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UNCLAS SECTION 01 OF 03 GUANGZHOU 010676 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM 
USDOC FOR 4420/ITA/MAC/MCQUEEN, CELICO, DAS LEVINE 
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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