Those living in developed countries take many benefits for granted. Whether it's clean water, a stable electrical grid, or grocery stores chock full of anything your palate desires, most people in developed countries are pretty well off. Especially compared to the average person in an emerging-market economy.
But one facet that many investors take for granted is that in a developed, capitalist economy, most businesses play by the same rules. That's not the case in the People's Republic of China, where the government allows certain districts to play by their own set of guidelines, in the name of economic development.
Known as “special economic zones” or “free trade zones,” these areas of the country have certain perks, such as market interest rates and lower export taxes.
Though the idea may sound strange to outsiders, these zones employ free-market principles to help liberalize certain sectors of the economy. The newest such zone, which opened in Shanghai's Pudong province in September, aims to help modernize the country's service industry, particularly the financial sector.
China has used this approach to economic development since the 1980s, when the country first established special economic zones in certain areas of Guangdong Province, Fujian Province, and Shenzhen. These original zones were geared towards modernizing the country's manufacturing sector, particularly the export of processed goods, by permitting the investment of foreign capital.
Now that the country's manufacturing sector has become a dominant global force, the Chinese government has decided to refocus its efforts on opening up its inefficient, costly services sector—particularly the financial industry. By granting the newest zone perks unavailable to the rest of China—such as letting the market (rather than regulators) set interest rates, allowing firms to convert foreign currencies to yuan, and letting businesses freely move money overseas—the Chinese government seems ready to revamp its financial sector through a healthy injection of free-market principles.
Big Economy, Small Changes
Newly appointed Premier Li Keqiang has touted the ambitious project, which began on September 29, as a symbol of China's commitment to economic change. He's following in the footsteps of Deng Xiaoping, who nudged China towards a market economy using special economic zones starting in the 1980s.
After the death of Mao Zedong, Deng set up the first special economic zone in Shenzhen, essentially walling off the city north of Hong Kong from the rest of the country and allowing foreign manufacturing firms to capitalize on low-cost Chinese labor. It was a monumental success and is often cited as a major factor that turned China into one of the world's largest trading powers.
Although this approach to economic liberalization may seem odd to Westerners, it fits with China's economic narrative, which historically avoids big, bold changes.
It minimizes risks by letting experienced local officials experiment with reforms inside a tightly sealed zone. Policies that don't work can be contained within the area. On the flip side, reforms that do work can be rolled out to the rest of Mainland China.
But since the Chinese government has been intentionally vague on certain rules and regulations, an air of uncertainty hangs over Pudong's potential success.
For instance, the Politburo hasn't addressed how it will keep ordinary Chinese citizens living outside Pudong from gaining access to the attractive interest rates offered by zone-specific banks.
Also, since firms in the zone can convert large amounts of yuan into dollars for use abroad, there is bound to be pressure from outside the zone for similar privileges.
This isn't the first time such issues have come to the forefront. When Chinese regulators turned a blind eye to banks offering “wealth-management products” that paid a higher rate of return than bank deposits, cash that was meant to stay contained in a special economic zone ended up bloating the shadow-banking sector. That hot money eventually made its way into large real estate and infrastructure projects, contributing to China's numerous “ghost cities.”
It also made the country more vulnerable to financial shocks, as many of the banks making these risky loans are leveraged to the hilt.
Give Me Golf Courses or Give Me Death!
Though the government is relaxing restrictions, there are signs that the Politburo isn't very keen on ceding all control.
As a part of the deal with Pudong, the Chinese government included a “negative list” of sectors in which foreigners cannot invest. The list cites several vices like guns, drugs, and pornography, which shouldn't be an issue. But it contains over 1,000 banned items, including an odd assortment of activities like news portals, golf courses, and “traditional Chinese tea processing techniques.”
Importantly, access to an uncensored Internet—which many touted as a surefire bet—was also left off the table.
“This is a place-holder for real reform,” said Derek Scissors, a resident scholar at the American Enterprise Institute. “It guarantees nothing, with at least a chance that something useful is going to come out of it.”
Avoiding the Middle-Income Trap
The Chinese government may not have a choice but to do everything in its power to make sure the zone succeeds. Soaring wages and an ageing workforce have aroused fears that the country could fall into what's known as the “middle income trap,” a phenomenon characterized by plateauing growth after a country reaches middle-income levels.
To avoid the “trap,” an economy must transition from cheap labor-driven growth to growth based on high productivity and innovation. Since the establishment of this new economic zone aims to improve the financial sector, and thus provide smaller Chinese with access to bank financing, it could be a crucial step towards a stable growth model.
But in order to attract major investors, China will need stable regulation, and the government will have to step outside of its comfort zone and let the reforms that work trickle out into the broader economy. That's the only way to foster innovation throughout all of China.
The Chinese government has demonstrated an inability to loosen its grip on the economy in the past. We'll see if it can relinquish control and allow the economy to flourish in the near future.
Robert Ross is a senior analyst at Mauldin Economics. A native of Cleveland, OH, he graduated top of his class from Loyola University New Orleans College of Business with a degree in economics. He currently works on numerous Mauldin publications, including Bull's Eye Investor, Yield Shark, and Transformational Technologies.