Leveling the Playing Field

The Shanghai Free Trade Zone is a bold market experiment to change the business environment in China

The Shanghai Free Trade Zone is changing China’s business environment

The China (Shanghai) Pilot Free Trade Zone has divided critics. Launched in September 2013, it is the first of its kind; an experiment to liberate China’s economy and position Shanghai as a global financial center, with the aim of testing how the rest of the country can be opened up to the world market. But nearly two years into it, many believe change is too slow and ineffective, pointing out that the zone lacks the business environment, amenities and infrastructure found in the nearby Lujiazui central business district.

Located on the outskirts of Shanghai, the free trade area started as an inauspicious 12-square-mile stretch of docks, hangars and warehouses encompassing four special zones situated along the coast. Officials had hoped it would become a hub for bold market experimentation achieved by loosening regulations across industries, including finance, banking, shipping, law and engineering.

In many ways the innovative project recalls Deng Xiaoping’s original special economic zones that boosted the country’s economy back in the early 1990s. During that period of“reform and opening up,”Deng’s free-trade zones – known as bonded areas or tariff-free zones – encouraged foreign manufacturing firms to set up shop in China and benefit from policies such as tax breaks, cheap land and low wages.

The sleepy fishing village of Shenzhen across the border from Hong Kong was one of the first beneficiaries of special treatment, and transformed into a sprawling manufacturing powerhouse in a matter of years.

Just as Deng’s reforms helped to galvanize the country after the stagnant 1980s, the timing of the Shanghai Free Trade Zone (FTZ) comes the year China’s economy grew at its slowest pace in 24 years after more than a decade of breakneck speed, a downtrend President Xi Jinping characterized as the“new normal” for China.

In a speech at the Asia-Pacific Economic Cooperation (APEC) in Beijing last November, Xi told business leaders that in the future China would focus on improving economic structures and“innovation” to fuel growth, rather than rely on manufacturing output and state-driven investment.

In recent years, China’s leaders have signed a series of international free-trade agreements that officials hope will open up, reform and stimulate growth in China’s consumer market.

But in order to meet the demands of these agreements, China needs to liberalize its market regulations to integrate with international standards.

These reforms are directly linked to the experimental policies taking place in the Shanghai FTZ, explains Professor Bo Chen at Shanghai University of Finance and Economics – a key consultant on the FTZ’s original blueprint.

“The Shanghai Free Trade Zone was created to provide a testing ground for such changes,”he explains.“The Chinese government has authorized Shanghai’s FTZ to temporarily waive existing laws and regulations so they have space to create their own.”

But experts say that what Shanghai’s FTZ offers in 2015 is not at all the same as what Shenzhen offered in the 1990s.

In an interview with the Financial Times at the end of 2014, the Communist Party secretary of Shanghai Han Zheng noted that the zone was very different in conception to its predecessors.

Rather than offering“incentives,”which are common to tariff-free custom zones and industrial parks, the Shanghai FTZ is a test area for innovation with no direct incentive policy for innovation, he added.

According to Jennifer Tyldesley, Consul Economic at the British Consulate General, those companies looking for a replay of the past were always going to be disappointed.

“If you were expecting trade and manufacturing promotion tax breaks of the likes offered in the original free-trade zones under Deng Xiaoping, well it was never going to be like that,”Tyldesley says.

“I think that’s what a lot of media and businesses have struggled to get their head round. The best way to understand its goals is to drop the word‘trade’altogether, and think of it as a free zone.”

In her eyes, the zone was introduced to explore ways to change the restricted business environment in China that would cut red tape and make it easier for businesses to act on market opportunities.

“If you look at it from this perspective, I think it’s been a lot more successful than

the commentators have given it credit for,” says Tyldesley.

Some Success Stories

The zone’s most notable achievement is the creation of the“negative list,”an inventory of industries in which foreign investment is prohibited or banned. Any commercial activity not mentioned on the negative list is automatically accepted.

The initial list contained 190 excluded items, which was reduced to 122 this May. Newly opened sectors include transportation, real estate, medical services and entertainment fields, with a further revised version expected later this year.

There has already been some success: last year, for example, the ban on gaming consoles was suspended and foreigninvested companies were granted the right to make consoles in the Shanghai FTZ and sell them in China. Microsoft was the first to snap up this opportunity and launched its Xbox One in October 2014. The introduction of the negative list also led to the first wholly foreign-owned hospital being established in the zone.

According to Xinhua, China’s national news agency, foreign investments have increased every month since the zone was established, with nearly 1,800 foreigninvested firms setting up in the zone.

Nevertheless, foreign participation remains disproportionately low. While 12,600 companies have registered in the FTZ since its establishment, only 14 percent were foreign-invested, the South China Morning Post reported in 2014.

Critics of the foreign investment policy also say the negative list is far too long, and a great deal of confusion remains over the specifics of the list.

“Some of the restrictions are necessary. Every country has some kind of exemptions for certain sectors. But if the restrictions are purely based on political ideological concerns, Western countries may not buy that excuse,”says Professor Weiping Wu, associate professor, Hong Kong Baptist University.

