15 Oct 2013 by Chi Lo

Chi on China – China’s FTZs, Structural Reforms & RMB Convertibility


  • The idea of establishing domestic Free Trade Zones (FTZs) in China has generated a lot of excitement about accelerating China’s structural reforms, capital account convertibility and RMB internationalisation.  They are indeed a step towards deeper changes.
  • Rhetoric and excitement aside, however, no one is asking the fundamental question of whether the incentives for the various FTZ stakeholders are compatible.  This is the single most important issue in determining whether the FTZs will be able to deepen China’s structural reforms.
  • The FTZs will not be a game changer until the incentive problem is resolved.  For the sake of systemic stability, fund flows between the FTZs will not be fungible in the medium-term; investment and business opportunities will be restricted to within each FTZ.

Qianhai, Kunshan and Shanghai are already FTZs, and there will be other areas (including Beijing, Tianjin, Nansha and Henqin) joining the queue.  Arguably, FTZs are “financial cousins” of the Special Economic Zones (SEZs) which China set up in the early 1980s to kick-start economic reforms by providing preferential tax treatments, supportive bureaucracy and market mechanism for foreign (and later domestic) firms to manufacture and export from them.  They were successful in transforming China into the world’s factory.  Now the FTZs’ focus is on commerce and finance, which is a natural next step up the value chain of economic reforms.

SEZs and incentive compatibility

From a policy perspective, Beijing used the SEZs as a tool to build political and public support for economic reforms in the 1980s and 1990s by allowing the “animal spirit” to be unleashed in these patches of market mechanism, i.e. by allowing people to get rich through private incentives.  Now that the economy is facing growth fatigue after three decades of reform, Beijing is trying to replicate the success of the SEZ model by creating FTZs to revive economic vigour.  However, things are not as simple as they were 30 years ago when incentive compatibility was not a problem.

The incentives to reform the economy were aligned among the SEZs’ stakeholders, including the central government, local governments and economic agents.  Since the onset of economic reform, China has pursued a supply-expansion development model by building and manufacturing first and assuming that demand will follow.  Together with globalisation, the SEZs incentivised all the stakeholders to focus on production and, hence, on getting rich by expanding China’s aggregate demand through exports.

The economic interests were further cemented by an implicit social contract struck between Beijing and the people following the Tiananmen incident in 1989.  Until recently, most Chinese had faith in their national leaders and accepted the post-1989 social contract in which the Party provided rising living standards in return for not questioning its monopoly of power.

FTZs and incentive incompatibility

However, things have changed, leading to the breakdown of the social contract.  First, income and wealth inequality has become more serious as the country has grown richer.  This has raised the awareness among the bottom strata of society that it is higher level policy, not just corruption and the incompetence of local officials, which bars them from sharing the benefits of growth.  Second, the wealthy and the intellectuals are taking more interests in politics and the reform process to protect/fight for their interests, or even to take part in the rent-seeking activity that has emerged as a by-product of economic reform.

In other words, the incentive incompatibility problem has arisen, and it is going to haunt the FTZs.  First, many of the vested interest groups that supported economic reforms to get rich are now turning against deeper reforms, as more reforms will destroy their rent-seeking opportunities.  Second, the intellectuals realise that upward mobility is capped and any advancement one manages to gain through hard work can be taken away by the elite group because the elites can do and get what they want at will.  Many intellectuals are, thus, turning away from reforms for the suspicion that more reforms would only benefit the elites.

Capital account convertibility, RMB internationalisation

Since the FTZs are focusing on finance and commerce, which are more fluid activities than manufacturing, as one can move liquid capital around much more easily than fixed assets, incentive incompatibility is going to be a serious problem in the FTZs.  Accelerating the capital account and RMB convertibility are almost impossible in the presence of incentive incompatibility as they will only lead to systemic instability.  Why is that?

Unlike the SEZs, where all stakeholders share a common economic incentive driven by the animal spirit, the FTZs stakeholders have different incentives.  The central leadership wants to deepen reforms, which inevitably involves full capital account and currency convertibility.  But the local authorities and many vested interest groups resist deeper changes to protect and maximize their short-term gains.  Meanwhile, the public, especially the intellectuals, wants accountability from the government and a more equal distribution of wealth.  These conflicting interests have created the potential for capital outflow as people seek better opportunities elsewhere or to escape from financial repression and related problems.

Potential capital flight

Potential capital flight is the single most important obstacle to Beijing making fund flows between the FTZs fungible when it allows free capital account and RMB convertibility in the FTZs.  This is because by allowing free access to the FTZs by other regions, China would effectively open up its capital account and risk massive capital outflow.

The worsening of China’s over-invoicing problem may be indicative of an ever increasing incentive for capital flight if the floodgates were opened.  When over-invoicing, a Chinese firm inflates its import bill by charging the import price of some commodity much higher than the actual cost.  By reporting an inflated import bill to the Chinese customs, this allows the passing of capital overseas, with the foreign (exporting) entity crediting the excess amount into its Chinese counterpart’s bank account outside of China.

One, though imperfect, estimate for over-invoicing is the difference between China’s import values and the export values of its corresponding trading partners.  In principle, after allowing for the small foreign exchange rate differences used in the different official reporting systems, they should be the same.  But the data show that China’s inflated imports bills had been getting larger over the years (Chart 1), suggesting a rising incentive of capital outflow.


This seems to run contrary to the perception of rising hot money flowing, until recently, into China.  Note the two sets of data do not necessarily contradict each other as they correspond to two different incentives (or two disjoint sets, technically): one is local capital wanting to get out of China (the over-invoicing problem), and the other is foreign capital wanting to come into China (the hot money inflow issue).  The players in these two sets are different and have different views on China’s investment climate.  Further, the over-invoicing problem has a persistent rising trend, but the hot money inflow is volatile from year to year.

Restrictions on the FTZs

So China’s closed capital account is barring capital flight from taking place.  This is also why Beijing is likely to restrict any financial activities with free convertibility ability to within the FTZs to avoid creating leaks for capital outflow.  Establishing rules for what financial institutions can do in the FTZs is complicated in the face of this loophole problem, which is induced by incentive incompatibility among the FTZs’ stakeholders.  To play safe, China will likely keep its asymmetric stringent capital control, which is to allow capital to come into the country much more easily than allowing it to escape.

Be realistic, the FTZs are not likely to be a game changer for deepening China’s structural reforms until the incentive problem is resolved.  They are likely to be restrictive experiment zones for onshore RMB convertibility and capital account liberalisation.  This practice is meant to minimise the possibility of massive capital flight that could destabilise China’s financial system.

Chi Lo
Senior Strategist, BNPP IP

This blog was originally published for BNPP IP’s professional investor clients.  | 25 September 2013 – 1

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