Shanghai Breaks Ground with Free Trade Zone

(Beijing) – From the Lingang New City in the farthest southeastern corner of Shanghai, heading northern through the Pudong Airport bonded zone and to the Waigaoqiao bonded zone in the north of the city, an area covering almost 28 square kilometers has been officially named a Free Trade Zone (FTZ), the first of its kind on mainland China.

The Shanghai Integrated Free Trade Zone, as the municipal government named it, is designed to be a testing ground for foreign-related reforms in four crucial areas: investment, trade, financial services and regulations.

The proposal to create the FTZ, approved by the State Council in a meeting chaired by Premier Li Keqiang on July 3, would gradually and completely liberalize cross-border trades and allow goods to move freely inside the FTZ.

It covers four existing Customs Specially Supervised Areas (CSSAs) in Shanghai, which are bonded areas where the rules for tax, custom and foreign exchange administration are more preferential than other parts of China. 

Differential policies can encourage trade between bonded areas and foreign companies, but because they often differ from one place to another, the compliance cost can run high for some trading companies.

An important task for the Shanghai FTZ is to consolidate the regulations of different CSSAs and reduce administrative costs, said Song Hong, director of the Institute of World Economics and Politics under Chinese Academy of Social Sciences.

In this respect, Shanghai can be a trailblazer for other local governments wanting to integrate their CSSAs, he said, adding: "This alone makes it significant."

The new FTZ, of course, has a much broader agenda. Its proposal plan has laid out a to-do list for things designed to significantly reduce administrative intervention to cross-border capital flows and movement of goods.

Measures being considered include widening the scope of businesses open to foreign investors, relaxing restrictions such as their share ownership ceilings and streamlining procedures by which investments are made.

Most noticeably, the proposal plans says the municipality is working to remove the requirement for government approval in a number of foreign investment areas.

Foreign investors launching a joint-venture with Chinese companies in designated fields will no longer need to hand in a contract to the government for approval – a simple registration will do. And like Chinese companies, they can report and then start a fixed-income investment rather than having to wait for regulatory clearance as foreign investors in other parts of the country must.

Chinese companies in the FTZ will benefit as well, since outbound investments are going to be much easier if the municipal government removes the approval requirement in a number of fields as the proposal plans.

Deepening financial reform is also a top priority on the FTZ's agenda. The proposal says explicitly that interest rates within the FTZ will be liberalized and market forces will determine capital costs.

In comparison, its statement about capital account convertibility is much less straightforward, saying only that pilot programs will be launched when the risk can be controlled.

One possible scenario may involve lifting the quota restriction on the amount of foreign investors' returns that can be converted into yuan, said Liu Hongge, chief economist of CCB International (Holdings) Ltd., an investment subsidiary of China Construction Bank.

Possible changes in the financial sector also include the futures market. Overseas companies, the proposal suggests, can be allowed to trade commodity futures domestically, and the FTZ can set up bonded warehouses for the delivery of commodity futures traded in overseas exchanges. This will reduce transaction costs for many Chinese traders, who now have to use warehouses in South Korea or Singapore.

'Brain, Heart and Toe'

Shanghai has long yearned to combine and upgrade its bonded areas to an FTZ, and it is not the only local government that has the ambition and sees the potential.

Two other port cities, Shenzhen and Tianjin, reportedly filed their applications for an FTZ to the State Council in 2005 or soon after, around the same time Shanghai submitted its proposal.

But Shanghai's proposal did not gain much traction until March, when the premier visited the city and encouraged it to create an FTZ. In the meeting when the proposal was approved, he said the pilot zone will be a crucial component in building an "upgraded Chinese economy."

Shanghai's success has undoubtedly sent a heartening signal to Shenzhen officials striving to make the city's Qianhai zone an FTZ as well. But some are also concerned about competition: like Shanghai's FTZ, Qianhai is also positioned as a testing ground for financial reform, including interest rate reform and capital account convertibility.

In January, a dozen banks in Hong Kong signed yuan loan agreements with companies in Qianhai. This is the only channel for overseas yuan to flow back to the mainland. Many are looking closely now whether this will be challenged.

One official from the Qianhai Administration Bureau, however, shrugged off the concern and said Qianhai and Shanghai are positioned differently.

"Beijing is the brain, Shanghai is the heart and Qianhai is a toe," he said. "Financial innovations can be risky. They are not suitable for the heart but can be tried out on the toe.

"If the trial is successful, it can be copied elsewhere. If not, there is always room for adjustment."

The official also repeated something that has been said often: Qianhai's competitive advantage is its proximity to Hong Kong. So what Qianhai should do, he said, is bring in talents and professional service institutions from Hong Kong and help the former British colony gain better access to the Chinese market.

An executive of a brokerage firm in Shenzhen also said Qianhai does not need to envy Shanghai because it should aim to rival Hong Kong.

Hong Kong's high property prices are one factor that could drive talent to Qianhai, he said, not to mention Qianhai's preferential personal income tax policy.

Reponses from Hong Kong have been mixed. The South China Morning Post, an English-language newspaper, said the establishment of Shanghai's FTZ threatens to eclipse the role Hong Kong plays in China's economy.

Many disagree. Pansy Yau, deputy director of research for greater China at the Hong Kong Trade Development Council, is among those who said it will take time to see what the FTZ can achieve.

"The FTZ is just a big circle that has several bonded areas connected," she said. "If it turns out that its policies are just like those bonded areas, there will be no real impact on Hong Kong's trade."