among international investors, they are actually only a part of the overall chain that is open to them – with several non-Chinese businesses among the names to benefit from expansion in China. Looking only at Hong Kong or US listings, there are distributors and retailers (Digital China, Gome); handset OEMs (ZTE, TCL Com, China Wireless, Lenovo, BYD Electronics, Foxconn); manufacturers of handset components (AAC Acoustics), handset chipsets (Qualcomm, Spreadtrum) and handset software (Google). Including the universe to Taiwanese listings adds names such as Synnex, a distributor/retailer, Unimicron, a handset component manufacturer, and Mediatek, and handset chipset builder, to the mix.

So what next? Like the rest of the world, Chinese are fascinated by iphones, though they are by no means mass market devices given the costs involved. “High end phones like the Samsung Galaxy and iphone represent maybe 5% of Chinese mobile subscribers as an addressable segment,” says Chu. First out of the blocks – in terms of launching an iPhone on a network that can actually use it properly, with reasonably full functionality – was China Unicom, with its WCDMA system; China Telecom is working on a CDMA version which will be similar to what Verizon sells in the US. (An analogy would be to see AT&T and Unicom bracketed on one side, CT and Verizon on the other.) Killa at Morgan Stanley considers the “euphoria” about a CDMA iPhone “is overdone”; Chu sees that it has great branding potential for China Telecom, but wonders: “Is it earnings accretive? Once you sign a commercial agreement with Apple, you will bring in high-end customers but the amount of subsidy you incur will be much more significant than on most Android phones.”

And after 3G, inevitably, comes 4G: in essence, a secure broadband service to mobile phones. Japan and Scandinavia have already built commercial 4G services, and China Mobile has built trial networks.

Widespread use of this in China is some distance away, but is worth thinking about. “The advent of 4G technology will draw focus to the issue of frequency spectrum, as radio frequency spectrum allocation suggests congestion,” says Chu. He thinks this is going to present more of a problem in India and Thailand than it is in China, since spectrum fees are relatively low in China, but he is already factoring it into his stock recommendations, ranking China Mobile a buy partly because the 125MHz of spectrum it has is ample for data growth. “With available spectrum becoming more and more limited, we believe mobile operators with ample spectrum will be much better placed to compete going forward,” he says. Either way, moving to 4G is going to incur considerable additional capex. Progress is great, but it never comes cheap.