SHANGHAI: With the free trade zone, the dozing Chinese panda may get a B12 shot and regain some of the massive potential from latter years.

While the financial world has put a ludicrously large focus on the Fed and tapering, something potentially huge is about to happen in Shanghai. And no one seems to have noticed it.

On 29 September of this year, the Shanghai Free Trade Zone (FTZ), which is the first of its kind inside mainland China, starts to operate.

This zone would presumably attract foreign direct investment (FDI), increase economic activity, increase inflows into China, and boost high-beta sectors; it could also be the start of a China-wide, massive economic reform.

Heck, even Facebook becomes available in the FTZ.

The nuts and bolts

As of now, the future appears to be somewhat opaque, while the actual story has been vastly under-reported in the Western World. So these are the main outlines of the FTZ, courtesy of the good people over at Bloomberg:

• Companies registered in the free trade zone can open special accounts to freely exchange yuan
• Draft plan lists 19 business sectors to be liberalized including banking services, health insurance, financial leasing, game devices, value-added telecommunications, cultural relic auctions, legal services, medical services, and ocean cargo shipping
• Foreign-funded and joint-venture banks will be allowed
• Chinese banks will be able to conduct offshore business
• Foreign-funded health insurance will be allowed on a trial basis
• Wholly foreign-owned international ship management companies will be allowed
• Foreign-funded companies will be allowed to make and sell game and amusement devices with those passing content inspection permitted for sale on the domestic market
• Foreign funded joint-stock investment companies will be allowed
• Limits on foreign investment proportions in joint-venture international shipping companies will be relaxed
• Non-Chinese flag ships owned or controlled by Chinese companies will be allowed to carry out domestic container operations

Sky high

Now what does all this mean for China, the global trade balance, Hong Kong, the yuan, and the United States?

As with all large and complex policy shifts, it’s very unpredictable, but judging by a recent report out of the Norwegian Consul General in Shanghai, it seems that this could have massively positive impacts on China, both in terms of real growth and in terms of snagging back both power and returns from the loosely controlled Hong Kong area.

This is how the Consul General summed up the news in a report last week — a report that has so far not been reported on by any conventional media outlet (bold emphasis added by the Consul General):

“The expectations to the Shanghai Free Trade Zone has created very high expectations globally. The World Bank supports the project wholly.

All investment centers talk about the Free Trade Zone very highly. The expectations to the Zone are sky high and the disappointments and frustrations would be great if the Zone would not meet the high demands.”

The Consul General also speaks of a great deal of media attention to this story, but my talks with asset managers and other people usually in the know has made me believe that this is a completely unknown story for most in the west. This could also mean that it is very much not priced in.

Shanghai vs. Hong Kong

First, let’s look at the other Free Trade Zone, in Hong Kong, and how its players are viewing what is going on.

In a word, they are terrified.

This is what the richest man in Asia, Li Ka-shing, told AFP about the plans:

The Free Trade Zone will have a big impact on Hong Kong. The free convertibility of the yuan will be favorable in the development of Shanghai. If Hong Kong does not catch up, it will lag behind others.

Currently there are four major financial centers in the world. New York, London, Hong Kong and Singapore. And Shanghai? Well, Shanghai is ranked at 24th, wedged between Vienna and Kuala Lumpur.

Even though the FDI flows have already started to shift from Hong Kong to Shanghai, with $75bn out of Hong Kong since 2011 and $57bn in to Shanghai, the move to open up Shanghai and China will almost certainly have long-term flow effects.

But with the plans to have a soft float of the yuan and more flow of capital both in and out, it’s not inconceivable that Hong Kong and Shanghai could switch places quite quickly in terms of financial centers.

Effect on assets

When it comes to affecting asset prices, there are some unusual issues, this being China and all.

Firstly, the correct expectations are important, and according to JPMorgan, they should be low in the medium term:

In our view, the markets’ excessive emphasis on financial reforms and unrealistic expectations on their progress is likely to result in confusion and disappointment after a short period of excitement (just as we saw with financial reform in Wenzhou).

Secondly, it can be expected that high-beta sectors will benefit the most from such an irrational exuberance, so things like finance or financial services might be the most effected.

But this being China, there’s not a vast array of ETFs or other simple trading vehicles creating trading opportunities. However, there are some iShares ETFs that correlate fairly well with the Shanghai Index SHCOMP. These are: 2827 (correlation: 0.85), 2823 (correlation: 0,88), 3024 (correlation: 0.877), and 2846 (correlation: 0.845).

A free market

So what does this all mean for China and the rest of us?

Truth be told, it’s hard to tell at this point. There’s a risk that policymakers and local players are overly excited about this, and it could be a dud.

But I’m seeing this as a glass-half-full kind of situation. Looking at the world in a truly global sense, there are two major disturbances in money and business.

On the one hand, you have a number of large QE programs altering the economic incentives and behavior to an almost perverse degree. Then on the other hand, you have this huge market participant, China, that has its own unique currency system. When everyone’s currency is freely traded and the largest exporter’s currency isn’t, it clearly could be problematic.

Essentially the fixed RMB rates could create some weird and unpredictable disturbances in the global markets.

So I like to think of the Shanghai Free Trade Zone as the single most important economic policy move in modern times in China. It’s the first real step forward in ages that does not involve manipulating up GDP by building cities no one lives in or building roads no one drives on. It’s proper progress that could bring China much closer to the world and close a lot of economic gaps.

Or it could just be another Potemkin village.

But I’m an optimist. I like to think this is the first step in turning China into an actual free market.

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Photo credit: Stéfan