By end 2005, there had been over 300 free trade agreements (FTAs) registered with the World Trade Organisation (WTO). Indeed, trade among members of FTAs now accounts for more than half of the global trade. Recently, China has pro-actively pursued FTAs with its neighbouring economies so as to safeguard the country's economic interests as well as to foster regional partnership. Apart from the two Closer Economic Partnership Arrangements (CEPAs) of the Chinese mainland with Hong Kong and Macau, the China-ASEAN FTA is of most importance among all FTAs signed by China.

China implemented the China-ASEAN Trade in Goods (TIG) Agreement in July 2005, a major step to forming a China-ASEAN Free Trade Area (CAFTA) with major ASEAN members by 2010. CAFTA is the world's third largest free trade area after the EU and NAFTA, with a combined population of 1.8 billion and GDP well exceeding US$2 trillion. The CAFTA-TIG Agreement covers tariff-lines representing more than 95% of China-ASEAN trade, which grew annually by 23% from 1997-2005 to reach US$130.5 billion.

Generally, FTAs are intra-bloc trade-creating given the preferential arrangements between FTA members, lowering trade barriers, increasing competition and economies of scale, and raising overall economic efficiency of member countries. At the same time, trade between FTA members and non-members are likely to be adversely affected because of the less faovurable treatment to non-members, thus resulting in trade diversion. The ASEAN-China Expert Group on Economic Co-operation, however, has suggested that CAFTA would likely lead to net trade diversion, with the gain in intra-bloc trade more than offset by the reduction in extra-bloc trade (with non-members). Although CAFTA may lead to net trade diversion, its impact on individual non-member economies would likely vary drastically, with much depending on how well these non-members are linked to the signatory countries individually.

As the bulk of Hong Kong manufacturing is now undertaken on the mainland, especially in the PRD, the preferential trade benefits associated with the CAFTA-TIG Agreement can be easily extended to Hong Kong companies on the mainland, as long as they abide by the stipulated country-of-origin requirements, irrespective of the fact that Hong Kong is a non-member of CAFTA. Generally, the origin rules require that no less than 40% of the value of a product must originate in China or ASEAN.

In view of the tariff-reduction schedules, items subject to import tariff rates of ASEAN members of exceeding 20% (as in apparel, textiles, toys and watches) will see larger reductions than items which attract tariff rates of under 20% (like jewellery and electrical machinery) in the initial years of CAFTA-TIG Agreement implementation. Hong Kong companies on the mainland will benefit from CAFTA-tariff cuts just like their indigenous counterparts, as their mainland-produced items are sold to ASEAN as China-origin exports. To receive tariff-reduction treatments, however, the origin rules require additionally that the consigned products should primarily be transported through CAFTA. Where these products are transported through non-CAFTA territories, neither should they be entered into trade or consumption, nor should they undergo any operations other than unloading/reloading. Similarly, Hong Kong companies manufacturing on the mainland will enjoy the lower cost of raw materials from ASEAN, as China's imports of raw materials from ASEAN, especially plastic and rubber, will enjoy reduced tariffs.

Hong Kong companies play a prominent role in the global supply chain and flourishing ASEAN-China trade. Hong Kong companies' substantial manufacturing investment on the mainland signifies that consigned products of China-origin via either direct/offshore trade or transshipment are entitled to CAFTA-tariff reductions. Hong Kong's role as a third-party trading partner, however, does not benefit from CAFTA in light of the stipulated origin rules, though the overall effect on Hong Kong is far from negative, with no appreciable trade diversion since the onset of tariff cuts in July 2005. Hong Kong's trade with ASEAN and the Chinese mainland, respectively, increased year-on-year by 16.3% and 17.2% in the eight months ending March 2006 with the corresponding re-exports trade rising 9.6% -- faster pace than what was evident in the preceding eight months.

Thanks to the WTO's Information Technology Agreement (ITA), the import tariffs for most related items are already zero-rated. ITA has been one of the key drivers for the flourishing China-ASEAN and intra-industry trade (also among subsidiaries of multinational companies in the region) since the late 1990s. In the specific case of electronics, electrical equipment and machinery,¹ China's exports to/imports from ASEAN grew annually from 1997-2005 by 28% and 40%, respectively, to US$24.5 billion and US$45.2 billion (these items represented 53% of the bilateral trade in 2005). Over the same period, Hong Kong's handling of China-ASEAN trade in these products expanded annually by 17% to US$16.4 billion.

