Made in PRD Study Hong Kong Industry: The Way Forward Summary - Research Findings

Contents Made in PRD Study Hong Kong Industry: The Way Forward Summary - Research Findings Research Methods 1 Conditions of Hong Kong Manufacturers Operating in the PRD Region Summary 1 Analysis of Questionnaire Results 1. Basic Conditions of Manufacturing Enterprises Time of Establishment 8 Size 8 Structure of Industries 9 2. Changes in Operational Conditions since 2008 Changes in Operating Costs 11 Changes in the Size of Workforce 12 Employment Conditions of Hong Kong Staffers 14 Changes in Equipment Investment 14 Changes in Markets 16 Changes in Importing and Exporting Channels 17 Source Locations of Capital 18 Conditions of Upgrading and Transformation by Enterprises 19 Conditions of Market Expansion 21 Research & Development and Design Activities of Enterprises 24 Conditions of Production Relocation 26 3. Future Directions of Hong Kong Manufacturing Enterprises Main Operational Strategies in the Next Three to Five Years 27 Investing in the PRD Region 27 Future Directions in Market Development 28 Research & Development and Design Activities 29 Future Plans for Production Relocation 29 4. Opinions on Business Environment in and Policy Expectations on the PRD Region and Hong Kong Changes in Business Environment in the PRD since 2008 31 Challenges to Operating in the PRD Region 32 Challenges to Relocating Production to Hong Kong 33 Policy Suggestions by Manufacturers on Promoting Industry Development in the PRD Region and Hong Kong 34

Made in PRD Study Hong Kong Industry: The Way Forward Summary - Research Findings A. Research Methods The research was conducted during March to December in 2014. The research team conducted questionnaire surveys, focus group sessions, in-depth interviews and literature reviews to examine the current situation, the changes in the operational environment and the future plans of Hong Kong-funded manufacturing enterprises operating in the Pearl River Delta (PRD) region since 2008. The research is composed of two parts a quantitative analysis and a qualitative analysis. The quantitative analysis was conducted mainly through questionnaire surveys. Two rounds of questionnaire surveys were carried out in Hong Kong and Dongguan to look into the changes in the operational environment and the mode of business of Hong Kong manufacturers. The qualitative analysis was done by holding focus group sessions and in-depth interviews with Hong Kong manufacturers, production service providers, research institutes, students in tertiary education and other industrial stakeholders. They were asked to give their views on the current situation, their future plans and suggestions on promoting development in the industrial sector. B. Conditions of Hong Kong Manufacturers Operating in the PRD Region Summary I. Summary Since 2008, Hong Kong manufacturers operating in the PRD region have encountered numerous challenges. Lacklustre international markets, coupled with discouraging factors in Mainland including the appreciation of Renminbi, labour shortages, rise in wage levels, labour disputes and policy adjustments to processing trade, these Hong Kong manufacturers have reduced the size of their workforce, increased their investment in automation, promoted research and development (R&D) and design activities, and expanded domestic sales market so as to stay competitive. These changes, reflected in the findings of the questionnaire surveys, have mirrored the emergence of some development trends. Basic Conditions of Manufacturing Enterprises 1. The results show that the majority of Hong Kong manufacturers in the PRD had their first investment in the Mainland between 1980 and 2000 (58.2 per cent of the respondents). Since 2001, with the basic completion of production relocation to the Mainland, Hong Kong manufacturers have slowed down their pace of investment in the PRD. After the 1

2008 international financial tsunami, the pace of Hong Kong investment and factory establishment in the PRD has further slowed down. The trend shows that the level of investment reached the peak in the 1990s but started to shrink later on, and that Hong Kong manufacturers influence in the PRD has been contracting. 2. Small-and-medium enterprises (SMEs) still form the majority of Hong Kong manufacturers in the PRD, with over a half of them making an annual turnover of HK$ 50 million or less. SMEs are mostly concentrated in Dongguan as the support for industries there is more comprehensive. Larger companies (about 20 per cent of the respondents) are more likely to break geographical restrictions and set up factories and branches in other areas in Guangdong, other Mainland provinces and overseas countries. The PRD is indeed a cradle for Hong Kong manufacturers to grow. 3. Hong Kong manufacturers in the PRD are characterized by their diversity. The three axes of manufacturing industries in the region are electronics, traditional industries (such as textiles, clothing and toys) and ancillary industries (such as metal production, plastic, moulding and paper printing). The majority of surveyed SMEs are engaged in the electronic or ancillary industries. In the PRD they together formed a relatively comprehensive, export-oriented value-added industrial chain, the pivot of which is Hong Kong manufacturers. Changes in Operational Conditions since 2008 1. Since 2008, Hong Kong enterprises in the PRD have experienced a number of changes in operating conditions. Indicators such as operating costs, employee recruitment, equipment investment, sales market, and import and export channels have mirrored such changes in the operation of enterprises. Under their own operating pressure and with the supportive measures for upgrading and transformation of the Mainland and the PRD Governments, manufacturers have significantly adjusted their business strategies. These adjustments include increasing marketing activities, investing in R&D and innovation, promoting the upgrading and transformation of enterprises, and starting to relocate production. 2. Enterprises are shouldering a heavier burden in all types of operating cost. Labour costs have risen most sharply, with 96.6 per cent of the responding enterprises saying they are paying higher labour costs and over one-third of them have experienced a 21 per cent to 40 per cent increase. A relatively steady increase is seen in land and lease costs, as a considerable number of Hong Kong enterprises owned their land and plants. Since many of the surveyed enterprises are conducting their financing in Hong Kong, borrowing costs have increased only marginally. 2

