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Why foreign banks pay over the odds for a China foothold

Brent Lewin | Bloomberg | Getty Images

If markets are spooked by fears of bad debts in China's banking system, why are foreign banks still willing to pay premium prices to gain access to the mainland?

Singapore's OCBC announced Monday that it was in exclusive talks to buy Hong Kong bank Wing Hang, Reuters reported. However, the estimated price tag of around $5 billion -- slightly less than two times its book value – has raised concerns that it is paying over the odds for the lender. Most mainland-listed banks trade at less than one times book value.

(Read more: New year, new woes for China stocks)

But the pricing of Hong Kong's local banks isn't likely to come down anytime soon.

"It's the price put on a small banking franchise here because there aren't many of them left," said Erwin Sanft, head of China and Hong Kong equity research at Standard Chartered. "If banks don't buy them now, there won't be any in the future."

In late October, China-based investment firm Yue Xie bought Chong Hing Bank, Hong Kong's smallest family-owned bank, for $1.5 billion, or around 2.1 times its book value.

"It could make sense for any foreign bank to acquire one of the Hong Kong banks because they have a good foothold here in Hong Kong, good deposit franchise and it's the bridgeway to China. And the Hong Kong banks provide good opportunities in lending to the Chinese customers," Sabine Bauer, senior director for financial institutions at Fitch Ratings, told CNBC.

Sanft expects banks are jockeying for Hong Kong's local lenders to exploit the growing international use of China's offshore currency, the yuan, with much of that business centered in Hong Kong.

The use of the yuan in cross-border trade settlements is set to grow by 50 percent to 6 trillion yuan ($988 billion) in 2014, according to a December Deutsche Bank report, reflecting the swift adoption of the currency in trade finance. In October, the yuan overtook the euro as the second most used currency in international trade finance, according to data from the Society for Worldwide Interbank Financial Telecommunication (SWIFT).

Acquiring a Hong Kong bank also offers a stepping stone into China's banking market at a time when the mainland banks are facing restrictions on their credit growth.

(Read more: Are China bank stocks cheap or just crummy?)

"The tighter credit conditions in China lead to stronger loan demand from the Hong Kong banks," said Sanft. "There's going to be increased demand from the mainland-based corporations."

If the Wing Hang deal succeeds, OCBC will be following in the footsteps of Singapore peer DBS, which in 2001 acquired Hong Kong bank Dao Heng in a deal widely considered overpriced at just over 3 times book value.

While completing a Wing Hang deal would double OCBC's China loan book, analysts are concerned about how well the deal will be executed, especially after DBS' experience.

In addition, Sanft noted, "Buying these smaller Hong Kong franchises fits better with the mainland banks because playing a bigger role or a central role in the growth of the offshore renmibi fits more easily."

(Read more: China's bad-loan skeletons to haunt markets)

He cited mainland-based China Merchants Bank's acquisition of a controlling stake in Hong Kong lender Wing Lung at around 3.1 times book value in 2008 as a more successful deal.

But the lure of entering the mainland's banking segment is likely to continue to draw foreign banks.

(Read more: China 'major' uncertainty facing global economy: Soros)

"As China develops from what was an agricultural society, into an industrial society, into a consumer-driven society, then products like financial services will become more attractive," Jim McCafferty, co-head of equities research at CIMB Securities, told CNBC. "The demographics of China fit in to that quite nicely. So from a top down point of view, there is no doubt demand is there."

Trading in shares of both OCBC and Wing Hang was halted ahead of the announcement.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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