Taiwan, Hong Kong and the Challenge of Mainland China by Paul Cavey

Leaping dragon, trailing tigers? Taiwan, Hong Kong and the challenge of mainland China by Paul Cavey

An Economist Intelligence Unit white paper written in co-operation with: Cathay Pacific Clifford Chance LONDON NEW YORK HONG KONG 15 Regent Street 111 West 57th Street 60/F, Central Plaza DHL London New York 18 Harbour Road HKUST (MTM Program) SW1Y 4LR NY 10019 Wanchai United Kingdom United States Hong Kong Primasia Securities Tel: (44.20) 7830 1000 Tel: (1.212) 554 0600 Tel: (852) 2585 3888 Fax: (44.20) 7499 9767 Fax: (1.212) 586 1181/2 Fax: (852) 2802 7638 Roland Berger E-mail: [email protected] E-mail: [email protected] E-mail: [email protected] May 2003 and ABN AMRO TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Contents

4 Executive summary

6 Introduction

PART I TAIWAN

10 The investment tide

15 The “hollowing out” myth 17 Industry focus: Taiwan’s semiconductors

19 The Taiwan advantage

24 The cost of economic constraints

28 The stifled service sector

PART II HONG KONG

34 The rise of services

43 The Hong Kong advantage 46 Industry focus: fund management

52 The longevity of logistics

57 Conclusion

58 Appendix: Survey results

Acknowledgements

The author would like to offer a special note of gratitude © 2003 Economist Intelligence Unit. to James Yang at Yang Ming Marine for explaining with All rights reserved. considerable patience the intricacies of cross-Strait All information in this report is verified to the best of the authors' and the publisher's shipping links. He would also like to thank Michelle Wu at ability. However, the Economist Cetra, Yvonne Liang at the Government Information Intelligence Unit does not accept Office, Shawn Lin at Mount Jade, Cynthia Chyn at the responsibility for any loss arising from Market Intelligence Centre, Floran Lee at Dragonair and reliance on it. Chris Smith at Primasia for their indispensible assis- Neither this publication nor any part of it may be reproduced, stored in a retrieval tance. Thanks also go to the Economist Intelligence Unit system, or transmitted in any form or by any team in Hong Kong, especially Lucia Lau, Connie Mak, means, electronic, mechanical, Edgar Ferdandez, Thomas Eccleshare and Charlie God- photocopying, recording or otherwise, dard. The author would also like to thank the many busy without the prior permission of the Economist Intelligence Unit. Hong Kong and Taiwan business managers and government officials who gave up precious time both to meet with us and to complete our surveys. Without their input, it would have been impossible to produce this report.

2© The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Preface

Leaping dragon, trailing tigers? Taiwan, Hong Kong and the challenge of mainland China was written at a time of significant global volatility. Not only did the war in Iraq begin—and appear to end—during the course of our research, but the SARS virus emerged as a new and unpredictable threat to the confidence of Asia as a whole, and of Hong Kong in particular. This report from the Economist Intelligence Unit takes a deliberately longer view. The shifting economic relationships between Taiwan, Hong Kong and the mainland may attract fewer headlines but they are far likelier to determine the future prosperity of the two tiger economies and their hulking neighbour. The research effort for this report comprised three key initiatives: ● The Economist Intelligence Unit held dozens of one- on-one interviews with executives, policymakers, aca- demics and analysts in Taiwan, Hong Kong and China. ● We also conducted a special survey of senior executives in both Taiwan and Hong Kong to ascertain their views on the challenge of mainland China. Some 150 executives participated in the survey, which was conducted in March 2003. ● Significant desk research drew on the resources and expertise of the Economist Intelligence Unit’s team of analysts in Hong Kong and London. The author of the report was Paul Cavey in Hong Kong. The editors of the report were Elisabeth Paulson, Charles Goddard and Graham Richardson.

The Taiwan advantage Executive PART I TAIWAN The attractions of China for the The investment tide island’s manufacturing summary entrepreneurs seem almost over- In recent years, Taiwan’s government powering. The range of incentives has begun to loosen some of the offered by local governments coupled restrictions on investment in the with lower labour costs means that mainland and to work towards the production can be undertaken at very setting-up of direct cross-Strait low cost. In addition, for many transport and financial links. Yet in manufacturers in Taiwan, investing in most areas, economic relations China also offers the opportunity to between China and Taiwan remain as tap a bigger market and establish restricted as ever. What is most brands. But China’s business notable about the battery of environment is far from perfect, and Introduction restrictions is its remarkable Taiwan’s offers advantages— ineffectiveness in preventing China’s growing economic strength is especially as a location for higher- Taiwan’s economic integration with seen as a threat to many countries. end activities such as research and China. Investment in China by Taiwan For Taiwan and Hong Kong, the development—that are too often companies has soared in recent challenges appear particularly acute. overlooked. As a result, while basic years. Particularly alarming for some They are, after all, no ordinary manufacturing has moved to China, on the island is not the amount of neighbours of China. Their close Taiwan remains at the core of the IT mainland investment per se, but geographical proximity and their hardware development process. historical and ethnic connections rather the rise in the proportion position them on the edge of China’s accounted for by firms from the lair. The worries evident elsewhere in island’s high-profile information The cost of economic the world over the rise of China’s technology (IT) hardware industry. economy are therefore felt constraints particularly strongly in Taiwan and The IT manufacturing sector seems to Hong Kong. These fears are, however, The “hollowing out” have thrived despite the restrictions misplaced. If the development of myth imposed on interaction with China, not because of them. So do they have stronger links with China is combined The political consequences of any economic utility? Probably not. with domestic reforms, the deepening cross-Strait economic ties In fact, it is possible that the welter emergence of the mainland dragon are a growing concern for many on of restrictions on cross-Strait links will benefit, not harm, the former the island. Indeed it is exactly these has been more effective at forcing tiger economies. political risks that the restraints on activity away from the island than cross-Strait economic activities are keeping it in. It has also increased largely aimed at heading off. The costs to those companies that argument that these restrictions are remain, thanks to the lack of needed to prevent a "hollowing out" transport links between Taiwan and of the domestic economy is harder to the mainland and limits on the free sustain. Manufacturing capacity has flow of goods and people across the indeed moved to the mainland. But Taiwan Strait. And while there is as certain processes move across the much the government could do to Strait, other more sophisticated improve the domestic operating activities emerge. Thus the domestic environment for IT hardware firms, IT industry has upgraded in textbook the health of the sector will fashion, creating a division of labour ultimately depend on the opening of between manufacturing facilities in more direct links between China and those in Taiwan. headquarters on the island and the new manufacturing sector on the mainland.

4© The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

The stifled service The Hong Kong sector advantage Manufacturing is not the sector that Hong Kong’s smooth economic has been hardest hit by the transformation seemed to come to a restrictions on cross-Strait economic shuddering halt with the downturn of links. The island’s often-ignored 1997, which has been followed by services industry has been much five years of economic misery. more seriously affected. Taiwan firms’ Contrary to the fears of many, these huge investments in China have been problems are not the result of closer supported by foreign rather than integration or greater competition local banks. Goods made in China with China. Certainly, Hong Kong no have been transhipped through ports longer holds the monopoly on service in Hong Kong and Korea rather than provision into the mainland that it Taiwan. The tight restrictions that once had. But there has been no prevent all but a small number of simple outflow of activity to China. mainlanders visiting Taiwan have Rather, as with Taiwan’s locked the island’s tourism industry manufacturing sector, there is a out of an important market. By developing division of labour, in removing the barriers that have which some lower-end processes prevented its growth to date, the move out, while higher-end ones opening of full direct links with China remain and expand. In fact, Hong would allow the service sector to Kong’s strengths will ensure that the become a new engine of growth for service sector continues to grow—as the economy. long as the government manages to open up further to China while pushing through reforms that will prove unpopular with domestic PART II HONG KONG vested interests.

The rise of services The longevity of Officials in Taiwan need look no further than Hong Kong for a model logistics of just what a strong services sector The logistics industry is a clear can do for an economy—and for a example of Hong Kong’s comparative lesson in how openness in China can advantage. Seaports in China have offer rewards. The manufacturing been developing rapidly, but Hong sector, which was the engine of Kong’s port remains the region’s growth in the 1960s and 1970s, largest. At the same time, the logistics virtually disappeared in the following industry in Hong Kong has been two decades as production moved to moving upscale, with air transport China. But this migration did not lead beginning to occupy a more important to a "hollowing out" of the Hong role. Hong Kong’s sophisticated hard Kong economy. Rather, departed and soft infrastructure gives it an manufacturing capacity created important competitive edge in both demand at home for expanded sea and air transport. The government support services. And by the 1990s seems to realise, however, that the Hong Kong had been transformed territory’s lead is not unassailable, from one of the world’s top makers of and has been making important low-end manufactured goods to a efforts both to improve transport links global services centre. with China, and to liberalise the logistics sector at home.

Leaping dragon, trailing tigers? Introduction

To many in Taiwan and Hong Kong, it is no will lead domestic investors to ignore the home economy coincidence that recent economic problems as well. With both domestic and foreign firms looking have emerged just as both economies have China’s way, will the local economy begin to shrivel? And for Taiwan and Hong Kong in particular the chal- become more closely entwined with an lenges do not end there. They are, after all, no ordinary increasingly strong mainland China. The neighbours of China. In addition to their close geo- concern persists that China’s gains will come graphical proximity, historical and ethnic connections at the expense of the former tiger economies. position them uniquely on the edge of China’s lair. This Such worries are misplaced. proximity should place Taiwan and Hong Kong in a perfect position to tag along on China’s upward economic apoleon labelled China a “sleeping giant” that, ride. But if the pessimists are to be believed, these con- once awoken, would shake the world. While nections may instead render Taiwan and Hong Kong Napoleon may have been more concerned with more vulnerable to the sapping potential of China’s NChina’s potential military prowess, these days it economy. Will China’s gains be at their expense? is China’s burgeoning economic strength that is being For several decades, Taiwan’s and Hong Kong’s for- closely watched. tunes were divorced from economic developments on the One only has to look at China’s recent economic per- mainland. Taiwan has been ruled as a separate entity formance to see why some countries are wary of China’s since the losing Kuomintang (KMT) took refuge on the seemingly unstoppable rise. In recent years, China’s eco- island after the end of the civil war on the mainland in nomic growth has soared, while most of the region has 1949. For the following forty years, there was virtually no struggled to climb out of an economic slump. Foreign contact between the governments on either side of the investment in China has risen, while some of its neigh- Taiwan Strait, bar the occasional exchange of verbal bours watch FDI levels flatten or fall. Even China’s entry insults and gunfire as both sought to establish them- into the World Trade Organisation (WTO) in 2001 can selves as the rightful government of China. Hong Kong’s seem a cause for concern. Some commentators heralded division from the mainland came even earlier, with the WTO membership as the country’s coming of age, one United Kingdom’s annexation of the territory beginning that would also force Chinese industries to compete in 1841. In the following 150 years, British officials over- against new, foreign competition. But for its economic saw the development of an economic and political system competitors, China’s ascension to the global trade club thoroughly distinct and separate from that of the main- also marks the country’s real emergence as a major rival. land. Much has been written about how China’s economic For the economies of Taiwan and Hong Kong, two of awakening will affect Southeast Asia, whose the original East Asian tigers, this alienation from China economies—while much smaller than China’s—tend to was probably more of a help than a hindrance. Between produce the same sorts of goods and services. Less has 1950 and late 1970s, when the mainland was itself iso- been written about the effect of China’s emergence on lated from the rest of the world, the economies of both the richer economies of Northeast Asia. Here, too, there Taiwan and Hong Kong prospered, driven by the develop- is concern that foreign corporate interest will dry up. ment of world-beating, labour-intensive manufacturing There is also a different worry, that the allure of China industries. Living standards continued to grow rapidly

6© The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

The giant wakes GDP and foreign investment in China, 1990-2001 GDP per capita , US$ FDI inflows (US$m) 900 45000

800 40000

700 35000

600 30000

500 25000

400 20000

300 15000

200 10000

100 5000

0 0 1990 91 92 93 94 95 96 97 98 99 2000 01 1990 91 92 93 94 95 96 97 98 99 2000 01 Source: EIU even as China’s economy began to reintegrate with the 1997. This event has been followed by two technical world economy in the 1980s and early 1990s. This was recessions, an increase in unemployment from 2.2% to thanks to the movement of their economies into higher- over 7%, a dramatic slide in the government’s finances, value-added activities: the manufacture of hardware for and four full years of falling consumer prices. the information technology (IT) industry in Taiwan, and To many in Taiwan and Hong Kong, it is no coinci- service provision—particularly for the emerging main- dence that these severe domestic problems have land economy—in Hong Kong. emerged just as both have become more closely In recent years the political and economic circum- entwined with an increasingly strong mainland econ- stances of Taiwan and Hong Kong have shifted again. omy. Indeed, there is a palpable fear that the current While on the one hand moving to promote the island as a downturns are not of a cyclical, temporary type, but are political entity distinct from China, in the early 1990s rather structural, directly caused by their changing rela- the government in Taipei also started to ease its almost tionship with an increasingly competitive China. complete ban on contact with China, allowing limited It is not necessary to spend long in either place to movement of people, capital and goods across the Tai- become aware of these fears. Newspapers in Taiwan talk wan Strait. Both trends continued after the election in of an exodus of investment and people to the other side 2000 of Chen Shui-bian of the pro-independence Democ- of the Strait. Some estimates suggest investors from the ratic Progressive Party (DPP) as president, an event that island have spent more than US$100bn in the mainland ended over 50 years of KMT rule, and also triggered a during the last ten years. Perhaps 400,000 people from period of unprecedented political instability on the Taiwan—almost 2% of the domestic population—now island. live in the Shanghai area of China alone and if tourists Hong Kong, meanwhile, was returned to Chinese sov- are included, there can be as many as 1m people from ereignty in 1997, albeit as a Special Administrative Taiwan on the mainland on any given day. To the south, Region (SAR)—an arrangement under which Hong meanwhile, figures showing increasing throughput in Kong’s previous way of life is supposed to be protected Shenzhen’s ports are eagerly seized upon as evidence of for a period of fifty years. Since the handover, contrary Hong Kong’s growing irrelevance as a transit point for to the expectations of some, Hong Kong’s distinct eco- mainland trade, while the decision of any foreign bank to nomic and legal systems have remained intact. Confi- establish an office in Shanghai is regarded as another dence in officialdom has, however, crumbled, with the nail in the coffin of the SAR’s financial centre. government of the Beijing-selected chief executive, In this report, we hope to show that these fears are Tung Chee-hwa, seeming to stumble endlessly from one overdone. In the first instance, the macroeconomic crisis to another. problems currently being experienced in both Taiwan Adding to the malaise, the economies of both Taiwan and Hong Kong are due less to China-related, structural and Hong Kong look their weakest in a generation. Tai- factors than to the cyclical downturn of the global econ- wan suffered a searing recession in 2001 and even today omy in 2001-02, aggravated by domestic political prob- unemployment, virtually unknown before the late 1990s, lems. Taiwan has also had to deal with a remains above 5%. Hong Kong’s downturn was triggered poorly-performing banking sector, while Hong Kong has by the 1997–98 Asian financial crisis which led to the struggled to recover from the bursting—in spectacular thumping crash of the stock and property markets in style—of a property market bubble.

From go-go to just so-so Key economic indicators for Taiwan and Hong Kong (%) Unemployment GDP growth

Hong Kong Taiwan 10

0 1990 91 92 93 94 95 96 97 98 99 2000 01 02 1990 91 92 93 94 95 96 97 98 99 2000 01 02 -2

-4

Source: EIU

At the same time, while these developments have been ties, to become an alternative engine of growth. accompanied by a movement of IT manufacturing capacity Hong Kong has clearly not been hobbled by the same from Taiwan to China, and the growth in the mainland’s kind of restrictions. Indeed, it is largely because of open- capacity to deliver some of the services over which Hong ness to China that the territory has evolved over the last Kong previously held a monopoly, there has been no sim- twenty years from a world centre for low-end manufac- ple outflow of corporate activity from either of the former turing to a global provider of high-end services (a pat- tiger economies. Rather, for both Taiwan’s manufacturing tern of development that Taiwan would be well-advised industry and Hong Kong’s service sector, the picture is to take notice of). But while Hong Kong has always been more one of a developing division of labour, in which open to capital movements, the interflow of goods and some lower-end processes move out, while higher-end people has been less free. This did not matter when Hong ones remain and indeed, more often than not, expand. Kong was the only city in China that offered an interna- Contrary to the fears of some, both Taiwan and Hong Kong tional-style airport, port and quality of life. But with the have sophisticated industry clusters—manufacturing of IT mainland’s physical and policy infrastructure improving hardware in one, services in the other—that will not be rapidly, this has now changed. Fortunately, the govern- easily replicated on the mainland. ment appears to realise this, and has been moving to This is no excuse, however, for complacency. Instead, improve transport links with the mainland, as well as the challenge, unsavoury as it may be to some, is actu- easing barriers to mainland people entering Hong Kong. ally to strengthen links with China, while at the same Closer links with the mainland on their own are, how- time carrying out domestic reforms that would be neces- ever, insufficient to ensure continued prosperity. Taiwan sary in any case. and Hong Kong will profit not from being part of China’s Take Taiwan. The island is well-placed to be a major economy, but rather from being distinct and well-run centre not just for the manufacture of IT hardware, but entities with especially strong links to the mainland. Tai- for its development. Without, however, being more open wan’s government needs, for example, to encourage to exchanges of people, resources and information with greater research and development activities, but must the mainland—an increasingly important location not also implement much-needed improvements in the coun- only for the mass-production of IT goods but also for try’s basic physical and regulatory structure. Officials in their sale—it will be difficult for the island to achieve this Hong Kong, on the other hand, need to strengthen the destiny. It is already arguable that the limits on eco- skills base of the economy, while taking on the vested nomic ties with China have been responsible more for interests that have prevented the territory’s economy pushing manufacturing capacity out of Taiwan than from being as competitive as is often claimed. keeping it in. At the very least, removing the restrictions This two-pronged policy prescription presents diffi- would allow the island’s service sector, which certainly culties for officials in both Taipei and Hong Kong. There has been crippled by the limits on cross-Strait economic is already concern in Taiwan about the leverage over the

8© The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

island’s political future that the government in Beijing bined with domestic reforms, however, Hong Kong would may gain through the island’s growing investment in, remain in demand—even if it is more expensive. The dan- and trade with, China. Admittedly, few governments ger for Hong Kong is that while the government increas- would relish the idea of cosying up to a partner that ingly seems to accept the first part of this policy maintains a standing threat to invade (See box on page prescription—the chief executive, Tung Chee-hwa, 12). But this is at least a route lined with possible eco- devoted a whole chapter of his 2003 policy address to nomic benefits for Taiwan. In any case, the alternative— the subject of closer links—fear of vested interests will economic irrelevance as China’s economy becomes ever prevent it from implementing domestic reforms. stronger—is hardly a palatable choice either. Taiwan’s president, Chen Shui-bian, has said that Further integration does worry some in Hong Kong as direct links are no cure-all for the island’s economy. This well—property-owners (and developers) fear closer is undoubtedly true, and is equally valid for Hong Kong. cross-boundary links will cause prospective homeowners But with the right domestic reforms, both former tiger to flee the territory in favour of cheaper investment economies have much to gain and little to lose from the opportunities in Shenzhen. If closer integration is com- leaping dragon.

Leaping dragon, trailing tigers?

