New zone to pave the way for more market-oriented reforms

Although the initial launch of the 29-square-kilometer Shanghai free trade zone in September was largely seen as a disappointment, important changes that have the potential to alter China's economic landscape are brewing.

The launch originally failed to meet expectations because there was little to no content on financial reform, the key area in which change was anticipated. Among the reforms discussed, but not initially included, were free conversion of the yuan and interest rate liberalization. Quashing hopes of imminent progress, on Oct 31, the government-run China Securities Journal said that there would be no timetable for financial reform.

However, the desire for financial reform in many ways misses the point of what is being achieved in Shanghai. All of China's most difficult reforms, from rural land and hukou to interest rate liberalization and state-owned enterprises, face intense opposition from vested-interest groups. In practice, this opposition essentially takes quick reform off the table.

One way to make progress on reform without directly breaking the hold of interest groups is to implement changes that gradually make the economy more market-oriented.

For example, instead of challenging China Mobile directly, the government is loosening entry requirements in the downstream services sector to allow newcomers into the telecoms industry. This introduces an element of competition that will force at least some reform in terms of efficiency gains in the SOEs if they want to retain their hold on these markets.

This type of change is currently happening in the free trade zone, as the main changes there relate to expanded foreign ownership and access to previously restricted sectors such as financial services, media, transport and telecommunications.

Understood from the perspective of increasing competition and encouraging new innovation, the proposal to allow foreign companies to raise money from an international board in Shanghai is less about financial reform, which continues to be disputed, and more about allowing foreign companies to invest funds raised in China to expand their domestic business and push forward other reforms.

There is also a step-change in terms of investment liberalization. For example, whereas companies previously could only undertake activities that were specifically allowed in a "positive" list, now they can conduct any activities that are not listed in a "negative" list. Companies in the free trade zone can also take advantage of favorable tax treatment.

While a lot of the focus is on the opening up to foreign investors, the real movers under the new liberalization have been domestic entities. According to government figures released at the end of last month, 213 domestic companies have been registered in the free trade zone versus just 21 foreign-funded companies. There is no doubt that domestic companies that are comfortable operating in "gray" areas of regulation are embracing the opening-up more aggressively than their foreign counterparts who, for better or for worse, must move more slowly owing to the lack of implementation details and the internal compliance and due diligence requirements.

With large-scale liberalization ongoing, it is no surprise that the Shanghai free trade zone is being compared with the creation of the Shenzhen Special Economic Zone in 1979, which initiated tax breaks and opened up the domestic manufacturing industry to foreign investment; changes that set the foundation for China's future growth.

Drawing parallels to Shenzhen, the Shanghai free trade zone should have obvious benefits for Shanghai's economy. After the Shenzhen Special Economic Zone was set up, the city saw annual economic growth of 25.8 percent over the following 30 years versus about 9.8 percent for all of China, according to government figures.

More importantly, as it happened in Shenzhen, the reforms being piloted in Shanghai will eventually be expanded nationwide. This will allow for the market-oriented reforms, removal of government red tape, and introduction of new competitive factors to be expanded to the broader economy.

A key barrier to larger economic reforms in China is the perceived risk that the government would lose the ability to stimulate growth through its system of state-owned enterprises if reforms were too drastic. If the liberalization in the Shanghai free trade zone is successful at driving growth, it will make government officials more comfortable with the idea of broader changes on a national level, setting the stage for large-scale reforms in the coming years.

The author is the head of the China office of London-based China economics research company NSBO.

(China Daily European Weekly 11/08/2013 page9)