The ties that bind

There was once a time when Hong Kong had a virtual monopoly on trade and business contacts with the Chinese Mainland. The pie was small but Hong Kong controlled a huge part of it. Now, the size of the Hong Kong slice has shrunk, but the pie has grown to gargantuan proportions.

So, to shift metaphors, what is a gateway to do when the walls abutting it come down? The answer is to adapt and take advantage of the new opportunities, which is what Hong Kong finally seems to be doing after several years of anguished self-doubt.

Hong Kong and China have become even more intertwined in the years since the handover of power from Britain in 1997. Total merchandise trade jumped from US$133.8 billion in 1998 to US$197.8 billion last year. The figures, in fact, continue a theme that goes back to the beginning of China's opening up. The Mainland's share of Hong Kong's global trade steadily climbed from 9.3% in 1978 to 43.1% last year.

By JPMorganChase's calculations, China-bound FDI from Hong Kong was US$17.7 billion last year out of a total of US$53.5 billion. This compares to an average annual contribution of US$20 billion from Hong Kong in the years 1994-97 before Asia's 1997- 98 currency crash. FDI continued to fall postcrisis for three years, reaching US$15.5 billion, its lowest point, in 2000.

The overall percentage decline in Hong Kong's apparent FDI also reflects other factors. The mid-1990s Hong Kong FDI numbers included disguised investment from Taiwan and from the Mainland itself which is now increasingly more correctly labeled.

JPMorgan economist Ben Simpfendorfer said Hong Kong's 2003 contribution, whatever its sources, still makes the territory a very significant player in China's FDI, accounting for a third of the total in 2003, far ahead of second-place Japan at 9.4%.

"What would actually be interesting is to try to ascertain whether genuine Hong Kong originated FDI has declined both absolutely and relatively," said Stanford economist Lawrence Lau, soon to become vice-chancellor of the Chinese University of Hong Kong. "I do not know the answer myself." There are no hard statistics on people movements, but it could be that several hundred thousand Hong Kong people now live on the Mainland, while growing numbers of Mainland visitors and residents have helped pick the Hong Kong economy up in the aftermath of the disastrous SARS epidemic just over a year ago.

When China accelerated its opening to the world in the wake of its accession to the World Trade Organization in 2000, Hong Kong's role as an investment gateway was bound to change as more companies opted to deal directly.

But China has now clearly accepted the responsibility to support and develop Hong Kong's economic prosperity, and as the Mainland economy grows, Hong Kong clearly stands to do very well in the future, playing a key entrepot role, even if no longer an exclusive one.

Hong Kong also has much to contribute to the Mainland as it slowly comes to terms with the differences that divide along with the ties that bind. The southern provinces particularly are very aware of the economic power that Hong Kong can deliver, and the Pan-Pearl River Delta Forum (see page 14), is a clear effort by Mainland regions to harness Hong Kong's might.

Other areas of the country, particularly Beijing and Fujian province have an interest in seeing Shanghai kept in place, and helping to keep Hong Kong a strong player in the game helps to balance off the growing power of Shanghai.

Many companies still prefer to make use of Hong Kong in terms of their China dealings. Hong Kong boasts a superb financial and services infrastructure, a free port and a convertible currency, an efficient bureaucracy, probably the world's cheapest telecommunications, the best air connections in the region and many tax and other advantages.

But it is the rule of law which usually tops the list of Hong Kong's advantages. It is widely felt that Hong Kong contracts stand a much better chance of being impartially and properly handled by a Hong Kong court than a China contract in a Mainland court, and that judgments are more enforceable.

"The reasons for foreign investors to go through Hong Kong are much less compelling than, say, 10 years ago," said Stanford's Lawrence Lau. "Having said that, many direct investors may still wish to maintain a presence in Hong Kong for finance, legal, logistical, tax and transfer-pricing reasons."

Hong Kong capital markets provide significant advantages for investors looking to play the China card, and for China companies looking to raise funds. HSBC and a handful of conglomerates aside, the Hong Kong stock markets are now dominated by China companies such as China Mobile, China Life and PetroChina. A total of 183 Chinese companies currently have listed shares in Hong Kong and have a combined market cap of US$189.6 billion, 27.3% of the total for both main and second boards.

The reason for the prominent China role of Hong Kong's capital markets is that China's capital markets remain highly protected. The renminbi is not a fully convertible currency, foreign investors cannot buy the renminbi-denominated A shares which make up most of the market except through the newly established and not fully operational QFII channel, allowing Qualified Foreign Institutional Investors the right to buy A shares under strict conditions.