PART I TAIWAN The investment tide

Taiwan’s battery of restrictions on transport, Pessimists were not reassured by the government’s trade and communications with China remain decision to introduce a new approach to economic relations with the mainland. Launched by the government of tight. The rules governing investment, president Chen Shui-bian, who took office in May 2000, however, have been eased slightly, the “active opening, effective, management” policy prompting the movement of more productive replaced the “less haste, be patient” principle that had capacity to the mainland. And with much of guided policy in the 1990s. Under the new approach the the mainland investment coming from number of sectors closed to mainland investment—which Taiwan’s all-important IT sector, these previously included, for example, the semiconductor and notebook industries—was eased, and the prohibition on changes are becoming ever more participation on any project costing more than US$50m controversial on the island. replaced with a case-by-case review for proposals worth more than US$20m. The most attention-grabbing part of “great sucking sound,” predicted Ross Perot, the approach—and the component that prompted the would accompany a damaging migration of comments of the TSU’s Mr Chen—was the decision in industry from the US to Mexico following the rat- 2002 to allow Taiwan firms to establish 8-inch semicon- Aification of the North American Free Trade ductor fabrication plants (fabs) on the mainland. The Agreement (NAFTA) in 1992. There are echoes of the government also committed itself to working towards the same sentiment being heard throughout Taiwan. “If the establishment of direct cross-Strait transport links, and government relentlessly opens investment to mainland started to ease the ban on direct financial links between China, it will exacerbate Taiwan’s unemployment and China and Taiwan. worsen the situation of funds flowing out of Taiwan.” Many industrialists in Taiwan doubted the sincerity of While the language of Chen Chien-ming, a Taiwan Soli- the latest opening, believing that “effective manage- darity Union (TSU) legislator, may not have been as ment” (which for many is indistinguishable from the evocative as that of the former US presidential candi- “less haste, be patient” approach) rather than “active date, the underlying sentiment is the same. Just as Mr opening,” is the guiding principle for the current gov- Perot expected the NAFTA agreement to drain the US ernment’s mainland policies. In terms of investment pol- economy, Chen thinks closer cross-Strait economic ties icy, this is a little unfair. The 2001 liberalisation was will produce a hollowing out of Taiwan’s economy. And hardly sweeping—Taiwan firms will, for example, be he is not alone. allowed to establish just three eight-inch semiconductor The feeling that Taiwan’s economy is being under- plants in China before 2005, and then only using depre- mined by an apparently unstoppable “go west” trend ciated equipment. But given that such factories are became even more widespread in 2001-02. Taiwanese regarded as the crown jewels of the island’s IT sector, investment in the mainland appeared to pick up—it that any at all were allowed to go did signify a real depar- became almost impossible to open a local business mag- ture from previous policy. azine without seeing an article about “Shanghai fever”— Yet in other areas economic links between China and just as the domestic economy fell into the worst slump in Taiwan remain as restricted as ever. In recent years ship- a generation. ping links between the two sides have only gradually

10 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

The three links fallacy

A discussion of economic relations mainland and Taiwan’s offshore have been more watertight—and thus between Taiwan and China usually islands of Matsu and Kinmen—a route more damaging—than have the limits pivots around the ban on the so- permitted since 2001. Even indirect on cross-Strait transport links. called three links, which include links have been liberalised in recent The government has moved in transport, postal and trade links. years. Rather than having to stop and recent years to allow mainland However this approach is misleading. tranship cargo in a third area as was investment in Taiwan’s property First, the three links really constitute previously required, boats travelling market, but this limited concession is only a single link. After all, with the between Taiwan and the mainland the only one that has been made. The advent of direct transport links, direct have increasingly been required only island also retains a long—albeit postal and trade links would naturally to pass through the waters of a third shrinking—list of goods that cannot follow. port, with a pilot boat coming out to be imported from China. And it Furthermore, the ban on direct sort the necessary paperwork in good remains very difficult for mainland transport links has not been as weather or via helicopter in adverse people to visit Taiwan. watertight as is often assumed. Direct conditions. By distorting the nature of cross-Strait flights remain beyond the Perhaps more importantly, the Taiwan’s current relationship with pale, but since 1997 ships have been focus on the three links is also China, the focus on the three links passing directly between Kaohsiung in misleading because it excludes other also misrepresents the potential for Taiwan and Xiamen and Fuzhou in types of ties that are equally economic development on both sides China. Vessels plying this route have important, such as financial of the Strait if bilateral ties are freed been prevented from carrying local transactions as well as the entry into up. We therefore believe that the cargo, but the same restriction has not Taiwan of mainland money, goods and wider approach to the issue taken in applied to ships sailing between the people. Restrictions in these areas the report is more useful. been expanded. Although boats have been allowed to China must touch down en route in a third destination, pass directly across the Taiwan Strait since 1997, they either Hong Kong or, since 1996, Macau. The most seam- are only allowed to sail between one of the island’s less services are provided by the Hong Kong carrier, ports, Kaohsiung, and two harbours in China, Xiamen Dragonair, and Air Macau, which are the only two airlines and Fuzhou. Moreover, cross-Strait cargo carried on this with permission to fly to Taiwan and to cities in the main- route cannot pass through customs in either Taiwan or land as well. The other airlines flying between Hong China; the route is only for transhipment to third desti- Kong or Macau and Taiwan have teamed up with third nations. Since the 1990’s some vessels have been carriers to shorten transit stops. In 2003 commercial air- allowed to sail between Taiwan and China without, as lines from Taiwan were allowed to fly to the mainland for was previously required, having to tranship cargo onto a the first time since the end of the civil war in 1949, but second boat at a third port during the voyage. These ves- they still had to land in Hong Kong or Macau en route, sels still, however, have to pass through the waters of a and this charter flight service was only offered during third port on route, most commonly Hong Kong or the the Chinese New Year period. Japanese port of Ishigaki. Direct financial links between Taiwan and China are True direct sailings were established in 2001, but only also all but non-existent. As part of the 2001 opening to between mainland China and Taiwan’s outlying islands of the mainland, larger local banks were allowed to apply to Kinmen and Matsu. And as with both the transhipment establish representative offices in the mainland. Since and “direct shipment through a third area” services, only 2002 local banks have also for the first time been able to vessels from Taiwan or mainland China (albeit sailing remit money directly across the Taiwan Strait. Such under a flag of convenience) can plough the Kinmen- remittances can only occur, however, through offshore Matsu-China route. Foreign shipping companies wishing banking units (OBUs), which are restricted from dealing to carry cargo across the Strait must still transfer it en- with domestic firms or individuals. The former minister route onto a second vessel, a change-over which usually of finance, Lee Yong-san, planned to extend this open- happens in Hong Kong, but which may also take place in ing to domestic banking units (DBUs), and to allow OBUs ports in Korea or Japan. to lend to Taiwan firms in the mainland. This proposal Air links between Taiwan and China are even less was unpopular with Taiwan’s pro-independence politi- developed. All passengers passing between Taiwan and cians, and was one of the factors that led to Mr Lee’s res-

Investment surge Approved mainland investment by Taiwan companies in selected sectors (% of total)

50 Food & beverage processing Plastic products Restrictions on the inflow of people and capital are even Basic metals products 40 stricter. The only mainland tourists currently allowed to Electronic & electric applicances Precision instruments visit Taiwan are those currently residing outside of 30 China, and even they can only enter as part of a tour group. And mainland investment remains virtually prohibited in Taiwan. 20 The rush to China 10 The most notable aspect of this battery of restrictions is that it has proved remarkably ineffective at dissuading Taiwan firms from investing in China. Taiwan’s govern- 0 1992 93 94 95 96 97 98 99 2000 01 02 ment approved mainland investment projects worth Source: Ministry of Economic Affairs, Taiwan US$26.4bn in 1992-2002. Mainland investment approved in 2002, at US$6.7bn, was more than half as much again ignation in November 2002. as the previous record-high recorded in 1997. Taiwan thus keeps close tabs and many limitations on And these figures are universally regarded as under- the outflow to China of capital, goods and people. But stating the true level of local investment in China. Rather the government retains even stricter controls on the than seeking government approval that may not have movement of resources to the island from China. In been forthcoming, many local firms have invested in recent years officials have allowed the import of a grow- China without the knowledge of Taiwan’s government. ing list of goods from the mainland—in 2002 the sale of Statistics from the mainland government show that Tai- China’s best-known beer, Qingdao, was allowed for the wan investment totalled US$31.2bn between the begin- first time on the island. But the government still retains ning of 1992 and the end of September 2002. Even this a list of 2,621 prohibited items, which includes a broad figure is likely to be below the real total. With direct range of agricultural, textile and steel products, inflows from Taiwan banned, all investment in the main- together with things like washing machines and cars. land from the island’s firms has been routed through

Between a rock and a hard place?

The debate over the establishment of would be best serving its people by ignoring of direct links would be portrayed as a first economic links with China often becomes these threats when creating its economic step towards unification—China's stated subsumed in politics. Those in Taiwan from policy towards China. At the same time, goal. Mainland officials presumably also the pro-independence camp, who want no however, those opposed to links need to hope that a softly-softly approach will political relationship with mainland China, accept that the main effect of the current marginalise Taiwan’s president, Chen Shui- tend on principle to be against closer regime of restrictions has not been to bian, whose pro-independence stance causes economic links. Meanwhile, pro-unifica- prevent Taiwan’s economy becoming more distrust in Beijing, and also appears to make tionists, who hope for the eventual closely integrated with the mainland, but him reluctant to work—as he has formally creation of a pan-Chinese entity embracing rather to stop the island’s economy pledged to do—towards the establishment of both mainland China and Taiwan, generally benefiting fully from the broad links that closer cross-Strait economic ties. take the opposite view. The bottom line? have developed. Supporters of closer links hope that the When it comes to dealings with China, it is In recent years the issue of direct links presidential election in 2004 will bring a nearly impossible to divorce politics from with China has been attracting more and breakthrough. Mr Chen, much criticised economics. more attention on the island. This is a result during his first term in power, might advance After all, ties between Taiwan and China both of Taiwan’s own economic difficulties, cross-Strait links in an effort to secure a are not all about computer chips. Whether it and ever-increasing local investment in the second. If he loses in March 2004, the is bluff or bravado, China's government has a mainland. It is also owing to developments in opposing team of Lien Chan and James standing threat to invade Taiwan if, for China itself, where the government appears— Soong are committed to opening direct links. example, the island declares independence. somewhat uncharacteristically—to be ready Even so, don’t expect regular direct flights This rhetoric is backed up with high military to offer concessions in order to achieve between Taiwan and China anytime soon. A spending and the build-up of a large arsenal closer economic ties with Taiwan. Mainland wild and reckless opening to China would of missiles directed at the island. It is officials seem to believe that in so doing, likely prove no less controversial than a difficult to argue that Taiwan’s government they are in a win-win situation. The opening stalled one.

12 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

third destinations, most commonly Hong Kong, Singa- Made in Taiwan… and China pore and the tax havens of the British Virgin Islands China-based production as a % of Taiwanese electronic firms' total production

(BVI) and the Cayman Islands. 90 What has attracted more attention in Taiwan in recent years is not the amount of mainland investment per se, 80 but rather the rise in the proportion accounted for by firms from the island’s high-profile information technol- 70 ogy (IT) hardware industry. From under 20% in the early- 60 to mid-1990s, the proportion of approved mainland investment accounted for by the electronic and electric 50 appliances sector rose to more than 50% in 2000. The proportion has dropped off since then, but in 2002 was 40 still at nearly 40% of approved mainland investment. 30 The heavy mainland investment of the electronics industry quickly becomes apparent in any tour of the 20 Kunshan-Suzhou-Wujiang region in China, the area lying to the west of Shanghai that in recent years has become 10 the focus of investment by Taiwan firms in the mainland. 2001 2002 2003* 0 According to Taiwan engineers in this area, it is a Desktop Notebook Mother- Servers Digital still Projectors Optical recreation of the island’s own Taipei-Hsinchu electronics PCs PCs boards cameras disk drives corridor. (Hsinchu, the home of Taiwan’s famous sci- * Forecast Source: Market Intelligence Centre, Taiwan ence-based manufacturing park, is the cradle of the island’s technology industry.) Sure enough, most of the big names in the island’s electronics industry—such as Taiwan in 2003. the industrial automation company Advantach (Kun- These trends are usefully illustrated by figures from shan), the producer of computer peripherals BenQ the Market Intelligence Centre (MIC), based in Taipei. (Suzhou), and the manufacturer of scanners Microtek According to the MIC, of the total desktop computer pro- (Wujiang)—have facilities in the region. duction of Taiwan firms, the proportion made on the Taiwan’s IT investments in China are booming. In mainland rose from 48% in 2001 to 55% in 2002, and is recent years, the level and range of output of the main- expected to rise further, to over 60%, in 2003. With the land facilities of Taiwan firms has expanded steadily—in easing of restrictions on investment in notebook com- line both with rising investment levels as well as changes puter manufacturing on the mainland, the proportion of in the nature of the IT hardware industry. In 2001 the Taiwan production made in China jumped from 5.2% in mainland factory of one Taiwan notebook manufacturer 2001 to 40% in 2002. The MIC expects it to rise further to was producing just 100,000 notebook computers a 60% in 2003. The movement of production capacity from month, less than the 250,000 monthly output from its Taiwan to China is visible from statistics for a range of facility on the island. In 2002, however, mainland pro- other products, from motherboards to digital still cam- duction surpassed that in Taiwan, rising to 350,000 units eras and projectors. Overall, MIC statistics show that of a month. This expansion is far from complete. With the the total IT production of Taiwan firms, the proportion building of a new factory, the company expects to be produced in factories on the mainland rose from 37% in making 600,000 notebook computers every month in 2001 to an estimated 47% in 2002, and is expected to China by the end of 2003, by which time production in increase to more than 50% in 2003. Taiwan would have fallen to 200,000 a month. This movement of productive capacity to the main- The evolution of BenQ’s operations on the mainland land has been controversial, for a number of reasons. tells a similar story. The company’s mainland manufac- Taiwan investment in the IT sector is, for one thing, turing operation opened in 1995, employing 56 staff. clearly supporting the growth of the mainland economy. The next year production of cathode ray tube (CRT) moni- According to the mainland’s State Economic and Trade tors began, and in 1998 the mainland factory began to Commission (SETC), China’s output of electronic goods make CD-Roms. By 2002 the mainland factory was manu- (in constant price terms) grew by 23.8% in 2002. And facturing goods including communication products, LCD Taiwan firms were responsible for much of this growth: monitors, digital cameras and colour laser printers, and MIC figures show that 64% of the mainland’s 2002 IT mainland employment had risen to more than 7,000. output was produced by Taiwan firms. (The MIC expects BenQ expects to shift further production to China from this proportion to rise to more than 70% in 2003.)

Trading places? Taiwan's exports to China and the US (% of total exports) US Chinaa 30

25 Tangled web The sourcing of materials for a Taiwanese optical device factory in China 20

s JAPAN len 15 om o Z CCD

memory PCB CHINA TAIWAN ASIC US 5 LCD DSP DRAM

0 1991 92 93 94 95 96 97 98 99 2000 01 02 Purchased locally CCD charge-coupled device in China: ASIC application-specific integrated circuits a Government statistics, calculated by (1) exports to mainland China according to metal cases, DSP digital signal processing devices Taiwan’s customs, (2) exports to mainland China through Hong Kong, according to plastic cases, PCB printed circuit board Hong Kong’s customs, and (3) 80% of the difference between exports to Hong Kong electronic parts LCD liquid crystal display according to Taiwan’s customs and imports from Taiwan according to Hong Kong’s customs. Source: Industry sources, Taiwan DRAM dynamic random access memory Source: Board of Foreign Trade, Taiwan

The increasing investment in the mainland by the tined for southern China to be exported in the first island’s electronics firms is also driving increased inter- instance to Hong Kong, from where they enter the main- action—which some interpret as dependence—between land by road. Taiwan’s economy and that of China. According to the The quality of the island’s data on exports to China former head of the government’s Council for Economic trade is improving, thanks to development in recent Planning and Development (CEPD), Chen Po-chih, while years of “direct shipping through a third destination,” as investment by US and Japanese firms in China is equiva- well as attempts by Taiwan’s government to reassure lent to just 1/1000th of the size of their respective coun- companies that they are free to export to the mainland. tries’ economies, Taiwan firms’ mainland investment Still, they are clearly deficient: while the proportion has amounts to 2% of the island’s GDP. risen steadily in recent years, in 2002 Taiwan’s recorded Apart from an expansion in investment, the migration exports to the mainland were still only 32% of the value of industrial capacity from Taiwan to China has also of those sent to the much smaller economy of Hong driven a rapid increase in cross-Strait trade. (For an Kong. Aware of this problem, officials in Taiwan produce example of how an investment in China can drive cross- estimates for trade with China, which splice together the Strait trade, see the chart above.) Yet as with the island’s island’s own trade data with those produced by Hong investment in the mainland, the restrictions imposed on Kong’s government. According to these, Taiwan’s direct cross-Strait contact have made it difficult to exports to China rose by 37.4% in 2002 to US$33.1bn. record accurately the amount of goods that passes This rapid growth was driven by exports of inputs for the between Taiwan and China. Fearing inquisitiveness from IT industry, with the value of shipments to China of elec- the government, some exporters have not been willing trical machinery, equipment and parts surging by 75.2% to report China as the final destination for their goods— last year to US$10.5bn, or 31.6% of the total. As a result and they have been aided in this common deceit by the of this rapid growth, China in 2002 overtook the US to rule that all exports bound for the mainland must first become Taiwan’s largest single export market. pass through a third destination, usually Hong Kong. Trade ties are growing. Investment ties are growing. Disingenuousness is not the only issue clouding trade And yet many of the barriers to cross-Strait ties are still statistics. Trading companies based in Hong Kong are big in place. This situation would provide sufficient fodder buyers of goods from Taiwan, but these goods are ulti- for a riveting policy debate. But of greatest concern to mately bound not for the SAR but rather for factories in the island is the flow of its precious IT sector to China. Is the mainland. In addition, it is common for goods from there cause for worry? In the next chapter we address the everywhere in the world—not just Taiwan—that are des- “hollowing out” fear.

14 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Leaping dragon, trailing tigers?

PART I TAIWAN The “hollowing out” myth

There’s little evidence to support the worry 5.5% of GDP in 1993 to 10% in 2000. Manufacturing that trade and investment with China is investment in real terms rose by 18.1% a year in 1996- “hollowing out” Taiwan’s economy, 2000, a faster rate of average annual growth than in any five-year period since 1971-75. particularly in the all-important IT sector. Manufacturing output has shrunk relative to the Sure, IT manufacturing has moved across the economy as a whole in recent years. But the manufactur- Strait, but only as the domestic ing sector has hardly shrivelled away. In 2001 manufac- manufacturing base has upgraded, in turing still accounted for a significant 26.4% of GDP. And textbook fashion. while this was below the 33.3% recorded in 1990, the shrinkage recorded in the 1990s was of a moderate scale. he political consequences of the rapidly deepening In fact the relative size of the manufacturing sector had cross-Strait economic relationship are a growing contracted much more sharply in the second half of the concern for many on the island. The pro-independ- 1980s—in 1986 manufacturing had accounted for almost T ence camp fears that businessmen with large 40% of GDP. Moreover, while overall manufacturing out- investments in China will become more supportive of uni- put has grown relatively slowly in recently years, the fication with the mainland than they otherwise would be. high-profile electronics sector has continued to expand Even less radical groups worry about the leverage over rapidly. Overall manufacturing output grew by an aver- Taiwan’s political future that the government in Beijing age of 6% a year in 1996-2000, but in the same period may gain through the island’s growing investment in, and production of the information and electronic sector trade with, China. Indeed it would be unreasonable for (comprising electrical and electronic machinery and pre- the government to ignore the possible political conse- cision instruments) rose by an average of almost 15%. quences of the deepening economic integration. Between 1996 and 2000 the value of Taiwan’s exports of electronic products rose from US$16.6bn to US$31.7bn. A great sucking sound? Of course, there’s no doubt that Taiwan’s good for- But the argument often made in Taiwan that these tune during that period owed much to the well-docu- restrictions are also needed to protect the vibancy of the mented IT bubble in the US, which spurred the stunning domestic economy is harder to sustain. In the first place, growth of the electronics sector. Thus when this bubble it is not at all clear that Taiwan’s links with China are burst, as it did in spectacular fashion in late 2000, Tai- leading to the “hollowing out” of the island’s industrial wan was hit by a searing recession. The island’s GDP con- sector at all. Taiwan investment in China has only been tracted by 2.2% in 2001, with manufacturing investment permitted since 1990, but since then domestic invest- plummeting by 34%. But the growth potential is far from ment has averaged more than 22% of GDP, above the exhausted. In 2002 the output of the domestic informa- average 19.8% recorded in the second half of the 1980s. tion and electronic industry, which had contracted by Admittedly, during the first half of the 1990s investment 9.6% in 2001, grew by 11%. was held up by increased capital spending by the govern- So no signs in electronics output numbers of the ment. But when public-sector investment fell off during widely feared “hollowing out,” despite the tangible the second half of the decade, it was replaced by capital increase in domestic interest in China in 2001-02. How spending by the manufacturing sector, which rose from then did production of the domestic electronics sector

Sunset… Taiwan's production of selected electronics manufactures (NT$m)

150000

125000 Motherboards 100000

75000 Monitors

50000

25000 Desktop PCs Keyboards Mouse 0 1991 92 93 94 95 96 97 98 99 2000 01 02

…and sunrise

400000

350000 Portable computers LCDs 300000

250000 Foundry wafers

200000

150000

100000 Interface cards

50000 Modems

0 1991 92 93 94 95 96 97 98 99 2000 01 02 Source: Taiwan Ministry of Economic Affairs

continue to grow so strongly in the second half of the fell consistently in the following two years. The fall-off in 1990s, given that such large amounts of investment were manufacture of desktop PCs has been particularly dra- going to mainland China? Simple: Taiwan’s IT industry matic, with production values dropping from NT$67.2bn upgraded in textbook fashion. As production of a particu- in 2000 to just NT$10.2bn in 2002. lar IT product peaks and then falls, new products take its One does not need to be a gadget geek to know that place in the output hierarchy until they too are replaced monitors and desktop PCs are no longer at the cutting by something smaller, faster or more sophisticated. edge of the IT revolution. These products have been suc- Earlier in the decade Taiwan’s IT industry was based ceeded in the market place by items that are more com- on the manufacture of products such as monitors, desk- pact, portable and functional, and domestic production top personal computers (PCs) and motherboards. The of these more sophisticated products continues to rise in value of domestic production of computer monitors Taiwan—at least until something better comes along. For peaked at NT$149.6bn (US$5.2bn) in 1997, and has example, the value of notebook computers produced in fallen steadily ever since. Domestic production of desk- Taiwan rose consistently from 1991 to peak at top PCs and motherboards did not peak until 2000, but NT$401.6bn in 2000. Dragged down by the global eco-

