There are high hopes on the Shanghai Free Trade Zone (FTZ) being a test bed for China to experiment full capital account and RMB convertibility. Don’t bank on it. The big thunderous call for convertibility will likely result in just a few small raindrops. This is because the FTZ has an inherent limitation that makes it unlikely to push through bold reforms, such as full currency convertibility, in any meaningful way in the medium-term. That limitation is a requirement by Beijing that the FTZ’s reforms must be replicable.
The FTZ experiment will have to be replicable in other parts of China, as the leadership’s aim is to roll out the experiment to the whole country after successful trials. This was what happened with the Special Economic Zones (SEZs) in the 1980s and 90s. However, this emphasis on reform replication brings a self-imposed constraint on the depth and scope of reforms in the Shanghai FTZ and all the other potential FTZs that are pending approval. It is also a constraint on the FTZ’s ability to deepen national structural reforms that will be needed to achieve full capital account and RMB convertibility.
Why so? Full RMB convertibility requires the support of an efficient and transparent framework. It will take many years for the Shanghai FTZ to build a legal and institutional framework that is based on the rule of law and that conforms to international norms in terms of transparency and integrity. During the process, the rest of the city and the country will still be struggling with moral hazard and rent-seeking problems. Thus, even when the FTZ does build such a framework, it will not be replicable in the rest of the country in the medium term. If it is deemed not replicable, there is no incentive to implement that reform in the FTZ.
Some reforms are only meaningful when they are implemented nationally. They include interest liberalisation, capital account and RMB convertibility, among others. These are the very reforms that the market is expecting from the FTZ as a catalyst for deep changes going forward. However, the FTZ is too small to be able to test these major reforms, especially in the presence of incentive incompatibility problems that are plaguing the country’s economic system.
Crucially, if the regulators fail to ring-fence the FTZ from the rest of the country, arbitrage activity will quickly overwhelm the FTZ’s financial systems and risk capital flight. However, if the regulators are able to segregate the FTZ, it will just be an isolated experimental area, with a limited impact on the drive towards national structural reforms. The best way to think about this is Hong Kong, which is a de facto free trade zone of China since its reversion to the motherland in 1997.
Hong Kong has already developed a world class financial system, which runs on the rule of law with a high level of credibility and integrity. It has a fully convertible capital account and currency, and its economy is running on free market principles. All these are exactly what the Shanghai free trade zone will try to emulate in the coming years. But Hong Kong is ring-fenced, quite successfully, from the rest of China with no free flow of investment and capital.
Hong Kong has always been known as a financial laboratory for China’s financial liberalisation, and Beijing wants the rest of the country to learn from it. Despite this “prestigious” status granted by Beijing, has it been able to push China’s structural reforms ahead? No! After all, many key Chinese financial institutions have already had operations in Hong Kong. They have learnt from it and from the cross-border operating environment for some years. It is doubtful if the Shanghai FTZ will offer any significant and new knowledge to the key Chinese financial players that they do not already know or have not learnt from Hong Kong.
The irony is that the very condition of reform replication that Beijing imposes on FTZs will constrain their effectiveness in pushing structural reforms out nationally. The local authorities will be reluctant to pursue bold changes that have little chance of being rolled out nationally, even though they may be crucial for deepening the nation’s structural reforms and building a world class financial system.
In the medium-term, benefits of FTZs will be limited to within their boundaries, with no fungible investment and capital flows between them and other parts of the country. The situation is exactly like Hong Kong. As for the currency convertibility experiment, unless one expects the rest of the country to implement full RMB convertibility in a few short years, there is little incentive for Shanghai to do a serious experiment on it.
Senior Strategist, BNPP IP
Opinions here are of the author’s and do not necessarily reflect those of BNPP IP.