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October 18, 2006
China: The Good, And The Maybe Not So Good
The following comes from an essay appearing in the latest annual report from the Federal Reserve Bank of Cleveland:
A recent research project completed at the Federal Reserve Bank of Cleveland by [Paul] Bauer, [Mark] Schweitzer, and [Scott] Shane examines a variety of factors that could influence the evolution of state per capita incomes over time...
The authors conclude... that the largest factor underlying relative income differences in 2004 is patents, followed by education then industry specialization... Bauer, Schweitzer, and Shane interpret the strong patent result... as income accruing to places that are relatively innovative and produce more patented inventions than other places.
That conclusion is more guesswork than evidence, but it is at least plausible. And if you believe it, this story, from the Financial Times, ought to grab your attention:
China has overtaken Germany in the global ranking of patent applications to become the fifth largest source of filings, underscoring an increasing prominence of Asian industrial powers in intellectual property.
In its first comprehensive report on patent activity, published on Monday, the World Intellectual Property Organisation found China had a sevenfold increase in patent filings in 10 years.
That would be the aforementioned "good." In the other category? Although the big financial market news of the day is the CME/CBOT merger, there's a pretty big deal brewing in the Chinese financial sector as well. From The Wall Street Journal (page A20 in the print edition):
Fannie Mae and Freddie Mac, meet ICBC. China's largest bank joins the ranks of publicly listed companies next week when it unveils what may be the world's largest-ever IPO in Hong Kong and Shanghai. But as with America's mortgage behemoths, investors are betting as much on implicit government support as on ICBC itself.
Headquartered in Beijing, the Industrial Commercial Bank of China Ltd. is China's largest commercial bank by total assets, loans and deposits. With more than 18,000 branches and $21.7 billion in 2005 operating income, it holds 15.4% of total loans in all Chinese banking institutions, according to its offering prospectus. For foreign investors hoping to profit from China's rapid economic growth, ICBC shares may seem just the ticket.
Since 1998, Beijing has injected $95 billion into the "big four banks," and carved out $305 billion of bad loans, according to Fitch Ratings. ICBC itself received a $15 billion state capital injection last year, plus a government-financed nonperforming-loan carveout of $85 billion. Foreign banks added an additional $20 billion; Goldman Sachs, Allianz Capital and American Express own 10% of ICBC's equity.
With all this money floating around, why worry? Well, bailing out banks -- or the implicit guarantee of doing so -- implants perverse economic incentives. Investors will be betting that public-company standards will help transform ICBC's lending practices, but there's no guarantee that the companies it is lending to have been transformed. Communist Party officials also still populate Chinese banks' boards of directors.
Like other state-owned banks, ICBC is still swimming in nonperforming loans -- which are classified according to Chinese, not international, standards. Fitch estimates a nonperforming to total loan ratio of 4.7%. If you kick in so-called "special mention" loans -- debts that haven't gone bad yet, but might -- the ratio jumps to 9.2%. ICBC also has heavy exposure to manufacturing, transportation and energy industries that are highly cyclical.
So, though government guarantees make the investment safer for private shareholders, the growth-enhancing power of financial intermediation is hampered if there are significant distortions in the allocation of funds. Maybe not so good.
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