Shanghai’s Free-Trade Zone Is Destined to Disappoint; The new commercial oasis is an experiment in how little reform Beijing can get away with—not how much

September 25, 2013, 12:51 p.m. ET

Shanghai’s Free-Trade Zone Is Destined to Disappoint

The new commercial oasis is an experiment in how little reform Beijing can get away with—not how much.

JOSEPH STERNBERG

When it comes to the triumph of China hope over China experience, it’s hard to match the current wave of enthusiasm over the impending opening of the Shanghai Free Trade Zone. This project, first announced in August and still shrouded in mystery on the alleged eve of its launch, is supposed to herald a new era in the country’s economic evolution away from export manufacturing and toward service consumption. Authorities may even allow access to banned social-media websites such as Facebook and Twitter in the 29-square-kilometer zone.Expectations are high thanks to various leaks this summer suggesting that some officials would like to go big. Some reports hint that interest rates could be fully liberalized for bank accounts in the zone. Others imply Beijing would fully open the closed capital account for businesses operating in the area. Perhaps foreign telecom firms will be allowed to invest in the zone, at last offering competition to domestic mobile-services heavies such as China Mobile.

But there’s a lot of reason for skepticism, and not merely because many of these reforms have not been announced officially. Something other than a test of expanded reform may be at work here.

As a growth stimulus, special economic zones have a mixed record around the world. Little mystery surrounds the question of which policies promote growth and which don’t, so the areas’ utility to economists as an experiment is effectively zero. Their main value is meant to be political, providing test cases to assuage a country’s more obstinate leaders that economic reform is desirable. But the political class generally knows that already. The reason reforms don’t happen more broadly is that the political class also knows that liberalization will dent their power.

China may appear to be an exception to this view. It’s not entirely.

Since 1978, Beijing has created special economic zones, coastal development areas and other projects large and small to carve out investment-friendly territory. By one count, more than 90% of municipalities now house some form of special zone.

In their earliest days, these zones arguably did serve a useful function of sorts, in that they allowed reformists in Beijing to introduce market forces. As the number of the zones expanded, they attracted much of the foreign direct investment, chiefly in manufacturing, that has fueled China’s export-led boom. And some reforms pioneered in the zones were later rolled out everywhere.

Note, however, that much as a transplant patient’s immune system never quite makes its peace with a new heart or liver, China’s Communist Party leadership never embraced the lesson of the special zones. Unwilling to cede too much control over the economy as a whole, authorities insist on shunting liberalization into special districts. The zones themselves, somewhat ironically, become vehicles of state control, allowing planners to channel investment into this region or that by establishing a new oasis of reform. It’s a clever way of ensuring that people remember prosperity is still bestowed by the Party.

This isn’t to belittle the astounding economic growth achieved within the special economic zones. But if the point of the zones was to pave the way for broad-based reforms later, you have to ask: Beijing has had 30 years to learn to love the wholesale liberalization that would make SEZs obsolete. What is it waiting for?

The hubbub in Shanghai starts to offer an answer. A characteristic of China’s development is the extent to which Beijing’s policies deliberately encourage the economy as a whole to grow far ahead of the ability of the services sector to serve it.

So it is that manufacturers are encouraged to grow and compete, but Beijing’s suffocating regulations on interest rates, initial public offerings and other capital-allocation tools deprive private-sector manufacturers of the money they need to expand. And so it is that the workers who are supposed to benefit from higher-paying jobs find themselves overpaying for services such as mobile calling plans since Beijing restricts foreign investment in that industry.

The Shanghai reforms being hinted at, and hoped for, are examples of exactly the things Beijing needs to do to allow the service sector to catch up: big-bang financial liberalization such as a removal of restrictions on interest rates banks pay on deposits and a fully convertible currency, both of which will start to allow the market to allocate capital more efficiently; greater competition, including foreign investment, in the telecommunications industries that are the backbone of a modern service economy; a reduction in censorship of the communications that travel through those telecom pipes.

If you’re not terrified by all that, it’s because you’re not an official in an authoritarian regime with a tenuous grip on legitimacy. Special economic zones in China have not turned out to be evidence of Beijing’s commitment to steady liberalization so much as evidence of Beijing’s desire to liberalize just barely as much as necessary to achieve rapid growth. Expect Shanghai to be less a test case for expanding reform than an exercise in determining exactly how little reform the government can get away with.