by Ned Collins-Chase
MA Candidate, Johns Hopkins University – SAIS
As China attempts to engage in meaningful capital account liberalization, it faces a balancing act: implementing reforms to boost productivity, spurring development of its service industry, and enhancing renminbi (RMB) convertibility, while at the same time avoiding the risks of capital flight and threats to the viability of state-owned enterprises employing millions of workers. Pilot Free Trade Zones (FTZs) have become one of the tools China will use to implement capital account reforms, with the Qianhai FTZ focusing on broadening financial flows between Hong Kong and the Shenzhen Special Economic Zone. While the Qianhai FTZ offers new avenues for China to continue its experimentation with economic reforms and advance capital account liberalization, these avenues cannot be fully explored without appropriate parallel sequencing of macroeconomic policy reforms at the national level.
The role of FTZs in China’s economic reform and the prospects for the Qianhai FTZ
The Shanghai FTZ, the first among the recent wave of FTZ announcements, was created as a testing ground for looser financial regulations and capital account liberalization.(1) The Chinese government disclosed plans for the zone to the public just two days before its official opening in late September 2013. The announcement was followed by a three-month silence by the government, and no official information about the zone was provided to potential investors. The three-month lag may have given officials time to win the support of skeptics within the government, as well as the opportunity to create further interest among investors by strategically releasing a series of information leaks regarding the FTZ.(2)
Salient policies implemented in the Shanghai pilot zone included fewer restrictions on foreign currency exchange; a “negative list” outlining industries in which foreign investment is still restricted, in order to facilitate the ease of investment in industries without these restrictions; and simplified company registration processes.(3) Some of the experiments from the Shanghai pilot zone have since been approved for nationwide implementation, including the use of a negative list and streamlined company registration procedures.(4) There are also early indications that the effects of China’s efforts to liberalize capital controls can be seen in the Shanghai FTZ, with data showing that Chinese capital controls have had less impact since the FTZ’s launch.(5) However, while there is a possible correlation between looser capital controls and implementation of the Shanghai FTZ, recent policy reversals have threatened progress, and the degree to which novel policies will be allowed remains uncertain.(6)
The Qianhai FTZ, part of the Guangdong FTZ group, is expected to officially open in 2020. It is different from the other FTZs in that it specifically seeks to leverage the offshore RMB market in Hong Kong. Hong Kong is already a major staging point for foreign firms seeking entry to China, and serves as a source for investment that can spur the development of more modernized industrial and services sectors. The Qianhai district will comprise 15 square kilometers of the total planned 28.2 square kilometers of the larger Guangdong Pilot FTZ in Shenzhen.(7) The stated purpose of the zone is to serve as a platform for modern service industry cooperation between Hong Kong and the mainland as a part of the Mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA) and the broader “Belt and Road Initiative” introduced by Xi Jinping. The government seeks to capitalize on Qianhai’s proximity to both Hong Kong’s financial sector and Shenzhen’s manufacturing sector to attract corporations seeking to develop a modernized service industry in the region.
To incentivize participation in this project, corporations and investors seeking to do business in Qianhai receive preferential treatment, including a steep reduction in the corporate income tax rate. There is some disagreement among sources as to exactly how much of a reduction this will be; some sources say the corporate tax rate will be 15 percent, while the official project website lists the reduction as a 15 percent decrease.(8) Both tax rates are lower than the 25 percent national rate and the 16.5 percent rate in Hong Kong. Qualified individuals within the zone will also receive tax subsidies. Qualified manufacturers can apply for financial support, and foreign-invested corporations will be able to avoid bureaucratic delays by utilizing one-stop administrative procedures established within Qianhai. The greater zone will, like Shanghai, also feature bonded ports outside of Chinese customs and value-added tax (VAT) exemptions. Moreover, to create a more level financial playing field for foreign corporations and investors, Qianhai will feature new judicial and arbitration reforms, which are touted as part of “a law-governed socialist demonstration zone with Chinese characteristics.”(9)
A major factor determining the success of FTZs as a tool for capital account liberalization is China’s commitment to actually implement policies allowing for looser capital controls. Because of the risks inherent in the liberalization process and recent
economic difficulties, this commitment is far from given. As mentioned, recent developments in the Shanghai pilot zone give cause for concern that similar difficulties may impede the success of Qianhai. Further concerns arise from the poor performance of one of the FTZs’ signature tools in promoting capital flows: RMB-denominated bonds issued outside of China, popularly referred to as “dim sum bonds.” After a difficult year for dim sum bonds and offshore RMB markets in 2016, prospects continue to look bleak for their performance in 2017.(10) It will be difficult for Qianhai to be successful in broadening capital flows between the Hong Kong RMB market and Shenzhen if demand for dim sum bonds remains weak.
