Shanghai FTZ: Expectations Have Never Been Aligned With Reality

“Unrealistic Expectations”

On September 29, 2013, China officially opened the Shanghai Free Trade Zone, or FTZ, an outwardly ambitious project to bring a new wave of foreign investment and reduction in restrictions that have plagued foreign businesses in China for years. The Chinese Communist Party promised sweeping reforms that would both reduce administrative burdens and create a generally more business friendly environment in the Zone, located in Shanghai’s Pudong District. Foreign investors, in anticipation of reform, purchased surrounding property immediately causing home prices in the area to surge 30 percent. Stock prices of logistics and shipping firms also climbed dramatically.¹ The announced framework in the FTZ was geared towards broad administrative reforms to simplify the burdensome processes that often impede or delay foreign direct investment in China’s economy. The announcement was bold and expectations even bolder. Han Zheng, Shanghai’s CCP Leader, and leader of the FTZ implementation, stated upon launch that the Shanghai FTZ would “transform the government’s role in business,” and that the “FTZ is part of a national strategy, a key decision that deepens reform, a breakthrough that overcomes the main obstacles of reforms. With this breakthrough, the government’s role can undergo changes. It can also boost scientific development and increase China’s competitiveness.”²

Foreigners who had done business in the Chinese market often shared the same frustrations; slow, unpredictable administrative approval processes, a largely unreliable legal system, highly limiting restrictions on sectors of capital investment, interest rate volatility, and the inability to convert currency in an expeditious manner. The Shanghai FTZ promised to fix many of these issues, initially in Shanghai but with an eye towards nationwide reform. In mainland China, sectors for foreign investment are controlled through a series of classifications such as “encouraged,” “restricted,” and “prohibited.”³ In what was the most anticipated reform, the FTZ announced the use of a “negative list,” allowing wholly foreign capital investment in any industries not on the list. When initially released, the list covered 16 service sectors including: agriculture; mining; manufacturing; production of power; gas and water; construction; wholesale and retail; transportation; computer information services; finance; real estate; scientific research; environmental; education; health; and sports and entertainment.⁴ The foreign expectation was for the release of the list to be a historical moment, opening foreign investment to markets never previously allowed. In reality, it was a similar set of restrictions dressed up to look like reform. While the negative list does not ban foreign investment in these industries, it does limit investment in joint ventures largely to small equity ownership stakes and requires a burdensome administrative process, leaving sectors of foreign investment in a similar place as it was prior.

Immediately upon release of the list, Chinese leadership began backtracking to quell foreign investor’s concerns by promising that the negative list would become less restrictive. Han Zheng stated “This is the 2013 version, and we will start garnering consensus for how to manage the negative list. Then we will have the 2014, 2015, and 2016 version. The NPC (National People’s Congress) gave us three years. We will make progress every year, making gradual improvements.” He also stated: “Even with the restrictive nature of the negative list, the reforms are progress. This is a major innovative reform. It frees companies from reviews. Companies used to register with the local bureau of industry and commerce in several different categories. But now there is only one category. We have realized the value of a ‘register first, approve later’ process in the FTZ, which means companies can start operating after registration, and applies to government licensing or approvals only when they deal with the businesses required under these procedures.”⁵ It’s a bold promise that as of yet, does not seem to be delivered.

Now entering the FTZ’s second year, Westerners are beginning to lower their expectations. While the 2014 “negative list” has been reduced from 190 items to 139, China has seen little actual change in this area. The negative list, offered as the most sweeping of political reforms in Shanghai, has made little difference in opening up Chinese markets to foreign capital, with criticisms by even the state-run media that the zone has been too conservative in reforms.⁶ Experts in Chinese business policies feel that there has been no significant change. The managing director of the China Market Research Group in Shanghai states: “It’s great talk by Premier Li Keqiang and a lot of senior government officials, but there’s no execution. Nobody knows what you can do.”⁷ In the areas of currency convertibility and interest rate volatility, there has been less movement than promised.⁸ What was expected to quickly become a hub for Western banking has seen very little growth. Only one offshore bank has opened a free trade account available to clients in China: HSBC, which had been negotiating with the Zone prior to the initial announcement.⁹ Xinhua, the state-run news agency, has touted that there has been growth over the past year from 8,000 businesses in the zone to almost 20,000; however this seems to be below expectations.¹⁰

