The Upcoming Shanghai Free Trade Zone: An Update on the National Pilot Project

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Following the announcement in July of an ambitious plan to develop mainland China’s first free trade zone in Shanghai, there have been several recent developments relating to the forming and unveiling of the zone.

Timeline

The State Council of China is said to have internally adopted a resolution, as early as July 3, 2013, to approve the General Plans for China (Shanghai) Pilot Free Trade Zone to establish a free trade zone in Shanghai (the “Shanghai FTZ”) as a national pilot project. 

More recently, a news release from the website of the Ministry of Commerce further suggested that on Aug. 22, the State Council officially approved the establishment of the Shanghai FTZ. Government sources have further revealed that the Shanghai FTZ will be officially launched on Sept. 27, 2013.

Most recently, on Aug. 30, the Standing Committee of the National People’s Congress released its decision to authorize the State Council to temporarily suspend the implementation of several Chinese laws in the Shanghai FTZ, effective Oct. 1, 2013. 

Location
The Shanghai FTZ is said to have a total area of 28.78 square kilometers covering the Waigaoqiao Bonded Zone, Waigaoqiao Bonded Logistics Zone, the Yangshan Deep Water Port area, and the Pudong International Airport. The Shanghai FTZ aims to function as a testing ground for a potential nationwide governmental administration structure reform, helping to facilitate and lubricate the structural adjustment to the Chinese economy. It is reported that the Shanghai FTZ will implement a series of breath-taking innovative policies and measures that could dramatically benefit businesses in the zone.

Administrative structure

Sources say that two levels of administration teams will be established to ensure the smooth operation of the Shanghai FTZ.  On the field in Shanghai, Baojun Ai, the current vice-mayor and the previous general manager of Bao Steel, will serve as the initial head of the administration committee of the Shanghai FTZ. It is important to note that Mr. Ai will remain as the vice mayor of Shanghai while additionally serving in this position.

On the top of the central government, a vice prime minister will head a working group comprising 26 central governmental agencies to coordinate the implementation and deal with any special issues in the Shanghai FTZ. 

Purpose

It is said that one of the purposes of the Shanghai FTZ is to test an alternative to the current governmental administration. China is currently experiencing a transition from a manufacturing-based economy to a more innovative and service-oriented economy. It is the belief of the Chinese government that its current governmental administration is not flexible and efficient enough to accommodate the demands of the new economy structure. 

In addition, China deems it as a great challenge to be excluded from the Trans-Pacific Partnership Agreement and its EU version, the Transatlantic Trade and Investment Partnership.  As a response to TPPA and TTIP, China needs to have something that offers flexible market entry and exit and equivalent benefits to the industrial players. The Shanghai FTZ is a field test for a new mechanism by the Chinese government for such an effort.

Reform and innovation

Several officials with various China central and Shanghai local governmental agencies consistently commented on various occasions that, “Shanghai FTZ is exploring a new administrative system, rather than simply offering incentives.” However, can a new administrative system succeed by itself without supporting preferential policies? The Chinese government apparently knows the answer. It is reported that 98 new policies are being considered for the Shanghai FTZ.  Upon the launching of the Shanghai FTZ, 54 new policies will be announced to the public, with the remaining 44 new policies made available by the end of the year.

The measures in the zone are expected to include a variety of incentives, including preferential tax treatment, reduced regulatory requirements and simplified process for business investment, and financial reform. The full context of the General Plans has not been released to the public.  We have summarized some key points uncovered by the media regarding the plans in our Aug. 5 advisory, “The Shanghai Free Trade Zone: A Test Ground for the New Economic Reform Polies in China.” We hereby provide an update on more details and recent developments of the General Plans based upon information from the government and media releases provided after Aug. 5, 2013. 

Financial innovations

Free conversion of RMB and release of capital account control

As noted in our Aug. 5 advisory, the “foreign exchange control on capital account would be released” inside the zone. It is reported that the Shanghai FTZ will gradually remove all restrictions on capital accounts, and allow enterprises, but not individuals, to convert RMB freely into foreign currencies. 

Given this, enterprises inside the Shanghai FTZ would be able to make foreign exchange settlements freely for the purpose of outbound investments and/or fundraising activities without any need of approval. Bear in mind, however, that the free conversion of RMB may trigger huge foreign exchange risks. Government insiders have revealed that the release of foreign exchange controls would probably be based on the risk of the investment project. For example, restrictions on outbound investment projects, whose risk is considered relatively low, could be released immediately; while restrictions on investment in real estate, stocks, and bonds may still be held for a period of time.

