Pilot FTZ's experiences are spreading

One benefit of the Shanghai FTZ has been the promotion of RMB internationalization

Three years ago, China's State Council approved the establishment of a free trade zone in Shanghai.

The aim of the move, on Aug 22, 2013, was to use the pilot project to gather two to three years of experience in transforming the role of government, introducing administrative innovation and opening-up policies that could eventually be spread across the country.

The Shanghai FTZ was launched on Sept 29, 2013, and it is now time to make an evaluation.

What should we expect to learn from the experiment?

There were two main pressures and one benefit that induced the Chinese government to set up the FTZ.

One pressure is from inside. China's economic growth has been slowing for around seven years, something which had never previously happened in China's history.

Continued weak international demand, rising labor costs and a sharp decrease in the efficiency of government investment contrast with the old economic growth model of heavy dependence on exports and investment.

The only way out is supply-side reform by cutting excess capacity, releasing domestic demand and stimulating entrepreneurs' innovative spirit. All of this will require the government to improve economic efficiency by developing the private economy, reforming the financial system and reducing intervention.

Another pressure is from outside - international economic and financial agreements shifting their emphasis from merchandise to services. A United States-led trade agreement, composed of the Trans-Pacific Partnership, the Transatlantic Trade and the Investment Partnership and the Multilateral Services Agreement, is isolating China from international trade.

To participate, China needs to make many of the changes that a free market economy requires. For example, the US, China's most important trading partner, in its bilateral negotiations, insists on using a negative list as a tool to manage foreign direct investment, which is a new practice for China and means that its government may need to adopt a completely new system.

Transformation of government functions is a huge project that those adhering to the old system may resist.

One benefit of the Shanghai FTZ has been to promote the internationalization of the renminbi. Though China is now the world's second-largest economy, its currency is still in a very low position. The key to promoting internationalization of RMB is to encourage more use of it, which requires building a reflux mechanism and gradually opening the capital account. However, capital account liberalization involves financial liberalization, which implies the opening up of China's financial industry, interest rate liberalization and other financial reforms.

For these reasons, big reforms are inevitable and imminent. But in a vast country like China, reform is not an easy thing. So Shanghai, as the center of China's financial market, which is quite a distance from China's political center, a bit more international and somewhat more market-oriented, was chosen for the experiment.

Although there are high hopes nationally for the experiment, we should lower our expectations because of several difficulties.

First, since the Shanghai FTZ covers only 28.78 square kilometers initially, whatever happens in the Shanghai FTZ, the economic impact outside it cannot be huge. However, the experiment is designed to be a controlled one and policies that can be copied will be strictly verified. As China is a large country with widely varying provinces, whatever administrative innovation that can be applied in the FTZ can hardly be generic enough to be applied nationally.

Second, as part of the national strategy, the opening-up policy is suitable for discussion, development and implementation top-down and the FTZ can hardly provide much experience.

Regarding the easy transfer of currency, the opening-up policy for finance requires extreme care.

Finally, almost every experimental policy from the Shanghai FTZ would need to be negotiated between many related departments before being put into practice, but the FTZ management committee, which is at a very low power level, can hardly handle coordination at provincial level.

Bearing all this in mind, we may find the Shanghai FTZ has succeeded in achieving some of its goals while others are destined to be unsatisfactory.

There are mainly two major innovations: one is the transformation of government functions and the other is the opening up of financial services.

As for accelerating the functional transformation of government, the important achievement is that a negative list has been introduced and administrative procedure has been simplified. With a negative list and simplified filing procedures, investors' filing costs will be significantly reduced and policy predictability will be much improved.

The introduction of a negative list involves a great deal of work since the restrictive provisions on direct investment are spread across a large number of administrative documents among various departments. The change of filing procedure is also an important step to transform the government's function from an approval authority to a service provider.

As for the opening up of financial services, FTA Accounts is an important innovation. It is a very important infrastructure for piloting RMB capital account convertibility, interest rate liberalization, and the cross-border use of RMB. But capital account liberalization is basically not advanced.

In fact, considering the complexity of the Chinese economy, the government may be more cautious about opening the capital account.

China's real estate bubble is closely linked with the banks' bad debt and the bad debt is closely related to China's financial crisis. As China's housing prices are very high, real estate funds can become flight capital if the capital account opens a door for them. Taking such a scenario into account, the FTA experiment in financial freedom must ensure the overall stability of China's economy.

There are also many micro innovations, in the cooperation mechanism among authorities, administrative supervision, investment facilitation, and tax regime, and some of them have been introduced to the whole country.

Covering such a small area and with a lower level of local government, in such a short period the FTZ's achievements have been rich, which is why the project has expanded very fast.

A year and a half after Shanghai, Guangdong, Tianjin and Fujian set up their own FTZs, and the Shanghai FTZ has expanded its area too. This month it is said that another seven FTZs will be set up soon.

This expansion can be regarded as a vote of confidence by other local governments and is an illustration of the success of the Shanghai FTZ.

The experiment aims to accumulate experiences that can be applied to other parts of China. Now three years have passed, besides improving current policies such as shortening the negative list, the Shanghai FTZ can have some new thinking patterns for its further experiments.

First, Shanghai can use its FTZ to promote its position as an international financial center by developing the FTZ as an interchange station for mainland RMB centers and offshore RMB centers and as an incubation center for financial technology companies.

To promote the internationalization of RMB, it is necessary to create a mechanism for the currency's reflux. As Shanghai is China's financial center and has created FTZ accounts, the time is ripe to turn the Shanghai FTZ into a bridge for communication between onshore RMB trading centers and offshore ones. Compared with the high risk of opening up the capital account for all foreign currency, the risk of allowing the yuan to freely enter and exit is low, because the total amount of the RMB is controlled by the central bank of China.

Shanghai is considered to be less entrepreneurial than Shenzhen, but in the new wave of financial technology entrepreneurship, Shanghai may have more advantages than Shenzhen. Shanghai should seize this trend by using the FTZ as a special economic zone for financial technology companies. Shanghai should try to provide conveniences of foreign exchange, reduced tax, talent introduction as so on for fintech companies.

Second, the Shanghai FTZ should improve the multidepartment coordination mechanism.

It has high costs in the as a new pilot policy because the FTZ committee needs to communicate with many higher-level administrative departments and the communication cost is high. It is time to replace the temporary communication mechanism with a formal one.

Finally, Shanghai FTZ should try to enhance cooperation with other FTZs.

There are already four and the number will soon be increased to 11. These some common experiments and some different ones. By cooperating they can help each other, learn from each other and cut costs in communication with higher-level administrative departments.

The author is a lecturer at the Management School of Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center. The views do not necessarily reflect those of China Daily.