Shanghai Has a Free-Trade Zone, so Now What?

The 29-sq-km enclave could either revolutionize world finance, or simply get mired in bureaucratic circumspection

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CARLOS BARRIA / AFP / Getty Images

Shanghai municipality Communist Party secretary Han Zheng inaugurates the Shanghai free-trade zone during a ceremony in the Pudong district of Shanghai on Sept. 29, 2013

More than 30 years ago, Deng Xiaoping, the father of China’s economic miracle, supported the creation of special economic zones (SEZs) as a method of introducing capitalism into the country’s communist economy. The zones, most famously Shenzhen, allowed foreign companies the freedom to invest and build factories, kick-starting the nation’s rapid growth. Such reforms eventually spread throughout the entire nation, turning China into the workshop of the world and forever altering global manufacturing.

Today, China’s leadership is dusting off this old policy to once again experiment with capitalism — this time in the realm of finance. If successful, the new measures could have a similarly epoch-making impact on the global economy, changing which currencies we use, where money flows and what financial institutions dominate global finance.

On Sunday, China officially opened the Shanghai free-trade zone, a 29-sq-km swath of land carved out of the country’s most populous city. Inside, foreign financial institutions will be allowed to invest and operate more freely than in the rest of the Chinese economy. Interest rates will be liberalized, cross-border financial flows freed up, and the renminbi, China’s currency, will be permitted to trade more easily. The hope is that the reforms implemented here, just like those in the SEZs, will eventually become national policy, leading to a fully convertible currency and open capital markets. We cannot underestimate how critical that would be. The renminbi could become an international currency to rival the dollar and euro. Chinese banks could become more integrated into global finance and competitors to Citibank or JPMorgan Chase. The reforms could also help the entire Chinese economy become more market-oriented and competitive.

Well, that’s the plan, at least. The government has so far been clear in its intention to introduce financial reforms in the zone, but not as clear on how they will actually take place. The details on what can and cannot be done there, and when certain reforms will be implemented, remain sketchy. The reforms planned for this Shanghai zone will be much more difficult than those that took place in the trade- and manufacturing-focused zones of yesteryear. Factories, and the shirts, shoes and TV sets they make, are easy to monitor and control; not so financial flows, which could surge in and out of the zone with destabilizing speed. Financial firms could also take advantage of different interest rates and currency values inside and outside the zone to turn a quick buck.

(MORE: China May Lift Social-Media Ban From Shanghai’s Free-Trade Zone)

There is great concern among Chinese policymakers about opening the inexperienced domestic financial sector too quickly to the global marketplace. It is therefore hard to gauge at this point how far and how fast the Shanghai free-trade zone will be allowed to develop, and there’s even more uncertainty about when any reforms attempted there will be introduced on a wider scale. The government attempted a similar step a year ago — announcing a zone near Hong Kong that was also supposed to experiment with financial reform — but it never really took off.

There is some hope that this Shanghai experiment will have stronger prospects. The Shanghai zone has the backing of no less a figure than Premier Li Keqiang, which could provide the experiment with the political heft to overcome opposition. The mere fact that the Chinese government is attempting such a bold step is a sign of a renewed commitment to economic reform, which has been stalled for more than half a decade. Still, many analysts expect the reforms to come slowly and have doubts about how readily they could be applied to China as a whole. The economy requires all sorts of other reforms — of bloated state-owned enterprises, poorly managed banks and weak rule of law — before a full financial opening of the nation could be successful.

“We believe markets need to curb their enthusiasm and lower their hopes,” economist Ting Lu of Bank of America Merrill Lynch commented in a report. “Testing some reforms in a carved-out small zone in Shanghai, the most developed city in China, could be useful to some degree, but many of those special policies may not add much value for a later promotion [if possible] to other parts of China.” So the greenback is safe, at least for now.

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