The Shanghai Free Trade Zone’s Financial Firewall

Nicholas Borst (Federal Reserve Bank of San Francisco)



Earlier this week the People’s Bank of China (PBoC) released details on new financial regulations for the Shanghai Free Trade Zone. In making the announcement, the central bank has finally caught up to the rest of China’s major regulators that have already released new regulations.

The PBoC document gives a general outline of both the new policy reforms and the measures that will be taken to control financial risk. The guiding principle, one which has been repeated in other government documents, is that the focus on the free trade zone is on the development of the real economy, particularly the service sector. The purpose of the zone is to experiment with policies that will promote economic restructuring and improve competitiveness. The financial liberalization in the zone will be designed to support these larger goals, not as an end in itself.

Two special accounts will be created within the zone, resident free trade accounts (RFTA) and non-resident free trade accounts (NRFTA). These special accounts will provide the PBoC with the ability to segregate and monitor financial flows in the zone from the rest of the financial system. The separation of resident and non-resident accounts allows for another level of differentiation in policies. In general, non-resident accounts will have more constrained channels for moving capital out of the zone and into the mainland. Capital, however, will be more or less freely transferable between RFTA and NRFTAs.

The policies in the PBoC document lay out a vision of a free trade zone that will have largely free flows of capital within the zone and between the zone and the rest of the world. Corporate and individual cross-border investment will be encouraged, with restrictions requiring prior approval being eased. Cross-border financing in both renminbi and foreign currencies will also be promoted. When conditions are right, accounts within the zone will be freely convertible into other currencies. The policies and procedures for foreign direct investment registration and renminbi trade settlement will be simplified and improved. The initial steps towards market-determined interest rates in the zone will come through the promotion of large sum negotiable certificates of deposit. When circumstances are favorable, the ceiling on deposit rates for foreign currency accounts will be lifted.

Financial flows between the zone and the mainland will be subject to more limitations. Approved financial transactions, such as loan repayments and investment, will flow freely between free trade accounts and regular domestic accounts for the same entity. Companies in the zone will be allowed to invest in foreign securities markets and derivatives investments. Importantly, overseas renminbi borrowed by companies in the zone must be used for normal business purposes and cannot be invested securities or derivatives. Enterprises within the zone will be allowed to issue onshore renminbi-denominated bonds. Signaling its cautious approach to financial risks in the zone, the document declares that the PBoC retains the right to implement temporary regulatory restrictions as needed to defuse risk.

The PBoC has indicated that it will begin implementing these new financial policies within three months with the goal of a complete rollout within a year. With these new regulations, the PBoC has laid the groundwork for a financial system within the zone that is less constrained by capital controls and government interference. The hope is that these measures, combined with reforms to the corporate registration system, will be a boost to the development of the real economy in the zone and will provide guidance on how to scale these changes up to the rest of the economy. Don’t expect the Shanghai Free Trade Zone to become a Trojan horse for liberalizing the entire financial sector. Nor is the zone a replacement for the existing QDII and QFII programs. Instead look at it as a window into what a more market-determined Chinese financial system might look like in the future.

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