FTZ a test ground for reform

This is the latest effort of the new leadership to promote the role of the service sector, which has remained relatively small given the country's level of development. With other cities vying to set up FTZs, the presumption is that successful innovations in Shanghai will then be adopted by FTZs in other cities, and subsequently rolled out across the country. This process, therefore, has the potential to transform China by opening up large parts of the economy to competition and reducing the role of the State.

Several global banks have warmly welcomed the plans. This should be no surprise. For them and other foreign companies, FTZs in Shanghai and hopefully in other cities could offer a bridgehead into markets in China that they have been trying to penetrate.

But there are stumbling blocks that are likely to prevent as rapid a transformation as some commentaries have suggested.

For a start, it looks likely that reform measures will be introduced over a period of years in Shanghai rather than at one go. One reason for that is that officials will want to avoid the instability that could follow a "big-bang" approach. Besides, simply reaching an agreement on how to proceed will prove difficult given the various ministries, regulators and levels of government involved.

The slow take-up of the property tax, still being tried out on only a limited scale in just two cities, is a reminder that pilot reforms can fall by the wayside when key interest groups don't agree on how to proceed.

Perhaps the most important difficulty for the FTZ's architects is the challenge of experimenting with new models on a meaningful scale while also containing their impact. It looks much more difficult than it is for traditional SEZs focusing on the manufacturing sector.

Proposals to loosen capital controls, for example, would open massive arbitrage opportunities for companies able to shift money in and out of the zone. There will be regulatory arbitrage too if FTZ-based companies are able to offer services to businesses elsewhere in China. If the zone does embrace significant liberalization then regulations will have to be put in place to govern transactions with the rest of China, such as quotas for lending from FTZ-based banks. In that case, the benefits will take time to spread.

In sum, the Shanghai FTZ will probably act as a test ground for reforms before they are rolled out elsewhere. In this regard, it is a means to achieving the government's long-stated plan of gradually opening up the service sector and the capital account without in itself accelerating either process. A great deal still remains uncertain. The Third Plenary Session of the 18th Communist Party of China Central Committee, scheduled for November, should provide a clearer picture.

The author is China economist at Capital Economics, a London-based independent macroeconomic research consultancy.