Chinas integration to the world economy and impact on economic links with hong kong

LIST OF FIGURES Figure 2.1 Comparison of Total Trade Value with Outward Processing Trade Value for Hong Kong – China Trade, 1985-2002.... 37 Figure 2.2 Unadjusted Grubel-Lloyd Index and

CHINA’S INTEGRATION INTO THE WORLD ECONOMY

AND IMPACT ON ECONOMIC LINKS WITH HONG KONG

LI JUN

NATIONAL UNIVERSITY OF SINGAPORE

2004

CHINA’S INTEGRATION INTO THE WORLD ECONOMY

AND IMPACT ON ECONOMIC LINKS WITH HONG KONG

LI JUN

(B.ARTS, SHANDONG UNIVERSITY)

A THESIS SUBMITTED FOR THE DEGREE OF MASTER OF SOCIAL SOCIENCES

DEPARTMENT OF ECONOMICS NATIONAL UNIVERSITY OF SINGAPORE

ACKNOWLEGEMENTS

I am in debt to my supervisor, Associate Professor Wong Chung Ming, for his precious comments and suggestions given to the entire thesis, his patient and generous guidance on my daily research Without his help, I would not be able to complete my study and finish the thesis at last

I wish to express my gratitude to Dr Jose Tongzon for his advice on research topics and Dr Zhang Zhao Yong who supplied me with the information on collecting the data I am also grateful to all those who have given me useful advices and information during the period of my research

The person whom I definitely should give my most thankful feeling is my dearest mother She has encouraged me to insist on completing my study even though she has been seriously ill Her love and courage is always my motive to do everything I also thank my father who has supported me on studying overseas all the time I have appreciated much Mr Xu Yan’s generous help and care first midst and last

Last but not least, I want to thank all my friends who have helped in one way or another to make my life pleasant during the course of the preparation for the thesis

TABLE OF CONTENTS

ACKNOWLEGEMENTS i

TABLE OF CONTENTS ii

LIST OF TABLES iv

LIST OF FIGURES vi

SUMMARY viii

Chapter 1 Introduction 1

Chapter 2 Trade Reform in China and Integration with Hong Kong 4

2.1 Trade Reform 5

2.2 Geographic & Commodity Composition of China’s Foreign Trade 9

2.2.1 Geographical Distribution of China’s Foreign Trade 9

2.2.2 China’s Revealed Comparative Advantages and Its Exports Expansion 11

2.3 Trade Flows between China and Hong Kong 17

2.3.1 General Theory of Economic Integration 19

2.3.2 Economic Integration Process in China and Hong Kong Economies 21

2.4 Hong Kong-China Trade: Presence of Economic Integration 23

2.4.1 Methodology 28

2.4.2 The Main Results 35

2.5 Conclusion 51

Appendix 1 53

Chapter 3 Foreign Investment in China and Hong Kong’s Contribution 56

3.1 The Evolution of Foreign Direct Investmet-Related Policies and Foreign Investment Development in China 63

3.2 Mainland Chinese Investment in Hong Kong 68

3.3 Hong Kong’s Investment in China 70

3.4 Regional Distribution of Foreign Direct Investment from Hong Kong to China 75

3.5 The Foreign Invested Enterprises in China 84

3.6 Conclusion 92

Chapter 4 The Development, Problems and Perspective of Guangdong – Hong Kong Economic Link 95

4.1 Guangdong in the Context of Reform in China 96

4.2 Guangdong – Hong Kong Production Connection 100

4.3 Developmental Problems in the Economic Linkage of Hong Kong and Guangdong 104

4.4 Analysis of Future Developing Strategies of Guangdong and Hong Kong 107

Chapter 5 Concluding Remarks 113

5.1 Main Conclusion of the Thesis 113

5.2 Problems with the Development of China’s and Hong Kong’s Economy 115

5.3 Prospects for China’s Economic Development and Hong Kong’s Role 120

References 127

LIST OF TABLES

Table 2.1 Volume of Imports and Exports in China, 1978-2002 (US$ billion) 5 Table 2.2 Geographical Distributions of China’s Exports and Imports, 1980, 1990, and 2001 (%) 10 Table 2.3 Revealed Comparative Advantage Indices (Exports), China and

Comparator, 1980-1996 13 Table 2.4 Changing Commodity Shares of Selected Labor-intensive Goods, 1980,

1990 and 1996 (%) 13 Table 2.5 Growth Rate of Exports for Labor-Intensive Goods, 1978-1996 (%) 13 Table 2.6 The World’s Largest Bilateral Merchandise Trade Flows in Some

Individual Years (million US dollars) 18 Table 2.7 The Estimated Average Proportion of Outward Processing Trade in Total Trade with China, 1989-2002 (%) 30 Table 2.8 The Estimated Proportion of Outward Processing Trade in Hong Kong – China Total Trade, 1989-2002 (%) 36 Table 2.9 An Intensity of Trade Analysis for Hong Kong-China Trade, 1980-2002 46 Table 3.1 Shares of Main Provinces and Municipalities of China in Realized Foreign Direct Investment from Hong Kong, 1986-2001 (US$1,000) 81 Table 3.2 FDI Flows, Total Exports, and Exports by Foreign Invested Enterprises (FIEs) in China, 1986-1999 (millions of US$) 87 Table 3.3 Status of Registered Enterprises with Foreign Capital in China, 1986-2000 90

Table 4.1 Shares of Guangdong & Shanghai in China’s GDP and Exports,

1978-2002 (%) 98 Table 4.2 Hong Kong's Imports from the Mainland Involving Outward Processing, 1989-2002 (US$ million) 101

