While Beijing has been gradually removing policy and tax incentives intended to benefit some industrial zones, there is one zone that is still getting favorable treatment: Shanghai’s recently annointed Lujiazui Trade and Financial Zone (LTFZ).
In stark contrast to the global financial firestorm, the financial sector is still performing relatively well in Lujiazui. Shanghai’s overall economy may have grown by a meager 3.1% in the first quarter of this year, but its financial sector swelled by 26% year-on-year. Industrial exports, long the economic flagship of the city, decreased by 26.3% over the same period.
This May’s second annual Lujiazui Forum brought together more than 700 policy makers, finance professionals and academics to discuss how to leverage this growth to make Lujiazui a global financial center rivaling London, New York and Hong Kong by 2020. According to Shanghai Party Secretary Yu Zhengsheng’s statement at the Forum, the city’s future as a mecca for international finance is "inevitable."
However, a laundry list of policy challenges call that inevitability into question. Relatively high taxes on capital gains, limited financial instruments, exclusion of foreign entities from public listing, and strict and conflicting regulations coming from multiple layers of regulatory bodies are all policy factors that hold LTFZ back.
These issues are compounded by a lack of talent and low institutional transparency. "In this stage of economic development, lack of competence in the legal framework and human resources make the market unripe," said Hingyin Lee, director of research and advisory for East China at Colliers International.
A particularly well-known problem is the restricted nature of the renminbi. Even foreign and domestic companies that are committed to China for the long term face strict limitations in moving portions of their earnings elsewhere. Dr Gary Liu, deputy director of the Lujiazui International Finance Research Center at the China Europe International Business School (CEIBS), notes that the dangers of capital flight and violent fluctuations in exchange rates do not mesh with Beijing’s preference for incremental and risk-averse reform.
With a need to work around these policy challenges, some foreign financial firms have shunned the gleaming towers of Lujiazui and chosen Beijing as their China base for lobbying convenience. In short, political access still outweighs operational concerns for some, and Lujiazui’s advantages are primarily operational.
Nevertheless, whatever its flaws, access to the most developed financial markets in China still makes Lujiazui attractive to other companies. The zone hosts stock, bond and financial futures markets, and the first and only credit rating agency in China.
In addition, the zone offers a host of incentives. Newly registered financial institutions receive awards of up to US$2.2 million, depending on the amount of registered capital they bring into the area, and the local government relinquishes its share of taxes on financial transactions. Earlier this year, Shanghai also axed the 40% tax normally levied on the incomes of senior executives working for financial institutions as part of efforts to lure expat bankers.
The experiments in policy and institutions in the zone have already spurred rapid growth. In 1992, Lujiazui was a modest 1.7 square kilometers of semi-pastoral land. Since then, it has expanded to a sparkling, urbanized 28 sq km. Financial markets transactions conducted there (including insurance, derivatives, currency exchange, futures and gold) reached US$24.5 trillion in 2008. The Shanghai Stock Exchange alone turned over nearly US$4 trillion last year, making it the seventh-largest exchange in the world.
Furthermore, Shanghai has been designated by the central government as the center for international finance on the mainland. Liu believes this is intended to prevent competition between Shanghai and other national and regional financial centers like Shenzhen, Beijing and Tianjin.
"Lujiazui is going to be the first place of experiment with future financial reform," said Liu.
Financial institutions have taken Lujiazui’s bait. Most of China’s banks, fund management companies and insurance companies are headquartered in the zone, and the total number of financial institutions in the city reached 899 by the end of 2008. It has cemented itself as the foreign financial capital of mainland China, with 17 foreign financial institutions choosing Lujiazui for their China headquarters.
There are also signs that the constraints on the renminbi are loosening. Calls for the renminbi to grow in international importance prior to the G20 summit this year have been matched with easing of restrictions. So far this year China has signed bilateral currency swap agreements totaling over US$84.8 billion with six countries.
This is supported by other initiatives. A pilot program, lanched in May, allows cross-border trade deals in renminbi in five Chinese cities, including Shanghai. From August, the State Administration of Foreign Exchange (SAFE) will permit firms to fund foreign branches with up to 30% of their total equity in currency outflows from China.
This new liberalization is driven, in part, by Beijing’s realization that so long as the renminbi remains unconvertible, it cannot serve as an international reserve currency.
"Having the renminbi as an international currency will have side effects, but officials know they need take the setbacks with the benefits," said Dr Chen Chung-Hsing, head of Xinhua Finance Ratings.
In the end, there are always questions about how far experimentation in Lujiazui can and will go. Even with the area’s preferred status and the support of local officials, each financial reform must first go through the conservative regulators in Beijing. Tu Guangshao, vice-mayor of Shanghai, said at the Lujiazui Forum that any financial policy "needs a coordinating authority at the national level to give us guidance." Such guidance will not always be in the interests of Lujiazui as a zone.
In this way, zone-level policies are an incomplete solution to investment difficulties. With macroeconomic financial policy set at the national level, Shanghai’s role in improving the financial investment climate is limited to lobbying regulators, firming up its current financial and legal institutions and enhancing soft environmental factors like improving human capital, creating think tanks and hosting conferences.
The big reforms from Beijing still seem to be a long way off to some.
"The financial crisis has confirmed the central government’s judgments on financial innovation, and it has been used as an excuse to slow down reform," said Liu of CEIBS. In support, he cited a futures market in Lujiazui, on hold since 2006, that probably would have opened but for the crisis.
With free convertibility unlikely for the near future, Liu predicts that other reforms are more likely, such as allowing more financial products, foreign share listings and Qualified Foreign Investor Institution (QFII) programs, and greater transparency in the stock market.
How China will allow foreign and domestic firms to operate in years to come is anyone’s guess, but as long as the country’s growth creates the opportunity for money to be made in finance, the banks will keep coming to Lujiazui. "Financial institutions look at the prospects and size of the market and come knowing competency will improve," said Lee of Colliers.
Chen of Xinhua Finance agrees, and goes so far as to say the policy climate should not drive decisions.
"Having a presence in China is inevitable," he said. "You just have to get here and make investments. Regulations change all the time; you just have to play along with it."