“It’s not you, it’s me”

This is not China’s first time utilizing localized experiments to develop nationwide reforms. Isolated experimentation in economic reform is an integral part of China’s success in the world economy. Beginning with the central government allowing businesses to lease land long-term in the late 1970s, China has seen a rapid transformation in domestic economic policy. Between 1981 and 2001, the proportion of the population living in poverty in China fell from 53 percent to just eight percent. Late in 1979, the first Special Economic Zones (SEZ) were commissioned in Shenzhen, Shantou, Zhuhai, and Xiamen, with the goal of testing progressive domestic economic policies for implementation on a national scale. The development of the SEZs were based on four underlying objectives: (1) utilizing incremental experimentation and workforce education through trade, supported by government policies, (2) attracting of foreign capital to promote export growth and generate domestic employment, (3) overcoming the common problem of limited resources by supporting large scale investment with outside capital, and (4) facilitating economic liberalization through policy measures and private innovation. The SEZs initially saw great success in meeting these objectives. In 1981, the four SEZs accounted for almost 60 percent of Foreign Direct Investment (FDI) in China, with Shenzhen accounting for the most. By the end of 1985, realized FDI in the four zones totaled US $1.17 billion. From 1980 to 1984, Shenzhen grew at a 58 percent annual rate, while the national average for GDP growth was only estimated to be 10 percent.¹¹ Foreign capital, technology, and management techniques drove economic modernization. The foreign capital enabled the country to acquire the needed technology and skills without draining the limited public revenue that existed after the Cultural Revolution. At the time of its designation as an SEZ, Shenzhen was a fishing village of no more than 30,000 people. It was no bigger than three square kilometers and lacked even a traffic light.¹² By the end of 2011, Shenzhen had 10.47 million permanent residents, ranked fourth in economic power on the Chinese mainland, and placed second in global rankings of economic strength compiled by the U.K. Economist Intelligence Unit in 2012.

Shenzhen’s success can be attributed to attracting FDI through favorable legal policies and reduced administrative and tax burdens on businesses. Shenzhen streamlined administrative processes, allowing foreign investors to have direct access to provincial and central level planning authorities through the local Shenzhen authority. As a result of these successful reforms at the local and provincial level, many of these practices were put into place nationally. However, despite Shenzhen’s 58 percent growth rate from 1980 to 1984, it was not until 1987 that land utilization for business became common throughout China. Even when it was most needed, change was predictably slow in China.

The China of today is not the China led by Deng Xiaoping, in need of rapid change to adapt to the world economy. In that sense, Shanghai is not Shenzhen. Western expectations are based on the success of prior localized reforms operating with a very different goal. Shenzhen was the first of its kind. The framework under Deng Xiaoping was to begin to experiment with economic policies that were unfamiliar in China’s system of governance. China is no longer a stranger to capitalism. Thus the focus of the Shanghai FTZ is not to experiment with new ideologies but to tweak existing ones. Where the SEZs were designed to focus on generating domestic growth through foreign direct investment, the FTZ is built with an eye towards opening borders to become a larger part of the international community. For a political class afraid of fallout and familiar with effective domestic economic policies, there is more to lose in Shanghai by rushing reforms. As such, the implementation of true change in Shanghai is predictably more gradual than that of the SEZs of the 1980s.

