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Government of the Russian Federation

National Research University Higher School of Economics

Faculty of World Economy and International Affairs

School of Asian Studies

Master's Programme

"Socioeconomic and Political Development of Modern Asia"

MASTER'S THESIS

Hong Kong's Economic Interaction with China Mainland in the 21st Century

Student М МЭ МСА 141

Zhanna Medvedeva

Scientific Advisor

Alexey A. Maslov

PhD, Professor

Moscow, 2016

Plan

Introduction

Chapter 1. Economic interaction of separated parts of a country: theoretical approaches and historical aspects

1.1 Comparison of a large economy of China Mainland with a small and open economy of Hong Kong

1.2 Historical overview: economic interaction between Hong Kong and China Mainland in the 1949 - 1997 period

1.3 Relations of Hong Kong and China Mainland in the light of the integration theory

1.3.1 Comparative analysis of the integration processes in Europe with the integration processes between Hong Kong and China Mainland

1.3.2 Theoretical concepts of integration

1.3.2.1 Federalism approach

1.3.2.2 Functionalism approach

1.3.2.3 Neofunctionalism approach

1.3.3 Theoretical concepts of integration applied to Hong Kong and China Mainland

Chapter 2. Impact of Free Trade Agreement of 2004 on re-integration between Hong Kong and China Mainland

2.1 Economic relations between Hong Kong and Mainland China under the "one country, two systems" model in the 1997-2003 period

2.2 Prerequisites for signing FTA

2.2.1 Interests of China Mainland in FTA

2.2.2 Interests of Hong Kong in FTA

2.3 Main contents of CEPA

2.4 Practical aspects of trade in goods and services within the framework of CEPA

2.4.1 General Principles of CEPA

2.4.2 Trade in goods

2.4.3 Trade in services

2.4.4 Promotion of Trade and Investment

2.5 Analysis of benefits of Hong Kong and Mainland China from FTA implementation

2.6 Impact of FTA on Hong Kong's economy

2.6.1 FTA promotes the development of Hong Kong's economy

2.6.2 FTA optimizes the economic structure of Hong Kong

2.7 Impact of FTA on economic re-integration between Hong Kong and Mainland China

Conclusion

References

Introduction

In 1842 Hong Kong became the colony of Great Britain and had been maintaining this status for more than 150 years - until 1997, when the handover of Hong Kong to the People's Republic of China (PRC) occurred and the PRC gained sovereignty over the island's territory. According to the Sino-British Joint Declaration and the Basic Law of the special administrative region (SAR), the Constitution of Hong Kong, the territory is granted a wide autonomy in governance for 50 years since the handover, i.e. until 2047.

Hong Kong and China Mainland has always been closely connected, re-integration between the parties has been taking place for a long period of time. Starting from 2000s economic re-integration processes between Hong Kong and China Mainland have accelerated in large part because of signature and implementation of the Free Trade Agreement (FTA), which was named Closer Economic Partnership Arrangement (CEPA).

The main subject of the research is economic interaction between Hong Kong and China Mainland and its influence on re-integration between the parties.

The main objective of the research is to examine particularities of economic cooperation between Hong Kong and China Mainland after signing the FTA and to assess the FTA's impact on the process of re-integration between the parties.

The objective of the research is to be achieved through the following tasks:

• to outline the main differences between the two economies;

• to examine common historical background in terms of economic interaction;

• to find an adequate theoretical approach, best suited for explaining the integration processes;

• to explore the application of the Hong Kong - China's FTA

• to reveal the interest of Hong Kong and China Mainland in the implementation of the FTA;

• to analyze the impact of the FTA on the re-integration process between Hong Kong and China Mainland.

According to the objective, the thesis was logically divided into main parts:

* In the first chapter "Economic interaction of separated parts of a country: theoretical approaches and historical aspects" the author conducts a comparison of Hong Kong and Mainland China's economies, analyzes economic relations of the parties from 1949 to 1997, describing existing integration theories and approaches and identifies which of the existing theories can better explain the re-integration processes between Hong Kong and Mainland China.

* In the second chapter, "Impact of Closer economic partnership arrangement on re-integration between Hong Kong and China Mainland" the author examines economic relations between Hong Kong and Mainland China from 1997 to 2003, reveals prerequisites for signing the FTA, considers its main content, analyzes practical aspects of trade between the parties in the framework of CEPA, identifies the benefits of the parties from implementation of the agreement, assesses the impact of CEPA on Hong Kong's economy and its impact on economic re-integration between Hong Kong and Mainland China.

In the thesis the following research methods were used:

ь Content analysis

ь Statistical analysis

ь Chronological analysis

ь Comparative analysis

Content analysis of the primary source, the Closer Economic Partnership Arrangement and its numerous Supplements, as well as of related articles and books was mainly used in the second chapter of the thesis to fulfill one of the research task - the assessment of the impact of the agreement on the re-integration between Hong Kong and China Mainland.