Liberalization of interest rates

Another plausible development in the financial industry for the Shanghai FTZ is to liberate bank interest rates and let the market determine capital costs. Notably, although the People’s Bank of China (“PBOC”) has recently removed restrictions on borrowing rates for bank loans (except real estate loans), the real impact on the market has not been obvious because the small and/or medium enterprises do not have the bargaining powers to negotiate loan rates with financial institutions. On the other hand, currently bank deposit rates are still subject to a 110 percent limit of PBOC’s base deposit rate. The General Plans aim to achieve total liberalization of the interest rates inside the Shanghai FTZ. A possible initial step the Shanghai FTZ may adopt is to permit the bank deposit rates to vary within a 120 percent range from the base rate. Slight as the change might be, it could impact the entire financial market, especially many financial assets whose prices are fixed based on deposit rates. 

Below is a list of the proposed nine reforming policies that may be adopted in the zone as financial innovations. 

No.

Expected policies to be adopted in the free trade zone

1.

Liberalization of the financial market rates

2.   

RMB capital account free conversion allowed on the condition that the risks are under control 

3.   

To permit foreign banks and domestic banks to establish joint venture banks; to remove restrictions on foreign banks to engage in RMB-related businesses

4.   

To allow the formation of foreign-invested restrictive licensed banks (which conduct no deposit-taking businesses), engaging in merchant banking and capital market activities 

5.   

To allow the formation of foreign-invested credit investigation companies

6.   

To allow some Chinese banks to engage in offshore businesses

7.   

To encourage financial leasing and provide corresponding tax incentives

8.   

To gradually allow foreign companies to engage in futures transactions

9.   

To provide tax incentives for project companies making offshore equity investments

Foreign investment regulation

Negative list

The Shanghai FTZ aims to provide foreign investors with “national treatment” status. It is intended to grant complete national treatment to foreign investment. Under current PRC law, foreign investments are divided into three categories under the 2011 Catalogue of Industries for Guiding Foreign Investment (the “Foreign Investment Catalogue”): "encouraged," "restricted," and "prohibited." Unlisted industries are deemed to be "permitted"—a fourth category that neither enjoys benefits nor is restricted from them.

As proposed at the executive meeting of the State Council on Aug. 16, the Shanghai FTZ can, based upon the Foreign Investment Catalogue, formulate its own “Foreign Investment Negative List”, a black list that provides any “prohibited” foreign investment projects in the zone. Foreign investors are permitted to invest in any sectors outside the list within the zone. The negative list is expected to be much shorter than this, although it somewhat overlaps with the current “restricted” and “prohibited” categories. It is reported that, except for those sectors that relate directly to foreign affairs and national security (such as military and energy), most other sectors will be open to foreign investors, including some of the currently restricted sectors—i.e., medical care, telecommunication, education, and entertainment. The list is still being finalized internally, and is expected to be released upon the official launch of the Shanghai FTZ.

It is likely that the following currently restricted sectors will be open to foreign investment in the Shanghai FTZ: 

Sectors

Expected Policies

Current PRC Practice

Restrictions

Medical care

Permit establishing wholly foreign-owned medical care institutions

Joint ventures only

Registered inside the zone; can provide service outside the zone

Telecommunication

Permit establishing wholly foreign-owned value-added telecommunication companies

Joint ventures only with foreign shareholders controlling 50% or less shares  

Registered inside the zone; can provide service outside the zone

Education

Permit establishing foreign-invested schools, including nursery schools and elementary schools

Prohibited

Registered inside the zone; can provide service outside the zone

Third-party payment

Permit foreign-invested third-party payment companies to obtain the Online Payment Business Permit

Currently no foreign-invested company obtains the Online Payment Business Permit

Registered inside the zone; can provide service outside the zone

Credit investigation

Permit establishing foreign-invested creditor investigation companies

Prohibited 

Registered inside the zone and provide service inside the zone; the service can be extended outside the zone if circumstances permit

