China's financial center Shanghai has received State Council approval to establish a pilot free-trade zone to explore investment and trade policy innovations and expand the opening of services industry, the official China Daily reported. The test will involve financial reform including interest rate liberalization and full convertibility of yuan.

The free-trade zone in Shanghai will be the first free-trade zone within mainland China, incorporating the special custom zones of Yangshan Deep Water Port, Pudong Airport and the Waigaiqiao Port. The project is expected to take more than 10 years to establish. When completed, the zone will provide world-class transport and communications facilities and a tax-free environment for domestic and foreign enterprises as a major hub of their supply chains in Asia.

The trade volume of Shanghai's bonded zones represented more than $100 billion in 2012, or 3 percent of China's overall trade volume. This announcement came only a few days after the high profile Lujiazui Financial Forum, at which China's financial leaders released a series of ambitious plans about China's future financial reform agenda. Beijing's support for Shanghai's continuous efforts to build an international financial center by 2020 was particularly highlighted.

Shanghai is expected to allow corporates to freely convert other currencies with the yuan within the free-trade zone, and to buy overseas assets and equities and raise funding abroad. In addition, foreign investment and funding activities for both domestic and international companies will be promoted within the free-trade zone. Shanghai also plans to test selected offshore businesses within the zone, including offshore banking activities and foreign exchange denominated cross-border financing.

The launch of a free-trade zone in Shanghai is in line with Beijing's efforts to finalize, by the end of this year, an operational plan for the eventual full convertibility of the yuan. Beijing is reportedly expected to liberalize the capital account by 2015.

In this context, a free-trade zone in Shanghai could be used as a testing ground for the yuan's full convertibility whilst simultaneously help to establish Shanghai as a key regional financial, trading and shipping center within Northeast Asia. It would also help to pave the way for Shanghai's on-going transformation into a global financial center, according to HSBC economists Ma Xiaoping and Qu Hongbin.

Following the recent opening-up of Qianhai (an experimental financial zone in Shenzhen) and Wenzhou (designated as trial area for financial reform), the creation of Shanghai's free-trade zone trial confirms the commitment of Beijing's top leaders to continue pushing forth on its plans for eventual full yuan convertibility and capital account liberalization, Ma and Qu said.

The State Council expects this experiment as an essential step toward upgrading China's economy. It also expects the pilot's eventual national roll-out in the future.