Arbitrage a risk in Shanghai free-trade zone
The free-trade zone in Shanghai has been depicted as one of the biggest steps towards Chinese economic liberalization, but some analysts argue the risk of arbitrage and a lack of transparency will be difficult to overcome – while there is no consensus on whether policymakers are committed to full-scale capital-market liberalization.
On Thursday, Deutsche Bank announced it has become the most recent international bank to receive approval from the China Banking Regulatory Commission to open a sub-branch in the Shanghai pilot free-trade zone (SFTZ).
The bank follows other international players – Singapore’s DBS, Citi, Hang Seng Bank, HSBC and the Bank of East Asia – which have received approval to begin operations in the zone, launched on September 29.
The zone has been heralded as a test bed for economic reforms aimed to be rolled out at the national level in the coming years. Reforms in the zone will facilitate freer trade and investment, currency convertibility, liberalized interest rates and a legal environment consistent with a market economy.
Although pitted as one of the biggest steps in China’s drive towards financial liberalization, some analysts have questioned how meaningful the move will be, complicated by China’s unique and heavily managed approach to capital-account convertibility.
“Progress of China’s liberalization programme will actually be a lot slower than what most people expect,” says Qinwei Wang, China economist at Capital Economics.
“Financial services, for instance, are not as easy to monitor as the manufacturing sector. I am very concerned of the arbitrage opportunities that will occur and this will really weigh down on the progress of the zone.”
Chi Lo, senior strategist at BNP Paribas in Hong Kong, adds: “For the renminbi to be fully convertible within such a small zone in China, policy would need to be air-tight to make sure that money doesn’t just sink into a black hole and disappear from the zone completely.
“But how can you in practice ring-fence a free-trade zone? So far there has been no game plan mentioned that would overcome this problem.”
According to Wang, in 2008, Beijing established a scheme that would have allowed domestic investment in Hong Kong through Tianjin – similar to the Shanghai experiment.
“But the whole project was shut down specifically because of arbitrage risks,” he says. For example, Beijing has hitherto refrained from clarifying the limitations for foreign bond issuance for Shanghai-based borrowers, raising the spectre of volatile capital flows in and out of China, and within the country.
Wang adds: “For example, if companies in the zone are able to borrow offshore, without regulations, this money could easily flow out of the zone into other regions, and capital inflows would continue to increase.
“Limitations will be needed on how much can be borrowed. The central bank has been accumulating reserves since the last quarter to keep the currency stable if this was to happen.”
Indeed, the lack of policy measures to deal with these arbitrage threats highlights the disagreement within Beijing about how ‘free’ the zone can afford to be, explains Lo.
“When the special economic zones were set up in the 1980s, everyone involved, including central and local government, entrepreneurs and people within the zone, all had aligned incentives to open up the zone – to get rich fast by effectively making China the world’s sweat shop,” says Lo.
“And it worked. Economic growth over the last 30 years has been miraculous.”
He adds: “But with Shanghai, there are no alignments of interest. For instance, while the international community wants transparency and accountability, local entrepreneurs prefer a closed economy where they can continue with rent-seeking activities and the like.
“There is an incentive compatibility problem which continues to drive a wedge between leaders. Nothing major can actually happen without a focus.”
Noticeably, a lack of senior officials at the zone’s opening indicated that the free-trade zone is still a point of contention among policymakers in China.
It is hoped that the third plenum of the 18th Communist Party slated to begin this weekend will shed more light on how the zone will work – or at the least indicate a new-found agreement among Chinese leaders regarding the SFTZ.
“At the plenum, policymakers will do better to focus on the three main problems facing China’s sustainable growth: capital allocation; bloated state-owned enterprises; and the fact that income is shifting away from households,” says Wang.