Lessons to Be Learned from the Shanghai FTZ

By+JOHN+ROSS

DEVELOPMENTS since the launch last year of Shanghais Free Trade Zone （FTZ） illustrate once more that certain Western media still fail to grasp that Chinas economic policy has achieved more than three decades of rapid economic growth. The significance of the FTZ and the lessons to be drawn from it， therefore， merit an analysis of its development.

China has famously developed its economic policy since the launch of its reform and opening-up strategy， in line with the dictum， “crossing the river by feeling the stones.” This policy， as compared to the “shock therapy”of the 1990s pursued in Russia and Eastern Europe， which resulted in their economic collapse， is one of the principal reasons for Chinas success. But after the announcement in 2013 of the Shanghai FTZ， certain media assumed that China was casting its success to the winds by adopting radical and untested policies， such as RMB capital account convertibility； that it was switching from the successful， tried-and-true approach to one that its critics favored， and which has consistently left a trail of disasters in its wake.

On a recent visit to the Shanghai FTZ， President Xi Jinping specified how the zone was to proceed. Management of the Shanghai FTZ “… should combine structural reform and the exploration of new methods， while controlling risks and gradually making improvements.” In other words， the “crossing the river by feeling the stones” mode would continue.

This prompted the Wall Street Journal to gripe： “Even supporters have been frustrated by the policy inaction， leaving many to wonder how serious the authorities are about true reform.” For the Wall Street Journal， “True reform” presumably constitutes the type of policies it commended in Russia and Eastern Europe that led to the greatest economic collapse of major economies ever witnessed in peacetime. Fortunately， China has declined to undertake such “true reform.”

The reality is that， since it was established， the FTZ has done the job set out in Xi Jinpings statement. More than 16，000 businesses have registered in the zone， and calculated innovations have been introduced in the financial and regulatory fields.

A key step in the FTZ is the move to a “negative list”approach to foreign investment – one where foreign investment is excluded only from explicitly prohibited or restricted sectors. This negative list has itself progressively reduced. The previous 190 sectors in which foreign investment was prohibited or restricted have now fallen to 129.endprint

Sectors open to foreign investors include oil refinery， nonferrous metal smelting and wholesale. Within the financial sector， foreign investors are now allowed to participate in the banking industry and use the services of finance， trust and currency that brokerage companies provide. “Cash pooling” – in effect treating different RMB accounts as a single one across borders in terms of their overall credit and debit position – is allowed in the FTZ， whereas it is prohibited in the rest of China. This gives greater flexibility to companies with respect to financial management.

The FTZ has thus brought into effect measures that make it easier for companies to operate and that create wider opportunities for foreign investment， but which do not signify radical or untested breaks from Chinas approach as a whole.

The explicit role of the FTZ as a testing ground is apparent in the Peoples Bank of China internally holding discussions on measures used within the zone， to ascertain those that work and that do not， or that require modification. They are preparatory to deciding exactly which measures should be rolled out across China.

Far from being conservative or purely pragmatic， Chinas approach to testing economic policy has a deep theoretical grounding. Using the Shanghai FTZ to illustrate this wider approach allows， in turn， a clearer understanding of policies in force in the zone.

Whether in the economy or elsewhere， the process of any change， its cause and effect， is often presented as one billiard ball hitting another， the first determining the course of the second. This model is false. In reality， the consequences for the second ball are determined not just by the effect of the first， but by slopes on the table， its smoothness， the spin on the ball， the quality of the felt， and a multitude of other factors. From a theoretical point of view， there are infinite factors affecting the ball， and it is their totality that determines its precise movement.

The same principle applies to an economy， and has directly practical consequences； an economy is far more complex than a billiard table， and numerous forces operate within it. The reason why， for example， share index tracker funds in developed markets， which average large numbers of shares， outperform selective stock picking is that share indexes summarize the maximum information available in the market on forces operating within it. Information available to an individual investor picking shares， on the other hand， is comparatively limited. To understand the precise consequences of any economic developments numerous factors must be taken into account.endprint

Apply this principle to Chinas economy， and the guiding framework “crossing the river by feeling the stones”becomes evident. Not all economic forces are of equal strength or importance. Some are so powerful， and therefore transparent， that answers can be derived purely from economic theory. Economists since Adam Smith have known that the most powerful force for developing production， including what is now known as “globalization，” is the division of labor. Modern economic statistics confirm this more than 200 years after Smith coined this principle. Consequently， Chinas attempt prior to its economic reforms of 1978 to contain a self-enclosed economy， a policy copied from the USSR， was bound to fail. The decision in 1978 to “open up” Chinas economy could hence be taken entirely from the point of view of the most fundamental economic forces.

But the most successful “opening up” of Chinas economy depends on more secondary factors， such as competitiveness among particular industries， the exchange rate， and the situation in different geographical regions. The relative importance of these factors， which were vital to predicting the success or failure of any policy， cannot be determined by pure economic theory but only by testing through practice – “feeling the stones.”

Within that framework the role of the Shanghai FTZ is clear. It must be remembered that the specific factors of economic development which must be judged change with time. In 1978， when China launched its economic reforms， it was a low-income country forced primarily to rely on low wages for economic advantage. But now China is， by World Bank criteria， an “upper middle-income” economy. Only 30 percent of the worlds population lives in countries with a higher per capita GDP than China， and 50 percent live in countries with a lower per capita GDP. China， therefore， cannot rely on cheap labor as its primary competitive advantage. Furthermore， Chinas working age population is no longer expanding.

Amid these new conditions， Chinas economic development increasingly depends on its investment level. Capital investment， and how efficiently that investment is used， accounts for 57 percent of growth in an advanced economy. The role of the Shanghai FTZ is precisely that of management innovation and improving investment efficiency– not in the sense of technological innovation， but in which regulatory and financial frameworks improve efficiency.

Those who imagined the FTZ signified Chinas abandonment of its tested approach and adoption of methods that failed elsewhere were simply misguided. The Shanghai FTZ is one of the stones that China feels solidly beneath its feet.endprint