Econ3350 project edited

ECON 3350 Group Project

Industrial Upgrading in Guangdong Province in the 12th Five-

Year Plan Period:

Implications for Hong Kong

December 2011

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Group 2

Jimmy Lee

Alex Wai

Coco Huang

Calvin Li

Contents

I. Introduction

II. Situation of Low Value-added HK manufacturing Firms in Guangdong

III. HK Participation in High-end Manufacturing Industry Development

IV. HK Participation in High-end Service Industry Development

V. Development of Producer Services support

VI. Development of Environmental Industry

VII. Development of Innovation and R&D

VIII. Conclusion

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I. Introduction

In development economics, industrial upgrading (or structural transformation) is

vital when a country transitions into a higher level of development. Industrial

upgrading refers to a fundamental shift in industrial structure from low-end (or low

value-added) industries towards high-end (or high value-added) industries. As China

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now advances into a new stage of development, its recent 12th Five-Year Plan

highlights the importance of (fastened) industrial upgrading. Guangdong, as a leading

province in terms of economic development (indicators include GDP per capita), will

be one of the regions that bear the upgrading task. With geographical proximity and

traditional linkages, such transformation will bring enormous opportunities and

challenges to Hong Kong. This paper will therefore explore several areas which are

crucial in Hong Kong’s point of view.

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II. Situation of Low Value-added HK manufacturing Firms in Guangdong

Recently there are more than 60000 HK-owned factories in the PRD region.

A special feature of earlier development in Guangdong province is “three

processing and one compensation”(三来一补): to assemble with supplied parts, to

process with materials, samples and compensation trade. This model has led

Guangdong to a speedy and great development, yet left behind problems as the

economy now undergoes a structural transformation.

As a result of global financial crisis, every economy and every firm around the

globe has been facing a bad time. The worsening global market adversely affects

many businesses of these low value-added HK-owned firms in Guangdong province,

which highly affects their normal running. Financial shortage also leads to a retreat in

the investment in those firms, limiting their further development.

In the meantime, RMB appreciation and a change in China’s trade policy and

export compensation have added troubles to these firms. Since export income

occupies a big share in their total income, all these factors will definitely result in

shrinkage of foreign business and a loss of profit.

In addition to problems of global environment and China’s policy, the rising cost

in industry generates difficulties for these enterprises. Because of continuously

surging inflation in China in recent years, the cost of raw materials increases rapidly.

At the same time the nagging labor shortages and worker demands for higher wages

to help offset soaring food and property prices contribute a lot to the rise in

manufacturing costs. According to a news report, a lack of 10% to 30% in labor

commonly exists in firms in the PRD region. Besides, the minimum wage in

Guangdong province has been raised by 21.2% and 18.6% respectively in there two

years, squeezing more profits from this low value-added industry.

Troubles point to a dim future for the low value-added industry. The vice

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chairman of Hong Kong Industry Association predicted that 30% of the HK-owned

firms in Guangdong might be unable to survive this predicament.

Given this worrying trend, how can Hong Kong firms survive?

On the one hand, firms themselves should adapt to the market, adjust the

products’ structure and create new products to fulfill various needs of consumers.

Opening up new markets can also be a solution, and many firms have done so

already in South Africa. The vital and core method is to upgrade the development

model so as to change the industry from low value-added to high value-added.

On the other hand, the Hong Kong government should take actions

immediately. Policies to encourage domestic consumption will help firms to gain

more consumers and business. Technology funds set up by government which

originally only aim at promoting domestic factory should broaden its helping range

and offer assistance to factories from Hong Kong. Besides, reduction in unnecessary

fine will benefit firms in trouble a lot.

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III. HK Participation in High-end Manufacturing Industry Development

Developing high-end manufacturing industry will be one of the emphases in

industrial upgrading. Transition is implied as we consider the current dominance of

low-end manufacturing industry. As quality of products is emphasized, skilled labour

becomes significant. Nevertheless, investment is equally important as a factor for the

high-end development. Investment in capital enhances the firm’s capability and the

firm can also provide training to improve its output per worker.

Indeed, high-end manufacturing involves either utilization of a more

sophisticated form of technology or designation of unique products (ODM / OBM). In

both cases investment play a crucial role, either in the form of financial or human

capital. Hong Kong therefore can serve as a provider of these forms of capital with its

clear advantages. In terms of financial support, Hong Kong can continue its

traditional function as FDI contributor; in terms of human capital, Hong Kong has

experienced expertise in product design, brand management, marketing and

advertising, which are essential ingredients of ODM / OBM business. Beyond that,

Hong Kong has the innovation capacity to support technological development

(discussed in later section).

