China’s GIFT city model..

Finance is hot again. Despite the west having  serious troubles over regulating their finance sector, the eastern world remains excited.

Indian FinMin recently released a paper on Finance SEZs  where the special zone will have complete freedom in finance. Just like in trade, SEZs are allowed near complete freedom same thing can be applied to Finance SEZs as well. This is of course keeping GIFT city in mind, Indian PM’s pet project when he was the CM of Gujarat.

Interestingly, China has already done something on those lines (how come they are always ahead when we make most of the noise and hype??). Prof. John Whalley has a piece on this:

Since September 2013 China has been operating a new form of free trade zone based in a small area of Shanghai, called the China (Shanghai) Pilot Free Trade Zone (SPFTZ). It reflects new thinking in China as to how to move forward to a new policy regime to maintain or even accelerate growth through liberalised capital account transactions and speeded trade clearance at one and the same time. It has been compared in significance to Deng Xiaoping’s 1992 southern tour which launched zone based foreign investment and trade policies which were the basis for China’s industrial growth and integration into the world economy. Several other areas (in Tianjin, Fujian and Guangdong) in China are now moving in the same direction and expectations of impact are high. While data is somewhat limited as the changes are recent, here we discuss the financial liberalisation impact of the SPFTZ thus far which seem to be positive.

The SPFTZ is located in the outskirts of Shanghai and covers four existing “bonded zones” (EY 2014). It has since been expanded in December, 2014, and its total area is now 120.7 square kilometres.

Although named as a “Free Trade Zone”, the SPFTZ has been seen from the beginning as a pilot zone for reform, not just for trade. The difference between the SPFTZ and conventional free trade agreements thus lies in two directions. Firstly, the SPFTZ is not an area established by bilateral or multilateral negotiation, but a unilateral policy trial area of the Chinese government. Secondly, the SPFTZ is not aimed at free trade with other countries through mutual agreement to lower trade barriers, but rather emphasises new reform directions inside China. Importantly it incorporates what are de facto new forms of capital account liberalisation. After one year’s operation, the SPFTZ has already seen several changes on existing arrangements.

This zone has all those liberal finance ideas.

The author analyses the impact of this change:

In a recent paper (Yao and Whalley 2015), we have employed three different approaches to evaluate the financial innovation part of the SPFTZ by focusing on China’s capital control. Firstly, we compute China’s capital flows in more recent periods after the SPFTZ following Ma (2008). Since the start of the SPFTZ on 30 September 2013, capital flows of China have increased. Before the start of the SPFTZ, the inflow and outflow volumes were about $300-400 billion per quarter. From the fourth quarter of 2013, overall capital outflows increased gradually to $620 billion. Capital inflows show a more rapid increase, from $402 billion to $636 billion, more than a 50% increase in three quarters.

Secondly, we conduct price tests for the impact of China’s capital controls after the SPFTZ. Assessment of the SPFTZ’s impact on capital controls can be achieved by studying the price spread between CNY and CNH. The CNY is the onshore exchange rate of the Renminbi, while the CNH is the offshore exchange rate of the Renminbi, in Hong Kong, China. If capital controls have been loosened, this price spread should show a tendency to diminish after the founding of SPFTZ.

Generally speaking the start of the SPFTZ has brought the price spread of CNY and CNH closer. In the year before the SPFTZ, the price spread reached 300 basis points (1 basis point equals 0.0001). But since the SPFTZ, especially since late March, 2014, the price spread seldom reached 100 basis points. Considering that the policy of supporting Renminbi cross-border use in the SPFTZ was declared on 21 February 2014, the price spread data fits this policy experience quite well.

A formal price test can be conducted by analysing the combination of onshore Renminbi interest rates, offshore dollar interest rates and non-deliverable forward exchange rates. If we do a formal test on the yield gap between onshore and offshore Renminbi, we can reject the null hypothesis that there is no structural change before and after the end of September 2013. There is a regime break in China’s capital control when the SPFTZ started.

All these tests give consistent results that the impact of capital controls in China is less since the SPFTZ. With the further successful practice of the SPFTZ and more pilot policies replicated in China as a whole, the impacts of China’s capital controls will diminish further. It is likely that China will choose a floating exchange rate, free capital account and independent monetary policy, just as other developed economies do, including the US, the EU and Japan, and the policy changes stemming from the SPFTZ will have played a key role.

Interesting. What China can’t do at national level it is trying to do in a selective special zonal way. In a way undermining the national regulations. Can GIFT city be used similarly as well? All these experiments look good when going is good as well. What happens in a downturn is important as well..

Infact unlike trade SEZs, finance SEZs are more complicated given how finance can flow from unregulated to regulated regions.

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