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### Viewing cable 06GUANGZHOU10676, Factories and Money: Visit by Federal Reserve

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
06GUANGZHOU10676 | 2006-04-07 08:04 | 2011-08-23 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Consulate Guangzhou

`

    VZCZCXRO5401
    RR RUEHCN RUEHGH
    DE RUEHGZ #0676/01 0970804
    ZNR UUUUU ZZH
    R 070804Z APR 06
    FM AMCONSUL GUANGZHOU
    TO RUEHC/SECSTATE WASHDC 4071
    INFO RUEHOO/CHINA POSTS COLLECTIVE
    RUCPDOC/USDOC WASHDC
    RUEAIIA/CIA WASHDC
    RUEKJCS/DIA WASHDC
    RHHMUNA/HQ USPACOM HONOLULU HI

` `

    UNCLAS SECTION 01 OF 03 GUANGZHOU 010676

    SIPDIS

    SENSITIVE
    SIPDIS

    STATE FOR EAP/CM
    USDOC FOR 4420/ITA/MAC/MCQUEEN, CELICO, DAS LEVINE
    STATE PASS USTR
    STATE PASS FEDERAL RESERVE BOARD FOR SCHINDLER
    USPACOM FOR FPA

    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

    GUANGZHOU 00010676  002 OF 003

    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

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