Since the research is focused on the issue of economic interaction, statistical analysis and work with figures were essential to achieve the research objective. Statistical data on GDP, GDP per capita, GDP growth rate, Export volume, Import volume, FDI, Index of Economic Freedom, Population size, External debt to GDP, etc. were extensively used to cover the topic.

Chronological analysis was a vital method for the research, as it made the paper more logical and structured. This method was mainly used to examine the following aspects: Historical overview: economic interaction between Hong Kong and China Mainland in the 1949 - 1997 period, economic relations between Hong Kong and China Mainland under the "one country, two systems" model in 1997-2003 and analysis of Hong Kong and China Mainland benefits from the implementation of CEPA.

Comparative analysis was used to show the differences between the economies of Hong Kong and China Mainland in terms of size and scale, degree of openness and level of development, macroeconomic tendencies and so on, to show similarities and differences of integration processes among the European states and between Hong Kong and China Mainland, to reveal the difference in interests of Hong Kong and China Mainland with regard to the FTA signature and implementation.

The use of all above described methods, equally contributing to the achievement of the research objective, was aimed to allow this thesis to become a comprehensive research of a complex issue.

On account of the fact that nowadays plenty of companies intend to trade with China and invest in China through their subsidiaries in Hong Kong, and the fact that most researchers devoted their attention to the topic of Hong Kong - China Mainland economic cooperation mainly during the landmark events in 1997 (Hong Kong Handover to China) and in 2003 (CEPA signature), the dire necessity to explore the latest developments in this field makes this research quite relevant.

Hence, it is vital to stress a relatively high practical applicability of the findings, which are bound to be interesting to everyone concerned with economic relations between Hong Kong and the Mainland including academicians, students, entrepreneurs as well as general public.

Hong Kong and China Mainland pursue different interests in cooperation under the FTA: China Mainland is more focused on political benefits, whereas Hong Kong is only concerned with the economic benefits. This statement can be formulated as the research hypothesis.

The research is based on a number of primary and secondary sources.

As for the primary sources, a lot of attention has been given to the original FTA and its Supplements as well as to reliable statistical data of the International Monetary Fund, World Bank, UNCTAD as part of the Euromonitor International statistical base, statistical section of the Hong Kong SAR Trade and Industry Department, National Bureau of Statistics of the People's Republic of China, China Statistical Yearbook.

As for the secondary sources, a number of works of Chinese and Western authors have been devoted to the issue of economic relations and re-integration of Hong Kong and Mainland China, however, in the Russian scientific community this topic has not been widely explored. Among the Russian researches it is necessary to pay attention to the works of V. Kovalenko and P. Ivanov, who described the stages of economic development of Hong Kong and Mainland China and analyzed the possibility of their further re-integration. With regard to the Western and Chinese scientific community, important contribution to the study of this topic have been made by the works of R.F. Ash, Y.Y Kueh, P. Baoxiang, A. Batson, H. Fung, Y.S. Samuel, P.J. Williamson and others.

Chapter 1. Economic interaction of separated parts of a country: theoretical approaches and historical aspects

1.1 Comparison of a large economy of China Mainland with a small and open economy of Hong Kong

Currently, Hong Kong and China Mainland are coexisting within the "one country, two systems" model. According to this approach, the Central People's Government of the PRC is responsible for foreign policy and defense of the Hong Kong's territory, whereas Hong Kong is entitled to maintain control over legislation, police, monetary system, taxes, duties, immigration policy as well as to have its own representation in different international organizations. At the same time China Mainland initiates various re-integration processes with Hong Kong. To the present moment, the most remarkable achievement in this sphere was the signature by the parties of CEPA in 2003, which has become the main instrument for intensification of re-integration processes between Hong Kong and China Mainland.

The economies of Hong Kong and China Mainland are completely different in terms of scale and differ considerably in terms of economic freedoms. The economy of Hong Kong is deemed to be one of the most liberal owing to the state noninterference with the economy, law level of taxation and free market. Hong Kong also is an important and reputable international trade and financial center with the highest possible concentration level of multinational corporations' headquarters in the Asia-Pacific Region. Following the traditions of British colonial government, the current government of Hong Kong still gives the highest priority to free market and private sector. With the advent of Index of Economic Freedom in 1995, Hong Kong has always been ranked as the freest economyIndex of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong. Core industries of Hong Kong are banking, finance, shipping and tourism, whereas the island's manufacturing base has been relocated to Mainland.

