Shanghai Blasted Over Stalled Free Trade Zone Reforms

An analysis by Michael Lelyveld
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Cars at the entrance of the free trade zone in Shanghai, China, Nov. 28, 2013.
Cars at the entrance of the free trade zone in Shanghai, China, Nov. 28, 2013.

Nine months after the launch of Shanghai's free trade zone to great fanfare, China's showcase economic initiative seems to have landed with a thud.

In an unusually critical report on June 17, the official English-language China Daily aired complaints from top leaders that the reform experiment had accomplished little so far.

"Most of the 10,000 enterprises registered in the FTZ (free trade zone) are disappointed with the slow pace of reform," China Daily said.

The commentary came after President Xi Jinping conducted an inspection tour of the pilot free trade zone on May 23-24, leaving nervous local officials with seemingly contradictory advice.

Xi urged Shanghai to "push forward" with reforms "while controlling risks and gradually making improvements," the official Xinhua news agency reported, leaving it unclear whether liberalization in the economic laboratory should go fast or slow.

On balance, the message seemed to be that the government wanted Shanghai officials to move more boldly with the reform agenda, but they would be responsible if anything goes wrong.

"Risk control is the bottom line to guarantee the whole process of constructing the zone, and the demands of various businesses for institutional improvement should be emphasized," Xinhua said in a paraphrase of Xi's remarks during the tour.

Having it both ways

Nearly a month later, the China Daily criticism also tried to have it both ways. While blasting Shanghai officials for the slow pace of change in economic and investment regulations, it made clear they would be on the hook for any missteps.

"This is the first time the State leader warned pathfinders not to make mistakes while blazing a trail," the commentary said.

Last September, Shanghai was tasked with opening the door wider to foreign investment in service sectors ranging from shipping to healthcare while experimenting with market-driven interest rates and full currency convertibility for China's yuan.

Successful reforms in the 29-square-kilometer (11-square-mile) zone were supposed to be spread throughout the national economy after a trial period of two to three years. The announcement was hailed as a high point in China's economic history.

"Standing on giants' shoulders to see further, China's metropolis Shanghai now tests and spearheads the nation's reform and opening-up drive, after an economic miracle created through such efforts spanning more than 30 years," Xinhua said at the time.

Early reports were enthusiastic about the FTZ decision to adopt a "negative list" of sectors to remain off-limits to foreign investors, instead of the government's "positive" list, which keeps investors guessing about what ventures may be disallowed.

But disappointment followed release of the FTZ's 10-page list, which maintained restrictions on a range of financial services, entertainment and other key businesses.

Foreign investment in over 1,000 specific business activities were still restricted or banned.

Last week, the FTZ dropped 51 restrictive clauses from the list of 190 business sectors subject to bans, Xinhua reported, but only 14 removed prohibitions on foreign investment, while the rest represented duplications with other lists.

In its criticism, China Daily complained that authorities have done little more than patch together a list of previous limits, noting that eased registration rules for new businesses and other breaks are already available outside the zone.

The paper blasted Shanghai officials, saying they "have not so far demonstrated a capacity for innovation."

No timetable has been set for more significant changes to exchange rate and currency controls.

Stuck on the drawing board

In the meantime, over 16,000 enterprises with 280,000 employees have reportedly registered in the zone, hoping for breaks that have been stuck on the drawing board. By the end of last month, 1,240 foreign businesses had registered, state media said.

In April, China Daily described FTZ trade growth in the first quarter as "flat" after volume edged up 2.1 percent from the previous period while exports dropped 5.2 percent.

"City government seems hesitant to take (the) role as a pioneer of policy for the nation," the paper said.

Derek Scissors, a resident scholar at the American Enterprise Institute in Washington, said the FTZ initiative has suffered from a mix of economic and political problems as officials shy away from the risks of major change.

"They continue to be petrified to actually do anything," Scissors said.

