China and the Hotel California Effect in Banking

ChinaEconomicsBlog is back after the Christmas break with a topic that has interested me for a while.

This is what I call the "Hotel California Effect" named after a paper by Holger Gorg a few years ago. Respect for sticking with the title even in the face of referees who did not understand what the title even meant.

This was the original paper:

Fancy a Stay at the 'Hotel California'? Foreign Direct Investment, Taxation and Firing Costs

Holger Gorg
University of Nottingham - School of Economics; Institute for the Study of Labor (IZA)

December 2002

IZA Discussion Paper No. 665

Abstract:
This paper looks at the trade off between investment incentives and exit costs for the location of foreign direct investment (FDI). This issue does not appear to have been tackled in much detail in the literature. The analysis considers the effect of profit taxation (as a measure of investment incentives) and an index of hiring and firing costs (proxying exit costs) on the location of US outward FDI in 33 host countries. The results suggest that US FDI, in particular in manufacturing is negatively affected by the level of profit taxation and exit costs. Hence, if countries want to attract FDI it may not suffice that incentives are provided in order to ease the entry of multinationals. Instead, it also appears to be important that exit costs are at a level attractive to multinationals. In other words, multinationals may not check into an attractive looking Hotel California type host country if it is difficult to leave.

Keywords: Foreign Direct Investment, Exit Costs, Firing Costs, Investment Incentives, Taxation

JEL Classifications: F23, H25, J65
Working Paper Series

For those still confused there are lyrics in the Eagles classic song of the same name (the final 3 lines) that read:

We are programmed to receive.
You can checkout any time you like,
But you can never leave!


To me this reminds me of the Chinese FDI policy. China has done very well managing to attract FDI from all over the world. Yet China has not been tested on how easily that FDI is allowed to leave.

The FT cover this issue in today's paper.

As an economist with a good knowledge of China it was clear that the massive investments by UK and US banks in Chinese banks would be high risk to say the least. If these investments were made with a 30-40 year outlook then fine and indeed on paper there have been short term profits from China's stock market boom. The question, as we know from the current crisis, is whether these assets can be sold at the perceived market price.

Routes out of China will be difficult to negotiate [FT]

Last week UBS became the first overseas bank to offload its stake in a Chinese bank in a move expected to trigger a wave of divestments.

Foreign financial institutions including Goldman Sachs, Citigroup, HSBC, TPG, Temasek, Allianz and Royal Bank of Scotland own stakes in leading Chinese lenders worth tens of billions of dollars.

These holdings were mostly acquired in 2005 and 2006 when Beijing was keen to import western capital and expertise to help reform its moribund banking sector.

Many in Beijing and elsewhere are now asking whether the likes of RBS will be tempted to sell out and book handsome profits in order to help repair balance sheets strained by the financial turmoil.

As some of the foreign banks position themselves for possible divestments, many are also wondering what happened to all the talk about “strategic partnerships” and “risk management assistance” that accompanied the original investments.

“The foreign banks promised little and have delivered even less [to their Chinese partners],” according to one person who was deeply involved in negotiations between foreign investors and Chinese banks. “But the Chinese side didn’t really know what to ask for and were more focused on getting deals done as a precursor to very lucrative IPOs.”

At least four other people involved in foreign investments in Chinese banks have said that, although there was interest at one level of the government in introducing western management practices and risk controls, the foreign investors were mainly brought in to provide window dressing for initial public offerings.

With names such as Goldman Sachs, Bank of America and RBS on their share registers, Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Bank of Communications that were technically bankrupt a few years earlier were able to achieve higher valuations when selling shares in Hong Kong and Shanghai.

UBS was considered to be in a slightly different category from the banks that signed up for “strategic partnerships” because its $500m investment in BoC was always considered a financial investment – a “pay to play” commitment that helped it to win a lucrative mandate to advise on the $10bn Hong Kong listing of Bank of China in June 2006.

Last week, UBS decided that the 1.3 per cent stake was no longer core to its strategy and sold it – for $835m – as soon as a three-year lock-in period expired.

UBS stressed that it was “committed” to its relationship with BoC and to its other mainland businesses.

But dealmakers say that any foreign institution mulling a stake sale will have to weigh carefully the potential downside, at a time when Beijing is trying to garner support for its largest banks.

Bank of America last month cancelled a plan to sell more than $3bn worth of its shares in CCB after being told by senior government and banking officials that Beijing was unhappy with the timing of the sale, according to people familiar with the matter.

The cancellation has raised concern among other banks which, like BofA, invested in Chinese banks as “strategic partners” that they will not be able to sell down shares.

“The Chinese stock market is in a terrible situation right now and if all the big foreign investors are running away from the banks then that would hurt confidence even more and the government would not be keen to see that happen,” said Wu Yonggang, an analyst with Guotai Junan, a Chinese brokerage.

Stake sales will also be limited by the need to find buyers for the shares.

“Banks round the world are reviewing non-core holdings and many will no doubt decide to sell their Chinese bank stakes,” says one banker in Hong Kong. “But these share sales can not all come at the same time as they will not be digested by the market.”

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