Beijing is truly walking a tightrope in its attempts at capital liberalization. On the one hand, China would like to see its currency attain greater weight in the global financial system, not only for the prestige it would bring, but also because of the belief that an increased proportion of trade financed by RMB would help China better withstand large-scale crises, such as the 2008 global financial crisis which threatened its export volume.(11) On the other hand, China’s economy is still largely following a model of maintaining exports and financing investment through domestic savings, and abrupt liberalization of currency valuation and capital flows could make China vulnerable to maintaining a trade deficit and the risk of large-scale capital flight.(12) Fears of the latter seem confirmed in China’s recent tightening of capital controls in response to the effects of a cheaper RMB, and the action’s deleterious effects on dim sum bonds in 2016.(13)
However, if China wants to succeed in its long-term aims of rebalancing its economy, it must liberalize. The necessity of this shift, coupled with the prospect of humiliating failure should the FTZ experiment prove to be a flop, gives Beijing a strong incentive to redouble its future efforts and to ensure Qianhai’s success.
Conclusions and policy considerations
Physical spaces in which to implement capital account liberalization are neither intrinsically useful nor harmful in the effort to reform capital control systems, but they may have benefits in the Chinese context. The use of pilot FTZs is indicative of China’s preference for gradualism in adopting economic liberalization, like the dual-track reforms created during the 1980s through Special Economic Zones (SEZs), and may reflect an effort to marshal support for these reforms by building on an existing, and popular, format. If China succeeds in this regard, the choice of using physical spaces to house FTZs is appropriate.
The formation of the Qianhai FTZ is a legitimate approach to capital account liberalization in theory, but in practice the zone will only be as successful as the overarching capital account liberalization that should accompany it. There are concerns regarding the function of the Shanghai Pilot Zone that represent real risks to the success or failure of the FTZ experiment. While the Shanghai Zone has already contributed to national economic policy reforms through the broader approval of a negative list, ambiguity remains regarding its possible contributions toward looser currency restriction and simplified corporate registration. Further, it remains questionable whether it can guarantee the implementation of meaningful reforms or create confidence among investors.
If China seeks to pursue internationalization of its currency, it must maintain a measure of caution, but also become more willing to accept levels of capital outflow. Without willingness to accept this risk, the tools at the disposal of FTZs will be considerably curtailed. Regardless of the type of currency convertibility and capital account liberalization China is willing to pursue, it must commit fully to these policies to maintain investor confidence, and to avoid retreating to tighter capital controls. Qianhai will be more likely to succeed if it demonstrates a credible guarantee by the government to pursue currency and financial liberalization, while assuaging fears of the growing pains of liberalization among local actors and domestic businesses.
1 David Groffman, “Introducing the Shanghai FTZ,” International Financial Law Review (2013).
3 Ibid.; “Introduction,” China (Shanghai) Pilot Free Trade Zone, 2017, accessed April 3, 2017, http://en.china-shftz.gov.cn/About-FTZ/ Introduction/.
5 Daqing Yao and John Whalley, “The Yuan and Shanghai Pilot Free Trade Zone,” Journal of Economic Integration 30, no. 4 (2015): 591-615.
6 Daniel Ren, “Shanghai FTZ firms’ overseas hopes dashed by policy U-turn,” South China Morning Post, December 30, 2016, http:// http://www.scmp.com/business/china- business/ article/2058199/shanghai-ftz-firms-overseashopes-dashed-policy-u-turn.
7 “About FTZ: China (Guangdong) Pilot Free Trade Zone, Qianhai and Shekou Area of Shenzhen,” China (Guangdong) Pilot Free Trade Zone, Qianhai & Shekou Area of Shenzheng, accessed April 3, 2017, http:// qhsk.china-gdftz.gov.cn/en/fta/201507/ t20150701_18141290.html.
8 Neil Gough, “A Muddy Tract Now, but by 2020, China’s Answer to Wall St.,” New York Times, April 2, 2014, https://dealbook. nytimes.com/2014/04/02/a-financial-centeris- envisioned-on-a-muddy-tract-in-southernchina/; “About FTZ: China (Guangdong) Pilot
Free Trade Zone, Qianhai and Shekou Area of Shenzhen.”
10 Rev Hui, “The 2017 Dim Sum Bond Disappearing Act,” Global Capital, February 9, 2017, http://www.globalcapital.com/article/ b11mqds7v12t9m/the-2017-dim-sum- bonddisappearing-act; Cathy Zhang, “Dim sum bonds under pressure from cheaper yuan and rise of panda bonds,” South China Morning Post, August 9, 2016, http://www.scmp.com/ business/markets/article/2001364/dim-sumbonds-under- pressure-cheaper-yuan-and-risepanda-bonds.
11 Arthur R. Kroeber, China’s Economy: What Everyone Needs to Know. (New York, NY: Oxford University Press, 2016).
12 David Keohane, “This isn’t the Chinese capital account liberalization you’re looking for,” Financial Times, July 17, 2015, https://ftalphaville.ft.com/2015/07/17/2134607/thisisnt-the-chinese-capital- accountliberalisationyoure-looking-for/.
About the author:
Edward (Ned) Collins-Chase is a rising second-year SAIS M.A. concentrating in China Studies. Ned previously served as Peace Corps Volunteer in Mozambique, and his research interests include China’s economic development, Northeast Asian security, China’s growing role in Africa, and U.S. grand strategy in the Asia-Pacific region.