In the end of 1970s populous China announced reform and opening up policy, which had led to the significant GDP increase of the country in 1980s at an average 10% annually Stephens L. Hong Kong - China Trade Links. - The Wall Street Journal, 1990, Vol. 8, №3. P. 32.. Nowadays, Chinese economy has the second largest GDP in the world. Formally, the PRC is a socialist country, nevertheless, up to 50% of the country's GDP is generated by the private enterprises China Economic Forecast 2015. - Oxford Economics, 2015. . The Chinese authorities officially term China's economic system as "Socialism with Chinese Characteristics".

In the end of 1990s the growth of Chinese economy slowed down to 8-9%, however, after China entered the World Trade Organization in 2001, export expansion and inflow of immense amounts of foreign investments have fostered and accelerated China's GDP growth Ibid..

Nowadays, China is the world's leader in mineral extraction (for instance, coal, iron, manganese, wolfram minerals) or extract substantial volumes of the minerals (for instance, oil, gas, uranium, rare earth metals). China is the largest manufacturer of most types of industrial goods and the largest world's exporter, for a long period of time it has been exporting textile, clothing and footwear, watches, sewing machines, bicycles and other types of labor-intensive products. Starting from 1989 the annual growth of China's export and import equal to 15% Batson A. Beijing Clears China for Hong Kong Trade. - The Wall Street Journal, 2007, №10. P.13..

In order to make a demonstrative comparison of the two economies we refer to the latest statistical data for 2015 and examines the indicators, which can show an immense difference in scale of Hong Kong and China Mainland' economies.

We will begin the comparison of the two economies with the size of the population. In 2015 in a populous China the population of 1.37 bln people was recorded, while the population of Hong Kong was just 7.3 million people ЌЃЌ`“Б±рЌsђ­‹жђ­•{НіјЖґ¦ http://www.censtatd.gov.hk/. It is evident, that the size of the population of China has contributed most to the creation of huge scales of the economy.

The GDP of China equal to $18.7 trillion, which is in contrast with the GDP of Hong Kong, amounting to $415.5 bln Euromonitor International Statistical Base. http://www.euromonitor.com/. The GDP growth rate of China was 6.8% and of Hong Kong was 2.4% in 2015, with an average annual GDP growth of China and Hong Kong over the past 5 years amounted to 8.5% and 3.7%, respectively Ibid. The GDP per capita is $14,107 dollars in China and $56,701 in Hong Kong International Monetary Fund. It is apparently that such a big difference is caused by the huge population of China. Despite the fact that Hong Kong is considered an extremely densely populated area, Hong Kong is able to create conditions for most of its citizens to enjoy a very high income and to have high living standards.

The unemployment rate in China was 4.5% in 2015 and in Hong Kong - 3.3%; China's inflation rate is 1.4%, half the rate of inflation of 3.1% in Hong Kong Ibid..

The inflow of foreign direct investment in 2014 in China amounted to $128 bln, which is similar to the amount of investment received in 2015 by Hong Kong - $103.3 bln Ibid..

According to the scale of economic freedom level from 0 to 100 points, China in 2015 scored 52 points that determined its 144th rating position among all other countries (Figure 1). The total number of "points" of the country is slightly lower (0.7) of the same period in 2015, which reflects certain deterioration in terms of the country's existing property rights, labor freedom and corruption. China was ranked as the 31st out of 41 countries in the Asia-Pacific region and the total number of its "points" is still below the average both worldwide and in the region.

In contrast to the Mainland, on the scale of the economic freedom level Hong Kong gained 88.6 points, which made the economy of Hong Kong the most open and freest economy in 2015 Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong. Logically, Hong Kong occupies the 1st position in this rating among the Asian-Pacific countries.

Figure 1 Index of Economic Freedom 2015, country-by-country comparison

Source: Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong

Hong Kong has demonstrated a high resistance to the global economic and financial crisis and still remains one of the most competitive financial and business centers of the world. Highly efficient legal system that protects property rights and supports the rule of law continues to be a solid basis for the development of Hong Kong's dynamic economy.

Effective regulation and Hong Kong's openness to the world trade provide a strong incentive for the entrepreneurial development, while macroeconomic stability minimizes uncertainty.

The Chinese economy, in turn, is subject to substantial political influence and guidance of the Communist Party of China (CPC). Although Chinese leaders are gradually embracing market principles to make the Chinese economy more efficient and competitive, the process of reform in the country has slowed down considerably in recent years.

Lack of political will for a more fundamental restructuring of the economy has led to the over-reliance of the Chinese economy on government funding. In the financial sector of China the state control is maintained mainly through subsidies and credit manipulation.

We will consider Hong Kong and China Mainland in terms of ten main indicators characterizing the level of economic freedom. The scale from the worst indicator as 0 point to the desired indicator and the highest 100 points was used for calculation.

The first category "Rule of law" includes such indicators as "Property rights" and "Freedom from corruption." For China this indicators equal to 20 points and 36 points, respectively (Figure 2). For Hong Kong property rights protection is 90 points and freedom from corruption - 74 points. Worldwide average indicators are 43 and 41 points, respectively.