16 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Industry focus: Taiwan’s semiconductors

The development of Taiwan’s semi- Revenue of Taiwan’s fabless advanced 300mm wafers in Taiwan for conductor industry has been a major companies—which design and sell at least six months. success story. Formed as spin-offs chips, but do not manufacture them— Even if these restrictions were not in from the government’s Industrial grew from US$700m in 1995 to place, the semiconductor industry Technology Research Institute (ITRI), US$3.6bn in 2001, with its share of would not move wholesale from Taiwan. United Microelectronics (UMC) and the world market rising from 12% to The attraction for semiconductor firms Taiwan Semiconductor Manufacturing 26% during the same period. Taiwan’s of manufacturing in China is neither (TSMC) are now the world’s dominant semiconductor design industry is now lower wages—the industry is heavily foundry producers of microchips. (A ranked second in the world, trailing capital-intensive—nor transport foundry is a semiconductor manufac- only that of the US. There have even costs—semiconductors are small, light turing plant that makes chips under been some reports of US semi- and very valuable. Rather, firms such as brand for other companies.) Accord- conductor design firms moving to TSMC want to be in China to sell in the ing to figures from Taiwan’s National Taiwan. local market without attracting the Chiao-Tung University (NCTU), After apparently tortuous debate, value-added tax that is levied on between 1995 and 2000, Taiwan’s Taiwan’s government in 2003 finally imported components. share of the global foundry market granted permission for TSMC to Investments by Taiwan’s well- grew from 21% to 70%, a period dur- establish a semiconductor fabrication known semiconductor firms will ing which worldwide foundry revenue plant (fab) in China. This will not open undoubtedly give a boost to the more than doubled, from US$5.1bn to up a stampede across the Taiwan Strait. mainland. It will, however, be some US$12.9bn. The global market shrank Before 2005 the government will allow time before China’s industry is in a in 2001, but Taiwan was less seriously only three current industry-standard position to rival that of Taiwan. affected than some, with the island’s 200mm wafer fabs using depreciated According to a semiconductor market market share growing further to 73%. equipment to set up on the mainland. research firm, IC Insights, based on It is, however, not just production Moreover, local firms will only be able current plans China could have 25 new that has grown. Again, according to to apply for permission to relocate fabs by 2005, but only a handful of NCTU, Taiwan is ranked number one in 200mm plants after they pour in these will be making 300mm wafers. the world for semiconductor testing “considerable” investment in Taiwan to By contrast, Taiwan already has five and packaging, with a market share of upgrade their technological levels; working 300mm fabs, and a further six 35%. Taiwan’s semiconductor design specifically, local firms must show that are likely to come on line before the capability has also expanded rapidly. they have been producing the more end of 2003.

nomic downturn of 2001 domestic production fell back remains much smaller than the production value of the to NT$345bn. But despite the sharp rise in mainland pro- semiconductor and display (flat panel and liquid crystal duction of notebook computers by Taiwan firms in 2002, display—LCD) industries. Under the Two Trillion pro- production on the island also increased, to NT$361bn. gramme, officials hope that by 2006 production value of While serving as the main source of sales growth in the two sectors will have grown to NT$1.5trn and the world computer market in recent years, notebook NT$1.3trn respectively. computers themselves are no longer the leading IT prod- Production of both technology-intensive sectors has uct that they once were. But although production of been rising rapidly in recent years. Taiwan is the home to notebook computers clearly remains important in Tai- the world’s two largest foundry producers of semicon- wan, the domestic IT industry does not currently rely on ductor wafers, Taiwan Semiconductor Manufacturing this activity. For one thing, in recent years domestic pro- (TSMC) and United Microelectronics (UMC). The domestic duction of Internet devices has expanded rapidly. The output value of the foundry industry increased more value of modems produced on the island has risen in than five times between 1996 and 2000. Output declined almost every year since 1992, reaching NT$55.7bn in in 2001—although, in a reflection of the strength of Tai- 2002. Between 1996 and 2002 production of interface wan in this sector, Taiwan’s share of worldwide semicon- cards more than quadrupled, rising from NT$20.8bn to ductor foundry revenue rose from 70% to 73%—but then NT$91.2bn. increased again in 2002 to NT$243.9bn. The growth of Revenue generated through the manufacture of the LCD industry has been even more rapid. Domestic Internet-related devices is rising quickly. However, it output value was just NT$20.4bn in 1998, but by 2002

When the chips are up… Revenues from Taiwan's semiconductor industry Share of global revenue (US$bn) (%)

9 80

8 70

7 60

6 50 5 40 4 30 3

20 2

1 10 Fabless Foundry Fabless Foundry 0 0 1995 96 97 98 99 2000 01 1995 96 97 98 99 2000 01

Source: SEMI; National Chiao-Tung University, Taiwan

had jumped to NT$328.9bn. with managers from some of Taiwan’s leading IT compa- The picture painted by all these statistics is clearly not nies, both on the island itself and in their facilities on one of an electronics sector that is rapidly being hol- the mainland. While some could foresee all production lowed out, to China or anywhere else. Instead, these fig- being moving to the mainland, most executives said that ures suggest that while much capacity is indeed being a division of labour existed between manufacturing facil- moved to mainland China, it is being replaced in Taiwan ities in China and those in Taiwan, which is determined by the expansion of existing activities or the develop- by the maturity, labour and value-added content, and ment of new ones. This story is confirmed by interviews scale of production of any particular product.

18 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Leaping dragon, trailing tigers?

PART I TAIWAN The Taiwan advantage

Lower labour costs in China are a draw for unconnected to a road network. Taiwan’s manufacturers, as is the opportunity It is labour, however, that remains the most impor- to tap a bigger market and establish brands. tant factor behind China’s appeal as an investment site. Some companies in China report paying assembly work- But Taiwan’s advantages—and China’s ers standard wages of just Rmb400 (US$48) a month. weaknesses—will anchor most manufacturers Other firms are more generous, but even for them the on the island for sometime to come. total cost of a production-line worker, after associated payments such as dormitory provision and social insurance are added in, is unlikely to exceed Rmb1,000 a he attractions of China for the island’s manufac- month. This is an amount far below the basic NT$18,000 turing entrepreneurs might seem almost over- (US$518) basic monthly wage received by a worker on an powering, even for those most strongly electronics production line in Taiwan. Moreover, wages T committed to the cause of Taiwan independence, for assembly workers in China do not appear to be rising: and so reluctant to contribute in any way to the while more and more foreign companies are establishing strengthening of the mainland’s economy. Local govern- manufacturing facilities in the mainland, it will be some ments in China are falling over themselves to attract for- time yet before demand catches up with the supply of eign investors. Granting generous tax breaks to Taiwan low-skilled labourers from China’s 500m rural workforce. companies is one common way to win pledges of invest- One manager in Guangdong did tell the Economist Intel- ment. But this is, perhaps, not the most important ligence Unit that, in the aftermath of the 16th National incentive. According to one company that spoke to the Congress of the Chinese Communist Party (CCP) in Economist Intelligence Unit, local officials are willing to November 2002, he was instructed by local officials to consent to “almost anything” that is requested. Certainly raise wages. (The manager attributed the directive to the land is routinely provided either for free or at very low 16th Congress, which called for the “building of an afflu- rates, but the Economist Intelligence Unit was also told ent society” in China.) Even so, the minimum wage will of examples of local governments investing in roads and have to be increased at a very rapid rate indeed if China water treatment plants on request. Taiwan companies is to lose its competitiveness to Taiwan in basic manufac- have also frequently been granted special permission to turing any time soon. build dormitories, used to house the cheaper workers Suppose Taiwan manufacturers could resist the very who come from China’s inland provinces in areas where low labour costs and generous incentive packages they would not normally be allowed. offered by local authorities in the mainland. Other, less obvious, reasons exist for establishing a presence on the China’s L-factor other side of the Strait. Most Taiwan manufacturing com- These incentives can add up. The result? Production can panies do not sell finished products under their own be undertaken at very low cost and very quickly. The name, but instead produce under contract for other com- Economist Intelligence Unit has found cases in which panies. It is a business model which, depending on the production began just a year after a Taiwan firm research, development and planning input supplied by expressed initial interest in a particular investment proj- the end-client, is known varyingly as original equipment ect, even if the preferred site was previously farmland manufacturing (OEM) or original design manufacturing

If you plan to increase investment in Taiwan, why? % end-market—a trend corroborated by the results of the 15 Expand production facilities survey conducted for this report of senior executives at Expand research and development 32 some of Taiwan’s top companies. Indeed, in our survey, Expand marketing and service the most common reason cited by firms already invested in China for increasing investment in China over the next three years was to take advantage of opportunities in the mainland’s domestic market. 53 Accessing China’s domestic consumers can be difficult, however. Many foreign manufacturing firms in China have export processing contracts that, in theory at If you plan to increase investment in China, why? least, prohibit them from selling domestically. Even if % this rule does not apply, or can be circumvented, 11 Increasing demand in China's imported components that are used in the production of domestic market goods sold domestically attract high rates of value- 32 Increasing global demand 15 added tax. Expand marketing and service Other companies see the potential to tap China’s mas- Expand production facilities sive market not through the consumer’s pocketbook, but Expand research and development though the government’s. The semiconductor industry, for example, is interested in the opportunities arising 21 21 from China’s introduction of a new national “smart” iden- tity card sometime in the next few years. With each card having its own chip, this development offers a potentially Source: Economist Intelligence Unit executive survey, Taiwan, March 2003 lucrative sales opportunity for semiconductor manufacturers—although at the very least China’s government is likely to impose local content requirements on the manu- (ODM). In this way many of the goods sold by such well- facture of the card, citing national security concerns. known companies as Dell, Motorola and Sanyo, are in Such business-to-business selling has long been the fact made by much less famous firms from Taiwan includ- mainstay of Taiwan’s contract-based manufacturing ing Quanta, BenQ and Premier. industry. But some local companies also see the main- These end-clients know that upstream production land as their chance to move away from the generally costs—and therefore their own procurement prices—can low-margin OEM and ODM work and towards the produc- be lowered if manufacturing is moved from Taiwan to tion and sale of goods under their own brand—the so- China. Naturally then, these big brand name companies called own brand manufacturing (OBM) model. A handful have been pressuring the smaller, largely anonymous of companies from the island have tried to make this leap manufacturers of their finished products to make this in the past and some, notably top bicycle maker Giant, move. These Taiwanese firms, not wanting to carry excess have succeeded. But most companies—including Acer, a inventory or incur import duties, have in turn requested computer company—have struggled to establish them- their own suppliers to establish production facilities in selves with end-consumers. China. The result is that entire supply chains have been Once again, China looks attractive. Many of the moving from Taiwan to the mainland, resulting in an world’s best-known brands are working to establish a across-the-board increase in the purchase of local raw presence in China, but few have sewn up any one market. materials and components. Managers of all the factories And in developing the China market, Taiwan companies visited by the Economist Intelligence Unit on the main- see themselves as having unique competitive strengths land reported that the proportion of components pur- over these other foreign brands. Executives we spoke to, chased locally had risen consistently in recent years. In a citing their cultural and linguistic similarities with the typical example one firm, a manufacturer of scanners, mainland, referred to China as their true “home market.” told us that when their company first started production Certainly, some local firms appear to be succeeding in in China, 70% of inputs were imported from Taiwan. Now, breaking into the China market. Giant, for, instance, is all but 10% of their inputs is procured locally. the number one bicycle brand in the mainland, with a Lower production costs are not the only reason that market share of around 4%. Some firms are even using China is looming larger in the minds of the big, brand- China to establish a brand for the first time. Tainan name electronics companies. For many of these firms the Enterprises’ upscale men’s clothing label, Tony Wear, is mainland is also becoming an increasingly important China’s third largest men’s clothing brand.

20 © The Economist Intelligence Unit

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Wages are not everything value-added products such as, say, projectors, tend to be Given the strength of the factors pressuring local firms manufactured in Taiwan. This division of labour does not to move to China, it may seem surprising that anything just characterise the electronics sector across the Taiwan at all is produced in Taiwan. But the attractions of the Strait. Textiles and garment manufacturers told the mainland are not all-pervasive. From the Economist Economist Intelligence Unit a similar story. Intelligence Unit’s interviews with company executives, The point is perhaps illustrated most graphically by a it is clear that doing business in China remains difficult local firm, Giant, which is one of the world’s leading and risky. The export-processing contracts that govern manufacturers of bicycles. The average price of a Giant the activities of many Taiwan firms in the mainland are bicycle made in Taiwan is US$240, whereas in China it is restrictive and inflexible—manufacturers have to report just US$70. Admittedly, this price difference partly in advance, for example, what materials in what quanti- reflects local demand considerations, with the cheaper ties will be used to make a particular item. In addition, bike made for the less affluent mainland market. But this while Taiwan itself is hardly a paragon of virtue with is not the only reason for the disparity, since Giant’s facil- respect to protection of intellectual property rights ities in China also produce for export. Instead this sug- (IPR), China is even worse. The ability of mainland gests that for Giant, as well as for many electronics firms, China firms quickly to copy products and manufacturing Taiwan offers advantages over China in the production of processes has always been a concern for Taiwan firms. higher-end products. But IPR considerations are becoming even more impor- Clearly, greater freedom from government interfer- tant as companies from the island invest more in ence in the production process, as well as simpler import research and development (R&D) and brand-building in and export regulations and Taiwan’s better transport an attempt to migrate from the basic OEM model of pro- and communication links with the rest of the world, are duction to ODM, and even OBM. factors that cannot be ignored by Taiwan’s manufactur- Another frequently cited drawback of China’s busi- ers. More important, however, is that the main R&D ness environment is the prevalence of job-hopping. The activities of Taiwan firms continue to be located not in willingness of a low-skilled assembly worker to jump ship China, but on the island. What is more, it seems unlikely when offered Rmb50 a month to work somewhere else that this division of labour will change any time soon. may not cause much of a hiccup: such people receive lit- Expanding R&D activities was the least common motiva- tle training and are easily replaced. The lack of corporate tion cited by companies in our survey as a reason for loyalty is, however, more of a problem when it comes increasing investment in the mainland during the next from skilled staff, people who tend to have positions of three years. By contrast, of the factors given by those greater responsibility, but who are also in short supply. companies that said they planned to increase invest- While Taiwan managers have much praise for the strong ment in Taiwan, expanding R&D activities was by far the fundamental knowledge of graduates in the mainland, most popular. they complain about the supply of engineers with Openness to the rest of the world is one reason why applied skills, particularly those with experience. The most R&D activity continues to occur in Taiwan rather shortage of such workers is becoming more severe as than the mainland. Engineers on the island are better more and more foreign firms establish manufacturing exposed to international trends in consumer technology capability in the mainland. Wages for skilled workers are markets than they would be if they were based in China. thus being bid up, a process which not only fuels the job- The standard of living and education system also seem to hopping phenomenon, but also cuts China’s cost com- help: corporate loyalty is stronger in Taiwan, and man- petitiveness. According to one executive that spoke to agers generally feel that workers on the island are better the Economist Intelligence Unit, an engineer with two to able to work in a team than is the case on the mainland. three years experience in Kunshan could earn as much as Taiwan’s competitive strength in this regard is also Rmb8,000 a month, which, once indirect costs are related to the depth and breadth of its IT sector, which included, is little different from the NT$42,000 a month has been built up during a period of twenty years. a similarly-skilled person would be earning in Taiwan. According to one executive, this background gives Tai- wan a particular efficiency in R&D activity that would not The pull of Taiwan be found elsewhere; another said it had imbued the The executives that spoke to the Economist Intelligence island’s engineers with a regard for quality that is absent Unit all had a consistent story to tell. While well-devel- in the mainland. oped products manufactured in large numbers and R&D activities also need to be near a web of support- requiring heavy labour input, such as scanners, are likely ing businesses, many of which do not exist in force on to be made in China, more sophisticated, newer, higher the mainland. In Taiwan, where firms have traditionally

22 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Early adopter % of LAN and WAN device production of Taiwan firms made overseas

Local area network (LAN) devices 17.3 2000 11.5 2001 29.7 2002

Wide area network (WAN) devices 16.5 2000 13.8 2001 26.2 2002

Source: Market Intelligence Centre, Taiwan

been OEM manufacturers and so less involved in cutting- oping local area network (LAN) and wide area network edge research, R&D engineering activity has been (WAN) technology sector. In 2000, 17.3% of the LAN focused on the testing of new products and associated production of Taiwan companies was manufactured out- production processes—technically speaking, the engi- side of the island. In 2001, however, new products and neering, design and production validation tests (PVT). processes—developed in Taiwan—came on stream, so Rolling out these new items of IT hardware and their the proportion of offshore LAN manufacturing fell to associated manufacturing process is no simple task. It 11.5%. As this technology matured production was cannot be done without R&D engineers, together with an moved away from Taiwan to save costs, and in 2002 the accumulated infrastructure of suppliers and other proportion of LAN goods made outside of Taiwan rose to expertise, on hand to correct any problems. almost 30%. It is for similar reasons, and not primarily While much production has been moved to the main- the continued restrictions on investment in the mainland, followed more recently by later stages of the R&D land, that the island’s semiconductor and LCD companies process such as the PVT, Taiwan remains at the core of have been rolling out their latest manufacturing facili- the IT hardware development process. This is clearly ties—300mm wafer and 5th generation fabrication illustrated by the product lifecycle of the rapidly devel- plants respectively—in Taiwan, not in mainland China.

Taiwan’s R&D vision

Taiwan has never been as “high-tech” attract major foreign multinationals to semiconductors, as well as consumer as might be supposed from its domi- establish R&D centres in Taiwan. The products such as notebook computers nance over the production of many IT usual range of incentives—financial and game machines. Intel, meanwhile, hardware products. Traditionally, the start-up support and tax holidays—is which has long based engineers in technology and design input has been available, but so is talent support: Taiwan to provide technical support to provided to Taiwan manufacturers on engineers who have just left university its many customers on the island, is an Original Equipment Manufacturing may be permitted to take up a four- establishing an R&D facility to work on (OEM) basis. As late as 1999 research year contract with an R&D centre network communications. and development spending in Taiwan rather than enrol in compulsory The influx of foreign companies to accounted for only 2% of GDP, which national service. Taiwan is undoubtedly welcome. But is well below the spending level According to the Market more important in determining reached in the US (2.7%) and Japan Intelligence Centre in Taipei, at least whether the government achieves its (3%) in 2000. ten foreign firms have already applied R&D target will be the decisions of The government wants to raise R&D to the Ministry of Economic Affairs to local firms. Here as well there have spending to 3% of GDP within six establish R&D centres on the island. been signs of improvement in recent years. To achieve this goal, officials The list of applicants includes such years, with Taiwan companies are planning initiatives such as the well-known names as IBM, Dell, becoming more involved in the establishment of a semiconductor Hewlett Packard, Sony and Intel. “concept” phase of product design academy and the setting aside Sony’s R&D centre, which already development. There is, however, still of capital to fund soft loans to R&D employs 30 people and will involve much to do to persuade generally activities. investment of NT$3bn over a three- thrifty Taiwan companies of the The government is also trying to year period, is focusing on benefits of investing in R&D.

Leaping dragon, trailing tigers?

