China has officially cut the ribbon on its new Shanghai Pilot Free Trade Zone this Sunday, opening a new area of relaxed state interference with the economy that promises to spur growth in the world’s most populous nation.  The zone integrates three existing special economic zones on the eastern outskirts of the city to form a 27 square kilometer industrial region located near the international airport.   Though China’s chief financial centre has seen growth rates lag in recent years, with this year’s growth rates dipping nearly a full percentage point below the national average, the government in Beijing is confident that the free trade zone will spur development yet again.  Some key figures in the current administration were conspicuously absent from Sunday’s ceremonies, however, indicating residual scepticism on the part of the establishment towards what many are calling the latest in a series of steps in the direction of Western capitalism.

Economists have long noted the positive effect of liberal legal institutions and regulations on wealth creation, and the establishment of this new free trade zone is sure to attract investment.   Already, the New York Times is reporting that land values in the zone have surged dramatically in recent months, along with the share prices of publicly listed companies in the area; an unmistakable sign that the market views this development favourably.

Since 1978, when Deng Xiaoping first relaxed the state’s interference with the economy in Shenzhen, creating the country’s first Special Economic Zone (SEZ), liberal enclaves such as these have been the primary engines of China’s rapid development.  In these regions, the ubiquitous restrictions on foreign capital investment, private industry, and free markets that have held the rest of the country back are relaxed, allowing for growth on a scale impossible in the rest of the country.  As a result, China has risen from relatively extreme poverty in the late 70’s and 80’s to being the world’s second largest economy.

The story is a familiar one for many.

As noted by Michael Strong, the ruler of Dubai decided in 2002 that the most reliable way to create a world-class financial hub in the city was to create a legal environment based on British common law.  He observed that the world’s principal financial centres, in London, New York, Hong Kong and Singapore were created in jurisdictions using this distinctly market-based mode of producing law.  Indeed, the remarkable success of Hong Kong and Singapore, which each retained elements of imperial British economic liberalism through their common law legal systems, was part of what inspired the Chinese leadership to undertake the SEZ experiment at the outset.  These cities had for many years enjoyed standards of living and levels of economic development that planners in Beijing found they could not match.

“The overarching theme of all the reform in the 1980s and 1990s was, simply put, liberalization,” writes Yao Wei, a Hong Kong-based economist at Société Générale.  “Local experiments in strategically important cities not only served as policy signals of reform commitment but provided guidance as to the path of upcoming changes.”

Echoing Ms. Yao’s comments, Beijing made clear its commitment to a more experimental approach to economic development in a statement released Friday.

“The zone should function as a test field for reforms and an open economy that would provide experience that can be duplicated and promoted nationwide,” reads the statement.

However optimistic these developments may seem, many observers are urging caution.

According to BBC analyst John Sudworth, China’s thirty-year experiment in liberalisation may not be set in stone (BBC LINK).  Researchers both in China and the west have long feared that powerful vested interests within the Communist party may cease to tolerate these reforms in the future, and that the country could quickly close its doors once more.  The Shanghai free trade zone may allow foreign companies to open travel agencies, theaters, banks, brokerage houses, telecommunications firms, sell health insurance or make video game gadgets, but for Western investors, crucial questions remain unanswered.

“A number of people are scratching their heads about what this means,” said Patrick Chovanec, managing director at New York-based Silvercrest Asset Management to the Los Angeles Times.  “The Chinese have been saying they are going to do something bold, but there is precious little detail on exactly what.”

Prime Minister Li Keqiang, the principal architect of the Shanghai project, has so far signaled his support for loosening the government’s grip on the currency market, banking system, and foreign investment, but detailed rules about what will and will not be allowed within the zone are not set to be published until next year.  Tellingly, the Prime Minister was absent from the opening ceremonies in Shanghai yesterday, leaving only Commerce Minister Gao Hucheng to represent the national government.

Minister Gao, however, did not miss a beat.

“The establishment of the Shanghai free-trade zone is a significant move for China to conform to new trends in the global economy and trade,” he assured reporters.

Though the events of this weekend are an encouraging development in China’s gradual transformation into a free and prosperous country, we can only hope that Minister Gao is right.  Only time will tell how far Beijing is truly prepared to go.