Shanghai Reform: Bold and Imminent

China’s big Third  Plenum promise of reform had all the right commitments, but some skeptics have withheld their applause. After all, the timing for major plenum reforms was left unstated and initial rules for the ballyhooed Shanghai Free Trade Zone (SFTZ) raised questions over the seriousness of reform intentions. We have argued that the SFTZ will be an important initial proving ground for big bang reforms unwrapped at the Plenum, and that the timing of reforms will be very aggressive and thus impact market – and macro – sentiment.  On December 2, the People’s Bank of China (PBOC) issued its first implementation document on the Zone after the Third Plenum, confirming high ambitions and an aggressive implementation timeline.

First tranche of SFTZ reforms aimed at liberalizing cross-border capital flows: The implementation plan provides great specificity on removing existing restrictions for cross-border capital movements; while it gives interest rate reform relatively little attention, we think the PBOC is avoiding provoking anxiety over that but expects movement to be inevitable in that area within a short period in light of the front-loaded moves.

Individuals and firms in the SFTZ will have more freedom to move capital across borders: Individuals in the Zone will be able to invest overseas directly, and foreign nationals will be able to play a more active role in China’s domestic capital market. Likewise, domestic and foreign firms registered in the Zone will have more freedom to raise money overseas and transfer capital between the Zone and the rest of the world.

Timing is clear and rapid, with a one-year deadline: The PBOC’s Shanghai chief said most of the measures should be implemented within three months. Within one year, they will have a plan based on the SFTZ’s performance to expand nationwide.

Momentum For Shanghai FTZ Reforms

The initial State Council development plan for Shanghai released in September lacked clarity about the purpose and rules of the Zone and invited wide-spread cynicism. We disagreed, and saw such “implementation experiments” as a necessary adjunct to national reform programs, and completely consistent with proven past Chinese approaches to liberalization in trade and other areas.  We counseled giving China the benefit of the doubt on this one, and deferring judgment until central authorities had laid out the connection to national-level reforms.

Following the Third Plenum Beijing a wave of ambitious specific reform measure programs have been launched: speeches by PBOC governor Zhou Xiaochuan and Finance minister Lou Jiwei have promised specific accomplishments within months; a PBOC document titled “Opinions of the People’s Bank of China about the Financial Support to the Construction of China (Shanghai) Free Trade Trial Zone” (the “Opinions”) has elaborated reform measures and put them in the context of national affairs; and a detailed explanation by PBOC Shanghai chief Zhang Xin laid out clear timing for each element of the SFTZ.

The tone and the objectives of the PBOC document is to resolve any doubt that Shanghai is enacting reforms immediately, at the front-end of the Xi Jinping era. The priority is to liberalize cross-border investment flows for both individuals and enterprises in the SFTZ. The document includes seven sections and 30 items of reform principles and decisions on removing barriers for cross-border flows, reflecting a much more assertive resolution than the September framework.

Unlike previous Special Economic Zones, the goal this time is to make Shanghai a “flat financial land” with less restricted policies and service models that could be duplicated nationwide. The following summary presents highlights from both PBOC documents and our interpretations of the substance and priorities of the reforms.

More Freedom for Individuals, Enterprises and Financial Institutions to Move Money Across Borders

Individuals and enterprises domiciled in the Zone can create Free Trade Accounts (FTAs) at any bank in the Shanghai region (not just in the Zone) to enjoy cross-border trading and investment convenience. Non-residents will have access to certain financial services under pre-establishment national treatment through FTAs set up at Zone banks.

Fund transfers will be free between resident FTAs and the following four types of accounts: 1) foreign accounts, 2) non-resident accounts in the rest of China, 3) non-resident Zone FTAs, and 4) other resident FTAs. In addition, non-financial entities can transfer funds between their own resident FTAs and other bank settlement accounts for trade, loan payments, industrial investment and other cross-border transaction needs “consistent with regulations”. Fund transfers between resident FTAs and bank settlement accounts in the rest of China will be treated as cross-border transactions for management purposes.

When conditions are mature, different types of currencies within the same account will be fully convertible. For now, a monitoring system will be established for currency exchanges under resident and non-resident FTAs. Immediate convertibility freedom for FTAs is not assured, but regulators intend to make FTA-overseas transfers unlimited, and because what happens overseas is unlimited, conversion is effectively inevitable.

For individual investors, qualified individuals in the Zone with FTAs can conduct all types of investment abroad, including securities trading, effectively dissolving the constraints on individuals under the QDII framework. Individuals can also transfer their after-tax income earned in the Zone abroad, without asking for repatriation permission (which has been an issue in the past). Qualified foreign nationals working in the Zone can invest in China’s domestic market, including in securities, through a non-resident special investment account at Zone banks.

