SHANGHAI’S pioneering Free Trade Zone has made progress in market deregulation after two years in operation, but it still has a way to go in living up to the high expectations many investors held at its unveiling.

Launched amid fanfare in September 2013, the zone is designed as a testing ground for deregulation and market-opening reforms. If successful, the format is expected to be rolled out nationwide.

As of the end of August, 26,111 new companies were set up in the zone, with 19 percent foreign-funded. The proportion of companies involving overseas capital rose from 12 percent in the last year.

In the first eight months this year, two-thirds of foreign investment has come from financial leasing companies that have invested US$19.1 billion in the zone.

Volvo Financial Leasing (China) Co is representative of that segment. It was set up by the Swedish-based vehicle and equipment manufacturer Volvo Group.

Financial leasing, whereby companies purchase assets to rent to clients, is a system favored by startups and by companies with weaker credit ratings.

The Shanghai zone appealed to Volvo because of its initiative allowing financial leasing companies to conduct commercial factoring businesses.

“The combination of financial leasing and commercial factoring businesses provides an expanded space for our company,” said Paul Le Houillier, general manager of Volvo Financial Leasing. “It enables all financial services to provide more flexible, targeted and available capital solutions to dealers and customers in China.”

The company also benefited from an initiative allowing multinational companies cross-border capital management.

“That helps us optimize asset allocation and capital structure inside the Volvo Group,” Houillier said. “We are able to manage our treasury operations in a more flexible way by tapping the offshore yuan market.”

The zone also set up an international assets and equity trading platform for financial leasing companies. It allows domestic and overseas companies to trade property rights, debt and equities of leased assets, a move to improve asset management and expand fundraising channels for leasers.

Casting off the past practice of trying to woo investors with preferential policies, the zone is designed to attract them with policy reforms. Efforts are underway to streamline customs procedures, deregulate foreign investment, liberalize controls on financial flows and cut government red tape.

Quadrupling size

In April, when the zone officially quadrupled in size, officials pledged to strive for “the greatest openness.”

The zone, which covers about 121 square kilometers, comprises the Lujiazui financial hub, the Jinqiao manufacturing zone, the Zhangjiang high-tech base and the three bonded areas of Waigaoqiao, Yangshan and Pudong International Airport.

The Shanghai government is banking on the zone’s success as a centerpiece of the city’s plans to turn itself into an international financial center and global science and technology hub.

By virtue of the zone’s openness, the city is encouraging private banks to operate in the zone, providing capital for technology startups. It is also planning to set up an international intellectual property trading platform and allow overseas venture capital to directly invest in innovative domestic businesses.

The zone operates under a free trade account system designed to permit account holders to move funds in and out of China outside of the strict capital controls that apply outside the zone.

In the past year, the regulator scrapped the need for administrative approval for overseas financing via free trade accounts and allowed account holders to raise up to twice the value of their registered capital. Foreign banks were also approved to handle free trade account services.

By the end of July, 28 financial institutions opened 22,726 free-trade accounts with companies in the zone, official data showed.

Despite all the zone’s groundbreaking initiatives, there’s more work to be done to achieve the ultimate goals of the pilot project.

“Although progress has been made in interest rate liberalization and cross-border financing, there is still a lot of work that needs to be done if Shanghai is to become an international financial center,” said Pei Changhong, head of the Institute of Finance and Trade Economics at the Chinese Academy of Social Sciences.

Pei said the zone should further deregulate the system to allow more room for financial institutions to set benchmark prices.

“There are also other issues that need addressing, such as information asymmetry and miscellaneous procedures that restrict the potential of overseas borrowing via free trade accounts,” he said.

Zhang Yong, director of the zone’s policy research bureau, estimated that the maximum overseas financing via the 28 financial institutions that so far have been approved to handle free trade account services could reach as much as 330 billion yuan (US$51.9 billion). Currently, only 7.5 percent of that sum has been tapped.

Further reforms

The zone’s regulator said in June that a package of further reforms covers nearly 50 items to boost capital account convertibility and facilitate cross-border trade and investment. They will be announced after approval by the central government.

The new package of measures will include the long-awaited Qualified Domestic Individual Investor scheme, also known as QDII2. It would allow individuals to invest in overseas capital markets.

On the zone’s official website, the date of the latest policy update is June 25, a time when China’s stock market was in a dramatic upheaval. That triggered speculation that the government might delay further reforms in the zone until the market settled down.

“The stock market turmoil and fluctuations in the yuan exchange rate have had an impact on the process,” Pei said. “Regulators may be having second thoughts about reform instruments and their capacity to monitor them. But in the long term, the goal of liberalizing the capital account should not change.”

The zone continues to have problems retaining investor enthusiasm.

The business service center in Waigaoqiao has become quieter in the past year — a dramatic change from its heady first days when investors crowded in to hear about new opportunities.

“When people talk about the free trade zone, they usually start with ‘I heard that…’,” said Dai Xiaojun, chief consultant of Shanghai Shengbao Investment Co, which provides advisory services to zone-related businesses. “Confusion persists as most people rely on hearsay in the absence of clear, explicit policy language.”

Disappointment prevails in issues like preferential tax policies that are supposed to be implemented but have yet to be clearly delineated, Dai said.

Dai said his company is receiving five inquiries a day, compared with 15 when the zone first opened.

Xu Mingqi, secretary-general of Shanghai Research and Coordination Center for FTZ studies, a government think tank, said the disappointment is a result of an expectation gap between investors and the government.

“Some investors expect the zone to be a tax-free place as its name suggests, and some interpret it to be a special economic zone where preferential policies are provided,” Xu said.

“But the government actually is banking on reform of the administrative management system of the zone, aiming to draw on international practices, improve administration efficiency, streamline procedures and boost transparency.”