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Collaboration efforts have also been in progress at the government level. In

2005, the two governments jointly set up the Guangdong/Hong Kong Technology Co-

operation Funding Scheme, which aims to upgrade the technological level of industry

in the Greater Pearl River Delta region and help developing the high value-added

industries. The scheme also aims to develop links among universities, research

institutes and technology enterprises in the region. Since its establishment, R&D

projects valuing RMB $200 million have been launched. These have favored

development in information and communications technology, critical precision

manufacturing technology, medical biotechnology and medical device. The Hong

Kong government should utilize these existing links and explore more possible areas

of collaboration as to strengthen Hong Kong’s role in such development. It should be

noted that Guangdong does not necessarily rely on Hong Kong in developing high-

end industry. It has developed various kinds of support to local development in

technology and capital needed, for example, it has announced to spend RMB $10

billion on development of rising industries and enterprise building. It has also invited

foreign experts to develop high-tech products. Under such circumstances, Hong Kong

should avoid duplicating Guangdong’s key projects, but instead acting as a

complement to its development.

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IV. HK Participation in High-end Service Industry Development

A major aspect of industrial upgrading is the development of service (tertiary)

industry, which is high-end by nature. Since the 11th Five-Year Plan, increasing the

share of tertiary industry in GDP has been an objective of Guangdong. It has now

announced a new aim of 48% by 2015. This not only means increasing services in

quantity, but also broadening and sophisticating services.

Meanwhile, Hong Kong inarguably specializes in service industry (see table

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below). It has, on the one hand, a high-skilled and knowledgeable labour force, and

on the other hand, successful past experience of transitioning from manufacturing to

services.

The signing of CEPA was a benchmark in Hong Kong-Guangdong collaboration. It

has also provided opportunities for Hong Kong businessmen and experts to

participate in Guangdong’s development. For example, the GD/HK CEPA Services

Expert Group was set up under the Hong Kong/Guangdong Cooperation Joint

Conference. Under CEPA, companies in HK enjoy preferential treatment when setting

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up businesses in various service sectors in Mainland China, and it opens up huge

markets for HK’s goods and services. These service sectors include medical services,

distribution, banking, securities, tourism, and professionals like accounting. Most of

the service sectors mentioned under CEPA are the leading and well-developed

industries in Hong Kong.

Through the economic integration between Guangdong and HK, HK can expand

its market to Mainland China providing quality services, promoting the services

industry development in Guangdong, this is a win-win situation. It should be noted

that expanding service businesses is a necessity rather than merely an opportunity.

After all, the major problem that Hong Kong businesses face is the lack of space.

With urbanization and growth in income under advanced development of

Guangdong, Hong Kong can no longer serve only as a service hub locally and to

mainland tourists. It can now establish its businesses in the mainland directly and

engage in the enormous market. Early success has already been seen in the 11th Five-

Year Plan period. According to estimates, there are more than 100 000 HK companies

that have been introduced to the area and during 2004-2009, business receipts

obtained by HK’s services industry due to CEPA-related businesses are up to HK$61.6

billion.

V. Development of producer services support

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There is a reason to allocate an independent section to ‘producer services’, as

separated from ‘services’, since producer services are truly distinguished strengths of

Hong Kong. For instance, producer and professional services has officially been

regarded as one of the four pillar industries in Hong Kong.

The “front shop, back factories” (前店後廠) collaborative relationship has been

maintained between Hong Kong and Guangdong since the economic reforms in

1978. Utilizing the comparative advantage of legal system and international

experience, Hong Kong specializes in providing producer services to PRD, including

financial services, professional services, trade-related services and communication

and media services.

However, statistics revealed that Hong Kong’ function of “Front shop” declines

with keen competition from mainland firms arose in recent years. According to a

survey conducted in 2003, only 30% of local producer services providers considered

themselves to have competitive advantages in PRD. Confronting the industrial

upgrading occurs in Guangdong province, Hong Kong’s producer services industry is

now restructuring to face the challenges.

For instance, the development of Hong Kong maritime industry has slowed

down in the past two decades with competition from Shenzhen Yantian Port and

Shanghai Pudong Port. Hong Kong was the 1st world largest container port from

1999 to 2004, in terms of cargo throughout, suppressed by Shanghai in 2006. The

difference of cargo throughout between Hong Kong and Shenzhen has also largely

narrowed, from 10 million TEUs to less than 1 million TEU in 2009.