3. The size of labour force employed by these enterprises has generally fallen, with the largest decrease being seen in general workers. The findings show that nearly two-thirds of the respondents are hiring fewer general workers, with 32 per cent hiring 30 per cent less on average. Manufacturers who survived the 2008 financial tsunami have since employed 10 to 20 per cent less general workers. Considering the fact that some enterprises had winded up their businesses during the period, it is estimated that Hong Kong manufacturers now employed about 4.5 million to 5 million workers in the PRD. 4. Responding enterprises are replacing Hong Kong staffers stationed in the PRD with Mainland employees. Over 30 per cent of the respondents have replaced all Hong Kong staffers with Mainland employees, with engineering and technical positions seeing the highest replacement rate. On the other hand, around 40 per cent of the enterprises indicate that they will continue hiring Hong Kong employees to fill positions of sales, marketing and administration, and that they will not be replaced by Mainland workers at the moment. Approximately 30 per cent of the enterprises hold a wait-and-see attitude in employing Hong Kong workers, suggesting that they are uncertain about their future development. 5. Amidst labour shortage, manufacturers have significantly boosted their investment in machinery and equipment, especially with Mainland-made equipment, and are shifting to a more capital-intensive mode of operation. They are thus having closer ties with the equipment manufacturing system in the Mainland. 6. Most respondents are still targeting overseas markets and the level of domestic sales in the Mainland remains low. The ratio of inter-plant transfer (i.e. upstream companies selling intermediate products to downstream businesses) has seen an increase, illustrating the economies of agglomeration among Hong Kong manufacturers, as well as the close interactions between them and the manufacturing system in the PRD. 7. Compared with 2008, the ratio of manufacturers using Hong Kong for import and export has declined. They are shifting their importing and exporting procedures to the Mainland. Although there is no sign of a complete shift in import and export channels, Hong Kong s role as an entrepot is facing challenges. 8. Compared with 2008, the ratio of manufacturers procuring all raw materials on the Mainland has increased, reflecting a weakening in the connections between Hong Kong-funded manufacturers and Hong Kong s logistics and production services on one hand, and the city s economic and trading system on the other. 9. Most responding manufacturers still regard Hong Kong as a major source of capital to further their development on the Mainland. Company profits, bank loans and extra 3

capital from shareholders are the major ways for them to raise capital, suggesting that Hong Kong banks and financial system have played a significant role in manufacturers financing. Close to 70 per cent of the respondents say they use Hong Kong or non-mainland capital entirely for their business development, and 37.9 per cent borrow from Hong Kong s banking system. Indeed, enterprises have shown a remarkably consistent response regarding their source location of capital. The location of capital coordination is a major symbol determining whether an enterprise belongs to Hong Kong. In fact, enterprises financing and borrowing activities are still tying them closely with Hong Kong s production services system. 10. Over half of the surveyed enterprises say they have been actively engaged in upgrading and transformation since the international financial crisis happened, with innovation in management being the most popular choice for conducting such improvements. Improving human resources management to ease the pressure of labour shortage is the most prevalent strategy among respondents to innovate management. Other strategies adopted include raising the level of product design and R&D (which will result in an increase in demand for talent in such fields), as well as brand building. Some surveyed original equipment manufacturers (OEMs) say they do not have the need to establish their own brands. Although a considerable number of enterprises have been upgrading and transforming, nearly 40 per cent of the respondents have kept the same business strategies and not made significant changes. The findings also show that factors like the business and innovation atmosphere, as well as the positioning on the industrial value chain of an enterprise, significantly affect enterprises decision on upgrading and transformation. 11. In the aspect of market expansion, 60 per cent of the respondents say they are keeping the same strategy in the global market and have not made significant changes. Nonetheless, a considerable number of respondents indicate that they want to enter emerging markets such as Eastern Europe and countries in the Middle East. 12. Nearly half of the surveyed enterprises indicate that they will boost domestic sales in the Mainland, and 70 per cent of them say they are selling directly to consumers. The research also shows a rising trend of enterprises adopting online buying platforms. Most Hong Kong-funded enterprises conduct domestic sales in Guangdong Province, followed by the Eastern China region which also has a relatively higher purchasing power. On the other hand, the inland market is of less interest to Hong Kong enterprises. Despite the prospects of domestic sales, nearly 30 per cent of the responding enterprises say that they will not be engaged in the business, citing reasons such as the lack of a domestic sales team, government s red-tape, heavy taxes, difficulty in securing payment, and the restrictions on enterprises engaged in processing trade and assembly. 4

13. Nearly half of the respondents have their amount of R&D expenditure less than 3% of their turnover volume, suggesting a relatively low level of R&D investment. About 40% of the surveyed manufacturers have their R&D activities entirely or mainly in the Mainland, and about a quarter have them entirely or mainly in Hong Kong. Around 28 per cent of the manufacturers are not engaged in scientific research and design activities. The level of R&D expenditure is determined by various factors, including the scale of enterprise, local industry system, the supply of R&D and innovation talent and the relevant atmosphere. Such factors are likely to vary in different cities. 14. A significant portion of the respondents are accepting R&D funding from the Mainland Government 1. To a certain extent, this reflects the relatively high level of financial support from the Mainland Government, especially from the Guangdong Government since the introduction of the "Eleventh Five-Year Plan", to promote R&D and emerging strategic industries. 15. The relocation of production lines has happened mostly after 2008. Before 2008, enterprises often relocated their production to Guangdong Province and other places on the Mainland. Since 2010, however, their relocation destinations have shifted to Southeast Asian countries and even back to Hong Kong 2, indicating the grim business environment in the PRD from the year onwards. Manufacturers that have relocated are mostly from labour-intensive industries, such as garment, textiles and toy production. Relocations of these enterprises are mostly of a partial nature, suggesting that most Hong Kong-funded manufacturers are still using the PRD as a production base while using their factories in the region to support and coordinate factories located in other countries. Future Directions of Hong Kong Enterprises 1. Augmenting automatic production and improving product design are the most popular strategies among the surveyed enterprises for the next three to five years. Meanwhile, around 30 per cent of the respondents say they will put more efforts in brand building, scientific R&D, or will remain the status quo. 2. Respondents show a tepid response towards investing in the PRD, with over 40 per cent of them saying their investment level in the region will remain the same and one quarter saying they adopt a wait-and-see attitude. 1 The sample size of the research does not cover all Hong Kong manufacturers. The analysis is for reference only and cannot be used as a comparison between the funding schemes of the two Governments. 2 Industries which have relocated their production to Hong Kong include electronic products, chemicals and pharmaceutical products, and printing and paper products. 5

