Limited Use of CEPA's Preferential Treatment So Far

CEPA I implemented at the beginning of this year covers 374 Hong Kong products whose original MFN tariff rates ranging from 1.5% to 35.0%. TID's statistics show that although more manufacturers are taking advantage of the treatment by applying for Certificate of Hong Kong Origin, the benefits gained are still marginal. For example, although applications jumped from August's 1895 to September's 2250, total value of goods involved amounted to HKD660mn or only 2.8% of domestic exports to China by the end of August. The savings of tariffs of RMB36mn are equal to about 5.5% of total goods value, suggesting limited utilization of the treatment.

Besides, in the first eight months of this year (two thirds of the period), domestic exports to China amounted to HKD23.8bn, or roughly two thirds of last year's total of HKD368bn. In other words, under CEPA I, growth of domestic exports to China has not accelerated significantly. This is another indicator of limited usage of CEPA.

A rational explanation to such developments is that CEPA only manages to halt the relocating process of Hong Kong's manufacturing to the mainland. As for the other goals of its design, namely to lure some working procedures to return to Hong Kong or to attract new foreign investments to Hong Kong, they have yet to bear fruits. Understandably, such investments are major corporate decisions that need time for proper research and study, before reaching a conclusion, and for the investments to yield desirable outcome. And cost may also come into play as a technical factor. Hong Kong's manufacturing is unique in its generally small scale. Unless the export volume is large, savings of tariffs may not be enough to offset costs to verify the value added according to the treaty. As a result, equal benefits do not apply to all products.

But Recovery Is in Sight

Even so, various economic indicators are flashing signs of recovery in the manufacturing sector. First of all, domestic exports have resumed growing. Although Hong Kong's manufacturing sector began the relocation process to the mainland some twenty years ago, consistent decline in domestic exports had only appeared in the last ten years or so. For most of the time from 1993 to 2003, domestic exports had been declining at an accelerating pace, bucking the trend of rising total exports. But starting in December last year, they resumed growth after 37 months of consecutive declines, and were up 1.3% YoY in the first eight months of this year. And the better performance of the volume index, in comparison with the value index, signals real expansion. But caution must be applied to interpret the numbers because growth in domestic exports was still below that of total exports and the GDP, suggesting that global economic recovery was the driver, instead of revival in the manufacturing sector.

That said, bank loans extended to the manufacturing sector have signaled much stronger recovery, which was arguably a more positive development. Hong Kong's anemic loan growth that lags behind economic recovery obviously does not apply to loans used in manufacturing. According to HKMA, manufacturing loans have increased by 5.4% and 8.8% QoQ in the first two quarters this year, far greater than the overall loans growth for local use. The same is true for when measured on YoY basis. And the manufacturing loans' out-performance has been gaining momentum for more than a year, reversing a decade long period of underperformance. Their proportion to total loans has now grown to 5.3% from the rock bottom 4.0%.

The employment situation in the manufacturing sector has also fared better. Although total manufacturing employment growth lags behind the labor market, its unemployment rate and underemployment rate have outperformed the general market this year by 0.1-0.6 and 0.2-0.5 percentage points respectively. The out-performance by these lagging indicators suggests that Hong Kong's manufacturing sector may have already hit the bottom and embarked on the recovery track after years of transformation.

The Still Important Manufacturing Sector

CEPA II, to be implemented next year, extends the zero tariff treatment to almost all of Hong Kong origin products, 184 of which are not yet in production up till now. Such a design is aimed at attracting new investments to Hong Kong. Thus the manufacturing sector, the government, and the academic community all need to do their job to help seize the opportunity, push for the manufacturing sector's transformation and revitalization by leveraging CEPA.

Although statistically, manufacturing accounts for only 4% of Hong Kong's economy today, a far cry from the 25% in its heyday, its economic importance is far greater than those numbers catching the eye. This is because the massive relocation taken place over the years to counter rising costs has resulted in large scale of outward processing trade and trade services. As a matter of fact, if considering all the manufacturing related economic activities, Hong Kong's manufacturing has been expanding instead of contracting over the years. The key is that there is less manufacturing activities within Hong Kong's border but much more manufacturing related trade and trade services activities, which are accounted for under the goods and services trade when calculating GDP.

Because of Hong Kong's status as an independent tariff zone and its unique tax regime, the revitalization of the manufacturing sector will carry multiple benefits. Firstly, it can diversify Hong Kong's industry structure to avoid over-concentration. The service sector now accounts for 87% of the economy, with the rest divided between manufacturing, construction and electricity, gas and water. But the surge in the service sector in the past two decades was at the expense of the manufacturing sector. Avoiding extreme concentration is generally beneficial to an economy. Secondly, it can reduce volatility in economic growth. A highly externally oriented economy like Hong Kong's usually has larger volatility in growth. A stable manufacturing base can certainly mitigate such unwelcome ups and downs and alleviate the pain caused by economic transformation. And thirdly, it can help reduce the employment pressure. Although manufacturing currently employs only 170000 people versus the 900000 at its peak, it is still the fifth largest employer in Hong Kong, providing jobs to 7.5% of the working class. This hits home the labor intensive nature of the sector when compared to its 4.0% GDP weight. Therefore, it can ease the pressure caused by Hong Kong's labor mismatch problems.

