China's Free Trade Ports are unlikely to meet investors' expectations

Hong Kong and Singapore are the models for China's planned Free Trade Ports in Hainan and Shenzhen. But if the Pilot Free Trade Zones launched over the past few years are any indication, the new ports are unlikely to provide genuine economic freedom with free capital flows and legal certainty.

China’s authorities have launched a new experiment to spur economic reform and opening. In April, the State Council announced a plan to establish a so-called Free Trade Port (FTP) in Hainan by 2025. Local authorities in Shenzhen also announced the implementation of an FTP by 2020. The aim is to create an environment that is responsive to market needs, provides spaces for experimentation and that will eventually strengthen the country's international competitiveness.​ But there is reason to be skeptical.

For many years, the Chinese government has used specially designated zones for testing economic reforms in local experiments. The policies that proved successful would then be replicated nationwide. The best-known examples of this approach are the Special Economic Zones (SEZ) launched in the 1980s. Back then, SEZs like Shenzhen or Xiamen served as catalysts for liberalizing China’s planned economy and played a central role for China’s opening-up to the world. 

Although China’s President Xi Jinping has re-centralized policymaking, testing reform measures remains an important tool for Chinese economic policies. At the end of 2013 the administration launched a series of “Pilot Free Trade Zones (PFTZ)” to honor the CCP’s commitment at the 3rd Plenum of the 18th Central Committee to let “market forces play a decisive role” in the Chinese economy. Shanghai was the initial PFTZ, and by 2018 there were a total of 11.

Pilot Free Trade Zones: broken promises of free capital flows and legal certainty

In this new round of reform, two experimental zones have raised high expectations among foreign investors as their goals to implement market-oriented standards are particularly ambitious: The Shanghai PFTZ aims at transforming the city into a world financial center. The Qianhai PFTZ in Shenzhen is intended to become a hub for the service industry and for closer cooperation with Hong Kong. Like the SEZs before them, the PFTZs offer more liberal trade and investment conditions for foreign companies in a still fairly closed Chinese economy.  A relaxation of China’s tightly controlled cross-border financial flows was on the table in Shanghai while the implementation of Hong Kong’s highly acclaimed legal system was discussed as a model for Qianhai.

However, so far this new round of experimentation has not met foreign investors’ expectations. In a survey conducted by the European Chamber of Commerce (EUCC) in June 2016, 83% of respondents stated they did not benefit from the opening of further sectors for foreign investment in the Shanghai Pilot Free Trade Zone. Capital controls were not fully loosened either. The experimentation with a free trade account, which enables companies registered inside the zone to freely move funds between the zone and overseas, was put on hold when central authorities cracked down on capital outflows in late December 2016. The attempt of the Qianhai PFTZ to replicate Hong Kong’s business-friendly environment was equally unsuccessful. Foreign companies’ reactions to the new zones remain muted. According to the latest available survey of the EUCC only 17% of respondents had established a presence in a PFTZ by 2017.

Free Trade Ports: one experimental zone inside another

President Xi’s call to establish Free Trade Ports “with Chinese characteristics” during the 19th CCP Congress was therefore met with skepticism in the international business community. The ports are to be created within existing PFTZs, effectively creating a new experimental zone within another. They are supposed to meet even higher international standards for trade and investment and are expected to compete with the successful free trade ports in Hong Kong and Singapore. 

As of now, it seems unlikely that a Chinese FTP will be able to match the success of Hong Kong and Singapore. Both ports benefit from a smart combination of two types of regulations: First, they grant global shipping companies favorable tax and business regimes. Second, and that is maybe even more important considering the highly globalized character of the maritime business, they offer well-integrated financial and legal services, providing an efficient, open and free ecosystem for their customers’ trade.

The lack of reform progress in the PFTZs makes it seem unlikely that Free Trade Ports established under their tutelage will manage to provide efficient financial and legal services.  A recent review by the central government of the policy experiments within the zones was not encouraging, with a few successful reforms in these two realms.

One challenge to policy implementation is the lack of incentives to conduct bold reform. Compared to the 1980s local officials enjoy less policymaking autonomy. Moreover, the harsh corruption campaign during Xi’s first term has intimidated local officials fearful of being targeted for deviating from the Party line. The top-down approach has proven incompatible with the decentralized decision-making process that worked successfully in the initial FTZs.

China’s political system stands in the way of genuine economic freedom

The central government has realized that it has to loosen its grip in order to inspire genuine economic reform on the ground. During the 19th Party Congress in the fall of 2017, the CCP leadership encouraged local officials to conduct bolder experimentation. This was also made explicit in the new guidelines for further reform inside selected Pilot Free Trade Zones published in May 2018, which called for further liberalization of the service sector.  On June 30th 2018 Chinese authorities announced the introduction of a new negative list for all PFTZ, bringing the number of prohibited sectors for foreign investment down to 45 compared to previously 95.

The renewed efforts of Chinese authorities to deepen reforms are undeniable, but the question whether a truly efficient, open and free market can be built within China’s authoritarian system remains open. Institutionalizing corporate governance based on the rule of law remains one of the key difficulties as it conflicts with the CCP’s position above the law. Potential discrimination and policy ambiguity result in insecurity among foreign companies. For example, recent practice has shown that investment restrictions continue to exist even in industrial sectors not on the negative list. For example, in 2015, new restrictions appeared under the National Security Review experimentation launched in selected PFTZs in 2015. In the same way, authorities backtracked on liberalizing capital account controls in late 2016 when the government tried to rein in capital flight.

The establishment of Free Trade Ports may well inspire bolder experimentations in the Pilot Free Trade Zones. The PFTZs are and will remain important for policy experimentation. However, fusing China’s specific economic and political approach with international trade and investment standards remains an impossible proposition. It is highly unlikely that free trade ports “with Chinese characteristics” will one day compete with Hong Kong or Singapore.

Aymeric Mariette was an intern at the Mercator Institute for China Studies from April to June 2018. He studied International Affairs at the Institut d’Études Politiques in Lyon and received a Masters Degree in International studies and Contemporary Eastern Asia from the École Normale Supérieure de Lyon.

This article first appeared in the MERICS Economic Indicators for the Q2/2018.