The SEZ experience

Read the article in the Cayman Financial Review Magazine 

Special economic zones (SEZs) are touted as one of the most successful policies for economic development. The number of zones worldwide has grown into the thousands over the last few decades. Their features change with the times. Still, after more than a half century of experience with special economic zones, their efficacy is disputed and inherently hard to assess. 

SEZs are geographically defined areas with different sets of rules, taxes and regulations from the rest of the country. Commonly cited reasons by governments to introduce SEZs are to increase employment and exports and diversify the economy. The concept of granting particular economic privileges to certain areas has been around since the 16th century. Even the members of the European Hanseatic League in Northern Europe, which enjoyed the status of free cities in the 13th century, can be seen as very early forms of SEZs.

The history of the modern SEZ began in Ireland with the Shannon Free Zone in 1959. Since the 1960, the number of SEZs has grown rapidly, and today there are over 3,000 different economic zones in more than half of the world’s countries. India was among the first larger countries to introduce SEZs in 1965. Other early SEZ adopters were primarily countries in South East Asia and Latin America.

The SEZ concept became increasingly popular with changes in developing countries’ trade policies. To protect domestic industries from international competition, trade barriers were for long the policy of choice for many countries. The new development model was export oriented rather than isolationist, and more governments started using subsidies and other benefits to encourage more companies to invest in the country and export. SEZs became part of this model.

SEZs had their great breakthrough in economic development with the transition of the Chinese economy. As part of their economic reforms in 1978, the SEZs allowed China gradually to open up for foreign investment without provoking the more traditional communists. China’s high degree of fiscal and political decentralisation allowed provincial leaders to adapt many of the regulations and other policies that attracted investment. Since sub-national officials depended on their economic performance for promotions by the government, they could use SEZs in a race against other regions to boost their personal credentials.

Other countries have since sought to emulate the Chinese SEZ path to economic success, alas mostly not with the same success. India’s SEZs did never really take off or attract as much investment as was anticipated. A common complaint concerns the uncertainty that the Indian government has created by constantly changing zone policies. Many countries in Africa have introduced seemingly well-run SEZs without seeing subsequent boosts in their economies. Large and oil-rich Nigeria has the most extensive African SEZ programme but many of its zones have failed to grow. The most successful SEZs in Nigeria have grown on the back of natural resources.

What is in a name?

SEZs take on many different names. Ireland calls them “industrial free zones” and “export free zones”, Mexico has “maquiladoras”, South Korea “duty free export processing zones” and “free export zones”, and Sri Lanka “‘investment promotion zone” to name but a few.

“Export processing zones” is a common label on zones that focus on manufacturing and generally offer low import tariffs and taxes to businesses if they produce for export. There may also be restrictions on companies not to use domestic capital. Therefore, the only connection many export processing zones with host countries is that they hire domestic workers. Export processing zones are often used explicitly as a policy to alleviate unemployment.

While other SEZs can be large and quite diversified, export processing zones tend to be smaller and host but a few or even a single factory. Their liberal environment and labour regulations often come under much criticism for outsiders about the poor conditions for the workers.

Beyond the developing world

In European and Northern American countries, governments primarily use SEZs to promote income equality rather than national economic growth. In attempts to even out living standards throughout the country, zones have mainly been located in the least developed areas. United States and France introduced Enterprise
Zones in poor areas with high unemployment. Poland introduced SEZs in towns where closed factories from the Soviet era caused deprivation and unemployment.

The latest development in SEZ policy making lies neither in the Western world, nor in the world’s poorest countries, but in the emerging markets of the late 20th century. With a mix of government and private initiatives, these zones are centres of international business and hubs for transportation. Rather than manufacturing, they focus on knowledge intensive areas like education, finance and R&D.

South Korea is a leader in this trend. In 2003, it launched the Incheon Free Economic Zone. The zone’s international airport is one of the busiest in the world, and it is equipped with everything that a traveller may wish for, including a golf course, ice skating rink, indoor gardens, a Museum of Korean Culture and a casino.

Also in the Incheon zone lays Songdo International Business District, a so-called Smart City. Also called a “Ubiquitous City”, Songdo has all its information systems interlinked, be they residential, commercial, medical and governmental. South Korea is aiming to build some 15 more such ubiquitous cities.

To bring international higher education to South Korea, they have introduced Songdo Global University, where institutions from around the world can set up shop. Four universities have already begun their programmes at the campus, with the American State University of New York at Stony Brook and George Mason University hosting the largest amount of students.

