(Reprinted from HKCER Letters, Vol. 14, May 1992) 


Creating A Telecommunications
Free Trade Zone in Greater China

Milton Mueller



This article addresses two of the broader trends affecting telecommunications strategies and opportunities in the Asia-Pacific region. One is the rapid growth of interChina trade: the increasing economic integration of capitalist Hong Kong and Taiwan on the one hand, and the socialist Mainland on the other. The other is the political reunification of Hong Kong and China in 1997, and the thawing of relations between Taiwan and the Mainland. These two monumental changes are altering the regional landscape. Together they have profound implications for telecommunications businesspeople and policymakers throughout the Asia-Pacific region.

It will be argued that the most constructive way to respond to these changes is by forging a regional free trade agreement in telecommunications services. This article advances a very specific and fairly easy-to-implement mechanism for the implementation of the free trade zone concept through liberalizing resale of international circuits.

Economic Integration and Political Change

Trade and economic/political integration are in fact the engines of the telecommunications industry growth in Greater China. Economic integration is leading to a regional division of labor which must be coordinated through massive information flows.

The growth in international telecommunications has been stimulated by growth in international trade following the opening of China. Direct foreign investment accounted for 54 percent of China's exports in 1990, and Hong Kong and Taiwan accounted for 75 percent of China's foreign investment from 1986 to 1990. This trade is predominantly intraindustry and intrafirm in character, which means that it can only be sustained by regular, efficient, and secure communications. Business and trade is thus responsible for the spectacular growth of telecommunications traffic in the area. In Hong Kong, outgoing voice minutes nearly quadrupled from 1986 to 1990, and fax and data minutes increased by a factor of 10.6 during the same five years. Hong Kong-China traffic alone accounts for half of this increase, and Hong Kong-Taiwan traffic accounts for another 8 percent. Taiwan only authorized transit telecommunications traffic to the Mainland in 1989. During the short period since, outgoing telephone traffic from Taiwan to the Mainland jumped from 3 million minutes to 14 million minutes. Taiwan now sends over 55 percent of its international telegraph messages to the Mainland.

Currently, Hong Kong serves as the hub of China trade--the central meeting point of knowledge, financial services, and trading opportunities. Hong Kong's intermediary function explains why the growth rates of telecommunications traffic exceed the growth rates of commodity trade. Far from diminishing Hong Kong's role, further liberalization by Taiwan and the Mainland actually enhance and reinforce Hong Kong's intermediary role in Greater China trade.

The Telecommunications Free Trade Zone Proposal

If the region is serious about seizing and advancing the opportunities for economic integration, then it can take one simple but dramatic step in that direction. Hong Kong, Taiwan, China, Macau, and Singapore should all enter into reciprocal agreements to liberalize resale of international circuits among themselves. I call this idea the "telecommunications free trade zone." Such an agreement would establish significantly freer trade in virtually all telecommunications services by liberalizing and harmonizing the conditions governing the use of international dedicated circuits.

By a "telecommunications free trade zone", I mean that each government in the zone would allow businesses to lease private circuits from their international carriers and market that capacity to third parties. The freedom to resell would preferably apply to voice as well as data and video. Of course, resale of this sort would only be allowed when the same rules were adopted by countries at both ends of the circuit. Like any customs union or common market, a telecommunications free trade zone involves reciprocity among the countries involved.

The free trade zone concept I am advancing is built entirely upon resale at both ends of the circuit. It does not require pure free trade in all other areas of telecommunications service or commodities. Taiwan and the Mainland, for example, currently restrict investment in telecommunications service providers by foreign companies. Whether or not this is a good idea, participation in a resale-based free trade zone would not require elimination of these restrictions. Resale also does not interfere with or supersede monopoly licensing arrangements for underlying carriers in the participating countries. It simply requires the monopoly to make leased circuits available to all comers on a nondiscriminatory basis and to liberalize its economic and physical restrictions on the use of them.

