1

17 December, 2014

The Shanghai Free Trade Zone

Tom Rafferty (Editor/Economist, Asia)

tomrafferty@eiu.com

2

• Background to development zones in China

• The origins and premise of the Shanghai FTZ

• Progress one year on

– Trade and customs

– Cross-border investment

– Finance

• Outlook for the Shanghai FTZ

Introduction

3

• China borrowed from economic zone models elsewhere in Asia as it looked to pilot market-opening reforms – Shenzhen SEZ launched in 1980 to attract FDI

• Zones since rapidly multiplied in number and form, aiming to decouple an area from the national or regional economy, exempting it from regulatory or infrastructural restrictions

• Administrative powers vary, but zones can normally offer preferential policies – typically over customs tariffs, land and business tax, relaxed business approvals, one-stop services

• Economic focus has been developing entrepot trading, in turn stimulating emergence of export processing activities. Also act as clusters for specific industrial or services activities

Background

Name No. Examples Description

Special economic zones (SEZs) 5 Shenzhen, Xiamen, Zhuhai,

Hainan, Shantou, Large, demarcated areas with high autonomy. Focus

on entreport trading, export manufacturing.

Economic and technological development zones (EDTZs)

210 Tianjin, Dalian, Suzhou, Lianyungang (Jiangsu)

Large areas, but more focused on specific industries than SEZs. Technology-intensive investment.

High-tech development zones (HTDZs) 113 Kunshan (Jiangsu), Xi’an,

Chengdu High-value added manufacturing. Similar to EDTZs, but with incentives to encourage innovation, R&D

Free-trade zones (FTZs) 15 Shanghai, Tianjing,

Chongqing Export processing and bonded warehousing. Exempt

from customs, tax refunds on trade.

New Areas 7 Pudong, Binhai (Tianjin), Liangjiang (Chongqing)

Urban expansion and redevelopment

China’s development zones

4

• High-profile success stories, but also lots of failures

– For every Shenzhen, there has been a Shantou

– Central government intervened in 1990s to close swath of zones

– Others absorbed under urban municipal structures

• No guarantee of success

– Competent management with strong political connections

– Proximity to foreign markets

– Economic rationale and strategy

• Today, the purpose of development zones increasingly called into question

– No longer decoupled from national economy as a result of policy changes e.g. WTO entry, tax incentives for foreign firms pared back

– FDI more focused on domestic market

– Criticism from corruption and fiscal perspective

Background

China’s development zones

5

Shanghai FTZ

• There were local discussions of an expanded “Shanghai FTZ” in 2012, but this may have been a bid for policy support rather than a reform initiative

• Only assumed wider significance once the new leadership appointed in late 2012 took an interest, especially Li Keqiang - visited Shanghai in March 2013

– Since become seen as his pet project - renamed China (Shanghai) Pilot FTZ

• Why Shanghai?

– Superior infrastructure and administration

– Existing FTZ and associated development zones

– Strengths in financial services, logistics and shipping

– Concentration of foreign investors

– 2020 goal to be a global financial centre

• Launched hastily in September 2013

– But plans were skeletal, regulations unclear

– Haste before November 2013 plenum?

Origins and premise

6

Shanghai FTZ

Origins and premise

7

Shanghai FTZ

• Shanghai FTZ clearly partly about harnessing strengths of existing developments areas under one unified unit

– Efficiencies from unifying administration

– Making customs inspection and quarantine more efficient

• But also clear that the Shanghai FTZ was meant to be more than a traditional development zone, focused on trade and export processing

– Incubator for major liberalising reforms, before being implemented elsewhere

– Reforms, not land/tax incentives, would attract investment

– Model was Shenzhen SEZ, “Reform 2.0”

• Reforms discussed by officials before it was launched included

– Registration-based rather than approval-based FDI regime

– Opening of the services sector

– Making RMB convertible under capital account

– Liberalising interest rates

– Using RMB for cross-border settlement

– Reform of the foreign exchange management system

– Reforms to laws and government administration

Origins and premise

8

One year on

Area What has been achieved What hasn’t been achieved

Streamlined customs clearance

Relaxed quarantine and inspections compared to other zones for people and commodities. Only shipping bill required for import, rather than formal customs declaration. Reduced inspection times for good imports. Bonded goods can be held for more than 6 months in warehouses, unlike other bonded zones.

Controls on flows of people and goods still apply when exiting the FTZ.

Expanded zero tariff policies

Customs duties and import taxes exempt on imports into FTZ. Lower tariffs on personal articles.

VAT and consumption taxes still apply on goods sold outside FTZ. Personal articles tariffs still high, including luxury.

Improved customs supervision

Electronic customs supervision, meaning no in-person applications. Efforts to integrate inspection/border control/customs management. No import/export quotas.

Online trade facilitation

E-commerce firms allowed to hold goods tariff-free in bonded warehouses facilitating direct mailing from overseas e.g. Amazon. Cross-border e-commerce platform (Kuanjingtong) for firms without local presence.

Lower logistic costs yet to result in lower prices for consumers. Spending restriction imposed on Kuanjingtong.

Demonstration platforms

Waigaoqiao Directly Imported Goods (DIG) Market allow overseas suppliers to reach customers without agents. Bonded exhibition centres give firms a low-cost means of testing the market for products.

Significance limited by access to only a limited market of consumers. DIG model could be extended to automobile imports.

Trade and customs

9

One year on

Area What has been achieved What hasn’t been achieved

Liberalisation of FDI regime

Foreign investment only needs to go through registration, rather than approval system, under “negative list”. Controls on FDI in 23 services sectors liberalised, ranging from permission to establish WFOE to relaxed JV requirements.