As China opens itself slowly to foreign capital flows, Hong Kong's role will inevitably change, and a large proportion of activity in the areas of foreign exchange trading and equities trading currently still in Hong Kong will inevitably shift to Shanghai. But by then, China will be bigger. It will not be the end of the world.

China business is now largely done from Mainland China rather than from Hong Kong, and the trend began long ago. IBM, for one, switched in 1992. "Since we established IBM China Co. Ltd, a wholly owned subsidiary of IBM in China, all investment is made directly without passing through Hong Kong," an IBM executive said. "And, of course, China contracts are signed in China by IBM China Co. Ltd."

A large number of companies have shifted their regional headquarters from Hong Kong to Shanghai in the past five years, a trend that can only continue given Shanghai's position at the heart of the world's fastest-growing consumer market. Beijing also attracts some companies, including the photocopier and camera giant Canon which shifted its regional headquarters there after China joined the WTO in 2001.

For Hong Kong, the bogeyman is now Shanghai, of course – just as Singapore was briefly when a stream of companies began shifting their regional headquarters there ahead of Hong Kong's return to Chinese rule. But the two cities are just no match, according to David O'Rear, chief economist of the Hong Kong General Chamber of Commerce.

"Hong Kong and Shanghai have completely opposite strengths and weaknesses," he said. "We have the rule of law – they don't. We have the financial system – they don't. We have a reasonable and honest bureaucracy and they don't. They have a large market and we don't. They have extremely good manufacturing capability and we don't. And they have low costs and we don't."

Bottom line: "The competition is in the things Shanghai does, not in the things Hong Kong does. There are hundreds of Mainland companies listed in Hong Kong – there are no Hong Kong companies listed in Shanghai. We just don't compete in the same areas." O'Rear pointed out that Hong Kong still accounts for most export manufacturing owned by foreigners in China, "and foreigners own 55% of all exports".

Stamford's Lau said the percentage of Hong Kong-originated FDI had, indeed, declined over the years, as both the industry mix and the scale of investment in China changed. "Major FDI projects are now more and more in industries in which Hong Kong businesses have no comparative advantage, e.g., automobile manufacturing, petrochemicals," he said.

The academic also singled out the rise in the number of wholly-owned foreign-invested enterprises as another factor. "Hong Kong's role as an intermediary partner has become much less necessary. Also, as foreign direct investors gain greater confidence and experience over time, and as China becomes more open and accessible, and more rule-based (at least in the major coastal areas), the need for a Hong Kong partner is diminished."

The move to establish wholly-owned operations in China didn't happen because multinationals suddenly thought that was the better route to take. Beijing only allowed them to set up Wholly Foreign-Owned enterprises (WFOEs) in the late 1990s, at last providing an alternative to joint ventures with state-owned enterprises, which had often proved costly, counterproductive and endlessly frustrating.

Another important Hong Kong role in the past decade and more has been as a place to recycle Mainland funds, but Stamford's Lau said that is less of a factor today. (Though difficult to quantify, conjecture had it once accounting for as much as a quarter of annual China-bound FDI.)

?Recycled investment used to be quite large, but the advantages of recycling Chinese as foreign direct investment have diminished (for example, preferential tariff treatment of imports of capital equipment), and the need for foreign exchange to supplement domestic resources has also declined greatly," he said. "Many Mainland enterprises have large retained earnings that can be reinvested."

While Hong Kong's investment in the Mainland is exaggerated because the FDI figures include investments from elsewhere, Mainland investment in Hong Kong tends to be understated, as Chinese University economist Sung Yun-Wing pointed out in a government- funded report attempting to quantify the benefits of Hong Kong's economic integration with the Pearl River Delta.

"There is an incentive for local authorities and enterprises in the Mainland to establish unofficial subsidiaries in Hong Kong to evade Mainland's controls on foreign trade and foreign exchange," the report said. As exchange controls continue to loosen, "more and more Mainland capital is expected to flow to Hong Kong as Hong Kong has stricter protection of property rights than the Mainland and the funds can also be used more flexibly in Hong Kong. In the long run, Mainland investment in Hong Kong is likely to exceed Hong Kong's investment in the Mainland."

According to Mike Rowse, the director general of InvestHK, the SAR's offshore investment promotion arm, 12% of last year's 142 completed projects involved Mainland investors committing to set up operations in Hong Kong. This year's investment target is 200 companies and the Mainland portion of projects completed by May had risen to 16%, a jump of a third over 2003.

"The numbers are so awesomely good, I'm a bit scared of them myself," he said. Among this year's investors in Hong Kong is major Mainland software player Kingdee, which chose to upgrade is Hong Kong office to be its Asia Pacific headquarters as a first step in its assault on the global enterprise applications arena. Indeed, that is a key pitch that Rowse makes with Mainland companies – that they consider Hong Kong as a springboard to the global market.