Broadly speaking, progressive elimination of tariff barriers within CAFTA over time, plus the dismantling of non-trade barriers, will continue to drive down the overall transaction costs and promote further development of intra-regional and intra-industry trade, recognising the product differentiation and scale economies that have already emerged in the region, and attracting related investment from outside CAFTA. This would likely benefit Hong Kong, which has long been a popular choice of regional headquarters for many companies to manage their regional activities.

Following the signing of the China-ASEAN framework agreement in late 2002, it took both sides about a year to implement the Early Harvest Programme in January 2004 and almost three years to implement the CAFTA-TIG Agreement. Although the China-ASEAN negotiations on trade in services (TIS) commenced in late 2003, the results are still being awaited. The vastly different service economies of ASEAN countries would inevitably touch on issues or aspects affecting many sensitive sectors of some ASEAN countries in the course of CAFTA-TIS negotiations.

The difficulty of achieving service liberalisations involving multiple parties can be best epitomised by the sluggish multilateral TIS negotiations under the WTO's auspices for the Doha Development Round, which lag behind the other strands of negotiations. At this stage, the extent to which Hong Kong may positively leverage a CAFTA-TIS Agreement, or be negatively affected by it, remains largely a matter of guesswork before the precise details unfold. Given the slow pace of CAFTA-TIS negotiations, CEPA will likely remain, in the foreseeable future, an effective venue for ASEAN service suppliers vying for WTO-plus access to the Chinese mainland.

In essence, Hong Kong has been an effective platform for ASEAN companies in exploring the Chinese mainland market and managing regional activities. For example, Malaysian conglomerate Kerry Group has used its Hong Kong subsidiaries, including Kerry Properties and Kerry Logistics, in managing properties, infrastructure and logistics businesses in Hong Kong and the mainland. DBS, the largest lender in Singapore, has built its presence in Hong Kong by way of bank acquisitions, indicating that the bank would be prepared to acquire stakes in banks in Asia despite the current limits placed on foreign ownership. Similarly, Recruit Express, one of Singapore's largest recruitment consultancies, is expanding its Hong Kong office with a view to turning it into Hong Kong's largest recruitment company by the end of 2007. Its Hong Kong operations set the sight on the massive potential of regional recruitment in Asia, the Greater China region in particular.


1. INTRODUCTION

Over the past few years, East Asian economies have concluded more than a dozen FTAs with partners both within and outside of the region and are currently undertaking an expanding number of FTA talks (see Appendix I). At a glance, the number of FTAs that East Asian countries are working on is well over 30.² Conceivably, regionalism achieved via FTA seems to be having a domino effect and expanding its driving power. Against this background, China also jumped onto an FTA bandwagon in the early 2000s,³ pursuing FTAs pro-actively with neighbouring economies so as to safeguard the country's economic interests as well as to foster regional partnership.

The Chinese mainland finalised its FTA in 2003 with Hong Kong in the form of the Mainland/Hong Kong Closer Economic Partnership Arrangement (CEPA). Prior to that, the mainland had concluded a framework agreement with ASEAN in late 2002 to form a China-ASEAN Free Trade Area (CAFTA) with major ASEAN members by 2010. A major step in achieving CAFTA took place in July 2005, when China and ASEAN started implementing the China-ASEAN Trade in Goods (TIG) Agreement.

In addition, China has signed some partial FTAs or Early Harvest deals with countries including Thailand⁴ and Pakistan,⁵ focusing on narrow categories of merchandise. Meanwhile, China is having or planning to have FTA discussions with a number of countries, including Australia, Brazil, Iceland, India, Japan, New Zealand, Pakistan, South Korea, the Gulf Cooperation Council and the Southern Africa Customs Union.

Apart from the two CEPAs with Hong Kong and Macau, the China-ASEAN FTA is of most importance among all FTAs signed by the Chinese mainland. As the Chinese mainland is the only party with which Hong Kong has forged an FTA and its FTA with ASEAN creates the world's third largest free trade area, this paper examines the economic effect of CAFTA on Hong Kong as a trade hub.


2. ECONOMIC IMPACTS OF FTA

To begin with, the economic benefits of FTAs lie largely in two areas. For FTA members, the economic benefits would consist of higher economic growth, greater competition, better scale economies, lower production costs, as well as gains in efficiency and economic welfare, while deepening economic integration (an ultimate goal can be identified in the European Union (EU)). On the other hand, non-economic benefits would comprise deeper mutual understanding among concerned FTA members, closer social ties and conceivably, political and social stability.

