• The newly elected Taiwan government is determined to foster closer ties with the mainland, including the introduction of direct chartered flights across the Strait on weekends and increasing the daily quota of mainland tourists travelling to Taiwan. A new era of cross-Strait economic relations is unfolding.
  
  
• Direct transportation, business and postal services ("three links") will stimulate further trade and investment across the Strait. Having long been the services hub and the bridgehead of Taiwanese companies doing business with the mainland, Hong Kong will benefit from increased business flows, helping to knit together Taiwanese and Mainland businesses.
  
  
• Cross-Strait trade re-exported via Hong Kong accounted for 3.4% of Hong Kong total trade in 2007. Traders that use Hong Kong for practical reasons like marketing, engineering and logistics are less likely to be affected by the "three links".
  
  
• The majority of cross-Strait trade re-exported via Hong Kong consists of electronic parts and components exported from Taiwan to the PRD. This is the result of busy intra-industry trade between electronics clusters in Taiwan and the PRD.
  
  
• Relaxation in Taiwanese investment on the mainland, and the mainland's commitment to high-tech industry development will lead to further technology co-operation across the Strait. Hong Kong's technology marketplace position will be strengthened, with rising demand of services support such as financial, legal (notably IPR protection) and logistics services.
  
  
• In the short run, limited by the frequency and geographic coverage of cross-Strait direct flights, only some 5% of Taiwan visitors and 20% of Taiwan's air cargo that transits through Hong Kong for destinations beyond the PRD would be affected. However, in the long run, Hong Kong might have to liberalise its visa requirements for Taiwanese visitors to Hong Kong, maintain Hong Kong-Taiwan flight frequencies and attract mainland tourists travelling to Taiwan to visit Hong Kong in order to maintain Hong Kong's vital role in the "three links".

Introduction

The inauguration of the Ma Ying-jeou's government on 20 May heralds a new era for cross-Strait relations. Progressing towards the improvement and development of relations with the Chinese mainland, the new government passed a bill on chartered cross-Strait direct flights and expansion of the daily quota of mainland tourists travelling to Taiwan, and will start discussion on actual arrangements with the mainland government in June. Apart from chartered flights and mainland tourist issues, Ma's government will also strive to increase economic ties with the mainland, particularly direct transportation, business and postal services across the Strait, or the so called "three links".

The "three links" are expected to bring increasing business flows across the Strait, and better division of labour in the region. Though the "three links" may create an impact on passengers using Hong Kong as a transit for travelling between the mainland and Taiwan, the impact on cross-Strait trade and investment via Hong Kong should be limited. This is because Taiwanese companies using Hong Kong as a trade and investment platform base their operations on practical needs rather than policy constraints.

In fact, if Hong Kong maintains and enhances its position as the most internationally orientated financial and commercial centre in the region, it would benefit from the improved cross-Strait relations and increased trade and investment flows. Demand for Hong Kong's services by mainland and Taiwanese companies will increase in facilitating their competition and growth in the international marketplace.

Taiwanese Investment on the Mainland

Globalisation has resulted in a rapid rise of foreign investment on the Chinese mainland, particularly in the information and communication technology industries over the last decade. Taiwan, being a major player in the electronics industry in the world, has also expanded its production on the mainland. This is evident from the fact that Taiwan's investment on the mainland has shifted in recent years from traditional labour-intensive industries to technology-intensive industries. By the end of 2007, electronics and computers had become the largest sector of Taiwanese investment on the mainland, accounting for over 30% of the total cumulative investment.

Investment and technical cooperation undertaken on the mainland by Taiwanese companies are subject to the approval by the Investment Commission of Taiwan's Ministry of Economic Affairs¹. While the Taiwanese government maintains a list of "prohibited" categories for investment and technical cooperation², approved investments by Taiwanese companies on the mainland are also subject to a ceiling of 40% of the total net asset value of the company. Notwithstanding these restrictions, Taiwan's approved investment on the mainland increased from less than US$1 billion per annum in the early 1990s to almost US$10 billion in 2007, accounting for 60.6% of Taiwan's total outward direct investment during the year. If investment by Taiwanese companies registered overseas such as the British Virgin Islands, and re-investment by Taiwanese companies on the mainland are included, the amount of Taiwanese investment on the mainland would be even bigger.

