China took another step toward liberalizing its financialregulations last fall by establishing the Shanghai Free Trade Zone,which now serves as a laboratory for trying out new rules andregulations for doing business in China.

Chinese regulators have proposed regulatory changes within thezone affecting everything from the interest rate paid on depositsto customs processes and cross-border pooling.

The free trade zone in Shanghai “will be a testing ground forall future reform in China,” said Debra Lodge, a managing directorand head of renminbi (RMB) business development for HSBC NorthAmerica. “In 2014, we are expecting a lot of change, additional newpilots and just easier processes for multinationals to dobusiness.”

While rules for companies operating within the zone requirefurther clarification from Chinese regulators, Lodge said that sheexpects to see “a much more open investment environment.”

She cited, for example, the fact that within the Shanghai FreeTrade Zone, there is no longer a cap on the interest rates paid onforeign-currency deposits of less than $3 million. “The market washoping for the same on RMB deposits, but that has not happenedyet,” she said.

In another development, companies doing business within the freetrade zone no longer have to get approval from the StateAdministration of Foreign Exchange to convert U.S. dollars into RMBin order, say, to build a factory. “Your capital account in U.S.dollars has been freed up, and you can convert that to RMB at willfor appropriate transactions,” Lodge said.

The ceiling on the total capital thatone business unit can loan to another unit of their company locatedoutside of China was boosted to 50% for those operating in the freetrade zone, from the 30% ceiling imposed on companies in the restof China.

And in a development of particular interest to corporatetreasuries, China has made cash pooling easier. Companies can usean RMB-denominated intragroup cross-border sweep to connect fundsheld within China, but outside of the free trade zone, with aglobal cash pool that their company operates outside of China via adesignated account within the zone.

“This is going to give multinationals with a lot of currencymovement and an existing cash pool the ability to incorporate theirChinese entities into the global cash pool,” said Lodge, picturedat left.

The changes being piloted in the free trade zone touch on manyaspects of doing business in China. For example, customs processesare being streamlined and electronic filing introduced. Employeesof companies operating in the free trade zone may remit theirentire salary outside of China, while workers in the rest of Chinaare limited to sending a maximum of $50,000 a year out of thecountry.

And Lodge said the March announcement by China's central bank,the People's Bank of China (PBOC), that the nation is launching adeposit insurance program to be introduced first in the free tradezone is a huge step toward the liberalization of the currency.Currently China has no insurance plan for funds held in banks.

A Physical Presence in the Zone

To take advantage of the pilot programs offered within theShanghai Free Trade Zone, companies must have a physical presencein the zone and have an account with a designated bank, Lodge said.HSBC opened a branch in the zone in January, “specifically forShanghai Free Trade Zone business,” she said.

At this point, the free trade zone is advantageous for thebiggest players, Lodge said. “If you are a multinational and youhave a lot of transactions going through your accounts daily, thenyou should consider having a presence in the zone,” she said. “Butrealistically, right now there are few companies at thatlevel.”

She predicted, though, that in six months' time, regulationscould evolve to the point where having a presence within the zonecould be worthwhile for companies doing fewer transactions.

“China has increasingly liberalized regulations with the aim ofcreating a much more competitive financial and cross-borderenvironment,” Kris Drake, head of corporate sales for China in Bankat America Merrill Lynch, wrote in an email. “The Free Trade Zoneitself has been a source for many of the financial liberalizationmoves that have occurred over the last few months.

“For multinationals with complex businesses in China, the resultis to allow more centralization of their financial activities,which better satisfies their desire for rationalization ofaccounts, efficiency, automation, visibility, and control,” Drakeadded. “We certainly find that our clients who operate sharedservice centers are able to bring more activity within scope,regardless of whether these are operated within China oroutside.”

The establishment of the Shanghai Free Trade Zone last Septemberfollowed changes that the PBOC announced last summer, including the RMBcross-border loan, a new structure that makes it easier forcompanies to make use of excess cash they have accumulated inChina.

The RMB cross-border loan structure has been “very popular withcorporates that are established in China and have been building upprofits, and historically could not reallocate to other parts oftheir organization,” Lodge said. She noted that previously, theonly way to repatriate cash held in China was to declare adividend, which is subject to taxation in both China and theU.S.

FX Volatility

Amid the regulatory changes, the Chinese renminbi—which hadgained steadily against the U.S. dollar in recent years—weakeneddramatically earlier this year. And in March, the PBOC widened theband in which the RMB trades against the dollar from 1% to 2%.

Alfonso Esparza, senior currency analyst at Oanda, argued thatthe RMB's retreat reflected both the financial liberalization thatis taking place and concerns about the state of China'seconomy.

The wider trading band gave FX market participants more room tomaneuver, he said. Use of the Chinese currency has grown to thepoint where it's now a top-10 currency, Esparza noted. Given thegrowing amount of business being done in RMB and the greaterconvertibility of the currency, the increased volatility makessense, he said.

Meanwhile, the Chinese manufacturing sector has seen its growthslow. Esparza said part of the RMB's weakness reflects the PBOC'seffort to give exporters a break and try to bolster theeconomy.

HSBC views the January and February volatility as a PBOC test ofthe consequences of the widening it announced in March. “If we wantadditional FX liberalization, we have to accept the two-wayvolatility, and that's exactly what we're seeing now and will seegoing forward,” Lodge said.

Given the recent depreciation, she is seeing more queries abouthedging programs. “A lot of people were previously not consideringthis,” Lodge said. “However, the volatility we are now experiencingis causing treasurers and CFOs to reconsider.”