LIST OF FIGURES

Figure 2.1 Comparison of Total Trade Value with Outward Processing Trade Value for Hong Kong – China Trade, 1985-2002 37 Figure 2.2 Unadjusted (Grubel-Lloyd) Index and Adjusted (Aquino) Index for Hong Kong – China Intra-industry Trade in Domestic Outward Processing Trade, 1985-2002 41 Figure 2.3 Unadjusted (Grubel-Lloyd) Index and Adjusted (Aquino) Index for Hong Kong – China Intra-industry Trade in Re-export Outward Processing Trade, 1985-2002 43 Figure 2.4 Intensity of Trade Index for Hong Kong – China Trade, 1980-2002 48 Figure 2.5 Trade Complementarity Index for Hong Kong – China Trade, 1980-2002 49 Figure 2.6 Country Bias (trade resistance) Index for Hong Kong – China Trade, 1980-2001 50 Figure 3.1 Total Investment in Fixed Assets in China by Source of Funds

(1981-2001) 57 Figure 3.2 Foreign Direct Investment in China by Country/Region, 1979-2001 (percent of total) 62 Figure 3.3 The Share of Hong Kong’s Foreign Investment in China’s Contracted Utilization and Actual Utilization of Foreign Capital (1986-2002) 71 Figure 3.4 The Share of Hong Kong’s Foreign Direct Investment (FDI) in China’s Contracted Utilization and Actual Utilization of Foreign Direct Investment (1986-2002) 71

Figure 3.5 Hong Kong’s Contribution to China’s Utilization of Foreign Investment (1986-2002) 74 Figure 3.6 Shares of Realized FDI in Total Investment in Fixed Assets by Regions of China, 1986-2001 83 Figure 3.7 the Proportion of Realized FDI from Hong Kong in Total Realized FDI Utilized by Regions in China, 1986-2001 83

SUMMARY

China opened its door to the outside in 1978, when it began the process of economic integration into the world economy A series of reforms in areas ranging from foreign trade, foreign investment, taxation and finance, banking, foreign currency and price control, to social welfare and housing, are being implemented Among these, reforms and achievements of trade and foreign investment are remarkable

Trade liberalization is a key component of China’s overall economic reform and modernization program So far it has proceeded unilaterally and generated a huge expansion of China’s role in world trade China adopted the policies that can facilitate the exports of labor-intensive products and export-oriented economy Although the regional distribution of China’s exports and imports has diversified around the world, it still relies to certain extent on Hong Kong’s position The revealed comparative advantage index is applied to analyze the composition of commodity for exports and its future changing pattern

Inflows of foreign direct investment to China virtually nonexistent before 1979, has poured at an accelerating speed since 1992 However, with more openness and more liberalization, the uneven geographical distribution of foreign investment between the east regions and the inner regions in China would be reinforced A large amount of investment from Hong Kong makes such regional inequality worse Through the investigation on the performance of foreign-invested enterprises, it is proved that foreign-invested enterprises made great contribution to China’s export growth

Hong Kong has played a strategic part in the process of connecting China with the outside world.China's "Hong Kong connection" has been vital to the success of its export drive Hong Kong’s contribution to the development of China's exports goes

much further An important finding obtained from my analysis is that a large proportion

of the foreign direct investment to China has come from Hong Kong and been mostly directed to export-oriented joint-ventures in the coastal provinces, Guangdong in particular

Hong Kong's involvement in export-oriented production in China is not just limited to joint ventures A tendency of economic integration between Hong Kong and China in trade would be checked The analysis of the outward processing trade involving intra-industry trade between their economic links as well as the adoption of the indices such as intensity of trade, complementarity and trade resistance can clearly demonstrate that an intensive economic integration trend exists in the Hong Kong-China link It is worthy noticing that much of Guangdong's success with processing using supplied or imported materials is based on partnerships with counterparts in Hong Kong The evidence suggests that the economies of Hong Kong and Guangdong are becoming increasingly integrated with one another Kinds of suitable and practicable development strategies would be explored to strengthen such close relationship

There is clearly an important opportunity to reinforce the pace of trade reform, foreign capital absorption and linkup with Hong Kong through China’s accession to the WTO Starting from a position of near-autarky, China has been catching up rapidly with other developing countries in integrating with the global economy Increased integration and openness have paid rich dividends in the way of faster economic growth Still, there

is much room for progress

Chapter 1 Introduction

Since the economic reform, China’s progress in trade expansion and increase of foreign capital inflows has been phenomenal China’s trade strategy is an important factor affecting trade growth Total trade increased from US$20.64 billion in 1978 to US$620.80 billion in 2002 with an average growth rate of 14.1 percent per annum Exports increased at an average annual rate of 16.1 percent and imports at an average annual rate of 12.8 percent during this period Such increasing expansion of China’s foreign trade over time is one of the most remarkable features of the impact of the reform programs The economic reforms policy, developing strategy and trade system perform deeply the economic interaction between China and the rest of world

China’s growing integration with global capital markets is reflected in its large shares in absorption of cross-border inflows from other countries Foreign investment especially foreign direct investment (FDI) is needed in financing the modernization of China China was actively channeling FDI into key areas essential to the long term development of the national economy and integrated more into the outside Total FDI attracted in China from 1979 to 2001 reached US$393.6 billion The recipient of foreign capital and technology has enabled China to restructure the industries and develop production expertise

Hong Kong has played an indispensable role in China’s economic reform Since

1993, Hong Kong-China trade became the world’s third largest bilateral trading relationship Hong Kong’s obvious advantage in trade liberalization supplies China with

a unique chance to open itself to the outside to develop the backward economy Similarly, Hong Kong’s investment heavily influences China’s utilization of foreign investment on quantity, quality and regional distribution as well It also gives the

impulse on China’s export rapid growth by foreign-invested enterprises in the Mainland

In Guangdong-Hong Kong relationship, the long-term and stable cooperation is still the focus and interest of both sides The role of Hong Kong in relation to China has become more significant

China’s accession to the WTO marks the beginning of its full integration with the world economy Its entry represents a grand strategy to ease the burden of reform,

because commitment to deeper reform and liberalization associated with the entry will not only boost efficiency, but also foreign investor confidence in Chinese economy at a time when it is desperately needed

The facts then make one ponder the reasons behind the success Questions that may rise are: how China could make outstanding progress in its external trade and attracting foreign capital? What are the changes of trade flows, pattern and developing strategy? What are the factors affecting the absorption of foreign investment, distribution and utilization? How do Hong Kong and China shed light on a sort of economic integration? What are the problems and prospects of further development between China and Hong Kong in terms of trade and investment? Will Guangdong keep close economic cooperation with Hong Kong? The effort of liberalization and integration on economic reforms of China seems significant

