The China (Shanghai) Pilot Free Trade Zone has been considered an important step in the further opening of China’s markets and a weather vane for the next phase of reforms.

The market focus has been largely on financial reform within the free trade zone, principally interest rate liberalization. Market watchers are particularly excited about the prospect of convertibility of the renminbi on the capital account, on a first-to-do and first-to-try basis, within the zone.

Ongoing discussions over the zone tend to generate the impression that it will be merely a testing ground for financial reform. Is that true?

We believe this understanding is too narrow and overlooks the importance behind supportive reforms in various areas within the zone. Excessive emphasis on financial reform and impractical expectations of its progress seem to be market hype creating castles in the air. That’s likely to result in confusion and disappointment in the short run.

 What is exactly included in the Shanghai free trade zone?

It is a testing ground for financial reform that takes on a new look. Overall, the pilot reforms within the zone comprise four areas: trade, investment, finance and government administration.

Trade

Upgrading trade is an essential part of the new zone and comprises two aspects.

The first is liberalization of traditional trading businesses to achieve free imports, storage, re-exports, processing and manufacture of goods within the zone. There are no essential differences from the preferential policies provided by existing bonded zones, but further initiatives may be undertaken to relax customs and tariff regulations.

Secondly, there is expansion of Shanghai’s position in relevant sectors in the development of the trade sector. For instance, the free trade zone has proposed to bring into full play the linkage of Waigaoqiao Port, the Yangshan Deep Water Port and the Pudong International Airport. It also proposes to develop Shanghai as an international shipping center by developing shipping finance, international shipping and ship management, among other things.

Moreover, an international commodity trading platform and warehouses for the delivery of commodity futures are expected to be built. International trade covering energy products, industrial raw materials and agricultural products is to be conducted within the zone. If these goals are achieved, they will boost Shanghai’s prosperity and profile as a free trade port.

Investment liberalization

Negative-list and pre-establishment national treatment policies will be adopted across the board within the zone. The negative list approach means that all sectors will be opened up, except those specifically excluded by law. Although there is only a single-word difference with the positive list approach — which allows only sectors specifically included by law — the two approaches are totally different. The negative list approach is a demonstration of decentralization of government power.

The pre-establishment national treatment will be offered to foreign firms, which means the majority of the investment within the zone will be subject to a filing system. Foreign investments within the zone will no longer be under the administrative control of the prevailing Catalogue for Guiding Foreign Investment, which sets restrictions on foreign ownership and scope of business.

Finance reform

Financial reform measures within the zone that are circulating in the market include nine aspects:

Interest rate liberalization, or market-oriented pricing for assets of financial institutions.

Convertibility of the renminbi on the capital account on a first-to-do and first-to-try basis.

Foreign banks and joint venture banks between domestic private capital and foreign capital to be allowed to establish.

Restricted license banks would be allowed to be established.

Foreign-invested credit ratings companies would be allowed to be established.

Some Chinese banks would be allowed to engage in offshore business.

Financial lease businesses would be encouraged and tax incentives offered.

Overseas companies would be gradually allowed to participate in commodity futures trading. Financial lease companies would be allowed to engage in the commercial factoring business related to their primary business, and overseas futures exchanges would be allowed to set up warehouses for the delivery of commodities futures.

Project companies engaged in overseas equity investment could be subject to a 15 percent corporate tax, in line with the high-tech service sector.

Government administration

Measures should be announced on addressing the administration process and legal restraints. We believe the transition of administrative functions of government is the most essential part of the reform within the free trade zone, redefining the relationship between government and the market.

For example, the negative-list approach on investment will help China to certify to the latest standards of international trade to enhance investors’ confidence and get them motivated. More importantly, it will represent a fundamental change in the existing concept of the administrative process in China. It will result in the market playing a more important role.

In terms of legal restraints, the Shanghai free trade zone has been allowed an ad hoc three-year suspension of implementation of three foreign investment laws — on wholly owned enterprises, Chinese-foreign equity joint venture and Chinese-foreign contractual joint ventures — that were enacted by the National People’s Congress in late August.

 What to expect in the near term?

The free trade zone is built by on the guideline of “complete deregulation of the first tier, safe and efficient full-control of the second tier and free flow of goods.”

The first tier refers to the relationship between the free trade zone and abroad involving goods that can freely exit from and enter into China free of customs supervision. The second tier refers to the relationship between the zone and the rest of the mainland, where movement of goods are subject to applicable taxes and regulation.

The guidelines are fairly easily understood when applied to trade of physical goods but somewhat confusing when applied to the financial industry. That has given rise to speculation and uncertainty. Does a financial institution have to open a branch or subsidiary in the free trade zone to benefit from the financial reforms? Does complete deregulation of the first tier mean full liberalization of financial operations within the free trade zone?

We believe the government is unlikely to make an aggressive move in reforming the financial market. In the near term, financial reform in the free trade zone will focus on three aspects:

Lowering the threshold for the establishment of financial institutions.

Potential removal of restrictions on certain offshore financial businesses, followed by extension of renminbi convertibility and cross-border investment.

Channels connecting the free trade zone and the rest of the mainland may be made available to enable capital flows to a certain extent but will be highly restricted in the near term.

The free trade zone cannot be built overnight. Some rules regarding the free trade zone have been unveiled. Those, however, are only the beginning rather than an end. More specific rules and improvements are expected to phase in over the next one or two years.