Removal of trade barriers between members of an FTA is akin to market enlargement, with firms of the FTA member countries presented with opportunities to sell into a larger and more integrated market on a greater scale of operations. When purchasers in one economy increase their demand for goods supplied by FTA members, this will constitute a trade creation. Should the demand for goods imported from non-FTA members decrease because of the preferential treatments to FTA members, trade diversion would entail. The net effect of an FTA is measured by the combined changes in intra-bloc trade (of FTA members) and extra-bloc trade (between FTA members with non-members).

Changes in trade flows may induce changes in the location of production between member countries of an FTA, with the relocations usually determined by the comparative advantages between FTA members, presence of industry clusters and possibly technology transfer (associated with FDI or otherwise).

3. CHINA'S FTAS THAT MAY AFFECT HONG KONG

With the preferential arrangements in trade in products and services as well as in trade/investment facilitation under CEPA, Hong Kong has benefited economically since the FTA was implemented in January 2004.⁶ Apart from CEPA, however, Hong Kong has yet to sign any FTA with economies inside or out of the region.⁷ In other words, nearly all FTAs that China and other countries in East Asia have signed could, theoretically speaking, affect Hong Kong negatively on account of the potential diversion of extra-bloc trade of these FTAs. Even though the overall effect on extra-bloc trade of an FTA might be negative, the impact on individual economies not being signatory members of the FTA could vary considerably and would not necessarily be negative.

4. CAFTA AND RELEVANCE FOR HONG KONG

The China-ASEAN FTA, the first "external" FTA signed by China, is perhaps the one with the most significant impact on Hong Kong and may provide ample business opportunities for Hong Kong companies, given their substantial manufacturing investment on the mainland (especially in Guangdong Province) and the prominent role of Hong Kong companies in the flourishing mainland-ASEAN trade.

While one would agree that ASEAN countries will gain increasing access to the mainland market with the China-ASEAN FTA over time, first in the area of trade in goods, their negotiations with China on trade in services and investment are underway, and it remains to be seen how ready ASEAN members are willing to open up their service markets.

4.1 How May Hong Kong be Affected by CAFTA?

China and ASEAN have a population of 1.8 billion with a combined GDP well exceeding US$ 2 trillion. CAFTA is the third largest global trading region after the EU and the North American Free Trade Zone (NAFTA).⁸ To analyse the effect of the China-ASEAN FTA, it is necessary to take a closer look at both the China-ASEAN trade and the re-export trade handled by Hong Kong.

China's Total Trade by Major Trading Partners (US$ million)

ASEAN-China trade has grown substantially in the past decade, even without the benefit of an FTA. China's total trade with ASEAN expanded more than five-fold during 1997-2005 to surpass US$130 billion, with a CARG of 23% (the highest among the top 7 trading partners). Trade with ASEAN represented about 9% of China's total trade in 2005, making ASEAN its fifth largest trading partner following the EU, US, Japan and Hong Kong. If the CARG of China-ASEAN trade from 1997-2005 is any guide, two-way trade will surpass US$200 billion well before 2010.

Since the Chinese mainland has yet to secure any FTA with its top three trading partners (namely, the US, EU and Japan, as listed in the above table), it can be postulated that the Chinese mainland's FTA with ASEAN, if anything, would be the FTA from which Hong Kong might expect to see the strongest economic impact, also bearing in mind that the Chinese mainland and ASEAN, respectively, the top and fourth largest trading partners of Hong Kong, account for more than half of Hong Kong's external trade.

Over the past decade or so, the structure of ASEAN-China trade has changed much to reflect the fast growing intra-industry trade. About half of the total trade between China and ASEAN is due to the fast-expanding trade of electronics, electrical equipment, related parts and components, and machinery (Harmonised Schedule Chapters 84 and 85). In both ASEAN and China, foreign invested enterprises, including both multinational corporations (MNCs) and Hong Kong companies, are responsible for a substantial share of the exports in intermediate goods and manufactured end products.

4.2 China-ASEAN Trade - Sharp Change in Trade Mix (by 2000)

China and ASEAN contemplated the creation of a free trade area in the early 2000s, taking into account closer economic ties as reflected in part by the change in the trade mix, which had undergone considerable changes in the preceding decade, and the growing interests of East Asian countries in pursuing FTAs.⁹

In the early 1990s, the top five ASEAN exports to China were oil and fuel, wood, vegetable oils and fats, computers/machinery and electrical equipment. Collectively, these five products amounted to 76% of all ASEAN exports to China. By 1999, the order of importance had shifted away from commodities and towards manufactured products. Computers/machinery and electrical equipment (HS Chapters 84-85) grew from 12% to 38% of ASEAN exports to China. Also, the share of the top five products decreased to 60% of total exports to China.