This thesis serves to clarify these doubts and to provide some insights on the aspects of factors affecting trade liberalization and foreign capital absorption, and issues

of regional disparity and commodity composition change in trade growth and foreign investment distribution and utilization The finding of economic integration within the China-Hong Kong linkage is made possible by computing certain indices and several

measures in their trade flows or by conducting empirical studies through analysis of the impact of investment for Hong Kong I propose some ideas for the future development

of Hong Kong-Guangdong relation

It is hoped that this thesis will provide readers with a better understanding of the processes and prospects of China’s liberalization on external trade and inward FDI, especially its economic link with Hong Kong Three goals of the thesis are as follows First, it provides a forum of academic research on China’s reforms in foreign trade and foreign investment Second, it makes clear the tendency of economic integration between Hong Kong and China Third, it may supply some good ways to discover and resolve the problems occurring during the period of reforms

The thesis is organized as follows: Chapter 1 offers general introduction Chapter

2 studies trade reform and expansion in China, touching on the characters, problems and suggestions of foreign trade The economic integration with Hong Kong in trade will be explored as well What is of interest then is the development of foreign investment Thus Chapter 3 intends to find out the role of foreign capital in China’s economic reforms Hong Kong’s important function in driving foreign capital will be described in this chapter After that, particular issues such as certain area in China that has a very intensive economic relation with Hong Kong are to be probed in Chapter 4 And

Chapter 5 goes on to do the conclusion and prospects for China’s economic

development and linkup with Hong Kong

Chapter 2 Trade Reform in China and Integration with

Hong Kong

Economic reform and the opening up of the economy to the outside world in the past twenty-six years (1978-2002) have been marked by an extraordinary expansion of foreign trade in China Total trade increased from US$20.64 billion in 1978 to US$620.80 billion in 2002 with an average growth rate of 14.1 percent per annum Exports increased at an average annual rate of 16.1 percent and imports at an average annual rate of 12.8 percent during this period Trade structure continued to shift in favor

of manufactured commodities The share of manufactures in total exports increased to

89 percent in 2001 from 49.7 percent in 1980 The geographic distribution of China’s foreign trade has been diversified China has become the largest recipient of foreign capital among the developing countries in recent years and became world’s fourth largest trading nation in 2002, rising from twenty-ninth in 1978 Official foreign exchange reserves increased from US$0.8 billion in 1979 to US$212 billion in 2001 It should be noted that the degree of openness of Chinese economy, reflected in the share

of foreign trade in GDP, has been higher and higher since 1978 From Table 2.1, the rapid growth of total trade and balance of trade can be distinguished In brief, following the economic opening up in the 1980s and 1990s, the Chinese economy has been deeply interacted with other economies outside It is to be hoped that China will open up wider and faster by further opening its market and increasing transparency to implement its commitments in the WTO That will entail integration of China’s economy with the world economy and bring China’s foreign trade system in line with international practice

Table 2.1 Volume of Imports and Exports in China, 1978-2002 (US$ billion)

Year Total Exports Imports Balance Trade/GDP(%)

an improvement in export incentives; and the substitution of less costly instruments for more costly instruments of protection, such as tariff or quotas China has made progress

in all three areas in the past over twenty years, as documented in Harding (1987), Hsu (1989), Lardy (1992), Wang (1993), Zhang (1993) and Li (1997)

China is the largest developing economy to embark on a strategy of trade liberalization The results appear to be nothing short of spectacular as shown in Table 2.1 In the first ten years of economic opening-up, China’s trade jumped sharply from

merely over US$20 billion in 1978 to over US$110 billion in early 1990s China’s role

in the world economy grew significantly during this decade of rapid trade growth These great achievements obviously could not be made possibly through the traditional rigid foreign trade system

The entire development of China's policies of foreign trade is an outcome of the influence of both Marxian and conventional western economic thought (Zhao, 1991)

As the general designer of China’s future economic development, Deng Xiaoping created his own theory combining communism thought with other western theories according to China’s real situation As he proposed a major transformation of China’s foreign trade and investment policies in the mid 1970s, Deng advocated a rapid acceleration of exports, concentration on industrial and mining products1 The State Council, China’s highest executive institution, promulgated a series of reform which over the decade of the 1980s began to erode the bias against exports inherent in China’s traditional trade policy and began to conform China’s foreign trade system to standard international rules These policy reforms included a decentralization of foreign trading authority; the introduction of new forms of trade – primarily as means of promoting exports – exports processing and compensation trade; the adoption of import and export licensing to control the volume and commodity composition of trade, which was regarded as a transition to liberalization of an import substitution trade regime (Krueger, 1978); a reduction in the degree to which the official exchange rate overvalued the domestic currency and a reduction in direct import subsides The latter two measures tended to bring the price of imports more in line with their true economic cost Devaluation, the rebate of various domestic taxes on exports goods, and a relaxation of

1

The text of Deng’s report, entitled “Some Problems in Accelerating Industrial Development,” was translated in Chi Hsin (1977, 239-76)

the state’s monopoly control over the allocation of foreign exchange reduced the bias against exports of the traditional foreign trade system

In addition to the policies already mentioned above, China adopted several other export promotion measures that were commonly observed in the early stages of trade liberalization in developing countries These included special programs of enhanced exports credits; preferential interest rates on domestic currency loans to firms producing for exports; subsidized domestic transport, storage, and insurance of export goods (Li, 1989) and the development of manufacturing facilities devoted exclusively to export production However, these export promotion programs appear to be in violation of the GATT (the WTO former) Code on Subsidies and Countervailing Duties (1979)1 to some extent

The decade of the 1980s was one of far-reaching reforms of China’s foreign trade system Much of traditional structure was profoundly changed China has instituted extensive reforms to its foreign trade policies since the 1990s Its openness on trade policy was above the average for all large developing countries in the early 1990s actually Trading system reforms have unfolded in a progressive manner

