The inauguration of the new China (Shanghai) Pilot Free Trade Zone (FTZ) on September 29 was celebrated with slavish press coverage. The Shanghai Daily called the FTZ a “major milestone on the road to reform” and a “new way to open China”. It gushed: “Banks are now scrambling to establish a presen ce in …the hot place to be in China.”
Many Chinese banks publicised their intent to establish branches in the FTZ, a fusion of four pre-existing bonded zones. Overseas banks were less effusive but still supportive. DBS and Citi declared their commitment to open FTZ branches on day one; HSBC and Bank of East Asia a few days later. Others will follow.
The initial furore is understandable. At the opening ceremony, commerce minister Gao Hucheng declared the FTZ a testing ground that would, among other things, allow the government to gauge the potential of future financial reforms.
More importantly, the State Council declared its backing for “free yuan [renminbi] convertibility under the capital account, interest-rate liberalisation and cross-border yuan usage” in the FTZ.
The optimistic view is that the FTZ will become a hotspot of experimentation in financial reform, with those reforms deemed workable spun out nationwide, much as Shenzhen’s unfettered capitalism spread outward from the southern entrepôt.
“Not long ago there were many in Beijing and elsewhere who did not expect China to proceed much further with marketisation. They argued that since statism couldn’t abide with further reform, reform would hit a glass ceiling,” says The Rhodium Group’s Dan Rosen, a former US administration official who was involved in China’s accession to the World Trade Organisation. “The FTZ terms make very clear that the opposite conclusion is in the driver’s seat.”
Yet many experts deride the dearth of detail about the FTZ’s supposed regulatory liberalisation and the lack of a timetable for such experiments.
“There have been big policy statements that focus on vision and big-picture objectives, as well as indications of high-level support from premier Li Keqiang, but the details and implementation plans are still lacking,” says Kenneth Jarrett, president of the American Chamber of Commerce (AmCham) in Shanghai. “These reforms are going to be politically difficult and take time to implement.”
“It’s not earth-shattering; everything they propose could be done within existing frameworks,” adds Fraser Howie, director of Newedge and co-author of Red Capitalism. “Why not have a new form of corporate registration and expand the business licence?”
Eyebrows were also raised by the timing of the FTZ’s inauguration, mere weeks before the Third Plenum (or the Third Plenary Session of the 18th Central Committee of the Communist Party, to give its full name), a secretive leadership meeting beginning on November 9. Similar meetings have yielded sizeable reforms to economic and financial policies.
The reason behind both the FTZ’s timing and the lack of details may well be the same – a bout of secretive-but-intense feuding between various bureaucracies and political factions.
It’s a turf war that could constrain the FTZ’s potential as a hub of financial reform.
Beijing’s commitment
The FTZ’s inauguration just six weeks ahead of the Third Plenum took people by surprise.
Equally surprising was the fact that neither premier Li nor any heads of major financial regulatory bodies attended the opening ceremony.
Both may be down to Communist Party politics. Gary Liu, executive deputy director of the CEIBS Lujiazui Institute of International Finance (CLIIF), a Shanghai think tank, theorises that the inauguration was a way to bolster Li’s reformist credentials.
“It will take a long time to implement the economic plan after the Third Plenum. Li Keqiang had to do something to show he was sincere about reform,” says Liu.
However, Li may have given the ministries little notice of the FTZ plan to circumvent opposition or intransigence. This could explain the paucity of hard details about the zone’s mechanics, and Li’s non-attendance at the inauguration as he arbitrates the resulting turf war.
“The premier is quite determined to promote liberalisation, but bureaucrats by nature don’t want to move so quickly,” says Liu. “Some people will be reluctant to give up their power. It’s a complex game, not only between Shanghai and Beijing, but also between so many ministries.”
If the FTZ works as stated, some mooted reforms could threaten the grip of China’s territorial regulatory bodies. Those likely to be affected include the Ministry of Commerce (Mofcom), the State Administration of Foreign Exchange (SAFE), and the People’s Bank of China (PBoC).
There have already been signs of disagreement in government circles about what the FTZ should encompass. Wang Xinkui, vice-chairman of the Shanghai Chinese People’s Political Consultative Conference, voiced disappointment at the scope of the “negative” list, a directory of fields in which foreign business investments are prohibited in the zone. In total, 190 subclasses of industries out of 1,069 were subject to special administrative measures.
