China Puts an Economic Backwater in the Spotlight

9 MINS READMay 2, 2018 | 15:20 GMT
The fortunes of Hainan, an island province in the South China Sea, are set to change with its designation as China's first free trade port.
NP Studio/

A raft of regulatory, financial and infrastructural work lies ahead for the Chinese government as it seeks to transform Hainan province into China's first free trade port.

  • Beijing will establish its first free trade port in the southern island province of Hainan.
  • The choice of Hainan, whose economic performance has lagged that of much of the rest of China, emphasizes the central government's priority on boosting the country's underdeveloped areas.
  • A weak economy and political isolation may make Hainan more willing to accept central government dictates as it shapes regulatory, financial and trade policies for the port.

Hainan, China's smallest province, will soon play a large role in the central government's efforts to reassert power over the country's provinces and further the process of opening the Chinese economy. As China's first designated free trade port takes shape in Hainan over the next two decades, the island province will become a testing ground for government policies that will shape the next phase of China's economic reform.

Starting with its designation as China's newest free trade zone, a number of trade, financial and capital reforms will be needed to transform Hainan into a free trade port, which the government envisions will eventually become an offshore center of trade and finance that facilitates the flow of commodities, capital and talent to and from the country. As with the changes that preceded the establishment of other special zones in China aimed at inspiring wider economic reforms, the extent of the regulatory shifts in Hainan and the timeline for their implementation could reveal the direction and pace of Beijing's long-overdue moves toward trade and financial liberalization.

Thirty years ago, Hainan, China's southernmost point, became the country's newest province after it was split off from Guangdong. It was concurrently christened as the country's largest special economic zone. Now, it will be the site of another ambitious economic experiment. In April, President Xi Jinping officially unveiled the free trade port at the Boao Forum along with other measures to open the country's economy. Under Beijing's plans, Hainan, whose economy is currently centered on tourism, will become a free trade zone by 2020. Infrastructural and regulatory changes necessary to develop the free trade port will begin by 2025 with the objective to create a "mature and globally leading system" by 2035.

Eventually, the Hainan free trade port will feature liberalization of trade, capital and financial systems that could well exceed those found in the free trade zone established in Shanghai and in 10 other regions since 2013. At their most ambitious, the plans for Hainan, at least in some minds, could eventually put it in the same league with global financial hubs such as Hong Kong, Singapore or Rotterdam. How exactly Beijing works toward that ambition will become clearer in the coming years.

The Big Picture
In Stratfor's 2018 Annual Forecast, we wrote that once Chinese President Xi Jinping tightened his control on power, he would create more room for foreign investment in pilot regions, but only insofar as these aligned with China's overarching strategy. Beijing's choice of economically underdeveloped Hainan province as the site of China's first free trade port confirms that forecast.

A Phased Approach to Opening Up

Unlike the 120-square-kilometer (46-square-mile) Shanghai free trade zone that features some regulatory autonomy in trade and finance, special tax rates, and customs exemptions, the prospective free trade port in Hainan will seek – at least according to official rhetoric – to create an institutional system outside of China's customs territory, and eventually, an offshore trade and finance center. In the months leading up to the announcement and shortly afterward, the province, once a policy backwater, witnessed a slew of state policies pointing to its growing significance in Beijing's economic vision.

The policy shifts included rules establishing visa-free access to the island for citizens of 59 nations, allowing casino gambling as well as betting on horse races and sports, and the creation of exchanges for shipping, commodities, energy and carbon trading. But those policies represent only a fraction of the changes needed to fulfill the ambitious plans for the Hainan free trade port. Its further development will certainly require a massive buildup of physical infrastructure such as seaports and airports, logistics facilities and technological and manufacturing capacities. But more critically, enabling all the necessary reforms would require a decadeslong process of developing a modern and mature regulatory regime and a system based on rule of law and non-interventionist governance. Laying the groundwork for those changes will require a range of reforms including liberalizing interest rates, relaxing capital controls, establishing currency convertibility, overhauling regulatory and legal frameworks, and easing controls over the internet and the flow of people.

It is common for developing countries to use special economic or free trade zones to attract export-oriented investment. Often, those zones operate in a unique business environment, giving them utility as testing grounds for policy reforms. Because policy changes are often tailored for the zones themselves and will not necessarily apply more broadly to other sections of an economy, regulatory experiments carry less political risk. In China, the proliferation of the special zones that began during the first phases of its economic opening in the 1980s speaks to those qualities.

