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The A-Share Premium: Could It Extend To Toxic Assets Too?

The Chinese government is attempting to turn its energy, export and consumption-led stock market into something that looks more familiar to American investors: a fully-fledged heavily financial services-weighted trading ring. That plan could create a strange tug-of-war in big-bank valuations.

Just last week, Shanghai broker Everbright Securities announced it was raising $1.6 billion for an IPO on the city's local exchange, in what is to be the first public listing of a financial services firm there since December 2002.

Days later, British bank HSBC said that it hopes to be among the first foreign companies to obtain a listing in China. Regional chief executive Sandy Flockhart explained the logic as potentially "widen[ing] our shareholder base and [giving] an opportunity to those ... who would like to invest in a financially diversified bank," according to The Wall Street Journal.

Then today, Hong Kong's Bank of East Asia said that it too, is planning a listing in Shanghai sometime next year. (Incidentally, Bank of East Asia has a funny history of "bank runs" started by rumors of its collapse: once in September last year, in the wake of the Lehman Brothers bankruptcy, and once before that, when a bystander mistakenly took a long line of passengers waiting for a bus for nervous depositors and messaged around the island.)

To Shanghai's Vice Mayor Tu Guangshao, turning Shanghai into one of the world's preeminent world financial centers has always been a long-term dream. On the occasion that I met him in 2005, he heartily endorsed Hong Kong-style capitalism, and indeed, envisioned it as the model for the future of his own city. Giving banks -- especially foreign ones -- Chinese "A-share" listings is a major step towards achieving that goal.

But in the aftermath of the subprime-meltdown, as international banks seek listings in Shanghai, that may create some confusion among domestic shareholders as to what the actual value of the bank, and its assets actually is.

In Hong Kong and China, it's commonly accepted by investors that companies which list in both places trade at a slight-to-hefty premium in the latter. It's called the "A-share premium," and it's mostly because of China's tightly-controlled and government-directed market environment.

While banks' valuations have performed pretty well in 2009, that's only because of the enormous capital hemorrhaging the year before. In other words, you could hardly say there's any kind of investor euphoria over financial institutions at the moment. But that's exactly what there's likely to be in Shanghai, when financial institutions list there, since IPOs nearly always generate massive excitement (again -- particularly foreign ones). That would be all very well, if it wasn't for the fact that most banks are sitting on a relatively large amount of toxic assets whose valuations look uncertain at best.

Take, for example, HSBC. The ADR has risen a respectable, though unremarkable, 11.5 percent this year. That's mainly because the quality of the bank's assets is being reflected in the stock price. When the British bank lists in Shanghai next year however, there is likely to be a substantial premium to the $188 billion market cap that HSBC commands in London and New York, as giddy Chinese investors snap up the shares.

That premium begs a question: since Chinese investors are obviously more willing to pay a higher price than American and British ones for, in part, the derivatives the bank holds, then does that mean that we have been undervaluing them? The argument is especially pervasive when you consider the growth rate of the Chinese economy.

It's a long shot -- not to mention an indirect one -- but if Shanghai expands listings of foreign banks quickly enough, the A-share premium may be the first real glimmer of hope for toxic western mortgage-backed derivatives.

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