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Relaxed trade policies may spur innovation, new competitiveness
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The China (Shanghai) Pilot Free Trade Zone will encompass four existing bonded zones in the Shanghai area.
While these zones already enjoy free tariffs for intra-country trade, internationally imported goods that enter into the mainland from these zones were still subject to import tariffs. After the establishment of the new zone, companies there are bound to enjoy more freedoms in international trade. At the very least, customs approvals will probably be simplified.
Besides trading freedom, businesses in the pilot zone will likely enjoy more operational freedom than those situated in other areas. The zone will also offer exclusive financial freedoms such as full currency convertibility and liberalized interest rates. The removal of trade barriers is obviously a key feature of the free trade zone and can be implemented almost immediately. The zone will adopt a “negative list” approach for foreign investment and trade, meaning foreign trade for both goods and services will be allowed as long as the goods or industry are not on the list. China currently uses a “positive list” approach.
In 2012, Shanghai’s total trade was 137 percent of the city’s gross domestic product. After the opening of the new zone, there is potential for trade to increase to around 150 percent of GDP in the first two years, and to more than 200 percent after that. The Shenzhen Special Economic Zone’s trade was 227 percent of GDP in 2012.
The leadership’s decision to initiate the trade zone shows that it has not given up on the trade sector despite its declining significance to GDP growth. Rather, it is adopting an innovative approach to instill competitiveness in the sector. This is particularly important as other economies are actively forming trading blocs and partnerships — the most prominent being the Trans-Pacific Partnership, whose members account for nearly 40 percent of global output and about a third of world trade.
The free trade zone serves as a testing ground for capital account convertibility onshore. Experiments on interest rate liberalization and free renminbi convertibility should follow soon after supporting soft infrastructure is set up — financial institutions will be encouraged to set up shop within the zone to provide renminbi services and trade finance. Interest rate liberalization will probably kick off first because national lending rates are already fully liberalized and leaders have talked about setting up a deposit insurance system for quite some time. If implemented successfully within the zone, it will likely be replicated nationwide quickly.
On the other hand, full currency convertibility will likely come afterwards. For one, interest rate liberalization is a pre-condition for capital account convertibility. Second, currency convertibility is a brand new experiment because it has never been tried onshore before. Even if full convertibility is implemented successfully within the zone, implementation nationwide will likely be very gradual.
At present, the most pressing challenge is how to set up an effective financial border for the zone. There must be regulations to prevent access to tax concessions and renminbi convertibility by non-zone companies. Also, a mechanism needs to be in place to prevent interest-rate arbitrage within and outside of the zone.
There is already one successful example of a special zone in Shanghai — the Shanghai Pudong New Area, founded in 1992. Apart from making significant inroads in attracting foreign investment, this zone also underpinned Shanghai’s development for the next two decades.
The Pudong area is considered special because it enjoys preferential policies not enjoyed by other special economic zones. One example is that foreigners are allowed to set up financial institutions and services companies within the zone.
In a sense, the new free trade zone will also enjoy similar operational freedoms because foreign-Chinese joint ventures and other cooperative ties will be treated the same as Chinese companies. In addition, like the Pudong area, the new zone will enjoy the removal of duties and preferential income taxes.
Given their many similarities, Pudong’s success can serve as a useful reference for the new zone. Pudong New Area’s GDP increased a staggering 63 times between 1993 and 2009 and made up about one-third of Shanghai’s economic growth in 2011. By comparison, China’s national GDP only grew 10 times over the same period.
Likewise, the Shenzhen Special Economic Zone, established in the 1980s, also enjoyed explosive growth of 25.8 percent annually on average in the past 30 years, even though it started out as a fishing village. The new Shanghai zone is bound to reap success more quickly after its launch because of the hard infrastructure already in place.
The Shanghai free trade zone is an excellent strategy, with limited downsides. From a trade perspective, it is timely to introduce this zone as global trade dynamics are slowly shifting from protectionism to cooperation. Besides, the new zone will enable China to capitalize on export opportunities from the West’s recent recovery.
The zone’s establishment is consistent with the country’s long-term goal to strengthen the services sector. Nurturing the trade sector helps to boost services sectors like logistics, finance and legal advisory. In the medium run, the zone could well be an incubator for the services sector.
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