Hong Kong has given up trying to compete with mainland China for most manufacturing business. Never mind the territory's reputation for efficiency, stability, low taxes and minimal regulation - it simply can't match the mainland's army of cheap labor and booming factories, churning out every conceivable consumer and industrial product. But now, China is siphoning off business in a sector that Hong Kong considers vital to its future well being: logistics and supply-chain management.

Consider New Balance Athletic Shoe Inc. For five years, the big seller of sports apparel and gear has been shipping the bulk of its China-sourced orders through mainland Chinese ports. At least 75 percent of New Balance products traveling by ocean now exit through the Port of Yantian in China's Guangdong Province, according to Jim Sciabarrasi, corporate manager of sourcing, purchasing and logistics.

The reasons? "It's a lot less congested and closer to our factories [in Guangzhou]," says Sciabarrasi. "There are fewer fees and fewer trucking elements. It's simpler, faster and cheaper. And Yantian is a very solid port."

That's an unsettling message for Hong Kong, which boasts the world's busiest container port and has long served as the logistical gateway to China. Yet it's echoed by a growing number of companies.

"From an administrative standpoint, we've chosen Hong Kong as our buying office location," says Angel Garcia, director of global trading with Ace Hardware Corp., largest hardware cooperative in the U.S. "It's the place to be on the ground. But for product sourced in China, we ship mostly out of the mainland. It's more cost-effective."

The same goes for toymaker Mattel Inc. "The majority of our products produced in China are shipped from China, not Hong Kong," says spokesperson Lisa Marie Bongiovanni. "There is not really a trend - we've been doing this for quite some time."

Few companies see it as an all-or-nothing proposition. Sciabarrasi says New Balance continues to ship through Hong Kong's port when it needs to reach countries outside the U.S. or Europe. Yantian lacks the variety of sailings to service the whole world efficiently, he says. And Ace Hardware's Garcia says Hong Kong still handles huge amounts of finished product and consolidations linked to China proper. Still, the mainland is grabbing an ever-larger share of business that once was exclusively Hong Kong's, and the trend shows no sign of slowing down.

Weathering Tough Times
While maintaining its status as East Asia's dominant hub for global trade, finance and logistics, Hong Kong has weathered more than its share of misfortune in recent years. First came anxiety surrounding the British-ruled territory's transfer to Communist Chinese control in 1997. Investors and citizens alike feared the loss of both personal freedoms and a freewheeling business climate operating under decidedly capitalist rules. That didn't happen for the most part, thanks to negotiation of a Basic Law for the new "Special Administrative Region," promising a continuation of Hong Kong's way of life for another 50 years.

But immediately after the handover, the sudden devaluation of the Thai baht triggered a currency and banking crisis throughout much of East Asia, and Hong Kong wasn't entirely immune. Determined to maintain the Hong Kong dollar's link to the U.S. dollar, officials instead witnessed a bursting of the property bubble. Virtually overnight, government revenues plunged due to a halt in property transactions. Foreign investors, thanks to the vaunted liquidity of Hong Kong's markets, pulled their money out. The result was six years of flat growth or economic contraction. Interest rates soared and unemployment peaked at 8.6 percent - remarkable for an economy that had boasted virtually full employment only a few years earlier.

Additional body blows came in the form of the high-technology bust and severe acute respiratory syndrome (SARS) epidemic, the latter of which caused travel and public life in Hong Kong to grind to a near-halt for a period of months.

Economic Partnership
Ironically, a place that had been considered the economic engine of China found itself turning to the mainland for help. Hong Kong Chief Executive Tung Chee Hwa - his very title an indicator of the territory's fixation on business - appealed to Chinese authorities to loosen restrictions on Chinese citizens visiting Hong Kong. Given the freedom to spend more and travel individually, instead of with expensive, confining tour groups, they flocked across the border. The mainland now accounts for 60 percent of Hong Kong's total tourist trade, says Michael Chan, executive director of Bank of China International Research Ltd. At the same time, China and Hong Kong entered into a Closer Economic Partnership Agreement (CEPA), which strips away all import tariffs for Hong Kong-originated goods and allows many Hong Kong businesses to operate in the mainland without a local partner.

	"The pie will get bigger. There's business to be done by everybody." - Dora Kay of Hong Kong Airport Authority

Those measures, combined with natural economic cycles and a promised increase in government spending, have spurred the beginnings of recovery in Hong Kong. "Economic activities are flourishing in the last couple of months," says Glenda Chan, principal economist in the Economic Analysis Division of Hong Kong's Financial Services Branch. Unemployment has dropped into the 6 to 7 percent range, construction of new luxury housing is on the rise, the government may soon resume selling land leases, and the restaurants are full again. The SARS scare has abated, and Hong Kong seems relatively untouched by the more recent spread of bird flu, which struck other parts of Southeast Asia. To prevent another outbreak, workers repeatedly sanitize office doorknobs, lay down sterilization mats at building entrances, and surreptitiously check the body temperature of every traveler passing through the airport.

