10. New regime: shanghai pilot free trade zone
On 23 September 2013, the Chinese government established the China (Shanghai) Pilot Free Trade Zone (“SHPFTZ”) in one of its largest cities – Shanghai. This is the latest major initiative of the Chinese government to adapt to global economic development trends and further its opening up to the outside world. As of August 2014, ten foreign banks have opened subsidiaries in the zone. They are HSBC and Standard Chartered, Citibank, Japan’s Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui Banking and Mizuho, as well as Hong Kong’s Bank of East Asia and Hang Seng Bank, Singapore’s DBS and Australia’s ANZ.
The measures launched in the SHPFTZ will be very different from those in other areas of China. As a key experiment for further economic reform, the new policy focuses on: (1) financial reform; (2) upgrading the customs and supervision framework; (3) simplifying administrative requirements; and (4) creating a competitive regulatory and tax environment. However, as the pilot program was only launched one year ago and implementing rules and regulations are required to implement the various policies announced for the new zone, it is difficult to assess the precise extent of the opportunities available to companies which set up in the SHPFTZ.
A. Applicable laws
The key regulations governing the SHPFTZ are the Notice of the State Council on Issuing the Framework Plan for China (Shanghai) Pilot Free Trade Zone (国务院关于印发中国（上海）自由贸易试验区总体方案的通知) (the “Notice”), the Decision of the Standing Committee of the National People’s Congress on Authorizing the State Council to Temporarily Adjust the Relevant Administrative Approval Items prescribed in Laws in China (Shanghai) Pilot Free Trade Zone (全国人大常委会关于授权国务院在中国(上海)自由贸易试验区暂时调整有关法律规定的行政审批的决定)and the Measures for the Administration of China (Shanghai) Pilot Free Trade Zone(中国(上海)自由贸易试验区管理办法). In December 2013, the People’s Bank of China issued its Opinions on Providing Financial Support for the Development of the China (Shanghai) Pilot Free Trade Zone (关于金融支持中国（上海）自由贸易试验区建设的意见)(the “Opinions”) which set out a framework for financial reforms to support the SHPFTZ.
B. Scope of the SHPFTZ
The SHPFTZ encompasses four previously existing free trade zones: the Waigaoqiao Free Trade Zone (the first free trade zone in Shanghai launched in 1990), the Waigaoqiao Bonded Logistics Park (the first free trade logistics park in China established in 2004), the Yangshan Free Trade Port Area (the first free trade port in China launched in 2005) and the Pudong Airport Free Trade Zone.
The scope of the policies for the pilot free trade zone will gradually be expanded depending on the needs and the progress of the pilot programme. For the purposes of this note, we have focused on the measures favourable to foreign-funded financial institutions.
C. Negative List
Instead of classifying the industries accessible to foreign investors into Encouraged”, “Restricted” or “Prohibited” categories (which is the system which applies in other parts of China), a “negative list” approach (the “Negative List”) has been adopted in the SHPFTZ which details the restrictions and prohibitions on foreign investment in the SHPFTZ. Any activities not included in the list are fully open to foreign investment. The restrictions applicable to the finance industry are however covered under Part J of the 2014 Revised Negative List which requires that all investment in banking-related financial institutions must comply with existing regulations. Banking-related financial institutions include commercial banks. Banking institutions are not therefore fully open to foreign investment in the SHPFTZ.
D. Financial reforms within the SHPFTZ
The Notice states that the SHPFTZ will open the financial services industry to qualified private capital and foreign-funded financial institutions, and support the formation of foreign-funded banks and Chinese-foreign equity joint venture banks in the SHPFTZ.
The government’s goal is to extend the opening-up and innovation in the financial sector in the SHPFTZ. Thus, the government, as stated in the Notice, may gradually:
- launch a pilot scheme for RMB convertibility under the capital account;
- allow interest rate liberalisation in the financial markets;
- allow the establishment of restricted licence banks;
- establish an international trading platform and allow market oriented pricing for assets held by financial institutions;
- allow the establishment of foreign-invested credit rating companies; and
- allow overseas enterprises to participate in commodity futures trading.
However, it should be noted that these are long-term proposals. Further and more detailed policies, guidelines and regulations are necessary before these proposals can be implemented. Since the launch of the SHPFTZ in 2013, there has not been significant progress towards implementing any of the above proposals.
