Overview

Closer Economic Partnership Arrangement

According to the CEPA agreement signed on 29 June 2003 and the annexes released on 29 September 2003, the Chinese mainland will apply zero tariffs to import products of Hong Kong origin by phases. The first phase of zero tariff treatment, which started from 1 January 2004, covers products in 374 mainland 2004 tariff codes. The second phase of zero tariff arrangement (CEPA II), which covers 713 additional products in mainland 2004 tariff codes, was agreed upon on 27 August 2004 and will start from 1 January 2005. In sum, 1,087 Hong Kong origin products, virtually all that is produced in Hong Kong, will enjoy zero tariff when exporting to the mainland. For other products that are not yet covered, the mainland has undertaken to apply zero tariff upon applications by local manufacturers, including products that are not yet produced but planned to be produced in Hong Kong. For example, among the 713 products allowed zero tariff in phase two, 184 are without existing production in Hong Kong. For these products, the zero-tariff treatment will be applied upon confirmation by both sides that the products have come into production.

Under CEPA, products of Hong Kong origin refer to goods wholly obtained in Hong Kong (which mainly include mineral products, fishery and agricultural products), or industrial products that have undergone substantial transformation in Hong Kong. The key criteria for determining substantial transformation include specific manufacturing or processing operations, change in 4-digit tariff heading, and value-added content of no less than 30% of the FOB value of the exporting goods. To give Hong Kong manufacturers greater flexibility in capitalising on market access opportunities, Hong Kong's existing specific process-based origin rules have been adopted in most cases.  

For instance, for 74% of the 713 products covered in CEPA II, including textiles and clothing, food and beverages, pharmaceutical products as well as some plastic and metal products, Hong Kong's existing process-based origin rules will be adopted as the CEPA rules of origin. Another 11% of the products will employ the change in tariff heading approach and only 7% will use the 30% value-added requirement as the CEPA rules of origin. For the remaining products, including fish and aquaculture products, both sides have also agreed on their rules of origin after taking into account the characteristics of the products concerned.

Potential Benefits

The immediate benefit of tariff-free access is cost savings for the Hong Kong domestic export items to the mainland. In the first eleven months of CEPA implementation, a total of 2,711 Certificates of Hong Kong Origin (CEPA) were approved, which involved a total value of HK$1,015 million. Textiles and clothing were the largest beneficiary, followed by pharmaceutical products, plastics and plastic articles, electrical and electronic products and colouring matters. Jewellery and precious metals as well as clocks and watches were among other beneficiaries.

Distribution of Products Approved with Hong Kong Origin

(as of 30 November 2004)

For the phase-two zero tariff products, the existing tariff rates range from 3% to 33.3%, with most of the products paying 10-19.4% tariff rates.

In the longer run, it is expected that zero tariff access to the mainland market will stimulate new manufacturing activities in Hong Kong and expand the amount of domestic exports. For example, in the second batch of zero tariff products announced in August 2004, 184 products are not currently produced but are planned for production in Hong Kong. Besides, existing production will also be expanded to take advantage of the zero tariff benefits.

Most manufacturers in Hong Kong will continue to use the mainland as their production base. However, some of them might consider expanding their existing facilities or setting up new production lines in Hong Kong to take advantage of CEPA. Besides, given the zero tariff advantage of Hong Kong's exports to the mainland, it is hoped that some foreign manufacturers with plans to set up production lines in the region will be attracted instead to Hong Kong.

Trade Creation Effect

In 2003, Hong Kong's domestic exports to the mainland amounted to HK$36.8 billion, of which HK$11.9 billion (32%) were consumed in the mainland market, with the rest shipped back to Hong Kong after processing under the outward processing arrangement (OPA). Even within the HK$11.9 billion non-OPA exports, the majority might also be exempted from tariff when imported into the mainland market as they are deemed to be machines and intermediate goods required for the purposes of export processing. Hence, only a small share of Hong Kong's domestic exports is believed to be sold to mainland end users and is therefore likely to benefit from CEPA. 

Though certain products which benefit from the zero tariff treatment recorded marked growth in domestic exports to the Chinese mainland in the first nine months of CEPA implementation, due to their small share in existing exports, the expansionary effect on overall domestic exports to the mainland was not significant. In January to September 2004, Hong Kong's domestic exports to the Chinese mainland declined by 1.1%.

Expansionary Effect of Selected CEPA Beneficiary Products

In the past, many Hong Kong products were not sold to the mainland market even though they might appeal to mainland consumers. This was due in part to the high level of import tariffs that made Hong Kong products too expensive for mainland consumers. With CEPA, Hong Kong products can be more price competitive and find new opportunities to break into the mainland market.