Investment in 139 sector remains banned under 2014 list. JV requirements still high in other areas.

Easier business registration

Subscribed registration system rather statutory. One-stop company registration process. Company registration completed before licence is granted. Reduced capital requirements.

Company registrations still taking about one month (vs a week in Hong Kong).

Encouraging outbound investment

Overseas direct investment (ODI) projects only require with FTZ authorities, rather than approval from national authorities. Online platform established to support overseas direct investment. Offshore portfolio investments permitted for qualified individuals and companies.

NDRC approval still required for ODI in some areas, including “sensitive industries”. Clarity lacking over qualifying individuals.

Cross-border investment

10

Area What has been achieved What hasn’t been achieved

Interest-rate liberalisation

Market-based interest rate for foreign-currency deposits under US$3m.

Liberalisation of interest rates on renminbi deposits. Deposit insurance system.

Capital-account opening

Two-way renminbi/forex cash-pooling via consolidated account allows MNCs to easily transfer funds between onshore and offshore affiliates. Free-trade accounts (FTAs) for residents and non-residents to trial relaxed off-shore transfers and some on-shore. Cross-border renminbi borrowing permitted, provided limited to projects in FTZ and overseas.

No cash-pooling structure and regulations onerous. FTAs ring-fenced in FTZ, with controls imposed on flows onshore (with some ‘permeation’). Conditions imposed on offshore loan-raising.

Reducing foreign—exchange controls

Free conversion of renminbi funds held in FTAs into foreign currency. More porous capital-account.

Fully convertible renminbi.

Financial sector development

Incorporation time shortened for foreign banks. Trial operations for restricted license (wholesale) banks. International gold exchange established September 2014, with offshore investment permitted through non-resident FTAs.

Full access for foreign banks and brokerages into domestic capital markets. Local renminbi-denominated bond issuance. Other commodity trading platforms under discussion.

One year on

Finance

11

• Against its stated purposes, the Shanghai FTZ has been a disappointment

– Benefits of the Shanghai FTZ relate mainly to trading and logistics activities

– Incremental financial reforms promise efficiencies, notably cash-pooling, but often burdensome

– Progress on promised ‘big bang’ reforms has been underwhelming, modest opening of the capital-account and few developments in terms of financial sector, interest-rate or exchange-rate liberalisation

– Governance reforms also limited, rather than a significant scaling back of its role

• Besides lack of significant reforms, there are practical problems in doing business in FTZ

– Lack of quality office space, mainly warehousing and small-scale manufacturing facilities; outside the main financial centre

– Limited geographic scale acts as disincentive to foreign firms looking to expand into the services sector

– Administrative planning issues are widely reported, poor policy coordination and too many bureaucracies involved; no umbrella agency established despite discussions

– Corporation tax is high, and incentives only apply to certain industries—disincentive to financial services firms compared with Hong Kong and Singapore

• Corporate interest has been mixed

– Over 12,000 companies registered in the FTZ since it was established, but few engaging in taxable activities

– Most engaged in trading (+50%), followed by services

– Foreign firms represent just over 1,500 of the total, most taking ‘wait and see’ approach

One year on

Summary

12

• Pace and nature of reform appears to have disappointed the central leadership

– Shanghai FTZ party secretary dismissed amid rumours of corruption in September 2014

– City bureaucracy conservative, economy dominated by SOEs and powerful vested interests

– Free-wheeling Shenzhen may have been a better choice

• Many of the reforms trialled in FTZ now being expanded nationally, reducing Shanghai’s distinctiveness

– Customs measures adopted in FTZ have been rolled out elsewhere

– Cross-border cash-pooling now permitted in other places (under slightly tougher restrictions)

– FDI liberalisations set to be copied under new NDRC guidelines, BITs and FTAs

– Interest rates on forex accounts liberalised nationwide

– Interest rates on renminbi accounts also being gradually liberalised

– Shanghai-Hong Kong stock-exchange connect more significant from capital-account perspective

• Timetable for the big financial changes resides with the central government

– Many of reforms are national in nature, do not suit pilot status

– Regulators biased towards conservatism and concerned about leakage and arbitrage in Shanghai FTZ

– National economic considerations will determine pace of reform efforts

The outlook

Troubles ahead

13

• Shanghai has first-mover advantage, but competition from other cities is heating up

– Xi Jinping has called on Shanghai FTZ to be expanded to other areas

– Provinces have discussed combining existing zones e.g. Tianjin, Fujian and Guangzhou, Chengdu

– Most areas will focus on trade and customs issues, but PRD zone would be very competitive

• Meanwhile, policy focus of the central government has shifted elsewhere

– Silk Road initiatives set to focus on central, western and southern China

• There is still a chance for Shanghai

– Talk of expanding FTZ to include Shanghai CBD, although this will prompt demands from elsewhere

The outlook

Troubles ahead

14

Conclusion

• Shanghai FTZ may have missed its chance to be a major pioneer of reforms, like Shenzhen in the 1980s

– Major policy shifts have been held back by national government

– Modest innovations and improvements it has introduced look set to be quickly replicated elsewhere

– Initial planning may have been poorly designed and rushed, but local bureaucracy may not have helped

• The failure of Shanghai does not necessarily bode poorly for the broader reform agenda

– Consensus behind the big financial reforms looks solid, but doubts persist over timing and scale

15

Analysis

• Regional economic, industry and policy trends in China

• 31 provinces + 287 prefectures

• Quarterly written reports on all provinces and 40 largest cities

Data

• Unique relationship with the National Bureau of Statistics

• Data cleaning, ranking and benchmarking

Forecasts

• State-of-the-art econometric framework—dynamic time series

• Data published on GDP, demographics, income bands published to 2020

Access China