Chen argues that the obstacle to reform doesn’t just lie in the wording of the rules – but bureaucrats’desire to implement them.

“Chinese officials are used to interpreting regulations. In many respects, that’s the source of their power. The reform is on government itself, which is very tough. Many bureaucrats didn’t want to give up their power [over the rules]. It can be difficult for foreign observers to understand,”Chen says.

“To make the negative list work for foreign countries, officials need to respect these new laws, and they need time to adjust to this. We are making progress, but compared to Western countries we have a long way to go.”

China’s leaders are keen to speed up the rate of reform. When Premier Li Keqiang visited the zone in September 2014 to mark the one-year anniversary of its establishment, he reiterated that companies should not be held back by “excessive government regulations and approval procedures.”

Since then, there has been visible progress and further restrictions have been lifted. In early 2015, for example, the government announced China would allow foreign companies to fully own e-commerce firms in the zone, a move that potentially opens up the country’s huge online retail market to global competition.

Amazon has already revealed plans to take advantage of the zone’s less stringent trade regulations and establish a logistics warehouse from which to sell a wider range of products in China.

Rate Of Financial Reform

Perhaps the main source of disappointment lies in the unfulfilled promises regarding financial reforms. When the Shanghai FTZ was launched, the central government pledged to pilot a range of economic

Foreign investments have increased every month since the zone was established

changes, including liberalization of trade and full-convertibility of the RMB. It also promised to reduce state control of interest rates, currency and foreign investment.

But halfway into its three-year term, foreign businesses are still waiting for policy changes that encourage currency liberalization. Last November, Shanghai’s mayor Yang Xiong vowed to roll out an institutional and regulatory framework to enable the convertibility of the RMB, but no timetable was agreed.

Regulators will not risk undermining the Chinese currency for the sake of speedy reforms, says Chen.“This is the toughest reform we have ever encountered. The central government is clear that we must move towards financial liberalization, but reforms will not be accelerated. In 2015, the global financial market is unstable, so we need to be cautious.”

Such explanations have not satisfied business, and at the end of 2014, finance analysts openly criticized the zone’s sluggish performance despite the implementation of some policy changes.

Last year, regulators lifted the ban on the cross-pooling of RMB, a liquidity mechanism that enables foreign investors to move capital between onshore subsidiaries to offshore headquarters via inter-company loans.

Additionally in 2014, the central government opened the Shanghai Gold Exchange, an international trading platform, in the zone. There are also plans to open eight more trading platforms for gas/oil, iron ore, cotton, liquid, chemicals, silver, bulk commodities and non-ferrous metals this year.

This year also saw a significant enlargement of the Shanghai FTZ to include the city’s Lujiazui financial district, where the city’s major multinationals and Chinese banks have their headquarters. In all the SHFTZ has nearly quadrupled in size to encompass nearly 47 square miles.

But as Tyldesley points out, the lack of a concrete timetable continues to discourage businesses from getting involved.“This is supposed to be a three-year pilot, and we’re now halfway in. If they’re not going to end it in 18 months’time, why not come out and say it? One of the biggest costs to

Initial teething problems will probably come in the form of bureaucratic integration

doing business anywhere in the world is uncertainty.” What does this all mean for Hong Kong? Ever since Shanghai’s financial reform ambitions were announced, Hong Kong-based financial experts have been concerned about the city losing its longstanding status as Southeast Asia’s global trade and financial hub.

As the undisputed window to the second largest economy in the world, the city offers foreign investors access to an international RMB trading center.

Hong Kong experts fear that if Shanghai underwent liberalization policies similar to Hong Kong, the global financial center would lose its economic advantage and its future role in China’s internationalization would be reduced.

“Particularly after the Occupy Central movement, there is a fear that Chinese government may try to deliberately develop this particular free-trade zone to replace Hong Kong’s economic role,”says Wu.“By developing an FTZ in Shanghai, they could achieve their ambitions more safely and reliably.”

However, in Mainland China, experts behind the reforms say there is little to be concerned about at this stage.

“Hong Kong has a very mature economic and political system, and this cannot be achieved overnight. I think if we could even be as successful as Tokyo in years to come, we would consider that a great achievement,”says Chen.

FTZ’s To Follow In 2015

Three more pilot free-trade zones were officially launched in Fujian, Guangdong and Tianjin in April 2015. As in Shanghai, foreign companies will be free to set up ventures without government approval, subject to the negative list, and will only need to report business plans to the authorities.

In Guangdong, the FTZ includes the Nansha New Area, Shenzhen Qianhai and Zhuhai Hengqin New Area. In Tianjin, the FTZ comprises Tianjin Port, Tianjin airport and Binhai New Area Industrial Park. The Fujian FTZ covers industrial areas in the provincial capital of Fuzhou, the whole of Xiamen and Pingtan, and a new industrial park targeting investment from Taiwan.

Initial teething problems will probably come in the form of localized bureaucratic integration. For example, the city of Fujian doesn’t have its own government, so provincial officials will need to collaborate on regulation.

“There could be internal administrative conflicts,”agrees Chen.“The Guangdong FTZ will include Shenzhen, which is directly controlled by central government rather than Guangdong city, so this could throw up difficulties.” BT