by Lin Li and Jun Ma

On 27 September, the State Council issued “the Overall Program for China (Shanghai) Free Trade Zone (SHFTZ)”. This document contains a list of 18 service sectors in six service areas that will see an acceleration in deregulation. The SHFTZ inauguration ceremony was held on 29 September; officials from state departments and Shanghai spoke at a press conference on SHFTZ.

The State Council document will serve as a policy framework for SHFTZ. It demonstrates the central government's determination to remove policy restrictions in trade and many service sectors, and implement investment and financial liberalization policies. SHFTZ is positioned as a testing ground for these reforms which, in our view, are prerequisites for China's eventual entry into the TPP (see our report on "Deregulation and Private Sector Growth" published on 13 September). The SHFTZ reforms are aimed at facilitating freer trade and investment, achieving currency convertibility, improving regulatory efficiency, as well as establishing a legal environment consistent with a market economy. The SHFTZ is expected to complete most of these reforms within the next two to three years.

Specific reforms in SHFTZ and implications

The key reforms to be implemented in SHFTZ include: 1) permitting foreign and private investors to enter many more sectors that were previously restricted. The specific reform is named a "negative list" management system, which means that unless a company's product belongs to the negative list, the establishment of the company in SHFTZ will no longer require government approval; 2) achieving RMB convertibility, interest rate liberalization and capital account liberalization. Our specific observations are as follows:

? Implementing a "negative list" as a prelude to TPP entry
SHFTZ, which will pave the way for China's eventual entry to the TPP, will result in an acceleration in policy deregulation and boost private sector development. We believe deregulation will be the most important policy factor that help boost China's growth potential over the longer term. Deregulation should greatly promote competition and channel financial resources to the most productive areas.
Establishing a “negative List” for managing foreign and private investment is one of the main features of the SHFTZ reforms. It is also one of the conditions required for TPP participation. The TPP negotiations, led by the US and joined by all major economies in the Asia Pacific Region (including Japan, Australia, Singapore), will likely result in a free trade area representing 40% of global GDP by the end of next year, and could over time become a more important driver for global free trade and investment than the WTO. If China is excluded from the TPP, China could lose a significant part of the global market and would continue to face hurdles on cross-border investment.

? Relaxing controls on private banks in SHFTZ
We expect SHFTZ to significantly relax the restrictions on new banks owned by private and foreign investors. The State Council document emphasizes the opening up of the financial sector to both domestic private and foreign investors. Specific measures include a reduction in entry barriers to allow the establishment of private banks and joint venture banks by domestic private capital and foreign financial institutions in SHFTZ. We believe the experiment in SHFTZ could eventually – over the coming five to ten years – lead to a few thousand new private banks (mainly village and township banks) in China .

? Developing a Shanghai-based offshore market
SFFTZ will allow banks to conduct offshore banking business. While details are not yet released, we expect policies to allow all firms in SHFTZ to open offshore accounts, and the financial transactions among the offshore accounts will not be subject to caps on interest rates, exchange rates and capital movements. Between ordinary accounts and offshore accounts, restrictions on fund flows will remain but will gradually be lifted to achieve eventual capital account openness.

? Improving market access to service sectors for foreign and private investors
In the appendix of the State Council document, market access restrictions on 18 service sectors are reduced or removed for foreign and domestic private investors. These include banking services, professional health insurance, financial leasing, ocean freight, international shipping management, value-added telecom services, gaming, game machine sales and services, legal services, credit investigation, travel, personnel intermediary services, investment management, engineering design, construction services, entertainment brokerage, entertainment sites, education and vocational training, as well as medical services.

? Improving legal framework and protection of intellectual property rights
The National People's Congress has approved the suspension of three Laws (relating to foreign investments) for SHFTZ, which is a strong indication that a new legal framework will be set up to regulate economic and financial activities in the zone according to international standards. We expect these legal revisions will involve changes in areas such as intellectual property rights, labor standards, bankruptcy, environmental protection, food safety and etc.

? Implications for Hong Kong
Mainland China and Hong Kong have rather different legal frameworks and administrative systems. The experience of the Shanghai Free Trade Zone can be a more useful reference for other regions in China, while lessons learnt from Hong Kong are not easily replicable in the rest of China. Essentially, SHFTZ will be another ‘off-shore’ market but under mainland legal and administrative guidance. The central government has more flexibility in managing risks arising from the experiments in SHFTZ.
In the short term, we do not expect any impact from SHFTZ on Hong Kong, as SHFTZ will likely attract a lot of new businesses from the rest of China and we therefore expect a net fund inflow to SHFTZ from other regions in China. In our view, Hong Kong does not need to worry too much about the leakage of RMB liquidity to Shanghai. In the longer term, however, if SHFTZ successfully leads to faster capital account liberalization, it may imply a greater challenge to the status of Hong Kong's RMB offshore center.

In conclusion, we believe that SHFTZ is a precursor to a more aggressive reform package in China, and that these reforms will eventually lift China's growth potential via enhancing the role of the private sector, services, and efficiency of capital resources. It should therefore be highly positive for China's equity market outlook in the longer term. In the short/medium term, Shanghai's exports, shipping, ports, financial and real estate are likely to be the key beneficiaries, in our view.

• [Editor:editor]