Shanghai's free trade zone - What's the hype about?

An archway posted with the sign of China (Shanghai) Pilot Free Trade Zone.
ChinaFotoPress | Getty Images

China is expected to launch the much-talked-about Shanghai free-trade zone this weekend, which has been lauded as a "testing ground" for major liberalization policies needed to propel the economy over the next few decades.

"The free-trade zone [will] play an important role in China's next round of reforms and opening up, the success of which will be crucial to invigorating the economy and unleashing its growth potential," said Jian Chang, China economist at Barclays.

(Read more: Is Shanghai's free trade zone really a game changer?)

The initiative, located in a 29-square-kilometer area in an eastern suburb of the city, is set to commence on September 29 and is seen as a strong testament to the new leadership's commitment to pushing ahead with reforms.

The successful policies – which will include financial, trade and investment reforms – will ultimately be rolled out nationwide, but likely after several years, say analysts.

CNBC anchors debate Shanghai's free trade zone
CNBC anchors debate Shanghai's free trade zone

What's most exciting about this economic experiment? According to Wei Yao, China economist at Societe Generale, it's the three-year suspension of several regulations on foreign investment that essentially allows overseas investors to invest as freely as their domestic peers.

Foreign companies will be allowed to invest in the banking, healthcare insurance, logistics, human resources and tourism sectors in the free-trade zones through subsidiaries or joint ventures, according to local media reports.

(Read more: China may lift ban on Facebook, others in free trade zone)

"The obvious way for China to accelerate service sector growth is through deregulation and de-monopolization. Various surveys on the service sector have consistently shown that the number one obstacle faced by private players is too much government interference. These are the exact issues that Shanghai's free-trade zone intends to tackle," Yao wrote in a note on Friday.

As China rebalances from a manufacturing-based to a consumption-driven economy, the services sector will become an increasingly important growth driver, say economists.

Major financial reforms are also expected to be carried out, including easing capital controls for firms in the zone by allowing full yuan convertibility and removing restrictions on bank interest rates. However, Yao said financial market liberalization appears to be taking a back seat in the initial stage of the project.

China's free trade zone: The upside & downside
China's free trade zone: The upside & downside

"This actually makes sense and should not be regarded as a disappointment. Any financial market liberalization concerning capital flows and/or financial market prices, if implemented only in a certain geographic area of an economy, would lead to arbitrage opportunities and, more often than not, to financial market speculation," she said.

Shanghai's gain, Hong Kong's pain?

The free-trade zone could be a game changer for Shanghai, boosting the city's status as a global financial, trade and logistics center, say experts.

(Read more: China's economic growth more like 4%: Marc Faber)

"Shanghai's impending transformation has upped the stakes for Hong Kong, which promotes itself as the world's business gateway to China," said Chang of Barclays.

If custom procedures are simplified and costs are lowered in the free trade zone, some firms may choose to bypass Hong Kong and ship their goods directly into the mainland, Chang said. Currently, around 55 percent of Hong Kong's re-exports go to China.

Furthermore, Hong Kong's appeal as a duty-free retail hub for Chinese shoppers could fade with the possibility of lower import tariffs making goods available at more competitive prices in the mainland.

—By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H