Factories and Money: Visit by Federal Reserve

UNCLAS SECTION 01 OF 03 GUANGZHOU 010676

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E.O. 12958: N/A
TAGS: ECON PHUM PGOV KCRM PREL CH TW KN
SUBJECT: Factories and Money: Visit by Federal Reserve
Senior Economist John Schindler

Reference: 05 GUANGZHOU 23995

THIS DOCUMENT IS SENSITIVE BUT UNCLASSIFIED. PLEASE PROTECT
ACCORDINGLY. NOT FOR RELEASE OUTSIDE U.S. GOVERNMENT
CHANNELS. NOT FOR INTERNET PUBLICATION.


1. (SBU) SUMMARY: Guangdong is not reaping long-term
benefits from the majority of its manufacturers because they
are processing and assembly plants, according to Guangzhou
academics. China should move away from this type of
manufacturing and focus instead on high value-added and high-
technology industries. This is already happening in the
Pearl River Delta, because of higher costs for land and
labor and the appreciating RMB. The academics are also
calling for the preferential tax rates for foreign investors
to be eliminated. The vice president of a state-owned
import/export company said his company is barely surviving,
and a three-percent appreciation of the RMB would drive it
into bankruptcy. Separately, a Bank of America
representative discussed the company's business strategy in
China, and a Fedex representative said some Chinese
officials are beginning to realize that customer service is
key. END SUMMARY


2. (U) During a visit to Guangzhou March 28-30, Federal
Reserve Senior Economist John Schindler met with two
economics professors, a government trade consultant, and
representatives from Bank of America and Fedex.
Interlocutors discussed manufacturing, trade, the exchange
rate, and the Chinese government's long-term approach to
dealing with these issues.

Be Gone, Assembly Processing
--------------


3. (SBU) The Guangdong manufacturing industry is overly
reliant on the processing and assembly (P&A) sector,
according to Huang Jingbo, Dean of Zhongshan University's
Economics Department. Two-thirds of Guangdong's
manufacturing industry is P&A, compared to 55 percent
nationally. In a separate meeting, Chen Lei, Deputy
Director of the Guangdong WTO Affairs Consultation Service
Center, estimated that 80 percent of Guangdong trade is in
P&A components and goods. Both observers said P&A
manufacturing is not a good investment for long-term growth
-- it has low profit margins, offers the lowest wages, and
involves very little technology transfer. Almost all P&A
manufacturing is for export, and most of the investment
comes from foreign (especially Hong Kong) companies. China
runs a deficit in ordinary trade, but a surplus in P&A
trade.


4. (SBU) The P&A sector is beginning to move out of
Guangdong because of rising wages and energy prices in the
Pearl River Delta (PRD),according to Chen. He said RMB 6
billion (USD 750 million) in FDI is relocating out of
Dongguan -- a manufacturing center between Guangzhou and
Hong Kong -- every year. These factories are going to other
provinces like Zhejiang and Jiangsu, or to other countries
like Vietnam and Laos, because of increasing costs and lower
profits. They are being replaced by higher value-added
manufacturing. Provincial and municipal authorities
encourage this trend because they would like to see a higher
level of manufacturing as well as more trade in services.
Chen said Chinese officials have noted that India is
successfully encouraging service sector companies by
reducing their taxes.

Slowing Export-Led Growth
--------------


5. (SBU) China's government would like to its slow export-
led growth in part to reduce China's reliance on imported
commodities, according to Shen Boming, economics professor
at the Guangdong University of Foreign Studies. Chen, from
the WTO Center, said Chinese leaders are serious about this
policy shift, citing several examples: GDP growth is no
longer the sole criteria in evaluating an official's
effectiveness, MOFCOM is increasingly concerned with issues
beyond FDI growth, and more competition is being encouraged
in the import industry. The government would also like to

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increase imports of high-tech products, but strict U.S.
regulations mean that "we can only buy airplanes."


6. (SBU) China's export growth will likely slow by itself
because China has already implemented many of its WTO-
related tariff reductions. Rising wages and land prices in
dense manufacturing areas will also increase overall
production costs. China's low-end manufacturers are finding
themselves in a bind, as they are reluctant to raise prices
but face bankruptcy if they do not. Shen said consolidation
in the industry is already happening -- particularly in the
textile and clothing industries -- but is not yet
widespread. The appreciating RMB has also eliminated some
domestic exporters that have thin profit margins. Despite
all of these factors, Shen said he expects China's growth
rate to be between eight and nine percent in 2006.

More Tax Equality!
--------------


7. (SBU) Huang said academics began debating in the 1990s
the utility of China's preferential tax treatment for
foreign investors. In the last few years, momentum has been
building to unify foreign and domestic tax rates. Both
Huang and Shen believe preferential tax policies for
foreigners should be scrapped. Huang said domestic
companies abuse the rules with "flow back" investments --
sending their money abroad and then back (see Reftel). When
asked, Huang noted he has not seen any studies on the effect
a unified tax rate would have on China's trade. Shen said
the government is concerned that such a change would reduce
FDI inflow, and thus slow the country's employment growth.