The FTZ plan has landed in the middle of China's growth slowdown, putting pressure on the central government to formulate new policies, which it has now passed onto Shanghai, insisting that the reforms must be tested experimentally before Beijing will risk adopting them nationwide.

But the central government has no intention of sharing the blame if new policies backfire.

"Xi Jinping is saying we need to liberalize, we need to have Shanghai as the centerpiece, and if anything goes wrong, it's all your fault," Scissors said.

The impasse has been aggravated by entrenched interests among state-owned enterprises that would face competition under eased investment and economic rules, slowing Premier Li Keqiang's reform agenda to a crawl.

Li "angrily pounded the table" in frustration at the standoff during a recent Beijing meeting, threatening to send "third-party watchdogs" to spur local reform efforts, China Daily said, citing China Business News.


The central government seems to realize that sustainable economic growth can only achieved through an easing of state controls, but it also appears wedded to the experimental phase in Shanghai, creating a backup for policy changes all along the line.

Much of the anxiety may be traced to the ultimate goal of making the yuan fully convertible on the capital account, which would allow free exchange with foreign currencies for investment and asset flows.

The yuan is already convertible under the current account for trade transactions. But the government fears it could lose control of the currency and the economy if unrestricted foreign exchange at market rates is allowed.

Regulators have already had their hands full trying to block various schemes to disguise inflows of "hot money" for currency speculation, raising fears that liberalization could, in a crisis, lead to reverse flows and uncontrolled capital flight.

The fear of a hypothetical scenario for capital flight has led to policy paralysis, said Scissors.

"They're so afraid of capital flight that if there's any change, somebody says 'capital flight' and everybody panics," he said.

Scissors argues that the entire FTZ experiment is inconsequential because the zone remains isolated from China.

"It is technically in China. Financially, it is not in China," he said.

Fears of capital flight through the zone are also misplaced, largely for the same reason.

"It only matters if it's connected to the rest of the country, and there's nothing about that," Scissors said. "They already have leaks. It's not like there's an airtight seal and now the zone is an additional risk."

Some central bank officials appear to be growing impatient with the policy impasse.


In a speech on June 24, Ma Jun, chief economist of People's Bank of China (PBOC) research bureau, said that fears of capital account convertibility are "overdone."

If full convertibility is allowed, "The capital either going into China or out of China is not going to be massive. There will be some, but maybe less than people think," Ma said, according to a separate China Daily report.

In what may be a step toward breaking the policy logjam, the PBOC announced on June 27 that it had removed the limit on interest rates that banks throughout Shanghai may pay on corporate foreign exchange deposits.

Xinhua said the move was the first expansion of a piloted reform outside the FTZ, raising expectations that it could be more widely applied.

Last week, the State Administration of Foreign Exchange (SAFE) announced that banks throughout the country will be allowed to set their own exchange rates with the U.S. dollar in over-the-counter transactions with clients.

A Bank of China analyst, cited by Reuters, called the move a "small step" in foreign exchange reforms, since rates in interbank transactions remain subject to controls.

Despite the political pressures, at least 20 other cities have been lining up for FTZ status in hopes of profiting from preferential government policies.

FTZ aspirants include coastal Qingdao city in Shandong province, Xiamen in eastern Fujian province and Chongqing municipality in the southwest, Xinhua said.

Last month, a senior Ministry of Commerce official poured cold water on the proliferation of FTZ plans, saying the zones "will not flourish everywhere." Xinhua did not identify the official.

Among many faults, China Daily charged Shanghai officials with an inability to deal with the overlapping authorities of central government ministries over key economic policies.

"So, pressing Shanghai to act as a reform pioneer, a role it has never played, becomes a test of Shanghai officials'
ability to coordinate different ministries," it said.

The criticism seems aimed at placing the burden on local officials to resolve policy conflicts among competing interests in the central government, rather than blaming Beijing for failing to clear the way for reforms.





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