Microsoft Word - HK-SMEs-Primer by Civic Exchange

Hong Kong SMEs The primer

See also the sister volume Hong Kong SMEs â&#x20AC;&#x201C; Market strategy

Christine Loh cloh@civic-exchange.org (852) 9802 8888

April 2002

Hong Kong Value creators

Rediscovering Hong Kong's strengths Hong Kong & Asian capitalism Hong Kong's business culture Industrialisation and reindustrialisation China rejoins the world Services unlimited Hong Kong's metropolitan economy Policy implications

Nimble and nifty Transforming Hong Kong www.clsa.com Find CLSA research on Bloomberg (CLSA <go>), firstcall.com, multex.com, and use our GEMinerÂŽ database @ clsa.com

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Contents

Executive summary........................................................................... 3

Introduction ..................................................................................... 4

Hong Kong & Asian capitalism........................................................... 9

Hong Kongâ&#x20AC;&#x2122;s business culture ......................................................... 14

Industrialisation and reindustralisation .......................................... 19

China rejoins the world ................................................................... 29

Services unlimited........................................................................... 35

Hong Kongâ&#x20AC;&#x2122;s metropolitan economy ................................................ 42

Policy implications .......................................................................... 55 All prices quoted herein are as at close of business 17 April 2002

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April 2002

Executive summary

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SMEs – Nimble and nifty Rediscovering Hong Kong’s strengths

Hong Kong is going through a period of “creative destruction” that will result in a new socio-economic order. The outcome will be the emergence of a new group of corporate and political leaders over the next five to 10 years.

Hong Kong & Asian capitalism

Hong Kong’s mission is to drive market capitalism in China. Today, South China is the nation’s major export value creator, powered by an impressive private sector that has been deeply influenced by Hong Kong.

Hong Kong’s business culture

No community has had to transform itself to become a metropolitan, fullservice economy within a decade and a half. Hong Kong remains highly competitive in its core competencies. The crowding out of low value-added activities is a sign of transformation, not decline.

Industrialisation and reindustrialisation

Hong Kong’s economic strengths are in light-industrial manufacturing – a sector that has been overlooked. Hong Kong is an undisputed powerhouse in the trading and managing production capacities all over the world. This is a highly sophisticated business that requires entrepreneurial flair and strong management skills: a unique combination.

China rejoins the world

This sector is the domain of the SMEs, who since the 1980s have expanded their capability manifolds by moving production to the Pearl River Delta. Hong Kong’s physical and cultural proximity to China remains a major competitive advantage. SMEs are combining the the world’s lowest-cost manufacturing at their backdoor with the management skills developed in one of the most entrepreneurial city-states.

Services unlimited

The SMEs have invested steadily in upgrading every aspect of the supply chain. They produce and help design some of the world’s best-known brands, particularly in electronics, garments and accessories, as well as toys. With China opening up its markets under the WTO schedule, Hong Kong’s SMEs are well poised to develop their own brands for what is finally a “home” market for them to grow. Dramatic growth in services complements Hong Kong’s manufacturing expansion and wealth accumulation.

Hong Kong’s metropolitan economy

Hong Kong’s SMEs have a strong record in value creation. By and large, they are doing well even during tough times. Many of the competitive players are still in private hands and have the potential to list as they require more capital to exploit the China and international markets.

Policy implications

As much of Hong Kong’s companies start to operate outside the SAR, the government will have to review its taxation system which presently does not collect revenues from activities abroad. In the main, the authorities need to understand where bottlenecks and inefficiencies lie, allow more efficient economic integration and infrastructure rationalisation with the Pearl River Delta, and let market forces work to bring about the adjustment in costs for the economy to grow according to where competitive advantages lie.

April 2002

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Introduction

Rediscovering Hong Kong's strengths A common view about Hong Kong’s problems …

In the current economic context, Hong Kong continues to make painful and short-term adjustments as unemployment rises, credit demand remains low, the budget deficit widens, deflation continues, and the linked-exchange rate to the US dollar makes Hong Kong uncompetitive. Some say that the cost of doing business in the city is still high and, with cheaper business centres elsewhere, Hong Kong may see more corporate relocations in the future. Most importantly, Hong Kong people seem to be losing self-confidence.

Alternative view … but it misses an important perspective

There is another compelling perspective. Hong Kong has already made some serious adjustments and is in more robust health than many other economies around the region. Prices have fallen substantially reflecting internal costprice flexibility. Research shows that companies have increased their productivity in order to meet the challenges presented by the Asian financial crisis since 1998 and the order books of the manufacturing firms, which are Hong Kong’s hidden strengths, are showing signs of growth. Hong Kong’s export of services has increased every year since 1993. Moreover, Hong Kong companies are strong investors outside Hong Kong. The city’s stock of investments abroad is at record levels and continues to rise. Hong Kong’s banking system is sound and its overall regulatory regime is in good shape. This is a picture of considerable strength, not weakness. Currently overshadowed by a psychology of gloom, it points to a source to reverse that psychology with a slight shift in perspective. Figure 1

A picture of strength, not weakness

Hong Kong net external claims, March 94 to November 01 6,000 5,000 4,000 3,000 2,000 1,000 0 Dec-90

Apr-92

Aug-93

Dec-94

Apr-96

Aug-97

Dec-98

Apr-00

Aug-01

Source: CEIC

Discipline of the peg

There is a tendency to look for scapegoats during tough times. Hong Kong’s linked-exchange rate gets its fair share of beating. It is easy to forget that competitiveness is determined by the efficiency of the economy. The peg has been in place for 18 years during politically uncertain times and has had an enormous confidence-boosting effect. What is less well appreciated is that the discipline of the peg has created a de-politicised force to get Hong Kong businesses to go up the value chain in order to remain competitive. This driving force is at work right now.

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April 2002

Introduction

Lower-end jobs are relocating but this is not all bad

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Lower-end value services are relocating to cheaper places and unemployment is likely to rise further, but the upside is that Hong Kong is transforming itself into a higher-end service economy. The pain of dislocation is real for those who find it hard to cope with rapid change. As with other major, successful metropolitan economies, low value-added activities are being crowded out by higher-value ones. This is a sign of transformation, not decline.

Process of creative destruction A new socio-economic order is being fashioned before our eyes

Make no mistake, however. What we are witnessing now in Hong Kong is a period of “creative destruction” that will result in the creation of a new socioeconomic order. There will be winners and losers in this process – and the outcome will be the emergence of a new group of corporate and political leaders. We may see some Hong Kong companies join the group of the world’s largest enterprises with China as a “home” market for their development and growth. New wealth will be created. The new pecking order will affect all aspects of the economic system, including the structure of the financial markets.

What we overlooked ... light industries

In the days when the property sector was king and then during the subsequent, albeit brief, dot.com era, Hong Kong’s manufacturing sector appeared old and tired. But after a flirtation with the so-called “new economy” sweethearts, “old economy” firms no longer look so bad. Hong Kong’s manufacturing sector needs to be brought in from the cold, particularly at a moment when we try to identify areas for long-term growth. This sector is mainly the domain of the small and medium enterprises (SMEs), which remains in good health and as entrepreneurial as ever. The foundations for this exceptional economic situation are well established and date back to the 19th century.

Light industrial powerhouse Hong Kong is the world’s most impressive light manufacturing powerhouse

Hong Kong companies constitute a manufacturing powerhouse for light industrial goods. This is often missed as production takes place outside of the territory – in China, particularly in the Pearl River Delta, and in other parts of the world. Hong Kong remains the world’s largest production manager and trader in certain industries, including textiles/garments, footwear, toys and electronics – basic products for which there is a constant demand.

A reminder: Hong Kong’s strengths

Hong Kong’s SMEs

April 2002

Hong Kong ranks first in the world in terms of export value in clocks, calculators, radios, electrical hair apparatus, telephone sets, imitation jewelry, toys and games, travel goods and handbags, and artificial flowers.

Hong Kong ranks second in the world in terms of export value in clothing and textiles, watches, electric food processing equipment, fur clothing, and umbrellas.

Hong Kong has approximately 290,500 small- and medium-size enterprises (SMEs), with 120,000 of them engaged in manufacturing. While the bulk of the production takes place in China, the more savvy SMEs produce or manage production globally. Another 10,000 plus companies are engaged in logistics and communication, including many firms in the transportation of goods. Thus, it could be said that half of all the SMEs are engaged in the physical aspects of the manufacturing supply chain.

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Introduction

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Small caps shed light on Hong Kong’s light industrial strength

Officially, manufacturing SMEs are defined as those with fewer than 100 employees. There are of course also many manufacturing companies that employ more people and thus are not classified as SMEs. They need to be included in an overall assessment of Hong Kong’s manufacturing prowess. This report refers to all of them as SMEs, including the small-cap listed companies. It is through the listed entities that a better assessment can be made since it is hard to get accurate information on private companies. Many of the leading Hong Kong manufacturing companies are still privately held. Since the top firms, listed or private, are among the world’s top companies in their fields with many having been in business for a considerable period of time, they are likely to be profitable and value-creating.

Hong Kong manages a global supply chain with the PRC as its largest base

Those that provide supply-chain support are mostly smaller service companies, including design, logistics and professional support services. Officially, service-sector SMEs are defined as those with less than 50 employees, though these sectors have many firms with higher levels of staff, including the major legal and accounting firms. It should not be forgotten that there are over 180,500 Hong Kong-funded investment projects in China, most of them engaged in supply chain activities. This figure represents 55% of all foreign-invested projects for China. The majority of the Hong Kong-funded projects (65%) are engaged in light industrial exports with an additional 14.5% in import/export activities, which are closely related to manufacturing. These investments need active management services, which are mostly supplied out of Hong Kong based firms.

Hub for high-valued manufacturing-related services

In other words, Hong Kong is a services hub for high-value manufacturingrelated services. All indications are that these services will grow in Hong Kong in the coming few years as Hong Kong continues to invest in smoothing out supply-chain services. Moreover, as China continues to open her markets, Hong Kong-based service providers will have even greater opportunities.

Hong Kong helped to create China’s largest private-sector base in Guangdong …

Hong Kong and Guangdong Province have always had close ties. The symbiotic relationship that exists between them goes back more than a hundred years. After World War II, Hong Kong became the dominant trade and commercial centre in the region, especially after China closed its doors to the outside world. However, since the reopening of China in 1978, Beijing’s pragmatism has enabled Hong Kong to play a role in introducing private enterprise on the mainland by moving Hong Kong’s industrial capacity across the border to South China. Surveys indicate that perhaps 60% of Hong Kongfunded investment projects are based in the south. The Pearl River Delta is now the wealthiest region of the mainland and is held up as a model for other regions to emulate.

… producing high-tech products

As more land and manpower became available, Hong Kong’ manufacturing base across the border enjoyed manifold increases, although the general impression in Hong Kong is that the city’s manufacturing has disappeared. It is also commonly believed that manufacturing involves low-tech production of relatively poor quality goods. That is certainly not the case today. Most of the factories under Hong Kong management produce goods for foreign labels and a good number are highly sophisticated. These facilities include state-of-theart factories that are as well managed as any of the best factories in the world. What sets Hong Kong companies apart from lower-cost competitors is their ability to manage global production efficiently and this is the key reason why they have remained competitive. Hong Kong firms tend to view China’s membership in the World Trade Organization (WTO) as positive for Hong Kong business. cloh@civic-exchange.org

April 2002

Introduction

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Hong Kong companies know best how to navigate the Chinese markets

Hong Kong companies are run by experienced managers of production capacities and processes. As China becomes the world’s cheapest producer for a whole variety of goods, Hong Kong companies have the advantage of knowing what to do in the China market. Hong Kong companies are well positioned to expand their reach manifold as overseas production capacities requiring sound management relocate to China. Even though it is state policy to liberalise trade, the China market is still an extremely difficult one to navigate, particularly for foreign companies unused to the way of doing business in the mainland. Hong Kong companies have learnt over the years to deal with the complexity and remain useful partners for the West.

Hong Kong SMEs’ record of value creation

Historically, Hong Kong entrepreneurship was motivated by the need to be self-reliant – until relatively recently, China’s political environment was highly unstable. Entrepreneurs had to be quick on their feet in order to survive. At the same time, the laissez-faire outlook of Hong Kong’s former colonial administration forced Hong Kong’s SMEs to become extremely demandresponsive to changes in world markets. The manufacturing industries developed superlative sub-contracting systems that enabled quick responses at reasonable prices. This is still what Hong Kong does well today. Moreover, Hong Kong companies have a record of value creation that is stronger than most other competitors.

Hong Kong brands as household names?

Hong Kong companies are China’s best private companies. These companies helped to introduce the mainland’s evolving private sector to modern capitalist business practices. Hong Kong companies now have a “home” market on the mainland, which provides them a new opportunity to expand their operations. Currently, only about 27.5% of Hong Kong companies sell to the mainland. Exploiting the “home” market as it liberalises under WTO regulations is a major opportunity for Hong Kong firms. As Hong Kong companies invest in brand development and marketing, a number of them will become household names over the next decade. Hong Kong is already proving that it can create successful brands.

Hong Kong’s mission A city with a “mission”

In order to understand the basis for Hong Kong’s future economic franchise, it is important to recognise its flair for manufacturing, the nature of the services facilitating increased sophistication in the production of goods and the breadth and depth of the multitude of SMEs involved in manufacturing, as well as the provision of a full range of related services. Finally, it is critical to understand Hong Kong’s mission in further transforming the Chinese economy.

Hong Kong is the heir of capitalism with Chinese characteristics

Previously, Hong Kong’s role was to provide a free environment for the development and growth of a form of capitalism with Chinese characteristics. Hong Kong’s current mission is to participate actively in bringing capitalism to the mainland as China’s economic and market systems continue to evolve. Imagine how change on the mainland might have proceeded in the absence of Hong Kong – China’s transformation to an increasingly market-based economy with needed support in capital, knowledge, institutional strength and human resources would certainly have been far slower. Indeed, no one could have foreseen the extent to which Hong Kong would help China’s economy, particularly in South China, develop from 1979 onwards.

April 2002

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Introduction

The process of “normalisation”

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Hong Kong is now in a period where people are still adjusting to its reunion with a China that is more dynamic than ever. Perhaps what is most difficult for Hong Kong residents at present is envisioning a “normal” relationship with the mainland after existing on the margins of China for 155 years – an accident of history and a political anachronism. Despite its precarious position, Hong Kong managed to thrive and do well. The present mood of uncertainty and self-doubt in Hong Kong reflects anxieties about change and the consequences of “creative destruction.” Many assume that China’s success will occur at the expense of Hong Kong. The challenge now is for Hong Kong to become normal - “normal” in the sense that its relationship with the mainland resembles the relationship between New York and the United States or London and the United Kingdom. During the process of “normalisation,” Hong Kong will have to find its role and place within the “one country, two systems” model. As China continues to develop, this will be an exciting, if sometimes bumpy, ride.

Quality of governance is the key to continuing success

Ultimately, Hong Kong’s loss of self-confidence has more to do with the perceived lacklustre quality of governance and the hardship of dislocation in the midst of rapid transformation - not the lack of economic opportunity. However, this hopefully momentary lapse in confidence must be viewed in the proper context. Given the duration of colonial rule in Hong Kong, local political leadership is in short supply. Hong Kong has able and honest administrators, but its politicians are inexperienced and have difficulty identifying strategies for making tough decisions and mobilising public support. Politics need to become more serious, but it is still too soon to conclude that Hong Kong cannot acquire the necessary skills for effective governance. To be fair to Hong Kong, it certainly has a tremendous entrepreneurial private sector, solid institutional strengths, a helpful sovereign power in Beijing, and a potentially large “home” market to exploit. The opportunities for Hong Kong and the ability of its companies to exploit these opportunities should not be underestimated.

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April 2002

Section 1: Hong Kong & Asian capitalism

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Hong Kong & Asian capitalism A macro view

Hong Kong occupies a very special place in the history of the development of Asian capitalism. Other Asian economic centres, including Shanghai and Singapore, have played a lesser role in this history. Today, as we look forward with questions about the future of Hong Kong, it is useful to look back because history serves a dual and reciprocal function. Over time, the fortunes of individuals, families, companies, governments and cities wax and wane in response to larger trends. Understanding the past helps us to understand the present and allows us to envisage the type of future that can be created.

A new generation of companies is emerging

Despite widespread fear about the future, Hong Kong’s fate does not appear to be in decline. A new generation of companies is now emerging in Hong Kong that is technologically savvy and demonstrates sound management practices. Local companies remain as entrepreneurial as ever. Hong Kong’s small and medium enterprises (SMEs) in both the manufacturing and the services sector are powering ahead and fuelling the evolution of the market in mainland China.

Two forms of Asian capitalism …

The accepted view is that capitalism was introduced to Asia after World War II. The only Asian nation to develop a capitalist system before this period was Japan, which embarked on a national programme of industrialisation at the start of the 20th century. This head start made it possible for Japan to defeat China and Russia in war in 1895 and 1905, respectively, and to enter World War II as an aggressor. However, hindsight reveals the biases inherent in this view. An alternative version of events is that China and Japan developed very different forms of capitalism at roughly the same time. Each represents a significant contribution to the global economic experience. Sociologist Gary G. Hamilton describes the Chinese model as one of “entrepreneurial deal-making” and the Japanese model as one of “corporatised political economy.” Both models have continued to evolve in complex ways that are difficult to measure. Both experiences have influenced the economic development of the Asian region as a whole. Both will shape development on the mainland as China seeks to modernise its economy. A better understanding of each of these models will help us to articulate a new economic franchise for Hong Kong.

Chinese vs Japanese capitalism

April 2002

Starting in the 19th century, both China and Japan began to lay the groundwork for capitalist evolution. Even at this point, the Chinese business model was already discernible. It had regional scope and an aggressively profit-oriented approach. However, within the context of the Chinese political economy, this model remained elusive and highly decentralised. Japan, on the other hand, developed heavy industry and produced impressive goods, including ships and sophisticated machinery. This was possible because the state vision and structure needed to support industrialisation already existed in Japan – and this was notably absent in China. Indeed, at the start of the 20th century, the Chinese state was on the verge of collapse. Yet despite political turmoil, Chinese entrepreneurs continued to thrive and remained a prominent merchant group.

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Section 1: Hong Kong & Asian capitalism

Japan’s experience G In 1884, during the Meiji era (1868-1912), Japan developed a comprehensive plan for economic development by borrowing ideas from Europe. The political system and the elite collaborated in making industrialisation a national goal. Government intervention and elite participation resulted in a mutually reinforcing system of development. G

The Japanese capitalist experience was not the product of the merchant class. Large, competing zaibatsu, such as Sumitomo, Mitsubishi and Mitsui, were created. The Japanese practiced primogeniture succession so that businesses would pass intact to the eldest son. Unlike the Chinese, few Japanese migrated to other countries.

Why did Japan adopt this path? Some Japanese scholars believe that Japan chose industrialisation instead of commercial expansion because Chinese merchants already controlled almost every port in Asia, including those in Japan. Japan saw the adoption of Western organisational capabilities as a way to compete with the Chinese merchants. They first created their own domestic markets and a corporate-oriented political economy before gradually integrating into the global economy.

