A Testing Ground for Reform

The Shanghai Free Trade Zone is up and running, but observers are still waiting for officials to implement reforms that would include broadening market access to foreign investors.

By Lingling Jiang 

Since the PRC government announced in September that it would establish the China (Shanghai) Pilot Free Trade Zone (FTZ), it has set two goals for the zone: reducing government intervention in the market and creating a better operational environment for business. Actions to achieve these goals have been proposed, but so far reform details have trickled out slowly.

The Shanghai FTZ—unlike other FTZs that have been operating in China for more than 20 years—was expected to be the country’s new testing ground for economic reforms. The zone is spread out over 29 square kilometers in Shanghai’s Pudong district and incorporates four existing “bonded zones,” which are supervised by customs authorities and allow imported goods to be exempt from tariffs as long as they do not cross into China proper. The central government has said that if the Shanghai FTZ’s reforms are successful, it will implement the same reforms to broader area after the FTZ’s three-year pilot period.

China’s State Council released a general plan for the FTZ in late September, but details have remained scarce. Limited progress has been made, particularly in speeding up the licensing process for new companies in the zone. Media reports indicate that roughly 800 companies have set up in the FTZ so far, including 332 financial institutions and financial service companies. Twelve domestic and foreign banks have registered, including Citigroup and United Overseas Bank Ltd. And a recent People’s Bank of China (PBOC) document indicated that upcoming initiatives would permit foreign companies with subsidiaries in the zone to issue RMB-denominated bonds, allow foreigners in the zone to buy and sell Chinese equities and bonds, and allow Chinese citizens to buy overseas financial products, according to Reuters.

Market access 

China’s Catalogue Guiding Foreign Investment restricts foreign investment in 78 industry sectors and prohibits it in 36 industry sectors. The Shanghai government released a “negative list”—a list of restrictions on investments in the zone—for the FTZ at the end of September, which was largely the same as the catalogue. Although a negative list approach was considered a positive first step in expanding market access for foreign investment, the negative list frustrated observers who said they expected restrictions on more industries to be lifted.

Other than a few industries—ship repair, credit evaluation, import-export commodity inspection and appraisal, agency services in the entertainment industry, and the operation of entertainment venues—all other restricted or prohibited sectors reinforce existing regulations from the Catalogue Guiding Foreign Investment.

In addition, roughly 50 items on the list were originally specified in industry-specific regulations. Most of these items deal with registered capital requirements and rules regarding legal representation, the duration of legal operation, and Chinese ownership proportions in joint ventures. For example, foreign manufacturers of motorcycles and automobiles are restricted to a maximum 50 percent share of a joint venture inside the zone. At the same time, a foreign company may establish two joint ventures that manufacture the same auto parts in the zone. These two requirements come from the National Development and Reform Commission Auto Development Policy issued in 2004, but these requirements have also been included in the negative list. The benefit of the negative list is that it brings together rules and regulations from multiple sources, negating the need for foreign companies to consult multiple documents.

In some cases, the negative list eliminates previous restrictions to foreign ownership and replaces them with minimum restrictions on registered capital and operations timelines. For example, foreign investment in medical institutions had been forbidden unless undertaken as a joint venture with a Chinese partner. But in November 2013, the Shanghai provincial government released regulations to guide foreign-owned medical institutions in the FTZ, which authorizes foreign investors to set up wholly-owned medical institutions. However, they must have registered capital of at least RMB 20 million ($3.28 million). The duration of operations may not be longer than 20 years and branches are not permitted.

As indicated by local government officials in conversations with the US-China Business Council (USCBC), the government will reduce the number of restrictions on the negative list each year, based in part on feedback from companies registered in the zone. (USCBC is the publisher of the China Business Review.) Government officials say that they did not have enough time to include all possible reforms in the first version of the list.

Financial reforms 

The PBOC document released December 2indicates that cross-border use of the RMB will be expanded, interest rates will be liberalized, and RMB convertibility under the capital account will be allowed in the zone. This sends a message to foreign investors that financial reforms—which many feared would never materialize—are still being pushed in the FTZ, even though implementing rules still need to be released. According to the document, enterprises in the zone will be able to set up a free trade account, and financial institutions serving enterprises in the zone will be able set up separate accounting units to meet the demand for overseas financial activities by the entities in the zone.

