Economic integration is the establishment of transnational rules and regulations that enhance economic and trade cooperation among countries. There have been a number of regional economic efforts undertaken over the last 30 years, although none of them has attained full economic integration. The most successful has been the EU. Less developed countries such as ASEAN and Latin America have also made integration efforts, but they have not been as successful. 

There are five levels of economic integration (Rugman & Hodgetts, 2000):

1. Free trade area. A free trade area is an economic integration arrangement in which barriers to trade (such as tariffs) among member countries are removed. Under this arrangement, each participant will seek to gain by specializing in the production of those goods and services for which it has a comparative advantage. So far, the North American Free Trade Agreement is a most representative free trade area. Other similar agreements include: Free Trade Agreement signed between Australia and New Zealand, Latin American Free Trade Association and ASEAN.   

2. Customs union. A Customs Union is a form of economic integration in which all tariffs among member countries are eliminated and a common trade policy toward non-member countries is established. This policy often results in a uniform external tariff structure. Under a customs union, member countries surrender some of the control of their economic policies to the group at large. The Caribbean EC and the former European Economic Community(EEC) are two actual examples.

3. Common market. A common market is characterized by (1) the absence of trade barriers among member nations; (2) a common external trade policy; and (3) mobility of factors of production among member counties. Based on the theory of comparative advantage, member countries would focus on the industries with competitive advantages and give up disadvantageous ones. The best example of successful common markets is the EU before the implementation of currency union.

4. Economic union. A deeper form of economic integration characterized by free movement of goods, services, and factors of production among member countries and full integration of economic policies, including: (1) unification of monetary and fiscal policies among the member nations; (2) common currency (or a permanently fixed exchange rate among currencies); (3) employment of the same tax rate and structures for all members. Most of the national economic policies of the individual countries are surrendered to the group at large.

5. Political union. A political union goes beyond full economic integration.  It occurs only when countries give up their national sovereignty to a single government. One successful example is the United States, which combined 50 separate states under a political union. The unification of West and East Germany in 1991 also created a political union. In contrast, Canada's constitution gives substantial economic powers to the provinces, so it is more of a federation than a political union. The former USSR has dissolved into a loose federation, rather than the political union held together by the Communist party.

Thus, it can be seen that economic integration is generally a process that starts in the form of free trade area and can finally develop into a single authority nation like USA. The contents for economic integration broadly include: reduction of tariffs, elimination of trade barriers → mobility of production factors → unification of tariffs, formation of a united external trade policy → formation of the united economic policy through unifying currency, government finance, tax rate and foreign exchange rate → establishment of a single government to form a political union. 

Experiences from regional economic integration over the past fifty years at different levels in general  produced a win-win situation, that means the members can get more development opportunities. The key reasons behind are that economic integration can facilitate the mobility of production factors and specialization among the members, improve efficiency of resources allocation, and therefore raise regional competitiveness.

II. The trend of economic integration between HK and the Mainland

Over the past twenty years, economic exchanges between Hong Kong and the mainland, especially Hong Kong and the Pearl River Delta, have mainly taken place at the  non-government or enterprises level . It was also undertaken with the existence of tariffs and border barriers, with most of the production factors unable to move freely in both directions. Therefore, it can be said that the true economic integration between both sides did not happen until the signing of CEPA between the HKSAR Government and the Central People's Government at the end of June 2003 . Under the CEPA framework, the mainland will gradually eliminate the tariffs imposed on Hong Kong products, open up 18 service sectors to Hong Kong companies ahead of schedule, and create a formal arrangement for people from the mainland to visit Hong Kong. CEPA is an open framework. Since its being signed, the HKSAR Government and the Central Government have completed the first round negotiations. The contents of the first round agreement include: open up one more service sector, i.e. telecom, to Hong Kong companies, finalize the concept of "Hong Kong Product" and "Hong Kong Company". The CEPA's second round talks will begin soon. The long term objectives that CEPA wants to achieve are to facilitate the full open up of mainland markets to the Hong Kong and Macau regions, to realize free mobility of production factors among Hong Kong, Macau and the mainland. 