3. To further expand the markets in developed countries (such as European countries, the United States and Japan; 45.8 per cent), the Mainland (44 per cent) and emerging countries (such as countries of ASEAN and in the Middle East; 39.3 per cent) are the more popular market strategies among surveyed enterprises. On the other hand, they hold a moderate and wait-and-see attitude towards the markets in developing countries (such as countries in South America and Africa). 4. In the aspect of R&D, the respondents generally show an interest in expanding related activities. Around 40 per cent of them indicate that they will boost R&D and design activities, through raising related expenditure and hiring more staff in this field. 5. For production relocation, destinations choices like Mainland provinces outside Guangdong, other countries and Hong Kong have become popular while Guangdong Province itself is losing its appeal to manufacturing enterprises. Plans to relocate production are most seen in industries of plastic products, electronic products, and electrical and optical products, and these industries intend to move their production to areas outside Guangdong. Meanwhile, the surveyed manufacturers are inclined to move their R&D activities back to Hong Kong. Opinions on Business Environment in and Policy Expectations on the PRD region and Hong Kong 1. Since 2008, many aspects of the PRD s business environment have improved. Import and export clearance, as well as electricity and power supply, has seen the most significant improvements. Conditions relating to financing costs and channels, and taxation have remained stable and even seen positive progress. In contrast, there has been a worsening in factors relating to human resources such as labour supply, labour relations, labour laws and levies. Over 70 per cent of the surveyed enterprises have noted a worsening labour shortage in the PRD in recent years, while some respondents say the Labour Contract Law in China has raised the frequency of labour disputes. 2. Issues relating to the supply of manpower and talent are the biggest challenges facing the surveyed enterprises operating in the PRD. Over 90 per cent of the respondents say they have experienced a rise in labour costs, and 70 per cent a general shortage of manpower. As for challenges originated from the Government, tax charges are the most difficult for Hong Kong manufacturers. Logistics costs and energy costs are also the problems that these enterprises have to deal with. Some respondents say a gap in succession/inheritance has impacted on the sustainable development of enterprises. 6

3. Manpower shortage and high labour costs are the biggest challenges to manufacturers production relocation to Hong Kong: Nearly 90% of the surveyed enterprises say the labour costs in Hong Kong are high, and roughly 70% think there is a shortage of local manpower. Land supply is the second greatest challenge to production relocation to Hong Kong for these enterprises. Nearly half of the respondents say they have observed an insufficient land supply and high land costs in Hong Kong. Regulations and rules, as well as the lack of industrial policies, are the challenges posed by the Government. Surveyed enterprises say they have seen a lack of local industrial development and supportive policies, as well as increasingly complicated regulations. Energy issues, a lack of industrial facilities and volatile business environment are the restraints and potential challenges facing enterprises opting to relocate production to Hong Kong. 4. Concerning how the Hong Kong Government should promote industrial development, manufacturers have given a fairly even response. Strengthening industrial talent training, tax concessions for R&D activities, assisting enterprises in the development of domestic sales on the Mainland, supporting the financing of SMEs and improving the support for industries are the top five policies and measures that manufacturers deem important. 5. Concerning how the Mainland Government should improve the business environment, more than three-quarters of the responding manufacturers suggest it reduce tax charges and local administrative fees and ensure sufficient labour supply. Policy issues related to government efficiency and regulations, such as improving government s efficiency and transparency, simplifying customs clearance procedures, and relaxing and simplifying foreign exchange management, are also of Hong Kong manufacturers concern. 7

II. Analysis of Questionnaire Results 1. Basic Conditions of Manufacturing Enterprises A total of 641 Hong Kong manufacturers responded to the questionnaire surveys. The characteristics of the surveyed manufacturers are remarkably consistent with the development interactions between Guangdong and Hong Kong industries. i. Time of Establishment a. The majority of Hong Kong manufacturers invested and set up their factories in the Mainland between 1991 and 2000 (48.6 per cent of the respondents). After 2001, with the general completion of production relocation to the Mainland, Hong Kong manufacturers had slowed down their pace of investment in the PRD. After the 2008 international financial crisis, the pace of Hong Kong investment and factory establishment in the PRD has further slowed down, reaching a record-low level since the 1980s. Time of Establishment b. According to published industry-related statistics collected by the research team, it is estimated that the number of surviving Hong Kong-funded manufacturers in the PRD has fallen substantially from its peak to 32,000 in 2013. Since 2001, Hong Kong manufacturers have slightly slowed down their investment in Guangdong Province. Since the global economic downturn in 2008, Hong Kong manufacturers influence in the PRD has been contracting. ii. Size a. Hong Kong manufacturers in the PRD are mainly SMEs, with those with an annual turnover of less than HK$ 50 million accounting more than a half of the total number. This is especially true in Dongguan, where 31.4 per cent of its manufacturing enterprises are of small and micro size with an annual turnover below HK$ 10 million. The figures show that although small and micro enterprises rely heavily on local industry support system, they are indeed an integral part of local industrial agglomeration. 8

b. A considerable number (about 20 per cent) of the surveyed Hong Kong manufacturers with an annual turnover of over HK$100 million have invested, established factories and set up sales departments in provinces outside Guangdong and in Southeast Asia. This shows that only when a manufacturer has reached a certain scale that it can have enough resources to explore markets outside the PRD and promote production expansion or relocation. Very often SMEs are mainly the ones which opt to stay local or to relocate production following the footsteps of the leading enterprises. Annual Turnover HK$ >1 billion 5.7% HK$ 100 million 1 billion 24.7% HK$ <5 million 12.8% HK$ 5 million 10 million 14.1% HK$ 50 million 100 million 14.4% HK$ 10 million 50 million 28.4% iii. Structure of Industries a. The structure of manufacturing industries is highly diversified, with electronic products enterprises comprising the majority of the respondents. Traditional industries such as textiles, clothing and toys, and ancillary industries such as metal production, plastic, moulding and paper printing, account for more than two-thirds of the total number of respondents. This shows that the business activities of Hong Kong manufacturers in the PRD essentially expand from electronic and traditional industries. These activities and industries together form in the PRD a relatively comprehensive, export-oriented industry value chain of which Hong Kong manufacturers are the pivot. Electronic Products Metal Production and Machinery Plastic Products Textile Printing and Paper Products Garments Toys Leather/rubber Furniture Electrical and Optical Products Chemical and Pharmaceutical Products Mould and Die Manufacturing Handbags and Cases Watches and Clocks Shoes Lighting Food and Beverages Jewellery Others 9

