The Real Economics of Hainan Free Trade port

‘Crossing a river by feeling for stones’ on China’s southern tropical island

By Zuo Lin

On June 1, 2020, the Communist Party of China (CPC) Central Committee and the State Council issued the Master Plan for Building Hainan Free Trade Port (“master plan” for short), which kicked off construction of the Hainan Free Trade Port (FTP), a special testing ground for comprehensively deepening reform with the highest level of opening-up.

Within a month, a series of implementation measures were published including guidelines on trials of the Seventh Air Freedom in the Hainan FTP and rewards for introducing talent to the island. The National Development and Reform Commission (NDRC) is set to allocate a total of 3.5 billion yuan (US$500 million) from the central budget for investment to make up for weak links in infrastructure and public services in Hainan FTP. On July 30, the Ministry of Finance and the State Administration of Taxation rolled out preferential tax policies for eligible enterprises and individuals in Hainan FTP. On July 1, an offshore duty-free shopping policy with unprecedented perks took effect on the island.

Such strong measures to implement the master plan attracted the attention of the public to the economic and social prospects of Hainan. How will the island province determine its overall position and seize opportunities for development in this experimental time?

Not a New Financial Center

Lin Nianxiu, vice minister of NDRC, summarized the contents of the “6+1+4” master plan in a briefing. The “6” refers to liberalization and facilitation on six fronts: trade, investment, cross-border capital flow, movement of people, movement of transport, and secure and orderly flow of data. The number “1” refers to building a modern industrial system, especially for tourism, modern services, and high-tech industries. The “4” means strengthening institutional arrangements in the four areas of taxation, social governance, rule of law, and risk prevention and control. Eventually, the foundations of the real economy will be consolidated, and economic innovation and competitiveness will be strengthened.

The master plan places great importance on the real economy. In terms of cross-border capital flow, the master plan emphasizes adherence to “financial services for the real economy with focus on trade and investment liberalization and facilitation, opening of capital projects in stages, and orderly promotion of free and convenient capital flow between Hainan FTP and foreign countries.”

“Many have predicted Hainan FTP to replace Shanghai as an international financial center with the preferential policy of ‘cross-border capital flow’,” commented Zhang Yong, chief expert and dean of the Silk Road Institute (Haikou) and a research fellow at Fudan University’s Shanghai Free Trade Zone Comprehensive Research Institute.

“But that will not happen,” Zhang continued, “Shanghai’s status will not be replaced by Hainan, nor will Hainan become a leading financial center. Hainan’s economic base is still relatively weak. The preferential policies will to some extent pool production factors to consolidate the island’s real economy.”

The policy of “zero tariff on certain imported goods,” especially “the rules of origin,” is also favorable for the real economy. According to the master plan, goods produced by designated industrial enterprises in Hainan FTP that do not contain imported materials or added value from imported materials of more than 30 percent will be exempted from import tariffs should they qualify for exemption when entering the mainland through the “second line,” and the import value-added tax and consumption tax will be levied in accordance with regulations. This is expected to jumpstart the great potential of Hainan’s high-end manufacturing industry.

“Had Elon Musk known about this policy before building his Tesla Gigafactory in Shanghai, he might have chosen Hainan instead,” Zhang noted. “Tesla’s Shanghai Gigafactory purchases its spare parts from all over the world, which are exempt from import tax through the Shanghai Comprehensive Bonded Zone. But when assembled vehicles are sold in the mainland market, import tariffs are levied on consumers in accordance with the requirements for imported vehicles. If a Tesla factory were built in Hainan, all the spare parts could be imported with zero tariffs. After being processed in Hainan FTP with added value of more than 30 percent, assembled vehicles would be entirely exempt from import tariffs for the mainland market, a plan that would be feasible.”

This policy is expected to drive the development of Hainan’s high-end manufacturing industry and create jobs. Zhang believed that by leveraging “the principle of origin” policy, Hainan can also make efforts to develop industries such as ecological and environmental protection, bio-pharmaceuticals, and new energy vehicles.

‘Tempting Offers’ for the Real Economy

Hainan’s industrial base remains relatively weak. Compared to Shanghai and Shenzhen, two other cities with pilot free trade zones, Hainan FTP has held a lower share of secondary industry since its establishment in 2018. Its industrial structure has been far from ideal, with excessive dependence on the real estate sector, for example.

In recent years, Hainan has strengthened regulations on real estate. According to Liu Cigui, secretary of the CPC Hainan Provincial Committee, Hainan suspended both land use approval and building approval for real estate developers in 2015. In 2018, Hainan began to implement home-purchase restrictions across the island. In 2019, investment in real estate development in Hainan fell 22.1 percent, of which residential investment fell 21.0 percent year on year. About 8.3 million square meters of commercial housing were sold, down 42.1 percent year on year, with a sales volume of 127.57 billion yuan (US$18 billion), down 38.8 percent year on year.

“This is an important feature of Hainan’s economic transformation as well as the transformation of its industrial development philosophy,” commented Lin Yongxin, dean of the Maritime Silk Road Institute at the National Institute for South China Sea Studies and a guest research fellow at the Research Center of Socialism with Chinese Characteristics in Hainan Province. Considering the trend of international economic development and the characteristics of Hainan’s geographical location and industrial base, the government has made plans for the development of tourism, modern services, and high-tech industries in Hainan to consolidate its real economy. According to the master plan, domestic enterprises registered in Hainan FTP engaged in tourism, modern services, or high-tech industries are encouraged to invest overseas, income from which would be exempt from Chinese corporate income tax to avoid double taxation.