Revitalize Hong Kong's Manufacturing by Leveraging CEPA

There is yet consensus on the goal of manufacturing's revitalization and the role of the SAR government in the process. But we can be certain that it is unrealistic to expect the heyday of the early 1980s to return, that CEPA's effects will not be unlimited even if it covers practically all products, and that without the government's involvement, the chance of success will be compromised. Only when we recognize these limitations can we systematically and selectively take measures to facilitate manufacturing's revitalization.

In the past, Hong Kong's rising costs kicked start the massive manufacturing relocation, which was the most efficient but also the cruelest choice made by the market. As high cost is a unique feature that was, is and will be with Hong Kong, only higher value added manufacturing can survive here. Even if subsidies in terms of land, tax and labor can help reduce costs for some manufacturing, they are only expedient measures that may not be economically and competitively viable in the long run. Thus it is unrealistic to hope to return Hong Kong's manufacturing to its glory days. Even CEPA is not without its limits.

CEPA II is arguably close to the pinnacle of opening to Hong Kong origin products. But it only benefits Hong Kong goods destined for China, not other markets. In 2003, 30% or HKD36.8bn of Hong Kong's domestic exports went to China. Among them, HKD24.9bn or 68% were for outward processing purpose, which was already under the zero tariff treatment. In other words, even if all Hong Kong products had enjoyed zero tariff treatment in 2003, that would have amounted to only HKD11.8bn or about 10% of all domestic exports. The root of the issue is still cost. The tariff rate currently applicable to the more than 1000 Hong Kong origin products is mostly 30% or less. But the land and labor costs of Hong Kong command premiums well above 30% over the mainland. So unless the value added is high enough, it is still not economically viable to be located in Hong Kong.

In consideration of these, measures taken to revitalize the manufacturing sector must be practical and selective. The biggest success of CEPA so far lies in strengthening Hong Kong's existing manufacturing and providing new development opportunities. And the SAR government needs to selectively push for those manufacturing that have long-term competitiveness and facilitate their growth. Once the market force and the government's efforts are combined, the chance of reviving Hong Kong's manufacturing sector will be maximized.

It is worth noticing that it was Hong Kong's manufacturers who proposed the extra 713 products covered by CEPA II, among which 184 had yet to be produced. This implies that there may be interests from the manufacturers to invest to produce these new products, or they expect CEPA can attract new foreign investments, introduce high tariff raw materials and engage in high value added and brand name productions, which is a very positive signal. Although the 184 products won't receive zero tariff treatment until 2006, we may begin to see related investment projects underway sometime next year, adding to the evidence of CEPA's benefits. The market will do its job this way. As for the government, it needs to carry out comprehensive and thorough studies of the product list to identify those that have keen demands in the mainland market and long-term competitiveness with all or part of the production located right here in Hong Kong. Then systematic and selective efforts must be made to promote Hong Kong's advantages to foreign investors. And land, tax and capital benefits can be offered as incentives. In 1H04 alone, Hong Kong's FDI inflows reached USD13.8bn, beating last year's total of USD13.6bn already. 20% of these foreign companies cited CEPA as the main reason for their investment decisions. Historically, 20% of Hong Kong manufacturing's value added originated from foreign owned corporations, showcasing our attractiveness to foreign interests. Thus it is a matter of how to promote our manufacturing and provide guidance to foreign capitals. If the government can assume a more proactive role, it can deliver the promise of "market leads and government facilitates".

Even Hong Kong's traditional manufacturing has come across new development opportunities under the globalization process.

In recent years, China's transformation towards a 'global factory' has resulted in its shouldering disproportionate pressure in trade. It is targeted by trade protectionism in the US, Europe and Japan, who jointly push for the RMB revaluation. As countermeasures, China and Hong Kong can strategically dispose manufacturing by taking advantage of Hong Kong's status as an independent tariff zone. The "Made in Hong Kong" brand name can legally and reasonably circumvent trade protectionism and reduce trade friction. This is also consistent with China's efforts to encourage outward direct investment and overseas expansion. Take Hong Kong's garment and textile manufacturing that accounts for 55% of domestic exports, has more than 3000 facilities and employs 48000 workers as example, it is facing threats of weakening and further relocating next year when export quotas are replaced by tariffs according to the WTO negotiations. But as China is under even greater threat from the US protectionism, US buyers now demand that productions to remain in Hong Kong, offsetting threats of the post-quota era. This establishes the environment for the basic manufacturing to transform towards a higher value added fashion industry. The same can be extended to plastics, toys, clocks and watches, hardware or other manufacturing. Since such arrangements are strategic, it needs the involvement of the SAR government to plan, coordinate and push along with the practitioners. When CEPA is combined with globalization, the task of revitalizing Hong Kong's manufacturing has a greater chance to succeed.