ASEAN exports commanding comparative advantages included mineral products (including mineral fuels), plastics/rubber, wood and wood articles, pulp and paper and fats and oils. In 2000 they accounted for 42% of China's imports from ASEAN.

ASEAN imports from China are always more diversified. In 1993 the top five ASEAN imports from China were computer/machinery, electrical equipment, oil and fuel, cotton and tobacco. Collectively they made up a little less than 40% of ASEAN imports from China. By 1999, electrical equipment and computer/machinery continued to be the top imports, but their share had increased to nearly half of all ASEAN imports from China.

Chinese exports wielding comparative advantages included base metal and metal articles, textile and apparel, footwear, vegetable products and prepared foodstuffs, vehicles, stone/cement/ceramics and miscellaneous manufactured articles. In 2000 they made up 38% of China's exports to ASEAN and only 8.8% of China's imports from ASEAN.

In short, the trade mix between China and ASEAN prior to 2000 had witnessed drastic changes in growing towards more manufactured products as a result of the dramatic rise in intra-industry and intra-regional trade.

4.3 Rapid Growth and Heavy Trade in Electronics-related Items (1997-2005)

China now mainly imports from ASEAN countries electronic products, crude and liquefied petroleum and gas and vegetable oil, and exports electronic and machinery products, textiles and garments, processed oil and cereals to ASEAN.

China's exports to ASEAN of electronics, electronics equipment, related parts and components (HS Chapter 85, represented as electrical machinery in the table below) expanded more than seven-fold from 1997-2005 or grew at a CAGR of 29%. Over the same period, China's imports from ASEAN of these items (HS Chapter 85) increased by almost 25-fold (growing annually at close to 50%) and posted a year-on-year surge of 31% in 2005. Most of the traded items were semi-manufactures, including integrated circuits, semiconductors, transistors, computer parts and components.

A closer examination of the bilateral trade in computer, machinery and electrical equipment (HS Chapters 84 and 85), reveals a sophisticated division of production activities in these industries in the ASEAN-China region, resulting from MNCs investing in both China and ASEAN amid the trend toward globalisation. In 2005, China's imports and exports of the concerned items accounted for 44% and 60%, respectively, of its total exports to and imports from ASEAN.¹⁰

China's major export & import items with ASEAN (US$ million)

4.4 Hong Kong-ASEAN Trade

Leveraging its world-class business and physical infrastructure, international commercial network, and the strategic location between the mainland and ASEAN, Hong Kong has greatly benefited from growing ASEAN-China trade, even before the Chinese mainland and ASEAN contemplated CAFTA in the early 2000s.

Hong Kong's extensive business networks on the mainland and in ASEAN countries are also an unparalleled advantage conducive to intra-regional trade. In addition to being a re-export hub, Hong Kong is also the preferred location of multinational corporations for establishing regional headquarters and offices in overseeing their trade and investment activities in the region.¹¹

From 1997-2005, Hong Kong's trade with ASEAN increased at a CAGR of 6.2%, expanding cumulatively by 62% to US$54.9 billion. Over the same period, China-ASEAN trade through Hong Kong increased at a CAGR of 8.6%, expanding cumulatively by 93% to US$24.3 billion. In comparison, China's total trade with ASEAN grew at a much faster annual rate of 23%, increasing more than five-fold to US$130.5 billion. Hong Kong's handling of China-ASEAN trade in the special case of electronics, electrical equipment and machinery (HS Chapters 84-85) registered remarkable growth, expanding more than threefold at a CAGR of 17% to US$16.4 billion over the 1997-2005 period. This compares well with the CAGR of 27.5% reported for Chinese exports to ASEAN in the same categories from1997-2005.

A closer examination of the Hong Kong's re-export trade in the narrow categories of electronics, electrical equipment and machinery of ASEAN- or China-origin would reveal an established trend of a greater amount of ASEAN-origin products flowing through Hong Kong to the mainland than China-origin products to ASEAN via Hong Kong. At any rate, this signifies the importance of Hong Kong as a conduit for facilitating mainland imports of electronics-related items from ASEAN by way of its excellent transportation and logistics arrangements. The difference reached US$1.9 billion in 2005, up from US$1.6 billion and US$1.3 billion in 2004 and 2003 respectively. For China-ASEAN trade as a whole, China has had a widening trade deficit with ASEAN in such products over the past few years, reaching US$20.8 billion in 2005.¹² This surpassed its overall trade deficit with ASEAN of US$19.6 billion.¹³

Hong Kong's Trade with ASEAN (US$ million)