Full economic recovery depends in part on Hong Kong's continuing status as a major player in Asian supply chains. To that end, it has drawn up plans for massive new infrastructure. Whether they will be justified by actual demand remains to be seen. But officials insist that Hong Kong will remain a dominant force in regional air, sea and land transportation for decades to come, despite the mainland's competitive challenge.

Port Keeps on Growing
Port statistics bear them out. In 2003, Hong Kong handled the equivalent of 20.4 million twenty-foot containers (TEUs), up 7 percent from the prior year. Total cargo volumes were up 8 percent, to 207.6 million metric tons. According to Raymond Fan, deputy secretary for economic development and labor, Hong Kong has borne the title of world's busiest container port for 12 years. Most significantly, about 70 percent of exports from southern China pass through Hong Kong's port each year.

By contrast, Yantian, the largest container port in Guangdong Province and Hong Kong's primary local competitor, handled less than 8 million TEUs last year. But the growth rate of container ports in all of southern mainland China was a whopping 40 percent, representing a 2003 total of 10.6 million TEUs and climbing.

Hong Kong enjoyed double-digit cargo growth until the late 1990s, says Peter Wong, managing director of ATL Logistics Centre Hong Kong Ltd., a huge berthside complex for freight distribution and consolidation. In the last four or five years, volumes have crept up by just a few percentage points. Meanwhile, southern Chinese ports, such as Yantian, Shekou and Chiwan, have grown steadily. Although they were a tough sell at first, "slowly people are beginning to accept that you can ship out of China," Wong says.

Shippers using mainland ports cite sharply lower costs as a major reason. Hong Kong sustains a terminal handling charge (THC) of US$100 per 40-foot container - the world's highest, according to Fan - imposed by carriers serving the port to recover costs. Add to that the cost of trucking containers from the mainland into Hong Kong - roughly another US$100 per box - and Yantian ends up costing between 10 percent and 15 percent less than Hong Kong for companies shipping out of southern China, Wong says.

Hong Kong officials would like to see the THC lowered, but have no control over the matter. The port is operated entirely by private interests, with government's role restricted to leasing the land. (Unlike other major ports around the world, Hong Kong doesn't even have a formal port authority overseeing operations.) And carriers and terminal operators have no particular loyalty to Hong Kong; major container lines serve both territory and mainland, while terminal owners and operators are the same at both locations. In fact, operations at Yantian and other southern China ports are controlled by Hong Kong interests.

Others call the THC a red herring, with little real impact on shippers' choice of ports. For one thing, the cost differential between Hong Kong and Yantian is narrowing. Hong Kong tariffs are on the decline, says Wong, even though the THC hasn't come down. Yantian may be 15 percent cheaper than Hong Kong, but the gap used to be closer to 50 percent.

Many believe the differential between Hong Kong and Yantian is offset by Hong Kong's less bureaucratic and more predictable customs service. According to a recent report by McKinsey & Co., some companies are willing to pay a premium of up to US$500 per forty-foot container to ship through Hong Kong. They cite the relative ease of customs clearance as a major reason; other factors include frequency of vessel calls, quality of port facilities and "brand-name" reputation.

Types of traffic expected to favor Hong Kong over the next three to five years include imports to China, high-value re-exports, less-than-containerload shipments and domestic exports. According to McKinsey, those segments account for up to 60 percent of Hong Kong's total sea trade. The remainder, says the report, is likely to shift to southern China ports.

New Projects Under Way
McKinsey says Hong Kong should forget about the THC issue and concentrate instead on boosting the efficiency of border crossings and trucking operations. Indeed, notes Fan, Hong Kong is building another bridge at the western crossing from Shenzhen, where 13,000 containers move each day. Slated for completion by year's end, the six-lane bridge will be for freight only. Truckers will save time and even be able to do multiple trips, Fan says.

McKinsey offers up another piece of advice which Hong Kong seems less likely to accept: postpone construction of additional port capacity until the territory "can eliminate its structural disadvantages vis-a-vis Southern China. Before that happens, major investments in terminal capacity will be risky."

Hong Kong isn't exactly rushing into new facilities. Its brand new Container Terminal 9 (CT9), at the Kwai Chung complex, only just began operations and will be completed this year. It will add 2.6 million TEUs of capacity to the port. Yet officials are already talking about building Container Terminal 10 (CT10).

Possible sites include Tsing Yi Island, site of CT9, and further west on Lantau Island, where the airport is located. The Lantau location, while distant from the rest of Hong Kong's container terminals, has the advantage of being closer to the western portion of the Pearl River Delta, a part of mainland China that officials believe has enormous commercial potential. Industrial development in that region would help to alleviate growing congestion in the heart of the Shenzhen economic zone and other more built-up portions of Guangdong Province. Lantau also has deep enough water to accommodate the largest containerships, matching the capabilities of Yantian.

At least one Hong Kong-based shipping executive believes CT10 will never be built. Current port facilities are seriously underutilized, he says, and future business is destined for the mainland. But others see a pressing need for the new terminal. "There will be a CT10," says Stanley C. Shen, general manager of corporate marketing with Orient Overseas Container Line Ltd. "There's enough business for everybody."

