Shanghai Free Trade Zone: A Test Ground for the New Economic Reform Policies in China

by Davis Wright Tremaine LLP
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Shanghai mayor Yang Xiong unveiled new plans to develop mainland China’s first free trade zone in Shanghai last January. On July 3, 2013, the State Council announced its principle approval of the General Plan for the Shanghai Free Trade Zone (“the Plan”), although the details of said Plan have not yet been released. The pilot zone will cover 28 square kilometers and will include the Waigaoqiao Port, the Yangshan Deep Water Port, and the Pudong International Airport, which together had a combined trade volume of over $100 billion USD in 2012. Shanghai won State Council approval to become an international financial center in 2009, with the intention of becoming a major international trade and financial services hub by 2020. It is estimated that the FTZ will be completed in ten years. 

The measures in the Plan are expected to include a variety of incentives, including tax breaks and reduced regulatory requirements for foreign and domestic businesses. These measures will hopefully stimulate economic agglomeration, allowing initial financial institutions that benefit from the FTZ policies to inspire a virtuous cycle of business growth and bring in related industries such as accountancy and legal services as the zone matures.

Critics vary in their hopes for the Shanghai FTZ, with some predicting that the pilot program will boost trade and regional integration, allowing Shanghai to develop an internationally competitive commodities exchange. The anticipated combination of a modern transportation and communications infrastructure with a tax-free business environment would provide a strong incentive for foreign and local companies to do business in the zone, offsetting the carry-over of recent economic slowdowns throughout the rest of the country.

More optimistic observers see the pilot zone as a testing ground for a potential nationwide roll-out of structural economic reforms, including the liberalization of interest rates and eventually making the yuan fully convertible. Rumors that the plan has been personally championed by Premier Li Keqiang have strengthened opinions that the Shanghai FTZ proposal represents one of the clearest signs of the new leadership’s determination to deliver major economic reforms and bring China into the free market system. The plan’s success or failure will be a significant reflection upon the new Chinese government. If, as proposed, the Shanghai FTZ serves as a pilot program for potential nation-wide policy reforms, its development would have major implications for the business environment for foreign investors and businesses across the country. 

Summary of projected policy package and preliminary analysis
Although details of the General Plan are not yet available, the Shanghai municipal government is expected to use the FTZ as a testing ground for innovative methods in trade and investment management, as well as taking the opportunity to open up several service industries to foreign investment, relax restrictions on ownership ceilings, and streamline certain approval procedures. DWT has compiled a list of potential regulatory changes in the FTZ from publically available sources and media reports.

Loosening of capital account controls
Foreign exchange regulations in the Shanghai FTZ would be relaxed relative to current standards. Under present-day laws and regulations, foreign exchange settlements under current accounts are only permitted for purposes under the business scope of a given company, and making settlements for capital accounts requires intricate administrative approval processes. It is expected that the government would loosen capital account controls. The government would also make the yuan freely convertible for foreign exchange settlements under current accounts. Both media reports and government announcements have stressed that the aforementioned pilot programs for foreign exchange would be implemented only after comprehensive risk analysis. 

Liberalization of interest rates
Recently, the People’s Bank of China abolished the minimum interest rate restriction for bank loans. This has been seen as the latest in a long-term policy of easing bank controls. People have predicted that interest rate liberalization would be more comprehensive in the FTZ, allowing market forces to determine capital costs.

Reduced restrictions for establishing branches or affiliates of foreign invested banks
Abridged approval procedures for foreign invested banks to set up branches or affiliates in the FTZ are expected to increase foreign capital flows within the zone. Foreign invested banks would also undergo a simplified process to incorporate joint ventures with Chinese investors.

Planned establishment of bonded warehouses for futures market
The government is anticipated to allow foreign commodities exchanges to establish futures delivery warehouses in the Shanghai FTZ. This move would directly challenge the commodities business in Singapore and South Korea, and aid the financial sector in Hong Kong to expand into commodities trading. Shanghai bonded warehouses would also reduce transaction costs for Chinese traders, who have previously had to use warehouses in other countries.

Increased foreign ownership of insurance companies
Sources have reported that foreign investors will be permitted to set up wholly foreign-owned healthcare insurance operations in the Shanghai FTZ, in contrast to present-day laws which only allow foreign investors to hold up to a 50 percent equity interest in local health insurance companies.  

