I have just read an interesting piece produced by Mary Amiti and Kevin Stiroh at the Federal Reserve Bank of New York, called “Is the United States Losing it Productivity Advantage?”
Although it is not primarily about China, it does lead to some interesting conclusions that may help us to understand long-term growth prospects in China.I have always been worried that the educational, labor and regulatory rigidities in China, an instinctive protectionism and reluctance to see disruptive new entrants to the market, and a cumbersome process of continuous management and manipulation by politically-determined decision-making at both the central and provincial levels, while they may be useful (or at least not too harmful) in the early stage of Chinese economic development, would create serious barriers to groowth as the gap between China and the advanced countries narrowed.
The authors’ explanation of the failure of Japan and Europe to continue narrowing the gap with the US seems to support this theory. Their list of what has hampered further productivity growth in Europe reads, with the exception of “restricted foreign direct investment”, even better as a description of China (and I suspect that it is only a matter of time before FDI becomes an awful lot less welcome in China). Specifically they say:
Why is productivity growth in Europe and Japan slowing? One key reason is that these countries are nearing the end of a “catch-up” phase, after largely closing the technological gap with the United States, the country whose production efficiency defines the world’s technology frontier. Economic theory predicts that economies very far from the frontier with low productivity levels will experience relatively strong productivity growth for two reasons. First, when levels of capital per worker are low, capital is relatively productive, so it has a high marginal product and makes a substantial contribution to labor productivity growth. Second, firms have the ability to imitate the latest technologies and production processes to which they are exposed through foreign direct investment or collaborative ventures. As economies approach the frontier and productivity levels rise, however, the marginal product of capital falls, imitation becomes harder, and achieving relatively fast productivity growth rates proves increasingly difficult. This progression toward the technology frontier helps explain why productivity growth in the 1990s in Europe and Japan was much slower relative to the United States than it was during the 1960s.
A second reason for slower productivity growth in Europe is that the labor and product market frictions that characterize many European economies may have become more binding. In a recent report on European policy reforms, the Organization for Economic Co-operation and Development (OECD 2006) highlighted a number of these frictions: barriers to entry in product markets and other regulations that inhibit competition, administrative burdens on new business formation, widespread public ownership, restricted foreign direct investment, limited financing structures for research and development, weak protection of intellectual property, excess regulation of the financial sector, and agricultural supports.
While these types of labor and product rigidities have long been a feature of many European economies, recent research summarized by Aghion and Howitt (2006) suggests that it is the interaction between an economy’s place in the catch-up process, its use of new technologies, and the flexibility of its markets that determines how fast its productivity will grow relative to the frontier. At low levels of productivity, the positive catch-up effects dominate, and countries may grow fast relative to the frontier. Closer to the frontier, however, market rigidities become more of a constraint, reducing the economy’s ability to innovate, make technological advances, and reallocate resources efficiently. In sum, market rigidities and institutional factors are more of a detriment to productivity growth for those countries that have achieved relatively high levels of productivity and are near the technological frontier.
There is considerable evidence, for example, that European economies have been less able to benefit from the information technology revolution since the mid-1990s. For example, one recent study (Inklaar, Timmer, and van Ark 2007) compares the growth rate of total factor productivity (TFP), a common measure of the overall efficiency of production, in the service industries of major European economies and the United States. The performance of service industries in this respect is particularly revealing because they are intensive users of IT and, in the United States, have played a key role in the recent resurgence of productivity growth. The study shows a stark divergence in TFP growth in the service industries of these countries, with slow growth in European services and much faster growth in the United States. The authors find no single factor, such as product market regulation, that would explain this divergence, but suggest that the difference in performance is linked to organizational structure, management, and workplace practices.
Two days after I posted my piece on how a Chinese acquisition of a foreign bank would destroy market value, China Minsheng Banking Corporation announced that it would spend $96 million to buy a 4.9% share in UCBH, the holding company for California-based United Commercial Bank.United Commercial Bank has $11 billion in assets and 71 branches, mostly in California (one in Hong Kong). Minsheng also announced that it planned to purchase another 5% of the company next year for between $115 and $172 million, and had an option to acquire a further 10% in 2009.
China Minsheng had $112 billion in assets as of June, 2007, and its share price closed today at RMB 16.3 per share, giving it a market cap of around $26 billion.Its share price was up 4.4% on the news of the acquisition, although by day end it gave some back to rise 3.1% net for the day. It has been up 90% year to date, even after a $2.3 billion share sale in March.
