Shanghai free trade will spur China reforms: Steinbock

A laborer working on a large sign reading China (Shanghai) Pilot Free Trade Zone on a gate of the Shanghai Waigaoqiao Free Trade Zone.
STR | AFP | Getty Images
A laborer working on a large sign reading China (Shanghai) Pilot Free Trade Zone on a gate of the Shanghai Waigaoqiao Free Trade Zone.

In the early 1980s, China introduced an era of reforms and opening up. The next stage began with Sunday's takeoff of Shanghai's free trade zone. If it proves to be a success, it could accelerate reforms across China.

Change was initiated already in March 2009, when the State Council approved Shanghai's plans to forge itself into one of the world's leading financial, trade and shipping centers by 2020.

Only a month later, Shanghai, along with half a dozen other major cities, also got the nod from the central government to use the renminbi in overseas trade settlement.

At the time, I wrote an analytic brief on the history, present and anticipated future of Shanghai's reforms to my Chinese think tank. Nonetheless, the topic was hardly noticed in Asia's financial hubs of Hong Kong and Singapore. Internationally, it was ignored as empty rhetoric.

In the 1920s Shanghai still dominated the Far East's finance and trade. As the "Pearl of the Orient" was crushed by colonialism, Japan's invasion, World War II and the Chinese civil war, Hong Kong began to industrialize and prosper. In Shanghai, Chinese reforms began only in the 1990s. But when the mainland's growth accelerated in the 2000s, Hong Kong still served as China's financial intermediary.

Now Shanghai is at the eve of a new era—and so is China.

(Read more: Shanghai's free trade zone opens for business)

Accelerated reforms

Last January, the new mayor of Shanghai, Yang Xion, unveiled Shanghai's plan to develop the mainland's first free trade zone in the Yangshan deep-water port, Pudong airport and the Waigaoqiao port.

In the past, Beijing has approved over a dozen bonded areas, which are prototypes of free trade zones. Other mainland cities have also lobbied Beijing for comparable zones, including Tianjin and Guangdong. But a more extensive zone in Shanghai could bypass that of Hong Kong over time.

The pioneering zone is about 28 square kilometers; but if it is successful, it will cover the entire Pudong district—that is, 1,210 square kilometers, or 467 square miles.

The launch of the Shanghai FTZ was accompanied by 18 new policy initiatives, which seek to reduce restrictions in half a dozen key industries, including financial services and telecommunications.

The smoother and faster the progress in Shanghai's FTZ, the more likely it is that companies will begin to move their primary activities from Hong Kong to Shanghai. In effect, the shift may already have started.

In 2012, foreign direct investment in Hong Kong plunged by 20 percent, but increased in Shanghai by $20 billion. Hong Kong still has a significant absolute FDI edge. But in relative terms Shanghai is catching up—fast.

New leadership supports changes

In the era of Hu Jintao and Wen Jiabao, Shanghai's reform plans were set aside. Back in the spring, President Xi Jinping, who had stayed in the city as party secretary in 2007, made it clear that Shanghai would be a pacesetter in the impending reforms. The new leadership believes that it is easier to achieve greater equity through economic growth, supported by the financial sector.

To Shanghai, the proposed reforms are critical because the megacity is maturing. As the momentum of the property markets has been shifting from the first-tiered megacities to second- and third-tiered urban centers, Shanghai needs accelerated reforms in finance and trade—to boost the megacity's maturing growth as well as its regional and global role.

Today, the renminbi is convertible for trade, but restrictions prevail on convertibility on the capital account. These concerns escalated after the global crisis, when the U.S. Federal Reserve began quantitative easing, which aggravated "hot money" inflows into large emerging economies.

Now the Chinese central government has allowed Shanghai's FTZ to introduce broader convertibility of the currency and freer market-oriented interest rates. At the same time, the central government will seek to defuse potential financial risks.

From the Chinese standpoint, it is a huge experiment. If it succeeds, Shanghai's reforms will be copied elsewhere in China. If it fails, political reassessments are inevitable.

(Read more: Global banks cautious on Shanghai free trade zone)

Financial reforms

Since the megacity's reforms have national and international significance, change has not come easy. In the past few months, Premier Li Keqiang has fought open opposition by financial industry regulators—including the China Banking Regulatory Commission and China Securities Regulatory Commission—to open Shanghai's financial services sector to foreign investors.

The reforms will not take place without resistance. Political conservatives support some economic reforms, but insist on the need for political controls. While Shanghai's FTZ will allow free access to Internet services, including Facebook, the latter have been tarnished by the U.S. NSA's excessive interference, as exemplified by the Snowden debacle.

Conservatives have their political apprehensions, while ordinary Chinese, just like ordinary Americans, have their privacy concerns. Shanghai's FTZ is advancing in parallel with China's financial reforms, which began last year, when China tightened rules on delisting companies, cut trading costs, increased quotas for foreign institutions and encouraged dividend payments.

Last March, China's securities regulator announced that China shall allow the residents of Hong Kong, Taiwan and Macau to open domestic accounts on the mainland.

For over half a decade, China's equity, bond and currency markets have expanded significantly. Now is the time for new reforms to allow commercial banks to grow their lending, to expand the fragmented bond market and to move gradually toward the securitization of loan portfolios.

The mainland is opening doors to foreign investors and financial institutions. Foreign banks are struggling to set up units in the FTZ, while Chinese banks hope to offer offshore banking business. Foreign commodities exchanges and trading companies may own warehouses in the area.

Some Chinese regulators are anxious that the FTZ could amplify external financial risks that could spread outside the zone. Their concerns are not entirely invalid.

If Chinese financial services had been more open before 2007, the crisis that pushed the United States and Europe to the edge of depression could have infected China's nascent financial sector as well. That, in turn, would have impaired global growth in the early days of the crisis, when China's double-digit growth cushioned the global impact of the financial crisis.

(Read more: Fed's dual mandate will begin to erode: Steinbock)

Huge stakes

Most importantly, Shanghai will have a crucial role to play as China moves from investment and net exports toward consumption. The mainland's new growth model requires more sophisticated financial services, which, in turn, can support more sustainable economic growth.

In early May, the State Council unveiled an extensive plan for economic reforms in 2013, which have the potential to make China's economic growth more balanced and sustainable in the years ahead. Shanghai's FTZ will support these changes, particularly financial reforms.

In the case of Shanghai's FTZ, the State Council is leading and coordinating the development of the FTZ, while Shanghai's municipal government is in charge of execution. Ministries have only a supporting role. In China, such policy administration is the exception, not the rule.

Reforms are expected to escalate by 2015, when the renminbi could become fully convertible.

Dan Steinbock is research director of International Business at India China and America Institute (USA) and visiting fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore). See also