Investment on the mainland has become increasingly important for the growth and development of Taiwanese companies. The majority of Taiwanese investments on the mainland aim at supporting expansion of parent companies, and act as a link in their overall global deployment. Capitalising on the advantages of the mainland as a low-cost production base, a number of Taiwanese companies such as Foxconn, Quanta, Asus and Yue Yuen have emerged as big players in the international marketplace.

As the Chinese mainland's industry structure continues to upgrade towards the upper stream of the production chain, and produces more high technology products such as integrated circuits and other electronic parts, there will be a wider scope of cooperation between Taiwanese and mainland businesses. Taiwanese companies are also interested in expanding their investment and relocating further production functions to the mainland to enhance their competitiveness. Further relaxation in Taiwan's investment on the mainland and establishment of the "three links" would expedite a new wave of cross-Strait industry and technology cooperation.

Hong Kong's Roles in Cross-Strait Trade and Investment

The rise of Taiwanese investment on the mainland has brought about a rapid growth in cross-Strait trade. Between 1997 and 2007, Taiwan's exports to the mainland increased from US$20.5 billion to US$74.2 billion, of which electrical, electronic and opto-electronic items accounted for the lion's share at some 70%. Taiwan's imports from the mainland also increased from US$3.9 billion to US$28.0 billion during the same period. Electrical, electronic and opto-electronic items again accounted for the largest share (around 50%) of Taiwan's imports from the mainland, reflecting an active intra-industry trade between the rising electrical and electronics industry clusters on the mainland and Taiwan.

Trade Platform

Since all goods traded across the Strait must be shipped via a third place as required by Taiwan's Government³, Hong Kong as a major international trade centre enjoys the advantage of its geographic proximity to Guangdong, where many Taiwanese companies are located, and has seen a strong growth in re-exports of Taiwan products to the mainland. As suggested by the fact that over 77% of Hong Kong's re-exports of Taiwanese products to the mainland were delivered by means of land and river transports last year, most cross-Strait trade re-exported via Hong Kong should be heading to Guangdong.

The amount of cross-Strait trade re-exported via Hong Kong increased steadily from US$11.5 billion in 1997 to US$ 24.1 billion in 2007 (accounting for 3.4% of Hong Kong's total trade). This is due to the strong growth in demand in Guangdong on the back of a large cluster of Taiwanese investments and the growing electronics industry there. On the other hand, Hong Kong is serving Taiwanese companies' practical needs in doing business with the mainland market.

Taiwan's indirect shipping requirement in cross-Strait trade has been relaxed over the past decade. Presently, Taiwan's exports to or imports from the mainland do not have to stop over in Hong Kong, such goods can simply be transhipped or have their shipping documents changed in the waters of Hong Kong, hence these need not be reflected in Hong Kong's re-exports trade. Moreover, as Taiwan's investment and trade with places outside Guangdong increase, and such trade can be shipped via other territories such as Japan and South Korea, the share of Hong Kong's re-exports in the total cross-Strait bilateral trade will drop, as it has from 46.9% in 1997 to 23.6% in 2007.

Re-exports of cross-Strait trade in Hong Kong are conducted by Taiwanese companies with a direct presence in Hong Kong or by their agents and distributors. Similar to other foreign companies that are not subject to the policy constraints of indirect trade, Taiwanese companies use the Hong Kong platform for practical needs and advantages. As the operation of the supply chain is becoming increasingly sophisticated, a wide range of services are sought by Taiwanese companies to support their operations on the mainland.