b. Looking into the relationship between the size of enterprises and the structure of industries, enterprises producing electronic products and those making electrical and optical products are the main force among enterprises with an annual turnover of HK$100 million. Ancillary industries, such as metal products and machinery, plastics and mould manufacturing, are mainly composed of small and micro enterprises (i.e. those with an annual turnover under HK$10 million). For traditional industries producing end products such as garments, toys and furniture, their levels of turnover spread more evenly. There are corporations but also SMEs engaging in the business. This shows the importance of diversity in both products and end markets to traditional industries and that manufacturers can choose their production scale according to their ability. The entry barriers to such industries are relatively low, which in turn bring convenience to start-ups in joining the business and to small and micro enterprises in expanding their production vertically. Distribution of Manufacturing Enterprises by Turnover Volume Ratio of Industries HK$ <5 million HK$ 5 million - 10 million HK$ 10 million - 50 million HK$ 50 million - 100 million HK$ 100 million - 1 billion HK$ >1 billion Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Electronic 17.5% 6.3% 12.5% 17.0% 16.0% 24.1% 36.4% Products Metal Production & Machinery 14.9% 18.8% 15.0% 20.1% 11.1% 11.7% 3.0% Plastic Products 12.5% 17.5% 16.3% 11.9% 13.6% 7.3% 12.1% Textiles 9.3% 7.5% 10.0% 12.6% 9.9% 7.3% 3.0% Garments 7.7% 5.0% 8.8% 6.9% 8.6% 9.5% 6.1% Printing & 7.4% 6.3% 8.8% 6.3% 9.9% 5.8% 12.1% Paper Products Electrical & 4.4% 1.3% 2.5% 2.5% 4.9% 8.8% 6.1% Optical Products Leather/rubber 4.0% 3.8% 5.0% 4.4% 2.5% 3.6% 6.1% Toys 4.0% 2.5% 6.3% 2.5% 3.7% 5.8% 3.0% Furniture 3.0% 6.3% 1.3% 1.9% 2.5% 4.4% 0.0% Chemical & 2.8% 1.3% 1.3% 3.8% 3.7% 2.2% 3.0% Pharmaceutical Products Mould & Die 2.3% 6.3% 1.3% 1.9% 1.2% 1.5% 3.0% Manufacturing Handbags & 2.1% 5.0% 7.5% 0.6% 1.2% 0.0% 0.0% Cases Watches & 1.6% 2.5% 0.0% 1.9% 1.2% 2.2% 0.0% Clocks Food & 1.2% 3.8% 0.0% 0.6% 1.2% 0.0% 6.1% Beverages Shoes 1.1% 0.0% 0.0% 1.3% 1.2% 2.9% 0.0% Lighting 0.7% 0.0% 0.0% 1.3% 2.5% 0.0% 0.0% Others 3.5% 6.3% 3.8% 2.5% 4.9% 2.9% 0.0% 10

2. Changes in Operational Conditions since 2008 i. Changes in Operating Costs a. An increase in all types of operating cost: Since 2008, factors such as the appreciation of Renminbi, the ongoing increase in minimum wage on the Mainland and labour shortage have lifted the operating costs of Hong Kong enterprises in the PRD. Less than five per cent of the surveyed Hong Kong manufacturers have experienced a decline in total operating costs however, such a drop is usually a result of the reduction of business scale. b. Soaring labour costs: 96.6 per cent of the responding enterprises are paying higher labour costs and over one-third of them have experienced a 21 per cent to 40 per cent increase. Only 1.8 per cent of the respondents say they have experienced a fall in labour costs, due mainly to a substantial layoff of employees. c. A steady rise in land and lease costs: About 42 per cent of the enterprises say land and lease costs remain at the same level as they had bought their land and built their plants in the PRD in early years. As long as they keep their production scale unchanged, they are less affected by the rising land and lease costs. d. A marginal increase in borrowing costs: Nearly 60 per cent of manufacturers note unchanged or falling borrowing costs, with most of those indicating an increase of less than 20 per cent. This is because the majority of Hong Kong manufacturers obtain their working capital from their profits and Hong Kong's financial system, and these manufacturers export-oriented mode of business has also reduced their reliance on Mainland financial resources. Increased Unchanged Decreased Total Operating Costs Labour Costs Raw Materials & Components Land and Lease Costs Borrowing Costs Tax Charges 11

Change in Costs Total Operating Costs Labour Costs Raw Materials & Components Land and Lease Costs Borrowing Costs Tax Charges Increased: by >100% Increased: by 81% - 100% Increased: by 61% - 80% Increased: by 41% - 60% Increased: by 21% - 40% Increased: by 0% - 20% Unchanged Decreased: by 0% - - 20% Decreased: by - 21% - - 40% Decreased: by - 41% - - 60% Decreased: by - 61% - - 80% ii. Changes in the Size of Workforce a. A general fall in the size of workforce: Information obtained from the in-depth interviews shows that Hong Kong manufacturers in the PRD, under the pressures of labour shortage and the ongoing increase in minimum wage, have generally reduced their size of workforce, hiring one-third less. b. Largest decrease seen in general workers: The findings show that nearly two-thirds of the responding enterprises have reduced the number of general workers. 17.3 per cent, 15.9 per cent and 16.3 per cent of the respondents say they hire 1 per cent to 20 per cent less, 21 per cent to 40 per cent less and 41 per cent to 60 per cent less general workers respectively these enterprises cover nearly half of the respondents. c. A smaller drop for technicians and management personnel: Less than half of the enterprises have employed fewer technicians and management personnel. Twenty per cent to 30 per cent of the enterprises have maintained the same employment size of these personnel, and enterprises are instead more affected by the shortage of general workers. Skilful and knowledgeable workers are still valued by manufacturers. Manufacturers do all they can to maintain their existing scale of related workforce, in an attempt to maintain their daily operations and to promote the upgrading and transformation of enterprises. 12