PART I TAIWAN The cost of economic constraints

The restrictions on shipping and air links, as invested in China. Nobody knows just how much cheaper well as on labour mobility, imposed by cross-Strait transport links will be if ships and planes Taiwan’s government may have forced some were permitted to travel directly between Taiwan and China. Much will depend on how direct links are opened manufacturing business out of the island, as up, both in terms of the number of landing points well as increasing costs to those that remain. opened on either side of the Strait, and the number of The health of the IT sector will ultimately firms allowed to operate such routes. Savings will in any depend on the opening of more direct links case vary between companies: those firms that currently between headquarters on the island and need to send cargo or passengers between Taiwan and manufacturing facilities on the mainland. Shanghai will clearly benefit more from direct links than will those companies that have their primary China base in Guangdong. nalysis of Taiwan’s electronics sector does not Still, it is clear that direct transport links will gener- reveal a simple picture of an industry hollowing ate cost savings for Taiwan firms. Lee-in Chen Chiu, a out to China, but one in which low-end activities scholar from Taiwan’s well-respected Chung-Hwa Aare being relocated in the mainland, while Institute for Economic Research, has found that cargo higher value-added processes remain—and often transport costs for manufacturing firms in Taiwan would thrive—on the island. So are the limitations Taiwan fall by 14.6% with the establishment of direct transport imposes on cross-Strait investment of any economic use? links; passenger transport costs would fall even further, Superficially, they might seem to have played a part in by 27.1%. Dr Chen found that the savings for the electri- keeping Taiwan’s manufacturing at home: after invest- cal and electronic equipment sector would be 15.8% and ment restrictions were eased in 2001, for example, the 25.5% respectively. While not as much as some—Dr Chen proportion of notebook computers produced by Taiwan found that direct links would cut the material and firms in the mainland leaped. passenger transport costs faced by the rubber industry Investment rules form only one part of the govern- by 23% and 50% respectively—the savings are still ment’s attempts to restrict economic links with the significant. mainland, however. It is at least arguable that the other In recent years, limited quasi-direct cross-Strait ship- restrictions, such as the lack of transport links between ping links have developed. True direct links would, how- Taiwan and the mainland and limits on the free flow of ever, still make a difference. While Ishigaki is not that far goods and people across the Taiwan Strait, have forced out of the way for a vessel passing from, say, Kaohsiung as much manufacturing activity out of Taiwan as invest- to Shanghai, the detour to the waters around the Japan- ment restrictions have kept in and increased costs to ese island adds perhaps a day to the total length of the those that remain. journey. Cash outlays are also involved. Shipping lines that spoke to the Economist Intelligence Unit said pay- China: so near, and yet so far ment of US$3,000 a vessel is required for port clearance At the simplest level, the restrictions on direct cross- in Ishigaki, considerably lower than the US$5,000 Strait shipping and air links clearly add to the opera- reportedly charged in Hong Kong; if cargo has to be tional costs of the many Taiwan companies that have offloaded en-route, the cost is higher still. Altogether,

24 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Direct links, Taiwan style Vessel departures from Taiwan

Shanghai

Ishigaki (Japan) China

the current cost of shipping a twenty-foot equivalent 340 876 unit (TEU) container on a continuous voyage between Taipei Kaohsiung and Shanghai ranges from US$250 (if the car- Xiamen rying vessel passes through the waters off Ishigaki) to US$350 (Hong Kong). These costs could fall by 10% and Taiwan 30% respectively with the introduction of direct links. Comparable data for air travel costs is more difficult Kaohsiung to obtain. But industry experts that spoke to the Econo- Hong Kong Number of vessels mist Intelligence Unit thought a reasonable charge for a 5,092 000 1993 5,648 passenger flying directly between Taipei and Shanghai 000 2002 would be around NT$8,000-NT$10,000; currently, the Source: Ministry of Transport and Communications, Taiwan cost of flying between these cities via Hong Kong or Macau is typically NT$16,000. This saving is clearly significant, but is perhaps not as important as the reduction ing from indirect links may cause mainland factories to in journey time that would be the result of direct links. A hold greater inventories from suppliers based in Taiwan direct flight between Taiwan and Shanghai would take than would otherwise be the case. around 90 minutes, much shorter than the six hours With the journey for passengers travelling between needed for the current indirect route. Direct links would, Taiwan and anywhere but the south of China currently in fact, free up even more productive time for business being so long—and so inconvenient—it is not a trip that people than the 270 minutes saved. As one executive anyone wants to make too frequently. As a result, it is explained to us, the current journey, consisting of two more difficult for, say, engineers to be based in Taiwan flights and a stop off, really is wasted time, good for nei- but still oversee effectively operations in China. In the- ther working—nor sleeping. ory, this could have two results: some manufacturing that would otherwise move to the mainland remains in Keeping in or pushing out Taiwan, or engineers who would commute from the It is inconceivable that these costs have not had an island instead live and work in China. With more and effect on the division of labour between Taiwan and more manufacturing capacity being based in the main- China. But while advocates might argue that the ban on land it seems likely that the pendulum will swing increas- direct cross-Strait transport links has kept companies in ingly towards the second outcome. This will not just lead Taiwan, it is in fact just as likely that the associated costs to a “brain drain” of skilled workers from Taiwan to in terms of both money and time have pushed firms out China. With more skilled engineers living on the main- to China. Admittedly, transport generally accounts for land, upstream stages of the R&D process will be able to only a small proportion of the final price of a good, so it move there as well. seems unlikely that the extra costs associated with indi- It is not just the ban on direct transport links that rect cross-Strait transport alone would have forced many causes difficulties for the island’s manufacturing indus- facilities on the mainland to buy from a local supplier try. Many electronics firms told the Economist Intelli- rather than one still based in Taiwan. But, the ban on gence Unit that the tight restrictions on mainland direct links causes other costs: longer lead times result- people coming to Taiwan made it very difficult for them

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

What policy initiatives are needed to ensure Taiwan's economic growth? % 4 Establishment of direct links to China 31 Ending of restriction of flow of goods between Taiwan and China 35 Reduced taxes Improved domestic infrastructure Other 11 19

Source: Economist Intelligence Unit executive survey, Taiwan, March 2003 to bring employees from China to headquarters on the most important. island for training. The result: experienced people from But while direct links are no panacea, they are impor- Taiwan had to go to the mainland instead. With the tant for Taiwan’s economy. While 35% of companies that promise of time overseas being one of the major non- responded to our survey thought continued economic monetary perks offered by foreign companies to main- growth needed improved domestic infrastructure, 31% land employees, these restrictions may also affect the also said the establishment of direct links was necessary. ability of Taiwan firms in China to prevent job-hopping. And it would seem that Taiwan’s all-important IT sector In addition, while it was not a complaint heard from has little to fear from the opening of direct links with the electronics companies, some textiles and garments com- mainland. Contrary to what is increasingly becoming panies that spoke to the Economist Intelligence Unit established wisdom, Taiwan’s IT hardware industry has said the continued ban on the imports of certain types of not been hollowing out to China—though this is less goods from the mainland affected their ability to pro- because of investment restrictions than because of the duce in Taiwan. pull of the mature IT sector that has developed on the Speaking in October 2002, Taiwan’s president, Chen island over the last twenty years. Indeed, it is more likely Shui-bian, said that the opening of direct links with that the future of Taiwan’s IT hardware sector will be China was not a “cure-all” for the island’s economy. This secured through the opening of more direct links is undoubtedly true. Indeed, most of the companies who between headquarters on the island and the manufactur- responded to our survey said that of the different policy ing base that is rapidly developing on the mainland, initiatives needed to ensure Taiwan’s continued eco- rather than the preservation of the current system of nomic growth, improved domestic infrastructure was the ineffective controls on cross-Strait economic ties.

Leaping dragon, trailing tigers?

PART I TAIWAN The stifled service sector

The ban on links with China has clearly Department, 121 Taiwan companies had regional offices stunted the development of Taiwan’s services in the territory in June 2002. A survey by the TDC found that 59.9% and 29.6% of Taiwan companies in south sector. Taiwan’s banks have missed out on China and the Shanghai area respectively had offices in considerable business because they have not Hong Kong. According to the Taipei Trade Centre in Hong been allowed to provide services for their Kong, more than 3,000 Taiwan firms maintain an active clients investing in China. It is largely presence in the territory. Taiwan companies have also set because of the ban on direct links with the up over 10,000 paper companies in Hong Kong. mainland that Kaohsiung is slipping down Taiwan’s frustrated bankers the ranking of the world’s biggest ports. And Yet it is the island's financial service sector which has the island’s tourism industry would be far probably felt the effects of the government's restrictions larger if mainland residents were allowed to most intensely. Of the firms surveyed by the TDC, over visit. 80% said they used Hong Kong’s banking system for transferring funds between Taiwan and China. This is partly out of convenience. Until recently, for example, aiwan's powerful IT sector has managed to thrive Taiwan banks have been prohibited from setting up despite the battery of restrictions imposed by Tai- branches in the mainland. The domestic banking units wan's government on cross-Strait links. Yet, as (DBUs) of Taiwan banks have also been banned from T this report has argued, the sector may have per- dealing with mainland banks. Overseas branches and formed even more strongly had some of these con- OBUs have been less restricted, but even these have not straints been eased sooner or more broadly. been able to deal directly with entities in mainland China These policies have had other side-effects on Tai- but only, for example, with the overseas branches of wan's economy. The government’s cold attitude towards mainland banks. It thus made sense for local companies mainland investment by local firms, for example, has to try to avoid using Taiwan banks for their mainland forced much corporate activity offshore. Firms that did financing requirements. Each stage in the elongated not want to bother with the government’s approval process added costs and caused delays. A local company process set up foreign subsidiaries for secrecy; even was much better off using a foreign bank—although those that did gain official permission were banned from these could not deal directly with entities in the main- investing in China directly. Partly as a result, many Tai- land either, their branches in Hong Kong could. Banks wan firms have offshore subsidiaries. Paper companies in on the island have been almost completely excluded the British Virgin Islands or Cayman Islands are the easi- from doing business with the mainland. est to establish. Incorporating in Hong Kong or Singa- Banks complain that, being more closely supervised, pore is more involved but has advantages in terms of they have not been able to circumvent these restrictions investor perception. Still, whichever location is chosen, in the same way that manufacturing companies, for the network of offshore subsidiaries clearly affects cor- example, have been able to evade the rules that have porate transparency. It also reduces economic activity in sought to dissuade them from investing in China. This is Taiwan. According to Hong Kong’s Census and Statistics not strictly true. Taiwan’s Shanghai Commercial and Sav-

28 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Does money come back to Taiwan?

The debate over Taiwan’s economic links with Is there truth to the perception that Taiwanese companies do not China is clouded by the perception that large bring profits earned in China back to Taiwan? amounts of investment flow out to the mainland, while little of the resultant profit % If yes, why? returns to Taiwan. In a sense, this complaint No 10 is not without basis. According to figures Yes Tax implications from the Central Bank of China (CBC), Taiwan Restrictions on direct links between in recent years has consistently recorded a Taiwan and China net outflow of foreign direct investment Need to re-invest (FDI), but it has perversely also recorded a large net outflow of resultant incomes. Lack of domestic investment opportunities At the same time, however, the vast majority of the respondents to our survey 90 Source: Economist Intelligence Unit executive survey, reported that the perception that profits do Taiwan, March 2003 not return to Taiwan was false. One reason for this difference is that the government’s restrictions on investment in China have pays it US$610 for each unit. This is the value taxed again as soon as they entered Taiwan. forced companies to hide the true state of of the export from China, although a change The government has been pledging to end their mainland operations from the of invoice on route means it enters the US at the double taxation of mainland profits, but government. US$700, which is the price the US customer so far only appears to be doing so on a It is interesting to note, for example, that pays directly to the parent company in company-by-company basis. the CBC statistics indicate Taiwan firms re- Taiwan. Still, while earnings generated through invest none of the income they earn abroad, In this way, the Taiwan-owned factory in transfer pricing may return to Taiwan, it is when local firms report that this is a common China makes profit sufficient enough to avoid unlikely they all do. Furthermore, while way that their mainland units fund the unwanted attention of the mainland tax progress on the double tax issue would lead expansion. And that this method is used is no authorities, while the parent company to some more profits being repatriated to surprise. With China’s system of capital ensures most earnings are kept outside of Taiwan, it is likely even then that a large controls, Taiwan firms are no keener on the mainland. Such revenue from China- proportion would continue to be kept having their capital tied up on the mainland made exports that is booked directly in offshore. This is because the main obstacle to than is their government. Taiwan would represent a return of profits, money flowing back to Taiwan is not the To avoid these capital controls, Taiwan although it would not show up in the CBC’s island’s strained relationship with China but firms also usually try to ensure profits earned direct investment income statistics. rather the immature nature of the island’s from mainland operations are not booked in This kind of financial trickery is capital markets. In Taiwan, for example, China. For export-oriented firms, a unavailable for those firms that are selling to annual inward and outward remittances are commonly used method of achieving this is China’s domestic market. Those firms that limited to US$5m a year for individuals, and transfer pricing. Imagine a parent company want to pay dividends to shareholders at US$50m for companies and standards of in Taiwan receives an order from a US home can take profits out of China once they corporate governance are below customer for 1,000 notebook computers at, pay relevant mainland taxes. Until recently, international best practice. Hong Kong, by say US$700 each. Assume also that the however, even these profits were not coming contrast, offers free, unfettered capital computers cost US$600 a unit. Typically, the back to Taiwan: with the island lacking any flows, and, by virtue of its deep and parent company would then sub-contract its kind of double-tax arrangement with the sophisticated financial markets, a wide range factory in China to produce this order, and mainland, these funds would have been of investment options.

ings Bank, through its Hong Kong-owned subsidiary, the government reacted by allowing Taiwan’s largest Bank of Shanghai (which is co-owned by the mainland’s banks to establish representative offices in China. It also own Bank of Shanghai) established a representative allowed banks to deal directly with entities on the main- office in China without needing the permission of the land. This latter concession almost came to nothing after island’s government. And First Sino Bank, also based in one of China’s big four commercial banks said it would Shanghai, has a “special strategic relationship” with the only deal with Taiwan banks that first accepted the “One Far East National Bank, a US institution owned by one of China” principle. This insistence was soon dropped, but Taiwan’s leading private financial-services groups, even after these changes Taiwan’s banking sector will Sinopac Financial Holdings. still find it hard to win business from Taiwan companies Still, these de facto breaches of the ban have required in China. Under mainland regulations, a foreign bank a fair degree of ingenuity, and have been few and far can only open a branch two years after establishing a between. The banking sector has thus for some time representative office. And it is only the OBUs, not DBUs, been lobbying for an easing of the restrictions. In 2001 that can deal directly with entities on the mainland, and

then only to remit money, not to issue loans. tages that give Taiwan firms in the mainland a competi- Taiwan banks will therefore continue to be left out of tive edge in other industries are just as relevant to the the loop. But while the biggest beneficiaries will con- banking sector. By allowing local banks to expand in tinue to be Hong Kong and foreign banks, mainland scale and sophistication, direct links would also help banks will also play an increasingly important role. Dur- resolve the formidable domestic challenges faced by Tai- ing the 1980s and 1990s Taiwan companies found it very wan’s banks: weak balance sheets, heavy government difficult to borrow money from mainland banks. But interference and cut-throat competition. recently this situation has changed. China’s banks are Easing restrictions on direct cross-Strait financial keen to strengthen weak balance sheets and lending to flows would clearly be helpful for the development of the large firms from Taiwan and other overseas economies— island’s financial sector. It would not, however, be a which are seen as better credit risks than local compa- panacea. There is much else Taiwan’s government needs nies—is a favoured method. Reports also suggest that to do to raise the quality of the island’s financial sector. China’s big four banks have been instructed to forge Ending state involvement in the banking sector is one. relationships with Taiwan’s top 300 firms as part of the (In 2001 the government owned stakes in 17 banks in mainland government’s strategy of using stronger eco- Taiwan, which together had a market share of more than nomic ties to achieve unification with the island. 50%.) Relaxing the restrictions on general inflows and Whatever the reason, according to both Taiwan manu- outflows of capital, as discussed earlier, is another. Offi- facturers and bankers, mainland banks are falling over cials also need to address generally poor standards of themselves to lend to firms from the island. We heard corporate governance on the island. These measures one story of a Taiwan firm receiving an unsecured loan of would help improve the international competitiveness Rmb60m, together with a stand-by support facility, and relevance of the island’s capital markets and will be before its mainland factory had even been built. One important in ensuring that Taiwan firms, while perhaps banker told us that if the Agricultural Bank of China eventually issuing IPOs for their growing mainland busi- knows that a Taiwan firm on the mainland is listed at nesses in Shanghai, keep their main listing in Taipei. home—which indicates a degree of accounting transparency—it would provide a line of credit within a An odd way to become a transport hub month. From the point of view of Taiwan companies, bor- While the ban on direct transport links has attracted rowing funds from a mainland bank also helps build more attention, it has arguably not been as harmful to political goodwill with local officials. Of the companies Taiwan’s economy. After all, unlike banks on the island, we surveyed, 64% reported their subsidiary in China Taiwan transport firms have not been completely left out already had a relationship with a mainland bank. of the loop: local shipping lines and airline companies The restrictions on direct cross-Strait financial links are involved in indirect transport links, and the flow of have not only cost Taiwan banks revenue; the limits have goods and people has been an important source of busi- also robbed the island’s banking industry of an impor- ness for the island’s sea and air ports. Still, the ban has tant mechanism of upgrading. As they ventured into clearly been damaging. For one thing, Hong Kong, not China, Hong Kong firms maintained close relationships Taiwan, has become Asia’s leading transportation hub. with local banks in Hong Kong, which were then forced This was not inevitable. While geographically Hong Kong to adapt to the increasing scale and sophistication of is well-positioned to be a transport hub, so is Taiwan. their clients. Taiwan banks have not had the same oppor- And, even without links Kaohsiung, Taiwan’s largest tunity. Partly as a result, Taiwan’s bigger, global firms port, is today the fifth largest port in the world, and the now complain that the island’s banking sector cannot island is the home to two of the world’s largest shipping offer the services they need. lines, Evergreen and Yang Ming, as well as the biggest The opening of direct links will not make either the intra-Asia carrier, Wan Hai. superior services provided by Hong Kong’s financial sec- In recent years Kaohsiung has, however, been slipping tor, or the lower prices offered by mainland Chinese down the global league tables, and this is largely because banks, disappear. But the island’s bankers are confident of the ban on direct cross-Strait shipping links. Between that direct links would give a great boost to their busi- 1999 and 2002 Kaohsiung’s throughput grew from 6.3m ness. Taiwan firms are not known for their profligacy, to 8.5m TEUs. But in 2002 throughput in Pusan in Korea and often complain about high-priced Hong Kong. Local reached 9.3m TEUs, up from 4.5m TEUs seven years ear- banks are also confident that with their deeper under- lier, boosted in part by trans-shipment from ports in standing of the needs of Taiwan firms, with easier access northern China. Of more symbolic importance, in 2002 they would be able to win back business from mainland Kaohsiung was overtaken by Shanghai, where the port rivals. Furthermore, the linguistic and cultural advan- handled 8.6m TEUs, up from just 3.1m TEUs in 1998.

30 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Do drop in… more often Foreign visitor arrivals in Taiwan Japan US

800000

600000

400000

200000

0 1993 94 95 96 97 98 99 2000 01 02

Source: Taiwan Ministry of Transport and Communications

These numbers do not even tell the whole story. The ban Kaohsiung’s port has been built by the government, and on direct links does not only make it costly to trans-ship is managed by the Kaohsiung Harbour Authority (KHA). China cargo through Taiwan. Given the increasing impor- The KHA runs two container berths itself, and leases—at tance of mainland China, it also risks leaving Taiwan out “reasonable rents” according to industry insiders—the as international shipping routes develop. remaining 23 out to shipping lines. In addition to Tai- The airline industry is in a similar position. After wan’s own companies, tenants include foreign industry increasing rapidly in the first half of the 1990s, the num- leaders such as Maersk Sealand. With direct cross-Strait ber of arrivals at Taiwan’s main Chiang Kai-Shek (CKS) links these firms would have the opportunity to trans- International Airport near Taipei rose from 54,473 in ship cargo through their own specialised berths in Kaoh- 1997 to 66,224 in 2002. Taiwan aircraft have tradition- siung rather than having to use Hong Kong’s expensive ally been banned from flying over the mainland’s air- terminal operators. space, pushing up travel times for airlines flying from Similarly, airlines may prefer to use Taiwan over Hong Europe. The same delays do not affect passengers flying Kong as a hub: unlike Hong Kong, Taiwan has an open from the US, but they are then faced with a long, incon- skies agreement with the US. One barrier to this is the venient flight if they want to go on to visit mainland poorer quality of Taiwan’s physical infrastructure. Termi- China. This is not an abstract issue. One US airline we nal One at CKS opened 23 years ago. While airlines spoke to reported seeing signs of a change in travel pat- acknowledge Terminal Two, which opened only in 2000, terns, as executives from high-tech firms on the west is much better, they complain that the length of time coast of the US opt to visit China only, rather than stop- between its planning and completion makes it too feel ping off in Taiwan and then travelling to the mainland. old-fashioned in some respects. Taiwan also still lacks a Taiwan has lost its chance to establish a formidable rail link between the airport and the city. None of this lead as Asia’s leading transport hub. But the island could negates the strength of the case for direct links. It just still become important in this respect if direct links were reiterates that Taiwan’s economic future will not be opened soon. In both the sea and air business, Taiwan secured by a breakthrough in this area alone; better has some notable competitive strengths over Hong domestic infrastructure is needed as well. Kong. Kaohsiung has 25 container berths—more than By encouraging more people from the US and Europe the 24 Hong Kong will have even after the completion of to visit Taiwan, direct links might help the government the long delayed Container Terminal 9 (CT9). Further- to achieve its target of doubling the number of tourists more, unlike the facilities at Kwai Chung in Hong Kong, by 2008. This goal would not only be achieved, but would

almost certainly be surpassed, if an easing of the ban on benefited more than any other economy from Taiwan’s direct links was accompanied by a relaxation of the limits restriction on links with mainland China. Hong Kong pro- that currently prevent all but a small number of mainlan- vides many of the services for Taiwan firms in China that ders visiting Taiwan each year. As visa restrictions have could presumably be supplied by Taiwan’s economy been relaxed in recent years, mainland visitors have itself. Taiwan's bans have been Hong Kong's boons. become the mainstay of Hong Kong’s tourist industry. It But that is not the only salutary lesson from the Hong is highly likely that Taiwan would prove an even more Kong experience. Openness to China is another. In the attractive destination for mainland travellers. Taiwan’s next few chapters of this report, the Economist Intelli- urban areas cannot compete with the skyline of Hong gence Unit will look how the growth of Hong Kong’s serv- Kong island. But the unpopulated east coast of Taiwan is ice sector over the last twenty years has in fact been beautiful, and the island has a justified reputation for driven in large part by the territory’s integration with good food. That Taiwan is a democracy with politicians China. Fears of “hollowing out” persist in Hong Kong willing to stand up to leaders in Beijing makes the fasci- too. Yet while the territory has indeed lost certain sec- nation only greater. tions of its economic base across the boundary with the In fact it is not just in tourism that the economic mainland, this report will again show how new sectors development of Hong Kong should be of interest for offi- develop in their place and some old ones continue to cials in Taiwan. For one thing, the former UK colony has deepen.

