New FTZ seen as a major step for deeper reform (3)

However, opinions are divided on how the liberalization of the interest rate and yuan capital accounts should be achieved.

Zhou believes, as long as the regulator can segregate the offshore market in the zone and the onshore market with strictly separated accounts and settlement channels to prevent cash flow between the two markets, it is possible for trials of liberalizing interest rates and yuan capital accounts to be carried out simultaneously.

"We can view Shanghai's FTZ as a smaller Hong Kong, so it is feasible for us to isolate risks in the offshore market from the onshore market, albeit not entirely," Zhou said. He added that in the beginning regulators may further control risks through limited quotas of capital flow in and out of the zone.

However, Sun Lijian, deputy director of the School of Economics at Fudan University, said interest rate liberalization should be the first priority.

Otherwise large amounts of hot money would flow in to profit from an interest arbitrage, threatening China's financial market and real economy.

"I suggest regulators liberalize interest rates in the zone first and soon take this nationwide. Only when interest rates are fully under market forces nationwide can we try capital account liberalization in the zone - the sequence is important," Sun said. "The reason is as long as the space for arbitrage exists, there would always be hot money flowing in disguised as trade capital - we have seen a lot of similar situations in the current state of foreign trade."

However, the process of interest rate liberalization should be quick, as opening-up of capital accounts is the core competitiveness of a FTZ, Sun said.

China has previously planned to try out liberalization of interest rates and yuan capital accounts in some special regions, but these were not fully realized due to concerns about risk. For example, the country intended to liberalize interest rates in the Wenzhou financial reform pilot zone, but eventually gave up the trial.

It also launched a special trade zone last year in Qianhai, Shenzhen, allowing Hong Kong banks to offer cross-border yuan loans to Chinese mainland companies operating in the zone. But to date, the yuan still lacks full convertibility in Qianhai with no news on what that long-awaited status will eventually arrive.

No matter what detailed policies come out, the FTZ in Shanghai will bring an unprecedented impact to China's financial system, Sun said. "It will inevitably drive forward the process of opening financial markets, not just in the FTZ, but in the country as a whole."