Changes in inbound investment regulations
Foreign companies planning to incorporate affiliates in the Shanghai FTZ zone may face reduced approval requirements, including: a replacement of approval by the local Commerce Commission with a simple registration procedure; exemptions from the need to submit a joint venture contract when entering into joint venture operations with Chinese counterparts in the FTZ; and being allowed to have fixed-income investments in the FTZ, providing that such investments are reported to the relevant authority.

Changes in outbound investment regulations
Chinese companies seeking to invest abroad may face reduced limitations on raising funds overseas. The government may also remove the approval requirements for companies registered in the FTZ and investing overseas in specific fields. Currently, outbound investments by Chinese companies are subject to prior approval by local branches of the National Development and Reform Commission (NRDC) and the Ministry of Commerce (MOC).

Lowered minimum registered capital requirements
Companies in some industries incorporated in the Shanghai FTZ would benefit from a lower minimum registered capital requirement. This policy is anticipated to encourage the development of industries such as finance leasing, which have previously suffered from prohibitively high minimum registered capital requirements.

Liberalization of cross-border trading and free movement of goods within the FTZ
Customs formalities in the FTZ would be greatly simplified, allowing goods to move freely in and out of the FTZ. It is anticipated that the entry of goods may require only a registration of the variety and value of imported goods, rather than facing inspection or other forms of customs interventions.  

Encouragement of foreign-owned international travel services
Currently, foreign-owned travel agencies are not allowed to provide international travel services in China. However, foreign investors may be allowed to set up joint ventures with Chinese partners in the Shanghai FTZ to provide international travel and holiday services to Chinese nationals. Travel agencies will still not be allowed to organize travel to Taiwan. 

Conclusion
Precedents for the Shanghai Free Trade Zone date back to the Shenzhen Special Economic Zone, established in 1980, which was one of the most successful economic liberalization experiments in China. However, less well known examples since then also attest to the risks of legislating economic zones: the Shantou SEZ, which was begun in Guandong Province the same year as Shenzhen, has seen far less growth. Preferential tax treatment zones in Yantai and Liangyungang, established in 1984, have helped local economies but are relatively unknown outside of their immediate territories. A new economic pilot program in Qianhai earlier this year has attracted few investors, who say they are waiting for improved financial infrastructure reforms before starting ventures there. A similar program in Wenzhou has been crippled by delays in liberalizing interest rates; critics have speculated that the existing agencies in the region would have insufficient manpower and resources to effectively regulate the zone even if it were successful.

Some believe that the Shanghai FTZ will succeed where its predecessors have failed because it is uniquely advantaged. Like Shenzhen, Shanghai’s zone will be situated in a vibrant economic area, able to draw on a talented pool of financial professionals and businesspeople. The zone will include one of the best-equipped and largest trade ports in the world, which can handle a large volume of trade and potentially form the basis for a robust financial market. The Plan includes a specific proposal for liberalizing interest rates, having apparently learned from the lessons of Wenzhou. Perhaps most importantly, the Shanghai FTZ is said to be directly backed by Premier Li. Many have attributed Shenzhen’s prosperity to Deng Xiaoping’s strong support for its development in the 80s, and it seems reasonable to think that Li’s backing will have a similar role in the success of the Shanghai FTZ.

Advocates of Chinese economic reform are cautious, warning that Shanghai will need to implement additional regulatory and legal reforms and clarify some of the provisions described in the July 3 announcement before it can create a sustainable environment for investors. The preliminary scope of the plan for Shanghai’s FTZ seems promising, even if it is not the augur of immediate national economic liberalization that some had hoped for. However, many details of the pilot program still need to be fleshed out. For example, if the zone does successfully promote ‘financial product innovation’ and provide a haven for previously restricted goods and services such as game consoles, travel agencies, and healthcare insurance operations, regulatory differences inside and outside the zone will cause price differences, and officials will have to deal with leakage and arbitrage issues as the FTZ develops. Despite these uncertainties, the FTZ is expected to serve as a much-needed boost for Shanghai’s economy, and potentially for the national economy as well; foreign investors looking to do business in China will need to keep an eye on the pilot program’s development and implementation.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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