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Shanghai Free Trade Zone Could Challenge Hong Kong

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There is a lot of action in the wake of China’s approval of a free trade zone in Shanghai. While not all of it is good, plenty of opportunities lie ahead, maybe even for Hong Kong, which otherwise could feel the sting of competition.

Premier Li Keqiang will preside over the opening of Shanghai’s new free trade zone on Sept. 29, ushering in reforms that range from easier conversion of the yuan to more liberal interest rates and relaxed restrictions on foreign investment. The FTZ is part of a plan by Li to shift the Chinese economy away from investment and exports and toward services and consumption as a means of sustaining growth. The reforms are also a way to transform Shanghai into a global financial center by 2020, which was first announced in 2009.

Li said at the World Economic Forum recently that “an important part of economic-system reform is financial reform. It is because it is such a complicated systematic project, it indicates China’s reform has entered a deep-water zone, or the most difficult phase.” While President Xi Jinping has not been thought likely by many economists and political strategists to change China drastically, Li had promised to open up China’s economy “no matter how deep the water.”

Hong Kong served in an FTZ capacity for more than a hundred years and is China’s biggest financial center. The rise of Shanghai means that the former crown colony will have to boost its competitiveness if it is not to be left behind, according to Asia’s richest man, Li Ka-shing, chairman of of Hong Kong-based Cheung Kong Holdings Ltd. and Hutchison Whampoa Ltd.

Li Ka-shing was reported saying that the new FTZ “will affect Hong Kong heavily.” There have been other rumblings about how Hong Kong must focus on economics rather than politics, or risk its reputation as a financial center.

However, John Blank, chief equity strategist for Zacks, said that since Hong Kong “has been free trade for over a century. It is already service driven.”

Blank regards the news about Shanghai as potentially huge. “It’s a major thing for China,” he said, calling it the biggest thing since the country opened up for reforms in the 1970s. And although many reports are downplaying its importance because of the less-than-breakneck pace of the reforms it will undertake, Blank said that Beijing’s cautious approach is a sign that the country is taking the reforms seriously.

Regardless of all the caveats and the slow pace of change, the mere announcement of the new FTZ, made in August, sent shares of companies with “Shanghai” in their names shooting skyward, whether they were connected with the new free trade zone or not. That’s created an additional $45 billion in value—more than the value of the entire Vietnam stock market—that former World Bank economist Andy Xie has termed a bubble. Investors need to be wary along those lines as they consider the FTZ’s opportunities.

Blank agrees with assessments that change will not come to China overnight. However, the lifting of capital controls and restrictions on foreign earnings is “very, very important. People in the Transpacific Trade Partnerships and WTO have said for years that the Chinese have to open their financial system. If this happens, and it’s way too early to say it will; the devil is in the details. It’s much more than people think. It’s the first step in getting this liberalization under way,” he said.

There are three major factors in the initial process that indicate liberalization in Shanghai will be a slow process. Describing the first, Blank said, “Just to give you an idea of why you have to hold back some enthusiasm, they have a ‘negative list.’ The free trade zone will explore a ‘negative list’ management approach, so if you’re on the list you can’t do business [there]. There are 10,000 items on the negative list right now.”

The second is the fact that plans for the FTZ “involve 98 pilot programs that will be divided into two parts. The first part will not have much content about financial liberalization,” Blank said. So, between the “negative list” and the 98 pilot programs, drastic financial change is “certainly not going to happen any time soon.”

The third factor is that change is designed to be a three-year process. While those three years might be looked at as delay, the methodical approach of the Chinese means that it is likely a five-year plan will succeed it, he said, adding a five-year plan that will have been in the planning stages for a year or even two, indicating a thoughtful approach.

“Would they do it any other way? Would anyone else? They could say, okay, let’s do it [limited liberalization] for three years, on the stuff we can handle, and restrict the amount of [change],” Blank said. Then they would implement the changes in finance after changes in trade, since finance is “much more complex and much more dangerous.” Citing a Chinese proverb about “crossing the river by stepping on the stones,” he said. “They’re going to cross the river but do it one step at a time.”

The new FTZ is indicative of the direction of China’s new presidency, Blank said, which he believes will bring substantial change to the country. Xi recently visited Los Angeles, he said, in the wake of a billion-dollar investment from a major capital center in Shanghai in a six- or seven-block area of downtown Los Angeles near the Staples Center. “Shanghai is, more than anything, kind of the center of their activities for this [sort of investment], said Blank.

“It’s clearly big news, and we should not think negatively of it even in light of its restrictions and its plodding nature. It’s welcome news, and not surprising. The thing about the restrictions is that this has been thought about. It’s a very elaborate plan,” Blank said. “Full yuan convertibility and flexibility of interest rates is the financial language of reform. If that’s actually going to be done, that’s a very good definition of liberalization.”