There is no denying that this is a convoluted set of arrangements.  Clearly, the People’s Bank preferred to lock-in progress immediately rather than haggle over the clumsiness of the details.  Still, firms and individuals are accustomed to arcane arrangements and will manage to deal with this.

Financial institutions and enterprises registered in the Zone will be able to borrow RMB capital from abroad for use at home, the only restrictions being on marketable securities and derivatives and entrusted loans. Presumably, these entities will be able to conduct regular lending at home with the RMB capital raised overseas and also pay off domestic debt. In addition Zone entities other than banks will also be able to borrow from overseas, regardless of currency type. Zone enterprises will be able to create internal bi-directional RMB capital pools to ease the transfer between home and foreign accounts. The PBOC will accordingly revise its accounting method of China’s foreign debt, which currently doesn’t include RMB-denominated foreign debt.

Zone financial institutions and enterprises will be able to invest and trade in Shanghai’s securities and futures exchanges under certain rules, expanding de facto the scope of the QFII regime. Overseas parent companies of Zone enterprises will be allowed to issue RMB bonds in China’s domestic market to increase their yuan base, extending the dim-sum bond trial beyond Hong Kong. Domestic firms are also welcome to locate their financial centers to the Zone, where forex regulations are simpler than in the rest of China.

Outbound investors registered in the Zone will be able to conduct cross-border transactions and convert currencies directly at Zone banks without approval from the Shanghai government. In fact, excepting only a few exporters on the state’s special supervision list, banks in the Shanghai region – not just Zone banks – can now settle all cross-border transactions for Zone individuals and entities directly to meet their current account and direct investment needs.

Interest rate reforms Not the Focus, but unavoidable

Qualified Zone financial institutions will be included in the trial for Certificate of Deposits (CDs). According to PBOC deputy governor Hu Xiaolian, issuing CDs will be the first step of interest rate reforms, followed by the replacement of the PBOC benchmark rate by a market-based benchmark, and finally the removal of the cap on deposit rates. Eventually, the PBOC will remove the cap for small foreign-currency deposits in regular Zone accounts.

But consider that the reduction of restrictions on cross-border capital flows for Shanghai individuals, with an expectation of rapid extension to other Chinese (see below) means that not freeing up domestic deposit rates will rapidly lead to capital flight.  Already of course most well-off Chinese have flown from bank deposits to wealth management products to avoid financial repression for there savings (caps on deposit rates). With the additional option of investing overseas, especially with the coming slower Chinese trend GDP growth and the end of equilibrating movement in the RMB, deposit caps hurt China’s banks instead of helping them.  The CDs step will be shortly followed by additional movement on interest rates, over the coming 1-2 years, in our view.

Timing and Nation-wide expansion

PBOC Shanghai chief Zhang Xin said the goal was to implement most of the measures described above in three months, explore and summarize the success of the SFTZ model in the three months after that, and then use another six months to form a financial management model applicable to the rest of China – that’s one year in total from now.

This timeline is far more aggressive than the 2-3 year expectations laid out in the September SFTZ plan.  Most likely central authorities including Bank Governor Zhou Xiaochuan are concerned that waiting too long would provide an excuse for slowing national reforms (If Shanghai can’t do it yet, how can others be expected to?). Immediate reform measures to be taken in the Zone include removing restrictions for cross-border RMB transactions and forex management, as well as the establishment of the FTA accounts. As discussed above interest rate reform will be second-tier because of its wider systemic implications for the Chinese marketplace but cannot be deferred very long.

Since the goal is to apply the SFTZ model nationwide, separating the Zone from the rest of China is not intended. In fact, “limited penetration” (of capital into the rest of China) will be inevitable and reasonable, said the Shanghai chief.

our takeaways

The PBOC action plan will mute the SFTZ naysayers. While providing us with clarity on the Zone’s reform priorities and pace, it is a window into China’s future path, and the right focal point for considering the forthcoming global implications, including for exchange rates, RMB internationalization, market access in China’s services markets, and impact of Chinese direct and portfolio capital flows around the world.

Progress on capital account opening will propel reforms in other areas. When capital exchange restrictions weaken, the more flexibility that depositors and investors will have and the increased risks derived from it will unleash the fundamental momentum to drive industrial advancement and reforms at home.  In other words, if this happens as we expect it to, the world will face a far more competitive China in the near future than was otherwise likely to be the case.