Figure 2 Comparison of Hong Kong and China Mainland by the "Rule of Law"

Source: Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong

For China Mainland we can conclude that its judicial system is under excessive political influence and under influence of corruption. Intellectual property rights in China are still very weak: violations of copyright, patents and regulation for the use of trademarks are a common practice and occur everywhere. Corruption in its various forms has a very negative impact on the banking and finance, state procurement and the construction industry.

In contrast to the Mainland, the effectiveness of legal system of Hong Kong encourages people to recognize and respect the importance of law. Hong Kong Basic Law provides effective protection of property rights and creates conditions for lawful trade in licenses.

The judicial power of the island is separated from the legislature and executive powers, and the traditional intolerance of Hong Kong citizens to any manifestations of corruption, subsequently supported by the strict anti-corruption measures, allows to maintain the efficiency of local authorities.

The second category "Limited government" focuses on such indicators as "Fiscal freedom" and "Government spending". For these indicators China Mainland scored 69.7 and 74.3 points and Hong Kong gained 92.6 and 90.7, respectively, while the worldwide average scores are 78 and 62 points (Figure 3).

Figure 3 Comparison of Hong Kong and China Mainland by "Limited government"

Source: Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong

In China the maximum personal income tax rate is 45%, and the maximum corporate income tax rate is 25% Hong Kong analytical and information portal "Business in China" http://asia-business.biz. Overall, the tax burden in China equals to 18.2% of gross national income Ibid.. Government spending in China amounts to 23.6% of GDP. To date, China's government debt has decreased, however, the significant part of this debt is embedded into extra budgetary obligations. The personal income tax rate in Hong Kong is 15% and the corporate income tax rate amounts to 16.5%. Hong Kong's tax system is simple, transparent and effective; the tax burden on population is relatively small at the level of 14.5% of gross national income Ibid.. Government spending accounts for 19.2% of GDP Ibid..

In the third category "Regulatory efficiency" three main aspects are examined: "business freedom", "labor freedom" and "monetary freedom". In this category, China gained 54.2, 62 and 70.6 points, while the worldwide average scores are 63, 61 and 72 points, respectively. For Hong Kong these scores are 97.4, 89 and 81.8 points (Figure 4).

Figure 4 Comparison of Hong Kong and China Mainland by "Regulatory efficiency"

Source: Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong

Overall, China's state regulation system still remains complicated and ambiguous. The costs for obtaining a permit to conduct business may be three times higher than the average annual income from this business Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong. The labor conditions in the country are considered to be quite tough. The government exerts control over the prices for most types of energy resources, raw materials and other strategically important products.

In contrast, examining the Hong Kong situation we can observe that the system of state regulation of Hong Kong provides substantial support to business community and its efficient functioning and development. Registration of a company in Hong Kong only takes three days; specifically Hong Kong authorities do not impose any requirements for the minimum amount of capital for the establishment of a company Hong Kong analytical and information portal "Business in China" http://asia-business.biz. In spite of the increased pressure of inflation, Hong Kong authorities also maintain effectively monetary stability.

The last category "Open markets" involves the following indicators: "Trade freedom", "Investment freedom" and "Financial freedom". On these indicators China Mainland scores are 72.8, 30 and 30 points, respectively, and Hong Kong on all indicators gained 90 points (Figure 5). Worldwide averages scores are 75, 52 and 50 points.

Figure 5 Comparison of Hong Kong and China Mainland by "Open markets"

Source: Index of Economic Freedom 2015. http://www.heritage.org/index/country/hongkong

China Mainland uses a lot of non-tariff barriers in trade and investment regime in the country cannot be considered as transparent and highly efficient. The state continues to exert tight control over the financial sector and uses it as the most important instrument to control other sectors of the China's economy. The state owns all the major financial institutions in the country, which provide loans in accordance with the state's interests and public policy priorities, especially it implies to financial support for state-owned enterprises.

Unlike China Mainland, Hong Kong's trade regime is regarded as one of the most competitive and effective regimes in the world. Hong Kong is a free port, which erects the minimum number of non-tariff barriers to trade with zero tariff rates. An effective and transparent regulation for the implementation of investment, existing in Hong Kong for a long period of time, continues to attract a large number of foreign investors. Hong Kong established itself as a competitive financial center with a high degree of transparency and openness.

To sum up, the economies of Hong Kong and China Mainland are vastly different in size and vary greatly in terms of the presence of economic freedom. In spite of these differences, currently, the dynamic integration process between a small open economy of Hong Kong and a large closed economy of China Mainland is taking place and, presumably, reaching heights.

