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April 24, 2014

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Shanghai’s pilot FTZ brings opportunity, innovation, but may attract hot money

SEVEN months after its launch, the Shanghai Pilot Free Trade Zone is still creating a lot of buzz among world business leaders.

The zone, an experiment with financial reform, has rolled out unprecedented measures such as the free convertibility of the yuan inside the zone.

In the past, since the yuan was not freely convertible, currency flows in and out of the country were restricted.

“One of the greatest benefits of the zone is the convertibility of the currency for investing purposes, and it also facilitates cross-border trade and investment,” said Nancy McKinstry, CEO of Wolters Kluwer, a Dutch information services and publishing company, in an interview with Shanghai Daily. “People used to ask the question, can we get the money in and out? Now it’s an old consideration.”

However, with freer flow of capital also comes the increased risk of arbitrage.

Unfettered exchange of the yuan inside the FTZ might attract hot money, with speculators making arbitrage on the differences of exchange rates, said Michael Thomas, Regional Director North Asia at Wolters Kluwer Financial Service. “Keeping the cap on deposit rates is one way that limits the potential for exposure, and this is one of the reasons why the deposit rate is still being controlled inside the FTZ,” said Thomas.

But at some point, he said, the state will have to release that mechanism, but likely in a gradual progression. “Currently the rate is 10 percent. I think it will increase to 20 percent or 30 percent before authorities actually open it completely. It’s too much of a risk to do it overnight,” he told Shanghai Daily.

Money-laundering and other forms of financial fraud, such as tax evasion, also are among the risks of freer capital inflows and outflows. The fear is real but not unique to China. Any free trade zone will attract criminal activity. To promote trade, there are tax benefits to trading through the zone, said Thomas. “There is room for criminal elements to exploit the loophole and claim tax breaks by claiming that trade is going through the zone when it isn’t actually,” he said.

And the profits made through illegal means can also be “laundered” to hide their origin and become “clean” after being moved quickly out of the FTZ.

Heightened risks

The heightened risks for these crimes mean that Chinese financial regulators are confronted with a tougher job.

Since financial innovation is growing exponentially, especially in the e-commerce or Internet banking sector, the regulators are grappling with the task to gather transaction information. However, “they themselves have some doubts about the accuracy of information they get,” said Thomas.

According to McKinstry, regulators are struggling to keep up with all the changes in a fast-moving, dynamic market. “The regulators will want to regulate some of the entities, like Alibaba (Chinese e-commerce giant) and PayPal, that emerged as a variation of classical banks in the historical definition but ended up being significant players in terms of the money flows,” said McKinstry.

Asked if China had an adequate number of regulators to cope with the challenge, McKinstry said she couldn’t speak from China’s perspective but said it’s a huge problem in the United States.

Due to the promise of better pay and career advancement, “highly skilled regulators get recruited and work in private companies,” she said. “And if you just look at the average age of (US) regulators, they are all reaching retirement age in five or ten years.”

“So it’s going to be quite an issue down the road, not enough regulators,” she added. Thomas said the search for financial talent is a struggle everywhere in the country, because “you’ve got so much growth in the financial sector.”

Although China is now on the shallow side of a talent pool, which some pundits think will hurt the FTZ’s prospects, Thomas is more optimistic.

“I think because it’s quite clear that it is the major financial hub, key talent will be attracted to Shanghai,” he said.

But he admitted that as the country taps into more sophisticated trading of derivatives, the lack of internal expertise means talent must be brought in from overseas.

For instance, “Many Chinese working in the London and New York financial hubs are now lured back because they can make more (money) back home,” Thomas said.

While the future of the Shanghai FTZ remains to be seen, there is already a clamor across the country to follow Shanghai’s lead and set up regional versions of the FTZ.

Tianjin in northern China, for example, is keen to establish its own FTZ. The city started contemplating the move long before Shanghai did and it has reportedly submitted its FTZ proposal to the central government.

Shasha Chang, China CEO of Wolters Kluwer, described this enthusiasm as a “second wave of economic reform.”

The first wave came in the early 1980s with the establishment of Special Economic Zones in southern China. They attracted direct foreign investment that helped the nation become a manufacturing superpower, propelling a fast-growing, export-driven economy.

“I think the second wave of economic reform is going one step further and they (state authorities) want to prove that we are going toward the direction of a truly market economy,” said Chang.

Thomas agreed that over time China will open more FTZs, but “I don’t think there will be an explosion of zones across the country before the government is happy about the Shanghai zone.”

He said it’s unhealthy to have too many zones because of the potential for property bubbles, which already exist inside the Shanghai zone and may spell trouble when they collapse.

“Ultimately, this is meant to be an experiment for China to liberalize its economy. You ought to focus on the experimental area, gradually open up when you are comfortable. And then China will start to implement the same opening up structures within the whole of the mainland,” said Thomas.




 

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