“This policy is not applicable elsewhere in the country, which could make Hainan the bridgehead for Chinese companies to go global,” said Lin.

Hainan FTP still has the important mission to build an international tourism and consumption center. With outbound shopping becoming increasingly difficult due to the spread of COVID-19 overseas, adjustments to the duty-free shopping policy in Hainan could encourage Chinese consumers to purchase high-end goods and services from China instead of from overseas.

July 1, 2020 was the first day of official implementation of the amended public notice on offshore duty-free shopping in Hainan. According to media investigations, an iPhone 11 Pro Max 512GB that sold on Apple’s official website for over 12,700 yuan (US$1,814) went for only 10,210 yuan (US$1,458) in a duty-free store in Hainan, which saves the consumer about 2,500 yuan (US$356). The categories for duty-free goods have been expanded to attract younger consumers. Meanwhile, “moderate competition” has been encouraged. The seventh amendment to the policy has been the most vigorous since the offshore duty-free shopping policy in Hainan was first introduced in 2011.

The notice stipulated that operators with duty-free distribution qualification can participate in offshore duty-free operations in Hainan FTP. Zhang Yong expects the number of operators to grow and promote healthy market competition.

“Moderate competition will cause more offshore duty-free goods to become available and push down prices to rival those seen in Paris, Hong Kong and other cities,” opined Zhang. “And compared with overseas, the rent and labor costs in Hainan are much lower. This means tremendous potential for the operators in Hainan who can break through wholesale bottlenecks and secure duty-free goods such as famous overseas brands. Hainan businesses just need to establish proper arrangements for product debuts, post-sale service, and other customer service.”

“Chinese people have considerable capacity for consumption,” Zhang continued. “Present domestic consumption supply does not fully meet the consumption demands of Chinese residents. Implementation of relevant policies of Hainan FTP will in many cases transform cross-border consumption into domestic consumption. In the new round of reconstruction of the global industrial chain, supply chain and value chain in the post-pandemic period, Hainan should seize the opportunities created by the latest amendment of the offshore duty-free shopping policy to join domestic business cycles and become a strategic link between domestic and international economic cycles.”

Storage and logistics could be another important aspect of Hainan’s future development. According to the master plan, “There is no storage period for the goods in Hainan Free Trade Port, and the storage place can be chosen freely.” Lin Yongxin and Zhang Yong both consider this a tempting offer because storage in the comprehensive bonded zones of other parts of the country have time limits and higher costs. The preferential policy in Hainan will greatly reduce the price of storage.

“By establishing a storage and logistics base in Hainan, businesses can qualify for export tax rebates more easily,” explained Zhang. “They can also build global maintenance and repair centers in Hainan to get more convenient clearance than on the mainland. It is a positive signal for Hainan’s promotion of free trade.” Last year, Hainan approved the customs supervision model 1210 (a supervision method code from China Customs) for island-wide bonded cross-border e-commerce trade, which is very likely to make the island a cross-border e-commerce retail import services base and a logistics and distribution hub for companies from across China.

“The services trade is also very important for Hainan,” continued Zhang, “The sector involves human resources, regulation, and even personal income tax. Cross-border supply, overseas consumption, and movement of natural persons constitute cross-border services trade. The master plan suggested that a negative list of cross-border services trade in Hainan FTP be formulated and released, which would be more than welcome. I believe that continuous development of free trade port policies and the improvement of relevant systems and laws will make the negative list shorter and shorter while the positive list grows longer and longer, which will fill in some of Hainan’s weak links in manufacturing.”

Next Steps

Development of Hainan FTP has been, to amend a Chinese phrase, crossing another river by feeling for stones.

Supervision needs strengthening. Referring to “customs special supervision zones” in other free trade areas of the country, the master plan coined the term “special customs supervision zones” for Hainan FTP. The former emphasize the special status of supervising customs, with some reforms of customs management systems while the latter seek to innovate customs management systems disruptively.

“Risk prevention is a prerequisite for Hainan FTP,” said Zhang. “It cannot be accomplished by Hainan alone and demands the coordinated efforts of the whole country. Duty-free shopping is one example. Duty-free shopping in Hainan being at a price advantage is likely to attract resellers and smugglers. The master plan stipulated that the offshore duty-free goods purchased must be final goods for personal use by consumers. They are not allowed to enter the domestic market for re-sale. Distribution agents are not allowed to shop there. But it’s not clear whether the re-sale of offshore duty-free goods in other cities will be supervised or not.”

Furthermore, efforts are needed to optimize market entities and the business environment. The current population of market entities in Hainan is relatively small, and some leading enterprises in the province have experienced problems with various business operations. Hainan has worked with the State Council’s State-owned Assets Supervision and Administration Commission to attract 100 centrally-administered state-owned enterprises to the island to promote the development of more market entities there through preferential policies such as tax exemptions and reductions. Within a month after the release of the master plan, the count of market entities in the province increased by more than 23,300, up 52.33 percent year on year. By the end of June this year, more than 1.01 million market entities had registered across the province. Among them, more than 346,000 are enterprises, and more than 664,900 are self-employment operations.

Zhang Yong is looking to 2025 for the island’s greatest challenge and landmark achievement: island-wide special customs clearance operation. In the interim, the zero-tariff policy in Hainan will be confined to existing comprehensive bonded zones. Zero tariffs for the whole free trade port would not be possible without independent customs operations across the island. The institutional system needs some major development by 2025.

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