Shanghai’s Fascinating Free-Trade Zone

Shanghai, China’s new free-trade zone, has potential to be a beacon for business in the long run. Photo by Feng Li/ Source: Getty Images.

China officially unveiled its much-ballyhooed Shanghai free-trade zone (FTZ) Friday, days ahead of its scheduled opening. In a very broad sense, a promising development, as China looks to gradually open up to the global marketplace. But even with the big reveal, details are scarce, and it remains to be seen whether the reforms will have a material impact on the country’s future growth. So while the incremental liberalization is a step forward for China’s economy and global market presence, the market and investment landscape seem little changed—equity investors’ take on China should be unaffected.

The FTZ is the latest in China’s efforts to gradually open its markets to foreigners, benefitting consumers through increased competition and trade. To achieve this, China has introduced reforms in 18 industries, with two at the forefront: opening up currency exchange and allowing banks more latitude to determine interest rates.

Currency exchange is expected to provide means for many multinational firms to purchase or rent property within the FTZ—giving rise to REITs within Shanghai almost overnight. (However, China tempered expectations by setting limitations on the amount of commercial real estate firms can purchase or rent in the FTZ.) Furthermore, freer currency exchange will add flexibility and reduce costs for global firms active in the FTZ—associated with exchanging the currency.

The second major area allows banks more latitude to determine interest rates in the FTZ. Since interest rates often govern loan profitability—and are the banks’ return for taking the risk of extending loans—it actually should boost some firms’ access to capital. Notably, the smaller, seemingly riskier domestic borrowers likely gain increased access to loans. Across the 18 industries, reforms include private and foreign travel agencies, Health Care organizations, firms and art. And revisions could come as time goes on.

In the near term, however, it seems premature to expect material market and global macroeconomic impact. The Shanghai FTZ is of limited size presently, and the recent release of China’s “negative list”—providing a list of do not’s within the FTZ—was more expansive than some analysts thought likely. Despite this, some have suggested investors may be underestimating the overall significance of the FTZ, as companies don’t need to actually have operations within the FTZ in order to take advantage of new programs. Many firms can simply register and/or invest in the area in order to capitalize on the FTZ—a low barrier to entry.

But questions remain on how much officials will allow businesses operating in the FTZ to access all of China. And, it’s unclear how China can conduct an effective, controlled test of freer Yuan convertibility and interest rates. Officials are set on keeping financial freedom localized, building an effective firewall between the FTZ and the rest of the country to maintain some degree of control over the money supply and the currency. If capital flows freely, the levers they’ve historically used to goose growth may be less effective. The plans announced Friday don’t shed light on the specific ways they aim to do this. Questions remain, like:

1. How do they aim to keep foreign capital from leaking out of the FTZ and into the rest of the country?
2. How do they aim to keep funds from, say, Guangdong from departing China through the FTZ?
3. How will they limit individuals from taking advantage of the region’s potentially higher bank deposit rates?
4. If national banks reincorporate in the FTZ, will they be able to offer freer deposit rates nationwide, or will their customer base be limited to individuals residing in Shanghai?
5. If the latter, how great is the incentive for banks to go through the potential administrative hassle of relocating?

Suffice it to say, there are a lot of reasons to be skeptical of the impact of the Shanghai FTZ alone. However, while it may seem strange to only open one city, it is not the first time China has tested reforms on a localized basis to work out the kinks before a nationwide rollout. For example, in 1980, China turned Shenzhen into a special-processing zone—allowing foreign firms to use low-cost Chinese labor. It was successful and expanded—aiding China in becoming one of the world’s largest trading powers. The FTZ might have similar potential over the long term, depending on the magnitude and success of the reforms tested.

It seems reasonable to expect officials to shed more light as things get off the ground. Even then, however, it will take time to see how great the nationwide—and global—benefits could be. Officials could spend years tinkering with and testing the new rules before going nationwide. Those expecting large gains in the short term seem likely to be disappointed—incremental progress over time seems the more likely endgame. Ditto for those who expect this to be China’s magic ticket back to double-digit economic growth. Not that it needs to be for a bull market and global economic growth to continue—China’s growing off a bigger base than before and its economy likely adds more value to the world in the foreseeable future as a result.