The Shanghai Free Trade Zone, scheduled to be launched tomorrow, will become the proving ground for experimenting with economic reforms.
The 29 square kilometre zone along Shanghai's coastline includes existing free trade port areas and the Pudong airport and will combine the free movement of goods associated with a FTZ with the policy-driven initiatives of a free trade area, says Deloitte partner Caesar Wong.
"Shanghai is really special. The Chinese government is saying: 'Can we have another Hong Kong?' Hong Kong is good at business because there are no controls on what you can do."
The FTZ will be a proving ground for further liberalisation of the mainland's capital account and financial services.
Changes are to include interest rate reform and exchange rate convertibility, and foreign banks and insurance firms should have a fast track route to opening branches in the zone.
Analysts at ANZ Bank have compared it to Malaysia's Labuan as a distinct geographical zone with separate monetary policies from the rest of the country, though the exact timeframe for reform implementation is not yet clear, nor are the legal and regulatory structures in place for the zone to fully function.
Given the fungible nature of money, the greatest challenge will be controlling the flow of capital between the FTZ and the rest of China. If capital account liberalisation takes place, the different interest rates and exchange rates will create trading distortions and arbitrage opportunities for traders on both sides of the FTZ.
It is not clear how this will be managed, or which government body will assume authority. "There must be a new supervisory framework regulating banks operating in the free trade zone," ANZ analysts wrote in a recent report.
Regional trading hubs such as Hong Kong and Dubai succeed in part because they do have defined controls and regulatory structures.
Without such controls and further reforms of the mainland banking system, says ANZ, there is a danger that leakage from the FTZ could upset the country's financial stability. At the same time, argues the report, a rush to liberalisation might precipitate a crisis similar to that experienced by the Thai banking system in the 1990s before its collapse in the Asian financial crisis.
Banks will probably need to build control systems to ensure money is not being misused outside the zone, says Clare Lu, a partner at Qin Li law firm in Shanghai.
As a bonded duty free area goods can be handled, manufactured, altered and re-exported without interference from customs; and it is expected that import duties and VAT will not be levied. The zone is designed to become a hub for logistics' firms and cargo operators and will be attractive for the bonded warehousing of commodities and raw materials, which can be used in trading or as loan collateral, and export manufacturers.
However, the geographical limitations of the FTZ will automatically restrict the latter while government emphasis appears to favour service industries in line with overall national focus towards higher value-add businesses, including foreign human resources firms and international travel agents.
Needless to say, guarding against smuggling between the FTZ and the rest of Shanghai would be a significant challenge.
With an eye on Hong Kong and other low-tax jurisdictions, the zone will be cutting its business taxes to a 15 per cent corporation tax for qualifying investors. This compares with Hong Kong's 16.5 per cent taxation rate. It is expected that income tax cuts will also be made. The mainland's top band rate is 45 per cent.