The magnitude of economic growthin China over the last few years hasbeen truly astonishing. China's GDPhas expanded an average of 9.6% eachyear for over 25 years. Overall tradevolume has exploded to more thanUS$1.76 trillion. The trade surplus， astaggering US$177.47 billion， has bal-looned to untenable levels. The wavesare being felt on a global basis and areforcing the Chinese Government to re-think and reshape the strategies respon-sible for fueling much of this historicgrowth while remaining conscious of thelong-term need for sustainable growth.

China used to provide generous taxbreaks and other such incentives to lurevast quantities of foreign direct invest-ment (\"FDI\") into China. This strategyworked well for decades and exportmanufacturers arrived in droves， builtmodern factories and hired millions ofworkers.The economy overallbenefited. But things in China changequickly and these incentives are beingphased out.

One of the cornerstones behindChina's success has been the growthin export manufacturing through a pro-gram called Processing Trade. Thisprogram has saved companies billionsof dollars in duty and VAT costs. With-out Processing Trade， prices for Chi-nese export goods would be lesscompetitive. But recent regulatorychanges to Processing Trade are in-creasing costs， adding operational com-plexity and causing companies to recon-sider China's status as a preferred glo-bal manufacturing base.

The following article outlines thebasics of how the Processing Trade ，re-gime works， the impact to companyoperations from recent changes， com-mon issues encountered by ProcessingTrade entities and some thoughts re-garding what the future may hold forexport manufacturers.

Introduction to ProcessingTrade

Processing Trade is the name givento the program which permits a com-pany to import raw materials free ofduty/VAT for producing export goods. Itis used by a majority of export manu-facturers to legitimately manage indirecttax costs.

In just over 25 years the value ofProcessing Trade has increased 333times from US$2.5 billion in 1981 toUS$831.9 billion in 2006 and accountedfor over 50% of the total import/exportvalue. In the first half of 2007， the Pro-cessing Trade total import and exportvalue rose 17.6% to US$440.9 billion.

The following two types of manu-facturing structures are employed un-der the Processing Trade program inChina:

* Contract Manufacturing (進料加工)-The manufacturer purchases allraw materials for their own account，owns the goods through production andsells the finished goods to its customers.The manufacturer earns a profit on thesale of the goods.

* Toll Manufacturing (來料加工)-Anoverseas company purchases the rawmaterials for their own account and con-signs them to the manufacturer. Themanufacturer imports the materials butis only responsible for the processingactivities and does not sell the finishedgoods， Instead， they earn revenuethrough a \"processing fee!' paid by theoverseas company.

Most factories manufacture underProcessing Trade using one of theabove structures.

How Does Processing TradeWork?

The Processing Trade program al-lows for the upfront exemption of dutyand VAT on imported raw materials，which are considered to be in a\"bonded\" state， These bonded rawmaterials must be tracked and recon-ciled to the final exported finishedgoods； With such a program， Customsis concerned that raw materials whichwere never duty/VAT paid are intro-duced into the domestic market withoutpayment of the relevant taxes. Thus， atracking mechanism is necessary tomonitor the inputs and outputs:

Processing Trade's trackingmechanism is commonly referred to asa \"customs handbook\" or \"customslogbook\". A customs handbook can beeither a paper-based book or can be anelectronic version， sometimes referredto as either an \"e-handbook\" or \"networksupervision\". The picture below is asimple graphic illustration of how inputsinto the customs handbook are trackedand reconciled to outputs:

The actual procedures are muchmore complex than outlined above andcan be difficult to practically apply in acompliant manner. But since the pro-gram may save the export manufacturersignificant costs， it is usually worth theadditional administrative burden tomake it work.

Recent Changes to ProcessingTrade- Prohibited， Restricted and WhatNext?

There has been a flurry of new Pro-cessing Trade regulations promulgatedover the last couple of years.Unfortunately， the new regulations aretriggering concerns over how it will im-pact the operations of exportmanufacturers. Many of these ruleswere issued with little or no warning and/or without detailed implementationmeasures. For example， a recent rulewas announced one day and becameeffective the very next day. Companiesare beginning to express their frustra-tion at the suddenness and lack of trans-parency accompanying these rules andwondering what will happen next.