Conversely, PBoC deputy governor Yi Gang stated that financial reform in the sector wouldn’t be rushed.
Still, plenty of observers believe the zone will yield serious reforms.
“We think this is a milestone in the opening up of China, not only of the financial market but especially for foreign investment and for China to move further toward more service-oriented, innovation-driven and less export-dependent businesses,” says Christoph Angerbauer, general manager of German Industry and Commerce in Shanghai. “People are talking about this being Shenzhen 2.0.”
Others believe the zone is a sensible place to test the sort of financial-market liberalisation China requires.
“The country has already reached a juncture where the old economic models do not work to guarantee sustainability of growth anymore. Yet, it is too risky to open up the country at one go,” says Chris Yeung, chief economist at DBS in Hong Kong. “The experimentation of the free-trade zone will allow policymakers to learn from the real experience of managing a free-trade zone under capital-account convertibility.”
A more cynical view, expressed by both Chinese academics and western experts, is that the existence of the FTZ’s ‘negative’ list demonstrates that real economic reform in China is far off.
“China is still not prepared to open up. They should stop having lists and let people do business,” says Howie. He worries that the regulators’ apparent foot-dragging over the FTZ will similarly bedevil any national economic reforms the Communist Party is considering.
Inaugurate it and they will come
The vagueness of the proposed reforms hasn’t stopped local corporates from flocking to the 29-square-kilometre zone, centred in the Waigaoqiao area northeast of Shanghai’s financial district.
Angerbauer says hundreds of Chinese companies are registering daily, eager to take advantage of anticipated tax incentives and business opportunities.
Many private Chinese companies have struggled to gain bank funding because of competition with state-owned enterprises. They see the FTZ as a potential new source of capital. Whether they will be allowed to tap it, however, is still unknown.
Speculators have also moved in, driving up property prices in Waigaoqiao. Joe Zhou, research director at Jones Lang LaSalle, says small office rents have doubled to about Rmb7-Rmb8 per square metre per day since the zone’s inauguration. The cost of good retail space has increased almost 50% because of demand from domestic and international banks.
In some instances, though, the “offices” of newly registered companies are just empty floor space in vacant buildings, delineated with marking tape.
Foreign banks active in and with China have been keen to follow Citi and DBS, opening in the zone. It makes political sense, the opportunity cost is relatively low, and they may quickly begin making money in areas such as trade finance, says CLIIF’s Liu.
It’s unclear exactly what products banks will be able to offer, although Liu believes it will include derivatives, something Chinese companies with large trading activities need for risk management.
The proposed reforms also allow wholly foreign-owned banks or joint-venture banks to set up joint-venture banks with private Chinese investors. This may open the doors to foreign asset managers and hedge funds, allowing them to access private Chinese capital.
Howie says foreign financial institutions may be allowed to set up companies that invest in Chinese securities without going through the Qualified Foreign Institutional Investor (QFII) programme – although again, lack of legislation means this is uncertain.
Corporate constraints
Zone officials are also likely to want multinationals to shift their Asian financial operations from Singapore and Hong Kong.
Western companies and trade bodies are interested. Many have praised the FTZ’s speedier business registration process and the opening up of areas like health insurance, shipping, investment management and construction, although specifics are unknown.
But most international corporates want to see more regulatory detail before opening an office, let alone conducting broader operational shifts. Angerbauer says no German company had committed to the zone as of late October, although plenty are looking.
Getting multinationals to move regional operations is likely to rely on two things the zone will struggle to offer: transparency and rule of law.
“Several open questions await answers in the coming months and years: how far-reaching will the reforms in the Free Trade Zone turn out to be, will the regulatory reforms usher in deeper legal reforms, can one expect the Chinese legal regime in its financial hubs to start resembling the legal regimes of the world’s other great financial centres?” asks O’Melveny & Myers in a thought piece, “China (Shanghai) Pilot Free Trade Zone – From ‘One Country Two Systems’ to ‘One Country Multiple Systems?’”
It would be much easier to convince international companies to base their China operations in the zone if it demonstrably improved the country’s baroque business licensing laws and capital-account restrictions.
“If there are reforms around the free convertibility of the renminbi for capital accounts – as well as other reforms such as internationally competitive tax treatment – international businesses may find it financially advantageous and more convenient to consolidate operations in China and manage them from the FTZ,” says AmCham’s Jarrett.