“Barren rock turned capitalist paradise”

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China’s experience G In the final years of the Qing Dynasty (1644 -1911), the Chinese court was unreceptive to Western ideas. The ruling elite was more interested in administration than economics. The Qing court may have looked splendid, but by the turn of the century, it was in serious trouble. A national development plan was simply not possible at the time. The economy was organided according to the networks of individual merchants. G

By the 19th century, these commercial networks covered most of East and Southeast Asia and, as a result of extensive Chinese migration all over the world, included links to countries like the United States and Australia. The typical economic unit was the small family business. The Chinese practiced patrilineal succession in which each son received an equal share of the father’s assets. This facilitated the creation of interconnected commercial relationships.

By the early 1900s, Chinese merchants operating within the sphere of Chinese commercial influence were able to compete with Western producers in sales of consumer products. However, due to the prevalence of small family businesses and without a state vision, it was hard for the Chinese to develop heavy industry.

Conventional wisdom portrayed Hong Kong as a “barren rock turned capitalist paradise.” According to this narrative, Hong Kong was an unimportant fishing village before British colonisation. Thanks to the laissez-faire economic policies of a benevolent colonial government, it was transformed into an extraordinarily powerful world economic leader. Hong Kong’s colonial regime thus acquired legitimacy by implementing the “correct” economic policies. This view of history downplayed the role of China and the local population and gave the colonial government primary credit for the transformation of Hong Kong. Even those who criticised colonialism accepted the colony’s economic prowess. Indeed, both the 1984 Sino-British Joint Declaration on the transfer of sovereignty to China in 1997 and the Basic Law, Hong Kong’s post-1997 constitution, sought to preserve Hong Kong’s economic system.

A more complex history The early days

Hong Kong’s history is actually far more interesting and complex. It should be noted that by the mid-19th century, South China, especially the Pearl River Delta region, was already an extremely busy commercial area in global terms, due largely to the entrepreneurial abilities of the Cantonese. Cantonese dynamism was not in administration, which was Beijing’s forte, but in business. Indeed, the less government interfered in business matters, the better. For centuries, Chinese merchants from Canton (Guangzhou) shipped goods between China, Southeast Asia and eventually the West. In 1771, the British East India Company opened an office in Guangzhou. By 1844, some 100 foreign hongs were doing business on the South China coast. Their position on the mainland, however, remained precarious, and in 1834, the British showed an early interest in taking possession of the island of Hong Kong in order to secure their trading rights in China. Although Ningbo (near Shanghai) and Formosa (Taiwan) were considered more attractive options, British

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April 2002

Section 1: Hong Kong & Asian capitalism

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traders in Guangzhou preferred Hong Kong. Hong Kong had a distinct advantage over other areas because of its proximity to Guangdong, which was already a base for light industry, commercialised agriculture and trade. In other words, Guangdong’s trading identity was strongest, surpassing even that of Shanghai. On 25 April 1836, the Canton Register stated: “If the lion’s paw is to be put down on any part of the south side of China, let it be Hong Kong; let the lion declare it to be under his guarantee a free port, and in ten years it will be the most considerable mart east of the Cape.” Remember the compradors?

While the taking of Hong Kong provoked resentment, sustaining colonial domination was made possible because the local Chinese bourgeoisie found it convenient. Many prominent Chinese businessmen were prepared to be flexible in their loyalty and profited from helping to build the infant colony. In return, they were rewarded with land grants and monopolies. The creation of a Chinese business elite was therefore linked inseparably to Hong Kong’s colonial history. Chinese businessmen profited as a result of commercial opportunities available in Hong Kong that were not available to them on the mainland. The most successful businessmen of this era were the compradors, who benefited from their ability to bridge the cultural divide between foreign and local merchants.

Hong Kong and 19th century expansion in Asia

The compradors invested in Hong Kong and established trading links wherever possible, serving as the middlemen between the foreign and Chinese communities. From their perspective, Hong Kong’s was ideally positioned to become a world commercial base, as it was located close to China and along a major East-West trade route. European colonial expansion into East and Southeast Asia provided compradors with opportunities to extend their reach regionally, thereby bringing the region into the world market. By the late 19th century, Hong Kong was operating as a regional business centre and its economy was already integrated with the larger world economy.

The Southern Chinese created a powerful “bamboo network”

A direct consequence was the rapid growth of the Asian region as a source of the raw materials, such as tin, rubber and sugar, needed to meet growing European appetites. Chinese merchants and workers moved to follow the flow of business and eventually controlled regional trading networks. Chinese migration proved to be big business for Hong Kong, providing multiple opportunities in shipping, ship brokering and worker recruitment. The overwhelming majority of these Chinese migrants were from the Pearl River Delta region. Hong Kong’s reach as a migration centre included China, Southeast Asia, Australia, the United States and the Caribbean.

Chinese sojourners

Within Asia, Chinese merchants learned local customs and languages. Unlike European merchants, they found ways to access isolated communities in order to buy and sell goods. Most importantly, they knew how to utilise China’s resources. They created complex credit arrangements that linked producers and consumers with traders and established multiple networks of agents. A large percentage of Chinese wealth was generated by the redirection and reallocation of Asian goods within Asia, rather than the distribution of European goods to Asian markets. Chinese served as the lingua franca of the Asian business world. Chinese merchants were able to tap into global markets by capitalising on the activity of the colonial powers.

April 2002

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Section 1: Hong Kong & Asian capitalism

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Useful multiple identifications …

This system of trade created some conflicts between different groups, but the Chinese in Hong Kong also viewed foreign traders, including Indians, Portuguese and the British colonialists, as business partners. The livelihood of these various groups was linked in complicated ways. Located on the margins of the Chinese state, Hong Kong provided a meeting point between Chinese and British merchant cultures and a space for multi-ethnic affiliations.

… which have become adaptive advantages

Chinese merchants moved comfortably between different worlds – in their hometowns in South China, in the world of the foreign community, among the overseas Chinese, between colonial leaders in Hong Kong and within local Chinese society. The colonial experience fostered a unique brand of multiculturalism in which the Chinese merchant class had more than one source of identification, a true adaptive advantage in the Darwinian sense of the word. Today, Hong Kong remains the one of the easiest places in the world for foreigners to settle and set up foreign businesses.

Colonialism – A steppingstone for the Cantonese

Colonial expansion in Asia created the socio-economic context for trade. Indeed, it was a dispute about trade that led to the cession of Hong Kong to Great Britain. That arrangement provided the framework for Chinese traders to expand their business in the region. Hong Kong was the keystone in this expansion for both Europeans and Chinese traders, but from an economic perspective, Cantonese compradors ultimately benefited the most. They became superlative middlemen. Indeed, it was this form of middleman capitalism that formed the basis for the Chinese capitalist experience. Not to be overlooked “Although colonial expansion was a crucial factor in creating the geo-economics and political context, the most indispensable element in Hong Kong’s rise as a trading centre was the establishment of a business network linking Chinese merchants from Hong Kong and China to Southeast Asia and beyond.” Tak-Wing Ngo Hong Kong’s History: State and Society under Colonial Rule, 1999

Creating a share interest for the status quo

Conventional wisdom portrays Hong Kong as the classic colonial state in which the government stayed out of people’s lives by promoting economic laissez-faire policies and political non-intervention. That picture is too simplistic. The colonial state was never politically neutral. Its economic policy reflected colonial business interests. In other words, the colonial policy was to maintain a trade-dominated economy because trading interests were paramount. Hong Kong was seized for trade purposes rather than territorial aspirations and served as the base for penetration of China and other Asian markets. Thus, the colonial administration was structured to facilitate trade and serve British interests. The most important British merchants were incorporated into the Executive and Legislative Councils, the backbone of the political establishment. As the Chinese traders grew rich and their influence increased, they too were co-opted into the administration. Indeed, the wealth of the Chinese community quickly surpassed that of the European community. For example, in the period from 1880 to 1881 alone, properties worth some HK$2 million – a very sizable sum for the time – passed from European hands into Chinese hands. Institutional co-optation of the local business elite was a highly effective method of maintaining political stability. It gave the government a good feel for local sentiment and linked the personal interests of political appointees with maintenance of the status quo.

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April 2002

Section 1: Hong Kong & Asian capitalism

Chinaâ&#x20AC;&#x2122;s tolerance

April 2002

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China tolerated Hong Kongâ&#x20AC;&#x2122;s colonial identity for over a century because it served Chinese interests to do so. At the end of the 19th century, more than 50% of Chinaâ&#x20AC;&#x2122;s imports and 37% of its exports moved through Hong Kong. The compradors were able to exploit the activity of their Chinese and British masters to their own advantage. After the fall of the Qing court in 1911, Cantonese merchants continued to profit from trade, even though Chinese political life was in disarray for many years. Cantonese merchants were active throughout China, including Shanghai, where they formed the largest group of businessmen. Hong Kong operated as the organisational centre for their commercial activities.

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Section 2: Hong Kong’s business culture

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Hong Kong’s business culture Demand-responsive capitalism

In terms of business organisation, the Chinese and the Japanese capitalist experience could not be more different. The Japanese strategy was to create internal markets and build an impressive, corporate-oriented political economy. The Chinese strategy relied on the familial and business networks of individual merchants. This business model, best represented by the Hong Kong experience, was characterised by its flexibility and the absence of state patronage – indeed, it emerged as a result of the need for self-reliance. Therefore, unlike the Japanese business model, which was supply-driven, Chinese business was demand-responsive.

The SME business model

It may be difficult to understand how this business model functioned in practice. It certainly differs greatly from the multidivisional structure that characterises the Anglo-Saxon model of business – the business-school model of modern capitalism. The typical Chinese business was a small- or mediumsized family enterprise. In recent years, management schools have recognised the Chinese model as worthy of study. Despite the fact that its structure seems lightweight and haphazard, it has proven to be a phenomenally competitive economic machine. As we assess the legend of Hong Kong – the “barren rock turned capitalist paradise” – and attempt to outline its future, we need to look closely at the organisation and business culture of local SMEs and their responses to new challenges.

Culture affects business

Business success depends on many factors, including political circumstances, history, technology, development and culture. Culture cannot be omitted from this list since it conditions the actions and reactions of a particular society to specific situations. Culture may be described as “the collective programming of the mind” that results in a societal structure.

Mindscape of Hong Kong entrepreneurs

The mindscape of the Hong Kong businessperson is central to Hong Kong’s continued economic success. Social scientists have identified three characteristic features of the cultural universe of local business: G

Insecurity – The general sense of insecurity about the present and future reflects China’s turbulent history. In the past, widespread poverty, coupled with uncertain politics, created a powerful incentive for selfsufficiency.

Paternalism – Confucian ideology conditioned Chinese society to respect authority. According to Confucianism, legitimate authority is vertical in structure and paternal in nature, meaning that subordination (loyalty) is rewarded with benevolent leadership that is beneficial for everyone.

Trust (Guanxi) – Different horizontal relationships form concentric circles of trust and dictate individual behaviour. The family is the primary unit of personal identification and trust.

The meaning of guanxi Guanxi demystified

Chinese society is deeply influenced by guanxi, a complex concept meaning “contacts,” “connections” or “relationships.” There are four key aspects of guanxi:

1. Informal relationships - maintained through informal interactions over time. 14

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April 2002

Section 2: Hong Kong’s business culture

Nimble and nifty

2. Particular relationships – people relate to one another as individuals rather than as occupants of specific roles. Personal interaction is needed in initiating and nurturing guanxi. Individuals develop sentimental bonds for each other over time. 3. Reciprocal relationships - Individuals exchange favours, which may range from access to scarce resources to opportunities to political support. 4. Trust - crucial for the relationship between different parties, as nothing else will ensure reciprocity in informal and personal relationships. The difference between the social influence of personal relationships and networks in the West and in Chinese society is the extent to which they permeate daily life. Widespread guanxi networks constitute a form of social capital that is specifically Chinese. Scholars have noted that in a social setting where markets are unstructured, politics uncertain and where there is a weak tradition of regulation and rule of law, guanxi is a substitute for more centralised organisation. Guanxi vs the rule of law

Chinese business culture represents the response of Chinese businesspeople to particular social and political traditions. In other words, Chinese business culture is a response to uncertainty. Hong Kong’s strong entrepreneurial tendencies are the result of its unique history. Hong Kong’s precarious existence on the margins of the Chinese empire and its status as a remote British colony created an atmosphere in which flexibility, responsiveness to changing circumstances and risk-taking became second nature. In the absence of a formal legal structure, still in the embryonic stages in mainland China, informal business networks based on family ties, kinship and other types of bonds provided an efficient way for Chinese businesspeople to gather information, hire labour, raise capital and enforce reciprocity.

Hong Kong's rule-of-law advantage

British colonial authorities developed a system of law in Hong Kong that was rooted in the Common Law tradition. The 155 years of colonial rule enabled local entrepreneurs to become familiar with a regulatory system that went beyond guanxi. Under the rule of law, contractual terms could be enforced using a pervasive and impartial system, fostering a sense of mutual commitment and facilitating the formation of a greater number of business commitments. Chinese business and capital “Historically, the first and most important source of capital for Chinese entrepreneurs has been family and friends. Because there are limits to what family and friends can provide, external sources are necessary … The evolution of Chinese banks created a system that was more personal and less reliant on hard statistical data than Western banking. Today’s Chinese banks draw on that heritage, on an ability to analyse a given business situation and place a value on trustworthiness … Close economic and cultural ties between Hong Kong and China affect Hong Kong bankers’ attitudes towards credit risk in China … They are generally more optimistic than foreign bankers, particularly when evaluating Sino-Hong Kong joint ventures … [At the Bank of East Asia] we combine the stringent analysis of modern banking with the time honoured tradition of Chinese business. To determine our risk, we combine what we know to be true, with what we can prove.” David K P Li, 1997 Deputy Chairman and Chief Executive, Bank of East Asia Ltd. Dynamic Hong Kong: Business & Culture, University of Hong Kong Press

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Section 2: Hong Kong’s business culture

The typical SME

Challenges for family SMEs

Nimble and nifty

The typical family-style Chinese SME reflects a paternalistic and nepotistic business culture and usually starts on a small scale with a simple structure. The style of operation is “lean and mean” in order to remain highly adaptive to changing circumstances. Decisions are made very quickly because the dominant owner usually makes them. Strategic alliances are common. Largescale versions of this model now exist in Hong Kong and Taiwan as both private and listed companies. Although they are now managed professionally, many are still dominated by founding family members who continue to make key decisions. Entrepreneurship and management “I think family enterprises in Asia today are at a cross-roads. We are facing a range of new opportunities, but there are significant challenges too: challenges to become multicultural, transnational corporations; challenges to retain the flexibility and speed of response typical of tightly controlled family companies while at the same time professionalising and putting systems in place that are appropriate for large companies; challenges to remain efficient in spite of growing size … a strong bias among Asian companies – and a key strength – is entrepreneurship … The [corporate] structure needs to evolve not into a large centralised bureaucracy, but into a series of small, relatively independent, entrepreneurial profit centres.” Victor K Fung, 1997 Chairman, Li and Fung Group. Dynamic Hong Kong: Business & Culture, University of Hong Kong Press

Melting-pot entrepreneurialism

It should also be noted that Hong Kong’s major companies include those set up by non-indigenous merchants. Like the local Chinese merchants, foreigners had to adapt to constantly changing conditions in order to survive. Scottish moneymen transformed HSBC from a Hong Kong-grown bank into a global banking giant; the Kadoories, a Jewish refugee family, founded CLP Power and built many magnificent hotels throughout the region; Hutchison developed from a venerable British hong into a global conglomerate; while the vision for mobile-phone company SUNDAY came from a Canadian entrepreneur who has adopted Hong Kong as his home. Hong Kong’s flag airline carrier, Cathay Pacific, which was originally started by British merchants and is now partly owned by mainland interests, is perhaps the best example of melting pot enterprise in Hong Kong, a fact reflected by its strong multicultural image and workforce.

Corporate governance

The key criticism of Chinese business culture is that it is biased towards the private rather than public interest. Management scholar Gordon Redding observes that the Chinese business culture “has a voracious appetite for state-granted monopoly … Over time it will be reigned in, tamed, made much more societally accountable.” This will require the growth of social pluralism and the emergence of social consciousness “of a much higher order” than currently exists in Hong Kong, Taiwan or mainland China.

Discipline is coming, albeit slowly

CLSA’s report on corporate governance, The Tide’s Gone Out: Who’s Swimming Naked? (October 2000), noted the generally low awareness of corporate-governance practices in Asia, even among corporate leaders. While Hong Kong’s Western-influenced rules and regulations are fairly well developed and far ahead of those in other jurisdictions, general business practices and corporate culture remain Asian in nature. However, the CLSA report, Make me holy … but not yet!, published in February 2002 noted that improvements are on the way. Regulatory authorities and related professional

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Nimble and nifty

Section 2: Hong Kong’s business culture

bodies are working hard to turn around corporate resistance to greater disclosure, discipline of senior management and supervision by an independent board. Hong Kong companies have a strong record in profitability

Hong Kong has one of the highest ROE–COE (%) in the region

The other outstanding feature of Hong Kong companies is their strong record of value creation. The entrepreneurial abilities of Hong Kong firms and their capacity for creating value are clearly visible when compared to performance in other parts of the region. Over the last five years, the average ROE of Hong Kong’s listed companies has been the highest in the region, resulting in a superior performance by Hong Kong equities, despite deflation. Figure 2

Regional markets – ROE vs COE ROE (%)

China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand

1997A

1998A

1999A

2000A

2001CL

Avg

27.7 14.6 18.2 10.1 2.9 10.1 13.5 10.7 22.1 (34.9)

9.1 11.2 16.8 (46.6) (4.1) 5.1 9.9 5.8 12.8 (9.5)

10.7 23.8 17.2 23.9 11.7 12.6 9.5 10.8 14.5 (37.4)

18.1 11.1 18.2 19.0 11.7 9.7 7.5 12.6 20.6 3.8

15.3 9.1 16.8 14.3 7.9 9.9 6.6 7.2 7.5 0.4

16.2 14.0 17.4 4.1 6.0 9.5 9.4 9.4 15.5 (15.5)

COE (%)

ROE-COE

Long-term avg 13.4 10.4 19.8 18.4 11.4 13.4 18.3 9.4 11.4 14.4

(%) avg 2.8 3.6 (2.4) (14.3) (5.4) (3.9) (8.9) 0.0 4.1 (29.9)

Source: CLSA Emerging Markets, CLSA GEMiner®

Hong Kong and the PRC is much more than a maquilladoras zone …

A later section of this report describes the ways in which South China used its kinship ties and geographical proximity to Hong Kong and Taiwan to transform from a mere maquilladoras zone into an integrated economy. Hong Kong’s strongest companies are growing not only due to the availability of cheap labour in mainland China – they are also growing as a result of sound investments, technological sophistication and solid management ability. Today, the region is more than just a centre for light industries and cheap export. It is the breeding ground for a brand of capitalism that is distinctively Chinese as well as a launching pad for Hong Kong, Taiwanese and Chinese companies moving towards becoming global enterprises. Some of these companies are already big league players in the world economy. Regional success has been driven by state retreat, rather than state intervention, and the subsequent growth of private enterprise.

… the region has developed real breadth and depth

April 2002

The following chart shows the overall strength and depth of the South China Triangle as an economic region. This chart is not intended to be comprehensive but rather to provide a snapshot of some of the major companies operating in this area.

