Economy, Talking Point

In the zone

Li Keqiang makes bold push to create a free trade area in Shanghai


My word is my Bund: Premier Li bulldozed his way through bureaucratic opposition to the free trade zone

When Deng Xiaoping began the long process of reforming China’s broken economy after three decades of Maoist policies, his boldest idea was to create a special economic zone. The goal? To lure foreign firms and to foster an environment in which free market business practices could be tested.

Given Shanghai’s pre-eminence in the 1920s – when it was China’s commercial capital and home to 300,000 foreigners – the city was mooted as a possible site for the zone. But its chances were shot down by Chen Yun, who in the late 1970s was effectively Deng’s number two.

Chen was actually a native of Shanghai but that turned out to disadvantage its bid. Growing up there he had been repulsed by the behaviour of Shanghainese capitalists and their ‘foreign imperialist’ friends in the quasi-colonial concession areas. Born in poverty – and later self-educated – Chen saw the bustling hub as a hotbed of inequality. When British police fired on a crowd of workers in May 1925 – killing several protesters – the 20 year-old joined the Communist Party. Chen would rise through the ranks to become the ‘father of Chinese economic planning’ (see WiC189), and the standard bearer for leftist economics.

Nearly six decades later, Chen retained an instinctive distrust for his hometown and the moneymaking DNA of its citizens. Give the Shanghainese a sniff of capitalism, Chen thought, and it would be akin to opening Pandora’s box; and probably worse if you added overseas money to the mix.

In the wranglings over the new zone’s location, Chen took an anywhere-but-Shanghai stand, and as Ezra Vogel notes, his political capital was sufficient to swing the decision.

“Chen worried that the ‘comprador mentality’ of bending to the will of foreigners remained alive and well in Shanghai; he opposed making Shanghai an experimental area and his view carried the day,” writes the Harvard historian.

So a small fishing village called Shenzhen was given the privilege instead.

However, 35 years later Shanghai is finally getting its chance, courtesy of China’s new prime minister, Li Keqiang. Against some internal opposition, he has given Shanghai a free trade zone (FTZ).

Why is it significant?

At a symbolic level the announcement reinforces the sense that economic reform is back at the top of the agenda. After all, the move triggers memories of the 1980s, a transformational period in which a series of special economic zones were created. Their success set China’s economy on a new course, leading to a wave of privatisations in the 1990s, as well as further policies designed to encourage entrepreneurial activity.

Market reformers have had a less happy time over the past decade, with state-led capitalism appearing to be in the ascendant during the Hu Jintao administration.

This was epitomised by the trend known as guojinmintui – a term that translates ‘the state advances as the private sector recedes’. It was an era in which state-owned enterprises and politically-connected interest groups did particularly well.

The first indications that the reformers were making a comeback came in January last year when newspaper editorials began trumpeting the anniversary of Deng Xiaoping’s 1992 Southern Tour (see WiC136). This historic event was a deliberate gesture on Deng’s part, throwing his political clout behind market reforms at a time in which conservative factions were seeking to oppose them.

Today it looks like Li Keqiang is picking up the reform mantle from Deng. As we pointed out in WiC186, Li is the first premier to have trained as an economist. At his first press conference as premier he told reporters: “Reform is about curbing government power. As a self-imposed revolution, it will require real sacrifice and will be painful. The core of the plan is to transform government functions, redefine and rationalise the relations between the government and the market and society.”

Li’s first domestic trip as prime minister, says Century Weekly, was deliberately made to Shanghai. The city had tabled a proposal to create a free trade zone in 2005 but the idea had failed to gain traction. But in March Li reportedly told Shanghai officials to pursue the idea once more, saying it would help China to build “an upgraded economy”. He asked them to come up with a list of policy changes that would be required to make it a success. By May he had received 21 suggested initiatives, reports the South China Morning Post.

Immediately, there was opposition to the idea.

According to the Hong Kong newspaper, both the securities regulator (the CSRC) and the banking regulator (the CBRC) pushed back against a number of the policies the Shanghai officials were floating. But Li appears to have shown little patience for the delaying tactics, apparently rebutting each objection, and then approving the new zone – quite possibly in record time – at a State Council meeting on July 3.

What will it encompass?

In a free trade zone, goods can be imported, manufactured and re-exported without intervention from customs authorities. This one will span 28 square kilometres in Pudong and be the first of its kind in mainland China.

According to the Shanghai Daily, the city’s Party Secretary Han Zheng said of the move: “The central government has allowed Shanghai to run this pilot programme, making the city a pioneer in the government’s efforts at reform. Shanghai should continue to be a role model in accelerating reforms, and this programme will be among the most important missions for the city in the second half of this year.”

He added: “The top priority right now is to design a set of laws and rules to regulate the zone when it starts to operate.”

