Shanghai Free Trade Zone – What Next?

When the Shanghai Free Trade Zone (FTZ) was first launched at the end of September last year, many viewed the program as “the most important attempt at reform since [those of] Communist leader Deng Xiaoping, the architect of China's transformation to a market economy.” Combining four existing special areas, including a free trade zone, a logistics park, a port area, and an airport free trade zone, the 29 square kilometer FTZ located in Shanghai’s outskirt was expected to be a laboratory for China’s next step in opening its domestic market to international businesses.

As the one-year mark passed, however, many financial and corporate managers have expressed frustrations over the lack of substantive reform within the high-profile FTZ. "I think that [the Shanghai Free Trade Zone] was oversold. And in many ways, it was overbought," said Patrick Chovanec, chief strategist at Silvercrest Asset Management. According to senior analysts, FTZ has in essence become a tax-free trade zone and mostly focused on free exchange of merchandize and goods, which are hardly among the most urgent matters for China, already world’s largest exporter and second-largest importer.

In contrast to trade, measures to liberalize the capital markets and financial sector fell short of expectations. Both mainland and foreign banks, for example, are still heavily subject to regulations regarding how much capital they can loan to finance different projects. In July, lenders in the free trade area jointly wrote a letter to the China Banking Regulatory Commission (CRBC), asking for looser capital control on loans for fixed-asset investments. “The CBRC's rules have a lot of limits on what we can do in the free-trade zone. In order to create an active financing market in the zone…some limits would have to go,” said a banker who declined to be named.

To date, the most important measures taken within the FTZ include substantial reduction of red-tape and bureaucratic procedures at customs, the opening up more industries such as healthcare and engineering to foreign investment, and allowing the transfer of Yuan-denominated funds between companies’ entities registered within the FTZ and those offshore or in mainland. In addition, earlier this March, the government also lifted the deposit-rate ceiling for foreign currencies.

However, these modest overhauls post a stark contrast in comparison with the originally publicized plan, which not only called for the free convertibility of Yuan and float of interest rates, but also potentially establishing marketplaces to trade financial derivatives and foreign company shares. “We see the FTZ focused mainly on the flow of goods in and out. When it comes to capital flows, even though they’ve put out a lot of rules and regulations, we don’t see much substantive progress,” says Peng Zhenwei, economist at CEBM Group, a Shanghai-based research firm. The adopted reforms seem particularly weak considering that foreign companies already have established mechanisms to transfer funds between its subsidiaries.

In addition, the lack of transparency continues to prevail as foreign investors are often unclear about the exact rules and how they are carried out in practice. "I'm confused and I follow it (the rules). Maybe there are some lawyers out there who aren't confused, but I doubt it", said asset manager Chovanec. Currently, instead of issuing a list of restricted activities, the government is reviewing projects on a case-by-case basis, which further adds to the uncertainty of foreign business owners who want to take advantage of the reform. According to Reuters, as of June 2014, newly registered foreign companies (excluding Hong Kong and Taiwan) represented only 6% of companies operating in the FTZ.

As Dai Haibo, the chief director of FTZ, stepped aside amid rumored corruption charges China’s Premier Li Keqiang visited the free trade area right before its one year anniversary in September to remind businesses how much the central government is invested in the program. Li emphasized the importance of treating domestic and foreign firms equally in order to attract multinational giants to move their research, investment and sales departments to the FTZ. It is perhaps still too early to determine the failure of the pilot program. As Li reminded FTZ officials during his inspection tour: “The scope of the free trade zone is limited, but the potential for reform is limitless.”

In a speech earlier last week, Shanghai’s mayor pledged to speed up the liberalization process within the free trade area and gradually move toward goals such as the full convertibility of the Yuan, but he gave no specific timetable. China has been closely monitoring and controlling the inflow and outflow of capital in order to prevent foreign “hot money” from disrupting domestic markets. "We will gradually put in place an institutional and regulatory framework to enable the convertibility of the RMB under the capital account … so that the financial sector can better serve the real economy," he told business leaders in a speech.

According to People’s Daily, some 12,000 companies have registered within FTZ since last September. Foreign trade amounted to $121.7 billion during its first year of operation.