But the Chinese Authorities have adifficult job too and it is impossible tosatisfy everyone. As China endeavorsto address international trade，economic， social and politicalchallenges， it is increasingly utilizingtrade programs， such as ProcessingTrade and export VAT refunds， as\"tools\"to guide certain macro-economic poli-cies and adjust long-standing invest-ment patterns. The Vice Minister ofMOFCOM， Wei Jianguo， stated that \"weare striving to improve the developmentof China's Processing Trade programin a bid to promote trade balance andreduce the trade surplus\". Many differ-ent Agencies have a vested interest inmaking sure their opinion is incorpo-rated into the changes.

Not all companies and types of pro-duc'tion can enjoy the benefits of Pro-cessing Trade. Companies must beapproved by MOFCOM and Customsto conduct such activities. There is alsoa list of products and processes whichare prohibited from using ProcessingTrade. Finally， a new \"Restricted\" cat-egory was recently introduced.

Prohibition List

There has always been a list of des-ignated products which China does notallow to be produced under ProcessingTrade. The most recent List places pro-hibited products in into the followingcategories: exported finished goods;imported raw materials; and combina-tions of finished goods made with cer-tain imported raw materials. Prohibitedproducts can be manufactured for ex-port but the raw materials cannot beimported on a bonded basis. That is，customs duty and VAT would be pay-able at the time of importation and thisincreases manufacturing costs.

The following recent policy adjust-ments have significantly expanded theproduct coverage of the Prohibition Listover the last year:

* Decree No. 139 and 145(September 2006) stated that productswith a 0% export VAT refund rate wouldbe placed on the Prohibition List;

* Announcement No. 82 (November2006) released an updated version ofthe Prohibition List;

* Announcement No.17 (April2007) added items to the List as well asconsolidated different Prohibition Lists;

* Supplement to AnnouncementNo.17(July 2007)included additionalitems and clarified others that are noton the List;

* Others.

Many of these rules wereconfusing， contradictory or inconsis-tently interpreted by various localAuthorities. From now on， the Authori-ties will no longer issue a formal regu-lation every time the Prohibition List isupdated. Rather， it will be updatedonline and companies must monitor thechanges. The ease with which theonline Prohibition List can be revised islikely an indication to expect futurechanges， possibly both additions anddeletions.

The Authorities have stated they in-tended to target products and activitieswhich are not entirely in line with China'slong-term strategic goals (i.e.， those withhigh energy consumption; create highlevels of pollution; use China's naturalresources; and are considered to below-value add).

Restricted List

A new \"restricted\" category wasadded to the changing landscape ofProcessing Trade. On July 23rd， An-nouncement No. 44 created a list of re-stricted products that covers over 1，800tariff codes and places monetary andgeographic restrictions on exportmanufacturers. The new restrictionscan have a serious impact on acompany's supply chain， cash flow andoperating location.

A summary of the HS chapters ofproducts affected is provided in the tablebelow:

These products were selected fora number of reasons， but the approachwas to identify products with relativelylow-value add， high amounts of manualintensive labor and those causing fric-tion with China's trading partners. Bytargeting such production and encour-aging the westward movement ofinvestment， the Authorities are hopingto address a number of social issues atthe same time.

The following restrictions are im-posed on affected products:

* Companies must post cash de-posits for the estimated amount of theirduty/VAT liability. Companies with an Aor B grading are allowed to post only50% of the amount， while C grade com-panies will have to post 100%. If an Aor B grade company is already locatedin middle and Western China， then thedeposit requirement may be waived.

* If a factory to manufacture re-stricted products was not approved toconduct Processing Trade before July23rd， then the company will not be al-lowed to conduct this activity in thecoastal provinces of China. That is， thecompany will need to be located inmiddle and Western China if it wouldlike to manufacture under ProcessingTrade.

* A company currently manufactur-ing under Processing Trade without im-port/export rights must obtain the rightsbefore October 23rd to be able to con-tinue producing such products.

* The restricted list applies to E-handbooks but does not apply to spe-cial zones (e.g.， export processing zone，bonded zone， etc.) and special types ofbonded factory transfers.

There is a relatively short transitionperiod under which companies canpostpone some of the aboverequirements. Companies can submittheir export contracts and must receiveapproval from MOFCOM and Customsby August 23rd in order to continue un-der the old rules (i.e.， not required tolodge a cash deposit). The informationcontained in a registered contract can-not be changed and once the total quan-tity has been reached or the handbookexpires， then the new rules will apply.Thus， companies producing goods onthe Restricted List should act immedi-ately to register a contract and obtain acustoms handbook.

What'S Next?

It is tricky to try and predict the nextProcessing Trade changes to be intro-duced by the Authorities. This is espe-cially true in the current environmentwhere changes are announced with littleor no warning. However， it is apparentthat further changes will be coming asthey seek to improve the program andaddress a multitude of challenges.

