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Big reform plans for China's newest trade zone set high expectations

The sunrise rises over the skyline of Lujiazui financial district of Pudong in Shanghai September 27, 2013. REUTERS/Aly Song
The sunrise rises over the skyline of Lujiazui financial district of Pudong in Shanghai September 27, 2013. REUTERS/Aly Song

By Pete Sweeney

SHANGHAI (Reuters) - China has formally announced detailed plans for a new free-trade zone (FTZ) in Shanghai, touted as the country's biggest potential economic reform since Deng Xiaoping used a similar zone in Shenzhen to pry open a closed economy to trade in 1978.

In an announcement on Friday from the State Council, or cabinet, China said it will open up its largely sheltered services sector to foreign competition in the zone and use it as a testbed for bold financial reforms, including a convertible yuan and liberalized interest rates. Economists consider both areas key levers for restructuring the world's second-largest economy and putting it on a more sustainable growth path.

No specific timeline was given for implementing any of the reforms, though these should be carried out within 2-3 years, it said, adding financial liberalization may depend on adequate risk controls. Chinese state media have cautioned that dramatic financial reforms are unlikely this year.

An executive at a foreign multinational in Shanghai said his firm was waiting for more clarity. "Is this Shenzen 2.0 heralding the beginning of a new era in trade, or a flash in the pan to simply boost economic confidence?"

LOW-HANGING FRUIT

Frances Cheung, economist at Credit Agricole CIB, wrote in a note that the initial focus would be on promoting trade. "We note that one thing that is relevant to the RMB (renminbi) is under Point 2, where eligible Chinese banks in the FTZ are allowed to do offshore business, which is not the opening-up of the onshore RMB market as some might have looked for."

The zone, formally titled the China (Shanghai) Pilot Free Trade Zone, is slated to open on Sunday, and China will suspend certain national laws governing the establishment of foreign businesses in the zone effective October 1.

In addition to setting goals for improving financial services, trade and governance, the announcement details initiatives covering 18 different industries ranging from shipping and insurance to education and foreign banks.

The creation of the zone is hoped to reinvigorate Shanghai's economy, which has begun to lag the rest of China, and help it compete with Hong Kong as a financial centre.

In addition, state media have announced that China will soon join negotiations for an agreement on trade in services with the World Trade Organization, and many have speculated the Shanghai FTZ is also an opening move to position China for membership in the U.S.-led Trans Pacific Partnership initiative.

The document made no specific mention of allowing access to blocked foreign websites such as Facebook or Twitter from within the zone, as reported in some foreign media. However, a clause did say foreign companies might be allowed to offer "specialized telecommunications services" in the zone, and permission to offer services that break existing Chinese laws might be granted on a case-by-case basis by the state council.

MANAGING EXPECTATIONS

Hopes that Beijing will follow through on its plans have prompted speculative investment in property in and around the zone and in shares of companies expected to benefit from its construction and operation.

Shares in Shanghai International Port Group Co Ltd <600018.SS> and Shanghai Waigaoqiao Free Trade Zone Development Co Ltd <600648.SS> soared from mid-August - at one point, Waigaoqiao shares were up 332 percent before investors began taking profits on Thursday ahead of a week-long holiday.

Real estate values have also risen steadily around the zone on expectations that Chinese and foreign companies will move to rent or redevelop existing properties or build new facilities.

But economists have warned that while improving the environment for goods and services trade within the zone will be simple, the deeper financial reforms that have excited multinational corporate treasurers will prove more difficult, mainly given the risk of uncontrollable arbitrage across the zone's porous borders and internal political resistance.

Michael Klibaner, head of Greater China research at Jones Lang LaSalle, said there will be operational challenges to selling the zone to investors. For example, he noted that while the three geographic areas composing the zone - Waigaoqiao, Yangshan Port and the Pudong International Airport - are technically within Shanghai, they are over an hour's drive from the city center.

For example, Yangshan Port, the furthest part of the non-contiguous FTZ, is over 70 km (44 miles) from downtown Shanghai - further than Baltimore, Maryland is from Washington, D.C.

"If you think about some of these services, like offering foreign funded health insurance or joint venture travel agencies for outbound tourism, these are customer-facing offerings," said Klibaner. "How are you supposed to reach your customers if you are separated physically from them?"

He added that this distance is irrelevant if companies are simply allowed to register in the zone without relocating operations there, but that would only encourage arbitrage.

"I can just imagine a parade of armoured trucks full of cash driving into the zone," he said, referring to the possibility that Chinese individuals would use the zone to skirt restrictions on currency conversion.

Economists and investors are also nervous about the disappointing history of similar initiatives, in particular the FTZ in Qianhai near Shenzhen, which was promoted as a centre for capital account opening under the sponsorship of outgoing President Hu Jintao. So far, observers say the reforms have been limited, and investor interest has waned.

May Yan, an analyst at Barclays Capital in Hong Kong focused on zone coverage, said Friday's announcement did not constitute a "breakthrough".

"My concern is that Shanghai will turn out like Qianhai," she said. "Which is nothing, where basically nothing happened."

(Additional reporting by Michelle Chen in HONG KONG, and Xiaoyi Shao and Kevin Yao in BEIJING; Editing by Ian Geoghegan)

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