Free Trade Zones in China

The success of those first special economic zones, which were created in the coastal Guangdong and Fujian provinces, in facilitating China's interactions with the world's economy, inspired Beijing to expand them into other coastal regions. They spread from the Yangtze River Delta to cities along the Yellow and Bohai seas in the first phase of its development model emphasizing coastal-oriented, low-end manufacturing. But surging prosperity on the coast led to a massive wealth gap with interior regions. So as low-end manufacturing neared a peak, Beijing began to establish special zones in the country's central and western regions, catalyzing their growth with favorable fiscal and policy frameworks while also using them to test new fronts of trade and financial liberalization. Those zones were touted at the time as the vanguard of the country's trade and financial reforms. Similarly, Hainan's nascent free trade port and subsequent development of its high-value service sector is being promoted as the next great step in China's economic evolution toward full financial and trade liberalization.

From Backwater to Frontier

The promise of the economic development that the free trade port project would bring inspired fierce competition in China, with as many as 11 cities and provinces submitting proposals. The central government fosters such competition as part of its strategy to secure its influence by doling out support and preferential policies to create regional dependencies. That Hainan won out over some of the country's economic powerhouses like Shanghai, Guangdong and Tianjin, not only reflects Beijing's deep-seated geographic and strategic concerns, but also reveals the underlying logic in its push to rebalance the national economy.

Before the free trade port went to Hainan, Shanghai had been seen as the most likely frontrunner. After all, it already possesses a free trade zone and is the country's busiest port with well-established infrastructure and advanced rule of law. But concerns about the effects of unfettered trade and capital flows on Shanghai's financial stability, and the central government's ongoing struggle to rein in the wealthy and sometimes competing power base may have informed the decision. By contrast, Hainan's relatively weak political and economic position, which makes it less likely or able to challenge government dictates, is arguably a plus in Beijing's eyes. The island province's geographic isolation from mainland China also could have further tipped the scales in its favor. Hainan's physical separation from the rest of the country makes it easier for the central government to control points of entry and exit, thus reducing the risk that the more aggressive experiments in liberalization instituted there would spread to the rest of the country. Hainan could likewise find itself the beneficiary of the changing political and economic dynamic surrounding Hong Kong as Beijing works to guard against overreliance on the former British colony as a financial intermediary and to seek alternative gateways to the global economy.

Political considerations aside, to transform Hainan into the free trade port will require extensive physical development. Combined, its three biggest cargo ports, Haikou, Yangpu and Basuo, handle just 1.5 percent of the country's total cargo tonnage (the share is even smaller when considering container volume alone). That volume, which is less than 10 percent of the tonnage that passes through Shanghai's port alone, puts Hainan last among all of China's coastal provinces. Although Hainan has the designation as a special economic region, that status dates to the first phase of China's coastal-oriented economic boom. In the intervening decades, it received far less support from the central government than other coastal regions, and its weak agriculture-based economy has left its development well below national average, on par with underdeveloped western provinces such as Ningxia and Qinghai. Tourism and real estate speculation have provided some economic growth, although failed real estate ventures have torpedoed the province's economy on several occasions.

Unlike the coastal special regions or the Shanghai free trade zone, which were established in a drive to develop its coastal economies to generate capital, Beijing's elevation of Hainan reflects its desire to reallocate resources and attention on previously underdeveloped regions of the country. Over the past five years, the province had already received increased attention from the government, including some service industry liberalizations not seen in other regions, such as establishing duty-free shops. And as China advances its Belt and Road Initiative, the province is also ideally positioned to take advantage of increasing trade and infrastructural connectivity with Southeast Asia.

An Uncertain Path Forward

Whether the bold plans for Hainan will be realized is uncertain. Given China's ongoing political and economic recentralization and the delays it has experienced in implementing other promised reforms, such as yuan convertibility and capital account relaxation, due to more pressing economic priorities over the past five years, the level of commitment to the proposed reforms might not match current ambitions. Similarly, economic conditions could also limit the pace and scope of Hainan's transformation.

Unlike previous development efforts in Hong Kong and Shanghai, which benefited respectively from the adjacent Pearl River Delta and Yangtze River Delta, no economic centers surround Hainan, making its competitive advantage uncertain, at best. However much Beijing would like to diversify away from Hong Kong, it has a considerable advantage with its well-established transport and financial infrastructure, rule of law and open economy. The likelihood that Hainan could provide serious competition in the near term is remote. China's economic ambitions have yet to be realized in Shanghai, either. When its free trade zone was established, it had been anticipated that the region would quickly blossom into an international center of finance and information. But the absent rule of law there, combined with China's closed capital account and a shortage of professional intermediaries, has held that ambition in check so far. Hainan's seemingly beneficial geopolitical position on the edge of Southeast Asia could actually represent a drawback as disputes over the South China Sea persist.

As China seeks to reassert centralized power over the provinces and curb the inequality caused by overreliance on specific coastal provinces, Hainan will provide a safe testing ground for regulatory and economic reforms. Furthermore, it will serve as a model for spreading development to long-neglected regions while diluting the influence of both the mainland south and Hong Kong. As it pursues the next phase of its economic development with concerns about stability and centralization paramount, China will have to approach reform with a healthy dose of caution.

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