The Prohibition List is likely to bein a continual state of revision. This Listis now published online and this givesthe Authorities greater flexibility to addand delete items，

The Restricted List will be moni-tored and likely adjusted from time totime. The Authorities are keen to un-derstand the economic and operationalimpact of these changes and are will-ing to listen to how this affectsbusinesses. They may even initiatecertain adjustments where the resultsdiffered from the expected outcome.The geographic restrictions satisfyChina's long-term goals of developingnot only the coastal regions but cascad-ing employment opportunities to West-ern provinces， so we see this beingused further.

Currently， HS codes are being usedto select the affected products. This isnot a perfect method as products whichwere not targeted to be in the Prohibi-tion or Restricted Lists may end up be-ing captured therein. Thus， it may be plausible for additional criteria， otherthan just the HS codes， to be contem-plated in future changes.

An even more radical position maybe to ask \"whether Processing Trade， in its current form， nasoutlived its usefulness?\". If so， then fundamentalchanges in the program or a scrappingof the entire program may be necessary.The Authorities are already contemplat-ing alternatives，but such structuralchange will not come easily.

Common Issues

As mentioned， Processing Tradeprovides a huge cost savings to exportmanufacturers. To enjoy the benefitscompanies must understand the regu-lations and employ operational proce-dures to ensure compliance. Failure todo so will result in additional duty/VATliabilities payable. Given the large vol-umes and quantities of goods manufac-tured for export， the resulting costs canDe material and usually come as an un-welcome surprise，

A few of the most common issuesare listed below:

* Outdated handbook system - theold handbook was not very flexible anddata reported at the beginning of theregistration process (e.g.， values，quantities， wastage and consumptionrates， etc.) changes frequently. It is achallenge to update the handbook regu-larly to reflect these facts but the e-handbook is simplifying the process.

* Inability to reconcile bonded in-ventory-it can be difficult to appropri-ately track the usage of the bonded rawmaterials and many times there is alarge variance between the quantityCustoms has in their records and theactua physical quantity in thewarenouse， Customs will view a nega-tive variance as unfavorable and requireduty/VAT to be paid on the difference，

\"Domestic sales - some manufac-turers will sell goods to both the domes-tic and export markets. Bonded rawmaterials may be included in goods solddomestically. Domestic sales includingbonded raw materials must be reportedto Customs and duty/VAT paid thereon.Many companies forget， or overlook therequirement， to report their domesticsales in a timely manner.

\"Closure of a handbook-manytimes it is too difficult for the operationalstaff to reconcile the handbook at thetime of closure， Thus， the irreconcilableending balances are \"rolled forward\" tothe beginning balances of a new handbook. The irreconcilable balancesthen compound over a period of timeand increase the risk exeosure to thecompany.

We nave seen many companfesstart operations under Processing Tradewithout detailed internal controls， poli-cies and procedures in place to avoidnoncompliance. Most who have faceda serious issue with Customs say theywished upfront time had been investedto design procedures that could haveprevented the issue. This is also moreevident when there is not a dedicatedcustoms staff to manage the processand/or there is a high rate of employeeturnover.

Conclusion

Processing Trade has and will con-tinue to play an important role in the de-velopment of China's economy， TheAuthorities are beginning to experimentwith the program as a \"tool\" to engineerand force changes they believe are nec-essary for China's long-term growth. Byprohibiting， restricting or encouragingproduction in certain industries or of spe-cific products， they hope to nudge theeconomy towards a level of higher value-added manufacturing.

The new regulatory changes cansignificantly impact company operationsas well as future investment decisions.With all the restrictions and complexityto manufacture in China these days，many companies are closely scrutiniz-ing the business case for locating export-oriented factories in China versus othercountries. The Authorities recognize thatthese changes negatively affect a num-ber of businesses and are monitoring theimpact. But they seem willing to accepta certain level of downside to addressthe larger issues such as the tradesurplus， environmental pollution， limitedenergy and natural resources， balanceof wealth in China and social order. Theyprobably recognize that some FDI willbe lost as a result， but are hoping thatthis is from companies at the lower endof the value-add spectrum.

It will be interesting to watch as theaffects from these changes are mani-fested in the economy. Companies willbe casting a wary eye to see how thesechanges are implemented. TheAuthori-ties are also eager to see if this experi- ment in tinkering with Processing Tradewill pay off as expected. Either way， wewill have to wait for a while to see howthis all plays out.