Shanghai Free Trade Zone and Offshore Banking

Sara Hsu

The Shanghai Free Trade Zone was incorporated on September 29, 2013, with the aim of testing some liberalization measures, including financial liberalization. Although the zone is currently moving at a glacially slow pace in terms of liberalizing interest rates and financial flows, there are plans to allow funds to be transferred offshore. If and when this occurs, some financial flows moving offshore may be legitimate—going to real investment in countries like the United States, Japan, and Australia—while others may move truly offshore to known tax havens.

China has already been in the news recently, due to an exposé on offshore accounts held by members of the Chinese leadership. About 22,000 mainland Chinese and Hong Kong citizens were revealed to have accounts in tax havens in the Caribbean and South Pacific. The money is associated with hidden wealth. Some of this is suspected to stem from transactions that may not have been entirely above board. A current anticorruption campaign is attempting to eliminate some of the worst abuses.

While some opening up to financial flows may allow the expansion of legitimate foreign investment in China and benefit growth, the existence of offshore transfers and the possibility of widening the ability to transfer funds offshore means that China may soon be beholden to the same level of illicit money flows as other nations. These types of flows, as experts know, can include the means for money laundering, capital flight, and corporate crime. Facilitating these flows may work against China’s aims of reducing corruption, and may boost the ability of the wealthiest to hide their assets, increasing inequality.

China’s reluctance to move according to plan in the Shanghai Free Trade Zone, allowing interest rates to fluctuate and international transactions to occur, may show that the leadership is having second thoughts about opening the door to offshore banking. Analysts have speculated that this is because funds may easily move from the domestic banking system to the Shanghai Free Trade Zone, and from the zone to offshore banks, since the firewall surrounding the zone is insufficient. This would be highly destabilizing to both the financial system and to the real economy, both in terms of opening the door to financial fraud and to financial speculation.

Although China wants to enhance its financial markets and has previously experimented with reforms in a small section of the economy, it is unclear whether opening up one experimental area to freer financial flows is a good idea. Financial flows are liquid and can move electronically; unlike foreign direct investment, where multinationals set up factories in a particular area, financial flows can easily be transferred. Therefore a better method of further marketizing China’s financial economy may be to make incremental reforms across the economy as a whole.

Gradual loosening of restrictions on international financial flows may be a positive development, as China is currently quite closed off to financial flows from the rest of the world and therefore to international financial investment as one source of growth. Transfers to known offshore financial centers, however, should be tightly controlled to guard against fraud and other abuses. In this way, the delicate process of financial reform can be handled appropriately.