For example, Taiwanese electronics companies are making use of the strong industry cluster in Hong Kong, which includes local and foreign companies facilitating their development on the mainland and Asia. Taiwanese companies such as Macronix, Winbond, EMC and Sunplus have not only set up a sales force in Hong Kong, but have also design engineering teams to support business operations in the region. While Hong Kong's free port status is advantageous in the territory's role as a logistics hub, electronics traders here are also efficient in rendering engineering and consultancy solutions for their clients in Hong Kong and on the mainland.

Investment Management

Currently, there are some 5,000 active Taiwanese companies in Hong Kong, up from an estimated 3,000 companies in 2002. The companies in Hong Kong were set up mainly to look after their investments and operations on the mainland. According to a previous HKTDC survey, Taiwanese companies in Hong Kong perform a number of roles, including corporate management, fund transfers, purchasing and marketing. Among the surveyed Taiwanese companies, 80.9% indicated that they use Hong Kong banks for fund transfers between Taiwan, the mainland and Hong Kong.

Many Taiwanese companies in Hong Kong and on the mainland agree that Hong Kong has an obvious leading edge as a service platform, particularly in areas such as the free flow of capital, a sound and transparent legal system, world-class financial services and a full range of value-added professional and trade support services. Taiwanese views on Hong Kong are consistent with other multinational companies that have set up regional headquarters/offices in Hong Kong.

Financial Centre

Currently, Taiwan's domestic banks can only service Taiwanese companies' operations on the mainland via their offshore banking units (OBUs) under the supervision of Taiwan's Financial Supervisory Commission⁴. Moreover, the OBUs are restricted to serving only mainland businesses that are approved by the Taiwan's Investment Commission. As a result, the financial needs of Taiwanese companies' operation on the mainland are hardly being met by Taiwan's financial institutions. For example, a major financial need of Taiwanese manufacturing companies on the mainland is mortgaging and leasing of plants and machinery. However, it is difficult for Taiwanese companies to obtain financing for such assets in Taiwan. Taiwanese banks generally require the principals in Taiwan to undertake the financing for such mainland-based business.

Many Taiwanese companies, therefore, prefer to obtain financing in Hong Kong to support their business and operations on the mainland. While Hong Kong financial players are familiar with mainland businesses and have established a presence on the mainland, they are capable of extending credit to mainland-based Taiwanese businesses based on an evaluation of the related mainland accounts without recourse to their principals incorporated in Taiwan. In these circumstances, Taiwanese banks have expanded their presence in Hong Kong to serve their Taiwanese customers, strengthening Hong Kong's financial hub position in cross-Strait trade and investment activities.

Taiwan's Executive Yuan adopted in March this year a proposal to allow overseas subsidiaries of Taiwan's financial holding companies and banks to invest in mainland banks, and relax the restrictions on the cross-Strait financial business scope of OBUs and overseas branches. Even though this would give Taiwan's banks greater flexibility in arranging financing for Taiwanese companies' operations on the mainland, given the advantages of Hong Kong as an international financial centre and the benefits of CEPA that gives banks incorporated in Hong Kong easier access to the mainland market, Taiwanese banks will continue to use Hong Kong as a platform to enter the mainland market and to serve Taiwanese companies on the mainland. Currently 16 Taiwanese banks have already set up licensed banks and two have set up representative offices in Hong Kong⁵.

Apart from banks, listing on the Hong Kong Stock Exchange is another option for Taiwanese companies to obtain financing for their mainland business. As at the end of March 2008, about 54 Taiwanese companies were listed in Hong Kong (both the main board and GEM), with a market capitalisation of some HK$317 billion. Prominent examples include Foxconn International Holdings, TPV Technology Limited, Proview International Holdings Limited, Want Want China Holdings and Uni-President China Holdings.

Apart from consideration of the capital raising ability of the Hong Kong stock market, Taiwanese companies listed in Hong Kong would enjoy greater flexibility in seeking strategic partnerships and investors from local, mainland as well as international players. The Hong Kong stock market has also facilitated a strong venture capital and private equity fund market in the territory to support technology and high-tech industry development in the region. Hong Kong is the top venture capital market in Asia with the largest pool of venture capital under management. Some 600 venture capital specialists in Hong Kong are well positioned to support and finance Taiwanese companies' business ventures on the mainland.

