China is stepping on the reform accelerator, opening its capital account much faster than expected.
Just one year after launching its first free trade zone in Shanghai, China is now liberalising offshore borrowing for firms registered there.
The Shanghai free trade zone was originally billed as a three-year trial, but China is forging ahead, expanding Shanghai and launching three new zones on 1 March.
"The speed at which China is expanding the free trade zone scheme has come as a surprise to many observers"
While not the sole conduit for reform in China, the trade zone scheme is crucial to the prospects of a fully convertible renminbi (RMB), and the speed at which China is expanding the scheme has come as a surprise to many observers.
The recent announcement that offshore borrowing for firms in the Shanghai free trade zone will be relaxed further – and that the new regulation will include banks – is a significant breakthrough and suggests China is committed to achieving full convertibility of the RMB. Other pilot schemes are likely to follow.
Shanghai an important test bed
The latest policy changes follow China’s announcement last December that it would expand the pilot Shanghai free trade zone, by including sites such as the Lujiazui financial district, and establish three new hubs in Tianjin, Fujian and Guangzhou.
Launched in September 2013, the Shanghai free trade zone has been an important test bed in China for freer trade, and a more liberal business and financial environment.
"The Shanghai free trade zone is contributing to China’s financial reform"
The fact that China is now expanding the zone and replicating it in other cities confirms that the government considers it a success:
First, the zone is bringing real benefits to China’s economy and corporates. According to official data, export-import trade passed through the zone between January and August rose 11 per cent compared to the same period of 2013, before the zone was established.
Second, the Shanghai free trade zone is contributing to China’s financial reform. Initiatives such as cross-border RMB sweeping, which allows corporates to repatriate their trapped cash onshore to offshore – are crucial to promoting RMB internationalisation. Between January and August last year, two-way RMB flows arising from cross-border sweeping reached more than CNY27.2 billion.
More free trade zones a sensible step
Third, the risks associated with the zone are proving manageable. A negative list was put in place to restrict foreign funds from investing in specific industries within the zone, such as sensitive or overheated sectors. This list has since been shortened, demonstrating the Chinese government’s growing level of confidence in the zone.
Furthermore, commercial banks are enforcing know-your-customer procedures to ensure that the funds moving in and out of China are supporting genuine trade.
Bearing in mind this track record in Shanghai, launching new free trade zones seems a sensible way forward given China’s sheer size.
The Guangdong free trade zone, including Qinghai, will mainly serve corporates from the high-end financial services industry located in Hong Kong, the Pearl River Delta and Macau.
The Tianjin zone targets those located in the northern area, where some 80 Fortune 500 companies have established their presence, including many international multinational firms.
Meanwhile, the Fujian zone will make use of its strength on trade with Taiwan, and in the international logistics business.
"China is committed to driving financial reform in a bid to reach the endgame of full convertibility of the RMB"
While details have yet to be ironed out, the three zones are expected to implement similar policies to Shanghai, which will continue to cater for corporates in eastern part of China and overseas.
Corporates that have embraced China’s liberalisation via the Shanghai zone are befitting from first-mover advantage, but the free trade zones are not without challenges.
Many multinational corporates feel uncomfortable with the piecemeal and unpredictable way in which China announces its policy changes. Some are reluctant to set up an entity in a free trade zone, only to find another new, more user-friendly policy around the corner.
Expansion of zones will take time
In addition, RMB appreciation is no longer seen as a one-way bet, which poses an even bigger challenge for corporates as they will have to start hedging their RMB exposure.
Expansion of China’s free trade zones is likely to take time. Their scale will be small compared to the broader economy and it is unlikely that the zones will have a huge impact on activities beyond their boundaries.
What is clear, though, is that China is committed to driving financial reform in a bid to reach the endgame of full convertibility of the RMB, and more free trade zones will act as stepping stones along the way.
A version of this article appeared in the South China Morning Post on 25 February 2015