Shanghai free trade zone takes it slow

Shanghai free trade zone takes it slow

One year after the establishment of Shanghai Pilot Free Trade Zone, foreign investors have become impatient for more financial liberalization measures. Yet, this is not a convenient time for China to push the reform too far too fast.

In early October 2014, a third party assessment on the first year performance of Shanghai’s Free Trade Zone (SFTZ) was sent to be reviewed by China’s State Council. The report, not available to the public so far, reportedly acknowledged the institutional innovation in the SFTZ, while noting several reform areas that are progressing relatively slow. For foreign investors, however, ‘too slow’ might be a better term for China’s reform.

Foreign investors and businesses’ disappointment is most palpable when it comes to loosening capital controls and liberalizing interest rates in the SFTZ. Quotes like “nothing has really changed” and “we don’t see much substantive progress” were picked up by mainstream financial news services.

So far this year, cross-border fund flows in the SFTZ totaled USD 25 billion, only 15 per cent of Shanghai’s total cross-border flows. The total RMB borrowings from overseas stood at RMB 17.4 billion, or about 0.87% of the total RMB offshore storage. Indeed, it is almost now consensus that the SFTZ has made greater progress in cutting red tape, boosting international trade and improving local logistics than in its primary focus.

In terms of the actual capital flow-loosening measures, banks in the SFTZ established a system of special FT bank accounts that allow easier transfer with overseas accounts in early 2014. Meanwhile, fund flowing from FT accounts to other parts of China would be tightly controlled, acting as the last defense line that keeps hot money at bay.

Built upon the FT account system was the commencement of cross-border RMB borrowing business that enabled Chinese corporations and financial institutions to borrow money denominated in RMB from overseas. Multinational corporations can also transfer capital from and to their overseas accounts via their special RMB cash pools set up in the SFTZ.

Apart from more flexible utilization of MNCs’ internal capital, the SFTZ now provides faster and cheaper solutions for MNCs and private equity firms to invest abroad by streamlining government approval procedures and reducing red tapes.

“In practice, however, regulators have been cautious about opening that channel [i.e. capital account liberalization],” wrote Financial Times. For example, direct investment to foreign countries, though faster than before, still requires government approvals on a case-by-case basis for deals bigger than USD 300 million. Therefore, investors and businesses are more dissatisfied about the de facto effects of the new open-up policies than about the policies per se.

The Chinese government’s caution against rapid capital account liberalization is likely out of fear of speculative capital flows. Due to its slowing economy and other countries’ monetary policies, China experienced major capital outflows in 2012 and early 2014.

The graph below shows the purchase and sale of foreign currencies by China’s banks during capital account transactions, which indicates the extent of capital outflows during 2012 and 2014. Bank of America estimated that China suffered capital outflow of USD 27 billion in June and July 2014, on fears over the health of the economy.

Chinese banks currency exchange with their clients

Source: data collected from the Chinese State Administration of Foreign Exchange

The risks associated with the outflows could multiply if other pilot free trade zones in China start replicating the SFTZ’s liberal approach to capital control, which would ultimately increase the size of speculative inflows and outflows.

And in the long term, China needs to rebalance its economy without sacrificing its people’s jobs and the country’s growth rates, which all require a relatively flexible monetary policy and stably low exchange rates. That means opening up its capital account could tie the Chinese government’s hands during China’s economic reform.

Categories: Asia Pacific, Economics

About Author

Roger Yu Du

Roger works for a strategic advisory group that provides services to investors focused on Asia. He holds a master’s in International Political Economy from the London School of Economics and received his BA in International Relations from Fudan University in China, with a focus on East Asian affairs.