Although the results are mutually beneficial, the CEPA framework bases not on the principle of the equality between two sides, but a customized offer from the needs of the Hong Kong and Macau's long term development by the central government under the "one country principle". Therefore, CEPA is different from NAFTA as well as the EU. Generally speaking, the contents involved in the CEPA are more comprehensive than those of NAFTA and the Caribbean EC, but not as rich as that of the EU. It should be emphasized that, under the CEPA framework, the measures undertaken or being planned will produce profound impacts on the economic integration between Hong Kong and the mainland, especially Hong Kong and the Pearl River Delta:

1. The relaxation of the mainlander visit. The expansion of the "individual visit" scheme will propel people flow and capital flow between both sides, and make production factor mobility freer and more convenient. 

2. Speed up the construction of cross border infrastructure. The completion of the three big cross border projects now undertaken or being planned including the Western Corridor, Hong Kong-Zhuhai-Macau bridge, and Guangdong-Hong Kong-Macau express railway, will greatly improves regional commute, and provides the important strategic infrastructure for deepening regional economic integration.

3. Open the offshore Renminbi businesses. The central government announced that Hong Kong can conduct the yuan businesses including deposits, exchange, remittance and credit cards. Although the current measures are far from the conditions Hong Kong necessary to develop as a renminbi offshore center, but this can be an important step heading to this direction.

4. Closer cooperation in policy making. Due to CEPA's great forces to propel economic exchanges between Hong Kong and the mainland, the communication and co-ordination at different levels between Hong Kong and the mainland including HK and central government, Hong Kong and Guangdong province, and Hong Kong and Shenzhen have been strengthened. The examples are: the official in charge of Hong Kong and Macau affairs has been raised to the level of State Vice-president, the official in charge of the Guangdong-Hong Kong Cooperation Joint Conference has also been upgraded to the level of government heads in both sides, Shanghai and Hong Kong has set up a official communication channel, and reached a cooperation pact in eight areas. Hong Kong and Beijing or other provinces are likely to set up an official channel similar to that between Hong Kong and Shanghai. From the long term perspective, economic policies in both sides will become more coordinated, though not converged.

5. Strengthen the cooperation in industries and projects. Hong Kong's advantages in the financial industry and some manufacturing processes will provide a broad development space for the regional cooperation. In future, a lot of cooperation opportunities for industries or projects exist between Hong Kong and Shenzhen, Guangzhou, Beijing and Shanghai. The areas with the highest potential for cooperation include: airports, finance, logistics, tourism, exhibition and professional services, etc. 

The implementation of the above measures will swing deep and far-reaching impacts on the economic integration between Hong Kong and the mainland, and particularly those between Hong Kong and the Pearl River Delta. In the short term, as the immediate result of zero tariff treatment on products made in Hong Kong and Macau under CEPA, the two way economic exchanges between Hong Kong and the mainland, and especially those between Hong Kong and the Pearl River Delta will make the region develop into a Free Trade Area. In the long run, the integration of Hong Kong, Macau and the mainland will likely develop into a Common Market.

As being widely recognized, Hong Kong's key advantages include: well-established legal system, and upon which the market institution (such as intellectual property protection), advanced communication infrastructure, English speaking popularity, and developed international network. On the other hand, the advantages of the mainland lie in its lower operating costs.

Based on each other's comparative advantages, distinct division in industries will be developed between Hong Kong and Guangdong, and between Hong Kong and Shanghai. In future, the division between Hong Kong and Guangdong will concern  the different focuses along the production process. Hong Kong side will mainly engages in R&D, product design, training, part of logistics, management, and the value-added services related to the supply chain management. While the Pearl River Delta will play key roles in production, part of R&D, procurement, and part of logistics. Meanwhile, the division between Hong Kong and Shanghai will lie on the financial sector by product lines. Hong Kong will gain its edge in private banking, wealth management, corporate finance and some advanced derivative products that are still not allowed to be developed in Mainland's financial market, while Shanghai will focus on traditional banking services, such as trade financing, consumer and corporate lending.