Rising Trade and Investment Due to the "Three Links"

The availability of direct flights across the strait will shorten the travel time from Taiwan to the mainland by more than half and reduce the transport cost as well. Moreover, as Taiwan is expected to further relax its restrictions on trade and investment across the Strait, these developments are expected to stimulate increased passenger and business flows between the mainland and Taiwan.

In providing financial services and logistics support to Mainland/Taiwan economic cooperation and transactions, Hong Kong and Hong Kong service companies will enjoy increasing business opportunities as a result of more trade and investment flows across the Strait.

Further Investment Relaxation

As part of the policy pledges of Ma Ying-jeou, Taiwan may replace the 40% rule on Taiwanese investment on the mainland by a control regime of the export of technologies that are considered crucial for national security. As Guangdong is anticipating rapid development in the electronics, automobiles and petrochemical industries under its prevailing industrial restructuring and upgrading programme, and Taiwanese companies are keen to relocate further production processes to the mainland amid globalisation as well as to tap the mainland market, it is expected that Taiwanese companies will increase their investment on the mainland if investment restrictions are relaxed.

It is also reported that Taiwan may consider letting capital from the mainland invest in Taiwan. In this connection, Vincent Siew spoke openly at the Boao Forum in April that mainland capital is welcome to participate in the 12 infrastructure projects of "i-Taiwan" proposed by the President.

Removal of Trade Restrictions

There are also suggestions that Taiwan should liberalise its trade restrictions on its import regime against mainland products. At present, Taiwan still prohibits imports of 2,352 items of mainland-origin products. The prohibited import list mainly includes agriculture and food items, raw materials and intermediate inputs. Notably, certain textile items, electrical and electronic products, as well as auto parts are under the prohibited list. Such restrictions have not only resulted in higher costs of such intermediate inputs for production in Taiwan, but also hamper an optimal deployment and integration of the supply chains across the Strait. If Taiwan liberalises such imports, it would certainly benefit the relevant trading companies and manufacturers, and stimulate further trade and investment flows across the Strait.

Outlook of Cross-Strait Cooperation in Industry Upgrade and Hong Kong's Opportunities

The Chinese mainland government has clearly spelled out the need to accelerate the advancement of high-tech industries. Though the size of its high-tech industry remains relatively small on the mainland at present (4.6% share in GDP on 2006), its triple growth in value-added output from 2001 was indeed impressive. The information technology and electronics industries is expected to be the fastest growing sector, and to provide plenty of opportunities for Taiwanese companies in areas such as R&D, production and distribution.

More and more multinational information technology and electronics companies have set up their manufacturing bases on the mainland, and activities on the mainland have been broadening from final assembly to R&D and production of key parts and accessories. It is expected that China will gradually move up from the low-value-added end in the international division of labour to perform more high-value-added tasks.

As the mainland's high-tech industries advance and more key parts are available locally, Taiwanese companies will be able to lower their reliance on imports for production. As the supply chain is shortened, Taiwanese firms would enjoy better control of production and delivery time. While overall efficiency increases and transaction costs decrease, these companies will become even more competitive in the international market.

Given Hong Kong's large cluster of electronics players, which consists of companies from Hong Kong, mainland, US, EU, Japan, and others, it is likely that Hong Kong will be increasingly relied upon by Taiwanese companies as a technology marketplace for supporting their mainland activities and supply chain internationally.

More importantly, as Hong Kong is well positioned to provide a safe and flexible business platform for both mainland and Taiwanese companies, together with its sophisticated financial services, Hong Kong is able to facilitate and enhance economic cooperation across the Strait, lining up the advantages of all three places to create an increasingly competitive and closely knit economic region.

Impact of Direct Transportation on Hong Kong

As Taiwanese companies now managing their mainland trade and investment in Hong Kong would continue to use Hong Kong after the "three links" for practical reasons, direct chartered flights for passengers and cargo across the Strait now being discussed would not have a significant negative impact on Hong Kong. Contrarily, it is expected that the increase in trade and investment across the Strait stimulated by the direct flights would generate more business opportunities for Hong Kong.

