The Shanghai Free Trade Zone – A New China Paradigm for Western Investors?

Posted on December 31, 2013

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When it comes to foreign companies, funds and investors doing business in China and positioning themselves to do business in China, the question on the minds of everyone is the significance of the Shanghai Free Trade Zone.  What does it mean for China, and to investment in China?  Answers to these questions are contained in a research report made available by Mr. Macaluso to his clients which is excerpted below.

The Shanghai Free Trade Zone – A New China Paradigm for Western Investors?

Executive Summary

It is not possible to properly understand the magnitude of what the Shanghai Free Trade Zone could mean for China and to investment in China without reflecting on the success of Shenzhen.  If the Chinese government is, as it seems to be, as serious about the Shanghai Free Trade Zone as it was about building the Shenzhen Economic Development Zone, this one initiative could have a material impact on China’s economic development and on investment in China for decades. Shenzhen was conceived 30 years ago and started from a much lower base of infrastructure and economic sophistication than China possesses today. The Shanghai Free Trade Zone will develop its potential over a much shorter period of time. The implementing regime is not fully announced and so there is much uncertainty, but that we think is temporary and likely deliberate to allow for input.  As the various constituents for the Shanghai FTZ, and there are many, begin to digest the possibilities, the implementation regime will become more clear.  This report also includes a summary of where implementation stands currently relative to each of the major components of the initiative.

Shanghai and Shenzhen

Shanghai free trade zoneThe Shanghai Free Trade Zone, officially referred to as the China (Shanghai) Pilot Free Trade Zone, became a reality on September 29, 2013.  Geographically it covers quite a large area – about 29 square-kilometers (about 11 square miles) in the pricy and important Pudong District of Shanghai. The Shanghai Free Trade Zone includes four existing bonded zones, Waigaoqiao Free Trade Zone, Waigaoqiao Bonded Logistics Park, Pudong Airport Free Trade Zone, and Yangshan Free Trade Port Area (Land and Harbor.)[1] (See map below.)

The Shanghai Free Trade Zone in our view is a bold and elegant attempt by China to continue the Chinese economy on a path to a world class economy. Many believe the Zone represents the most important attempt at economic reform since the creation of China’s first special economic zone in Shenzhen in 1980. Shenzhen in the early 1980s was for all intents and purposes bare land separating the Mainland from Hong Kong.  The designation of the Shenzhen special economic zone led to development on a massive scale.

Shenzhen Futian Skyline (W)Today Shenzhen is a major manufacturing center, is home to many successful high-tech companies and to a major Chinese stock exchange. The city also counts two of the 30 tallest buildings in the world. The success of the Shenzhen Economic Development Zone is truly an achievement for China.  In 2010 the Shenzhen special economic zone was expanded from 396 square kilometers (153 sq mi) to 1,953 square kilometers (754 sq mi) and border controls with the rest of China relaxed.

If the Chinese government is, as it seems to be, as serious about the Shanghai Free Trade Zone as it was about building the Shenzhen Economic Development Zone, this one initiative could have a material impact on China’s economic development and on investment in China for decades.

Shanghai Free Trade Zone Liming Map[3]

The China State Council has promulgated the “Framework Plan for the China (Shanghai) Pilot Free Trade Zone” (the “Framework Plan”) and the Shanghai Municipal People’s Government has released the “Administrative Measures for the Shanghai Free Trade Zone” (the “Measures”), as well as some official interpretations, all of which set forth broad guidelines about financial innovation and administrative management reforms.  We will briefly discuss the most significant aspects of the rules that have been published.

Less Restrictive Foreign Investment Rules

One of the goals of the Shanghai Free Trade Zone is to attract more foreign investment to China. An enticement for attracting more foreign investment is providing national treatment to foreign investors in the Zone.  According to the Framework Plan, the Zone will adopt a “Negative List” approach toward foreign investment management, meaning foreign investment in all sectors would be allowed unless listed as prohibited or restricted on the “Negative List.”  Foreign investment projects in sectors not on the Negative List would only need to comply with record-filing procedures to proceed.