On 1 July 1994 China promulgated its Foreign Trade Law, which was formulated

to unify national foreign trade behavior and regulations and enhanced the transparency

of China’s foreign trade legal framework Since 1990 the government has further deregulated foreign trade franchise management, as a result, more local enterprises have obtained the authority to conduct foreign trade Between 1991 and 1993, with all the export subsidies and most of import subsidies lifted by the central government, a range

of state-owned foreign trade enterprises were forced to be responsible for their own profits and losses In 1994, the government cancelled the mandatory plans and targets

1

Agreement on Interpretation and Application of Article VI, XVI, and XXIII of the General Agreement on Tariffs and Trade, Geneva: GATT

for foreign exchange to be turnedin to the central government Foreign trade companies could operate like other enterprises by paying taxes to the government In the reform of import and export control system, imported commodities were catalogued in 1992 instead of listing import substitution commodities in detail New policies on the management of imported commodities were published Since 1994 the State has issued invitation to tender for export quotas in selected commodities with the aim of standardizing quota management, introducing fair competition, curbing subjective decision making and increasing efficiency At the same time, China was switching from direct government control to legal and economic leverage in its management of foreign trade by drafting related regulations By the early 1990s China’s average tariff rate – 47.2 percent – had been among the highest in the world Since 1990, China has unilaterally slashed its tariffs on a number of occasions In 1992 the overall tariff rate was cut down to 39.9 percent and it dropped to 23 percent in 1996 Till 2001, the entire tariff level was reduced to 14 percent, which is the average rate of the developing countries Non-tariff barriers categories covered almost a third of China’s imports in

1996, down from more than half in 1992 The system of government examination and approval was abolished at the end of twentith century By January 2005 China promises

to eliminate non-tariff measures which were applied to more than 400 products in 2001 These figures indicate that China has committed itself to further trade liberalization and offer to reduce tariffs and eliminate most non-tariff barriers under the provision of the WTO agreement Before the mid-1980s, China maintained rigid control over foreign exchange In late 1980s foreign exchange regulation markets were established To foreign trade companies, they were allowed to retain a portion of their foreign exchange earnings for their own use and trade in foreign exchange on the market since 1990 The government allowed foreign-invested enterprises to participate directly in the settlement

and sale of foreign exchange by banks On January 1994 the official rate for the Chinese Yuan was merged with the market rate and the Yuan became convertible under the current account Recently, China promise to adjust its currency – renminbi – to the more flexible exchange system step by step It is paving the way for the full introduction of the market mechanism into the foreign exchange control system

China’s foreign trade has developed very rapidly in the recent years with its gradual reforms on trade policies and institutions Deepened domestic reform, continued trade liberalization and its accession to the WTO offer China a guarantee to fulfill the tasks in the further reform The integration of the Chinese economy into the region and the global economy is beneficial for both China and its trading partners

2.2 Geographic & Commodity Composition of China’s Foreign Trade

As studied on several multi-countries cases by Harrigan and Mosley (1991) and Papageorgiou, Michaely and Choksi (1992), a support for view that trade liberalization and trade expansion are related is offered Liberalization reduces anti-export bias and thus provides a conductive setting for export expansion, which is the main proposition behind their studies To China, the anti-export bias reduction has been achieved through

a series of comprehensive reform programs and trade policies aimed at eliminating distortions due to the high degree of government restriction on trading activities The effort of trade liberalization on trade patters of China will be discussed below

2.2.1 Geographical Distribution of China’s Foreign Trade

The regional distribution of China’s foreign trade around the world diversified significantly during the period 1980-2001, particularly in relations to Hong Kong, European Community (EC) and North America (Table 2.2)

Table 2.2 Geographical Distributions of China’s Exports and Imports, 1980, 1990, and

2001 (%)

Export Import

1980 1990 2001 1980 1990 2001

East Asia (excl China) 47.7 64.5 39.0 31.2 49.0 28.2

Source: Calculations based on data from Direction of Trade, International Monetary Fund, Washington, D.C, 1991; International

Trade Statistics, World Trade Organization, 2002

China’s exports shares with Hong Kong has increased in the past twenty years,

growing from 19.7 percent in 1980 to 43.3 percent in 2001, while its import shares

increased from 6.3 percent to 36.6 percent during the same period A picture of Hong

Kong’s shares in total Chinese trade is clearly sketched from Table 2.2, Hong Kong is

the only partner having the continuous increasing shares of exports and imports of

Chinese products from 1980 to 2001 although during the twenty years, there might exist

some individual years with slight fall or drop-off Especially from 1980 to 1990, the

share in exports more than doubled to reach an estimated 37 percent in 1990 As the

share of the Hong Kong market has grown, those of others have shrunk This suggests

that China depends on Hong Kong more for its exports than imports China’s export

dependence on Asia is dominated by its relationship with Hong Kong Its trade with

Hong Kong accounts for the predominant portion of its total trade

East Asia is China’s important trading partner In the 1980s and 1990s, China’s shares of export and import with East Asia were quite large: 47.7 and 64.5 percent in export in 1980 and 1990; 31.2 and 49.0 percent in import in 1980 and 1990 respectively Such close economic activity is partly because of their geographical proximity and convenient transportation The shares dropped sharply after 1998 and this region only absorbed 39 percent in 2001 due to the severe impact of Southeast Asian Financial Crisis The same situation happened to Japan and newly industrializing economies (NIEs) The economies having flexible foreign exchange rate and mainly relying on the exported-oriented and domestic industrialization were negatively affected The total trade of China of course was influenced by its main trading partners

The patterns continue to hold for the trading relationship between China and European Community, China and North American Free Trade Agreement (NAFTA) There are gradual increases in export shares with EU and NAFTA The two big economy units are becoming most important trading partners of China Even though the shares with Australia are not large, China’s exports to and imports from Australia are steadily increasing Its import share with ASEAN was also higher in 2001 than previous years There is an increasing need for China to diversify its trade distribution, which may provide much more opportunities to secure smoother development of its foreign trade, especially after experiencing the serious shock of financial crisis in East Asia