Clearly, policies need to be approved in a number of areas. For example: the matter of the currency. As is well known, China imposes capital controls which prevent renminbi from flowing freely in and out of the country. In its first phase it is not thought that Shanghai’s free trade zone will evade these restrictions.

In the short term what could be more significant is the way in which foreign banks will be able to set up subsidiaries in the zone. The official proposal also says explicitly that interest rates in the zone will be liberalised, with market forces to determine the cost of capital.

What else? Red tape for foreign companies setting up in the zone will be reduced. And foreign firms will also be able to operate in industries previously subject to restrictions. For example, news has emerged that video games console makers like Nintendo, Sony and Microsoft will be able to sell their devices in China, provided they are made in the zone. For the last 13 years these consoles have been banned by the authorities in Beijing (although they could be obtained on the black market).

That ban had proved a fillip to China’s domestic games makers and to internet giants like Tencent, which have profited heavily from the sector. The idea behind this move is to create more competition in the local games market.

Other proposals support Shanghai’s stated goal of becoming a leading international financial centre by 2020. Accordingly, Chinese banks will be allowed to conduct offshore banking using units in the FTZ. Commodities trading in the zone will also be considered as offshore too. And foreign commodity exchanges will be allowed to own warehouses there (currently they have none in mainland China, the nearest being in South Korea and Singapore).

What does it mean for Hong Kong?

The Shenzhen Economic Daily thinks it could have major ramifications for Shanghai’s main rival. Currently Hong Kong benefits from its unique status in a number of ways. For instance, in recent years hordes of mainland Chinese have flocked to the territory to take advantage of the shopping. China’s luxury tax means that items like Swiss watches and Burberry trench coats are much cheaper in Hong Kong (depending on the item, the tax ranges from 27% to 59%). In future, says the Economic Daily, those same shoppers might be lured to malls in the new zone (which will have zero duty and zero tax) charging similar or cheaper prices. Rather than take their kids to Hong Kong Disney, they will go to the Pudong Disney near the zone instead.

Business, a Chinese magazine, agrees that mainland tourists may prefer going to the new zone in Shanghai. After all, in Hong Kong Chinese visitors are limited to bringing back two cans of foreign baby formula. In the free trade area in Pudong, they may be able to load up with a suitcase full – sold by foreign firms in the zone that manage their supply chains to the same level of integrity as in Hong Kong (one reason mothers buy foreign formula in the territory is that they fear the stuff sold on the mainland is sub-standard or fake).

It may be a coincidence but the Shanghai Daily reported this week that Hong Kong is now considering lifting the restriction on infant formula purchases – a measure that has been in place since March.

And as a financial centre?

The zone’s more obvious threat to Hong Kong is as China’s sole offshore banking centre. Hong Kong is currently the place where rich Chinese deposit their ‘rainy-day’ or contingency funds. In recent years it has been positioning itself as the leading banking hub for offshore renminbi too. As part of that it has built up the dim sum bond market (where issuers tap into renminbi circulating outside China).

Could Shanghai’s new zone – with its emphasis on attracting foreign and domestic financial firms – threaten Hong Kong’s market leadership? Obviously, yes, and particularly so if the zone proves successful in attracting a critical mass of major companies. The potential is huge: there aren’t many places where a “mini-Hong Kong” can be injected into a metropolis that already numbers more than 23 million people.

Then again, challenges will need to be overcome, not least in replicating some of Hong Kong’s ‘soft’ infrastructure, such as its legal expertise. While it’s hard to quantify, there’s also the institutional value of Hong Kong’s history as a British colony, its proven rule of law and its status as a special administrative region, i.e. sovereign but separate.

Regardless, the Hong Kong-based SCMP is anything but complacent on hearing news of Shanghai’s new challenge. The new zone “threatens to eclipse Hong Kong’s traditional role in China’s economy,” the newspaper warns. Could it be time to go short on Hong Kong’s vastly overpriced property market?

Ah yes, the timing…

One reason Hong Kongers won’t be hitting the panic button just yet: the free trade zone’s opening date is unconfirmed, says Shanghai Daily. Clearly much more detail is required on how the zone will work, too. Other cities in China will be watching jealously and may lobby hard for Shanghai not to get too many new privileges.

But the zone is also being taken as a message that reform is back on the agenda, with Li Keqiang ready to tread a new path. The theory is that he is ready to accept lower growth rates as he seeks to rebalance the economy. And also, that he favours the tougher medicine of structural reform over the easier tonic of massive government stimulus.

The stratagem is being touted as ‘Likonomics’. And with its greater emphasis on competition and market mechanisms, the new Pudong free trade zone is the most visible indicator yet of the long-term direction that Li’s economic policy may take.

WiC suspects that – were he still alive – Chen Yun would not be pleased…

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