The launch of Shanghai's free trade zone has brought a surge in optimism that China is ready to accelerate the pace of economic reform. The choice of China's financial capital and the focus on markets deregulation and capital account liberalization makes this potentially of enormous significance to global markets. The caveat for now is that the rules under how the free trade zone will operate remain to be laid out.
But the path being forged by Shanghai to achieve reform through deregulation and the simplification of administrative rules is encouraging. Measures to liberalize trade, ease rules on investments, currency controls and interest rates, can all help to increase the openness and competiveness of China's economy and boost investment flows.
The Communist Party Plenum that is scheduled to take place from 9-12 November 2013, is likely to see some interesting developments, and a more detailed blueprint of the FTZ should emerge.
That said, the FTZ cannot be viewed as an end point, but a stepping-stone for China to reach its capital account and financial reform goals, while also ensuring wider system deregulation and further development in other sections of the economy.
For example, the plan to allow currency convertibility within the FTZ supports China's strategic goal to expand international trade in the RMB. Last month the Bank of International Settlements said that the RMB is now among the ten most actively traded currencies in the world. So far, this rapid ascent has mainly been trade settlement related through new offshore RMB trading centres in Hong Kong, London and Singapore. Now Shanghai's FTZ can potentially play a role to further boost RMB circulation internationally as an onshore centre.
Another important aspect of the Shanghai FTZ – particularly for international institutions and capital markets – is it's targeted at financial services. At the moment, private sector investment – domestic and international – in the financial services sector is largely prohibited, and therefore any reduction in what are currently strict barriers to entry is most welcome.
The China Securities Regulatory Commission (CSRC) recently announced that the FTZ will permit securities and futures institutions to open up wholly owned subsidiaries and remove restrictions on some of the businesses in which they can operate.
It was also announced that qualified financial institutions and enterprises located in the FTZ, as well as those employed in the zone, may trade securities and futures outside mainland China as long as they meet certain provisions.
Additionally, moves to deregulate interest rates within the zone will likely help to spur financial innovation such as offshore financial products. So far, five overseas financial institutions – Bank of East Asia, Citi , DBS,HSBC and Deutsche Bank – have been given licences to operate in the FTZ
While the pace, timing and scope of these businesses are still unclear, introducing competition through interest rate deregulation is an important step towards achieving financial reform and better allocation of capital. They are also necessary before China can fully open its capital account and allow the RMB to be market determined.
In the newly released set of FTZ rules, one can find the necessary building blocks for the development of China's futures industry. The bonded trade areas, along with capital account opening, could enable physically deliverable futures contracts. The authority could therefore control and contain the size of capital flows and the amount of currency convertibility through the simple mechanics of physical delivery rather than speculative trades.
CME Group is well placed to assist in the reform process, because of our experience and global reach, and this holds true here given the many seeds planted in the FTZ concept. For instance given China is the world's largest consumer of a variety of commodities, being an active participant in international commodity futures markets is the natural direction to go towards. As China opens its capital account and internationalizes its commodity markets, this should enable greater liquidity, price clarity and efficiency in its markets. CME Group has the know-how to work and partner with organizations in China to bring international distribution, as well as providing a robust platform with international standards of risk management. The reverse scenario of CME Group assisting domestic players to have better global access is equally important for the development of entities within the FTZ.
Of course how far and how fast Chinese authorities move is still a subject of much debate. But it is encouraging that the reform initiatives in the zone have the support of the State Council, China's highest national decision-making body. Overall we expect a continuation of a gradualist pace of reform as mainland authorities experiment with new measures.
It is also positive that authorities appear to recognize the importance of creating an environment that welcomes international capital and organizations. The intent towards reducing red tape, government bureaucracy as well as easing restrictions on internet access and investment by foreign telecommunication providers, is very encouraging. Together, these initiatives all move Shanghai closer towards its goal of becoming an international financial centre by 2020. It might be too much too soon to expect a trade zone with open communications, currency flows and legal safeguards – but it is definitely moving in the right direction.
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