Article – China Plans to Create a Free Trade Zone in Shanghai

August 28, 2013
The Chinese central government took what could be a bold step toward economic deregulation on Aug. 23 when the State Council officially approved the establishment of a free trade zone in Shanghai. The Shanghai zone will feature reforms not included in the special economic zones created in previous phases of Chinese economic development. If fully implemented, these measures will make the Shanghai zone a testing ground for economic liberalization under China’s current one-party system.
Unlike Qianhai in Shenzhen or the Pudong New Area in Shanghai, the Shanghai free trade zone will seek not only to integrate four existing bonded trade areas into a unified tariff-free trade complex, but also to introduce substantial economic reforms within the zone’s 28 square-kilometer (11 square-mile) jurisdiction. According to Xinhua, those reforms include nothing less than full interest rate liberalization, full yuan convertibility and significant relaxation of capital controls for businesses operating in the zone.
No official deadline for the zone’s completion has been set, and the government has provided no concrete details on how it will implement some of the more sweeping financial reforms. According to Xinhua, the Shanghai municipal government submitted 42 instructions for implementing the free trade zone, elaborating on 21 measures outlined by the project’s primary top-level backer, Premier Li Keqiang, in July. However, neither set of guidelines is publicly available. At least one report says the zone will take 10 years to complete — a realistic time frame given the scale of operations and nature of reforms proposed.
First, integrating four independent bonded trade areas (the Shanghai Pudong International Airport, Waigaoqiao port and the land and harbor segments of the Yangshan deep-water port complex) with a combined trade balance in 2012 of $100 billion will involve significant technical and logistical challenges. Large-scale projects such as this often face operational issues along with bureaucratic hurdles, small-scale opposition from mid-level government figures and other obstacles. Bringing financial reforms to fruition on top of these difficulties will not be easy.
According to Chinese and Hong Kong media, China’s top banking and securities regulators voiced strong opposition to the zone during meetings with Li between March and July. The regulators argued that much more preparatory work would be needed before anything like interest rate and capital account liberalization could be fully implemented in Shanghai, especially considering the city’s deep financial and trade ties to other Yangtze River Delta industrial hubs and newly industrialized regions along the river’s middle and upper stretches. As the 2012-2013 spike in illegal cross-border trade and exchange-rate arbitrage between Shenzhen and Hong Kong illustrates, there are ample opportunities to exploit discrepancies that might emerge between a Shanghai free trade zone and surrounding areas. More concerning is the impact that a financial crisis within the zone might have on Yangtze River economies, especially considering the regulatory challenges that maintaining two different but connected economic systems will create.
In addition to promises to liberalize interest rates and reduce or remove restrictions on capital flows, the Shanghai zone will allow foreign commodities exchanges to set up bonded warehouses on the mainland, thus allowing Chinese and foreign commodities traders to cut costs by maintaining inventories domestically rather than in Singapore or South Korea. Other measures will reduce restrictions on foreign banks establishing branches within the Shanghai zone, encourage foreign direct investment into previously state-controlled sectors like health care and insurance and streamline customs procedures for imports and exports. These measures will also face technical and logistical challenges but do not come with the same financial and economic risks as interest rate and capital account liberalization.
Shanghai is not the only city to have pushed for a free trade zone of this kind. As early as 2005, municipal governments in Shenzhen and Tianjin submitted similarly ambitious proposals for their own zones, though Shanghai’s selection has likely ended those bids for now. In China, regions and even individual municipalities compete fiercely for the central government’s attention — an artifact of the strategies used historically by centralized powers in China to secure their influence by encouraging regional dependence on the central government for funding and other preferential policies. China’s national economic policy still is shaped not only by technical considerations but also by deep-set geographic and strategic concerns — for example, Beijing’s need to control potential rival power bases in Guangdong, Shanghai or Chongqing by reinforcing their reliance on central support and occasionally cracking down on specific high-profile political leaders in those areas.
These patterns could have informed the central government’s decision not to award the zone to Shenzhen, located in Guangdong province near Hong Kong. Beijing has worked long to guard against overreliance on Hong Kong as a financial intermediary and to create multiple gateways between the mainland economy and the outside world. Cities like Shanghai and Tianjin, along with their second-tier inland counterparts, actively position themselves to take advantage of this changing political and economic dynamic.
The approval of the Shanghai Free Trade Zone comes at an opportune moment for Beijing and for Li, its primary supporter, who has cast himself as a reformer and proponent of deregulation. In the short term, the Shanghai zone plan sends a strong signal to global markets that China’s new leaders are serious about economic reform, and it provides a strong segue into the Third Plenum meetings in November, when the administration is expected to unveil major financial sector reform plans. More important, the announcement signals that Beijing understands that China’s economic transformation is inexorable, and that as China’s economy moves toward higher value-added industries, it will be forced to embrace greater global financial integration.
Courtesy of Stratfor.

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