Fan, too, backs the notion of another container terminal in Hong Kong. But the final decision won't be made until completion of a government study of Hong Kong's port needs through the year 2020. "We think we do [need CT10]," he says. "The question is when, where, how and how big. Later this year, all those things will come."

The CT10 project is dwarfed by another venture: the proposed construction of a 29-kilometer bridge linking Hong Kong with Macau and Zhuhai, key locations in the western Pearl River Delta. The bridge would hit Hong Kong at Lantau Island, offering direct access both to the Chek Lap Kok airport complex and CT10, assuming the latter is built there.

Presently containers from the mainland must cross the mouth of the Pearl River to Hong Kong by ship or barge, a journey which takes between five or six hours, says Kenny Tang, general manager of cargo with Cathay Pacific. A bridge would cut transit time down to less than an hour, making Hong Kong an even more competitive option for moving goods into and out of mainland China.

Hong Kong officials and commercial interests alike seem to favor the bridge, although the project hasn't even made it through the design stage. Equally uncertain is the price. In the opinion of Bank of China's Michael Chan, early estimates of US$1.9bn (HK$15bn) are far too low. He calculates the cost at closer to twice that amount.

Airport Still Dominates
Hong Kong is no stranger to massive public works projects. In July 1998, it wrapped up nearly nine years of planning, design and construction of the Hong Kong International Airport at Chek Lap Kok. The work involved creation of an entire island to accommodate the 3,100-acre complex, a brand new town next to the airport, and erection of a bridge and high-speed rail system to link the airport with central Hong Kong. The core airport construction program alone cost some US$20bn.

Hong Kong's airport handled 2.64 million metric tons of freight last year, cementing its position as number one in the world for international air cargo. That was a 6.6-percent rise over the prior year, despite the SARS scare and a sluggish U.S. economy. "It confirms China's position in the world, in particular the Pearl River Delta," says Dora Kay, head of international marketing with the Hong Kong Airport Authority. Some 70 percent of cargo moving through airport facilities was generated by China, she notes.

For now, Hong Kong's airport has less to fear from the mainland than does its port. Hong Kong serves some 140 global destinations by air, versus 20 for Guangzhou, its nearest mainland competitor, Tang says. Cargo operations at Chek Lap Kok are considered far more efficient than those of the mainland. And for air cargo shippers, time is of the essence. Most won't gamble on smaller, less sophisticated facilities, despite their relative proximity to manufacturing plants in China.

Solectron Corp., one of the world's largest contract electronics manufacturers, ships out of China almost exclusively by air. Jim Molzon, vice president of sourcing and logistics, says the company has manufacturing sites in Shenzhen in southern China, and Suzhou about two hours west of Shanghai. Product from Shenzhen flies out of Hong Kong, due to the wide variety of services and difficulty of moving freight within China. Even goods traveling between Shenzhen and Shanghai require transshipment through Hong Kong. "[China's] intra-country logistics are not nearly as advanced," says Molzon.

Hong Kong plans to triple its annual freight capacity at the airport from 3 million to 9 million metric tons, while nearly doubling passenger capacity from 45 million to 87 million. At the same time, in keeping with the territory's bias toward private ownership, the entire complex is likely to be privatized. The process will take about 18 months, Kay says.

Still another big project on the boards is a logistics park on 173 acres on Lantau Island, 10 minutes from the airport. Kay says Chek Lap Kok doesn't have enough land to host a full-blown logistics center, creation of which "would do wonders for Hong Kong." Coupled with the freedoms allowed under CEPA, the logistics park could be a magnet for multinational companies looking for value-added services, such as consolidation and vendor-managed inventory programs, to support their China trade. A final decision, and timetable for construction, have yet to be announced.

Hong Kong's Advantages
Logistics is only part of Hong Kong's sales pitch. Officials tick off a laundry list of the advantages of basing regional operations in Hong Kong instead of mainland China: an open economy, political and personal freedoms, free-flowing capital, an easily convertible currency, no investment restrictions, an established legal system, privately owned banks, zero tariffs on most items, and low taxes, among other things. Even if companies choose to utilize mainland ports, they say, Hong Kong remains the preferred location for regional offices, with ready access to a wealth of financial, administrative and management resources.

Hong Kong claims to do an especially good job of handling finished goods or production parts with multiple origins or destinations, then shipping consolidated loads into or out of China on a just-in-time basis. "Managing global supply chains is where Hong Kong excels," says Wong.

On the pure distribution front, Hong Kong seems resigned to losing a fair portion of its business to mainland China, whose manufacturing base has burgeoned in recent years thanks to low labor costs. Companies have a natural need to utilize ports close to the source of production. Fan says Hong Kong isn't overly concerned about whether its port and airport remain the number one links between China and the world. The important thing, he says, is that freight volumes through Hong Kong continue to grow, and that the territory stay a key player in the China trade.

Others insist that Hong Kong and China can comfortably co- exist as global logistics gateways, much as New York and Los Angeles do in the U.S. "I really think that the pie will get bigger," says Kay, echoing the remarks of OOCL's Shen. "China is going to open up. There's business to be done by everybody."