1.2 Historical overview: economic interaction between Hong Kong and China Mainland in the 1949 - 1997 period

Starting from 1980, average annual growth of Hong Kong's economy had been 6.5%, while GDP per capita had increased by 4 times from $5630 in 1980-1985 to $24520 in 1996 Hong Kong SAR: Meeting the Challenges of Integration with the Mainland. - International Monetary Fund, 2004. P. 31.. During this period, Hong Kong's economy undergone a number of structural changes and became closely linked with the economy of China Mainland and the rest of Asia through trade and investment. The significance of the manufacturing sector of Hong Kong and export of domestic goods decreased, therefore Hong Kong began to develop actively its service sector. This transformation had not led to an unprecedented increase in unemployment in Hong Kong, although unemployment had often accompanied similar changes in other parts of the world. This favorable situation largely contributed to the possibility of shifting the production base of Hong Kong to China Mainland.

For most part of its history, with the exception of a 30-year period from 1949 to 1979, Hong Kong has been a strategic port of China. In the early 1950s due to the Korean War the Western countries imposed embargo against China and Hong Kong had to abandon its role of a key port of China and began to develop its own manufacturing industries. Hong Kong specialized in the production of labor-intensive consumer goods, focusing on low-cost labor force and entrepreneurial skills of its businessmen and manufactures, who mainly came from Shanghai and other large cities of China Mainland.

By the time when China changed the direction of its development in 1978 and started to implement a policy of openness and economic reform, Hong Kong had already created its large and internationally competitive manufacturing sector, which called for relocation. Hong Kong's manufacturers quickly arrived at a decision to use China Mainland for this purpose, where at that time labor costs were 15 times less and costs of land and fixed capital were10 times less than on the territory of Hong Kong Samuel Y.S. Processing Trade in China-Profits Tax Implications on Hong Kong Manufacturers. - The International Tax Journal, 2011, Vol. 37 №2. P. 35..

Over the next 15 years of processing work of Hong Kong as well as the steady growth of China's rapid export trade contributed greatly to the development of auxiliary industries of Hong Kong in the service sector and led to the significant structural changes in the economy. The share of the industrial sector declined from 25% of GDP in 1980 to less than 9% by 1995, while the total share of services increased from 30% to 85% of GDP Jianfa S. Hong Kong under Chinese Sovereignty: Economic Relations with Mainland China, 1978 - 2007. - Journal of Economic Literature, 2007. P. 328.. More significant changes took place in the structure of employment: employment in the industrial sector decreased from 41% of total employment in 1980 to 13% in 1995, while employment in the four key sectors of the tertiary sector increased from 37% in 1980 to 63% in 1995 Ibid. P. 330..

At the end of the 1980s due to the reform and opening up policy in China a steady decline in relative prices in the industrial sector happened, it was unexpected for the Hong Kong's market of factors of production, which could not adapt quickly to these new conditions. At the same time, the growth of regional trade and the needs of other countries in trade and investment cooperation with China once again showed Hong Kong's advantageous and favorable location.

As it has already been noted, a remarkable fact of the structural transformation of the economy of Hong Kong was that this transformation did not slow down the pace of economic growth and did not led to a significant increase in unemployment. In fact, real GDP growth remained stable throughout the whole period, since 1988 in the service sector more than 700,000 jobs were created, thus compensating for the loss of about 500,000 jobs in the industrial sector Fung H., Zhang J. An Assessment of the Closer Partnership Arrangement Between China and Hong Kong. - The Chinese Economy, 2007, №5. P. 38.. In the 1980s, the average annual productivity growth was 4.5% Ivanov P. Hong Kong. Istoriya I sovremennost. - M: Nauka, Glavnaya redakciya vostochoy literaturu, 1990. - c. 121.. Even in the 1990s, when Hong Kong's services sector was quite developed, the average annual growth of labor productivity in Hong Kong amounted to 4% Fung H., Zhang G., Zhang Y. The Prospects for China's Free Trade Agreements. - The Chinese Economy, 2007, №8. P. 15.. Estimates of the total growth of productivity of all factors of production in Hong Kong in the 1980s range from 1.75% to 4.5% per year, higher than in most OECD countries over this period Ibid. P. 20..

During the process of structural changes Hong Kong reached a new high stage of development and succeeded in becoming one of the major international financial centers. By 1997, more than 500 banking institutions had established their branches in Hong Kong, including 82 of the world's top 100 banks. Foreign assets held by banks and depository institutions exceeded $600 bln, which enabled Hong Kong to become the fifth largest banking center in the world at that time Ibid. P. 19.. More than 70% of banking transactions were conducted in foreign currency and Hong Kong ranked the fifth position in stock market turnover in the world.

