In addition, the mainland will allow Hong Kong permanent residents with Chinese citizenship to set up individually owned stores in all parts of the mainland to provide four kinds of services, namely import and export of goods and technologies, photography and photographic processing services, washing, cleaning and dyeing services, and repair and maintenance of motor vehicles and motorcycles. This initiative is expected to further stimulate the entrepreneurship of Hong Kong residents, and foster a stronger economic integration between Hong Kong and the mainland.

Background

Hong Kong and the mainland jointly announced further liberalisation measures under the third phase of the Mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA III) in October 2005, which will largely take effect from January 2006. CEPA was first concluded in June 2003, and implemented from January 2004. On the heels of this first phase of liberalisation measures (CEPA I), Hong Kong and the Chinese mainland agreed under the CEPA framework in August 2004 a second phase of liberalisation measures (CEPA II) to further Hong Kong's access to the mainland market with effect from January 2005. Under CEPA I and II, the mainland is applying zero import tariff for 1,108 Hong Kong products, while providing preferential treatment to 27 service areas.

Trade in Goods

CEPA III Provisions

Under CEPA III, the mainland agrees to give all products of Hong Kong origin tariff free treatment, except for prohibited articles such as used electrical machinery and medical products, chemical residual, municipal waste, tiger bone and rhinoceros horn. But eligible products must fulfill the CEPA rules of origin to enjoy tariff-free treatment. In addition to the goods covered by CEPA I and II, Hong Kong and the mainland have agreed on the rules of origin for 261 products. These include certain dried or processed fish, diary products, fruit juices, chemical products, plastics in primary form, fabrics, garments, tube or pipe fittings, mechanical and electrical products, and spectacles.

Of the total 1,369 products covered by CEPA I, II and III, Hong Kong's existing process-based origin rules have been adopted for 1,014 of them (74%). These include textiles and clothing, food and beverages, pharmaceutical products, and certain plastic and metal products. As there are no specific needs to change their production processes to meet the requirements of the CEPA rules of origin, Hong Kong manufacturers have greater flexibility in cashing in on the emerging market access opportunities.

In the meantime, the requirement of "change in tariff heading" is applied to 155 products (11%), such as electronic parts and components, while a 30% valued-added requirement is applied to 116 products (9%), such as electronic products. Special rules of origin have also been agreed on 84 products (6%), such as fish and aquaculture products, taking into account the characteristics of the concerned products.

Breakdown of CEPA Rules of Origin

For products which have no agreed CEPA rules of origin at present, Hong Kong will initiate discussions with the mainland twice a year upon requests by local manufacturers. A notice to announce the timetable and procedures for Hong Kong manufacturers to submit requests will be issued by the Trade and Industry Department (TID) in due course. Once the discussions are concluded, TID will inform Hong Kong manufacturers of the details of the CEPA rules of origin for the concerned products.

Cost Saving for Hong Kong Products

The immediate benefit of tariff-free access is cost saving for Hong Kong domestic export items being sold to the mainland. From January 2004 to September 2005, a total of 8,296 Certificates of Hong Kong Origin (CEPA) were approved under CEPA I and II, incurring a total value of HK$2,796 million. Textiles and clothing were the largest beneficiary, followed by pharmaceutical products, food and beverages, plastics and plastic articles, paper and printed articles, and chemical products.

Distribution of Products Approved with Hong Kong Origin
(as of 30 September 2005)

Note: The total figure is smaller than the sum of all product types as one Certificate of Origin can cover products of more than one type.

With all products of Hong Kong origin included in CEPA III, it is expected that zero tariff access to the mainland market will stimulate some manufacturing activities in Hong Kong, and provide an impetus for Hong Kong's domestic exports to the mainland. While the CEPA rules of origin have now been agreed for 261 products only, all other products will subsequently be eligible for tariff-free access amid applications by Hong Kong manufacturers and the rules of origin being agreed and met. Besides, existing production can also be expanded to take advantage of the zero tariff benefits.

Apparently, most manufacturers in Hong Kong will continue to use the mainland as their main production base. But some of them may consider revitalising their existing facilities or setting up new production lines in Hong Kong to take advantage of CEPA III. Meanwhile, given the zero-tariff advantage of Hong Kong's domestic exports to the mainland, it is hoped that some foreign manufacturers that plan to set up production lines in the region will be attracted instead to Hong Kong.

