China seeks to repeat Deng's Shenzhen success in Shanghai

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An archway posted with the sign of China (Shanghai) Pilot Free Trade Zone is surrounded by scaffolding in Shanghai on Sept. 23, 2013. Source: ChinaFotoPress via Getty Images

Three decades after Deng Xiaoping's experiments with capitalism in the southern city of Shenzhen began lifting millions from poverty, his successors are applying that same strategy to the tougher task of making China rich.

Playing the role of Shenzhen is 11 square miles of low-rise office buildings, white warehouses and concrete parking lots on the outskirts of Shanghai. The zone, set to open in two days, will test policies that reduce state controls on interest rates, the currency and investment. By giving markets and the private sector a bigger economic role, China may become a high-income nation by 2030, according to the World Bank.

"Reforms unleash huge dividends," Premier Li Keqiang told an economic work meeting in March, two weeks after taking office. "It's time for the country to choose a new trial for opening. Shanghai is qualified and has the foundation."

Li and President Xi Jinping are seeking new growth engines as rising wages and a shrinking workforce erode the returns of policies that transformed China into the world's biggest exporter. The challenge for Deng's successors will be to control Shanghai's free-trade zone enough so that side effects don't derail the broader economy, while ensuring the experiments aren't so constrained as to be ineffectual.

"The new leaders have staked their credibility on the zone," said Willy Lam Wo-lap, a professor at the Chinese University ofHong Kong.

Few details about the rules to be implemented in the zone have been announced before an opening reported to be on Sept. 29 by the official Xinhua News Agency. Premier Li will travel to Shanghai to officiate the ceremony, two people with knowledge of the matter said Sept. 13.

Yuan convertibility

A draft plan for the zone seen by Bloomberg News this month included proposals to liberalize 19 business sectors including banking, health insurance and shipping. China will also allow trial convertibility of the yuan under the capital account with the pre-condition that risks can be controlled, it said, without giving details for how steps would be implemented.

China will announce 32 policies for Shanghai's free-trade zone at its opening, the Economic Information Daily reported Sept. 25. No financial reforms will be in the first batch, the newspaper reported, citing a person it didn't identify.

Shares surge

The lack of specifics hasn't hindered a surge in shares of companies related to the zone, which the State Council approved in July. Shanghai International Port Group Co. (600018), which operates berths in the zone, has more than doubled in market value. A statement the company issued Sept. 5 saying it couldn't quantify the impact of the free-trade zone on earnings was followed by two consecutive days in which its shares gained by the 10 percent daily limit.

The opening of Shanghai's free-trade zone also comes ahead of a November meeting of the Communist Party's central committee, at which Xi and Li are expected to push forward more detailed economic plans. It was at such a plenary meeting in 1978 that Deng laid out his plans for reforms.

Officially established in 1980, the Shenzhen Special Economic Zone allowed foreign investors to set up factories that employed workers to make shoes, toys and electronics for export. Policies tested there were later spread nationwide, sparking a more than 97-fold fold expansion ofChina's economy. More than 600 million people have been lifted out of poverty, according to theUnited Nations.

It also transformed China from an agrarian society into one where urban residents now outnumber those in the countryside and where rising wages have pushed Nike Inc. (NKE), Top Form International Ltd. (333) and other companies to seek lower labor costs in countries such as Vietnam and Cambodia.

Middle income

China's leaders must now avoid the "middle income trap" as productivity gains from low-cost labor and technology transfers disappear, the World Bank said in a report last year. That won't be easy. To become a high-income nation, China would need per capita gross domestic product of $24,079, the report said. It was $6,188 in 2012, according to World Bank calculations.

Japan, South Korea, Taiwan, Hong Kong and Singapore are the only economies that have moved from middle-income to developed nation status while maintaining relatively high growth rates, according to Nobel laureate Michael Spence, a professor at New York University's Stern School of Business.

Capital flows

Testing policies in the Shanghai zone that may help China make that leap isn't without risk. Restricting trials to zones such as Shanghai may encourage capital inflows seeking to exploit loopholes, Wu Xiaoling, a former deputy governor of the People's Bank of China, said at a business conference in Beijing this month.

Some senior Chinese central bank officials disagree with allowing interest rate liberalization in the zone, Ma Yu, a researcher with the Ministry of Commerce, wrote in an article published by the Southern Metropolis Daily on its website yesterday. Shanghai's free-trade zone may lure too much money from other parts of China if controls on rates are loosened, Ma wrote, without identifying the central bank officials.

To limit risks, authorities are confining the trials to four bonded zones in the far eastern part of Shanghai. That segregation may also limit the benefits.

Effects limited

Eight of 17 respondents to a Bloomberg News survey of analysts said the zone will have no effect or a negligible impact on growth over the next five years, while eight said it will boost annual expansion by 0.1-0.5 percentage points. One economist in the survey, conducted Sept. 18-25, said growth would increase by 0.5-0.9 points.

The effects may be different if policies tested in the zone are applied more broadly. China's leaders need a lab that helps them build political support so that they can implement difficult reforms on a national scale, said Fred Hu, the founder of private-equity firm Primavera Capital Group and a former Greater China Chairman at Goldman Sachs Group Inc.

The use of well-defined areas such as Shenzhen's economic zone, pioneered and applied by Deng, is "a proven reform strategy that today's leaders would do well to emulate," he said.

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