Changes in the Size of Workforce Increased Unchanged Decreased General Technicians Management & Workers Other Personnel Changes in Workforce Increased: by >201% Increased: by 101% - 200% Increased: by 81% - 100% Increased: by 61% - 80% Increased: by 41% - 60% Increased: by 21% - 40% Increased: by 1% - 20% Unchanged Decreased: by 1% - 20% Decreased: by 21% - 40% Decreased: by 41% - 60% Decreased: by 61% - 80% Decreased: by 81% - 100% General Technicians Management & Workers Other Personnel 13

iii. Employment Conditions of Hong Kong Staffers a. Enterprises are replacing Hong Kong staff stationed in the PRD with Mainland employees, with over 30 per cent of the surveyed enterprises having replaced all Hong Kong staffers with Mainland employees. Engineering and technical positions (such as production and quality control) have seen the highest replacement rate partly because of the lack of young Hong Kong engineering talent. b. Nearly 40 per cent of the enterprises say that they will continues to fill positions of sales, marketing and administration with Hong Kong employees, and that these positions will not be replaced by Mainland staffers. Such preference is due to the export-oriented nature of Hong Kong manufacturers, which requires them to employ Hong Kong employees rich experience in international marketing. Since the headquarters of enterprises are mainly located in Hong Kong, these enterprises have retained administrative positions for Hong Kong employees. c. About 30 per cent of the enterprises hold a wait-and-see attitude towards hiring Hong Kong employees: Such attitude is particularly noticeable in Dongguan, reflecting the uncertainties on future development felt by the enterprises operating in the city. This result is down to the fact that the majority of Dongguan enterprises are of small and medium size the smaller the scale, the more willing they are to replace Hong Kong employees. Replacement of Hong Kong Employees R&D Sales & Marketing Finance, Accounting &Legal Engineering & Technology Administration Unknown Will not be completely replaced Will be completely replaced after 5 years Will be completely replaced within 5 years Already replaced completely iv. Changes in Equipment Investment a. Manufacturers have invested significantly more resources in equipment, and are gradually moving from a labour-intensive mode of production to a capital-intensive one: Labour shortage in the PRD has driven manufacturers to speed up their progress towards automatic production, which in turn leads to an increase in equipment investment. Post-financial tsunami statistics from the Mainland show that Hong Kong, Taiwan and foreign enterprises have, despite the economic 14

downturn, increased their investment in the PRD the increase which is brought by investment on equipment enhancement aiming to ease the pressure of labour shortage. Manufacturers are also upgrading their production process and shifting from a labour-intensive mode of production to a capital-intensive one. b. Manufacturers are procuring more Mainland-made equipment: Nearly three quarters of the respondents procure equipment that is made on the Mainland, with only 42.2 per cent say they buy from overseas a trend that shows that Mainland-made equipment is narrowing its gap with its overseas counterpart in terms of technology, and that its relatively low prices have drawn the attention of Hong Kong-funded enterprises. In the process of equipment procurement, Hong Kong manufacturers have strengthened their ties with the Mainland s equipment production system. Changes in Equipment Investment Decreased Unchanged Increased Investment in overseas equipment Investment in Mainland equipment Changes in Equipment Increased: by >201% Increased: by 151% - 200% Increased: by 101% - 150% Increased: by 81% - 100% Increased: by 61% - 80% Increased: by 41% - 60% Increased: by 21% - 40% Increased: by 1% - 20% Unchanged Decreased: by 1% - 20% Decreased: by 21% - 40% Decreased: by 41% - 60% Decreased: by 61% - 80% Decreased: by 81% - 100% Investment in overseas equipment Investment in Mainland equipment 15

v. Changes in Markets a. Most respondents are still targeting overseas markets and the level of domestic sales in the Mainland remains low: The research studied the ratio of export, inter-plant transfer and Mainland s domestic sales the three major sales channels - to the total turnover of the enterprises. Of the respondents, 33.2 per cent and 35.4 per cent say, respectively, the entirety and over half of their turnover is exports. Only 5.4 per cent and 11.4 per cent of the surveyed enterprises say, respectively, the entirety and over half of their products are sold in the Mainland s domestic market. The domestic market is the least popular option among the three major sales channels. All Responses 50% - 99.9% of turnover All turnover Export Interplant Mainland s Transfer Domestic Market b. The ratio of inter-plant transfer of Dongguan manufacturers is significantly higher, indicating the economies of agglomeration among Hong Kong manufacturers in the city, as well as the close interactions between them and the manufacturing system in the PRD: Dongguan is a agglomeration place for Hong Kong manufacturers, with 36.8 per cent and 10.2 per cent of the respondents in Dongguan sell, respectively, all of and over half of their products by inter-plant transfer. This shows a high degree of interaction between manufacturers in Dongguan and the upstream and downstream industries in the local manufacturing system. c. The proportion of exports of manufacturers is slightly higher than the combined total of the proportions of inter-plant transfer and of domestic sales, suggesting that the amount of actual domestic sales could have been underestimated: Inter-plant transfer is essentially a special type of domestic sales, and the level of domestic sales activities of Hong Kong enterprises could have been underestimated by the management mechanism of the Customs. Since final products are actual exports, they have to meet international technical standards, suggesting that Hong Kong manufacturers are having their product specifications in line with the international requirements. However, the sales of such goods mostly happen in the Greater PRD region. 16