2.2.2 China’s Revealed Comparative Advantages and Its Exports Expansion

As trade in natural resource intensive products depends to a considerable extent on the country’s resource endowment (Balassa and Bauwens, 1988), the study is limited to comparative advantage in manufactured goods Following earlier work by Balassa (1965), a country’s relative export performance in the individual product categories has been taken to reflect its ‘revealed’ comparative advantage within the manufacturing

sector For this purpose, the ratio of country’s share in the world exports of a particular

commodity to its share in the world exports of all manufactured goods is calculated In

evaluating ‘revealed’ comparative advantage, we have given greater weight to export

performance than to export-import ratios

The concept of ‘revealed’ comparative advantage (RCA) was first employed by

Balassa (1965) The RCA of country i in the trade of product j is measured by the item’s

trade in the country’s exports relative to its share in the world trade It is available

though computing the following equation:

)//(

)/( ij it wj wt

where RCAij is country i’s revealed comparative advantage index; Xij is the amount of

country i’s exports of product j; Xit is country i’s total exports and subscript w refers to

world totals For example, a ratio of 1.10 (0.90) means that the country’s share in a

particular product category is 10 percent higher (lower) than its share in all

manufactured exports

Due to the data available constraint, Tables 2.3, 2.4 and 2.5 only present the

estimation of China’s revealed comparative advantages and commodity shares of

selected labor-intensive goods in comparison with other main East and Southeast Asian

countries till 1996 As evidence of the conformity of China’s patterns of trade to its

factor endowment, the figures show that, except for textiles, China enjoyed increased

comparative advantage in all goods, in particular, toys, travel goods, footwear and

clothing, over the separate sub-periods

Table 2.3 Revealed Comparative Advantage Indices (Exports), China and Comparator, 1980-1996

Textiles and Yarn Electrical Appliances Travel goods Clothing Footwear Toys

1980-1989 1990-1996 1980-1989 1990-1996 1980-1989 1990-1996 1980-1989 1990-1996 1980-1989 1990-1996 1980-1989 1990-1996 China 4.7 3.2 0.3 0.9 5.0 7.0 5.1 5.3 1.9 5.7 4.3 8.4 Hong Kong 2.3 2.2 2.0 1.5 7.6 1.8 13.3 9.7 1.1 0.2 21.5 3.6 South Korea 3.3 3.3 1.8 2.1 8.9 4.8 6.3 2.2 7.1 3.8 4.3 1.4 Malaysia 0.4 0.5 2.2 2.9 0.0 0.3 0.9 1.2 0.3 0.3 0.6 1.4 Singapore 0.6 0.5 2.5 2.4 0.4 0.3 1.0 0.6 0.2 0.2 1.3 0.7 Taiwan 2.7 3.2 2.2 1.8 14.2 3.5 4.4 1.3 9.0 2.2 10.0 3.8 Thailand 1.8 1.1 0.9 1.3 2.3 4.3 3.1 3.0 1.7 3.8 1.0 3.1 Vietnam 0.6 0.7 0.1 0.0 0.1 7.2 2.1 3.9 1.1 7.2 1.2 0.5

Source: date of 1980-1889 is from World Bank, 1991

date of 1990-1996, calculation based on United Nation’s international trade data, International Trade Statistics

Table 2.4 Changing Commodity Shares of Selected Labor-intensive Goods, 1980, 1990 and 1996 (%)

Textiles and Yarn Electrical Appliances Travel goods Clothing Footwear Toys

1980 1990 1996 1980 1990 1996 1980 1990 1996 1980 1990 1996 1980 1990 1996 1980 1990 1996 China 13.2 11.6 8.0 1.3 6.4 12.3 0.5 0.6 1.8 9.1 15.5 16.6 1.1 3.2 4.4 0.4 2.9 3.7

Source: See Table 2.3

Table 2.5 Growth Rate of Exports for Labor-Intensive Goods, 1978-1996 (%)

As indicated by indices, the major categories of Chinese exports during the 1980s were miscellaneous manufactures group: travel goods, clothing, footwear and toys.The leading ranks remained during the period of 1990s This group generally comprises labor-intensive goods Besides, RCA index exceeded unity for manufactured goods classified by material: textile and yarn in the 1980s, but dropped in other periods In short, miscellaneous manufactures have the higher ‘revealed’ comparative advantage.With regards to China’s ‘revealed’ comparative advantage in less labor-intensive and industrial production, due to its relatively low level of industrialization and lack of access to technology in the early reform years, China did not gain obvious advantage in these industries For instance, the index for export of electrical appliances (such as sound recorders and reproducers, television image etc.) was under unity all the time even though it reached 0.9 in 1996

Compared with its main comparators in the ASEAN, China does not appear to have relative advantages with respect to travel goods, footwear, clothing and toys although the index of all the categories has been raised in the sub-periods Over the past decades, there was growing labor intensity for manufacturing exports The finding indicates more competition than complementarity between China and the ASEAN countries and NIEs, as all are in similar stage of development and reliance on exports of labor-intensive products and low-skill goods

With regards to South Korea and Taiwan, they enjoyed considerably comparative advantage in some labor-intensive goods, such as travel goods and footwear, in the first sun-period Malaysia and Singapore were at a disadvantage in the production of other labor-intensive products than electrical goods While Vietnam and Thailand, two of ASEAN countries, gave us an impression that they were specialized their exports in travel goods, clothing and footwear Another economy’s revealed comparative

advantage in individual goods showed in Tables 2.3 and 2.4 is just complementary to China’s reciprocal products It is Hong Kong China increased comparative advantage

in electrical appliances, travel goods, clothing, footwear and toys in the period of 1990-1996, while Hong Kong decreased its production of the above goods in its local This suggests that Hong Kong since the 1980s has moved its labor-intensive goods production out to its neighborhood Guangdong province, southern China Hong Kong grasped the chance of China’s opening to the outside and made full use of it to restructure economic system to purse more growth Reflected in Table 2.5, the growth rate of exports for labor-intensive goods in China between 1978 and 1996 was 18.7 percent on the average, while Hong Kong experienced a negative increasing (-4.7 percent) in its growth rate of exports for labor-intensive goods in 1990-1996 period The commodity composition of China’s main labor-intensive products before

