Impact of China’s free trade zones

August 2015  |  FEATURE  |  BANKING & FINANCE

Financier Worldwide Magazine

Free trade zones (FTZs) can have a significant impact on a country’s trade and economic outlook. Designating FTZs within a nation can boost imports and exports and wider growth. FTZs lower the barriers to economic development by removing bureaucratic red tape and tariffs, making countries more attractive to new businesses and foreign investors alike. They can have a substantial knock-on effect in other areas too, such as job creation.

For the economies of developing countries, FTZs can be a particular boon as they play catch-up with the developed world. Accordingly, we have seen the increased use of FTZs in recent years, with more than 3500 up and running globally. The various zones account for approximately 68 million jobs and generate around $500bn worth of annual trade. Undoubtedly, FTZs are here to stay.

Repurposing an economy

In China, FTZs are a particularly interesting proposition. The Chinese government, bearing in mind the recent slowdown of the country’s previously rapid financial and economic growth, has turned to FTZs to help re-tool the national economy. Though FTZs in China are still experimental, they have a major role to play.

In recent years the Chinese economic slowdown has been notable. According to data from the International Monetary Fund (IMF), the economy grew at an average rate of around 10 percent per year over the three decades up to 2010. However, since the turn of this decade economic growth in the country has been stymied. Though most nations would jump at the chance to record growth of 7.4 percent, as China did in 2014, that figure represents a significant drop off from previously recorded growth – its slowest in 24 years. Furthermore, the IMF has forecast growth of 6.8 percent in 2015 and 6.3 percent next year. In the first quarter of 2015 it recorded 7 percent, the worst quarterly result in six years.

Chinese inflation dropped in May 2015, falling to just 1.2 percent. Interest rates were cut that month, for the third time in six months. The Chinese government has moved to strengthen local governments, offering economic support as the economy has been forced to face up to its worst financial and economic year in decades.

Imports and exports have also fallen dramatically during the last year. In May, imports dropped 17.6 percent year on year to $131.26bn, while exports fell for the third consecutive month, by 2.5 percent to $190.75bn.

Though the slowdown has been detrimental, it is important to note that much of Chin’s economic decline has been by design. The government has acknowledged that it is prepared to accept a slower but sustainable level of growth going forward. Attempts are being made to repurpose much of the economy. Government officials are hoping to move toward a more consumer focused model in the coming years, away from the investment driven expansion which has powered the economy for decades.

Clearly, these are time of upheaval in the world’s second largest economy. As the country’s economic growth loses momentum, and the central government adopts new tactics, could FTZs provide a valuable tool in the rebirth of the Chinese economy?

The SPFTZ

Thus far, the impact of the Shanghai zone has been negligible. In operation since 2013, when it was launched with great fanfare as the site of future free market reform, the zone has been a disappointment for both foreign and domestic companies active within its borders. The reforms promised by the Chinese government have been trifling. Equally, local governmental officials have been far from enthusiastic about its impact to date.

In an effort to revitalise the FTZ project, the Chinese state council has now opted to open three additional FTZs in Guangdong, Tianjin and Fujian. The Shanghai zone – officially known as the China (Shanghai) Pilot Free Trade Zone (SHFTZ) – will be expanded to incorporate three new areas – Lujiazui, Jinqiao and Zhangjiango – in addition to the zone’s existing and established areas.

Furthermore, the SHFTZ’s expansion will enable the zone to develop higher value-added trade in merchandise and services. It will also be able to experiment with reforms within the government system. The FTZ’s industrial and policy roles will be extended by the expansion. The inclusion of Zhangjiang and Lujiazui within the zone has been viewed by some as a move by the Chinese authorities to generate greater focus on advanced, knowledge-intensive manufacturing, services and investment processes, as well as trade. In all, the SHFTZ will implement around 25 measures set out by the Chinese State Council designed to boost financial innovation within the zone and faciliate trade and investment both internally and externally.

Given the extent of the criticism faced by the SHFTZ, the expansion of the Chinese FTZ project will come as little surprise. Going forward, it will not be confined purely to advancing China’s financial reform agenda; it will go some way to improving geopolitical relations in the Asia-Pacific region.