vi. Changes in Importing and Exporting Channels a. The ratio of enterprises using Hong Kong port for importing and exporting has declined: Since Hong Kong manufacturers are engaged in export processing, they can often take advantage of the city s free port, importing raw materials and components and exporting manufactured goods via it. In 2014, manufacturers which had their import and export of materials and products completely via Hong Kong account for 39.4 per cent and 31.7 per cent of the total number of the surveyed manufacturers, down from 47.3 per cent and 36.9 per cent in 2008 respectively. Enterprises which do so via the Mainland have remained at 5% (for import) and 11% (for import) of the total number of the surveyed manufacturers. There has not been a complete shift in import and export channels, indicating Hong Kong manufacturers preference for and dependence on Hong Kong channels. However, Hong Kong s role as an entrepot is facing challenges as enterprises are indeed moving their importing and exporting activities to the Mainland. b. The ratio of enterprises procuring all raw materials from the Mainland has increased: The ratio has risen to 12 per cent in 2014 from 9.9 per cent in 2008. The trend is, on one hand, due to the improved support from the PRD s manufacturing system, so that manufacturers can satisfy the needs of international customers without importing raw materials and components from overseas. On the other, manufacturers have expedited their pace of conducting domestic sales, so that they can procure and produce in the Mainland, no longer need to re-export via Hong Kong. Such trends show that Hong Kong-funded enterprises are possibly leaving Hong Kong s logistics and production service system and fading out their connections with the city s economic and trading system. Changes in the Export Channels of Manufactured Products since 2008 In 2008 All via Hong Kong Partly via Hong Kong In 2014 All via the Mainland Not exporting products Not specified Total All via Hong Kong 35.8% 5.5% 0.3% 0.3% 5.4% 47.3% Partly via Hong Kong 29.4% 0.2% 0.3% 1.2% 31.1% All via the Mainland 0.5% 9.5% 0.3% 10.4% Not exporting products 0.2% 4.3% 0.2% 4.7% Not specified 3.5% 2.1% 1.0% 6.6% Total 39.4% 37.5% 11.1% 5.4% 6.7% 100.0% 17

Changes in the Import Channels of Raw Materials since 2008 In 2008 All via Hong Kong Partly via Hong Kong In 2014 All via the Mainland All procured in the Mainland Not specified Total All via Hong Kong 27.4% 3.8% 0.2% 2.0% 3.6% 36.9% Partly via Hong Kong 38.4% 0.9% 2.3% 41.6% All via the Mainland 4.5% 0.2% 0.5% 5.2% All procured in the Mainland 0.2% 0.0% 8.6% 1.1% 9.9% Not specified 5.9% 14.5% 1.6% 3.0% 1.4% 26.5% Total 100.0 31.7% 42.7% 5.6% 12.0% 8.1% % vii. Source Locations of Capital a. Most responding manufacturers rely on Hong Kong and non-mainland capital to further their development in the Mainland: Close to 70 per cent of the respondents say they use Hong Kong or non-mainland capital entirely for their business development, and 10.6 per cent say they are financed by over half of such capital. Only 12.6 per cent of the surveyed enterprises use Mainland capital entirely for their business development. The responses from manufacturers show that most of them regard Hong Kong as a major source of capital. Currently, some Mainland enterprises, through round-trip investments, make use of Hong Kong finance channels to invest back in the PRD. Indeed, manufacturers have shown a remarkably consistent response regarding their source location of capital. The location of capital coordination is a major symbol determining whether an enterprise belongs to Hong Kong, and also acts as an important channel linking enterprises to Hong Kong s production service system. From both the Mainland and Hong Kong/ non- Mainland places 18% Source Locations of Capital All from the Mainland 13% All from Hong Kong or non- Mainland places 69% 18

b. Profits, bank loans, and capital from shareholders are important ways for enterprises to raise funds. Meanwhile, banks and the financial system in Hong Kong have played a major role in enterprises capital raising: The structure of the capital from Hong Kong is more diversified, including profits, bank loans, capital from shareholders, investment from affiliating enterprises and initial public offering (IPO). In contrast, most of the capital from the Mainland is profits, suggesting that when enterprises expand their business in the Mainland, they have to rely on their profits there. When enterprises expand their investment, they are more dependent on the support from Hong Kong capital, including shareholders capital, loans from Hong Kong s banking system (37.9 per cent of the respondents say they are borrowing from Hong Kong banks, while only 15 per cent from Mainland banks). Such dependence shows that these enterprises capital coordination, financing and borrowing activities are still closely tied to Hong Kong s economic system. Structure of Capital Sources All Partly All Partly From the Mainland From Hong Kong and non- Mainland places Profits Loans from Banks or Credit Cooperatives Shareholders Capital Initial Public Offering (IPO) Investment from Affiliating Enterprises Private Loans viii. Conditions of Upgrading and Transformation by Enterprises a. 45 per cent of the surveyed enterprises choose management innovation as the way to upgrading and transformation: Labour shortage in the PRD has prompted enterprises to make improving human resources management as the most important way to innovate management. b. About 30 per cent of the enterprises say they will augment product design and R&D activities: The majority of the enterprises adopt their own design and own form of R&D to strengthen their capabilities in related fields. Derived from this trend is the huge demand from enterprises for design and R&D talent followed by a resultant talent shortage pressure in related fields. 19

c. About 20 per cent of the enterprises choose to establish their own brands as the way to upgrading and transformation: Some enterprises indicate that they are original equipment manufacturers (OEMs) and thus there is no need to establish their own brands. Their positions in the value chain determine whether they have to do so. Those producing intermediate goods and components are more inclined to strengthen their design and R&D, and seldom or do not build their own brands. Keeping the same strategy Management innovation Improving human resources management Automatic production Information management Brand building Increasing investment in brands Building new brands Brand agency Brand mergers and acquisitions Augmenting product design Self- design Commissioning industrial design organizations Augmenting scientific R&D Self- R&D Cooperating with Hong Kong R&D organizations Cooperating with Mainland R&D organizations Cooperating with international R&D organization s Outsourcing R&D Enterprises Operating Strategies since 2008 d. Nearly 40 percent of the enterprises opt to maintain the same business strategy and have not made significant changes: The ratio is particularly prominent in the survey conducted in Dongguan, while Hong Kong manufacturers operating in Guangzhou, Shenzhen and other places have a greater motivation in upgrading and transformation. Enterprises founded after 2009 are still at their early stages and thus most are keeping the existing strategy. However, the year of establishment does not greatly affect enterprises decision on upgrading and transformation. Those founded in the 1980s and 1990s do not lack the incentive to upgrade and transform themselves. Indeed, it is more often up to the decisions of entrepreneurs whether the enterprises are to maintain the existing mode of operation or not. 20

