Shanghai’s Zone of Timidity; Capital controls prevent a serious challenge to Hong Kong

Updated October 10, 2013, 7:23 p.m. ET

Shanghai’s Zone of Timidity

Capital controls prevent a serious challenge to Hong Kong.

The main result so far of Shanghai’s “free trade zone,” which opened September 29, has been confusion. The rules governing it remain unclear, no senior leaders showed up for the launch, and most foreign banks are taking a wait-and-see attitude before deciding whether to open branches. The disarray suggests a battle is underway within the Communist Party over financial reform, and that the trade zone is a proxy.This is also raising doubts about whether a reform vision will emerge at the November third plenum of the Central Committee. From one perspective, signs of conflict may be good news because it means Beijing is grappling again with how to make its banks competitive and the currency convertible.

The bad news is that would-be reformers are clearly on the back foot. The Shanghai trade zone holds out the prospect of only limited exemptions from capital controls and circumscribed opportunities for foreign banks to compete for Chinese customers.

Contrast that with Hong Kong, the former British colony that is now a Chinese “special administrative region” and a real free-trade zone. Along with no tariffs and no capital controls, it has a fully developed rule of law and low taxes. Shanghai can’t compete on the rule of law and low taxes, so it’s essential that a zone with “free” in the name at least offers the free movement of goods and money.

The last time Shanghai aspired to steal Hong Kong’s crown, in 2001, the effort went nowhere. But not before Fang Xinghai. assistant president of the Shanghai Stock Exchange, famously cited capital controls as one of his city’s strengths, since they supposedly made it easier to mobilize domestic savings. Other advantages in Mr. Fang’s eyes included better political connections and a bigger economic hinterland.

It’s hard to imagine now, but at the time many analysts expected full yuan convertibility within five years. Instead Beijing has pursued a hybrid system, allowing yuan to migrate offshore for trade financing and then be traded, mostly in Hong Kong. But since this market is segregated from onshore yuan, most of China’s savings are kept bottled up.

Most Beijing policy makers probably know that these restrictions mean Shanghai can’t overtake Hong Kong as a world finance center and efficient allocator of capital. But the Party’s control over the commanding heights of the economy depends on the cheap credit guaranteed by capital controls. As long as Chinese savers can’t seek higher returns abroad, they have to be content with low interest rates on bank deposits or other investments. The Party can direct government-controlled banks to lend to state-owned enterprises without too much concern for profits.

The modest loosening of the Shanghai trade zone and the hoopla surrounding it shows that China’s reform outlook remains unpromising. So China’s most entrepreneurial companies will continue to list their shares abroad, and the smaller private companies that are the engine of economic growth will be deprived of the credit they need.

As China’s growth rate slows, the incentive to copy Hong Kong and do away with half-measures like the Shanghai trade zone will increase. The question is when the Communist Party will accept the need for a true breakthrough.