32 © The Economist Intelligence Unit

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Leaping dragon, trailing tigers?

PART II HONG KONG The rise of services A booming manufacturing sector ignited Hong Kong’s economy in the 1960s and 1970s. The sector virtually disappeared from the late 1970s as production moved to China. But this migration did not lead to a “hollowing out” of the Hong Kong economy. Instead, the economy has transformed from one of the world’s best-known producers of low-end manufactured products to one of the world’s major international services centres.

uring the 1960s and 1970s Hong Kong, a city Kong’s manufacturing enterprises generated around with less than 5m people, became one of the 30% of Hong Kong’s GDP, and provided work for almost manufacturing powerhouses of the world. Lever- 50% of the workforce. Daging cheap labour costs and entrepreneurial ability, Hong Kong companies led the world in the export Hong Kong’s disappearing clothes of labour-intensive goods such as toys, plastic watches Since then the “Made in Hong Kong” label has become and clocks. Hong Kong was even more dominant in the harder to find. With the opening of China to foreign production of textiles and garments, becoming a world investment in the late 1970s, Hong Kong companies force in the industry by the 1970s. In these years Hong began to move their manufacturing operations across the border. By 2001 the number of manufacturing firms had fallen to just 17,258, which generated 5% of GDP "Made in Hong Kong" no more? and employed around 200,000 people, under 10% of the Hong Kong's domestic exports (HK$ bn) total workforce. In many ways the manufacturing sector was a victim 80000 of its own success. The rapid economic growth generated by the success of Hong Kong’s exporters of garments, plastic flowers and toys in the 1960s and 1970s pushed 70000 up wage and other production costs in Hong Kong. To Apparel and remain competitive, local entrepreneurs began thinking clothing about moving their factories elsewhere. With China 60000 opening up to foreign investment in the late 1970s, their Electrical gaze increasingly turned northwards. goods 50000 At that time, Hong Kong manufacturers relocated to Textile yarn, China for the same reason that drove Taiwan’s IT hard- fabrics and made-up ware firms there in the 1990s: geographical and cultural 40000 materials proximity, generous incentives offered by the Chinese Office machine government, and cheap wages for assembly workers. The parts 30000 pull was perhaps even stronger for Hong Kong investors Watches and because a larger proportion had relatives in the main- clocks land, particularly in the neighbouring province of Telecoms 20000 equipment Guangdong. It is perhaps no surprise that this region, Jewellery which also shares the same Cantonese dialect of Chinese Printed matter that is spoken in Hong Kong, has been by far the most 10000 Articles of popular destination in China for Hong Kong investors. plastic According to some reports, Guangdong has received 70%

0 Toys etc of the total mainland investments made by firms from 1993 94 95 96 97 98 99 2000 01 02 the territory. No more surprising, the attention of Hong Source: Census and Statistics Department, Hong Kong Special Administrative Region Kong investors have been focused on the area of Guang-

34 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA 52,566

dong closest to the territory, the so-called Pearl River The shrinking factory floor Delta. The number of companies operating manufacturing facilities in Hong Kong During the next twenty years, some manufacturing 1980 2001 industries almost disappeared in Hong Kong: for example, by 2001 the plastic products sector employed just 4,353 workers, down from 85,595 in 1980. The combined textile and garments industry remained the biggest 17,258 domestic manufacturing sector, accounting for around 25% of manufacturing employment and a similar proportion of gross output. The size of this sector is, however, 3,572 3,950 5,966 1,789 3,700 1,845 10,474 1,546 7,268 1,843 less a reflection of Hong Kong’s continued comparative 5,092 881 advantage in textiles production than the result of the All manufacturing industries Wearing Textiles Printing Plastic Fabricated Machinery quantitative quotas imposed by industrialised apparel and products metal economies against textile and garment imports from publishing products particular countries, notably China. Source: Census and Statistics Department, Hong Kong Special Administrative Region Previously known as the Multi-Fibre Agreement, the trade restrictions are now under the auspices of the World Trade Organisation (WTO) in the form of the Agreement on production chain have been relocated to China. Nonethe- Textiles and Clothing (ATC). These quotas have not been less, in order to gain the all-important “Made in Hong as restrictive as they might have been for Hong Kong com- Kong” label, it has still been necessary for the finished panies. With the consent of the US government Hong good to be produced in the territory. At the same time, Kong firms have been allowed to establish Outward Pro- with quotas in individual countries being limited, Hong cessing Arrangements (OPAs) in which some parts of the Kong firms had to look beyond China as a location for gar-

Pearl River Delta

The Pearl River Delta (PRD) has PRD: The Changing Face of Hong Kong estimated 59,000 factories in China become a frequently used term. Not Manufacturers,” published by the that in 2001 were producing for many people who use it, however, Hong Kong Federation of Industries, manufacturing and trading firms could define exactly the area it found that the areas of the PRD most registered in Hong Kong, almost 90% describes. A recent study published favoured by Hong Kong firms are were in five PRC cities: Dongguan, by a non-profit institution in Hong Dongguan, Shenzhen and Guangzhou. Shenzhen, Zhongshan, Guangzhou Kong, The 2022 Foundation, tried to According to this study, of the and Huizhou. set the record straight. The report, “Hong Kong and the Pearl River Delta: Main jurisdictions in the Greater Pearl River Delta region The Economic Integration” used the definition of the PRD Economic Zone set out by the Guangdong provincial government in 1987. This includes the capital of Guandong province, Guangzhou, together with two of Guangzhou China’s original Special Economic Zhaoqing Huizhou Zones (SEZs), Shenzhen and Zhuhai, Foshan Dongguan and Dongguan, Foshan, Jiangmen, and Zhongshan, and the urban areas Zhongshan Shenzhen of Huizhou and Zhaoqing. According to the report, this Hong Kong Jiangmen region attracted US$80.5bn in foreign Zhuhai direct investment (FDI) in the period 1985-1999, 70.8% of which was Macao supplied by companies in Hong Kong and Macau. Another study, “Made in

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

ment factories with local entrepreneurs consequently Hong Kong’s remaining garment producers would “roll- investing in Southeast Asia, Africa and South America. up their tents” and move to China. Such a development Under the ATC, the system of quantitative restrictions would make life very difficult for those made unem- on imports of textiles and garments is being phased out, ployed. With the unemployment rate among low-skilled and is scheduled for complete removal by 2005. Many workers in Hong Kong rising rapidly in recent years—job- apparel manufacturers are, however, sceptical that this lessness among those educated only to primary school schedule will be met. The ATC was back-loaded: the first level rose from 2.5% in 1997 to 9.8% at the end of three stages of the process, in 1995, 1998 and 2002, 2002—assembly labourers laid-off from the garment involved the removal of not less than 16%, 17% and 18% industry would struggle to find new jobs. And with much respectively of the 1990 clothing and textile imports of the flow of garments between Hong Kong and China covered by the ATC; the remaining amount, likely for related to OPAs that would be made obsolete with the most countries to be 49% of 1990 imports, is supposed phasing out of quotas, cross-boundary trade would also to be liberalised in one fell swoop on January 1, 2005. be affected. (The border between Hong Kong and China Even the limited removal that has occurred to date has officially became the boundary with the return of Hong triggered complaints from OECD manufacturers. And the Kong to Chinese sovereignty in 1997.) US and other countries have several ways of trying to clamp down on imports from China (see box: Less sup- From ten-storey factory to ten-storey office port for bras). The ATC provides for a special transitional The further migration of the textile and garment industry safeguard mechanism that allows countries to impose would not, however, sound the death knell for Hong quota restrictions for up to three years on imports which Kong’s economy; nor would it much reduce the impor- cause “serious damage, or actual threat thereof,” to its tance of the garment and textile industry to Hong Kong. domestic industry. Furthermore, the agreement under This is because the marked deindustrialisation of the last which China gained membership of the WTO in 2001 twenty years has been accompanied by the rapid devel- includes a special textiles provision that can be used opment of a related service industry in its wake. As one until the end of 2008 against all products subject to the industry participant put it, whereas twenty years ago he ATC. The WTO agreement also included a China-specific managed a 10-storey garment factory in the territory, he safeguard, effective until 2013, allowing countries to now runs a 10-storey office. According to the Hong Kong take action against any import from China causing mar- Trade Development Council (TDC), by 2002, more than ket disruption. 15,000 companies in Hong Kong, employing over 90,000 If quotas were removed, it is likely that Hong Kong’s workers, were involved in garment import-export trade. manufacturing sector would contract further: as one While far fewer than the 300,000–plus people employed local manufacturer put it, with the removal of quotas in garment manufacturing factories in 1980, positions in

Less support for bras

In 2002 women’s bras attracted more in 2002, with a market share of In September last year, the ATMI than the usual amount of attention in almost 20%. China won market share called on the US government to the US. As part of the largely through low prices. According impose special quotas on exports of a implementation of the third phase of to the industry group, the American selected number of goods from China, the WTO’s Agreement on Textiles and Textile Manufacturers Institute arguing that “imports of Chinese Clothing, on January 1st 2002 the US (ATMI), the price of bras imported textile products are currently government removed quota from China fell to US$29 per dozen experiencing their greatest surge in restrictions on the import of certain last year, “by far the lowest of any history.” Apart from bras, the ATMI types of bras. In the following twelve major supplier.” called for restrictions to be imposed months the value of bras imported to Such rapid sales growth on imports from China of knitted the US from China more than undoubtedly boosted China’s fabrics (which according to the ATMI doubled, to US$289.8m. As a result, economy. Many US women have also rose by 22,000% in the first six China leapt from being the fourth presumably welcomed the availability months of 2002), gloves (up 300%) largest supplier of bras to the US in of cheap underwear of increasingly nightwear/dressing gowns (up 2001, with an 8.7% share of the high quality. China’s export success 400%), and textile luggage (up import market, to being the largest has not, however, pleased everyone. 400%).

areas such as buying and sales tend to be better paid as trading rather than manufacturing firms. Other com- than basic assembly jobs. panies have grown up with the sole purpose of intermedi- That the service sector has grown so quickly should ating production from the mainland. As a result, not be surprising. During the last twenty years the aver- paralleling the fall in the number of manufacturing firms age Hong Kong company in the textiles and garment in Hong Kong has been a rise in the number of import and industry has become immeasurably more sophisticated. export companies, from under 18,000 in 1980 to a peak Running both the OPA chains and global manufacturing of more than 100,000 in 1994-96, at which time they facilities that have appeared in response to the system of employed over 500,000 people. The importance of main- export quotas maintained in industrialised countries land manufacturing as a source for economic activity in has, for example, been no simple business (OPA chains in Hong Kong was further illustrated by a report published particular have developed into very complex animals— in November 2002 by the Hong Kong Federation of see the chart The garment game). Expansion overseas Industries, “Made in PRD: The Changing Face of Hong has also meant an increase in production scale: while Kong Manufacturers.” This study found that the 63,000 even at its peak total manufacturing employment in local manufacturing and trading companies economically Hong Kong never exceeded 1m, most surveys estimate active in the mainland in 2001—defined as firms with that firms in the territory now employ around 10-11m investments in, management control over, or subcon- workers in China. This has increased demand for workers tracting arrangements with manufacturing facilities in such as accountants, buyers and sales staff. At the same China—employed around 477,000 people in Hong Kong. time, while many Hong Kong companies have continued It is not only the evolution of local firms that has to manufacture for other firms under the OEM model, pushed Hong Kong’s economy into the service sector. during the last twenty years others have started to The willingness of foreign firms to use the territory as a develop their own brand names. Examples include the base from which to develop markets in the wider Asian chain stores Espirit, Baleno, Bossini, Giordano, Jean region—particular China—has also been an important West and Moiselle. These changes at the company level factor. Hong Kong’s pre-1997 status as a British colony have promoted Hong Kong’s transition from a garment- which, at least for firms from the OECD economies, manufacturing centre to a global sourcing hub for the afforded it a “safeness” often considered lacking in other apparel sector. Asian cities, was one reason for the territory’s attractive- This pattern—the partial replacement of departed ness to foreign firms. In concrete terms this related to manufacturing capacity with expanded support serv- the strength of the rule of law, the wide use of English, ices—has been replicated in other sectors. While the and the availability of western-style social amenities not number of manufacturing firms in Hong Kong has fallen available elsewhere. The quality of Hong Kong’s trans- dramatically during the last twenty years, not all of these port infrastructure was another attraction—although companies have shut down completely. Indeed, after feelings towards the skyscraper-skimming flight into the shifting all their manufacturing operations to the main- old Kai Tak airport were mixed, ranging from exhilaration land, some have merely been reclassified in Hong Kong to pure fright. Pulled in by these factors, foreign firms

The garment game The processing of a woven shirt exported under a Hong Kong certificate of origin

These "make-ups" are trucked back to 5 3 the Hong Kong workshop for major Finished goods are Material is 2 The Chinese assembling The semi-finished trucked back to purchased workshop: cuts the processes: sewing products are Hong Kong and and pattern, makes up together the front trucked back to exported from imported the collar, sews the 1 Imported panel and back the Chinese Hong Kong under from front placket and materials are panels setting the workshop for certificates of sourcing front yoke to front cross-docked and sleeves, collars and finishing: origin and quotas. countries panel, and the trucked from Hong back yoke to the cuffs closing the button-hemming, Kong to a back pane, cuts the side seam inspecting, workshop in China button-holes washing, ironing, 6 packaging

Source: USI Textiles, Hong Kong. 4

38 © The Economist Intelligence Unit TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

At your service… Manufacturing Trade, restaurants and hotels Employment in Hong Kong, 1980-2002 Transport, storage and communications Financing, insurance, real estate and business services

1,000,000

800,000

600,000

400,000

200,000

1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 Source: Census and Statistics Department, Hong Kong Special Adminstrative Region established regional and China offices in Hong Kong, 5.6% of GDP in 1980 to a high of 7.6% of GDP in 2000. employing accountants and sales and marketing profes- As well as having expanded in size during the last sionals. According to the government’s Census and Sta- twenty years, the services industry has grown in sophis- tistics Department (CSD), of the 948 regional tication. In the late 1970s, for example, the financial headquarters and 2,171 regional offices in Hong Kong services sector in Hong Kong was centred on the com- on 1st June 2002, which altogether employed more than mercial banking industry. It was not, however, until 160,000 people, around two-thirds belonged to compa- 1981 that the government allowed foreign-based banks nies from the US, Japan and five western European coun- to operate in Hong Kong. They jumped at the chance: by tries. the end of 2002, 107 licensed banks in the territory— 80% of the total—were incorporated overseas. The inter- The bankers move in nationalisation of the banking sector has not, however, The transition of the average business in the territory just involved foreign banks coming into the territory. from a local factory making goods to an office dealing Local institutions have also been looking out. The pro- with larger manufacturing facilities in China, as well as portion of funds lent by authorised institutions for use the development of Hong Kong as a regional centre for outside the territory rose from 30% in 1981 to a peak of foreign firms, have contributed to the growth of a spe- almost 60% in 1992–95. cialist services industry. The overall services industry The breadth of the financial services industry has also now accounts for 82% of GDP, up from 65% of GDP in expanded over the last twenty years. The Stock Exchange 1981. Within that sector, the contribution of the finan- of Hong Kong (HKSE) was formed in 1986, following the cial services and insurance sector to the overall economy merger of four existing stock exchange companies. It grew to an all-time high of 12.1% in 2000, up from a low was then merged with the Hong Kong Futures Exchange of 6.1% in 1985; from just 66,467 in 1981, employment in March 2000 to become part of Hong Kong Exchanges in the financial services sector alone rose to around and Clearing (HKEx). In the twenty years from 1982 the 137,000 by the end of September 2001. Between 1981 number of firms listed in Hong Kong almost tripled, ris- and 2001 the business services sector expanded from ing from 273 to more than 812, with capitalisation 2.1% to 4.4% of GDP. According to the Law Society of expanding from HK$131.6bn (US$21.7bn, 68% of GDP) Hong Kong, between 1992 and 2002 the number of law to a peak of HK$4.8trn (US$615bn, 372% of GDP) in firms in Hong Kong rose from 427 to 682, with the num- 2000, before falling back to HK$3.6trn (280% of GDP) in ber of lawyers increasing from 2,720 to 5,957. Similarly, 2002. As a result of this expansion the HKSE became the the number of accountants registered with the Hong second largest stockmarket in the region. The value of Kong Society of Accountants rose from 1,924 in 1982 to outstanding bonds (other than the Exchange Fund Bills 6,032 in 1992, and to almost 20,000 ten years later. and Notes issued by the Hong Kong Monetary Authority, Finally, the transport and storage sector, which includes HKMA) meanwhile, has grown from just 13.3% of GDP in activity at Hong Kong’s sea and air ports, expanded from 1995 to 32.6% in 2002. The variety of debt instruments

Market maker increased. By 2002 there were 38 foreign law firms in Selected indicators, Hong Kong stock exchange Hong Kong and 750 overseas lawyers; a top law firm, Clif- Number of listed companies ford Chance, had 89 lawyers in 1996 rising to 134 in 1977 2000. Lawyers speak of a great expansion in the breadth 82 and depth of work being done in Hong Kong. As with 87 accountancy, this evolution has been driven by a general 92 increase in the size and sophistication of client compa- 93 nies, as well as by the development of Hong Kong as a 94 financial services centre. 95 Trade-related services have also boomed. Much of 96 Hong Kong’s manufacturing industry moved out to China 97 during the 1980s and 1990s. But most of the goods were 98 still transported back to the territory to be exported out 99 to the rest of the world: as late as 1994, 40% of the 2001 goods sold by China to the rest of the world were re- 01 exported through Hong Kong. During that period, goods 02 were brought back to Hong Kong for inspection or pack- 0 100 200 300 400 500 600 700 800 aging, or for consolidation, tasks which even now can be difficult in China because of the mainland’s more restric- Market capitalisation tive customs requirements. Goods were also attracted (HK$bn) back by Hong Kong’s developed transport links with the 1977 rest of the world. The territory’s deep-water container 82 port at Kwai Chung has 18 berths. The sometimes hair- 87 raising flight into the old airport did not prevent Hong 92 Kong enjoying air connections to most places in the 93 world, with the number of flight departures rising from 94 27,000 in 1980-1981 (April-March) to over 82,000 in 95 1997-98. This connectivity was complemented in 1998 96 with the opening at Chek Lap Kok of a new airport. 97 The final ingredient in the rapid development of Hong 98 Kong as a service economy has been the growth of the 99 tourism industry. Between 1981 and 1990 the number of 2001 foreign visitors (excluding those from China) to Hong 01 Kong grew from 2.5m to 5.9m. In 1992 the government 02 started to include mainland Chinese residents in its sta- 0 1000 2000 3000 4000 tistics, and the total number of tourists reached 13m in Source: Hong Kong Exchanges and Clearing 1996. The number fell back to 10.2m in 1998, but increased again in the following years to reach a new has also expanded, with the HKMA’s Hong Kong Mort- record of 16.7m in 2002. This directly drove an increase gage Corporation, for example, beginning to sell mort- in the contribution to GDP made by hotels and boarding gage-backed securities. houses, from HK$1.3bn in 1980 to an all-time high of The development of the financial sector has added HK$14.1bn in 1996. This contribution shrank in the last impetus to changes that were happening anyway in the few years, but at HK$8.7bn in 2001, the sector was still professional services sector. In the 1970s, the average much more significant than it had been twenty years accountant in the territory would have doing simple before. Total tourism receipts followed a similar pattern, audit and Hong Kong tax work. Today, according to rising from HK$6.5bn in 1980 to an all-time high of industry insiders, the same accountant must address HK$93.6bn. In 2001 tourism spending in Hong Kong issues related to Chinese tax, the management of totalled HK$64.3bn (4.9% of GDP). finances between Hong Kong, China and possibly a third As the product offering of Hong Kong’s service sector country, as well as the structuring of business opera- widened and deepened during the 1980s and 1990s, its tions. With Hong Kong becoming a major centre for customer profile also changed. Hong Kong’s stand-alone financing and mergers and acquisitions (M&A), demand service sector established more of a regional role, selling for accountancy services such as due diligence has also to firms in Korea and Southeast Asia and, as restrictions