The Opinions published in December 2013 again only provide a framework for reform and implementing rules will need to be adopted to bring to fruition the policies outlined in the Opinions.
E. Banks in the SHPFTZ
Approval process for establishment
As mentioned above, the current regime requires a foreign financial institution to have had a Representative Office in China for at least 2 years before it can set up a WFOE bank or a Foreign Bank Branch. Subject to approval by the CBRC and under special circumstances, qualified banks are allowed to directly establish a WFOE Bank, a JV Bank or a Foreign Bank Branch in the SHPFTZ within a shorter time period without having to set up a Representative Office initially.
Free Transferability between Free Trade Accounts
In contrast to the tight regulations and control over foreign exchange in other parts of mainland China, banks set up in the SHPFTZ can freely convert and transfer capital between overseas accounts and a new type of dual RMB and foreign currency free-trade bank account (an “FTA”), which the central bank will treat as an offshore account. Residents of the SHPFTZ (entities and individuals) are able to open an FTA at any Shanghai bank (a “Resident FTA”). Non-residents of the SHPFTZ can open FTAs with banks or their branches in the SHPFTZ. Free transfer of funds is allowed between Resident FTAs and:
- offshore bank accounts;
- non-resident accounts in China which are outside the SHPFTZ;
- non-resident FTAs; and
- other Resident FTAs.
Transfers of funds are also allowed between a Resident FTA of a non-financial entity and its other bank settlement accounts for the purpose of current account transactions (essentially trade-related transactions), loan repayment, industrial investment and other permitted cross-border trading activities. Fund transfers between Resident FTAs and other Chinese bank accounts outside the SHPFTZ however remain subject to restrictions on cross-border fund transfers.
Banks must apply for a permit to open FTAs for corporate clients from the central bank. However, there have been reports that foreign banks have encountered difficulty in obtaining these permits. As at July 2014, none of the ten foreign banks which have incorporated subsidiaries in the SHPFTZ has obtained this permit.2
The Opinions also state that RMB and foreign currencies in Resident FTAs and Non-resident FTAs will be freely convertible at some point in the future, when the time is considered right. The time frame is however unclear.
Institutional direct investments outside China
For the purpose of cross-border direct investments made by investors of the SHPFTZ, the time-consuming approval requirements when receiving foreign currency from trade or licensing (please refer to “Reform of the foreign exchange administration” as set out below), or converting RMB into foreign currencies for outbound payment may be bypassed.
Individual cross-border investments
Qualified Chinese individuals who are working in the SHPFTZ will be allowed to make various outbound investments including investments in securities pursuant to rules that are yet to be issued. This will enable Chinese individuals in the SHPFTZ to buy overseas financial products whilst bypassing the current Qualified Domestic Institutional Investor (QDII) Program. This is quite a significant measure as the eastern city of Wenzhou has been lobbying for years for this kind of approval from Beijing to no avail, due to capital flight concerns. It should be noted that as offshore investment requires approval from various other authorities and that there has been no successful case to date of an individual actually obtaining approval for any such offshore investment, the practicality of this measure remains uncertain. In addition, income derived by SHPFTZ individuals may be remitted overseas after tax deductions. This is a major relaxation as compared to the Shenzhen Qianhai Economic Zone, which does not allow non-financial firms that borrow offshore RMB to use the proceeds outside its zone.
While foreign-invested enterprises in the PRC are not allowed to convert their foreign currency capital to invest in the PRC securities and futures markets, the Opinions provide that SHPFTZ financial institutions and enterprises will be allowed to invest and trade on Shanghai’s securities and futures exchanges at some point. Foreign parent companies of subsidiaries in the SHPFTZ will also be permitted to issue RMB-denominated bonds in China’s domestic bond market, although the rules governing such issues have yet to be published.
Financing from overseas
SHPFTZ institutions including Chinese or foreign-funded enterprises, non-banking financial institutions and other economic organisations registered in the SHPFTZ will be able to obtain RMB and foreign currency financing overseas through FTAs after obtaining Government approval. It is worth noting that overseas RMB borrowed by companies in the SHPFTZ will have to be used for normal business purposes and cannot be invested in securities or derivatives. In any case, the PBOC retains the right to implement temporary regulatory restrictions as needed to minimise risk as it sees necessary.