So what about my prediction?The first part of my prediction, that the announcement of the purchase of the California bank would cause a surge of nationalist pride that caused share prices to rise, turned out to be true, although with the A-share index up 2.55% today, it probably didn’t need much to see an increase.Nonetheless I would have been surprised at any other reaction – when banks from developing countries make their first US acquisition, the local retail market almost always sees that as a brave and exciting step forward, and share prices always rise.
The question is what happens next.It is inevitably going to be a little complicated, but probably not much. First, UCB is only 10% the size of Minsheng, and Minsheng is only committing to buy 10% of the bank, so this represents an acquisition that will increase assets by only around 1%, and the acquisition price for the full 10% is significantly less than 1% of Minsheng’s market cap, so it is hard to see it as a major acquisition (although if spending less than 1% of the bank’s capital can cause its share price to rise by 3-4%, perhaps they should do a few more small purchases before their next stock deal).
Secondly, and perhaps more importantly, with the A-share market regularly notching up 2-3% days up and down, any revaluation of Minsheng shares is likely to be hidden in the big swings that the share prices is likely to take anyway, especially since the price is driven by retail punters, and not institutional investors. Even if Minsheng’s price drops like a stone in the next few weeks, that is far more likely to reflect market volatility than it is to reflect a change in investors’ perceptions caused by the acquisition.
My conclusion is that this, unfortunately, is not the test case to indicate whether or not the option model makes a good prediction, although in reading about the acquisition I did see that, according to Reuters, “last month, central bank governor Zhou Xiaochuan urged the country's banks to take stakes in overseas institutions”.The option model does suggest that the regulators would love to see more of the same
Several people after reading the last entry have written to me wondering whether the fact that Minsheng is in relatively good shape in any way invalidates the analysis.For example, in the comment section, Twofish writes
One problem with the option model is that all of the banks that are thinking about overseas purchases have good balance sheets. One could argue (correctly I think) that these balance sheets have hidden liabilities and aren't really as good as they appear. The trouble then is that it’s not clear how this works with the option model.
The other issue is that one can argue (correctly) that the banking system is a mess. Minsheng is one of the banks that everyone thinks is in good shape, and so it's not clear again how Minsheng stock relates to the model since Minsheng has high intrinsic value.
The option model might work better for non-financial SOE's. Banks in China are tightly regulated (by Chinese standards) and there is no way that the CBRC is going to let an insolvent bank make purchases without dealing with the insolvency first. However, other industries are much less regulated, and there are a lot of overseas purchases there.
My first response (as you can guess, I still can’t respond directly to comments) is that I am skeptical about how good Minsheng’s balance sheet really is. When you say Minsheng is a good bank, you mean relatively good. They experienced enormous loan growth in the past three years – a period that saw tremendous loan growth in the banking system in general – and it is hard to believe that an awful lot of new loans might not go bad in a downturn.
This is not just perversity on my part.In my Latin American banking days I remember that nearly every LDC (as we called them back then) had at least one bank that was much better than the rest – it was always referred to as the Rolls Royce or “class act” among its peers – but that bank inevitable suffered severely during a sharp contraction, especially if that contraction was accompanied by a generalized banking contraction.No matter how good Minsheng is, it is still likely to be very susceptible to country-wide credit deterioration, and the fact that small banks in China depend much more heavily on purchased funds than large banks makes me worry that if a sharp contraction is accompanied by liquidity hoarding (as it usually is), Minsheng, along with the other small banks, may suffer disproportionately.
Secondly, and far more importantly, the model works best with bankrupt or near-bankrupt institutions because they create the purest play on time value, but what is important is that in the share price the time value component significantly outweighs the intrinsic value component. Minsheng trades at extremely high multiples (I think price to book exceeds 3.2), so even if it has more intrinsic value than most other Chinese banks, its stock price still consists largely of time value.In that case, any event that reduces time value while increasing intrinsic value – like a transaction that reduces expected volatility – can still easily reduce the former more than it increases the latter.
By the way I don’t think that only banks with good balance sheets will be approved for overseas purchases. I think that all the large bank (ABC perhaps more slowly than the rest) will get approved if the “right” deal comes along.Certainly now it is hard to imagine the PBoC not welcoming any transaction that creates capital outflows
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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) highlighted a number of these frictions: barriers to entry in product markets and other regulations that inhibit competition, administrative burdens on new business formation, widespread public ownership, restricted foreign direct investment, limited financing structures for research and development, weak protection of intellectual property, excess regulation of the financial sector, and agricultural supports.
January, 2008