The Shanghai free-trade zone, China’s first, will officially open for business on September 29. Just about every China economy maven has been following the months-long saga regarding the establishment of the zone because in Shanghai the central government will punch a gaping hole in the country’s currency wall. The renminbi has been convertible on the current account since December 1996. The region-wide crisis that began in the middle of the following year thwarted Beijing’s goal of achieving full convertibility by the turn of the century. Since then, Chinese technocrats have made a series of promises regarding capital account liberalization. In January 2011, for instance, the State Administration of Foreign Exchange announced that the currency would be fully convertible within five years. Then, SAFE boss Yi Gang also noted that Beijing would manage the transition by implementing a series of small steps “progressively.” In fact, Beijing has slowly made the yuan, as the currency is informally known, more available in markets outside mainland China—principally Hong Kong—but the current slowdown in the economy seems to have pushed full convertibility further into the future. As a practical matter, Beijing cannot implement this critical reform until it first restructures its financial markets and puts its ailing banks on a sounder basis. Li Keqiang, the only known reformer on the Communist Party’s Politburo Standing Committee, has evidently decided to accelerate the process of currency liberalization. Li sponsored the Shanghai zone, which will cover 11.1 square miles in the Pudong New Area. Various drafts of the zone’s rules have been leaked to foreign news organizations, and analysts are wondering what reforms Li will unveil when he officiates at the opening ceremony, probably on the 27th in Shanghai. The betting is that the premier will announce some form of full convertibility for transactions in the zone. Hong Kong’s South China Morning Post reports an “internal government document” states that “on the condition risks can be controlled” firms in the zone will be permitted to “undertake convertibility of the yuan on the capital account on a first-to-do and first-to-try basis within the zone.” The authorities apparently hope the zone will operate, in the words of Reuters, “as a fully liberalized trading hub for the Chinese currency.” If Premier Li’s rules allow companies across China to access the zone’s financial institutions, he will have effectively made the renminbi fully and freely convertible. If, on the other hand, financial institutions in the zone will only be able to do business with zone companies, his experiment may be limited in impact. Because the country is not yet ready to open itself up to essentially unrestricted inflows and outflows of cash, Beijing’s rules will undoubtedly ring-fence the zone. That’s the theory, but we are, after all, talking about China. And in the China that exists in the real world—as opposed to the China in the minds of technocrats—rules are rarely enforced. In fact, even before Li cuts the ribbon on the Shanghai zone, “hot money” has been coming in and out of the country without inordinate difficulty through, among other stratagems, fake export and import invoicing. In fact, early this year the gross falsification of export invoices showed how easily Chinese businesses could manipulate the rules to enrich themselves. Once banks in the Shanghai zone have the right to convert currency, businesses outside the zone will find ways to deal with those banks to convert currency and freely move cash in and out of the country, more or less at will. The Chinese people are, if anything, geniuses in avoiding Beijing’s carefully constructed regulatory frameworks. The 2013 Shanghai zone has been compared to Deng Xiaoping’s great 1980 experiment, the Shenzhen Special Economic Zone, so it’s instructive to see how the laobaixing—ordinary folks—handled Deng’s rules. We credit Deng with the startling transformation of the Chinese economy because he permitted individual initiative. Peasants on large collective farms, for example, were allowed to form “work groups” to tend designated plots. Deng’s policies, however, specifically prohibited these groupings from including just one family. But his restrictions did not last long: families started to till their own plots—and local officials condoned the clear violation of central rules. Subterfuge on the farm was followed by subterfuge in the towns and cities. Private industry was strictly prohibited, but entrepreneurs flourished by operating their businesses as “red hat” collectives and enterprises—private companies operating under the guise of state ownership. And in Deng’s new special economic zone members of the Shenzhen business community showed the same imagination as the plucky peasants and entrepreneurs: they took advantage of the relaxed regulations and moved money both in and out of China, right under the noses of zone bureaucrats. Deng’s reforms succeeded because, in the 1980s, the Chinese people disobeyed Deng’s rules, and you can expect disobedience this decade as well. Even if Premier Li locks down the Shanghai zone, money will come swooshing through the area on its way to and from the rest of China. And if despite everything Li strictly controls every cent—actually, every fen—coming and going in Shanghai, he will not be able to keep his eye on all the other zones. Take another currency experiment, the Qianhai zone in western Shenzhen, the so-called “Manhattan of southern China” where the People’s , the central bank, has a special interest. Qianhai, to compete, will have to offer at least as good terms as available in the Shanghai zone. That gives the PBOC every incentive to get permission to relax the Qianhai rules—and for businesses there to evade whatever restrictions are on the books. Now, provincial officials want their own free-trade zones. Tianjin, which just lost out to Shanghai in the competition to host the special area, will continue seeking permission for a relaxed currency framework so that it can fill the empty buildings in its Yujiapu financial district. Further south, there are plans for Hengqin island in the Zhuhai zone and Nansha, a district of Guangzhou, and Guangdong province also wants a superzone to include parts of the province, Hong Kong, and Macau in order to fully integrate Hong Kong’s offshore renminbi business. In the absence of nationwide reform, it looks like China will embark on reform by zone, like it did in the early 1980s. And as zones compete in our decade, the location with the easiest rules and most lax enforcement will win. The result of rampant zone creation will be, as a practical matter, capital account convertibility for the entire nation. It’s coming soon. Follow me on Twitter @GordonGChang
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