A Struggling State-Owned Enterprise
--------------


8. (SBU) State-owned Guangdong Machinery Import and Export
Co. (GMG) is struggling to adapt to China's increasingly
competitive business environment. A decade ago, GMG was one
of the few companies in Guangdong that had an export
license. Company employees sat in their offices and waited
for customers to come to them, said Chen Zhicheng, GMG's
vice president. The situation is very different now, with
export licenses commonplace, and GMG cut off from government
subsidies or preferential loans. Chen said if the company
does not make a profit, it would go bankrupt like any
private company. He complained that his company is now
working at a disadvantage, however, because it pays its
taxes in full, treats its workers well (and cannot easily
fire them),and is burdened with prior pension obligations.
In addition, GMG must hand over some of its profits to its
holding company under the Guangdong Department of Foreign
Trade and Economic Cooperation.


9. (SBU) GMG primarily exports and imports machinery
products for customers and does very little manufacturing,
in essence operating as a logistics company. It also
provides credit for small purchasers. GMG exported USD 240
million in goods in 2005, including shipping-container
vessels, gardening tools, machinery parts, pumps, lighting
products, and MP3 players. It imported USD $230 million in
goods, primarily telecom, medical, and power plant
equipment. Chen said GMG is making a profit, but not a
large one. He blamed rising wages, more expensive raw
materials (e.g. lead for batteries that the company
manufactures),and the rising value of the RMB as cutting
into the company's profits. When asked how far the RMB
could appreciate before the company would go bankrupt, he
said approximately three percent (an indication of the
company's profit margin).

Bank of America: Waiting for the RMB Door to Open
-------------- --------------


10. (SBU) Bank of America (BOA) conducts three types of
business in China: dealings with financial institutions,
foreign exchange settlement, and trade financing for
exporters, according to Wu Ke Wei, vice president for the
bank's South China financial institutions group. Wu said
they plan to add a corporate and investment management
department as well as a cash management department in the

GUANGZHOU 00010676 003 OF 003


near future. He differentiated BOA's business strategy from
Citibank's: BOA concentrates on enterprise business while
Citibank deals more with financial institutions. When asked
about plans to open retail outlets, Wu said BOA agreed not
to do so for three years as part of its deal to purchase a
nine-percent stake in China Construction Bank (CCB) in 2005.
When asked about BOA's relationship with CCB, Wu said BOA is
not involved in CCB's management, but does provide training
on issues such as retail business to branch-level offices.


11. (SBU) Julia Yu, branch manager for Guangzhou, said she
expects China will allow foreign banks to conduct RMB
transactions before December 2006, and BOA has already
prepared its application. Yu said Chinese regulators
recently introduced stricter requirements for foreign banks
to accept imported foreign exchange, including extensive
checks of supporting documents (this is likely due to
concerns about currency speculators). Simultaneously,
China's rules on foreign exchange leaving China have
loosened, and outward FDI has increased as a result.
Regarding the appreciation of the RMB since July 2005, Wu
said he has been surprised to see more clients request to
change foreign exchange into RMB. Some clients have
complained that they have lost money as a result of the
appreciation, and others have shown an interest in hedge
investments.

Fedex Finds Better Access
--------------


12. (SBU) Alex Yim, managing director and chief
representative for Fedex in South China, said he has seen
Chinese officials adopt a more customer friendly attitude in
recent years. Fedex established its Asia/Pacific hub in
Guangzhou in 2005, but it basically serves as a global hub
because of flight patterns. Fedex has a good working
relationship with Guangdong Customs, and Yim described the
director general as forward-thinking and pro-Western.
Guangdong Customs has asked Fedex for input as it drafts new
customs clearance procedures, which would allow clearance
for cargo at any entry point and simplify the value-based
categorization system. Yim said he was told that this draft
would serve as a blueprint for national regulations.
Separately, Yim said the Air Traffic Bureau (under CAAC)
invited him recently to serve on a consultation board
comprised largely of representatives from Chinese companies.
He was also asked by the Logistics Institute of Jiaotong
University to serve as a visiting professor, responsible for
two or three seminars a year. This would not only allow him
to train the next generation of logistics professionals, but
would also give him a different "hat" to wear in an official
capacity.

Comment: Time to Shape Up
--------------


13. (SBU) The honeymoon between South China and P&A plants
appears to be over, and the government is looking for higher
value-added operations to take their place. Dongguan is a
good example of this phenomenon, as the city -- which is an
hour's drive from the Hong Kong border -- has literally run
out of land and is reportedly no longer approving permits
for low value-added or polluting manufacturers. Many
relocate to inland areas within Guangdong or to other
provinces, where local governments are eager for investment
of any kind. With a profit margin somewhere around three
percent, profit-sharing and pension commitments could mean
the end for state-owned enterprises in situations similar to
GMG's. However, with the right vision and leadership, such
companies may be able to learn to adapt. GMG, for example,
has the potential to successfully transform itself into a
reliable logistics provider. Separately, the Air Traffic
Bureau's invitation to Fedex's Yim to serve as a consultant,
as well as Custom's cooperation in drafting new regulations,
are signs of a Chinese bureaucracy that recognizes the long-
term benefits of good customer service.


14. (U) Mr. Schindler has cleared this cable.

DONG