Shanghai Free Trade Zone: Putting Reform Over Opening

Western expectations for Chinese economic reforms have long fixated on the “opening” associated with market access and financial liberalization. Frustration has ensued. One example in this litany of unfulfilled expectations is the Shanghai Free Trade Zone (SFTZ), which was launched in September 2013 and recently expanded to include Tesla’s new Gigafactory.

In 2013, many saw the SFTZ as a harbinger of a significant reform program centered on capital account liberalization and the relaxation of market controls. Indeed, it was initially approved by Beijing as a testing ground for implementing policies thought necessary to secure a Bilateral Investment Treaty with the United States and to possibly even join the Trans-Pacific Partnership.

Given these options are now off the table, perhaps it isn’t too surprising that the SFTZ lost steam. But the spotlight on how the SFTZ has under-delivered on market openings obscures its still important and ongoing functions. That is, the zone was never designed to exclusively serve foreign firms but was also meant to advance governance reforms deemed essential to the long-term viability of the Chinese economy.

What Happened to the SFTZ?

The SFTZ rode a wave of hope during its first couple of years, but both official statistics and discussions on a recent research trip to Shanghai corroborate widespread anecdotal reports that business has soured on the SFTZ. The number of new foreign-invested projects in the SFTZ last year was less than one-third of its peak in 2015, and the level of foreign direct investment fell for the first time in 2018 after two previous years of slowing growth. The SFTZ is now favored more by larger, well-established companies rather than by dynamic upstarts (see Figure 1).

Figure 1. Foreign Interest Falters in the SFTZ Notes: Data from 2018 are estimates. The SFTZ was expanded significantly in April 2015.
Source: Shanghai Statistical Yearbook 2018; SFTZ website.

Multiple sources said that the SFTZ factors little into the business decisions of most foreign firms, which are much more preoccupied with talent shortages, advisory services, and rising costs. There is little optimism that the SFTZ will deliver on what’s most desired by Western multinationals—full freedom to move and convert currencies across Chinese borders—Beijing’s current economic agenda does not prioritize capital account opening.

What’s the SFTZ Really For?

The SFTZ was always at least as much focused on improving China’s domestic economic system as it was about improving market access for foreign firms (see Figure 2). Although the volume of new domestic enterprises and registered capital has petered out in recent years, local firms that operate in the SFTZ are subject to higher regulatory standards that are meant to increase their competitiveness at home and abroad.

Figure 2. Far More Domestic Firms Than Foreign Projects in SFTZNote: Data unavailable for registered capital in 2018.
Source: Shanghai Statistical Yearbook 2018; SFTZ Website.

This aspect of China’s reform agenda is often overlooked. In multiple discussions, the current aims of the SFTZ were described as pioneering new standards and approaches for how the Chinese government could better interact with businesses in order to reduce inefficiency and improve firm performance—in the service of making economic growth more sustainable (see Figure 3). Put another way, the underlying intent of the SFTZ is to incubate a better environment to do business.

Figure 3. Trade in SFTZ Is Still Humming Despite Complaints (in $100 million)Source: Shanghai Statistical Yearbook 2018.

Beijing wants to recast the role of the state in the private economy as more of a referee that simply enforces rules against bad actors rather than a gatekeeper of commercial activity by any actor—a significant conceptual shift that could bolster long-term prospects for how the Chinese economy functions. SFTZ measures that improve economic governance include: lowering taxes; streamlining customs; removing capital requirements for new company registrations; moving from approval to registration procedures for various business licenses; self-reporting of environmental performance and cybersecurity compliance; and adopting negative lists for foreign investment.

Although the Xi Jinping administration has been less experimental than its predecessors, Shanghai’s mayor Ying Yong claims that over 100 institutional innovations first introduced in the SFTZ have been applied nationwide. Local trials and gradual scaling of successful policies has long been a hallmark of Chinese policymaking, but the focus on administrative fundamentals seems to be improving the Chinese business environment (see Figure 4). The pace and scale of change is still much slower than many firms and foreign governments would like to see, but that’s because the main intended beneficiaries of these reforms are Chinese companies.

Figure 4. China’s Score on the Ease of Doing Business Index is Increasing (Out of 100)Source: World Bank.

The Bigger Picture

What’s happening in Shanghai is especially significant because it fits squarely into Premier Li Keqiang’s major initiative to “Delegate Power, Streamline Administration, and Optimize Government Services” (known as fang guan fu in Chinese). The SFTZ has proved an effective avenue for Li to press state reforms within the confines of the so-called “top level design” framework that Xi espouses.

Improving efficiency is increasingly important as China tries to transition out of its capital deployment phase of growth, which is delivering rapidly diminishing returns. Today, more efficient capital allocation is needed to raise productivity and returns on assets. Shanghai, commonly perceived as the best place to do business in China, serves as a model for local government officials across the country, many of whom visit the city to learn from the SFTZ. The State Council has now replicated and adapted the SFTZ reforms in 17 other FTZs around China.

As Evan Feigenbaum has argued, China’s definition of “reform” is not the same as that of most market observers, because it means not only “market liberalization” but also “administrative measures to increase bureaucratic and operational efficiencies” and “a rebalancing of authorities and decision powers among central and local levels of government.”

Consequently, most of Beijing’s current policies, including in the SFTZ, don’t match the priorities of Western observers. Chinese economic reforms are primarily aimed, as they have always been, at making China’s hybrid system more competitive and successful.

Neil Thomas is a Research Associate at MacroPolo. Read more of his work on politics, political economy, and US-China relations here.