Mainland consumers have become increasingly sophisticated in recent years, especially the emerging middle class consumers who are willing to pay more for goods offering the latest international trends, good design and style, and high quality. According to an earlier TDC study, mainland middle-class consumers generally have a favourable image of Hong Kong products, and over half of the surveyed consumers find Hong Kong products quite or very appealing. In general, these consumers consider Hong Kong products trendy, good in taste and creative in design. Moreover, Hong Kong companies are considered adept at quality control. Hence, a "made in Hong Kong" product or brand accepted by mainland consumers can command a measurable premium.

Effect on Manufacturing Investment

While increased opportunities in exporting Hong Kong-originated products to the mainland market might encourage existing local industries to expand their output and production capacity, it is also expected that some Hong Kong and foreign companies might be attracted by CEPA to set up new production lines in Hong Kong. With reference to the product coverage of the second phase of CEPA, 184 products that are not currently produced in Hong Kong are included. This demonstrates well the positive effect of CEPA by attracting new manufacturing activities to be located in Hong Kong. New products that are planned for production in Hong Kong as a result of CEPA include albumins and albumin derivatives, toughened safety glass, medical apparatus and massage apparatus.

At present, most Hong Kong factories on the mainland are producing under OEM arrangements for overseas markets. Even though some companies have developed their own brands and started selling to the mainland domestic market, most of them are positioned at the middle- or upper-middle end of the market. In light of the zero tariff arrangement, Hong Kong companies might be interested in starting a new product line of premium products or new brands in Hong Kong to target the higher-end of the mainland market.

It is agreed that although a "made in Hong Kong" label is able to charge a higher price for certain lifestyle and fashion products in the mainland market, it must be complemented by a strong or premium brand image. This is because, for most mass-market products on the mainland, price is a dominating factor of consideration in purchase. Even for branded products, once the brand is accepted, its place of origin is of less importance. Hence, setting up a mass-market product line in Hong Kong might not be feasible or profitable.

Industries that are likely to benefit from CEPA's zero tariff arrangement and justify production in Hong Kong for selling to the mainland market would need to fulfil one or more of the following criteria:

• High savings in tariffs;
• Depending on imported raw materials or intermediate goods from overseas rather than sourcing from the mainland;
• Production that Hong Kong commands a good image or reputation, hence able to charge a higher price for the "made in Hong Kong" label;
• High-price products with value-added in terms of brand, design, technology, etc. rather than the labour input;
• Predominant share of intellectual property (IP) input in the overall cost structure, hence requiring strong IP protection;
• Limited quantity rather than mass production;
• Availability of sufficient skilled workers in Hong Kong, or more realistically, ability to adopt advanced technology in production.

Only niche and high-end products of traditional industries will benefit from CEPA. Lifestyle products such as high fashion and accessories, fur garments, precious jewellery and stylish watches are likely to capitalise on the strength and reputation of Hong Kong in design and quality control, and to develop upmarket brands or products for the mainland's emerging middle class.

Apart from traditional industries, Hong Kong may also be able to attract some new local and foreign investment in industries that require strong protection of their proprietary technologies, formulae or inventions. This is particularly true for some industries that are still restricted from forming wholly-owned foreign companies on the mainland. For example, foreign investors must form joint ventures on the mainland if they invest in the "restricted industries" ¹ such as production of photosensitive materials, satellite television receivers and parts, and some pharmaceutical products like antibiotics and immunity vaccines. Since the IP value of the proprietary technologies or inventions of these industries is high, foreign investors may prefer investing in a wholly-owned venture in Hong Kong to forming a joint venture on the mainland.

Even for some industries that do not have any restrictions in the shareholding by foreign investors in manufacturing projects on the mainland, foreign investors may still be attracted to set up R&D facilities or production of proprietary products in Hong Kong if they are targeting the mainland market, or making use of the advantage derived from the economic synergy of Hong Kong and the mainland. This is particularly true for medium-sized foreign companies which are not familiar with the mainland's business environment and cannot afford to invest in their own independent R&D facilities on the mainland. Hong Kong's high standards of IPR protection, its status as a free port and the added CEPA advantage to allow tariff free and more efficient trade with the mainland, would be an edge in attracting foreign companies to invest in Hong Kong.

¹   In line with the direction of its industrial development, the Chinese government has published a set of Provisions on Guidance for Foreign Investment and a Catalogue for the Guidance of Foreign Investment Industries. The Provisions divide foreign investment projects into four categories, namely encouraged, permitted, restricted and prohibited. For projects falling under the restricted category, there are more stringent restrictions on foreign investors in terms of application procedures and equity shareholding of the joint venture. In the latest Catalogue (effective 1 Jan 2005), there are 13 broad manufacturing sectors on the restricted list.

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