Instead of the traditional trade-related services like the logistic industry, Hong

Kong is now focusing more on the area of professional services to grape the new

opportunities created in PRD. This refers to our earlier discussion of professional

services marketing, design and brand management in the ‘high value-added

manufacturing section’.

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VI. Development of environmental industry

One initiative during the Five-Year Plan period is to reduce environmental

pollution and to pursue cleaner production process. This creates a new form of

market – the market for cleaner energy use. Since Hong Kong is a more developed

economy and has seen the need for cleaner energy earlier, it has a comparative

advantage in the environmental industry. Therefore, the Five-Year Plan period sees

growing demand for Hong Kong environmental products. According to the prediction

from Hong Kong Trade Development Council, the overall consumption of

environmental related products and services in Pearl River Delta will increase to

HKD$90 billion by 2018.

Studying Hong Kong’s position in the economic development in China, the

Greater Pearl River Delta Business Council indicated the possible development of our

environmental industry. For instance, Hong Kong’s professional services firms can

introduce foreign capital and technology to promote regional recycling industry and

achieve economies of scale. Our strengths in urban water treatment, energy saving in

buildings and environmental impact assessment technology services can assist

mainland’s corporation overcoming the obstacle of industrial upgrading.

Environmental consulting services providers can engage in projects of energy

efficiency and education for mainland cities to achieve the national target to reduce

carbon emission intensity.

Besides, Hong Kong has reached agreements with the Guangdong government

on various favorable policies, relaxing restrictions and limitations to allow local

professional firms to engage in the mainland environmental industry.

A highlight of collaboration efforts has been the “Cleaner Production

Partnership Programme”. It has been established between Hong Kong and

Guangdong since fiscal year 2008/09, in which funding and subsidies are provided for

Hong Kong invested corporations in Guangdong to pursue cleaner production. With

requirements to purchase products and services only from the registered

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Environmental Technology Service Providers, it creates opportunities for the local

environmental industry to develop its business in Guangdong. Moreover, Hong Kong

enterprises can now participate in Clean Development Mechanism (CDM) projects on

the mainland. As around one-third of CDM projects are carried out in Mainland

China, Hong Kong enterprises can explore new business opportunities in projects

with major technology transfer, like the development of renewable energy.

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VII. Development of Innovation and R&D

As stated in the 12th Five-Year Plan, the aim of China is to achieve quality

growth. The emphases of ‘innovation and R&D’ and a ‘knowledge-based economy’

follow this guidance naturally. This is particularly the case in Guangdong, which

strives to become a leading province in innovation capacity. Meanwhile, the Plan has

also mentioned the need to strengthen Hong Kong’s innovation capacity in business

and industries. In this section, we will analyze how Hong Kong’s existing assets can

help support innovation development in Guangdong, as well as the required

strategies and improvements.

Firstly, we identify 3 possible functions of Hong Kong in innovation:

(1) Hong Kong firms in Guangdong can conduct innovation;

(2) Hong Kong can serve as the research base in the PRD;

(3) Innovation exchanges can be facilitated between the duo.

Secondly, we can classify innovation activities into different types. According to

the Oslo Manual, there are 4 types of innovation.

Product innovation Includes significant improvements in

technical specifications, components and

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materials, incorporated software, user

friendliness or other functional

characteristics.Process innovation Includes significant changes in

techniques, equipment and/or software.Marketing innovation Any new marketing method including

significant changes in product design or

packaging, product placement, product

promotion or pricing.Organizational innovation Includes a new organisational method in

the firm’s business practices, workplace

organisation or external relations.

Accordingly, we can analyze the present strengths and weaknesses of Hong Kong

as an innovation hub. The Oslo Manual again provides a convenient framework that

defines the favorable institutional environment for innovation. We can see in the

table below that Hong Kong already endows these sets of basic infrastructure.

Required Infrastructure / Settings Hong KongEducational system - Hong Kong has a 9-year

compulsory education system

that provides basic knowledge to

its labour

- Hong Kong has several high-rank

world-class universities that

provides skilled labour and also

serves as research institutesCommunications - Hong Kong has well-developed

transport infrastructure, for

instance, a sophisticated MTR

network

- Hong Kong has been providing

one of the best

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telecommunication and internet

servicesFinancial institutions - Hong Kong is well-known as a

financial centre

- Many banks and financial

institutions set up their

headquarters in Hong KongLegislative and macro-economic settings - Hong Kong has a sound legal

system

- The linked exchanged rate system

has provided stabilityMarket accessibility - Until recently, Hong Kong’s

market environment is still very

dynamic

- Setting up of businesses is very

convenient

It is interesting, however, to investigate the areas where Hong Kong lacks either

capacity or initiatives for innovation. It should be noted that Hong Kong’s R&D

expenditures are constantly lower than those in other NIEs (see figure below). In

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addition, according to a recent report, firms generally do not rely on universities and

public research organizations for product and process innovation. If we consider the

fact that the Hong Kong government’s support for innovation is based primarily on

university-industry links, this reflects inefficiency in input-output relationship. Hong

Kong firms are also characterized by their market-oriented investment for any type of

innovation, which may hinder long-term technological advance. The

shortsightedness is also seen in public R&D allocations, which emphasize short-term

returns.

