What Investors Should Know About Shanghai’s Free-Trade Zone

September 26, 2013, 10:05 a.m. ET

What Investors Should Know About Shanghai’s Free-Trade Zone

WEI GU

Shanghai’s free-trade zone is set to launch Sunday despite almost no clarity about what exactly will be freely tradable. Investors have bid up the shares of real-estate companies in the zone and pundits have made predictions ranging from currency convertibility to access to Facebook FB +1.86% . In the first case, investors are thinking too narrowly; in the second, the pundits aren’t thinking much at all. The Chinese government historically hasn’t made big, bold changes all at once, but has taken incremental approaches to new and risky ventures. The step-by-step internationalization of the yuan is a good example.“The government is testing the water, to see what new ideas the businesses can come up with,” said Vivian Jiang, a managing partner in tax and business services for Deloitte in Shanghai.

The way to view the free-trade zone is to think about the government’s immediate needs and goals. The stock market started in Shenzhen, China’s first special zone. Shanghai, with more than 400 regional headquarters for multinationals and offices for nearly all major global banks, is ripe for the next round of economic experiments.

First, investors are thinking too narrowly because companies that register in the zone don’t necessarily need to operate from it to enjoy the benefits, according to people who have seen draft rules for the zone. That means commercial-property landlords and financial-services firms in the whole city may see increased demand if more multinationals are going to establish their headquarters in Shanghai or expand existing operations.

Second, some are predicting major changes when even the small ones that are more likely to occur will have big impacts. One of the biggest could be an easing of restrictions on capital movements and currency exchanges for multinationals, as well as legal and tax considerations. If the new zone allows foreign companies to move money more easily, it could benefit them just by reducing costs and adding flexibility. This could be the extent of the financial liberalization.

Other changes will likely fit with the economic reform goals already made clear by China’s leadership, including increased consumer spending and improved health care.

Foreign travel agencies could be allowed to participate in the boom of Chinese outbound travel. More than 100 million Chinese are expected to travel abroad from July this year through next June, according to China Outbound Tourism Research Institute. Domestic companies that currently dominate this market, such as Ctrip and China Travel Agency, could see more competition from the likes of Expedia.

Private hospitals and retirement homes are another area of interest for foreign investors. Currently, they are only allowed access to the market through joint ventures. Having more foreign players should also help ease the burden of China’s overcrowded hospitals.

The free-trade zone will allow game producers and gaming console makers such asNintendo, 7974.TO -0.35% Sony 6758.TO +0.62% and Microsoft MSFT +0.78% to manufacture and sell directly in China, according to people familiar with the situation. But this isn’t an easy market for foreign players because piracy in China is rampant and domestic online gaming companies are already very strong.

Art sellers are also hopeful. Christie’s just had its first China auction in Shanghai on Thursday. Indonesian Chinese farming tycoon Budi Tek said he would have to pay hefty taxes to bring in his art collection to decorate his private museum in Shanghai. This may change with the free-trade zone, because art is also an area that the government is keen to promote.

Politically sensitive sectors, such as media, are likely to be among the last areas to open up. Facebook and Twitter will continue to be behind firewalls in the trade zone, according to the People’s Daily newspaper.

Given the potential risks and pushback from China’s massively profitable banks, financial liberalization is likely to be gradual.

One area in finance likely to benefit is credit research. The government will be less hands-on about business registrations, which means businesses need credit-research services to help them figure out the counterparty risks. Foreign credit firms are going to be allowed in the new trade zone, according to British law firm Clifford Chance.

Companies used to the government’s heavy-handed approach in China keep asking their lawyers, “How do I make sure I am in compliance without seeing the full details?” Even when the government releases full details of the free-trade zone in the next few months, they are likely to be broad strokes rather than detailed regulations about what can and can’t be done. That’s the whole point of the experiment anyway: to let the market play a bigger role in the Chinese economy.

But it doesn’t have to be all guesswork. For companies and investors, the smart thing to do is to think about innovative businesses that fit with China’s development goals, namely the shift to a more balanced economy. Those are the ones that are most likely to benefit from some opening-up of formerly restricted sectors.