1997 indicates the relative importance of these products in its total exports The rapid expansion of China’s exports during the period 1978-1996 was to lesser extent due to the improvement in China’s export competitiveness Currency depreciations in China certainly contributed to the expansion of its exports, but the expansion was mainly due

to the strong growth of world demand of goods made in China Other factors such as cheap labor, other costs and non-price factors (for instance, large increase in capital investment in China’s export sector) influenced the expanding progress to some extent The proportion of labor-intensive goods from China into the major markets of world increased rapidly during the period 1980-1996, especially between 1990 and

1996 with labor-intensive goods shares much higher than manufactured goods However, the value share of manufacturing industry in GDP has been growing yearly

As mentioned at the beginning, China’s trade structure has continued to shift in favor of manufactured commodities since the mid of 1990s The share of manufactured goods in

total exports is higher than that of labor-intensive products now It has been contended that China’s advantage in manufacturing exports could have been accentuated by Hong Kong’s production in South China, which has been counted in US trade statistics as China’s exports to the United States Besides, China is involved much into the development of capital-intensive goods and high-tech industry That is the reason that China attracts more and more foreign investment to facilitate its foreign trade growth The contribution of foreign capital inflows to the rapid development of China’s foreign trade can be seen from the operations of foreign-invested enterprises in China’s exports, which is analyzed in the following chapter

One of the reasons that the share of capital-intensive goods in China’s manufacturing exports accounted for a small percent is most probably because of less distorted prices In early 1990s, reform of trade policy on export subsides accessed a progressive period The reduction of export subsidies to capital-intensive exports from state-owned enterprises was carried out to large extent Therefore, China exported more and more along the lines of its natural comparative advantage in a large pool of low-wage unskilled labor Furthermore, when the financial crisis happened all over the ASEAN region in 1997, and as real wages and unit labor costs in the Asian NIEs rose, China saw a light in exports of traditional labor intensive goods

2.3 Trade Flows between China and Hong Kong

The rapid expansion of China’s foreign trade after 1978 is one of the most remarkable features of the impact of the open-door strategy Between 1980 and 2002 China’s merchandise trade grew on average by over 14 per cent annum – almost three times as fast as world trade, a little bit faster than that of Hong Kong1 Their share of global trade during these two decades increased: China by almost 8 per cent and Hong Kong by almost 5 per cent2 Imports and exports contributed about equally to Hong Kong’s trade expansion at the early 1980s, whereas the decreasing contribution of exports and imports growth appeared at the end of 2002 Between 1980 and 1991, the average annual growth rate of Hong Kong’s exports to China and imports from Chinawas 31.86 per cent and 23.57 per cent representatively In the whole 1990s, Hong Kong’s total exports to and imports from the Mainland rose At the beginning of 1990s, its value of total exports to China was US$27 million When the year 2000 came, the value of exports to the Mainland reached US$70 million The imports from China increased also fast, from US$30 million in 1990 to US$92 million in 20003

1

Global trade grew by 4% p.a., Hong Kong’s by 12% See United Nations, Economic and Social

Commission for Asia and the Pacific, Statistical Yearbook for Asia and the Pacific, 1980-2000;

International Trade Statistics, 2002

2

Calculated by the writer according to the data from Statistical Yearbook for Asia and the Pacific, International Trade Statistics

Table 2.6 The World’s Largest Bilateral Merchandise Trade Flows in Some Individual

Years (million US dollars)

Trade Partners 1981

Value Rank

1991 Value Rank

1993 Value Rank

2001 Value Rank

1) The data of 1981 involved with Germany refers to the trade value with Federal Republic of Germany (FRG)

For 1991, 1993 and 2002, the figures are related to Germany (FRG and German Democratic Republic unified

in Oct 1990)

2) The China-Hong Kong figures include both domestic and re-export trade

3) The figures that United States is with its partners include re-export trade

In a word, Hong Kong-China bilateral trade has grown at an extraordinary rate

See Table 2.6, at the beginning of 1980’s, their trade value only ranked 11th among the

main world bilateral trades, but rose rapidly in the following decade In 1991, Hong

Kong-China trade became the world’s fourth largest bilateral trading relationship and

got the third place in 1993 Although China in the late ten years vigorously traded so

much with the other countries besides Hong Kong, the value of their bilateral trade

flows reached 221,611 million US dollars in 2001 The figures in Table 2.6 highlight

the process whereby Hong Kong and China has each become the other’s more important

trading partner; especially China is making critical contribution to Hong Kong’s overall

trade performance

2.3.1 General Theory of Economic Integration

Economic Integration is generally defined as ‘movement toward one price for any single piece of merchandise, service, or factor of production’ (Drysdale and Garnaut, 1993) It means the lowering of barriers to economic interactions across countries or regions, thereby facilitating trade and investment Economic integration is essentially a process of unification, which also means coherence is imposed upon previously separate, even disparate, geographical regions (Ash and Kueh, 1995)

The global economy, in this sense, is considerably disintegrated Its appearance may be pursed by certain country’s economic interest or some countries’ common goal

A situation of disintegration will persist where barriers or resistance to trade are present Such resistance to trade can be defined as a phenomenon that prevents or retards the immediate movement of commodities in response to price differentials (Drysdale and Garnaut, 1993) The economic theory generally concentrates on tariffs, controls on factor movement, and exchange integration These barriers can be directly related to an institutional-based approach to economic integration However the effect geographical and cultural distances exert on a process economic integration may be of overriding importance (Sung, 1992) This statement is well used in the discussion on the case of economic interaction of Hong Kong-China

Economic integration can occur through institutional channels such as the establishment of a free trade area or granting mutual discriminatory preferences to the parties involved It can also occur naturally without the establishment of a former institution, as in the case of a fall in transportation costs as a result of technological

advancement, the reduction costs of information, bargaining and marketing due to the cultural similarity among the trading partners The market integration is identified around institutional and legal barriers to trade, involving capital movements and other forms of economic integration It is appropriate for the case where the initiative has remained primarily with enterprises acting separately from state decisions, and where official encouragement of regional integration does not include major elements of trade discrimination (Drysdale and Garnaut, 1993)