40 © The Economist Intelligence Unit

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

on cross-Strait social and economic contact were eased Some of these IPOs have involved state-owned giants in the 1990s, Taiwan. In fact, Hong Kong has benefited from the mainland such as the telecoms companies China more from Taiwan’s restrictions on links with mainland Mobile (1997), China Unicom (2000) and China Telecom China than any other place. As we have seen boats (2002), the oil firms PetroChina (2000), China Petroleum unable to sail directly across the Taiwan Strait tradition- and Chemical Corp (Sinopec, 2000) and China National ally have passed instead first through Hong Kong. People Offshore Oil Corporation (2001), and one of the main- from Taiwan wishing to visit the mainland similarly have land’s big four banks, Bank of China (2002). These list- had to touch down en route in a third area, and Hong ings have not only been large, they have been very Kong has been the most popular stopping-off point. Tai- complex affairs, generating much work for the invest- wan companies, prohibited from investing directly in the ment banks, lawyers and accountants in Hong Kong mainland, have established subsidiaries in Hong Kong. involved in advising on the corporate restructuring and Restricted from offering services to clients from domestic financial reforms necessary to allow these former state- banking units (DBUs) in Taiwan, local banks set up busy owned enterprises to come to the market. offshore branches in Hong Kong. In short, Hong Kong China has generated work for Hong Kong’s legal provides many of the services for Taiwan firms in China industry in another way. Many foreign firms sign con- that could presumably have been supplied by Taiwan’s tracts on the mainland not under China but rather for- economy itself. eign—most commonly New York, London or Hong Kong—law. Disputes that arise can then be heard in an New clients in China overseas court. Of course, in some cases firms may shy And now demand from China itself is growing. According away from litigation. Going to court is expensive, and to the Census and Statistics Department, Hong Kong’s enforcement of foreign judgements in China can anyway service exports to the mainland grew from 16.6% of the be difficult, given the absence of legal instruments such total in 1995 to 24.9% in 1998, before falling back to a as bilateral treaties of enforcement. Companies do, how- still-high 22.9% in 2000. A 2002 survey by the HKTDC ever, have another option: arbitration. This is a cheaper found that 14.4% of private-sector enterprises in the route, and can be more effective in producing results mainland provinces of Guangdong, Jiangsu and Zhejiang because China is a signatory to the UN Convention on had already established an office in Hong Kong. The CSD Acknowledgement and Enforcement of Foreign Arbitral survey found that by June 2002, 96 mainland firms had Awards. Regardless of whether arbitration or litigation is established regional headquarters in Hong Kong, with a chosen, Hong Kong is a popular venue. Its geographical further 170 having regional offices in the territory. position helps, but it also has a generally well-respected The increasing importance of demand from mainland legal system, as well as a supply of skilled arbitrators. firms for Hong Kong’s services industry has perhaps been The mainland has also been becoming an increasingly most obvious in the financial sector. According to the important market for Hong Kong’s tourism industry. HKMA, for example, at the end of September 1998 local Between 1992 and 2001 the number of visitors from the banks in Hong Kong had outstanding loans to non-bank mainland rose from 1.1m to 4.4m to account for more Chinese entities of HK$75.9bn, equivalent to 4.5% of than 50% of the total increase in tourist arrivals during total assets. Hong Kong’s capital markets have also ben- this period. The number jumped again in 2002, rising by efited, with Chinese-controlled companies incorporated 53.4% to 6.8m, boosted by an easing of restrictions on in Hong Kong—”red chips”—starting to list on HKSE in mainland residents visiting the territory. Perhaps sur- 1986. Only five red chips went to the market in the fol- prisingly, mainland tourists have also individually been lowing six years, but seven listed in 1992, and twenty the spending large amounts of money in Hong Kong. During next year, when they were also joined by “H-shares,” or 2001 mainland tourists to Hong Kong spent an average China-incorporated companies. By the end of 2002, 72 of HK$5,169 (US$660) per head and were particularly red chip and 76 H-share companies were listed in Hong heavy shoppers. While hotel bills accounted for nearly Kong. In 1998-2002 these firms raised HK$520.5bn, 50% of spending by US visitors in 2001, for example, equivalent to two-thirds of the total equity funds raised mainlanders blew more than 60% of their cumulative on the territory’s stockmarket during this period. HK$23bn expenditure in Hong Kong’s shops.

Leaping dragon, trailing tigers?

PART II HONG KONG The Hong Kong advantage

Structural factors, namely the growing after all, accompanied by some disturbing political and capacity of cities in mainland China to economic reverberations. For the moment at least the provide many of the services that are territory’s special political position remains largely pre- served, but Hong Kong’s transition to a Special Adminis- currently supplied by Hong Kong, are being trative Region (SAR) of China has been far from smooth, blamed by some for the territory’s current with the last six years being marked by an extraordinary economic slump. In fact Hong Kong’s number of crises and controversies. Some of these have strengths will ensure the robustness of the been purely man-made. Quarrels between the UK and services sector for a long time to come—as China led to the mainland replacing the sitting Legisla- long as the government pushes reforms that tive Council (Legco) in 1997 with an appointed Provi- sional Legislative Council, thereby derailing the political will ward against complacency. through-train that was supposed to carry Hong Kong through the 1997 handover. In 1999 the government decided to invite China’s legislature to overturn a right ong Kong’s smooth economic transformation of abode ruling issued by the territory’s Court of Final from manufacturing to services seemed to come Appeal that same year. More recently there has been the to a shuddering halt with the sharp downturn of push to fulfil Article 23 of the Basic Law, which calls for H1997—the year in which Hong Kong also hap- the Hong Kong authorities to enact legislation prohibit- pened to return to Chinese sovereignty. In October that ing acts of “treason, secession, sedition, and subver- year, the stockmarket crashed, with the benchmark Hang sion” against the central government (the Basic Law is Seng Index falling from over 15,000 in early October to Hong Kong’s mini constitution). But even the non man- under 10,000 at the end of the month, and the bubble in made crises, such as the first outbreak of avian influenza the property market burst, precipitating a 40% fall in in late 1997 have been marked by a high level of govern- average real estate prices during the following 12 ment bungling. months. These events contributed to the economy The handover also produced some economic phenom- slumping into a severe recession. The economy started to ena that were not conducive to steady rates of GDP grow again in 1999, and expanded by a robust 10.2% the growth. There was a rush of tourism in 1995 and 1996, following year, but then fell back into recession in 2001. fuelled in part by the desire of some foreigners to see Since then many questions have been asked about the Hong Kong as a British colony. This motivation came to future direction of the economy. Is Hong Kong’s econ- an end in 1997, with the inevitable fall-off in tourism omy beginning to lose out from the migration of busi- then exacerbated by high prices and rumours of full ness to China? Is it losing its edge against its traditional hotels for the period of the transition itself, as well as rival, Singapore and its new competitor, Shanghai? Has damaging revelations that Japanese tourists were being Hong Kong seen its best days? singled out for uniquely high charges in Hong Kong. Some of this pessimism is overdone, though it is not Optimism surrounding the transition also fuelled a real difficult to see why some in Hong Kong might point a fin- estate investment boom, pumped up by capital from ger at the 1997 handover as a possible cause of the both Hong Kong and mainland China. Rather than cool- malaise. The return to Chinese sovereignty in 1997 was, ing this over-heated market, monetary policy in Hong

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Kong added fuel to the flames. With the Hong Kong dol- caused by the Asian crisis of 1998-99 and the more glob- lar being fixed to the US dollar at HK$7.8: US$1, local alised slump of 2001-02. interest rates are in effect set by the US Federal Reserve rather than by the HKMA. Pre-1997 inflation was much Rivals across the boundary higher in Hong Kong than the US, so real interest rates Despite these arguments, a growing perception exists in in the territory were low or even negative as the bubble Hong Kong that cyclical factors alone do not explain was inflating. And then, with prime interest rates (the Hong Kong’s economic malaise. Serious structural chal- lending rates banks charge their best customers) lenges do, in fact, exist. The chief concern is that the remaining at 8% in the following three years but con- rapid development of physical infrastructure and the sumer prices starting to fall, high real interest rates rein- general business environment in China is gradually rob- forced the scale of the subsequent crash. bing Hong Kong of its position as the monopoly supplier Of course, Hong Kong’s lifeblood is international of services into the mainland. The monopolistic position trade—in recent years exports and imports of goods and that Hong Kong has enjoyed for the last twenty years has services have amounted to more than 250% of GDP. After contributed to the development of significant depth in growing by an average of 8.7% a year in 1993-97, particular industry sectors, from fashion to financial exports of goods and services expanded by a much more services, which will be difficult to replicate anytime moderate 4.8% in 1998-2002. But did this have anything soon. Yet at the same time, monopolies are rarely effi- to do with the return of Hong Kong to Chinese sover- cient, and the rapid growth of the 1980s and early 1990s eignty? Probably not. This poorer performance was in generated considerable complacency that may render large part due to the depression in external demand some industries vulnerable to more nimble and less pro-

Shanghai vs Hong Kong

For years, the rivalry between Hong that really began to boom. And by the shops. Shanghai has closer links—and Kong and Singapore was the headline- turn of the century and the first few boundary-free travel—with the grabber. Denizens of both cities kept decades thereafter, Shanghai shone Chinese interior and closer ties with an eye on the number of cranes, the as the most cultured city in China— the government in Beijing. And it is arrival of new banks and the and arguably Asia—as well as the the new natural destination for proliferation of trendy restaurants in country’s commercial centre. challenge-seeking expatriates, in the an attempt to gauge who was winning That was soon to end. The way Hong Kong once was. the contest to be Asia’s number two emergence of the People’s Republic of Talk like that has some in Hong (after Tokyo) financial centre. Now, China in 1949 ended Shanghai’s reign Kong worried that Hong Kong will for Hong Kong at least, there is a new as the country’s most sophisticated then become the new Venice, a kid on the block and a new rivalry to city. And Shanghai’s loss was to be reference to another trading contest. Shanghai is in the ascendant Hong Kong’s gain. Businessmen fled powerhouse that declined after losing and if the administrators are to be Shanghai in their thousands in the its monopoly on trade with Asia in the believed, anxious to reclaim its crown first few years after the communist 1400s. That analogy glosses over as China’s main commercial centre. revolution, setting up shop in Hong some of Hong Kong’s strengths. The In contrast to many other great Kong instead. Already a steadily territory offers a stronger legal cities of the world, both Shanghai and growing trading city, this influx was system, deeper financial and business Hong Kong have had rather short one of many factors that helped ignite services, a lack of capital controls, lives. Both were sleepy fishing towns the city’s manufacturing boom in the wider use of English and decades of until the middle of the nineteenth coming decades. experience as a modern business hub. century when both came under Now Shanghai is back on the scene It will take more than a coat of paint strong—and uninvited—foreign and there is much talk about the for Shanghai to catch up with all these influence. After China’s defeat to return of the old “Paris of the East.” qualities. But what Shanghai lacks in Britain in the Opium Wars, China gave The city government—and their polish it is gaining in brute, economic up its sovereignty to Hong Kong, bosses higher up the chain—are keen strength. Shanghai’s GDP has been Shanghai and other treaty ports. Both to build Shanghai into a showcase growing faster than Hong Kong’s and cities began to develop as important city, shining up the old buildings and may catch up with its old rival very trading centres but it was Shanghai building glittering, new towers and soon—if it has not already.

Industry focus: fund management

Hong Kong’s asset management So far, Hong Kong’s government around US$2bn a year in new assets industry has grown rapidly over the has been less pro-active than for the fund management industry, past two decades. In the late 1970s Singapore’s. In a reflection of their and MPF funds are expected to total the sector was dominated by just attitude towards foreign investment US$123bn in 30 years’ time. three firms, but there are now more in general, officials have tended to There is also the small matter of than 150 that at the end of 2001 were prioritise the provision of an China, of course. Thanks to exchange responsible for managing almost attractive overall business controls on the renminbi, mainland US$190bn in assets. In a reflection of environment rather than specific residents are generally prohibited Hong Kong’s role as an international incentives for the fund management from investing abroad. Chinese financial centre, more than two- industry. Although Hong Kong officials have talked, however, of thirds of these funds were sourced by remains a larger fund management allowing residents to invest in closed- non-Hong Kong investors. centre, its lead over Singapore has end funds in Hong Kong. Even if they In asset management as in other narrowed in recent years as its AUM do not receive such a fillip, fund industries, however, there are worries has fallen from an estimated managers in Hong Kong are also about Hong Kong’s ability to compete. HK$3.5trn (US$448bn) in 1999 to eyeing the vast potential of the Singapore’s aspirations as a regional HK$1.5trn (US$188bn) in 2001. mainland market, where an estimated centre for the fund management But the territory still has US$1trn-worth of household savings industry are a particular threat. The considerable strengths. The recent is lying dormant in state banks. ABN government there retains a range of fall in AUM is somewhat misleading— AMRO Asset Management’s purchase incentives to attract foreign fund restructuring at one big fund in early 2003 of a 33% stake in managers, such as tax holidays and management firm played a large part. Xiangcai Hefeng, a Shanghai-based subsidies of up to 50% on staff Fund managers in Hong Kong praise fund manager, signalled the first full salaries. And according to Fund the government’s non-interventionist foray into the Chinese market by a Management in Hong Kong and approach, and have few policy foreign fund manager. Others will Singapore, a paper by Matthew requests to make of officials. They follow. Shanghai, of course, will want Harrison of Hong Kong Exchanges and also note that the territory’s industry a piece of this pie. But Hong Kong Clearing, assets under management is benefiting from the establishment fund managers think the territory’s (AUM) in Singapore have increased in 2000 of a compulsory old-age oft-cited advantages—rule of law and steadily from S$37bn (US$21bn) in savings scheme, the Mandatory so on—put it in a strong position to 1992 to S$307bn (US$173bn) in Provident Fund (MPF). The scheme compete effectively with mainland 2001. currently generates a stream of rivals.

tected competition. with offices in the city has grown rapidly, to 48 in 2002. One of the most talked-about threats to Hong Kong’s In 1991 only eight firms were listed on the Shanghai position has been the rise of Shanghai. Few doubt that stockmarket, but there are now 646, and in the interven- the northern city’s leaders want to reclaim the mantle of ing period the market’s capitalisation grew from the financial and commercial capital of China, a title lost Rmb2.9bn (US$545m, or 0.1% of GDP), to Rmb2.7trn to Hong Kong after the Chinese Communist Party (CCP) (US$333bn or 28.8% of GDP). took power in the mainland in 1949. And the rate of Professional services firms reveal that Shanghai, pre- development of Shanghai over the last ten years cer- viously the favoured destination only for China hands, is tainly makes it difficult to doubt that this is anything but fast becoming the place to be for young and ambitious a completely plausible goal. The glittering skyline of people from all over the world, including those from Pudong and the rapidly improving transport infrastruc- Hong Kong and those who have never picked up a copy of ture are just the most visible signs of this. A survey of Red Star Over China (see box Shanghai vs Hong Kong). North American, European and Japanese multinationals Shanghai’s growing popularity is partly a result of the in 2000, conducted by a professor from the University of increase in sophistication of work to be done—the time Hong Kong, Michael Enright, found that 3% of firms had when professional service firms worked only on plain regional headquarters in Shanghai; not a large number, vanilla FDI deals for naïve incoming foreign multination- but significant considering ten years earlier it would als is fast coming to an end. The quality of life for foreign probably have been zero. The number of foreign banks residents in Shanghai has also improved markedly in

recent years, with the creation, for example, of many larger than the Hong Kong one. more international bars and restaurants. But most industry participants tended to think the It is not only the take-off of Shanghai that is causing territory’s position as an international centre for the tex- concern in Hong Kong; developments in neighbouring tile and garment industry will prove rather durable. Shenzhen, notably the rapid growth of its port, are also Largely because of quality of life issues, companies we generating ripples of concern. In 1998-2002 container met with were confident that for some time to come the throughput in Hong Kong’s ocean and river ports grew by majority of foreign buyers would prefer to do business in an average of 6% a year, much slower than the 47% Hong Kong rather than in the Pearl River Delta. They also annual growth achieved in the same period by Shen- noted that English-language skills, an attribute consid- zhen’s largest port, Yantian (Shenzhen’s other two ports ered essential for the sales and marketing activities of are Shekou and Chiwan). Furthermore, it appears that Hong Kong’s internationally-oriented firms, were better there is almost insatiable demand for the services of in the territory than on the other side of the boundary. these ports. Throughput at Shenzhen’s largest port, Hong Kong’s internationalisation, both in terms of the Yantian, grew by more than 55% last year as new capacity city’s exposure to trends from the rest of the world, and came on stream; even then there were reports of severe the ability of local people to travel without the proce- congestion as trucks waited to enter the port. It thus dures that encumber mainland residents, was considered seems likely that use of Shenzhen’s ports will grow as fast a further competitive strength. as new capacity can be rolled out. Phase III of Yantian’s This nuanced picture is not unique to the garment and expansion plan, which involves the addition of 4 berths textile industry. Regular TDC surveys of Hong Kong’s to the existing 6, raising total designed annual capacity trade and trade supporting services have found that in from 3.9m to 6.5m TEUs, is expected to be completed by recent years the proportion of firms planning to locate the end of 2005. Phase II of the expansion of Shekou, different functions in China rather than Hong Kong has which will double the number of berths to 4 and annual shown an across-the-board increase. And the latest sur- designed capacity to 1.8m TEUs, will be completed by the vey, carried out in the first quarter of 2001, found that in end of 2003. Media reports have suggested that Shen- the next five years some functions will be located zhen’s local government plans to increase port handling overwhelmingly in the mainland, such as manufactur- capacity to 11m TEUs by 2005 and to 18m by 2010. ing/packaging (86.3% of surveyed firms), quality con- The situation in Hong Kong appears very different. trol (78%), sample-making (73.4%) and material Capacity at the territory’s ocean port of Kwai Chung will sourcing (71.9%). These activities are, however, lower- increase by 33% in the next few years as the delayed six- end ones that are closely related to the production berth Container Terminal 9 (CT9) is finally completed. In process itself. Higher-end activities, on the other hand, contrast to China, this new capacity will take some years continue to be located in Hong Kong. Thus, the 2001 sur- before it is fully utilised: the Economist Intelligence Unit vey found that the vast majority of firms would in the spoke to three of Hong Kong’s four terminal operators, next five years still retain in the territory functions such the private firms that run the territory’s port facilities, as regional headquarters (85.4% of surveyed firms), none of whom expressed any expectation that this devel- business negotiation (72.4%), trade financing (90.1%) opment would lead to a one-off increase in overall and insurance (84.9%). In addition, for those firms plan- throughput at Kwai Chung. Indeed, CT9 was not men- ning to locate higher-end functions in Hong Kong during tioned as a determinant in the latest port throughput the next five years, more planned to expand the scope of forecast published by the Hong Kong Port and Maritime these activities than to downsize them; the opposite was Board. true for lower-end activities. The TDC’s surveys look mainly at local small- and Still headquartered in Hong Kong medium-sized enterprises (SMEs). This is an important So are Hong Kong’s service sectors losing out to the sector: it is after all local manufacturing and trading mainland’s evolving industry? Looking at the headlines, SMEs that form the bedrock of Hong Kong’s economy. one could be forgiven for thinking that Hong Kong is Still, it can be argued that such firms are less footloose quickly fading from the map. Such a conclusion would, than most—home and family ties might be sufficient to however, be misguided. Take the support-service side of keep a firm in Hong Kong even though financially it the garment and apparel business. Executives in a num- would be better off moving to China. ber of textile firms did tell us that to save costs they had These conclusions were corroborated by our own sur- already moved back-office positions, such as clerical vey of Economist Intelligence Unit clients in Hong Kong, officers, across the border. One firm even told us that in which tend to be multinational companies. Conducted the next few years their mainland office would become specifically for this report, our survey did not reveal a

What is likely to happen to your Hong Kong-based activities in the following business areas over the next three years? % Strategic management Finance and treasury Marketing and distribution Back-office services and decision making

47 47 49 53 51 53

Expansion Downsizing Source: Economist Intelligence Unit executive survey, Hong Kong, March 2003

simple outflow of corporate activity from Hong Kong. The outweighed decisively the number thinking it “good” or results of this exercise did suggest that in all areas sur- “very good” in all but two categories. The exceptions veyed—strategic management and decision-making, were low property, utility and staffing costs, and ease of finance and treasury, marketing and distribution, and access to the national market. The low cost category was, back office services—activity during the last three years by contrast, one of the only two in which the number of has been a migration to China, particularly Shanghai, at “reasonable” and “poor” responses outnumbered the the expense of Hong Kong. But Hong Kong is far from “good” for Hong Kong. The other was not ease of access imminent irrelevance. In fact, the increasing importance to the national market; interestingly, the proportion of of China as a production centre or market for many multi- respondents thinking Hong Kong rated “good” or “very nationals has clearly been benefiting the territory. For good” in this category was larger than for China. Rather, each of the four business activities surveyed, our poll the other outlier in Hong Kong was the availability of found that an almost equal number of firms have consol- English-language skills (and even in this area Hong Kong idated their business in Hong Kong, with some business scored better than China). activities moving from China as well as other cities in the None of this suggests Hong Kong is becoming irrelevant region, particularly Singapore. And when asked to as a location for the offices of local and foreign companies. describe the broad trends that characterise the nature of Far from it. Despite the economic difficulties of the last five existing business activities in Hong Kong, the companies years, the number of lawyers registered with the Law Soci- surveyed reported a strong expansion in Hong Kong in ety of Hong Kong rose by almost 1,000 between 1997 and three of the four business areas over the last three years. 2002, with the number of foreign lawyers increasing by Only in back-office services, a lower value-added activ- almost two-thirds. During the same period the number of ity, was the balance between companies reporting accountants on the books of the Hong Kong Society of expansion and those reporting a downsizing of activity Accountants rose by more than 6,000. Foreign profes- more evenly matched. sional services firms do report expanding offices on the It is not even clear that this picture will change deci- mainland. But in general this appears to be in addition to, sively during the next few years. Most firms reported that rather than at the expense of, capacity in Hong Kong. Fur- back office services in Hong Kong would be further thermore, while the functional ability of offices on the downsized during the next three years. But a clear mainland is growing, the deepest pool of expertise in the majority of firms reported that finance and treasury region remains in Hong Kong. activities in Hong Kong would be expanded in 2002-04. Admittedly, the financial-services sector has shrunk And in both strategic management and decision-making in recent years, with output falling by 2.7% in 2001. As a and marketing and distribution, as many firms reported major financial centre, however, Hong Kong could hardly they would expand activity in Hong Kong over the next remain immune from the consequences of the ending of three years as reduce it. the great US bull market in 2000. Furthermore, even in These results should not be surprising. Hong Kong’s 2001 the gross output of the sector, at HK$146.9bn in business environment remains highly regarded by multi- 2001, was still the second-highest on record, and larger national businesses, and not just relative to that in than any other sector in Hong Kong except China. The number of companies reporting China’s busi- import/export trade. Few other cities in the region, and ness environment as “reasonable,” “poor” or “very poor” nowhere in China, are able to compete with the depth