The released 2013 edition of the “Negative List” is, however, still similar to the previous Foreign Investment Industry Catalog.  The list has 190 items, accounting for 17.8% of all the 1069 sub-categories of the nation’s economy.[4]  Those include restrictions on investments in oil and natural gas exploration, telecommunication and broadcasting, pharmaceutical manufacturing, and banking and insurance.  Foreign auto companies are still limited to a 50% stake in any joint venture.  Investments in some industries, such as news portals and online gaming, are not permitted.[5]  But government officials have said on various occasions that the list will be shortened gradually over the next two-to-three years.  The next update is expected in May 2014.

The Chinese government is undertaking efforts to “encourage  multinational corporations to set up Asia-Pacific regional headquarters or  operation centers with trade, logistics and settlement functions in the  Shanghai Free Trade Zone.”[6]  So far the response has been a bit tentative.  Some foreign companies seem to be adopting a somewhat conservative approach to the Zone pending more implementing rules being promulgated.  Whether, and to what extent, a foreign-invested enterprise can conduct business outside of the Zone with the benefits of the Zone is an interesting open question.  The government will have to balance many factors relative to regional and national development goals to arrive at an answer and it will need to harmonize laws currently applicable in other parts of China, including those relating to Foreign Direct Investment.

More Streamlined Administrative Management

The business registration system in the Shanghai Free Trade Zone is slated to be optimized. Three major laws regulating foreign investment, the Law  of the People’s Republic of China on Wholly Foreign-Owned Enterprises (WFOE Law), the Law of the People’s Republic of China on Sino-Foreign Equity Joint Ventures (EJV Law), and the Law of the People’s Republic of China on Sino-Foreign Cooperative Joint Ventures (CJV Law), as well as 11 administrative examination and approval items, are suspended for 3 years in the zone.[7]  Under those laws, the establishment, amendment of articles, dissolution and all other major changes of the WFOE, EJV and CJV must receive prior approval.

Financial Sector Reform

The Framework Plan provides that “the finance sector will be fully opened to private investors and foreign invested financial institutions.”  Also, government officials have been quoted as saying that financial sector  changes are at the heart of experimentation in the Zone.[8]  There is likely to be permitted more liberalization on the movement of funds for example.  The Framework Plan in this regard sketches a blueprint for the Zone as a Zone within which foreign and domestic enterprises would use global market resources to obtain cross-border financing.

A few large institutions have already established a presence in the Shanghai Free Trade Zone.  These include Citibank, HSBC, Deutsche Bank, Singapore based DBS, Southeast Asia’s largest lender, and six Japanese banks.  In addition, all major Chinese state-owned banks have established a presence in the Zone.  A key question here too is whether, and to what extent, the financial flexibility available in the Zone will be allowed to extend to the rest of China.  If the financial services regime applicable within the Zone becomes accessible to any firm in the country, China would have opened its financial sector to a large degree.

Opening the Service Sector

The Framework Plan provides measures to open up the service sector.  The Appendix specifically mentions the following six areas: financial services, shipping services, commercial and trade services, professional services, cultural services, and social services.  Qualified foreign financial institutions will be allowed to set up wholly foreign-owned banks and Sino-foreign equity joint venture banks with eligible private capital within the zone.  Under the Framework Plan, the ultimate objective seems to be to create an environment of equal market access for all investors.[9]

Conclusion

At this point, it is too soon to tell the extent, and over what time period, China’s ambitious aims for the Shanghai Free Trade Zone will be realized. As some Chinese officials have stressed, the Zone remains a work in progress and many new laws and regulations are expected to be released gradually.  But the comprehensive plan for the Zone is almost certain to bring more foreign investment to China.  If the experiment of Shanghai Free Trade Zone goes well, the importance of Shanghai as a financial center in East Asia will continue to grow.


[1] English translations of the zone names may vary in different documents.

[2] Framework Plan for the China (Shanghai) Pilot Free Trade Zone

[3] Map Source: Baidu Encyclopedia

[4]周汉民交大《上海自贸区政策解析和发展机遇》高端讲座精粹节选

[5] Special Administrative Measures (Negative List) on Foreign Investment Access to the China (Shanghai) Pilot Free Trade Zone (2013)

[6] Framework Plan for the China (Shanghai) Pilot Free Trade Zone

[7] China Briefing – China Relaxes Foreign Investment Rules for Shanghai Free Trade Zone

[8] The Wall Street Journal – China to Test Looser Grip on Economy

[9] Framework Plan for the China (Shanghai) Pilot Free Trade Zone