Economies of Hong Kong and Southern China were closely related to each other through trade and migration throughout the history. China traditionally supplied to Hong Kong a large amount of food and water, and Hong Kong traditionally served to China as a major port. Starting from 1978, the economic interaction between the economies has focused on new areas: production, investment, services and finance. At the same time, Hong Kong's economic ties with other countries of East Asia also strengthened rapidly.

In 1997 China was the largest trading partner of Hong Kong, while Hong Kong was the third largest trading partner for China. In 1996, China consumed 1/3 of Hong Kong exports and provided 37% of Hong Kong's imports. Hong Kong, in turn, received 1/5 of China's exports and consumed 6% of China's imports Ibid. P. 23..

Trade flows between Hong Kong and China are very complex. About half of Hong Kong's total exports to China are resources, raw materials and materials sent to China for further processing; ѕ Hong Kong's imports from China are the results of these activities, which are re-exported by Hong Kong to different parts of the world, especially to the US, Japan and EU countries Ibid. P. 28..

These re-export operations include a wide range of services (transport, insurance, financial and commercial) and the activities that accompany the production process (design, cost calculation, quality control, packaging, etc.) provided by Hong Kong companies.

The complexity of trade relations between Hong Kong and China increased as a result of the growing importance of transit transportation of goods, when the goods shipped from China should be shipped to the destination via a transshipment bill of lading. The volume of transit cargo increased from 4 million metric tons in 1991 to more than 9 million metric tons in 1995 Sung,Y., Wong K. Growth of Hong Kong Before and After Its Reversion to China: The China Factor. -Pacific Economic Review, 2000, Vol. 5 №2. P. 201.. In general, when the transit of goods did not include such a high added value, as the re-export trade, the generated added value in the areas of transport, communications and banking services was monitored by the statistical agencies of Hong Kong. Along with the gradual simplification of procedures for cargo execution and the improvement of ways of using port facilities in China, the shift from re-export operations to another way of trade was taking place.

Product processing activities of Hong Kong's manufacturers on the Mainland could be described as an execution of contracts with Chinese firms for the production of semi-finished or finished products, which will subsequently be imported by Hong Kong for re-export to other markets. However, such operations were initially allowed only in special economic zones in Southern China. Along with the opening of China's other cities and provinces to foreign investment and international trade, the product processing activities of Hong Kong's industrialists were spreading to other parts of China. According to estimates, by the end of 1991 Hong Kong companies controlled more than 14,000 companies with more than 3 million employees in the Guangdong province Ibid. P. 203.. In 1996, the cost of raw materials imported for processing was estimated at $29 bln, the output of the processing factories was $59 bln and Hong Kong's re-export of these products to other countries amounted to $71 bln Ibid. P. 204..

The speed of the manufacturing base relocation from Hong Kong was the highest in the early 1990s. Hong Kong firms have begun to relocate more complex and higher value added production processes to Southern China, expanding their existing base, while the processes with low value added were relocated to the northern and western provinces of the country, where the cost of labor and land were still at a very low level.

In the 1990s, a new way of economic integration between Hong Kong and China Mainland emerged - Hong Kong's services outsourcing from China. However, the outsourcing of traditionally provided by Hong Kong's services from the Chinese firms was limited to a labor-intensive activity such as the publication of printed materials, information processing and document processing within financial institutions.

In 1996, the total number of Chinese companies operating on the territory of Hong Kong was estimated at 2 thousand Ibid. P. 203. . At the same time, Chinese companies were most active in the trade sector of the Hong Kong's economy.

Since 1979, Hong Kong was the source of more than 80% of foreign direct investment for China Mainland Williamson P. J. China Invests In Hong Kong. - Global Logistics, 2008, Vol. 49 №1. P. 12.. In 1995, the volume of investments, implemented by Hong Kong firms, totaled $20 bln and the volume of accumulated investments by 1995 reached $80 bln ЌЃЌ`“Б±рЌsђ­‹жђ­•{ЌHТµГі€ХЏ‹ http://www.tid.gov.hk/. China, in turn, was the second largest Hong Kong's investor in the direct investment volume: by the end of 1995, the accumulated volume of Chinese investment in Hong Kong amounted to $14 bln Ibid..

To summarize, Hong Kong throughout most of its history has been a strategically important port of China. After the relocation of the manufacturing base to the Mainland, Hong Kong began to specialize in financial and intermediary operations, largely connected with the re-export of products. Also, Hong Kong and China are large trading partners for each other and important sources of direct investment.

1.3 Relations of Hong Kong and China Mainland in the light of the integration theory

economy integration trade china

The history and cultural differences explain the fact that the integration in various regions of the world is emerging in different ways. Modern concept of integration is largely associated with the integration in Europe after the World War II. However, nowadays the integration processes can emerge in different ways, for example, in the case of the North American Free Trade Association (NAFTA) and Association of South-East Asian Nations (ASEAN). Since the concept of integration is largely based on the European integration, initially it is necessary to compare the experience of integration among the European countries with the integration processes between Hong Kong and China Mainland.

