The minister of foreign trade and economic cooperation, on November 11, signed a WTO membership document at Doha, marking a new phase in China's transition to the market-based economy. As China has already ratified its membership, China will officially become a full member on December 11, 2001.

The liberalization of manufacturing and services industries, acceleration of economic reforms and the removal of trade barriers in China will change economic landscape and accelerate economic restructuring in Hong Kong in the period ahead.

With a population of over 1.3 billion, the opening up of the China's domestic market will bring numerous business opportunities. After the terrorist attacks on the US, the Hong Kong economy is reeling from the combined effects of accelerated global economic downturn and internal economic restructuring. Amidst sluggish global economic environment, Hong Kong business has shown great interest in positioning themselves to capitalize the opportunities arising from the opening of China's lucrative market.

Effects on trade

Thanks to its geographical proximity and extensive transportation network, Hong Kong has thrived on its role as a trading hub serving the Mainland and the world. In the first eight months of 2001, excluding the transshipment, total exports to and imports from China accounted for 37% and 43% respectively.

We do believe that Hong Kong will inevitably face more competition from neighboring ports, such as Yantian and Shekou. Meanwhile, Hong Kong could also see its traders losing some transshipment and re-export business as some Taiwan and Western companies may pass through the territory on their trips to China.

Nonetheless, the WTO agreement calls for reduced tariffs on agricultural and industrial products and eliminate quotas and nontariff restrictions by 2005. The ports in China, as well as in Hong Kong, will be gained from booming trade volume arising from the removal of trade barriers and drastic cuts in tariffs. More importantly, the well-established networks, clear legal system and efficient support services will allow Hong Kong to compete from a position of strength.

Effects on investment

In addition to the positive effects on trade volume, Hong Kong could benefit from huge influx of foreign investment in China. Amidst imminent China's WTO entry, an increasing number of foreign companies have set up their regional headquarters or representative offices in Hong Kong.

According to a Government survey, the number of regional operations of foreign companies in Hong Kong increased by 7.9% in the 12 months to June 2001 to a record 3,237. Analyzed its breakdown, the number of regional headquarters rose by 10.4% to 944, while regional offices climbed 6.8% to 2,293. Despite high input costs, low taxes, simple tax system and free flow of information in Hong Kong are the key favourable factors for investment. Going forward, China's accession to the WTO will continue to attract more multinational corporations to Hong Kong as China still lacks the favourable economic, legal and political attributes.

Hong Kong firms are primarily small and medium-sized business. Many are concerned that the traditional role of Hong Kong companies as middlemen, liaising between China and the rest of the world, will be undermined after China's WTO entry. It might be true that the big multinational corporations may pass through Hong Kong and set up their own offices in China, but for the smaller Western companies, they have limited resources to explore the China market. The experience of Hong Kong businesses to deal with the diverse and complex investment environment in China will be of great benefits to foreign enterprises by shortening their learning curves. Thus, cooperating with the small and medium-sized enterprises in Hong Kong is still valuable to foreign companies in providing front-line services and adding value to their operations.

In addition, Hong Kong's business service sectors can benefit from robust inflows of direct investment in China. Past experience suggest that as foreign companies make investment in China, they will create demand for different kinds of supporting services in Hong Kong, such as legal advisory, management consultancy, accounting and market research services. Apart from these, as the domestic market gradually liberalizes, there is rising demand from the Mainland enterprises to sharpen their competitive edge. Thus, a large base of Mainland clients is also the potential customer for Hong Kong professionals.

Hong Kong's future: High-value added economy

Despite immeasurable opportunities ahead, Hong Kong can no longer be heavily reliant on its role as an intermediary as China integrates with the world. Instead, Hong Kong should have to reinvent itself in the restructuring process.

For most service industries, market access liberalization will be phased in over a period of up to 6 years. As Hong Kong's economic relationship with China has matured in recent years, there has been a notable shift in the composition of Hong Kong's direct investment in the Mainland from industrial processing to a wider spectrum of business ventures.

Going forward, the economic success will hinge on its competitiveness of being a leading international financial and business center in the region. By using the Peal River Delta as a manufacturing base, Hong Kong should focus on developing high-end areas in finance, telecommunications and information technology, which China's still vague and inconsistent regulatory system is not favourable to their developments.

Threats and opportunities for Hong Kong business

Sectorial analysis on selected industries

Manufacturing

Over the past two decades, Hong Kong manufacturers have significantly expanded their production facilities in China's Pearl River Delta in search for lower land and labour costs, leading Hong Kong to become the largest source of foreign direct investment in the Mainland. The WTO membership for China would remove the uncertainty of non-PNTR treatment of China and also provide a multilateral framework for China to discuss and resolve trade disputes with the US and other overseas partners, thus benefiting Hong Kong manufacturers. Further, the lowering of tariffs on imported materials and machinery will also help manufacturers operating in the Mainland to lower their input costs and enhance their competitiveness.

The flip side of the same coin is that the preferential treatment for foreign-funded enterprises will be gradually removed amidst the introduction of the national treatment in China. Meanwhile, the Hong Kong manufacturers should seek to improve their productivity as the indigenous Chinese enterprises have started to catch up.