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Section 2: Hong Kong’s business culture

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Figure 3

Some major economic players in the South China Triangle Category Agro-food

South China Ng Fung Hong

Electronics

Galana Guangdong Kelon Konka Group Shenzhen Huawei TCL Group

Textiles/clothing/ sportswear/shoes

Other manufacturing industries

Finance

Guangdong Development Bank

Hong Kong Café de Coral Dairy Farm Garden Lam Soon Food Lam Soon Lee Kam Kee Vitasoy International Goodway Gold Peak Industries Johnson Electric Kingboard Chemicals Nam Tai Electronics Surface Mount Technology TVP Technology VTech Holdings Varitronix International Bossini International Carry Wealth Holdings Esquel Esprit Holdings Fountain Set G2000 Giordano International Glorious High Fashion Kingmaker Footwear Li & Fung Ltd Pegasus International Silcon Electronics Texwinca Holdings Theme International Top Form Tungtex (Holdings) Yangtzekiang Garment Yue Yuen Industrial Dunwell Enviro-Tech Elec & Eltek Hung Hing Printing Kin Yat Holdings Lung Cheong Toys Lung Kee Techtronic Industries Sun Hong Vision Group Surface Mount Toonsland Wah Sing Toys Bank of East Asia Dah Sing Bank Hang Seng Bank HSBC

Taiwan President Tingyi

Acer Compal Quanta Tatung TSMC UMC Winbond

Far Eastern Tungtex Hualon

Nanya Formosa Plastics

Bank of Taiwan

Source: CLSA Emerging Markets

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Section 3: Industrialisation and reindustralisation

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Industrialisation and reindustralisation A forgotten story: Pre-WWII Hong Kong’s first industrial phase

The pre-WWII story of Hong Kong offers useful insight into the nature of the place and people but it is a forgotten part of the city’s development. While trade was important, there was a lively manufacturing industry, which was often ignored by the colonial government because British business was by and large not involved. The nature of selective historical representation has overlooked an important part of the Hong Kong legend.

Overlooked data

The Hong Kong and Macao Business Classified Directory of 1927 recorded 3,000 factories and workshops in Hong Kong. By 1940, the number recorded was over 7,500. Census statistics bear out the importance of industry. In 1931, some 25% of the working population worked in manufacturing. Figure 4

1931 Census: Hong Kong working population Manufacturing Commerce and finance Transport and communications Agriculture and fisheries Total working population Total population

111,156 97,026 71,264 64,420 470,794 849,751

Source: CLSA Emerging Markets

Hong Kong industry was already significant …

Industry in Hong Kong Cantonese hands was much larger, more advanced and of a wider range than is recorded by conventional accounts. Some of them were also highly competitive. There were factories of over 50,000 square feet employing over 1,000 workers in the 1930s. A British report even recorded complaints about the “invasion of the United Kingdom market” by Hong Kong products. Strong sectors included rubber shoes, cosmetics, weaving/dyeing, metal works and leatherwear. At the time, torches produced in Hong Kong dominated the Southeast Asian market formally the terrain of British and Japanese producers. Unfortunately, there are no economic statistics since official GDP only date back to 1961 and no industrial data was collected till the 1970s.

… especially against China at that time

According to official statistics, China only had 3,935 registered factories in 1937. Guangdong Province had 101 factories with 10,814 workers and Shanghai had 1,235 factories employing 145,226 workers. While it is not known how many unregistered factories and workshops there may have been, comparing official numbers, the tiny colony of Hong Kong already had an impressive manufacturing base.

Yet, industry was a marginalised activity in Hong Kong

Hong Kong’s industrial history was downplayed from official accounts because it did not fit the official vision of the colonial government. The belief was that Hong Kong’s prosperity was largely due to its status as a free port. The British thought any investment other than in trade was risky given the turbulence in China. Hong Kong was deemed unsuitable for industrial development because “the demand for the return of Hong Kong to China is always latent”. A government commission encapsulated the widely held view in 1934 that there was “little scope in a colony like Hong Kong, having no natural raw products and small domestic consumption, for the ambitious scheme of economic reconstruction or national planning which has become the modern fashion”.

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Section 3: Industrialisation and reindustralisation

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The British were disinterested

The lack of British merchant interest in manufacturing left the sector to the local Chinese, who financed the development of light industry in Hong Kong. Any kind of official protection or subsidy for their businesses was out of the question. The locals developed a network of relationships linking larger and small factories to larger and small trading firms, thereby building a manufacturing system that could act and react quickly to changing market demands. It transformed itself into a sub-contracting system par excellence, which metamorphosed into companies like Li & Fung into becoming world leaders today.

Manufacturers had no political clout

The local manufacturers were not invited into the bosom of the establishment like their richer comprador compatriots who ran trading and commercial businesses. They remained marginal as a political force and did not have the power to influence official decision-making.

A rude awakening Post-war realities and 1949

WWII and the subsequent years disrupted much of Asia’s way of life and resulted in a fundamental change to the entrepreneurial base of the Chinese merchants. Two aspects had the greatest impact:

Establishment of the PRC

Establishment of the People’s Republic of China in 1949 – the new government cut China off from the rest of the world economically thereby cutting the nation off from the overseas Chinese merchants. With the onset of the Cold War, Hong Kong’s role as an entrepôt declined especially after 1951 with the United Nations embargo on China during the Korean War. The hongs and the compradors had to adapt, those who didn’t did not survive.

Independence movements in Asia

End of colonial rule in East and Southeast Asia – as countries gained independence, the new governments preferred to support domestic industrialists rather than ethnic Chinese enterprises even where the Chinese owners had become their nationals. Chinese businessmen felt insecure as governments throughout the region questioned their loyalty. Anti-Chinese sentiments and race-inspired unrest were not uncommon.

Only safe haven …

It was colonial Hong Kong that offered a safe haven to the many people who wanted refuge. The colony became a secure place to do business and/or park money for a rainy day. Moreover, Hong Kong attracted an inflow of capital and skill not only from China and Southeast Asia but also the West since it was the one stable place amidst a sea of uncertainty. Ironically, it became China’s only gateway to the world. China had an economic interest in the British colony doing well since it was where it earned much of its foreign exchange. The bi-annual Canton Trade Fair was placed in Guangzhou for very good reasons.

… and Hong Kong’s luck

As China closed her door to the West and concentrated on developing relations with the Soviet Bloc countries, Hong Kong was lucky that the timing coincided with the rise of consumerism in Europe and the United States demanding cheap light industrial goods. Hong Kong’s SMEs refocused their energy into serving that demand as one door closed, and another opened.

Shanghainese refugees Why the Shanghainese overshadowed the Cantonese

The conventional story is that the Shanghainese refugees brought capital and know-how igniting Hong Kong’s industrial development between 1948-1951. The big players were wealthy and were members of the economic elite in pre-1949 Shanghai. They left because their wealth was being collectivised with their personal safety in question.

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Section 3: Industrialisation and reindustralisation

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History can often be selective

The local Cantonese manufacturers and the Shanghainese did not mix. The reasons are complex. Suffice to say that the Shanghainese chose not to throw in their lot with the politically weak Cantonese manufacturers and did not join their Chinese Manufacturers’ Association (CMA). Instead, they sided with the colonial establishment and joined the British dominated Hong Kong General Chamber of Commerce. The colonial administration exploited the differences to keep the local manufacturers' demand for protection at bay. The government even set-up and subsidised the Hong Kong Federation of Industries as a counterweight to the CMA, which became dominated by the Shanghainese.

The Cantonese entrepreneurs are among the most successful merchants ever

As a result, the nature of selective historical representation highlighted the entrepreneurial prowess of the Shanghainese over that of the Cantonese in Hong Kong. With no disrespect to the Shanghainese and their ability, the Cantonese were no slouches. Existing at the margin of China and of Chinese cultural political and cultural consciousness, the Cantonese are among the most successful merchants the world has known.

Post WWII: Hong Kong’s second industrial phase Guerilla-style tactics quick in, quick out …

Starting in the 1950s and by the 1960s, the SMEs in the manufacturing sector became Hong Kong’s most dynamic and important sector. Industry was able to grow quickly at the time because there was already an existing base, even though it had been officially ignored.

… adaptation to the times

Hong Kong people felt insecure living under the shadow of a revolutionary China – they knew the stability they enjoyed was a precarious one. By and large, they were wary of making large, long-term, investments. Better to do things for a quick return. Money offered options in case people needed to run for their lives. Their business mentality could be described as guerilla-style tactics – quick in, quick out. Scholars have described the tactics thus: …“ seek out an opportunity for high profit margins in a particular good, develop the formula, exploit it by rapidly flooding the market before the established firms can respond, make profits over the short term, and then leave the market for another one before competition forces the prices down”.

Policy of convenience

The official view in the mid-1960s reinforced that mentality. The government believed that Hong Kong’s only competitive advantage was lower labour costs. There was therefore no government encouragement for developing a more capital-intensive manufacturing base at a time when South Korea, Singapore and Taiwan started to compete with Hong Kong, with their governments supporting industrial upgrading.

China’s Open Door Policy

That mindset had an origin. Up until 1958, Hong Kong’s budget surpluses were kept in sterling in London. Hong Kong’s reserves were used to support sterling rather than finance Hong Kong’s own development. It became convenient to believe and to have people believe that capital investment was inappropriate. It wasn’t until the mid-1970s that the government noted the need to help industry. By 1979, when a special government-appointed committee worked out a series of recommendations they had in effect become redundant. China had announced its Open Door Policy.

April 2002

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Section 3: Industrialisation and reindustralisation

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Laissez-faire, Hong Kong style Hong Kong’s economic development in its various phases has never been planned or directed by the government. This has been consistently the situation as Hong Kong experienced landmark events of development like entrepôt trade activities in the 1950s; industrialisation in the 1960s; internationalisation of the financial sector in the 1970s; and economic transformation in the 1980s, with an expansion of the service sector and the relocation of industries in China in the latter half of the decade. This policy of non-intervention has been credited for producing positive results and hence has been labelled as a principal of ‘positive non-interventionism’. The rationale is that the minimal role of the government has given the private sector the maximum scope of flexibility to do business in accordance with free market forces … However, on closer inspection, it is evident that the degree of intervention … is greater than generally assumed … The most important instrument of government policy influencing individual industries ... is its land policy … Nonetheless, the government … has not directly assisted the private manufacturing industries, which have been the pillars of the local economy.” Edward K Y Chen, 2000 Economist and President of Lingnan University The Business Environment in Hong Kong, OUP Sub-contracting system par excellence …

A key aspect of the guerilla-style tactics of Hong Kong SMEs was the development of an extremely flexible sub-contracting system, which had its roots from the pre-war days. The web of relationships among manufacturing and trading firms enabled a firm to take an order and then sub-contract the work to a production unit. The sub-contracting system is a substitute for net investment and it reduces the risk when demand changes. Inventory could also be kept to a minimum.

… and how it worked

A firm would bid for as much work as possible, then spread what it could not cope with to others. They invested in machinery that could cope with multiple usages in order to maximise capacity. The factories were also multifunctional. Take the wig industry in the 1970s. In 1970, it accounted for 8% of Hong Kong exports employing 39,000 workers. By 1977, the industry had basically disappeared. Hong Kong stuck to light industries such as electronics, clothing, watches and toys because it offered them flexibility to hop from one popular item to the next in no time and without too much disruption and pain. Response time was critical to the success of Hong Kong’s firm, many of which became highly specialised in a particular aspect of the production chain. Many of them were involved in only one aspect of the whole process. Thus, in producing circuit boards, there could be a different contractor doing the masking and etching, component inserting, wave soldering, and product testing. The result was that the entire process took less time, especially when the subcontractors’ workshops were geographically close to each other, thereby reducing transportation time. Their relationships with each other were based on trust, not contract. Transaction costs were minimal.

. . . and by the 1970s subcontracting was an innovation

The extremely efficient subcontracting system was a genuine innovation under the social and political circumstances of the day where the Hong Kong government practiced a laissez-faire policy. Business folks had to sink or swim on their own.

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Section 3: Industrialisation and reindustralisation

Nimble and nifty

Conditions made sense for Hong Kong to focus on OEM

Hong Kong became adept in its role as a subcontractor in Original Equipment Manufacturing (OEM). Hong Kong SMEs operated between the brand-owning multinationals from Europe and the United States and the low-cost subcontractors in Hong Kong. For a small place like Hong Kong with a modest domestic market, the globalisation of production starting in the 1970s gave Hong Kong a market reach to grow its industrial capacity. To make a buck, Hong Kong firms became highly market-responsive. They prided themselves in being able to be the first to get the products to market for the overseas brands.

Not all “cheap and nasty”

The OEM experience helped Hong Kong’s SMEs to upgrade technologically and also to improve their management efficiency. The OEM model of development was relatively low risk not requiring heavy capital investment. To stay ahead of ferocious competition from Taiwan, Singapore and South Korea (who all had a lot more government support), Hong Kong had to continuously find ways to give customers value for money and on-time delivery under a laissezfaire system. Incremental adjustments and improvements to the OEM process occurred consistently. While Hong Kong was not involved with “discovery science”, its SMEs became very good at making sophisticated light industrial products for the world market.

“Re-industrialisation” in the 1980s

Hong Kong’s transit in the late-1970s and early 1980s from a manufacturing to service economy is well known, and the details will not be repeated here. The transit is often referred to as Hong Kong’s “de-industrialisation”. It may be more accurate to describe it as “reindustrialisation” since Hong Kong’s manufacturing moved next door to South China and continued to grow dramatically. But, out of sight was out of mind. Moreover, the sex appeal of the services sector in general and the property market in particular from 1980 to 1997 made manufacturing in the poor cousin’s backyard looked dated.

Hong Kong’s SMEs moved quickly to South China

China’s Open Door policy, adopted in 1978-1979 radically altered the economic prospects of Hong Kong where growth was constrained by the availability of land and labour. The early investors across the border were SMEs moving their processing businesses to South China taking advantage of lower costs. Hong Kong was like a super corporation that subcontracted its orders to South China through the provision of designs and materials, and distributed finished products worldwide. The production facilities Hong Kong companies set up across the border often used simple, mature, and standardised technologies, which was a natural progression from their local OEM experience. While they were not technologically advanced processes, they were well suited to the conditions across the border and helped to raise industrial standards there.

Remember the Tamagotchi? Example of “quick in, quick out”

The design ability, speed and efficiency with which Hong Kong SMEs could exploit opportunities with their tradition guerrilla-tactics was best seen with the Tamagotchi craze in 1997. A Japanese firm invented a small electronic virtual “pet” toy in 1997. The “pet” needed looking after a great deal. As an infant “pet”, it needed to be fed like a baby. The piece would “inform” the owner when the “pet” needed nursing. A poor caregiver would be warned – your “pet” could die. The Tamagotchi became an overnight craze. Every child had to have one and some adults too. Hong Kong companies were so quick off the mark that they

April 2002

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Section 3: Industrialisation and reindustralisation

Nimble and nifty

flooded the markets in a matter of weeks producing lower cost versions at their mainland factories beating the Japanese manufacturers. Like all crazes, it faded as quickly as it blossomed. Competitive strategies

Hong Kong is beginning to face serious competition from mainland manufacturers and lower cost developing economies from around the world. Labour-intensive manufacturing (in the middle of the value-added “U” curve) is the basic OEM process typically the lowest end of the value-added production cycle.

OEM to ODM to QRM to OBM

To stay ahead, the more aggressive Hong Kong SMEs, such as those featured in this report, are working both the front and back ends of the product development cycle. At the front end, they invested in product research and design (Original Design Manufacturing - ODM). ODM involves production arrangement where the manufacturer provides product concept development and detailed design as well as makes the products under the overseas buyer’s brand. From the overseas buyer’s point of view, ODM allows him to transfer the responsibilities for product development and design to the supplier so that the buyer can focus on marketing and distribution. Kin Yat is a good example. It has transformed itself from an OEM to an ODM supplier of high-value mechanical and electronic toys. Its major client is Hasbro and is likely to be able to sign Lego up as a new client. Its strategy is to invest in R&D to become a QRM (Quick Response Manufacturer). At the back end, Hong Kong manufacturers have improved quality control, transportation, marketing, and have even begun to get into brand name development (Original Brand Manufacturing – OBM). Esprit is a good example and has been outperforming its global peers. Figure 5

Production development cycle Value added

Production development cycle Source: CLSA Emerging Markets

Relative distribution OEM, ODM and OBM

A 1999 survey conducted by the Hong Kong Trade Development Council (HKTDC) showed that while the majority of Hong Kong manufacturing companies are still actively engaged in OEM production, a high number of them are also in ODM production. There is also a trend of more companies getting into OBM production. Some 38% of Hong Kong manufacturers engage in sourcing/production in two or more locations – a sign of solid management skill.

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Section 3: Industrialisation and reindustralisation

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Figure 6

Percentage distribution (HKTDC)

OEM

27%

29%

5% 20%

ODM

Brandname

The above figure does not add up to 100% because some of the companies were engaged in more than one type of production arrangement. Source: HKTDC

Hong Kong companies know they are competitive

Going further up the value chain

What was interesting about the survey was that Hong Kong companies still considered themselves to be competitive in global production because they were still more efficient than their competitors. The latest news from the likes of Fountain Set, Kin Yat, Johnson Electric and Kingmaker indicate that orders are picking up well. Hong Kong manufacturers said their key strengths were: G

Flexibility in production (different products, switch product lines, adapt to buyers’ specifications, take small orders, etc.)

Short delivery lead-times (sensitive to market changes, quick response, etc.)

Good quality control (including product safety, environmental performance, etc.)

Reasonable prices

Good reputation (reliability, respect for customers’ intellectual property, etc.)

Figure 7

Path to exploiting core competencies Development stage

Innovations

Subcontracts OEM

Organisational G Production in HK and PRC G Strategic alliance with overseas buyer G Increase vertical integration

ODM

G G

OBM

G G G G G G

Technological G Process improvement to reduce cost and defect G Extend production and management know-how through increasing vertical integration New supply sources G Adapt products Improve design and development G Invest in incremental technologies for alliance partner New designs and marketing Production in HK, PRC and export G New products in mature markets technologies Full functional integration Increase focus on product/market diversification Continuing and new alliances with brand owners Alliance with R&D institutes

Source: Adapted from Judith Hollows and Clive Dilnot – From Replication to Innovation: The Development of Hong Kong Manufacturing Firm, 2001

April 2002

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Section 3: Industrialisation and reindustralisation

Silicon Valley –Hong Kong style

Nimble and nifty

Just as management experts try to explain the might of Silicon Valley in hightech innovation, the same factors can be seen working in the Pearl River Delta. Hong Kong companies have concentrated their production facilities in the eastern and central parts of the region, where the clustering effect produced four advantages: 1. Providing a pooled labour market of workers with similar skills. 2. Creating a pool of other specific skills and inputs in greater variety. 3. Developing the required intermediate goods and services. 4. Enhancing information and knowledge flow that helps innovation.

Benefits of subcontracting

Everyone benefited . . .

