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When people applaud the benefits of the coming Closer Economic Partnership Arrangement (CEPA) between the Chinese mainland and the Hong Kong and Macao special administrative regions, they should be aware of some of the challenges of free trade, experts said.

"CEPA may help some domestic and foreign producers avoid taxes by moving some of their production to Hong Kong and Macao,?said Wang Yuquan, general manager of Frost & Sullivan Consulting's China branch.

Other results of CEPA may be heavy speculation by Hong Kong and Macao investors on the mainland and increased competition of the Hong Kong service industry with their fledgling mainland counterparts.

The cautionary note came after CEPA took effect this year on January 1.

The mainland signed the CEPA deal with Hong Kong last June 29, and with Macao on October 17.

Under CEPA, Hong Kong and Macao do not levy tariffs on goods originating on the mainland. Starting on January 1, there are 374 items from Hong Kong and 311 from Macao that are tariff-free entering the mainland.

The dropping of tariffs between the mainland and Hong Kong and Macao could, unfortunately, provide some domestic and foreign manufacturers with a legitimate way to avoid paying taxes.

The mainland gives many export-oriented producers low or even no-tariff treatment.

So, some producers may export goods to Hong Kong and Macao for processing, to give them a made-in-Hong Kong or Macao cachet, to avoid being taxed, Wang explained to China Business Weekly.

But, Wang Liaoping, director of the Ministry of Commerce's Department of Taiwan, Hong Kong and Macao, dismissed that possibility: "Manufacturing costs in Hong Kong and Macao are very high, so average producers won't process their goods there just to avoid paying taxes.?

It was Wang's department that was mainly responsible for the free trade pact.

"We've also worked to define the term 'made in Hong Kong or Macao?to avoid allowing some foreign producers to avoid tariffs,?Wang told China Business Weekly last week, on the sidelines of the CEPA seminar.

According to Kang Qiang, a senior official of the General Customs Administration, those goods completely produced from raw materials in Hong Kong or Macao, or those with at least 30 per cent of value derived from Hong Kong or Macao labour or materials, can qualify for the 'made-in-Hong Kong or Macao label.

But, in spite of all that, there are still ways for manufacturers to avoid taxes, because it is very difficult to tell whether the value added was 30 per cent or not, especially in the case of luxury goods.

In addition, smugglers could take advantage of the massive flow of goods to the mainland that results from CEPA.

Kang maintains, however, that customs authorities on the mainland and in Hong Kong and Macao have come up with procedures to deal with smuggling.

"All certificates of origins will be checked thoroughly and authorities in the three areas will exchange information easily to avoid false documentation,?Kang said.

What may be more challenging, however, is from Hong Kong speculative investments.

According to CEPA, 18 service industries on the mainland in finance, banking, accounting, and real estate development will be opening to Hong Kong and Macao investors.

This comes two to five years earlier than the opening that China has promised as part of its World Trade Organization (WTO) commitments.

The regional free trade areas like those between the mainland and Hong Kong or Macao are permissible under WTO rules.

Most of the capital from Hong Kong and Macao is in the service sector, especially real estate. So, CEPA could allow Hong Kong investors to pour money into speculation on the mainland, causing a real estate bubble, Wang pointed out.

Even before CEPA, Hong Kong investors were already speculating in the mainland's real estate market, especially in nextdoor Shenzhen.

The opening of accounting, banks and insurance to Hong Kong and Macao, only makes real estate speculation easier, Wang added.

"Speculation by Hong Kong investors itself is not so scary, but if there are no measures on the mainland to prevent fallout, such as rising housing and land prices, people on the mainland could suffer,?Wang said.

Clement Leung, the deputy director-general of Hong Kong's Trade and Industry Department, did admit that CEPA would bring more competition to Hong Kong producers by attracting mainland manufacturers to move a part of their production there.

But, at the same time, they will leave the bulk of their production in low-cost parts of the mainland, thus challenging Hong Kong's producers.

"But, in a market economy, this is natural. I see no reason to worry,?Leung told China Business Weekly last week.

Wang also added that one long-term challenge from CEPA may be the privileged status of some Hong Kong and Macao businesses on the mainland, although that does not contravene WTO rules.

Many Hong Kong merchants make money by acting as intermediaries between Chinese producers and foreign importers. As the mainland opens further to the world, these possibilities, though, have diminished.

As CEPA allows Hong Kong or Macao to enter the mainland's service sector earlier, Hong Kong merchants have strengthened their intermediary status.

"And, some of them may denigrate the mainland to keep themselves irreplaceable, thereby harming China's image and trade relations,?Wang Yuquan said.

"In the long run, however, the problem can be solved by the increased ability of people on the mainland to deal directly,?Wang concluded.

(Business Weekly 01/13/2004 page1)