Given that the ultimate or target market of these companies is the mainland, savings in tariffs in Hong Kong must be substantial enough to offset the higher Hong Kong production costs. Alternatively, for products with high value-added content (in terms of brand, design, quality, technology, etc.), or intellectual property (IP) input being the major component in their total cost structure, production in Hong Kong would be more feasible if Hong Kong can generate a higher IP value, or provide better IP protection.

In these circumstances, it is expected that some high value-added or IP input industries that do not require a mass scale of production would probably be set up in Hong Kong. These industries are likely to be high-end lifestyle products that have a strong design element. A case in point is watches, for which the CEPA rules of origin have been relaxed under CEPA III. Given widespread food safety concerns on the mainland, food processed in Hong Kong may also instil better confidence in product quality among mainland consumers. A "Made in Hong Kong" label for these products is expected to be a sought-after item by mainland consumers, and their production in Hong Kong seems feasible. In the meantime, production that requires strong protection of the investor's proprietary technology or R&D results, such as medicines, may further find Hong Kong a better investment location, although sales across the border are subject to a set of rules governing drug importation into the mainland.

As a rough indication, Hong Kong origin products currently attract higher mainland import tariffs, or those selling substantially to the mainland, are likely to have better market potential under CEPA III. But it should be noted that there is also potential for products with insignificant exports to the mainland at present, or even for products with no existing production in Hong Kong, provided that these products possess high value-added content or considerable IP input, and the reduction in import tariffs is substantial.

Hong Kong Origin Goods Likely to Have Better Potential under CEPA III

Effect on Manufacturing Investment

While increased opportunities in exporting Hong Kong originated products to the mainland market may encourage existing local industries to expand their output and production capacity, it is also expected that some Hong Kong and foreign companies may be attracted by CEPA III to set up new production lines in Hong Kong. Under CEPA III, the rules of origin have now been agreed for 261 products only. But all Hong Kong origin products will subsequently be eligible for tariff-free access amid applications by Hong Kong manufacturers and the rules of origin being agreed and met, including those without existing production in Hong Kong. This demonstrates well the positive effect of CEPA III in attracting new industrial investment and new manufacturing activities to be located in Hong Kong.

At present, most Hong Kong factories on the mainland are producing under original equipment manufacturing (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.

Likely Criteria for Industries to Benefit from Zero Tariff

• 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, quality, 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

Like the previous two phases of CEPA, only niche and high-end products of traditional industries will benefit from CEPA III. Lifestyle products, such as high fashion and accessories, stylish watches and spectacles, are likely to be able 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. Lifestyle products aside, a "Made in Hong Kong" label may be crucial for certain processed food products, which have the upper hand over mainland brands in terms of quality and safety of consumption.

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 if they invest in the "restricted industries"¹, such as production of certain medicine materials, small crawler dozers and small truck cranes, on the mainland. 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 advantage of CEPA that allows tariff-free and more efficient trade with the mainland, would be an edge in attracting foreign companies to invest in Hong Kong.

Trade in Services

CEPA III Provisions

Regarding trade in services, there are 23 liberalisation measures under CEPA III, covering 10 areas - legal, accounting, audiovisual, construction, distribution, banking, securities, tourism, transport and individually owned stores. In general, the liberalisation measures allow earlier access for Hong Kong service suppliers to the mainland ahead of China's WTO timetable. In sectors like audiovisual, transport and distribution, the concessions go beyond China's WTO commitments. The mainland, on the other hand, will allow qualified mainland securities and futures companies to set up subsidiaries in Hong Kong.

Legal Services

CEPA III further liberalises the arrangement that Hong Kong law firms can operate in association with mainland law firms. Instead of operating in association with mainland law firms just in the place where a Hong Kong law firm's representative office is located, as permitted under CEPA II, the Hong Kong law firm can have its representative office operate in association with one mainland law firm situated in the concerned province, autonomous region or municipality. This offers greater flexibility for Hong Kong law firms looking for association arrangement with mainland law firms in geographical terms. However, Hong Kong lawyers participating in such associations cannot handle matters of mainland law.