Furthermore, the subcontracting culture has helped to promote collaboration to achieve economies of scale and flexibility through the following means: G

By subcontracting one company’s order to other firms enabling the company to accept bulk orders beyond its own production capacity and capabilities;

By combining raw materials orders from different firms so that a bulk order could be made to achieve discounts and lower transportation costs;

By sharing raw materials, machinery, tools and spare parts to reduce raw materials inventory and increase operational flexibility.

Gradual economic integration between Hong Kong and South China had a number of consequences: G

It stimulated fast economic growth for all concerned;

By relocating its factories to South China, Hong Kong’s manufacturing capability increased manifold in size;

Integration led to regional specialisation and promoted global trade. Hong Kong became a very successful service centre that supported mainly manufacturing-related services;

Guangdong became a production powerhouse providing employment to millions in China, including from other provinces;

The transformation accelerated the growth of the non-state sector in South China, which was something Beijing wanted to encourage since the state-owned enterprises (SOEs) were hemorrhaging. Private enterprise already contributes 40% to China’s overall industrial production, and this ratio is closer to 80% in Guangdong. The smaller, privately owned, Chinese business enterprises in South China form a key pillar to China’s economy.

Reverse marketing . . . bring international brands to China

Adapting its manufacturing business to the political, administrative, and social conditions in the Pearl River Delta region and beyond provides another Hong Kong innovation, made easier by kinship ties. For example, post China’s WTO entry, Esquel believes it can offer its services to the multinational brands that want to enter the China market because it is already producing high-end goods for them, works with Chinese parties that are trustworthy, and knows how to operate generally on the mainland.

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Section 3: Industrialisation and reindustralisation

Sign of undiminished enterprise?

Nimble and nifty

The business environment since 1997 has been tough. Nevertheless, a healthy number of new companies have been incorporated in Hong Kong even as many were wound-up. The city’s record of incorporation provides a sign that its enterprising nature is still very much alive even during the most testing of times. Figure 8

Companies incorporated in/outside Hong Kong Number registered and dissolved Year 1998 1999 2000

Public Private Total incorporated incorporated 267 29,680 29,947 363 35,197 35,560 388 42,971 43,359

Total dissolved 29,983 19,367 22,826

Public on register 5,934 6,058 6,310

Private on Total register 468,660 474,594 484,830 490,888 505,193 511,503

Source: Companies Registry

There is much that is positive although news of the negative will dominate media reports

To keep growing, a company must develop competitive strategies and consolidate competencies. Hong Kong has many strong companies who see solid growth potentials in the coming years, such as those in this report. Media reports are more likely to focus on the bad news, however. For example, the government’s SME Information Centre estimated that up to 10,000 enterprises might close as a result of China’s accession to the WTO and the continuing slowdown in the domestic economy. It should be noted that there is a brighter side to the story and investors can identify many good performers among Hong Kong companies.

Strength of Hong Kong’s SMEs

There is no dispute that SMEs play a vital role in the development of an economy. Technically, SMEs are defined as manufacturing firms with fewer than 100 employees or non-manufacturing firms with fewer than 50 employees. The number of employees in Hong Kong is the sole criterion but many of these companies may have quite large operations outside the SAR. In Hong Kong, the 290,000+ SMEs employ 1.4 million people, which represent 60% of the workforce (excluding civil servants). The manufacturing sector includes most of the companies in import/export since the majority of them are involved in production in China and elsewhere. They are classified as trading companies because they no longer do manufacturing locally. These two sectors make up the majority of Hong Kong SMEs and employ the largest number of people by a long stretch. The transport and storage sector is very much a part of the manufacturing supply chain, thus more than 50% of the SMEs are directly engaged in the process. Figure 9

Distribution of Hong Kong SMEs (Sept 2001)

Total Industry Services

Manufacturing Mining, quarrying, gas, electricity, and construction Import and export Wholesale, retail, restaurants and hotels Financing, insurance, real estate and business services Community, social and personal services Transport, storage and communications

Number of SMEs 290,460 19,532 674 98,647 84,673 47,995 28,978 9,961

Number of employees 1,374,580 133,403 10,587 413,777 381,001 218,620 152,214 64,978

Source: HKTDC

The small caps provide a glimpse of Hong Kong’s overall muscle power

April 2002

Many of Hong Kong top manufacturing companies employ more than 100 employees and thus fall outside the official classification of SMEs. To analyse Hong Kong’s manufacturing prowess, the larger companies ought to be

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Section 3: Industrialisation and reindustralisation

Nimble and nifty

included as well. The small-cap manufacturing companies provide insight into how the sector is doing since as public companies, they provide a high level of information that could be extrapolated to cover private companies in the sector. Many of the most competitive Hong Kong manufacturing firms are still in private hands. Some of Hong Kong’s best

In 1999, Forbes Magazine, ranked seven Hong Kong companies among the “Top 20” companies among the Best Small Companies worldwide. This is a substantial hitting average for such a small place, and it shows Hong Kong’s exceptional ability. The seven companies are Café de Coral, Giordano, Glorious Sun, Guangdong Kelon (listed in Hong Kong), Hung Hing Printing, JCG Holdings and Varitronix. A look at three of the seven provides insight into how small-cap Hong Kong companies are responding to intense competition to maintain managerial excellence and bottom-line success.

Giordano Café de Coral Hung Hing Printing G Giordano was established in 1980 as a G Café de Coral was founded in 1969 and it G Hung Hing has over 50 years in

casualwear wholesaler. In 1981, it opened its first Hong Kong retail outlet. Its products were positioned at the high end of the market until 1986, when the brand was re-positioned to a low-mid range market. Today, the G company has numerous brands – Giordano, Giordano Ladies, Giordano Junior, and Bluestar Exchange. It has over 950 retail outlets in more than 26 countries Instead of lowering prices in a tough economic environment throughout G most of Asia, Giordano improved quality to give customer value, streamlined processes for greater efficiency and controlled costs. Its managers saw themselves in a longterm business and did not want to adopt a cheapened approach and sought to distinguish Giordano from competitors. Its aim was and is to exceed customer expectations. China and South Korea were the star markets in 2001. They compensated for weaknesses elsewhere. Since April 2001, Giordano set up numerous joint-venture outlets in Germany in REAL supermarkets, which are doing well. Giordano has also ventured into G Japan where it expects good prospects. Stores are also opening under the Bluestar Exchange label in China. Giordano has small production facilities in China to support its retail needs. Its strategy is to outsource more in order to enhance cost efficiency. In 2000, it sold a portion of factory shares to staff.

was the first company to provide Chinese fast food in Hong Kong. Today, it has central food-processing plants in Hong Kong and Guangzhou. The group also provides institutional catering. Its ability to provide a vast menu of mass production Chinese food at good prices in a self-service environment resulted in strong growth. It has a master menu of over 300 items and the menus change four times a day for breakfast, lunch, afternoon tea and dinner. It has over 195 stores, mainly in Hong Kong with a dozen or so in China/Macau. It has also built a series of successful G brand outlets, which include in addition to Café de Coral: The Spaghetti House, Ah Yee Leng Tong and Super Super Congee. It also owns a chunk of the Manchu Wok chain in the US and recently bought China Inn’s 17 restaurants, plus three Japanese and Chinese bistros through a joint venture company in which it has a 48% stake. In total, it has over 200 G restaurants through JV operations in North America. Although they represent only 1% of its profit, Café de Coral has an aggressive plan to build its overseas network. Over the years, Café de Coral has developed a highly sophisticated supplychain management process with state-ofthe-art technology throughout to be able to provide its array of food services. It reengineers every three to four years in order to improve the supply chain. Over 85% of its food sourcing comes from countries other than China in order to maintain consistent quality, even though costs are higher. Café de Coral achieves outstanding industry performance. It has cash to invest and is seeking acquisitions overseas, including some in China. Its management expertise compares with the best in the world.

business and has become one of the most sophisticated printing and packaging companies of paper products. Since it already has strong technological abilities, the company focuses on developing product lines in order to stay competitive. Its products include manufacturing of paper and cardboard boxes, corrugated board and cartons, complex stationary, printing children’s books and paper toys, and paper trading. In 2001, it also reduced margins in order to compete. Hung Hing continues to invest in advanced technology and machinery for its vertically integrated processes, which includes centralised paper sourcing and trading, product production, and customer service. Hung Hing produces products for customers all over the world, including those in China. The group has obtained a printing licence to set up a 100% owned plant in Wuxi, a city close to Shanghai, which aims to serve consumer product companies in China. With many multinationals producing consumer goods in China, Hung Hing expects strong growth once the Wuxi plant is completed later this year. Current China sales is about 15% of group turnover.

Source: CLSA Emerging Markets

cloh@civic-exchange.org

April 2002

Section 4: China rejoins the world

Nimble and nifty

China rejoins the world 1978-1979 in Chinese history

The decision by China to modernise in 1978 marked the beginning of its reentry to the global system after a long period of isolation. In making this decision, China chose to ditch Soviet-style development in favour of a market approach. Reforms implemented during the late 1970s initiated a process of change that would transform the economic relationship between Hong Kong, Taiwan and mainland China and shape development of the entire region for the next two decades.

Marxist-Leninist-Maoist Ideology Impact on central planning and investment strategies

To appreciate the boldness of China’s decision to reform in 1978, it is useful to review the structure of the centralised socialist state established in 1949 that monopolised almost every aspect of the nation’s economic, social and political affairs. In the early days of the People’s Republic, Chinese leaders were preoccupied with two major problems: preventing the capitalist contamination of China and protecting the country from attack by foreign powers. Market and consumer values were discouraged, while capital investments were concentrated in the interior and away from more vulnerable coastal areas. Beijing sought to develop a self-reliant economy by emphasizing the production of grains and basic heavy industry goods, particularly iron and steel, in order to achieve high rates of industrial growth. Beijing’s tight grip on decision-making gave local authorities limited room to propose alternative initiatives.

A period of “growth without development”

The result was a stagnant economy. Most people led a subsistence-based rural lifestyle without the opportunities or incentives for developing economic activities. While grain, iron and steel production increased, in reality, these increases constituted “growth without development” since there was no corresponding increase in the standard of living for the population.

Neglect of South China

As a result of Beijing’s interest in heavy industry, provinces with iron ore, coal and petroleum became the focus of China’s central planners. Major industrial complexes were located in North, Northeast and Southwest China. By comparison, the once-vibrant South China region suffered from official neglect for over 25 years. The principle of self-reliance was essentially a closed-door policy. North and Northeast China were considered important to China’s development in strategic terms. However, South China’s strength, particularly in the Pearl River Delta, was in commerce – a sector frowned upon by the socialist regime for ideological and strategic reasons. This, coupled with the geographic proximity of South China to capitalist Hong Kong, Macao and Taiwan, made it seem unwise to base any important economic activities in Guangdong and Fujian, the two major cities in the region.

Post-Mao pragmatism

April 2002

The new post-Mao leadership under Deng Xiaoping valued results, not ideology. Deng adopted very different policies that had a profound effect on China’s development still apparent today. He opted for efficiency over dogma and contact with the outside world over self-reliance. Rather than viewing South China as unorthodox and unsafe, Deng developed a bold strategy to use this region as a testing ground for market mechanisms. Beijing reduced state intervention in local affairs and gave the Guangdong and Fujian authorities greater leeway to maneuver.

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Nimble and nifty

Section 4: China rejoins the world

Deng’s experiment

Moreover, the establishment of Special Economic Zones (SEZs) in four southern Chinese cities (Shenzhen, Zhuhai and Shantou in Guangdong Province and Xiamen in Fujian Province) in 1980 and the designation of the Pear River Delta region as an Open Economic Zone in 1985 provided the basis for a unique experiment in which socialist China tried to create a market economy by taking advantage of British Hong Kong, Portuguese Macao and the Kuomintang’s Taiwan. This extraordinary decision by Chinese leaders showed that Beijing was very much aware of the economic strength of those areas that had remained independent of socialist control in 1949. Beijing’s pragmatism enabled China to conduct controlled experiments on a domestic level using international and capitalist models.

Start of impressive regional development

Since the 1980s, the development of the Pearl River Delta has been inseparable from that of Hong Kong, a relationship allowing growth of a much greater magnitude than was ever imagined in 1979. Equally important were the new economic ties between mainland Chinese, Taiwanese and the people of Hong Kong that resulted from the experiment. The term “Greater China” was coined to describe the creation of an economic network that was truly regional in scope. Figure 10

Map of the Pearl River Delta Region Guangzhou

Pearl River Delta

Dongguan

CHINA

Huizhou

Huiyang

Shenzhen Zhongshan

Jiangmen Zhuhai

Hong Kong

Macau The Pearl River Delta Region covers 47,430 square kilometers and has 25 municipalities, 3 counties and 450 statutory towns, in addition to Hong Kong and Macao, with a population of about 30 million. Source: CLSA Emerging Markets

Why did the experiment succeed? 1. Complementary production capacity

There are at least four reasons for the success of Greater China: First, success lies in the complementary production capabilities of the three areas. Differences in the availability of land, raw materials, labour, capital, management skills and technology formed the basis for economic integration.

cloh@civic-exchange.org

April 2002

Section 4: China rejoins the world

Nimble and nifty

2. Different comparative advantages

Second, each area also enjoyed different comparative advantages. The mainland was ideal for labour-intensive manufacturing. Taiwan had specific manufacturing technology to offer. Hong Kong had a well-developed legal, financial and infrastructure system that made it the natural choice for an international business centre linking the region’s productivity to world demand.

3. Close kinship links

Third, the region as a whole was held together by “trust relationships” based on kinship. Businesspeople could not rely on legal relationships because the Chinese legal system remained underdeveloped.

4. Beijing allowed local decision-making

Fourth, Beijing’s willingness to delegate authority to the local authorities in exploring new possibilities made it possible for both administrative and entrepreneurial innovation to occur.

Local autonomy in practice: Dongguan County Take the case of Dongguan . . .

Dongguan is a small county in the Pearl River Delta located between Shenzhen and Guangzhou. In 1986, it was estimated that Dongguan residents had 650,000 relatives in Hong Kong and Macao combined, plus another 180,000 in other parts of the world. Kinship ties have helped this particular county to grow even more rapidly than other areas of South China.

. . . impressive growth by any account

Since 1978, Dongguan has achieved an average annual GDP growth of about 13%. In the early days of reform, the strategy of the local authorities was to develop the county as an export-oriented centre for manufacturing, specifically processing and assembly, and commercial agriculture. The first investors were mainly small Hong Kong firms with kinship ties to Dongguan that were seeking to set up factories for the production of textiles, clothing, plastics products, metal and machinery and shoes. These projects required low-skilled local workers. When Dongguan was granted still greater autonomy in 1988, the authorities invested heavily in the development of transport infrastructure, power supply and telecommunications. At the end of the 1980s, Dongguan had more miles of paved roads per kilometer than any other county in China. The authorities continued to expand their objectives for the area. Development plans for 1996-2000 aimed to shift Dongguan production from low-value products to higher-valued products and achieve a greater degree of technological advancement. “As foreign-financed companies are usually less willing to invest in high-technology sectors, the Dongguan government realised that locally-financed industry must play an important role in initiating the crowing-in process … To further accelerate economic restructuring [the authorities have] encouraged a group of low-valueadded, labour-intensive and resource-consuming locally funded enterprises … to relocate in the less developed north-west of China.” Godfrey Yeung Foreign Investment and Socio-Economic Development in China: The Case of Dongguan, 2001

Surprising truth about FDI

April 2002

Research shows that China’s overall comparative advantages lie in light industrial manufacturing (such as textiles, garments, footwear, sporting goods, machine tools, toys etc) and agricultural and food products. This is not surprising, as these are all areas dominated by competitive private enterprises for which South China is the main export producer.

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Section 4: China rejoins the world

Nimble and nifty

Whilst China received substantial FDI . . .

What is surprising is that fact that much of China’s Foreign Direct Investment (FDI) is not concentrated in these areas. Instead, figures from 1988 to 1999 show that large amounts of FDI went to heavy machinery, transportation equipment, chemicals and minerals and fuels, areas in which China has fewer comparative advantages than some regional competitors, such as South Korea. On a long-term scale, this phenomenon could have major geopolitical significance. China is now attracting ever-greater amounts of global capital: in 2001, it took nearly 80% of all foreign investments in Asia.

. . . much of it supported inefficient SOEs

Harvard economist Huang Yasheng believes that FDI in China is motivated by the wrong factors and often occurs at the expense of more efficient, privately owned domestic companies because China’s state policy discriminates against private enterprise in favour of less successful SOEs. Up until 1999, private domestic enterprises could not form foreign joint ventures or receive loans from Chinese banks. China’s lending statistics show that although private enterprises accounted for 30% of the value of total industrial output in 2000, they received less than 1% of total bank credit. Private businesses have been forced to set up companies in Hong Kong in order to form joint ventures in China, enjoy tax breaks and access bank loans, as well as foreign currency.

Policy disadvantaged the more competitive private sector

Other scholars have observed that private enterprises tend not to invest in R&D because they cannot afford to do so. This then prevents them from moving up the value chain. Another concern is that global competitors will relocate to China following WTO accession and will be able to enjoy the same cost structure as Chinese companies in light industries. The domestic private sector may then lose its hard-earned competitive edge. Mainland businessmen are thus turning to the stock market to fund growth and reap more immediate capital gains. There is now widespread discussion of the attempt by businessmen to fight for media limelight in promoting their companies and increasing stock value rather than invest in product development, a trend that fuels stock market bubbles.

Hong Kong’s SMEs’ investments were small but went to the most competitive sectors

Although relevant to Hong Kong and its role in transforming the mainland, discussion of the numerous systemic problems crippling China’s development are beyond the scope of this report. Suffice to note that investments from Hong Kong SMEs in light industrial manufacturing, whilst smaller in value individually when compared to large investments in heavy industries, are nevertheless the most productive because they are directed at China’s most competitive sectors.

“Flying geese” model An integrated economy

South China is much more than a cheap maquilladoras region like Mexico. It is an economic block geared towards supplying the global market. The complementary capabilities of Hong Kong, Taiwan and Guangdong have created what is referred to as the “flying geese” model of economic integration, which utilises the advantages of concentration, specialization and the existence of a mass consumer market in the region. This combination has resulted in a much more dynamic integration than would have been the case if South China had developed as a low-cost base for cheap production similar to production areas in developing regions around the world, including Mexico and Southeast Asia.

cloh@civic-exchange.org

April 2002

Section 4: China rejoins the world

Further integration

Nimble and nifty

Since 1979, China’s Open Door Policy has driven the economic integration of South China, Hong Kong and Taiwan. What exists today is sub-regional integration made easy because of geographical and cultural proximity.

Economic integration Meaning of economic integration

Economic integration means a lowering of the barriers between two economies in order to lower transaction costs. The barriers may be: G

Natural – eg, geographical, such as distance and topography, making transportation costs prohibitive;

Cultural – eg, different linguistic and cultural norms; and

Institutional – eg, tariffs, movement of capital and labour, exchange control etc.

Countries may enter into multilateral agreements to promote economic integration by forming trade blocs, such as free trade areas, customs unions, common markets or economic unions. Closer Economic Partnership Agreement (CEPA)

However, true political and institutional integration is still a long way off. Even after the reunification of Hong Kong and China, the “one country, two systems” framework presents significant challenges to further integration.