Hong Kong is another world leader among SEZs. As a Chinese “special administrative region”, it has more autonomy than other zones. Not only are Hong Kong’s tax rates and regulation different from the rest of China. It also has a different political system, its own policies on trade and a common law judicial system. Hong Kong scores highest in economic freedom by both the Fraser Institute and the Heritage Foundation. Despite a population of only 7 million (less than the state of Virginia), it is world leader on several fronts. Its port is second only to New York and Rotterdam in container throughput. Hong Kong has become a financial hub and hosts the sixth largest stock exchange in the world. According to the United Nations, it can also boast of the longest life expectancy in the world.

In other parts of China, SEZs are focusing on industries beyond manufacturing. The Dalian Software Park, for instance, hosts around 40 Fortune 500 companies and now employs over 50,000 people. Benefits to multinational firms in this zone include incentive schemes to place foreign employees with a Bachelor’s degree or higher in China.

The Communist Party is promoting the SEZ in Shanghai as an international financial centre. The latest flagship of the project, the Shanghai World Financial Centre, was finished in 2008. With its 492 meters (1,614 feet), this skyscraper was then the second tallest building in the world. The central government is working hard for Shanghai to overtake Hong Kong as a financial centre. Hong Kong has become the third most prominent international financial centre, after only London and New York, in the Global Financial Centres Index of the Z/Yen Group. Shanghai is yet merely number 24.

Just ahead of Shanghai in the same ranking is the city-state of Dubai, another cultivator of SEZs. Still a small fishing village in the 1960s, Dubai has been transformed into a metropolitan finance and tourism centre, much thanks to the royal family’s aggressive strategy of low tax, low tariffs and marketing. The Jebel Ali Port became the largest port in the Middle East when it was built in 1979. The port is now a central maritime link between the Far East and the West. In 1985, Dubai introduced the Jebel Ali Free zone, which includes the port and a land area that currently houses more than 6,000 companies. The free zone offers tax exemptions, less regulation and freedom of ownership. It hosts business parks like the Dubai International Financial Centre, Dubai Internet City and the famous Palm Islands.

Making SEZs work

Depending on the particular problems of a country, SEZs can offer different incentives to help investors to overcome them. The first Chinese zones provided more openness to foreign capital than the rest of the country. If labour regulations are onerous, SEZs can offer regulatory exemptions. While people often think of low taxes and tariffs as the features of SEZs, they are not universal recipes for attracting foreign investors. In many African countries, the cost of doing business lies rather in a lack of security, malfunctioning judicial systems and corruption than taxes and fees. SEZs are not the answer to all these problems, but they have potential. Defective institutions are sometimes easier for a government to improve in a confined space, while low-level corruption is easier to police in a zone than in a country as a whole.

Many of the benefits with SEZs seem to be nothing more than ways to get around government created problems, which means that SEZs are always the second best option after countrywide economic reforms. Still, SEZs can be useful if they help overcome political resistance to economic reform. If policy makers cannot agree to lower taxes, they may still do so for a confined area. In 1980’s China, government conservatives thought capitalism would destroy the country.

Reformists still managed to introduce zones as test-beds for capitalism, sufficiently far away from Beijing not to disturb the old guard.
While successful policies are different between SEZs, private zone ownership and development has generally been a more successful policy than having the government run the zones. Private investors have a better sense of how to attract the right kind of companies to a zone. They are also reluctant to throw money at zone in poor locations. Politicians on the other hand, are more prone to build what is fancy and appealing than commercially viable.

The government developed Philippine zone in Bataan became a blatant example of such government miscalculation. The authorities constructed a great dam to power the zone, upgraded the port and built a new industrial centre and large modern office buildings. A few years later, the office buildings stood deserted and the zone had merely created half of the expected jobs. To avoid pursuing similarly unsuccessful zone projects, government should initially demand substantial private investment.

The future of SEZs

Ask anyone twenty years ago what an SEZ is and the connection would have been made to cheap Asian labour toiling at sewing machines. Today, while the same image comes to mind for some, others will mention office buildings in Dubai or new cities on reclaimed land in South Korea. If the current trend in SEZs continues, this image will gradually come to dominate.

The old manufacturing zones are still widespread throughout the world. Bangladesh is one county known for their garment industry zones that thrive on the local cheap labour. However, cheap labour of the sort found in Bangladesh is becoming increasingly rare as well as less relevant for multinational companies. These are all great signs of progress.

Most countries with SEZ have seen economic growth and decreasing poverty rates. Yet, we cannot conclude from this that the zone policies have achieved this task. Political factors, globalisation and trade liberalisation in other countries are probably just as important drivers of economic growth. After decades of research on the effects of SEZs, the effects of SEZ policies are still not well understood.

 

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Incheon Free Economic Zone