Nonetheless, for cross-Strait passengers and cargo that use Hong Kong for transit only, it would be more likely that they would bypass Hong Kong once direct flights become available. In the short run the impact on Hong Kong would be softened by the constraints on increasing the number of direct flights, especially the difficulty in arranging scheduled flights on top of the proposed chartered flights (chartered flights every Friday-Monday by July and chartered flights every day by year-end). In order to maintain Hong Kong's vital role in the long run after the "three links", Hong Kong could consider further liberalising or removing visa requirements for Taiwanese visitors to Hong Kong. At the same time, it is necessary to maintain Hong Kong-Taiwan flight frequencies as well as our connectivity with mainland cities if Hong Kong is to avoid being marginalised.

As Taiwan plans to expand the daily quota of mainland tourists to Taiwan from the existing level of 1,000 to 3,000 in the first year and 5,000 in the second year, this would mean additional passenger flows across the Strait. Hong Kong can benefit from this new passenger demand if Hong Kong's tour operators and airlines are able to provide attractive travel packages.

Cross-Strait Passengers

The majority of Taiwanese visitors are using Hong Kong as a transit point for their ultimate destination in the mainland or vice versa. In 2007, out of the 2.2 million Taiwan visitors in Hong Kong, almost 90% (7% of Hong Kong's total visitors) were either entering Hong Kong from the mainland or departing for the mainland via Hong Kong on a transit basis⁶. In terms of passenger flow, according to the Airport Authority, in 2007, total cross-Strait passengers transiting in Hong Kong amounted to 5 million (11% of the total number of passengers). The forthcoming direct flights between Taiwan and the mainland will certainly have an impact on the number of visitors to Hong Kong or passenger flow at the Hong Kong airport.

Though transit passengers are likely to switch to direct flights across the Strait when available, those travelling to or from the PRD will less likely be affected. Given Hong Kong's advantage of proximity to the PRD, and frequent air connections between Hong Kong and Taiwan, plus highly efficient transfer services by buses and ferries to major destinations in the PRD, Hong Kong will continue to be competitive in serving as a transit hub for air passengers. It is estimated that only some 5% of the transiting Taiwanese visitors who travel to and from the rest of the mainland beyond the PRD by air currently will to be affected.

Air Cargo/Logistics Hub

Hong Kong movements of air cargo loaded to and unloaded from Taiwan amounted to 0.5 million tons in 2007⁷, or 13% of Hong Kong's total air cargo movement. Since most of such cargo is either shipped to or from the PRD, Hong Kong's role as an air cargo/logistics hub will not be severely challenged by direct air traffic links between Taiwan and the mainland. In particular, this cargo consists of electronics products that are highly in demand for just-in-time delivery.

As mentioned in the previous section, Taiwanese companies use Hong Kong as a platform for distributing their products to the mainland, the PRD in particular, for practical business reasons. Many Taiwanese companies prefer to ship their parts and component items to Hong Kong for temporary warehousing, even for those to be distributed in the northern part of the mainland. This is due to the better security rendered by Hong Kong services providers. Hong Kong is an especially ideal choice for Taiwanese companies to handle high-value items that are related to third parties' and their own proprietary information, given the reputation of Hong Kong's legal system and relevant protection of IPRs. Others may also ship their goods to Hong Kong first for further engineering processing, such as programming for certain integrated circuits, testing and high-precision assembly, before delivery to the mainland.

Given the foregoing, Taiwanese goods re-exported to the mainland via Hong Kong by air (and vice versa) should not generally be affected by the weekend cross-Strait direct flights. It can be reasonably expected that 80% of the goods that are re-exported via Hong Kong to the PRD would not be directly affected. Less than 20% of such exports may be impacted, depending on the availability of direct flights between the mainland and Taiwan. In volume terms, it can be estimated that direct flights across the Strait may affect about 3-5% of Hong Kong's air cargo movements.

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