Hong Kong is trying to get first mover advantage

In December 2001, Hong Kong proposed the establishment of a free trade zone (FTZ) between Hong Kong and the mainland. The original idea was the brainchild of the Hong Kong General Chamber of Commerce. After an initial meeting between officials from Hong Kong and Beijing on 25 January 2002, the arrangement under negotiation is now referred to as a Closer Economic Partnership Arrangement (CEPA). Any agreement will have to conform to WTO rules. Hong Kong would like to see an agreement before the end of the year.

Hong Kong’s view …

The Chamber hopes that this will give Hong Kong companies time advantage to get market access within 12-18 months of China entering the WTO. Under the terms of entry, China will progressively open up her markets over a three to five-year period. Hong Kong’s SMEs in the manufacturing sector is of course already well entrenched in China but the services sector is not. The Chamber notes, for example, that according to China’s WTO schedule, by 2005, all restrictions on distribution, auxiliary services – warehousing, advertising, technical testing and analysis, and packing services – will be phased out and wholly foreign-owned subsidiary forwarding companies will be permitted. By 2007, China will relax ownership limitations on foreign managed consulting firms, and foreign retailers and chain store operators will no longer have an equity limitation. A time advantage starting for Hong Kong companies in 2003-2004 could be valuable for Hong Kong companies to develop a stronger position before full liberalisation.

… but there are difficulties

There are many difficulties still to overcome, however. A key issue is what constitutes a Hong Kong company. Another possible problem could be pressure from mainland provinces on Beijing questioning why Hong Kong should be given preferential treatment. No doubt Beijing has many considerations to take into account in its negotiations with Hong Kong.

Beijing will likely think of something that gives Hong Kong a boost

At a minimum, Beijing will find some tariff advantages for Hong Kong-origin goods, and will probably set up some form of formal and regular exchange through consultation with Hong Kong. Whether the CEPA works or not, Beijing

April 2002

cloh@civic-exchange.org

Section 4: China rejoins the world

Nimble and nifty

has many “goodies” it can offer Hong Kong, which will also benefit the reform process. The announcement on 11 March 2002 that mainlanders with foreign exchange holdings may be allowed to invest in the Hong Kong stock market is a case in point. Appropriate packaging could be done in order to make the CEPA look as attractive as possible for all interest groups. Issues involving cross-border traffic, including the efficiency of cross-border transit and freight and customs clearance, will take high priority. Talks are now occurring between Beijing, Hong Kong and Guangdong to co-ordinate infrastructure developments in South China. These initial efforts should not be dismissed because they are necessary for more comprehensive integration. Non-discrimination and impartiality under the WTO rules more powerful than anything else

The most powerful force for continuing integration is China’s continuous effort to develop a market economy in which economic relations will operate on an increasingly non-discriminatory and impartial basis – two principles at the heart of the WTO framework.

cloh@civic-exchange.org

April 2002

Nimble and nifty

Section 5: Services unlimited

Services unlimited Hong Kong’s transformation into a service hub …

Economic development in Hong Kong from 1980 to 1997 was in direct response to China’s bold program of reforms. During this period, Hong Kong’s development was characterised by a distinct shift from manufacturing to services (including the flourishing of a real estate sector); revival in entrepôt trade with China and migration of Hong Kong’s manufacturing capacity across the border to South China, particularly the Pearl River Delta. Hong Kong also became a very attractive base for multinational corporations operating in China and East Asia. Many of these multinational enterprises used Hong Kong as a stepping-stone in accessing production capabilities on the mainland.

… to service manufacturing in China and elsewhere

While Hong Kong’s shift to a service-based economy is well documented, what is less well understood is that this move has actually made Hong Kong more competitive as a manufacturer for a number of key reasons. Firstly, by relocating production capacity to China, the scale of manufacturing increased many times over. At the end of April 1999, there were 180,653 Hong Kongfunded investment projects in China, representing nearly 55% of all foreigninvested projects in the country. The majority of the projects were in manufacturing for export. The amount for each investment was relatively small. Investments in import/export projects were also closely related to manufacturing. The largest chunk of investments, not surprisingly were located in South China, particularly the Pearl River Delta. Hong Kong companies simply took over parts of South China to expand their manufacturing capabilities. Figure 11

A look at Hong Kong’s investment by sector in China …

Distribution of investment by sector

Real estate 3.9%

Infrastructure 1.3% Services 5.2%

Wholesale/ retail 9.5% Import/export 14.5% Manufacturing 65.6%

Source: 1999 HKTDC Survey of 1,649 companies

April 2002

cloh@civic-exchange.org

Nimble and nifty

Section 5: Services unlimited

Figure 12

â&#x20AC;Ś and where investments have been made

Geographic distribution of investment Inland provinces Yangtze Delta 8.0% and neighbouring areas (including Shanghai, Jiangsu & Zhejiang) 14.0%

Other coastal areas 5.9%

Pearl River Delta 59.7%

Guangdong (other than PRD) and Fujian 12.4% Source: 1999 HKTDC Survey of 1,631 companies

Manufacturing has been profitable and reinvestments made

Second, the manufacturing-related services provided by Hong Kong complement the physical production process. The physical expansion into China required substantial support in everything from banking, financing, management, design, professional services, to transportation. Profits made were reinvested and/or repatriated in Hong Kong, which arguably fuelled the property and retail boom there.

Services have become embedded in production of goods

Third, the growing importance of the high-end service component of manufacturing, such as design, has rendered the division between manufacturing and services somewhat artificial. In other words, services have become embedded in the production of goods. Figure 13

Awesome speed of transformation

GDP composition and contribution by economic activity: 1980-1995 (%) GDP composition

Structural changes

Contribution to GDP growth

1985 1990 1995 1985-90 1990-95 1985-90 1990-95 Industry 29.9 25.3 16.0 (4.6) (9.2) 21.4 4.8 Mining and quarrying 0.1 0.0 0.0 (0.1) 0.0 0.0 0.0 Manufacturing 22.1 17.6 8.8 (4.6) (8.8) 13.8 (1.9) Electricity, gas and water 2.6 2.3 2.3 (0.4) 0.0 1.9 2.4 Construction 5.0 5.4 4.9 0.4 (0.5) 5.7 4.3 Services 69.6 74.5 83.8 4.8 9.4 78.5 95.2 Commerce and trade 22.8 25.2 27.4 2.3 2.2 27.1 30 (Trade) (12.6) (15.3) (17.1) (2.7) (1.8) (17.5) (19.6) (Wholesale/retail) (5.8) (5.3) (5.0) (0.5) (0.3) (4.9) (4.7) (Restaurants/hotels) (4.4) (4.6) (4.1) (0.1) (-0.5) (4.7) (3.5) Transport and communication 8.1 9.5 9.8 1.3 0.4 10.6 10.3 Finance and real estate 16.0 20.2 24.9 4.2 4.7 23.7 30.6 (Real estate) (6.6) (9.7) (12.4) (3.1) (2.7) (12.2) (16.3) (Financing/insurance) (6.4) (7.0) (10.6) (0.6) (3.6) (7.5) (15.7) (Business services) (3.0) (3.6) (3.8) (0.5) (0.2) (4.0) (4.1) Community, social services 16.7 14.5 17.1 (2.2) 2.6 12.7 20.3 Ownership of premises 10.5 10.6 12.7 0.1 2.1 10.7 15.2 Agriculture and fisheries 0.5 0.2 0.1 (0.2) (0.1) 0.1 0.0 Total domestic product 100 100 100 100 100 Source: Adapted from Toyojiro Maruya, Hong Kong Economy and Society, 1998

cloh@civic-exchange.org

April 2002

Section 5: Services unlimited

Nimble and nifty

The table shows that the pace of the change to a service economy accelerated from 4.8% during the second half of the 1980s to 9.4% during the first part of the 1990s. The shift was particularly rapid in the areas of finance and insurance, as well as in real estate. The fact that Hong Kong statistics record “ownership of premises” as a separate service category reflects the importance of private property rentals as an economic activity and source of income. Current franchise in trade, manufacturing and finance/services

Hong Kong’s impressive list of achievements

The rapid structural transformation that has taken place in Hong Kong over the past 20 years was in response to unpredictable changes in the business environment in mainland Chinese and worldwide. Today, Hong Kong has three primary identities – as a regional trade centre, as a global manufacturing management centre and as an international financial and services centre for trade and manufacturing. Hong Kong’s multiple identities

G GDP per capita is over US$24,100 G Trading generated 18% of GDP and employed 500,000 workers in 104,000 trading firms

G World’s 9th biggest trading economy G World’s 9th biggest services exporter G World’s most service-oriented economy, with a focus on manufacturing-related producer services

G Services generated 85% of GDP in 2000, employing 87% of the workforce G Ranks 1st in the world in terms of export value in clocks, calculators, radios, electrical hair apparatus, telephone sets, imitation jewellery, toys & games, travel goods & handbags and artificial flowers

G Ranks 2nd in the world in terms of export value in clothing, textiles, watches, electric food grinders, mixers & juices, fur clothing and umbrellas

G G G G G G G

Logistics generates 5% of GDP and employs 140,000 workers World’s busiest airport in terms of cargo World’s busiest container port World’s 9th largest stock market Estimated 1998 outward direct investment from Hong Kong was US$19 billion Hong Kong is the 2nd largest venture capital centre in Asia 3,237 overseas companies had regional operations in Hong Kong in 2001 (944 regional HQ + 2,293 regional offices) - 50% of the regional offices were in the distributive trade sector and over 90% covered the Chinese market

G 64% of Hong Kong’s exports originate in mainland China G Guangdong is the largest source of exports in China, accounting for 37% of total exports

G Guangdong is China’s richest province G Hong Kong handles 40% of China’s total foreign trade

Source: CLSA Emerging Markets

The perceived threat from China are exaggerated As trader . . .

April 2002

There is concern in Hong Kong about whether China’s accession to the WTO will mean less business for Hong Kong traders as Chinese companies will now be able to deal directly with foreign firms. But the key issue is not whether a simple middleman role exists for Hong Kong. The success or failure of any dealmaker depends on the ability to see opportunity and assume risk rather than hoping to maintain agency margins. London and New York have not lost their role as trading hubs and neither should Hong Kong, which has a longstanding trading culture. The physical commodities trader, Noble Resources, is a good case in point in demonstrating that the business is viable with solid knowledge of the industries, good business acumen and exploiting the support services readily available in the SAR.

cloh@civic-exchange.org

Section 5: Services unlimited

. . . as supply chain manager . . .

Nimble and nifty

There are also fears that Hong Kong’s role as production manager will diminish as outward processing in South China levels off due to the relocation of production to cheaper areas and/or the saturation of world markets by Chinese products. In the near term future, Guangdong will continue to be the largest source of exports in China, and the province’s proximity to Hong Kong will allow Hong Kong to maintain its sourcing role. Over the medium-term, the indicators are positive for Hong Kong. For example, the World Bank estimated that with WTO accession, China’s share of world export apparel could rise from 19% to 47% by 2005. Furthermore, Hong Kong companies have the ability to move production inland to even lower-cost regions. Indeed, Hong Kong’s SMEs appear to be doing precisely that. According to Professor Wang Yan-keung, who lectures at the Hong Kong Productivity Council, smaller companies are moving into other provinces, such as Hunan, Shanxi and Shaanxi. The initial investments are small but promising attractive returns.

. . . don’t overlook Hong Kong SMEs’ role as global production managers

What is often overlooked is that Hong Kong’s strongest players are global manufacturing managers, not simply China production managers, and are now developing global marketing capabilities. Historically, Hong Kong’s SMEs have concentrated on the United States as the major market for exports, but are diversifying in order to target Europe, Asia and, of course, China, where strong growth is expected.

Domestic consumptionled growth

With China as Hong Kong’s “home market” and with the Chinese government supporting domestic demand, Hong Kong’s firms should do well in areas where consumer spending is strongest, including the Pearl River Delta. Hong Kong’s proximity to the Pearl River Delta is a clear advantage as the availability of Hong Kong TV broadcasts in Guangdong means that residents are already familiar with Hong Kong brands. Even if export-reliant growth tapers off in the future, the likely growth of the mainland market provides tremendous opportunities for Hong Kong companies.

One-stop services economy

To support its trading and manufacturing management role, Hong Kong has developed into a one-stop service centre and is now the only such centre in the region possessing a critical mass of a wide variety of service providers:

Hong Kong is doing well in services

Wholesalers and retailers

Freight service

Telecommunications and Internet

Banking and financial services, securities and fund management

Design, advertising and market research

Professional and business services

Real estate and infrastructure

Entertainment and tourism

Hong Kong is a net exporter of services. Even through the Asian financial crisis, the export performance remains impressive. Losses in 1998/1999 were quickly made up and expanded by 2000 and further increased in 2001. The chart shows exports of services began to exceed domestic exports in the mid1990s. Last year, services exports at HK$336bn was more than double domestic exports of HK$153bn. The sharp increase in services while exports of goods manufactured in Hong Kong have fallen reflects an economy able to transform and exploit competitive strength and long-term opportunities.

cloh@civic-exchange.org

April 2002

Section 5: Services unlimited

Nimble and nifty

Figure 14

Hong Kong services exports vs domestic exports 350

(HK$bn)

Domestic exports

Service exports

300 250 200 150 100 50 0 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 Source: CEIC

Case study: Professional and business services sector High-value services have been developed over the years

In the services sector, the biggest value-added process for Hong Kong is the distribution of global knowledge used in structuring projects in China and regionally. It is useful to examine the professional and business services sector as a representative example of Hong Kongâ&#x20AC;&#x2122;s service sectors. Professional and business services include legal, accounting, auditing and bookkeeping, architectural, surveying, engineering, business management and consulting services. In 2000, this sector included 9,861 establishments and employed nearly 80,000 people. This represents a growth of 7% and 4% respectively in the number of establishments and the number of persons engaged in the professional and business services sector between 1995 and 2000.

There is breadth and depth the extent of which is still unavailable elsewhere in Asia

Many major international firms offering a range of professional services are already located in Hong Kong in order to service customers engaged in regional operations. Local service providers have teamed up with these international firms to access global knowledge while overseas companies have acquired Hong Kong firms to gain local insights. International firms have also acquired companies started by long-time foreign residents as a way of gaining access to local markets and expertise.

Services are vital to the economy

This is a high value-added sector. In 1999, value-added constituted nearly 68% of the gross output of the sector with 73% of the value-added distributed as employee compensation. The corresponding figures for the economy as a whole were 54.8% and 55.6% respectively. The number of professionals in this sector also continues to increase. Between 1995 and 1999, the number of professional accountants increased from 9,856 to 16,104 and the number of lawyers increased from 4,209 to 5,448.

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Section 5: Services unlimited

Figure 15

Membership of selected professional associations 1995-1999 Lawyers Registered architects Professional accountants

20,000 16,000 12,000 8,000 4,000 0 1995

1996

1997

1998

1999

Source: Hong Kong – The Servicing Economy (Census Statistics)

Hong Kong is servicing China’s market reforms

Even though Hong Kong companies are now doing business in China and elsewhere, their support services providers are still based in Hong Kong. The service capacity of Hong Kong is critical in providing support for China’s trade and market expansion. China itself has a poorly developed service sector. Services only account for about 33% of China’s GDP. Even in higherincome cities, such as Shanghai and Beijing, the contribution of services to the GDP is only about 50%. The potential expansion of Hong Kong’s readymade services to the mainland would provide exceptional growth opportunities. Moreover, as China restructures her economy, much of the necessary services support will continue to be sourced from Hong Kong-based financial and professional providers. Hong Kong’s advantages as a services provider

Low transaction costs

G G G G Low risks

Rule of law with developed property rights system Free port and relatively open economy Sound banking and financial system Low and simple tax regime

Low exchange rate risk and uncertainty

G Fully convertible currency G Exchange rate fixed to the US dollar G Fully open and deep capital market Next to a rapidly growing South China

Capital-raising centre

Proximity to rapidly growing South China region

G Potential for lowering production costs in Hong Kong G Potential for expanding turnover in Hong Kong G Potential for raising living standards in Hong Kong International capital-raising centre for China Source: CLSA Emerging Markets

Another look at subcontracting Subcontracting helps to provide consumer choices

It was once believed that it was necessary to integrate the vertical and horizontal aspects of the production process under one roof in building a production powerhouse. This organisational structure is well suited to the mass production of a single product. It is less suited to provide short cycles of

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Section 5: Services unlimited

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a large variety of products in small volumes. However, in many industries, consumers demand frequent variety and new choices, which means producers must offer many more choices in a shorter cycle at lower volumes of each type of product. Hong Kong’s SMEs are subcontracting experts in light industries . . .

Producers need a different organisational structure to cope with new demands. Specialised production is the best response. Increasing the number of stages in specialised production helps to increase variety because more features and functions can be added to products at a lower cost at each stage. However, coordinating many specialised divisions at each stage of production is a very demanding task for one company, requiring large amounts of capital and management resources. An effective way of handling this is to subcontract the specialisation processes to others.

. . . arguably among the most efficient managers in the world

The development of Hong Kong’s unique subcontracting system was discussed earlier in this report. Hong Kong’s extensive experience in subcontracting is a competitive advantage that is often overlooked. Subcontractors producing individual components of a product provide an essential service by smoothing the production process for the industry as a whole. Independent subcontractors have a strong incentive to improve their products and develop new ones at competitive prices. Indeed, since the 1990s, independent subcontracting has been a major trend in many sectors. International openness facilitates the vertical disintegration of large production processes in favour of more specialised production. With a higher degree of market openness, a specialised subcontractor has more downstream buyers from different parts of the world and therefore has greater incentives to invest in specialised production. This has particular relevance for Hong Kong, given its complete transformation to a manufacturing-supporting service economy positioned within China’s larger industrial economy.

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Hong Kong’s metropolitan economy Where do we go from here?

1997 was a watershed year for Hong Kong. The reversion of sovereignty to China marked a new phase in its development. When Hong Kong was ceded to Britain in the 19th century, China was a declining power, looking inward for solutions to its problems. Today, China is a rising power with a decidedly outward-looking attitude.

Building on existing strengths

Beijing’s Hong Kong is the true heir to capitalism with Chinese characteristics and its economic influence on the mainland is already widespread. The combination of Hong Kong, Taiwanese and overseas Chinese capital has enabled South China, and in particular, the Pearl River Delta, to resume its historic role as the hub of China’s commercial and trading activities. Hong Kong was once described as China’s “golden goose.” Today, the goose has grown in size – the entire South China region has become the industrial backbone of China and, unlike other areas of China, is dominated by the private sector.

Hong Kong’s fourth industrial phase

Another look at the PRD

The creation of a dynamic and integrated Pearl River Delta region resulted from the combination of Beijing’s open-door policy, relaxation of state intervention, increases in global production and kinship ties – 80% of overseas Chinese, including those in Hong Kong, originated from the Pearl River Delta – as well as the influence of Hong Kong’s market capitalism and consumer culture.

Can Guangdong and Hong Kong find a way to collaborate?

South China’s growth and development over the last two decades has effectively reshaped China’s entire economic landscape. By removing bureaucratic constraints and liberating local decision-makers, Beijing allowed the South to experiment with market reforms. Building on Hong Kong’s dynamism and Guangdong’s historical role in trading and light industry, the South adapted quickly. In general, this region of China has always preferred economic utility to political correctness.