As the quota restrictions imposed by US disappear, more Hong Kong textiles and garment manufacturers are expected to relocate their production facilities to the Mainland, leaving the high value-added activities, such as design, research, marketing and packaging, in Hong Kong.

On the retail market, with a relatively close-end distribution system in the Mainland and the strict regulation on the ratio of exports to domestic sales for foreign-funded enterprises, Hong Kong manufacturers with production in the Mainland generally do not establish operation in China to take advantage of the massive consumer market. China's WTO entry will bring ample opportunities for manufacturers as restrictions on domestic sales by foreign manufacturing companies will be eased. According to the survey conducted by the Chinese Manufacturers' Association of Hong Kong, 83.4 percent of 168 respondents had declared an interest in entering the China's market in the next two years.

For the IT industry, China will participate in the Information Technology Agreement after accession to the WTO and this will have great impact on manufacturers of IT equipment. One direct opportunity is the expansion of domestic export and re-export of technology products to the Mainland.

Equally important, the liberalization of the telecommunications sector will increase the demand for IT equipment and generate enormous opportunities for manufacturers of IT equipment.

Retail and Distribution

Having a population of over 1.3 billion, China is a lucrative consumer market. However, foreign-funded firms' participation in distribution services is severely restricted. After WTO entry, China will phase out restrictions on distribution services for most products within three years and allow foreign companies to set up hypermarkets, department stores and most types of chain store. It will also scrap space restrictions for foreign-owned stores.

The liberalization in the retail sector will help Hong Kong retailers to expand their business in the second tier cities. However, based on the existing regulations, a foreign partner needs to have an annual sales value of over US$ 2 billion three years before its application or have assets topping US$ 200 million one year before its application. In the light of huge turnovers requirement, majority small Hong Kong companies therefore may consider teaming up with other overseas investors to take advantage of market opening.

More importantly, the elimination of restrictions on trading and distribution and the boost in trade volume will generate greater demand for international freight forwarding and logistics services. Given that the logistics services in China are still in their infancy, Hong Kong has the comparative advantage in developing as a logistics hub on geographical proximity, advanced port facilities, extensive distribution network and human expertise.

To enhance their competitiveness, Hong Kong business should upgrade their logistics services by providing a comprehensive sophisticated export services to overseas customers, including sourcing, freight and insurance handling, warehousing and distributing. The logistics service providers can also make use of information technology to expand their business in the global market.

Banking

According to the Regulations Governing Foreign Financial Institutions promulgated by the State Council in 1994, foreign banks mush have a minimum asset of US$ 20 billion at the end of year before applying for the establishment of a foreign bank branch. The foreign banks may only provide services to non-resident individuals, foreign and joint-venture enterprises and handle approved foreign currency lending, import and export settlement for Chinese enterprises. By the end of September 2001, there were 190 foreign institutions in the Mainland operating 158 branches and 217 representative offices in China with total assets of $ 44 billion.

Currently, foreign banks are mostly limited to foreign currency business with foreign-funded enterprises and only 32 foreign banks have been approved to conduct renminbi business in Shanghai and Shenzhen.

After China's WTO entry, restrictions on foreign banks' operations, in terms of scope of business, clients and geographical coverage, will be gradually relaxed. Upon accession, foreign banks will be permitted to provide services in China without client and geographic restrictions for foreign currency business. For renminbi business, in addition to Shanghai and Shenzhen, foreign banks will be allowed to provide services in Dalian and Tianjin upon accession. Services could expand to Guangzhou, Qingdao, Nanjing and Wuhan within 1 year; to Jinan, Fuzhou, Cheungdu and Chongquing within 2 years; to Kuming, Zhuhai, Beijing and Xiamen within 3 years; to Shantou, Ningbo, Shenyang and Xian within 4 years. All geographic limitations will be removed in 5 years. Foreign banks can conduct renminbi services with local firms within 2 years and local individuals within 5 years.

Despite broader market access, in the near term, foreign banks are expected to focus on renminbi business to foreign firms operating in China in light of poor accounting system and limited credit information for the Mainland enterprises.

Foreign banks are likely to focus on trade financing, syndicated corporate lending, foreign exchange transactions for foreign-funded enterprises or large Mainland enterprises. Although it is costly for foreign banks to establish a nationwide network to compete effectively with the local ones, Hong Kong-based banks however will have the advantage over the foreign banks on the broad clientele, particularly in the Pearl River Delta of China.

As about 40% of the Mainland's imports and exports are routed through Hong Kong, Hong Kong-based banks will also have an advantage to capture the opportunities arising from increased trade and related financial services. Meanwhile, there will also be increased lending to finance offshore trade as Hong Kong trading companies remain the principals in sales contracts on the back of strong business connections with the Mainland and overseas suppliers and buyers.

For the retail banking services, domestic banks in China have also been accelerating innovation in regard to new lines of business and products. In addition to the traditional savings and lending services, many domestic banks now provide multi-functional individual accounts that involve deposits, payments, remittance transfers and securities. They have also eased credit to home and car buyers.

