At the end of September, a new free-trade zone was launched in Shanghai, the aim being to mark the start of a new era not only of openness in investment, trade, and finance, but also of deeper Chinese integration into the global value chain. The zone promises to kick-start a new round of liberalizing reforms and help China’s economy adapt to the latest demands of globalization.

Over the next decade, global competition will come to be defined as competition over the global value chain. As the United States and other developed countries pursue “re-industrialization” and the Chinese economy’s low-wage comparative advantage diminishes, China must re-establish its competitiveness by positioning itself at the top of the global value chain, which implies the need to promote trade and upgrade its industrial infrastructure.

This requires, first and foremost, that China build a national value chain and elevate its manufacturing sector, which currently depends excessively on foreign research and development, imports of raw materials and semi-finished parts, and external demand. The sector’s domestic value chain is woefully weak.

The Shanghai free-trade zone promises to facilitate progress in three crucial areas. First, it should improve the manufacturing sector’s localization rate for parts and components by accelerating the transmission of raw materials and intermediate inputs and integrating export-oriented producers with domestic industries.

Second, in accordance with China’s 12th Five-Year Plan, the free-trade zone aims to extend the industrial value chain and improve value-added content, promote the coordination of domestic and foreign investment in manufacturing, and strengthen the sector’s classification and assessment capacity. At the same time, it should preserve a level playing field by explicitly prohibiting rule changes, limiting the establishment of entry and exit barriers in various industries, and using taxation, finance, and brand authentication to cultivate core competitiveness.

Third, the free-trade zone should encourage multinational corporations (MNCs) to expand their Chinese operations beyond factories; China should be home to their design, distribution, and service divisions as well. This would optimize relationships between parent and subsidiary companies and prompt a shift from the simple production model of the past to a model characterized by integrated services and global operations.

Over the last decade, MNCs have increasingly expressed interest in establishing regional and global headquarters and R&D centers in Shanghai. As of September 2012, Shanghai was home to 393 MNCs’ regional headquarters.

In this sense, China has a rare opportunity to expand its growth potential by stimulating domestic demand. The gradual improvement of its labor force in terms of skills and productivity, together with its relatively strong capacity to absorb high-value foreign investment, will drive economic development; and MNCs’ shift in strategic focus from Western markets to those in the Asia-Pacific region will transform the global value chain.

As the Shanghai free-trade zone becomes a global financial hub, it will have to determine how to attract high-level factors of production. To this end, in addition to its taxation, finance, and trade-facilitation policies, it should establish trade-promotion mechanisms in the world’s major export markets, so that firms can build comprehensive networks of international trade-service platforms and trade-cooperation zones overseas.

China’s future competitiveness also depends on its integration into a new wave of global and regional regulatory regimes. Although there are several ongoing trade and investment negotiations – including the Trade in Services Agreement (TISA), the Trans-Pacific Partnership (TPP), and the Transatlantic Trade and Investment Partnership (TTIP) – Chinese policies remain largely defined by the traditional World Trade Organization (WTO) framework.

But the emerging arrangements would offer far more room for maneuver than the more restrictive WTO regime. For example, TISA negotiations in the fields of finance, securities, and legal services have resulted in no restrictions on foreign ownership or the scope of business. But China’s adherence to WTO rules on foreign investment prevented it from participating in TISA negotiations, ultimately impeding its trade and investment ambitions. (International politics was responsible for China’s exclusion from the TPP and TTIP negotiations.)

Against this background, the Shanghai free-trade zone demonstrates China’s readiness to participate actively in global free-trade negotiations, with the goal of promoting a comprehensive free-trade strategy and safeguarding Chinese interests worldwide. Shanghai’s role in trade, finance, investment, and shipping – together with an increasingly open service sector, improved regulatory environment, and focus on institutional innovation – will eventually lead to domestic market reform and drive China’s integration into new trade agreements.

The Shanghai free-trade zone’s final objective is to help China exploit fully the demand potential of its domestic market. China’s initial globalization “dividend,” accrued through low factor costs, is rapidly diminishing, and a new era – characterized by reliance on the massive domestic market to absorb foreign high-level factors of production, such as technology and human capital – is just beginning.

The task for China’s leaders is to expand policies aimed at boosting domestic demand, while working to improve the economy’s skills base and enhance its relative capacity to absorb high-value-added, high-tech foreign investment. Advancing an innovation-driven development strategy and promoting emerging industries would improve the quality and level of foreign support and cooperation.

With rapid growth in the local market, China could become a leading source of global demand, a hub of high-level factors of production, and a strategic center, with the Shanghai free-trade zone at its core. At this level, China would finally have the domestic value chain that it needs to sustain competitiveness and rapid economic growth.

Read more blogs on China.

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Author: Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.

Image: The Chinese flag is seen with the Pudong skyline in the background REUTERS/STR New

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