The PRD region needs to compete with other regions

The significance of change in South China is especially great when compared to the simultaneous economic development of the Yangtze Delta region with Shanghai as the dominant city. The Yangtze Delta region is developing quickly because it is moving up from a low base. To stay ahead, the Pearl River Delta needs to strengthen the economic integration of its many cities, municipalities, counties and towns and attract investment in higher-value manufacturing and services.

Develop as a metropolitan area

South China’s strongest growth area is the triangle between Hong Kong, Guangzhou and Macao with Shenzhen and Zhuhai topping the league tables in terms of growth in production, population and income. Within this area, numerous towns have formed clusters of activity, redefining the countryside through the juxtaposition of industry and agriculture and creating a distinct metropolitan environment. There is little doubt that South China will lead national economic growth for the foreseeable future. Policy makers in China are now studying the spatial development experience of the Pearl River Delta, viewed as a great success, to see what lessons can be distilled for use in other parts of the country. Scholars believe that over the next two decades, continued economic liberalisation and decentralisation may mean that mainland China has up to nine regional economies (including the Pearl River Delta and Shanghai regions) with relatively independent industrial structures.

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Section 6: Hong Kong’s metropolitan economy

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Figure 16

PRD - an area of significant wealth

City statistics (2000) Cities Hong Kong Shenzhen Zhuhai Dongguan Guangzhou Shanghai Beijing

Population (million) 6.8 7.0 1.2 6.4 9.9 13.2 11.0

GDP per capita (US$) 24,100 4,970 3,325 4, 060 4,300 4,180 2,750

Source: CLSA Emerging Markets

Hong Kong vs China – A good complement Hong Kong and China need one another … and Hong Kong remains useful to manage production in China

Hong Kong and China enjoy dual complementarity. Firstly, the proximity of the Pearl River Delta to Hong Kong enabled the creation of a pool of expertise and supporting industries in a relatively low-cost environment and the development of vertical and horizontal linkages. While the global production network of Hong Kong manufacturers now extends beyond the Pearl River Delta, the skill base existing in this area allows it to move up the value chain at a faster rate since Hong Kong firms must diversify into higher-end products to stay ahead. There is also a strong clustering effect in some sectors, such as toys and electronics. Secondly, Hong Kong firms must also meet cost challenges for low- and medium-end products. While some production facilities have moved out of the Pearl River Delta to lower-cost areas in China, the country as a whole remains competitive not only in terms of cost but also in terms of productivity. Hong Kong’s physical and cultural proximity to China remains a major competitive advantage for SMEs in the manufacturing of light industrial products.

Productivity – Not so easy to measure Production management of light industrial capacities may not sound exciting . . .

The general impression that Hong Kong’s productivity is limited is derived from a history in which growth was linked to OEM for exports to rich countries, primarily the United States. A related concern is that while exportled growth has many advantages, including access to foreign exchange, it is inferior to domestic consumption-led growth because of its dependency on external factors. Still, it is unlikely that the United States will lose its appetite for goods made in China (much of it under Hong Kong production management) given comparative advantages in production. At present, China’s export per capita basis is only US$200. China still exports less than all other significant trading economies. Its export growth potential will remain strong for the foreseeable future and allow Hong Kong's SMEs producing from the mainland to grow their exports from these bases.

. . . but it is a critical part of the global economy and is Hong Kong’s major strength

Hong Kong’s true productivity strengths are often overlooked. As with every economy, there is a large disparity between the highly productive end of the scale and the low end of the scale but it is important to understand higherend activities since they have high value-added and will be the main driver for Hong Kong's GDP. G

April 2002

In the global supply chain, Hong Kong is a key manager for light manufacturing products, which it sources from China and other lower-cost economies;

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Hong Kong companies produce, manage, and/or trade the production of goods and services with a higher intellectual property content than lowercost economies;

As illustrated by the various companies highlighted in this report, Hong Kong companies generate high intellectual property content in goods and services because many have already increased productivity through technological upgrades and management innovation;

The flexibility of Hong Kong companies remains legendary. As producers and production managers, their ability to guarantee quality and quick turnaround time mean that they are still international leaders; and

Hong Kong companies have a strong track record of value creation. It is the largest value creator in the region. There is value to be created in producing basic things well and developing the products to meet market needs. It is not “discovery” science, but Hong Kong’s ability to meet market demands for a range of light industrial products and services requires a very high level of sophistication and business acumen.

“High-tech” state subsidies

Hong Kong has done it without state subsidies

Critics sometimes argue that Hong Kong has been disadvantaged by the failure of past governments to invest in high-tech, but Hong Kong’s ability to remain nimble and adaptable has also enabled technological and management upgrades. The case of Hong Kong provides support for the libertarian philosophy of economist F A Hayek that an economy that leaves more choices to the individual is likely to be more successful than one with a high degree of state intervention.

Continuing transformation . . .

Hong Kong’s manufacturing history had humble beginnings. Despite this, the strength and success of the manufacturing industry should not be overlooked. While Hong Kong still has some OEM operation, a transition to ODM and OBM is clear. Hong Kong companies make world-class products, such as the electronic components for cars made by Johnson Electric, high quality branded fashion apparel down to shoes for the best known global brands.

. . . Hong Kong now has successful international ‘brand names’

In some sectors, such as garments and toys, Hong Kong companies are developing brands. Hong Kong manufacturers are diversifying their markets. The opening of the Chinese market will offer key “home” market opportunities. The better Hong Kong SMEs are now investigating the best ways to capture the advantage in China.

The SMEs continue to invest steadily in their own growth

Leading companies are also continuing to invest in technology and managerial ability. These companies are not just manufacturers of old-economy products, such as garments, electronics and toys, but own the intellectual capital that has been invested in their design, production and marketing, even if for another label.

A new generation has taken the helm

Moreover, a new generation of Hong Kong businesspeople are now at the helm. As a group, they tend to be well educated and are developing their businesses globally. They have a better understanding of technology than previous generations and are comfortable hiring a multiethnic pool of professionals as business managers. Sound management is given a priority and the best among them have earned global recognition in their particular fields.

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The new generation of Hong Kong-Chinese entrepreneurs

“Good management 101 is a must, a foundation for everything else. But practicing management 101 day in and day out is very boring. It’s like doing the scales for a pianist … There are many management equivalents of doing the scales, but let’s take a simple one, good accurate data collection, whether it’s for financial management or marketing … Also, communication is so important … it’s not fancy strategies and fancy technology that are key to running a successful business. It’s basic management skills … Since my dad’s era, competition has been based on having a [textile] quota and cheap labour. As a manager, there is nothing to write home about – that you’ll only be competitive if your workers remain as poor as possible. That’s not a very good aspiration. So if we think that what we want to do is to bring about economic well being, then we must be able to maintain our competitiveness while raising living standards.” Marjorie Yang, 2001 Chairman, Esquel Group

Technology and entrepreneurship Technology needs application before it becomes useful

Without entrepreneurship, technology may never reach the marketplace. Corporate entrepreneurship is the sum of a company’s innovation, renewal and venturing efforts. Hong Kong entrepreneurs are not restricted to tapping domestic technological skills – they can go anywhere for technological innovation. The world has no shortage of innovators. The rate of technological change has accelerated far more rapidly than the ability of markets to absorb change. The problem is not in getting people to be more innovative – there are plenty of innovative people – but in figuring out how to make innovation usable. Ultimately, it is customers and clients who determine whether or not good ideas become successful innovations.

How to bring ideas to market or bring markets to ideas

Key is finding ways to bring ideas to the market or bring markets to the idea. The privately owned Dunwell Group provides a good example of how an engineer-entrepreneur works with customers and potential customers to see how new ideas can be used to solve the technological problems of a consumer. By making new technology more adaptable and therefore more adoptable, Dunwell could become one of tomorrow’s leading applied technology companies.

Dunwell doing well Technology application Hong Kong style

More than twenty years ago, Cheng Sr. had a small business importing machine tools for the watchband manufacturing industry in Hong Kong. This was a classic mom-and-pop operation. By 1983, as Hong Kong’s political future looked increasingly uncertain, the prospects for business survival were truly grim. The family business was on its last legs. Mr. Cheng became very ill from stress. His eldest son, Daniel, who was the operation director of a sophisticated medical paper-converting factory in the United States, was called back home to help out. Daniel Cheng, an industrial design engineer by training, observed the rise of videocassette manufacturing in Hong Kong. His research showed that better stainless steel tape guides and pins for videocassette cartridges by developing a new production process. After starting off with a small production of 40,000 units, the business was producing 3 million pieces a

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Section 6: Hong Kong’s metropolitan economy

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month by the end of 9 months. At its height, Dunwell made over 100 million parts per month - 40% of the world’s supply of videocassette guides and pins. They milked this opportunity but it was clear that new initiatives would be needed for the future. Profits from the videocassette business were use to finance R&D in various technology-based opportunities, such as epoxy formulation for a new high-end seamless flooring business. In 1993, Daniel Cheng identified an opportunity to buy a failed oil recycling plant in Hong Kong. By 1995, it was functioning well and by 1997, its products were showing a modest profit. Dunwell now collects waste oil from over 1,000 waste producers in Hong Kong and reprocesses it for sale. The firm has worked out an efficient way to manage a complex and diverse collection system, which is a management innovation. This business is now expanding to Singapore and mainland China. Dunwell feels confident that the technical and management processes can be adapted to suit local conditions. Furthermore, Dunwell bought the rights to a membrane technology developed in the United States in order to market it in Asia. The technology can be used to separate waste from waste oil or wastewater. Daniel uses his Hong Kong plant as an R&D laboratory. He believes the equipment components for the membrane process can be produced much more cheaply in China than in the United States while the membranes can be manufactured in Hong Kong, which provides good intellectual property protection. There are significant opportunities for both oil recycling and wastewater treatment in China. The latter could become a US$500 million revenue business within 10 years upon securing 1% of the mainland market. The Internet allows the firm to operate and monitor its membrane businesses in Hong Kong and overseas. If a client does not pay, he will not be given the new password to login for the next month, thereby limiting commercial risk. Dunwell is looking to IPO in a couple of years.

But is Hong Kong pricing itself out? Admittedly, Hong Kong is an expensive place in which to base operations. Comparisons with other cities show that Hong Kong is still among the world’s most expensive cities. Still, there are two sides of the story.

To move or not to move . . .

Whilst Hong Kong is not cheap as a business hub, it does provide a breadth and depth of supply chain support that is hard to beat. As shown below, in Hong Kong’s core competence areas, business people recognise the value and are staying put. However, in low-end areas, even in the services sector, jobs are being lost to the mainland. A recent example is mobile phone operator, SUNDAY, moving a part of its support services to Shenzhen in March 2002.

. . . moving lower-end jobs elsewhere is a sign of transformation, not decline

The HKTDC noted in a 1999 report, Hong Kong’s Competitiveness Beyond the Asian Crisis that: “Hong Kong’s competitiveness has depended on its dynamism and its ability to evolve and change under the pressure of market forces. As in other major, successful metropolitan economies, low valueadded activities have been crowded out by high value-added activities. This is a sign of progress, not decline”.

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Section 6: Hong Kong’s metropolitan economy

Corporate restructuring

Another useful perspective is to look at how Hong Kong-based companies have restructured to stay competitive. The Hong Kong Monetary Authority published a study in May 2001 showing the speed at which the adjustments took place – an indicator of Hong Kong’s ability to adapt.

Hong Kong’s ability to adapt quickly remains impressive

Both fundamental and financial restructuring have taken place since the Asian financial crisis. Restructuring involved the reduction of operating costs (labour, rents and interest payments), which, generally account for over half of total operating expenses. There have been significant reductions in fringe benefits and wage cuts for new entrants to the employment market. The cost for new staff fell by more than 20%. Significant downsizing has also occurred, with the unemployment rate standing at 6.8% today from 4.5% in early 2001. New rentals have dropped by between 50% and 65% since mid-1997. An international rental survey showed that Hong Kong slipped from 3rd to 6th on the list of the world’s most expensive location to rent office space in 2001. The cyclical downturn has been severe but has facilitated much of the required structural changes. Figure 17

Total occupancy cost per square metre, per year (Euros) 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400

Milan

Mumbai

Geneva

Frankfurt

Hong Kong

New York

Moscow

Paris

Tokyo

London

200 0

Source: Cushman & Wakefield, Healey & Baker, iMail

Companies also reduced interest cost by switching to cheaper financing and tightening controls on borrowing, which has raised company credit ratings. As a result, after surging sharply to 32.6% in 1998, the corporate finance charges to earnings ratio fell back to 13.8% in 1999. Companies also sought to improve their loan structure and liquidity, with the most pronounced improvements occurring among manufacturing companies. Liquidity improvements were partly achieved through a tightening of inventory control. The series of charts below show that restructuring helped to improve profitability by 1999. Compared with the performance of other regional economies, Hong Kong did exceptionally well. Moreover, the competitiveness of Hong Kong’s exports helped companies regain ground lost to Asian competitors, who achieved most of their restructuring gains through currency depreciation.

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Section 6: Hong Kongâ&#x20AC;&#x2122;s metropolitan economy

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Figure 18

Figure 19

Debt leverage of HK companies

Interest burden of HK companies

0.6

Non-financial

(%)

of which manufacturing

0.5

30 25

0.4

20 15

0.3

10 Non-financial

5 0.2

of which manufacturing

0 1996

1997

1998

1999

2000

2001

1996

1997

1998

Figure 20

Figure 21

Current ratio of HK companies

Profit margin of HK companies

2.0

(%)

1.9

Non-financial

of which manufacturing

1.8

1.7

1.6

1.5

1.4

1.3

1.2

1999

2000

2001

1999

2000

2001

(%) Non-financial of which manufacturing

0 1996

1997

1998

1999

2000

2001

1996

1997

1998

Figure 22

Figure 23

ROE of HK companies

Inventory-to-sales ratio of HK manufacturing sector

(%)

Non-financial

of which manufacturing

(%)

18 17

16 15

15 14

11 1996

1997

1998

1999

2000

2001

1996

1997

1998

1999

2000

2001

Source: CLSA Emerging Markets

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Section 6: Hong Kong’s metropolitan economy

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Jobs that are staying Some high-end service functions are staying put

Nevertheless, Hong Kong is not cheap. The question is whether it offers good value to businesses. Certain functions can be performed more efficiently in Hong Kong than across the border in China or elsewhere in the region. The textiles and apparel industry, vital to both China and Hong Kong, is a good example of this fact. Signs show that the firms in this sector have good business reasons for remaining in Hong Kong rather than moving out to lower-cost pastures. Overlooked strengths “There is currently a lot of talk in Hong Kong about moving textiles/clothing industry offices to the mainland. Land and labour costs are lower there but we have decided against it. What truly tips the scales for Hong Kong is the complete community of skills and services in the industry – one stop shopping. “Hong Kong has a huge pool of people skilled in the industry. The Hong Kong Polytechnic University, vocational institutes, and other trade related schools continue to produce graduates for the industry each year. And, Hong Kong’s history in textiles/clothing production and trading with overseas companies has created an experience base that is difficult to match on the mainland. The workforce in Hong Kong has greater familiarity and understanding of the standards of quality, design and timeliness required by major brands than workers in China, and the gap is unlikely to close soon. “The concentration of industry supply chain companies in Hong Kong is unmatched anywhere in the world. Virtually any fabric, leather, snap and button, zipper, elastic, thread, and yarn supplier can be found in Hong Kong, whether they be Japanese, Korean, American, Taiwanese, or European. Likewise for the supplier of the related bits and pieces that go in, on, or around a finished garment – labels, hangtags, plastic hooks, hangers, printed fabric bags, and even carton boxes. The wide choices available and specialization in the production of even corrugated cardboard and poly-bags would surprise most non-industry folks – yet, the global marketplace demands that these choices be available. The fact that these resources are contained in one place increases productivity almost incalculably. A phone call in the morning can result in an array of samples delivered that afternoon by a salesperson skilled in discussing their relative merits. Keen competition among the suppliers also result in companies like ours being exposed to and offered the latest products, which in turn, allows us to have a competitive edge with our customers overseas. “Hong Kong’s sophisticated trade related infrastructure allows us to be more efficient. Communications technology is reliable and costs are extremely reasonable. A wide array of hotels and restaurants are available for visiting clients. In our cases, these are almost all Americans or Europeans, who like the total package of what the city has to offer. The Hong Kong Trade Development Council offers an extensive range of services to exporters. Shipping facilities, both air and sea, are world class. This is particularly important for us as we bring in expensive materials from around the world to send to factories on the mainland. The large number of shipping lines calling in Hong Kong allows for great flexibility in dates and times are fast. Ground transportation to our factories in the Pearl River Delta is now plentiful and competitively priced. Moreover, the banking and trade finance services in Hong Kong are comprehensive.” Bartow Fite, March 2002 Director, Mandarin Associates Limited (A trading company for worldwide brands in outdoor wear)

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Section 6: Hong Kong’s metropolitan economy

A look at two industrial sectors An in-depth look at electronics and garments

Business success comes with the combination of production factors – land, labour and capital – being put together most efficiently for producing what there is a market for. All else being equal, companies that can squeeze the most value out of the supply chain and manufacturing process will enjoy greater returns on capital. Hong Kong has a number of companies with sound management ability who are strong candidates to move even further up the value chain. Two representative industries are electronics and textiles/garments, both of which have developed breadth and depth to a degree that is not available in other rival lower-cost economies and certainly not across the border. This is why firms continue to use Hong Kong as their operating base despite higher costs.

I: Electronics Success

Electronics are Hong Kong’s largest merchandise export earner and accounted for 32% of total exports in 1999. This success is due to the ability of Hong Kong electronics manufacturing and trading companies to market a wide range of consumer electronics and source electronics components and parts on a worldwide level. While expanding their production bases in China, Hong Kong’s electronics industry has real depth and its proximity to mainland China and its expanding facilities in the mainland, are significant advantages. Hong Kong firms in this field enjoy an excellent international reputation as reliable suppliers of high-quality products at reasonable prices, despite reliance on imported components. Hong Kong management quality is high and firms can gain a competitive edge through fast application of the latest technology to product design and development.

Challenges

55% of Hong Kong’s electronics exports are actually re-exports from mainland China. Hong Kong’s OEM experience has helped Guangdong to become a formidable competitor in low-to-medium end consumer electronics in recent years. Guangdong is the largest production base for China’s electronics industry, accounting for 22% of the total industry output. 60% of Guangdong’s output is generated in Shenzhen. The Chinese Government has targeted the industry as one of the nation’s “pillar industries” with the expectation that by 2010, it will be the largest industry in the country. Figure 24

China’s electronics output 90 80

77.7

70 60 50

36.4

31.8

28.4

23.5

23.1

21.8

21.5 13.3

20 10

Shaanxi

Shanghai

Zhejiang

Shandong

Sichuan

Fujian

Beijing

Tianjin

Jiangsu

Guangdong

Source: China Electronics Industry Yearbook 1999

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Section 6: Hong Kong’s metropolitan economy

A successful “flying geese” model of development

Nimble and nifty

About 45% of the investment in China’s electronics industry comes from Hong Kong and Taiwan, much of which has been used in the formation of a range of mainland domestic electronics enterprises that now pose a challenge to both Hong Kong and Taiwan's manufacturing, particularly in audio-visual equipment, household electrical appliances and lower-end electronics products. From the perspective of the Chinese government, this illustrates the success of the “flying geese” model of development outlined in an earlier part of this report in which the pull from Hong Kong and Taiwan helps to improve mainland industry. Figure 25

Hong Kong Electronics Export by Origin, 1999

Re-exports of other origins 36% Re-exports of China origin 55%

HK domestic exports 9% Source: CEIC, CLSA Emerging Markets

Opportunities

Better sourcing

In spite of the challenges, China’s entry to the WTO and the prospects for economic liberalization over the next few years provide tremendous opportunities for Hong Kong companies: G

Sourcing – As the quality of mainland products improves, significant opportunities for Hong Kong’s electronics manufacturers and traders to source low-priced components and parts will emerge. Given their facility for speedy application, Hong Kong firms will be able to expand their businesses worldwide.