The Asia-Pacific economic integration draws such attention The emergence of new institutions – to a considerable extent private but increasingly intergovernmental –

to reduce the costs of trade expansion has been important in the Asia-Pacific region In contrast to this form of integration, economic integration in Europe has flourished within the institutional arrangements of regional economic identities such as the European Community (EC), the North American Free Trade Area (NAFTA) or the Australia-New Zealand Closer Economic Relations Trade Agreement They are patterned to “institutional integration”, which discriminates against economies outside the region: the removal of internal barriers to trade has been accompanied by the maintenance of external barriers It might be more accurate to prefer the term

“discriminatory integration” to “institutional integration” for arrangement of the EC and NAFTA kind since their goal is to establish certain elements of cooperation and coordination between the participating nations by discriminatory removal of all trade impediments

The form of integration taking place with respect to Hong Kong-China differs from the economic integration associated with the EC, NAFTA kind but similar to the APEC There is no formal institutional framework underpinning the integration process The initiative for integration stems primarily from the new “institution” – private enterprise and the market force Different from these government-sponsored regional efforts, a close economic relationship among Mainland China, Hong Kong and Taiwan has gradually evolved – despite lack of support from the governments involved This integration is led not by a bureaucracy but by business people, sometimes against the political will of governments The convergence is characterized

by the rapidly expanding trade and capital flows among these three economies People usually use the term “Greater China” to describe this phenomenon

2.3.2 Economic Integration Process in China and Hong Kong Economies

As mentioned in the previous paragraphs, there is no institutional economic integration arrangement for the Mainland and Hong Kong Besides the culture and linguistic affinities, the geographical adjacency has no doubt helped to facilitate their economic interaction The example of two economies is representative of a relatively small divergence from the law of one price in terms of non-official resistances to trade A larger comparative cost differential exists, in terms of wages and land rents, relative to the costs of overcoming resistances to trade Relatively low trade resistances to trade influenced by geographical and cultural factors are considered to be very important in this model of economic integration

The existing unilateral institutional factors without a formal institutional integration scheme definitely augment China-Hong Kong bilateral trade relation Through its significant open-door policy in 1978, China stepped to decentralize the powers of trade and investment, reallocating its resources from centralized command to

a market driven system The special economic zones therefore were operated Hong Kong and Taiwan became the biggest beneficiaries The market-oriented form of integration is reflected largely in outward processing-oriented activity between the Mainland and Hong Kong This outward processing activity was initiated by Hong Kong investment in factory operation in the coastal China, such as Guangdong, Fujian and Zhejiang Province Such outward processing trade has primarily destined for the third market A large proportion of this trade type would plausibly be of the intra-industry one (this point would be developed shortly)

The market integration of the Mainland and Hong Kong mainly involves merchandise trade come-and-go There are two kinds of commodity markets in China, one is export processing industries, and the other is import-competing industries It should be noted that what is called outward processing by Hong Kong officials is generally known from the Chinese side as export processing (Wong, 1991) In the Mainland, especially in the coastal areas of China, the former industry type developed rapidly relative to the import-competing industries largely because the exported goods were not restrained by foreign exchange controls Exported-oriented production in the form of outward processing activity is dominant in the Hong Kong-China link Simply, such activity commences with a production process in the original country-Hong Kong

and semi-manufactures are then exported to a foreign country-China, prior to re-importation into the original country for the final packaging, designing and distribution The production is largely the labor-intensive goods The great labor cost and land rents differential between Hong Kong and southern coastal China have prompted the former economy to relocate a large amount of its labor-intensive manufacturing activity, while Hong Kong’s manufacturing industries even the whole economy has become increasingly service-oriented

2.4 Hong Kong-China Trade: Presence of Economic Integration

Since the late 1970s, Hong Kong manufacturing industries have moved to the southern China areas Guangdong province and its Pearl River Delta having the low-waged and abundant labor have become the main relocation of increasing amount of Hong Kong’s labor-intensive industries, which is the reflection of the liberalization of China economy with an increasingly high labor and land cost restraint being faced by Hong Kong The traditional Heckscher-Ohlin theory of international trade assumes two factors

of production and makes international differences in factor endowments including the critical and single factor determining comparative advantage (Bhagwati, 1964) The theorem states that a country’s exports use intensively the relatively abundant factor possessed by that country Balassa (1989) provided a test for the Heckscher-Ohlin theory for manufactured goods by simultaneously introducing trade flows, factor intensities and factor endowments in the framework of a multi-country and multi-product model His findings confirmed the hypothesis in indicating that relatively

capital (labor) abundant countries export relatively capital (labor) intensive commodities The concepts of relative factor intensity and relative factor abundance from the Hecksher-Ohlin theorem is generally defined well in a two country two commodity world, which is just applicable to Hong Kong-China trade, where a difference in the relative scarcity of a factor of production – labor, between one region – Hong Kong, and another – China, and the related difference in comparative cost are reflected The main empirical prediction of the Hecksher-Ohlin model of international trade is that the pattern of international trade can be greatly explained by differences in the relative capital and labor endowment of countries

Although the Heckscher-Ohlin theory itself has a set of very strict assumptions, the model can be modified to incorporate market imperfections such as the presence of resistances to trade, which include transport costs, official barriers and transaction costs, all operating to maintain price differentials between countries There is a negative relationship between the level of resistances to trade and the level of international trade flows In the case of Hong Kong-China trading, relatively lower resistances to trade exists in Chinese export-oriented industries than in import-competitive industries

Hypothesis

An increasing relocation of outward processing industries from Hong Kong to the Mainland, particularly to Guangdong province, occurred over time Springing from this relocation process, in the Hong Kong-China link a large comparative cost differential together with declining trade resistances (country bias) led to an increasing level of

outward processing trade from the 1980s to the early 2000s, in which the intra-industry trade accounts for a significant proportion