Who should be part of this agreement? The primary object of the proposal is to promote free trade in telecommunications services among Greater China. At the very least, the telecommunications free trade zone should include Hong Kong, China's Guangdong, Fujian, Guangxi, and Hainan provinces, Macau, and Taiwan. This rapidly developing economic area would benefit most from such an initiative.

The Benefits of International Resale

Resale may seem like it is too small and technical a change to warrant a label as extravagant as a "telecommunications free trade zone." But that is precisely the beauty of the proposal. Although it is a simple change to make, it could set in motion powerful economic forces with beneficial effects. Let me explain in more detail the benefits of international resale.

1. Resale is the most effective way to attack the accounting rate problem.

We are all aware of the controversy surrounding the accounting rate method of settling international traffic. The actual cost of providing international telecommunications service has plummeted in recent years, but rate reductions have been slow to follow in switched services, in part because of the rigidities of the accounting rate system.

The availability of bi-directional resale will exert downward pressures on accounting rates that are currently set too high. Under a resale regime, a reseller offering switched IDD between two countries will pay the cost of an international private line plus the domestic long-distance rate in the country of termination. If the terminating country's accounting rates are significantly higher than its domestic long-distance rates, the resale carrier will be able to profit from the difference. In order to avoid this kind of arbitrage, a carrier will have to rationalize the relationship between its accounting rate and its domestic long-distance tariffs.

A good example of one of these rate gaps occurs between Hong Kong and China. If one calls Beijing from Hong Kong, the price is HK$9.50 per minute. On the other hand, the domestic long-distance rate from Guangzhou to Beijing is only about HK$2.50, a little more than one fourth of the international rate. An operator who leased a private line from Hong Kong to Guangzhou and plugged into the Mainland's network could undercut the Hong Kong-Beijing rate by a substantial margin.

2. Resale rationalizes the telephone companies' rate structure, thereby improving efficiency and eliminating price discrimination.

Resellers will also be able to exploit large gaps between the per-minute charges for switched service and the flat monthly rate for private leased lines. If switched service is priced too high relative to the cost of a dedicated circuit--as is often the case--then a reseller will be able to offer customers significant discounts on switched traffic by connecting private leased circuits to the public network.

This kind of arbitrage is especially salient in this part of the world, where the gap between the rates for private and switched services appears to be growing. PTOs in Hong Kong, Australia, and Singapore have reduced some private leased circuit rates by as much as 50 percent in the past three years. Obviously, no comparable reductions have been made in switched services.

An environment of open resale introduces automatic correctives to prevent these distortions. Resale will drive the prices of both switched and dedicated services to their actual costs. As long as the telephone companies' switched and dedicated rates are properly balanced and reflect true costs, the TAs revenues cannot be hurt by resale. Indeed, under the proper pricing structure, resale can help them enormously: In essence, it allows hundreds of new companies to go out and market their underlying facilities.

3. Resale will extend the benefits of competitive forces to the whole market and not just large users.

Currently, large users, who can afford dedicated facilities, get better rates and more options than smaller users. A resale environment allows smaller users to share in the benefits and options now restricted to users with concentrated volumes.

For example, some calculations based on the monthly tariffs for 1.544 Mbps leased circuits show that a reseller of voice service between Taiwan and Hong Kong could undercut the rates of Taiwan's DGT by 40 percent and still clear a 20 percent per-minute profit on all the traffic it carried. It could undercut Hongkong Telecom International's (HKTI's) rate by 4.5 percent on traffic going in the other direction and still clear a 10 percent per minute profit. Applying the same assumptions to Australia-Hong Kong traffic, a reseller of IDD voice could undercut HKTI's rate by 37 percent and the Australian carrier's rate by 20 percent.

4. Resale will encourage innovation and entrepreneurship in the telecommunications marketplace.

In addition to its efficient pricing effects, resale provides a means of entering the telecommunications business that is less capital-intensive than one which relies on constructing and operating facilities. By lowering the price of entry, resale helps to cultivate a new entrepreneurial class in telecommunications. New sources of business experience, technical expertise, and service innovation outside of the dominant telephone company are cultivated.

