On September 27th the State Council officially established the Shanghai Free Trade Zone, a 28 square kilometer area outside of the city where a series of liberalization experiments will be conducted. China is no stranger to special economic zones; they have played a critical role in driving growth and reform in the past. What’s new here is the attempt to erect a firewall around financial liberalization, allowing firms to experiment with new policies before they are expanded to the whole financial system.
With respect to the financial sector, the goal of the new zone is to promote financial innovation, interest liberalization and full capital account convertibility. Over the next several years restrictions in all these areas will be loosened. Moreover, investment approval for the zone is shifting to a negative list system, meaning investment areas not explicitly prohibited will be approved. Following the State Council announcement, the CBRC and CSRC released follow-up guidelines for banks and securities firms seeking to establish operations in the zone.
From a broader perspective, the FTZ has the potential to promote two key areas of economic reform, helping Chinese firms expand abroad and strengthening domestic capital markets. China has long pushed domestic firms to expand abroad as part of the “going out” strategy, but overseas investment is still small relative to the size of China’s economy and largely dominated by state-owned enterprises. Expanding abroad may become easier now with new regulations that encourage firms within the FTZ to seek financing abroad and allow domestic banks to more easily offer cross-border financial services. This should make overseas expansion easier for smaller firms who often lack strong banking relationships and have limited access to foreign financing.
Chinese capital markets should also receive a boost from the FTZ. Qualified individuals and companies in the zone will be allowed to invest in foreign and domestic equity and futures markets. This represents a break from the existing QFII and QDII programs where investment quotas are allocated by SAFE. Instead of a quantitative restriction on inflows and outflows, there will be a geographic restriction. Depending on how easy it is for financial firms to set up operations within the zone, these new rules could help boost the foreign share of portfolio investment in China which right now stands at a measly 4 percent of GDP.
The key dynamic for policymakers regulating the FTZ will be how to promote substantive liberalization without spreading financial risk to the broader economy. To be successful, the FTZ will need to make it easy for both foreign and domestic firms to establish operations and move capital across the border. However, due to the fungibility of capital, financial flows are very difficult to contain within set geographical confines. To counteract this, the requirements for establishing within the zone will have to be tight enough to keep out firms without legitimate international operations. This should help limit, but not eliminate, the impact of the zone on the rest of the economy.
The Shanghai FTZ is the most exciting reform announcement since the Xi Jinping-Li Keqiang administration came into office last fall. The experiments conducted within this zone over the next several years will have a significant influence on the future shape of financial reform. It also has improved Shanghai’s chances of developing into a genuine international financial center. As always, the devil will be in the details. Tianjin’s Binhai New Area and Shenzhen’s Qianhai Economic Zone were rolled out as testing grounds for financial reform with great fanfare but have yet to make a large impact due to lack of implementation. In order for the zone to truly be successful, policymakers will need to become comfortable with allowing the capital inflows and outflows they have resisted for so long.