In the meantime, 55% of the foreign invested enterprises in China, many of them based in Hong Kong, lose money – all the more mysterious because many keep expanding operations, according to Matthew Wong, a partner at PricewaterhouseCoopers in Shanghai. "The government became suspicious."

The answer to the conundrum is that a lot of foreign companies in China are booking a lot of their revenue in Hong Kong, not in their China-based companies, which are often run as close to break-even as possible due to higher tax rates on the Mainland.

Recent increases in cross-border investing have come as liberalizations have been phased in, in accordance with China's WTO commitments. But investors on both sides of the border have also been spurred to action by the much-discussed Closer Economic Partnership Arrangement (CEPA) between Hong Kong and the Mainland, which took effect in January.

Beijing municipality, which has been promoting itself as a headquarters location, recently credited CEPA for helping to attract new investment this year. The Beijing Municipal Commerce Bureau reported in May, for example, that authorities had approved US$370 million in investment commitments from 124 Hong Kong companies in the first four months after CEPA took effect, 32% up on the same period a year earlier. Targeted areas for this batch included property, manufacturing and software development, but also areas the Mainland is hungry for – consulting, legal, economic and logistics services.

CEPA allows offshore manufacturers to move their goods into China at zero tariff if 25% of the value-added is done in Hong Kong – whether the company is located in Hong Kong, establishes a local joint-venture or outsources that portion of the job to a local company. A second route allows goods in from Hong Kong tariff-free, if Chinese companies can contribute the value-added, but in this case the requirement is 30%. And there is a third tariff-free option that applies to 374 product categories covering 90% of what Hong Kong traditionally exported to the Mainland. Here, exporters have to use Hong Kong to convert a product bearing one code into a product bearing another – for example, turning plastic into a toy.

This all suggests a revival of Hong Kong's largely-retired manufacturing sector, which strikes some people as strange. But not to Rowse. "We are starting to have some serious inquiries – there's certainly interest in gold and jewelry," he said.

CEPA allows for possibly interesting options for services companies, such as law and accounting firms and logistics and tour companies, to offer services tariff-free – but only until China opens up these fields to all other foreign companies in just over two years when WTO rules covering these areas are phased in.

In the services area, CEPA also offers what Rowse called "WTOPlus" opportunities that give Hong Kong-based companies advantages that lie beyond any promises China undertook to the WTO. Two examples he offered concerned financial services: Hong Kongbased banks, for one, are not required to put up the same capital adequacy ratios as other offshore banks – and SAR insurance companies can buy bigger stakes in Mainland insurance companies.

Hong Kong's integration with China is a long-running story, and as each chapter opens, and integration deepens, the story takes a new twist. The latest is June's announcement of a new grouping of SARs and provinces pledged to coordinate economic policy – forming what could be the beginnings of a trade bloc to counter the growing economic might of Shanghai and hinterland provinces along the Yangtze.

Besides the Hong Kong and Macao SARs, the forum ties together Yunnan, Guizhou, Guangdong, Fujian – Taiwan's Mainland business base – Jiangxi, Hunan, Guangxi, Hainan and Sichuan. Altogether, as one official said, the cluster would create a market as large in population terms as the European Union. Delegates to last month's Hong Kong summit included representatives from Beijing as well as provincial and SAR officials. And it was there that the provinces committed themselves to removing non-tariff barriers among themselves.

Reports said little on how this spirit of mutual cooperation would translate for provinces outside the group. But despite China's history of being riven by different economic interests, Beijing endorsed the project.

Does the bloc suggest Hong Kong will narrow its focus to engaging the bloc – if attending to a market of 400 million can be described as narrowing focus – or try to maintain its push north to pace Shanghai?

It is hard to say at this point. Hong Kong economic ties are shifting in other ways, as ports along the coast and even inland develop the sophistication only Hong Kong once claimed – thanks in part to Cheung Kong Infrastructure and Hutchison Ports, both Hong Kong based Li Ka-shing interests.

Airline and cargo links with China are also changing – but too slowly from the perspective of local Hong Kong flag carrier Cathay Pacific, which has so far not been able to capitalize on the growing Mainland-Hong Kong links.

Those links are now just one part of China's fast-growing links with the whole world. But in the end, Hong Kong benefits massively from China's development.

The prospect of a greater Hong Kong, including Shenzhen and beyond, playing a core role in the development of southern China and standing equal to Shanghai in servicing the whole Chinese market is much more interesting in business terms than the narrow advantages Hong Kong enjoyed when China was closed.