Shanghai free-trade zone

Shanghai free-trade zone (FTZ) is the first Hong Kong-like free trade area in mainland China. The plan was first announced by the government in July and it was personally endorsed by Premier Li Keqiang who said he wanted to make the zone a snapshot of how China can upgrade its economic structure. Other mainland cities and provinces including Tianjin and Guangdong have also lobbied Beijing for such approvals. The Shanghai FTZ will first span 28.78 square kilometres in the city's Pudong New Area, including the Waigaoqiao duty-free zone and Yangshan port and it is believed it may eventually expand to cover the entire Pudong district which covers 1,210.4 sq km of land.

CommentInsight & Opinion

Shanghai free trade zone won't thrive without all stakeholders on board

Chi Lo says local officials, interest groups have no reason to back reform

PUBLISHED : Thursday, 10 October, 2013, 12:00am
UPDATED : Wednesday, 09 October, 2013, 10:32pm
 

The launch of Shanghai's free trade zone has generated much excitement about accelerating China's structural reforms, capital account convertibility and internationalisation of the renminbi. Rhetoric and excitement aside, however, no one is asking the fundamental question of whether the incentives for the various stakeholders of the free trade zone are compatible.

This is the single most important issue in determining whether free trade zones can deepen China's structural reforms.

For the sake of systemic stability, fund flows between the free trade zones will not be fungible in the medium term; investment and business opportunities will be restricted to within each zone.

These conflicting interests have created a strong incentive for capital flight, the biggest obstacle

Other areas are expected to join the free-trade-zone queue. Arguably, these zones are the "financial cousins" of the special economic zones, which China set up in the early 1980s, and a natural next step up the value chain of economic reforms.

From a policy perspective, Beijing used special economic zones as a tool to build political and public support for reforms, and it is trying to replicate the success of that model, to revive economic vigour. However, things are not as simple today.

The incentives to reform the economy were aligned among all stakeholders of the special economic zones. Together with globalisation, they gave everyone a reason to focus on production and, hence, on getting rich by expanding China's aggregate demand through exports.

Economic interests were further cemented by an implicit social contract, struck between Beijing and the people following the 1989 Tiananmen incident, in which the party provided rising living standards in return for people not questioning its monopoly of power.

Most Chinese accepted this social contract - until recently. Now, wealth inequality is more serious, raising awareness among the poor that it is policy, not just corruption and incompetence, that bars them from sharing the benefits of growth. Also, the wealthy and intellectuals are taking more notice of the reform process to protect their interests.

In other words, the incentives are not compatible. Many of the interest groups that supported economic reforms to get rich are now turning against deeper reforms, as they will destroy rent-seeking opportunities. Intellectuals realise upward mobility is capped, and many believe further reforms will only benefit the elite. Since the free trade zones focus on finance and commerce, which are more fluid activities than manufacturing, this incompatibility is going to be a serious problem.

The central leadership wants to deepen reforms. But local authorities and many interest groups are resisting more changes to protect their short-term gains. Meanwhile, the public wants accountability from the government and a more equal distribution of wealth.

These conflicting interests have created a strong incentive for capital flight, the single biggest obstacle to allowing fungible fund flows between the free trade zones when Beijing allows free capital account and renminbi convertibility in them; by allowing free access to the free trade zones, China would effectively open up its capital account and risk massive outflows. This is also why Beijing is likely to restrict to within the zones any financial activities with the potential for free convertibility.

Establishing rules for what financial institutions can do in the free trade zones is complicated in the face of this.

Realistically, the zones are not likely to be a game changer for deepening China's structural reforms until the incentive problem is resolved.

Chi Lo is a senior strategist at BNPP IP (Asia) and author of The Renminbi Rises: Myths, Hypes and Realities of RMB Internationalisation and Reforms in the Post-Crisis World. Opinions here are the author's own

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