Deflation in Hong Kong

Since 1997 property prices in Hong Hong Kong’s economy are, however, Supporters of the China-causes- Kong have fallen by around 60%. In questionable. The Foundation 2022 deflation theory might still argue that 1998–2002 consumer prices fell by report claims that property in the PRD the outflow will grow as boundary 10%. Some believe that this process serves distinct categories of demand, restrictions are eased further. But the of deflation is being driven by deep- such as weekend and holiday homes or HKBPA survey found that only 8.3% of ening integration with China, as residences for the elderly. The report people would consider living in improvements in cross-boundary also cited information from the Hong Shenzhen if the boundary was open immigration procedures and trans- Kong Business Professionals 24 hours a day, and crossing time was port links allow local people easier Association (HKBPA), that in 2001 only cut to 15 minutes or less. And while access to the property and consumer 1.4% of people living in Hong Kong more Hong Kong people might go out markets in cheaper Shenzhen. had purchased a property in Shenzhen. to China, there are still many changes This theory is simplistic at best, In addition, while the number of that can be made to encourage more and erroneous at worst. There has personal trips to the mainland did rise mainlanders to visit Hong Kong. Visa indeed been an outflow of capital and in 2001 from the 33.8m recorded the restrictions on tourists can be eased goods from Hong Kong to the previous year, related expenditure fell further, for example, as can the strict mainland. According to one article from HK$29.4bn. limits that make it difficult for skilled cited in the recent 2022 Foundation In any case, as far as price professionals to live and work in the report on the PRD, people from Hong movements in the territory go, the territory. Kong purchased 6.1m square feet of tendency of Hong Kong people to buy If integration with China cannot housing in Shenzhen in 2001. The property and goods in China is only explain deflation in Hong Kong, what government’s Census and Statistics half of the story—just as important is can? The most important factor is the Department found that Hong Kong the willingness of mainland people to exchange rate. With the Hong Kong residents travelling for reasons other spend in Hong Kong. And there has dollar fixed to the US dollar, local than business made 35.7m person- indeed been a strong inflow of interest rates have been determined trips to the mainland in 2001, resources from China. This is most more by economic conditions in the spending HK$27.6bn in the process. obvious in terms of tourism: US than in the territory. As a result, According to the planning expenditure of mainland tourists real interest rates in Hong Kong were department, 211,000 people, visiting the territory rose from too low during the mid-1990s—which equivalent to 8% of the workforce, HK$18.3bn in 2000 to HK$23bn in helped fuel an unsustainable property travelled frequently to China for 2001. People from the mainland have investment splurge—and too high business in 2001. also become more important investors afterwards—exacerbating the pain of The adverse effect of such flows on in Hong Kong’s property market. the inevitable downturn.

and breadth of financial services available in Hong Kong. made to change the admission of mainland professionals Hong Kong’s prosperity is not pre-ordained however. programme (first introduced in 1994, and again in 2001 There are concerns about the declining standard of Eng- after being discontinued in 1997) and the admission of lish in Hong Kong; if the territory wants to continue to be talents scheme (established in 1999). But with neither a major business centre for China, the government also could the government be accused of opening the flood- needs to work to improve the general standard of Man- gates. The first was restricted to workers in the IT and darin. Language skills are not, however, the only prob- finance sectors, who were not allowed to take their fami- lem. Indeed, historically the overall education system in lies with them to Hong Kong; the second nicknamed the Hong Kong has been poorly funded: government spend- “Einstein” scheme by Hong Kong’s chief secretary for ing on education in 1990–95 averaged just 2.9% of GDP, administration, Donald Tsang, was limited to mainlan- compared with 5.3% in Taiwan. Given this, it is welcome ders with doctorates. Given these strict rules, it should that government spending on education has been not be surprising that between 1997 and 2001 an aver- ramped up in recent years, to 18.9% of total public age of 16,700 foreign professionals a year arrived to spending in 1996–2001, from 17.5% in the preceeding work in Hong Kong, but by the end of 2002 the Einstein six-year period. scheme had attracted just 256 people, and the profes- The shortage of skilled local workers has not pre- sionals scheme just 12 more. vented the economy moving into higher value-added In a major review of Hong Kong’s population policy activities. This is because Hong Kong has traditionally released in early 2003, the government sought to end made it easy for skilled people from North America, this inequality. Announcing the new stance, Mr Tsang Europe and Japan to live and work in the territory. The said for “any particular jobs that the local employer can- territory’s rulers have, however, never been as welcom- not fill, we can contemplate importing from all over the ing for skilled workers from the mainland. An effort was world now, including the mainland of China.” The shift in

attitude is important, and not just because it will from small brokers, the government failed on several increase the supply of skilled workers in Hong Kong. The occasions to abolish minimum broker fees. (The liberali- presence of large numbers of western and Japanese pro- sation finally occurred on April 1st this year.) The dis- fessionals has been an important factor in the growth of tinction between barristers and solicitor pushes up the Hong Kong as an international services centre. It is diffi- costs of commercial litigation in Hong Kong (particularly cult to imagine a Hong Kong closed to skilled workers because most barristers in the territory are skilled in from China maintaining the same relevance as the main- criminal rather than commercial law). land’s economy becomes more powerful. The change is Brokers and barristers are small fry. Far more power- also important as Hong Kong seeks to attract mainland ful are the conglomerates that dominate many sectors of firms to establish regional offices in Hong Kong, a flow the economy, from the property market to supermarkets. that will help to offset any movement of local and foreign Critics allege that the influence of these companies has workers to China. prevented the government from introducing the legisla- Hong Kong’s financial services sector arguably faces tive and institutional measures that are used elsewhere the greatest threat from mainland competition. Hong to encourage competition. The conglomerates reject Kong’s importance in this area is partly a result of its charges of anti-competitive behaviour, as do officials, regime of free capital flows—a policy that will not be who say that as a small, extremely open economy, Hong replicated on the mainland for many years to come. Kong is competitive enough without burdensome legis- Superior financial regulation has also been a factor. But lation. In a sense both the government and its critics are while regulation in Hong Kong is perhaps the best in right. According to an IMF working report issued in Asia, it is far from perfect, and there is much that can be August 2000, Hong Kong’s economy is “neither signifi- done to ensure the HKSE remains the market of choice in cantly more nor significantly less competitive than the the region for top-class firms wishing to raise capital. average OECD country.” Nevertheless, officials have not Officials already have a blueprint for some of the reforms simply dismissed the allegations that Hong Kong’s econ- that need to be made in the form of a report issued in omy is not as competitive as it could be. In 1997 they March 2003 by the government-appointed Expert Group established a competition policy advisory group (CPAG), to Review the Operation of the Securities and Futures and in the following years moved to promote greater Market Regulatory Structure. As the well-known editor of competition in areas such as telecoms and banking. a corporate governance website, David Webb, wrote, The government has also made efforts to liberalise the “While the name of the group may have lacked punch, air services industry. Since the new airport opened in the report certainly did not.” Its central recommenda- 1998, Asia Airfreight Terminals has been offering cargo- tion was that regulatory power over listings should be handling services, breaking the monopoly previously taken away from HKEx, itself a listed company, and enjoyed by Hong Kong Air Cargo Terminals Limited invested in a new Hong Kong Listing Authority under the (HACTL). A third company will soon join the fray: in Octo- main capital markets regulator, the Securities and ber 2002 the Airport Authority awarded the express Futures Commission (SFC). In Mr Webb’s words, the pro- delivery company, DHL, a franchise to develop an express posals would “establish a regulatory framework which is cargo terminal. In June last year the government moved a necessary part of the improvements needed to raise away from its previous policy of allowing only one local Hong Kong to international standards.” carrier to fly any given route, with Dragon Air being On the same day the report was released, the govern- allowed to join the larger Cathay Pacific in flying to ment announced that it had accepted the recommenda- Taipei. This was followed four months later by the signing tions. Whether it implements them, however, remains to of a new US-Hong Kong aviation agreement. While not be seen. While HKEx initially announced it would cooper- enshrining “open skies,” the new accord did give US car- ate with the government in making the changes, a few riers expanded fifth-freedom rights in Hong Kong. (This days later the exchange’s chairman, Charles Lee, said he allows airlines to carry passengers to one country and would send a letter to officials opposing them. This is then fly on to another.) This will perhaps be painful for worrying, mainly because the government has a record Cathay and Dragon, but it is likely to prove useful in bol- of not taking on vested interests. This reticence does not stering the territory’s position as a hub for the air indus- just affect the standard of regulation in Hong Kong. It is try. Reform of Hong Kong’s financial markets will provide also responsible in part for the high costs that our survey a further test of whether the government’s ability to put suggested form the main deficiency in the territory’s the interests of the economy above those of individual business environment. Thus, faced with fierce opposition companies is limited to selected industries only.

Leaping dragon, trailing tigers?

PART II HONG KONG The longevity of logistics

Hong Kong’s role as a gateway for goods and the China-Hong Kong boundary. This not only adds to peoples—by sea, land and air—is also facing direct costs. It also causes delays: a government-spon- new challengers from China. But, again, the sored study to produce a Master Plan for Hong Kong’s logistics development, issued in December 2002, found statistics don’t point to an exodus. And Hong that a truck travelling from Kwai Chung to Dongguan Kong’s strengths make a major migration of would take 7 hours under good circumstances, and more traffic unlikely. than 15 under bad—a considerable length of time for a 100-kilometre journey. Thus, the cost of trucking a Forty- foot Equivalent Unit (FEU) from Dongguan to Yantian is he development of Hong Kong’s services sector around US$180, far below the US$490 needed to send has been promoted by the territory’s position as the container by road to Hong Kong. There is a cheaper an all-purpose gateway, both for China and for option: barging. But while barging an FEU to Kwai Chung T the wider Asian region. This report has already only costs around US$300, it is less convenient. While discussed Hong Kong’s important role as a intermediary trucks can ship one container when it is ready, a barge for services between China and the rest of the world, Tai- needs to wait for other boxes before it can move. wan and China as well as a favoured base for foreign The costs of transporting cargo from factories to ports firms venturing into mainland China and the wider Asia are not the only ones faced by exporters. They also have region. to pay terminal handling charges (THCs), which are Of course Hong Kong’s original strength lay in its role levied by shipping lines supposedly to recover the costs as a trading entrepôt—a role it still plays today. Hong imposed by the terminal operators who load and unload Kong remains the largest port in the world and has containers. While there is little transparency on the posted double-digit throughput growth in two of the last issue, it is common knowledge that THCs are high in five years, and a further 7.4% expansion in 2002. Still, in Hong Kong, not just in comparison with China, but com- some ways, it should not be surprising that port business pared with the rest of the world: according to the Eco- is being diverted away from Hong Kong. The phasing out nomic Services Bureau, in 2001 the THC for sending a of apparel quotas under the ATC and the gradual liberali- TEU to the US was US$274 from Hong Kong, much more sation of China’s customs regulations—which is allowing than Shenzhen (US$141), Taiwan (US$135), Japan larger foreign firms, for example, the unprecedented (US$101), and Shanghai (US$65). It is difficult to deter- freedom to consolidate cargo before shipment from the mine precisely how this situation has come about. The mainland—are just some of the recent developments exporters and shipping lines we spoke to attributed that have reduced the need to re-export goods through some of the responsibility to the oligopolistic power of Hong Kong. Hong Kong’s four terminal operators. These firms, for their part, claim that the charges they levy for use of Last sailing from Hong Kong? their facilities (which they call container terminal And shipping through China can be an attractive option. charges—CTCs) do not tally with the THCs that the ship- Hong Kong, for one thing, is further away than Shenzhen ping lines charge exporters. And all players accept that from factories in the Pearl River Delta. To be shipped from in any case, Hong Kong’s unique port structure, in which Kwai Chung, cargo also has to pass through controls on port development—from the purchase of land to the

TAIWAN, HONG KONG AND THE CHALLENGE OF MAINLAND CHINA

Floating your boat Terminal handling charges for sending a Twenty-foot Equivalent Unit to US (HK$), 2001

274 Hong Kong 141 Shenzhen building of infrastructure—is financed entirely by the 135 Taiwan private sector, would probably make port facilities in the 104 territory more expensive to use than would be the case Singapore with government-funded facilities elsewhere. 101 Japan Shenzhen’s cost advantage does appear to be narrow- 100 Indonesia ing however. The ESB says that between 1995 and 2001 81 South Korea the cost of trucking cargo across the boundary from 78 China fell by around 30%. The gap in THCs also appears Malaysia to be closing. According to the Hong Kong Port and Mar- 62 Thailand itime Board, while average charges in Hong Kong have 65 Shanghai not fallen in recent years, they have not risen either. At 46 Philippines the same time, THCs in Shenzhen do appear to be Source: Economic Services Bureau, Hong Kong Special Administrative Region increasing. Ports in southern China are not monopolised by the government. Rather, Shenzhen has copied the private-sector model of port development from Hong a sophisticated range of supporting services, from trade Kong: indeed, Hutchison International Terminals (HIT), finance to insurance. Importantly, it also has better con- which independently operates 10 of Kwai Chung’s exist- nectivity. In 2002 Hong Kong had more than 160 ocean- ing 18 berths and has an interest in two more, also oper- going sailings per week, compared with just 60 in ates the container port at Yantian, in which it has a 48% Shenzhen. A total of 700 vessels, or approximately two a stake. Admittedly, land costs are not as high in China, day, arrived in Hong Kong from the US during 2002. This 14,582 16,211 18,098 17,826 but they appear to be rising; in any case, it would be sur- is important: a container which misses a sailing to the US prising if a private company faced with an excess of from Shenzhen may have to wait a costly couple of days demand over fixed supply on the scale of that currently for the next one; the delay in Hong Kong, by contrast, in evidence at Yantian did not respond by hiking prices. would be a matter of hours. This appears to keep freight Hong Kong will not price itself out of the market. rates from Hong Kong down: according to the Economic While being more expensive than ports across the bor- Services Bureau, the ocean freight charge in 2001 for a der, Hong Kong’s port has other strengths, such as deep consignee in the US would have been US$2,110 for an water (its only competitor in the region in this respect is FEU shipped from Yantian, but US$1,810 for one sent Yantian), more efficient document handling services, from Hong Kong. streamlined customs procedures, and the availability of Clearly, connectivity and documentation procedures

Shipshape Shipping volumes by port ('000 TEU) 1998 1999 2000 2001

7000

6000

5000

4000

3000

2000

1000

0 Guangzhou Shekou Yantian Shanghai Tianzin Ningbo FuzhouKeelung Taichung Shantou Chiwan Quingdao Xiamen Dalian Kaohsiung

CHINA TAIWAN HONG KONG

Source: Hong Kong Port and Maritime Board, Taiwan Ministry of Transport and Communications, Guangdong/Shanghai Statistical Yearbook, The Report on China's Shipping Development.

Ocean Air Still afloat? Hong Kong exports by mode of transportation Land Other (HK$ bn)

700

600

500

400

300

200

100

0 1990 91 92 93 94 95 96 97 98 99 2000 01 Source: Census and Statistics Department, Hong Kong Special Administrative Region

are improving in China. But it will take years for China to the HK$1.3trn of water-borne cargo. Air cargo has also develop the depth and breadth of supporting services been growing robustly. After growing by 6% a year in that has been a critical factor in Hong Kong’s strength as 1995-98, the volume of air cargo handled expanded by a shipping hub. In any case, even if Hong Kong’s non- 12% a year in 1999-2002. The proportion of Hong Kong’s cost lead does eventually disappear, its port operators total international trade carried by air has increased have every incentive to cut THCs to ensure Kwai Chung steadily in recent years, rising from 17.7% in 1992 to retains a role: these private firms have after all invested 27% in 2001. huge amounts in the development of the port infrastruc- As in the container port industry, it is indisputable ture. Hong Kong will not retain its position as the world’s that Hong Kong’s position as a pre-eminent air hub has busiest port forever, but it will remain an important ship- been partly due to the low level of development of the ping hub for sometime to come. mainland’s airport infrastructure. And as with sea ports, the mainland is now beginning to catch up. A new, mod- Hong Kong spreads its wings ern terminal in Beijing and the flashy Shanghai Pudong In some ways, the focus on water port TEU throughput is airport both opened in 1999. There are also four interna- unhelpful. As one port operator explained to us, some tional airports within 100km of Hong Kong, in Macau, ports have recorded increases in throughput that were Zhuhai, Shenzhen and Guangzhou. The largest, the over- not organic, but rather merely the result of expansion in crowded Guanzhou Baiyun Airport, recorded passenger the geographical scope of a particular port authority, and cargo throughput of 12.8m and 0.5m tons respec- motivated by a desire to appear on the list of the world’s tively in 2001. A new airport is, however, being built top ten container ports. More seriously for Hong Kong, which will have the capacity to handle 25m passengers the attention given to the issue of port throughput and 1m tons of cargo a year. Airports in China also enjoy growth risks detracting from the territory’s expansion as a considerable price advantage over the HKIA: Hong an air hub in recent years. In 2001 the Hong Kong Inter- Kong has a higher cost base in any case, and historically national Airport (HKIA) at Chek Lap Kok was the fifth there has not been much competition thanks to the dom- busiest in the world in terms of international passenger inance of one cargo handling firm, Hong Kong Air Cargo throughput, with 32m travellers using its facilities; the Terminals Limited (HACTL), up until the late 1990s. airport was even busier in 2002, recording passenger China’s air connections with the rest of the world have throughput of 33.5m. The airport is also the world’s also improved markedly in recent years: the number of largest hub for international air cargo. The weight of weekly international departures from Shanghai rose cargo moved might sound small: in 2002 just 2.5m tons from 41 in 1985 to 554 in 2002, and from Beijing, from compared with the 192.5m tons handled by Hong Kong’s 44 to 405. sea ports. But air cargo is much more valuable. Air trade Still, Hong Kong’s competitive position as an air hub in 2001 amounted to HK$824.1bn, not much less than remains strong. This is partly because of the availability