In addition to allowing mainland law firms to employ Hong Kong lawyers as per CEPA II provisions, CEPA III touches upon the employment capacity relating to Hong Kong residents allowed to practise on the mainland. While working in a mainland law firm, a Hong Kong resident shall not simultaneously be employed by the representative office set up by any other foreign law firm on the mainland, whether it is set up by a legal firm in Hong Kong, Macau or any other foreign country. This may serve as a useful clarification of the employment capacity for a Hong Kong resident allowed to practise on the mainland.

Accounting Services

In general, CEPA does not include significant market liberalisation measures for Hong Kong's accounting firms and professionals. For smaller Hong Kong accounting firms, the main option for them to serve the mainland market is via the Temporary Audit Business Permit. Under CEPA III, the validity period of the Temporary Business Permit is two years, an extension from one year that is allowed under CEPA II. This will help reduce the administrative burden for Hong Kong accounting firms compared with the requirements which otherwise apply to non-CEPA beneficiaries.

Construction Professional Services

Under CEPA, construction professional services include construction design services, engineering services, integrated engineering services, urban planning and landscape design services (except overall urban planning services).

While CEPA allows Hong Kong construction professional services firms to operate wholly-owned units on the mainland, most Hong Kong firms are small enough in size to find it hard to comply with all of the current grading qualifications and professional requirements.

For example, as stipulated under Article 15 of Decree No. 114 of the Ministry of Construction (MoC), i.e., Regulations on Administration of Foreign-Invested Construction and Engineering Design Enterprises, there are strict requirements on the number or proportion of China-qualified architects, engineers and technical staff with relevant design experiences in the staff composition of these enterprises. CEPA III indicates that this restriction is to be relaxed, with the exact details to be announced in coming weeks.

Article 16 of MoC Decree No. 114 requires that China-certified architects, engineers and key technical personnel must stay for a cumulative period of no less than six months each year. CEPA III is surely good news for Hong Kong-invested construction and engineering design enterprises and urban planning services enterprises, offering them greater flexibility in personnel deployment for projects on the mainland, as the period of residence of the concerned personnel in Hong Kong will also be counted as their period of residence on the mainland.

CEPA III also benefits Hong Kong's smaller urban planning service companies, as they can join hands with each other to form a joint-venture urban planning enterprise on the mainland, and their individual performance, be it in Hong Kong or on the mainland, will be taken into account in qualification assessment by mainland authorities.

Audio Visual Services

CEPA III relaxes the scope for Hong Kong companies operating wholly-owned units in respect of business of cinema construction and renovation, allowing them to construct or renovate more than one cinema theatre at one location for film-screening business.

For Hong Kong-mainland co-produced films, existing CEPA provisions lift the restrictions on the ratio of principal creative personnel from Hong Kong and only require one-third of the leading artists to be from the mainland. Besides, the film story of these co-productions is no longer required to take place in China. Building on these relaxation measures, CEPA III further allows the Cantonese versions of Hong Kong-mainland co-productions to be distributed and screened in Guangdong Province.

Similarly, the Cantonese-version of Hong Kong-produced films solely imported by the Film Import and Export Corporation of the China Film Group Corporation can be distributed and screened in Guangdong Province. In addition, CEPA III further lowers the copyright ownership of Hong Kong-produced Chinese-language films for quota-free importation to the mainland from more than 75% under CEPA II to just more than 50%.

China is a multi-ethnic country with many people speaking different dialects aside from Putonghua. Allowing Hong Kong-mainland co-produced films to be dubbed in Cantonese for distribution within Guangdong Province under CEPA III will help retain the original flavour of such films, offer greater choices to Guangdong audiences and facilitate a greater market penetration. This is also true for the Cantonese versions of films produced by Hong Kong companies and solely imported by the China Film Group.

Distribution Services

CEPA aims at removing the remaining hurdles for Hong Kong companies to participate in the mainland's distribution business, which is already very open. One of the most significant relaxation measures in CEPA III is to allow Hong Kong retailers with over 30 stores on the mainland to be the controlling shareholder in their businesses from January 2006 onwards. This is expected to provide higher flexibility and incentives for Hong Kong's large retailers to embark on more aggressive expansion in the mainland market.