Shanghai's Long-awaited Free Trade Zone Opens Sunday

On Sunday, China's State Council is due to set in motion a long awaited pilot plan for the 28.78 sq km Shanghai Free Trade Zone, marking a major milestone for the country's cautious, step-by-step economic liberalization that began 30 years ago.

It is a Big Bang that has Hong Kong officials looking nervously over their shoulders. Shanghai has been talked about as China's financial capital since at least 1995, prior to the takeover of the former British crown colony by the Chinese government, when Fortune Magazine carried a cover story titled "The Death of Hong Kong." The tycoon Li Ka-shing, Asia's richest man, for instance, warned publicly recently that the impact of the Shanghai FTZ will be much bigger and come much more quickly than the territory anticipates.

Critics have said Hong Kong, still saddled with the colonial mentality that characterized the territory prior to 1997, will have trouble meeting a competition characterized by the ability to act fast and without the hobbles of an often-fractious Legislative Council and a chief executive's office that has been steadily losing public support for a variety of reasons.

The territory's main attributes, however, remain the enforceability of contract and the rule of law, both of which are absent in the mainland, and a communications and transport infrastructure that rank among the best in the world although parts of China are catching up fast.

Some of the details of the FTZ plan were released Friday to allow experiments within the zone, in Shanghai's Pudong district, including easing restrictions on yuan, investment, trade and business management.

According to Xinhua, the state-owned news service, the opening permits reforms in six different fields including financial services including banking, health insurances and leases. Logistics are to include shipping and port management. Commercial enterprises include telecommunication and gaming services, professional services refer to a closer working with HK law enterprises, credit surveyors, travelling agencies, recruitment companies, investment managers and construction. Cultural and entertainment imply performer agencies and entertainment resorts. Social services mean education, vocational training and medical care.

"Under the preconditions that risk can be controlled, China will create conditions to test yuan convertibility under the capital account, market-set interest rates and cross-border use of the Chinese currency in the zone," according to the plan. Regulations in the zone will also be eased in 18 sectors from finance, shipping, commerce to culture.

The zone is to be modeled on existing free trade businesses in the country's economic hub - Waigaoqiao Free Trade Zone, Waigaoqiao Free Trade Logistics Park, Yangshan Free Trade Port Area and Pudong Airport Comprehensive Free Trade Zone, allowing domestic banks to provide services to depositors who are residents in other countries, according to Xinhua. It will also allow eligible foreign-funded financial institutions to set up banks and team up with qualified private banks to establish joint-ventures.

Investor expectations equal those generated when the country joined the World Trade Organization in 2001. So far, authorities have remained carefully tight-lipped on the exact policy incentives to be offered within the reform test-bed, leaving pundits to interpolate, estimate or even randomly guess what may come, just two days ahead of the National Day celebration and November's Third Plenum political conference.

With the situation unclear as to how precisely the various announced experiments will benefit and promote economic restructuring across the entire country, there will not be a quick, simple answer. By definition, pilot exercises take time and a fair dosage of mistakes will be made before the government figures out what works and what doesn't.

Despite this, there is little doubt that the zone, the brainchild of Prime Minister Li Keqiang, will steer the premier's "big market, small government" economic doctrine.

By that it is apparent that the initial details of the FTZ will be geared towards laying the ground rules for businesses - both domestic and foreign - looking to establish operations. That will foster the "big market" side of the equation, characterized by a comprehensive mix of corporates with international experience and entrepreneurial spirit.

That is the key to the State Council's decision to review four major ordinances, specifically the laws on Foreign-Capital Enterprises, Chinese-Foreign Equity Joint Ventures, Chinese-Foreign Contractual Joint Ventures and Cultural Relics Protection. The suspension of these laws for three years starting Monday is designed to break investment barriers and reduce approval protocols for the FTZ, creating the "small government" backdrop.

Furthermore, the State Council has requested that the pilot zone adopt a "negative list" regulatory regime where any sectors not specifically covered by the list will be permitted. However, the list has allegedly over 10,000 restricted items to start with, which most definitely defeats its own purpose.

Chinese analysts close to the formulation of the pilot project also suggest that beyond today's announcement, details of the reform guidelines will be unveiled in stages gradually over the coming months and into 2014, and in particular, contents relating to financial liberalizations will not appear initially.

This can only mean Premier Li wishes to focus on the real economic effects of the free trade area for now. Such policy inclinations should most immediately boost foreign trade through Shanghai, which has been underwater since the summer of last year, contracting 3.6 percent annually during the first half of 2013 even as China's overall 1H trade expanded by 8.6 percent annually, total imports and exports through Shanghai as a proportion of overall Chinese foreign trade have declined to just 10.5 percent year-to-date, compared with 12.6 percent in 2008.

In comparison, trade through Guangdong has remained roughly the same at 27 percent during the same time. Shipping, logistics and supply chain service providers based in Shanghai should experience improving fundamental from the anticipated trade liberalization.

Hong Kong-listed Shanghai free trade zone concept stocks spared no time in riding the wave higher on the optimistic outlook, but the gains are far more muted in comparison to their A-share peers listed in Shanghai. Relevant shipping companies, logistics and port operators listed in Hong Kong have moved higher by as much as 22 percent since July 3 when the State Council approved the creation of the zone. Their Shanghai peers have surged between 15 percent to 200 percent since.

(Steve Wang is Research Director and Chief China economist for the Hong Kong-based REORIENT Securties Ltd. He is a regular contributor to Asia Sentinel.)