FTZ a test ground for reform

The free trade zone (FTZ) set up in Shanghai is expected to be a testing ground for new policies, with focus on liberalizing China's service sector, financial services in particular. Successful innovations will ultimately be rolled out nationwide, but probably only after many years. As such, this is an experiment worth watching but probably not the game-changer some believe it to be.

The imminent establishment of FTZ, covering 29 square kilometers in eastern Shanghai, has been welcomed as an important step forward in China's economic liberalization. The details of how the FTZ to operate remain sketchy and many details will probably remain so for some time. But the overall plan and general rules, which have been released, as well as comments in the official media have given a broad outline of what to expect.

The FTZ amalgamates four existing trade areas in Shanghai that are home to many trading companies. The key new development will be wide-ranging liberalization of the zone's service sector, including opening it up to foreign companies. This focus on liberalization of services marks a key difference with the special economic zones (SEZs) set up in the 1980s, which targeted manufacturing.

Three sets of reforms have been proposed. First is the lifting of controls on investment in service sectors, including healthcare, education, shipping and other business services in the FTZ. Across China, these sectors remain dominated by State-owned enterprises and are largely protected from foreign competition.

Second, financial services will be covered by the reform. According to the plan, the government will consider to ease capital controls on companies operating in the FTZ (allowing renminbi convertibility and access to global financial markets), to remove restrictions on bank interest rates, and to allow both domestic and foreign banks to offer a broader range of financial services. Further details are still missing.

And third, the government's role in administering the FTZ will be curtailed. For example, all forms of investment will be allowed unless explicitly prohibited by the "negative list". This would be far less restrictive than the usual practice of limiting investment to areas that have explicitly been permitted.

This is the latest effort of the new leadership to promote the role of the service sector, which has remained relatively small given the country's level of development. With other cities vying to set up FTZs, the presumption is that successful innovations in Shanghai will then be adopted by FTZs in other cities, and subsequently rolled out across the country. This process, therefore, has the potential to transform China by opening up large parts of the economy to competition and reducing the role of the State.

Several global banks have warmly welcomed the plans. This should be no surprise. For them and other foreign companies, FTZs in Shanghai and hopefully in other cities could offer a bridgehead into markets in China that they have been trying to penetrate.

But there are stumbling blocks that are likely to prevent as rapid a transformation as some commentaries have suggested.

For a start, it looks likely that reform measures will be introduced over a period of years in Shanghai rather than at one go. One reason for that is that officials will want to avoid the instability that could follow a "big-bang" approach. Besides, simply reaching an agreement on how to proceed will prove difficult given the various ministries, regulators and levels of government involved.

The slow take-up of the property tax, still being tried out on only a limited scale in just two cities, is a reminder that pilot reforms can fall by the wayside when key interest groups don't agree on how to proceed.

Perhaps the most important difficulty for the FTZ's architects is the challenge of experimenting with new models on a meaningful scale while also containing their impact. It looks much more difficult than it is for traditional SEZs focusing on the manufacturing sector.

Proposals to loosen capital controls, for example, would open massive arbitrage opportunities for companies able to shift money in and out of the zone. There will be regulatory arbitrage too if FTZ-based companies are able to offer services to businesses elsewhere in China. If the zone does embrace significant liberalization then regulations will have to be put in place to govern transactions with the rest of China, such as quotas for lending from FTZ-based banks. In that case, the benefits will take time to spread.

In sum, the Shanghai FTZ will probably act as a test ground for reforms before they are rolled out elsewhere. In this regard, it is a means to achieving the government's long-stated plan of gradually opening up the service sector and the capital account without in itself accelerating either process. A great deal still remains uncertain. The Third Plenary Session of the 18th Communist Party of China Central Committee, scheduled for November, should provide a clearer picture.

The author is China economist at Capital Economics, a London-based independent macroeconomic research consultancy.