China launched a free trade zone in its commercial hub Shanghai on Sunday, state-media reported, with the project seen as a testing ground for much-needed reforms in the world???s second largest economy.

The zone, which covers 29 square kilometres (11 square miles), "started operating Sunday", the official Xinhua news agency said, adding that it was "a test bed for the Chinese leadership's drive of deepening market-oriented reforms and boosting economic vigour".

Reforms in the zone will be closely-watched as a key test of China's ability to make long-pledged structural changes as it attempts to shift its economic model in the face of slowing growth.

The government will allow free yuan convertibility under the capital account on a trial basis, according to a statement released by China's State Council cabinet on Friday.

Market-set interest rates, seen by analysts as a key reform for China's economy, will also be trialled, according to the statement.

Restrictions on foreign investment will be eased inside the area, which will also loosen controls on 18 service sectors ranging from finance and shipping to culture services.

Excitement over the launch has boosted stocks of Shanghai-based firms and spurred a rally in home prices and land costs in areas neighbouring the zone in the past few weeks, state media have reported.

But analysts interviewed by AFP adopted a cautious approach.

"It shows that the new government is keen on making reforms," said Stefan Sack, vice president of the European Chamber of Commerce in China.

"We have to see what kind of regulations will really be implemented there."

But he added that "a free trade zone in Shanghai alone will not change how business is done in China".

Unlike with previous special economic zones launched by China's government, the Shanghai free trade zone's (FTZ) emphasis on the service sector, rather than export-oriented manufacturing, has been welcomed by economists.

China's government has been struggling to shift the domestic economy away from dependence on big-ticket investments and more towards consumer demand as the key growth engine.

President of the US chamber of Commerce in Shanghai Kenneth Jarrett said the zone's plan showed a clear emphasis on service sectors.

"It suggests that the government does plan to have the service sector as a major component of what the FTZ will do," he said.

"Our members are eager to find out more. But there is a sense that the zone could offer real opportunities for our member companies."

The project has been pushed by China's Premier Li Keqiang, who took office in March, and hopes it will set a model for future reforms to be carried out nationwide, analysts and government officials have said.

A plenum of the ruling Communist party, scheduled for November is expected to announce nationwide economic reforms.

But analysts say major changes are likely to be cautious and subject to lobbying from interest groups which benefit from China's current economic model.

"Li Keqiang... seems to be associating his office and his own reputation with this initiative, which is why people are taking it as the first indication as we get close to the plenum of what the economic reform agenda will look like," Jarrett said.

China's economy, the world's second largest, expanded 7.7 percent in 2012, its slowest pace in 13 years. Growth stood at 7.7 percent in the first three months of this year and slowed further to 7.5 percent in the April-June period.