The experiment that could signal China’s next 'great leap'

A few years ago I did a tour of Shanghai on a mini-bus with a group of chain-smoking city officials and politicians. After a lunch of hairy crabs, we set out for the Himalayas Centre in Pudong, the city's financial hub.

The centre is a vast complex of shops and restaurants, with a hotel, theatre and museum too. And it's a very odd place. The museum, for example, looks like a great cave with it's curved stone walls looming above you.

It's a beautiful place. And the centre itself is just as impressive. Designed by the renowned Japanese architect Arata Isozaki, the centre houses a luxury hotel, high-end shopping mall, museum and theatre. And it is now recognised as one of the many symbols of China's economic awakening.

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But while they have built many impressive buildings around Shanghai, the truth is that the construction boom was fuelled by a flawed growth model. It required massive amounts of unscrupulous lending from banks. And it required both a fast growing economy and a fully functioning export engine to sustain it.

But now the economy is slowing, and the export engine has started to sputter as costs rise.

So the government is embarking on a new experiment afree trade zone' that it hopes will breathe new life into Shanghai. If this experiment is successful, it will probably be rolled out across many other major cities. So it is well worth keeping an eye on what happens in this district over the next 12 months. I'll tell you what I expect to happen today.

Shanghai will pioneer currency reforms

When China started its economic liberalisation in the late 1970s, the government created a special economic zone at a small fishing village called Shenzhen. Over time, this proved hugely successful, making China the manufacturing factory of the world and the second largest economy in the world. I've talked before about how the price of property rocketed in this region during that period. And how this story is now playing out again in Southeast Asia.

The new initiative in Shanghai was announced in August with scant details, and is due to launch later this month. Bank of America Merrill-Lynch believes it will cover 29 square kilometres that's just over a tenth of the size of Birmingham. And the South China Morning Post reported recently that the zone might be expanded over the entire 1,210 square kilometre Pudong district.

Shanghai will receive a 250bn ($41bn) loan from the Agricultural Bank of China, to help fund the free-trade zone, according to the South China Morning Post.

The zone will liberalise trade. It might also mean the removal of interest rate and foreign currency exchange controls. The zone will also have its own set of bureaucratic standards, bringing them in line with international standards of finance.

I think what the Chinese really want to do is to re-establish Shanghai as a pre-eminent financial centre for China as it was until WWII. Remember, AIG started in Shanghai, and most British banks used to have their flagship branches in Shanghai rather than Hong Kong. I think they envision being able to compete with Hong Kong and other global financial centres such as London and New York. HSBC and Standard Chartered have already expressed interest in participating. I also expect other firms to line-up, particularly within Asia.

The zones could spring up all over China

Corporate China continues to look less healthy, particularly in the manufacturing sector, due to overcapacity, rising labour costs and a strengthening yuan. All the earnings growth in non-financials on the Chinese stock market come from non-core earnings, meaning companies are turning on each other, according to BoA Merrill-Lynch. Without sufficient demand for their products and services, companies are being forced to take market share from competitors. When everyone is doing that, it means the profitability for whole sectors is going down the drain. Think internet providers which used to be plenty but now are few...the consolidation phase was very painful for many of them as they were forced to leave the business or go bankrupt. The same is happening in China now.

In fact banks, which face a future of rising bad loans, accounted for 56% of total market earnings this year, according to BoA Merrill-Lynch. That's not good.

The fact is that China needs to change its growth model, and the new Shanghai Free Trade Zone looks like an important piece in that puzzle. It is likely to be used as a blueprint for China. How well can it cope with yet more liberalisation? And what reforms are needed for the country to compete head on in the high value-added segments of the global economy? Many of the important questions about China's future may be resolved in this new economic zone.

As a policy-driven market it will be essential to track closely what the new leadership under Xi Jinping, who is expected to lead China for the next decade, is thinking. We are likely to learn more around the Third Plenary Session of the Communist Party to be held in November.

My view is that China and the rest of Asia have been indiscriminately sold down over the last few months. Foreign investors have been fleeing Asian stocks (and many locals followed them, helping to accentuate the drop) hinting that a recovery is on the horizon. It is hard to tell when that will happen but my best guess is the seasonally strong November to January period.