Electronic Manufacturing Services (EMS) EMS is subcontracting

WTO will help Hong Kong companies in China

April 2002

In the electronics sector, the role of OEM and ODM is overshadowed by the emergence of EMS, the ultimate sub-sub-contractors, who provide the manufacturing capacity to supplement OEM/ODM capacities. EMS focus on making non-brand products for everyone else. Their expertise is in specialised supply chain management and parts procurement. Although this is a lowmargin business, it serves an important role in smoothing out increasingly shorter product cycles within the electronics industry. There is constant pressure to launch new products. In 2000, 26% of the world’s EMS were supplied from Asia. China’s role as an EMS supplier is expected to grow as China becomes more competitive. International EMS providers include Elecoteq Network, Flextronics and Jabil Circuit, as well as Hong Kong firms Nam Tai Electronics, VTech and Surface Mount Technology G

WTO – China’s WTO membership will secure greater market access for Hong Kong and mainland companies. As the mainland’s domestic distribution process is liberalised, Hong Kong companies will also have a chance to compete with prominent mainland companies.

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Section 6: Hong Kong’s metropolitan economy

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Figure 26

Top 10 mainland Chinese electronics enterprises (accounting for over 40% of industry total) Rank 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Enterprise Name Legend Group Holding Co. Shanghai General Electronics (Group) Co. Ltd. TCL Group Konka Group Sichuan Changhung China Great Wall Computer Group Beijing Telecommunication Equipment Factory Haixin Group Panda Electronics Co. Shenzhen Huawei Technology Co.

Sales in RMB in 2000 20.3 17.5 13.2 13.2 13.0 12.1 11.5 10.7 10.3 10.2

Source: HKTDC

Hong Kong finally has a “home” market

“Home” market – Changes on the mainland mean that Hong Kong companies will finally have a “home” market to exploit. The Pearl River Delta, for example, is China’s wealthiest region and represents a large group of potential consumers. However, Hong Kong firms must start to brand their products so that local and mainland consumers know that they are of high quality. Now that there is an assured and substantial “home” market, strong companies should be willing to invest in OBM, technology differentiation, marketing and logistics.

More M&A activities?

M&A – Fears that Hong Kong itself is technologically weak can be addressed by using Hong Kong capital to tap into the technical strength of the mainland. The number and variety of Hong Kong-mainland partnerships will increase, from Hong Kong firms setting up R&D operations across the border to joint ventures or mergers and acquisitions.

II: Textiles & garments Hong Kong is a textile and apparel giant

In terms of the textiles and garments industry, Hong Kong’s greatest strengths include its responsiveness to fashion trends, quality assurance, short production cycles, quick response, reliable delivery and other valueadded services.

Figure 27

Hong Kong textiles/clothing industry summary Threats G Competition from China G Competition from other low-cost economies G Overseas buyer consolidation

Strengths G Depth of industry G Dominant world player G Major companies well-capitalised G Advanced technology G Most responsive to market trends G Solid reputation G Good management capabilities G Physical and cultural proximity to China

Opportunities G China’s WTO membership G End of quota system

Strategies G Diversified global manufacturing G “Brand” development G Get ready for “home” market in China G Improve supply chain management to stay ahead

Source: CLSA Emerging Markets

Importance to Hong Kong and China

This sector is vital to both the Hong Kong and the Chinese economy. It is the largest manufacturing sector in China, employing 14% of the manufacturing workforce, and the country’s top foreign exchange earner. In Hong Kong, this sector still represents close to half of domestic exports, despite the relocation of most production facilities across the border. Moreover, it is still the largest manufacturing employer, employing 23% of the manufacturing workforce.

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Section 6: Hong Kong’s metropolitan economy

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However, when domestic exports and re-exports are combined, Hong Kong is the world’s largest clothing exporter after mainland China. Hong Kong is also the second largest textile producer in the world. Recent data for 2000 shows that 82% of Hong Kong’s imports of textile/garments from the mainland were related to outward processing and 96% of outward processing takes place in the Pearl River Delta. Global trader and producer

The Hong Kong Trade Development Council (HKTDC) noted that 54% of Hong Kong’s offshore trade in garments is generated on the mainland. The remainder is produced in a number of other overseas locations, including Central America, Canada, Africa, France and Asia. Production diversification means that Hong Kong companies can reduce costs, respond quickly to the market and “arbitrage” quotas. An overseas buyer can order garments made around the world from Hong Kong companies because these companies have multiple overseas branches. Hong Kong companies are flexible, mobile, offer incomparable services and are prepared for the winding down of the quota system. The HKTDC described this sector thus: “Hong Kong is not only a key production centre but also a global hub for sourcing fabrics, textiles materials, clothing and accessories. Companies engaged in the garment trade in Hong Kong are experienced in sales and marketing, quality control, logistics arrangements and clothing designs. The professionalism that they command and the combined services offered are not easily matched elsewhere.” Figure 28

Market positioning of Hong Kong clothing Price

Designer

Bridge Hong Kong

Better

Moderate

Budget

Conservative

Updated

Advanced

Taste Source: HKTDC

2005: End of quotas What will happen with the end of textile quotas?

Quotas govern world trade in the textiles and garment industry. The exports of competitive producers like China, are restricted by limiting the number of quotas available to particular countries. A large percentage of the quotas in Hong Kong and Taiwan are recycled for China-origin products.

April 2002

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How the quota system works

The quota system has shaped the competitive environment and business dynamics of the garments sector for many years. Understanding how the system works is a mind-numbing task. Essentially, a quota is the maximum number of garments that can be exported legally by a particular country into the importing country on an annual basis. The many categories of quota are classified according to certain criteria, such as fibre content, knit or non-knit, garment type and sub-type and specific and non-specific categories. Once the quota for a particular category has been used up, all further imports of that category from that country are embargoed for the rest of the year.

Quota system and Hong Kong

Initially, all quotas are held by the government of the exporting country and then allocated to the industry. In China, quotas are held by semigovernmental organizations. In Taiwan, the government sells them to the industry. In Hong Kong, the government allocates all quotas directly and permanently to the industry on a historic output basis. Thus, it is hard for new entrants to break into the business unless they buy quotas. Over the years, a substantial and lively trade in quotas has developed in Hong Kong.

There could be “antisurge” mechanisms to replace quotas

Quotas are supposed to be completely eliminated by 2005. This will change the entire operating environment for Hong Kong companies involved in the textile and garment business. “Quota arbitrage” will become irrelevant. Manufacturers will need to work harder on design, quality, efficiency, costs and related support services, as well as improve factory working conditions and minimise environmental impact in order to meet the demands of their multinational clients. However, “anti-surge” mechanisms are expected to come into place for China-origin exports, which may limit export quantity to safeguard against “market disruption” in the importing country. Low-tomedium end products and “hot” items are mostly likely to be targeted. In order to avoid being caught by these mechanisms, Hong Kong manufacturers will have to continue to upscale.

Hong Kong’s global brands

Hong Kong “brands” are successful overseas and are now gaining ground in mainland China. One of the most successful international brands is Esprit, which has 450 retail outlets worldwide. Others successful Hong Kong brands include Bossini, Episode, Toppy, Giordano, G-2000, U-2 and Baleno. While foreign-branded apparel products backed by a strong marketing budget are also beginning to arrive in China, Hong Kong brands are doing well on the mainland and in other international markets. Esprit, for example, has built solid markets in both Europe and has just bought out the brand-name rights for the United States. Spirit of Esprit “It’s a pretty fast paced business. Every three or four months you have to look at what can make you or break you … as a brand we are selling more than just merchandise. We are trying to sell at a premium and that means connecting to an emotional need … People don’t buy clothes to keep warm. They buy them to express themselves and the labels then become a status symbol … business is a marathon race, not come by day, fly by night … you need to really stay focused … I don’t distract myself with these other so-called ‘money making opportunities.’ I guess everything is a moneymaking opportunity, but only if you know what to do.” Michael Ying Chairman, Esprit Holdings Ltd, 2002 Hong Kong Business, January 2002 Issue

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Section 7: Policy implications

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Policy implications Hong Kong’s health is tied to that of the Chinese economy

There is little doubt that Hong Kong’s future prosperity is tied to the health of the Chinese economy. In practice, this will mean further economic integration with South China under the “one country, two systems” principle. Polices of the Hong Kong government should be guided by the need to maximise the benefits of this integration and smooth any disruption associated with change.

City with a mission

Hong Kong’s “mission” today is to act as a catalyst in bringing market forces to China and facilitating the rapid transformation of China’s economy. This is also the “mission” that Beijing would like Hong Kong to play. For example, on the 18 February 2002, the People’s Bank of China governor, Dai Xianglong, said Hong Kong would be the testing ground where Beijing could test the RMB’s convertibility on the capital account, and on the 11 March, he said Beijing may allow Chinese mainlanders with foreign currency holdings to invest in the Hong Kong stock market for the first time, bringing in potentially substantial funds into the market.

Hong Kong is most effective if its economy is competitive, transparent and reflects international standards

Hong Kong will be most effective in fulfilling this “mission” if its own economic system is competitive, transparent and reflects high international working standards. Hong Kong’s effectiveness as a catalyst for change and transformation will be compromised unless it continues to improve its own system. Good public policy can help economies to remain cutting edge. Although far from comprehensive, the list below summarises some of the key areas requiring the urgent attention of Hong Kong authorities.

1. What are Hong Kong’s competitive advantages? Hong Kong has undoubted strengths but . . .

Hong Kong remains highly competitive in many areas: light industrial manufacturing and supply chain management, its many institutional strengths, its breadth and depth of professional and management services, and its substantial reserves to weather cyclical downturns. Despite the large budget deficits, Hong Kong is still in a very sound financial state. It has HK$370 billion in cash equivalent reserves and more than HK$430 billion in other investment holdings. Moreover, the expected recurrent deficit of around HK$40-50 billion for the next few years can be dealt with, as discussed below. Its companies are well positioned to capitalise on opportunities made available by China’s entry to the WTO.

. . . the local mood is unnecessarily dull and unhappy

Yet, the mood in the city remains poor. The collapse in confidence appears to be caused by political as much as economic factors. Negative equity for 17% of those with property mortgages and four years of deflation have not helped domestic psychology. But there also seems to be a belief that Hong Kong’s systemic weaknesses, such as its domestic cartels, weak education system, outdated social policies, and its awkward political system, cannot be remedied.

2. Why the collapse in confidence? A former insider’s interpretation

April 2002

“What made this crisis manifestly different from all the other challenges to Hong Kong’s prosperity since World War II was the collapse in public confidence. The community had lost its long-standing conviction that the economy would manage to create additional wealth and new job opportunities, however adverse the political or business environment which Hong Kong faced. Equally important, the bureaucracy’s credibility had been damaged, and the community declined to share officialdom’s view of what should be done. Confidence fell abruptly at the very start of the [1997]

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downturn, and pessimism rapidly pervaded the entire community. Under these circumstances, domestic consumption slumped. Deflation became chronic. Official efforts to talk up property prices failed. Announcements of bold initiatives inspired more cynicism than public enthusiasm … Behind Hong Kong’s inability either to resist the onset of recession or to recover promptly with its traditional resilience lay a challenge that was much more political than economic … The challenge was created by the fact that Hong Kong’s economic impasse had more to do with the quality of its administration than with economic fundamentals. The SAR found it difficult to identify strategies: G

First, to tackle the difficult decisions involved in taking charge of Hong Kong’s economic future; and

Secondly, to mobilise the public’s support for the Government’s strategies to transform the economy.” Leo Goodstadt, 8 January 2002 Pre-1997 Director of the Central Policy Unit, Hong Kong Government

Gaps in how business and officials perceive Hong Kong’s strengths and weaknesses

The lack of confidence in Hong Kong solving its problem seems to be attributed to the perceived quality of governance. This is perhaps understandable when the post-1997 political leadership needed time to develop a new governing strategy that can deal effectively with the systemic weaknesses. However, the importance of the quality of governance may not be fully appreciated by the Hong Kong administration. Results of a 1999 survey published in September 2001 indicated Hong Kong as well as multinational companies and Hong Kong officials had very different views as to the factors affecting business. There were also large differences between corporate and official perceptions of the relative importance of these factors. Management scholar Edmund R Thompson, who designed the survey, noted that in nearly all cases where significant differences existed, officials had a more positive view than businesses. The survey highlighted that much of Hong Kong’s advantages as a business centre can be attributed to government policy. Hong Kong’s only “innate” advantage is its proximity to China and the Asia-Pacific region, which is a product of geography. The quality of governance, whether there is a sufficiently competitive business environment, government philosophy as regards intervention, and even quality of the natural environment are crucial when businesses assess Hong Kong. Quality of governance is key

A scholar’s view of the problem

Indeed, [Hong Kong officials] tend systematically to overestimate the advantageous aspects of Hong Kong, especially those relating to the government itself, such as the efficiency and transparency of government. They also particularly overestimated the advantages of rule of law, lack of corruption and an independent judicial system. However, when it comes to pollution, public servants significantly underestimate the degree to which this is thought to be a problem for Hong Kong. Interestingly, public servants overestimate the degree to which lack of full democracy is a disadvantage to Hong Kong. Certainly, if Hong Kong public servants think that the mechanisms by which governments obtain and retain power are as serious a concern to senior business managers overall as concerns about what those governments actually do in terms of maintaining a free and impartial business macro-economic and institutional framework, this finding would suggest that they are mistaken … This finding hints that firms are perhaps not so much interested in how governments come to be, but rather in the quality of their governance … competitive constructs, such as non-intervention … are entirely created, or destroyed, by government action … The danger of public

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servants overestimating the robustness of these constructs … is that it might wreck them through a barely perceptible process … Other policy constructs, like an impartial legal system … are not just policy-sensitive but fundamentally reputational … A few minor transgression can swiftly establish a bad and long-lasting reputation.” Edmund R. Thompson The China Quarterly, Number 167, September 2001

3. What should be the economic role of the government? Business takes a keen interest in how the government sees its role in the economy

As the abovementioned survey shows, business takes a keen interest in how the Hong Kong government sees its economic role and is watching developments closely as the new administration starts to articulate its governing strategy. Hong Kong’s traditional attitude on the government’s role in the economy is to provide an adequate infrastructure and a conducive institutional environment rather than direct intervention. That policy of “positive non-intervention” was credited with producing Hong Kong’s dramatic growth for many years in the past.

There is a gradual redefinition of that role since 1997 . . .

There has been a gradual redefinition of the Hong Kong government’s economic role during the Chief Executive, C H Tung’s, first term of office (1997-2002). The Financial Secretary, Antony Leung, provided the latest statement on the government’s role during his maiden budget speech on 6 March 2002.

. . . in the words of the Financial Secretary

Policy of “Selective intervention” “I am a firm believer in market economy. I believe the market can allocate and utilise resources more effectively and has greater capacity to foster creativity, provide economic impetus and create employment opportunities. Some may have the impression that, to maintain Hong Kong’s economic freedom, the Government should be passive and distance itself from the economy. I disagree. I am of the view that the Government should have a clear vision of the direction of economic development and be a proactive market enabler. This role includes – G

First, maintaining an institutional framework conducive to market development …

Second, providing the infrastructure in which the private sector will not invest,

Third, providing the appropriate environment and resources required to raise the quality of our human capital …

Fourth, secure more favourable market access for our local enterprises through multilaterial and bilateral economic and trade negotiations …; and

Fifth, considering the need to take appropriate measures to secure projects beneficial to our economy as a whole when the private sector is not ready to invest in them”. Antony Leung, Financial Secretary Hong Kong Budget - 6 March 2002, paragraph 42 and 43

A policy of selective intervention

April 2002

The evolving strategy appears to be one of 'selective intervention', such as with the stock market intervention in August 1998, and bypassing of the established tendering process for giving the development right for the Cyberport to one company in March 1999. The government’s current enthusiasm for developing the “logistics” industry is another example.

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The peg is still useful as a de-politicised tool to force the economy to upscale

Nimble and nifty

In terms of macroeconomics, with its currency linked to the US dollar, Hong Kong has limitations in the exercise of monetary policy. The HK dollar will likely de-link at an appropriate time, probably when the RMB is closer to being convertible. For now, the government is adamant that it has no intention of making any change. The peg still has its usefulness. For the last 18 years, it has not only provided a confidence boost, it has also acted as a de-politicised tool to force Hong Kong businesses to go up the value chain in order to remain competitive. The force remains at work today and is likely to transform the economy once again to a fully service oriented economy at lightening speed. In terms of its fiscal policy, the latest Budget indicated that there could be changes on the horizon, as the government needs to increase its recurrent revenues.

4. Is Hong Kong suffering from structural deficits and should taxes be raised? The 2002-03 budget

The 2002-03 Budget needs to be read together with two sister documents released a few days beforehand. The first report from the Task Force on Review of Public Finances stated that Hong Kong is facing ongoing and persistent “structural” fiscal problems. It highlighted the urgent need to controlling the growth of government expenditure.

“Structural deficits” of the old operation environment

It should be kept in mind that the use of the word “structural” by government officials does not refer to a structurally different operating environment from say twenty years ago in Hong Kong, but merely to the fact that existing large contributing sources of public revenues are expected to generate smaller amounts of government income. The Task Force pointed to the property market and investment income from Hong Kong’s fiscal reserves as two key areas.

Pressure building for a GST …

The second report from the Advisory Committee on New Broad-based Taxes noted that Hong Kong’s tax base is continuing to become narrower, and concluded that “a GST is the only new tax with the long-term capacity to broaden the tax base which is not incompatible with Hong Kong’s external competitiveness”.

… although there are other ways to raise taxes

This conclusion ignores the fact that the government could reduce allowances under salaries tax to bring over 700,000 workers back into the tax net. Since 1993, they have been dropped off, resulting in 62.5% of Hong Kong’s working population not paying tax today compared to 50% in 1992. Closing the gap between the standard and the effectives rates of profit tax by reviewing other allowances is also an option. Marginal changes in the corporate tax structure are unlikely to have any major impact on external competitiveness.

Cutting expenditure

Since 1997, the general price level of the economy has fallen by 12%, whereas the price of government expenditure has remained unchanged. The share of public expenditure in the economy averaged 16% in the 1980s, 17% in the 1990s, but rose to 22% in 2001-02 because the government had to adopt what it called a “counter-cyclical fiscal policy” to cushion the pain. The plan is to reduce this share to 20% of GDP or less by 2006-07, although in the current Budget, there will be a rise in spending by 2% in real terms. The current year deficit is expected to be HK$66 billion or 5.2% of GDP, with projections showing deficits of around HK$40 billion for the next five years assuming fiscal policy remains unchanged.