Diversified risk-hedging tools
SHPFTZ enterprises will be able to conduct currency risk hedging based on real management needs and qualified SHPFTZ enterprises may also be allowed to make foreign securities and foreign derivative investments, pursuant to rules that are yet to be issued.
Liberalisation and reform of interest rates and foreign exchange administration
Liberalisation of interest rates
The Opinions state that certain qualified financial institutions in the SHPFTZ will be added to the list of institutions which may be permitted to issue large-denomination negotiable certificates of deposit with priority, and when conditions are right, the ceiling on interest rates for small-denomination deposits in foreign currencies in general accounts may be lifted. No clear guidance or timeframe has however been given.
Reform of foreign exchange administration
In February 2014, the SAFE issued its Notice Concerning Support for the Implementation of Foreign Exchange Administration in the China (Shanghai) Pilot Free Trade Zone (关于印发支持中国(上海)自由贸易试验区建设外汇管理实施细则的通知)(the “SAFE Notice”). The SAFE Notice seeks to simplify the process of foreign direct investment (FDI) and facilitate the management of capital accounts in the SHPFTZ. Under the SAFE Notice, foreign invested enterprises registered in the SHPFTZ are allowed to convert all of their foreign exchange equity capital into RMB. The relaxation does not however apply to foreign exchange received from other sources, such as loans. The converted RMB are required to be held in a special RMB account and can be used for activities within the entity’s scope of business. Converted RMB cannot however be used to acquire listed securities, make loans, repay loans (including loans transferred to third parties), or purchase real estate other than for the entity’s own use (except in the case of a real estate company).
The SAFE Notice also relaxes the prohibition on conversion of foreign exchange capital into RMB to fund equity investments. All foreign invested entities in the SHPFTZ are allowed to use their foreign exchange capital to invest in equity, subject to the target entity registering with its local administration of foreign exchange and opening a special RMB account to receive the proceeds.
The SAFE Notice also enables a number of cross-border transactions involving an entity established in the SHPFTZ to be processed directly by banks, without the need to register with the SAFE. The shortening of the process should give foreign-invested enterprises in the SHPFTZ more freedom in using their capital, considering that outside the SHPFTZ, SAFE circular 142 (which was designed to prevent “hot money” from flowing into China) prohibits foreign-invested enterprises from using their funds to acquire domestic companies without certain verification procedures and restrictions.
Provision of external loans
Entities in the SHPFTZ will be able under the SAFE Notice to provide foreign exchange loans to their overseas subsidiaries of up to 50% of the lender’s shareholder equity, as compared to 30% in the rest of China.
The PBOC’s stated goal was to implement its reforms in the Opinions within three months with the objective of a complete inauguration within a year. Time is however running out as nine months have already passed. It should also be noted that the PBOC only has administrative authority over banking, and the Opinions cannot be read in isolation without considering other governmental examination and approval procedures, which require the coordination of the State Council. The cooperation of other regulators such as the National Development and Reform Commission and the CSRC is also required. As a general comment, the pace of foreign investment reform in the SHPFTZ reflects the gradual manner in which China is experimenting in moving towards a more flexible and open market.
F. Securities Companies in the SHPFTZ
There is very little difference in the foreign investment restrictions applicable to securities companies whether they are established in or outside the SHPFTZ. According to the Negative List, the shareholding of a foreign investor in a securities company in the SHPFTZ must not exceed 49%. The scope of business of a foreign-funded securities company in the SHPFTZ is the same as for foreign-funded securities companies established outside the SHPFTZ. A foreign-funded securities company must have been established in the SHPFTZ for 2 years before it can apply to expand its scope of business and that remains subject to approval by the government.
G. Securities Investment Fund Management Companies in the SHPFTZ
As with securities companies in the SHPFTZ, securities investment fund management companies are included in the Negative List and are subject to a 49% limit on the amount of foreign investment which is allowed.
H. Futures Companies in the SHPFTZ
According to the Negative List, only futures companies incorporated in Hong Kong and Macau are allowed to establish a futures company within the SHPFTZ and the amount of investment remains subject to a 49% cap even for these futures companies.
This note is provided for information purposes only and does not constitute legal advice. Specific advice should be sought in relation to any particular situation. This note has been prepared based on the laws and regulations in force at the date of this note which may be subsequently amended, modified, re-enacted, restated or replaced.
2 “Foreign banks in Shanghai free-trade zone lack permits to transfer funds freely”, South China Morning Post, 8 July 2014