Direct links and Hong Kong

Hong Kong is the favoured stopping-off point Hong Kong could even continue to remain Guangdong. for cargo and passengers travelling between an important hub for cross-Strait trade that is Big bang or not, visitor numbers to Hong Taiwan and China. The territory will therefore not related to southern China, thanks to Kong are still likely to be hurt by this change be hurt when direct cross-Strait transport political semantics from Beijing. China has in policy, although the effect on the broader links are finally established. Hong Kong’s traditionally defined cross-Strait transport economy would be muted. Visitors from Airport Authority thinks direct links would links as “domestic.” Therefore only local firms Taiwan to Hong Kong are outnumbered only affect 8% of the current passenger flow are allowed to provide transport services. This by those from mainland China. Taiwan through HKIA. In 2001, air cargo to and from policy already affects the conduct of cross- visitors are, however, the shortest staying— Taiwan generated 13% of total throughput at Strait trade. While single vessels from Taiwan in 2002 almost 80% left the same the day as Chek Lap Kok. In terms of ocean freight, the and China (albeit sailing under flags of arriving—and consequently do not spend Hong Kong Port and Maritime Board (PMB) convenience and via the waters of a third much—a modest HK$4,422 a head in 2001, thinks that in 2001 cross-Strait trade via destination) can already carry local cargo less than visitors from all regions except non- Hong Kong accounted for 1.1m TEUs, or 5.9% between the two sides, foreign ships have to China Asia. Much will depend on whether the of Hong Kong’s total throughput. trans-ship such goods en route, usually in opening of direct transport links will be Not all of this business will, however, be Hong Kong but sometimes in Korea. In recent accompanied by an easing of restrictions on lost. It is difficult to believe that cargo and months leaders in Beijing have suggested an direct cross-Strait financial flows. Without people wishing to travel between Taipei and, easing of the “domestic” definition. It is not the latter, many Taiwan managers of say, Shanghai, would first pass through Hong clear, however, what practical significance is mainland-based businesses will continue to Kong if they could possibly avoid doing so. heralded by this change in rhetoric. A failure visit the territory to do their banking. But with Taiwan businesses having invested to grant foreign players so-called cabotage Whatever happens, Hong Kong won’t be so heavily in Guangdong province, it is clear rights would help Hong Kong remain an as hard hit by the establishment of direct that much of the cross-Strait trade passing important hub for cross-Strait trade. transport links as some other areas. Around through Hong Kong is actually bound for In any case, do not expect a “big bang” 60% of the passengers passing through southern China. In an apparent indication of opening of direct links. Ports and airports in Macau’s airport, for example, are flying this, only 20% of the Taiwan-related cargo China are likely to be opened up to links with either to or from Taiwan. The Japanese handled by HACTL in 2002 was in direct Taiwan on a selected basis. A wild and island of Ishigaki would also be affected. The transit (although some of the remainder reckless opening would be unpopular. With island has become an important transit point could have been destined for northern China direct links in the first instance being for local vessels passing indirectly across the after consolidation by a local importer in limited, there will still be demand for the Taiwan Strait. According to the Ishigaki Hong Kong). The PMB estimates around 60% Taiwan-Hong Kong-China route. Moreover, branch of the Okinawa Regional Customs of the cross-Strait TEU’s passing through China’s government could select to open Clearance Office, 3,265 boats called at Hong Kong is related to southern China. If, as areas for links in a way that limits the impact Ishigaki for clearance in 2002, accounting we have suggested likely, Hong Kong on Hong Kong, in particular by excluding for 93% of all visits registered by the port. manages to remain competitive vis-à-vis the Guangdong. This would not be without With each boat paying around US$3,000 in sea and air ports in Guangdong, it is likely to precedent. One industry participant told us port fees, this business provides a retain a large portion of South China-related that all ports in China are open for “direct significant source of business for the local cross-Strait trade. links via a third area” except those in community.

of the same supporting services that make it such an these streamlined customs procedures, trucks can make important place for the shipping industry. The physical the trip between HKIA and Dongguan in just four hours. infrastructure is also excellent: the HKIA, which cur- In 2001 a Marine Cargo Terminal was opened, linking the rently has the capacity to handle 45m passengers and 3m airport to 20 river ports in the Pearl River Delta. Finally, tons of cargo a year, is generally regarded as one of the Hong Kong also still enjoys a wide lead over the main- best airports in the world. Progress has also been made land in terms of connectivity with the rest of the world. in reducing transit times to and from China. Under In 2001 the airport was serviced by more than 65 airlines HACTL’s branded SuperLink China Direct service, flying to 90 international destinations (and 40 in main- launched in 2000, cargo arriving at HKIA is carried in land China). Between April 2001 and March 2002, HKIA sealed trucks across the Hong Kong-mainland boundary, registered over 84,000 passenger plane landings, up with final China customs clearance not happening until from 68,000 in the same period four years earlier. the goods reach the final destination in the PRD. With It should be clear then that Hong Kong’s strength as a

hub for the sea cargo and air industries is based not just Hong Kong with the western side of the PRD. This would on physical infrastructure, but also on streamlined pro- seem to make sense from Hong Kong’s point of view: it cedures and the availability of a wide range of support- would make the territory the geographic focal point of ing services. This is important: while it is relatively the region. It could also be good for China. The 2022 straightforward for the authorities in China to build sea Foundation report on the PRD argues that, by opening up ports and airports, creating an advanced soft infrastruc- the west of the delta for investment by Hong Kong firms, ture is a much more complicated and lengthy affair. the bridge would trigger a similar process of develop- Hong Kong cannot rest on its laurels. With a large ment to one that occurred in the east after local compa- proportion of cross-Strait cargo and passenger flows nies started to move there in 1978. As we have seen in being routed through Hong Kong, the territory will terms of soft infrastructure, significant steps have been clearly be adversely affected when direct transport links taken in recent years to liberalise the both air cargo han- between China and Taiwan are finally established (the dling and the airline industry itself. These changes will impact is, however, likely to be smaller than commonly introduce more competition, and will bolster Hong thought—see box, Direct links and Hong Kong). And Kong’s position as an air services hub. while development of the necessary infrastructure will The recent SARS outbreak in Hong Kong and China not be completed overnight, it is clear that cities on the has thrown Hong Kong’s tourist industry into a tailspin. other side of the boundary have ambitions to serve as Prior to this worrying development, Hong Kong’s contin- major hubs for the cargo and people that originate in the ued status as an important air hub looked certain to sup- Pearl River Delta. port future growth in the local tourism industry. Hong Kong authorities cannot do much about the first According to the World Tourist Organisation, China will development but a two-pronged approach can be used to become the world’s most visited country by 2020. An used to address the second: cutting the cost of cross- increasing proportion of these people will fly directly to boundary transport, and improving Hong Kong’s soft and from China, but the numbers being hubbed through infrastructure. The government has been moving ahead Hong Kong could continue to grow even as the territory on both fronts. For example, the Western Crossing, a loses market share; in any case, Hong Kong’s peculiar 5.1km dual three-lane bridge linking Hong Kong with history and spectacular skyline are likely to continue to Shenzhen, is due to be opened in 2005. Transport links prompt people visiting China to include the territory as will be further enhanced if proposals laid out in the an add-on. Hong Kong’s attractiveness will also grow December 2002 Master Plan, such as new rail and road once the territory’s Disneyland opens in 2005. This logistics pipelines linking Hong Kong to the east of the theme park will also pull in more people from the main- PRD, and a new sea link to the west, are implemented. land, especially from the south who, with easing visa Proposals have also been revived for a bridge linking restrictions, will anyway find it easier to visit Hong Kong.

Leaping dragon, trailing tigers? Conclusion

Ignoring the challenge presented by greater for the economy. The development of a better infrastruc- economic integration will only harm the ture is also key, if Taiwan is to benefit fully from direct economies of Taiwan and Hong Kong. The links. But President Chen and others need to realise that the absence of direct links could soon destroy certain challenge is to strengthen links while industries—not protect them. Service sector develop- introducing reforms at home. ment has undoubtedly already been badly damaged by restrictions on trade with the mainland. Hong Kong’s government is currently struggling to At moments of great change, risk and reward can be dif- find a clear policy direction, buffeted by troubles not all ficult to balance. The rapid development of economic of its own making. Officials in the territory understand, links between China, Taiwan and Hong Kong has been however, that openness to China was an important factor driven by businessmen seeking substantial future finan- behind the rapid rates of economic development cial rewards. Against this, links have frequently been achieved in the 1980s and 1990s. It should therefore not held back by politicians or other groups worried about be surprising that rather than worrying over-much about real or imaginary risks—about the “hollowing out” of Tai- the seemingly inexhaustible advantages enjoyed by the wan or Hong Kong industry, for example. mainland, officials in Hong Kong are now talking of The good news is that optimism has so far triumphed improving further the cross-boundary flow of goods and over caution. As discussed above, Taiwan’s extensive people. Shrinking from the challenge of China is not an regulations about investing in the mainland have failed option—but neither is ignoring the challenge from to control Taiwanese firm’s investment on the mainland. vested interests at home. Just as important in securing At the same time Taiwan’s industrial base has not been the territory’s economic future will be a willingness to destroyed, as some had feared, but has had to upgrade— tackle entrenched local constituencies, ranging from in textbook fashion. In a rather different way, Hong civil servants to large local businesses, that have in the Kong firms have replaced domestic production capacity past prevented Hong Kong’s economy from being as free, with trading and intermediation with production on the efficient and well-supervised as is often claimed. Offi- mainland—to both sides’ substantial benefit. cials have shown some sporadic willingness to address The bad news is that governments have yet to catch this issue, but have yet to demonstrate the political will up completely with reality. This will limit their ability to to adopt the comprehensive approach that is needed. capitalise on future gains. Closer links between China, Hong Kong and Taiwan Taiwan’s government has yet to grasp all the implica- will continue to present risks to certain sectors. But gov- tions of integration. President Chen is right to say that ernment policies—from all sides—should now focus on establishment of direct links would not be a “cure-all” the rewards.

Leaping dragon, trailing tigers? Appendix: Survey results

The Economist Intelligence Unit conducted two surveys Methodology for this report, one targeted at major companies in Tai- Both surveys were conducted in March 2003 via email wan the other at senior executives of multinational com- and the Internet. Additional follow-up was provided by panies with a base in Hong Kong. The broad aim of the trained telephone surveyors. Results were compiled, and surveys was to elicit responses on whether and if so, conclusions drawn, by analysts at the Economist Intelli- how, the respondents’ businesses are adapting to the gence Unit in Hong Kong. surge in growth of the mainland China economy. The two The Hong Kong survey was distributed electronically surveys differ, of course, in their substance. The issue for to some 1,000 multinationals. Of the total of 84 Taiwan is to determine to what degree Taiwan corporate responses, six were declared null and void, and the investment in mainland China is having an impact on the remaining 78 (just under 8%) viable and usable. island’s economy. Is it contributing to the “hollowing The Taiwan survey, conducted in Chinese, was distrib- out” of the economy, as some believe, or is it, to take the uted electronically to some 550 Taiwan “Innovalue” opposite view, a healthy indication of comparative firms, so designated by the China External Trade Devel- advantage at work as Taiwan moves itself upwards on the opment Council (CETRA) for their innovative products economic ladder into higher value-added manufacturing and trading and investment practices. Innovalue firms and services? Additionally, the Taiwan survey sought to represent, by and large, the biggest and most successful understand to what extent the lack of direct links (trans- companies in Taiwan, many of them IT manufacturers port, human and capital) between Taiwan and China is (chip-maker TSMC, computer peripherals producer BenQ having an impact on cross-Strait investment and eco- and notebook computer maker Compal among them). A nomic activity, and whether a lifting of restrictions on total of 77 responses were received (a roughly 12.6% direct links would be advantageous, or otherwise, for response rate), with 69 being viable and usable. Taiwan’s businesses and economy. Our Hong Kong survey had different antecedents. As an international services centre, Hong Kong’s evolving inter-dependence with China requires us to understand the dynamics of regional management structures and headquarters, an issue central to the territory’s present economic structure and strengths; in particular we have sought to determine to what degree China’s economic emergence, among other things, is affecting the location strategies of global corporations and their regional operations.

Companies already invested in China Assuming full air and sea direct links are What policy initiatives are needed to established in 2003, how would your ensure Taiwan’s economic growth? investment plans be effected? Improved domestic infrastructure 39 What are your investment plans over the Taiwan China Establishment of direct links to China 35 next 3 years? Increase 16 28 Reduced taxes 22 Taiwan China No change 29 20 Ending of restriction of flow of goods Increase 27 43 Decrease 1 1 between Taiwan and China 14 No change 15 3 Other 8 Decrease 2 1 Is there truth to the perception that Taiwan companies do not bring profits If you think direct links are essential, earned in China back to Taiwan? And if please rank the following according to If you plan to increase investment in yes, why? China, why? their importance to your business yes no respondents Most 2nd Total 5 45 important most least Increasing demand in China’s domestic market 36 Tax 1 Transport: direct sea and air links 28 15 3 Because of increasing global demand 23 Restrictions on links between Taiwan and China 3 Financial: Expand marketing and service 23 Fear of government a loosening of Expand production facilities 17 inquisitiveness 0 restrictions on Expand research and development 13 Need to re-invest in China 3 capital flows 17 20 9 Other 0 Lack of domestic investment People: a loosening opportunities 2 of restrictions on mainland people If you plan to increase investment in travelling to work Taiwan, why? What does the government need to do in Taiwan 2 10 34 respondents to encourage the return of profits: Expand research and development 34 respondents Expand marketing and service 21 More incentives made available 7 Expand production facilities 10 Improve investing environment for businesses in Taiwan 4 Since investing in China have staff Solve the tax problem 4 nos./the wage bill: Stabilise the financial policy 3 staff nos. wage bills Facilitate production upgrade 1 Increase 14 20 No change 17 14 Does your mainland subsidiary have a Decrease 16 15 banking relationship with a Chinese bank? respondents How much of a hindrance to your business is the lack of direct cross-Strait links with Yes 32 China? No 18 air sea No effect 9 12 How big a hindrance to big business Inconvenient 17 18 is the absence of functioning Taiwan banks on the mainland? Very inconvenient 23 19 Very significant/inconvenient 10 If direct cross-Strait links were Not significant. At present Taiwan banks established, which would be most are establishing a presence in China 10 important to your business? Quite significant 4 total An obstacle to sales expansion 1 Time saved travelling 7 Freer movement of people 5 Are you optimistic or pessimistic Costs saved travelling 1 about Taiwan’s economic future? All of above 36 respondents Pessimistic 26 Optimistic 24

Companies not yet invested in China If you think direct links are essential please rank the following according to their importance to your business Most Why have you not invested in China? important 2nd most 3rd Least respondents Transport: direct sea and air links 11 7 2 1 Lack of direct transport links Financial: a loosening of restrictions on capital flows 8 6 6 0 between Taiwan and China 14 People: a loosening of restrictions on travel 1 6 12 0 Financing difficulties due to lack of Taiwan banks on the mainland 8 Government restrictions 6 Concerns over intellectual property 6 Other 7

Do you plan to invest in China in the next 3 years? If yes, why? yes no Total 13 10 Increasing need to tap domestic China market 11 Hope that direct cross-Strait transport links will be established 6 Hope that direct cross-Strait financial links will be established 5 Improvement in China’s business environment 8 Other 2 Other specified 0

After investing in China do you expect staff nos. in Taiwan to: respondents Increase 5 No change 10 Decrease 5

Are you optimistic about Taiwan’s economic future? respondents Pessimistic 13 Optimistic 9

What policy initiatives are needed to ensure Taiwan’s economic future? respondents Establishment of direct links with China 18 Improved domestic infrastructure 15 Reduced taxes 13 Other 3

Location status Why? If finance and treasury activities have respondents been consolidated in Hong Kong where have they moved from? What is the present status of your office Shift of corporate focus from SE Asia in Hong Kong? to China in particular 17 respondents respondents Shift of corporate focus from SE Asia Singapore 6 to NE Asia in general 8 Asia-Pacific regional HQ 42 Tokyo 3 Other 15 China/greater China HQ 18 Beijing 2 Northeast Asia regional HQ 5 Shanghai 2 Other 13 If strategic management and decision- Other 14 making activities have been moved away from Hong Kong, where have they been Why have they moved? How long have you had an office in Hong relocated to? respondents Kong? respondents respondents Shift of corporate focus from SE Asia to Shanghai 16 China in general 12 Between three and six years 6 Beijing 5 More than six years 69 Shift of corporate focus from SE Asia to Singapore 3 NE Asia in general 5 Less than three years 3 Tokyo 0 Other 8 Other 13 If finance and treasury activities have Strategic management and decision Why? moved away from Hong Kong, where have making respondents they been relocated to? Need to be closer to major market 23 respondents What trends characterise changes in your To save on labour and property costs 4 Shanghai 11 strategic management and decision Singapore 5 making activities in Hong Kong over the Other 8 last three years? (you may choose more Beijing 3 than one) What is likely to happen to your strategic Tokyo 0 respondents management and decision-making Other 12 activities in Hong Kong over the next Expansion due to increase in size of China business 33 three years? Why? Expansion due to increase in size of Asia respondents respondents Pacific business 23 Downsizing 35 To be closer to major market 14 Expansion due to consolidation in Hong Expansion 31 To save costs 6 Kong of activities previously undertaken elsewhere in the region 11 Other 10 Downsizing due to migration to elsewhere in the region of activities previously Finance and treasury What is likely to happen to your finance undertaken in Hong Kong 22 and treasury activities in Hong Kong over Downsizing due to reduction in size of Asia What trends characterise changes in your the next three years? Pacific business 5 finance and treasury activities in Hong respondents Downsizing due to reduction in size of China Kong over the last three years (you may Expansion 27 choose more than one option) business 0 Downsizing 24 Other 15 respondents Expansion due to increase in size If strategic management and decision- of China business 26 making activities have been consolidated Expansion due to increase in size in Hong Kong, where have they moved of Asia Pacific business 18 from? Expansion due to consolidation in HK respondents of activities previously undertaken elsewhere in the region 9 Singapore 10 Downsizing due to migrationto Shanghai 3 elsewhere in the region of 14 Tokyo 3 Downsizing due to reduction in size Beijing 2 of Asia Pacific business 6 Other 17 Downsizing due to reduction in size of China business 1 Corporate activites previously undertaken in HK Other 14

Marketing and distribution What is likely to happen to your Why? marketing and distribution activities in respondents Hong Kong over the next three years? What trends characterise changes in the To be closer to major market 14 nature of your marketing and distribution respondents To save costs 13 activities in Hong Kong over the last three Expansion 26 Other 6 years? (you may choose more than one) Downsizing 25 respondents What is likely to happen to your Expansion due to increase in size marketing and distribution activities in of China business 31 Back-office services Hong Kong over the next three years? Expansion due to increase in size respondents of Asia Pacific business 22 What trends characterise changes in the Downsizing 36 Expansion due to consolidation in Hong Kong of activities previously nature of your back-office activities in Expansion 10 undertaken elsewhere in the region 7 Hong Kong over the last three years? (you may choose more than one) Downsizing due to migration to elsewhere in the region of corporate activities respondents previously undertaken in Hong Kong 13 Expansion due to increase in size of Downsizing due to reduction in size Asia Pacific business 12 of Asia Pacific business 4 Expansion due to increase in size of Downsizing due to reduction in size China business 14 of China business 2 Expansion due to consolidation in Hong Other 12 Kong of activities previously undertaken elsewhere in the region 3 Downsizing due to migration to elsewhere If marketing and distribution activities in the region of corporate activities have been consolidated in Hong Kong previously undertaken in Hong Kong 20 where have they moved from? Downsizing due to reduction in size of respondents Asia Pacific business 4 Shanghai 4 Downsizing due to reduction in size of Singapore 4 China business 2 Tokyo 4 Other 22 Beijing 0 Other 15 If back-office have been consolidated in Hong Kong, where have they moved from? Why? respondents respondents Shanghai 5 Shift of corporate focus from SE Asia Singapore 5 to China in particular 19 Tokyo 2 Shift of corporate focus from SE Asia Beijing 0 to NE Asia in general 3 Other 11 Other 6 Why If marketing and distribution activities respondents have moved away from Hong Kong where Shift of corporate focus from SE Asia to have they been relocated to? China in particular 15 respondents Shift of corporate focus from SE Asia to Shanghai 16 NE Asia in general 3 Beijing 5 Other 6 Singapore 1 Tokyo 0 If back-office activities have moved away Other 11 from Hong Kong, where have they been moved to? Why? respondents respondents Shanghai 14 To be closer to major market 26 Singapore 3 To save costs 3 Beijing 1 Other 3 Tokyo 0 Other 11

General What policy initiatives are need to secure Hong Kong’s economic future? respondents More efficient transport and communication links with mainland China 43 Are you optimistic or pessimistic about Improved domestic infrastructure 14 Hong Kong’s economic future? Reduced taxes 19 respondents Political reform 31 Optimistic 34 Action to increase competition in the domestic economy 43 Pessimistic 27 Other 15 Other 10 How important are the following factors in the decision as to where to locate corporate activities (please indicate on a scale of 1:5, with 5 being the most important) 12345 Availability of skilled managers/support staff 3 5 9 16 35 Availability of English-language skills 3 7 12 26 16 Availability of professional support services 2 3 18 25 14 Transport and communications infrastucture 6 2 16 30 15 Low property, utility and staffing cost 5 6 27 17 11 Political stability 0 6 11 21 28 Stable economic policy environment 0 3 14 22 26 Benign tax regime 3 8 12 30 14 Ease of access to national market 3 7 12 24 19 Ease of access to regional markets 1 3 15 22 22 Transparent legal and regulatory environment 0 2 10 24 31 Other 0 0 0 2 5

How does Hong Kong rate in these areas? 12345 Availability of skilled managers/support staff 2 7 15 23 24 Availability of English-language skills 1 8 27 24 7 Availability of professional support services 2 1 11 23 28 Transport and communications infrastucture 1 1 3 22 43 Low property, utility and staffing cost 16 23 21 4 0 Political stability 2 2 16 28 19 Stable economic policy environment 2 7 16 33 7 Benign tax regime 23 3 6 25 30 Ease of access to national market 5 4 14 20 22 Ease of access to regional markets 2 2 9 31 24 Transparent legal and regulatory environment 1 0 6 30 33 Other 1 1 0 1 1

How does mainland China rate in these areas? 12345 Availability of skilled managers/support staff 2 21 31 11 3 Availability of English-language skills 4 25 30 5 1 Availability of professional support services 3 24 26 9 0 Transport and communications infrastucture 4 17 39 6 1 Low property, utility and staffing cost 0 3 18 27 19 Political stability 5 4 35 17 6 Stable economic policy environment 1 9 34 17 3 Benign tax regime 12 16 27 10 0 Ease of access to national market 1 7 21 16 20 Ease of access to regional markets 7 20 20 13 4 Transparent legal and regulatory environment 16 26 16 3 2 Other 1 1 0 0 2