1.3.1 Comparative analysis of the integration processes in Europe with the integration processes between Hong Kong and China Mainland

There are big differences between European integration and the integration of Hong Kong with China Mainland, which are indicated in different incentives to the integration, different relations between the involved countries or regions, differences between the participants of this process. The main driving force behind the creation of the European Union was a desire to reach a political agreement and to ensure peace on the continent. According to Ash and Kueh, the prevention of future wars between France and Germany, the creation of a third force in world politics and the return of the world's leader status to Western Europe are often referred to as the political objectives to be achieved through the economic integration Ash R.F., Kueh Y.Y. Economic Integration within Greater China: Trade and Investment Flows between China, Hong Kong and Taiwan. - The China Quartely, 1993, №136. P. 13.. China Mainland and Hong Kong, on the contrary, first reunited with the help of bilateral negotiations on the restoration of the sovereignty of China, and then continued the gradual process of integration. The main driving force behind this integration is also different from the EU integration.

First, the parties have sought not only to the further development and overall well-being, but also to the formation of a sovereign state in the end.

Second, all EU Member States are the sovereign units, but Hong Kong is not a sovereign unit: it is a former British colony and, at present, a special administrative region of China.

In other words, the case of Hong Kong and China Mainland is not a typical example of international integration, it looks more like a reunion of two separate political entities, such as East and West Germany. In addition, Hong Kong has historically been a part of China, so the two societies still have many similarities in language and culture, while EU Member States have their own unique historical and cultural heritage.

Third, the integration processes within the EU and between Hong Kong and the Mainland are very different in terms of the environment they are taking place in. For example, all EU countries have two similar features: the capitalist market economy and democratic government. Hong Kong is also characterized by the presence of the capitalist economy, individual freedoms and the recognition of the importance of law, but its government is not democratic. China Mainland is even more different, as it is building "socialism with Chinese characteristics." From the economy's perspective, the Chinese Mainland and Hong Kong are very different in scale, the degree of openness, the system of market regulation and the level of development. As described earlier, the Hong Kong's economy is small, open and highly developed, and the economy of China Mainland is large, fairly closed and less developed.

The integration of Hong Kong and the Mainland should be considered as a special case. This is not the integration of sovereign states, but the re-integration of a sovereign state with its current special administrative region, when both participants of this process have different political, economic and social systems.

1.3.2 Theoretical concepts of integration

Integration is a further development of the regionalization process, when the relations of neighboring countries lead to their de facto union into one big national economy, which requires the appropriate decisions on the level of economic policy. It is important to remember, that integration is not simply related to globalization, but it is the regional phenomenon. The political component is an essential part of the integration, implying the implementation of a unified and coordinated economic policy.

The integration can be divided into two types: positive and negative. Positive integration occurs when the countries, involved in the integration process, develop the productive potential of all their members, which is possible through the coordinated and coherent industrial, monetary and fiscal policy. Negative integration exists when the removal of mutual protectionist restrictions takes place within the association.

The classic type of integration is considered to be a transition from economic cooperation to cooperation in the political sphere. However, the practice shows that it also happens vice versa: when the countries firstly achieve effective cooperation in political issues and then they reinforce this cooperation through closer economic ties. These efforts are not always necessary, because countries may not have any common economic interests. Such kind of integration should be considered as partial and incomplete. Obvious examples of such integration are ASEAN and Shanghai Cooperation Organization (SCO).

Considering Greater China, which includes China Mainland, Taiwan, Macao and Hong Kong, it can be argued that the concept of "integration" is only applicable to the integration with Hong Kong and Macao, and to a lesser extent - with Taiwan. In addition to the agreements with Hong Kong, Macao and Taiwan, over the past decade China managed to conclude a number of free trade agreements with Chile, Pakistan, New Zealand, Singapore, Peru, Costa Rica and the agreement on creation of free trade zone with ASEAN countries.

However, when determining the nature of the interaction of China with other countries, a large number of factors should be taken into account, as close interaction does not always mean integration. However, China Mainland and Hong Kong can certainly be regarded as the parties involved in the mutual re-integration process that has been going on for a long time and is maxing out.

The main stages of economic integration include: free trade zone, customs union, common market, economic union (economic and monetary union) (Table 1).

Table 1 Main stages of economic interaction

	Removal of trade barriers between participants	Common external trade strategy	Free movement of production factors	Common financial and economic strategies
Free trade zone	?	-	-	-
Customs union	?	?	-	-
Common market	?	?	?	-
Economic union	?	?	?	?

