Nov 14, 2013 03:09 PM

Balancing Financial Reform and Risk in the New Zone

Han Zheng unveiled the Shanghai Free Trade Zone on September 29

(Beijing) – Questions remain about how some of the more audacious reforms will be put into practice, but guidelines for the new China (Shanghai) Free Trade Zone clearly map out plans to experiment with more liberal interest rate and capital account mechanisms.

These financial liberalization steps are also priorities on the Chinese government's agenda for nationwide financial reform, which means any tests that succeed in the Shanghai zone could be expanded to reach other parts of the country.

The bottom line reason behind operating rules for financial reform is risk control, said Han Zheng, the city's Communist Party chief who also serves on China's 25-member Politburo, in an interview with Caixin on October 25.

Han elaborated on the reform moves at the center of the initiative and the need to strike a balance between opening doors to commercial and financial activities and preventing risk. Excerpts from the interview follow.

Caixin: What financial reform initiatives can be expected in the FTZ?

Han Zheng: The first is gradual liberalization of the capital account. The second is marketization of the interest rate system. The State Council has been emphasizing reforms in these areas for several months, and what's been done so far has involved partially liberalizing lending rates. There's still a long way to go and a lot of exploring to do before all lending rates are liberalized. These steps will be tried first in the FTZ. But while a decision has been made, the implementation rules have yet to be written. These will start to be released toward the end of the year, gradually of course.

Then we have the cross-border use of the yuan for trading and settling accounts. This has increased demands for regulation. We need a new set of regulations. The State Council has made a decision to pursue the guidelines, and authorities in charge are now fleshing it out. The principle is clear: There will be as much openness as possible as long as risks can be controlled. This is not something we can afford to get wrong. Efforts to open up, reform and liberalize are no more important than those aimed at guarding against risk. We need to open up further, and devise regulations to control risk accordingly to match the degree of openness. Last but not least, there is the issue of foreign exchange management.

These are the four financial components. Implementation details will be announced in pieces, not all at once. On any road trip, we take one step at a time.

When you say guard against risk, do you mean the risks to the FTZ from outside China?

Han: The FTZ is connected to the outside world. There are no barriers. There is a "firewall" between the FTZ and the rest of China: It's a scheme involving strict policies and rules for risk control. Because the FTZ is in China but outside the area covered by China's customs agency, its connections to the outside world must be monitored for risk.

Many things are still being worked out. My thought is that we should use this opening-up process as a springboard for reform. We should take greater reform strides while sticking to the bottom-line need to protect national security and prevent financial risk. We are almost ready to start implementing the rules. The only part that still needs work involves risk prevention.

It seems regulatory arbitrage will be inevitable in the FTZ, with its pursuit of more liberal interest rate and capital account regulations. What is the plan for striking a balance between tolerating reasonable arbitrage and protecting financial order?

Han: The People's Bank of China is working on making the policy now. I believe it will develop measures that prevent regulatory flaws and loopholes. We cannot reform and allow more risks. Preventing risk is the bottom line. This line cannot be crossed during the push for reform. How good we are at preventing risk will determine how big our reform steps are.

We absolutely cannot take systemic and holistic financial risks.

What are other highlights of the FTZ in addition to investment and financial reform?

Han: In trade, we need to update the customs rules. For customs agents to clear goods before checking them will be a major innovation. We also have other measures lined up designed to facilitate trade and make it more convenient. They will further open shipping, trade and related services.

Overall, we could not bet our hopes on everything being ready the minute the FTZ was launched. This is a gradual process that takes time. The central government has given us three years to complete the process and come up with a whole set of measures that can be replicated and used elsewhere.

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