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Shanghai Free Trade Zone Underlines Risks Ahead

Business, China, Company Strategy, Economics, Environment, Innnovation, Sustainability, Technology
By John Richardson on 02-Oct-2013

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By John Richardson

MUCH ballyhoo greeted last week’s launch of the Shanghai Free Trade Zone – an eleven-square-mile experiment in economic liberalisation on the outskirts of the city.

Comparisons have been drawn with 33 years ago, when Deng Xiaoping set up the Shenzhen Special Economic Zone as an antidote to the poverty and economic stagnation that was afflicting China.

When the Shenzhen experiment was spread across much of the rest of eastern and southern China, hundreds of millions of people were lifted out of poverty as China became the workshop of the world.

But when people today look back on the long-term outcomes of Shenzhen, they are just as likely to focus on the negatives as well as the positives. These have included corruption, much-greater income inequality, chronic air, land and water pollution and over-investment in manufacturing.

The Shanghai Free Trade Zone experiment is another bold attempt to transform China that also carries risks, in both the short and long term.

Although the details of what will happen within the trade zone are pretty sparse, announcement to date include:

  • The development of a crude-oil futures trading market, which China currently lacks. If this were to become a nationwide benchmark for crude pricing, it could obviously help local chemicals producers set their cost floors.
  • The permission for ten banks, eight Chinese and two foreign, to open branches in the zone. These include Citigroup, the Development Bank of Singapore and all of China’s largest banks. Crucially, the banks will be allowed to set their own interest rates, including deposit rates, and trade in foreign exchange. Freeing-up deposit rates nationwide would unlock much-greater domestic consumption.
  • Foreign companies will also find it easier to set up operations across 18 different industries inside the zone. These include travel agencies, theatres, brokerages and telecommunications firms.

Fisher Investments, the US-based independent investment advisers, has identified the following practical difficulties in making the zone work:

  • How do does Beijing aim to keep foreign capital from leaking out of the zone and into the rest of the country?
  • How do they aim to keep funds from elsewhere in the country leaving China through the zone?
  • How will they limit individuals from taking advantage of the region’s potentially higher bank deposit rates?
  • If national banks are reincorporated in the free-trade area, will they be able to offer freer deposit rates nationwide, or will their customer base be limited to individuals residing in Shanghai?
  • If the latter applies, how great will the incentive be for banks to go through the potential administrative hassle of relocating?

And the blog would also argue that “vested interests” are sure to work towards the failure of the Shanghai experiment. How will Beijing tackle these vested interests?

But let’s assume, for argument’s sake, that the Shanghai experiment is a roaring success and so gives Xi Jinping and Li Keqiang greater confidence to spread some of its reforms across the whole of China.

Will this guarantee a new sunny upland of constant and strong chemicals demand growth in China? No.

For example, if the biggest reform of all – the removal of the cap on deposit rates – does go nationwide, many problems would remain, according to the excellent Financial Times columnist, Henny Sender.

“China has already removed the floor on interest rates, emboldening state-owned enterprises to ask for lower borrowing rates. With the next step, removing the ceiling on rates, depositors will ask for more returns on their savings, squeezing the money banks make in the process,” she wrote in this article.

“While the banks have been told to prepare for this change for a while, doubts linger about whether they have the risk management skills for this brave new world. Banks in far more sophisticated markets have yielded to the temptation to borrow short and lend long to swell their margins with disastrous results.

“The challenge will be especially daunting for second-tier banks, just below the big four state-owned banks, [such as} Bank of Communications and Citic Bank.

“Another consequence of the coming deregulation will be a rise in the cost of capital for most borrowers. In the long run, that could be a good thing. When capital is expensive, it tends to get allocated more carefully.”

But in the shorter term more expensive capital would represent a further blow to companies already burdened with rising debts that are being serviced by declining operating cash flows, she warned.

Sender added in her article that bankers who gathered in Singapore recently think that the removal on deposit rates could happen across China in the next 18 months.

All the above further underlines that while it is great news that Xi and Li know where China needs to head if it is to escape a middle-income trap, getting from Point to Point B will involve lots of experiments and failures, as well as successes.

And ultimate success cannot be guaranteed.