Hong Kong is dead. Economic roadkill on China’s way to world domination. Starting this weekend, a free-trade zone opening in Shanghai will supplant the former British colony as the gateway to the world’s most dynamic economy.

That’s the chatter in the city of 7 million people, where some business leaders fear becoming China’s Chicago, long ago eclipsed by New York as a financial and cultural center. Shanghai’s new free-trade zone, opening for business Sept. 29 on 11 square miles of land, will offer freer yuan trading, more flexible interest rates, relaxed restrictions on foreign money, and maybe even access to Twitter, Facebook and other websites banned across China.

None other than Li Ka-shing, Asia’s richest man, has warned of an existential threat. Shanghai “will affect Hong Kong heavily,” the property magnate recently told local news media, and the city must act immediately to raise its competitiveness. That warning is as intriguing as it is silly.

To spark an Adam Smith moment in Shanghai, China’s Communist Party would, virtually overnight, have to embrace a variety of things it has avoided. Leaders would have to create something approaching a first-world legal system and sound rule of law, ensure social justice, force politically connected companies to compete on their own, and allow unfettered free speech and access to websites such as Bloomberg.com and NYTimes.com, which have been banned for more than a year for daring to run stories about official corruption. China would have to tolerate Google and stop rerouting anyone typing “Tiananmen Square crackdown” to bland tourism brochures.

Can a regime really step back and let traders and financiers run amok when its leadership model is based entirely on control, stability and a playing field level only for princelings and state-owned enterprises? Don’t get your hopes up. In fact, there’s reason to worry a Shanghai trade zone that’s free in name only will exacerbate China’s financial woes. This Shanghai zone could well sap momentum and the will to implement more sweeping reforms nationally, which China desperately needs.

Another risk China might not appreciate is the danger of welcoming capital flows of the kind that overwhelmed Southeast Asia in 1997. To maintain 7.5 percent growth, as Premier Li Keqiang has pledged, means more borrowing by state-owned companies. That’s why it’s highly unlikely Beijing will allow complete yuan convertibility and full-blown interest-rate deregulation.

“This must increase the uncertainty of capital inflows and outflows,” says Michael Pettis, a finance professor at Peking University. “The additional point, however, is that as debt rises, so does expected volatility. Increasing uncertainty at the same time you increase the volatility of the system’s response to changes is a very risky business. The more debt there is, the bigger the reaction of the financial sector to overwhelming inflows or outflows of capital.”

Leaders are also risking a flight of capital from other parts of the country. China can’t contain free capital flows within a specific geographic region just a taxi ride away from the nation’s financial capital. The zone will be viewed immediately as a kind of “green zone” for the elite who became millionaires and billionaires though illicit land grabs, old-fashioned rent-seeking and insider trading. Wouldn’t this create fresh avenues for corruption among party officials? State-owned banks outside the zone also may experience runs on balance sheets.

If China is going to open up, it should do so nationally and evenly. A freed yuan would accelerate and deepen China’s integration with the world economy, create the bigger service sector China needs to wean itself off exports, enable markets to better price risk, reduce trade frictions, and insulate China from U.S. charges of currency manipulation. Far from achieving any of these goals, this Shanghai half-measure is a distraction. Beijing will also have some explaining to do if 1.3 billion Chinese hear that a bunch of privileged foreigners in their financial green zone can tweet away and click “like” on the Facebook pages that 20-something mainlanders can’t access.

So then, what is the real motivation here? That China is being so vague about what its Shanghai zone will offer and working on such a tight schedule to open it sure does make one wonder. Surely, political symbolism is part of the motivation. As they try to hone their reformist chops, who better for Li and President Xi Jinping to channel than Deng Xiaoping, who in the 1980s experimented with the Shenzhen Special Economic Zone?

The Shanghai experiment also seems aimed at Hong Kong’s stubborn pro-democracy movement, which is set on pushing the case for the universal suffrage Beijing has no intention of granting.

“It’s leverage over Hong Kong,” says Andy Xie, an independent economist with past stints at the World Bank and Morgan Stanley. “If Hong Kong becomes ungovernable, the Shanghai free-trade zone will become real. Now, it is designed as a bird in a cage, as all China’s reforms have been.”

For the moment Hong Kong can breathe easy. That’s not to say the city doesn’t need to continue raising its game as an economic and cultural center. But with apologies to Mark Twain, rumors of its demise are greatly exaggerated.

By William Pesek

William Pesek is a Bloomberg View columnist. ― Ed.

(Bloomberg)