Keeping the Same Operational Strategy Total 1980-1990 1991-2000 2001-2008 After 2009 All Research in Research in Dongguan Hong Kong e. Local business environment for innovation and the positioning in the industry value chain have significant influence on enterprises decision on upgrading and transformation. The findings show that the majority of the respondents in Dongguan adopt a consistent operational strategy and that they are not very willing to invest in product design and scientific R&D. Only 14 per cent of the surveyed enterprises say they have adopted a brand-building strategy, as a considerable number of manufacturers in Dongguan are engaged in the production of intermediate goods and components. The results indirectly illustrate how the business environment for innovation in the PRD, industrial system, as well as the enterprises positioning in the industry value chain, can significantly promote or restrain the adoption of innovative business strategies. ix. Conditions of Market Expansion a. International Markets Market Strategy: The majority of the surveyed enterprises maintain the existing strategy that has been adopted ever since (59.4 per cent). Some (39 per cent) are expanding in the international markets, while a few say they are cutting down activities in the international markets. Conditions of International Market Expansion Responding Enterprises Ratio All Dongguan Hong Kong All Dongguan Hong Kong Effective responses 431 323 108 100.0% 100.0% 100.0% Same market strategy 256 213 43 59.4% 65.9% 39.8% Expansion 168 110 58 39.0% 34.1% 53.7% Reduction 7 0 7 1.6% 0.0% 6.5% 21

Market Orientation: The affluent markets in Europe, the United States and Japan are the main targets of manufacturers. A significant portion of the surveyed manufacturers also aim at developing markets in Eastern Europe and the Middle East. Results of the survey conducted in Dongguan show that some manufacturers hold a wait-and-see attitude when developing international markets this might be down to their inter-plant transfer mode of operation, which does not require them to go overseas directly. Current Major Markets (Multiple) All Research in Dongguan Research in Hong Kong Europe & the US Japan and South Korea Australia and New Zealand South Asia The Middle East Eastern Europe ASEAN Africa Russia South America New Markets Currently Being Developed (Multiple) All Research in Dongguan Research in Hong Kong Europe & the US Eastern Europe Japan and South Korea ASEAN South America South Asia The Middle East Russia Africa Australia and New Zealand b. Domestic Market in the Mainland Market Strategy: Nearly half of the surveyed enterprises indicate that they will strengthen domestic sales in the Mainland. Meanwhile, despite the prospects of domestic sales, 29.6 per cent of the responding enterprises say that they will not be explore the Mainland domestic market, citing reasons such as the lack of a domestic sales team, limited knowledge of domestic sales, difficulty in securing payment, widespread copyright infringement activities, complicacy in customs management, heavy taxes, and engagement in processing semi-finished products. 22

Restraining Factors on Domestic Sales: Restrictions arisen from the nature of enterprises or products have deterred some surveyed enterprises from conducting domestic sales. A considerable number of manufacturers in Dongguan say they will not consider domestic sales as they are engaged in processing trade and assembly and do not have final products to sell. This leads to Dongguan manufacturers weaker inclination for domestic sales. In contrast, there is a stronger inclination for domestic sales from foreign-invested enterprises, those producing end products, and manufacturers based in Guangzhou and Shenzhen. Inclination for Domestic Sales All Research in Dongguan Research in Hong Kong Maintaining Enhancing Developing in the near Future Reducing Not Considering Domestic Sales Channels: Seventy per cent of the surveyed enterprises say they are selling directly to consumers when conducting domestic sales. Two main direct sales channels include selling end products directly to final consumers, and selling semi-finished products to downstream manufacturers in the form of inter-plant transfer. Much of the direct sales of manufacturers in Dongguan are of domestic sales in such form. Domestic sales via online buying platforms is gaining its pace to be a major domestic sales channel as important to manufacturers as agents and wholesaling. Domestic Sales Channels All Research in Dongguan Research in Hong Kong Directly to Consumers Agents Wholesaling Others Online Buying Platforms Franchising 23

Regions of Domestic Sales: Most surveyed enterprises (90.4 per cent) conduct domestic sales mainly in Guangdong Province, followed by the Eastern China region (55 per cent) which also has high purchasing power. On the other hand, the inland market is less covered. There are two major reasons which drive enterprises to engage actively in the Guangdong market: first, their familiarity with the market, which enables them to better manage their marketing activities; second, the sales and interactions between component manufacturers and downstream processing enterprises. x. Research & Development (R&D) and Design Activities of Enterprises a. Nearly half of the respondents have their amount of R&D expenditure less than 3% of their turnover volume, suggesting a relatively low level of R&D investment. RaQo of R&D Investment to Total Turnover Volume >10% of Turnover, 9% 7% - 10% of Turnover, 9% 5% - 7% of Turnover, 11% 3% - 5% of Turnover, 23% <1% of Turnover, 19% 1% - 3% of Turnover, 29% b. About 40% of the surveyed manufacturers have their R&D activities entirely or mainly conducted in the Mainland, and about a quarter have them entirely or mainly conducted in Hong Kong. During the focus group sessions, some Hong Kong manufacturers indicate that they have always conducted R&D activities in Hong Kong. This shows that although their manufacturing activities have all been moved to the PRD, manufacturers are still basing their R&D activities in Hong Kong. However, around 28 per cent of surveyed manufacturers, many of them found in the Dongguan survey, have not engaged in R&D and design activities. 24

