Highlights:  The highly anticipated China (Shanghai) Pilot Free Trade Zone (the “Zone”) was officially launched on September 27, 2013, followed by a flurry of implementing rules and measures.  The central government of China expects the Zone to be the country’s testing ground for groundbreaking economic reforms to be extended nationwide in the future.  The most notable reforms in the Zone, among others, are: (i) reforms on investment administration system; (ii) further open up of service sector; (iii) financial system liberalization, and (iv) transform of government functions.  Even though details of how the reforms will work remains sparse, we believe the Zone has been poised to move on the direction towards what it is set out to achieve.

The Shanghai Pilot Free Trade Zone was Officially Launched On September 29, 2013, Followed by a Series of Legislations

On September 29, 2013, China officially launched the China (Shanghai) Pilot Free Trade Zone (the “Zone”). Two days earlier, on September 27, 2013, the State Council approved the Blueprint for the Zone (the “Blueprint”), which is the overarching framework for policies within the Zone. On September 29, 2013, the same day of Zone’s launch, the Shanghai municipal government issued the negative list (discussed in details below) and five other administrative measures governing the administration of the Zone, the procedures of establishing foreign-invested enterprises (“FIEs”) in the Zone. A series of rules were also issued by various industry regulators and other agencies to support the contemplated reforms in very general terms.

Objectives of the Zone Reforms

On the Chinese central government level, expectations of the Zone are much more than just a traditional bonded zone, which features primarily import and export businesses with released customs intervention. The Zone is expected to serve as China’s testing ground for groundbreaking economic reforms to be extended to other areas or even nationwide in China. With Premier Li Keqiang’s strong backing, the Zone’s significance could be comparable to that of the Shenzhen Special Economic Zone established more than 30 years ago.

Major Reforms in the Zone

We touch on a few of the most significant reforms in Zone below. The reforms explored in the Zone are designed to be adoptable and implantable nationwide in the future if the pilot in the Zone turns to be successful. We even see the State Council is now proposing to expand certain reforms within the Zone, namely, the loosened requirements of registered and paid-in capital and annual inspection with the Administration of Industry and Commerce, to the rest of China in the near term.  It worth noting that no financial benefits/subsidies, like the previously reported lower 15% income tax rate, will be implemented in the Zone.

A. Reform on Investment Administration System.

i. Negative List

Until now, the most concrete and significant reform can be seen in the Zone is the adoption of the “negative list” approach towards foreign investment administration, which means that foreign investment in all sectors should be allowed to set up in the same manner as domestic companies, unless listed in the “negative list” (the “Negative List”). The Negative List covers 18 main sectors divided further into 1,069 subcategories, incorporating 190 special regulatory measures. This approach represents a long leap for foreign investment administration in China, from the government authorities’ approval on each project to a treatment equally applied to domestic and foreign investors (unless the foreign investment is on the Negative List).

The 2013 version of the Negative List, as published on September 29, basically list all categories that are already restricted or forbidden (including almost all the items under the restricted and forbidden categories for foreign investment under the 2011 Foreign Investment Industrial Guidance Catalogue), with only a few service sectors newly opened to foreign investors in the Zone. For foreign investors looking for new opportunities in the Zone, the extent of open-up is below their expectation, but the Negative List will be subject to annual updates in the following years.

ii. Filing System Supersedes Approval Review

One of the centerpieces of the Zone reforms is a change from a pre-approval system for foreign investment to a filing system with the Administrative Committee of the Zone, for FIEs to be established in the Zone (except for the industry sectors on the Negative List). The filing system, as well as loosened requirements of registered and paid-in capital and annual inspection with the Administration of Industry and Commerce, will save those FIEs substantial time and effort, and will reduce the uncertainty inherent in the interaction with Chinese government authorities. Nonetheless, for FIEs engaged in special industry (e.g. telecom and healthcare) where special permit/license from industry regulator is required, they are still not able to engage in full-fledged business until such special permit/license is obtained.

B. Further Open up of Service Sector

In general, the Zone does not “welcome” manufacturing enterprises. The Blueprint provides more market access to foreign investors by lifting market entry restrictions and eliminating certain qualification thresholds in 18 service sectors (in six major investment areas) ranging from finance to cultural services. Nevertheless, the open-up in the Zone will still be subject to the existing nation-wide limitation, and below some hype over the reform in the Zone, there will no free-market policies totally matching those of Hong Kong or other foreign jurisdictions in the short term.

C.     Financial System Liberalization

There has been much anticipation over the financial system liberalization reform in the Zone. Such reform will be a multi-step and time consuming process, and implemented step-by-step on a trial basis. The Blueprint commits to a wide range of financial reforms, including convertibility for RMB in capital account items and liberalization of interest rates. The China Securities Regulatory Commission’s measures also contemplate to support inbound investment in domestic capital market and outbound investment in foreign capital market. Currently, the reform is only at the general policy level, while implementing regulations still need to be promulgated by the State Administration of Foreign Exchange and other government agencies.

As of October 29, 2013, eight Chinese banks and five foreign banks have set up their branches in the Zone, but at this moment these branches are only carrying on traditional banking business in the Zone. The financial institutions are expecting special approval from the banking and foreign exchange regulators, which will probably require the banks to set up a separate system for the new businesses only allowed to be conducted within the Zone.

The financial system reform will not be boundless. The capital outflow from the Zone to the rest of China will remain subject to restrictions under the exiting foreign exchange control regulations. Unlike other reforms that mostly benefit foreign investors, the financial system reform is anticipated to benefit domestic investors more.

D.    Transform of Government Functions

In the Zone, the Administrative Committee functions as the window to interface with enterprises, so that enterprises will enjoy one-stop services and do not have to deal with various government authorities separately. The bureaucratic reform illustrates the direction of governmental reform in China in the long haul.

Our Thoughts

The framework of Zone policies, as released to date, is far from mature. In most areas (such as financial system reforms), there is little articulation on the detailed implementing rules. It remains to be seen how the detailed rules will give effect to the objectives announced in the Blueprint by the State Council, which intended to push forward the reforms more extensively. However, the lack of detailed implementing measures does not diminish the significance of the Zone reforms. With high aspirations on the highest level of the government, the reform is on the direction towards what it is set out to achieve.

For multi-national companies already having presence in China (especially those having entities doing business in the Zone), generally we see no immediate demand to set up new entities in, or relocate existing entities to, the Zone in light of the reforms within the Zone.