Much to do in making the Shanghai FTZ work

Special economic zones in China are starting to look like Russian nesting dolls. 

A free trade zone (FTZ) on the fringes of Shanghai set to officially launch on September 27 will be formed out of four zones that already have special status. Those zones, which include a sea port and an airport, were carved out of a larger zone that was opened in the early 1990s covering all of Pudong, the city’s financial district. 

In essence the new free trade zone – which has been hailed as the vanguard of reform since it was announced in July – will be a zone within a zone within a zone. And it’s not the only zone in China to suffer an identity crisis. 

Last year, officials in Shenzhen announced they would open a special tax and finance area called the Qianhai Bay zone in the already existing Qianhai zone that was opened in 2010 on the border with Hong Kong. The greater Qianhai zone itself was built out of the Shenzhen Special Economic Zone, the mother of all China’s free-market experiments. 

The new Shanghai FTZ will be substantially different to those that came before it – at least that’s the buzz in the media. Regulators have leaked that banks such as HSBC and Standard Chartered could be among the first to enter. Some business personalities have even wagered that the zone will rival Hong Kong as a beckon of free trade in the region. 

But the success of the zone will be inked into the details of the project. Until banks and companies understand exactly how the FTZ will operate, specifically how much the policies inside will spill into the rest of the country, all bets are off on it being the spark that re-ignites the country’s reforms after a 10-year chill. 

Guesswork

What’s considered known about the zone is guesswork for now. 

One overarching hope for the 29-square-kilometer area is that China’s financial regulators will leave some of the paperwork at the door. Regulation on foreign direct investment should become easier in the zone in a number of ways. 

For example, the government may fasttrack approvals for banks while also allowing them to offer more services. Full foreign ownership could be possible in many currently restricted sectors such as telecoms and healthcare. 

At the same time, industry watchers are betting that the yuan will be fully convertible in the FTZ, a step that would turn the area into an offshore banking center. The government may also liberalize interest rates and allow for market valuations on financial products. 

In the spirit of “free trade,” Shanghai’s zone could be a platform for duty-free exports. 

It could even be an answer for corporations scared off by the lack of rule of law in China. Many expect the better enforcement of Hong Kong law on contractual matters within the zone. Regulators may also recognize Hong Kong certifications for accountants and lawyers. 

Time warp

However tentative the plans might be, insiders have encouraged them. The FTZ has been one of the most talked about topics in the Shanghai financial community this summer. Still, the government will need to release a set of detailed plans on what the zone will look like before it can convert critics. 

“I’m still taking this with a large dose of salt,” Joanne Wood, chairman of investment banking advisor Capital Eight, said during the Shanghai International Financial Forum on Tuesday. 

A major challenge on the surface of the project will be the timeframe in which the zone has been proposed, confirmed and prepared for a grand launching ceremony presided over by its parton saint Li Keqiang, China’s premier. 

The State Council announced the zone in early July, at which point it became clear that the project had Li’s support. It was made official in August, and last week Chinese media said the zone would launch at the end of September, squeezing the entire process into just three months. 

This will be a soft launch. At the very earliest, the FTZ will begin operations next year, but even that is optimistic. The Qianhai zone in Shenzhen took a full three years to swing into action; in fact, it still under development and isn’t expected to be at full capacity until 2020. The voracity with which Li has pushed for the Shanghai FTZ has led to concerns about how much can actually be accomplished. 

“Expect delays,” Jeffrey Richert, associate director of PwC management consulting in Shanghai, said at the Shanghai International Finance Forum. 

Another stumbling block could be infrastructure in the area. If major international financial institutions are to set up there, they will need proper buildings to house offices. Much of that doesn’t exist at present and it’s unclear how long it will take to put in place. 

The spillover

On a deeper level, one outstanding question on the potency of the zone is “spillover,” or the degree to which policies governing the FTZ will be allowed to influence business in the rest of the country. 

For foreign businesses such as HSBC and Standard Chartered, that will be a central issue when considering whether to setup a presence in the zone. Ideally, foreign banks would be allowed to establish a branch or representative office within the zone but offer those services as well as a fully convertible yuan on the outside. 

The implications for such a step from the government are, by any measure, groundbreaking. A report this month from Standard Chartered said this would basically open up China’s capital account. 

That’s a jump in reform China probably won’t make – for now. A report from JPMorgan said it expects capital flow between the zone and the rest of the mainland to be “highly restricted” in the near term. 

“So far, it appears unlikely for banks’ privilege in the zone to be extended to their entities outside the zone. But the spillover could take many forms,” Wang Qinwei, London-based China economist at Capital Economics, told China Economic Review. 

More plausible would be that banks in the zone could offer some services such as loans to customers that are based elsewhere. This would still be a big step in easing capital controls in China, Wang said. 

If that spillover is curtailed, Richert at PWC said on Tuesday that he envisioned a far-less vigorous push into the FTZ once it opens. Wang at Captial Economics said restrictions on all spillove
r would dampen hopes for quicker reform and liberalization in China’s financial system. 

One thing is clear: The zone is setting the pace for financial liberalization in the rest of the country. China’s new administration, particularly Li Keqiang, have much riding on its success. 

The challenges to making substantial reform in a short period of time will be vast. Details of the project revealed during the next few months – and even years – will give the world a glance at China’s commitment to continue opening up.