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Civil service pay probably to be reduced by 4.75%

A key area where the government wants to reduce spending is in civil service pay. Personnel-related expenses account for 70% of government operating expenditure. The Financial Secretary has floated the idea of cutting civil service pay by 4.75% from October 2002, which would save HK$3 billion in the current year, and HK$6 billion in a full year. So far, this appears to have the support of the legislature. Arguments might come, however, over the salary-related portions of subventions to the various organizations that will also be affected, such as public sector teachers, doctors and nurses.

Cutting more may be difficult

Many have said that civil service pay can be cut deeper in view of the fact that the price level of the economy has dropped by a much larger margin but the government is constrained by Article 100 of the Basic Law – Hong Kong’s constitution – which provides that public servants may retain their pay, allowances, benefits and conditions of service no less favourable than before 1997. There are obviously different legal interpretations of what the provision means but the government does not wish to invite a legal challenge. The 4.75% cut approximates the pay increase in the 2001-02 financial year.

The government does not want to cut capital spending even though there is room

An obvious area for reductions in spending is the substantial public infrastructure programme announced by the Chief Executive in October 2001, which will involve HK$600 billion in spending over a 15-year period, with HK$400 billion coming from government coffers and the balance from the MTRC and KCRC in rail expansion. That works out to an average of HK$24 billion spending per year. These investments don’t all have to come from public coffers since there could be opportunities to create the right conditions for the private sector to invest. The legislature may have different ideas though. On 8 March, it voted down a funding request for one of the stated projects from the administration for the initial design work for a highway that would cost HK$22 billion when completed. The ability to finance these projects and their efficacy are clearly matters that require greater debate.

Lets have another look at GST as a source of revenue

The Advisory Committee on New Broad-based Taxes does not recommend taxing profits generated by the overseas investments of Hong Kong companies. Nevertheless, this is another area requiring further analysis to get a better handle on Hong Kong’s changing fiscal picture as its economic activities increasingly move offshore.

But first lets review GDP and GNP data

GDP represents the total production value of all units produced by residents within the territory. GNP, the total income earned by residents (individuals and companies) of a particular territory, regardless of the location of incomeearning activities, is obtained by adding to GDP factor income earned by residents from outside the territory and deducting factor income earned by non-residents within the territory.

April 2002

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Section 7: Policy implications

Figure 29

Hong Kong’s GDP/GNP 1993 to 3Q01 1,000,000

GDP

GNP

900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0 1993

1994

1995

1996

1997

1998

1999

2000

2001

Source: CLSA Emerging Markets, CEIC

Hong Kong’ s GNP shows healthy investment profits from overseas investments

Hong Kong companies have expanded their overseas investments, including investment in China, and have invested especially heavily in infrastructure BOT projects. For example, Hopewell Holdings invested in toll highways, Hutchinson and Wharf in ports and Swire Pacific in aircraft maintenance and container terminals. Some of those projects are now operational and are turning in profits.

Hong Kong companies have extensive investments in China

Hong Kong SMEs have also invested in China, expanding beyond South China to Shanghai and Yangtze Delta area in recent years. The Hong Kong Trade Development Council noted that there were 180,653 Hong Kong-funded investment projects in China as of the end of April 1999, representing nearly 55% of all foreign-invested projects in the country. The majority of the projects were in export production. Since 25% of them intended to make further investments in the mainland, the total number of Hong Kong-funded projects is likely to be higher still today. Data since 1Q99 shows that foreign reserves change has been lower than the current account surplus and net portfolio flows. That means that apart from the current account and net portfolio flows, other capital transfers and flows are net out of Hong Kong – another indication that Hong Kong companies are investing outside Hong Kong. Figure 30

Current account, net portfolio flows and foreign reserves 8

(US$ bn)

6 4 2 0 Current Account Foreign Reserves chg Net Porfolio Investment

(2) (4) Mar-99

Aug-99

Jan-00

Jun-00

Nov-00

Apr-01

Sep-01

Source: CEIC

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Section 7: Policy implications

What is clear is that these investments have brought profits to Hong Kong even though a large portion must have been reinvested for future gains. Government statistics show that the Real Net External Factor Income Flow is strong – they may in fact be even stronger since Hong Kong’s GNP figures are probably inaccurate. GNP is likely to be much higher because they capture only profits repatriated which would be lower than the total profit of Hong Kong companies' external operations owing to the high amount of reinvestments. There have been few opportunities for investments in Hong Kong, thus it makes sense for companies to invest and reinvest offshore profits outside the territory, especially in China where the economy remains vibrant and access to international markets improves with WTO entry. GNP data is probably on the low side since there is no need for Hong Kong companies to report overseas profits

Greater growth in GNP would be expected relative to GDP for Hong Kong, if Hong Kong companies are expanding their operations outside the SAR with greater profits that would be attributable to Hong Kong residents relative to the more limited growth in profits from Hong Kong operations attributable to non-Hong Kong residents. The available data, however, shows GNP growth trending down quite closely following GDP growth. Although in the last two quarters GNP growth is positive while GDP growth negative, there is little positive consolation in the data: it is due to net income flow out of Hong Kong attributable to non-residents falling much faster than attributable income to Hong Kong residents from outside Hong Kong. Still, the fact that the official data on GNP quite certainly not capturing the full extent of Hong Kong companies' foreign earnings gives reason to believe that the SAR's true GNP must be greater than reported. Figure 31

HK GNP and GDP growth

(%)

GDP

GNP

8 6 4 2 0 (2) (4) (6) (8) 1994

1995

1996

1997

1998

1999

2000

2001

Source: CEIC

GDP/GNP mismatch Hong Kong is likely to earn more income from overseas in the future

April 2002

“An increasingly large share of Hong Kong’s income comes from overseas. Indeed, GDP may not be a good measure of our current economic performance. In the past decade, GDP has been more volatile than consumption, although this is less evident in periods before the past decade. This is unusual. In most countries, GDP tends to rise faster than consumption in economic upswings and to fall faster in business downswings. But in Hong Kong, the opposite is true. As an increasingly large share of our income is earned outside Hong Kong, GDP becomes a poor approximation of GNP. This mismatch implies profound long-term budgetary implications. In Hong Kong, fiscal revenue is derived from economic activities performed within the territory. As an increasing

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Section 7: Policy implications

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proportion of income comes from outside Hong Kong, the revenue base becomes a smaller part of Hong Kong’s regionalised economy. However, Hong Kong residents continue to demand public expenditure. This sets the stage for revenue growth to fall short of expenditure growth and gives rise to a widening gap between expenditure and revenue. This gap presents another possible source of the structural deficit Hong Kong may be facing”. Richard Y C Wong, 2001 The University of Hong Kong

As Hong Kong integrates with South China and its economic reach continues to expand globally, it may need to examine ways in which to raise fiscal revenues from offshore activities. A consumption tax may be justified

While raising taxes is always unpopular, a consumption tax may have its place for Hong Kong. The absence of a tax on offshore profits is arguably an attractive feature of Hong Kong as a business centre and if government does not want to tax offshore profits, then an alternative is to tax consumption that takes place within Hong Kong. In theory, consumption taxes, such as a goods and sales tax (GST), are the least costly form of taxation as long as the taxation system is simple, though they seldom are. The Financial Secretary made it clear in his Budget that a GST is very much on the cards: “The Chief Executive and I have stated clearly that the Government will not introduce [a sales tax] while there is a downswing in the economy. Nevertheless, the Government will continue to study the details of a Goods and Services Tax for implementation as and when necessary”.

But for now Hong Kong relies on the old formula

Despite the rhetoric, the 2002-03 Budget still relies on investment income, as well as revenues form land and asset sales to make up the required revenues in the foreseeable future despite the Financial Secretary lamenting that these income sources are unstable. It also means that there could be a missed opportunity as windfall from these sources would go towards covering the expected deficits rather than be used to put Hong Kong in a stronger position, such as to privatise schools and universities, and cleanup the environment.

Greater role for Hong Kong citizens needed to invest in their own future

A great city cannot be built by the government alone. The citizenry must also play a part and Hong Kong’s people are wealthy. Hong Kong allows its residents to keep much of the money that they earn in a low tax environment. Its generous public housing programme – some might say overgenerous – has enabled many people to accumulate wealth over the last thirty years. Indeed, by providing cheap housing for nearly 50% of the population, the government has enabled Hong Kong residents to establish successful small businesses. Hong Kong also has a large number of entrepreneurs and professionals who are extremely wealthy. While many donate to charities, such as schools and hospitals, they can do much more to help Hong Kong realise the aspiration to become “Asia’s World City.”

Hong Kong’s citizens can do so much more with their wealth

Hong Kong’s wealthy residents could provide endowments for universities so that they could become private institutions, a measure that would improve the quality of education. They could donate more generously to local sports, the arts and environmental causes as well as supplement the public purse in helping Hong Kong accumulate intellectual capital by funding research in

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science and technology as well as the social sciences and public policy. The advantage of private money is that it can be applied in more creative ways.

5. How can Hong Kong prepare to become a totally service-oriented economy? Hong Kong is fast becoming a fully service economy

Between 1980 and 1997, the percentage of Hong Kong workers employed in the service sector rose from 42.1% to 79.3%, while the percentage of those in manufacturing fell from 45.9% to 9.8%. That trend will continue and reflects a very fast rate of change for a small community of several million people. Change throws up winners and losers, creating new patterns in the corporate and social pecking order and in the structure of the financial markets. The change has also had a tremendous impact on Hong Kong’s manpower needs.

Services have unlimited potentials for growth

There is a misconception that Hong Kong has no industries anymore and that services are more limiting. The authorities and relevant public bodies need to work harder to help Hong Kong people see the real strength of their own industrial power in light manufacturing industries and to see the unlimited potential in service provision as part of a knowledge economy.

The current transformation is good for capital, but may be less so for labour

This report shows that Hong Kong’s manufacturing business coped with fast transformation reasonably well. Investments across the border have increased, which will result in profits for Hong Kong-based companies. Hong Kong’s mission to help China modernise its economy is ongoing. But while the picture is reasonably positive for capital, it may be less so for Hong Kong’s labour force, particularly for workers that cannot adapt to changes in the economy or acquire the high level of skills needed in the services industry. There will be social dislocation that needs to be attended to. This will have to be through a combination of greater training to increase labour flexibility and improved transport and integration with the mainland to facilitate relocation to where jobs move for those with these skill sets.

Investment in education

The Hong Kong government is well aware that it needs to inject more funds into education even though it education costs make up almost a quarter (23%) of total government spending. Hong Kong’s school system remains lacklustre and is in urgent needs of reform. In 1999, 23,000 students sitting the major secondary school examination did not pass –equal to 18% of the total number of local school students. It is beyond the scope of this report to explore this issue in detail, but improving the education base is a crucial step in Hong Kong’s development as a full service economy. It will cost a massive amount to upgrade education over the next decade – a good reason for the government to raise taxation. The root of today’s education problems rest with insufficient past investment in this vital area.

A clear and comprehensive competition policy will help Hong Kong?

Since the 19th century, the evolution of Hong Kong’s economic franchise has been reflected in the transformation of its industrial enterprises. Hong Kong was founded on trade and commerce and the nimble manufacturing and trading SMEs were its standard bearers. Today, the manufacturing and trading sectors remain competitive even though they face tough competition. However, the other sectors of Hong Kong’s economy are still heavily dominated by cartels and oligopolies. These were established when the government granted industry monopolies – as with electricity and transport – or when government policy enabled companies to assume a dominant position – as in property, brokerage, container terminals and banking. Thus, until recently, banks could collaborate in fixing deposit rates.

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Foot dragging has not impressed international business

Nimble and nifty

So far, the government has rejected a comprehensive approach for adopting a competition policy and necessary legislation. It prefers to deal with competition on an ad hoc sector-specific basis. Thus, the provision of telephone services has been deregulated but not brokerage fees. A sectorspecific approach is, in effect, a selective approach. Some would argue there is an inconsistency in protecting only some sectors. Government backs a cartel?

A recent example of government backing the brokerage cartel

“The Hong Kong Government … has caved into pressure from a small but vocal minority to … maintain anti-competitive price-fixing practices in Hong Kong’s brokerage industry … Hong Kong’s economy is still a system of cartels … The New York and London commissions were deregulated in 1975 and 1986 respectively … If Hong Kong had a comprehensive and fair competition law, as most modern economies do, then the price fixing arrangement for broking would be illegal … Hong Kong [is] the only remaining market in the 15 largest markets in the world where brokerage rates were rigged, Taiwan having been the last to deregulate on 1 July 2000 … There can be no economic justification for anti-competitive practices.” David M Webb, 24 January 2001 www.webb-site.com

The price of further delay

The problem with the government’s approach is that the lack of competition in the local service industries could adversely affect the growth of this sector. When prices are higher than they should be, Hong Kong’s overall competitiveness is affected. It is the government’s role to undertake studies to understand where bottlenecks and inefficiencies lie and then ensure that policies and fiscal incentives are adjusted to improve efficiency. Where costs need to be adjusted, the economy would be able to expand more efficiently if the government facilitates a faster adjustment of these costs.

6. How should further integration with the PRD Metropolitan Region be structured? The PRD region is an outstanding area for further development

The Pearl River Delta region is one of the largest and fastest growing urban areas in the world. It has a population of 30 million, but if the entire population of Guangdong Province is added, the total population is over 90 million. The region has some outstanding assets – an excellent harbour in Hong Kong, a good harbour in Yantian, extremely fertile soil and coastlines and mountains of exceptional beauty.

It can out compete other regions by getting its act together

With competition from the Yangtze Delta (Shanghai, Zhejiang and Jiangsu) and other Asian urban regions, the Pearl River Delta authorities need to step up the economic integration of the many cities, counties and towns in the region in order to ensure continued domestic and foreign investment in high value-added manufacturing and services.

cloh@civic-exchange.org

April 2002

Section 7: Policy implications

Pearl River Delta (Hong Kong and Guangdong)

Area: 178,997 sq km Population: 93 million Exports (goods): US$295 billion Import (goods): US$295 billion Trade/GDP (%): 213% Per capita GDP: US$2,978 Nature of economy: Externally based, HK$based and has a high level of light industries and services.

Nimble and nifty

Yangtze Delta (Shanghai, Zhejiang and Jiangsu)

Area: 210,741 sq km Population: 138 million Export (goods): US$72 billion Import (goods): US$64 billion Trade/GDP (%): 59% Per capita GDP: US$1,678 Nature of economy: Domestically based, RMB-based and has a high level of SOEs and heavy industries.

Source: CLSA Emerging Markets

Compared to other metropolitan regions around the world, the Pearl River Delta has several unique characteristics. Settlements of very high density are dispersed over a large area without much continuity. This spatial dispersion is partly due to topography and the creation of administrative boundaries and partly to its development history. The natural topography of mountains and plains is a given. The development history of the region is shaped by the dominance of Guangzhou, Shenzhen and Hong Kong, which form a powerful triangle around the smaller economic sub-centres. Improve internal accessibility and resource efficiency

Because increasing returns of scale are possible with large consumer markets, the economic potential of a metropolitan region is more than the sum of its parts. However, economies of scale can only be realised if the region is well integrated. Fragmentation is usually the result of defective infrastructure networks, which reduce accessibility and therefore limit the economic potential of the entire region. Another major constraint is the natural environment. Misuse or under-use can prove costly.

Develop the mindset of “mutual benefits”

The various authorities in the Pearl River Delta region need to cooperate in order to have a better understanding of the region’s comparative advantages and allow each settlement area optimal use of its resources. The duplication of major facilities, such as airports and ports, is a waste of resources and generates unnecessary economic and environmental costs. So far, every subarea, including Hong Kong, has tried to maximise construction of major facilities like ports and airports seen as required to accelerate GDP growth. However, the degree of duplication is highly apparent.

Guangdong and Hong Kong must create the capacity for collaboration

As yet, no real mechanisms exist for the various authorities to discuss and agree on maximizing comparative advantages. But there are early signs of better coordination. During a press conference on 5 March 2002, the State Development and Planning head, Zhang Peiyan, said that: “Competition is inevitable between the ports, airports and other infrastructure of [Hong Kong and Guandong] … But they can also cooperate. At the request of the Hong Kong government, the central government has agreed to improve coordination between the two in finance, trade, tourism and infrastructure”. Hong Kong and Guangdong just has to ensure that Beijing’s coordination does not turn into a leading role in how the south should develop.

“Logistics” and all that

Hong Kong needs to think in terms of regional benefit rather than local profit and must recognise some basic realities:

Hong Kong companies own much of the PRD’s infrastructure already

April 2002

Hong Kong interests in the Pearl River Delta are through substantial investments in factories, transportation infrastructure etc. The Hong Kong investing public also owns a chunk of mainland infrastructure, such as the Anhui Expressway and Zhejiang Expressway through listing in Hong Kong;

cloh@civic-exchange.org

Section 7: Policy implications

Nimble and nifty

Over time, South China may become more competitive in providing certain transportation and logistics functions. Hong Kong needs to bear this and comparative advantages in mind when considering whether to build more “hardware”, such as container terminals and “logistics parks,” within Hong Kong itself, particularly when the government should look for savings in public spending; and

More goods are likely to be shipped from mainland ports in future

The end of the textiles/garments quota system in 2005 is likely to mean that a growing number of future shipments will likely be made directly from Chinese ports, which will impact the volume of shipping coming in/out of Hong Kong. Attempts to keep physical cargo coming through Hong Kong may be ineffective if it fights against market forces. The ongoing market-driven transformation of Hong Kong into a higher valueadded services centre should not be obstructed by seeking to retain lower value-added activities.

Useful to have a joint infrastructure database for policy makers to make see where efficiency lies

Perhaps a soft way to initiate cross-border discussion is for Hong Kong and Guangdong to agree on the joint establishment of a database on the region, which will enable authorities to understand better the flow of goods and people, establish an accessibility profile for the region and examine how to use existing infrastructure more efficiently rather than build more.

Make the PRD region competitive by removing monopolistic practices

A very simple example illustrates the areas in which inefficiency affects the Pearl River Delta region as a whole. The freight rate recommended by the Container Trucking Companies’ Association of Shenzhen for a 40-foot container to be transported by road from Dongguan to Yantian Port was HK$1,650 while the rate for transport from Dongguan to Hong Kong was HK$3,700. The difference in cost (HK$2,100) cannot be explained simply by the difference in distance, which is minimal, or by the additional time needed to cross the border into Hong Kong, or even cost of labour. Excessive returns on capital through anti-competitive practices will hinder Hong Kong’s longterm growth. Cross-border trucking requires a special vehicle licence, the issuance of which appears to be tightly controlled. Hong Kong and Guangdong authorities need to have a good understanding of the regional trucking business in order to understand why there are barriers to competitiveness. The Pearl River Delta region will be able to compete with the Yangtze Delta and other regions only if the various coordinate and bring down these and other barriers to greater economic integration.

cloh@civic-exchange.org

April 2002

Nimble and nifty

Notes

April 2002

cloh@civic-exchange.org

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