Proposition

The intensive outward processing trading relationship developing between Hong Kong and China should be found with empirical evidence as a typical reflective of an on-going process of economic integration, which would have a developing trend over time

The general statement of economic integration of Hong Kong-China can be described in the following way: A large comparative cost differential together with low resistances to trade has generated an on-going process of market-oriented economic integration This interaction process has primarily been dominated by large and increasing levels of outward processing trade, a great proportion of which is intra-industry trade Particularly, Hong Kong-Guangdong relationship appears almost perfect communality with such manner A relatively small and narrowing gap exists between the actual and potential level of trade for outward processing activity in their trading relationship, which also exhibits a relatively low level of trade resistances The proposition is expected to be led on the basis of the combination of comparative cost differentials and relative low trade resistances The combination thus will conduct a relatively intense trade relationship for Hong Kong-China Increasing relative trade intensity is one of indications of a process of economic integration

One of the reasons I adopt intra-industry trade as one of analysis methods to strengthen the proposition is that outward processing trade in Hong Kong-China

framework is compatible with the foreign processing-based mode of intra-industry trade The term of “intra-industry” that was defined first by Grubel and Lloyd (1975) as the simultaneous exports and imports of goods belongs to the same ‘intra-industry’, thus representing the exchanging of goods and services within, rather than between, industries They highlight three types of commodities in which intra-industry trade takes place Foreign processing-based trade falls within the third category, which is heterogeneous product of vertically adjacent or complementary stages of production in the same industrial sector This type of trade occurs when a product is exported, processed in the foreign country, and then re-imported by the original country It is a suitable description for the trade relation in Hong Kong-China link, particularly it is reflected in their outward processing trade Foreign processing-based trade is consistent with the Heckscher-Ohlin model because this trade manifests the exploitation of comparative advantage in the production of certain service Furthermore, it is also consistent with outward processing trade to some extent because the definitions of these two types of trade match closely and both are Heckscher-Ohlin based Actually and more strictly, intra-industry trade is the trade (including exports and imports) in different varieties of the same goods (such as television, cars and washing machines), which is based on product differentiation and economies of scale It seems that intra-industry trade does not seem easily reconcilable with the Heckscher-Ohlin factor-endowment model However, Salvatore (2004) pointed out a great deal of intra-industry trade is in fact based on international differences in factor endowments and comparative costs Thus there seems to be much less conflict between intra-industry

and the Heckscher-Ohlin theories than it might appear at first sight That is to say, explained by economic of scale and product differentiation, intra-industry trade is in fact consistent with trade based on the Heckscher-Ohlin factor-endowment model The outward processing trade between Hong Kong and China is just involved with a great deal of intra-industry trade based on different stages of production process (using

low-wage labor to assemble or process the semifinished products)

Another reason why I use intra-industry trade is that a number of factors suggest the outward processing trade occurring in the Hong Kong-China relationship closely matches the intra-industry trade frame Both outward processing trade and foreign processing-based intra-industry trade are based on the factor endowment differences Besides, both types of trade can be reflected in component-based production where labor-intensive processes are likely to be significant Moreover, relatively low transport cost, cheap transaction costs, high cultural and language similarity are present in Hong Kong-China link and impulse export processing-type trade

The intra-industry trade based on Hecksher-Ohlin theory is driven by factor endowment difference and empirical evidence has been found for the prevalence of intra-industry trade in manufacturing industries between countries with clearly different factor endowment patterns And there exists a positive link between economic integration and Hecksher-Ohlin-based intra-industry trade The intra-industry trade between Hong Kong and the Mainland is expected to be driven by factor endowment differences not by other patterns To a large extent we can propose the Hong Kong-China bilateral relationship consists primarily of outward processing trade, of

which a significant amount is intra-industry; and this trading relationship represents a close economic interaction process It is about to empirically examine the hypothesis and proposition in the following parts of Chapter 2

2.4.1 Methodology

I employed first the definition of merchandise trade I have used in the thesis It can be found in the Appendix 1 with the data sources The practical analysis of the Hong Kong-China, the Mainland economic integration process are concerned with outward processing trade, intra-industry trade and the process of economic integration

Outward Processing Trade

The intension of economic cooperation in Hong Kong-China linkage has increasingly reflected the integrative influence of the outward processing operation

“Outward processing” is a genetic term coined by Hong Kong officials to refer to economic cooperation arrangements made between Hong Kong companies and manufacturing entities in the Mainland under the Hong Kong-based companies sub-contract part or the whole of their production processes to their Chinese counterparts, mainly located in the Pearl River Delta region of Guangdong Outward processing trade is involved much proportion in the total trade of Hong Kong with the mainland of China, especially in the convergence of its re-exports and domestic exports of China Most of Hong Kong’s imports involving outward processing were further processed or packaged in Hong Kong for exports to third countries If the processing substantially changes the form or nature of the products, then it is classified

as Hong Kong’s domestic exports, that is, exports of good made in Hong Kong Otherwise it is classified as Hong Kong’s re-export Just as Wong (1991) mentioned the finished products in China were then shipped back to Hong Kong for direct re-exports to overseas markets The impact of the relocation of Hong Kong manufacturing activities in China, and associated outward processing operations for re-export through Hong Kong, is quite significant in the past years

Since the Census and Statistics Department of Hong Kong conducted on a quarterly basis the survey on the trade involving outward processing in China as from

3rd quarter of 1988, the estimates of the value of outward processing trade are made for the years 1985 to 1988 inclusive The use of 1985 as the starting date for these estimates reflects two points Firstly, the large growth in manufacturing activity that stimulated outward processing trade is generally believed to have commenced in the mid 1980’s following the second round of Chinese reform in 1984 Secondly, the estimated values for 1985-1988 are based on the outward processing data for 1989-2001 Using this data set to estimate values as far back as 1980 would not be feasible

The average proportion of total trade accounted for by outward processing during the 1989-2002 period is used to find approximate values for the 1985-1988 periods These averages are calculated for total trade, domestic trade and re-export trade (See Table 2.7) The figures reveal that between 1989 and 2002 the average 50 per cent of Hong Kong’s exports to China was destined for outward processing and related to FDI