Stepping up efforts to enhance the competitiveness of the domestic banking industry, the Chinese government has recently given a nod for domestic commercial banks to open investment banking operations including entrustment of investment fund, securities information consulting and financial consulting.

Nonetheless, services provided by foreign banks are still attractive to domestic customers in China on higher quality and wider range of financial products offered, in particular, mortgage, credit card and investment products. Meanwhile, foreign banks will use electronic delivery system such as Internet and mobile phone to penetrate the Chinese market instead of setting up branches.

Insurance

The insurance business in China is dominated by three state firms, which are China People's Insurance, China Life Insurance and China Reassurance. The Chinese government has issued 19 licenses to foreign insurers, of which nine licenses were granted to European Union insurers in September 2001, when the insurance issue has stalled the finalization of China's WTO entry terms.

At the moment, foreign insurers can engage in general insurance and re-insurance but they can only offer services to foreign-invested companies or foreigners in China. Life insurers are limited to individual life products and are required to establish joint ventures with Chinese insurance companies. Owing to rein restrictions on geographic locations and business activities, foreign insurers contribute only one percent of the nation's total premium income, most of it in the hands of American International Group Inc (AIG).

After accession to the WTO, the Chinese government agreed to grant licenses on a prudential basis, without numerical restrictions and loosen the geographic limitations. So far, the government has opened only cities of Shanghai and Guangzhou, though AIG has branches in Shenzhen and Foshan. Upon accession, Shenzhen, Tianjin, Foshan and Dalian will be firstly opened up to foreign insurers. Within two years of accession, Beijing, Chengdu, Fuzhou, Suzhoou, Xiamen, Ningbo, Shenyang, Wuhan and Tianjin will also be opened. All geographic limitations for future licenses will be eliminated within three years.

Foreign firms will also be allowed to all health coverage to domestic and foreign clients within four years and group, pension and annuities policies within five years. For general insurance, foreign property and casualty firms will be allowed to provide master policy and large-scale commercial risk insurance upon accession.

Despite various changes, foreign insurers are unlikely rushing into the market. The biggest hurdle is huge costs of doing business. Foreign insurers are paid-up a minimum capital requirement of 200 million yuan for each Mainland city branch license and a further 50 million yuan for each of a maximum of two sub-branch licenses.

In granting licenses, Hong Kong indigenous insurers are difficult to compete with multinationals on financial side. Nonetheless, the adoption of prudential criteria and lowering of the capital requirement may give Hong Kong's indigenous insurers a better chance to enter the Mainland market.

As Hong Kong insurers are more familiar with political environment and policy in China, they can cooperate with the multinationals, which are interested in the Mainland market but do not yet have a foothold. An alternative way for Hong Kong insurers to gaining a foothold is to invest in existing insurers in China. More importantly, as China is in a blank state with regard to many financial derivatives, Hong Kong could help the Mainland insurers by exporting its expertise in investment and risk management.

Securities and fund management

After China's WTO entry, foreign securities firms will be allowed to establish joint ventures so as to participate in the underwriting, sales and trading of renminbi securities onshore. However, as the Chinese government gives investment licenses on a bilaterally negotiated basis. It is doubtful whether Hong Kong securities houses can get investment licenses as Hong Kong lacks either a foreign country or domestic status.

Nonetheless, as restrictions on ownership and listing rules are gradually relaxed, we expect a large number of the Mainland enterprises will rely on equity finance for expansion and seek a listing in Hong Kong to tap overseas fund, lifting fund raising activities in Hong Kong. In addition, the financial services sector could benefit from the rising activities in arranging merge and acquisitions, takeovers, corporate bond issuance for Mainland enterprises. Meanwhile, massive economic restructuring in Chinese provinces and municipalities will also enhance further development in bond market.

For the fund management industry, there are currently 30 closed-ended funds, worth around 80 billion yuan, listed on the Shanghai and Shenzhen stock exchanges. These funds are mostly managed by 10 fund management companies with a poor reputation on market manipulation, inter-fund collusion and poor performance.

After China's WTO accession, foreign firms will be allowed to hold an initial one-third share in local fund management companies, with the investment ceiling rising to 49 percent three years after entry.

Foreign firms view China as an enticing market in light of 1.4 trillion yuan idle cash in banks and shortage of experienced local fund managers. Recently, a slew of foreign firms stepped up efforts to set up joint ventures in China amidst China's pending entry to WTO.

Implications

Because of free capital and information flows and currency convertibility, Hong Kong's importance as an international financial and business center will be enhanced after China's WTO entry.

The factor of economic complementary remains crucial for Hong Kong economic success. Despite fierce competition, China's opening up will revitalize Hong Kong's growth momentum through provisions of lucrative trading and financial opportunities. In the medium term, the economic prospects can gradually improve, encouraged by numerous business opportunities and the low interest rate environment. In the long term, whether Hong Kong can stay ahead hinges on its successful development in higher-value added services and the sustained competitive advantage as a leading international financial and business center.

Expected future market access conditions in China

Sources: HKTDC publications and press materials

Daniel Chan, Dr.
Senior Economist
Head of Economic Research