The first stage of economic integration is the creation of a free trade zone. Participants reduce internal customs duties in trade with each other, voluntarily abandon the protection of national markets within the association, but when interacting with other countries they act individually, rather than collectively. Participants maintain economic sovereignty and individually impose external tariffs for trade with countries that are not involved in this association. As a rule, the creation of a free trade zone begins with the signing by the two closely cooperating countries of bilateral agreements, which are then joined by new members (e.g., NAFTA: Mexico joined the original agreement between the United States and Canada). Most of the existing economic integration associations are functioning at this stage, and in many cases a free trade zone is the first and, at the same time, the final stage of integration.

Then the participants of a free trade zone move to the creation of the customs union. At this point they unify external tariffs, implement common trade policy, together impose tariff barriers against third countries. If the customs tariffs against third countries are different, the companies of countries outside the free trade zone are able to penetrate the markets of all participants of the economic association through the border of one of the participating countries. The unification of external tariffs can reliably protect a single regional market and act as a strong trading bloc in the international arena. It is important to note that when creating customs union member countries of the integration associations lose part of its external economic sovereignty. Not all participants of the free trade zone are striving to create a customs union, as it requires substantial efforts for coordination of the economic policy.

The next stage of integration development is a common market. At this point, members of the association eliminate restrictions on the movement of factors of production, which greatly enhances their economic interdependence. Freedom of resources movement requires high level of organization of intergovernmental coordination resources from the participating countries. However only freedom of movement of goods, services, labor and capital in order for forming a single market is not enough.

To complete the economic union it is also necessary to adjust the levels of taxation, harmonize economic legislation, sanitary and technical standards, to coordinate social security system and national credit and financial institutions. After that, the countries are moving to the next stage of integration - the economic union. The creation of a common regional currency system, one central bank and a common currency as well as the coordination of monetary policy are essential parts of the economic and monetary union.

With the development of economic union, the prerequisites for the transition to a higher level of regional integration - the creation of a political union may emerge. In this case, a single market space is transformed into one big economic and political system. During the transition from an economic union to a political union a new actor of international relations appears and expresses the interests and political will of all member countries of the union. In fact, a large new federal state appears.

The integration processes are often explained through three different approaches: federalism, functionalism and neo-functionalism. All these approaches have been used for the analysis of integration processes in the post-war Europe.

1.3.2.1 Federalism approach

Federalism is used to describe the process of European integration since the World War II. Integration for the Federalists "requires the creation of a two-tier management system - common federal government and local governments" Ibid. P. 14.. The case of the EU represents the trend towards the creation of the Federal Government, while the Member States may serve as "local governments".

Federalists pay much attention to the creation of institutional order and supranational government. In this system, the central federal institution takes responsibility for defense and foreign relations. But in terms of the integration sequence Federalists insist that "political integration should be the first step, followed by economic integration" Ibid. P. 16.. Federalists believe that political integration can create favorable conditions for economic integration. Through the coordination and control of the federal government the member states, pooling their financial resources, can step by step plan their economic integration. The strength of the federalist approach is that they pay a lot of attention to the outcome of the integration, and their weakness lies in the lack of a detailed analysis of the integration process Ibid. P. 14..

1.3.2.2 Functionalism approach

Functionalism is regarded as the second popular concept of integration. In this case, "not the end of the integration process, but human needs are the priority" Baoxiang P. The Analysis of Regional Economic Cooperation between Mainland China and Hong Kong/Macao under CEPA. - Special Zone Economy, 2007, №22. P. 29.. Functionalists place high importance on human needs and social welfare and are convinced that "cross-national institutions are able to ensure the welfare of society much better and more effective, than the national government" Ibid. P. 34.. Functionalists are more focused on society, especially on the international community, than on the state. They are convinced that "with the help of different international institutions people can solve many social and economic problems, contribute to the development of dependence of countries from each other and create a peaceful international environment and the society opposed to war" Ibid. P. 32..

Another distinctive feature of functionalist approach is the assumption that cooperation between the two countries should not begin with the political sphere. In particular, the functionalists believe that cooperation should develop in the technical field, what will boost cooperation in other areas, because technical sphere usually cannot provoke political conflicts Ibid. P. 30.. The EU began with the European Coal and Steel Community, where the economic cooperation was the first step. During the interaction in economic and social spheres the participating countries will face common challenges, and while dealing with these challenges, they will enhance international cooperation. Over time, such cooperation and the establishment of certain common values will fall into their habits. This, in turn, will facilitate their cooperation at a higher political level. Functionalists believe that the development of science and technology along with improved economic cooperation will improve political cooperation.

1.3.2.3 Neofunctionalism approach

Neofunctionalism is the last of the key concepts of integration. Neofunctionalism developed due to the discrepancy of functionalist ideas and real integration processes taking place in Western Europe Ash R.F., Kueh Y.Y. Op. cit. P. 19.. As can be seen from the name of this approach, it developed on the basis of functionalism ideas. However, these two approaches have three main differences.