Research & Development and Design AcQviQes No aciviies, 28% Mainly in other countries or regions, 1% All in other countries or regions, 3% Mainly in the Mainland, 15% All in Hong Kong, 12% Mainly in Hong Kong, 14% All in the Mainland, 27% c. When looking into the relationship between the level of R&D spending and manufacturers year of establishment, location and relevance with their respective industries, it is found that such spending level to a certain extend is related with factors such as the location of manufacturers. Dongguan manufacturers are found to spend less on R&D than their Hong Kong counterparts, and such difference is correlated by various factors such as the scale of enterprise, local industry system, the supply of R&D and innovation talent and the relevant atmosphere. Ratio of R&D Investment to Total Turnover Volume (All) <1% After 2009 Ratio of R&D Investment to Total Turnover Volume (Hong Kong) Ratio of R&D Investment to Total Turnover Volume (Dongguan) <1% <1% After 2009 After 2009 25

d. The majority of the respondents accept funding from the Mainland Government on R&D and innovation 3 : There are 43 enterprises saying that they received funding from the Mainland (39 enterprises) or Hong Kong government (five enterprises) on R&D and scientific researches, of which one company in the electrical and optical products industry received funding from both Governments. It is found that, compared with its Hong Kong counterparts, the Mainland Government has funded more research projects, also with larger sum of money. Funding in the Mainland is concentrated in industries of electronic products, electrical and optical products, chemicals and pharmaceuticals, and metal products and machinery. The amount of funding ranges from tens of thousands of RMB to 100 million RMB or more (the median amount of funding is 800,000 RMB). To a certain extent, this reflects the relatively high level of financial support from the Mainland Government, especially from the Guangdong Government since the introduction of the "Eleventh Five-Year Plan", to promote R&D and emerging strategic industries. xi. Conditions of Production Relocation a. Relocations of production lines have been taken place mostly after 2008. Before 2008, enterprises often relocated their production to Guangdong Province and other places on the Mainland. Since 2010, however, their relocation destinations have shifted to Southeast Asian countries and even return to Hong Kong, suggesting a tougher business environment in the PRD. b. Enterprises that have conducted relocation are mostly from labour-intensive industries, such as garments, textiles and toy production. In recent years, many of them have shifted their production to Southeast Asian countries. This is directly related to the shortage of general workers in the PRD and labour shortage has become the key restraining factor to manufacturing on the Mainland. c. The vast majority of these enterprises have had their relocation a partial one. Only one of the 37 manufacturers who engaged in production relocation has completely moved to Hong Kong, others having moved partially. This suggests that most Hong Kong manufacturers are still basing their production in the PRD. Taking advantage of the interactions between the factories in the PRD and the headquarters in Hong Kong, as well as the superiority of the support from the PRD industrial system over that from other Southeast Asian countries, manufacturers have used their factories in the region to support and coordinate factories located in other countries. 3 The sample size of the research does not cover all Hong Kong manufacturers. The analysis is for reference only and cannot be used as a comparison between the funding schemes of the two Governments. 26

3. Future Directions of Hong Kong Enterprises i. Main Operational Strategies in the Next Three to Five Years a. Augmenting automatic production and improving product design are the most popular strategies among the surveyed manufacturers (around 41.2 per cent) for the next three to five years. b. Around 30 per cent of the manufacturers say they will enhance brand building, and the same percentage goes with remaining the status quo. Around 27.5 per cent say they will enhance R&D in technology. c. A significant portion of the surveyed manufacturers in Dongguan opt to maintain the status quo, sell their companies, or wind up their businesses. In contrast, manufacturers in the PRD outside Dongguan are more inclined to enhance brand building, product design and R&D in technology, increase investment, plan for production relocation, reduce the production scale and/or shift to the service industry. This indicates a certain degree of difference on the future strategies among Hong Kong manufacturers in different cities in the PRD. Main OperaQonal Strategies in the Next Three to Five Years Moving back to Hong Kong Winding up the business Selling the business Reducing producion scale and shijing to service industry Producion relocaion Increasing investment, such as by mergers Augmening R&D in technology Enhancing brand building Remaining the status quo Augmening automaic producion Improving product design 1.3% 1.3% 3.1% 3.7% 5.2% 5.3% 27.5% 30.6% 30.6% 41.2% 41.2% ii. Investing in the PRD Region a. The respondents show a tepid response towards investing in the PRD, with over 40 per cent of them saying their investment level in the region will remain the same and one quarter saying they will adopt a wait-and-see attitude. One-fifth of the respondents say they will increase their investment, while less than 10 per cent will have a cut. 27

b. Most enterprises established between 1980 and 2000 opt to maintain or reduce their scale of investment, while those after 2001 say they have not decided their future investment directions. Nearly half of the Dongguan manufacturers say they will maintain the current level of investment, with a quarter saying they remain undecided. This shows that for manufacturers who had started investing in the PRD in early years, their enterprises and the industries they are engaged in have entered a mature stage, meaning that their room for further development is limited and that they are prompted to maintain or reduce their scale of investment. Meanwhile, enterprises founded after 2001 are still at their growing stage and they remain undecided on their way forward in face of the challenging business environment in the PRD. Undecided Reduce Remain unchanged Increase After 2009 iii. Future Directions in Markets a. To further expand the markets in developed countries (such as European countries, the United States and Japan; 45.8 per cent), the Mainland (44 per cent) and emerging countries (such as countries of ASEAN and in the Middle East; 39.3 per cent) is the most popular market strategy among surveyed enterprises. On the other hand, they hold a moderate and wait-and-see attitude towards the markets in developing countries (such as countries in South America and Africa). b. Most Dongguan manufacturers remain undecided and hold a wait-and-see attitude, while the majority of manufacturers in other cities in the PRD say they will expand their markets. 28

Undecided Reduce Remain unchanged Increase Developed Emerging Developing Domestic Countries Countries Countries Market iv. Research & Development and Design Activities a. Around 40 per cent of the responding manufacturers indicate that they will boost R&D and design activities, through raising related expenditure and hiring more experts in the field. Thirty per cent remain undecided on their R&D strategies. Only a handful of enterprises say they will cut related expenditure. b. In the aspect of R&D, the respondents generally show an interest in expanding related activities. A significant portion of Dongguan manufacturers remains undecided, pushing up the ratio of enterprises which are not certain on the issue. Undecided Reduce Remain unchanged Increase R&D and design employees R&D and design spending v. Future Plans for Production Relocation a. Mainland provinces outside Guangdong, other countries and Hong Kong have become popular destinations for production relocations: Among the 38 manufacturers who are planning to relocate, 14 say they will relocate to provinces outside Guangdong and 11 will relocate to other countries in Southeast and South Asia. Only six will relocate to other regions in Guangdong outside the PRD, suggesting that the province itself is losing its appeal to manufacturing enterprises. 29