It is of strategic importance for Hong Kong and the mainland to integrate into a common market in that:

1. From Hong Kong's perspective, the economic integration among Hong Kong, Macau and the mainland under CEPA has a great instructive meaning to Hong Kong's repositioning after the return of its sovereignty to China. Hong Kong needs to reposition itself, because after the sovereignty handover, its integration with China has been severely constrained by the strict regulations on mainland visitors, in addition to the totally independent and different legal, currency, and tariff systems. Meanwhile, Hong Kong's role as the bridge and window to China is under severe competition due to the rapid development of China's economic reform and opening up policy, making Hong Kong face the situation of being marginalized.

If Hong Kong can fully access the mainland market, it will be able to concentrate itself on international finance and trade services targeting the mainland markets. If it could not, Hong Kong has to reconsider its long-term strategies as a small and separate economy, and promote a diversified industry structure. Now that CEPA has removed the major barriers of the two-way interactions between Hong Kong and the mainland, suddenly the door is opened to Hong Kong, which is now aware of what role and position it should take in the new round of economic globalization and China's development.

2. From the mainland's perspective, the greatest strategic meaning in its economic integration with Hong Kong is that through the free flow of production factors between the two areas, Hong Kong will continue its role as the international finance center and trade service center which serves the whole China's economic development, incorporating Hong Kong into China's economic system. Having a free, open, disciplined, and globally reputed international finance and trade center like Hong Kong within its economic system, China can greatly enhance its advantages in the global economic division and cooperation. Existing and potential severe competition between Hong Kong and other major Chinese cities like Shanghai, Guangzhou, and Shenzhen can be effectively avoided, improving industrial division and cooperation among major cities, reducing duplicated investments, and strengthening the whole nation's economic competitiveness. Problems such as excessive competition, overlapping of roles, and duplication in constructions among adjacent cities or areas mainly result from the production factors unable to flow freely. Once production factors are allowed to flow freely, the invisible hand of the market forces will automatically push each player to concentrate on industries in which it has comparative advantages, and discard those activities which it has a comparative disadvantage, and then, transform the vicious competition into rational division of labor. This will make every party better off.

III. Strategy implications

From the government's perspective, the key is to focus on infrastructure construction from the whole region's long-term interests, and take initiatives to align with the trend and demand of economic integration development. The future tasks should include: to further promote the free flow of production factors, to speed up the planning and constructions of cross border infrastructures, to strengthen legal coordination, regulations and financial supervision, to facilitate the mutual recognition of professional qualifications, and to improve the levels of the security and environment protection.

For example, for the greater Pearl River Delta (include Hong Kong and Macau) to form a metropolis, only one land corridor to link Hong Kong and the west PRD is far from enough, it may needs two, three, four or more in the future, which asks for our foresights in strategic planning and cooperation between governments of both sides.

Another example is that as more and more people and enterprises move to Hong Kong from the mainland, and the commencement of offshore Renminbi business here, Hong Kong and the mainland need to cooperate closely in financial supervision, narrow down the differences in market rules and supervision, so as to enable the sustainable and healthy development of such cross border operations.

From the perspective of the enterprises: the key is to identify the strengths and weaknesses of both Hong Kong and the mainland, particularly those of greater PRD and YRD, and then optimize the location of the manufacturing process. Among the nine primary and support activities of the value chain (inbound logistics, operations, outbound logistics, marketing & sales, service, procurement, technology development, and human resource management) (Michael Porter, 1985), undoubtedly Hong Kong is able to provide very attractive conditions for some of these activity processes. CEPA's definition of "made in Hong Kong products" will also benefit Hong Kong by differentiating its functions from that of the mainland along the value chain. We believe that those enterprises who are good at taking combining advantages between Hong Kong and the mainland will outperform their peers in future competition.
     

Tse Kwok Leung
Senior Economist