We suggest several strategies to address these problems. At the government

level, it is imperative that Hong Kong should recognize the importance of innovation

to Hong Kong firms and (once recognized) provide the necessary fund support. In this

regard, Hong Kong has made some progress. For instance, since 2006, 5 Research

and Development Centres and the InnoCentre are established. There is also the

setting up of the Innovation and Technology Fund. However, a bigger problem is how

coordination is done, for which the Innovation and Technology Commission is

responsible. As pointed out in a paper1, more varieties of funding schemes should be

pursued as to increase the forward-looking capabilities of innovation projects, for

instance, schemes that do not require industry sponsorship. Besides, the approval

process must be simplified as innovation is in essence very much related to time.

At the firm level, information exchanges can be facilitated through exhibitions

and joint research, because R&D cooperation means the sharing of risk and financial

burden, which can overcome shortsightedness of individual firms. Universities, as

another set of major players, should enhance their connections with firms as to

understand the demands for innovation. This can not only utilize the functions of

universities as research bases, but also increase the sustainability of research

activities as a market scope for innovation products is provided. Last but not the

least, we should note that Hong Kong firms can also cooperate with universities and

research institutes based in the mainland. Only with a broader vision can

1 Savantas Policy Institute (2009). ‘‘Reinvigorating Hong Kong’s Innovation System: An Overview of Hong Kong Innovation Project’’. pp12

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stakeholders of Hong Kong fully embrace the opportunities of Guangdong industrial

upgrading.

VII. Conclusion

This paper reviews several areas that Hong Kong can develop and benefit from in

Guangdong’s industrial upgrading. Indeed, it should be pointed out that these areas

are not separate. It is not difficult to see that linkages exist among these areas. For

example, innovation and R&D actually provides the technological base for high-end

manufacturing industry development. The development of ODM/OBM businesses is

also beneficial to the producer service sector. While the harsh situation faced by

Hong Kong manufacturers in Guangdong is introduced, the innovation and R&D is

actually a ‘survival strategy’. The interrelations between all these sections can be

summarized as: coordination and cooperation.

To facilitate these efforts, the Hong Kong government certainly has a role to play.

We argue that based on increasing complexities of businesses, regional specialization

and integration, and the necessary public good such as R&D expenditure, Hong Kong

can no longer follow a ‘laissez-faire’ policy. To advance economic achievements, to

embrace the opportunities of 12-5 and to face the challenges in a new era, the Hong

Kong government needs to play a proactive role in coordinating different areas of

development and, negotiating and cooperating with the Guangdong government.

Only by doing so, Hong Kong will not risk becoming irrelevant to the rapid and

dynamic changes happening in Mainland China. We believe the structural

transformation in Guangdong can produce a win-win solution to both parties

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involved.

List of Reference:Hong Kong Trade Development Council (2011). “Environmental Protection Industry in Hong Kong”. Hong Kong Industry Profiles

Yeh, Anthony (2008). “Hong Kong’s Producer Services Linkages with the Pearl River Delta”, Centre of Urban Planning and Environmental Management

Hong Kong Marine Department (2011). “Ranking of Container Ports of the World”

HKSAR Government (2010). “Supplementary Notes for Hong Kong enterprises to implement CDM projects on Mainland”

Hong Kong Productivity Council (2011). “Cleaner Production Partnership Programme Overview”

Savantas Policy Institute (2009). ‘’Reinvigorating Hong Kong’s Innovation System: An Overview of Hong Kong Innovation Project’’

Web Sources:NewsGD - 12th Five Year Planhttp://www.newsgd.com/specials/12thFive-Year/default.htm

Cleaner Production Partnership Programmehttp://www.gov.hk/en/residents/environment/business/cppp.htm

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http://www.gov.hk/en/residents/environment/business/cppp.htm

http://www.newsgd.com/specials/12thFive-Year/default.htm

Econ3350 project edited

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