Cultural relics auction

Permit establishing wholly or jointly owned cultural relics auction companies

Prohibited

Registered inside the zone and the auction must be conducted inside the zone

Health and pension insurance

Permit establishing foreign-invested health and pension insurance companies

No specific regulation

Registered inside the zone and can provide service outside the zone

Entertainment places

Permit establishing wholly foreign-owned entertainment places, such as bars and theaters

Wholly foreign-owned entertainment places are not allowed

Registered inside the zone and can provide service inside the zone only

Game consoles seller

Permit establishing sales and service company for game consoles

Prohibited by Ministry of Culture

Registered inside the zone; can provide service outside the zone

Printing

Permit establishing wholly foreign-owned printing companies

Joint ventures only, with Chinese shareholders controlling the majority shares

Registered inside the zone; can provide service outside the zone

 National treatment

Foreign investors in the Shanghai FTZ will be given full national treatment and have equal market access with domestic investors.

  • For any foreign investment not on the negative list, the Shanghai FTZ will remove all current applicable government approvals required on foreign investment, including its establishment, split, merger, business scope expansion, and business term extension. Same as domestic enterprises, foreign investors are only required to go through the registration process with the local registration authority in the free trade zone.
  • With respect to foreign investment in a business where a special operation permit is required, investors are permitted to directly apply for the permit after establishment of the enterprise. Additionally, most unique distinctive requirements for certain permits on applicant eligibility specially designed for foreign invested applicants will be relinquished.
  • Inside the Shanghai FTZ, the concept of total investment and regulation centered around the balance between registered capital and the total investment amount will be waived.  Foreign invested enterprises in the Shanghai FTZ can borrow without statutory limitation debts to finance its operation.

Businesses registered in the Shanghai FTZ, with only a few exceptions, will be allowed to provide services outside the Shanghai FTZ without the need to establish any branch. Details of the exceptions will be announced with the 98 new policies.  However, to what extent such a policy will be acceptable by provinces and cities other than Shanghai remains unclear.

On Aug. 30, 2013, in order to remove the legal obstacles and pave way for the upcoming negative list, the Standing Committee of the National People's Congress temporarily suspended the implementation of the examination and approval requirements under three fundamental laws governing foreign investments in China: the PRC Foreign Enterprise Law, the PRC Equity Joint Venture Law and the PRC Cooperative Joint Venture Law, in the Shanghai FTZ.

Tax and customs duty
China is a country renowned for its heavy tax burden. Research shows that as many as 76 percent of enterprises in China are eagerly expecting the government to carry out a tax structure reform and provide more tax incentives. To compete with other FTZs in the world, the Shanghai FTZ will certainly provide tax preferential treatment to qualified enterprises doing business in the zone.

EIT

Currently, all enterprises, except those recognized as hi-tech enterprises or others, are subject to a 25 percent enterprise income tax (“EIT”). News resources show that the Shanghai FTZ would, under certain conditions, reduce the EIT rate to 15 percent for qualified businesses, which is even lower than the existing 16.5 percent rate in Hong Kong. It is the hope of the Shanghai FTZ that the reduced rate will attract more business investments in the zone, particularly international investments.

Customs duties

As a free trade zone, the Shanghai FTZ will be expected to function as a free port and a shopping center with zero tariffs, including luxury consumer goods. If the Shanghai FTZ permits zero tariffs inside the zone, experts anticipate that prices for imported luxury consumer goods sold in the zone could be reduced by 30 percent, compared to current prices outside the zone. Price difference on luxury consumer goods between the Shanghai FTZ and Hong Kong would also gradually diminish. The Shanghai FTZ thus may function as a shopping center for luxury consumer goods for people in mainland China. However, the specific customs regulations that will apply to customers seeking to bring luxury goods purchased in the zone into other areas of China remains unknown.

Expectations
The launch of the Shanghai FTZ was personally endorsed by Premier Li Keqiang. It will be the first opportunity to show the new Chinese leadership’s vision and determination to promote economic reform in China—especially Premier Li’s view on China’s economic development, which, according to economists, is for the purpose of “deceleration, deleveraging and improving growth quality.” Even though the General Plan and its associated innovations and policies have not been finalized and officially released yet, the market and businesses in China have responded positively toward the Shanghai FTZ and are buying into this important step toward a brighter future.

We are keeping close watch on the Shanghai FTZ development and will provide timely coverage on Sept. 27, 2013 on the finalized General Plan.