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How Free is China’s Free-Trade Zone?

China announced the establishment of a “free-trade zone” in Shanghai with great fanfare, hoping to quickly attract a wave of new foreign investment. However, there are already rumblings that many of China’s historically cloistered markets will remain so, making “free” a heavily qualified descriptor.

The point of the free-trade zone is to provide a region less bridled by China’s often cumbersome and complex business regulations, especially regarding the approval process for the receipt of outside capital.

The free-trade zone is designed to be especially attractive to banks, which explains why eight Chinese and two foreign banks have already applied for and obtained approval to set up new branches in the zone. Citigroup and the Development Bank of Singapore are among the banks that have already received approval.

Banks that establish branches in the free-trade zone benefit from  greater freedom setting interest rates and accepting foreign capital. In order to sequester an influx of foreign money into the zone, the Chinese government is prepared to establish a currency “firewall” that prevents the funds from leaking into the rest of the economy.

Reportedly, banks will also be granted higher loan-to-deposit ratios, which should permit banks to lend more in relation to their yuan deposits. At least in principle, higher ratios should function as a catalyst to growth, unleashing more capital to expanding businesses.

However, almost immediately after the grand unveiling of the new free-trade zone, officially called the “China (Shanghai) Pilot Free Trade Zone,” the government also released a “negative list,” which enumerates all the regulatory restrictions on business that will remain in place. More specifically, the negative list catalogues all the industry areas that will still be insulated from foreign investment.

The negative list is constructed to provide a prohibitive brand of guidance: If it isn’t specifically mentioned on the list, then it isn’t circumscribed by the government. Silence implies liberty in this case. In this way, the negative list functions like a constitutional enumeration of powers in that it implicitly places limits on governmental jurisdiction, implying what it can’t do by exhaustively listing what it can.

The length of the negative list surprised many, adducing more than 200 restrictions and running more than ten pages in length.

Some experts interpret the scope of the restrictions as evidence that China’s commitment to market liberalization is still tepid at best. Eswar Prasad, a China expert at Cornell University, said, “The list makes it clear that progress toward financial-sector and other reforms will be slow and grinding, even in this controlled environment.”

China defended the free-trade zone, noting that less than one-fifth of 1,069 economic sectors is covered by the negative list. A statement posted on the Chinese government website said, “From a detailed breakdown of industries on the negative list for the pilot Free Trade Zone, it is clear than China is sincere about opening up to foreign investment.”

Similarly, Tom Liu, chief executive at Chinascope Financial, Ltd., said, “The list is quite extensive but it doesn’t necessarily reflect the resolve to reform. It reflects the prudence with which the authorities want to begin this program.”

Damon Paling, Partner at PricewaterhouseCoopers WMS Shanghai, said, “The initial negative list was in line with expectations and covers eighteen sectors including agriculture, manufacturing, finance and public services. What is important to note is that list is a temporary for 2013 and will change in 2014 as the accelerated liberalization continues,” in an email to the Sourcing Journal.

Paling continued to explain that the free-trade zone is intended to be an incremental unfurling of tight economic restrictions, largely managed by Shanghai’s local government. “Rather than being a “big bang” event a series of reform measures are to be released over the coming months and years. The government will control risks by adopting a step-by-step principle for rolling out these measures. The majority of the new rules and regulations to support business in the FTPZ are to be issued by the Shanghai municipal government,” he wrote.

Other experts are quick to observe that the negative list expires at the conclusion of 2013 and then is open to revision. Since this list is a common topic between China and the U.S. during their current round of negotiations regarding an investment treaty, it is certain to become a bargaining chip for China. In fact, it may have been specifically formulated to allow China latitude to negotiate.

The strictest provisions within the negative list involve realty, completely banning the building of villas in the zone by foreign companies. Frank Chen, executive director of CBRE Research, explains this prohibition as a means to control an unsettled real estate market. “The bottom line is: the government wants to avoid speculation in the property and land market. After the announcement of the free-trade zone, property prices in the surrounding area started to jump. They have to clamp down on speculation.”