The newly created zone will also help the Chinese government to trial new batches of reforms in specialised locations. The Fujian district, for example, will help to strengthen China’s economic links with Taiwan and develop cross-Strait economic cooperation between the two countries. By contrast, the Tianjin zone will help foster deeper economic connections with neighbouring Japan and South Korea.

Negative List

The State Council has also updated and replaced its 2014 Negative List. The new 2015 Negative List became effective on 8 May 2015 and provides an outline of the sectors in which foreign investment is restrained. This new list, which will apply to all four FTZs, contains the details of 122 prohibited or restricted business areas, reduced from 139 in the 2014 list. The new list points to a loosening of Chinese restrictions on foreign investors looking to do business in the country. Until late 2014, the Negative List itself did not exist; previously, investors were merely provided with a positive list.

As expected, the new list largely maintained the restrictions that applied in other parts of the country – areas such as publishing, news, internet content, films and auction houses, as well as legal practices, banking and asset management.

However, the new Negative List did makes significant changes in a number of sectors. The most notable now open to foreign investors are mining, medical and pharmaceutical product manufacturing, and telecoms. The manufacture of weapons and ammunition has been removed from the ‘prohibitive’ category under the new list.

The shipping industry will be greatly affected by the changes occurring within the four zones. China hopes to bring its FTZs, particularly the zone in Shanghai, to the forefront of international maritime centres, and is providing more favourable policies to shipping-related industries.

Meanwhile, foreign investors in the FTZs must maintain compliance with the Catalogue of Industries for Guiding Foreign Investment, the guiding principle covering all foreign investment in China. In accordance with the Catalogue, no Sino-foreign investor joint venture will be permitted to operate in certain fields. Accordingly, foreign investors must pay considerable attention to both the Negative List, and the Catalogue.

Criticisms

To date, the SHFTZ has not been as successful as many people had hoped. Although there is a great deal of optimism surrounding the expansion of the program, there are still a number of caveats.

The expansion of the FTZs must form just part of the wider revitalisation of the Chinese economy. It is important that the economic liberalisation that is being offered to the FTZs is disseminated out into the wider Chinese economy, as it will be difficult for them to operate in isolation.

It is equally important that the deployment of FTZs does not detract from much needed social and economic reform in China. There has been some small reform to Chinese state owned enterprises but more needs to be done. There have also been calls for reforms to public finances, land ownership and the country’s residency permit system. It is important that cornerstone reforms such as these do not get passed over in favour of the FTZ project.

Conclusion

The announcement of both the expanded FTZ in Shanghai and the proliferation of the scheme to new areas is the next step in the landmark retooling of the Chinese economy. Given the geographic locations of the zones, Chinese economic links with Hong Kong, Macau and Taiwan are likely to be strengthened, as the liberalisation of certain key sectors acts as a beacon to investors from these regions. Banks, e-commerce firms, foreign traders and other high-end service providers should be drawn to the new zones. Should they prove to be successful, expect to see more free trade areas open up across the country.

The deregulation of currency transaction in the new FTZs will also go a long way toward helping to internationalise the renminbi, a further target of the Chinese government. Beijing hopes to include the currency in the IMF’s Special Drawing Rights basket later on this year. Making the Chinese currency fully convertible is one of the biggest implications of the FTZs from the perspective of a foreign investor. Full convertibility will allow Chinese banks to conduct offshore business, truly compete with London and New York as global financial centres, and ultimately circulate the renminbi globally.

The free trade program could be a game changer for the Chinese economy. Though there are some drawbacks and complications, the collective impact of the zones could re-energise the national economy and keep China on a level footing internationally. The government has used the SHFTZ as testing ground or laboratory over the last two years. Now that the experiment has been expanded slightly and future economic liberalisation is becoming more of a reality, the lessons learnt in the SHFTZ must be translated to the wider economy. If the Chinese state really does hope to repurpose parts of its national economy, the new measures introduced in the zones – such as private capital participation in the financial sector and access to investment opportunities in new areas of the economy – must be expanded out of the zones and applied across the entire country.

The process is still in an embryonic state, but the FTZs could be the springboard to launch the Chinese economy into open waters.

© Financier Worldwide

BY

Richard Summerfield