The government wants to minimize any risks posed by the new financial measures, including opportunities for arbitrage and the laundering of illegal funds. To reduce the chances of either occurrence, PBOC and the Shanghai government will carefully monitor cash flow in and out of the zone. PBOC might also take provisional measures to control capital flow in the zone, if the central bank thinks risks have risen above an acceptable level.

As the main Chinese financial policy-making body, PBOC released opinions to clarify the financial reform measures that authorities intend to implement in the zone. China’s major financial regulators have all released measures or opinions to support financial sector reform in the zone.  These documents include measures creating a new account system that facilitates risk management, exploring ways to facilitate currency exchange in investing and financing activities, expanding cross-border use of RMB, promoting interest rate liberalization, and deepening reform in the foreign exchange administration. With these efforts to advance RMB internationalization put into practice, the Shanghai FTZ could become a market for RMB offshore bonds, foreign currency, and credit, according to analysts.

Foreign companies operating in the zone might realize additional benefits from being able to make cross-border investments without prerequisite approval (such as Qualified Domestic Institutional Investor status). According to PBOC rules, they can also issue RMB bonds and set up cash pools to transfer capital between domestic and overseas operations. These capital transfers will be capped initially, but may be expanded later. Individuals will also be allowed to invest abroad using revenue generated within the FTZ.

Banks, by setting up separate accounting units to serve enterprises and individuals within the zone, will also be able to participate in the inter-bank market. The process for cross-border RMB settlement is also expected to be streamlined.

Administrative licensing 

The central government has begun to address issues related to obtaining business licenses within the zone. The typically complicated approval process for new business entities and investment projects has long been one of the main hurdles for foreign companies operating in China. According to the Shanghai FTZ policies, all enterprises and investment projects not included on the negative list will need only to file records with zone authorities, as opposed to getting pre-approval from other government agencies, such as the National Development and Reform Commission. Companies in sectors on the negative list must still seek investment approval as they have in the past.

In the first two months of the zone’s operation, small- and medium-sized domestic companies accounted for the majority of the 800 new companies that registered. This large number indicates that the registration process for new companies in non-restricted sectors is more efficient. However barriers still exist for manufacturing and service companies.  For example, an agricultural company not subject to restrictions on the negative list could set up easily in the FTZ,  but the company would still require approval from industrial authorities if it wanted to process cotton.

All facilities set up in the FTZ will still be subject to antimonopoly review by relevant authorities.

Customs and taxation 

Other processes that have been simplified in the zone include customs clearance and taxation.

Customs clearance

Customs and inspection procedures and requirements have also been simplified in the FTZ. The “enter first, clear later” policy for incoming overseas shipment means that companies could enjoy shorter import times. This is particularly valuable for urgently needed import commodities where timing is critical. Companies could also save money on warehousing costs with shorter processing times. In addition, all customs documentation may now be submitted electronically, including paperwork required by the Shanghai Entry-Exit Inspection and Quarantine Bureau. This means that companies do not have to prepare and submit two sets of documents, saving time and manpower.

Taxation

The Chinese government has taken action in the past to attract investment to specific regions of the country through tax incentives. But zone officials have repeatedly stated that they do not intend to offer widespread tax incentives in the FTZ. This is likely the case because such incentives would not be replicable nationally, a requirement of all new policies in the zone. Government authorities are also likely wary of tax base erosion or profit shifting from other parts of China to the FTZ. But industry-specific tax incentives are still on the table, such as value-added tax (VAT) refunds on financial leasing or duty exemption on equipment for manufacturing.

In addition, according to people close to Customs, there will not be additional tariff exemptions for products shipped into mainland China from the FTZ.

What companies should expect

Decision documents released after the third plenum of the 18^th CCP Congress report reaffirmed central government signals that the Shanghai FTZ will serve as a test case to explore channels for further economic reform throughout China. If the Shanghai FTZ is successful, Tianjin, Guangzhou, and Zhuhai will likely be the next cities to establish foreign trade zones. The competition between localities could place more pressure on the Shanghai government to implement reforms quickly.

Besides attracting new investment, zone authorities would like to establish best practices for dealing with foreign companies—practices that they hope will be replicable in other areas of China to drive improvements in the country’s business operating environment. Enthusiasm for foreign investment in the zone has driven local authorities to listen to companies’ suggestions and learn from successful overseas business models.

[author] Lingling Jiang ([email protected]) is a manager for business advisory services at the US-China Business Council’s office in Shanghai. [/author]

(Photo by Brad Wang via Flickr)