Can China Save the Shanghai Free Trade Zone?

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Chinese Premier Li Keqiang wrapped up an inspection tour of the Shanghai Free Trade Zone (FTZ) this week. The FTZ, which formally opened on September 29, 2013, was expected to become a laboratory for extensive financial reforms, providing a blueprint for the marketization of China’s financial sector. Amid criticisms that the reforms are not moving fast enough, Li urged government officials to push through new policies.

Li has a lot riding on the success of Shanghai’s FTZ, as he was reportedly one of the major political backers for the project. When it opened in September 2013, expectation for the new FTZ were sky-high. Hu Shuli, the editor-in-chief of China’s Caixin Media Company described the project’s importance in an op-ed: “Clearly a major plank of the leadership’s reform drive, the Shanghai free trade zone could well mark the third major milestone in the liberalization of the Chinese economy, following the establishment of the special economic zones in the 1980s, and the country’s entry into the World Trade Organization in 2001.” Hu added, “Shanghai’s mission — to liberalize trade, ease rules for investment, streamline its administration and restructure its financial system in line with international standards — is a matter of national interest.”

So far, however, the FTZ has not lived up to that admittedly ambitious billing. At the beginning of September, the Financial Times described a growing sense of disappointment at the lack of progress on promised financial deregulation within the zone. FT argued that there had been a “near total lack of substantive changes” on issues such as liberalizing interest rates and loosening restrictions on capital flows. Instead, the zone seemed to be focusing on easier (and less crucial) reforms, such as the relaxing restrictions on merchandise trade. Financial reforms are much more critical for China’s long-term economic rebalancing.

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Reuters came to a similar conclusion in its own analysis this week, calling the FTZ’s first year “disappointing.” Despite plans to turn the Shanghai FTZ into a major hub for foreign and multinational corporations, Reuters noted that, as of June 2014, newly registered foreign companies represented only 12 percent of firms operating in the FTZ — and foreign companies based outside of Hong Kong and Taiwan accounted for a mere 6 percent.

The lack of reform progress has frustrated both businesses and China’s central government. As Zach noted on his “Pacific Realist” blog earlier this week, the struggle to get the Shanghai FTZ off the ground represents the larger difficulties reformists like Li and President Xi Jinping face in changing long-standing policies. It’s particularly embarrassing given the fanfare from Beijing surrounding the new project. The Shanghai FTZ was supposed to symbolize China’s new era of economic reform; its slow progress raises larger concerns about the political viability of economic rebalancing. As CEBM Group chief economist Su Chang told Financial Times, “What we know for sure is Beijing is not very happy with the current status of the free-trade zone.”

In another blow to the project, the Shanghai FTZ will have to find a new chief. Xinhua reported on Monday that “Dai Haibo no longer serves as Communist Party chief and executive deputy director of the administrative committee of the China (Shanghai) Pilot Free Trade Zone (FTZ).” That report did not make clear why Dai had left his post. According to the South China Morning Post, Dai was forced to step down due to suspected disciplinary violations, part of a broader anti-corruption campaign focusing on Shanghai.

FTZ insiders lamented the loss of Dai, whom SCMP described as “a technocrat with experience attracting foreign funds to economic zones.” A Pudong government official told SCMP that Dai’s departure “could somewhat slow down progress in developing the free-trade zone” — a worrisome sign, especially considering progress was slow enough even with Dai at the helm.

Against this backdrop, Li Keqiang’s inspection tour of the Shanghai FTZ served as a reminder of how invested the central government is in the project. Li also threw his weight behind the need for further (and faster) reforms. According to Caixin’s report, Li was shown the new, streamlined “negative list” that regulates off-limit business activities in Shanghai. On one table was the original list, with 186 articles. A second table contained the modified list, with 151 articles, while the third table had the list as its stands today: 35 articles. Li reportedly pointed to the third table and said that the FTZ must continue to shorten its negative list, providing more space for the market to develop. Li also argued that shortening the negative list would make government oversight simple and more effective — it’s harder to prohibit something than to permit something, Li said.

Li placed a special emphasis on making the FTZ more welcoming to foreign firms. When FTZ officials bragged to Li that Chinese state-affiliated companies and privately owned companies both received equal treatment, Li was not impressed. He stressed that it’s not enough for SOEs and private firms to be on equal footing; foreign and domestic companies must also be treated equally. Li reminded everyone that the Shanghai FTZ should entice multinational companies to move their research and development, investment, and sales departments to Shanghai. To attract these giant firms, Li said, the FTZ needs to be more open.

Li’s high-profile visit to the Shanghai FTZ is a reminder that the zone is still a work in progress. It’s far too early to label the initiative a failure, even if progress so far has been disappointing. Wang Ju, senior foreign exchange strategist at Hong Kong’s HSBC, told Financial Times that the “initial preparation stage could seem to be long and slow.” But that does mean change won’t come. “Once the reforms kick in,” Wang added, “things will change fast.” Even with the slow pace of reform, Shanghai FTZ has already attracted some foreign giants (most notably Amazon). Xinhua noted that the number of businesses operating the zone had ballooned from 8,000 to 20,000 in the past year.

Ultimately, the FTZ experiment in still on-going. There are already plans to open 12 other FTZs within China, including in the city of Tianjin and in Guangdong Province. While basically modeled off the Shanghai version, each of these FTZs will test out new policies and approaches. According to CCTV, an independent organization is currently evaluating Shanghai’s FTZ in part to see how best to set up FTZs elsewhere in China.

As Li reminded FTZ officials in Shanghai, “the scope of the free trade zone is limited, but the potential for reform is limitless.” So far, the FTZ hasn’t lived up to that potential. With new directives from on high, its first anniversary on the way, and looming competition from the other planned FTZs, now is the time for the Shanghai FTZ to get serious about the promised reforms.

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