Oct 21, 2013 05:48 PM

Will Economic Reform Policies Get into the Zone?


The Shanghai Free Trade Zone (FTZ) launched last month is touted as an important part of the Chinese government's new reform strategy. By supporting the China-U.S. Bilateral Investment Treaty (BIT) talks and also preparing for eventual participation in the Trans-Pacific Partnership (TPP) negotiations, the Shanghai FTZ may help take China's economic opening to a new level. These steps could also benefit the Chinese economy in a similar way to WTO accession more than a decade ago. But there are still uncertainties about what the Shanghai FTZ can achieve.

Some commentators compare the Shanghai FTZ with the Shenzhen Special Economic Zone (SEZ) launched about 30 years ago. It is certainly correct that both are important steps undertaken by the central government to liberalize the economy. However, there are important differences. While the Shenzhen SEZ focused on manufacturing industry, the Shanghai FTZ concentrates mainly on service sector liberalization. The Shenzhen SEZ's initial success led to large numbers of SEZs and industrial parks across the country. By contrast, senior policymakers indicate that there will be no other FTZs of the same type. The Shanghai FTZ itself will likely be short-lived as most of the experimental policies, if successful, should be extended to the whole nation within two to three years.

The Shanghai FTZ, covering an area of 29 square kilometers, is built on four existing tariff-free zones. The State Council identified six key service areas for further opening in the Shanghai FTZ: finance (such as banks, medical insurance and financial leasing); shipping; telecom and computer games; professional services (like legal services, credit investigation, travel agency, human resources, investment management, project design and construction services); cultural services; and social services (like education, training and medical services).

The Xi Jinping-Li Keqiang leadership's new opening strategy has two clear motivations.

The first is to support sustainable growth in China. While the country has achieved very rapid economic growth since the beginning of economic reform, serious imbalance, inefficiency and inequality problems dim the outlook for continuation of strong growth. China's GDP per capita has also risen from US$ 200 in 1980 to US$ 6,000 in 2012, and it is now a middle-income country. The once unlimited supply of labor has been replaced by labor shortage and rapid wage growth. All this means that China needs further reforms to improve economic structure and support industrial upgrading. WTO entry at the end of 2001 generated positive impacts on the economy. But the economy now needs new impetus to take it to the next level. The new opening strategy underpinned by the Shanghai FTZ will hopefully serve that purpose.

The second motivation is to be a part of the rule-making process for the future of the world economy. Given the difficulties with WTO's Doha Round, the TPP negotiation, if successful, may well design set the blueprint for a new standard of global economic liberalization. Although China has expressed a suspicion of, and reluctance to join, the TPP, a number of senior officials have now indicated that China wants to participate in the negotiations. This is because the high standards for state sector reform, protection of intellectual property rights, service industry liberalization and the freeing of agricultural trade are all potential reforms on which the Chinese government wants to embark in the national interest. As one official put it, a TPP without China is incomplete on its own — but it is also a loss for China. More importantly, by participating in TPP negotiations, China would be able to help make rules for the future global economy.

This is why the Shanghai FTZ has accepted the two conditions China agreed to in negotiating the BIT with the United States: pre-entry national treatment and the negative list. In this sense, the Shanghai FTZ is the test ground for a future China-U.S. BIT and could also become an important preparatory step toward eventual TPP participation. If China can demonstrate through the Shanghai FTZ its ability to liberalize the service sector and protect intellectual property rights, then it might be able to increase the TPP negotiating parties' confidence in welcoming Chinese participation.

Still, it is not yet clear exactly what the Shanghai FTZ will achieve. While it adopts the negative list approach, it is a very long list. This was perhaps why initial responses by foreign companies were less than enthusiastic. There is also a question about the government's support for the Shanghai FTZ. The public was surprised that no national leader attended the FTZ's opening ceremony, and there are reports of reservations among government departments about the policy experimentation.

A more fundamental issue is whether service sector liberalization can actually be effectively tested in such a small area. Local authorities have been emphasizing the importance of the Shanghai FTZ to interest rate, exchange rate and capital account reforms, but it is not clear how it will work. Taking interest rate liberalization as an example, can the FTZ form market-based interest rates among just a dozen banks and another dozen corporates, without the reference of a risk-free yield curve? And how would the FTZ control inward and outward capital leakage? Would the FTZ set strict quotas for every institution or would it establish strict capital account controls vis-a-vis the rest of Shanghai? The same applies to other service industries. Would a new telecom company established inside the FTZ be able to service clients outside the FTZ? If the answer is no, then no company would want to establish operations in the FTZ. If the answer is yes, then it really means nationwide liberalization.

Recall how, at the beginning of the reform period, the Shenzhen SEZ had an important demonstration effect because almost nobody had experience in a market economy. But now the Chinese economy's transition to a market economy is more than halfway there. And many remaining reforms are not conducive to experimentation in a small area. So while the Shanghai FTZ is a very important step, as a part of the government's new opening strategy, a more promising focus may be on the reform programs to be unveiled at the third plenum of the Communist Party's 18th Central Committee meeting within the next few weeks.

The author is professor of economics at the National School of Development, Peking University, and adjunct professor at the Crawford School of Public Policy, Australian National University

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