The Free Trade Experiment

The biggest step in the liberalisation of China’s financial services sector or a damp squib?

With the recent media hype about Shanghai’s New Free Trade Zone (“FTZ”), questions are being raised as to whether the FTZ opportunity will live up to expectations or if it is a damp squib. The FTZ, another Deng Xiaoping style pilot reform strategy has the potential to be expanded and/or replicated. China’s mantra, “crossing the river by feeling the stones” is particularly pertinent to describe the FTZ experiment that, if successful will be slowly disseminated nationwide as China moves to liberalise its economy and integrate with the rest of the world. 

On September29 2013, China officially opened its first ever FTZ as opposed to the ‘special economic zones’ (“SEZ”) such as Qianhai. The Shanghai FTZ covers an area of 29km2 and promises to act as an experimental ground for the heterogeneous liberalisation of 18 chosen industries (the majority of which are services based – financial, shipping, business, professional, cultural and social), liberalisation of interest rates, RMB convertibility, less stringent foreign investment criteria and much more. Furthermore, the FTZ will allow foreign banks to operate without a Chinese partner and provide  access for financial institutions and qualified foreign individuals to invest and trade in Shanghai’s securities and futures markets (access was previously restricted to buying into funds regulated and restricted with quotas through either the Qualified Foreign Institutional Investor (QFII) or Qualified Domestic Institutional Investor (QDII) programs). In addition, as the world’s largest energy consumer, officials have stated plans to create an international oil futures trading platform in the FTZ to improve the nation’s commodity markets and to hedge its risk. Foreign banks who open a branch (as opposed to a representative office) in the FTZ will be offered simpler and faster regulatory requirements, specifically when applying for RMB settlement licenses. The ultimate intention being to create an international hub for financial services, shipping, law, and architecture as China takes steps towards deregulating its financial system. Particularly attractive to foreign institutions is the proposed relaxation of the Great Firewall to provide access to popular web sites like Twitter, Facebook and YouTube which are otherwise banned in China.

Shanghai’s FTZ has attracted a lot of positive and negative media attention, but there is no doubt that, should the scheme be successful, it will pave the way for China’s integration into the modern world. Labelled by some as the “third wave of economic reform” (the first being Deng Xiaoping’s policies in the 70s and 80s and the second when China entered the WTO in 2001), the Shanghai FTZ has the potential to allow the nation to, in the words of Premier Li KeQiang, reap the “dividends of opening-up”, unleash more "reform dividends" and share greater "development dividends". Strong supporters of the new FTZ see it as a momentous step away from China’s export led growth model, to a more sustainable and liberalised consumer-led growth model. As China begins to foster domestic growth, it will be crucial for its services based industries to both develop and mature to be able to compete on the world stage. In the next five years, the Shanghai FTZ is expected to contribute between 0.1 per cent to 0.75 per cent to China’s GDP each year and, more importantly, provide a new model to attract foreign investment which can be applied to other cities and provinces.

Looking further forward, the Shanghai FTZ will also stimulate a fresh wave of investment and infrastructure spending, which will offer a wide range of opportunities. Local property prices and FTZ stocks have soared since the opening of the FTZ in September, and full convertibility of the RMB in the FTZ will allow foreign companies to raise capital through derivatives trading or private share placements – a huge step forward for the local financial services industry.

Whilst the plan seems to be an overwhelmingly positive step forward for China, there are sceptics and critics of the Shanghai FTZ, who see it as a potential ‘damp squib’. Most of the criticism and scepticism stems from the lack of detail that has emerged so far, and many wonder how the Government will prevent the major changes proposed for the FTZ from spilling over into the rest of the nation.  For example, it is not clear how banks in Shanghai’s FTZ will be allowed to set different interest rates within the zone to that of the rest of the country.

At the time of writing, 25 companies and 11 financial institutions have received approval to start operating in the FTZ from a variety of sectors. Whilst it is not easy to tell, the success of the FTZ will be a long term process as reforms in China typically start slowly out of the gate. However, local government officials have confirmed their commitment to maintaining the integrity of the FTZ by erecting a “rigid and impermeable wall” around the FTZ so as to ensure nobody ‘games the system’. However, much of the details of the benefits and principles to be applied within the FTZ have yet to be confirmed.

Described as the boldest reform in decades and with the opportunity to spur investment and innovation, particularly in China’s services industry, the success of the new Shanghai Free Trade Zone is uncertain. But one thing is certain, the symbolism, reflecting a new vision of China’s leadership and a step towards a more liberal and sustainable long term growth model, is promising. For now, we can only watch and wait.