Angerbauer adds that foreign companies often resort to capital increases to raise extra cash for their Chinese operations. This requires a three-month registration process as well as SAFE approval. Easing or eradicating capital-account restrictions in the FTZ would allow company units based there to readily source money from international markets or their offshore divisions.
Financial experiments
The FTZ’s broadly worded goals encompass a lot of financial experimentation. Interest rate liberalisation may be the first reform under the microscope.
CLIIF’s Liu says this will require companies and investors being able to operate “special” or “offshore” accounts with their own interest rates, subject to restrictions. “You will not be allowed to transfer money from an offshore account to a domestic one without permission from the regulator,” he said.
Monitoring such transactions will be costly, and may be impossible to comprehensively police. However, China’s regulators are likely to insist on effective oversight of such accounts if they are to limit the zone’s impact on the broader economy.
“Different interest rates will lead to arbitrage in and out of the free-trade room,” Liu says.
In a country where people have deftly capitalised on loopholes, “this is the part that poses the biggest technical and regulatory challenges,” says Yeung.
National economic policy adjustments may hasten change. Now that lending rates are effectively free, analysts expect nationwide liberalisation of long-term interest rates to follow. “This will happen regardless of the FTZ,” says Yeung.
It may be less hazardous for the FTZ to allow free renminbi convertibility under the current account. There has already been some national loosening, with Chinese domestic investors able to invest up to US$50,000 per annum in foreign securities. More liberalisation would mean more transactions.
“If foreign currency is allowed to be freely converted into renminbi in the Free Trade Zone and flow to other regions of China, or if renminbi is allowed to be freely converted into foreign currency in the FTZ and transmitted overseas for investment or other purposes, cross-border transactions through the FTZ will undoubtedly increase,” writes O’Melveny & Myers.
One foreign banker in China expects that fears over the impact of such unfettered convertibility will lead regulators to retain restrictions.
Similarly, don’t expect capital-account control loosening to feature heavily among any eventual FTZ reforms.
“China isn’t financially healthy. There are many uncertainties, including asset bubbles, and house prices are too high,” says Liu. “If you open up the capital account, there will be large-scale capital flight [from the country].”
Another idea, possibly years away, is to use the FTZ to trial a fully floated renminbi. Doing this within the zone would allow the PBoC to influence where it traded and, if things went awry, use instruments to force the currency back toward the band.
Need for clarity
For all the encouraging FTZ rhetoric, it will be impossible to assess its importance until reform details emerge.
“There are great things promised, but there are no plans or guidelines… no one has enunciated the upsides,” says Newedge’s Howie.
The government needs to offer transparent rules. It must also accept that the zone will not be an easily contained entity like Shenzhen. Unlike factories, money moves quickly.
Most difficult will be controlling the spread of capital from the zone. Funding-starved private businesses elsewhere will seek money from within it, regardless of prohibitions. If companies outside the zone see that those within it enjoy competitive advantages, they will demand similar treatment. Interest-rate differentials will lead to capital arbitrage.
“The Chinese,” says Angerbauer, “are skilled at exploiting loopholes; they have been doing it very well for the past 30 years.”
Liu says that regulators will struggle to predict the extent of any arbitrage. “There will be ups and downs, and if the government thinks it is too risky, they may change their mind,” he says.
Additionally, the zone has limited ability to work as a hub of monetary experimentation. Many reforms can only be tested once nationally enacted.
Yet Rosen is optimistic. “I expect major financial reforms to be announced nationally this year, and hence the operating rules for Shanghai will be taken seriously,” he says.
Political support may matter most. Just as Shenzhen benefited from former leader Deng Xiaoping’s stamp of approval, the FTZ’s success may hinge on the imprimatur of another lofty figure.
“Li Keqiang can’t decide everything. This is a complex system, and [Chinese President] Xi Jinping has said nothing so far. If he believes [the zone] is important, he can express his support openly, but he hasn’t yet,” says Liu, who suggests that no signal will be forthcoming until after the Third Plenum.
Shanghai may be proud of its new Free Trade Zone, but foreign investors will remain ambivalent until the objections of entrenched interests can be quelled and more specific reforms unveiled.
Xi needs to throw his weight behind his premier if the FTZ is to become a true catalyst for economic reform.