Not many people outside the U.S. are aware of the extent to which long-distance competition in that country has been carried on by resellers and driven by resale competition. More than 200 of the long-distance competitors in the U.S. are resellers. Competition from Sprint and MCI in the late 1970s was not very successful until the Federal Communications Commission liberalized resale of AT&T's WATS service in 1981. WATS resale allowed them to achieve universal termination almost immediately, and they used market position gained through resale to build their own systems.

5. Reciprocal resale will promote regional integration of the telecommunications marketplace.

In addition to the above-mentioned effects, resale will have the far more important effect of integrating the regional market for telecommunications services. Simple resale will lead to the homogenization of rates, services, and features. Carriers and resellers will be able to more easily provide regional service offerings (since the demand for service clearly is becoming predominantly regional rather than local or global). The transactions costs of establishing international networks will decline significantly. Irrational price gaps across and within the participating countries will disappear through arbitrage. The geographic scope of the service market will broaden, increasing the number of players in the market, intensifying service and price competition, promoting diversification and specialization, and fostering economies of scale in overall industry organization. For major users, this will make Greater China a very attractive place to hub. For the trading economy as a whole, this will be a powerful boost.

Resale as a Viable Step to Liberalization

The advantage of resale is that it dodges or eliminates many of the political and institutional problems associated with the introduction of competition, and thus is a much easier way to move toward liberalization. Consider one by one the arguments against full-fledged liberalization that have been advanced in recent years.

1. Legal obstacles. In Hong Kong, many people in government and industry are sympathetic to competitive liberalization of international telecommunications. Yet, they argue, it is dangerously destabilizing for the territory to abrogate an exclusive license before it expires. Many other countries likewise would require major legislative changes before facilities-based providers could enter the market.

Resale, in contrast, does not require alteration of the terms of the HKTI license, nor does it alter Hongkong Telecom's status as the exclusive provider. It is a purely regulatory matter.

2. Economies of scale. Some critics of liberalization argue that competition will dissipate economies of scale in telecom service and lead to less economically efficient service. Resale, however, relies on the facilities of the established carrier. Economies of scale (assuming that they exist and are significant) would not be dissipated.

3. Accounting rates. The accounting rate system has also been cited as an obstacle to full liberalization. The argument is that decreasing collection rates on the competitive side of the international circuit merely increases the traffic imbalance and rewards monopolistic carriers with high collection rates by increasing their settlement payments. This argument does not apply to reciprocal resale. Resale drives down accounting rates by allowing users to bypass the accounting rate system in cases where it exceeds domestic long-distance rates by unreasonable proportions.

4. Diversion of revenues. Telecommunications authorities in developing countries fear that a competitive regime would divert traffic and revenue from the public network and thus prevent them from building infrastructure. Resale, of course, would not bypass public operators at all. It would merely exploit the arbitrage possibilities created by their rate structure. Once their rates were rationalized, resale would benefit them by increasing the demand for their services and network usage.

In conclusion, all of the arguments against competition in the international arena do not apply to resale. A telecommunications free trade zone is an easy medicine to administer when compared to the drastic surgery of facilities-based competition. There is no need to break up phone companies, reconfigure the network, or negotiate hundreds of new operating agreements. Nor is there any need to worry about asymmetric regulation, cross subsidies, discriminatory pricing, and all of the other headaches that can occur when a dominant monopoly is beset by fledgling competitors.

While the resale prescription goes down easily, it really is a wonder drug. It would be a fertilizer for telecom entrepreneurs, a strong tonic for large and small users, a powerful stimulant for the telecommunications industry and trade in general. For the telephone companies, the immediate effects might seem unpleasant. It would nevertheless dramatically improve their long-term health by purging them of bloated IDD rates, unclogging the accounting rate system, and rationalizing their rate structures.

Dr. Milton Mueller is Assistant Director of the International Center for Telecommunications Management at the University of Nebraska at Omaha. He is the author of International Telecommunications in Hong Kong: The Case of Liberalization, a HKCER Paperback.


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