“Not a Dud”

Despite disappointment from foreign investors, the Shanghai FTZ is starting to see some progress. If the FTZ is the more predictable marathon, rather than the anticipated sprint, it is on pace to serve its purpose. Prior to January of 2015, Chinese regulations had heavily restricted technology related industries to limited joint ventures with local partners. A wholly foreign owned technology company had been unheard of in China. An announcement in January 2015 from the Ministry of Industry and Information Technology stated that it will now permit wholly foreign-owned “online data processing” and “transaction handling” industries, geared toward e-commerce industries. While it will likely take considerable time before corresponding rules and regulations are released, this move could allow Western companies to compete with Chinese e-commerce behemoths such as Alibaba on their home turf.¹³

In regard to currency convertibility, while reforms have moved dramatically slower than initially announced, there have been significant changes in the FTZ. In February of 2014, FTZ-based businesses were granted the ability to create a two-way cash pool of yuan, now the fifth most traded currency in the world.¹⁴ The cash pool allows individuals at these companies to engage in cross-border trade settlements using the yuan, making capital flows much easier in and out of China. Prior to this change, currency often had to be converted into a foreign currency before leaving China’s borders. The policies were largely successful and have been implemented on a national scale in a short period of time.¹⁵ Whether as a result of these policies or otherwise, the yuan has overtaken the Canadian and Australian dollar in world trade.¹⁶

Another aspect of the FTZ that has benefited small and middle-market foreign investors entering the Chinese market is the rise of serviced offices. Serviced offices are rentable office spaces that come with technology infrastructure, fully furnished work spaces, and secretarial services. These services have allowed foreign businesses to maintain a presence in China without having to deal with skyrocketing commercial real estate prices in an unpredictable Chinese business environment.¹⁷ These offices are a part of the reforms allowing a presence in China with minimal upfront capital. In addition to serviced offices, the authorities are correcting a major disadvantage of the FTZ: it was far away from the central business district. The FTZ was geographically isolated from the ports and airport, making many of its liberalized policies difficult to take advantage of for businesses operating in the main business zones in Shanghai.¹⁸ The expansion of the FTZ will move into the Shanghai city center where large multinational companies and banks already have their headquarters.¹⁹

Small businesses are not the only ones assisted by these reforms. Amazon.com, which already has significant operations in China, is opening a new logistics warehouse to try to lower shipping charges and speed delivery in and out of the zone.²⁰ Relaxation in tariffs, as well as import/export regulations, has made for increased ease in logistics and transportation. Amazon.com intends to capitalize on these reforms with its new warehouse. Microsoft Corp. announced in September that it would release its signature game console, the Xbox One, in the FTZ after the country lifted a more than decade-long ban on gaming.²¹ Even Victoria’s Secret is opening a store in the FTZ. Although limited to a $1.1 million capital investment, it is the firm’s first move into the Chinese market. The lingerie brand was attracted to the ease in logistics and warehouse services, allowing it to reduce wait times for product delivery from months to weeks.²²

After early success in the zones, China has announced there will be three new FTZs, each experimenting with its own economic reforms. The zones will be located in Guangzhou, Tianjin, and Fujian, focusing on specific geographic areas within those cities.²³ While the reforms are likely to be slow, China is determined to make FTZs part of the future, in the way Shenzhen was a part of the past.

“No Surprises”

It is hardly surprising that the FTZ has not lived up to Western expectations. It was, however, the Western expectations that were unrealistic, not the rate of reforms in the FTZ. China’s appetite for radical reforms has slowed dramatically since the early 1980s, as China has adapted to a new economic status quo. What was once an economy based almost exclusively on providing cheap labor has now developed a thriving service sector, a domestic luxury goods market, and a banking sector that is beginning to rival any modern nation. As the level of reform required to transform the landscape of China slows down, its rate of experimentation does too. This is not to say that experimentation as a result of policies in the FTZ could not have dramatic change on the way the Chinese do business, it is just that it will not happen at the pace Westerners would like. Chinese authorities are being slow and methodical in their rate of reform. The pace of change is as much about mitigating the risk of moving backward as it is about moving forward. In the words of Deng Xiaoping: “Keep a cool head and maintain a low profile. Never take the lead but aim to do something big.”